The news media are replete with stories about those who have allegedly lost more than $50 billion as a result of investing with Bernard Madoff, in what may turn out to be first worldwide Ponzi scheme scandal in history.
According to Wikipedia.com, "A Ponzi scheme is a fraudulent investment operation that pays returns to investors out of money paid by subsequent investors rather than from profits." The scheme is named after Charles Ponzi, the Boston swindler who became notorious for using the technique after immigrating to the United States in 1903.
Ponzi and Madoff paid their investors a small amount of money derived from a large pool of money. It is often explained that, in a Ponzi scheme, the new money coming in is used to pay off the older stakeholders, but this is not necessarily true.
The money is being distributed to all stakeholders. For example, if there is a pile of surplus cash available one month and no new money comes in that particular month, a "distribution" can still be made. What really happens is a "return of capital," rather than a distribution of a dividend from earnings generated from the enterprise. The problem with this model is that it is not sustainable.
How many companies in corporate America have similar situations?
Look at companies distributing cash in the form of "dividends" that are greater than their earnings. Some even tout the positive aspect of this, claiming the stakeholders need not pay taxes on the distribution, or a portion thereof.
All banks paying dividends that are reporting losses are really operating a similar scheme. Other than using buzz-words such as "transparency" to hide behind, these companies are executing, economically, the same activity: distributing funds from a pool of assets belonging to the stakeholders themselves, to the very same stakeholders, without creating new wealth.
Ever wonder about a stock buyback program? If a company is buying back stock in an amount greater than its earnings, its similarity to a Ponzi scheme is that it, also, is not sustainable in the long run.
A better approach for a company that is intent upon distributing a dividend would be for the company to make a "stock dividend." While the entity receiving this piece of paper can recognize an amount of cash if it so desires, it can only do so by selling the stock on the open market. In this case, the company itself is not diminished, since it issued shares, not cash. Once a real "cash" profit is made, a distribution can be made on all the shares outstanding.
For the past several years, companies have been operating a simple variation of a Ponzi scheme: paying out that which was not really created. The reason it has morphed into a true disaster is due to the addition of leverage, or borrowed funds, to acquire stock and equity positions in entities that are claiming to make such superlative returns.
With debt so cheap, it became a tantalizing opportunity to borrow in order to take advantage of the "spread" between what a Madoff-like return would be vs. the low cost of borrowed funds. So, individuals and corporate investors end up losing not only everything they have, but also what they don't have.
What should be done about what has occurred? At the very least, corporations should spell out in bold type, with complete transparency, the "return of capital" in their quarterly and annual reports. "Return of capital" data should be required whenever comparing one company with another.
Clearly, good corporate practices dictate that companies should not be buying back stock in amounts greater than their earnings and should not be paying a dividend if they are operating at a loss. Whether these "good corporate practices" should be guidelines or regulations is a topic for full and transparent discussion.
