Chapter 6

Getting to Know the Most Common Fraud Schemes

In This Chapter

Examining frauds committed by businesses against the public

Recognizing frauds committed against businesses

Focusing on frauds against the government

Getting acquainted with the Ponzi scheme

Everyone is affected by fraud, either directly or indirectly. Even if you haven't been a victim of fraud, you pay for it. Think about it: Does your credit card company really need to charge you 24 percent interest and all those big fees? It does so to make up for all the costs associated with phony credit cards, stolen credit cards, and customers who just don't pay.

This chapter introduces some of the most common types of fraud committed by businesses, against businesses, and against the government. The goal here isn't to give you all the details about every type of fraud imaginable. Instead, this chapter simply gets you thinking about what fraud often looks like so you have a sense of the scope of work an accountant may encounter when addressing possible fraud — the willful intent to deceive.

Frauds Committed by Businesses

The goal of most businesses is to earn a profit. The more successful the business is, the bigger the profit it earns and the bigger the return on everyone's investment in the business. Sometimes the pressure to earn a profit drives business owners, executives, and managers to commit fraud. Business owners get greedy. Executives are driven to please the stockholders. And managers are eager to keep their jobs and earn bonuses and recognition from their superiors. All these motivations and more often tempt people in business to commit fraud. The following sections explain the types of fraud often committed by businesses and the people who operate those businesses.

Preying on vulnerable populations

Some businesses thrive by taking advantage of people who are weak or unknowledgeable. Here are just a few examples:

• Robbing the poor: The financial meltdown in the United States beginning in 2007 was largely driven by the unethical practice of convincing people who couldn't really afford mortgage loans that they could (and offering mortgage products with adjustable rates that started out low but increased rapidly over time). Some of the same companies engaging in these shady practices also encouraged mortgage applicants to falsify information in order to qualify for loans, which is straight-up fraud.

  See the upcoming section “Dealing in subprime and predatory lending” for more detailed information about fraudulent mortgage practices.

• Scamming the sick: Another common (and horrible) fraud scheme involves offering phony cures for deadly diseases. Many innocuous foods and chemicals, and even some dangerous items, have been hawked as cures for cancer and other diseases.
• Taking advantage of the elderly: People who are constantly concerned about their health and finances and worried about being a burden to their children can be especially vulnerable to fraudsters who spin tales of how they can make money and regain their health. Throw in the possibility that the elderly person's sight and hearing may not be perfect, and that he may be suffering from dementia, and you have lots of layers of vulnerability.

  Many elderly people are easily talked into signing documents they can't read or understand. The next thing you know, their savings and possibly even their home are gone. The American Association of Retired Persons (www.aarp.org) maintains a section on its website with the latest scams and frauds targeting the elderly. AARP also provides information on how not to become a victim of these frauds.

Picking investors’ pockets

Would you like to make millions with only a small investment? Of course you would! Unfortunately, it rarely happens that way. Yet many people get at least three pieces in the mail every day promising riches from investing in gold, penny stocks, foreign stocks, systems for investing when the market is going up, systems for investing when the market is going down, distressed real estate, and so on. Invitations to free seminars or luncheons where someone will expound on the only proven system for getting rich are also plentiful. Besides the mailers, advertisements play on the radio, appear in newspapers, and pop up on websites. The only ones getting rich from these schemes are the promoters.

Although the investment schemes advertised in mailers and newspapers may seem easy to spot, other types of investment fraud are much less obvious to the general public. Some businesses use fraudulent methods to manipulate their own stock values (or the values of stocks they've invested in) and steer investor decisions in ways that benefit the business rather than the investor.

Doing business with bribes

If you've ever watched TV or read a newspaper, you're likely familiar with the concept of greasing someone's palm in order to get special consideration. Why would a company resort to bribes to conduct business? Some bribes are relatively minor, such as when a company offers a bribe in order to speed up the processing of an application that would have been approved, anyway. Other bribes are much more serious, such as when a company offers a bribe to be allowed to create dangerous conditions for its employees or the public. For example, after several deadly crane collapses in New York City, the city's Department of Investigation launched probes into the crane business. It found that a large crane company had bribed inspectors from the Department of Buildings to falsify inspection reports. This bribery had deadly results.

In some foreign countries, bribing government officials is legal and considered a normal business practice. But U.S. companies doing business abroad aren't allowed to engage in bribery, even in countries where the practice is legal. Bribery abroad is a violation of the Foreign Corrupt Practices Act (FCPA), which prohibits paying bribes to foreign government officials for obtaining or retaining business.

