Kurt: In today's discussion, we're talking about what due diligence is in the EB5 context. That...
Rupy Cheema: Typically a senior loan will have conditions regarding draw schedules and construction...
Material Change Under PPM
This question was submitted by Rohit Turkhud of Fakhoury Law Group.
Structural Weaknesses in Path America's Offering
Kurt: As you’re no doubt aware, the SEC has made allegations against Path America. These allegations include the defendant’s misappropriations of $17.6 million of EB5 investor funds. Of that, it’s alleged that $2.5 million was spent on a personal residence, and other money was spent on various gambling expenses. It’s also alleged that a great deal of the money has been diverted to unrelated projects, which may threaten the green card petitions of EB5 investors.
As an investor or an agent representing an investor, it's important that you be circumspect when evaluating projects where the entire enterprise is under the control of a single person, as it is in the case of Path America. Rupy, what are some of the weaknesses that you see in Path America’s transactional structure?
Rupy Cheema: The way our process works is that we look for internal controls that are in place to protect the EB5 investors’ funds. If we had reviewed this offering when it was going to market, we would have identified numerous risks. For example, we would have pointed to the organization’s structure and the various entities involved in the offering, and we would have identified the controlling persons of each entity. Specifically, we would have noted that those controlling persons, being one and the same person, was a clear weakness and a risk to the offering.
And if, indeed, there is just one controlling person, you want to see what controls or safeguards have been put in place in order to protect the investor fund. You want to look at how the money is being released into the project.
While I believe there was escrow of the investor fund, keep in mind that escrow is only as good as its release conditions. I believe that, in this case, the escrowed amounts were being released upon the filing of the I-526 petition. Further, there would have been no other monitoring in place to release the money into the project. It seems that a single person had access to the purse strings, where they had signing authority on the NCE's bank account and they had the signing authority on the JCE's bank account. This person was able to divert funds to wherever they wanted, really.
What we would be looking at in a due diligence review is to see if there was any kind of fund administration in place. And it seems that, beyond the money being released from escrow upon the I-526 filing, there was no fund administration in place. In a related-party transaction, especially when the JCE and the NCE people are the same people, you would then want to look for construction monitoring. For example, has any kind of a third party construction monitor been hired that could assess the progress of the construction?
Another of the things we would identify is whether or not the fund release was tied to the construction milestones. In the Path America deal, it seems like all controls were lacking, at least that’s my assessment of it.
Kurt Reuss: How common is it for you to see lenient release conditions in an escrow account and some of these other items that you've mentioned?
Rupy Cheema: Its more common than you'd think. The risks can be mitigated, however, if the NCE management is unrelated to the JCE management. Then, if there are conditions to closing the loan or the investment that is going to be made to the JCE, the NCE won’t close the loan until those certain conditions are met. So you do have some oversight. And that’s really what you want to look for—what oversight is in place?
We do occasionally see deals where there is self-dealing and there are no third-party controls in place. From an investor’s viewpoint, I think those are very high risk deals.
Kurt Reuss: Rupy, you had mentioned earlier that managing multiple projects was also an issue that you saw in this offering. Can you talk a little about that?
Rupy Cheema: Normally in private placements, we do see a disclosure that would say the NCE may be managing multiple EB5 projects, so potentially there could be a conflict. One thing you may not see in the PPM is how many projects a developer who's using EB5 funds is managing. I have reviewed projects where the developer, because the projects were similar, was constructing two or three projects at the same time. Because of the lack of monitoring, there may not be transparency of where the funds are going.
I think that it becomes a very risky situation when the developer's motivation is to complete more than one project. They have free rein as to how to use the EB-5 funds, or because no one's monitoring it, EB-5 funds can be diverted without anyone’s knowledge. I think that's something that should always be identified, how many projects the developer is currently managing and who really are the principles in each project.
Kurt Reuss: Michael, do you have any suggestions or something to add to Rupy’s comments?
Michael Gibson: Rupy provided a great summary of what the major concerns are. The practical thing that's important to consider is how can you protect yourself in terms of not having this happen to your project?
I know that in a lot of projects, when people think about the loan portion of the transaction, they don't want to add unnecessary layers of complication or costs and I think if there's a lesson to be learned it's that there are some reasonable steps that you can take to protect yourself from just this type of occurrence, of fraud.
