Consumers are Totally Inadequately Protected in the Case of Crowdfunding
By Tobias Pielsticker, Attorney-at-Law and Specialist Lawyer for Banking and Capital Market Law
Despite the small investments in each case, crowdfunding represents a major risk for consumers and in many cases this risk will materialize in the years to come with losses running into millions. This situation is the result of inadequate consumer protection by the platforms and a lack of opportunities for investors to defend themselves effectively.
The intensive advice I have provided to hundreds of investors on various crowdfunding platforms in the real estate sector since 2021 has led to the conclusion that consumer protection is completely underdeveloped in these investments and that the platforms are also taking advantage of this situation for their own benefit. In the early years of these business models, the serious effects did not become visible only because real estate project development and real estate prices experienced an extraordinary boom at the same time. These days are now over and the shortcomings that have always existed are becoming apparent.
Real Risks are not Apparent to Consumers
The legal requirements, including those under the Crowdfunding Regulation (EU) 2020/1503, allow for a very formalistic information that usually does not make the real risks of crowdfunding transparent. It is sufficient to point out the abstract risks of the legal structure and the possibility of a total loss, however, it is less important for the consumer that a total loss is possible, but rather what it depends on and how likely it is. As a mere buzzword, total loss is hardly meaningful, as it is also conceivable with government bonds, for example, but is very unlikely there.
In the case of crowdfunding for a real estate project, the probability of a loss depends above all on the likelihood of successful realization and marketing, from which a repayment to the investors can be generated. The assessment of this likelihood is not based on legal factors, but on facts, such as the performance of the project developer, the location of a property, the construction status and the senior liabilities already encumbering the project. However, sufficient information on these facts is not required and is therefore often not provided.
Practice shows that many projects have failed not because of an unfavourable development, but because the property project was already in a serious crisis beforehand, was excessively burdened with senior liabilities or was developed by an incompetent project developer who had already caused negative reports in the past. Without information about such circumstances, no investor can make an investment decision on their own responsibility, but on the other hand there are no clear requirements that would oblige a platform to provide such information. The problem is also reflected in Art. 5 of the Crowdfunding Regulation, which is promisingly titled Due Diligence Requirements, but then reduces this due diligence to a minimum that is usually completely worthless from the investor’s point of view.
To a certain extent, the Crowdfunding Regulation therefore also contains a false labelling, as is the case with a number of platforms with their alleged ratings. The platforms promise investors that they will carry out a professional review and evaluation of the projects, although the checks are often only superficial and the evaluation therefore lacks a serious basis. This is possible because neither at European nor at German level are sufficient standards in place for such a review and evaluation.
The effects in practice can be illustrated by the experience gained from a double-digit number of lawsuits against a crowdfunding service provider before the Hamburg District Court. This company operates one of the largest German platforms for crowdfunding and in the proceedings in question, consumers are asserting claims for damages in connection with a failed project. The platform had rated the project with its own class A and thus the second-best rating, only to then defend itself against the consumers‘ claims by arguing that, as a mere intermediary, it had only provided the platform in this case and had therefore not checked the information provided to it for accuracy or completeness and had only had to make a very rough risk assessment without any guarantee. This is just one example of how consumer trust in the examination and evaluation of a project by a platform can be abused.
Another example of misleading consumers is the widespread advertising with collateral, although this has no economic value at all. The Hamburg Higher Regional Court is currently preparing an investors‘ class action lawsuit against the same platform, in which the question will be examined as to whether it was permissible to advertise the crowdfunding project with a security in the form of a first-ranking land charge, although this land charge was virtually worthless for the investors due to the priority protection of the buyer of the property.
The same applies to personal guarantees that are partially presented as collateral for qualified subordinated loans, even though, due to the requirements for qualified subordination, the guarantee must also be structured in such a way that it can only be enforced if the debtor is solvent. The security could therefore only be used if it is not needed at all due to the debtor’s solvency.
However, this is only a minor issue with regard to subordinated loans with qualified subordination. The much bigger problem here is that such a structure always puts consumers at an unreasonable disadvantage, as their rights are extremely weak. This also means that the Crowdfunding Regulation cannot be applied to these loans, which are not necessarily repayable.
The qualified subordination serves primarily to circumvent the requirements for conducting banking operations in terms of deposit business, and this must be seen as a self-contradiction in relation to consumers. In the area of normal loans, which give consumers a strong legal position vis-à-vis the borrower, they are also protected by the German Banking Act (Kreditwesengesetz) insofar as only particularly qualified and reputable persons may be borrowers – in
contrast, there are no such requirements for borrowers in the case of qualified subordinated loans, even though these place consumers in an extremely weak legal position. Lawmakers would therefore be well advised to prohibit subordinated loans with qualified subordination in relation to consumers completely.
In this context, too, it is hypocritical for platforms to defend themselves by claiming that they recommended consumers seek legal advice on a crowdfunding project. The average return on crowdfunding is estimated to be less than €600. Legal advice, which would inevitably have to include an assessment of the project, would therefore be significantly more expensive than the potential return.
Consumers are De Facto Navigating a Legal Vacuum
The latter nexus also applies in another area that increases the risks for consumers through crowdfunding. Specifically, in most cases, it cannot be expected that errors and breaches of duty on the part of platforms in the intermediation of crowdfunding will be sanctioned at all, because neither the consumer has a sufficient interest in doing so nor would legal assistance be available.
The German legislator has found the elegant term ‘rational disinterest’ to describe this phenomenon. It refers to cases where consumers deliberately choose not to pursue their claims because they consider correctly the effort involved to be disproportionately high. A typical example of this is claims for delayed or cancelled flights, but legal service providers offer success-based support in return, which ensures that consumer protection does not come to nothing.
In the area of crowdfunding, the losses are often only in the three-digit or low four-digit range, so that sole consumers must also be left with the impression that enforcing a claim for damages would not be economically viable for them. At the same time, there are no legal service providers offering support similar to that available for air passenger rights. There is an understandable reason for this: unlike a cancelled flight, it is much more difficult to enforce a consumer’s claim in the event of a failed crowdfunding project.
This also applies to legal support, which is generally not feasible for financial reasons. The average amount of crowd financing in Germany is likely to be less than €5,000, and at the same time, legal preparation involves a great deal of work, as the legal arrangements are complex and both the construction project and the project developer must be reviewed.
As a result, successful action against platforms on behalf of aggrieved consumers is only conceivable where a large group comes together and thus gains clout. However, this is the exception, and in many cases, consumers have no possibility of pursuing claims for damages.
The platforms are naturally aware of these connections, and it would be surprising if they had not been incorporated into their business models. In many cases, at least, there is evidence of a completely underdeveloped complaints management system, which may be based on the assumption that consumers are unable to defend themselves effectively anyway.
Such a legal vacuum could also be curbed by higher and clearly defined standards for information provision by the platforms, as this would make it easier for consumers to seek legal redress in the event of errors or breaches of duty.
Conclusion
Today, crowdfunding poses a much greater risk to consumers than they are aware of. This is particularly true for offers on the Grey Capital Market. The consequences will become very clear in the next years, as the failure of many projects is already foreseeable today. The fact that the individual amounts are often small should not obscure the point that consumers often invest large portions of their disposable income in this segment by spreading their investments across many crowdfunding projects. Politicians and regulators must take action!
The insight can be downloaded here and in a German translation here.
Photo Credits:
- Tobias Pielsticker: Tobias Pielsticker
- Empty pockets: derneuemann @ Pixabay
- Stairway: Mikewildadventure @ Pixabay
- Desperate: Fotorech @ Pixabay