RCBJ Retrospective: THE COMING INTEGRITY ACT: WHAT DILIGENCE IS DUE?

05.20.16 | Archived

homeirerThe Coming Integrity Act: What Due Diligence is Due? 

by Michael G. Homeier, Esq., Founding Shareholder, Homeier & Law, P.C.

Senate Bill 2415, the “EB-5 Integrity Act of 2015” (the “Act”), was introduced on December 17, 2015 to revise the EB-5 Regional Center Program (the “Program”), followed two months later by introduction in the House of Representatives of the very similar companion bill H.R. 4530. The Act remains a work in progress, pending passage by both houses of Congress and eventual signing by the President. With the anticipated circus of the upcoming electoral season, only the most optimistic observers believe passage might occur before a new Congress, and new President, take up a re-introduced Act in early 2017 (after the Program is again extended beyond Sept. 30, 2016).

Nevertheless, the Act as currently introduced remains highly significant to EB-5 participants. Improvements and corrections proposed by industry stakeholders and successfully negotiated into the prior legislation before it was shelved in mid-December 2015 remain in the Act. The Act addresses primarily the securities and corporate aspects of that prior legislation. Stakeholders can look to the Act to see what additional requirements Congress seems bent on adding to the Program. Depending upon how successful are presently-ongoing efforts to improve the Act, clarify its terms and application, and avoid unintended adverse consequences that could cripple or kill the EB-5 Program, it seems safe to assume the process will end up with Program changes more or less along the lines proposed in the Act presently.

The crosshairs of the Act’s focus are squarely set on regional centers (“RCs”). This no doubt reflects the popular misconception of the Program as uniquely fraught with fraud, criminal activity, and terrorist drug-running investors laundering millions of ill-gotten dollars through EB-5 investment, with the thinking evidently being that if only RCs could be enlisted (or compelled) to become more actively involved in policing the EB-5 process, all those ill effects could be eliminated. So it is entirely unsurprising that among the primary changes contained in the current Act is the imposition of a certification requirement on RCs, that they attest that they, the projects they sponsor, and the people with whom they work are all in compliance with the securities laws (federal and state). This is not a one-time certification requirement, instead it is imposed on every RC at numerous stages of the EB-5 process, including as part of the application for regional center designation, the application for project pre-approval, and the filing of regional center annual statements as to bona fides of involved persons, as to securities law compliance, as to third-party promoters, and as to “associated new commercial enterprises” (as defined in the Act).

The securities laws impose compliance obligations on “issuers,” the companies that actually “issue” (sell) the investment opportunities that are acknowledged to be securities. Usually in the EB-5 industry, the issuer is an entity legally separate and distinct from the RC entity, even if they may share common ownership or control. The determining factor is not what an entity calls itself, instead it is what the entity does. If an RC sells its own ownership interests, it is an issuer in addition to being an RC, and bears the issuer compliance obligations; but if the RC does not sell its own interests, the issuer obligations are not imposed by the securities laws.
This is where the Act breaks new ground: to involve RCs more actively in oversight of the EB-5 industry, the Act adds its compliance certification requirement to impose “issuer-like” obligations on what are technically non-issuers—the RC that is not a securities seller. This is a “sea-change” in the risks attaching to participation in the Program: where previously only actual issuers bore securities-level risk, for engaging in the sale of their securities, now non-issuers (RCs) will carry such risk, even though not actually engaged in selling securities—and not under the securities laws, but under the Act. Although the RCs’ risk may still be less than that borne by an actual issuer, it is far more than the current minimal risk of performing only the RC function. To avoid this, many RCs may simply get out of the industry altogether.

Returning to the new certification obligations themselves, they require that the certifier speaking on behalf of a regional center is to make his certification “to the best of the certifier’s knowledge, after a due diligence investigation.” To understand what this certification requirement means, it must be broken into its constituent parts.

