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IJLMA
54,3 The Miller-Modigliani
1961 Ponzi scheme,
alias “dividend irrelevance”
234
Stanley Paulo
Lincoln University, Canterbury, New Zealand, and
Chris Gale
School of Management, University of Bradford, Bradford, UK

Abstract
Purpose – The purpose of this article is to expose the Miller-Modigliani 1961 Ponzi scheme that has
masqueraded as a dividend irrelevance proof, and show that it constituted a Ponzi scheme at the time of
publication and ever since publication. This is important especially as Miller-Modigliani 1961 stated in
the first sentence of their article that their dividend irrelevance proof was targeted at corporate officials,
investors and economists seeking to undertake and appraise the functioning of capital markets.
Design/methodology/approach – The equations and notation used by Miller-Modigliani 1961 to
prove dividend irrelevance were carefully considered and analysed in order to establish whether proof
reliably, validly and unambiguously proved dividend irrelevance. In addition, statute on both sides of
the Atlantic, UK and USA, was considered in order to ascertain the legal standing of their proof.
Findings – This article shows that the Miller-Modigliani 1961 dividend irrelevance proof constituted
a recipe for a Ponzi scheme in terms of statute at the time of publication and ever since publication.
Since Miller-Modigliani 1961 made extensive reference to the works of eminent finance researchers and
academics of the 1930s, 1940s, and 1950s, as well as to their Modigliani-Miller 1958 seminal article, and
attentively present and discuss the intricacies of the arguments these researchers made to the
progression of knowledge, it would be challenging to content that they were unaware or ignorant of
important legislation that applied in 1961.
Originality/value – There is no evidence from a scrutiny of publicly available secondary sources to
suggest that the Miller-Modigliani 1961 Ponzi scheme, alias “dividend irrelevance” has previously
been done or published. This is surprising because the Miller-Modigliani 1961 dividend irrelevance
proof has occupied a particularly prominent position in the finance literature and has been the subject
of numerous studies and research projects.
Keywords Dividend irrelevance, Financial fraud, Miller-Modigliani, Ponzi scheme, Pyramid schemes,
Pyramid selling, Dividends, Fraud
Paper type Research paper

[. . .] He who has studied insufficiently, and teaches and acts according to his defective
knowledge, is to be considered as if he sinned knowingly [. . .] (Maimonides).

International Journal of Law and
Management
Vol. 54 No. 3, 2012
pp. 234-241
q Emerald Group Publishing Limited
1754-243X
DOI 10.1108/17542431211228638
1. Introduction
The purpose of this article is first to shed light and expose the 1961 Ponzi scheme of the
Nobel laureates Miller and Modigliani (henceforth MiMo 1961) upon which their
dividend irrelevance argument is based, and second to show that it constituted a Ponzi
scheme according to statute both at the time of publication and ever since publication
in 1961. Many authors of stature would agree with the statement of De Angelo and
De Angelo (2006, p. 294) that MiMo’s 1961 dividend irrelevance theorem forms the
foundational bedrock of modern finance theory, and consequently it has occupied
a prominent and respected position in the literature of corporate finance textbooks and The 1961
journal articles (Brigham and Ehrhardt, 2011, p. 565; Gitman and Zutter, 2012, Ponzi scheme
pp. 573-4; Berk and deMarzo, 2011, pp. 559-60).
This article begins with an explanation of a Ponzi scheme, after which the MiMo 1961
Ponzi scheme is presented and discussed using their original equations and notation.
Thereafter statute that proscribes Ponzi schemes is presented so that academics,
authors, students, practitioners and consultants are informed of the seriousness of this 235
type of financial fraud. The law views Ponzi schemes as particularly serious crimes. To
the extent that the Sarbanes-Oxley Act of 2002 (henceforth SOX) stipulates in Section
407 that the audit committee of each issuer in the US must have at least one member who
is a “financial expert” as defined by the Commission in Section 407(b)(1)(2)(3)(4), it is
highly improbable that such financial experts could plead ignorance of the existence of a
Ponzi scheme within their firms. Ponzi schemes conflict directly with SOX Section 807,
subsection 1348 concerning securities fraud, and under this section, contained in
Chapter 63 title 18 of the US Code, the penalties are severe and comprise multi-million
dollar fines and extensive periods of imprisonment.
In the UK, Ponzi schemes are not as well known, to the public at least, as their cousin,
the “pyramid scheme”. A Ponzi scheme often presents an apparently real investment
opportunity, as discussed below, whereas the pyramid scheme will typically only offer
individuals a right to a return if they pay a fee to join the scheme and are then able to
recruit other members, frequently friends and family, to the scheme. Pyramid schemes
were directly outlawed as long ago as the 1970s, following a virtual epidemic of them, by
Part XI of the Fair Trading Act 1973, as amended by the Trading Schemes Act 1996, the
Trading Schemes Regulations 1997 and the Consumer Protection from Unfair Trading
Regulations 2008. They could also fall foul of the Gambling Act 2005. Clearly
Ponzi schemes which simply hide their multilevel pyramid natures could be prosecuted
under these statutes and regulations but purer Ponzi schemes will now be prosecuted
under the relatively recent Fraud Act 2006 having previously usually been dealt with by
the false accounting provisions of Section 17 of Theft Act 1968 or the common law
offence of conspiracy to defraud. Where a limited liability company is involved, the
wrongful and fraudulent trading provisions of Insolvency Act 1986 and Companies Act
2006 are often brought to bear and, where appropriate, the provisions of the Company
Directors Disqualification Act 1986. In much of the EU, similar ad hoc, rather than
specifically anti-Ponzi provisions are applied.

