Submitted by Douglas Litowitz, law professor and securities lawyer in Chicago who has lived and worked in Asia.
The EB-5 investment program - created by Congress and administered by the USCIS - is defrauding Chinese investors by the thousands. The Chinese investors are stuck in an American-made morass of federal securities law violations and state law fiduciary violations.
For those who don’t know what EB-5 is (or who know it only vaguely as a shady scheme that President Trump’s former son-in-law was tied up in), the term “EB-5” is simply a visa designation for entry to the United States - like, for example, “H1-B.” Under the EB-5 program, a foreigner can earn a green card and a path to citizenship by investing in a new American business that creates a certain number of jobs. Each big city in America is covered by one or more “regional centers” which act as sponsors for EB-5 projects.
Once upon a time, EB-5 was rarely used. When the program was created, the USCIS designated a limited number of slots for permanent residence approval each year. This numerical limit was not a problem because EB-5 was restricted mostly to small groups of investors who funded small-scale developments. No one dreamed of using it to build massive projects.
But then came the financial crisis.
Lending dried up. Developers started to panic. They scrambled for money. If they wanted to build a hotel or a mall, they could not obtain junior financing. Sure, they could get a senior loan and maybe a secondary loan from American banks that insisted on being fully secured by the real estate and fixtures, but what about the junior financing that they needed? If the project needed $500 million but the land and fixtures were worth only $300 million, who would supply the remaining $200 million of risky financing? No American bank wanted to lend that money because it was essentially unsecured and junior in ranking.
The solution was found by mutating the small-scale EB-5 funds into massive Delaware entities with hundreds of Chinese investors. Each of these massive EB-5 funds holdsup to hundreds of millions of dollars which are then lent out to a developer in risky financing. In a shamelessconflict of interest, the developer itself often sets up the EB-5 fund under his complete control, then fills it up with Chinese money, and then loans the money to another of his corporations in a risky 4th and 5th position loan. In this way, most EB-5 funds are mere playthings of America developers and their enablers; once the money is in, the Americans shut out the Chinese from any involvement or information.
The EB-5 funds are sold in China through ‘finders’ (that is, unlicensed brokers) who put on lavish productions with raffles and free buffets and winking assurances that the Chinese investors are getting the American dream with profit. Americans who are associated with the project usually come to China to tout the project, and the marketing is effective (this is what put Trump’s son-in-law in hot water). The Chinese sign up by the thousands, even though they can barely read a paragraph of the paperwork. They don’t even know what they are signing, they are just told that it is a gold rush with profit and path to citizenship at the end of the rainbow, so they sign everything put in front of them, even if they cannot read English. They trust in the American system. They cannot imagine that American law would leave them broke and without any remedy or citizenship.
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Let’s compare the theory of EB-5 with the reality of EB-5.
In theory, EB-5 works like this: (1) Chinese investors are recruited to each give $550,000 for a project that has been sponsored by a regional center and tentatively approved by the USCIS – typically a resort, hotel, shopping mall, or condominium complex; (2) the investor’s money is divided into $50,000 of ‘administrative expenses’ that is pulled off the top and $500,000 of ‘investment funding’ for which the investor receives a Delaware limited partnership interest; (3) the Delaware limited partnership eventually recruits hundreds of Chinese investors and holds up to hundreds of millions of dollars, calling itself an “EB-5 Fund”; (4) this massive pool of money is put into escrow and then loaned out to a development company under a loan agreement that makes the EB-5 Fund an extremely junior lender to the project; (5) the project gets built and hopefully generates sufficient returns to repay the loan; (6) once the loan is repaid, the EB-5 Fund returns the money back to the Chinese investors with interest and then dissolves; and (7) while the above has been taking place, the investors have been working with immigration lawyers for the project who have by now successfully petitioned the USCIS for permanent residency, which eventually gets granted on the grounds that the project generated sufficient jobs. Then the investor becomes a US citizen.
In theory, everyone wins. A city gets a new hotel or hospital or mall. Americans get good jobs. A developer gets junior financing to complete a construction project. The immigration lawyers get a stream of clients. And the Chinese investors have the legal right to live out their days in America.
