Crowdfunding: The Bankruptcy Loophole

January 30, 2018

Crowdfunding Origins: Fans Expand Their Range

Crowdfunding as we know it today first gained prominence in 1997, when fans of the near-defunct British rock band Merillion happily coughed up $60 000 to fund a USA tour by their favourite act. A capital raising model predicated the passion of fan power was naturally suited to the creative arts, and many musicians, film makers and other types of creatives followed Merillion’s lead to give their supporters the opportunity to get involved in an intimate creative and commercial experience.

In the early 2000s, fuelled by increasing levels of digital connectivity, the global public fell in love with the novel idea of becoming a business fan – of, in other words, playing a personal role in getting unique commercial projects off the ground. As this idea matured, major crowdfunding portals emerged, including the likes of Kiva, IndieGoGo, Kickstarter, GoFundMe and many others. The age of business crowdfunding had arrived.

Familiar Failures

Today, we routinely hear of major crowdfunding projects that seek – and secure – millions of dollars in backing. Of course, with so many projects on the go, we also increasingly hear of the failures. Where did all the money go, backers of failed projects ask? Where is the product that was promised? What can be done to hold creators to account?

IbackPack, for example, raised $720 000 USD in 2015 through Indiegogo, and then another $70 000 USD from Kickstarter in 2016. Thereafter, the project seemed to vanish. Videos were removed from project pages and communications stopped. The project leaders cited battery issues, but were met with scepticism. No refunds were offered to backers. Many major crowdfunding projects have followed this familiar pattern, from the CST-01 Super Thin Watch to the Skarp Laser Razor to the ZANO Autonomous Drone.

In such cases, formal legal language is often utilized by angry backers, who instinctively view themselves as creditors. The reality, however, is that crowdfunding does not operate within the same legal framework as conventional business, and very seldom do crowdfunding creditors even exist.

Legally, Backers Are Not Creditors

In typical transactions, a commercial relationship is made in which equity is issued or a debtor/creditor relationship exists. However, crowdfunding is based on a contractual agreement that operates outside of these typical relationships and limits the application of the Bankruptcy and Insolvency Act.

Firstly, the American JOBS (Jumpstart Our Business Start-ups) Act prevents the issuance of equity for crowdfunding projects. Simply put, you can’t sell equity without abiding by existing securities regulation statues, which preclude crowdfunding for equity stakes. Even when project creators operate outside the USA they remain largely bound by the American legal framework. This is because most of the major crowdfunding portals are US based, and their contracts are set up according to US law.

Also, unsecured claims are a crowdfunding rarity. In conventional business, if a company fails to deliver the finished goods it fails to satisfy the terms of a contractual agreement. The funder can then make an unsecured claim. With crowdfunding, however, the terms of the contract created by the portal (see, for example, the Kickstarter Terms of Use) usually centre on ethical intentions rather than legally defined actions. Failed creators need only demonstrate good faith actions (‘responsible’ use of funding, diligent effort etc.) If they meet these terms they are able to declare the project failed – without providing a refund or delivering the product.

Absent an equity stake, and unable to claim as unsecured creditors, crowdfunding backers are not creditors in the legal sense. The only legal creditors to the business might be those who have supplied existing loans and company suppliers, who will generally be paid immediately on provision of their service (using crowdfunded money, of course). This means the creators of failed crowdfunding projects don’t need to file a bankruptcy. They can simply walk away. 

Two Key Implications

This unique legal paradigm expounds two important philosophical points, relevant to backers and creators respectively:

  1. Backers will always be fans

Crowdfunding backers should be aware that legally they will always fall into the fan category. Essentially, their support equates to the decision to give a loan to a distant family member, made on the primary basis of trust. Such lenders, we all understand, are foolish to assume repayment or project delivery according to the letter of any law. Rather, they should view their contribution through the lens of a fluid (often, exciting, but equally often disappointing) human experience.

  1. Creators can manipulate the system

First time entrepreneurs often struggle to secure financing from a formal institution. While they may have a great idea, they lack assets to offer as collateral and a track record of business activity. A crowdfunding failure, however, puts the same entrepreneur in a much better position to approach a formal lender. Even when the project fails dismally, backers effectively gift creators assets and a track record of activity. It is therefore distinctly possible, and logical, for failed creators to use crowdfunding support to leapfrog into a position from which to approach a financial institution. In this context, crowdfunding failure can be planned and carefully executed as a positive business step. If the backer doesn’t understand this at the outset, they can easily end up feeling conned.

Conclusion – Being a Business Fan Isn’t The Same as Being in Business

Supporting a company as a fan is uncertain, and formal legal processes often don’t apply. Indeed, astute business people can easily take advantage of the fan’s passion to better their commercial standing. Context, as always, is the key factor. Those looking for a clear legal framework and positive returns should stick to conventional investments. If, on the other hand, supporting the development of raw potential through an uncertain process excites you, crowdfunding could be exactly the experience you’re looking for.


Michael Litwack is a Manager in the Restructuring practice of Farber. His practice focuses on corporate restructuring, insolvency, and distressed financial advisory services. Michael can be reached at 416.496.3087 and mlitwack@farbergroup.com