A Ponzi scheme is an investment fraud that pays existing investors with funds collected from new investors. Ponzi scheme organizers often promise to invest your money and generate high returns with little or no risk.

But in many Ponzi schemes, the fraudsters do not invest the money. Instead, they use it to pay those who invested earlier and usually keep or skim some for themselves—often to fund an extravagant personal lifestyle.

With little or no legitimate earnings, Ponzi schemes require a constant flow of new money to survive. When it becomes hard to recruit new investors, or when large numbers of existing investors cash out or demand their money back, these schemes tend to collapse.

Ponzi schemes are named after Charles Ponzi, who duped investors in the 1920s with a postage stamp speculation scheme.

Ponzi Scheme Red Flags

Many Ponzi schemes share common characteristics. Look for these warning signs:

• High returns with little or no risk. Every investment carries some degree of risk, and investments yielding higher returns typically involve more risk. Be highly suspicious of any guaranteed investment opportunity.

• Overly consistent returns. Investments tend to go up and down over time. Be skeptical about an investment that regularly generates positive returns regardless of overall market conditions.

• Unregistered investments. Ponzi schemes typically involve investments that are not registered with the Securities and Exchange Commission (SEC) or with state regulators. Registration is important because it provides investors with access to information about the company’s management, products, services, and finances.

• Unlicensed sellers. Federal and state securities laws require investment professionals and firms to be licensed or registered. Most Ponzi schemes involve unlicensed individuals or unregistered firms.

• Secretive, complex strategies. Avoid investments if you don’t understand them or can’t get complete information about them.

• Issues with paperwork. Account statement errors may be a sign that funds are not being invested as promised.

• Difficulty receiving payments. Be suspicious if you don’t receive a payment or have difficulty cashing out. Ponzi scheme promoters sometimes try to prevent participants from cashing out by offering even higher returns for staying put.

In California, Ponzi schemes are considered a form of investment fraud and are illegal under both state and federal law. The California Corporations Code, along with federal securities laws, prohibits fraudulent investment schemes, including Ponzi schemes. These laws require investments to be registered with the Securities and Exchange Commission (SEC) and state regulators, and for investment professionals and firms to be licensed or registered. The California Department of Financial Protection and Innovation (DFPI) oversees the enforcement of these regulations. Violations of these laws can lead to criminal prosecution and civil enforcement actions. The DFPI also provides resources to help investors identify and avoid Ponzi schemes and other investment frauds. Investors are encouraged to be cautious of investments promising high returns with little or no risk, overly consistent returns, secretive or complex strategies, and difficulties in receiving payments or cashing out. If an investment opportunity exhibits these red flags, it may be a Ponzi scheme, and individuals should report it to the appropriate authorities.