Lawsuit by State Attorney General

Crowdfunding on the major sites like Kickstarter and Indiegogo has been relatively free of fraud. I believe this is because the crowd on the major sites does a commendable job of identifying bad apples and warning prospective funders away from them.

Government watchdogs like state attorneys general have not been required to bring very many investigations or lawsuits against fundraisers on the major sites. This relative dearth of fraud is remarkable given how popular crowdfunding has become.

However, the Washington State AG has initiated a lawsuit against Ed Nash and his company Altius Management. They raised money on Kickstarter to deliver a playing card game. They raised over $25,000, exceeding their goal. But they have not delivered and have ceased communicating with backers.  "Kickstarter fraud: Washington files first consumer protection lawsuit involving crowdfunding," geekwire, May 1, 2014  http://www.geekwire.com/2014/attorney-general-asylum-playing-cards-crowdfunded-project/

Rewards-Based Crowdfunding Stimulates the Economy

The Pebble watch is about to ship.  That shipment will be a milestone in Crowdfunding history.

The Pebble watch is a famous, rewards-based crowdfunding project.

Web History

Rewards CF has made (is making) an impressive impact on the economy.  It's the kind of serendipitous thing an economist could never have predicted.  It's one of those 2 + 2 = 5 things.

The Web Needed to Mature Before Rewards-based Crowdfunding Could Flourish

Web 1.0 was about experts creating web sites that the masses could see.  In Web 1.0 Amazon was able to build a store and sell to the masses.

Web 2.0 was about the masses being able to talk and create and share content publicly and cheaply (via youtube, Myspace, facebook, twitter).  Eventually, as Web 2.0 really became cheap and integral to our lives, a new form of economic activity emerged: rewards crowdfunding.

A New Economic Tradition

Rewards Crowdfunding broke traditional models.  It did not give equity (stock) or IOUs (debt) to backers because those financial instruments carry too much baggage.  Rewards Crowdfunding is not a mere charity transaction.  It is something beautifully new.

Rewards Crowdfunding is about telling a story to people who are spread all over the place, involving people in the story, showing people they will get a little piece of the story and keeping people engaged in the story.  It creates new companies and new jobs in an otherwise ossified economy.

–Benjamin Wright

Proving Crowdfunding Good Faith | Transparency

Crowdfunded projects are wise to keep detailed records.  Records help insulate project owners from legal liability.

Failure is an Option

Fully-funded, rewards-based crowdfunded projects can fail.  For example, a game project called “Haunts: The Manse Macabre” exceeded its funding goal on Kickstarter.  It raised $29,000 to make an online game.  It told backers (people who contributed money) that they would be rewarded with certain levels of access to the game when it launched.

But the project is unlikely to launch.  It encountered problems and roadblocks.  Although it paid developers to create parts of the game, the developers have left, the game is not finished and the project is about out of money.

Legal Liability for Fraud

Did the project owner commit fraud?  Could backers sue the project owner, or could a consumer watchdog like a state attorney general take action against the owner?

Although I don’t know the answer to those questions for  “Haunts: The Manse Macabre,” the answer for some projects could be yes.

Address Risk

From the outset, a project owner must prepare for risk.  The owner is wise to warn potential backers of the risk of failure.

Kickstarter says projects funded through it are expected to make a good faith effort to complete their projects.

Good faith is a subjective standard.  Like beauty, good faith is in the eyes of the beholder.

Evidence of Compliance

To establish that the owner did make a good faith effort, detailed records of the project’s activities can be invaluable.  Detailed records can include accounting ledgers, emails, instant message logs, and even a daily diary of activities.

Opening to Outside Review

Another step an owner can take is to be utterly transparent as work on the project unfolds.   To achieve transparency, an owner could post the records it is making, for public viewing as soon as they are made (or soon afterward).

When the owner makes a payment or makes a draft of a deliverable, they can post it on the web for public scrutiny.  They should invite comments.  Example: “As we execute the steps of the project, if anyone thinks we can do better, then please say so publicly or in a private message to the project owner.”

Such transparency helps to invest third parties – both backers and critics – in the actual execution of the project.  It contributes to an eventual defense like this from the project owner: “I was showing you every step as we did it.  If you thought I was not making a good faith effort, then why didn’t you say so months ago?”

–Benjamin Wright

Cease and Desist Order for Equity “Crowdfunding”

Securities regulators are paying attention to crowdfunding, even before JOBS Act regulations go into effect.

The Pennsylvania Securities Commission issued a cease and desist order to fund raisers Tabletop Arena, LLC and Christopher Melville, who claimed they were “crowdfunding.”

Securities Registration?

The Massachusetts Secretary of the Commonwealth (Securities Division) also brought an administrative complaint against Tabletop and Melville, noting that they fraudulently offered and sold unregistered securities through their website, as well as Facebook and Twitter.

Crowdfunding as Buzzword

From the perspective of securities regulators, Tabletop and Melville were just old-fashioned hucksters, hawking unregistered securities, while using a new buzzword, crowdfunding.

Well-established Pattern of Illegality

The investigation followed a pattern of illegal behavior that was established well before crowdfunding became a popular meme.  The fund raisers said on the web they were looking to raise funds from investors in exchange for limited liability company membership interests.  In one instance, a resident* from Pennsylvania inquired about the opportunity.

The fund raisers then tried to sell the equity securities to the Pennsylvania resident, without complying with applicable regulations, such as registering the securities or following an exemption, such as determining that investors and potential investors are “accredited.”

–Benjamin Wright

*It is probable that the Pennsylvania resident was an agent of the Pennsylvania Securities Commission. The PSA has a reputation for making "sting" inquiries about investment opportunities.

