When Crowdfunding Becomes Crowdfrauding

Leslie P. Littrell
Analyst
September 8, 2014

Crowdfunding is the relatively new process of using social media to receive small contributions from many different individual investors. While the first instance of crowdfunding dates back to 1997, when a British rock band by the name of Marillion funded its United States tour by soliciting online donations from fans, the concept of crowdfunding is only recently becoming widespread amongst entrepreneurs and investors.

It is important to note that there are two different types of crowdfunding, rewards-based crowdfunding and equity crowdfunding. Rewards-based crowdfunding exists when an investor puts up money for a new project, and the business gives the investor some type of incentive in return once the project reaches its fundraising target. While still awaiting additional regulations to be made legal, equity crowdfunding is when an investor receives actual equity in the startup company in return for an investment.

JOBS Act and Equity Crowdfunding
The JOBS Act was designed to make it easier for entrepreneurs and small businesses to gain startup funding by exempting crowdfunding activities from compliance with the Securities Act by not requiring an initial public offering, which can be very costly and time consuming. Many potentially successful businesses couldn’t afford to embark on an initial public offering (IPO) and in turn, could not formalize. Although the Jumpstart Our Business Startups (JOBS) Act was signed into law in April of 2012 by President Barack Obama to allow for equity crowdfunding to take place, the Securities Exchange Commission (SEC) was tasked with setting provisions of how the law would be implemented to ensure protection of both investors and entrepreneurs, and those provisions remain to be completed.

Crowdfunding Fraud
While crowdfunding opens the door for exciting opportunities to new companies and individual investors, it also brings about the possibility for fraud. The following list includes several different types of fraud that could occur within crowdfunding:

Campaign fraud: This is the most apparent type of fraud within crowdfunding. It transpires when a particular campaign solicits and accepts funds from investors by intentionally misleading the investor about the nature of the project and/or its outcome. One example of this would be the case filed in Washington against Ed Nash and his company, Altius Management. In October 2012, Nash raised over $25,000 from over 800 supporters for a card game. His fundraising target was only $15,000 thereby requiring him to deliver the product to his supporters once he reached that target. The estimated delivery date of December 2012 passed, and customers never received the product. The Washington State Attorney General’s office filed suit against Altius Management under the Consumer Protection Act (CPA) in April of this year, and the case is ongoing.

Investor fraud: Opportunities exist for investors to commit fraudulently to funding a particular project or campaign with the intent to later reverse the transaction, leaving the campaign lacking in its funding requirements.

Broker fraud: There is the potential that the broker or website conducting the transaction could aid either party in the above mentioned frauds or could simply fail to complete the transaction as scheduled.

As crowdfunding becomes more mainstream, the potential for fraud in these areas will inevitably increase.
Though crowdfunding has already largely benefited the economy and hopefully will continue to do so, it is vital that individual investors and entrepreneurs alike be aware of the opportunities that exist for fraud to occur. Otherwise, the job creation initially sought by this new legislation will likely not survive.