Like any professional involved in a private securities offering, regional centers must be careful when preparing offering documents to effectively communicate all of the offering’s necessary disclosures and risk factors. Such disclosures are often complicated in EB-5 offerings—and seldom uniform from project to project. As a result, care must be taken to ensure that a project is properly analyzed and that its disclosures are independently verified.
Following is a thorough—but not necessarily complete—examination of the key risk factors that every EB-5 offering should address.
Regional Center Role
The role a regional center plays may vary from project to project, and so it is vital that for any given transaction, the regional center’s role is clearly delineated. For instance, a regional center may simply sponsor a project, but it might also serve as a manager or general partner in the new commercial enterprise (NCE). Regional centers are also often involved in marketing a project to investors.
Sponsoring a Project
One of the primary functions of regional centers is to sponsor EB-5 projects. For the regional center, this means ensuring that the offering complies with all of the requirements of the EB-5 Program and the Securities and Exchange Commission (SEC). For the project, regional center sponsorship typically means having access to a larger number of EB-5 investors and the ability to count direct, indirect, and induced job creation toward the EB-5 Program’s employment creation requirement—a distinct marketing advantage when seeking EB-5 investors, and the reason most EB-5 projects are sponsored through regional centers.
Regional centers are compensated for these services, and the rate of compensation should be disclosed in offering documents.
Serving as Manager or General Partner
Often, a regional center serves as the manager or general partner of the NCE. When this is the case, the offering documents should clearly indicate the role of the regional center regarding EB-5 Program compliance, reporting requirements, and the administration/operation of the NCE.
The disclosures should also include how the regional center will conduct its due diligence and perform its administrative responsibilities, as well as whether or not the regional center will employ any third-party professionals to fulfill these duties.
Instead of the regional center serving as the manager or general partner, it may be better to have a separate entity fulfill that role to minimize the regional center’s liability in case the project fails.
Marketing the Project
Another common activity undertaken by regional centers is marketing their sponsored projects to potential investors. The primary responsibility for regional centers as it relates to marketing is ensuring that such activities fully comply with all SEC regulations.
Since most regional center offerings are private, they must fall under an exemption, such as Regulation D or Regulation S. In essence, this means that investors will need to demonstrate they fulfill the SEC requirements for accredited investors.
Another pertinent issue is how investors are sourced and whether the migration agents who source investors are paid a finder’s fee. SEC compliance will likely involve issues related to broker-dealer registration (Securities Exchange Act of 1934), investment adviser registration (Investment Advisers Act of 1940), and investment company registration (Investment Company Act of 1940).
These securities issues will be discussed in greater detail in a following section.
Avoiding Conflicts of Interest
In addition to the roles the regional center plays in the EB-5 project, the regional center’s relationships with the other parties involved in the offering must be fully disclosed.
Certain relationships will present inherent conflicts of interest and should be avoided. For example, if the developer is affiliated with both the regional center and the NCE and serves as the general partner of the NCE, a conflict of interest exists because, essentially, the lender is administering a loan to itself. In such cases, an independent party could administer the loan to prevent the conflict.
Disclosure of the relationships between the regional center and other parties serves to protect the investors and demonstrate proper oversight.
Escrow Arrangement Options
Nowhere does EB-5 law require that investor funds go into escrow—such arrangements are, in effect, the result of the tension between EB-5 Program requirements and investor expectations. The EB-5 Program requires that an investor’s capital be fully committed to an EB-5 project at the time the I-526 Petition is filed. Investors, however, desire some way to limit their financial risk. Placing investor funds in escrow satisfies the EB-5 Program’s requirements while helping limit investors’ financial risk.
Whether an escrow arrangement exists—and if so, how it is structured—must be fully disclosed in the offering documents.
Some regional centers offer no form of escrow arrangement, and investor funds are placed directly into the NCE. In an arrangement like this, the regional center may offer refunds to investors whose I-526 Petitions are denied. Offering documents should clearly disclose all procedures and risks related to any such refund.
Specific elements that should be addressed include the extent of the guarantee and the source of the refund—or the collateral used to ensure sufficient funds will be available to cover any such refund.
Escrow Released Upon I-526 Filing
Some regional centers use an escrow arrangement that allows for the release of investor funds once an investor’s I-526 Petition is filed. In this way, the investor has some assurance that, at the very least, his/her attorney received the information needed to file the I-526 Petition and it was successfully submitted to United States Citizenship and Immigration Services (USCIS).
Variations of this arrangement exist in which the funds are released from escrow upon filing, but only when at least one I-526 Petition has received approval—or only if the project has gained exemplar status. Such arrangements substantially reduce the risk for investors since their funds will only be released from escrow pending the approval of the project. In such cases, I-526 Petition denials are still possible, but these are generally the result of problems with an investor’s personal information, source of funds, etc.
