The Incorporation Transparency Act

J.W. Verret —  7 December 2009

This post is based on a legal backgrounder I recently published with the Washington Legal Foundation, which is available here.  This analysis is cross-posted from the Harvard Law School Forum on Corporate Governance and Financial Regulation.

The Incorporation Transparency and Law Enforcement Assistance Act, introduced by Senators Levin, Grassley, and McCaskill and currently pending before the Senate Homeland Security Committee, is being sold as an anti-terrorism and anti-money laundering provision. The bill requires that states maintain an accurate and updated list of all beneficial owners of corporations and limited liability companies they create and make that list available to law enforcement and others by subpoena and likely as part of a state’s public records, just as they do for other entities’ formation documents. Publicly traded companies are exempt from the current text of the bill, but privately held companies are directly targeted.

New business entities, including corporations, limited liability companies (LLCs), limited liability partnerships (LLPs), non-profit organizations, and other entities file formation documents with a state’s Secretary of State.  Competition among states for business creation is fought in part through the crafting of innovative business entity laws. State laws require business entities to maintain updated contact information for an agent who can receive service of process for the purpose of litigation.  But owing to the complexities of business ownership, states have not undertaken the impossible task of keeping an up-to-date list of all current owners of all business entities organized under a particular jurisdiction’s laws.  The Levin bill would require that the states collect and maintain beneficial ownership information on corporations and LLCs, but not LLPs, non-profit organizations, or other business entities.  As such, it would be ineffective at hindering use of those entities for the crimes that the bill is intended to stop.  Even if terrorists were to comply with the self-reporting requirements of the bill, they would nevertheless merely switch to using these alternative business entity types for their illegal activities.

The strongest critique of the Levin Bill is that it relies on individuals voluntarily reporting their beneficial ownership information.  Indeed, the burden of the Levin Bill will fall most strongly on the companies least likely to break the law. The bill’s penalties are particularly harsh in light of the inherent difficulties in determining beneficial ownership of entities with a large number of owners, some of whom may be corporate entities themselves. Business entities trade ownership in themselves and entities in which they invest to segregate specific investment risks and place them with the pool of investment capital most appropriate for that investment’s risk profile and time horizon. Trading ownership shares of entities covered by this bill could take place frequently, and the owners need not necessarily notify the filing entities of the change.  Further, as beneficial owners change hands involuntarily – including through settlement of an estate at death, seizure of securities put up as collateral to a creditor, or divorce proceedings – beneficial ownership status can remain uncertain for extended periods of time. Thus, entities can become non-compliant with the reporting requirements of the Levin Bill despite their expensive efforts to the contrary as a result of the inherent uncertainty in determining beneficial ownership.

The bill purportedly allows states to decide whether to keep the beneficial ownership information private or make it publicly available. Under the right-to-know laws of 38 states, those states would not be permitted to keep beneficial ownership information of businesses private without constitutional amendment. Costs to business privacy would be significant.  Legitimate businesses have important interests in maintaining the privacy of the ownership structures they use to invest in new projects.  This not only impacts purchase prices for target companies, but also purchase prices for target assets, particularly real estate.  High profile real estate developers may be unable to accumulate and assemble significant parcels of land needed for major development projects in an environment where their control of these entities is a matter of public record.

Another reason incorporators may seek to keep beneficial ownership information private is that the identity of the buyer of a target company in an acquisition may give added negotiating leverage to targets in the short term. Making ownership information public may come at the longer term expense of fewer bids overall.   Publicizing ownership information could also threaten vital intellectual property or trade secrets for participants’ joint ventures. Maintaining privacy for beneficial ownership information may also be vital to executive recruitment in private companies. Where equity stock grants in business entities are used as a form of compensation, publicizing beneficial ownership information may harm an executive’s financial privacy.  It may also be the case that investors in politically sensitive projects would want to minimize reactionary public response to their investments, as where college endowments invest in forestry projects that some interest groups oppose or a state pension fund invests in companies overseas.

In short, the Levin Bill stands to impose tremendous costs on millions of American businesses in the form of compliance requirements, uncertainty over beneficial ownership definitions that make honest compliance difficult, and the risks of public knowledge about proprietary business information that could destroy business development projects.