When Crowdfunding Goes Bust: Fraud and Consequences

Crowdfunding sites like Kickstarter are increasingly being used for great things. They help bright entrepreneurs raise funds to create what they wouldn’t have been able to through traditional money funding methods. Currently, most of the Kickstarter campaigns that successfully meet their fundraising goals reward the investors with a finished project; however, some projects fail due to overpromising or simply fraud.

Overpromising- Sometimes people dream too big. In fact, only 25% of successfully funded Kickstarter campaigns finish on time (although 75% finish within eight months of their projected finish date). Most run of the mill coders are not going to be the next Blizzard (the Company that owns World of Warcraft, an insanely popular online subscription game) overnight. In fact, many creative people, while good at creating, have no business acumen to help them reach the goals they’ve set. One example of this overreach is Erik Chevalier, would-be creator of a board game entitled “The Doom That Came to Atlantic City.” His kickstarter campaign was wildly successful, and despite only asking for $35,000 he received over $122,000 from investors. Unfortunately, he underestimated the time, cost, legal issues, and myriad other complications that come with designing and selling a game, and he terminated the project after spending most of the money. He has posted updates on his Kickstarter page, explaining to his backers that he intends on refunding all of the money per the Kickstarter Terms of Service, but does he really have an obligation to do so?

Fraud- Sometimes people dream too big, and sometimes people are thieves from the get go. Kickstarter works because of the implicit trust between the parties involved. If you donate this small amount of money, I will give you this small reward in return. Undermining this whole community funding idea however, are the fraudsters and thieves that are out to make a quick dollar. Not much information is available as to how many fraudulent Kickstarter campaigns have been created because Kickstarter does not keep or publish that information; however, Forbes reports that no fraudulent campaigns have successfully been funded thus far. There are some notable examples of fraudulent accounts, including what could have been a $120,000 free-range beef scam that was brought to light by the social networking site Reddit mere minutes before being successfully funded. Several other fraudulent accounts have been made, including a copycat scam where the scammers re-launched a legitimate but failed kickstarter campaign for blue-tooth enabled controllers in order to make their scam look authentic. A third type of scam that has surfaced on Kickstarter combined the two methods from above: copying/stealing artwork from a legitimate company to add authenticity to a video game called Mythic that was never going to be created. Fortunately, none of these scams were ever successfully funded, and the investors did not lose their money but if for some reason, the fraud is not discovered in time, backers can do little to get their money back thanks in part to Kickstarter’s laissez-faire approach to settling disputes.

Kickstarter Terms of Service and Uncovering Fraud by Self-Regulation- With the growing opportunities for abuse in the Kickstarter community, one would think that Kickstarter would protect the interests of those providing the money for the campaigns (Kickstarter takes a generous commission before turning over the funds). In fact, the opposite is true. On Kickstarter’s Accountability page, it references its Terms of Service for those that start campaigns. The Terms of Service include a clause that states:

If your project is successfully funded, you are required to fulfill all rewards or refund any backer whose reward you do not or cannot fulfill. A failure to do so could result in damage to your reputation or even legal action on behalf of your backers.”

“All dealings are solely between Users. Kickstarter is under no obligation to become involved in disputes between any Users, or between Users and any third party. This includes, but is not limited to, delivery of goods and services, and any other terms, conditions, warranties, or representations associated with campaigns on the Site. Kickstarter does not oversee the performance or punctuality of projects.”

“Kickstarter does not offer refunds. A Project Creator is not required to grant a Backer’s request for a refund unless the Project Creator is unable or unwilling to fulfill the reward.”

Essentially, Kickstarter passes the buck onto the investors to self-regulate and make sure that they are spending money on legitimate projects, because Kickstarter won’t step in and mediate if there is any sort of dispute. The Accountability page clearly places the onus on the backer to decide the worthiness and validity of a project; a sort of caveat emptor approach. Kickstarter further distances itself from the relations between its users by using a third party payment processing company, Amazon Payments, which holds all information on both parties that could be used to hold the project creators accountable. As things stand now, if a fraudulent project were to be successfully funded and Kickstarter turned over the funds to the scammer, there would be very little recourse for the buyer. Sure, you could sue the project creator, but you would have to figure out who that person is and decide whether it is worth the attorney’s fees to sue someone for such a small amount of money. Kickstarter sure isn’t willing to help.

As crowdfunding becomes a larger part of how companies and individuals fund their projects, consumer protections are going to need to be implemented. Kickstarter should not be allowed to sit back and watch as users of its site get scammed because it doesn’t even employ workers to check the validity of a new project. These protections will be hard to implement however, because drawing a distinction between someone that legitimately used the money for a project but failed and a person that took the money and ran is not something easily defined. We do not want to penalize those with the entrepreneurial spirit who simply could not make their dream a reality. We only want to penalize those that would abuse the system that up until now has worked quite well.  It looks like this is a bridge that we quickly need to cross.

