October 22, 2012
Crowdfunding: Potential Legal Disaster Waiting To Happen
By: Stephen Ma JD '95, Bryan Sullivan
In theory, crowdfunding appears to be a great way for people with good ideas to take advantage of the Internet. Throw your idea online and a slew of like-minded investors will give you money to bring your idea to fruition. Artists have been doing it successfully for a few years on Kickstarter to fund creative projects, and teachers on Funding4Learning to fund education projects. To bolster this burgeoning concept, in April 2012, the United States Government passed the Jumpstart Our Business Startups (JOBS) Act, which contains crowdfunding provisions to help these entrepreneurs raise funds. Taking a closer look at crowdfunding reveals a system fraught with peril that will likely lead to an increase in litigation.
The JOBS Act allows any Zuckerberg wannabe with an idea to skirt securities laws to attract equity investors. Anyone, be it an entrepreneur or corporate entity, can raise up to $1 million from investors putting in no more than $10,000 each, or no more than 10% of their income, whichever is less. That amount increases to $2 million if the crowdfunding entity supplies the “crowd” investors with audited financial statements. Under this system, a crowdfunder will not have to disclose financial statements until it has more than 1,000 shareholders; traditional, full regulatory SEC disclosure rules kick in at 500 shareholders. Essentially, it allows startups to raise up to $50 million in an IPO without having to comply with the SEC’s full regulatory structure and related fees. Yes, you read that correctly – and we can only guess the disasters and class actions resulting from the future of crowdfunding.
William Galvin, Secretary of the Commonwealth for Massachusetts, was so concerned about crowdfunding risks that in August he sent a letter to the SEC identifying crowdfunding’s many pitfalls. The letter is spot on. Mr. Galvin writes:
While this picture of the potential benefits of crowdfunding is undeniably attractive, as regulators we must be vigilant that the exemption will not become a tool for financial fraud and abuse…Unscrupulous penny stock promoters have used misrepresentations to market obscure and low-value stocks to individuals, often through pump and dump schemes. These kinds of fraud operators have not gone away.
The risk for fraud is far more real than crowdfunding participants or the SEC want to admit. By its nature, crowdfunding appeals to a less sophisticated investor who will invest in any project they think will be the next Facebook. Typical crowdfunding investors, even with basic disclosure requirements for participation, won’t have the investment savvy to determine whether an investment is real or a fraud. After all, many fraudsters and scam artists are brilliant at presenting their investments on paper to meet the very basic disclosures of crowdfunding. Just look to Charles Ponzi and Bernie Madoff, both appearing as entirely legitimate businessmen, who were able to dupe sophisticated investors and, in Madoff’s case, the SEC itself. The bottom line is that, while unintentional, crowdfunding is tailor made to assist fraudsters in duping unsophisticated “investors.” Indeed, even if the SEC, in an attempt to avert fraud, increases the amount of disclosures, the individual investment contributions will still be too small for law enforcement authorities to expend resources to investigate or for attorneys to take on a fraud lawsuit, unless of course a contingency business litigator can bring a class action. Galvin likely would agree with this concern since he specifically noted:
The typical crowdfunding offering will be small (many may be far below $1 million), so there is the great risk that these offerings will fly under the radars of many regulators.
Even more disconcerting is the impact of social networking and potential fraudulent schemes through crowdfunding. On this issue, Galvin writes:
We expect that various kinds of social media will be used in tandem with crowdfunding. This may involve forums or message sharing through a portal’s website; it may involve current social media channels (especially Twitter and Facebook); and is likely to involve new channels and technologies…There is the great risk that pump and dump operators will use social media to improperly promote these offerings.
Even if the particular crowdfunding investment is legitimate, the entire process will still be fraught with risk since unsophisticated business people will likely use crowdfunding to raise money for their new enterprises. After all, if they were sophisticated, they would probably pursue traditional routs to raise money such as preparing an airtight business plan for the full execution of their idea displayed in a “deck” for potential investors who vet the likelihood of the venture’s and its participants’ success. Many crowdfunding investors will not be able to provide useful feedback since many of them will be seeking a “get rich quick” scheme; and they will be sadly disappointed when the business they invest in fails since many do within the first 5 years. For every Facebook, there are ten Friendsters.
Such business failures will inevitably result in litigation as people attempt to recoup whatever money they can from a failing crowdfunding entity. When they accept the inability to recover from the judgment-proof (due to lack of personal funds) individuals behind the crowdfunding entity, crowdfunding losers may target the U.S. government and the JOBS Act for remuneration just as some did in the wake of the Madoff scandal when, among others, The Litwin Foundation, a charitable foundation, sued the SEC for blowing “countless opportunities” to stop Madoff.
While crowdfunding requires certain minimum disclosures, people seeking funds via crowdfunding portals will not have to adhere to the same the level of disclosure as normal businesses with a prospectus. Many lawsuits against crowdfunding entities may likely have merit since these entities won’t have the business experience or savvy to make even the minimum appropriate disclosures or hire an attorney to guide them through disclosure drafting and execution. This concern was raised by Galvin as well:
In this segment of the market, company information may be limited or simply false, and investors typically lack investment sophistication and are often insufficiently cautious.
Entrepreneurswho use crowdfunding are also at risk. Crowdfunding puts the ideas of many early stage entrepreneurs at risk of being stolen by better-funded investors or large corporations. In the traditional investment model, entrepreneurs can use non-disclosure and non-circumvention agreements to protect their ideas and business plans. However, many crowdfunding enthusiasts will lack the expertise and knowledge to properly execute and implement such protections. Moreover, if their idea is stolen, many crowdfunding users will lack resources to fully litigate against a better-funded adversary who lifted the idea.
In order for crowdfuding to work without disastrous results, the government will have to, among other things, mandate that entrepreneurs seeking funds provide as much disclosure as possible, clearly define investor rights, and possibly commit to a specific schedule of financial reporting or business updates to ensure proper communication between the crowdfunding entities and investors. Without this, people receiving the capital contributions can “disappear,” and investors will be left wondering what is going on and where their money is being spent. The SEC would be wise to take heed and carefully read Galvin’s letter to avert such disasters, or this could be another instance of the U.S. government attempting to show the public it is forward thinking while neglecting to think ahead.
Ultimately, the likely scenario is that crowdfunding will lead to, perhaps, one Google and thousands of Friendsters. And plenty of lawsuits.
Bryan Sullivan and Stephen Ma are attorneys withEarly Sullivan Wright Gizer & McRae, aLos Angeles-based entertainment and business law firm.