2. Ponzi schemes
In 1857 Charles Dickens’ novel Little Dorrit described a scheme that decades later was
called a Ponzi scheme after the notorious felon Charles Ponzi applied such a scheme in
the USA (Clarke, 2011). A Ponzi scheme is a fraudulent investment operation that makes
disbursements by way of dividends, interest or capital gains to an existing pool of
investors, not from profits earned, but from new investment capital made by new
investors. When the new investment raised is insufficient to pay returns to the
existing investors, the scheme collapses. Ponzi schemes may last for extensive periods of
time, but as a result of an economic shock, financial crisis, or other disruption, they may
prematurely collapse. In time, all Ponzi schemes collapse because the disbursements
become so large that they cannot be sustained by the inflow of new investors with fresh
funds to prop up the scheme and keep it from collapsing. If, on a regular basis as a result
IJLMA of the dividend paid by a firm the firm has to raise fresh capital by way of a new issue of
54,3 securities to replenish the shortfall caused by the dividend disbursement, in order to
keep the firm in operation, and the dividend paid is not funded from profits made in the
normal course of business, a Ponzi scheme exists.
In recent times, a number of Ponzi schemes have been uncovered and include
Pearlman, Madoff and Stanford. In 2009 Madoff was sentenced to 150 years in prison
236 and ordered to make restitution of $170 billion by Judge Chin (Zambito et al., 2009).
Madoff’s projected release date is 14 November 2139. In 2006 Pearlman was sentenced
to 25 years in prison (MSNBC.com (www.msnbc.msn.com/id/23473811); Reuters, n.d.).
In 2009 Stanford was charged by the US Securities and Exchange Commission with
operating a Ponzi scheme and is awaiting trial (Driver, 2009). In the UK, in the
unreported case of Rv Freeman in the Crown Court at Southwark, a company director
who admitted spending £14 million of investors’ money in a Ponzi scheme was jailed in
February 2011 for eight years in total. Whilst some of this penalty was attributable to
offences related to bankruptcy and company director disqualification related offences,
the main thrust of the prosecution was under the fraudulent trading provisions of
Section 213 Insolvency Act 1984. Somewhat flippantly, perhaps the UK can match
neither the size of the Ponzi schemes carried out nor the sentences imposed in the USA!
As will be shown in the following section, the Ponzi scheme of MiMo 1961 was
carefully and elaborately crafted around 30 primary valuation equations, and has
remained undetected as a Ponzi scheme since publication.