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~ by kchab on September 15, 2013.

8 Responses to “When Crowdfunding Goes Bust: Fraud and Consequences”

  1. Crowd-funding is about bringing the small business dreams back to Middle America by removing the costly hoops one must jump through in order to make that dream a reality. Therefore, in my opinion any attempts at regulating crowd-funding by and through the same governmental commissions which plague our traditional system, will come at the price of sacrificing the ideals and goals of crowd-funding—connecting small business entrepreneurs to small time investors. In taking back the reigns from large corporations, who are backed by even larger investment firms, is not without its own risks and growing pains. Caveat emptor may seem harsh, but how can we claim the protections of the SEC while simultaneously pushing away from corporate America?
    Recognizing this inherent opposition, we must nonetheless find a workable deterrent and possible avenue of retribution against those who would use crowd-funding for fraud. Instead of relying on current or proposed legislation, which will promote the same type of undue costly regulations crowd-funding was designed to overcome, why not turn instead to the basic principles of common law fraud. Skeptics will tout the “impracticality” of this application, citing the nominal amounts each investor puts up as insufficient incentives to promote bringing suits. Skeptics also dismiss the entire field of “class actions” developed as an appropriate counter balance to such situations. Merely dismissing these valid legal recourses available to investors without more is insufficient as a means of justifying more regulations.
    In fact, the current restrictions of the JOBS Act ought to be reconsidered altogether, keeping in mind the true intent behind the concept. See Mcllwain & Murray, Is Crowdfunding to be Crowdless?, The Hill’s Congress Blog (05/13/13 04:30 PM ET), available at http://thehill.com/blogs/congress-blog/economy-a-budget/299341-is-crowdfunding-to-be-crowdless (discussing ways to reduce the cost of capital through crowd-funding in order to make it more competitive). With every new technology and business venture comes a wave of growing pains in the form of law suits and legislation. However, we will never be able to break away from traditional models if the same legislature which created those models form the rules and restrictions on the new technologies as well.

  2. I wholeheartedly agree with hkruzyk. I think that Kickstarter is a wonderful way to help great ideas take off. Kickstarter seems to me like a virtual tip jar for inventions. The same way that you would donate to a musician you appreciated on the street, you can give money to someone who you think has a great idea. While fraud and overreaching are certainly foreseeable consequences to such a movement, I think that over-regulating Kickstarter could lead to limiting access to the average citizen. There has already been some criticism thrown towards celebrities who use kickstarter. ( http://www.nytimes.com/2013/05/26/magazine/was-it-ethical-for-zach-braff-to-take-to-kickstarter.html?_r=0 )
    Additionally, I think that the donors should recognize that this is just an act of charity. Continuing with my tip jar metaphor, how would you feel if you found out your money went to support a drug habit instead of producing a record? You would probably shake your head and move on, not bring a lawsuit. The amount is too insignificant, and it is given without too much expectations. On kickstarter, there is even more protection than of someone who donates to a musician on the street. You have a contact link to put pressure on the donee and monitor his progress. This, to me, defeats the large incentive for fraud. I am a part of the Reddit community, and I appreciate the power of community to not only let it grow, but to let it die. Forums and comments available on Kickstarter or on other sites allow the users to self-regulate potentially fraudulent or unproductive ventures.
    As far as potential remedies goes, I am unsure on where I stand. I think that the possibility to sue for fraud might allow for bigger donations. I also think that the costs that class actions might bring could potentially deter unethical kickstarter conduct. I still worry that these potential liabilities might scare off your average kickstarter and we will be left with an elite group of idea generators that probably could receive funding a number of other ways.

  3. Unfortunately, history teaches us that regulations are needed because if fraud can be committed, it will be committed. While common law fraud may seem as if it could provide a remedy, you must remember that the common law development of fraud was very fractured, leaving gaping holes and inconsistent application to similar behaviors. Investment transactions outstripped the ability of law to kept investors protected. That really is the root of the problem. With the advent of new technology comes new opportunities for fraud. The question becomes, can lawyers think ahead enough to imagine how law may need to respond next year, not just last year, to the new opportunities for crime that technology creates.

  4. The ever-present risk of fraud, as illustrated in this post, reinforces my belief that some government oversight is necessary in equity crowdfunding. Generally, backers on Kickstarter choose to support projects that peak their own creative interests. Further, creators on Kickstarter do not relinquish any ownership in their projects, and backers do not profit from their pledges to said creators. The driving force behind Kickstarter’s success is the collective creativity of project creators and the collective enthusiasm of backers. In an effort to mitigate risk to backers of a project, Kickstarter uses an all-or-nothing approach to funding, where project creators only receive the money collected if the project has met its funding goal.
    In order for equity crowdfunding to succeed, investors must be given incentive to invest their money in a business. In calculating risk, an investor will want to assess his/her potential loss and determine the probability that such a loss will occur. In order to make that determination, necessary business disclosures must be made available to prospective investors. Unlike backers on Kickstarter, investors will only open their wallets if there is a strong likelihood that they will profit from their initial investment. I believe government oversight – e.g. JOBS Act – serves to mitigate risks in the marketplace, and fosters further investment.

