November 17, 2015, by Richard Hyde

Crowdfunding and the Consumer

Crowdfunding is the practice of obtaining investment for a project from a wide variety of individuals. Rather than going to institutional investors, and obtaining funding through traditional debt or equity, those who seek crowd funding appeal directly to the public, and ask for funding, often in small amounts. Whilst crowdfunding can be used to finance personal ventures and as a medium for sponsorship, it has the potential to function as an important means of funding allowing businesses to develop products and  bring them to market. In such cases backers will often receive a reward for their funding, which is often a completed product. One of the most popular crowdsourcing platforms for this type of investment is Kickstarter, but a number of other platforms exist

Crowdfunding Contracts

As Rory Cellan-Jones has been reporting, people who pledge money on crowdfunding websites can be disadvantaged when the projects fail to deliver. Kickstarter has a detailed set of terms which govern the relationship between creator and backer, with the creator obliged to “complete the project and fulfil each reward.” If the creator fails to fulfil this obligation, the backers may have the ability to bring a claim for breach of contract against the trader. Whilst the standard required by the contract appears clear, the creator can avoid liability in the event that the project is not completed if they provide information to backers on the progress of the project and “work diligently and in good faith to bring the project to the best possible conclusion.” This is a term which takes into account that “backers must understand that when they back a project, they’re helping to create something new — not ordering something that already exists. There may be changes or delays, and there’s a chance something could happen that prevents the creator from being able to finish the project as promised.” Mollick suggests that most projects miss their target delivery date, even though the creators work hard to try and fulfil their promises. It seems fair and reasonable to provide a term allowing an extension in time in the investment contract, particularly where the creator must “offer to return any remaining funds to backers who have not received their reward (in proportion to the amounts pledged), or else explain how those funds will be used to complete the project in some alternate form.”

Whilst the contract between creator and backer exists, backers may be unwilling to seek remedies in contract (or in misrepresentation (or if a consumer the remedy under the Consumer Protection from Unfair Trading Regulations 2008 part 4A) if they have been induced to invest by false information). The amount invested may be small, and the cost of taking contractual action may be large, both in terms of expense and in terms of time. As Leff memorably argued, a private individual would need “superspite” to bring a claim. This means that the Claimant must be willing to inflict damage to him or herself in order to succeed against the Defendant. A further factor that might add to the costs of the case might be the cross-border nature of a crowdfunding dispute. As a creator and backer can be from different jurisdictions, questions of both jurisdiction and governing law may arise. Whilst the Kickstarter terms provide for disputes with Kickstarter to be governed by New York law and heard in New York, they do not provide guidance on the conflict of law questions occurring in disputes between creators and backers. Instead, these must be adjudicated through application of national and European law, not to mention the practical challenges of conducting litigation against an overseas body (particularly if that body is based in a jurisdiction outside the EU).

Crowdfunding and Consumer Protection

Given these challenges, it is likely that public regulation, and regulatory bodies, will play an important role in preventing detriment to backers. The obvious avenue is through consumer law, particularly that governing unfair commercial practices, although where particular sector specific legislation applies this will also play a role. The most obvious example is in relation to food, where food information is covered by a detailed regulatory regime, as are health and nutrition claims. The Unfair Commercial Practices Directive, implemented in the UK by in the Consumer Protection from Unfair Trading Regulations 2008, proscribes “misleading actions.” A presentation (such as on a Kickstarter page) about a crowdfunded project that contains false information (including false information about the development of prototypes or false information about the anticipated progress of the project) will be misleading, provided that it “causes or is likely to cause the average consumer to take a transactional decision he would not have taken otherwise.” Detailed discussion of the transactional decision test and the average consumer standard is beyond the scope of this post, but the result of the transactional decision test is that the Unfair Commercial Practices Directive does not look at the decisions made by actual consumers in response to a false or misleading statement; instead it looks at the effects that the misleading statement will have on a hypothetical consumer who is “reasonably well informed, reasonably observant and circumspect.” A misleading action is a criminal offence, which can be punished with up to two years in jail. However, misleading actions are only criminally prohibited when they are made to consumers.

Typically, investors in projects wouldn’t be seen as consumers. On a traditional funding model investment would be seen as a business to business transaction that would not attract the special protections of the EU Consumer Law acquis. However, the Kickstarter model is different. With its encouragement for large numbers of small investments in return for a reward, perhaps a copy of the good that results from the completed project or for creative possibilities (such as an appearance as a character in a crowdfunded book; a personal interaction with the creator; or a memento provided by the backer), the model doesn’t look like professional investment, but instead more like a model that involves a relationship between business and consumer. This is supported by the findings of research into Kickstarter, which shows that “most of the contributors at any point in the funding cycle are one-time backers that likely come from the entrepreneur’s own social circle.” This can be contrasted with peer-to-peer lending sites, such as Prosper, which may seem much more like investment businesses, depending on the practice of the .

In order to assess whether backers have the protection of the Unfair Commercial Practices Directive, it is first necessary to decide whether one of the parties is a consumer. Consumers are defined in the Unfair Commercial Practices Directive as “individual[s] who in relation to a commercial practice is acting for purposes which are outside his business.” It appears that in most cases the backers will not be professional investors, and will therefore be consumers. These backers will see the project not as a investment, but as a potential pre-sale of something that has not yet been created. They should therefore be protected as consumers and not treated as investors. Second, one must decide whether the creator is a trader. Traders as defined as those “acting for purposes relating to his business.” In some cases the creators are clearly businesses, but in others the status is less obvious (for example, projects involving arts or dance). Where the creator is not a trader, the relationship will be a consumer-consumer contract, and outside the scope of consumer law. The backer will be thrown back on the contract, with the challenges discussed above. Finally, it must be demonstrated that the misleading action is “directly connected with the promotion, sale or supply of a product to or from consumers.” In most cases the Kickstarter page will be concerned with the promotion of a product, and in some cases the reward will involve supply. Product is defined broadly to mean any good or service, so will cover most projects funded on Kickstarter or the rewards offered by the creator. However, it may be argued that where the project is neither involves the production of a good or the performance of a service, and the reward is intangible, then the Unfair Commercial Practices Directive is not engaged.

If the Directive is engaged, and a misleading action can be shown, enforcers may be able to obtain an injunction to prevent the misleading information being published. This power is found in the Enterprise Act 2002 part 8. Following the changes to the Enterprise Act by the Consumer Rights Act 2015, public enforcers may also be able to secure redress for backers who have suffered loss as a result of misleading actions by creators.

Posted in EnforcementUnfair Practices