3. The Miller-Modigliani 1961 Ponzi scheme

As shown by Paulo (2010, pp. 369-82), MiMo 1961 commence their analysis with
equation (1) which they use to state “[. . .] the fundamental principle of valuation [. . .]”
(MiMo 1961, p. 412), namely:
dj ðtÞ þ pj ðt þ 1Þ 2 pj ðtÞ
¼ rðtÞ ð1Þ
pj ðtÞ
where:
r(t) ¼ the discount rate, cost of capital and is independent of j;
dj(t) ¼ dividends per share paid by firm j during period t; and
pj(t) ¼ the price of (ex any dividend in t 2 1) of a share in firm j at the start of
period t.
MiMo 1961 rearrange equation (1) and produce equation (2) for each j (i.e. firm) and for
all t (i.e. all periods t) (MiMo 1961, p. 412):
1
pj ðtÞ ¼ ½dj ðtÞ þ pj ðt þ 1Þ
ð2Þ
1 þ r ðtÞ
MiMo 1961 (1961, p. 413) then introduce additional notation, specifically:
n(t) ¼ the number of shares of record at the start of t;
m(t þ 1) ¼ the number of new shares (if any) sold during t at the ex dividend
closing price p(t þ 1), so that;
 n(t þ 1) ¼ n(t) þ m(t þ 1); The 1961
V(t) ¼ n(t)p(t) ¼ the total value of the enterprise; and Ponzi scheme
D(t) ¼ n(t)d(t) ¼ the total dividends paid during t to holders of record at
the start of t.
Using the above notation, MiMo 1961 (1961, p. 413) rearrange equation (2) to produce
equation (3):
237
1
V ðtÞ ¼ ½DðtÞ þ nðtÞpðt þ 1Þ

1 þ rt
1
V ðtÞ ¼ ½DðtÞ þ V ðt þ 1Þ · mðt þ 1Þpðt þ 1Þ
ð3Þ
1 þ rt
MiMo 1961 (1961, p. 414), “[. . .] Specifically, if I(t) is the given level of the firm’s
investment or increase in its holding of physical assets in t, and X(t) is the firm’s total
net profit for the period”, we know that the amount of outside capital required [after
paying the dividend] will be:
mðt þ 1Þpðt þ 1Þ ¼ IðtÞ 2 ½XðtÞ 2 DðtÞ
ð4Þ
MiMo 1961 equation (4) says that the quantity of new equity finance raised from the
issue of new shares (m(t þ 1)p(t þ 1)) is equal to the increase in investment (I(t)) minus
total net profit (X(t)) less dividends (D(t)).
Since MiMo 1961 have defined:
mðt þ 1Þpðt þ 1Þ ¼ IðtÞ ¼ DðtÞ;
MiMo equation (4) can be re-written as:
mðt þ 1Þpðt þ 1Þ ¼ mðt þ 1Þpðt þ 1Þ 2 ½XðtÞ 2 mðt þ 1Þpðt þ 1Þ

or as:
IðtÞ ¼ IðtÞ 2 ½XðtÞ 2 IðtÞ

or as:
DðtÞ ¼ DðtÞ 2 ½XðtÞ 2 DðtÞ

When: m(t þ 1)p(t þ 1) ¼ m(t þ 1)p(t þ 1) 2 [X(t) 2 m(t þ 1)p(t þ 1)] is rearranged:
mðt þ 1Þpðt þ 1Þ ¼ mðt þ 1Þpðt þ 1Þ 2 ½XðtÞ 2 mðt þ 1Þpðt þ 1Þ

mðt þ 1Þpðt þ 1Þ 2 mðt þ 1Þpðt þ 1Þ ¼ 2½XðtÞ 2 mðt þ 1Þpðt þ 1Þ

XðtÞ ¼ ½mðt þ 1Þpðt þ 1Þ

which says that the firm’s total net profit in period t is equal to the funds generated
from the new issue of shares.
When: I(t) ¼ I(t) 2 [X(t) 2 I(t)] is rearranged:
IðtÞ ¼ IðtÞ 2 ½XðtÞ 2 IðtÞ

IJLMA IðtÞ 2 IðtÞ ¼ 2½XðtÞ 2 IðtÞ

54,3 XðtÞ ¼ IðtÞ
which says that the firm’s total net profit in period t is equal to new investment.
When: D(t) ¼ D(t) 2 [X(t) 2 D(t)] is rearranged:

238 DðtÞ ¼ DðtÞ 2 ½XðtÞ 2 DðtÞ

DðtÞ 2 ½XðtÞ 2 DðtÞ
2 DðtÞ ¼ 0
XðtÞ ¼ DðtÞ
which says that the firm’s total net profit in period t is equal to the dividend.
When considered in combination:
XðtÞ ¼ IðtÞ ¼ mðt þ 1Þpðt þ 1Þ ¼ DðtÞ
i.e. net profit ¼ new investment ¼ new shares issued ¼ dividend paid
which is none other than the recipe for a ”Ponzi-scheme“!

