RCBJ Retrospective: What We Learn From SEC Investigation

02.09.16 | Archived

What we Learn From SEC Investigation (Vol. 4, Issue 3, January 2016) 



The Securities Exchange Commission (“SEC”) has clearly increased its degree of scrutiny in investigations with respect to the EB 5 Program since the end of 2012, especially after the Chicago Convention Center case that was filed by the SEC in February of 2013, where the SEC took a very active role in protecting the return of investor capital based upon the existence of obvious fraud and misrepresentation in the offering documents. Since that point in time, the credibility of the EB-5 industry (including industry best practices, heightened due diligence from regional centers and agents and heightened investigation by the SEC) has elevated the degree of scrutiny and protection for the EB-5 program. One must be mindful of the fact that the SEC will take an active role in stopping any projects involving fraud and misrepresentation and will bring actions for fines, sanctions and injunctions related thereto. This overall heightened role of the SEC, as well as the industry in general, has significantly improved the awareness of issues that were apparent in the Chicago Convention Center case and, in general, has avoided repeats of that type of situation.


Fraud in Offering Documents. Pursuant to the Securities Act of 1933 (the “1933 Act”), the SEC is actively enforcing any violation of Rule 10-b(5) under the 1933 Act. As noted above, any potential violation will result in an action for injunctive relief and civil sanctions, as well as possible criminal action. The SEC does not in and of itself bring criminal proceedings. It would need to refer any criminal action to the Justice Department.

Escrow Violations. The SEC has also taken a very heightened interest in potential discrepancies and misrepresentations related to escrow arrangements. Investors believe in most cases that they have some form of protection by having funds placed in escrow and certain pre-conditions being satisfied. In some certain situations, the escrow is really a fiction or does not exist at all and funds are directly distributed to the project company for use in the project without having necessary pre-conditions, such as at least an I-526 filing for the applicable investor or a minimum number of subscribers having subscribed to purchase units in the project, thus ensuring that at least the minimum amount of EB-5 funding has been satisfied.

Improper Use of Funds. Certain SEC investigations focus on the actual use of proceeds and whether they were applied in accordance with the offering documents and the business plan utilized in connection with the EB 5 program. It is apparent that budgets always vary to some degree and that is acceptable. However, if funds are slated for one project and then utilized for another project or applied for other purposes that were not otherwise disclosed in the offering documents, that would constitute a breach of the disclosures set forth in the offering documents and again result in a potential action by the SEC. The SEC has no tolerance for these situations, especially if they are material in nature.

Broker-Dealer Issues. Probably the most active area of SEC scrutiny, investigation and action involves alleged broker-dealer violations. This is in part due to the complaints from the broker-dealer industry and FINRA related to parties that are apparently receiving inappropriate commissions in connection with transaction-based compensation in the EB 5 program. In connection therewith, the SEC will undertake very detailed investigations to determine if the instrumentality of United States commerce was utilized in any manner in effectuating the sale of the EB-5 security and whether commissions were improperly paid. As part of this process, the SEC will seek discovery of all emails, written correspondence, documents, telephone records, bank accounts and the like to determine exactly what happened in connection with investor solicitation, as well as the flow of funds and the payment of compensation to all parties involved in the transaction. This will not only involve business information, but personal information as well, such as personal telephone records, personal emails and personal bank accounts.

Investment Advisor Issues. Pursuant to the Investment Advisors’ Act of 1940, the SEC will investigate whether unlicensed parties are providing investment advice in connection with the sale of securities. This would apply to parties that recommend various EB-5 offerings to investors, since by providing multiple choices of projects to invest in, this could be deemed the rendering of investment advice as opposed to just acting as a broker-dealer for a specific transaction.

Investment Company Act of 1940 (the “IC Act”). A lesser known concern is the SEC’s overview of the IC Act and potential violations for not registering under such Act or obtaining an exemption. I am not aware of any formal action undertaken by the SEC with respect to the EB 5 program related to the IC Act, although the SEC has, on several occasions, taken the verbal position that the creation of an new commercial enterprise (“NCE”) to receive investor funds and make a loan to a project is deemed to be trading in securities under the IC Act. Many practitioners believe that this position is not properly supported under the facts and circumstances of the EB-5 program, since arguably there is no trading in securities, only the sale of a security in order to make a loan to a specific project company (referred to as the “job creating entity” or “JCE”). Notwithstanding this potential defense, it is always advisable to comply with a verbal position of the SEC in order to avoid becoming a test case in the future. Based upon our several calls with staff attorneys at the SEC, who have acknowledged their doubt whether the IC Act applies, the SEC’s Division of Investment Management will enforce the provisions of the IC Act as if they apply.