In reality, every American involved in this project carefully avoids telling the Chinese directly and point blank that the escalating number of Chinese investors cannot be absorbed by the yearly 10,000 EB-5 visa quota, forcing the Chinese to wait indefinitely while a federal bureaucracy shuffles its feet and bumps against the limit of permissible visas. The wait is now over 10 years. Meanwhile, the Chinese investors are shocked to realize that the EB-5 fund paperwork says that they cannot get their money back from the EB-5 fund – not even interest payments - until every investor in the fund gets approved for unconditional visas. Their money, if it even exists, is locked up indefinitely.
I am in Beijing as I write this. I have just met with investors who point up to the clouds and tell me that their family’s money and green cards and dreams are up in the sky -- that is, nowhere. They have no idea when they will get any money back, no idea how their investment is going, and no idea what is going on. And no one will talk to them. When they call the US developers, lawyers, and regional centers, they are told to go away. When they approach the Chinese ‘finders’, they are told to go away. American lawyers and American businessmen have played them for suckers.
With nowhere to go, they come to us. Hundreds of Chinese investors have contacted our team, pleading for help in extricating themselves from an impossible morass. There are thousands behind them. They just want their money back, period. They feel gullible and ashamed for believing the rhetoric that American markets were efficient, that managers were accountable, and that regulators were rooting out securities fraud. They were wrong. They wanted to come to America to escape corruption and fraud, but they found it on the path here.
The SEC should be all over this. But in fact they have taken action only against the obvious cases of fraud. In Chicago, one EB-5 fund was a Potemkin Village of development signs with no actual ownership of property; in many states, developers absconded with Chinese funds; in Palm Beach, a project barely got started before the EB-5 money disappeared; in South Dakota an investment in a meatpacking plant went bankrupt and left the Chinese with nothing; in Vermont, a ski resort project collapsed spectacularly; lawyers across the country have been punished for pushing clients into EB-5 structures and thereby acting as unlicensed brokers. The tales of horror keep coming one after another - problems have arisen all across America. Forbes Magazine called it, “The dark, disturbing world of the visa-for-sale program.”
Greed is a powerful motivator. When you give a developer hundreds of millions of dollars of foreign money from nameless and faceless people who cannot monitor the investment, and the developers know that the money doesn’t have to be returned for a decade or more, there is too great a temptation to waste the money or abuse the investors. And when the developer itself is put in charge of the EB-5 Fund, the developer is effectively both the borrower and the lender, so it has no incentive to act on behalf of the lenders who are Chinese investors. In many cases, the project runs into trouble and gets turned over to the senior lenders, cutting out the Chinese EB-5 fund. In other cases, developers simply abscond with the Chinese money since they know that it won’t have to be returned for a decade. The SEC issued an alert in 2013 warning investors of EB-5 “immigration scams,” but the SEC hasnot yet realized that even the seemingly “normal” EB-5 projects are shot through with securities laws violations. A few of these are listed below.
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(1) Money Laundering and Transfer Limits. EB-5 investors typically pay $550,000 to invest in an EB-5 fund. This is itself a violation of Chinese law that imposes a $50,000 per person annual limit on moving money outside of China. Few people in China are walking around with that kind of money, and if they are, they can get citizenship in easier ways than EB-5. So for the EB-5 investors who are mostly middle to upper-middle class, this money is assembled from family members and from “grey income” generated in many cases by phony mortgage loans from questionable operators in China. So right off the bat, the Chinese ‘finders’ are involved in shady contortions to assemble and then convert the investors’ Chinese yuan to American dollars through a mysterious kind of alchemy that is not legal in China. In many cases, family money is transferred out of China in pieces for a stop in Hong Kong where it is reassembled into a chunk of $550,000. The Americans know this, and they turn a blind eye.