4. The MiMo 1961 Ponzi scheme: then and now

The MiMo 1961 Ponzi scheme, “alias dividend irrelevance theorem”, constituted and
continues to constitute a Ponzi scheme ever since its publication in 1961. In the first
sentence of their article MiMo 1961 target “corporate officials”, “investors” and
“economists seeking to undertake and appraise the functioning of capital markets”
(MiMo 1961, p. 411). In 1961, before 1961 and ever since 1961 the finance industry and
profession were and still are required to comply with statute such as the Securities Act
1933, the Securities and Exchange Act 1934, the Investment Advisers Act 1940,
SOX 2002 (which extends, in particular, the Securities Act of 1933 and the Securities
and Exchange Act of 1934), and the Restoring American Financial Stability Act 2010
(Henceforth RAFSA 2010). RAFSA 2010 specifically seeks:
To promote the financial stability of the United States by improving accountability and
transparency in the financial; system, to end “too big to fail”, to protect the American
taxpayer by ending bailouts, to protect consumers from abusive financial services, and for
other purposes (RAFSA 2010, p. 1).
Thus, even at present, legislation is being enacted that aims to thwart fraudulent
financial practices such as Ponzi schemes.
MiMo 1961 could not possibly have been unaware or ignorant of important
legislation that applied in 1961. They refer to the works of eminent finance researchers
and academics of the 1930s, 1940s and 1950s, such as Graham and Dodd (1934), the
Lutz and Lutz (1951), Williams (1938), Dean (1951a, b) and Durand (1957), among
others, not only in their 1961 article but also in the Modigliani and Miller 1958 article
(henceforth MoMi 1958) (Modigliani and Miller, 1958). In so far as they make repeated
reference to, and attentively analyse and discuss the intricacies of the contributions of
these authors in MiMo 1961 as well as MoMi 1958, they have presented solid evidence
of their knowledge of these authors and their works (Graham and Dodd, 1951).
Consider, for example, Security Analysis (Graham and Dodd, 1934) in which an
approach to financial analysis and management was presented that was consistent with
the legislation of the early 1930s such as the Securities Act of 1933, the Securities and
Exchange Act of 1934, the banking acts of this period that included the Glass-Steagall The 1961
Act of 1933 (repealed in 1999), as well as the requirements of the Security and Exchange Ponzi scheme
Commission that in turn was instrumental in creating the Financial Accounting
Standards Board that in turn created generally accepted accounting principles. Unlike
Dewing’s (1919) Financial Policy of Corporations, that was largely an historically
descriptive anthology of the practice of finance through the ages, Security Analysis
inaugurated an analytical approach to financial analysis and management (Graham and 239
Dodd, 1934). Consider too the works of Dean (Capital Budgeting, 1951a; Managerial
Economics, 1951b) in which Dean, mindful of the contributions of the legislature, in
particular the determinations of Justices Douglas and Brandeis with regard to the cost of
capital and the weighted average cost of capital, among other financial topics (Paulo,
2003, pp. 329-31), incorporated judicial findings and determinations into his works in an
attempt to construct financial models, propositions and theories that were compliant
with the law and satisfied the requirements of sound research methodology.
The importance of sound research methodology in finance for the national interest
of the USA is presented, together with other related objectives, to justify the Securities
and Exchange Act 1934. Title 1, Section 1(3) of this act, states:
Frequently the prices of securities [. . .] are susceptible to manipulation and control, and the
dissemination of such prices gives rise to excessive speculation, resulting in sudden and
unreasonable fluctuations in prices of securities which (a) cause alternately unreasonable
expansion and unreasonable contraction of the volume of credit available for trade [. . .] and
commerce; (b) hinder the proper appraisal of the values of securities and thus prevent a fair
calculation of taxes owing to the United states [. . .]; (c) prevent the fair valuation of collateral
for bank loans and/or obstruct the effective operation of the national banking system and
Federal Reserve.
In short, this act is justified on the basis of the importance of the proper valuation of
financial securities in the national interest of the USA.
