Parties to litigation normally cannot keep their identities out of the public eye--plaintiffs and defendants are named in the complaint that starts a lawsuit. Complaints are public documents that are filed with the court. But a group of allegedly defrauded investors in Ohio recently used a limited liability company to bring a securities fraud lawsuit while keeping their names out of the court records.
The events that led to this lawsuit are sadly reminiscent of the Bernie Madoff debacle. Fair Finance Co. is an Ohio loan company founded in 1934. The company was owned by the Fair family and sold investment certificates to Ohio residents for a generation, including to members of Ohio’s Amish community. In 2002 wealthy Indianapolis investor Timothy Durham took control of the company.
In November 2009 the FBI raided Fair Finance’s offices and seized computers and records. Federal investigators suspected that Fair Finance was being operated as a Ponzi scheme, according to court records. The ongoing investigation has not yet resulted in any charges or arrests, but the company and its eight Ohio offices have been closed since November 24, 2009.
On December 21, a lawsuit was filed by a group of Ohio residents against Fair Finance and several other defendants, including Timothy Durham. In their complaint the plaintiffs seek rescission and damages for breach of contract, securities fraud, and negligent misrepresentation.
The lawsuit was brought by 16 plaintiffs. Two are trusts, 13 are individuals, and one is Fair Recovery, LLC. Fair Recovery is an Ohio LLC that was formed on December 10, 2009. According to the complaint, Fair Recovery is pursing the claims of 20 individual investors, all of whom are members of the LLC. The LLC members invested a total of $1,360,000 in Fair Finance.
Under Ohio’s LLC Act, an LLC is formed by filing Articles of Organization, and according to Fair Recovery’s Articles of Organization, its purpose is “to engage in any lawful act or activity.” The Articles are not required to disclose the LLC’s members, and Fair Recovery did not disclose its members' identities.
According to local newspaper reports, some members of the local Amish community invested with Fair Finance and have claims against it. The articles point out that the Amish faith discourages its members from settling disputes in court, and speculate that Fair Recovery was formed to press the legal action on behalf of Amish investors and to keep their names out of the public record. The law firm representing Fair Recovery and the other plaintiffs declined to say whether any are Amish.
This is a rather novel use of an LLC. Apparently Fair Recovery has no other business, and was formed simply to press the claims of its members in the litigation against Fair Finance. Using such an entity would not normally confer any benefit in litigation, so it appears that the only added value it provides is protection of the privacy of its members.
It remains to be seen how well the LLC will hold up as a privacy shield. For one thing, the identity of Fair Recovery’s members will probably become the subject of pretrial discovery procedures. For example, the defendants will be entitled to depose the Fair Recovery members to investigate the details of their claims. But pretrial discovery information is not usually filed with the court, so the identity of the Fair Recovery claimants presumably will be kept out of the court records prior to trial. The trial itself should be open to the public, but it may or may not be necessary at trial for testimony to identify the Fair Recovery members. Fair Finance must know, of course, who its investors are. It can probably determine easily who the Fair Recovery plaintiffs are, and could disclose that information if it chose to do so.
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.
Congress is considering a bill that would require organizers of LLCs to disclose the LLC’s members on formation and periodically thereafter. (The bill also applies to corporations and corporate shareholders.) On June 18, 2009 the U.S. Senate Committee on Homeland Security and Governmental Affairs held a hearing on the Incorporation Transparency and Law Enforcement Assistance Act, S. 569. This bill was introduced in 2008 and re-introduced in 2009. One of the co-sponsors in 2008 was then-Senator Barack Obama. Gary Rosin has reported on the hearing here.
This bill would require all the states to change their laws so that organizers of LLCs would be required to provide the state at the time of formation with the names and addresses of the LLC’s “beneficial owners”. Each LLC would have to update its list of beneficial owners in an annual filing, or if the state does not require annual filings, each time a change is made in the ownership. S. 569 § 3. “Beneficial owner” is defined broadly as an individual who has “a level of control over, or entitlement to, the funds or assets of a corporation or limited liability company that, as a practical matter, enables the individual, directly or indirectly, to control, manage, or direct” the corporation or LLC. Id. Since a beneficial owner has to be an individual and not an entity, any multiple levels of ownership would have to be traced to find the individuals who are the beneficial owners.
This definition is breathtakingly broad. For a variety of investor requirements and legitimate financing and tax efficiency reasons, many businesses involve complex structures with multiple entities, various ownership and voting rights, and contractual relationships with nonmembers. The terms “control” and “as a practical matter” are undefined and will be difficult to interpret in some contexts. In many cases individuals who are not members of an LLC could nonetheless fall within the definition of beneficial owner, requiring that their names and addresses be reported to the state.
The information that the states must collect is to be given to the federal government or other states in response to:
· subpoenas from any state or federal agency or congressional committee;
· written requests by a federal agency on behalf of another country under an international treaty, agreement or convention; or
· orders from a federal court responding to a request by a foreign or international tribunal or litigant.
This bill has so many things wrong with it that a critic can view it as a target-rich opportunity. Professors Ribstein, Bainbridge and Verret have criticized the bill’s weak justification, lack of clarity, high costs and low benefits, ineffectiveness, unconstitutionality, and lack of wisdom in federalizing an area of law that has traditionally been a matter of state control.
S. 569 would be a radical change because in this country members of LLCs (and shareholders of corporations) are not generally required to be identified when the entity is formed or at any later time. There are some specific occasions when members and shareholders must be identified, such as in response to discovery requests in litigation, in response to law enforcement subpoenas, or when a shareholder or member makes a request in compliance with the applicable state LLC or corporate statute, but those are event-driven and relatively infrequent.
There is one case where some states require that members of an LLC be routinely identified, and that is when the LLC is member-managed. Many states require that the identity of corporate directors and LLC managers be provided to the state, and make that information publicly available. But if there are no managers other than the members, then all members are managers, and some states require in that case that all the members be identified. Washington and California, for example, require that all members of a member-managed LLC be periodically identified in a statement filed with the state. RCW 25.15.105(1)(e); Cal. Corp. Code § 17060(a)(4). Oregon requires that at least one member of a member-managed LLC be identified in an annual report to the state. ORS 63.787(1)(d).
S. 569 does not require public disclosure of the member and shareholder information that it would require the states to collect, but it does not bar disclosure by the states. It’s likely that over time this member and shareholder information would be made publicly available by at least some states, under the combined pressure of the feel-good label “transparency” and the usual legislative and bureaucratic mission creep.
All of this information would be collected to further the goals stated in the bill of preventing wrongdoing by U.S. corporations and LLCs with unknown owners. Since LLCs and corporations cannot act except through human agents, i.e., directors, managers, and officers, the ownership of a wrongdoing LLC can be investigated through application of the existing law enforcement tools to the agents of LLC. The testimony in the hearing on the need for this information to be collected is not compelling.
But even assuming that there is a law enforcement need for uniform collection of ownership information, it seems unlikely that a criminal who forms an LLC for an illegal enterprise will dutifully use his correct name. An alias or a straw man can easily be used, or the wrongdoer can use an entity not covered by the bill. Meanwhile, the nearly two million new LLCs and corporations formed in this country each year, and all ongoing LLCs and corporations, will be attempting to comply with the new filing requirements. Only law-abiding businesses would be burdened by these requirements.