Second Post in a Two-Post Series on the CTA Implementing Regulations

As we just blogged, the Financial Crimes Enforcement Network (“FinCEN”) has issued a final rule (“Final Rule”) regarding the beneficial ownership information (“BOI”) reporting requirements pursuant to the Corporate Transparency Act (“CTA”).  The Final Rule will require tens of millions of corporations and limited liability companies registered to do business in the United States to report their BOI to FinCEN.  FinCEN views this development as a “historic step in support of U.S. government efforts to crack down on illicit finance and enhance transparency.”

The Final Rule defines a “beneficial owner” whose information must be reported as “any individual who, directly or indirectly, either exercises substantial control over such reporting company or owns or controls at least 25 percent of the ownership interests of such reporting company.”  In this post, we focus on the “substantial control” prong of the beneficial ownership definition: “any individual who, directly or indirectly, . . . exercises substantial control over such reporting company.” (emphasis added). The Final Rule generally adopts the language of the proposed rule issued by FinCEN in December 2021, with some minor adjustments.

FinCEN expects reporting companies to always identify at least one beneficial owner under the “substantial control” prong, even if all other individuals are subject to an exclusion or fail to satisfy the “ownership interests” prong.  As we will discuss, the Final Rule contemplates that a covered reporting company may need to report multiple individuals under the “substantial control” prong.  Further, and although FinCEN still needs to issue proposed regulations regarding the following, the Final Rule’s broad definition of the “substantial control” prong under the CTA presumably will lead to FinCEN expanding the definition of “beneficial owner” under the existing Customer Due Diligence (“CDD”) rule applicable to banks and other financial institutions (“FIs”).

Substantial Control

FinCEN believes the definition of “substantial control” in the Final Rule strikes an appropriate balance.  According to FinCEN, the definition of “substantial control” is based on established legal principles and usages of the term in different contexts, while also being flexible enough to account for the several ways that individuals may exercise substantial control over an entity.

As with the 2021 proposed rule, the Final Rule sets forth three specific indicators of substantial control: (1) service as a senior officer of a reporting company; (2) authority over the appointment or removal of any senior officer or majority of the board of directors (or similar body) of a reporting company; and (3) direction, determination, or decision of, or substantial influence over important matters of a reporting company.  As the Final Rule explains, these indicators support “the basic goal of requiring a reporting company to identify the key individuals who stand behind the reporting company and direct its actions.”  While the first indicator aims to identify individuals with nominal or de jure authority, the latter two indicators identify individuals with functional or de facto authority. The definition is broad, and reflects FinCEN’s desire to collect information on all true beneficial owners, and to avoid true beneficial owners hiding behind a designated nominee.  However, the breadth of the definition certainly will create compliance headaches as covered reporting companies attempt to draw lines regarding who precisely exercises “substantial control.”  Further, and as we will discuss, FIs likely will need to adjust their requests for BOI from companies covered by the CDD rule in order to obtain BOI on all persons exercising substantial control.

First Indicator: Senior Officers

The first indicator of “substantial control” is an individual who “serves as a senior officer of the reporting company.”  A “senior officer” is defined as “any individual holding the position or exercising the authority of a president, chief financial officer, general counsel, chief executive officer, chief operating officer, or any other officer, regardless of official title, who performs a similar function.”  FinCEN describes this language as “provid[ing] clear, bright-line guidance on one category of persons who exercise a significant degree of control over the operations of a reporting company through executive functions.”  Contrary to the 2021 proposed rule, the Final Rule omits corporate secretaries and treasurers from the definition of a “senior officer.”

Second Indicator: Authority to Appoint or Remove

The second indicator of “substantial control” is “authority over the appointment or removal of any senior officer or a majority of the board of directors (or similar body).”  Based on comments received by FinCEN in response to the 2021 proposed rule regarding perceived ambiguities, the Final Rule deleted language about the ability to appoint or remove a “dominant minority” of the board of directors.”  To “ensure clarity,” FinCEN deleted this reference. 

Third Indicator: Direction Over Important Matters

The third indicator of “substantial control” broadly includes an individual who “directs, determines, or has substantial influence over important decisions made by the reporting company,” including the following lengthy list of decisions:

  • The nature, scope, and attributes of the business of the reporting company, including the sale, lease, mortgage, or other transfer of any principal assets of the reporting company;
  • The reorganization, dissolution, or merger of the reporting company;
  • Major expenditures or investments, issuances of any equity, incurrence of any significant debt, or approval of the operating budget of the reporting company;
  • The selection or termination of business lines or ventures, or geographic focus, of the reporting company;
  • Compensation schemes and incentive programs for senior officers;
  • The entry into or termination, or the fulfillment or non-fulfillment, of significant contracts; [or]
  • Amendments of any substantial governance documents of the reporting company, including the articles of incorporation or similar formation documents, bylaws, and significant policies or procedures[.]