“Certify” is a term of art in the legal profession. It is commonly defined to mean “to authenticate or vouch for a thing in writing; to attest as being true or as represented.” Similarly, “certification” is defined as “the formal assertion in writing of some fact; the act of certifying or state of being certified.” To maximize its authoritative nature, many times the assertion is required to be given under oath: “I declare under penalty of perjury under the laws of the State of California that the foregoing [statements are] true and correct,” as but one example. The Act itself is silent as to whether its certifications must be given under oath sometimes, always, or never. (Note that the administrative agencies involved (including U.S. Citizenship and Immigration Services and the Department of Homeland Security) have broad rulemaking authority, and could add an oath even if the Act itself as finally adopted was to remain silent on the point.)

The term “certifier” is defined in the Act. As to all Act provisions imposing the certification requirement on RCs, the certifier is someone speaking for (on behalf of) the RC.

As to the concept of “best knowledge,” that concept is nowhere explained in the Act. So again, to understand what might reasonably be meant by an undefined term, we look elsewhere for guidance by implication. In the legal profession broadly, allowing a person’s statement to be limited to only what the person knows about is called a “knowledge qualifier.” Formally, a knowledge qualifier “qualifies” or limits a statement so that it only applies to what the speaker knows, and the speaker would only be liable for a false statement if he had actual contrary knowledge about the fact. In the case of the Act’s proposed requirement, if the speaker didn’t know when he gave his certification that what he said was untrue, he would not have acted wrongly if he turns out to be wrong.

There is a vigorous debate in the legal world disputing the proverbial number of angels dancing on the head of the pin, in this case whether or not the phrase “to the best of one’s knowledge” differs at all from “to one’s knowledge.” Some lawyers assert it is repetitiously redundant and adds nothing, because logically “to the best of X’s knowledge” means exactly the same thing as “to X’s knowledge.” Others argue that adding “the best of” is a significant (and dangerous) modification, because it could support an assumption that it implies some sort of heightened level of knowledge, perhaps involving a duty to investigate. The language of the Act renders this dispute moot for our purposes: the certification is explicitly to be based on “a due diligence investigation.” The knowledge that the certifier will be held to have and upon which he must make his statements, and perhaps give his oath, is that which would be produced by such an investigation.

How much diligence is due under the Act? The Act doesn’t say. No provision specifies what is required as the necessary “due diligence investigation” upon which the certifier’s certification may properly be based. Once again, to understand what the Act requires, in the absence of added explanation or court interpretation, we must look outside the Act for guidance.

“Due diligence” as a legal concept is commonly understood as referring to an investigation into the facts of something. In practice, what diligence is due differs according to the transaction or situation. The type and extent of diligence due in the case of a purchase or sale of an existing business involves different considerations and an investigation appropriate for that kind of situation. The same investigation would not be appropriate to a case involving the offer of securities financing a real estate development. In legislation focused on the latter kind of transaction, determining what kind of inquiry is typical in a securities law context should illuminate what Congress intends to require by the Act.

As introduced earlier, in an offering situation, the securities issuer and its principals must comply with the existing legal duty under the securities laws to exercise reasonable care to ensure that all material information about the issuer’s investment opportunity is disclosed accurately and completely to prospective investors, so that their investment decision can be an informed one. Securities law due diligence is the process of undertaking a reasonable investigation to confirm that the offering statements, documents, financial statements, and all other information provided to potential investors are complete and omit no material information.

Due diligence of an EB-5 securities transaction typically involves the issuer engaging qualified professionals from the various areas involved in such transactions, including immigration lawyers, economists, accountants, engineers, and financial, marketing, and other consultants. It may also involve engaging qualified outside or third-party experts (including U.S. registered broker-dealers, contributing one of their “value-adds” when brought into a project) to double-check information, detect red flags, or objectively evaluate the reasonableness of claims made in the offering documents.

Due diligence is an active, not passive, activity. It must be customized and tailored to the facts and circumstances of each particular offering: it is “impossible to lay down a rigid rule suitable for every case defining the extent to which such verification must go. It is a question of degree, a matter of judgment in each case.” Since the adequacy of due diligence is determined on a case-by-case basis, each due diligence investigation stands or falls on the thoroughness of the investigation, and its appropriateness to that offering. It is an ongoing and dynamic process, and even after the conclusion of an investigation, it might need to be resumed anew if conditions change.

