June 18, 2009
Senate Homeland Security & Governmental Affairs Committee
"Examining State Business Incorporation Practices:  A Discussion of S. 569, The Incorporation Transparency & Law Enforcement Assistance Act"

Testimony of Hon. Elaine Marshall, NC - Co-Chair, NASS Company Formation Task Force

Chairman Lieberman, Ranking Member Collins, and Members of the Committee, on behalf of my colleagues at the National Association of Secretaries of State (NASS), I would like to extend our appreciation for your invitation to participate in this hearing.  I am wearing two hats today; one as North Carolina Secretary of State, a job I have proudly held since 1997, and the other as the Co-Chair of the Company Formation Task Force formed by the National Association of Secretaries of State (NASS) in February 2007.

 As Co-Chair of the NASS Company Formation Task Force, I oversaw the drafting and release of the body’s report and recommendations, which were adopted by the full membership in July 2007 and reaffirmed in July 2008.  I also helped to introduce a resolution to oppose the first iteration of the bill we are here today to discuss, S. 2956:  “The Incorporation Transparency and Law Enforcement Assistance Act,” a resolution which was unanimously supported by my peers and adopted by NASS in July 2008.

As such, I remain opposed to the enactment S.569 because of the additional record keeping requirements it will place on states and the uncertainty of the costs associated with implementing such broad changes.  In making the case against this bill, I would like to discuss the mechanics of business formation and record keeping at the state level and highlight how the passage of S.569 will negatively alter those processes.  I will also explain why the NASS approach is more prudent and less expensive.  To the extent that much of the information sought by law enforcement already resides with financial institutions and in IRS files, we respectfully suggest that Congress redirect its attention to requiring those institutions to share it, instead of having state agencies collect it.

First, a bit of background on how NASS became involved in this issue.  Along with many of my colleagues, I became aware that several federal agencies were examining the issue of ownership information collection by state governments at the beginning of 2006, just before the U.S. Government Accountability Office (GAO) released its April 2006 report on this topic.[i]  As you may know, GAO concluded that the laws of incorporation in most states allow company owners varying degrees of anonymity and privacy, which led some in Washington to wonder if the process was being used by criminals hoping to elude detection by authorities.  Just prior to the release of the GAO report, a separate report from the U.S. Treasury and other agencies raised related concerns about limited beneficial ownership information.[ii] 

In November 2006, Senator Levin (D-MI) chaired a hearing in the Permanent Subcommittee on Investigations and heard testimony from the federal agencies responsible for these reports, as well as the state corporate division directors from Massachusetts, Delaware, and Nevada.  At the conclusion of the hearing, Senator Levin announced that he was not satisfied with the efforts of the states to collect ownership information, warning that more aggressive state action was needed to improve what he saw as inadequate practices.

In early 2007, I sent a letter to Senator Levin on behalf of NASS asking that he hold off on introducing federal legislation until our association had an opportunity to convene a Task Force to review the issue and develop meaningful recommendations for federal and state consideration.[iii]  In February 2007, Nebraska Secretary of State John Gale and I agreed to serve as Co-Chairs of the NASS Company Formation Task Force, along with other members, including Secretaries from Georgia, Indiana, Minnesota, Nevada, New York, and Wyoming.  Senior corporations division staff from Delaware, Massachusetts, and Maine also agreed to participate. 

In July 2007, members approved the NASS Company Formation Task Force Report and Recommendations,[iv] which include the following:

• A ban of bearer shares and interests in bearer form, a practice that was for all intents and purposes prohibited by state case law, but not clearly outlined in state statutes.[v]
  
  
• A requirement that entities file a periodic report that includes the name and address of a natural person in the U.S. who has responsibility for providing access to the list of owners of record for a business entity.  That name would be part of the public record and, therefore, available to law enforcement without a subpoena.[vi] 

These basic recommendations have served as the basis for drafting the Uniform Law Enforcement Access to Entity Information Act, which is scheduled for a final vote before the Uniform Law Commission in July 2009.  You will hear more details about this body and its draft language from Harry Haynsworth, but it is important to note that we have worked with this group since they began their drafting in 2007.

