By now, many of you may have heard of the Corporate Transparency Act (“CTA”) and how it may increase compliance costs for many of your businesses in 2024. In brief, beginning January 1, 2024, the CTA will require foreign businesses registered to conduct business in the United States, as well as domestic corporations, limited liability companies, limited partnerships, and other similar entities (“Reporting Companies”) to disclose beneficial ownership information to the Financial Crimes Enforcement Network (“FinCEN”).[i] Willful failure to comply with reporting obligations can result in steep financial penalties of $500 per day, with a maximum penalty of $10,000. Reporting Companies formed prior to January 1, 2024, will have one year to file their initial report. Whereas, proposed regulations issued on September 27, 2023, extend the period for which Reporting Companies formed between January 1, 2024, and December 31, 2024, have to file their initial report, from 30 days to 90 days from the date of the company’s formation. Further, if a change of ownership occurs in the ordinary course of business, the regulations state that a Reporting Company has 30 days to file the updated report.[ii]
Absent being defined in the CTA as one of the 23 highly regulated businesses[iii] or a large operating company[iv] (domestic corporations with at least 20 employees and tax returns showing more than $5 million in gross receipts), you most likely will fall subject to the reporting obligations of the CTA.
What Does This Mean For Your Corporate Transactions in 2024 and Beyond?
For many of the readers familiar with the corporate transaction process, you are no stranger to the representation and warranty section of your purchase agreement. For those business owners contemplating buying or selling a business in the future, the Representations & Warranties (as hereinafter defined) section of the purchase agreement, where deals are often highly negotiated, relate to the provisions which include statements of facts regarding a company’s business, assets, liabilities, and operations (“Representations”) and the business’s or business owner’s statements of assurances (“Warranties”).
For example, it is standard practice to include a Representation and Warranty of “Organization, Qualification, and Capacity” in a purchase agreement, stating, in short, that the business is comprised of a certain type of entity (limited liability company, corporation, partnership, etc.), and that the entity is organized and validly exists in good standing under the laws of the state where organized.
Why do I use this specific example? As it relates directly to the new reporting obligations of the Corporate Transparency Act. An entity not in compliance with the CTA may risk violating its Representation and Warranty of “Organization, Qualification and Capacity” and thereby opening the seller to liability. Here, the potential for liability would depend on the specific language of the purchase agreement. As we move closer to 2024, it is more important than ever to confirm that a Representation and Warranty exists in your purchase agreements as to compliance with the CTA, and further, its inclusion in the definition of fundamental representations in such purchase agreement. Its inclusion being of importance, noting that, as of now, confirmation of any specific company’s compliance with the CTA is not public information nor readily accessible.
Per the CTA, an individual who has provided FinCEN with the information required of a Reporting Company may request and receive a FinCEN identifier thereby mitigating potential risk of liability for noncompliance. But, with the implementation of the new program slated to begin on January 1, there is uncertainty regarding the timing of the receipt of these identifiers. With more than 32 million preexisting entities forecasted to file with FinCEN and approximately 2 million new entities to be formed and filed in 2024, it is realistic to think that an identifier request may be delayed.
How Does This Affect Representation and Warranty Insurance or Baskets and Caps?
The inclusion of another Representation and Warranty comes with the required adjustments to Representation and Warranty Insurance (“R&W Insurance”) and baskets and caps within the purchase agreement. Both R&W Insurance and baskets and caps are utilized as clawbacks to effectively adjust the purchase price if something in the Representations and Warranties is found to be incorrect after closing. R&W Insurance is provided by third-party insurance companies to cover potential costs associated with any breach by the seller of a Representation and Warranty. With the widespread adoption of R&W Insurance, how insurance brokers work this into their calculations for potential claims against failure to comply with the filing requirements of the CTA will be completed by them and an area upon which to pay attention.
Whereas R&W Insurance provides money from a third-party, baskets and caps are provisions within the purchase agreement that serve as a pool of cash, typically taken from the funds provided for the purchase of a company or its assets, to make claims against if there is a breach of a Representation and Warranty. Attorneys will need to assess the risk of each specific deal regarding the potential liability of seller non-compliance with the CTA and adjust the basket and cap for claims against the company for this violation. This will all depend on the deal specifics and negotiations between the parties given the information delivered during the due diligence process.
The Global M&A market witnessed something similar during the 2020 global pandemic. With the inclusion of a “new” Global Pandemic Representation and Warranty, the R&W Insurance industry and lawyers had to assess new potential risks and help clients minimize potential claims. In the end, it will be interesting to see how this plays out. As always, buyers beware.
Be sure to watch out for additional education and outreach regarding beneficial ownership reporting requirements, as FinCEN is expected to provide future resources, such as guidance, FAQs, and interpretive advice.
[i] Beneficial Ownership Information Reporting Requirements, 87 Fed. Reg. 59498
[ii] See Beneficial Ownership Information Reporting Requirements Final Rule, CFR 1010.380(a)(2), (Sept 30, 2022).
[iii] See 31 CFR 1010.380(c)(2) for a full list of the 23 exemptions from the definition of “reporting company.”
[iv] See my colleague, Ryan K.M. Taylor’s article “ New B.O.S.S., Same as the Old Boss? New Clarity on the Corporate Transparency Act, on DE Insights at New B.O.S.S., Same as the Old Boss? New Clarity on the Corporate Transparency Act – DarrowEverett LLP.