Peering into the RWI crystal ball (Part I): The Corporate Transparency Act

An astrologer and physician, Michel de Nostredame (most widely known simply as Nostradamus), gained global notoriety for his book Les Prophéties, in which he sought to predict future events several hundred years into the future.

With the new year upon us and given that Nostradamus’ prophecies did not specifically address the representations and warranties insurance (RWI) market in 2024, we will be putting on our Nostradamus hats to discuss the anticipated impacts on and changes to the RWI market for 2024 and beyond. While we look forward to discussing these trends and impacts throughout the year, this first installment focuses on RWI-related considerations with respect to The Corporate Transparency Act (CTA).

This article provides (i) an overview of the CTA, (ii) a summary of the types of transactions that are generally relevant in the context of the CTA, (iii) a discussion regarding the types of representations and warranties that are likely to be implicated by the CTA, (iv) quoting stage-related considerations when issuing and obtaining non-binding indication letters (NBILs), (v) potential underwriting inquiries that carriers may consider when assessing the risks arising from the CTA and (vi) a reminder to incorporate CTA-related items in the bring-down process.

What is the Corporate Transparency Act?

The Corporate Transparency Act is designed to combat money laundering and deter illicit finance by requiring certain companies that are formed or registered to do business in the United States (Reporting Companies) to report beneficial ownership information to the US Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN). The FinCEN portal for accepting beneficial ownership reports opened on January 1, 2024, and Reporting Companies will be required to make filings as early as March 31, 2024 (see compliance dates below). See our overview of the reporting requirements and common pitfalls under the CTA, "New year, new reporting requirements".

Compliance dates

The CTA prescribes 23 exemptions. Many of the exemptions under the CTA are targeted at large or sophisticated institutions, so the CTA will largely target small companies, closely held businesses, family offices and shell companies. These targets are not typically subject to heavy regulation and may be less equipped to handle the increased reporting requirements and regulatory burden.

What transactions are relevant?

There are no tell-tale signs that the CTA may be implicated in a particular transaction because this is an entity-by entity analysis. Consequently, carriers will need to be vigilant throughout the underwriting process, beginning in the quoting stage, during underwriting and when negotiating the RWI policy.

Transactions in highly regulated markets such as banking, money services businesses, investment advisers or public reporting companies are of less concern because these entities will generally fall into one of the 23 exemptions under the CTA. Importantly, these exemptions include large operating companies with at least 20 full-time employees in the US and that file US tax returns demonstrating more than US$5m in gross revenue. However, these and other particular exemptions require careful analysis to assess their applicability.

Closely-held or family-owned targets should be of particular concerns to underwriters. These types of businesses are usually less familiar with strict regulation and may lack the necessary compliance function, policies and procedures to adequately comply. Underwriters should note when the seller of a target is a trust or an affiliate or subsidiary of a trust. Trusts that are formed without a filing with the secretary of state or similar state office do not qualify as reporting companies. However, if a target is owned by a subsidiary or affiliate of a trust, careful analysis should be conducted to confirm whether a separate exemption applies to the selling entity, as they may otherwise be a Reporting Company.

Carriers should also be wary of complex transaction structures with several layers of entities. These are especially prevalent in real estate, projects, investment funds and private equity transactions or other structures that utilize special purpose vehicles and shell companies. The CTA analysis for compliance should be conducted for each entity, which includes new entities that were created solely to consummate the transaction. Foreign ownership is also not a “pass” for CTA compliance. Foreign companies that are registered to do business in the US, which do not qualify for an exemption, will be required to file beneficial ownership reports under the CTA. Certain exemptions also have different standards for foreign-owned businesses, such as the inactive entity exemption, so careful analysis and distinction is required.

