“Crowdfunding” or “crowdsourced funding” is a new outgrowth of social media that provides an emerging source of funding for a variety of ventures.  Crowdfunding works based on the ability to pool money from individuals who have a common interest and are willing to provide small contributions toward the venture, which potentially collectively add up to a critical mass of capital.  Crowdfunding can be used for accomplishing a variety of goals (e.g., raising money for a charity or other causes of interest to the participants), but when the goal is of a commercial nature and there is an opportunity for crowdfunding participants to participate in the venture’s profits, federal and state securities laws will likely apply.

Crowdfunding advocates have called on the U.S. Securities and Exchange Commission (“SEC”) to consider implementing a new exemption from registration under the federal securities laws for crowdfunding efforts.  For example, it has been suggested that the SEC exempt crowdfunding offerings of up to $100,000, with a cap on individual investments not to exceed $100.  The SEC is considering whether to implement an exemption for crowdfunding, in addition to a variety of other measures to encourage capital formation.

Absent an exemption from registration with the SEC (or actually registering the offering with the SEC), crowdfunding efforts that involve the sale of securities are in all likelihood illegal.  In addition to SEC requirements, those seeking capital through crowdfunding need to be cognizant of state securities laws, which include varying requirements and exemptions.  By crowdfunding through the Internet, a person or venture can be exposed to potential liability at the federal level, in all fifty states, and potentially in foreign jurisdictions.

The perils of crowdfunding were recently highlighted in an action, In the matter of Michael Migliozzi II and Brian William Flatow, that the SEC brought against two individuals in connection with their efforts to allegedly raise small contributions using the Internet in order to purchase Pabst Brewing Company for $300 million.  Migliozzi and Flatow settled the proceeding, consenting to a cease and desist order relating to the alleged violation of the registration provisions of the Securities Act.  The order indicates that Migliozzi and Flatow established the BuyaBeerCompany.com website, and then used Facebook and Twitter to advertise the website.  They sought pledges from participants in the crowdfunding effort, and in return participants were told that if the $300 million necessary to purchase Pabst was raised, the participants would receive a “crowdsourced certificate of ownership” as well as an amount of beer of a value equal to the money invested.

While no monies were ever collected from the crowdfunding participants that solicited pledges, the SEC alleged that Migliozzi and Flatow nonetheless violated the registration provisions of the federal securities laws by offering the security (in this case, the crowdsourced certificate of ownership) without registering the offer with the SEC or having an exemption, such as the private placement exemption, available for the offer.

Going forward, the SEC must carefully weigh concerns about the potential for abuse and fraud in connection with crowdfunded offerings as it considers whether to establish crowdfunding-specific exemption.  While amounts contributed by each individual in a crowdfunding scenario may be small, the potential to raise large amounts of capital exists given the power of social media (BuyaBeerCompany.com purportedly received over $200 million in pledges).  Given all of these factors, we are likely to see more crowdfunding cases come out of the SEC before the SEC comes forward with any proposals for exemptive relief.

In the end, crowdfunding is subject to what now seems like an old rule of thumb:  Just because you are raising money over the Internet or through social media does not mean that the same “old” rules as to the offer and sale of securities no longer apply.