Wednesday, March 20, 2013
What is a get-rich-quick scheme?
JOHANNESBURG - The court decision to freeze bank accounts linked to the 2% a day scheme, Defencex, may well mark the collapse of SA’s latest get-rich-quick scheme.
The move follows a report submitted by Standard Bank to the Financial Intelligence Centre, which stated that activities on accounts linked to Net Income Solutions, which is a parent to Defencex, are suggestive of a pyramid scheme.
Investors are now unable to make deposits into the scheme or to withdraw their promised magnificent returns according the scheme’s mastermind, Chris Walker. Surprisingly, members have reacted to this news with an outrage directed not at Walker or at Defencex but at the banks, media and government.
Unfortunately, even if it is shown that Defencex is in fact a Ponzi scheme, its investors will not be the first nor the last to fall victim to this type of illegal business practice.
SA has a long, fertile history of quite extravagant get-rich-quick schemes, some of which had been valued at hundreds of millions, if not billions, of rands.
Tanya Woker is the former vice-chairperson of the Department of Trade and Industry’s Consumer Affairs Committee, a body responsible for rooting out prohibited business practices prior to the implementation of the Consumer Protection Act (CPA) in 2011. She recalls hearing reports of an average of five different suspect schemes a month during her tenure and believes that the situation has only gotten worse.
While sophisticated schemes succeed in taking money from SA’s economic elite, the country’s socio-economic disparities create prime breeding ground for “opportunists” looking to take advantage of the financial desperation of the poor, she says.
In an effort to help potential investors identify potential get-rich-quick schemes, this two-part series aims to describe what type of get-rich-quick schemes are prevalent in SA, how they work and how to identify them before it’s too late.
What is a get-rich-quick scheme?
By South African law there are three prohibited archetypal forms of get-rich-quick schemes.
These include pyramid schemes, chain-mail schemes (which have largely gone out of fashion) and what are known locally as money multiplication (Ponzi) schemes.
The basic structures of these schemes are relatively simple.
There are, however, countless variations on these three basic models, with the more sophisticated schemes often driving some revenue through the sale of legitimate products or through actual investments.
The larger and more ‘successful’ schemes typically operate in a hybrid-type manner, blending apparently genuine product or investment initiatives on the front-end with illegal financial structures on the back-end. This means that they try to look like legal businesses on the surface, but the financial structures they use to generate profits are illegal.
A common example of this type of hybrid, where the boundaries between legitimate business and illegal scams can be blurred, are Multilevel Marketing Companies which blend product sales with the recruitment commissions indicative of a pyramid scheme.
The complexity and sophistication of many modern-day schemes means that on face value they can be difficult to distinguish from actual legitimate businesses; SA’s Tannenbaum and Sharemax cases and, internationally, the MadoffPonzi scheme, are good examples of this.
However, all illegitimate schemes share one defining characteristic and that is that the majority of the returns enjoyed by investors are generated not through any underlying value-adding entrepreneurial or investment activity, but simply through the re-distribution of new members’ money to already exiting members.
In short the money you ‘make’ from involvement in one of these schemes is simply money taken from another member of the scheme.
It is therefore impossible for every member of the scheme to make money and as the business itself has costs and the schemes’ mastermind expects a handsome fee for his work, on average, members of a scheme must lose money.
One well-publicised example of a scheme with very similar characteristics to Defencex is Miracle 2000.
Pyramid schemes, which primarily generate cash through recruitment commissions, are rather common in SA, says Woker.
In a pyramid scheme, any new member joining the pyramid would need to pay a fee and that fee would go towards generating the profits for members’ higher-up in the pyramid hierarchy and for the business itself.
The new member would also be asked to recruit additional members.
A proportion of the fee of those recruited members would go to the new member while some of it would go to the pre-existing members. This would process continues until there are not enough potential new members to sustain the business and the bottom falls out.
One example of such a scheme was the Newport Business Club which opened its doors in SA in October 1996, according to Woker.
An investigation into the scheme found that by July 1997 it had 6 354 members. Of those, 61% had not recouped any money at all from their involvement and 30% had lost money.
In contrast, each of the promoters earned over R16m.
With Ponzi schemes investors are promised that if they invest an amount of money today they will at some later stage receive a significantly larger repayment.
Unlike pyramid schemes, Ponzi schemes do not have a hierarchical structure and generate revenue through repeated or once-off investments of varying amounts by members.
These investments are then directed to finance the interest pay-outs owed on investments made at an earlier date.
As Ponzi schemes effectively promise a set interest repayment on an investment, investors expect to earn in much the same way as they would with a bank deposit.
However, unlike a bank, investors would expect significant repayments on their investment which far exceed those one might expect from a bank.
In the case of Defencex, members were promised a 2%-a-day return, payable after 75 days. This is calculated at an effective annual interest rate of in excess of 600%.
With a bank one might expect to receive annual interest of around 6%.
Also unlike a bank, investments into a Ponzi have a very low likelihood of actually being repaid while the back-end financial structures of the two ‘businesses’ remain fundamentally different.
A traditional bank borrows from one individual at a low rate and lends to another at a higher rate. The difference between the cost it charges borrowers and the amount it pays depositors generates a profit for the bank.
In this way the bank facilitates a flow of money. Each R1 it lends it expects to eventually give back to the depositor and each R1 it borrows it expects to get back from the lender.
A Ponzi, however, simply takes money at the one end (new investments) and gives it out at the other (payouts on old investments and payments to the business and the promoter).
A Ponzi acts like a funnel, sucking up money to pay off members until there are not enough members to suck money from and the whole scheme implodes, leaving most members poorer than they were before.
Part two, on warnings signs of a Ponzi scheme, to follow.