Laundering money

Laundering money is a process used to make money earned illegally appear as though it was earned through legal business activities. Organized crime and drug traffickers often have a lot of cash money to launder by using methods such as these:

• Around the world in 80 days: The cash is taken out of the United States and deposited in banks in foreign countries. The best countries to go to are those with bank secrecy laws, because investigators can't get any information about the accounts. The money is often moved from country to country. After traveling the world for a while, the money is transferred to the U.S. entity in the guise of a loan from a foreign contact.
• The shell company: A company is set up that does no actual business. The “dirty” money is put into the business as sales. Taxes are paid on the revenue, after which the money is “clean” and available for any use.
• The blender: A criminal may control a small legitimate business. The “dirty” money is deposited into that business and reported as sales. Taxes are paid, after which the money can be used.

The U.S. government has enacted several laws to try to combat money laundering. For starters, any cash transaction over $10,000 must be reported to the Internal Revenue Service. If you get lucky in Las Vegas and cash in chips for $10,000 or more, the casino will ask you for your Social Security number and report the transaction. If you then walk over to a car dealer and pay for a car with $10,000 in cash, the car dealer will likewise ask for your Social Security number and prepare a report to the IRS.

If a bank suspects that someone's transactions are being broken up into amounts smaller than $10,000 to avoid the reporting, the bank will still make a report to the IRS. (However, if a business has routine bank deposits of $10,000 or more, it may request an exemption from the required filing.)

Also, transporting more than $10,000 in cash in or out of the United States without a customs declaration is illegal. Reporting requirements also exist for money transfers; money transfer agencies are required to report any money transfer of $3,000 or more.

Perpetrating construction fraud

Construction fraud usually occurs when a contractor doesn't complete a project according to the specifications of the contract, doesn't build according to the relevant building codes, or bills inappropriately. Here are some specific examples of construction fraud:

• Accepts a deposit and then doesn't perform the work or return the deposit
• Falsely claims to be a minority-owned business in order to gain an edge in bidding for a government contract
• Charges for high-quality materials but uses cheaper materials
• Intentionally underestimates the cost of a project to win the contract and then adds costs during the project
• Overbills for time worked
• Bills for hours worked by a fake employee
• Cuts corners by not following building codes without passing along the savings to the customer
• Diverts money, materials, or labor from one project to another

Dealing in subprime and predatory lending

These two problems, related to mortgages, often go hand-in-hand:

• Subprime lending occurs when a mortgage is given to a homeowner who isn't eligible for that mortgage. Maybe the homeowner doesn't make sufficient income or can't make a sufficient down payment. Or perhaps the home is appraised for more than it's worth.
• Predatory lending occurs when a loan officer talks a homeowner into taking out a mortgage he doesn't need or can't afford. Also considered predatory are interest rates and fees that are substantially higher than the homeowner could have received from a reputable lender.

Usually, the victims of subprime and predatory lending are desperate and/or lack financial sophistication. And usually, they don't have an accountant or attorney in the wings waiting to offer advice on whether a deal seems legitimate. The U.S. financial crisis that began in 2007 certainly shined a spotlight on these despicable practices, but that doesn't mean they're certain to end.

Taking advantage of employees

Many employers play by the rules, but some want to write their own rulebooks when it comes to what they expect from employees. How can they get away with treating employees unfairly? Especially when the economy is fragile, people earning paychecks don't want to rock the boat; they're too concerned about feeding their families.

Here are some of the most common rackets run by unethical employers:

• Violations of wage and hour laws: An employee is entitled to 1½ times her hourly rate for any time in excess of 40 hours a week. This goes for employees who earn a weekly salary (depending on their level of responsibility within the company), as well as those who earn an hourly wage. Many employers who violate this law tell employees that they aren't eligible because they're on salary.
• The 1099 versus W-2: When an employer pays an employee, the employer assumes a whole host of tax and insurance obligations including Social Security tax, Medicare tax, unemployment insurance (state and federal), workers’ compensation insurance, and disability insurance. All these obligations can add up to a tidy sum. To save money, the employer may treat the employee as an independent contractor, meaning the employee gets a fee and the employer has no tax obligations. At the end of the year, instead of getting an employee's W-2 form with wages and tax deductions listed, the independent contractor gets a form 1099 just listing the gross amount paid. In some cases, the financial impact to the worker isn't clearly explained.
• Discriminatory benefits: An employer that has a benefits package, such as health insurance and pensions, must make the benefits available to any employee who works more than 1,000 hours per year (about 20 hours per week). The employer also must notify all employees about benefit plans and eligibility rules. Many small businesses have a plan for the owners and omit the employees. Employers may also have pension plans that get more expensive for the business as employees get older. To save money, these companies fire employees whose plans are getting too expensive.
• Safety violations: The federal and state governments have many rules for safety in the workplace, but some employers flout those rules, which can have deadly consequences. Depending on the nature of the job and job site, employers are supposed to provide rest breaks, rest areas, first-aid supplies, and safety equipment. Many localities also require emergency exits, emergency lighting, and regular fire drills.