Escrow Released Upon I-526 Approval
Another escrow arrangement used by regional centers is to release investor funds from escrow only upon I-526 Petition approval. This arrangement provides the least amount of risk for investors since their money will not be used until their EB-5 petition has been approved.
Other Escrow and Refund Arrangements
One possible escrow arrangement involves a partial holdback of funds that ensures that at least some of an investor’s funds will be available if his/her I-526 Petition is denied.
Other potential components of escrow and refund arrangements might involve substituting another investor for an investor whose I-526 is denied, minimum escrow amounts, developer guarantees, further contributions from the developer, etc.
In any case, such arrangements, policies, and assurances should be adequately disclosed in the offering documents.
Project Specific Risks
Any project, regardless of its nature, has generic risks—but offering documents must also take into account the risk factors that relate specifically to an individual project. These unique risks are related to the project’s industry category, the project’s capital stack and source of funds, and a number of other elements.
Industry Category—Certain risks are unique to each industry, and so every project should be analyzed in light of its industry to determine the related risks.
Capital Stack—The makeup of the capital stack must be fully disclosed in offering documents. Capital sources will likely include developer equity, senior debt, EB-5 funds, and may even involve incentives such as government and tax credits, grants, etc. All funding sources should be identified, and each source’s funds should be given as a percent of the total capital stack. Development cannot commence until all funding sources are identified.
Senior Debt—A detailed disclosure must be provided regarding the project’s senior debt, including all terms and conditions. The more senior debt taken on by a project, the larger the risk of default and foreclosure. Due to this risk, an intercreditor agreement should be in place to help protect the NCE’s interests by enabling it to take on the position of the developer in the event the developer defaults on this debt. To that end, a regional center might have its own due diligence team and specific internal controls—or it might engage the services of other professionals—to increase investor protection. Any intercreditor agreement or other safeguard would need to be clearly disclosed as well.
Capital/Equity Stake of the Developer—Offering documents should disclose how much capital and equity are being provided by the developer. Doing so enables a better assessment of the risk the developer is taking on relative to other stakeholders.
EB-5 Capital—The amount of EB-5 capital being sought should be clearly disclosed, as should any risks associated with failing to raise the desired amount of EB-5 funds. The offering documents should demonstrate whether the project’s completion depends on EB-5 capital and should describe how the project will be financed in the event the project fails to raise the entire EB-5 capital amount. For instance, offering documents should disclose whether additional capital will be raised as necessary by taking on additional senior debt, equity, mezzanine financing, etc.
EB-5 Loan Collateral—The project’s collateral should be analyzed to determine how much surplus equity might exist to protect the EB-5 loan. Disclosures should be made regarding the loan-to-cost ratio, loan-to-value ratio, and loan-to-stabilized-value ratio.
Expected Employment Creation—The economic analysis should clearly demonstrate how jobs will be generated and should indicate any associated risks.
Potential for Cost Overruns—Every project should anticipate the potential for cost overruns, and the mechanisms put in place to fund such overruns should be clearly described.
Securities Compliance—While every EB-5 project has certain risks related to securities—by nature, an EB-5 project is a securities offering—each project is unique and its securities risks will depend on a number of factors, including the offering’s structure, size, and marketing strategy.
NCEs Using a Loan Model
When an NCE is created specifically to loan the pooled EB-5 investors’ funds to the job creating enterprise (JCE), the SEC considers the NCE to be obligated to register under the Investment Company Act of 1940.
In order for the NCE to be exempt from the registration requirement, two exemptions are often sought: the C-1 Exemption, which limits the EB-5 project’s offering to no more than 100 investors, and the C-5 Exemption, which requires the NCE’s transaction to involve real estate collateral or mezzanine financing that qualifies as mortgage-backed collateral.
The offering documents should disclose whether the NCE is bound by the Investment Company Act of 1940 and whether the offering requires one or both exemptions.
Marketing Through Broker-Dealers
If the EB-5 offering involves any kind of “directed selling efforts” within the U.S., only registered broker-dealers may be compensated for such services. Paying finder’s fees to unregistered agents operating within the U.S. without an issuer exemption would be a violation of the Securities Act of 1934 and would allow investors to invoke the right of rescission.
Offering documents should disclose how the offering will be marketed and whether any exemptions apply. Also, potential compensation—and a description of who might be compensated—should be fully disclosed.
Marketing Through Investment Advisors
As with broker-dealers, any investment advisor who offers investment advice pertaining to securities must be registered under the Investment Advisers Act of 1940. This securities issue should be addressed in offering documents much the same way that the presence of broker-dealers is addressed.
Obtaining the Necessary Exemptions
Two exemptions are typically employed in order to avoid registering the securities offering: Regulation D, which relates to domestic sales, and Regulation S, which relates to foreign sales. Adequate disclosures should be made regarding these exemptions as well as whether the offering employs one or both.