Among the more noteworthy aspects of the recently enacted Jumpstart Our Business Startups (JOBS) Act are the legislation’s crowdfunding provisions. These provisions are intended to allow small businesses a new means of raising funds directly from investors using the Internet. But many commentators are concerned about these provisions. Among other things, some have noted that the transaction costs that the Act required fund-raising companies to incur may deter start-ups from using crowdfunding. And a number of other commentators have raised concerns about fraud.
The possibility of crowdfunding fraud, and some suggestions about possible means of preventing the fraud, is discussed in an August 22, 2012 Thomson Reuters News & Insight article entitled “Crowdfunding: Small-Business Incubator or Securities Fraud Accelerator?” (here), written by Lyndon Tretter of the Hogan Lovells law firm. The author notes that many commentators are “concerned that the potential for fraud on the crowd may outweigh the promise of new financing for legitimate startups.” Among other reasons for these concerns is that with crowdfunding, “the risk of fraud increases because the pool of investors includes those who have no personal relationship with the business owner and who may be geographically remote from and thus unable to oversee the business itself.”
The author notes that, while the JOBS Act expressly provides investors the opportunity to seek a recovery if they believe they have been misled, because each crowdfunding investor will only have a relatively small stake in the enterprise, they may lack the incentive or resources to pursue a recovery. Even in the aggregate, the investors’ collective investments may not be enough to attract the interest of the traditional class action attorney, so the civil liability provisions “may not prove to be very useful in practice.”
To address these concerns, the author proposes that the SEC promulgate rules designed to address the likeliest sources of abuse: the promise of unrealistic returns on investment and the ability of insider to use the money they raise for themselves of their own benefit. The author specifically proposes that the SEC use its rulemaking to require the fund raisers to state the personal investments that the insiders have made in the enterprise; require particularized disclosure of the anticipated use of the offering proceeds; require disclosure of any salary, benefits or compensation the issuer is expected to pay in the next year; and require disclosure of any transaction with a related party that the issuer anticipates in the coming year. The author also suggests that the SEC encourage investors to consider the benefits of investing locally, under circumstances when investors might have a better chance to monitor the company directly.
The author also proposes augmenting the JOBS Act’s civil liability provisions, among other things by allowing claimants to recover their attorneys fees incurred in pursuing a claim if the claimant can show that an individual insider intended the issuer’s disclosure to be misleading.
I think the author has done a commendable job of trying to think of ways to protect investors and to try to make the crowdfunding less susceptible to fraud. Unfortunately, it seems inevitable that there will be those who abuse the crowdfunding mechanism. It is bad enough that the crowdfunding procedure specified in the JOBS Act will be cumbersome and costly, as I noted in a prior post. But if there are highly publicized instances where crowdfunding is abused and investors are defrauded, prospective investors may be deterred altogether, and in the end the process could not only be costly but ineffective.
It will be interesting to see the SEC’s rules when they are finally released. But it will be even more interesting to see what becomes of the crowdfunding mechanism – in particular, what kinds of companies use the process, whether they process becomes a standard means of fundraising, and whether or not there are problems with fraud or other abuse. I wonder whether with all of the potential problems crowdfunding will prove to be an important and useful innovation or a just another failed initiative.