The Fraud Examiner

Another Fraud in the Crowd?
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January 2014 

The Fraud Examiner 


Crowdfunding has become a hot topic among investors, regulators and fraud examiners as the phenomenon has gained traction over the last few years. This method of raising funds allows entrepreneurs to appeal directly to a large number of individuals through an online crowdfunding platform, thus avoiding banks, brokers or other intermediaries. 


While it has been used to generate financial support for new products, artistic support and charity, the recent JOBS act created an exemption to federal securities laws by allowing crowdfunding to be used as a means to buy and sell securities. Regulators like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have proposed new rules and are still determining what controls are needed to help protect investors in this new frontier.


To gain some insight into this emerging issue, The Fraud Examiner spoke with Eric Miles, CFE, CPA, CFF, partner in charge of Moss Adams’ Business Risk practice for Northern California and national practice leader for the firm’s technology industry group. Miles has participated in several panel discussions on crowdfunding and shed some light on securities crowdfunding.


Crowdfunding has existed for a few years now. But can you tell us what is new with the concept of “securities crowdfunding?”  

We currently have product-based and donation-based crowdfunding, but securities crowdfunding will allow a non-accredited investor to participate in early startups through Internet portals. The SEC has proposed new rules that would affect this type of investing. What we would potentially see with securities crowdfunding is a whole new class of investor, and that, frankly, might be where some of the fraud risk comes from. You have investors who may not do the same amount of due diligence (as experienced investors or venture capitalists).


What will be the main differences between existing crowdfunding and the new securities crowdfunding?  

Product crowdfunding involves an entrepreneur saying, “I want to create this new product.” As a participant, you are not buying equity or debt. You’re buying the product, or some other definable benefit. So to this point, we’ve had product crowdfunding or, in some cases, donation crowdfunding, where you are giving to a cause. But now (with securities crowdfunding) we are talking about debt and equity funding.  Which, to me, is light years different in terms of risk. When you invest in a product, there is an end point. The product is made (and then it either sells, or it doesn’t). Equity investing means you buy this equity and you don’t really know what you are going to get. It could be fraud, or it could be a failed idea.


What makes security crowdfunding inherently more risky? 

I think one of the main questions here is why a company would use it. If you are a company that needs to use securities crowdfunding, that is a warning sign in and of itself. The reason I say that is because if you have a viable product, a venture capital group (or other more traditional financing means) would have backed you.


So with some of these startups, you have to wonder: is there going to be a stigma? Are people going to ask themselves (or others) before they invest, “why are they using security crowdfunding when, if they had a viable business model, they could have received the funding by other means?”


One of the questions I’ve been asked is what concerns me the most. Equity securities can be really squishy in terms of “what is expected.” The company could go bankrupt. Or it could be a fraud. Also, what happens if you invest and then have no control over future investments? Your investment could be diluted out of any value.


Another issue is pump and dump. Although the SEC proposed rules specifically addressing the advertising of crowdfunding securities, I think there is still a real concern that you are going to have various parties pumping up through social media the value of the investment... basically like selling stock. They will be pumping it up and then selling pretty worthless securities. This is not an uncommon type of fraud for penny or microcap securities, and I would imagine it could be worse with securities crowdfunding. This plays into the risks of emotional investing, especially using an Internet portal. 


Do financial experts agree about the risks of securities crowdfunding? 

There are two schools of thought on crowdfunding today. There are people, like me, who are skeptical – who see the potential for harm. Then there are those who believe in the “wisdom of crowds”  the assertion being that the crowd itself, because of its collective wisdom, can identify fraud. This is fueled by social media and our overall connectedness in today’s world. Editor’s note: Read more on the merits vs. risks of crowdfunding in this ABC News article from September. 


What else do you see in the proposed SEC rules that garners our attention? 

There is an interesting aspect that is going to make this fascinating. The SEC put a lot of onus on these intermediaries (the portals) in expecting them to do some of their own due diligence (in terms of vetting the investment opportunities). According to what I’ve read, investors may be able to hold those portals accountable (in the case of fraud). I’m curious to see who gets in the game here. There are the proposed SEC rules, and then there is another set of rules from FINRA. If I were a potential portal, I would have my own rules: if you want to raise money on my website, you need to go through these due diligence checks in order to do that.


What advice would you give investors who are considering participating in a crowdfunding opportunity? 

Don’t put all of your eggs in one basket. These types of investment opportunities are highly speculative.  


Eric Miles, CFE, CPA, CFF, is the partner in charge of Moss Adams’ Business Risk practice for Northern California and national practice leader for the firm’s technology industry group. Miles specializes in business risk management including internal audit consulting, SOX 404 and enterprise risk management. Miles is the outsourced director of internal audit for several organizations and specializes in the technology, life sciences and healthcare industries. Miles is a Certified Public Accountant (CPA), Certified Fraud Examiner (CFE), Certified in Financial Forensics (CFF) and holds a Certification in Inventory Management (CPIM). 



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