 

In May 2008, Senator Levin expressed his dissatisfaction with the NASS approach and introduced the Incorporation Transparency and Law Enforcement Assistance Act (S.2956).  He reintroduced this bill in March 2009 as S.569.  NASS and a number of other prominent organizations are currently on record in opposition to this bill, including:  the Uniform Law Commissioners, the American Bar Association (ABA), the National Conference of State Legislatures (NCSL), and the International Association of Commercial Administrators (IACA). 

 

During the past several years, this coalition has been working together to find appropriate state legislative and administrative answers that would:

1. Avoid the federalization of the company formation process, which has always been a state function.  Federal legislation will bring federal rulemaking and regulatory authority into an area that has traditionally been the jurisdiction of states;
   
   
2. Create a way for company ownership data to be held by private individuals designated by the entities, rather than the Secretary of State or other state agency;
   
   
3. Require that law enforcement agencies use subpoenas to inspect the ownership records rather than mandating that the Secretaries of State or state governments secure and provide them;
   
   
4. Avoid an immense, unfunded mandate requiring states to fund the hardware, software and staffing to collect, update, preserve and make accessible such data.  There would also be a substantial cost for public education efforts regarding the complete change to filing requirements;
   
   
5. Prevent the office of the Secretary of State from becoming a law enforcement agency if compelled to regularly cross-check the entity ownership data against the Office of Foreign Asset Control’s Specially Designated Nationals (SDN) List and report any suspicious matches.  States are concerned that if required to collect and maintain beneficial ownership information, they will ultimately be required to verify the information and cross-check it all with the SDN List.  This issue is especially important because while verification and cross-checking are not required in S.569, Senators Levin and Grassley, as co-sponsors, have said that states should verify the ownership information and run the information against the SDN List.  

Here are some additional reasons why the NASS approach is more desirable:

 

The NASS recommendations strike an appropriate balance by supporting the goals of law enforcement without unnecessarily restructuring state governments or negatively impacting the business community.  In its 2006 report on ownership information laws for corporations, GAO concluded that, “if a requirement to collect company ownership is considered, it would be useful for policymakers to consider options that balance the conflicting concerns among states, agents and law enforcement agencies.”[vii] 

 

With nearly two million corporations and limited liability companies (LLCs) currently being formed within the United States each year, the NASS approach does not place an enormous unfunded mandate on state governments.  Redirecting state agencies away from their current, ministerial role to one of collecting and processing ownership information will be an extremely costly venture. 

 

As part of cost comparison research that is currently being conducted by NASS, initial state responses indicate that the costs associated with implementing S.569 are generally higher than the costs associated with the state uniform law approach being drafted by the Uniform Law Commissioners; and in some cases, substantially higher.  For even the most technologically advanced states, maintaining beneficial ownership in a database will require the development and design of a new system.  In some cases, this move will involve multiple state agencies (i.e. Secretary of State and Department of Licensing.)  It will also require the states to conduct extensive, comprehensive and costly public education campaigns to ensure compliance.

 

Furthermore, there is concern regarding the competitive grant program in S.569 that is supposed to provide funding for states to carry out the mandates of the federal law.  We believe this funding is already overcommitted with original requirements to support state and local homeland security efforts. Much of the funding is also required, by law, to go straight to local government for first responders.  Therefore, it is unlikely that the Secretary of State's office would ever see any of this funding.

 

Finally, states have spent tens of millions of dollars in recent years improving their online transactions in order to make state government more responsive to the needs of citizens and business communities.  Transactions that used to take substantial time are now conducted swiftly and efficiently with Internet-based, online technologies.  We are concerned that S.569 will turn back the clock and undo such state progress and technological investments.  States need to meet the needs of the American legal and business community to facilitate important and legitimate commercial transactions worth trillions of dollars.

 

Additionally, the NASS approach does not overburden small businesses, many of whom are struggling economically right now.  In crafting its recommendations, one of the major goals of the NASS Company Formation Task Force was to avoid any increased financial or filing burdens on small businesses, particularly “mom and pop” or family-owned businesses.  These entities are easily identified by bankers and chambers of commerce as legitimate, small business enterprises.  NASS also recognizes the millions of entities that consist of owners who are licensed by the states to perform specialized services, such as doctors, lawyers, accountants, engineers and realtors.  Since these professionals are already vetted under state law and must have their licenses renewed on a regular basis, we believe it is important to avoid adding to their document filing duties and related costs.

