By Robert V. Cornish, Jr.
Financial services professionals and securities attorneys alike vividly remember the morning of September 15, 2008. After a weekend of rumor and panic, venerable Lehman Brothers, a Wall Street institution for over a century, sought protection in a New York bankruptcy court.
A litany of financial institutions worldwide, ranging from Iceland’s Glitnir Bank, insurance powerhouse AIG and brokerage stalwart Merrill Lynch, proceeded to sink under the weight of overextended credit and speculation from hedge funds and sovereign wealth managers.
For every bank or brokerage firm that sought a bailout from their respective government, there were likely multiples of hedge funds that simply failed and closed. Compounding these issues, some prominent investment firms, such as Madoff and Stanford Financial, were revealed to be Ponzi schemes as investors sought safety in cash and precious metals. Global market confidence was accepted to be near an all-time low.
What followed was a global debate on the nature and scope of the regulation of financial markets. In the United States, that debate included defining institutions as “too big to fail” in order to prevent future, more drastic meltdowns. The global consensus was that easy credit, whether for a hedge fund or a mortgage would soon become a thing of the past, and further regulation would soon follow. Public pension funds and labor union funds fanned the flames for further regulation, all bearing losses of millions of dollars and suddenly having the retirement security of thousands in danger. Ultimately, in the U.S., the Dodd-Frank market reforms were the result. One would think that the alternative investment community would have been doomed under such a scenario. However, this is not the case.
Alternative Investment Community Thriving
Today, the alternative investment community is thriving more than ever, albeit in a more institutionally regulated environment. The compliance culture of investment managers is more so than ever a differentiator between equally performing vehicles, no doubt because of the memories of September 2008. Those firms that project a culture of compliance, in my observation, vastly outnumber those that do not, and for good reason. Firms that continually adapt and project a culture of compliance appear to be best positioned as ongoing enterprises in the long term. That is good for investors and market participants alike.
Likewise, market participants in the EB-5 arena will always remember their “Lehman Brothers” day as April 12, 2016. That was the day the U.S. Securities and Exchange Commission (SEC) announced its receivership action against the Jay Peak EB-5 Project and its principals.
While there has yet to be the mass tumbling of other EB-5 Regional Center projects in the same manner as banks and brokerage firms in September 2008, Jay Peak and the clarion calls of other failed projects in the past have had perceived and actual chilling effects on everything from capital raising efforts to obtaining title insurance for real estate based projects. This, of course, has led to a flurry of activity in Washington to either reform or terminate the EB-5 Regional Center Program. Yet, in my view, the near industry-wide efforts to project compliant businesses by alternative investment managers post-2008 has not been met with the same institutional urgency by the EB-5 community, despite good efforts by EB-5 trade organizations and other concerned market participants.
This is unfortunate. Like the alternative investment community following the 2008 market meltdown, the EB-5 community needs to embrace its mistakes, adapt to increased regulation, and ultimately become more attractive to financial institutions. This is increasingly the case as pension funds and other institutional investors seek to invest in emerging managers, private equity and real estate ventures in their own backyards. In order to reap the benefits of what appears to be a “going local” wave of institutional investment in the U.S., the EB-5 community must itself become institutional much in the way the alternative investment community did following the events of September 2008. How might the EB-5 community accomplish this?
1. Market participants must become more “institutional” in their operations. Prior to 2008, the pension and investment consultants were more willing to look over internal controls and sound business practices in the name of yield or performance. The due diligence questionnaires of major pension and investment consulting firms, as well as that of the Alternative Investment Management Association (AIMA) post-2008, show an increased sensitivity to not only how managers perform, but also how their business is managed. Corporate documentation and board minutes are often reviewed as thoroughly as investment performance. The delegation of authority and documentation of reporting lines is reviewed in detail, especially when control persons are performing more than one distinct managerial role, in particular compliance. Internal controls concerning the handling of customer funds are also subject to scrutiny. Those in the EB-5 community not only need to be aware of the degree of institutional due diligence that will be performed on their projects going forward, but also their underlying businesses.
2. Market participants must become more “institutional” in the use and selection of outside vendors. In working with institutional investors on a global basis, hedge funds are generally only open to consideration for substantial investment when they have retained respected and experienced (a) securities counsel, (b) auditors and (c) fund administrators. The days of investment managers “self-auditing” performance and using fund administration as a profit center are now gone for good reasons. In the realm of EB-5, the use of outside professionals is even more important. First, while those in EB-5 work with wealthy or accredited clients, such clients are often not sophisticated to such a degree as to be able to discern conflicts of interest and other legal matters of importance. This is especially important in the “loan to equity” model employed in EB-5 projects, as investors may have little legal recourse given their participation in an intermediary lending vehicle. Second, experienced professionals are trained and have the knowledge to ascertain issues before they harm investors. While the cost of having professionals narrowly tailor offering documents and marketing materials to a transaction is often expensive, the time and money spent generally makes for a better product. Third, and perhaps most importantly, the language barrier between issuers and investors generally means that someone other than the investor will review offering documents. The importance of having well-drafted documents, skilled professional assistance in handling customer funds and fund administration cannot be overemphasized. As the EB-5 industry develops and matures further, it will likely become more institutional in this regard, thus instilling heightened market confidence.
