Start-Ups And The CTA: Substantial Control

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Taft Stettinius & Hollister

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Established in 1885, Taft is a nationally recognized law firm serving individuals and businesses worldwide, in both mature and emerging industries.
In an attempt to combat money laundering and criminal activity, the Corporate Transparency Act (the CTA), recently passed by the U.S. Congress, has made waves because of its onerous and consequential regulations.
United States Corporate/Commercial Law
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In an attempt to combat money laundering and criminal activity, the Corporate Transparency Act (the CTA), recently passed by the U.S. Congress, has made waves because of its onerous and consequential regulations. The CTA requires certain businesses to report beneficial ownership information (BOI) on persons deemed to be "Beneficial Owners" to the U.S. Department of Treasury's Financial Crimes Enforcement Network (FinCEN). Failure to comply with the CTA can result in heavy civil penalties and criminal penalties of up to two years imprisonment. Importantly, if an individual director, investor, or employee — who is a Beneficial Owner — has not complied with the CTA, the company and its senior officers may be held liable for the violation.

An entity regulated by the CTA is referred to as a "Reporting Company." Unless a company qualifies for one of the 23 exemptions identified in the CTA, it will be considered a Reporting Company. Because many start-ups will not qualify for one of the 23 exemptions, most officers and directors of start-ups, and even certain investors and employees, will be required to report their BOI pursuant to the CTA.

An individual must report their BOI if they have a 25% or more ownership interest — financial or equity — in a Reporting Company or if they have "Substantial Control." While there are many articles discussing the general framework of the CTA, this article focuses on who might be deemed to have Substantial Control of a Reporting Company.

According to FinCEN: An individual exercises Substantial Control over a Reporting Company if the individual meets any of four criteria:

1. The individual is a senior officer.

Senior officers considered as Beneficial Owners usually hold the traditional officer roles of president, CEO, COO, CFO, or GC. In the case of start-ups, a high level employee could be considered a senior officer (e.g., a founder or senior employee), if they exercise similar powers to those senior officer roles. The CTA does not focus on the formal title of an officer, instead it looks at the powers of that individual. Thus, if a high level employee exercises c-suite level powers (i.e., powers exercised by a president, CEO, COO, CFO, or GC), they could face reporting obligations under the CTA regardless of their official title.

2. The individual has the authority to appoint or remove certain officers or a majority of directors of the Reporting Company.

When it comes to the ability to appoint or remove certain officers or a majority of directors, certain equityholders with individual-based rights may be implicated. It is common for a group of preferred equityholders to have the power to appoint officers or directors, however, this rule focuses only on individuals with appointment and removal power. Thus, if there is a purchase agreement, side letter, voting agreement, or any other arrangement that allows for the election/removal of an officer or director pursuant to the consent/veto of an individual equityholder (e.g., a "Key Holder" as described in the National Venture Capital Association (NVCA) model documents), then that individual would be a Beneficial Owner, even if they own less than 25% of the Reporting Company.

Under this rule, venture capital firms or other investor funds that may have less than 25% equity in a start-up could feasibly still have the ability to appoint the majority of board seats or certain senior officers, which would be considered Substantial Control and would trigger BOI reporting by such an investor.

3. The individual is an important decision maker.

Under the sweeping regulations promulgated by FinCEN, an individual is considered an important decision maker if they direct, determine, or have substantial influence over important decisions made by the Reporting Company regarding:

  • Attributes of the business.
  • Selection/termination of business lines and ventures.
  • The geographic focus of the business.
  • Entry/termination/fulfillment of significant contracts.
  • Financing decisions of significant amounts (e.g., major assets, real estate, compensation schemes for senior officers, or debt).
  • Corporate structure (e.g., reorganization, merger, dissolution).

Corporate Structure

With respect to situations where an individual's substantial influence over corporate structure (e.g., approving a reorganization, merger, dissolution, etc.) would be significant enough to qualify as Substantial Control, an individual with singular veto power or approval rights, even if such a corporate change also requires a majority vote of preferred equityholders, would likely be considered a Beneficial Owner.

Other Important Decisions

According to FinCEN's Small Entity Compliance Guide, a minority equityholder with under 25% ownership in the Reporting Company who does not have veto powers over changes in corporate structure may still be deemed a Beneficial Owner if they have substantial influence over the selection or termination of business lines or ventures, or geographic focus of the Reporting Company; the entry into, termination, or fulfillment of significant contracts; the nature, scope, and attributes of the business of the Reporting Company; the sale, lease, mortgage, or other transfer of any principal assets of the Reporting Company. This wide scope of important decisions allows for many possible scenarios where equityholder control over particular business operations could, on its own, lead to an individual being classified as a Beneficial Owner.

Employees

The vast majority of employees will be exempt from the CTA's reporting requirements as the regulations state that Beneficial Owners cannot be an "employee of a Reporting Company, acting solely as an employee, whose Substantial Control over or economic benefits from such entity are derived solely from the employment status of the employee."

However, this exception does not apply to those employees acting as senior officers (again, president, CEO, COO, CFO, or GC). Importantly, the determination of whether an employee is categorized as a senior officer is not based on that individual's official title but instead on the powers and performance of that individual. Essentially, the rule tests whether an employee acts in "a similar function" to that of the enumerated senior officer positions.

In the start-up realm, emerging companies usually have a small number of employees, and those employees can often (1) wear many hats simultaneously and (2) hold a relatively large amount of power and discretion. Because of this rule, it is possible that a start-up could have a finance employee who holds little to no equity and is not officially an executive, but due to their outsized control over the Reporting Company's finances, that employee would be deemed to be acting as a CFO (i.e., a senior officer). In light of this rule under the CTA, some start-up employees might run the risk of being treated as having Substantial Control, regardless of their official title.

4. The individual has any other form of Substantial Control over the Reporting Company.

Lastly, the regulations contain a catch-all subsection requiring individuals with "any other form" of Substantial Control over the Reporting Company to file their BOI.

Given that all levels of equityholders, officers, and directors (and even certain employees) of start-ups may be determined to have Substantial Control, start-ups (including their attorneys and investors) should be proactive in seeking the FinCEN Identifiers of individuals. Such proactive measures may include asking for an individual's FinCEN Identifier on an employment agreement, equityholders' agreement, or similar forms that are executed at the onset of any engagements.

To reiterate, the penalties for failing to report beneficial ownership to the government involve criminal and/or civil penalties for the company and its leaders, even if it is an investor or employee that is found to be out of compliance. With this said, there may be an urge to over-report all employees, investors, or others as Beneficial Owners out of an abundance of caution. However, this strategy of over-reporting might create additional and unnecessary risks because of the requirements to continuously report changes to an individual's BOI. Starting in 2025, Reporting Companies will have 30 days to update changes to BOI, which would include new addresses, name changes, expired identification documents, or other details. For example, if a Beneficial Owner gets married and changes their name, if they move to a new address, or if their driver's license expires, the Reporting Company will have 30 days to make sure that information is updated with FinCEN. Otherwise, the Reporting Company may face penalties for being out of compliance. Thus, given the tight timeline for updating BOI, the over-inclusion of unnecessary individuals as Beneficial Owners may do more harm than good.

Rather than move forward with a blanket approach to registration of BOI, it is important that start-ups and their business leaders meet with their attorneys well in advance of reporting deadlines in order to develop and implement a clear, thoughtful, and continuous CTA compliance strategy for identifying and reporting beneficial owners.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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