Representations and warranties where CTA-related exposures could be implicated

Octopuses are often referred to as masters of camouflage due to their innate ability to alter their skin colors instantaneously in an attempt to seamlessly blend into their overall surroundings. While certain M&A practitioners may take the more direct ‘bull in a China shop’ approach by creating bespoke representations and warranties expressly referencing or pertaining to the CTA, we anticipate that other M&A practitioners may take a more indirect approach by incorporating the CTA (and even camouflaging its applicability) into numerous representations and warranties (including related defined terms).

At its core, the CTA is an anti-money laundering law, even if its overall impact will be felt in numerous categories of representations typically contained in an acquisition agreement. In addition to any bespoke CTA representations, the most relevant representations that will address compliance with the CTA will generally be the anti-bribery, anti-corruption and anti-money laundering (AML) representations. However, other insureds may seek to have CTA-related items broadly covered through the use of defined terms or even generic language relating to “compliance with applicable laws”. We also anticipate that M&A practitioners may also seek to obtain coverage under the RWI Policy for representations which speak to qualifications for exemptions from the CTA—for example, representations may speak to the qualification of particular categories or that, at a minimum, the target falls within at least one such category. Given the complexity and nuances of the 23 categories of CTA exemptions noted above, a carrier will need to therefore carefully evaluate and inquire as to the analysis conducted with respect to the applicable exemption, given that such representation hinges largely, if not entirely, on standalone independent legal analysis to be performed by the insured’s representatives.

Companies may also build requirements for CTA compliance into their organizational documents, which may be covered broadly by the organizational representations—for example, that the target has complied and will continue to comply in all respects with the terms of its organizational documents.

Compliance with the CTA will require Reporting Companies to handle sensitive personal identifying information of beneficial owners and applicants. The collected PII will include the name, date of birth, physical home address and copies of identifying documentation of each beneficial owner. This may impose additional data privacy obligations on entities that otherwise do not handle large amounts of PII. Therefore, M&A practitioners are likely to consider incorporating these obligations within the representations and warranties pertaining to data privacy laws.

In addition to the representations referenced above, we anticipate that covenants will be utilized to address CTA-related compliance matters in the interim period. While covenants are not directly covered by the RWI Policy, these covenants may leave helpful bread crumbs for assessing the target’s overall risk profile under the CTA, including in the case of covenants that require investors or owners to comply and cooperate with the target in connection with its CTA obligations. Of course, it may be the case that these covenants are instead embedded within the representations themselves.

Considerations during the quoting stage

Throughout the past several years, we have noted the significant impact that the ‘quoting stage’ can have on the overall underwriting process. Among other things, the quoting stage and the terms of the NBIL provide a carrier with the most leverage to ultimately pare back or, if not excluded, mitigate the risk associated with a particular diligence point or matter. However, even in instances where a particular risk is not entirely excluded, the quoting stage is a valuable opportunity for a carrier to signal to an insured the particular type (and level) of diligence that will need to be undertaken in order to obtain favorable coverage.

We anticipate that carriers will take differing approaches to the CTA in their quotes, as there is never a one-size-fits-all strategy due to variances in risk appetite and the overall context of each transaction. Nevertheless, we believe that carriers should consider one or more of the following approaches:

• Even if not outright excluded, carriers may include a footnote that matters pertaining to the CTA will be subject to underwriting in order to put an insured on notice that commensurate buy-side diligence will be necessitated in order to receive favorable coverage;
• In the event a pre-closing transaction is being contemplated, carriers may consider noting that its coverage of such item matters will be assessed from a CTA-related perspective, even where the “tax consequences” are excluded from coverage;
• Given that CTA-related representations are likely to fall within the scope of true fundamentals (i.e. with respect to organizational-related matters), carriers may explicitly clarify that treatment of CTA-related representations as “fundamental” will be subject to diligence (or alternatively, such representations will be deemed to be treated as “general” representations); and
• As CTA-related risks and exposures are not created equal for each target, carriers may elect to include permissive language (similar to the approach taken with respect to sanctions-related exposures pertaining to the Ukrainian-Russian conflict) that an exclusion may apply based on the overall risk profile of the target—for example, investment funds and financial-related arenas, where CTA-related exposures are likely to be fairly prominent.

