Crowdfunding or crowdfrauding?

Fraud Spotlight: Analyses of lesser-known frauds

Red Ferrari. Designer clothes. Steve Tan appeared to be living the American Dream. In less than two months in the summer of 2013, Tan had raised more than $1.5 million in a crowdfunding campaign on the popular website, Indiegogo, to produce a new smartwatch. However, this apparent overnight success ended in a debacle when more than 11,000 investors lost thousands of dollars.

According to PCWorld (Kreyos smartwatch: We're not a scam, just a trainwreck, by Jared Newman), Tan's Kreyos Meteor smartwatch was supposed to be waterproof with voice and gesture control, and a seven-day battery. He said it would monitor the wearer's heart rate and sleep cycles and would seamlessly connect to mobile devices.

However, a year after the crowdfunding campaign, according to the PCWorld article, many investors hadn't received their watches and those who did found numerous problems. Then Tan, in a post on the Medium site, The Rise and Fall of Kreyos, claimed his manufacturing partner perpetrated an "intricate conspiracy" against Kreyos and said it had pocketed close to $1 million of the raised funds. He said the company now didn't have any remaining money for repairs or refunds. But investors saw photos of Tan on social media climbing into that Ferrari and posing with filled designer shopping bags. (Tan claims a friend owned that Ferrari and the shopping bags belonged to his friends' wives.) Naïve incompetence? Or crowdfunding becomes crowdfrauding?

Rewards-based and equity crowdfunding

Businesses that use rewards-based crowdfunding often are late in delivering their products, if at all, according to Should Crowdfunding Sites Do More to Vet Projects? by Nick Shchetko, The Wall Street Journal, Nov. 25, 2014.

Situations are further complicated because often the players don't know who's responsible for failed projects — the company, the funding platform/website or the investors. Some crowdfunding platforms say they have screening mechanisms to detect fraudulent campaigns, but they also clearly state they don't settle disputes and aren't liable for fraud cases, according to The Wall Street Journal article.

Entrepreneurs have been using rewards-based crowdfunding as a major funding source since 2009, according to the Fundable website. A new business will use a rewards-based crowdfunding campaign to promote its projects through social media channels. Investors donate money in return for a reward — typically the new product. If the business hits its funding target prior to the campaign deadline, it's required to deliver the product shortly after to its investors, according to A Brief History of Crowdfunding, by David M. Freedman and Matthew R. Nutting, updated Jan. 3.

Equity crowdfunding allows investors to invest money in a new venture promoted through social media in exchange for equity in the company rather than a product. This allows new companies to solicit funds and give dividends to investors without the labor and expense of an IPO — an initial public offering. However, entrepreneurs and investors are still awaiting regulations from the U.S. Securities Exchange Commission (SEC) before equity crowdfunding can become a major source for new companies, according to "A Brief History of Crowdfunding."

After the SEC devises and implements its rules to decrease fraud risks, entrepreneurs will be able to solicit equity investments not only from accredited investors (roughly 1 percent of the population) but from everyday investors as well, according to the Forbes magazine June 28, 2012, infographic, Crowdfunding: Saving the U.S. Economy, by Ilya Pozin.

The SEC hasn't indicated that it's studying regulations for rewards-based crowdfunding. Although the average investment in rewards-based crowdfunding often is much smaller than the average investment in equity crowdfunding, the Kreyos smartwatch example clearly shows how quickly contributor dollars pile up, which increases the potential for huge frauds.

In April of 2014, the Washington State Attorney General's Office (AG) filed suit against Edward J. Polchlopek III (a.k.a. Ed Nash) and his company, Altius Management, LLC of Nashville, which quickly raised more than $25,000 on Kickstarter from 810 investors — $10,000 more than his stated goal — to print a deck of "retro-horror"-themed cards, called Asylum. (See Kickstarter fraud: Washington files first consumer protection lawsuit involving crowdfunding by Taylor Soper, GeekWire, May 1, 2014.)

According to the complaint, the defendants marketed the Asylum playing cards Kickstarter campaign during September and October of 2012. The company said investors would receive Asylum playing cards, Asylum-style poker chips, dice, sketches, a ceramic "dealer button" and even a costume straitjacket in exchange for their money.

The company reached its $15,000 funding goal prior to the Oct. 31, 2012, campaign ending date. This resulted in a charge to the accounts of all backers on that date. The defendants then represented on the campaign website that delivery of rewards to all backers would take place in December of 2012, but as of the date the lawsuit was filed, not a single backer had received any of his or her promised rewards.

The defendants haven't posted an update to the campaign website since July 13, 2013, nor have they responded to investors' complaints. The Washington State AG lawsuit, the first of its kind in the U.S., seeks restitution for investors. The case could provide legal precedent for future crowdfunding fraud.

According to 10 Red Flags Used To Spot Crowdfunding Scams and Con Artists, (a guest post by Elena Mikhaylova in Salvador Briggman's blog on CrowdCrux), here's some advice you can give your clients, family members and friends who should look for red flags in crowdfunding campaigns.

1. "Pay attention to the sources of raised funds. Campaigns succeed largely because of new companies' efforts in publicizing their stories to the public. A campaign could be fraudulent if it's raised a substantial amount of money with little or no social media activity. Don't lower your guard simply because many others have seemingly invested in an idea. Be sure to check for social activity on the entrepreneur's Facebook or Twitter account — not just the number of followers. It's very easy to buy thousands of followers or fans for an insignificant amount of money [through sites such as www.fastfollowerz.com, www.twitterwind.com and www.buylikesandfollowers.net], therein providing a false impression of campaign popularity. Significant changes in either the amount of pledges or the dollar amount of those pledges near the beginning or end of a campaign can be a sign of a company stirring up fake account activity to spur interest or reach a funding goal."
2. "Research the company behind the campaign. Verify the company has a physical address and a legitimate website [by simply throwing the name into your favorite search engine and seeing what you find. Also, search for the company's rating on the Better Business Bureau website.] Check out company management's profiles, and authenticate accomplishments. A company created immediately prior to its campaign launch could be an indicator of a faux campaign. Management should always be transparent and responsive in its communications with potential investors. So, don't hesitate to ask questions and look at other public communications between the company and investors."
3. "Step back and objectively compare a campaign's prices and funding goals to those in other campaigns. Compare prices and funding goals to similarly designed products in other campaigns. Prior to investing, fully understand the product and how it functions. In the Kreyos case, the company promised technology that other industry giants such as Apple and Samsung have yet been unable to provide. Of course, as always, if something looks too good to be true, it probably is."

New frontier

Entrepreneurs and investors are speculating about the future of crowdfunding after the SEC issues regulations. Rules implementation will need to balance necessary investor protections against fraud but not eliminate all entrepreneur liberties — the original hallmarks of crowdfunding.

Investigating fraud in crowdfunding could be a new frontier for CFEs. Because, as always, easy money begets fraud.

Leslie Parker, CFE, CPA, is a forensic analyst at Forensic Strategic Solutions Inc.

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