By Angelo Paparelli, Mark Katzoff, Christopher Robertson, and Gregory White
While the Village People warbled that “it’s fun to stay at the YMCA,”[1] when it comes to the ICA, the Investment Company Act of 1940 (the “ICA” or the “1940 Act”), the better advice may be to “run, run away.”[2] Most people who consider investment companies, to the extent they think of them at all, probably associate them with mutual funds. Conceivably, while keeping company with Fidelity or T. Rowe Price might put an EB-5 fund in the vanguard of the EB-5 industry, as this article will explain, there are compelling reasons why an EB-5 fund would try to avoid investment company status under the securities laws.
This article will explore what it takes to be dubbed an “investment company” under the 1940 Act, and provide an overview of some of the common methods for avoiding inadvertent status as an investment company. The article will also describe the unpleasant potential consequences of inadvertently being tagged as an investment company, including possible rescission, ineligibility to satisfy the EB-5 “at risk” capital rules and a duty to register as an investment advisor.
What Is an Investment Company?
Section 3(a)(1) of the 1940 Act defines an investment company in pertinent part as a company which: “is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities” or “is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.”
Section 2(a)(36) of the 1940 Act defines a “security” in pertinent part as “any note, stock, treasury stock, …, or, in general, any interest or instrument commonly known as a “security”.”
EB-5 funds, investment funds which raise money solely or primarily from investors seeking to qualify for “green cards” under the EB-5 program, most commonly use all of the funds they raise from investors to make loans to job-creating entities (“JCEs”) for which the funds receive promissory notes. The funds may also make equity investments in JCEs for which the funds receive stock or limited liability company (“LLC”) or partnership interests if the JCE is an LLC or partnership. These notes or stock may be considered “securities” under the 1940 Act by virtue of being expressly included in the definition of “security” cited above[3] and, accordingly, once the funds are invested, virtually all of the assets of an EB-5 fund will consist of notes or stock, an EB-5 fund would potentially fall within the definition of an “investment company.”[4]
That said, in the main, EB-5 funds are typically very specialized structures which usually hold only one note or stock investment, the terms of which underlying investment are generally fixed for five or more years and often require little to no management. Since the JCE has actually been selected at the time the investor invests in the fund, the investor is not so much relying on the management of the fund as it is the quality of the JCE, in contrast to a mutual fund which would generally have a portfolio consisting of multiple securities and the investor would rely more on the management of the fund to adjust the portfolio as appropriate. In the case of an EB-5 fund making a loan, investment in the fund arguably resembles more a purchase of a loan participation than an investment in an investment company. For this reason, among others, it is not clear that an EB-5 fund is necessarily “engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities.”[5]
As discussed further below in this article, being a investment company requires an expensive registration and reporting process. Hence it is best if an EB fund can qualify for an exemption from the definition of “investment company” that would render the fund outside the scope of the ICA.
100 Is the Magic Number[6]
The most common exemption from the definition of “investment company” is under ICA § 3(c)(1), which provides an exemption if the number of investors in a fund is not more than 100, and the fund does not engage in a public offering. This exemption would currently allow an EB-5 fund to raise between $50,000,000 and $100,000,000, depending on whether the project is in a targeted employment area, based on the current minimum investment for EB-5 investors, which is either $500,000 or $1,000,000. Another way to increase the size of the fund offering while staying within the 100 investor limit is to increase the minimum size of investment in the fund above the amount required to make the investor eligible for the EB-5 program. However as most funds set the minimum investment in the fund at the required $500,000 or $1,000,000 amount for EB-5 purposes, a fund which attempts to increase the smallest investment it will accept to a figure far beyond the EB-5 requirements may find itself at a competitive disadvantage from a marketing standpoint in trying to attract investments from investors who may be looking to invest the smallest amount necessary for EB-5 purposes.
Two Funds Are Not Necessarily Better Than One
The 1940 Act provides specific rules for counting investors. These generally involve situations where an investment in a fund is made by an entity. Since investments in EB-5 funds are made by individuals looking to obtain green cards, entity-related rules are not particularly relevant.
