Blog : The Crowdfunding Fraud Danger

by Ed Zwirn on November 1st, 2013

This one received wide bipartisan support, so you know who to blame. The persuasively named "Jumpstart Our Business Startups (JOBS) Act of 2012" mandates the creation of a setup that will enable startups and small businesses to raise capital through securities offerings using the Internet through "crowdfunding."

Crowdfunding has already been used to fund artistic endeavors such as films and musical recordings, with a specified target of funds to be raised and contributions or donations usually rewarded with a token of value, like premiere tickets or film credits, or a copy of the album when it comes out.

Starting next year, according to a proposal mandated by JOBS, the stakes are about to be raised on this fundraising method, with the promulgation of rules allowing companies to sell up to $1 million of securities annually without going through the bother of registering with the SEC, provided they disclose certain information and produce financial statements.

These sales are to be conducted either through traditional broker-dealer operations or through a new type of entity called a "funding portal."

Individual investors stand to benefit from greater access to private company offerings, which are currently restricted to "accredited" investors with a net worth of $1 million or an annual income of over $200,000. Under the new rules, people with an annual income or net worth less than $100,000 will be able to invest the greater of $2,000 or 5% of their annual income into these Internet offerings.

The advantages of these new rules are obvious: Not only will small companies be more easily able to raise funds, the current rules of the initial public offering game, which effectively ensure that small investors have no shot at the "initial" price, will be turned on their end by allowing private companies to skip going public, for the time being, and try to raise money directly from investors.

One thing seems certain: An explosion of penny stock offerings will hit the Street by the end of Q1 2014, beleaguering a regulatory structure that is at best struggling to keep up with fraud prevention and prosecution and, given political realities, is not likely to be bolstered by the hiring of any new SEC staff any time soon. Even excluding the possibility of fraud, the presence of a greater number of risky investments out there will mean that many people will get burned, many of them seriously.