Why Fraudsters Won't Sink Equity Crowdfunding As the SEC works on final regulations for equity-based crowdfunding, one of the pervasive fears has been that non-professional investors will be swindled by fraudsters. But is there really reason to worry?

By Catherine Clifford

Opinions expressed by Entrepreneur contributors are their own.

To those who fear that opening up equity crowdfunding to unaccredited investors will result in rampant fraud, some experts in the space say: Don't underestimate the crowd. In most cases, fraudsters will be outed.

When an entrepreneur is raising money with crowdfunding, social buzz tends to correlate with money raised. The more you hustle to get your story out, the more money you raise. And usually, it's the entrepreneur's friends and family that make that first push to get the word out and initiate contributions, said Alon Hillel-Tuch, co-founder and chief financial officer of crowdfunding platform RocketHub, during a panel discussion about equity crowdfunding held at Fordham Law School in New York City last month. When a crowdfunding campaign raises a significant amount of money without a corresponding amount of social activity, that's often a sign of a red herring.

"You know, fraudsters don't have friends and family that support them. By definition, they lack that," he said. "So what we've noticed is when a project goes live on RocketHub right now and starts getting a lot of funds from people with no social media activity, that raises a red flag within our fraud detection engine and we actually are able to close projects purely based on social trends."

Related: Real Estate Has Benefited Most From SEC's General Solicitation Rule Change

Hillel-Tuch compared launching a crowdfunding campaign to getting middle schoolers to start dancing together. "Boys on one side and girls on the other side and music is playing and nobody's dancing, right? But then somebody starts dancing. If it's the high school quarterback, everybody else shows up, obviously. But if it's someone else, maybe some people start joining in, maybe some of the cliques show up and eventually you notice everyone is dancing. But someone had to start it and that person had to have social capital," Hillel-Tuch said.

The analogy may sound simplistic. But the point is that a crowdfunding campaign, by its very nature, requires social momentum. And if there isn't the requisite amount of social momentum, the ball just won't get rolling. While the U.S. is still fretting about how exactly it should best protect its investors, there's plenty of evidence in other countries that that shows that the crowd does a very impressive job protecting investors. In Australia, where equity crowdfunding has been in place for 8 years, the Australian Small Scales Offering Board has had zero complaints of fraud, said Kim Wales, founder of Wales Capital, a management consulting firm focused on the implementation of the Jumpstart Our Business Startups, or JOBS Act.

In the U.K., where companies have been legally raising money through crowdfunding for three years, there have also been zero instances of fraud, says Wales. "And why is that? Well, because we're turning over a lot of the due diligence to the crowd," she said, at the same panel discussion at Fordham Law School.

Passed in April 2012, the JOBS Act, made it legal for anyone -- including non-professional or unaccredited investors -- to participate in equity-based crowdfunding. (Before this, equity crowdfunding was only open to accredited investors – or those deemed sufficiently wealthy.)

Related: Steve Case: JOBS Act Is Working, But D.C. Still Needs to Do More for Entrepreneurs

In equity-based crowdfunding, an entrepreneur gives a piece of his or her company in exchange for cash, making it a riskier proposition than donation-based crowdfunding, in which an entrepreneur might give away gifts or recognition in exchange for cash.

As the Securities and Exchange Commission continues to finalize the rules for equity-based crowdfunding, there's been a question of the how much responsibility the government should have in protecting a non-professional investor from losing money on a startup. "The JOBS Act and what we have to do with crowdfunding puts us squarely in the crosshairs of capital formation and investor protection," said Joanne Rutkowski, a member of the SEC division that is working to finalize the equity crowdfunding rules, at the panel. "There's a tension there, and it's just something that you have to work within. You're never going to resolve it," Rutkowski.

That may be so, but the crowd has shown that it is a fairly impressive fraud prevention tool. And investing now is very different than it was 80 years ago, when the SEC first came out with major federal regulations on the offer and sale of securities at a federal level.

"Access to information is very, very different," said Hillel-Tuch. "The amount that you can see as an individual from your home, from your computer is unimaginable to somebody in the '30s. It's incredible. So when you look at offerings, does fraud happen? Yes. It does. People try to commit fraud on our platform every single day. I'm not going to deny that. Do they succeed? No. No one has. Why? Because it's so social."

Crowdfunding is "such a social kind of mechanism," he said.

Related: Crowdfunding's Next Hot Frontier: Real Estate

Wavy Line
Catherine Clifford

Senior Entrepreneurship Writer at CNBC

Catherine Clifford is senior entrepreneurship writer at CNBC. She was formerly a senior writer at Entrepreneur.com, the small business reporter at CNNMoney and an assistant in the New York bureau for CNN. Clifford attended Columbia University where she earned a bachelor's degree. She lives in Brooklyn, N.Y. You can follow her on Twitter at @CatClifford.

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