Another potentially greater concern would arise if an EB-5 fund either has affiliated funds that either cater to non-EB-5 investors and invest in the same JCE, or that have similar investment objectives. The SEC has, in certain instances, required that the holders of substantially similar funds be integrated for the purposes of determining whether the 100- investor test is met. For example, if Fund A had 60 investors and Fund B had 70 investors, and the SEC took the view that the funds should be integrated, both funds would be deemed to have 130 investors and thus be disqualified from using the 3(c)(1) exemption. The SEC’s main criterion for determining if funds should be integrated is “whether a reasonable investor in two or more entities relying on ICA § 3(c)(1) would consider the interests to be materially different”. The factors the SEC considers in reaching this determination include whether the funds share the same investment objectives, portfolio securities and portfolio risk/return characteristics.[7]
Avoid a Public Offering
The other requirement of ICA § 3(c)(1) is that the EB-5 fund not engage in a public offering of its securities. Generally, EB-5 fund offerings are conducted as private placements under Regulation D of the Securities Act of 1933, as amended (the “1933 Act”) which covers sales to “accredited investors,” and Regulation S under the 1933 Act, which covers sales directed to persons outside the United States. Offerings that comply with these regulations would generally not be considered public offerings.[8] To the extent that an EB-5 fund engages outside agents to market the fund it must be careful that the activities in which the agents engage do not result in the fund being deemed to be engaged in an unregistered public offering, both because of the potential impact on the § 3(c)(1) exemption and because that may result in the right of investors to rescind their investment.
“Let Me Tell You About the Very Rich. They Are Different From You and Me.”[9]
Section 3(c)(7) of the 1940 Act exempts a fund from the definition of investment company if all of its security holders are “qualified purchasers,” generally defined as a person owning at least $5,000,000 in investments either individually or with his or her spouse. Any fund that qualifies for the § 3(c)(7) exemption would not be integrated with funds seeking to use the § 3(c)(1) exemption. Accordingly, it is possible to create a fund or funds parallel to a fund using the § 3(c)(1) exemption that is limited to qualified purchasers which would allow the § 3(c)(1) fund to meet the 100-investor test. However, it may be difficult to find sufficient investors that met the qualified purchaser standard and the persons marketing EB-5 fund investments may not want to take the extra step of verifying compliance with the qualified purchaser standard.
“I just love real estate”[10]
Section 3(c)(5) of the 1940 Act also exempts from the definition of “investment company” an entity purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. The SEC has interpreted this to include companies that make loans which are “fully secured” by interests in real estate. Through no-action letters, the SEC has opined that in order to be fully secured, the value of the real estate collateral must be at least equal to 100% of the principal amount of the loan at the time the loan is made. Where the security interest is subordinate to another loan, the value of the real estate must be at least equal to 100% of the aggregate principal loan made by the company seeking the exemption and the senior loan.[11] In some of the no-action letters on the topic, the lender confirmed the value of the real estate with a third-party appraisal. The Capital Trust letter cited in the footnote is particularly notable because the SEC approved a structure where the loan was not directly secured by real estate. Instead, it was secured by a pledge of interests in a company that held real estate, with the value of the real estate both exceeding the first mortgages directly secured by the real estate and the mezzanine loan secured by the interests in the company. The SEC took the position that, after taking a number of factors into account, the mezzanine loan was the functional equivalent of a second mortgage directly secured by a security interest in the property.
“What! Me Worry?”[12]
Investment companies are subject to a number of operational and reporting requirements under the 1940 Act ranging from the composition of their boards to providing periodic, and public, reports. These requirements would substantially increase the costs of operating an EB-5 fund. In addition, § 47 of the 1940 Act provides that any contracts made in violation of the ICA are unenforceable and subject to rescission. In addition, § 7 of the 1940 Act expressly prohibits an unregistered investment company from offering its securities for sale in interstate commerce. As a result, if an EB-5 fund were to become an inadvertent, and unregistered, investment company, the investors in the fund would likely have the right to rescind their investment and request the return of their money. While, as a practical matter, the investors may not be inclined to do so, so long as the investment is progressing and they appear on track for their green cards, given that they have a potential legal right to rescind the investment and receive a guaranteed return of capital may lead the USCIS to conclude that their investments are not “at risk” and that as a result the investors are not qualified for the EB-5 program. In addition, if an EB-5 fund is found to be an investment company, its manager or general partner may be deemed an investment adviser to an investment company and thus be required to register as an investment adviser under the Investment Advisers Act of 1940, rendering the manager or general partner subject to significant regulatory requirements, including ongoing reporting obligations and restrictions on operations.
