RelayRides, one of the leaders in the emerging peer-to-peer car-sharing market, skidded to a stop in New York last week. The company shut down service in the state after officials issued a consumer alert about its insurance policies, calling them "illegal and inadequate."

Benjamin Lawsky, New York's superintendent of financial services, issued a damning statement about the company's policies.

“RelayRides sold New Yorkers a false bill of goods. Despite RelayRides’ assurances to the contrary, their New York customers could get left holding the bag financially for an accident because the company’s insurance is illegal and inadequate.”

RelayRides operates a sharing service in seventeen cities that allows car owners to rent their vehicles to anyone for short periods of time, bypassing traditional car rental services. RelayRides' closest competitor, Getaround, offers a very similar service in five cities.

With a presence in twelve more cities than its competitor, RelayRides got out ahead in the race to expand to new markets. But its problems in New York show why expanding too quickly can create major headaches.

The problem, according to New York officials, is that RelayRides assumed vehicle owners were covered under its $1 million insurance policy through a local insurance company. So the company told people renting out their cars that they would be reimbursed for any damages and would not have to bring their own insurer into a claim.

However, New York law says that anyone driving a vehicle -- renter or owner -- must be considered under a car owner's personal insurance. So when RelayRides told customers they would be protected by its own insurance policy if anything bad happened, the company was engaging in false advertising, according to New York officials.

On May 16, RelayRides shut down its service in the state. 

"Innovation, by its nature, does not always fit within existing structures. Although we’ve been careful to ensure the protections offered to our member community comply with legal frameworks around the country, we learned in conversations with the NY Department of Financial Services that it believes there is noncompliance with certain unique aspects of NY insurance law," said CEO Andre Haddad in a statement.

The news came just one day after RelayRides acquired a competitive car-sharing service, Wheelz, which increased the company's size by 20 percent and gave it some interesting new technology plays for connecting renters and car owners. The company's spokesman, Steve Webb, declined to comment beyond the official statement. But Webb did say that "every state is different, and we're working on a case-by-case basis to understand the difference."

Car sharing firms are saying little about these problems publicly. For example, before RelayRides abruptly ended service in New York, a spokeswoman at the competitor firm Getaround was eager to do an interview. Shortly after the news broke, however, the company avoided all of Greentech Media's requests for an interview on the subject.

Companies operating sharing services are no strangers to controversy -- particularly in New York. Just yesterday, New York City banned the room-sharing company Airbnb from facilitating short-term rentals, saying it violated a law preventing landlords from running illegal hotels. Also last week, SideCar, a company that uses a mobile app to create peer taxi services, was forced to suspend services in New York after a judge found it violated taxi laws.

So are these examples of companies expanding too quickly without truly understanding the law, or are they examples of archaic regulations that aren't keeping up with innovative business models in the sharing economy?

Robin Chase, the founder of Zipcar, thinks it's both.

"I'm not surprised RelayRides got kicked out of New York," said Chase in an interview. "The company's expansion was breathtaking to me. In many states, the car owner is unprotected, and they were putting car owners' insurance at risk. New York is a particularly bad state to operate in."

Chase, who co-founded the pioneering car-sharing firm Zipcar in 2000, started GoLoco, a ridesharing company in 2007. (Since all passengers are going to the same place and the service is not a "taxi," the company does not violate insurance laws).

In 2011, Chase started the peer-to-peer car company Buzzcar in France. One of the main reasons for the shift to France was her ability to get an insurance policy that would actually cover all parties. Since only California, Oregon and Washington state have adopted insurance laws to accommodate car sharing, Chase worried about the legal implications of expansion in the U.S.

As a long-time entrepreneur in the car-sharing space, Chase is extremely excited about the potential for new business models. But she worries that some startups are either naive or deliberately hiding the reality of insurance regulations.

"I'm all for transportation innovation. And we need to change insurance laws so that it can happen. But right now some companies are basically lying about what will happen with a customer's insurance, or they don't know -- and that's creepy. I'm stunned at some of the VCs that are backing them."

Leading car-sharing companies have been raking in the venture capital. RelayRides brought in $13 million from a range of firms, including Google Ventures and General Motor Ventures; Wheelz, the company just acquired by RelayRides, raised $14 million from Fontinalis Partners and Zipcar; and SideCar recently closed a Series A round with Google Ventures and Lightspeed Venture Partners for $10 million.

Of course, Zipcar faced its share of problems when starting out as well. The company received some complaints from homeowners worried about a business operating on the street in their neighborhoods. But people eventually became comfortable with the concept, and those complaints faded. 

Zipcar was able to avoid many of the regulatory headaches other firms are currently dealing with because it operated its own fleet of vehicles. The new wave of peer-to-peer services cuts out the middleman -- making car sharing more efficient, but also making insurance liability much more complicated. Since insurance laws are set on a state-by-state basis, putting the regulations in place to make the sharing economy easier to implement will be more difficult than overcoming simple perception barriers.

“I have no doubt that shared cars are 100 percent the future. But right now it’s illegal in some states,” said Chase. “We need to enable people to share their cars, and something needs to change legally to allow that to happen.”

Startup peer-to-peer car-sharing companies will need to spend precious time sorting through these regulatory issues if they are going to protect their customers and continue expanding. Although some question the prudence of expanding into markets where the law is unaccommodating, the strategy has spurred a needed debate about regulatory reform as the lines between consumers and traditional companies blurs. It may just take this kind of legal scuffle to create change.