Before Madoff and Ponzi: 19th-Century Business Frauds

By Robb, George | Phi Kappa Phi Forum, Spring 2012 | Go to article overview

Before Madoff and Ponzi: 19th-Century Business Frauds


Robb, George, Phi Kappa Phi Forum


In the Republican presidential primary debates last September, then-candidate Gov. Rick Perry of Texas caused a furor by referring to Social Security as a Ponzi scheme. As most listeners knew, Ponzi schemes are a type of fraud in which investors make payments to a business that then distributes returns to these investors from their own money or from money paid by subsequent investors, rather than from any actual profits earned by the business. Ponzi schemes are doomed to failure since they only work by bringing in new investors to pay off old ones. This momentum cannot be sustained indefinitely, and the racket eventually collapses in on itself amid revelations of graft.

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Perry upset many when attempting to argue that Social Security was not self-supporting and that money paid in by current workers was going to those already retired rather than being invested for their own subsequent golden years. However, the most famous--and valid--recent case would be Bernard Madoff's brokerage business; it was exposed in late 2008 as a $65 billion Ponzi scheme that had hoodwinked thousands of investors through false documents claiming steady double-digit returns. Madoff's fall resulted in June 2009 in a 150-year sentence in federal prison, the maximum penalty, for the-then 71-year-old con man. (1)

Press coverage of Madoff invariably mentioned the 1920's swindler from Boston, Charles Ponzi, an Italian immigrant and career criminal for whom this type of investment fraud is named. Pretending to speculate on postage stamps through foreign currency rates, Ponzi trumpeted a 50 percent return on investment in 90 days and bilked more than 30,000 people out of almost $10 million before being arrested in August 1920 and spending several years in jail. Upon release, he ran another scam, this time selling Florida swampland as prime real estate, and eventually was deported to Italy in 1934. A destitute Ponzi died in the charity ward of a hospital in Rio de Janeiro in 1949 at age 66 and was buried in a pauper's cemetery. (2)

Ponzi schemes, however, are much older than their namesake. They originated in the tremendous expansion of the stock market during the Industrial Revolution of the 19th century.

Laying fraudulent tracks

Ponzi schemes existed as early as the 1840s, many of them associated with the extraordinary profits promised by the development of railroads in Great Britain, the world's first industrial nation. The building of vast railway networks necessitated enormous amounts of capital, far more than could be raised by business partnerships or private firms. Financing railroad construction required the creation of joint-stock companies, enterprises whose capital is held in shares sold to the public through the stock market. This expansion of big business and the complexity of the corporate form prompted a world of new opportunities for criminal exploitation. Company organization increased the distance between the nominal owners, the shareholders, and the active directors, and heightened the impersonality of this relationship. Thus, directors were more open to the temptation to subject the investments of the faceless thousands to a wide variety of manipulations. Investors usually lacked the financial know-how to protect themselves from fraud and received little assistance from the government. (3)

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The ease with which a joint-stock company could be created then was astonishing. Seven persons had only to take up one share each in a concern to achieve incorporation. They might have no significant stake in the company, but they could sell its shares to the public, have themselves or their friends appointed directors, and trade on the firm's capital with no personal liability beyond their own small shareholding. (4)

The worst examples of company fraud were those promotions devised merely to rob gullible investors. It was quite common for swindlers to buy a bankrupt factory or depleted coal mine and float it as a public company. …

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