This article is the third in a series of articles on how EB-5 regional centers and sponsors can evaluate broker-dealer, investment company and investment adviser registration requirements under U.S. securities laws.
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As mentioned in Part 1 of this article, “EB-5 offerings do not fit standard SEC registration requirements,” U.S. securities laws were designed primarily for offerings of securities in the U.S. to protect U.S. investors, and these laws are not well suited to the EB-5 investment market. Nevertheless, it is necessary for EB-5 regional centers and sponsors of EB-5 offerings to understand the requirements of U.S. securities laws, and to structure EB-5 offerings in a way that will allow them to qualify for exemptions from the registration requirements. In Part 1 and Part 2 of this article, we discussed the requirements for exemption from registration of securities under the Securities Act of 1933 and exemption from registration as a securities broker-dealer under the Securities Exchange Act of 1934. In this Part 3, we discuss the registration requirements and exemptions under the Investment Company Act of 1940 (“ICA“).
What is an “investment company” under the Investment Company Act?
The ICA generally applies to every public or private company which invests over 40% of its assets in securities of one or more other companies, except securities of its own wholly owned subsidiaries. This definition includes any EB-5 fund, whether it is a limited partnership or limited liability company, that invests in the securities of a project company. For example, in the EB-5 “equity” model, if an EB-5 investment fund consisting of EB-5 investors (the new commercial enterprise or “NCE”, using USCIS terminology) purchases preferred equity interests in the project company (the job creating enterprise or “JCE”), the fund will be investing in securities of the JCE, and will therefore be deemed to be an investment company under the ICA. Loans are also considered securities under the ICA, meaning that in the EB-5 “debt” model, if an EB-5 investment fund makes a loan to a JCE, the fund will be deemed to be an investment company under the ICA. However, if the EB-5 fund itself owns the project (EB-5 investors are direct equity holders of the JCE), or one of its wholly-owned subsidiaries owns the project (EB-5 investors are equity holders in the fund, and the fund’s wholly-owned subsidiary owns the project), then the fund will not be considered to be investing in securities, and so will not be an investment company under the ICA. If an EB-5 investment fund meets the definition of an investment company under the ICA, the fund will be required to meet all of the requirements of the ICA, unless the fund is able to rely on one of several exemptions from the ICA, which will be discussed further below.
Could an EB-5 fund comply with the requirements under the ICA if it does not have an exemption?
The simple answer to this is that an EB-5 fund would find it virtually impossible to comply with the requirements of the ICA. Therefore, an EB-5 fund will have to qualify for one of several possible exemptions from the ICA. To understand why it would be so difficult to comply with the requirements of the ICA, here is a brief summary of the major requirements: First, the EB-5 fund (investment company) is required to register its securities offerings with the Securities and Exchange Commission (“SEC”), and comply with the disclosure requirements under the ICA. The SEC must approve the offering documents before any offering of securities is made. This typically means the investment company will go through a process lasting several months in which the SEC will submit comments and questions before approving the offering documents, which will require multiple revisions to the investment company’s offering documents, adding substantial cost and time to the offering process. Following registration, an investment company is required to provide annual and quarterly reports to its investors, including audited annual financial statements, which are also required to be filed with the SEC. The cost of compliance with these registration and reporting requirements is so great that typically only the largest investment funds that seek to raise funds in the U.S. public stock markets will seek to qualify under the ICA.
In addition to these requirements, an investment company is also required to appoint independent directors to fill at least 40% of its board of directors, and in some cases must have a majority or super-majority of independent persons on its boards of directors. An investment company is also required to have a registered investment adviser manage its investments. In addition, an investment company is subject to restrictions on transactions with affiliates of the manger. All of these requirements would create substantial additional time delays and costs to the EB-5 investment process. As a practical matter, therefore, it is highly unlikely that any EB-5 fund would ever register under the ICA.
Should the Investment Company Act apply to EB-5 investment funds?