This section touches on only a few of the rules that govern employers’ responsibilities to their employees. Employers have many rules to follow, many of which are complex. The leading source for information in this area is the U.S. Department of Labor (www.dol.gov). Safety issues fall under the aegis of the Occupational Safety and Health division of the Department of Labor (www.osha.gov). You can also find information about many employment issues at the Internal Revenue Service website (www.irs.gov). Your state's Department of Revenue and Secretary of State's websites are two more resources for information about employment issues.

Frauds Committed against Businesses

Despite what you may be thinking, businesses aren't always on the giving end of fraud; sometimes they're on the receiving end. And they can get it from all sides: employees, customers, vendors, and the public. This all adds to the cost of doing business; some of those costs are explained in this section.

Employee theft

At some point, an employee has to be trusted. The trust may be as simple as access to the premises and a desk with supplies. It may be as important and complex as access to cash receipts, valuable inventory, formulas and trade secrets, or customers. An employee in a position of trust can easily commit asset misappropriation or embezzlement: the appropriation of entrusted assets for one's own use.

Asset misappropriation can be as simple as the employee using the copy machine for a personal copy or taking home office supplies. But it may also be as serious as diverting cash.

Vendor and customer fraud

A company's customers and vendors can also be sources of fraudulent activity. A customer may open a credit line with no intention of paying. A vendor may take a deposit for an order and disappear.

To prevent being a victim, a company must check out who it's doing business with to make sure potential customers and vendors have a history of delivering as promised and making timely payments.

Many sources of information about businesses exist, including rating agencies such as Dun & Bradstreet and information services such as Mergent. If a company is too small to afford subscriptions to these services, some public libraries make them available. And some banks that subscribe to these databases may allow a business customer to look up a certain name.

A company can't rely on online information to make decisions about which customers and vendors to trust. It doesn't take much for a fraudster to set up a pretty website.

Insurance fraud

Insurance fraud occurs when someone files a claim with an insurance company to get benefits that he's not entitled to — or when someone otherwise intentionally causes an insurance company to pay out money that shouldn't be paid out. The Coalition Against Insurance Fraud (www.insurancefraud.org) estimates that insurance fraud costs about $80 billion per year. And guess what? To stay in business, the insurance companies that face such daunting amounts of fraud spread the joy to all their customers in the form of higher insurance premiums.

Here are just a few examples of what insurance fraud can look like:

• A doctor bills an insurance company for procedures he didn't perform.
• Someone stages a car accident in order to file an injury claim against the other driver's insurance company.
• To collect cash from her insurance company, someone reports a car or boat stolen when it's not, or reports a phony fire or robbery.

Filing a phony insurance claim or a false police report is a criminal offense, so people perpetrating insurance fraud are taking a whole lot of risk.

Real estate and mortgage fraud

Leading up to the mortgage meltdown that started in 2007, banks and loan officers were certainly guilty of committing fraud against borrowers, but at the same time, many borrowers were ripping off the banks. Here are several common scams involving real estate and mortgage fraud:

• Illegal flipping: Flipping houses can be legal or illegal. The legal practice consists of buying a house, fixing it up, and selling it for a profit. The illegal form consists of several people buying and selling the house and having its value artificially inflated with each purchase. At the end of the chain, the person who took out the inflated mortgage distributes the proceeds among members of the ring and disappears.
• Cash back at closing: With cash back at closing, a homeowner agrees to sell a home for significantly more than the asking price and then kicks back some or all of the surplus cash to the buyer. This isn't a huge problem if the buyer makes the mortgage payments and eventually pays back the principal, but if the buyer defaults on the loan, the bank may get stuck with a property that's worth less than what's owed on it. Cash back at closing is illegal.
• Lying on loan applications: Some borrowers want a home so badly that they're willing to lie on their loan applications — inflating their income or net worth, so their financial condition looks good on paper. This practice dupes the bank into approving a loan application it would otherwise reject or lowering the interest rate it would otherwise charge to cover a riskier loan. Some companies facilitate this scam online by providing fake pay stubs and proof of ownership of valuable assets.

