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On June 27, 2012, The Motley Fool electronically submitted the letter reprinted below to Secretary Elizabeth M. Murphy of the U.S. Securities and Exchange Commission. We hope these proposals will help protect ordinary investors.

Dear Ms. Murphy,

As individual investors, we are concerned that the JOBS Act lowers the bar for the vast majority of companies going public and re-exposes Americans to some of the worst financial abuses in recent memory. We believe it is incumbent on the Commission to mitigate these abuses and protect the integrity of our capital markets.

To this end, please consider the following recommendations that expand on our senate testimony. The first section contains our recommendations associated with Title III of the JOBS Act -- the creation of a crowdfunding market. The second section contains our recommendations related to Title I -- the exclusion of "emerging growth companies" from the prevailing regulatory regime. The third section contains our recommendations associated with Title II of the JOBS Act -- the removal of Regulation D's general solicitation ban for Rule 506 offerings.

I. Title III Recommendations -- Crowdfunding

A. Introduction 
In principle, we're not opposed to crowdfunding. However, the opportunities for misuse and abuse are enormous due to the inherently speculative nature of start-ups, as well as what will certainly be weaker accounting scrutiny and corporate governance.

As the SEC designs the rules governing the crowdfunding market, it will need to focus on investor education; liability and accountability for intermediaries, issuers, and key persons; clear and comprehensible disclosure; and prohibitions on scams.

No matter which figures you look at, the failure rate for start-ups is high. According to Harvard Business School, 30% to 40% of start-ups lose most or all of their money, 70% to 80% fail to meet projected returns on investment, and 90% to 95% fail to meet declared projections.
B. Investor education 
As the statute makes clear, brokers and portals must verify that investors understand the risks of investing in crowdfunding.

Kate Mitchell, former managing director of the National Venture Capital Association and head of the IPO Task Force, recently noted that 40% of her venture capital investments lose their money, 40% basically break even, and only 20% make money. Crowdfunding will presumably have a lower success rate than Ms. Mitchell's fund, given that, among other things:

  1. crowdfunded companies are far earlier in their development life cycle than venture capital investments,
  2. many of the best ideas will already have been poached by venture capital firms,
  3. non-professional individual investors may not have the opportunity or expertise to conduct venture-capital-level due diligence, and
  4. criminals are obviously aware of No. 3.

Title III charges the Commission with designing a quiz that would be made available by portals or brokers that investors would need to pass before investing in crowdfunded ventures. Among other things, investors would need to demonstrate that they understand the rate of start-up failures and the risks inherent to crowdfunding:

This suggests a different, and more involved process, than simply checking a box ostensibly verifying the reader has reviewed a series of terms and conditions. There should be several multiple-choice questions tailored to testing whether prospective investors understand the nature of crowdfunding risk, the potential for fraud, their legal rights and issuer responsibilities, and the probability of losing the entirety of their investment in speculative, early stage ventures, among other things.

C. Liability and accountability 
If crowdfunding is to succeed as a start-up funding mechanism rather than as a backwater for hucksters and frauds, the Commission will need to ensure that there is sufficient transparency, liability, and accountability such that quality issuers are distinguishable from low-quality issuers.

A few examples:

