Limiting Securities Litigation Risks in EB-5 Offerings: What Regional Centers and Issuers Need to Know
The flurry of federal suits filed by the U.S. Securities and Exchange Commission (SEC) in the past few months against several companies and individuals for alleged fraud and false statements in soliciting foreign investors under the EB-5 Immigrant Investor Program shows that the government is taking a tougher approach to enforcement in the EB-5 space. Recent SEC suits include SEC v. Luca International Group, LLC, SEC v. Path America, LLC, SEC v. EB5 Asset Manager, LLC and SEC v. Robert Yang et al. Although the SEC’s complaints in these cases describe extreme situations involving the defendants’ misuse of investor funds to fund their own personal purchases, the securities laws invoked by the SEC have broad coverage and can be used to sanction less egregious conduct. Indeed, in some cases merely negligent misstatements to investors can trigger liability.
The SEC’s principal claims in the cases referenced above were brought under the primary anti-fraud provisions in the federal securities laws – Section 17(a) of the Securities Act of 1933 (15 U.S.C. § 77q(a)), and Section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. § 78j(b)), as implemented by SEC Rule 10b-5 (17 CFR § 240.10b-5). These are not the only enforcement statutes in the federal securities laws, of course, but they are the broadest and most commonly used. This advisory outlines the key provisions of these laws as they may be applied to EB-5 investments. In addition to explaining how civil anti-fraud statutes apply in the EB-5 context, we also offer guidance to regional centers, broker-dealers and issuers of EB-5 securities on how to mitigate risks of future litigation in the specific area of securities fraud.
Background on EB-5 projects and the securities laws
Administered by U.S. Citizenship and Immigration Services (USCIS), the EB-5 Immigrant Investor Program offers foreign investors an opportunity to secure permanent residency in the United States by making a capital investment in a commercial enterprise that will create or preserve at least 10 jobs for U.S. workers. The minimum investment is $1 million per investor, or $500,000 for an enterprise that creates jobs in a Targeted Employment Area (TEA), which is defined as a rural area, or as an area that has an unemployment rate that is at least 150% of the national average.
Promoters of EB-5 projects need to be aware that the investments they are offering to foreign nationals are frequently structured as a type of security that is subject to federal and state securities laws. In particular, the terms “security” and “securities” are very broadly defined in the Securities Act and Securities Exchange Act to include not only traditional stocks and bonds but any “investment contract,” among other items. See 15 U.S.C. § 77b(a)(1); 15 U.S.C. § 78c(a)(10). The U.S. Supreme Court has in turn interpreted “investment contract” to mean “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” SEC v. Howey Co., 328 U.S. 293, 298-299 (1946). Under that broad definition, most EB-5 investments, apart from those where the investor is actively involved in the management of the enterprise, would constitute a form of security.
Consequently, even though the investments offered in EB-5 projects are typically not publicly traded and are usually exempt from SEC registration requirements, they may still be subject to the anti-fraud provisions in Section 17(a), Section 10(b), and Rule 10b-5. The registration exemptions available under Section 4 of the Securities Act (15 U.S.C. § 77d) and SEC Regulation D (17 CFR § 230.501 et seq.), for example, do not shield exempt securities from claims under Section 17(a), Section 10(b), and Rule 10b-5.
What do Section 17(a), Section 10(b), and Rule 10b-5 prohibit?
Generally speaking, Section 17(a), Section 10(b), and Rule 10b-5 prohibit the use of fraudulent schemes or practices, untrue statements of material facts, or misleading omissions of material facts, in connection with securities transactions. Rule 10b-5 provides that:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
The language in Section 17(a) is similar, although there are some significant differences discussed below.
What is a material fact?
Litigation under Section 17(a) and Rule 10b-5 commonly involves claims that the issuer or a related party made misstatements or misleading omissions of material facts. Section 17(a)(2) and Rule 10b-5(b) both prohibit use of “any untrue statement of a material fact” or any omission of “a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.” But what is a material fact?
The Supreme Court has said that a fact is material where there is a substantial likelihood that it would be viewed by the reasonable investor as having significantly altered the total mix of information made available. See Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309, 1318 (2011). In Matrixx, for example, the Court held that adverse reports about a serious side effect of a pharmaceutical company’s leading product were material, even though they were not statistically significant, because it was substantially likely that a reasonable investor would have viewed their disclosure as significantly altering the total mix of information available. This is not to say, of course, that a company must disclose all material facts. See id. at 1321-1322. But where a company chooses to address a topic, the disclosure must be accurate and sufficiently complete so as not to be misleading. In Matrixx, for instance, the Supreme Court concluded that the non-disclosure of the adverse reports was a material omission because the company had also stated that its revenues were expected to increase 50% or more, despite the fact that there was an undisclosed, significant risk to its leading revenue-generating product.