Many scams involving real estate and mortgage fraud rely on inflated appraisals indicating that a property is worth significantly more than it really is.

Bilking the Government

The government is always a convenient target for fraud. Because government is big, bulky, and subject to political pressures, it has a hard time controlling frauds despite its many efforts. The ways to commit fraud against the government are countless. This section describes some of the most common frauds — and how the government's forensic accountants try to uncover them.

Tax fraud

The more taxes that are imposed, the more people try to wriggle out of paying them. But the wriggling counts as tax fraud, and the consequences of getting caught can be severe. Title 26 of the Internal Revenue Code says that tax fraud is a felony, and anyone committing it may be subject to imprisonment, fines, or both.

Title 26 also provides some examples of tax fraud: Evading paying taxes (including estimated taxes), refusing to remit any taxes collected from other parties (such as withholding tax), signing a tax return that you know contains untrue information, intimidating a government employee who is enforcing the tax law . . . the list goes on.

For a while now, the U.S. Congress has not given the IRS sufficient funds to investigate and stop tax fraud. As a result, the IRS should be collecting a huge amount of money that it's not collecting. The difference between what's collected and what should be collected is called the tax gap. If the IRS were able to collect 100 percent of the tax due under the tax law, the country could see a rewrite of tax law to lower the rates or reduce deficit spending.

Someone is always coming up with a new way to evade taxes. Schemes range from deceptively simple to very complex. The IRS tries to stay one step ahead of the tax cheats, but usually is a few steps behind.

Using an audit to uncover tax fraud

The IRS does have several tactics in its war against the cheats. Perhaps the most powerful is the dreaded tax audit. IRS auditors are, in essence, forensic accountants, and they do compliance auditing. The absolute best defense for an audit is to do the tax return correctly in the first place. If the return is correct, the audit is a mild pain that will go away. If the return is wrong, the IRS will collect the unpaid taxes along with any interest and penalties and, in extreme cases, refer the case to the criminal investigation division.

How does the IRS choose which returns to audit? Every few years, the IRS runs programs to determine where taxpayers are cheating the most. To do so, the IRS pulls returns randomly, conducts audits, and determines which kinds of errors and omissions are being seen the most. After completing this process, it has its computer system flag any returns that come in bearing the same signs as the faulty returns in the audit. The signs may include your occupation, the relationship of your mortgage interest deduction to your income, the number of children you're claiming, the relationship of your charitable giving to your income, and so on.

Of course, the IRS also audits returns based on information from whistleblowers, other auditors, and criminal investigations. If you know that someone is committing tax fraud, you can file form 3949-A with the IRS. The IRS will analyze your information, and if it conducts an audit and manages to collect money, you may be eligible for a cash reward (which is taxable income — what the IRS giveth, the IRS taketh away).

Income tax

In the United States, the income of individuals and entities such as corporations is subject to tax (unless an exception applies to that individual or entity). That's why April 15 is such a banner day for accountants. For individuals, tax is computed based on gross income less certain adjustments and itemized deductions. For a business, tax is computed on revenues less ordinary and necessary expenses.

Businesses and individuals may commit income tax fraud in one or both of the following ways:

• Reporting less income than actually earned
• Deducting unqualified expenses

How can you avoid reporting income? If you have a business that collects cash from its customers, the cash can go directly in your pocket, and you just don't report the income. If you get checks, you could cash them at a compliant check-cashing agency or send them to a bank overseas. Trading valuable goods or services without reporting goods or services received is another form of tax fraud.

What about deducting too many expenses? Often, in closely held businesses, the owners charge personal expenses to the business. By doing so, they reduce the net income of the business and reduce their tax obligation. Ferreting out this type of fraud is rather easy: You examine the invoices for company expenses to determine the real recipient of the goods or services. For example, look at all the utility bills and find the address being serviced (which is shown right on the bill). Determine whether the address is a business site or the business owner's home. A small-business owner charged his toddler's daycare provider as a business consultant. The bills clearly indicated that he had committed tax fraud.

Sales tax

Sales tax is imposed on the purchase of certain goods and services. Sales tax exists in most states, but not all. Many local governments (counties and municipalities) also impose a sales tax. The Tax Foundation (www.taxfoundation.org) tracks sales tax percentages by state, which may vary widely among states.