Specifically, a securities due diligence investigation typically involves establishment of a due diligence team of lawyers, accountants, and other experts to engage in, among other information-gathering and –confirming actions: interviews of management employees about the business; interviews of suppliers, distributors, customers, accountants, and counsel; physical inspection of plants, factories, laboratories, and project sites; review of company documentation and financial statements; examination of primary contracts; analysis of ongoing, pending, and threatened litigation; analysis of the business plan and economist reports for consistency and absence of obvious calculation errors; even the examination of trade journals and similar publications about conditions in the issuer’s industry. Pre-formed checklists may be useful in crafting a list of questions and identifying issues, but no list will satisfy the duty of due diligence in every situation, and rigidly following a checklist does not automatically establish the adequacy of due diligence.

It might seem self-evident, but bears reminding: all documents, statements, and other information resulting from the investigation must actually be read. Due diligence cannot adequately be performed by simply taking statements and information at face value and relying on their veracity, and then merely reporting that date accurately. The reviewing team must be wary of red flags or any information which would or should otherwise strip those reviewers of their confidence in the accuracy of the offering documents.

This due diligence requirement imposed on issuers under the securities laws is obviously complicated, involves many moving pieces, and is definitely expensive to conduct properly. Many issuers involved in the Program conduct limited diligence, because of time and cost, while others completely ignore the requirement altogether. They do so at their peril: ignoring the due diligence obligation carries a significant liability risk, one that is imposed on the principals owning and managing the issuer personally, rather than on the entity itself.

In adding “issuer-like” securities compliance obligations on RCs, the Act seeks to impose an additional due diligence obligation on RCs, separate and apart from that already existing under the securities laws imposed on issuers. This revives the question of, how much diligence will be due from an RC under the Act? Which in turn raises a prior question: about what, exactly, is the RC to certify?

As stated above, the various certifications to be required of RCs under the Act apply either to certifying compliance with securities laws broadly, or compliance with requirements under the Act specifically (such as the bona fides promoters, and agent requirements).

As to the former, it seems logical to guess that the due diligence standard applicable to offerings would also be applicable to RC certifications confirming broad securities law compliance. In turn, this raises the next question: must the RC conduct its own independent full-blown securities law-level due diligence investigation, or may it instead satisfy its due diligence obligation by reliance on the due diligence conducted by the issuer, at least in part? Practically, the RC may lack the capacity or be too far removed to conduct as thorough an investigation of a complex offering as required of the issuer, and may lack the resources or knowledge to do so effectively. Thus, it would seem sensible to allow RCs to be able to reasonably rely to a significant degree on due diligence conducted by the issuer, so long as the issuer’s diligence was itself reasonable. However, if RCs are permitted to do so, it is likely that such reliance can be neither absolute nor passive, there must still be some active review of both the offering itself and the issuer’s own due diligence efforts conducted by the RC to qualify reliance as reasonable.

Similarly, as to certifying the narrower issues of compliance with other requirements of the Act, such as bona fides (no “bad actors” involved), promoters (brokers and other non-issuer sellers), and agents (prohibition of foreign government involvement), if the RC’s inquiry is reasonably crafted and conducted to investigate the issue thoroughly, that should suffice. There will likely still be interviews or written Q&A, inspections of contracts and records, background checks, and licensing confirmations, but more narrowly drawn to the specific point targeted. Given the more limited scope, cost and capability should be much less problematic.

Presently, alas, all of these potential resolutions, no matter how sensible, remain mere conjecture. As negotiations continue over the provisions of the Act, stakeholders (especially those hailing from the securities and corporate law areas) should pursue clarification of exactly what is Congress’ intent as to the due diligence requirements, and the addition of language requiring that reasonable diligence will be all, and everything, that is due under the Act to help confirm the credibility, safeguard the benefits, and ensure the integrity of the Program.

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