EB-5 investment funds should not be considered investment companies under the ICA, because their investment purpose and method of operation is entirely different than the typical mutual fund that invests under the ICA. A mutual fund is designed to invest in a basket of different securities, and the manager typically has discretion to purchase and sell different investments during the life of the fund. In stark contrast, each EB-5 fund is established to invest in one single project, which is fully disclosed to the EB-5 fund investors at the time of the investment. The manager of each EB-5 investment fund has virtually no discretion to liquidate the original investment and reinvest in a different investment. In fact, the only time that an EB-5 fund manager is typically given any authorization to make a new investment on behalf of the fund is when the original investment is repaid to the EB-5 fund, for reasons outside the control of the EB-5 fund, before the date required by USCIS regulations that the EB-5 investors’ investment must be sustained and “at-risk”. For example, a JCE that is not controlled by the EB-5 fund manager might be forced to sell a project earlier than planned, or might refinance a project and receive funds in excess of the debt refinanced. As a precaution to protect EB-5 investors, some EB-5 funds authorize the manager to reinvest the proceeds received by the fund in an alternative investment under those limited circumstances. Most EB-5 funds will include provisions in their equity or loan documents that prohibit a project owner from selling or refinancing a project until the date that EB-5 investors are no longer required to hold the investment. Nevertheless, as an additional precaution, it is typical to include a provision that would allow for reinvestment of the proceeds of an investment solely to protect the eligibility of the EB-5 investors for their permanent green cards. This provision is not intended to give broad discretion to EB-5 fund managers to reinvest the funds of EB-5 investors, and in fact the typical EB-5 fund will provide for a distribution of capital back to the EB-5 investors within about five years, after they have fulfilled the “at risk” requirements to obtain their permanent green cards.
Notwithstanding that the ICA was specifically designed for a totally different kind of investment fund than an EB-5 investment fund, the SEC has thus far taken the position that EB-5 funds are subject to the ICA, and are therefore required to comply with the ICA or qualify for one its exemptions. We would urge the SEC to examine this issue further, and to recognize that EB-5 funds are not investment companies under the ICA. However, until that happens, every EB-5 investment must be structured to comply with one of the exemptions from the ICA, or risk the penalties for violation of the ICA, which include a right of rescission.
What are the possible exemptions available to EB-5 Funds under the ICA?
There are four potential exemptions under the ICA that may be available to EB-5 investment funds. Every EB-5 fund that invests in securities of a JCE that is not a wholly-owned subsidiary of the fund itself will need review each of these exemptions and determine which of them will best suit the requirements of their particular investment. The following is a brief description of each of these possible exemptions:
Exemption 1: Not more than 100 investors (Section 3(c)(1) Exemption). Every EB-5 fund that has no more than 100 investors will likely qualify for the exemption provided by ICA Section 3(c)(1), which is the exemption for 100 or fewer investors. Since most EB-5 funds are offered at $500,000 per investment, this means that a maximum of $50 million can be raised under this exemption. Larger funds need to consider other exemptions. What about splitting an offering of over $50 million into two funds that each offer the same investment terms? The SEC’s position is that it will integrate the offering of two funds if their terms are so similar that they are in fact part of a single offering. However, it would be possible to create two different funds that have different terms of investment that would not be integrated into a single offering, such as by offering one fund first that makes a loan maturing in five years, closing that offering, and then offering a second fund six months later that makes an equity investment with a different preferred return than the first offering, and a different time and method of repayment. It would be very important to structure each of the two funds so that there as many differences as possible in order to avoid an integration of the two offerings. If this is not possible, then it will be necessary to find a different exemption for the entire offering, or to find a different exemption for that portion of the offering that exceeds $50 million.
Exemption 2: Direct investment by the Fund in real estate or in a mortgage loan secured by real estate (Section 3(c)(5) Exemption). For those EB-5 funds that will own real estate directly, or will make a loan secured by real estate, the exemption provided by ICA Section 3(c)(5) will likely be available. However, the SEC’s position is that this exemption is not available if an EB-5 fund makes an investment in a JCE other than a wholly-owned subsidiary, even if the JCE owns real estate. This is a problem for any EB-5 fund that invest in preferred equity of an unrelated company that will develop a real estate project. For an EB-5 fund that makes a mezzanine loan to finance a real estate development project owned by a third party, the fund will only qualify for the 3(c)(5) exemption if the fund’s loan is secured by a mortgage on the real estate. This can be a problem, because the senior lender to the real estate developer will often not permit a mezzanine lender to take a mortgage in the property, even if it is subordinated to the senior lender.
