A Deep Dive into the Corporate Transparency Act

In episode #29 of Industry Insights podcast, Andrew Weiner joins host Joel Simon for the second episode of our two-part examination of the Corporate Transparency Act (CTA). In this episode, Weiner turns his attention to the unanswered questions and ambiguity underlying phrases like “beneficial owner” and “substantial control.”

Joel Simon: Let’s continue our chat about the CTA! My understanding is that it does not apply to larger or more established companies, but it would seem that funds, new investment vehicles and almost any typical startup business would be required to report information that has historically been kept secret. Why is this such an important development?

Andrew Weiner: I agree with you, Joel, that the CTA will be a particular burden on small businesses, which generally won’t have an exemption but are the least able to undertake another paper-intensive obligation. I agree that it is likely subject to the regulations the many major businesses can avoid any substantial disclosure. Particularly as a real estate lawyer, there are numerous substantial entities that will still have to comply and it will still be a big deal, at least for my industry. A second important question: Who is a beneficial owner of the reporting company whose personal data must be disclosed? The definition of “beneficial owner” with respect to any reporting company is any individual who directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, either exercises substantial control over the reporting company or owns or controls not less than 25 percent of the beneficial interest of the reporting company. This is a binary test. Control parties must be disclosed, and 25 percent or more beneficial owners must be disclosed. In addition, the CTA requires disclosure of applicants—anyone who files an application to form a reporting entity under any state or tribal law, or an application to qualify as a non-U.S. reporting entity to do business in the U.S., must also be identified and disclosed. This is a bit of a head-scratcher since filers are almost never principal owners or control parties but are more likely to be legal assistants, in-house counsel or junior associates in law firms. Staff of corporate service companies may perhaps also be considered applicants. This is likely to shake up the manner in which entities are formed.

Simon: It seems to me that regulators will have their hands full in fleshing out the details on this one, and that lawyers and clients should try to get a jump on things to stay ahead of the curve. What are some examples of issues and scenarios that you can see need to be addressed?

Weiner: The definition of “beneficial owner” is, at its fullest literal extension, breathtakingly broad, subjective and full of ambiguities. Perhaps the regulations will help, perhaps not. The statute, for example, does not mention attribution roles. Are members of the family aggregated? Are affiliated companies always aggregated? Substantial control is not a recognized term in normal business activities. The phrase “arrangement, understanding, relationship or otherwise”—will this be used to allow fishing expeditions by FinCEN? If an entity has an interest in a reporting company, as I mentioned earlier, but no individuals who themselves are beneficial owners of the reporting company in which it has an interest, it may also be a reporting company. In this event, its beneficial owners must be reported so an entity that does not do anything other than invest in another reporting company and not control it and not own 25 percent will have people who control the second entity. If the entire chain must be disclosed and can be cross-indexed, then this is a much deeper investigation than first appears. As to substantial control, if decisions are made by unanimous or supermajority consent, or if decision-making is diffuse or if an individual is required directly or indirectly for a quorum, is that substantial control? How about control over day-to-day operations or typical major decision rights? If you are an entity whose chair or key investor actually makes major decisions, or at least needs to be consulted but has no formal direct authority, is he or she reportable? Can the lender or creditor class cross the line if the loan documents or rules in the bankruptcy give them control or funding rights. As to ownership, in determining 25 percent or more beneficial ownership, how are complex capital stacks evaluated? How are tiered returns, promotes, contention payments and equity kickers taken into account? How about different classes of stock, particularly preferred stock. And who makes this decision? Is it the company that reports or the investor who has the information? To be determined. The approach taken by treasury in its regulations will, as with many things as to the CTA, be key.

Simon: When do you think that approach will be known?

Weiner: I suspect that the draft will be available by the end of summer 2021 and perhaps before. Treasury has been working on this for a while in anticipation of legislation. A lot will depend on whether treasury prefers objective and easily definable standards, which may leave some loopholes open, or open and ambiguous language that will theoretically close all loopholes but will be harder to apply. The potential for conflict between those who are tasked with reporting and those who possess the information is also clear. How will conflicts between sponsors and investors, attorneys, particularly in-house counsel, and clients, management, and owners, LLC or partnership investors among themselves—how will these be resolved? Does a reporting party have a right to rely on the information it receives? What does it do if it questions the information? I propose the adoption of a form certificate like a FERPTA certificate on which a reporting person can rely. Maybe that will be used? Treasury has a number of domestic and international models as well that can be used, some of which are relatively workable. My advice to clients is that it is not prudent to wait for the regulations. I have already been asked by some clients to determine whether or not an exemption applies. For other clients, we are already working on adding provisions to their formation documents or for financial institutions and loan documents that address CTA compliance. Our form provisions will contain broadened indemnifications for failure to comply or for bad information. But perhaps other remedies should also be considered. Privacy and confidentiality provisions of existing documentation should also be made consistent with the CTA. We expect to be asked by investors to propose language that deals with who makes decisions as to their own disclosure, which is a more fraught issue. I expect that discussions with in-house counsel of our clients will also be very interesting since their conflict position is acute. Our foreign and family office clients should be the most proactive in this regard. For lawyers, what obligations does a lawyer or law firm pick up by forming a reporting company or by having formed it in the past before the CTA was adopted? How will the process for entity formation change? Will law firms still be involved? What if a client refuses to disclose or the attorney has information that the client is not fully disclosing? What if there’s a disagreement over the definitions of substantial control or 25 or more percent beneficial ownership? Should engagement letters and disengagement letters by law firms be revised? There is no future for bearer instruments in the U.S. The CTA bans the issue in some bearer shares and bearer certificates evidencing ownership as a means to prevent end runs around the disclosure requirements.

Simon: How much lead time do you think we have in order to get ready for the new rules that will be coming down the pipe, and what kind of penalties apply for lack of compliance?

Weiner: There’s good news here. No one has to comply until the regulations become effective, which is not likely until 2022. At that time, newly formed entities must comply with the CTA as a condition precedent to being formed. Compliance is also a precondition to qualification to do business. This is of course a major change from present practice where simple submission of a short notice is the sole requirement. Note that most states have not even begun the process of changing their rules to incorporate this requirement. They have 10 months to go. And the registry itself does not yet exist. Existing entities do not have to disclose until two years after the effective date, so that’s more than two years. And the government contractor disclosure obligations are delayed for two years. Another timetable relates to the existing customer due diligence rules imposed on financial institutions. These are presently inconsistent with the CTA. There is an express provision in the CTA that the CDD rules are to be conformed to the CTA within one year. This is widely considered to be a signal that financial institutions will be permitted to rely on the registry for information rather than collecting it themselves. We will see. Once the CTA is effective, reporting companies must disclose changes in their previously disclosed information within one year after the change. Our standard CTA provision for formation documents will require this disclosure by investors or co-owners, and perhaps require a periodic certification of no change. As to fines, penalties … civil and criminal fines and penalties apply both to willful reporting violations and to unauthorized disclosure or use of database information. For willful reporting violations, there are civil penalties of $500 per day. There is a fine of not more than $10,000 or up to two years imprisonment, or both. Penalties may increase if the violation is in connection with a pattern of illegal activity. Penalties for unauthorized disclosure or use of database information are higher.

Simon: Well, this certainly is an area people should keep an eye on as the rules come out, public comments are solicited, and compliance regimes ramp up.