Determining appropriate disclosure for an EB-5 investment, as for any securities solicitation, requires careful consideration. It is best undertaken in consultation with an attorney who has been involved in and understands the underlying project thoroughly.
Who can bring suit?
The SEC has jurisdiction to bring actions to enforce Section 17(a), Section 10(b), and Rule 10b-5 either in federal court or in administrative proceedings before its own administrative law judges. See 15 U.S.C. §§ 77h-1, 77t, 78u, 78u–3. In addition, purchasers and sellers of securities may bring their own private suits for violations of Section 10(b) and Rule 10b-5. See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 318 (2007); Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975).
Who is potentially liable?
Rule 10b-5(b) states that it is unlawful to “make” any untrue statement of a material fact or any misleading omission of a material fact. The Supreme Court has therefore held that direct liability for a violation of Rule 10b-5(b) is limited to the “maker” of the statement, i.e., “the person or entity with ultimate authority over the statement, including its content and whether and how to communicate it.” Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2302 (2011). Rule 10b-5(a) and (c) respectively make it unlawful to “employ” or “engage” in a fraudulent scheme or practice. By analogy, it can be argued that liability under those provisions should be limited to the person or entity that actually employed or engaged in the fraudulent scheme or practice. See SEC v. Kelly, 817 F. Supp. 2d 340, 344 (S.D.N.Y. 2011) (“Scheme liability under subsections (a) and (c) of Rule 10b-5 hinges on the performance of an inherently deceptive act that is distinct from an alleged misstatement.”).
However, other persons may be subject to suit even if they did not directly make a material misstatement or omission or engage in fraud. For example, in contrast with Rule 10b-5(b), Section 17(a)(2) makes it unlawful “to obtain money or property by means of any untrue statement of a material fact….” Some courts have interpreted this difference in phrasing to mean that Section 17(a)(2) is not limited to the maker of the statement. See SEC v. Strebinger, 2015 U.S. Dist. LEXIS 93566, at *22 (N.D. Ga. June 11, 2015); but see SEC v. Kelly, 817 F. Supp. 2d at 345 (“Because subsection (2) of Section 17(a) and subsection (b) of Rule 10b-5 are treated similarly, it would be inconsistent for Janus to require that a defendant have made the misleading statement to be liable under subsection (b) of Rule 10b-5, but not under subsection (2) of Section 17(a).”).
In addition, Section 20(a) of the Securities Exchange Act (15 U.S.C. § 78t(a)), makes a person who controls a primary violator of Section 10(b) jointly and severally liable for the violation, “unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action.” The courts are divided as to whether the plaintiff must show that the alleged control person “culpably participated” in the underlying fraud. See, e.g., Ark. Pub. Employees Ret. Sys. v. Harman Int'l Indus. Inc. (In re Harman Int'l Indus., Inc. Sec. Litig.), 2015 U.S. App. LEXIS 10552, at *47 (D.C. Cir. June 23, 2015).
And most significantly, unlike a private plaintiff, the SEC has the power to sue persons who aid and abet a violation of the securities laws. See 15 U.S.C. § 78t(e); Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 162 (2008) (“Aiding and abetting liability is authorized in actions brought by the SEC but not by private parties.”).
What is the standard of liability?
A claim under Section 10(b) and Rule 10b-5 requires proof that the defendant acted with scienter, and not merely negligently. See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976). The Supreme Court has defined “scienter” as “a mental state embracing intent to deceive, manipulate, or defraud.” Id. at 193 n.12. Although the Supreme Court has never decided the issue, the federal courts of appeals have held that some form of reckless behavior may be sufficient to satisfy this scienter requirement, although they have differed as to the degree of recklessness required. See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 319 n.3 (2007).
The standard for liability under Section 17(a) is different, however. While Section 17(a)(1) requires scienter, mere negligence is enough to support a claim under Section 17(a)(2) and 17(a)(3), because those provisions only prohibit obtaining money by use of a misstatement or omission, or engaging in a transaction or practice which “operates or would operate as a fraud,” focusing on its effects. See Aaron v. SEC, 446 U.S. 680, 697 (1980).
What damages and penalties can be assessed?
