There are a number of responsibilities involved in supervising the New Commercial Enterprise's (NCE’s) EB5 loan to the Job Creating Enterprise (JCE). What are the best practices for ensuring proper supervision and what are the potential issues that can arise?
David Appel: One common issue is when a project starts and there's no money in the budget for supervising and administering the loan to the JCE.
Supervision of the NCE’s loan needs to become an industry practice, starting with the formation of the private placement memorandum (PPM) and while the loan agreement is being negotiated. The cost of supervising and administering the loan need to be part of the New Commercial Enterprise (NCE) budget but I never see an NCE budget. I see an operating agreement.
We know what kind of income is coming in, and we know, more or less, the level of administration expenses being paid, however when it comes to construction monitors, accountants and ongoing legal costs, there's no budget for them. It becomes a very difficult task to create the necessary integrity, objectivity and independence on a go-forward basis.
Ron Fieldstone: Moreover, you must try to explain to a developer that the NCE, by definition, has no working capital. Once the investors put in their $500,000, all of that money must go into the EB5 project. It cannot be used to administer the NCE. We also know that all of the administration fee is going to third parties. Normally, the NCE never keeps any portion of the admin fee. So where does the NCE get money to do anything? There are two sources:
- One source is interest that the NCE may get paid on a regular basis. That may take time to receive.
- The second source is for the developer to pay or reimburse the NCE's expenses just as any lender/bank would get reimbursed for these costs. This is what we at Arnstein & Lehr do and this must be prepared in the loan documents.
In a scenario where EB-5 money is used to pay back a bridge loan and the project is virtually finished or it's received its CO and the money is just going to reimburse the other lender or the developer, you don't have to worry about construction because you’ve got a completed project. That makes supervision a lot easier because you no longer have to administer, you just need a CO and a title report to make sure everything's clean.
A lot of times the investors get the money and the operating agreements designate somebody to pay the expenses. Does the manager pay it? Does the developer pay it, or is it coming out of the investor interest? That's a structure issue in the offering documents that needs to be addressed. A lot of people don't focus on this because they don't really recognize that the NCE is an operating entity that requires working capital.
Rupy Cheema: What I notice in a majority of operating agreements is that the operating expenses are a first priority payment, then you have a guaranteed management fee which will accrue if the annual cash flow is not sufficient to cover costs.
Investor distributions are derived from the net cash available after expenses and management fees. Investors may not understand that their cash flow distributions, including capital distributions may be reduced by the costs if the NCE has insufficient cash available to cover operating costs.
Robert Cornish: When EB5 regional centers are doing these projects and receiving bottom-line revenue, we need to ask what is the actual business plan and business objective of the regional center? There's an ongoing trend in the hedge fund world to look at funds as ongoing businesses. Anybody can start a fund or start a project. They can't necessarily run a business.
In the due diligence process people need to distinguish whether the regional center is a one-shot deal or whether it is an ongoing enterprise that is going to be generating revenue and profit.
Rupy Cheema: In our experience a majority of the offering documents include cash flow projections for the project entity, but rarely do we find a proforma presented for the NCE. There may be a line item in the operating agreement that states that the NCE will have operational, administrative and legal expenses, but there is no specific budget allocated to them.
Ron Fieldstone: There is a role that is necessary which we haven't addressed yet - loan enforcement. Typically a bank would have a third-party service provider that would confirm compliance of various requirements. For instance, is insurance properly in place, are taxes being paid, is the title search clean or are there liens filed against the property?
These are standard items that can be delegated to a third party administrator. There's a cost to it, but they have to be done.
The other thing which needs to be addressed is what happens in the event of a default? Whether a technical default under the EB5 loan, or a monetary default which is more serious — especially if it's a senior loan default.
What does the NCE do if there's a senior loan default? The NCE administrator needs to be in the position to determine what to do and at least appoint independent counsel to take legal action against the borrower to enforce the loan documents.
This can cause issues because the NCE may not have money if for example, the borrower is not paying the interest current. Now the NCE needs to hire a law firm. Where is that money coming from?
That is a very interesting dilemma for an NCE relying on developer’s interest.
David Appel: What happens when you have a project that only has a $5 million or $10 million loan? The amount of income coming into the NCE could never cover its costs. When you start getting into bigger funds then it's a lot easier to pay these costs, but in the smaller deals it definitely becomes more problematic.
Ron Fieldstone: Either increase the interest rate for the NCE, or require the borrower to fund or reimburse some of those costs directly. Somebody's got to pay these expenses or else the job is not going to get done correctly, which is not acceptable.
Kurt Reuss: NCEs are ongoing businesses and need sufficient capitalization to operate as a going concern. Investors need to recognize the importance of conducting due diligence on the NCE's projected financials to ensure that loan administration and supervisory costs are part of the operating budget.