Teasing out the issues in underwriting: Sample agenda questions

The Below sets forth a few sample inquiries we are likely to see utilized during the underwriting process in some form, including annotated drafting notes as to why such questions are likely to be asked from time-to-time:

• Was basic diligence conducted regarding the CTA compliance? Were these items expressly diligenced under the buyer’s standard Q&A tracker? Were any representations added to address CTA-related matters?
  • Note: It will be important for carriers to identify whether exposures arising from CTA-related issues are being entirely allocated to the RWI Policy, especially in a no seller indemnity structure. These questions seek to generally inquire about the buyer’s approach to CTA-related matters. Where limited diligence has been performed, it will be helpful for insureds to communicate why its relevance is limited (or entirely inapplicable).

• Does the target evaluate reporting requirements on an entity-by-entity basis? Has the target evaluated their corporate governance structures, policies and procedures to address CTA-related changes? Does any Reporting Company within the target’s structure provide trainings or routine compliance reminders to beneficial owners to capture any required changes and updates?
  • Note: These questions seek to garner further information on the overall hygiene of the target’s compliance function, including whether it has considered and evaluated its overall compliance with applicable reporting requirements under the CTA.

• Are new entities or special purpose vehicles being formed in connection with the transaction, including with respect to a pre-closing reorganization? Are those entities in compliance with filing requirements or is there an applicable exemption?
  • Note: These questions seek to inquire about the implications of transaction-specific risks pertaining to the CTA, including pre-closing reorganizations and restructurings. These pre-closing transactions frequently include the formation or utilization of an ancillary entity, and even where an underwriter seeks to exclude the tax consequences of such transactions, it will be left exposed to the risks arising under the CTA.

• Is the target complying with data privacy laws when handling personal identifying information in the context of the CTA?
  • Note: While this question speaks to items typically addressed during the cybersecurity and data privacy portion of the underwriting call, carriers addressing such matters in the general corporate section may elect to inquire specifically about compliance with data privacy laws in the context of the CTA.

• Has the potential exposure with respect to the CTA been quantified? How many beneficial owners are implicated?
  • Note: Carriers may ultimately elect to ask the foregoing catch-all question with respect to compliance with laws matters in lieu of the above. Nevertheless, it is important to assess whether a significant number of beneficial owners are implicated in the target’s overall corporate structure—more beneficial owners allows more room for error and non-compliance with respect to the CTA, including the filing of and updates to required reports. Violations of the CTA can carry civil penalties (up to US$500 for each day the violation continues, up to US$10,000) and criminal penalties (including fines up to US$10,000 and/or imprisonment for up to two years) for each party that fails to comply.

Don’t forget about the bring-down process

While carriers may largely seek to inquire about CTA-related matters during the initial underwriting phase, the bring-down process provides another opportunity to confirm that no CTA-related exposures have arisen during the interim period (given that the representations and warranties will be brought down to closing). In light of the fact that material facets of a pre-closing reorganization or other pre-closing restructuring are likely to occur during the interim period, carriers may consider confirming that no events have arisen which could trigger any further CTA-related scrutiny. Likewise, it may be the case that during the initial underwriting phase an insured indicates that a CTA-related filing will be made by the target or its affiliates after binding of the RWI Policy—in such instance, carriers should seek to obtain further comfort that all requisite filings have been made during the closing bring-down call.

Lastly, carriers should carefully consider whether new CTA-related compliance obligations have arisen during the interim period, which were not addressed during the initial underwriting call (because the CTA was not then in effect) but are relevant because the pertinent representation(s) is being brought down to closing. This will be especially true in the event that the applicable representation(s) has forward-looking aspects. In this initial transition phase, additional questions and consideration may be warranted.

Stay tuned

Even Nostradamus would have a difficult time predicting the full effects of the CTA on the M&A and RWI landscape; however, we will continue to monitor the evolving regulatory landscape of the CTA and the evolving impact on carriers.