Kurt Reuss: Ozzie, to me the key issue in the Path America offering is the 'related party' aspect of the transaction. How do you deal with related-party disclosures in your PPMs?
Ozzie Torres: It is probably the central focus of the disclosure items. Of course, you want to disclose the project and the parties, and all of the material agreements. Clearly, you’ll find that related party disclosures are the most difficult and yet the most important aspects of disclosure, coupled with other conflicts of interest. You want to make sure that you don't bury these disclosures.
At the same time, you want to make sure that there's at least a reference to them in the executive summary section. The theory being that a lot of people, if they read anything at all, will at least read that. The executive summary should be a place where it should be pointed out that there are related-party transactions or that there is a controlling person on both sides of the equation.
In regard to the Path America situation, I don't think any document or any securities lawyer, for that matter, could have possibly protected against what occurred, because this is outright fraud. The complaint doesn't allege that there were any shortcomings in the PPM itself; what it says, essentially, is that the PPM failed to disclose that there would be a fraud. And that is what the complaint is about. You can't protect against a fraud. All you can do is try to put in procedures and mechanisms that will make the transaction a more balanced one.
Of course, it also depends on where we sit as counsel. Do we represent the project? Do we represent the regional center? Do we represent the fund? Most of the time the fund is not necessarily represented by its own counsel or else counsel chooses to act as counsel for the project, and it prepares these documents essentially on behalf of the project.
I've heard some securities lawyers say that they feel that that is the safest option, because they don't want to wear the hat of the fund. Once you put that hat on, then you theoretically have to ask, "Okay, who's protecting these investors?"
Of course, every PPM is full of disclosures and disclaimers which caution, "We do not represent the investors. The investors need to have their own counsel," etc. But at some point, the hatchet could fall upon counsel for the fund.
Something that could be recommended if you see a controlling person, such as in this case, on the limited partnership (the fund side), we might want to see an investment manager, partner, or some entity that has control over the investment aspects of the offering or one that comes into existence once the offering is complete.
I've seen that in a couple of deals, where you might have the principals of the controlling parties on both sides run with the offering. Then once the offering is complete, you have an investment manager that takes over. From that moment the investment manager becomes the party in charge of ensuring that the funds are properly disbursed. They may have some co-signing rights on the bank accounts, etc.
Another thing you might want to see are audit rights and audited financial statements. I think that's debated all the time. The argument is often about the expense of having audited statements. Had there been any kind of audit or any kind of reports it might have been possible to get a glimpse of some wrongdoing. You really have to look at related-party transactions together with conflicts of interest. It's important that you disclose those both early on and in the body of the PPM.
Rupy Cheema: Ozzie, I agree that it's very important to have audit rights. In this case, though, audit rights, even quarterly or bi-annually, might have been too late to figure out what's going on. It's the real-time monitoring that's extremely important in any of these deals.
Kurt Reuss: Ozzie, one last question. There's an article that Doug Hauer wrote this weekend that was very good on this topic. He pointed out that given the SEC’s recent scrutiny of EB5 offerings, people should be aware that these related-party transactions are likely to have more SEC scrutiny than they might otherwise. Do you think that's a strong argument against having a related-party transaction?
Ozzie Torres: Yes and no. Where things can go wrong is when someone has their hand in the proverbial cookie jar. It's really that simple. If you have a situation where you have the same control persons on both sides, it begs the question of how can you be both borrower and lender? In the event of a default, the investment manager’s role is to be the party on the fund side that will exercise the remedies that can come about from a default. Of course that may be way down the line, but in any event that is the easiest pickings. When things can more easily go wrong is when the hand is in the cookie jar? It's an easy one to go after.