Tax Treatment

In crowdfunding, it is popular for project organizers to say that they are taking gifts or donations.  The organizers may believe no sales or income taxes are owed in relation to the gifts or donations.

But commonly the projects promise rewards or products (such as a game console in the famous crowdfunding example of Ouya) to the backers who pledge funds.

Recharacterization

A concept in tax law and accounting is known as “recharacterization.”    A tax authority may “recharacterize” a transaction from one tax treatment to another if the facts of the situation warrant it.

Tax-free Donation?

For example, a crowdfunded musical artist may maintain that backers gave him gifts.  But he promised music CDs to his backers.  State and federal tax authorities may recharacterize the transactions as sales of goods.  Their justification would be simple: the backers gave money; he gave products in exchange.  (Furthermore, he was not registered under with the IRS as a 501(c)(3) charity.

Under such a recharacterization, the artist would need to report income (revenue minus expenses) for income tax purposes.  He also may have been required to collect sales taxes in relevant states.

Penalties and Interest

If a state tax authority audits him later, and determines he failed to collect required sales tax, he not only would have to pay the tax.  He may also be liable for penalties and interest.

Often, the collection of sales tax requires registration with the state tax authority before (or soon after) any transactions occur.

Use Tax

In theory, when someone buys something, where sales tax is owed but not collected, they are required to report and pay so-called "use tax."  In the example of the musical artist, his backers would have to report and pay use tax on the value of the CD.  Although use tax is rarely enforced against individuals, states like Pennsylvania are drawing more attention to it.

–Benjamin Wright

Attorney Wright is an informal advisor to Yellow Brick, the social marketplace for crowdfunding.

Update 2014:  Detailed Guide on How to Plan for Taxes in Crowdfunding Campaign.

Risk Factors | Contingencies

Kickstarter terminated a scam project after it had collected $21,000 in pledges, but before it funded.

bogus

The scam said it was raising funds for a groovy new game controller (think Ouya), but the scam was really just a sloppy knock-off of an earlier, unsuccessful crowdfunding pitch by a group that was legitimately trying to make a game controller.

Fortunately, someone detected the scam and alerted Kickstarter.

Proof of Project Legitimacy

But the experience dredges up an unhappy topic.   When a potential backer sees an attractive crowdfunding campaign, how does the backer know if it is legit?

What’s more, even if the project leader is sincere, how does the backer get answers to questions like these:

1.  Competence.  Does the project leader have the talent and experience to bring the project to fruition after funding?

2.  Risks.  What are the risks that the project will not reach its goal (e.g., delivery of a game console), even after it is well-funded?  Any enterprise that seeks to raise money in pursuit of a goal faces risks . . . from hurricanes . . . to competition . . . to supplier bottlenecks . . . to changes in market conditions.

3.  Refund.  What happens if the project funds, but the leader realizes – some time before it spends all the money – that it will not reach the stated goal?  Will money be refunded to the backers?  (If so, what will be the logistics of that refund?)  Does the leader get to pocket the money?  Will the money be given to a charity or to a related project?

Think Like an Investor

Erik Kain at Forbes cautions that crowdfund backers should think like "investors" before they put money in a project . . . even though the legal terms of the project explicitly say that they money is just a donation.  As they pledge money, the backers should ask whether the project and its leader have demonstrated enough understanding of the risks be worthy stewards of the money.

–Benjamin Wright
Attorney Wright is an informal advisor to Yellow Brick, the social marketplace for crowdfunding.

Dispel Allegations of Fraud

The most common forms of crowdfunding today are based on donations and rewards.  Many folks are raising funds over the Internet by just asking for charity donations or by promising some kind of reward, including priority shipment of a new product, in exchange for money.

Compared to equity crowdfunding (which typically involves the sale of securities), donation/rewards crowdfunding is relatively unregulated.  [Donation/rewards crowdfunding is also known as "project" crowdfunding.]

Remedies for Fraud

Nevertheless, people raising money through donations/rewards crowdfunding can still be subject to review by government regulators.  Example regulators are the Federal Trade Commission and state attorneys general, who investigate and punish fraudsters, particularly people who prey on the general public.*

Also, the people who contribute money to a crowdfunding project can sue to get their money back (plus maybe attorneys fees) if the project is fraudulent.  The injured people might unite into a class action lawsuit against the people running the project.

Full Disclosure

Thus, people leading crowdfunding projects want to give themselves margin for error.  They want to go to pains to ensure there can be no claim that the money contributors were tricked or cheated.

A key to avoiding any allegation of fraud is full disclosure of the facts, including facts that might turn off contributors.

Being Upfront about Negative Facts

Naturally, project leaders want to create compelling pitches – with videos or slideshows – that explain why a contributor should support the project.

But they should also be candid about negative facts, such as administrative fees that will be charged or risks that technical or logistical problems may delay or prevent delivery of a promised product.

Video Makes Good Evidence

On the Internet, video can be a very effective medium for making key points clear to common people.  This video is an example of what could appear on a web page promoting a crowdfunding project:

I am not saying that crowdfund project leaders should put all disclosures in video.  Text and FAQs are often adequate.

But select disclosures in video can be strong evidence that the project leaders were candid and honest.

–Benjamin Wright

*The Texas Attorney General essentially shut down the Texas Highway Patrol Museum because it misspent donated funds on liquor, cigars and fancy trips.  Nathan Koppel, "Texas Museum Reaches the End of the Road," Wall Street Journal, Aug. 30, 2012.

Update:  Inexperienced entrepreneur who raised $35K, but could not deliver, meets legal disaster.