Tips to Minimize SEC Enforcement and Investor Security Claims in EB-5 Offerings
By Russell C. Weigel, III, Partner, Hoffman & Weigel PA
Pre-Offering Planning- Avoiding Registration Violations and Misrepresentation Allegations
The Regulatory Context of All Capital Raise Solicitations by U.S. Companies
As a general matter of federal and state law, all offers of securities must be registered on a form prescribed by the state in which the offering is conducted or the SEC, unless the offering qualifies for a statutory exemption from registration. “Registration” is a regulatory process whereby applicable securities regulator (state or SEC) reviews the merits of the offering or the quality of disclosure about the offering or both. The registration process is designed to result in a vetted offering or offering document for use by the general public without regard for their investment experience or sophistication in business or financial matters. Such registered offerings are also called “public offerings.” Registered offerings usually are relatively expensive compared to exempt offerings because registered offerings bear the expense of audited financial statements usually prepared by accountants using GAAP and with the disclosure text of a prospectus or offering circular prepared by experienced securities counsel.
On the other hand, unregistered offerings – private offerings conducted pursuant to an exemption from registration – are often substantially less expensive to prepare and conduct and avoid the delay and expense associated with governmental review. Because the private offerings lack government review, offerings conducted pursuant to an exemption from registration receive strict scrutiny after the fact for compliance with applicable exemption requirements in litigation or in government securities investigations. Almost all EB-5 offerings are conducted using private offering exemptions provided by federal law. The exemptions provided by Regulation D Rule 506 (domestic private offerings) and Regulation S (offshore private offerings) are the two varieties typically utilized in EB-5 capital fundings. Each of these regulations has specific requirements that must be literally followed at the risk of litigation with the SEC for violation of federal securities registration requirements.
Once the proposed securities issuer has determined the initial terms and structure of the proposed offering (the nuances of EB-5 regional center compliance concerns aside), a primary planning determination is the exemption(s) from registration through which the offering will be conducted. Planning for compliance with an offering exemption means that both the contents of transaction documents and offering sales materials and the conduct of the offering’s sales effort must be achieved within the confines of the chosen exemption(s). For example, in an offering in which Regulation D Rule 506(c) and Regulation S are the chosen exemptions, purchasers must make their purchases offshore and they must be verified accredited investors. Such investors must have a verifiable and documented liquid net worth of more than one million dollars not including the value of their primary residence or an annual income exceeding two hundred thousand dollars over the prior two years even if the EB-5 qualifying investment amount is only five hundred thousand dollars. These are not difficult requirements in concept, but if the requirements are not met the entire offering can be rescinded in a SEC federal court civil action predicated on the non-compliance by, or disqualification of, one investor.
The private offering memorandum (“POM” or “PPM”) and related subscription agreement and limited partnership or operating agreement and escrow agreement, if any, must conform to the requirements of the offering exemption(s) and be vetted for accuracy of wording and over-disclosure to avoid misrepresentation and fraud claims. Such documents typically are prepared by experienced securities counsel. For example, when the descriptions of the issuer’s prospects in the offering document appear to be facially precise, a close reading might reveal a statement that infers an outcome or implies a limiting factor but does not come out and say it. When this happens, the PPM writer might be deliberately trying to hedge a risk known to the writer that should be identified and disclosed as a risk or evaluated for materiality considerations and possibly eliminated from the text. Likewise, over-disclosure can occur, for example when a photograph is included in the PPM. Pictures tell a thousand words, but the thousand words told might not be the words the issuer imagined or intended to be out there. Or, too much detail is provided that is not material to the business of the issuer of the terms of the offering. Or, it could be that material information, such as the fees being earned by related parties or the offshore brokers, is not fully disclosed. Ultimately, the disclosure package should disclaim where it cannot be offered and to whom it can be offered. Since the most probable reader of the PPM will actually be an SEC enforcement investigator or a plaintiff’s attorney one day, great care in the draftsmanship and presentation of the offering documents is paramount.
