The Beneficial Ownership Bill Just Won't Go Away
The Incorporation Transparency and Law Enforcement Assistance Act, S. 569 (the Bill), is still alive. Two weeks ago the Senate Committee on Homeland Security and Governmental Affairs held a hearing on the Bill, on November 5 (the Hearing). The list of witnesses and their prepared testimonies are available, here. The Committee’s previous hearing on the Bill was on June 18, 2009.
The principal purpose of the Bill is to require the states to change their laws to mandate that organizers of LLCs and corporations provide each state with lists of the “beneficial owners” of the entity being formed, during the formation process and annually thereafter. Each beneficial owner must be identified by name and address. For more details, see my previous blog on this Bill, Big Brother Wants to Crack Open Your LLC.
The Bill’s definition of “beneficial owner” is awe inspiring in its scope and ambiguity. A beneficial owner is defined as an individual “who has a level of control that, as a practical matter, enables the individual, directly or indirectly, to control, manage, or direct the corporation or limited liability company.”
Only human beings are included in the definition of beneficial owner, so multiple levels of ownership will have to be traced. If an LLC or corporation is a member of an LLC, for example, the ownership will have to be followed up to the individuals at the top of the ownership structure.
In many cases it will be unclear which individuals have the ability, as a practical matter, directly or indirectly, to direct the affairs of an LLC with multiple levels of ownership. And if an organizer knowingly omits the name of an individual that is later determined to somehow have the practical ability to directly or indirectly control the entity, that organizer may be fined up to $10,000 and sent to jail for up to three years.
This is a bad bill. It is one more example of the federal government attempting to federalize an area of commerce traditionally handled by the states. It would be an invasion of the privacy of millions of legitimate business people. The bureaucrats promoting this Bill disregard the legitimate commercial interests many business people have in not disclosing their ownership of a business.
The Bill is justified by organizations such as the Treasury Department, the Justice Department, and the Federal Law Enforcement Officers Association as being helpful in investigations of crimes such as money laundering and wire fraud. The testimony skates briefly over the fact that LLCs and corporations can act only through their human agents, officers, and employees. For example, to open a bank account an LLC must have a person appear on its behalf at the bank and identify himself or herself to the bank’s satisfaction. LLCs and corporations are required to have registered agents in their state of formation and every state in which they do business. The records of an LLC, including its ownership records, may be searched if a judge issues a search warrant on probable cause.
The Bill appears to be driven in large part by law enforcement’s desire to peer into business records without a warrant and without any need to alert the business that the government is looking at its records.
The proponents of the Bill deprecate its impact on the states. For example, it was asserted in John Ramsey’s prepared testimony at the Hearing, on behalf of the Federal Law Enforcement Officers Association, that “this Bill does not require any state to enact any law with respect to corporations; it merely requires the states to add one more question to their existing incorporation forms and to make the information provided available to law enforcement upon presentation of a legally authorized subpoena or summons.” That is incorrect; the Bill does not contemplate a voluntary process. For the states to make it mandatory on an LLC to disclose its beneficial owners, the states will have to pass laws or adopt regulations.
Mr. Ramsey dismissed the costs on the states, saying “beneficial ownership information can be collected via existing electronic incorporation methods and stored in existing electronic databases.” He should talk to those who would be responsible for complying with the Bill’s requirements. Senator John Ensign testified at the Hearing that the Nevada Secretary of State estimates that its costs for implementing the required systems could reach as high as $10 million, with ongoing annual costs of approximately $1 million.
Kevin Shepherd represented the American Bar Association at the Hearing. He testified:
In our view, the imposition of a federal regulatory regime focused on beneficial ownership information is not workable, would be extremely costly, would impose onerous burdens on state authorities and legitimate businesses, would run counter to formation practices of major countries (including Canada, Mexico, Japan, and China), and will not achieve the laudable goal of assisting federal law enforcement authorities with pursuing and prosecuting criminal activity.
Mr. Shepherd pointed out in his remarks that the United Kingdom has studied and considered this issue. The UK authorities concluded that there were significant disadvantages and no clear benefits to adopting a system requiring up-front disclosure of beneficial ownership of entities, especially since it was unlikely that those engaged in criminal activities would provide true information. Financial Action Task Force Third Mutual Evaluation Report, Anti-Money Laundering and Combating the Financing of Terrorism, The United Kingdom of Great Britain and Northern Ireland at 234.
Jack Blum, a Washington attorney who testified at the Hearing in support of the Bill, conceded that criminals would be able to conceal the identity of the beneficial owners of entities formed for nefarious purposes. It does seem rather unlikely that criminals and fraudsters would worry about complying with a law intended to make it easy to catch them.