(2) Unlicensed Brokers. The Chinese ‘finders’ and the American developers (and their lawyers) are selling US denominated securities in China but are often unlicensed in the US as broker-dealers, and also unlicensed in China, even though they are placing securities with buyers, a classic example of broker-dealer conduct. Many, if not most, of these EB-5 Funds are sold without any licensed broker involvement, and no suitability analysis, to unsophisticated and unaccredited buyers. The EB-5 offerings are not registered in China and should not be marketed to private Chinese citizens in the first place. The finders are motivated by hefty commissions paid by the American promoters, often receiving millions of dollars to place the securities with Chinese citizens. And often the immigration lawyers and regional centers and developers are part of the road shows in China, making them effectively brokers as well. It is odd - indeed, sordid – for lawyers to stand up in front of strangers and promote investment in a project that will funnel legal work to them.
(3) Non-Accredited Investors. The paperwork for each project requires the Chinese investor to attest that he is an “Accredited Investor” so that the Fund will qualify as a private placement under Regulation D and not be deemed a public offering. But in fact virtually none of the investors are accredited. Most of them are using pooled family money or borrowed money. Regulation D requires that the issuer of securities (the American company) verify the Accredited Investor status of the investors, and not simply rely on their statement that they are accredited. But no one bothers to verify the assets and income of the investors by looking at their bank statements.
(4) Unregistered Investment Companies. EB-5 funds typically have more than 100 persons in them, which triggers a requirement to register as an Investment Company, and it triggers a requirement that the Fundshould be advised by a Registered Investment Adviser. But the EB-5 funds refuse to register. They often divide the investors into two groups of fewer than 100, hoping to come under the threshold by insisting that the two offerings are not integrated, or they proceed under the lie that all investors are accredited or qualified investors (high net worth). Most recently, EB-5 funds claim to be exempt from registration under the Investment Company Act on the preposterous notion that they are ‘real estate funds’ because the EB-5 fund holds a worthless 4th or 5th mortgage with a negligible loan-to-value ratio. This is akin to borrowing $10 million from your local bank and giving them a mortgage on two square feet in your backyard and then calling it a “real estate loan.” In reality, everyone knows that the Chinese investors are making unsecured loans and basically getting IOUs that have a nominal 5 year term but will almost never get paid at maturity. And rarely are the funds advised by Registered Investment Advisers. Many of the offerings are made to hundreds or thousands of investors through unregistered brokers, unregistered funds, and without registered investment advisers.
(5) 10b-5 Securities Fraud. The EB-5 funds do a bait-and-switch whereby they come to China and make promises in person during the road show that are later disavowed in the offering memorandum. For example, they often make untrue statements to the Chinese about the likely term of the loan being 5 years, the speed of getting USCIS approval in that time frame, that the loan is fully secured, that financing at senior levels is already in place, that the projections show a timely completion date within profitability in a few years, and so forth. I know that this happens because I have been recruited to make these exact types of presentations. It is fraudulent to imply a certain level of performance and to put on a big show and give out raffle prizes, then turn around and saddle the investors with offering documents that waive all their rights and disclaim all representations.
(6) Abuse of Regulation S. Some of the developers try to hide behind Regulation S, which covers securities that are sold offshore to non-residents. But the whole point of an EB-5 investment is to bring the investors to America,which is the very opposite of the point of Regulation S. And further, many of the investors and family memberswho contribute capital to a pool of money invested by a Chinese national are already living in the US under a university visa. It is not uncommon to attend an EB-5 show in China where you will meet students from American universities who are helping their families pool money so that one of them can be the designated investor. Just from an ethical perspective, it is repugnant to use Regulation S as a shield to prevent US companies from misconduct structured in America.
(7) Breach of Fiduciary Duties. The next point is shocking. In many, perhaps most cases, the EB-5 fund is controlled by the very developer to whom it lends money. I will say that again so that it sinks in: the Chinese investors put their money into an EB-5 fund that is controlled by the developer who then instructs the Fund to loan money to the developer’s construction company. The Chinese arefunding the developer’s left hand which then lends money to his right hand. This is an inescapable, fatal conflict of interest: no developer will effectively lend money to itself and then declare itself in default.
