Combating Pump and Dump in Crowdfunding Markets

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New article shows how small businesses and startups may trade shares fairly and efficiently.

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Portable beer taps. On-demand gas delivery. Hydrogen-infused spring water.

The small businesses that created these products have one major thing in common: Each became a hundred-thousand-dollar company through online equity crowdfunding.

Through equity crowdfunding, companies are funded by small contributions from a large body of investors. In exchange for their contributions, these investors receive shares of the company’s stock. Equity crowdfunding typically takes place on the Internet. Popular equity crowdfunding websites include FlashFunders, Indiegogo and MicroVentures, CrowdFunder, and Angel’s List.

TicketBis, a secondhand ticket-selling website popular in Europe, Latin America, and Asia, launched on Angel’s List in 2009 with an initial seed investment of $500,000. More than 40 investors later, TicketBis had acquired over $16 million in capital. Seven years after the launch of their Angel’s List campaign, TicketBis was acquired by eBay, which also owns popular ticket-selling website StubHub, for $165 million.

Professor Janet Austin of the University of New Brunswick argues that equity crowdfunding is a critical funding source for small businesses due to its accessibility and low administrative costs. Small businesses and startups, in turn, play critical roles in economies worldwide, accounting for 64 percent of new private sector jobs in the United States, as well as 95 percent of all firms in Organization for Economic Cooperation and Development economies.

Thus, Austin pushes for the continued development of secondary markets dedicated to trading crowdfunded securities to facilitate small businesses’ access to capital. She emphasizes, though, that the government must strictly regulate these markets, because crowdfunded securities frequently fall victim to pump-and-dump schemes. Pump and dumps occur when investors artificially inflate their securities’ prices by disseminating false, misleading, or exaggerated information. Investors then sell these artificially high-priced securities for a substantial profit.

Austin contends that one financial market that requires protection from pump-and-dump schemes is the United States’ Over-the-Counter (OTC) Market, which is operated by the Financial Industry Regulatory Authority (FINRA). In the OTC Market, crowdfunded securities are traded alongside corporate bonds, government securities, and other types of securities not listed on the United States’ larger exchanges.

The OTC Market has been the target of many pump-and-dump schemes in the past. In 2010 alone, the U.S. Securities and Exchange Commission (SEC) litigated 17 pump-and-dump cases involving the OTC Market. Pump-and-dumps schemes occur so frequently that four different agencies—the Federal Bureau of Investigations, the U.S. Department of Justice, the SEC, and FINRA—have specific response efforts dedicated to curtailing fraud and manipulation on secondary markets.

Austin proposes three regulatory solutions to thwart the proliferation of pump-and-dump schemes and make equity crowdfunding as fair and efficient as possible. She urges regulatory bodies to vet the companies whose securities are traded on the market, promulgate rules to ensure that securities have greater liquidity, and impose effective enforcement mechanisms to deter companies from pumping and dumping.

First, Austin argues that regulators of secondary markets need to strengthen their vetting processes. She suggests that regulators require anyone selling securities through crowdfunding websites to obtain certification from “market intermediaries,” which gauge companies’ potential for fraud and manipulation. Austin recognizes the potential for conflicts of interest between the market intermediaries and the companies they vet, since the companies would pay for the market intermediaries’ services. Still, she asserts that market intermediaries can help reduce fraud.

Second, securities sold on secondary markets are typically illiquid, or unable to be sold quickly and easily without a substantial loss of value. In the case of crowdfunded securities, smaller companies are only financially capable of issuing a small amount of securities in the first place, which means that investors are often unwilling to sell their securities at prices that buyers are willing to pay.

Austin states that markets hosting crowdfunded securities need greater liquidity. She contends that the inability to liquidate crowdfunded securities makes it easier for perpetrators of pump-and-dump schemes to inflate each security’s price, since buyers’ demand for the crowdfunded securities exceed the small supply available on the market. Among other options, Austin argues for requiring securities to be sold non-continuously and only during batch auctions, which would simplify the market’s surveillance of the trading.

Finally, Austin recommends an assortment of enforcement and penalty mechanisms to deter potential pump-and-dump perpetrators. For instance, Austin pushes for market intermediaries to generate regular reports about companies, implement sophisticated software surveillance systems, act leniently in punishing whistleblowers, and impose harsh prospective penalties for pump-and-dump fraudsters.

As small businesses and startups continue to proliferate, equity crowdfunding should also continue to develop as a funding source to allow for easy, simple access to capital. Thus, regulators may have no choice but to adopt Austin’s regulatory framework for secondary markets to ensure that crowdfunded securities are traded with minimal fraud. Who knows—perhaps, with more capital, the next great children’s television network or Italian food truck could be born.