“And in the End”[13]
Recent SEC enforcement actions against EB-5 funds and certain of their principals[14] have made claims under virtually every aspect of the securities laws, unregistered offerings, unregistered investment advisers and unregistered broker-dealers, except, as far as we know, the 1940 Act. This does not mean that the SEC will not direct its attention to the ICA in the future. Substantial, unpleasant consequences follow a material failure to comply with the 1940 Act. Nonetheless, various bright line tests discussed above, if followed, should allow EB-5 funds to be exempt from the provisions of the 1940 Act. Thus, EB-5 funds should take care and seek competent EB-5 securities counsel when preparing their structure to fall within one of the exemptions under the 1940 Act. Otherwise, they may well find that they’re “caught in a trap” and “can’t walk out.”[15]
[1] Village People, “Y.M.C.A,” from their 1978 album Cruisin’.
[2] Slade, “Run, Runaway” from their 1984 album Keep Your Hands Off My Power Supply.
[3] With respect to notes in particular, there are court cases, e.g. Reves v. Ernst & Young, 494 U.S. 56 (1990), that apply a multi-factor analysis to determine whether a note is a security, but a detailed discussion of those cases is beyond the scope of this article.
[4] Any potential argument that an EB-5 fund is not “engaged in the business of investing in securities” because it only invests in a single JCE over its life is beyond the scope of this article.
[5] There may be circumstances, particularly where the NCE is making a loan to the JCE, where the NCE’s investment in the JCE may be repaid prior to the final adjudication of all of the I-829 petitions of investors in the EB-5 fund. Under those circumstances, the EB-5 fund may need to redeploy the returned funds into another EB-5 investment. It is unclear how this would affect the above analysis.
[6] With apologies to the Schoolhouse Rock assertion that “Three Is the Magic Number.”
[7] See, e.g. Shoreline Fund, L.P. No-action Letter (pub. avail. April 11, 1994). In Shoreline the SEC stated that it would not respond to further no-action requests on the topic of integration unless they raised novel issues.
[8] Rule 506(c) of Regulation D does permit general solicitation of offerings if certain additional steps are taken to verify an accredited investor’s status either by reviewing documentation supporting the status such as bank records or tax returns or by having certain professionals such as registered broker-dealers, registered investment advisers, attorneys or CPAs certify that they have verified the investor’s status. Such offerings are not considered public offerings for the purposes of the 3(c)(1) exemption.
[9] The quote is from F. Scott Fitzgerald, “The Rich Boy,” a short story published in 1926.
[10] “It’s tangible, it’s solid, it’s beautiful. It’s artistic, from my standpoint, and I just love real estate,” Donald Trump, interview, Jan. 9, 2002, cited at http://www.notable-quotes.com/t/trump_donald.html#yzcJlUDKp12kpmAm.99 (last viewed on Sept. 17, 2015).
[11] See, e.g., Capital Trust, Inc. No-action Letter (pub. avail. May 24, 2007).
[12] Alfred E. Neuman, the public face of Mad Magazine.
[13] “The End,” Track 8 from the Beatles’ Abbey Road album.
[14] See, e.g., Securities and Exchange Commission v. Luca International Group, LLC et al, Civil Action No. 3:15-CV-03101 (N.D. Cal. filed July 6, 2015) where the SEC’s charges included claims of securities fraud, the sale of unregistered securities and persons acting as unregistered broker-dealers and unregistered investment advisers.
[15] “Suspicious Minds” Track 27 on the album ELV1S: 30 #1 Hits.
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