 

It is also important that any changes in law remain simple and straightforward so as not to result in unintentional non-compliance.  Definitions used for “beneficial owner” in S.569 assume that whoever controls the funds of the entity also controls the management.  This is not necessarily the case and confusion about definitions could lead to problems for small businesses.  Definitional clarity/consensus is an issue that is specifically acknowledged by the Financial Action Task Force (FATF) in its 2005-2006 report entitled, “Annual Review of Non-Cooperative Countries and Territories.”[viii]  The FATF report states,

 

….the exercise was a useful tool for FATF members to identify several

areas where there were differences of interpretation within the FATF

regarding certain FATF NCCT criteria (“horizontal issues”), for

instance:…difficulties in establishing beneficial ownership with regards

to legal entities, including bearer shares and trusts.  The FATF decided

that no reviewed jurisdiction would be listed based on these issues.[ix]

 

Unlike S.569, the NASS Company Formation Task Force recommendations also support the protection of privacy for investors and family members and would not make their personal business matters a part of the public record.  While S.569 does leave it up to each state as to how it would handle the public nature of the additional information that must be collected, that simply means the state would be forced to establish and maintain costly redaction and parallel systems - one public and one protected.  We hope that representatives from the small business community, venture capitalists, and other business-related entities will be asked to discuss the impact that S.569 would have on them and that they will be involved in any deliberations on this legislation.  It does not appear that any are here today to testify.

 

In summary, the NASS approach and the work of individual states reflects significant progress in addressing the Financial Action Task Force (FATF) Recommendations.  To date, only one nation in the world – Italy – is in compliance with their recommendation on the collection of beneficial ownership information.[x]  In its mutual evaluation of the United States in June 2006, FATF notes of its Recommendation 33 on beneficial ownership,

 

While the investigative powers are generally sound and widely used, there

are no measures in place to ensure that there is adequate and timely infor-

mation on the beneficial ownership and control of legal persons that can

be obtained or accessed in a timely fashion by competent authorities. 

There are no measures taken by those jurisdictions which permit the

issuance of bearer shares to ensure that bearer shares are not misused for

money laundering.[xi] 

 

The official FATF recommendation for corrective measures on Recommendation 33 was to,

 

Undertake a comprehensive review to determine ways in which ad-

equate and accurate information on beneficial ownership information

may be available on a timely basis to law enforcement authorities for

companies which do not offer securities to the public or whose securities

are not listed on a recognized U.S. stock exchange. It is important that

this information be available across all states as uniformly as possible.[xii] 

 

That is exactly what the NASS Task Force and collaborating organizations have done by proposing an alternative approach to S.569. 

 

In the meantime, the states that have been scrutinized in those early federal government reports have moved forward to strengthen their processes and to address real or perceived loopholes in the law.  For example, Nevada, which was featured during the subcommittee hearing in 2006, passed legislation in July 2007 that requires any non-publicly traded corporation to maintain a list of its owners of record at a registered office or principle place of business in the state.[xiii] The entity must also file the name and contact information of the custodian of the list of owners with the Secretary of State’s office.  Any change to the list of owners must be updated within 10 days.  Upon the request of any law enforcement agency in the course of a criminal investigation, the Secretary of State can require the corporation to provide a copy of the list of owners within three business days.  Failure to do so could result in suspension or revocation of the entity’s charter.  For an LLC, the same requirements apply, however the list that is required is of managers and members.

 

Wyoming and Delaware have also passed significant legislation since the release of the multi-agency, federal government reports in 2006.  The NASS Web site offers summaries of business formation laws and filing requirements if you would like additional information.[xiv] 

 

In my home state of North Carolina, S.569 would be a significant burden, and we are a state recognized for innovation with technology and maintain an in-house programming staff, who report to me. Other states will experience an even larger burden if they are not as well developed electronically or have to depend upon outside vendors or other state agencies to perform and manage their computer programming work. Our experience with technology has been achieving a high level of customer satisfaction as well as internal efficiencies for filing and cash management functions. We would be very reluctant to consider any rollback on technology with regard to managing the workload in North Carolina.

