They Told Us This Would Happen

Crowdfunding websites –fundraising sites that allow private companies to run investment campaigns soliciting money from the general public– are seeing an increase in fraud. Scammers have taken to crowdfunding websites, offering anything their imaginations can devise to raise money.

They often pitch inventions that don’t even work.

In other cases, fraudsters don’t follow through with their production plans and simply keep the money they raised. We’re not talking just a few dollars, either, in many cases it’s been several hundreds of thousands of dollars.

It’s something crowdfunding critics have warned us about for a long time.

You may have heard of the palm-sized food scanner that supposedly tells you the nutritional contents of any food you are eating?

After raising nearly $400,000, the gadget’s maker TellSpec out of Toronto admitted the device – which it previously claimed was successfully tried, tested and proven – needs to be reconfigured because it doesn’t work as promised.

Then there was the watch-like device that supposedly measures your calorie intake, level of hydration, and stress level, which technicians have revealed cannot be done.

The device’s maker Healbe Gobe out of Moscow falsified more than just its scientific data but even its location, claiming to be in San Francisco. Needless to say a workable device has yet to be produced despite $900,000 raised – in a still ongoing campaign!

And who can forget the outrageous claims of a mind-reading headset that allows you to understand your dog’s thoughts? “No more woof,” the makers proclaim. Except that one last woof you hear as your money gets whisked out of your hands.

“That settles it then. Crowdfunding is a sham, and it must be done away with,” critics might rule. But maybe that’s going a little too far. The bath water may be dirty, but there still is a healthy baby in it.

Let’s take a look at some of the benefits that crowdfunding has to offer, try to pin point where things seem to be going wrong, and then try to find a solution for it.

Plenty of Success Stories

Internet fundraising campaigns targeting the general public date back to the beginning of the internet in the mid-1990’s, when musicians raised money from their loyal fans to finance concert tours in exchange for tickets; essentially pre-ordering their seats. Movie companies and record producers have also raised capital for films and albums that would otherwise never have been made for the lack of traditional funding available to them.

As crowdfunding websites gained more recognition, private companies have been able to raise funds to develop successful products including:

• Hidden Radio – a small, sleek, portable speaker for music and internet conferencing.

• SkyBell – a camera system with audio and microphone that works through a smartphone app that allows you to answer your doorbell even when you’re not home.

• Pebble – a wristband that sends you instant notifications of phone calls, emails or other app triggered alerts which you preprogram.

• Oculus Rift – a head-mount display for virtual reality 3-D gaming.

• The Scanadu Scout – a wearable medical “tricorder” (familiar to Star Trek fans) which reads your vital signs and wirelessly sends them to your smartphone for a diagnosis within seconds, alerting doctors of a heart attack, seizure or other medical episode in real time, or informing parents of their child’s state of health while apart.

Inventions have been engineered, shops and restaurants have opened, and artists have created masterpieces in film and music – all thanks to a series of deregulations in capital fundraising requirements that made crowdfunding possible.

The Doors Open Wide

Deregulation was crucial in taking crowdfunding to the next level. Previous restrictions on crowdfunding limited what entrepreneurs could offer in return for the money raised, such as a copy of the finished product or other merchandise. In an effort to spur the growth of start-up private companies and job creation, the “Jumpstart Our Business Startups Act” (aka JOBS Act) was passed by Congress and signed into law in 2012, lifting a lot of the restrictions on the solicitation of investment money, including:

• Increasing the amount of money a private company can raise or the number of shares it can offer to the public without requiring registration with the SEC.

• Allowing private companies to advertising fundraising campaigns and sell shares to the general public (aka Title II, enacted in September 2013), though only to accredited wealthy investors.

• Allowing private companies to sell shares to non-accredited public investors (aka Title III, due to be enacted later this year).

With each lifting of a restriction, the door to investment solicitation and fundraising was opened wider and wider.

Even before Title III comes into effect, entrepreneurs and private companies can already advertise their projects on crowdfunding portals, offering merchandise or products in exchange for investments from anyone, accredited or not.

It is indisputable that reduced regulations make possible all those legitimate fundraising campaigns that resulted in jobs being created, entrepreneurs being rewarded, and investors being equitably compensated.

But this wide open door is letting in more than anyone bargained for. Make it too easy to get inside and you’ll get the thieves and poachers who have no intention of playing by what few rules still remain.

Where the Problem Lies

It is commonly believed that simply putting up a few disclaimers on crowdfunding websites is enough to keep the program running smoothly. As long as investors are aware that there might be fraud, the onus lies entirely upon them.

This is the direction that crowdfunding portals have taken. The disclaimer on crowdfunding portal Indiegogo has received a great deal of criticism lately for not taking a strong stance on known cases of fundraising fraud at its site:

“If we find fraudulent contributions on your campaign, we may remove them from your campaign Funds and Fulfillment pages. We may also ask you for more information, if we determine your campaign to be a high fraud risk.”

Note that Indiegogo doesn’t promise it will act to investigate or remove fraud; it just warns that it “may”. Similar disclaimers can be found at other crowdfunding portals.

The problem is that sites must devise their own fraud detection standards and implement their own procedures to get rid of fraud. We now have a number of different standards and no guarantee that anyone is enforcing them.

In most cases, the portals do not have the resources to conduct investigations themselves. They certainly would not have the funds to fight any court battles that might arise if an accused fraudster ever challenged their ouster.

Then there is the issue of lost revenue. The more campaigners they have on their site, the more money the site earns. This prompts the portal to simply look the other way at potential fraud. It is simpler and cheaper for crowdfunding sites to put up “investor beware” disclaimers that relieve them of any policing responsibility.

But taking this “investor beware” approach defeats the entire purpose for which the JOBS Act was originally intended – namely to enable entrepreneurs to approach the public for investment money to fund their startups and create jobs. For if there is no confidence in the system, and if there is a growing fear that investors are unprotected, they will simply stop investing in such projects.

There is only one solution… going back the other way, just a little.

Some Supervision Required

Crowdfunding campaigns and the stock market are quite comparable to one another.

Brokers caution their clients on the dangers of stocks, and investors assume all the risks. A broker is not responsible if a company listed on an exchange misappropriates investment money and perpetrates fraud. The broker is just the middleman between companies and investors, a position replicated by crowdfunding portals who simply introduce investors to entrepreneurs.

Thus, the solution to cracking down on fraud in the crowdfunding space is not necessarily to force the portals to step up their policework. As brokers, it really isn’t their job.

So let’s make the companrison between stock market investing and crowdfunding investing complete by introducing an agency that would do for crowdfunding what the SEC does for Stock markets.

Yes, another regulatory body.

While the JOBS Act does not require participating private companies to register with the SEC, it should require them to register with this new crowdfunding regulatory agency. The only difference, of course, is that the crowdfunding agency would be operating under the laxer rules that the JOBS Act makes possible. The agency would also have the power to investigate any reports of fraud as the SEC does, and to shut down any illegitimate campaigns it finds.

While this does close the barn door just a little, it would keep out only the fraudsters, as legitimate fund raisers who meet the other requirements would still be able to come on in. It would also result in more investors coming in as confidence in crowdfunding campaigns is restored.

Joseph Cafariello