Should federal prosecutors in California charge you with running a Ponzi scheme, you likely will have questions about the exact nature of the alleged offense.

A Ponzi scheme is a form of financial fraud. Often, although not always, it involves a perpetrator, generally a high-ranking and highly respected stockbroker, illegally obtaining funds from clients to convert to his or her own use, usually by means of a scam akin to a pyramid scheme.

Original Ponzi scheme

The scheme gets its name from Charles Ponzi, an Italian immigrant living in Boston during the 1920s. His scheme involved international reply coupons. These were the means by which people who sent international snail mail to friends or family members could assure themselves of a response. The international reply coupon paid in advance for the recipient’s reply letter.

Ponzi discovered that European countries sold international reply coupons for less than their market price in America. He then bought an inordinate number of European international reply coupons that he sold to his “investors,” to whom he promised a 50% investment return if they resold them to others.

As generally happens in a pyramid scheme, Ponzi’s first-tier “investors” did indeed make the promised profits. How? Because Ponzi paid them off with the money he obtained from selling additional coupons to his second-tier “investors.” In both instances, naturally, he kept some of the sales money for himself as his own profit. His scheme worked so well that he continued it on down the ladder of “investors,” raking in profits.

Ponzi’s downfall

Problems quickly developed, however. Unbeknownst to Ponzi, only about 27,000 international reply coupons existed in the entire world. Within a few months, federal investigators were looking into Ponzi’s activities after “investors” started complaining.

To give everyone, including himself, the promised profits, Ponzi would have had to have sold over 160 million coupons. Since this was impossible, the feds obtained two federal indictments against Ponzi, wherein they charged him with 86 counts of mail fraud. Ultimately, he entered into a plea agreement whereby he pleaded guilty to only one of the charges and served a five-year federal prison sentence.