The Verge has another interesting article on how Kickstarter handles fraud in the wake of the Mythic scam. While the article is filled with a lot of interesting information, I found a statement from an unnamed Kickstarter board member troubling. According to Emily Gera, this board member said “that the company ‘can't’ protect backers from potential fraud because Kickstarter is more a platform than a business. Besides, the board member argues, backers don't stand to lose too much money if they are scammed.”
Now, it is important to acknowledge that these statements are made in the context of donation- and reward- based crowdfunding, rather than the soon-to–be-legal securities based crowdfunding, with all of the differences that entails. Securities-based crowdfunding will have more money at stake and the needs and expectations of crowdfunding investors, rather than donors, are likely to be greater. That said, we respectfully but strongly disagree with the idea that fraud isn’t a big deal provided the dollar amount is low, or that, when you consider all the damage that fraud can do to the crowdfunding ecosystem, such a thing as a low-dollar fraud even exists.
The damage of fraud is more than just the money lost by the initial victim; it is also the cascade of secondary effects that happen as a result of the fraud. The victim is not only out the money, they also lose the opportunity to invest that money in a legitimate venture or project--and legitimate ventures lose the use of that money. In addition, as stories of fraud occur, more people get scared away from crowdfunding. Likewise, with the pool of potential money drying up and a compromised reputation, crowdfunding becomes less attractive to businesses as a means to raise money. It isn’t hard to see that some relatively “small” frauds can have a huge and disastrous impact.
Kickstarter, for its part, say that it is just a middle man and can’t vet all the projects, and that its community is pretty good at sniffing out frauds. While Kickstarter’s reliance on “the crowd” to prevent fraud may be an acceptable or at least tolerable solution in the donation space, there are strong reasons to be skeptical that reliance the crowd alone is sufficient, especially for securities-based offerings.
Further, while the donation and reward crowdfunding spaces that Kickstarter occupies are outside the scope of federal securities regulations, that isn’t true for securities-based crowdfunding. Securities-based crowdfunding is already somewhat controversial because of investor-protection and fraud concerns, and there is a risk that if regulators believe the players in the space are unable or unwilling to fight fraud on their own, the regulators will either shut the space down or mandate regulations that are too burdensome for crowdfunding to work. A donation platform harms its investors and itself by not proactively fighting fraud, but a securities-based platform that is unwilling to proactively fight fraud could end up not only harming its customers (both investors and entrepreneurs), but could end up threatening the very existence of securities-based crowdfunding. This means that securities-crowdfunding platforms are all dependent on each other’s ability to prevent fraud, since one sufficiently bad apple could cause the government to spoil the bunch.
Crowdfunding must protect its investors, and the legitimate businesses seeking money, from fraud. While some risk is inevitable and must be tolerated it should never be dismissed as unimportant simply because the amount of money lost isn’t perceived as high. We at CrowdCheck can help with this fight by providing effective, right-sized due diligence; we hope you will join us.