 

North Carolina currently has 548,000 entities within our databases, and all filings are examined before filing to prevent our databases from population by legally deficient entities.  North Carolina does not permit online creation filings, but does accept Annual Reports online.  We have robust online filing abilities in other subject matter areas, including electronic notarization with a well-developed law, national e-notary standards, and a few authorized e-notary vendors.  More than 100 individual notarized lobbying reports were filed online for the first quarter of 2009.

 

To assess the costs to the states under S.569 is almost impossible. Without administrative rules, calculating the cost is an inaccurate undertaking.  What the bill states versus what we think it means – or will mean – in order to be effective are quite different. For example, adding additional fields to forms is not very hard, establishing a new searchable database is not overly difficult if you have prior experience in the activity, and committing the business logic rules to text is the tedious “finishing up” activity that requires discipline. All are doable when looking to the future.

 

My colleagues and I have a serious concern regarding certain provisions of S.569 in that there will be a huge burden on both the entity as well as the filing agent at the time of creation. No corporation or LLC has any members or owners of any description at the moment the filing is made.  It is only after that filing has been made that ownership interest or other stakeholders can be determined.  Therefore, the filing process will be a two-fold filing function rather than a one-time event. Please note that almost every state has an expedited filing process to meet the legitimate needs of the business community, as requested by the business Bar of each state.

 

In 2008, 58,000 new entities were created in North Carolina.  The unknown, but expected, requirement for this bill to be meaningful is the application to existing business entities.  If proposed Sec. 2009 (a)(1)(B) requires all existing entities to provide beneficial ownership information on an annual basis (not just those businesses created after the effective date), then entirely new processing and educational programs will have to be crafted.  Everyone will need to provide citizenship or status information.  Screening by physical addresses will be inadequate.  Responsibility is placed on formation agents, but the bill is silent as to the responsibility for those entities created without a formation agent, estimated to be sixty percent of North Carolina's filings.  An educational undertaking to all new entities, approximately 58,000 per year, is of one cost.  If all 548,000 entities of record must be informed, the cost is much greater.  Theoretically, we have annual contact with 450,000 entities; however, for the 94,000 North Carolina nonprofits that have no current annual report filing requirement, the challenge will be extremely difficult.

 

If existing entities (548,000) will be made to comply, several staff members will need to be added or redirected from existing workloads to assist filers to understand the changes and to begin the dissolution process for noncompliance. Without additional staff, either current processing becomes delayed for all or backlogs build up for certain other equally valuable functions.  Additional personnel costs are hard to determine without addressing concerns expressed by my colleagues as to the application and interpretation of S.569.  Attempting an evaluation based on most responsibility falling on the state, I estimate a minimum fifty percent staff increase in the customer service and back office functions of North Carolina’s corporations division.

 

If there is no requirement for existing entities to comply, costs for North Carolina would be under $100,000 to create new forms, a new confidential database, and the associated business rules and search abilities.  If S.569 is applied to the existing 548,000 active North Carolina business entities of record, costs seriously escalate.  A single mailing (letter size, folded with three sides perforated, mailed at bulk rate) by a competitive bid will cost approximately slightly under $390,000. A re-mailing of a fifteen percent default group would be almost $58,000.  Storage of paper filings and archiving become costs estimated at $150,000 per year, as retention schedules are met.  As online filings become more common, storage and archiving costs become lower but equipment replacement expenses escalate.

 

The huge volume of materials S.569 will generate over just a few years needs to be considered.  On its face, Annual Report numbers will not increase, but Annual Reports are public in most states.  If they contain confidential beneficial ownership information in order to keep current, redaction will need to occur or separate filing systems will need to be maintained, possibly increasing the image load exponentially.  North Carolina is currently “burning out” two of our sixteen servers a year as we find ourselves in a constant backup mode with the 20 million images we currently maintain (not all of these are business entity items).

 

I can predict two significant factors that will occur in North Carolina if nonprofits are made to file Annual Reports. First, general confusion will be the norm as nonprofits seldom have “owners” of any definition; second, resistance and pushback will be huge as church folks especially consider reporting to the state highly objectionable (North Carolina knows this from trying to implement nonprofit Annual Reports in the early 1990’s); and the Secretary of State’s Office will spend vast amounts of resources dissolving and reinstating nonprofits, as well as others, for years.  I can’t begin to describe the ongoing societal nightmare and administrative difficulties this will create.

