Open Accessibility Menu

Crowdfunding and Online Stock Markets for Startups Opens Door for Investment Fraud

David P. Meyer

Congress is currently considering loosening restrictions on who can invest in companies before they go public. I caught wind of this on a recent story covering crowdfunding on NPR. In theory, the changes sound good; shouldn’t everyone have the right to invest in the company of his or her choice? But, like most legislative changes, there’s a downside: The proposed rules could also create 21st-century boiler rooms where dodgy deals are peddled in social media to unsophisticated investors.

Under current law, only “accredited investors” (read: individuals with net worths of at least $1 million, excluding their residences) can invest in these types of non-public start-ups. The exception is, of course, the entrepreneur him-or-herself. Entrepreneurs can invest in their own businesses, but if they want to obtain investments from friends and families, those friends and families must qualify as “accredited investors.”

If they don’t, they’re cut out of the deal. Some say these rules prohibit the average investor from making the kind of investment deals that have made many people – particularly in Silicon Valley – rich. And, these same people are now pushing Congress to relax the current rules and to allow “crowdfunding.”

Crowdfunding would allow companies to raise capital through social networks like FaceBook and Twitter, and to obtain small investments from just about anybody – regardless of the investor’s net worth or familiarity with investment strategies.

Advocates say crowdfunding could “unleash a torrent of new money” for new creative ideas and projects. But, investor protection advocates, including myself, are concerned about the potential for investment fraud through crowdfunding in these new online stock markets for start-ups. And, for good reason.

Crowdfunding could potentially open up the business of lining up investors to almost anyone with a website. This means everyday investors could have a particularly difficult time sorting out fraudulent set-ups from legitimate start-up opportunities, especially when it is so easy to design polished and trust-inspiring websites. This is particularly true in our web-savvy society, in which people are increasingly comfortable conducting financial business online. Such familiarity with online financial transactions would likely translate into decreased skepticism, a fact con artists would certainly use to their advantage.

Additionally, it’s worth asking why – when instances of investment fraud continue to rise – regulators and legislators would be considering looser restrictions in today’s market. The “accredited investor” rules are designed to protect investors who are often less familiar with complicated investment strategies and who often do not have the financial resources to handle a significant loss in the market.

While it is understandable that less wealthy investors would desire the right to invest in legitimate start-up opportunities, allowing unregulated or loosely regulated markets to flourish on the Internet would almost certainly result in increased investment fraud and lessened investor protection. In today’s market, there has to be a better solution. Let’s hope Congress agrees.