The importance of sound research methodology in finance also receives attention in
the US Code title 18 chapter 63 Section 1341, Frauds and swindles, and reads:
Whoever, having devised or intending to devise any scheme or artifice to defraud, or for
obtaining money or property by means of false or fraudulent pretenses, representation, or
promises, or to sell, dispose of, loan, alter, give away, distribute, supply, or furnish or procure
for unlawful use any counterfeit or spurious coin, obligation, security, or other article [. . .]
shall be fined under this title or imprisoned not more than 20 years, or both [on each count].
Financial propositions, models and theories that lack epistemological rigour and defy
the principles of sound research methodology can be interpreted as falling within the
ambit of Section 1341.
Section 1343 extends Section 1341 to include fraud by wire, radio, or television, signs,
signals, pictures or sounds, and Section 1344 further extends the reach of this legislation
to encompass bank frauds where the fraudster or swindler “[. . .] shall be fined not more
than $1 million or imprisoned not more than 30 years, or both [on each count].”
In the UK, as already mentioned, financial arrangements such as Ponzi schemes can
conceivably be prosecuted under Part XI of the Fair Trading Act 1973 as amended by
the Trading Schemes Act 1996, the Trading Schemes Regulations 1997, and the
Consumer Protection from Unfair Trading Regulations 2008. Moreover, such financial
arrangements could now fall foul of the Gabling Act 2005 or the Fraud Act 2006.
IJLMA As most of this type of offence will only come to light in an insolvency, where the flow
54,3 of money has broken down, and been committed through the vehicle of a limited
liability company, charges usually include those drawn from Insolvency Act 1984.
Section 213(1) reads “If in the course of the winding up of a company it appears that
any business of the company has been carried on with intent to defraud creditors [. . .]”
clearly importing an element of knowledge of the fraud which is for the prosecution to
240 prove. This was done in the Freeman case noted above. However, although attracting
lower penalties, Section 214 Insolvency Act 1986 provides:
(1) Subject to subsection (3) below, if in the course of the winding up of a company
it appears that subsection (2) of this section applies in relation to a person who is
or has been a director of the company, the court, on the application of the
liquidator, may declare that that person is to be liable to make such contribution
(if any) to the company’s assets as the court thinks proper.
(2) This subsection applies in relation to a person if:
.
the company has gone into insolvent liquidation;
.
at some time before the commencement of the winding up of the company,
that person knew or ought to have concluded that there was no reasonable
prospect that the company would avoid going into insolvent liquidation; and
.
that person was a director of the company at that time.
Thus, meaning that if, objectively, a person knew or should have known of the scheme,
they have liability under this section. The “I didn’t know” defence has no place at all
here although, it seems, the authorities are more prepared now than formerly to engage
with Section 213 following the BCCI and other banking scandals of recent years. The
MiMo 1961 Ponzi scheme masquerading as a “dividend irrelevance proof” targeted at
“[. . .] corporate officials [. . .] investors [. . .] and economists [. . .]” (MiMo 1961, p. 411)
does not and has never complied with statute on either side of the Atlantic.

5. Conclusion
This article has analysed the MiMo 1961 “dividend irrelevance proof” and has shown it
to constitute a recipe for a Ponzi scheme. In terms of statute, it is difficult to deny that the
MiMo 1961 “proof” constituted a Ponzi scheme when it was published. In terms of statute
enacted since the MiMo 1961 “proof” was published, it continues to constitute a
Ponzi scheme. Despite much detailed analysis and discussion of MiMo 1961 over an
extensive period of time, and despite the “bedrock” position it occupies in the literature of
financial theory, this recipe for a Ponzi scheme has remained undetected for half a
century. On both sides of the Atlantic, the UK and USA, statute regards Ponzi schemes
as particularly serious crimes that merit severe penalties by way of fines and
incarceration.

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Corresponding author
Stanley Paulo can be contacted at: paulos@lincoln.ac.nz

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