Importantly, FinCEN has replaced the phrase “important matters affecting” the reporting company in the 2021 proposed regulations with “important decisions made by” the reporting company.  FinCEN made this change to address uncertainty identified by commenters that external events, customer actions, or actions beyond the reporting company’s control theoretically could “affect” the reporting company.  The Final Rule is meant to focus on important internal decisions.

The Final Rule contains an important exception to the definition of “beneficial owner” applicable to third-party nominees, intermediaries, custodians and agents, which should be read in conjunction with the above language that persons with “substantial influence” over important decisions made by the reporting company represent beneficial owners.  As FinCEN explains:

FinCEN does not envision that the performance of ordinary, arms-length advisory or other third-party professional services to a reporting company would provide an individual with the power to direct or determine, or have substantial influence over, important decisions of a reporting company. In such a case, the senior officers or board members of a reporting company would remain primarily responsible for making the decisions based on the external input provided by such third-party service providers. Moreover, if a tax or legal professional is designated as an agent of the reporting company, the exception to the ‘‘beneficial owner’’ definition provided in 31 CFR 1010.380(d)(3)(ii) with respect to nominees, intermediaries, custodians, and agents would apply.

The Catch-All: Everyone Else, and Indirect Means

The Final Rule retains the catch-all provision of the “substantial control” definition from the proposed rule: substantial control can include someone exercising “any other form of substantial control over the reporting company.”  This provision, which is vague at best and circular at worst, aims to recognize that control exercised in novel and less conventional ways nevertheless can be “substantial.”  Additionally, it could apply to the existence of different governance structures, like series limited liability companies and decentralized autonomous organizations.  For these types of organizations, FinCEN notes that different indicators of control could be more relevant. 

This provision is broad because FinCEN wants to prevent sophisticated bad actors from structuring their relationships to exercise substantial control over reporting companies without the formalities usually associated with such control in ordinary companies.  It is similar to the final provision on substantial control, now set forth in 31 C.F.R. § 1010.380(d)(2), which states that a person “may directly or indirectly, including as a trustee of a trust or similar arrangement, exercise substantial control over a reporting company through” (emphasis added) the following mechanisms:

  • Board representation;
  • Ownership or control of a majority of the voting power or voting rights of the reporting company;
  • Rights associated with any financing arrangement or interest in a company;
  • Control over one or more intermediary entities that separately or collectively exercise substantial control over a reporting company;
  • Arrangements or financial or business relationships, whether formal or informal, with other individuals or entities acting as nominees; or
  • Any other contract, arrangement, understanding, relationship, or otherwise.

Relationship with Existing CDD Rule for FIs

Finally, FinCEN considered comments urging a definition of “substantial control” comparable to the approach laid out in FinCEN’s existing CDD rule applicable to FIs.  Under the “control” prong under the CDD rule, covered new legal entity customers of FIs must provide BOI for only a single individual “with significant responsibility to control, manage, or direct a legal entity customer.” FinCEN concluded, however, that adopting the CDD rule’s definition would be inconsistent with the CTA’s broad objective of creating a comprehensive BOI database for all beneficial owners of reporting companies.  According to FinCEN, limiting the reporting of individuals exercising substantial control to one person would create an “artificial” ceiling presenting opportunities for evasion or circumvention by bad actors.  Instead, FinCEN believes, requiring reporting companies to identify all individuals who exercise substantial control will provide law enforcement with a more comprehensive picture of who makes “important” decisions at reporting companies.

FinCEN concluded that this expansion of persons whose BOI must be reported was appropriate despite the fact that commentators “contended that FinCEN’s [expanded] definition would impose significant burdens on financial institutions that spent years updating systems, procedures, and controls to implement the [existing] CDD Rule.”  Although FinCEN still needs to issue proposed regulations “conforming” the CDD rule to the new CTA BOI regulations, it is reasonable to expect that FinCEN indeed will require FIs to change their systems and require covered entity customers to report BOI for all persons exercising substantial control, rather than just one person. 

Perhaps in anticipation of potential litigation, FinCEN took pains to claim defensively that the CTA did not prevent FinCEN from taking this approach, even though the CTA defines “beneficial owner” as “an individual” who exercises “substantial control or owns or controls at least 25% of a reporting company’s ownership interest.” (emphasis added). Specifically, FinCEN stated, in part, that “the CTA does not mandate a single-individual reporting approach with respect to substantial control. The statute’s reporting requirement specifically calls for the identification of ‘each beneficial owner of the applicable reporting company,’ not just one.”  Further, according to FinCEN, “[m]any definitional provisions in the U.S. Code use formulations comparable to the CTA’s reference to ‘an individual’ in contexts where the plural is clearly indicated by the overall structure of the statute.” 

Time will tell whether industry groups will launch lawsuits challenging the Final Rule, or, downstream, challenging the likely expansion of the existing CDD rule under the CTA.

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