 

Secretaries of State around the country are very concerned that the term “beneficial ownership” is not well-established in American jurisprudence and that it will fall upon us to interpret what that means.  It is also of concern that the law would apply to formation agents but does not specify who would be responsible in the case that a formation agent is not used.

 

Filing offices have no desire to be the default keeper and verifier of the identity of the non-U.S. citizen benificial owners.  We are also concerned that verification of such information may ultimately fall on the filing entity, which would create a larger than imaginable problem for us.  Also of concern is that states will be required to compare the list of entities in their databases with the Suspicious Designated National list, unless Secretaries of State or other state filing agencies are exempted from that part of the federal law.

 

We have a history of cooperation with all law enforcement in North Carolina, and as I now begin my thirteenth year as Secretary of State, we have never had a request from a law enforcement agency that we could not fulfill.

 

If you sense resistance from my colleagues, you are correct.  We understand the concern with money laundering – we all want it discovered and stopped, and we all want to assist law enforcement.  But we do feel these efforts are going to be of limited effectiveness compared to other possible avenues of recourse, such as through other government agencies or adding safeguards to the multiple money pathways existing today.

 

Because of the foregoing, the NASS Company Formation Task Force has been working with the drafting committee of the Uniform Law Commission during the past year and a half to craft an alternative that will provide a pathway to find the information that the Senate seeks, without placing the burden on the state administrative filing office.

 

Given the lack of a clear belief in the efficacy of this plan, additional functions will be necessary.  Verification will be needed by someone, cross checking with other lists will be needed, concern that updating will be inconsistent (annual to some, as needed with others), and difficulty with definitions are a few of these layers.  Fearing those future costly requirements, NASS requested ULC to propose a uniform law with an expectation that it could provide meaningful assistance to law enforcement with a minimum burden on the large number of legitimate small businesses that populate our databases and provide the economic engines of our states.

 

S.569 (previously S.2956) has already had a serious beneficial effect and has achieved results. Highlighted states have closed perceived gaps in the law.  We have put considerable intellectual effort into an alternative workable process that I believe is doable for states to enact.  NASS has not taken an official position on the ULC Uniform Act proposal because ULC has not finished its processing, though it will finish by mid-July. Shortly thereafter, NASS will hold its annual summer meeting.  I will honestly tell you I have concerns about the NASS meeting due to state budget travel restrictions, including North Carolina’s, but I will be there.

 

Whether or not beneficial ownership information is public or confidential is of concern. Since beneficial ownership under S.569 is to be provided upon specific legal process, it is deduced the information shall be confidential.  Some states have strong open records laws and constitutional provisions that will be problematic.  I would intend to have an additional database developed in North Carolina and declared an exception to North Carolina’s public records law to avoid all the inquiries and complaints regarding marketing mailings, family law litigants seeking corporate information, debt collectors, the just plain nosey, and more.  If the Suspected Designated National law applies to us, verification of names would be a huge challenge of unknown cost. Public education costs could be expensive.

 

We all must remember that either of these proposals represents a cultural change – not just for the filing offices who view their function as simply ministerial, but a cultural change for everyone engaged in business of most types in the United States of America.  Sadly, ground zero for the fallout to these cultural changes will be each state’s filing office, and we are gravely concerned. Viewing the financial and human asset commitment contrasted with the efficacy of the proposal, it is hard to find significant added value and meaningfulness.

 

In closing, NASS members are wary of any federal law that burdens states and legitimate businesses yet provides lawbreakers with the ability to evade it.  The obvious argument is that the extremely small number of entities that are registered to do business that may be engaged in money laundering, terrorist financing and tax evasions are probably not going to file accurate or truthful information to state government.  Therefore for the overwhelming number of legitimate, law abiding businesses, trying to stay afloat in these difficult times, we think the NASS approach is a more reasonable, simple and unobtrusive solution which would allow small business owners to comply without having to hire a legal team to decipher filing requirements.

 

My colleagues and I are thankful for the opportunity to testify today and for the opportunity to submit additional written testimony for the record.  I am including the NASS Company Formation Task Force Report and Recommendations, along with the association’s July 2008 resolution to pursue our alternative approach to S.569.[xv]