Private placement offerings are an increasingly active part of the securities business. One especially complicated and emerging area of private placements is the EB-5 Investor Visa Regional Center Program. Under the current rules of the program, an investor interested in a U.S. green card may place $500,000 or $1 million into an at-risk investment, issued by or affiliated with a United States Citizenship and Immigration Services (USCIS) designated regional center.[1] If job creation requirements are met as anticipated in the investment deal, an investor will be eventually eligible to secure lawful permanent residence in the U.S. This program is spiking in popularity along with other citizenship-by-investment programs around the globe.
As with many forms of illiquid investments, EB-5 deals offer an exit strategy premised on an entity or business stabilizing and having funds to pay back investors. Investors who lose their money may well file lawsuits against issuers and any other party who induced them into a deal, including lawyers, brokers, or regional centers. Additionally, SEC complaints (with their Section 17(a) negligence standard) are almost a daily occurrence with respect to private placements. Given the likelihood that we will continue to see litigation and regulatory actions in this area, due diligence is essential. Investors seek due diligence for reassurance that a deal is sound, even if risky. Issuers, regional centers, and broker-dealers will find due diligence helpful in future litigation or investigations. Regardless of where you stand in a deal, due diligence is more important now than ever before in EB-5 transactions.
This article talks about why due diligence matters to various parties in EB-5 offerings. We will also provide strategic guidance about EB-5 due diligence to practitioners, regional centers, and issuers of EB-5 related securities.
Background
While the rules of SEC regulation applicable to all securities offerings are somewhat relaxed in a private placement context, a proper and thorough due diligence investigation is still required in a deal.
In a standard private placement transaction, issuers don’t always know how to go about performing due diligence. Because many entities, including EB-5 regional centers, issuers of an EB-5 security, or broker-dealers who control the marketing and sales efforts of a deal (hereinafter, “underwriters” which we are using in the broadest meaning of the word), are unaware of the exact level of due diligence required of them (and their counsel), they may choose to rely on pre-made checklists purporting to cover everything required of them, or on declarations from a service or counsel that “due diligence”[2] has been performed. This same confusion is magnified in the EB-5 space. EB-5 issuers and regional centers can be equally unsure about how to ensure that due diligence is performed.
There is no “one size fits all” checklist for adequate due diligence investigations, and given the fact that an underwriter is responsible for its agent’s inadequate investigation, it is worth discussing what is required of regional centers and issuers in undertaking due diligence investigations in the EB-5 context.
Private Placement Offerings
To set the stage for a discussion about due diligence, let’s first review some basics on private placement offerings. Typically, securities are sold or otherwise offered in accordance with the Securities Act of 1933 (“1933 Act”), which regulates the public offering of securities. Offerings under the 1933 Act must generally be registered with the Securities and Exchange Commission (“SEC”) according to the provisions of Section 5 of the 1933 Act, which states that, among other things, it is unlawful for any person to sell or deliver unregistered securities or to fail to file a registration statement along with a sale of securities. These provisions generally exist to protect unaccredited, ordinary investors from being taken advantage of in the offering of securities by a far more sophisticated entity.
Private placement offerings are an exemption from the general rule of registration with the SEC. Private placement offerings occur pursuant to Regulation D of the 1933 Act, which contains SEC Rules 504, 505, and 506, which essentially allow the issuer of the securities to sell them without registering the sale with the SEC. EB-5 private placements sold within the U.S. almost always rely on Rule 506. Many EB-5 issuers also rely on Regulation S, which is an exemption from SEC registration for an offering conducted abroad to non-U.S. persons.
Private placement offerings are unregulated and sometimes risky, as they are devoid of all of the protections offered to ordinary buyers through SEC registration. These risks are heightened in today’s EB-5 industry. Fees paid to deal facilitators and brokers, investors unfamiliar with the U.S. investment system, and aggressive business tactics only increase the risk level of EB-5 deals.
As a result of risks in the broader context of private placements pursuant to Regulation D, the rules generally allow for private placement sales only to sophisticated investors who have enough knowledge and experience in financial and business matters to evaluate an investment. In Regulation S transactions, the investors may be unsophisticated. Foreign investors coming into an EB-5 deal pursuant to Regulation S may have very little understanding of American business transactions, investments, or laws. This raises the stakes for due diligence.
In offerings relying on Regulation S or D and geared at a foreign investment market such as EB-5, substantial protections flow to investors, issuers, and regional centers from sound due diligence. This begs three questions: (1) What is due diligence? (2) How does a party in an EB-5 transaction go about ensuring that due diligence is performed? and (3) How does due diligence protect one from private or SEC litigation?
Due Diligence Generally
Pursuant to the federal securities laws, an issuer, and any parties acting for that issuer, must exercise reasonable care in ensuring that the information given to the offerees and purchasers is complete and accurate. “Due diligence” is, in simplest terms, the process of ensuring – to the best of the investigator’s ability – that the statements, documents, and other information passing from the issuer to the purchasers are correct and devoid of any false or misleading information, to the same degree that the investigator would if evaluating his own property.
Statutory Authority
Analogous statutes provide helpful language regarding what constitutes due diligence. These all advance our assessment of due diligence as a concept in EB-5 deals. Section 11 of the 1933 Act (15 U.S.C. § 77k) offers a bit of guidance on due diligence. The statute provides for civil liability of experts, underwriters, accountants, directors, and generally every person who signs a registration statement, in the event of a suit for alleging misstatements or omissions of material facts in the registration statement. Pursuant to Section 11(b), the above parties can raise a due diligence defense to such a suit, provided they meet the requirements outlined in the statute. It is worth noting that the issuer of a registration statement may not raise a due diligence defense, and is thus not covered by Section 11(b).
Section 11(b)(3) has a few different due diligence prongs, depending on whether the registration statement in question was purportedly made under expert authority, and whether the person attempting to avoid liability is an expert under whose authority the registration statement was made. The first states that a person (again, other than the issuer) is exempt from liability for the release of a registration statement that does not purport to have been made on the authority of an expert which contains an untrue statement of material fact or omission of the same, if the individual can prove that he or she had, “after reasonable investigation, reasonable ground to...
