For many entrepreneurs and investors, Investment Crowdfunding holds great promise: it will open new channels to finance capital-starved businesses by democratizing investments. Despite this potential, many have never heard of Investment Crowdfunding (we will do our part to correct that!). And some who have heard about Investment Crowdfunding disparage these upsides with a more sinister view. Their discontent stems primarily from fear of the unknown and is suggestive of other times when enfranchisement expanded (think of voting rights, equal employment, and opening of executive suites). Skeptics worry that allowing ordinary people to invest directly in small businesses threatens to empower those who are ill-equipped to handle new responsibilities.
Naysayers warn of rampant fraud under Investment Crowdfunding. They fear investors will fall prey to the unscrupulous. Who better for a hustler to target, the reasoning goes, than “unsophisticated” investors, unaccustomed to the freedoms enabled by the JOBS Act?
The concern is understandable and we take it seriously. We all need to be on guard against those intent on victimizing the unwary.
But let’s put this threat into context and examine the remedies already embedded in the law.
Detractors worry that online intermediaries (“portals”) are vulnerable to fraud. So let’s explore the reality. As with all legitimate portals, iCrowd will be regulated by the Financial Industry Regulatory Authority (FINRA), the regulatory organization that oversees the brokerage industry. FINRA sets minimum capital requirements and mandates that their members secure fidelity bond coverage to insure against fraud by its employees. When the SEC issues its final rules allowing Investment Crowdfunding to proceed, you will be able to verify that portals are registered with FINRA. If you find an unregistered portal, stay away. It will be acting outside the law.
What about the companies raising capital by selling securities to the crowd? Aren’t they a risk for fraud? Provisions in the JOBS Act and the transparency of Investment Crowdfunding mitigate the risks of this type of fraud. Broadly, protections fall into four categories: prevention, detection, impact management, and punishment.
The JOBS Act requires portals like iCrowd to help prevent fraud. The crowdfunding regulations that the SEC must establish will include standards for background checks of company managements and owners. The background checks may reveal those with past records, but the checks’ effects will be more potent than that. The submission of personally identifiable information will pierce the anonymity that conmen crave. Requiring issuers to provide personal information is intended to deter fraud.
But that is not the sole measure intended to prevent fraud. Investment Crowdfunding campaigns are all-or-nothing, meaning that capital raisers must meet the entirety of their preset target funding levels or no money changes hands. And transactions occur only after at least a 21-day notice period for investors to review management information. The task of a fraudulent issuer is complicated by the challenge to convince not only one individual or even a few, but instead to convince an entire crowd to fall for the scam.
“Crowd diligence” is one of the most powerful assets in Investment Crowdfunding. And it is an important tool to detect fraud. Platforms like iCrowd will promote transparency in the offerings on its site. That means not only that companies will undertake full disclosure, but also that investors’ comments about offerings will be visible to all. Scams require opacity, where individuals remain in the dark about the facts that reveal fraud. But expect that the crowd will contain knowledgeable investors—those acquainted with issuers’ character or with a personal knowledge of the business. Investors sharing such knowledge can fracture a potential fraud.
How does crowd diligence work in practice? Analogies with Investment Crowdfunding in the U.S. are imprecise, but we have an example of a fraudulent fund-raiser on Kickstarter. Mythic, purportedly a roll-playing-game developer, sought funds on Kickstarter, boasting of a large team of experienced developers with a successful new game in the offing. The crowd recognized that Mythic fabricated the backgrounds of its team and represented other developers’ work as its own. The crowd shone a light on the scam and it shriveled. On a broader scale, the Australian Small Scale Offerings Board (ASSOB) has been crowdfunding since 2005. To date it appears there have been no frauds in over 100 successful campaigns.
Nonetheless, fraud prevention and detection are not assured. With that in mind, the JOBS Act contains provisions to minimize the impact when fraud occurs: the law imposes limits on the amounts individuals may invest in crowdfunded offerings. This limits potential losses to a low level relative to income or net worth, thereby preventing the catastrophic losses that we see when fraud occurs with other forms of investment.
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