Defining "Substantial Control" Under the Corporate Transparency Act - Part 1

In its proposed regulations, FinCEN has proposed a definition of "substantial control" that will increase corporate governance and filing obligations for millions of U.S. companies.

The Corporate Transparency Act (or "CTA") was adopted by Congress in December 2020.  When implemented by FinCEN - the Financial Crimes Enforcement Network - the law will require almost every U.S. company to file a report that discloses the company's beneficial ownership. FinCEN issued proposed regulations in December 2021.  

The proposed regulations define "beneficial owner" to mean (a) any person who directly or indirectly owns more than 25% of the company, or (b) any person who has "substantial control" over the company. FinCEN's proposed definition of "substantial control," however, is a complicated thicket of overlapping concepts that will pose challenging for many U.S. companies. As a result, a person is a "beneficial owner" if they have "substantial control" regardless of whether they own any stock in the corporation. 

FinCEN defines "substantial control" as:

• Service as a senior officer of the reporting company;
• Authority over the appointment or removal of any senior officer or a majority or dominant minority of the board of directors (or similar body);
• Direction, determination, or decision of, or substantial influence over, important matters affecting the reporting company, including but not limited to:

The nature, scope, and attributes of the business of the reporting company, including the sale, lease, mortgage, or other transfer of any principal assets of the reporting company;

The reorganization, dissolution, or merger of the reporting company;

Major expenditures or investments, issuances of any equity, incurrence of any significant debt, or approval of the operating budget of the reporting company;

The selection or termination of business lines or ventures, or geographic focus, of the reporting company;

Compensation schemes and incentive programs for senior officers;

The entry into or termination, or the fulfillment or non-fulfillment of significant contracts; and Amendments of any substantial governance documents of the reporting company, including the articles of incorporation or similar formation documents, bylaws, and significant policies or procedures; and

• Any other form of substantial control over the reporting company.

This multi-part definition will be challenging to apply for many companies.

For example, the proposed regulation includes "service as a senior officer" as "substantial control." Presumably then, each reporting company must list its chief executive officer as a "beneficial owner." But what other officers are covered? Would the reporting company's chief financial officer be a "senior officer." In many companies it would. The second prong of the definition, however, provides that "authority over the appointment or removal of a senior officer" is an indicator of "substantial control." If the CFO lacks the authority to hire and fire other senior officers, does that mean that the CFO lacks substantial control (and should therefore not be treated as a "beneficial owner"). 

The board of directors of a corporation, generally, has the power to appoint the corporation's senior officers. But is each member of the board of directors a beneficial owner by virtue of having substantial control? The proposed FinCEN regulation does state that every board member must be reported as a beneficial owner. But, elsewhere in its proposed regulations, FinCEN states that, "An individual may directly or  indirectly exercise substantial control over a reporting company through a variety of means, including through board representation . . . " This suggests that some board members may have substantial control while others may not. FinCEN does not clarify, however, how to distinguish between those board members who have substantial control versus those who do not.

These distinctions will be important for U.S. companies who need to file beneficial ownership reports under the CTA. The CTA provides that it is a felony for any individual to willfully file an inaccurate report. (CTA, Sec. 6403(h)).  Those responsible for corporate governance in U.S. companies will not want to put themselves in legal jeopardy for making a judgment call about which directors have substantial control and which do not.

As a result, corporate officers, board members, shareholders and their counsel will like choose an overly broad approach, including within the scope of "substantial control" any officer or director who might possibly be considered to have substantial control. This overly broad approach will thereby define each of these individuals as a "beneficial owner" whose personally-identifiable information will need to be included in the company's beneficial ownership report. 

In Part 2, I will describe some of the practical steps companies should consider when developing corporate governance procedures to comply with their CTA obligations. 

Update: FinCEN issues its Final Rule on beneficial ownership reports under the Corporate Transparency Act on September 29, 2022.  Portions of this post should be updated to reflect the Final Rule.