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Should banks be held liable for Ponzi schemes?

Ponzi schemes were named for Charles Ponzi after he defrauded customers out of approximately 20 million dollars back in 1920 (over $225 million today).

While the idea of paying out investors with their own money rather than any money earned legitimately via investment had been around prior to 1920, the name Ponzi become synonymous with the scheme based on the amount of publicity and high dollar loss associated with his activity (including the downfall of six financial institutions).

Over the past few years, we’ve seen a tremendous increase in the magnitude of Ponzi schemes. Fingers have been pointed at the fraudsters, as well as the SEC, and more recently, the guilty label is being extended to the financial institutions providing services for the schemes. 

In recent cases, the argument made by prosecutors was that the banks were negligent in not identifying red flags for these investor accounts, making them guilty of ‘aiding and abetting’ these criminals.  To be guilty of this, in most states in the US, there must be three elements:  the existence of fraud, the defendant’s knowledge of the fraud and proof that the defendant provided considerable assistance to the progression of the fraud scheme. Though this is the standard primarily under US law, this does not permit international financial services firms or banks from being included in the lawsuit, as seen in the case against Banco Santander in 2010, which involved defendants from seven different nations around the world.

The question of ‘knowledge’ of the fraud and providing assistance can be a bit subjective, since the banks didn’t know directly about the scheme. The question is: if they didn’t implement the appropriate steps to look for red flags or simply failed pay attention to them, does this make them guilty? For instance, in the Madoff scheme, an activity monitoring system to detect transfers between investor and personal accounts may have triggered an internal review of the activity and shut down accounts before investors were defrauded of the full $50 billion.

So what can banks do to prevent these schemes, and also ensure they are not on the receiving end of a lawsuit?  Financial institutions need to implement a sophisticated transaction monitoring tool that is flexible enough to quickly adapt to the changing fraud schemes. Activity monitoring must be implemented across the enterprise, in order to detect complex patterns of activity that may seem normal alone, but when viewed collectively may be a red flag for a large fraud scheme. Taking proactive measures to ensure that your institution is doing everything possible to prevent fraudulent schemes will help protect customers and keep your institution out of the hotseat should a new scheme appear, despite your best prevention efforts.

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