American businesses form approximately two million LLCs and corporations each year. These range from small, mom-and-pop businesses to entrepreneurial, venture-capital-funded start-ups to joint ventures between large organizations with complex ownership structures. This Bill would burden all of them with confusing and difficult-to-understand reporting requirements that will provide little or no benefit to law enforcement. The Bill should be rejected.
New York Court Holds Distribution Was Not a Misappropriation
Is it a distribution or a misappropriation when a managing member of an LLC withdraws funds from the LLC for his own use? That was the dispositive issue in Mostel v. Petrycki, 885 N.Y.S.2d 397 (N.Y. Sup. Ct. Sept. 2, 2009). It was dispositive because the answer to that question determined which of two different statutes of limitations applied.
Mostel had a judgment against Fulcrum Global Partners, LLC, a Delaware LLC (Fulcrum), from a prior lawsuit. Fulcrum went out of business and Mostel was unable to recover from Fulcrum on his judgment, so he brought a lawsuit against Petrycki, the founding member and CEO of Fulcrum. Mostel claimed that a $300,000 withdrawal from Fulcrum by Petrycki was a fraudulent conveyance under New York’s Debtor and Creditor Law, N.Y. Debt. & Cred. Law §§ 273, 273-a, 276 and 276-a.
According to Mostel, Petrycki’s withdrawal was a fraudulent conveyance because it was without consideration, and rendered Fulcrum insolvent and without assets to satisfy the judgment against it. If the withdrawal was a fraudulent conveyance, Mostel’s judgment against Fulcrum could reach the $300,000 in Petrycki’s hands.
Petrycki, however, asked for Mostel’s suit against him to be dismissed on grounds that his $300,000 withdrawal was a distribution to him by Fulcrum, and the lawsuit was therefore barred by the three-year statute of limitations in the New York Limited Liability Company Act and the Delaware Limited Liability Company Act.
Mostel riposted that the six-year statute of limitations applicable to the fraudulent conveyance claim should apply. (Mostel’s suit was filed more than three years and less than six years after the withdrawal.) Mostel argued that the $300,000 withdrawal was not a distribution because Petrycki did not have authority to withdraw the funds and had applied them for his personal use.
Since Fulcrum was a Delaware LLC, the court examined both the Delaware and New York LLC Acts. Both statutes provide that if a member receives a distribution that causes the liabilities of the LLC to exceed its assets, and if the member knew of the resulting insolvency at the time of the distribution, then the member is liable to the LLC for return of the distribution. Both statutes also provide that a member’s liability for receiving a wrongful distribution will end three years after the distribution, unless a lawsuit is brought on the claim before the end of the three years. N.Y. Ltd. Liab. Co. Law § 508; Del. Code Ann. tit. 6, § 18-607. Finding no difference between the two states’ laws, the court said it need not decide which state’s law governed – the result would be the same in either case. Mostel, 885 N.Y.S.2d at 399 n.1.
The New York courts had previously determined that in the case of an LLC distribution which is both wrongful under Section 508 of the LLC Act and a fraudulent conveyance under the Debtor and Creditor Law, the three-year limitations period of the LLC Act overrides the six-year limitations period of the Debtor and Creditor Law. O’Connell v. Shallo, 323 B.R. 101 (S.D.N.Y. 2005). So if the $300,000 withdrawal was a distribution, the three-year limitations period of the LLC Act would apply, and Mostel’s claim would be barred. If it was a misappropriation and therefore not a distribution, Mostel’s suit could go forward.
The New York LLC Act defines “distribution” as “the transfer of property by a limited liability company to one or more of its members in his or her capacity as a member.” N.Y. Ltd. Liab. Co. Law § 102(i). Fulcrum’s Operating Agreement gave all members the right to request a return of their invested capital, subject to the approval of the managing member. The agreement did not provide for any additional procedures when a managing member seeks a return of its own invested capital.
Mostel’s complaint conceded that Petrycki was the managing member and that his $300,000 withdrawal was a return of his capital contribution, so the court rather straightforwardly concluded that the withdrawal was an authorized distribution to Petrycki. The three-year limitations period applied and Mostel’s claim was time-barred. Mostel’s complaint was dismissed.
The lessons from this case? Apart from the obvious, of course – don’t delay filing a lawsuit for so long that a statute of limitations bars the claim – the case underscores the importance of written LLC agreements. It also shows the need for the members to consider carefully the distribution provisions in their agreement. Interim distributions should be authorized by the agreement, and the parties should think about what procedures or approvals will be necessary for different types of distributions. For example, in Fulcrum’s agreement, distributions on request of a member for return of its invested capital were allowed if approved by the managing member, and that provision validated Petrycki’s withdrawal as a distribution.
