Obama's "Incorporation Transparency Act" and The Shape of Things to Come
From guest blogger J.W. Verret, Assistant Professor, George Mason University School of Law:
The Senate Permanent Investigations Subcommittee is considering a bill introduced a few weeks ago by Senators Barack Obama, Norm Coleman, and Carl Levin, the "Incorporation Transparency and Law Enforcement Assistance Act," requiring states to determine the beneficial ownership of business entities formed under their jurisdiction and make that information available to their the federal government through subpoena.
In support of this bill, the Senators cite a handful of cases investigated by federal agencies that were later dropped because of difficulty determining beneficial ownership in the investigated entities. A proper analysis of the effects, costs, and likely constitutional challenges facing this bill reveals it as little more than a red herring - an empty gesture by a Presidential aspirant and Senators from contested districts meant to generate the appearance of being tough on corporate crime.
Other Alternatives
Legitimate prosecution of business entities engaging in activities that represent a threat to national security or violate tax, banking, or securities laws is a vital element of the federal government's law enforcement mandate. This does not mean that the state governments should be enlisted as subsidiaries of the Department of Justice merely because federal prosecutors find their work difficult or expensive.
There are other ways for the DOJ to determine the beneficial ownership of corporations. For instance, in Delaware, the home to more than half of all business entities, and 60% of the Fortune 500, nearly 2,000 cases are filed annually in Delaware's Court of Chancery against business entities. Delaware's plaintiffs bar skillfully uses the legal discovery process to determine beneficial ownership of those defendants.
Learning from Delaware - and the Costs
Perhaps federal prosecutors could learn something from Delaware lawyers in that regard. Legal discovery is an expensive and difficult process, but the fact that a handful of federal prosecutions have not resulted in successful convictions does not justify the federal government drafting the states into the service of federal agencies.
Indeed, the Constitution prohibits such an approach. In Printz v. U.S., the U.S. Supreme Court invalidated provisions of the Brady Bill that imposed mandatory regulatory requirements on local law enforcement. Justice Scalia articulated the Court's interpretation of state sovereignty succinctly: "The Federal Government may not compel the States to enact or administer a federal regulatory program."
The realities of business ownership, with its complex holding arrangements, make the costs of this bill prohibitive. Holdings are often structured with a network of ownership using flow through entities as well as powerful contractual rights held by non-shareholders. This is done for legitimate tax efficiency planning purposes as well as to sell specific interests to groups of investors or secure specific assets to interested creditors. The ownership structure of the Carlyle group or a typical grocery store franchise share that quality. This bill holds criminally liable any business failing to keep an accurate listing of its "beneficial owners" with the state in which it is registered, thus subjecting the two million businesses that form every year to unreasonable liability for a number of open questions of what being a "beneficial owner" really means in today's business environment.
Impact on Small Business
Professor Bainbridge of UCLA Law School has also observed that this bill will harm the millions of small businesses exempt from SEC registration trading on the pink sheets. Though the bill exempts entities registered with the SEC, recognizing that when shareholders trade in an active market an accurate list of their beneficial owners would be nearly impossible to maintain, it ignores that the same issue will be worse for smaller firms exempt from SEC registration.
The overriding drawback to this scheme is that only law-abiding businesses will feel its effects. Registrants of business entities used to cover illicit activities, such as money laundering or terrorism financing, would certainly lie on any form the states send them requesting beneficial ownership information. Unreasonable administrative costs are then imposed on state governments and small businesses with little effect on the exceedingly small percentage of businesses actually engaging in illicit activities.
The formation of over two million businesses each year is not something to be maligned by politicians hoping to spin momentary political hay. It is a result of a regulatory environment that has created a business entity formation system envied by developing markets around the world. If economic benefits of small business entities are to be protected, regulatory proposals should be subject to a sincere cost-benefit analysis.
What to Do Now
Most entities are formed in jurisdictions, such as Delaware, that have developed a specialized business court and corporate code to assure directors and officers maintain strict adherence of their fiduciary duty to their shareholders. The Obama/Levin/Coleman Act puts the success of this system in jeopardy.
Corporate counsel involved in the creation of LLC, LLPs, and corporations would be advised to inform their clients about this impending change, as well as the potential liability they face for failing to fully report their "beneficial owners" to the state's that chartered them.