Crowdfunding offers the ability for early-stage companies to seek investments from friends and neighbors in their social networks, fellow alumni, and others who have similar affinities. These connections may help reduce fraud that comes in the form of outright theft from investors. But selling securities creates potential for fraud liability in less sinister scenarios as well.
When the Securities and Exchange Commission thinks about fraud, it is not just thinking about someone creating a fake company selling fake goods and running away to Brazil with your grandmother's investment. A lot of less obviously outrageous behavior looks like securities fraud to the SEC.
In securities world, it is fraud if you knowingly make an untrue statement of a material fact in connection with the purchase or sale of a security and that leads to a loss.
Let's try an example:
TechCo organizes to sell an innovative tech product. TechCo is founded by individuals with demonstrated experience producing the technology involved in their product. To finance the business, TechCo turns to investment crowdfunding to gauge interest and generate a dedicated following. After a very successful round of crowdfunding, TechCo gets to work. But wait, TechCo’s representation about the manufacturing capacity of their suppliers was overly optimistic, and the founders knew at the time of the offer that the manufacturer would have significant issues producing the necessary quality and quantity. As a result, TechCo’s performance is suffering because it cannot produce its products on time and investors have become angry.
Fraud or no fraud? When it comes to the SEC (and plaintiffs' attorneys) TechCo has committed securities fraud. Nobody ran away with the money, lied about their product, altered financial statements, or told untruths about anything that TechCo is doing internally. Instead, TechCo misrepresented the current production capabilities of its supplier. Because the founders knew the company would have production issues but represented that it was able to produce the product, TechCo made an untrue statement of material fact at the time of the securities offering that investors relied upon when deciding to invest.
But who would do such a thing, you ask. Well, this scenario is based on the allegations against a successfully funded project on one of the major crowdfunding sites. While securities fraud does not apply to most projects on donation-based crowdfunding sites, backers could still rely on common law fraud and wire fraud to be made whole if they are able to prove their allegations.
Entrepreneurs are regularly put into situations where their optimism is critical for gaining traction with customers and supporters. However, when engaging with investors, those same statements of planned production, potential revenues, etc., can be hazardous to the entrepreneur's legal and financial health. Not only would investors have the right to rescind and the SEC to fine the company, but the company may be prevented from engaging in future rounds of non-registered capital-raising.
This potential parade of horribles can be avoided through proper disclosure. At CrowdCheck, we are here to help. We understand the challenges faced by early-stage businesses offering investment crowdfunding and can help deliver proper disclosure to potential investors. A fully informed investor is the best defense against securities fraud claims.