(8) Non-Waivable Conflicts of Interest. In most EB-5 arrangements, the Chinese EB-5 Fund is a lender to the project but has no independent lawyer, no independent appraiser, no power to call a vote, and no way to replace the general partner or managing member as the controlling person – the dictator - of the EB-5 fund. Often the fund has an offshore or remote entity created by the developer as its general partner, who cannot be reached. The investors’hands are absolutely tied. Even worse, they are forced to be represented by the lawyers for the very developer to whom they are lending money. The lender and borrowers have the same attorneys! In some cases, the Chinese sign partnership agreements that prevent them from even talking to other lenders. Most of their rights as LLC members or limited partners have been waived in the paperwork, including claims of breaches of fiduciary duty. This is all done in complicated language that 99.9% of Americans cannot understand, let alone Chinese people.
(9) Mischaracterizing Equity as Secured Debt. Most EB-5 funds are lenders to the project, but they are subject to an Intercreditor Agreement with the senior lenders who are often banks that hold secured 1st or 2nd mortgages. The Intercreditor Agreement prevents the EB-5 fund from declaring a default of the EB-5 loan. First they have to notify the senior lenders, let those lenders take all the money out first, leaving the EB-5 fund to pick up whatever is left, which in most cases would be nothing. In other words, there is no residual interest and no remedy for misconduct.
At this point, you might ask, “Where are the lawyers?” They are hiding. When the Chinese investors call the US lawyers for the developers, they are told to call the immigration lawyers. When they call the immigration lawyers, they are told to call the developer’s lawyers. Round and around it goes. The Chinese investors are lenders – often massive lenders of tens or hundreds of millions of dollars - but they have no idea if they can declare default, they have no right to foreclose, and no independent representation.
(10) Legal Malpractice and Failure to Warn Clients. The immigration lawyers do not tell the naked truth to theChinese investors. They should write in giant black lettersin Mandarin on every document that there is a crippling backlog of citizenship applicants and that the Chinese will have to wait indefinitely for their money and their permanent residence. But typical for lawyers, they hide disclaimers in the paperwork where the Chinese can’t find them. Make no mistake: the immigration lawyers purposely don’t tell the Chinese that Congress sets aside only 10,000 visas for EB-5 petitioners each year and that covers only about 3,000 families, and that since 2012 the EB-5 submissions have surpassed the annual quota by 100% to 500%. And what about the practice of bundling their legal services with the fees paid to the Chinese ‘finders’ – it is a very suspicious bundle of legal fees, investment fees, and brokerage commissions. The projects often force investors to use a particular immigration firm or else pay double for the immigration documents if they choose a lawyer of their own. And when the time comes to submit documents to the USCIS, much of the paperwork submitted by immigration lawyers for the projects contain errors, often due to erroneous information submitted by the Chinese finders. The whole thing is a giant ball of confusion among lawyers, brokers, and securities issuers – an unholy alliance of relationships that should not be combined into a single package.
If you are an American reading this, please try to put yourself in the shoes of a Chinese EB-5 investor. You invest in a Delaware LP or LLC that makes a massive loan to a developer, but even though you are a lender you have no right to foreclose on the loan or even to speak with the other lenders. You and the other Chinese investors hold a worthless mortgage. The maturity date of your investment is unknown and far away. You cannot get accurate information about the project. You have no idea when you will get the promised permanent residence. You have no idea how the loan is doing or when you can expect your money back. None of the federal securities laws seem to protect you. You cannot sue for fiduciary duty violations. You are not getting any interest payments. You cannot get an audience with anyone in authority for the transaction. You are completely cut off, and 7,000 miles away from your money.
Do we really want to tell these people – who are clearly victims of fraud - that this state of affairs is all their own fault for not being scrupulous English readers, and that American law is caveat emptor, and that they have no remedy? What message will that send about how America regulates its companies and its securities issuers?
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The EB-5 projects were not built by experts in securities law. Rather, the structures were built by immigration lawyers and real estate lawyers – people who knew very little about the requirements of registration with the SEC and very little about fiduciary duties in business structures.
Robotically, they simply “scaled up” EB-5 investments from 5-person equity deals to 500-person lending funds. They didn’t realize that this triggered a host of securities laws and corporate fiduciary duties.
The EB-5 program will not end well. It cannot be “fixed.” It is shot through with fraud.
The honest course is for the SEC to admit that the program has mutated into a scam, even in ‘normal’ projects. The Chinese money should be returned to all investors who want it back.