In connection with the 1940 Act, the following should be noted:

1. There is a so-called C(1) exemption for offerings involving no more than 100 subscribers.
2. If the offering involves more than 100 subscribers, then the so called C(5) exemption could apply, which involves the investment in mortgage-backed collateral. However, even though many transactions do involve mortgage-backed collateral, some transactions have so-called mezzanine pledges, since the senior lender will not otherwise permit a second mortgage on the project. The SEC has taken the position that one can otherwise comply with the C(5) exemption by otherwise meeting the requirements of the 2007 Capital Trust No Action Letter (“Capital Trust”). The six criteria set forth in Capital Trust are as follows: “(1) a Tier 1 mezzanine loan is a subordinated loan made specifically and exclusively for the financing of real estate; (2) both second mortgages and Tier 1 mezzanine loans are underwritten based on the same considerations and after the lender performs a hands-on analysis of the property being financed; (3) the Company as Tier 1 mezzanine lender exercises ongoing control rights over the management of the underlying property; (4) the Company as Tier 1 mezzanine lender has the right to readily cure defaults or purchase the mortgage loan in the event of a default on the mortgage loan; (5) the true measure of the collateral securing the Tier 1 mezzanine loan is the property being financed and any incidental assets related to the ownership of the property; and (6) the Company as Tier 1 mezzanine lender has the right to foreclose on the collateral and through its ownership of the property-owning entity become the owner of the underlying property.”

Based upon the above, the SEC has taken the position that only a first lien pledge of an interest in the borrower entity or its parent company would provide for the exemption and not a second tier pledge. There is no necessary support for this interpretation based upon Capital Trust, but again, this is an issue that has yet to be tested both administratively and in the courts.

As a result of the above, it is advisable for all transactions involving more than 100 investors to focus carefully on the C(5) exemption, the Capital Trust guidelines, as noted above, and the necessity of trying to accomplish a first lien pledge of the membership interest in the JCE or a parent company of the JCE.


Subpoena Process. If the SEC suspects there is a potential violation of securities laws, it will typically commence a private investigation pursuant to an investigatory order. Subpoenas will be issued to target parties and possibly other parties requesting documentation related to the applicable transaction. A copy of a formatted subpoena is attached to this article.

As part of the investigatory process, if the SEC determines that other parties are involved in the transaction, it will usually issue subpoenas to those other non-target parties with respect to the transaction and possibly other transactions. This may lead to a mushrooming effect, since one investigation can lead to multiple investigations based upon discovery that indicates that a particular party may have been paid improper compensation in other transactions as well. Therefore, a non-target party can become a target party once facts are discovered that implicate the initial non-target party. A perfect example would be a regional center paying improper broker-dealer commissions to third parties. As part of the initial investigation, the SEC would determine what other parties are receiving improper compensation, and then investigate those parties. As a result of that investigation, there may be other parties paying or receiving improper compensation that would generate further investigations as well.

Discovery Process. The discovery process is quite thorough and detailed and generally requires the production of all e-mails, correspondences, telephone records, bank records and documentation related to the transaction being investigated. This applies both from a corporate and personal standpoint. The SEC may perform separate interviews during the discovery process, including contacting investors or other parties and obtaining information as to the nature of selling activities and the materials provided to the investors. In addition, the SEC will look at websites and other published information to determine if there are any inconsistencies between the offering documents and what is otherwise published.

Deposition Stage. The SEC will typically conduct a deposition of the targeted parties to determine exactly what happened. It is our experience that the SEC is becoming more sophisticated with the EB-5 industry. Investigations are performed at the regional office where the target party is located or otherwise where the project is located. All investigations are apparently supervised by the main office in Washington, D.C. The deposition can be as short as a few hours, or extend for a few days. The SEC will generally ask for additional discovery material to further verify positions taken by deposed parties.

It is critical that any party receiving a subpoena or being deposed have qualified counsel to represent them at the discovery and deposition stages in order to ensure that this process is properly monitored. In certain situations, there are justifications for compensation paid, which do not amount to improper transactional-based compensation. In certain circumstances, it may even be advisable to have a criminal law attorney in attendance where the potential violations could be criminal in nature and not just civil. It is very important that counsel actively interview the deponent well in advance in order to gain access to all information and have a strategy with respect to the discovery process.

Negotiation and Settlement Stage. If the SEC determines that a violation is apparent, it is advisable to enter into negotiations in order to potentially obtain a settlement that may be a lot more favorable than actually having a formal legal action taken against the targeted party. The SEC has the ability to devote substantial resources to any litigation in this regard and the cost of defense is very substantial. Furthermore, the publicity of a formal lawsuit will be detrimental to all targeted parties. The most difficult part of the negotiation and settlement process is not just the monetary fine that may be imposed (which typically includes disgorgement of profits and interest), but also the negative publicity of any settlement that is otherwise published as part of an order and is made available to the public in general.

There are many situations where third parties are somewhat innocent in the process, but because they have received transaction-based compensation without being registered, they may have unknowingly violated broker-dealer registration laws. Many of these parties were not aware of the existence of the broker-dealer registration laws and relied upon agreements provided by regional centers or other parties at the time.

