Crowdfunding May Increase the Likelihood of Fraud

On April 5, 2012, President Obama amended the federal securities laws when he signed the Jumpstart Our Business Startups Act (JOBS Act). The purpose of the JOBS Act is to help small businesses raise money in a bad economy. The provisions amended are referred to as the "crowdfunding" amendments and experts opine these amendments may increase the likelihood of securities fraud.

What is Crowdfunding?

Essentially, the JOBS Act will allow companies to engage in early-stage funding through previously prohibited public solicitations and without making certain onerous disclosures to investors. The JOBS Act also will make securities registration requirements less onerous for companies. Prior to the JOBS Act, companies raising money through private securities offerings only were allowed to solicit investments from accredited investors, i.e., investors with a net worth of $1 million or more, excluding the value of their primary residence or investors with an income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year. The accredited investor requirement was an attempt to ensure that investors had at least some limited knowledge of risk as well as the ability to afford the potential losses. Now, companies will be able to sell equity interests to lower income investors and lower net worth investors without the same level of protective restrictions and obligations that previously were required.

Fraud on the Crowd

Experts are concerned that crowdfunding as a means of selling securities allows for more abuse and increases the potential for fraud. Crowdfunding is premised on obtaining funding through the internet. Experts are concerned that the internet will be used to cheat individuals out of their money by asking them to fund illegitimate businesses. Because of the less stringent or non-existent disclosure and reporting requirements and the internet's anonymity and reach, investors may not personally know the business owners and may not be in the same geographic area so they may be unable to confirm that the business is in operation.

For example, in August of this year, the Massachusetts Securities Division charged a man for a crowdfunding scam, alleging he cheated 20 investors of approximately $150,000. Due to misrepresentations that the man made, investors thought they were investing in an online gaming site, but really they were just funding the man's personal bank account.

Experts also are concerned that defrauded investors will not be able to recover their lost monies. While investors would be permitted to pursue legal action if they have been deceived, because of the relatively small dollar amounts that typically would be invested by investors, the amount of money at issue may be large enough to make a lawsuit economically feasible. Moreover, many of the entities and individuals that engaged in the crowdfunding fraud likely would be uncollectible. As such, even a successful lawsuit brought be defrauded investors may not result in a recovery of investment losses.

The Securities and Exchange Commission (SEC) has yet to adopt the rules that will help implement the JOBS Act. When and if the SEC does effectuate the JOBS Act, investors would be wise to be very careful when considering investing in a company that is raising money through crowdfunding.

Article provided by Dimond Kaplan & Rothstein PA
Visit us at www.dkrpa.com


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