Corporate Transparency Act Deemed Unconstitutional
Lauren Brooks March 7, 2024 A district court’s recent ruling complicates the future of the Corporate Transparency Act. How will this impact reporting companies?
Introduction to Regulation A Offerings
Regulation A, often referred to as “Reg A,” provides an exemption from the registration requirements pursuant to the Securities Act of 1933 for issuers seeking to sell securities to the public. Opting for a Reg A offering allows an issuer to raise funds from the public without incurring the heightened expense and liability associated with the registration process of a full-blown public offering. In 2015, the Securities and Exchange Commission (SEC) introduced final rules to establish two tiers under Reg A—Tier 1 and Tier 2. While both tiers share some similarities, variations exist in their reporting obligations and offering limits.
Reg A Tier Comparison: Tier 1 vs Tier 2
Both Tier 1 and Tier 2 offerings require the submission of an offering statement, consisting of Form 1-A and supplemental information, to the Securities and Exchange Commission (SEC). Following the submission, Tier 1 and Tier 2 issuers must await qualification by the SEC before commencing sales in the offering.
Under Tier 1, issuers can raise a maximum of $20 million in a twelve-month period without the requirement for ongoing reporting from non-accredited and accredited investors. Issuers do not have ongoing reporting requirements but must submit a report on the final status of the offering to the SEC. Testing the waters is permissible either before or after filing the offering statement subject to state securities laws. One advantage of a Tier 1 offering over a Tier 2 offering is that Tier 1 financials do not need to be audited.
Securities sold under a Tier 1 offering are not considered Covered Securities, which means that issuers must still comply with each state securities commission by registering or qualifying the offering prior to selling. This process requires coordinated review and approval from each state.
Under Tier 2, issuers can raise a maximum of $75 million within a twelve-month period from non-accredited and accredited investors, but they are obligated to meet periodic reporting requirements. These include submitting annual reports, semi-annual reports, amendments to address changes in circumstances, and a report on the final status of the offering. Testing the waters is permissible either before or after filing the offering statement subject to state securities laws.
Securities sold under a Tier 2 offering are considered Covered Securities. As such, Tier 2 offerings are preempted from state review and qualification.
Despite the increased reporting requirements associated with a Tier 2 offering compared to a Tier 1 offering, Tier 2 accounted for 70% of Regulation A offerings from 2015 to 2019.
Regulation A, Tier 2 Issuer Eligibility
Any company formed in the United States or Canada is eligible to seek exemption under Regulation A, Tier 2, with the additional requirement that its principal place of business must be in the US or Canada.
Additional scenarios that would disqualify an issuer include:
- Investment companies required to register under the Investment Company Act of 1940, or a business development company defined in Section 2(a)(48).
- A blank check company
- An issuer disqualified under SEC “bad actor” qualification rules
Limitations exist on what kinds of securities can be offered under Reg A. For example, an issuer cannot issue fractional undivided interests in oil or gas rights, or similar interest in other mineral rights. They also cannot issue asset-backed securities as defined in Item 1101(c) of Regulation AB.
Regulation A, Tier 2 Federal Compliance Requirements
Form 1-A
Issuers undertaking a Regulation A offering are obligated to submit Form 1-A to the SEC, consisting of three parts: Part I (Notification), Part II (Information Required in an Offering Circular), and Part III (Exhibits).
Part I consists of general information about the issuer, the issuer’s eligibility, and general information about the offering, such as the type of securities being offered and the anticipated fees associated with the offering.
Part II outlines the information required in the offering circular. The offering circular is where the issuer furnishes comprehensive information about their offering for potential investors, including general information about the issuer and the offering, as well as risk factors for the investment, dilution, plan of distribution, financial information, management, and more. The structure of the offering circular is regulated to promote consistency and honesty. Once approved by the SEC, the offering circular must be provided to all potential investors participating in the Regulation A, Tier 2 offering.
Part III contains exhibits to provide further context or evidence to support the information shared in prior parts of Form 1-A. For example, an issuer should attach any voting agreements that impact the rights of the securities holders as an exhibit.
Form 1-A must be completed at least 21 days prior to the SEC’s qualification of the offering statement.
For further information, see the SEC’s guidance for completing Form 1-A.
