Whenever the topic of fraud is mentioned, crowdfunding proponents immediately state that it already happens in the U.K. and that there hasn't been any fraud. They also insist that the power of the crowd will "out" any malfeasance.

Again, it goes back to what does the investor get out of this deal -- which carries a huge risk and very little chance to see any reward. Then who benefits from crowdfunding if it isn't investors?
  • Companies looking for capital get money from investors with no obligation
  • Crowdfunding portals that will earn money from listing companies, potential company profits and side revenue like job finders.
  • FINRA, which earns fees from crowdfunding portals registration -- a minimum of $15,000 for each firm

Of course, FINRA should be looking past fee-gathering and toward protecting investors, but that would require FINRA to hire more people to now police a whole new market. Unfortunately, FINRA is housed under the SEC, and the SEC is facing a funding cut of $108 million due to sequestration. The Investor Protection Fund will also be cut by $7 million. The SEC said it didn't expect furloughs or a reduction in force, but that the cuts would impact hiring and technology investment.

Other ways FINRA could protect investors would be by requiring portals to carry insurance in the event of fraud. So far, few insurance companies sound interested in providing this type of coverage.

Bob Sargen wrote in The Specialty Insurance Blog that, "We anticipate that underwriters will initially exclude capital raising activities via crowdfunding outright, or will charge an increased premium to cover this activity."

Some of the reasons they cite for not wanting to cover this activity?: claims from small investors, fraud from relaxed distribution controls and lack of knowledge leading to errors.

FINRA could provide for a marketplace of these shares after the one-year restriction. It should at least give these shareholders a chance to place some value on their investments.

FINRA could require the portals to hire supervisors just like regular broker-dealers. Of course, most websites are just now seeing their costs skyrocket -- welcome to the world of finance. FINRA could also require fraud-detection software. For now, these are just suggestions; there is currently little in the way of ideas for investor protection.

Investors need to be wary. Whenever there is a positive argument being made for an investor to crowdfund, it invariably comes from a crowdfunding company -- not a registered investment adviser and not from a registered broker-dealer. It tends to come from someone who will benefit more than the investor.

-- Written by Debra Borchardt in New York

>To contact the writer of this article, click here: Debra Borchardt.
Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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