3. Market participants must become more institutional in marketing related matters. Prior to 2008, the use of unlicensed finders and others to steer investment products to institutional investors was prevalent. Numerous “pay to play” scandals involving public pension funds such as CalPERS, among others, have changed that dynamic. Today, many hedge funds work with broker-dealers to not only sub-advise and distribute their product, but also to assist in sales practice compliance. Broker-dealers assume such responsibilities only after performing due diligence on their own on a fund or manager, and at a cost that balances their costs of compliance with potential risks. In the EB-5 arena, a small group of broker-dealers and investment advisers are assuming such roles, and more are looking to participate. Yet the use of such entities, especially in light of the dynamics of offering EB-5 securities overseas under Regulation S, is met with resistance. This attitude is not unnoticed by large Wall Street broker-dealers now absent from the EB-5 market, who appear to perceive risks in handling EB-5 transactions to outweigh monetary benefits. This is unfortunate, as the large investment banks and brokerage firms of the United States with overseas branches have access to clients who may be well-suited for EB-5 investments. From a risk management and marketing standpoint, the EB-5 community needs to embrace the use of broker-dealers and investment advisers as hedge funds have since the 2008 market crisis.
4. Market participants must become more institutional in managing risk. Broker-dealers and investment advisers are often required to be bonded for various sorts of bad conduct. Likewise, broker-dealers and investment advisers who seek institutional investment as an industry practice maintain insurance policies for errors and omissions, directors and officers liability, and in some cases litigation costs. At present, the EB-5 industry is in its infancy in working with large insurance underwriters who handle policies for broker-dealers and investment advisors. While some may infer that the institution of insurance (a) erases the “at-risk” characteristics of EB-5 investments, (b) may not provide the protection that is sought, or (c) insurance policies actually encourage risky behavior, many securities attorneys handling work for investment managers do not believe this to be the case. Insurance companies sometimes perform more due diligence on managers and funds than other market participants, given that deals gone awry often bear substantial reserve risks for the loss of invested funds or litigation. Like the hedge fund industry post-2008, the EB-5 industry should take affirmative steps with the insurance industry to show that its risks are worth insuring, buttressed through strong compliance culture and internal controls industry-wide.
5. Market participants must become more institutional in earning market confidence. The perception of fraud and misconduct in any financial market erodes the confidence of its participants. The financial services community was certainly not without fault for its conduct prior to 2008. Afterwards, however, a dialogue between regulators, legislators and market participants helped to revive confidence in the markets. While the EB-5 community has taken strong steps to communicate the benefits that EB-5 provides, those steps alone cannot instill confidence in the EB-5 industry. Rather, actions demonstrative of being respectful participants in a regulated industry will assist in reviving global market confidence.
A Looming Shadow of Regulation
Any looming shadow of increased regulation brings with it anxiety, uncertainty and sometimes disdain for the legislative process. There is little doubt that such feelings were not in short supply during the debate over Dodd-Frank and other regulations affecting alternative investment manager’s post-2008. Yet from this uncertainty, a compliance and regulatory scheme has evolved where new market participants are better prepared to act in the best interest of investors.
In 2016, the EB-5 community is now in the same place that the hedge fund industry was in 2008. The feelings among EB-5 market participants are remarkably similar to those of the hedge fund industry eight years ago, especially in light of potential reforms to the EB-5 program. Like the hedge fund industry, the EB-5 industry must take the steps necessary to demonstrate that it is worthy of regulation befitting market participants who realize that what they do affects perceptions of U.S. financial markets both domestically and abroad.
 See Andrew Sorkin, Lehman Files for Bankruptcy; Merrill is Sold, New York Times (Sept. 14, 2008), http://www.nytimes.com/2008/09/15/business/15lehman.html?_r=0.
 For an excellent discussion of the 2008 banking crisis in Iceland, see Daniel Chartier, The End of Iceland’s Innocence (2011).
See U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up, Wall St. Journal (Sept. 16, 2008), http://www.wsj.com/articles/SB122156561931242905.
 See Complaint filed in SEC v. Madoff, No. 08 Civ.10791 (S.D.N.Y. Dec. 9, 2008), https://www.sec.gov/litigation/complaints/2008/comp-madoff121108.pdf.
 See Complaint filed in SEC v. Stanford Int’l Bank Ltd., No. 3:09-CV-0298-N (N.D. Tex. Feb. 17, 2009), https://www.sec.gov/litigation/complaints/2009/stanford-first-amended-022709.pdf.
 See Complaint filed in SEC v. Quiros, No. 1:16-cv-21301 (S.D. Fla., Apr. 12, 2016), https://www.sec.gov/litigation/complaints/2016/comp-pr2016-69.pdf.
 See Interpretive Letter from FINRA to Brian Sweeney, Trustmont Financial Group, Inc., Aug. 26, 2013, available on www.finra.org. See also Escott v. Bar-Chris Constr. Corp., 283 F. Supp. 643 (S.D.N.Y. 1968), an important case discussing due diligence in the context of federal securities laws.
 This resistance is often tied to what is called the “shingle theory,” which means a broker-dealer inherently represents that it will deal with customers fairly and in accordance with the standards of the industry, which includes due diligence on products offered. See Charles Hughes & Co. v. SEC, 139 F.2d 434 (2d Cir. 1943), 131 U.S. 786 (1944).