What is the impact of a 'material change' to current and future investors?

Material Change Under PPM

This question was submitted by Rohit Turkhud of Fakhoury Law Group.

In general, the issuer of securities can be found liable for any omission of material fact or misleading statement of material fact.  This is the Rule 10b-5, often called the “anti-fraud” rule. This standard is measured at the time of each offer and sale of securities. In EB-5, the offers and sales typically take place over time -- sometimes over a year or more.

Accordingly, for sales that take place weeks or months after a PPM is finalized, an issuer can be held accountable for failure to disclose material changes or updates since the date the PPM was finalized, even if the PPM was correct in all material respects at the date it was released.  Issuers must continually monitor their project and consider whether any changes require an update to the offering materials so that the issuer can meet the Rule 10b-5 standard. 

There is no magic rule of thumb on when an update is required.  The determination requires judgment.  In my view, that judgement comes from many years of experience and practice evaluating facts for materiality, and reading the cases where a court or the SEC concluded that someone got it wrong.  This is what experienced securities lawyers do.  For example, I have been helping clients make these kinds of judgments in a wide variety of securities offerings for more than 20 years.

The issue of going back to persons who have already invested is different. They have already made their investment decision, and they do not have a remedy simply because something changed after their investment was made. However, issuers sometimes discover that something in the PPM was not correct when it was written.  When that happens, the issuer has to consider whether the fact was material, and if it was, the investor may have a right to rescind its investment.  Such rescission right lasts as long as the statute of limitations lasts. 

For federal law, that is two years after discovery or five years after the erroneous statement, whichever is shorter. A technique that issuers use in these circumstances is making a rescission offer to the investor after providing full disclosure of the erroneous fact.  Basically, the issuer says “Here’s the truth. If you want your money back, tell me now and I’ll give it back to you (with interest).” If the investor does not elect to receive back its investment, this technique may prevent the EB-5 investor from prevailing on a rescission claim later, even if brought within the statute of limitations. 

It is not certain that this technique will defeat a later claim, but most securities lawyers believe that it is very helpful to the defense of a claim. Having offered rescission can also be helpful in any SEC or state law enforcement action, though again, it does not prevent those authorities from bringing a case or prevailing on that case.

You can think about this like buying interests in a mutual fund.  (I chose a mutual fund for this example because mutual funds, like EB-5 issuers, offer their securities continuously over a long period of time.) The same anti-fraud laws apply to offers and sales of EB-5 securities as apply to offers and sales of mutual fund interests. Let’s say I receive disclosures from the mutual fund that say: (a) the fund will buy securities in a variety of industries in the discretion of its managers; (b) the funds currently holds 60% of its assets in energy stocks, which the managers believe are good investments because of certain facts about the energy industry.  I think energy stocks are going to go up, so I buy into the fund.  

Now assume that six months from now, energy stocks have gone down because underlying facts in the energy industry have changed for the worse.   During this six-month period, the fund reduced its exposure to energy stock from 60% to 30%.  This fund cannot continue to send the old disclosure to new investors when the underlying facts and exposure have changed, even if the old disclosure says it is dated six months ago.  If the fund did so, the new investors would probably have a claim.  But what about me who bought into the fund six months ago?  If the disclosed facts were correct six months ago when I invested, I don’t have a claim. But if the fund actually held 90% of its securities in energy stocks, I might have a claim. This is true even though I actually wanted exposure to energy stock.  

As we discussed in the webinar, my claim will be tested against what a reasonable investor cares about while making an EB-5 investment.