Crowdfunding: Potential Legal Disaster Waiting To Happen

[galambo]

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.

... article continues ...

http://www.forbes.com/sites/ericsavitz/2012/10/22/crowdfunding-potential-legal-disaster-waiting-to-happen/

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[JDBound]

Hard to read past all the FUD here. <sarcasm> It's really shocking that two attorneys are clamoring for more litigation on this issue. </sarcasm>

1. Why post the entire text of the article?

2. How does this bear even a tertiary relationship to Bitcoin?


edit: finally 100th post!

[Stephen Gornick]

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.

tl;dr: People are too stupid to know what the best use is for their money.

They are much better off letting the professionals on Wall Street manage it for them.   If there is no competition for investment, then everyone puts their money into the same pool of equities and thus it is easier for fund managers to make a great profit, even with mediocre choices or worse, from making really risky bets.

The people should be thankful there are regulators stopping such stupidity like dumping $120/year on some stupid idea like this and thinking they will have any equity worth a dime further down the road:
 - http://www.wikispeed.com/WhatWeNeed

Instead they should be investing in only listed securities where because the listed companies file reports you can trust there is no fraud and that you won't lose money:
 - http://finance.yahoo.com/quotes/HPQ,INTC,CAT,MCD/view/dv;_ylt=AtzVn5O1xTuk6.Mfsa8sAPcLv7gF

[galambo]

Hard to read past all the FUD here. <sarcasm> It's really shocking that two attorneys are clamoring for more litigation on this issue. </sarcasm>

1. Why post the entire text of the article?

2. How does this bear even a tertiary relationship to Bitcoin?


edit: finally 100th post!

1) I have reduced it to a shorter quote.

2) Its particularly unsettling to read that you've been in a coma for the last month. I hope the damage is not permanent.

[galambo]

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.

tl;dr: People are too stupid to know what the best use for their money is.

They are much better off letting the professionals on Wall Street manage it for them.   If there is no competition for investment, then everyone puts their money into the same pool of equities and thus it is easier for fund managers to make a great profit, even with mediocre choices or worse, from making really risky bets.

The people should be thankful there are regulators stopping such stupidity like dumping $120/year on some stupid idea like this and thinking they will have any equity worth a dime further down the road:
 - http://www.wikispeed.com/WhatWeNeed

Instead they should be investing in only listed securities where because the listed companies file reports you can trust there is no fraud and that you won't lose money:
 - http://finance.yahoo.com/quotes/HPQ,INTC,CAT,MCD/view/dv;_ylt=AtzVn5O1xTuk6.Mfsa8sAPcLv7gF

Most people are too stupid to know what to do with their money.

Most people would be better off with a pension plan than a self-managed 401k.

I'd rather own shares of companies you named, than a kickstarter style startup where 100% losses are all but guaranteed, like "wikispeed."

[Stephen Gornick]

Most people are too stupid to know what to do with their money.

Most people would be better off with a pension plan than a self-managed 401k.

I'd rather own shares of companies you named, than a kickstarter style startup where 100% losses are all but guaranteed, like "wikispeed."

I see.  You are likely one of those kind of people who think my life will be better without sugary sodas sold in sizes larger than 16 fluid ounces and that, in looking out for my welfare, that practice should be banned?

[JDBound]

Most people are too stupid to know what to do with their money.

Oh. Well now that that's settled, I have to go back to the law library to invest in a few promising "fake kickstarter style startups".

I see.  You are likely one of those kind of people who think my life will be better without sugary sodas sold in sizes larger than 16 fluid ounces and that, in looking out for my welfare, that practice should be banned?

+1

[dentldir]

2. How does this bear even a tertiary relationship to Bitcoin?

Bitcoin would be an incredible method for crowdsourcing investments.  And the JOBS Act has been mentioned many times in the context of the legality of securities.

Of course, all crowdfunding under the JOBS Act has to go through SEC approved channels, so Bitcoin wont get the spotlight when Title III is resolved.  (Advertise to general public ruling).

[rebuilder]

I don't understand the comparison of crowdfunding to investment. Investors get a stake in the company they're investing in. Crowdfunders get a hand-written letter or a piece of equipment or other goods, and they know that. There's no expectation of profit.

[Stephen Gornick]

I don't understand the comparison of crowdfunding to investment. Investors get a stake in the company they're investing in. Crowdfunders get a hand-written letter or a piece of equipment or other goods, and they know that. There's no expectation of profit.

You are confusing the donation-based (sort-of) crowdfunding that Kickstarter offers and the equity crowdfunding that was signed into law in the U.S. earlier this year.

See:

U.S. CrowdFunding Bill
 - http://bitcointalk.org/index.php?topic=73858.0

[dentldir]

You are confusing the donation-based (sort-of) crowdfunding that Kickstarter offers and the equity crowdfunding that was signed into law in the U.S. earlier this year.

See:

U.S. CrowdFunding Bill
 - http://bitcointalk.org/index.php?topic=73858.0

This.  Unfortunately, the SEC is dragging their feet on getting all of its provisions formalized.

Right now the "advertise investments to the unaccredited general public rule" has yet to be ruled on.  The accredited investor ruling came out a couple of months ago I believe.

[rebuilder]

I don't understand the comparison of crowdfunding to investment. Investors get a stake in the company they're investing in. Crowdfunders get a hand-written letter or a piece of equipment or other goods, and they know that. There's no expectation of profit.

