SEC v. Feng
Posted on Categories Court Decisions, Securities/Commodities Regulation

By Paul J. Dubow

*Identification of an investment entity as a limited partnership and the promise of a fixed return indicates that the investment is a security. **An unrevealed conflict of interest between a broker and a client can be considered securities fraud even if the client is not harmed, so long as there is a risk of harm to the client.

SEC vs. Feng, No. 17-56522 (9th Cir., 8/23/19).

Feng, an attorney, was charged by the SEC with fraud in violation of Section 10(b)(5) and failure to register as a securities broker, in connection with his representation of Chinese nationals who wished to participate in the U.S. Government’s EB-5 program. This program provided permanent residency to a foreign national, who invested either $500,000 or $1 million (depending upon the location) in a project, which created at least ten full-time jobs for U.S. citizens. Upon making the investment, the foreigners received U.S. visas, which became permanent when the investments created ten full-time jobs. Investors could pool their money into one project, but each investor had to invest the monetary threshold and be credited with ten jobs.

The funds were deposited at regional centers, which offered specific projects to investors and managed the pooled investments. They also charged the investors administrative fees up to $50,000. The regional centers issued PPMs, which described the investments as securities, offered a fixed return on the pooled investments, described the enterprise as a limited partnership (with the regional center as the general partner), promised a return of the capital contribution, subject to market conditions, and specifically stated that the administrative fees were not part of the capital contribution.

Feng solicited the investors and found the projects in which they invested. He also induced the regional centers to pay him commissions. He asked the regional centers not to tell the investors that he received commissions. Some investors asked for a reduction in the administrative fees and when the regional centers agreed to a reduction, they reduced Feng’s commissions by a similar amount. The District Court granted the SEC’s motion for summary judgment and Feng appeals.

First, he argues that the investments were not securities, notwithstanding the PPMs’ designation as such, and thus the SEC had no jurisdiction. Feng did not dispute that his clients invested money in a common enterprise managed by a third party, but claimed that the transactions were not securities, because the clients did not expect to make a profit. For one thing, the administrative fees often exceeded the return on capital and, also, their primary motivation was to obtain U.S. visas, not the expectation of profit. The Circuit Court disagrees. It holds that the PPMs’ identification of the investment entity as a limited partnership and the promise of a fixed rate of return indicate that the transactions were securities.

The Court does not doubt that the investors’ primary reason to participate in the EB-5 program was to gain US visas. But the investor’s interest in a visa was inextricably tied to the financial success of the regional center’s project. The EB-5 program by design linked the success of the investment to the investor’s success in obtaining a visa, because an EB-5 applicant needed to prove that the investment in fact led to the creation of at least ten full-time jobs. Feng also contests his designation by the SEC as a broker and counters that the advice that he gave the investors was legal advice. However, the fees that he received were from a third party and he reviewed and promoted certain EB-5 projects, based on their likelihood of success with particular emphasis on their ability to create jobs as well as the likelihood the projects could return the investors’ capital contributions.

Finally, the Court holds that Feng committed securities fraud, because he failed to reveal the conflict created by his secret receipt of commissions. Feng’s argument that there was no conflict, because his clients were not harmed, applies the wrong standard. The conflict of interest rule addresses the risk of harm to clients. In these transactions, there is a risk that Feng’s judgment would be swayed by the promise of commissions, i.e., he would prefer a regional center that paid a higher commission, but had a slightly lower likelihood of success over a regional center that offered a lower commission but had a better opportunity for the client. There’s a risk, too, that he would be loathe to recommend to a client that it ask for a reduction of the administrative fee, because the reduction comes out of his commission.

(P. Dubow)

(SOLA Ref. No. 2019-35-05)

NOTICE: The court decision synopsis published above represents an abbreviated description of the actual decision and is re-printed here for its educational value. The author's effort is to report concisely the substance of the decision or a selected portion of the decision; commentary or analysis is generally reserved for the italicized section at the bottom of the summary. Subscribers to SAC's Online Litigation Alert (SOLA), from which this synopsis is excerpted, have immediate access to the full decision, in addition to the synopsis. 

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