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How to Avoid Fraud in Equity Crowdfunding

When Congress passed the Jumpstart Our Business Startups (JOBS) Act in 2012, the most common fear expressed in connection with Title III of the act was fraud. Yikes! When the Securities and Exchange Commission issued its proposed rules for Title III in October 2013, SEC Commissioner Luis Aguilar warned that Title III crowdfunding “increases the risks of fraud, illiquidity, and self-dealing to relatively unsophisticated investors,” and especially certain “vulnerable” communities:

The use of crowdfunding to reach potentially vulnerable segments of society is a particular concern. Many of the SEC’s enforcement cases arise from ‘affinity frauds’ that exploit the trust and friendship that often exists among members of any ethnic, religious, or other community. [1]

Supporters of crowdfunding acknowledge that some fraud will probably occur, as it does everywhere—including the public securities markets. But they point to the low instance of fraud in rewards-based crowdfunding in the United States, and in equity-based crowdfunding in Australia (since 2006) and the United Kingdom (since 2012), where unsophisticated investors participate in private securities offerings. It is important to note that Australia and the UK have different securities regulations than the United States, and every country defines fraud a bit differently, so it is not necessarily an apples-to-apples comparison. But in general, equity crowdfunding has proceeded in those countries fairly successfully so far.

It is always important to protect yourself from fraud in all commercial transactions, including equity crowdfunding.

The following is adapted from literature published by the U.S. Securities and Exchange Commission. For more SEC info on avoiding fraud, visit: https://www.investor.gov/investing-basics/avoiding-fraud/what-you-can-do-avoid-investment-fraud

Affinity fraud

Affinity frauds are among the most common types of fraud that will likely occur in the equity crowdfunding environment. These frauds target members of identifiable groups, such as the elderly, or religious or ethnic communities. The fraudsters involved in affinity scams often are – or pretend to be – members of the group. They may enlist respected leaders from the group to spread the word about the scheme, convincing them it is legitimate and worthwhile. Many times, those leaders become unwitting victims of the fraud they helped to promote.

These scams exploit the trust and friendship that exists in groups of people. Because of the tight-knit structure of many groups, outsiders may not know about the affinity scam. Victims may try to work things out within the group rather than notify authorities or pursue legal remedies. See also “Investor Bulletin: Affinity Fraud,” SEC Office of Investor Education and Advocacy, September 2012.

Affinity scams often involve “Ponzi” or pyramid schemes where new investor money is used to pay earlier investors, making it appear as if the investment is successful and legitimate.

Pump and dump schemes

“Pump and dump” schemes have two parts. In the first, promoters try to boost the price of a stock with false or misleading statements about the company. Once the stock price has been pumped up, fraudsters move on to the second part, where they seek to profit by selling their own holdings of the stock, dumping shares into the market.

These schemes often occur on the Internet where it is common to see messages urging readers to buy a stock quickly. Often, the promoters will claim to have “inside” information about a development that will be positive for the stock. After these fraudsters dump their shares and stop hyping the stock, the price typically falls, and investors lose their money.

Online investment newsletters and blogs

While legitimate online newsletters and blogs contain valuable information, others are tools for fraud. Some companies pay online newsletters to “tout” or recommend their stocks. Touting isn’t illegal as long as the newsletters disclose who paid them, how much they’re getting paid, and the form of the payment, usually cash or stock. But fraudsters often lie about the payments they receive and their track records.

Fraudulent promoters may claim to offer independent, unbiased recommendations in newsletters when they stand to profit from convincing others to buy or sell certain stocks. They may spread false information to promote worthless stocks.

The fact that these so-called “newsletters” may be advertised on legitimate websites, including on the online financial pages of news organizations, does not mean that they must not be fraudulent. To learn more, see SEC tips on newsletters: http://www.sec.gov/investor/pubs/cyberfraud/newsletter.htm

Online bulletin boards and chat rooms

Online bulletin boards, chat rooms, and social media sites are places where investors can share information. While some messages may be true, many turn out to be bogus – or even scams. Fraudsters may use online discussions to pump up a company or pretend to reveal “inside” information about upcoming announcements, new products, or lucrative contracts.