You are confusing the donation-based (sort-of) crowdfunding that Kickstarter offers and the equity crowdfunding that was signed into law in the U.S. earlier this year.

See:

U.S. CrowdFunding Bill
 - http://bitcointalk.org/index.php?topic=73858.0

Ah, I hadn't heard of this.

In that case I tend to agree with the assesment that a shitstorm is a-brewin, even though the writer appears to be a rather stodgy status quo conservative.

[BlackHeartFund]

I can't imagine they aren't right. At the moment it is all fun and games, but once a bunch of househusbands/wives start losing $10k to serial fraudsters, there will be an uproar and a huge opportunity for lawyers.

[Stephen Gornick]

I can't imagine they aren't right. At the moment it is all fun and games, but once a bunch of househusbands/wives start losing $10k to serial fraudsters, there will be an uproar and a huge opportunity for lawyers.

The market wants equity crowdfunding.  The market will get equity crowdfunding.
 
This will not be for everyone ... and probably not most househusbands/wives, but there is a segment that wants this capability,

From another thread:

The Crowdfunding ammendment in the U.S. still won't allow trading of shares purchased for one year after buying them.  The genie is aleady out of the bottle though.  Kickstarter is not an equity platform but gave people a taste of what they want -- the ability to buy and trade equity in startups.   So if they can't get that from the U.S., they'll buy bitcoins and send them to wherever this service (equity crowdfunding) is offered.

[Edit: And, of course, it would be beneficial if that capital were to remain within the country.  Thus there will be a push to relax the regulation (to allow secondary markets, to allow foreign ownership of U.S. crowdfunded equity, etc.) or to apply tiers where micro-companies, under some threshold of equity valuation, can be formed with more leeway than firms above that threshold.]

[makomk]

tl;dr: People are too stupid to know what the best use is for their money.

They are much better off letting the professionals on Wall Street manage it for them.   If there is no competition for investment, then everyone puts their money into the same pool of equities and thus it is easier for fund managers to make a great profit, even with mediocre choices or worse, from making really risky bets.

It doesn't actually matter how intelligent they are, crowdfunding investors are inevitably going to make poorer, less well-informed decisions than proper venture capitalists. It makes no sense to spend more than the maximum amount you stand to lose on investigating an investment opportunity, so the smaller the individual investments the less investigation the investors do before putting money. Even if some of the crowdfunders are actual venture capitalists they're still going to make worse investments, though they'd probably do better at it than random outsiders with no investment experience.

(I'm pretty sure this is why so many investments are restricted to accredited investors too. Before the Internet, raising money from large numbers of small investors was very expensive, so the only reason to do it was if you wouldn't be able to raise the money from larger investors - for example, because the investment was a scam and you were taking advantage of the fact that smaller investors are less able to sniff this out.)

[Stephen Gornick]

crowdfunding investors are inevitably going to make poorer, less well-informed decisions than proper venture capitalists.

Some will, and some will spot opportunity in an idea that a venture capitalist won't.

I mean seriously, what self-respecting venture capitalist would back an idea about renting out an airbed in your spare bedroom?



Not VC superstar Ron Conway, for instance ...  "am [too] jammed now" was his response.
 - http://www.foundersatwork.com/1/post/2012/10/what-goes-wrong.html

Now with AirBNB valued at more than one billion dollars a few years later shows that while venture capitalists are smart they aren't smarter than everyone else.

And for that reason, I should be allowed to learn of and invest in opportunities as I see fit.  Today's regulations are prohibiting me (an "unaccredited" investor) from gaining access to the best information out there for me to make an informed decision.

I look forward to Bitcoin helping to tear these regulations down, whether it be painful or if they crumble under their own weight.

[dentldir]

Agreed.  I was fairly irritated when I first learned about the opportunities available to accredited investors.  I think it's a possible major reason for the growing income gap.

I hope crowdfunding can provide additional opportunities to small investors.  Since crowd funded shares are  not tradeable, I think it can be very different than pump and dump penny stocks.  It will have it's challenges for sure, but nothing we need the government to protect us from.

[Rudd-O]

The crowdfunding act was written in order to ensure that crowdfunding would be a stillborn enterprise -- to limit access to crowdfunding to a few powerful players, so that the existing mechanisms of wealth transfer from poor to rich (IPOs, stock market, bonds, et cetera) remain unchallenged.

Anyone who understand why government does what it does can see this.

[Boussac]

I don't understand the comparison of crowdfunding to investment. Investors get a stake in the company they're investing in. Crowdfunders get a hand-written letter or a piece of equipment or other goods, and they know that. There's no expectation of profit.

You are confusing the donation-based (sort-of) crowdfunding that Kickstarter offers and the equity crowdfunding that was signed into law in the U.S. earlier this year.

See:

U.S. CrowdFunding Bill
 - http://bitcointalk.org/index.php?topic=73858.0

Right, the "donation-based" sort is a work around the huge barriers to entry set up by banks to prevent crowdfunding from becoming too effective too fast.
Bank-managed, regulated IPOs are a great source of profits for lots of middlemen who get insider information well ahead of the individual investors.
Crowdfunding is one of the ways out of crony capitalism.

[Herodes]

Sorry, but I don't see the problem.

1. If you're asking to be funded, make sure you do everything legit, and that you actually deliver a product/service, even if it would be delayed somehow.

2. If you invest, never invest more than you stand to lose, and do your best to check if the project is legitimate or not.

I don't really see the problem at all!