BizTech Law Blog

Why Investment Crowdfunding May Not Be As Bad As They Say - Part I: Will Rampant Fraud Abound?

The JOBS Act, which became law on April 5, 2012, included for the first time in the U.S., a legal structure that will permit the use of general solicitation in connection with small, non-registered investment offerings in the context of crowdfunding.  The SEC still needs to adopt implementing regulations before this funding vehicle becomes available and the market decides if it is viable.  This will take several months, if not a year.  But in the meantime, the naysayers are hard at work, proclaiming their opinion that crowdfunding is a dangerous idea.

This article is in response to the widely publicized belief that crowdfunding is nothing but an invitation for fraud.  This is of concern primarily for investors.  Many advisors to investors are sounding the alarm.  From the beginning of time there has been and always will be fraud.  But is crowdfunding investing really higher risk than all other types of investment?  We think probably not.  Here's why.

First and foremost, the operators of the funding portals will be highly motivated to limit the occurrence of fraud through their sites.  If investors are defrauded by companies that do fundraising through a portal, the portal's reputation and ability to attract funders to its site will be severely damaged.  The portal operators are very aware of this issue.

Although E-Bay initially had problems with fraud, over the years, it has successfully reduced the incidence of fraud on its site to a point that users are quite comfortable using the E-Bay site.  Current (non-investment) crowdfunding portal operators report that they have been able to reduce fraud risks to a very low level.  Any portal operator is likely to utilize automated background checks and other proprietary methods designed to identify and exclude bad actors.  And in the world of social media, news of bad conduct travels quickly.  One bad act and a fraudster is likely to be ostracized in the social media community to such a degree that it will be very difficult to repeat the fraud.  We have also heard that some funding portals may buy insurance to cover the fraud risk.

One advantage to the crowdfunding approach to investing will be the transparency that it provides.  There will be an electronic record created of any fraudulent activity.  This will make enforcement easier than it currently is.  Unlike the boiler rooms where there is no record of the high pressure sales calls to vulnerable people, and the one-on-one fraud committed by creating a trusting relationship in the target's living room, place of worship, or other trust-inducing venue, there will be a complete record created that can be used to prosecute criminal and civil fraud cases.

The crowdfunding title of the JOBS Act also builds in protections intended to mitigate fraud, such as providing to the SEC the information to be posted on the portal before it is posted; requiring a background check on the principals of the company seeking funding; and prohibiting the funding portal and its principals from having a financial interest in the company that is posting a crowdfunding request.  The SEC is required to adopt rules addressing fraud prevention, and there will likely be other protections from fraud required by the SEC.

In addition to the possibility that companies engaged in crowdfunding through a funding portal will commit fraud, there is also a risk that crowdfunding portals will be created that are themselves fraudulent.  Under the regulatory scheme of the JOBS Act, funding portals are required to be registered with the SEC and with a self-regulatory organization.  Just as investors are currently able to easily check on a broker-dealer through the FINRA website, a similar process will be available to check on crowdfunding portal providers.  Investors should do their homework before using a funding portal, but that is no different than the situation with broker-dealers that exists today.

In short, while investors should always be aware of fraud risks, we do not believe the risk of fraud is likely to be higher with equity crowdfunding than it is today.  It is easy to be afraid of change; but we encourage our readers to embrace the prospective benefits of this new investment fundraising platform.

For more information, please contact Iris Linder at 517-371-8127 or by using the form below.

Categories: Crowdfunding, Venture Capital/Funding