You never know for certain who you’re dealing with, or whether they’re credible, because many sites allow users to hide their identity behind multiple aliases. People claiming to be unbiased observers may actually be insiders, large shareholders, or paid promoters. One person can easily create the illusion of widespread interest in a small, thinly traded stock by posting numerous messages under various aliases.

When you share information on an equity crowdfunding portal that is registered with the SEC and FINRA, on the other hand, you should be able to check out the profiles of all the other investors with whom you chat and collaborate. You can even communicate off-platform with crowdfunding investors to confirm that their credentials or experience is bona fide.

Red Flags

How do successful, financially intelligent people fall prey to investment fraud? Researchers have found that investment fraudsters hit their targets with an array of persuasion techniques that are tailored to the victim’s psychological profile. Here are red flags to look for:

If it sounds too good to be true, it is

Watch for “phantom riches.” Compare promised yields with current returns on well-known stock indexes. Any investment opportunity that claims you’ll receive substantially more could be highly risky. Be wary of claims that an investment will make “incredible gains,” is a “breakout stock pick,” features “low risk and high returns,” or has “huge upside and almost no risk!” Claims like these are hallmarks of extreme risk or outright fraud.

“Guaranteed returns” aren’t

Every investment carries some degree of risk, which is reflected in the rate of return you can expect to receive. If your money is perfectly safe, you’ll most likely get a low return. High returns entail high risks, possibly including a total loss on the investments. Most fraudsters spend a lot of time trying to convince investors that high returns are “guaranteed” or “can’t miss.” They try to plant an image in your head of what your life will be like when you are rich. Don’t fall for it.

“Everyone is buying it.”

Watch out for pitches that stress how “everyone is investing in this, so you should, too.” Think about whether you are interested in the product. If a sales presentation focuses on how many others have bought the product, this could be a red flag.

Pressure to send money RIGHT NOW

Scam artists often tell their victims that this is a once-in-a-lifetime offer and it will be gone tomorrow. Resist the pressure to invest quickly, and take the time you need to investigate before sending money.

Reciprocity

Fraudsters often try to lure investors through free investment seminars, figuring if they do a small favor for you, such as supplying a free lunch, you will do them a big favor and invest in their product. There is never a reason to make a quick decision on an investment. There is never a free lunch. If you attend a lunch that is supposed to be “free,” take the material home and research both the investment and the individual selling it before you invest. Always make sure the product is right for you and that you understand what you are buying, including the associated fees.

Where to Go for Help

If you have a question or concern about the legitimacy of an investment, or you think you have encountered a fraudulent offering, please contact the SEC, FINRA, or your state securities regulator to report the fraud and get assistance.

U.S. Securities and Exchange Commission
Office of Investor Education and Advocacy
100 F Street, NE, Washington, DC 20549-0213
Telephone: (800) 732-0330
Fax: (202) 772-9295

Financial Industry Regulatory Authority (FINRA)
FINRA Complaints and Tips
9509 Key West Avenue, Rockville, MD 20850
Telephone: (301) 590-6500
Fax: (866) 397-3290

 


Footnote

[1] Luis A. Aguilar, commissioner, U.S. Securities and Exchange Commission, “Harnessing the Internet to Promote Access to Capital for Small Businesses, While Protecting the Interests of Investors,” October 23, 2013.

About David M. Freedman

David M. Freedman has worked as a financial and legal journalist since 1978. He has served on the editorial staffs of business, trade and professional journals, most recently as senior editor of The Value Examiner (National Association of Certified Valuators and Analysts). He is coauthor of Equity Crowdfunding for Investors, published in June 2015 by…

Continue Reading Bio »   •   View all articles by David M. Freedman »

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