Negative Assurance Letters in EB-5 Offerings (Vol. 4, Issue 3, January 2016)
With increased scrutiny of the EB-5 program by lawmakers and more action with the Securities and Exchange Commission (SEC) stretching into 2016, we expect ongoing attention drawn to securities compliance and litigation risk mitigation throughout the EB-5 industry. It is foreseeable that issuers may be asked to provide disclosure or negative assurance letters (also known as 10b-5 letters) to parties in an EB-5 deal, such as broker-dealers, placement agents and state-owned regional centers that affiliate with projects. With the SEC striking issuers and EB-5 market participants with allegations of securities fraud, issuers and other parties involved in deals will be more concerned with reducing exposure in deals.
Brief overview of Rule 10b-5
Rule 10b-5 is a key anti-fraud provision under the Securities and Exchange Act of 1934 (Exchange Act). When you see a case of securities fraud prosecuted by the SEC, 10b-5 is most certainly among the allegations. 10b-5 liability can be broad, reaching issuers and other market participants in deals including broker-dealers, regional centers and placement agents, among others who participate in selling a deal. Negative assurance letters may provide participants in a deal such as broker-dealers or placement agents with a due diligence defense to 10b-5 and fraud allegations based on the issuer’s failure to disclose material facts in offering documents.
Because broker-dealers, placement agents and other market participants can be charged with fraud under 10b-5, issuers of EB-5 securities should be prepared to respond to requests for negative assurance letters. In the current climate of intense anti-fraud SEC litigation efforts, broker-dealers and placement agents may condition participation in a deal on issuance of a negative assurance letter. Negative assurance letters are not legal opinions, but they function as a defensive tool to confirm in future litigation that adequate due diligence was done as offering materials were prepared. At the same time, such letters do not provide comfort regarding the accuracy, fairness or completeness of offering materials, and they should not be used in a marketing process. Let’s briefly review what negative assurance letters are in a securities transaction, and then connect this concept to EB-5 practice.
What is a negative assurance letter?
In public offerings of securities, there is a customary practice of underwriters and initial institutional purchasers of securities to require that issuer’s counsel provide negative assurances regarding the disclosures in a registration statement. The reason is simple: underwriters and initial purchasers in registered offerings want to be reassured that offering documents do not contain false statements that can lead later to allegations of securities fraud or rescission claims. This practice of issuing a negative assurance letter has become more common in deals involving unregistered securities or private placements. Why is the term “negative” assurance used? As explained below, the focus in such a letter is on affirming that disclosures have not been improperly omitted, as well as ensuring that omissions are not misleading. In other words, a negative assurance letter is not an exercise to verify that facts are true in an offering, or to affirm the completeness of an offering. The focus is on disclosures, and more specifically on providing the recipient with a modicum of assurance that an issuer is not withholding material facts from investors, or misstating facts that belong to the relevant total mix of information about a transaction..
In a negative assurance letter, usually the lead securities and transactional counsel for a deal will provide a statement that affirms their involvement in the preparation of a registration statement. For such a letter to have any value or meaning, counsel would need to be able to assert that they followed the development of the offering by being present as discussions occurred with an issuer, management, other counsel and experts from various areas. In their negative assurance letter, counsel would state that after reasonable investigation, no facts came to their attention that caused them to believe that the offering document was misleading. Counsel would also affirm that nothing had come to their attention that caused them to believe that the offering materials omitted any material fact necessary in order to make the statements in the offering materials, in light of the circumstances under which those statements were made, not misleading. The recipient of such a letter may have a potential due diligence defense in later litigation alleging fraud, if that party relied on the negative assurance letter to confirm that due diligence was performed before the securities in question were sold.
How might negative assurance letters be relied on by market participants in an EB-5 deal?
A broker-dealer or placement agent selling a deal to investors will likely want to be able to assert that due diligence was performed before any sales were made. Requesting a negative assurance letter is not common among broker-dealers and placement agents in the EB-5 industry right now. But this may change as the SEC continues to cast a broad enforcement net. After-the-fact, mechanical or static due diligence that is accomplished by a review of an offering, without ever participating in drafting of the offering documents, is not effective. Such efforts do not catch deficiencies in disclosures. More specifically, by being present when a deal is shaped, securities counsel is aware of facts that may not have made the final cut into disclosures. Such counsel also has expertise in materiality with respect to disclosures. Hence a prudent broker-dealer or placement agent will ask securities counsel for a negative assurance letter before selling a deal.
Negative assurance is not an affirmation that statements in offering materials are true, or that disclosures are legally adequate. Rather, counsel affirms in a negative assurance letter that due diligence took place during the offering. State-owned regional centers that do not issue securities but that affiliate with EB-5 projects issuing securities would be prudent to require a negative assurance letter before accepting or affiliating with an EB-5 offering. It is noteworthy that in related-party EB-5 deals, where a regional center acts as an issuer and engages in selling a deal, a negative assurance letter would not be useful unless it were to be prepared for an unrelated third-party that had a legal claim to a due diligence defense in litigation. Due diligence certifications, attestations, or purported negative assurance letters that are provided to an issuer by counsel or a due diligence service may have no probative or evidentiary value in an investigation or litigation involving securities fraud.
EB-5 transactions are becoming a more normative part of the private offering landscape
As EB-5 financing becomes a permanent fixture in capital markets, the industry is going to adapt by integrating more normative practices that protect all parties in deals. The growth of the EB-5 industry is so compressed that we are seeing rapid developments on both the litigation and investigation fronts. This is taking place while there is a degree of uncertainty about what steps lawmakers or agencies may take in the near future to require EB-5 market participants to affirm compliance with securities laws.
2015 was an unprecedented year for EB-5. The increase in SEC enforcement and litigation is a good indicator that EB-5 market makers, regional centers, placement agents and broker-dealers will have to refine and calibrate practices to bring them in step with securities laws. With the EB-5 industry moving in the direction of more due diligence in deals and overall tighter compliance, we expect to hear more about negative assurance letters and additional due diligence steps that issuers will need to adopt.