Under Section 20 of the Securities Act (15 U.S.C. § 77t), and Section 21 of the Securities Exchange Act (15 U.S.C. § 78u), the SEC may bring a court action to enjoin illegal acts, to enjoin a person from serving as an officer or director of a public company, or impose civil penalties. The defendant may be ordered to pay the gross amount of pecuniary gain to such defendant as a result of the violation, or a penalty of up to $100,000 for a person or $500,000 for any other entity. See 15 U.S.C. § 77t(d)(2); 15 U.S.C. § 78u(d)(3). The SEC may also bring an administrative action in which it can assess penalties as high as $150,000 for a person or $725,000 for any other entity.
A private plaintiff may recover damages for economic loss sustained as a result of the alleged misstatement, omission, or fraud. For example, “a defrauded buyer of securities is entitled to recover the excess of what he paid over the value of what he got.” Rosado v. China North East Petroleum Holdings, Ltd., 692 F.3d 34, 38 (2d Cir. 2012).
Application in recent SEC cases
The SEC’s complaints in Luca International, Path America, EB5 Asset Manager, and other cases offer some examples of conduct subject to suit under Section 17(a), Section 10(b), and Rule 10b-5.
In Luca International, the SEC alleged that defendant Bingqing Yang targeted Chinese citizens who sought permanent U.S. residence through the EB-5 Program, among others, soliciting investments in funds to purchase interests in oil and gas ventures. According to the complaint, Yang and her chief fundraiser Lei Lei represented that investors could expect 20 – 30% in annual returns, and told investors that the investment funds were profitable when they were not. The SEC also alleged that Yang misappropriated investor funds for personal purposes, such as paying for a home and a family vacation, and used money from newer investors to provide returns to older investors in a “Ponzi-like scheme.” Based on these allegations, the SEC brought claims under Section 17(a), Section 10(b), and Rule 10b-5 against Yang, Lei, and several management companies controlled by Yang.
In Path America, the SEC asserted claims under Section 17(a), Section 10-b, and Rule 10b-5 against Path America, LLC and its controlling owner, Lobsang Dargey, a Bellevue, Washington-based real estate developer who also happens to be a brother-in-law of tennis star Andre Agassi. The SEC alleged that Dargey, through Path America, had diverted to himself and for his own personal benefit millions of dollars he had raised from Chinese nationals for EB-5 projects sponsored by Path America-owned regional centers. According to the SEC, Dargey spent some of the siphoned funds on a $2.5 million home in Bellevue, as well as at various gambling casinos. He also diverted EB-5 funds to projects that were unrelated to those disclosed in his offering documents to investors, meaning that the green card petitions pursued by EB-5 investors would be infirm.
In the EB5 Asset Manager case, the SEC alleged that defendant Lin Zhong, (a/k/a Lilly Zhong) purchased a $175,000 Sea Ray yacht, a $100,000 Mercedes Benz S-550, a $55,000 BMW X5 SUV, and private homes in Massachusetts and Florida using money she fraudulently obtained from investors, after telling them that 100% of their funds would be used in construction projects and that all investments would be held in escrow until their EB-5 immigration petitions were approved. While Zhong touted her background as a real estate developer to investors, she failed to disclose to them that she was the subject of a bankruptcy proceeding against her and that one of her development companies was in liquidation. Based on these allegations, the SEC sued Zhong and her company, EB5 Asset Manager, for violations of Section 17(a), Section 10(b), and Rule 10b-5. The SEC also sought and obtained a court order freezing assets controlled by Zhong and her company.
In Yang, the SEC asserted claims under Sections 17(a), 10(b), 10(b)-5 and 20(a) against various related Suncor entities, Robert Yang (the owner/President of the Suncor entities) and Claudia Kano, Senior VP and/or manager of the various Suncor entities). The SEC alleged that Yang, Kano and the Suncor entities diverted over $10 million for Yang’s personal benefit and to pay an undisclosed finders’ fee. The SEC also alleged that Yang and Kano made numerous misrepresentations in the offerings provided to investors. According to the SEC, Yang spent over $2 million of the misappropriated funds to repay a personal loan, purchase property for Yang and to support Yang’s medical practice. They also diverted EB-5 funds to projects that were unrelated to those disclosed in his offering documents to investors.
These are not the first securities suits brought by the SEC in the EB-5 space. In 2014, the SEC brought claims against two immigration lawyers in SEC v. Lee, for allegedly defrauding Chinese and Korean investors in connection with an EB-5 program. In that case, the defendant lawyers raised over $11 million to build an ethanol plant in Kansas as a purported regional center under the EB-5 program, when in fact nearly two-thirds of the investors’ funds were used for other purposes, such as financing an unrelated iron ore extraction project in the Philippines, and the ethanol plant was never built. The defendants also used investor funds to refund investments in other programs whose investors demanded their money back. The SEC brought claims against the two lawyers and certain companies they controlled for violations of Section 17(a), Section 10(b), and Rule 10b-5. The SEC also asserted claims against one of the lawyers as a “control person” under Section 20 of the Securities Exchange Act.
