Crowdfunding: Potential Legal Disaster Waiting To Happen
10/22/2012 @ 7:00AM |810 views
Guest post written by Bryan Sullivan and Stephen Ma
http://www.forbes.com/sites/ericsavitz/2012/10/22/crowdfunding-potential-legal-disaster-waiting-to-happen/
Bryan Sullivan and Stephen Ma are attorneys with Early Sullivan Wright Gizer & McRae, a Los Angeles-based entertainment and business law firm.
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.
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http://www.forbes.com/sites/ericsavitz/2012/10/22/crowdfunding-potential-legal-disaster-waiting-to-happen/