If the EB-5 fund’s loan is secured by the equity interests (membership or limited partnership) in the borrower or property owning company, and the EB-5 fund has many of the same rights as a holder of a mortgage in the property, there is a possibility that the 3(c)(5) exemption might be available. The SEC issued one no-action letter to Capital Trust, Inc. in 2007 in which the SEC found that a mezzanine lender whose loan was secured by equity interests in the property owner met this requirement because (1) the mezzanine loan was made specifically and exclusively for the financing of real estate; (2) the mezzanine loan was underwritten based on the same considerations as the senior secured loan on the property and after the lender performed a hands-on analysis of the property being financed; (3) the mezzanine lender exercised ongoing control rights over the management of the underlying property; (4) the mezzanine lender had the right to readily cure defaults or purchase the senor mortgage loan in the event of a default on the senior mortgage loan; (5) the true measure of the collateral securing the mezzanine loan was the property being financed; and (6) the mezzanine lender had the right to foreclose on the collateral and through its ownership of the property-owning entity become the owner of the underlying property. If an EB-5 fund cannot meet all or most of these conditions, the 3(c)(5) exemption may not be available.
Exemption 3: EB-5 Fund offered to only “Qualified Purchasers” (Section 3(c)(7) Exemption). An EB-5 fund that seeks to raise more than $50 million and that does not qualify for the 3(c)(5) exemption may consider using the exemption provided by Section 3(c)(7) of the ICA, which is for funds offered solely to “qualified purchasers.” Although the term “qualified purchaser” is defined to include a number of different types of entities, since EB-5 funds are only offered to individuals, only one definition is relevant to EB-5 investors, which is the one for investors with over $5 million in “investable assets.” The term “investable assets” refers to investment securities or investment real estate (other than the investor’s primary residence) that are owned by the investor. There is no requirement that investors provide verification of ownership of “investable assets”, but any EB-5 fund that seeks to use the exemption should require the investor to make a representation regarding the type of investment assets that the investor owns in order to support the use of the exemption. Having this additional qualification requirement is not the most desirable option, since it requires investors to meet higher qualification standards than are normally required for an EB-5 investment. However, in cases where there is no other available exemption, it may be useful. It is also important to note that the SEC does allow concurrent offerings of two related funds where one relies on Section 3(c)(1) and the other relies on 3(c)(7).
Exemption 4: EB-5 fund which is a “finance subsidiary” of the parent project company (Rule 3a-5 Finance Subsidiaries Exemption). For those real estate developers or other project owners who establish their own EB-5 fund to finance the parent company’s project, the exemption provided by SEC Rule 3a-5 for “finance company” subsidiaries may be available. A finance company is defined as a company that is established by a parent company for the purpose of financing the business of the parent company, and that is owned by the parent company, except for preferred stock with limited or no voting rights that is guaranteed by the parent (which may be subordinated to debt of the parent). This exemption is only available for EB-5 funds that are owned and controlled by the developer of the project being financed with the proceeds of the EB-5 fund, which makes it available only to a small group of EB-5 funds that are owned by the project owners.
How EB-5 regional centers and project sponsors can protect themselves against claims of violation of the ICA
EB-5 regional centers and project sponsors should always consider the ICA potential exemptions when structuring an EB-5 investment. If the offering amount is under $50 million, the offering will automatically comply with the Section 3(c)(1) exemption. If the offering amount exceeds $50 million, it will be necessary to find another exemption and structure the offering so that it complies with that exemption. We would welcome the SEC’s recognition that the ICA is not an appropriate law to apply to EB-5 funds because they are in no way similar to the sorts of mutual funds the ICA was designed to regulate. However, unless and until the SEC does adopt such a policy, it is necessary for every EB-5 regional center and sponsor to consider their available exemptions under the ICA.