Crowdfunding: A Potential Cash Source for Business That Could Make a Well-Intentioned Company's Financial State Worse

Legal Alert

Crowdfunding has long been a resort for those with bright ideas and little capital to bring an inspired cause to market. However, the introduction of the Internet and smart technology has generated a boom in the practice, as innovators and start-ups increasingly look online to generate crowdfunded financing. Perhaps, unsurprisingly, we’re now starting to see some of the downsides of turning to crowdfunding to bring ideas and products to market.

With the advent of low-to-no-cost viral marketing, and websites such as Indiegogo and Kickstarter1, inventors, entrepreneurs, and lay people alike are able to generate substantial sums of money, in short periods of time, with seemingly illusory obligations expected in return. Through any online crowdfunding campaign today, an innovator with little more than a noble cause and plans for a prototype can generate the capital needed to carry the innovator’s plan to fruition. Heck, up to a month or so ago, it was seen as a money tree planted in the proverbial Garden of Eden. But starting in July 2015, litigation has shown us the “ugly” in the tree’s apples.

Beware of Crowdfunding Jargon

To understand the risks, we must first understand the practice.

For years, crowdfunding has been used as an alternative form of financing for specific causes in need of financial support. Perhaps the most notable example of this practice is the recent viral “Ice Bucket Challenge” campaign that raised funding for and awareness of the battle against Amyotrophic Lateral Sclerosis. Typically, crowdfunding websites use varying terms to describe the cause being funded, the items and/or services at issue, and even the transactions that occur. Although there is variation in terms used, the campaigns and participants are all based on the same premise. Unfortunately, terms that have become accepted and perpetuated throughout crowdfunding’s history may be causing confusion with respect to what the roles and responsibilities of crowdfunding campaign users really are.

For instance, using appropriate jargon, a “Project Owner” on Kickstarter, or a “Campaign Owner” on Indiegogo will start a Project or a Campaign, wherein a future Reward or Perk is offered to a Backer or Contributor who in turn makes an immediate Pledge or a Contribution. In other words, a person creates a webpage, highlights a product or a service, and requests monetary contributions in exchange for, in nearly every case, the product or service featured, or some variation thereof, at some specified later date.

Most websites also provide their own terms of use. Aside from attempting to disclaim the website’s own liability, the terms of use may also provide Project and Campaign Owners with an insufficient understanding of their probable legal obligations. Indeed, in some instances, Project Owners who are “unable to complete their project and fulfill rewards . . . must make every reasonable effort to find another way of bringing the project to the best possible conclusion for backers.” Whether a Project or Campaign Owner can rely on his or her best efforts remains untested, as the only lawsuits dealing with crowdfunding have either resolved or been based only on specific facts involving a complete failure to deliver or refund.

A Potential Bonanza

Cynical views aside, crowdfunding has often proved extremely lucrative. Take Zack “Danger” Brown. In 2014, the young Ohio man started a Project on Kickstarter. With a total goal of $10, Brown solicited $1 or more Pledges from Backers with nothing more than a short YouTube video and an expressed desire to make potato salad. In return, Backers were promised a “thank you” and received a personal “shout out” from Brown while he made the crowdfunded potato salad. While this may sound like a joke, Brown received over $55,000 in Pledges and, as a result, launched the spinoff “Potato Stock” – a potato-themed concert – and is currently working on a potato salad cookbook.

The vast majority of crowdfunding campaigns, however, are less satirical. Some of the more impressive and noteworthy crowdfunding campaigns include: Star Citizen, a video game campaign launched on Kickstarter that raised an astounding $89,002,775; Pebble Time, a smartwatch campaign launched on Kickstarter that raised $20,338,986; and Flow Hive, a beehive honey extracting box campaign launched on Indiegogo that raised $12,174,187. Interestingly, crowdfunding has made its way into the legal community and has been used to finance large commercial lawsuits.

When Things Go Wrong

While media and crowdfunding websites usually tout success stories, often overlooked is the unclear legal landscape and challenges facing those seeking, and eventually obtaining, crowdfunding support. Indeed, in 2012, a disgruntled Backer of a portable i-pad stand, Neil Singh, sued the Project Owner, Seth Quest, for failing to deliver on his promises. As a result of the filing of Singh’s lawsuit, Quest was forced into bankruptcy and suffered damage to his reputation as a designer and creator.

