Terrorism Finance Meets Business Associations

J.W. Verret —  17 August 2010

Now that TOTM blog traffic is hitting all-time highs, I thought it would be a good time to share a link to my most recently published paper, Terrorism Finance, Business Associations, and the “Incorporation Transparency Act.” It is highly critical of Senator Levin’s “Incorporation Transparency and Law Enforcement Assistance Act,” over which Senator Levin, Senator Lieberman, and the Obama Treasury Department are currently haggling.

I got the idea to write an article about this Act from reading posts from colleague Ribstein and blog neighbor Bainbridge some time ago.  Senator Carl Levin has been pushing to mandate that states keep open registeries listing the names of all owners of business entities they form.  There are a number of problems with this proposal.  First, it is sold as an anti-terrorism measure.  During the first two rounds of hearings on the bill, officials from the various law enforcement agencies made vague references to the war on terror, which…don’t get me wrong, I support wholeheartedly.

They did not, however, provide any meaningful analysis for why alternative entities stand at the heart of terrorism finance.  To the extent that terrorism has involved intricate finance in the past, it has been through the Hawala system of underground Asian and Middle Eastern bankers.  But hawaladars don’t form alternative entities…they have no reason to.  Why would they need the protection of limited liability when the very nature of their business is, in both the United States and abroad, centrally an illicit enterprise?

Moreover, hawaladars function within a system of cultural and family bonds, with reputational costs as paramount, allowing them to transfer money outside of a sophisticated wire transfer system.  To a hawaladar, protection from personal liability for entity obligations is entirely useless.  But more importantly, the 9/11 Report describes how most international terrorists have been self-financing their activity, both from legal employment and illicit credit card fraud and drug distribution.  Also remember that the 9/11 hijackers did not use LLCs or LLPs in their activities either, and to the extent terrorists continue to use the banking system the Patriot Act already provides an extensive surveillance mechanism that the Levin Bill does precious little to supplement.  Even more ridiculously, the Levin Bill anticipates owners filing their identification with the relevant state of formation, thus we would rely on terrorists to accurately report their ownership information!

The Levin Bill fails to achieve its stated objective.  The truly pernicious part of the bill is the cost that would accompany its implementation.  Business privacy is an important element of business entity use.  Imagine if, instead of acquiring tracts of land in Florida through acquiring shell entities, Roy Disney had to acquire tracts through the Disney company directly?  Making beneficial ownership information public can potentially result in reapportionment of bargaining leverage because it potentially reveals insight about one party’s walk-away point.

The Levin Bill reporting obligations are triggered by ownership.  But what is an owner?  If I am the only creditor of an LLC, and I have all of the LLC’s assets secured as collateral, and the debt covenants provide me with veto power over all LLC decisions, am I an owner?  This part could get very tricky.  The Levin Bill ties in the definition of “ownership” to “control.”  That will get even trickier.  Furthermore, the Bill harms the entire enabling purpose of alternative entities.  One important advantage of using alternative entities is the freedom to design governance structures appropriate for a particular venture.  But where governance structures are arranged to avoid Levin Reporting obligations, rather than to create governance structures appropriate for a particular venture, that benefit of the alternative entity form is lost.

All in all, a very bad bill.  TOTM readers, be sure to write your Congressman.

UPDATE: One reader comments “If you’ve ever done due diligence for fraud, you would support this bill.”  Not true.  I agree completely that due diligence is a vital element of business relationships, so important in fact that I think its a bad idea for due diligence to be managed by the federal government in this context.