FinCEN Needs to Define "Substantial Control" in Regulations

In its Advance Notice of Public Rulemaking, FinCEN asked for comment on 48 separate questions arising under the Corporate Transparency Act (the "Act"). FinCEN Report Company has recently submitted written comments on the question of the meaning of "substantial control" in the Act.

The Act defines the "beneficial owner" of an entity, subject to certain exceptions, as "an individual who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise" either "exercises substantial control over the entity" or "owns or controls not less than 25 percent of the ownership interests of the entity."

This definition, which uses the disjunctive to include both owners of more than 25% of the ownership interests and others who exercise "substantial control" over the entity, is inherently vague. The first threshold is a bright line that can be easily applied in virtually all circumstances. An earlier version of the Corporate Transparency Act, introduced in the 116th Congress, defined "beneficial owner" with a three-part test that added the concept of a person who enjoys "substantial economic benefits" from the covered entity. By eliminating this third prong of the test, the drafters of the Act appear to have concluded that looking at substantial economic benefits would not be necessary if the test addressed the ownership of the entity. This leaves the concept of "substantial control," however, undefined.

In the case of a corporation, the shareholders of the corporation are the ones who own the "ownership interests" of the corporation. They have the power to elect directors to the board of directors. By having that power, the shareholders exercise some measure of "control." Likewise, the board of directors exercise control by appointing officers of the corporation. Those officers exercise some measure of control when they make business decisions on behalf of the corporation. Each layer of corporate governance is an exercise in wielding control to the extent that each layer has the power to appoint or remove the subordinate layer.

But the Act did not define "beneficial owner" to mean every shareholder, director and officer of a corporate covered entity. It would have been easy to have done so, and such a definition would have created a simple bright-line test that FinCEN could have implemented in regulations. Instead, the drafters of the Act used the term "substantial control," presumably because they wanted to describe a level of control that is higher than the control routinely exercised by shareholders with less than 25% ownership, or by directors and officers of corporations generally.

The body of law that is most closely related to the Act are the federal securities laws, found primarily in the Securities Act of 1933 (the "1933 Act") and the Securities and Exchange Act of 1934 (the "1934 Act"). The securities laws are closely related to the Act because both bodies of law pertain to the actions of corporate business entities, their issuance of securities to their owners and investors, and the governance of those entities to the extent that owners of those entities exercise control over them. The U.S. securities laws have developed a fully formed, though somewhat complex, body of law surrounding the term, "control".

The Act does not define "control"

SEC Rule 405, 17 CFR § 230.405, promulgated to implement the 1933 Act defines "control (including the terms controlling, controlled by and under common control with) [as] the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of voting securities, by contract, or otherwise."

SEC Rule 405 uses this definition of control primarily as a means to define "affiliates" of an issuer of securities so that "an affiliate of, or person affiliated with, a specified person, is a person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with, the person specified."

Securities lawyers often use these terms when evaluating securities transactions. For example, securities issued to an investor directly by "the issuer, or from an affiliate of the issuer, in a transaction or chain of transactions not involving any public offering" are subject to limitations on transfer under SEC Rule 144, 17 CFR§ 230.144. Restrictions on transfer vary based on whether the proposed transferor is an affiliate of the issuer. 17 CFR§ 230.144(b). In addition, other concepts that apply to securities and to publicly traded companies rely on these definitions of "affiliate" and "control".

The SEC takes the position that "control" status depends on the facts and circumstances involved. As a result, it has not conclusively defined when a person being deemed to be in "control" of an issuer. See, e.g., First Gen'l Resources Co., SEC No-Action Letter, [1988-89 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 78,251 at 78,253 (Aug. 23, 1988) ("[t]he Division [of Corporation Finance] has historically declined to express any view on the affiliation of any person to an issuer of securities on the ground that the question is a matter of fact best determined by the parties and their advisors.") Judicial case law also fails to provide any definitive standard to determine whether a person is in "control."

For those reasons, the SEC looks at all the "indicia of control" that relate to an individual and their potential power of control when the individual owns 10% or more of the corporation. Indicia of control can include (i) whether the individual is an officer or director, (ii) whether the individual is part of a larger group of shareholders who might exercise control collectively, (iii) whether the individual has any contractual right to control decisions, and (iv) other factors. The problem for FinCEN, however, is that it will not be feasible for it to direct covered entities to file their beneficial ownership reports on the basis of 10% shares who "might" be deemed to have these indicia of control. FinCEN needs a bright line test.

FinCEN Should Adopt a Bright Line Test

For clarity, the SEC should adopt a bright line test that relates solely to beneficial ownership. A strict 10% test, for example, would make it easy for companies to determine who needs to be included in their beneficial ownership reports.

We expect that roughly 20 million private companies in the U.S. will need to file a beneficial ownership report under the Act. Adopting a simple 10% will help to include the broadest number of companies and will avoid the ambiguity that would result if the test required a subjective determination regarding indicia of control.

About The Author

Jonathan Wilson is the co-founder of FinCEN Report Company with 31 years of experience in corporate, M&A and securities matters. He is the author of The Corporate Transparency Act Compliance Guide (to be published by Lexis Nexis in the summer of 2023) and the Lexis Practical Guidance Practice Note on the Corporate Transparency Act.

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