Twisting trust: social networks, due diligence, and loss of capital in a Ponzi scheme

Abstract

This paper examines a pre-planned fraud which ran undetected for more than five years and deceived 2285 investors for $240 million. We seek to uncover the effects of trust in social ties and conducting due diligence on 1) an investor’s initial amount of investment and 2) their overall loss of capital. Using data from a survey of 559 victims, we conduct two linear regression models to test for effects on investors’ amount of initial investments and their total net loss. By using two dependent variables, we examine effects of social ties and performing due diligence at the beginning stage and end stage of a Ponzi scheme. Performing due diligence and relying on information provided by industry professionals increased initial investments, while having performed due diligence also increased investors’ loss of capital at the end of the fraud, suggesting both social ties and due diligence contributed to fraud victimization. The findings are interpreted within the context of a particularly sophisticated fraud where document falsification was almost impossible to detect, contributing to a false sense of security among victims.