In a 2013 suit, SEC v. Ramirez, the SEC sued two real estate professionals and their companies for defrauding investors under an EB-5 program in which they targeted Mexican, Egyptian, and Nigerian investors. In Ramirez, the individual defendants started soliciting investors and promising them the opportunity to obtain EB-5 visas before the defendants had even obtained approval of their company as a regional center by USCIS. The defendants told investors that their investments would be held in escrow pending approval, but instead the funds were diverted to other undisclosed businesses or for personal uses. The defendants also solicited investments for a project that was not included in their application for approval as a regional center. The SEC asserted claims against the defendants for violations of Section 17(a), Section 10(b), and Rule 10b-5, as well as for aiding and abetting those violations. At the SEC’s request, the court later approved appointment of a receiver and ordered the defendants to turn over all of their assets to the receiver.
Conclusion: Recommendations to minimize litigation risk in an EB-5 offering
We have several strategic recommendations to regional centers, broker dealers and issuers of EB-5 securities.
First, know the parties selling your deal abroad. Material misstatements in the sales process made by a promoter to an investor can cost you later. If you rely on agents and market makers outside the U.S., know those parties and do not take risks entrusting the marketing of your deal to unknown parties. Also review all marketing materials with securities counsel to ensure that these materials do not contain any misstatements.
Second, know your deal so that your oral statements are always correct when you speak with investors. It is also important to have training and counsel from a securities lawyer on what you may and may not say about your deal before you enter the market. Along these lines, consider having a trusted securities litigator who knows your deal on your team. Having an investor-protective approach is the name of the game. As an issuer, work with securities counsel to know what investors need to know, and make sure you do not cut corners on disclosures. This is as important as knowing what not to say about your deal.
Third, do not enter the EB-5 marketplace until your deal terms are final. Having multiple versions of a private placement memo circulated makes the offering more difficult to manage—and increases the risk that there will be confusion in the market among investors. Also work with counsel to be clear that key elements of the risk of your investment are robustly described. If as an issuer you lack liquidity to compensate investors if your business or offering fails, you need to say that in your offering materials. Misstatements about an issuer’s experience or liquidity are common problems in private placements.
Fourth, an issuer should consult qualified counsel to know whether a specific fact or event is material to disclose to investors in an EB-5 deal. Omissions of material facts can lead the SEC or investors to claim later that you have run afoul of Rule 10b-5. Don’t bury your disclosures in your offering documents. In litigation later, context matters. Burying important facts in a private placement memo and having either confusing or overly legalistic language about basic facts in a deal might be viewed later as misleading and legally insufficient.
Finally, many EB-5 transactions involve related-party transactions and self-dealing. Such transactions necessitate experienced securities counsel precisely to ensure that investors have access to material information that would belong to the “total mix” of facts they need to make an informed decision. Proceeding with a deal that lacks proper disclosures on transactions conducted among related parties can result in rescission and fraud claims. Pulling a strong due diligence team into place early on in your deal can help ensure that transactions that lack arm’s length objectivity are in step with the market, backed up with third-party opinions (e.g., appraisals) and documented adequately.
1 15 U.S.C. § 77b(a)(1) provides that: “The term ‘security’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.” The definition in the Securities Exchange Act, 15 U.S.C. § 78c(a)(10), is substantially similar, though not identical.
2 See, e.g., Sonnenfeld v. City & County of Denver, 100 F.3d 744, 746 n.1 (10th Cir. 1996)
(“Although under § 3(a)(12) (15 U.S.C. § 78c(a)(12)) municipal securities are “exempted securities,” § 10(b) applies to fraud in connection with the purchase or sale of “any security,” and is not limited to nonexempt securities. Section 10(b) therefore applies to transactions in municipal securities, and it is well established that underwriters, brokers, and dealers in municipal securities may be liable in a private cause of action.”); “Securities Fraud,” 51 Am. Crim. L. Rev. 1661, 1676 n.78 (2014) (“The task of defining a security should not be confused with determining whether a security is exempt from regulation and disclosure requirements. Section 3(a) of the 1933 Act and section 3(a)(12) of the 1934 Act list exempt securities. These sections exempt a security from registration and disclosure requirements, but do not provide shelter from the criminal anti-fraud protection of Rule 10b-5 or other civil anti-fraud provisions.”).