Generally, sales tax is collected by the retailer from the purchaser at the time of purchase. Then, at a specified due date, the retailer remits the tax to the government. When sales tax isn't collected at the time of sale, in most cases the purchaser is responsible for paying the equivalent amount (to their state) in use tax.

Where does fraud come into play with sales tax? Sometimes a retailer collects the tax from its customers but doesn't remit it to the government. When this happens, usually the retailer is also neglecting to report all its income.

How can a business get caught skipping out on sales tax? In some cases, state auditors stand outside businesses and watch how many people go in and out and use the number to estimate sales. Some auditors use the gross percentage profit (GPP) method to estimate a company's sales amount, which involves comparing a company's percentage of profit to that same percentage in other companies in the same industry. (If the GPP of one company is much higher than the industry average, sales tax fraud is probably involved.) State and local governments are continually finding new and creative ways to pick up the underreporting of sales tax.

You can also use this method of estimating sales if you're representing a client who's buying a business.

Remember, sales tax is a fiduciary tax: The business collects and holds the government's money. If the business doesn't remit the tax to the government, the government can and will go after the responsible parties personally. These people don't have the protection of a corporation for fiduciary taxes. In other words, officers in a corporation can be held personally liable for not remitting taxes due to a government entity.

Employment taxes

In the section “Taking advantage of employees” earlier in the chapter, you read that some employers like to have employees accounted for as independent contractors. A principal reason for doing so is to save on the many employment taxes and other levies that an employer must pay, which can add up to quite a bit of money. These taxes and levies include:

• Employer's portion of Social Security: 6.2 percent of the employee's salary (the maximum limitation for Social Security taxes)
• Employer's portion of Medicare: 1.45 percent of the employee's salary
• Federal unemployment insurance
• State unemployment insurance
• Disability insurance
• Worker's compensation insurance
• Voluntary pension plans
• Health plans

Employment taxes can add up and put a significant dent in the bottom line of a business. But trying to pass off employees as individual contractors is risky business. Besides the IRS, other federal and state agencies (as well as private insurance companies) send auditors and forensic accountants to businesses to determine whether a company is classifying its employees correctly. If these auditors and forensic accountants determine that individual contractors should be classified as employees, the employers are on the hook for taxes and insurance premiums.

Transfer pricing

Transfer pricing is the price at which goods are exchanged between two separate accounting systems within the same holding company. Here's an example: Conglomerate, Inc.'s U.S. division buys widgets from Conglomerate's Martian division to put into a machine it assembles and sells in the United States. The transfer price is the price the U.S. division pays the Mars division.

Here's where the fraud comes in. Let's say the corporate tax rate on Mars is 15 percent, and the rate in the United States is 35 percent. If the transfer price is high, the Martian division makes more money and the U.S. division makes less money. For every dollar of profit transferred to Mars, Conglomerate saves 20 cents in tax. Artificially increasing the Martian price is a fraud. The IRS and the international conglomerates have forensic economists working to determine what a fair price is for the transfer of goods. For more information, take a look at www.transferpricing.com.

Contract fraud

The earlier section “Perpetrating construction fraud” discusses the potential for fraud related to construction work. But the potential for contract fraud against the government extends way beyond construction because the government hires contractors for just about everything: military research, medical research, hospital management, school management, prison management, and on and on. In any of these contract situations, the potential for fraud exists:

• Contractors may deliver substandard goods.
• Contractors may overbill.
• Contractors may charge items to these contracts that aren't used for the contracted work.

Here's just one example: Stanford University was accused of charging flowers for the home of the university president to a defense contract. The instant this accusation hit the news, every university in the country that had a defense contract initiated examinations to see whether anything was charged to government contracts that shouldn't have been. After a thorough forensic examination by the Office of Naval Research, Stanford paid the government $1.2 million for improper expensing from 1981–1992.

Any entity with government grants or contracts is subject to being audited by government examiners. These examiners look at accounting records as well as production or usage records.

Medicare and Medicaid fraud

Medicare is a federally sponsored and managed program (funded partially by the federal government and partially by the states) that provides medical care for the elderly and recipients of Social Security disability payments. Medicaid provides medical care for the poor. Both programs are at a high risk for potential fraud.

Healthcare provider fraud

Many of the frauds occur when so-called healthcare providers bill for services not rendered. For example, Florida has ongoing investigations of sham healthcare supplies providers. Here's how it works: A sham operation opens up in a storefront and somehow gets lists of seniors and their Medicare billing information. Then the fraudsters bill the Medicare program for wheelchairs, walkers, and other items that the patients’ doctors never ordered and the patients never received. Unfortunately, many times these guys close up shop and move on before the investigators arrive at their door.

