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With the EB-5 regional center program set to expire on September 30, 2016, and the corresponding talk of the renewal process and the potential legislative or regulatory changes that might come as part of that process, there has been renewed interest, and perhaps controversy, over the concept of using money from EB-5 investors to purchase bonds as part of an EB-5 investment vehicle. The idea is not new. A regional center in Ohio used EB-5 investment funds to buy municipal bonds to help fund a project as early as 2010 or 2011. Then there was the 520 bridge project in 2012. I have also represented a number of clients in conjunction with prospective EB-5 bond offerings. And while there are differences between them, bond deals typically share a few common factors that I will discuss further below.
So why is there interest in bonds? First, there is a perception, accurate or not, that a bond is a safer investment because it is backed by a state or local government. This provides a marketing advantage. Second, it provides access to projects that might ordinarily not be available for investors to invest in. Infrastructure projects, for instance, are generally public in nature. It’s hard to invest in a bridge, airport, or courthouse as a private individual, but bonds are a really good vehicle for such investment.
So why the controversy? First, all EB-5 bond projects involve pooling EB-5 investor money into a New Commercial Enterprise (NCE), and using that NCE to buy bonds. By using an NCE sponsored by a regional center to buy the bonds, EB-5 investors are able to claim credit for the job creation that occurs as a result of that investment. On the other hand, an EB-5 investor who buys the very same bond on the open market cannot claim any job creation that results from his or her purchase of that bond. So there is a question about why doing so through an NCE should allow the investor to claim credit for job creation for doing the same thing that investor could do on his or her own. Second, there is a perception, accurate or not, that bonds do not have sufficient risk to qualify under the EB-5 program rules, which specifically contemplate that the investment must be at risk. Lastly, projects funded with state or municipal bonds can have massive job creation, and it may seem unfair or unreasonable to let EB-5 investors claim credit for all of it.
To better frame the issue, there are a few key concepts that are helpful to understand. Keep in mind that the following may be a bit of an over simplification of some of them.
Bonds are debt instruments.
A bond is a type of debt instrument, sort of like a loan, but shares of the loan are sold to the public (or in some cases, institutional investors) in the form of bond certificates with a face value. The face value is essentially the principal, or what the bond will be redeemed for upon maturity. Bonds typically pay a yield over time, which is more or less like the interest on a loan. Bonds may be sold at a premium or a discount, meaning that the issuer may receive more or less than the face value for them. It is the bond proceeds, not the face value of the bonds, that represents the amount of money available to the “borrower.” Like the proceeds of a loan, bond proceeds are used to fund a job creating project – typically construction activities.
Bonds typically have interest reserves and offering costs built in.
Bond offerings will typically allocate a proportion of the bond proceeds to pay for offering costs and to establish a reserve from which to make interest payments while the project is being built and not generating income. This percentage can vary, but it is usually 5% or more. This is not unusual in the context of a commercial loan either, where a bank will require the borrower to use the proceeds of the loan to fund an account to be used to pay interest on the loan back to the bank while the project is under construction and not earning income. A commercial loan will also typically require the borrower to pay some of the expenses of the loan, either in the form of a closing cost payment, or funded by the proceeds of the loan.
There are two main types of bonds: revenue bonds and general obligation bonds.
Revenue bonds are backed by a pledge of the revenue created for the state or municipality as a result of the project. In the case of a bridge, that might be revenue from tolls. In the case of a street, park, or other infrastructure project, that might be revenue generated from increased property or sales tax created as new users move in as a result of the improvements (also known as tax increment revenue). General obligation bonds are backed by the full faith and credit of the State, which makes a general promise to pay the bonds, regardless of any source of revenue. Obviously, general obligation bonds tend to be a less risky investment than revenue bonds.
Bonds are typically really long term investments, but can be sold on the open market.
Bonds are typically issued for terms of 10 to 25 years. An investor can either hold the bond for the entire term and be redeemed by the issuing authority, or sell the bonds on the open market. However, bond values are substantially tied to interest rates, and there is significant risk associated with interest rate fluctuation (this topic is beyond the scope of this article, but worth mentioning).
Bonds and EB-5
As indicated above, there are a lot of similarities between bonds and loans, and it is well established that, in the regional center context, EB-5 investors can make an investment into a NCE that loans the EB-5 funds to a job creating project. However, there are a few potential pitfalls in creating EB-5 bond offerings that are not present in the usual EB-5 loan model. First, EB-5 investments must be at risk. While it is not impossible for a State to default on general obligation bonds, it is at least extraordinarily unlikely. This is probably why bonds are perceived to be less risky investments. However, revenue bonds, and especially tax increment bonds, are susceptible to shortfalls in expected revenue. If the toll revenue for crossing a bridge is less than the cost of operating that bridge, there may not be sufficient revenue to pay the yield or to redeem the bonds for face value. Similarly, if improvements to a neighborhood do not cause enough new owners or tenants to move into a neighborhood, there may not be a sufficient improvement in the tax base to pay the yield on the bonds or redeem them for face value.
