State warns of future scams capitalizing on 'crowdfunding' trend

A trendy online funding mechanism for nonprofits is about to come to the financial investment world, and state officials are predicting it will be their top swindle over the next year.

The state Department of Financial Institutions put crowdfunding, a sort of panhandling on the Internet at the top of its annual list, released today, of the top 10 ways you can be separated from your investment.

Crowdfunding doesn't legally exist as an investment device yet, but it's already a topic in Wisconsin because it's popular, successful and innovatively flexible, said Patricia Struck, the DFI Division of Securities' top cop and holder of the swindlers crystal ball.

"The idea has worked very well for nonprofits," said Struck.

Last June, for example, the Dane County Cultural Affairs Commission signed on to use a crowdfunding mechanism via power2give.org, which manages a system for residents to donate money to various cultural projects. It's similar to Kickstarter, a crowdfunding website that has raised more than $220 million for creative business and arts projects.

The problem with translating these kinds of "platform and infrastructure" into the investment world, Struck said, is the expectation of profit.

The JOBS Act, aimed at job creation and signed into federal law this year, will legalize crowdfunding. Once the regulations are finalized in the next year, businesses and entrepreneurs will be able to raise start-up money -- up to $1 million -- the same way as the Madison Children's Museum raises money for exhibits: through Internet portals.

Start-ups using crowdfunding will have to make disclosures to potential investors, but they won't have to pay the high legal fees normally associated with fundraising, Struck said. What worries regulators like Struck is that the rules are not drafted yet, so entrepreneurs could jump the gun and the lure of a trendy investment vehicle might cause investors to ignore the usual warning signs.

She said investors, especially "unsophisticated" investors, may think that crowdfunding carries less, or no, risk. But the adage with crowdfunding is the same as with any investment: Only invest what you can bear to lose.

"We know there are con artists out there who will take advantage of every opportunity to offer something that is too good to be true," Struck said.

"Also, it's kind of trendy. We all love helping small businesses out," she said.

But state officials already facing increased reports of Internet fraud predict JOBS-related activity will increase that trend.

There is no debate that crowdfunding works well for nonprofits, and the transformation from a focus on art to a focus on business already is occurring. For example, those at the Forward Technology Festival in Madison this week were scheduled to discuss the issue for start-ups.

Besides the crowdfunding warning, also new to the top 10 is the use of self-directed IRAs to disguise fraud, often a Ponzi scheme, and the "EB-5 investment for visa scheme," which is promoted as a way of investing in foreign capital.

Struck's advice is boilerplate, and not new to the list: Independently verify any investment opportunity as well as the background of the person and company offering the investment. State securities regulators can provide information about those who sell securities or give investment advice, and about the products being offered.

2012 Top Investor Threats

1. Crowdfunding and Internet offers. The 2012 JOBS Act makes significant changes to the methods startup businesses and entrepreneurs may employ to bring their ventures to the investing market. Many more rules and mechanisms must be put into place for those changes to actually take effect, and won't be until 2013. Small startups are among the riskiest of investment categories under the best of situations.

2. Use of self-directed IRAs to mask fraud. Fraud promoters pushing a Ponzi scheme or other fraud misrepresent the responsibilities of self-directed IRA custodians to deceive investors into believing that their investments are legitimate or protected against losses.

3. EB-5 investment-for-visa schemes. An immigration program linked to job creation grants a U.S. visa to foreign nationals who invest at least $500,000 in a new enterprise. Investors must beware of promoters who falsely claim that an investment in their venture is safer or guaranteed due to an influx of foreign cash.

4. Oil and gas drilling programs. Investments in oil and gas drilling programs involve a high degree of risk and are suitable only for investors who can bear the loss of the entirety of their principal. Some promoters will conceal these risks, using high-pressure sales tactics and deceptive marketing to peddle worthless investments in oil wells.

5. Promissory notes. Promoters flaunt high returns from private loan agreements, interim short term financing or startup capital opportunities. Be wary of promises of security and liquidity in these promissory notes, which are very often false or overstated. Investments of this nature are highly speculative and the risk of total loss of the funds invested is high.

6. Ponzi schemes. Ponzi schemes are scams in which money received from new investors is used to pay returns to those who invested previously to give the appearance of a successful investment. In reality, no investments are made.

7. Real estate investment schemes. Investors should be aware that schemes related to buying, renovating, flipping or pooling distressed properties are also popular with con artists.

8. Regulation D/Rule 506 private offerings. These are limited investment offerings that are highly illiquid, generally lack transparency and have little regulatory oversight. The 2012 JOBS Act relaxed restrictions on marketing these offerings.

9. Affinity fraud. The swindler encourages potential investors to trust him because they have something in common such as church membership.

10. Gold and precious metals. The hype surrounding gold, silver and other precious metals continues despite both the fact that these investments are just as vulnerable to risk as others, and signs that some precious metal markets are declining or increasingly turbulent. Though a promoter promises actual gold will be held in safekeeping for the investor, far too often, the gold simply does not exist or its value may not grow as represented by the seller.

Source: Wisconsin Department of Financial Institutions

(c)2012 The Wisconsin State Journal (Madison, Wis.)

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