Sometimes doctors and clinics bill for procedures they never performed. To combat this type of fraud, Medicare and Medicaid computers are programmed to look for excessive billing by providers. If the average clinic doctor sees 25 to 40 patients during an eight-hour day, and a certain doctor bills for 80 to 120 patients per day, alarm bells ring.

The Medicare and Medicaid computer programs also look for hysterectomies performed on men (yes, fraudsters are stupid enough to bill for this) and treatments for organs that have previously been removed (having more than one appendix is rare).

Recipient fraud

On the recipient side are many stories of fraud in the Medicaid program. For example, someone may not qualify for Medicaid but “rents” a Medicaid card when she needs to go to the doctor. She may pay a certain amount to use the card for a single doctor's visit or a higher amount to keep the card for a whole day.

Some people lie about their financial condition so they can get Medicaid benefits. Unfortunately, many local Medicaid offices are underfunded and too swamped to check out applicants thoroughly.

Social Security fraud

Social Security is a federal benefits program started during the Great Depression that provides benefits for retirees, widows and widowers, orphans, and people unable to work because of permanent disability. Eligibility and benefit amounts are complicated, and you can find more information at www.ssa.gov. The Social Security Administration (SSA) also administers the Medicare program.

Whenever the government distributes money, fraudsters line up to collect their share. Some of the common types of Social Security fraud are:

• Concealing work activity while receiving disability benefits
• Receiving Social Security benefits for a child not under that person's care
• Failing to notify SSA of the death of a beneficiary and continuing to receive and cash the checks of the deceased
• Concealing a marriage or assets from the Social Security Administration while receiving Supplemental Security Income payments
• Residing overseas and receiving Supplemental Security Income payments

The fraudsters accomplish their deceits in a wide variety of ways, including:

• Making false statements on claims
• Concealing material facts or events that affect eligibility for benefits
• Misusing benefits (for example, a surviving parent receives the orphan benefits for his or her children but uses the money for some other purpose)
• Buying or selling Social Security cards or SSA information
• Bribing SSA employees

The SSA relies on IRS agents to report possible frauds they find while they're performing audits. It also relies heavily on the public to report suspected fraud.

A Social Security number (SSN) is one of the critical pieces of information an identity thief needs to create a new set of papers and commit all sorts of crime. No one should ever give out their SSN unless they're in a situation in which they're required to do so by law. If a doctor's office asks for your SSN, ask why that information is necessary to practice medicine.

Introducing the Ponzi Scheme

This type of fraud deserves a section all its own. In a Ponzi scheme, a fraudster steals money to create the illusion of being legitimate so he can continue to steal money. The Bernie Madoff fraud that shocked the world in 2008 is probably the best-known example.

Here's how a simple Ponzi scheme works: Mr. Fraud needs money. He approaches Allison and says that he can invest her money and earn her an interest rate of 10 percent. Allison believes him and gives him $100. Mr. Fraud doesn't really invest Allison's money; he spends it. But he needs to give Allison her interest, so he approaches Billy with the same deal. Billy believes him and gives him $200. Mr. Fraud puts $10 in Allison's account (representing her interest on $100) and the remaining $190 in his pocket.

When the time comes for Mr. Fraud to give both Allison and Billy their interest, he approaches Charlie with the same deal. Mr. Fraud convinces Charlie to invest $300. He puts $10 in Allison's account and $20 in Billy's account to cover the interest. He puts $270 in his own pocket.

Uh oh, now Billy wants to withdraw money. Mr. Fraud finds Diana and convinces her to invest money. Diana gives him $400, part of which Mr. Fraud uses to put Billy's principal back in his account.

You get the picture. The Ponzi schemer keeps up an elaborate scheme of borrowing from Peter to pay Paul. At some point it gets too big to handle; the schemer just can't find enough new investors to pay off the old. When that happens, the house of cards comes tumbling down.

Early reports on the Madoff scheme indicated that Bernie actually started off as an honest financial advisor. When the market got a little bit soft, he started doing the Ponzi thing so that his investors would continue to get high returns. However, even when the market rebounded he couldn't earn enough money to make up for the money he had borrowed, so he kept the Ponzi scheme going. When the market took big hits in 2008 and investors needed to get their money out to cover their cash shortfalls, Madoff couldn't keep up anymore, and it all fell apart.