  1. Background checks: Sec. 4A(a) requires brokers and funding portals to obtain a background �check and a securities enforcement regulatory history check. 
    While obtaining these checks is an important step, the information could be even more effective at weeding out scammers if the Commission requires brokers and funding portals to prominently display the results of those checks, insofar as the information discovered bears on the honesty of the individuals checked. (We don't care about speeding tickets.)
  2. Crowdfunding history: Quality leadership is vastly more important for the fate of small companies than large ones. What's more, crowdfunding scammers are vastly more likely to repeatedly escape prosecution and regulatory enforcement than those at the small-cap level, given their lower profile and the smaller amounts of money involved. 
    The Commission should therefore also require brokers and portals to perform and disclose checks on the crowdfunding history of officers, directors, and people holding more than 20% of outstanding equity of the offered securities. 
    "History" here means their record of crowdfunded issues and each issue's status: proposed (pending), proposed (dropped), active (with link to most recent financial performance report), and terminated (with final shareholder return). Such a check shouldn't be too expensive, as the crowdfunding intermediary industry will have already collected all the data it needs. 
    This is important for allowing investors to have the material information they need to make informed investing decisions and for weeding out and apprehending repeat scam artists. Brokers and portals could flag suspiciously prolific individuals to potential investors and enforcement officers. It's one thing to seek funding for a variety of ideas -- it's another to raise $300,000 for 20 different ventures and continually "lose" the money.
  3. Residency requirement: In order to ensure access to legal recourse and enforcement actions, the Commission may need to require that all issuers' officers, directors, or holders of more than 20% of outstanding stock be residents or citizens of the United States, or of some country where the Commission would be able to easily pursue enforcement actions.

D. Prospectus disclosure 
The Commission should create and mandate a simple, uniform, easy-to-understand yet comprehensive template prospectus that is similar in principle to the mutual fund industry's summary prospectus.

Doing so would streamline the filing process for issuers, most of whom won't be able to afford a team of lawyers. A web-based template filing would also make it easier for portichs to collect and display the key information about each issuer that investors would need to know when screening for and analyzing issuers.

Among other things, the prospectus should disclose: issuer and individual backers' identities including executives, directors, and persons holding more than 20% of outstanding equity; business plan; financial statements (if applicable); proposed valuation; amount being raised; related party transactions; executive, director, and employee compensation; and any payments made for lead generation and solicitation (if applicable).It would also partially alleviate the need for the Commission to create a slew of rules that would otherwise be necessary to contain the potential for scams to proliferate in the fine print. It would clearly be abusive, for instance, for a start-up to raise $1,000,000 in exchange for 0.001% of its shares. In the absence of checks provided by underwriters and financial media, it would be relatively easy to scam investors in the crowdfunding market by hiding such information in the fine print of a 100-page legalistic prospectus.

In short, creating and mandating a fill-in-the-blank prototype (and providing an example of a good prospectus) would streamline the crowdfunding process by ensuring that issuers know what information they need to provide, help portals and brokers comply with their oversight role, protect investors, and save the Commission from having to consider and ban every possible scam that the traditional IPO process would have ordinarily caught.

E. Wanton dilution and other tantalizing scams 
Given the lack of traditional corporate governance enforcement mechanisms, the Commission will need to ban certain abusive practices outright.

Here are three examples, though there will undoubtedly be more:

  1. As noted earlier, it would be possible for an issuer to raise up to $1,000,000 in exchange for only a negligible ownership interest. While the statute sets a maximum aggregate issue amount at $1,000,000 per issuer and requires disclosure of valuation, it does not specify a maximum issuer valuation. The Commission will need to set one -- perhaps at something two, five, or 10 times the aggregate issue limit -- and each issuer's proposed valuation should be prominently communicated to potential investors via the prospectus.
  2. Similarly, unscrupulous issuers might sell a special class of shares to the crowdfunding public that they eventually dilute in future offerings, leaving insider shares undiluted. Unlike venture capital firms, crowdfunding investors won't have the ability to negotiate protection from potentially abusive dilution. The Commission should therefore implement a rule to protect investors from excessive dilution.
  3. Unsavory issuers may seek to pay outsized salaries, bonuses, dividends, or other perks to officers, directors, or outstanding shareholders. Such payments could be an effective and legal means of embezzlement. 
    What's more, due to the limited liquidity of crowdfunded shares, even if a reasonable salary is disclosed in a prospectus, investors will have little recourse if the issuer changes its compensation in later years, say, to the entire equity of the company. 
    In light of the unique features of the crowdfunding market, while we understand that the SEC is traditionally a disclosure-based organization, we believe it should set a maximum aggregate compensation amount for officers, directors, and dividends at some percentage of the issuer's tangible book value.