Crowdfunding in Bankruptcy: What Happens to Backers When the Project Fails? Part I: Why Crowdfunding Is Different

For the uninitiated, “crowdfunding” is a form of fundraising in which many relatively small contributions are sourced from a “crowd” of “backers” to support a prospective goal, product or company. Crowdfunding transactions can be structured as donations, pre-orders, loans or even equity investments. With the rise of internet platforms such as Kickstarter, crowdfunding has become an easy way for early-stage companies to obtain financing, test the market and bring attention to their products. According to one industry report, the total volume of crowdfunding transactions exploded from $2.7 billion in 2012 to $34.4 billion in 2015.[1] However, as crowdfunded companies fail to live up to early hype,[2] unique challenges are likely to arise in bankruptcy and other insolvency proceedings.

Traditionally, companies have obtained funding through either debt or equity. In debt transactions, lenders assume comparatively less risk in exchange for a fixed return. In an equity transaction, investors assume comparatively more risk in exchange for an unlimited potential return. These expectations are codified in the Bankruptcy Code’s priority scheme, with the order of distribution roughly tracking the amount of risk each class of claimants assumes in its dealings with the debtor.[3] That paradigm seems fair so long as risk and potential upside are linked.

However, through crowdfunding, a company can spread the risk of failure across thousands of backers while preserving all of the upside for its owners. Since the risk is so diffused, and because individual contributions are typically insignificant, backers have very little incentive to seek recourse should the company become insolvent. Thus, in the foreseeable event that only a handful of backers assert claims against a failed crowdfunded venture, is it really fair to allow the company’s owners to personally retain the value of backer contributions?          

To provide a real-life example, consider what would happen if the company behind the most successful crowdfunding campaign ever, video game startup Cloud Imperium Games (CIG), filed for bankruptcy. Over the past five years, CIG has raised over $150 million to fund the development of its upcoming title, Star Citizen, solely through crowdfunding.[4] After a successful Kickstarter campaign, CIG created a website through which backers can “pledge” money for development in exchange for virtual spaceships that will be available for use in-game when Star Citizen releases. To date, each of CIG’s more than 1.8 million backers has paid an average of $83.[5] Should the development of Star Citizen collapse, there would almost certainly be an enormous fight over the treatment of CIG’s backers in bankruptcy.

Do Crowdfunding Backers Have Valid Claims in Bankruptcy?

First, to what extent are backers entitled to participate in a bankruptcy case by, most importantly, filing a proof of claim? Section 101(5) of the Bankruptcy Code broadly defines the term “claim” as “a right to payment ...” or “a right to an equitable remedy for breach of performance if such breach gives rise to a right to payment....”[6] Thus, whether backers have valid claims turns on whether they have a valid cause of action under the terms of the crowdfunding transaction. For crowdfunding transactions that are clearly structured as a loan or equity investment, the claims are unlikely to be disputed. However, ambiguity arises where the transaction could be characterized as either (1) a pre-order or (2) a “donation” accompanied by a “reward.”

For example, Kickstarter’s terms of use provide that:

When a creator posts a project on Kickstarter, they’re inviting other people to form a contract with them. Anyone who backs a project is accepting the creator’s offer, and forming that contract.... When a project is successfully funded, the creator must complete the project and fulfill each reward.... The creator is solely responsible for fulfilling the promises made in their project. If they’re unable to satisfy the terms of this agreement, they may be subject to legal action by backers.[7]

Since Kickstarter’s terms of use expressly provide for the creation of a contract, Kickstarter backers’ claims should be allowed in bankruptcy.

Furthermore, Kickstarter backers are arguably entitled to priority status under § 507(a)(7) of the Bankruptcy Code, which elevates the claims of individual unsecured creditors, up to $2,850, arising from the pre-petition deposit of money for undelivered goods or services for personal, family or household use.[8] Since Kickstarter campaigns almost always involve consumer products, Kickstarter backers will frequently be entitled to priority status under § 507(a)(7). For example, former crowdfunding darling Skully Inc. scheduled its backers as priority unsecured creditors in its recent chapter 7 case.[9]

By contrast, CIG’s terms of service characterize backer contributions as “pledges” that, once spent by CIG on game development, are nonrefundable even if development ceases and the game and promised spaceships are never delivered.[10] While Star Citizen’s terms of service have not been challenged in court, they are obviously aimed at shielding CIG from liability to backers should the project fail.

Importantly, bankruptcy courts will disallow claims that are unenforceable by agreement or under applicable nonbankruptcy law.[11] Thus, if a bankruptcy court were to uphold CIG’s terms of service, the claims of Star Citizen’s more than 1.8 million backers would presumably be disallowed, effectively allowing CIG’s owners to retain the residual value of the more than $150 million in pledges. While that result seems required by a straightforward application of the Bankruptcy Code, it is at odds with the general principle that estate assets should be distributed according to the “risk-return package” assumed by each class of claimants.[12] In short, the Bankruptcy Code simply was not designed to deal with these types of transactions.

Now that some of the key concerns posed by crowdfunding in bankruptcy have been identified, stay tuned for Part II of this article, which will explore various potential solutions to these challenges.