  5. The Kickstarter situation is undoubtedly a sticky one. On one hand, I am inspired by the concept and the way it enables creative and entrepreneurial people to pursue their dreams and projects. I have even participated in a Kickstarter campaign where a Marine Corps officer made handmade pens out of stone and I received my pen on time. (Like to actual campaign – http://www.kickstarter.com/projects/1169387873/mason-pens-etch-your-name-in-stone) But on the other hand, I recognize that this type of forum is ripe for fraud and some type of government regulation is probably needed. (Especially considering that Kickstarter campaigns have now raised over $700 million – http://www.kickstarter.com/help/stats)

    I agree with Ariana that the exchange should be viewed more as a donation or tip. It should be clear to funders that this is not a normal e-commerce exchange where you pay money in exchange for a product. But that does not mean that people committing fraud should be able to get away with it.

    I also think that Kickstarter should not be able to just pass the buck and claim zero responsibility for fraudulent campaigns. Particularly because Kickstarter is a for profit company. Maybe regulation could require Kickstarter to take on some sort of liability, this would probably cause Kickstarter to investigate the background of creators. At the very least Kickstarter should verify the indentity of creators.

  6. There is little doubt that the internet has emerged as the most important arena in which the economy functions. Because of its unthinkable breadth, the internet brings people together on a scale that didn’t exist even fifteen years ago. This fact brings with it new and exciting opportunities for entrepreneurs and investors alike. But given the human condition, crowdfunding also serves as a new forum where those can engage in fraudulent behavior. So, while in theory it may be appealing to let this facet of the market handle itself, in reality, doing so would jeopardize the system itself as well as each individual investor and entrepreneur .

    I would echo those of my colleagues who have argued that governmental oversight over crowdfunding is both appropriate and necessary. In the field of economics, people are said to be rational maximizers of self-interest. They will act in such a way that makes them better off. This is not a bad thing when people play by the rules. However, those who utilize crowdfunding as a source of credit often do so remotely with no particular ties to one or any of the investors. Such an environment could actually act an incentive to act fraudulently because it provides the criminal free reign to act in his or her best interest AT ALL COSTS and without any real threat of investor oversight. Investing locally could help to mitigate the risk to the investor, but for business dealings occurring remotely from great distances, governmental oversight is the only way to create a legitimate system.

    Transparency is one way to way to address this. Fund raisers should be required 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. (From http://www.dandodiary.com/2012/08/articles/securities-litigation/concerns-about-crowdfunding/)

    In my opinion, such mandates would act as an incentive, not disincentive, to invest and engage in crowdfunding.

  7. I think that the current Kickstarter model, donations to projects that you are interested in and support, is a fantastic idea. The cases of attempted fraud do not surprise me because whenever there is an opportunity to make an easy bukc illegally there will always be someone willing to take advantage. What troubles me the most about the confirmed cases attempted fraud is that the basic of structure of Kickstarter is donations, I can only imagine the increase in attempted fraud that will follow the increase of money exchanging hands on Kickstarter when money can actually be made. Kickstarter’s terms of service clearly indicate that they have some serious concerns about their potential legal liability, because they are doing everything in their power to separate themselves from any responsibility for the actions of the creators. I believe that if the government is going to pursue the Crowdfunding policy, it must make sure that it provides sufficient regulatory oversight (although reduced to eliminate unnecessary red tape). I personally believe that a private cause of action (with possibly special class action clause and an attorney’s fees provision) should be added in order to supply wronged investors with an effective means of regaining lost investments.

  8. The risk that present for individual investor is not that high as many appear to be making it out to be. That is, with the proposed requirements in the JOBS Act, lowered bars though they are, still give a high level of protection to people looking to enter the investment arena with ideas a businesses that they have personal interest in. The upper limits imposed are sufficient to curb any high magnitude losses that an investor may face after throwing their hats, and money, into the crowdfunding ring.
    The important thing here is education. Websites like Kickstarter and others that provide the unique platforms for this new crowdfunding endeavor should be required to post explicit disclaimers and even require new potential investors to confirm that they are well aware of the risks involved in this structure. The metaphor of the tip jar is completely on point. Investors must be aware that this is a potentially dangerous field for them and that they are wary of the inherent risk. If you don’t look both ways before crossing the street, it’s largely your own fault for getting hit.

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