In thinking about your particular projects, as Rupy had mentioned, there needs to be numerous safeguards. For example, you can have reasonable draw conditions in your loan documents, an outside consultant who reviews the disposition and allocation of loan proceeds, a fund administrator who authorizes expenditures of proceeds or even mandate the need for two signatories to sign off on checks, loans or any financial instrument. I think all of these are layers of protection that are very reasonable. And while they do probably add some time, effort and cost to your project, ultimately they could provide protections against just this sort of thing happening.
Frankly, even if you trust everybody in a deal, do you really want one person to have the signing authority on a bank account with $125 million in it? I can't think of any person in the world that would say yes. The potential for these types of issues to come up are just too significant and too meaningful to the project, and the ramifications to the EB5 investors are very, very significant, obviously.
Kurt Reuss: Mike, can you talk a bit more about some of the suggestions we’ve mentioned, and how they might compare to the typical bank's draw monitoring of their own funds?
Michael Gibson: The protections that Rupy described and that I just alluded to are all steps that a traditional financial institution would take to protect their funds. Obviously, it can get more complicated if the NCE and JCE are affiliated but at some level, if you're dealing with any sophistication level, these types of protections aren't going to be unusual or add significant inefficiencies to access funds and advancing funds as they're required for the project.
A bank would always have a consultant who would review draw requests. A bank is not going to advance any of its own funds until it's comfortable doing so. The authority to do that obviously lies with the bank, and in most instances it's not one person signing off on a bank account. There are going to be multiple layers of protection that any institution would take to ensure that, when it's sending significant sums of money out the door, they're going out for a particular purpose that was intended when the loan documents were signed. I don't see why EB5 should be any different. In fact, it's probably more important, because proceeds need to go towards specific job creation purposes in order for everybody to meet the expectations of the project and obtain approvals of their immigration petition.
Kurt Reuss: Mike, when we talk about construction monitoring, what kind of costs are we talking about adding to the projects?
Michael Gibson: It's going to be a project-by-project basis and will depend on how complicated the EB5 project is. I guess I'd say two things about adding costs. One is, if you think about $125 million or any significant loan amount or offering for a project, adding a cost that's basically going to be a blip on the radar screen seems to me to be insignificant in terms of the fraud that could otherwise take place in a project.
In my experience, and you'd have to get a quote for any particular project, but you're not talking about significant costs. You're probably talking about $20,000 to $75,000 or somewhere in that range. That would be to monitor construction draws on a project. Again, depending on the complication, number of draws, and the amount of work that you're actually engaging someone to do. In the grand scheme of things, I think it's a layer of protection that should be considered on almost any project.
Dan Lundy: To some extent, it's being done already in most deals. You're already paying those costs, because you have a senior lender who is going to require this kind of oversight.
Michael Gibson: Dan’s right and that's a good point. Ultimately, though I think what we're concerned about here, even under a senior lender, is that fraud could still take place before the EB5 proceeds even went out. Once escrow is released and the funds are available to be lent, I think at that point, you need to also add some protections.
Rupy Cheema: The fact is the senior lender will have steps put into place to protect their funds, but they wouldn't necessarily be looking at how the EB5 fund is being drawn.
Michael Gibson: Right. All the senior lender wants to know is that the EB5 money is there and available for the project. Once it's released from escrow and available to be lent, they're not going to be monitoring that at all.
Dan Lundy: In some deals, they want a service disbursement agent, too.
Michael Gibson: Yes, in some deals, though not every deal.
Kurt Reuss: So, Dan, what you're saying is that in some deals, the senior lender will want to act as the disbursement agent for all the funds?
Dan Lundy: Usually, the senior lender's money goes in last. The senior lender will want to make sure that the money is actually being used for the purpose intended; that the construction is going to be completed. That’s because their money is coming in afterwards, and they don't want a half-built building.
Kurt Reuss: In the deal that we're talking about specifically here, Path America, it seems the money started going into places other than where it was meant to before the senior lender even started making loans.
Rupy Cheema: We don't know if there is even a senior lender. We don't know how much EB5 money. As Ozzie pointed out earlier, that can’t be determined from the complaint.