All participants in the sales effort must be aware of the need not to deviate from representations made in the PPM. The sales effort is often the cause of subsequent lawsuits alleging fraud and misrepresentation, especially when brokers or finders make promises or projections not included in the offering documents. Care should be given to the selection of sales persons (e.g., migratory agents) willing to solicit on behalf of the securities issuer because their representations as agents can legally bind the issuer as principal. All sales materials, including websites, and emails, should be vetted by the issuer during the planning stage for conformity to the PPM, and when possible only pre-approved written communications should be utilized by sales agents. Because legal or compliance counsel often are not retained to monitor the sales efforts of the live offering, this monitoring or reporting function oftentimes is abandoned although the issuer is legally responsible for what happens down the chain of sales people in contact with the purchasing investor.
Likewise, control of the sales agents can be necessary for compliance with securities offering exemptions to prevent too many offerees from coming into contact with the offering solicitation at the risk of inadvertently converting the private offering into an unregistered, non-exempt, public offering, which can subject the issuer to disgorgement and civil money penalty claims by the SEC.
Live Offering Correction and Post-Offering Remediation
Compliance During an Offering
Compliance issues abound during the live execution of the issuer’s private offering. Hiccups that occur in the field may not rise to the attention of the issuer until it is too late to remedy them, unless the issuer has installed an effective compliance reporting mechanism. Reporting regimes are rare in privately placed (and non-FINRA brokered) offerings and conflict with the sales agents’ incentives to sell the offering. However, with the issuer legally on the hook for misrepresentation and fraud-based sales practice claims, or registration violations, the issuer should be incentivized to create incentives for the sales chain to report problems and errors back to the issuer. This may enable the issuer to mitigate potentially destructive situations from conflagrating.
Perhaps the circumstance to be addressed derives not from the field but from a change of plan for the capital raise. How can you fix it and still raise capital from the same offering? So long as all investors will be treated equally, the EB-5 offering theoretically could be amendable for a material change, such as a change in use of proceeds, the dollar amount of the offering, the business plan, or a USCIS regulation or statutory change in the Regional Center program requirements, for some examples, provided that pending I-526 petitions are not jeopardized. In essence, if all existing investors are provided information about the proposed change to the offering and the event causing the proposed change, and they approve the change in writing, the change can be adopted and implemented for use by prospective investors without undergoing the expense of conducting a new offering and/or rescinding the existing one. Some proposed changes cannot be accomplished due to language barriers, agents’ resistance, or for other circumstances. Indeed, the occurrence of an event or circumstance that would disqualify the offering from reliance on an offering exemption may disqualify the entire offering and force a rescission offer to all purchasers. All proposed changes should be reviewed with securities counsel.
Post-offering compliance can also be effective. With the federal statutory look-back period being five years for SEC enforcement concerns, even when projects are completed and partnership distributions have been made, project sponsors may still run the risk of being sued for securities violations. In other words, even happy investors with green cards do not create an immunity from suit for the project’s sponsors if the SEC believes a material misrepresentation occurred or proceeds were misused, for examples.
Experienced independent securities compliance counsel can be retained to conduct a mock SEC investigation of a closed offering for the purpose of identifying potential problems and making recommendations for corrective action before a real investigation or investor lawsuit occurs. Depending on the issuer’s budget and perception of areas of concern, the scope of review can be tailored narrowly or deep. Mock investigators can review the offering documents, sales materials, documentary support for statements made, communications with sales agents and investors, financial statements and support therefor, dig for undisclosed conflicts of interest, and review board authorizations or the lack thereof; the support for compensation disclosure, use of funds, and financial disclosures; and conduct employee and agent interviews if necessary. Corrective actions could include the preparation of remedial disclosure documents, board resolutions, contract amendments, corrected titles and deeds, and rescission offers. In essence, a remedial defensive effort can include any action or activity that can be properly and legally be constructed to memorialize understandings, agreements, authorizations, and representations to build or buttress a legal defense file to be maintained in case of investor or regulatory action. Remember, just because the immigrant investor got her green card doesn’t mean she won’t sue you to get her investment back after the fact.
These are tips. No business runs perfectly, but there are relatively inexpensive commonsense steps that you can take to protect your business now rather than doing damage control later if a lawsuit occurs or if the regulators come knocking. And the EB-5 industry is under scrutiny. The more well-documented and transparent the offerings are, the better the image of IIUSA and its members.