More recently, on June 10, 2015, the Federal Trade Commission (“FTC”) brought an action against the Project Owner behind a board game called The Doom That Came to Atlantic City for violating Section 5 of the Federal Trade Commission Act relating to unfair or deceptive acts or practices. In that case, Defendant Erik Chevalier raised more than $122,000 with the representation to Pledgers that they would receive certain Rewards, including a copy of the board game and/or certain pewter figurines. After raising the money, however, Chevalier allegedly announced that the game would not be produced and that refunds would be issued. Few Pledgers, if any, received refunds. The FTC Complaint was followed by an immediate Stipulated Judgment wherein Chevalier received a “suspended” monetary judgment and was enjoined from certain further acts.

On July 22, 2015, for the first time ever, a state court judge ordered out-of-state defendants to pay restitution, penalties, and fees in excess of $50,000, in connection with a failed Kickstarter Project. As alleged, defendants Altius Management, LLC and its president (“Defendants”) marketed and managed the Asylum Playing Cards Kickstarter Project in late 2012. Defendants allegedly induced hundreds of Backers, some of whom were from the State of Washington, to pay $25,146, with the representation that Backers would receive decorated playing cards as well as other Rewards. Defendants, however, were said to have not delivered Rewards or refunds. Based on this, the Washington State Attorney General’s Office brought claims for misrepresentation and failure to deliver Rewards, as well as failure to refund, under Washington’s consumer protections laws prohibiting unfair methods of competition or deceptive business practices in connection with any trade or commerce. While Defendants were ordered to pay more than twice what they received through the crowdfunding website, based on Washington’s pro-consumer laws, Defendants faced potential liability in excess of $1.6 million.

Lesson for Entrepreneurs

These cases are all important for at least three reasons.

  • First, they are recent in the timeline of crowdfunding’s relatively young but murky history. Legal boundaries to crowdfunding practices are now in the early stages of becoming defined. Those boundaries will only become settled through more litigation and government regulation. Crowdfunding campaigners, especially businesses, should be thinking about where their campaigns and rewards will likely exist within the bounds of consumer protection and other laws.
  • Second, the cases illustrate that certain crowdfunding campaigns are, in reality, pure transactions for goods or services between manufacturers, sellers, and consumers. Many campaigns are not, as some websites may suggest, investment or donation opportunities that require, in return, only best efforts in achieving an early and preliminary campaign message.
  • Third, because of the transient and borderless nature of crowdfunding, Campaign and Project Owners are now on notice that they can be hauled into any state or federal court for alleged unfair or deceptive business practices, and could be ordered to pay restitution, fines, and fees well in excess of what they originally received.

Now that the fuse is lit, it is likely that we will see an influx in claims brought by attorneys in states with laws that heavily favor consumers. Indeed, under California’s Consumer Legal Remedies Act (see Civil Code section 1750, et seq.), and California’s Unfair Competition Laws, (see Business and Professions Code sections 17200, et seq., and 17500, et seq.), government agencies and consumers alike may bring claims for, among other things, unfair methods of competition and unfair or deceptive acts or practices, as well as untrue or misleading advertising. Indeed, these are precisely the claims that have survived early stages of recent litigation and resulted in settlement or judgments against innovators and business.

While the limited number of actions that have been brought involved complete failures on the part of the campaigners to deliver products or refunds, it begs the question as to what other conduct is actionable under the FTC’s or states’ consumer protection laws. As we have seen, poor planning, lack of sophistication, larger than expected demand, and unforeseen legal and regulatory hurdles have caused many campaigners to push out previously envisioned delivery dates, change product designs and intended uses, and ultimately fail to meet, what ultimately may be considered, reasonable consumer expectations.

We have no illusions that the Siren of crowdfunding won’t continue to lure many hopefuls, but they would be well advised to watch as future test cases further clarify the risks and liabilities.

If you have any questions about the content of this alert, please contact a key contributor.

1 Websites such as Kickstarter and Indiegogo are by no means the only crowdfunding websites. But given their prevalence in the practice, we refer to them here for exemplary purposes.

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Jamie Moss (newsPRos)
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w. 201.493.1027 c. 201.788.0142

Mac Borkgren
Senior Manager, Marketing Communications & Operations

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