Second, EB-5 deals are typically structured so that the investors each make an investment of $500,000 or $1 million into the NCE, and pay an administrative fee to cover offering and marketing costs. On average, this fee is around $50,000, or 5 or 10% of the capital contribution. The reason that offering and marketing costs are separate from the investor’s $500,000 capital contribution is because Matter of Izummi states that 100% of the required minimum investment amount must be deployed to the entity most closely associated with the job creation, and not used to pay administrative or offering costs. Additionally, the EB-5 rules generally do not allow for the establishment of an interest reserve to pay the interest on an EB-5 loan. This is because EB-5 investors cannot have a guaranteed return of capital or on capital. An interest reserve is just that- a guarantee that the interest will be paid to the NCE, which in turn will typically distribute some percentage of that to investors as profit. Worse still, if the EB-5 funds are used to fund the interest reserve, not only do you have a guaranteed return on capital, but 100% of the investment amount has also not been disbursed to the entity most responsible for creating the jobs. These two points are inconsistent with the normal practice in bond offerings, where the 5 or 10% for offering costs and interest reserves is paid from the bond proceeds.
The fact that EB-5 money may be used to buy bonds that are publicly available is not explicitly prohibited by the EB-5 statute or regulations, and it appears to be permissible under current USCIS policy. However, it was explicitly addressed in proposed legislation last December. The draft bill circulated by Senator Grassley contained the following prohibition:
Publicly Available Bonds—Alien investor capital may not be utilized, by a new commercial enterprise or otherwise, to purchase municipal bonds or any other bonds, if such bonds are available to the general public, either as part of a primary offering or from a secondary market.
Interestingly, this provision took aim at the publicly available nature of the bonds, not the issues identified above with the at-risk or job creation requirements for EB-5 investments. I have often said that optics are very important in EB-5, and I believe that this is one case where that is particularly true. The same Senators and Congress People who would like to see EB-5 used for infrastructure projects seem to be opposed to the single vehicle that is best suited for that purpose, and the reason would seem to be the appearance that by having an NCE buy publicly available bonds with EB-5 money in order to count the resulting job creation is gaming the system. It just looks bad to them. Unfortunately, there may not be anything we can do about that perception, other than pointing out how allowing EB-5 funds to be used to purchase bonds is an expedient way to use EB-5 money to fund infrastructure projects.
So what would the perfect EB-5 bond project look like?
- Number one on the wish list is an EB-5 specific series of bonds, issued by a state or municipality only to an NCE sponsored by a regional center. Unfortunately, this may not fit easily within the structure of the laws of most states regarding the issuance of bonds. Even if it did, it might be hard to convince a municipality to invest the time, effort and money into creating an EB-5 only bond series. However, if it were possible, such a bond could be structured with no interest reserve and with offering costs paid from a source other than the bond proceeds (i.e. an administrative fee).
- Revenue bonds, not general obligation bonds. While USCIS may have approved a bond project in the past where the NCE used EB-5 funds to purchase general obligation bonds, it seems unlikely that it would do so again given the current adjudicatory climate. Even I have doubts that general obligation bonds have the kind of investment risk contemplated by the regulations. Revenue bonds, on the other hand, have investment risks, and sometimes significant ones, and should satisfy the at-risk requirement.
- An EB-5 investor’s minimum investment would be increased in an amount sufficient to cover the portion of the bond proceeds used to fund the interest reserve and offering costs. In addition, the portion of the yield funded by the interest reserve amounts would be dedicated to pay the Manager or General Partner of the NCE, and not allocated to EB-5 investors. The interest reserve only covers a small portion of the yield, not the entire yield over the entire term of the bond. Therefore, it is possible to structure the EB-5 offering so that the interest reserve does not cause an at-risk or job creation issue. For instance, if 10% of the bond proceeds were allocated to interest reserves and offering costs, each investor would have to invest $550,000.
- The EB-5 offering would claim a reasonable portion of the overall job creation. While EB-5 investors are entitled to claim credit for all jobs that result from their investment in the NCE, including jobs created by non-EB-5 investment into the same project, it wouldn’t be reasonable to claim 100,000 jobs from the construction of a public stadium when the EB-5 investment is only $20 million. EB-5 investors are currently limited to claiming jobs that will be created within two-and-a-half years of the approval of the I-526 petition. Simply applying this rule could eliminate some of the more outlandish claims to job creation. However, in all cases, some degree of discretion is required to avoid negative perceptions.
There are, of course, many more details that must be considered in an EB-5 bond project, but the above should serve as an introduction to the concepts, the public policy implications, and the interaction between the current EB-5 rules and bond offerings in general.
 While a recent regulatory notice by USCIS assumes that the bulk of this $50,000 fee is paid to the regional center, this is not the case. Almost all of this money will be used to pay overseas agents and finders to pay for the costs of recruiting investors. The remainder is used to cover operating, legal, and administrative costs, which are substantial. The administrative fee is a cost of doing business, and usually not a windfall for regional centers.