If attorneys are involved as targets, they often obtain conflict of interest waiver letters from clients so that there is full disclosure that they are receiving other compensation along with fees for representing the investor. This may satisfy ethical requirements, but does not otherwise mitigate the potential violation of the U.S. broker-dealer laws. As part of this process, it is very important to distinguish between a payment for transactional-based compensation compared to a payment for legal services rendered in connection with the applicable transaction. In certain situations, there is a real question whether a regional center or developer can compensate an attorney for providing legal advice to a client who was otherwise recommended to invest in the program by the attorney. Same may be deemed to be transaction-based compensation as opposed to a payment of legal fees incurred by the investor for the advice given by the attorney.


Marketing Activities by Targeted Parties. As noted above, the first inquiry will be a discovery request of all materials to determine whether the instrumentality of United States commerce was utilized. The best defense in the process would be to show that there was no marketing activities to investors through the instrumentality of United States commerce, and that all marketing activities were done offshore, and that sales were made by foreign exempt migration agents or marketing agents. It is important to demonstrate that a party that is a target of an investigation may not actually have been involved in dealing with investors at all, but merely assisted developers and regional centers to gain access to migration agents or brokers who otherwise find investors, even though transaction-based compensation is paid.

Tracing the Money/Who Gets Paid. The SEC will carefully trace all funds that may have been paid to the targeted party. If a lawyer is a target, then it is very important to distinguish payment for legal fees as opposed to attorney transaction-based compensation. As discussed above, there is a fine distinction between the two.

Investor Contacts. The SEC will focus in detail on what contacts are made with investors. The best case scenario is the targeted party having absolutely no contact with investors whatsoever. If an immigration attorney represents an investor, that obviously negates that potential argument unless the investor already invested in the program prior to the immigration attorney becoming involved in representing the investor.

Review of Offering Documents. As noted above, the SEC will carefully review the offering documents in addition to all marketing materials, emails and the like during the discovery process to determine if there are discrepancies, inconsistencies or marketing activities that would violate securities laws.

Review of Loan Documents. The SEC will now actually seek discovery of loan documents to determine if the applicable loan transaction was carried out in accordance with the offering documents. When funds are disbursed to the JCE pursuant to a loan, it is essential that loan documents would have been executed either prior to or simultaneously with the loan proceeds being advanced.


In any discovery or deposition, the attorney-client privilege is very important and is respected by the SEC. In this regard, to the extent that confidential information is provided by a client to an attorney, the privilege can be asserted. Generally, the SEC will ask for a description of the types of information for which a privilege is claimed. A perfect example would be personal information contained in an investor’s I 526 petition filing. Other types of privileged information would include legal advice provided by an attorney to a regional center in connection with securities or immigration matters.


Expansion of Investigation. As noted above, the SEC has been extending investigations based upon information discovered in one matter that leads to additional claims being made against other parties. For example, a regional center may receive a subpoena as a fact witness and not a target party. However, if the documentation produced shows that the regional center may have paid improper compensation in the applicable transaction, then the SEC would otherwise seek additional information from the regional center to determine if this had occurred in other transactions.

Interview of Investors and Other Parties Affiliated with Offering and Transaction. The SEC has now taken a more active investigatory role in this regard. The mere fact of an active investigation may create disclosure issues in offering documents. Furthermore, the contacting of investors directly will generally have a chilling effect on the applicable EB-5 project.

Minor Technical Violations Compared to More Significant and Repetitive Violations. There is a practical distinction between minor technical violations compared to more significant and repetitive violations. The SEC is far more inclined to seek enforcement action where violations are repetitive and extensive in nature compared to possibly a one-time violation.

Investor Protection Concerns. The SEC has definitely heightened its activities to protect investors. Generally, the SEC works off tips received from either disgruntled investors or other parties or professionals and then conducts an investigation to determine if there is merit to the allegations made.

Offshore Marketing Activities and Ability of Offshore Agents to Avoid SEC Regulations under the Securities Exchange Act of 1934 (the “Exchange Act”). It is very important that offshore agents who are active in marketing EB 5 programs ensure that they are not conducting any marketing activities in the United States or utilizing the instrumentality of United States commerce. In connection therewith, it is always advisable that offshore agents do not directly have United States-based offices, since there could be a concern that these offices may be engaged in marketing activities. On the other hand, it is less of a concern if offshore agents have unaffiliated agents who source deals for the offshore migration agents and have offices in the United States since sourcing deals and providing due diligence investigation and loan administration services should be appropriate. It is also noteworthy that it is acceptable in order to preserve the Regulation S exemption as well as avoiding broker-dealer registration to have investors visit a project in the United States for due diligence purposes. It is appropriate to provide due diligence information on the project as long as no marketing activities take place in the United States. This is a very delicate issue and important that all parties involved in the EB 5 process understand the distinction between providing due diligence information compared to providing any form of marketing services or conducting marketing activities.


It is apparent from our SEC investigatory experiences, as well as our regular communications with various departments of the SEC, that there are many pitfalls in EB 5 transactions that need to be carefully evaluated in order to mitigate against a potential SEC investigation and/or action being commenced.


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