A 'No Objection Letter'
The sale of Reg A securities cannot commence until the Financial Industry Regulatory Authority (FINRA) provides the issuer with a ‘No Objection Letter’. The ‘No Objection Letter’ indicates that FINRA has completed its review of the offering.
FINRA’s review consists of two rounds which take approximately 10 to 25 business days in total. After the review, FINRA will return one of three letters: a ‘No Objection Letter’, a ‘Defer Letter’, or an ‘Unreasonable Letter’. A ‘No Objection Letter’ signifies that the offering review is complete, and the issuer can proceed based off the information submitted. ‘A Defer Letter’ is granted if FINRA has concerns or questions and needs further documentation. An ‘Unreasonable Letter’ is given if FINRA deems that the terms of the offering do not comply with corporate financing rules.
Qualification
Once initial requirements are fulfilled, the SEC will provide a notice of qualification and the issuer will choose their qualification date. Issuers must wait until the SEC’s approved qualification date to begin official sales of the offering. The qualification date is reported in state securities filings.
Testing the Waters
Although the sale of Reg A securities cannot commence until FINRA provides the issuer with a ‘No Objection Letter’ and the SEC qualifies the offering, there is a process known as “Testing the Waters” in which the issuer can lawfully gauge investor interest prior to qualification. By testing the waters, issuers are permitted to solicit interest in a potential offering from the general public, even before the filing of the offering statement.
Ongoing Compliance
Adherence to federal securities laws extends beyond the initial requirements. Issuers must satisfy ongoing reporting requirements. The following reports are the most common forms of maintaining ongoing compliance. This list is not all-inclusive and issuers should do thorough investigation into additional reporting requirements for their specific circumstances.
1-K Annual Report
Issuers of Reg A, Tier 2 offerings are required to submit electronic annual reports through EDGAR within 120 days of the issuer’s fiscal year end. Through the 1-K, the issuer discloses business operations from the past 3 years (or, if established less for than 3 years, since inception) and provides updates to information submitted in Part I of Form 1-A.
1-SA Semiannual Report
Tier 2 issuers must electronically file Form 1-SA within 90 calendar days of the end of the first 6 months of the issuer’s fiscal year. In this report, the issuer discloses interim financial statements.
1-U Current Report
Reg A, Tier 2 issuers must submit 1-U reports within four business days of significant events.
Significant events include:
- Fundamental changes
- Bankruptcy or receivership
- Material modification to the rights of securityholders
- Changes in the issuer’s certifying accountant
- Non-reliance on previous financial statements or a related audited report or completed interim review
- Departure of the principal executive officer, principal financial officer, or principal accounting officer
- Unregistered sales of 10% or more of outstanding equity securities
1-Z Exit Report
The 1-Z is an exit report that is mandatory for all issuers involved in Tier 1 offerings, and it must be submitted within 30 calendar days following the conclusion of their Regulation A offering. Tier 2 issuers are only required to disclose termination of the offering if it was not disclosed previously in a 1-K annual report.
Regulation A, Tier 2 State Compliance Requirements
Introduction to Blue Sky Compliance
Blue sky laws are state regulations designed to prevent securities fraud. The term originates from the depiction of the unregulated securities industry as speculative, where offerings were deemed to have “no more basis than so many feet of blue sky.” Blue sky laws vary based on the state where the offering is sold.
Under Regulation A, Tier 1, the securities sold are not deemed Covered Securities. As such, issuers must still comply with each state securities regulations by either registering or qualifying the offering prior to selling. This process requires coordinated review and approval from each state.
Under Regulation A, Tier 2, the securities sold are deemed Covered Securities. As such, states are preempted from requiring registration or qualification of offerings. However, states can, and often do, mandate notice filings.
In-Depth Blue Sky Compliance Resource
Understand more about state Blue Sky compliance for Reg A, Tier 2 offerings by downloading our resource, The Path to Blue Sky Compliance.
Understand more about state Blue Sky compliance for Reg A, Tier 2 offerings by downloading our resource, The Path to Blue Sky Compliance.
Reg A, Tier 2 Notice Filings
Submission of notice filings is the most common state compliance requirement for Reg A, Tier 2 offerings. A majority of states require notice filings, with only 12 states not mandating notice. Although the filing itself is similar between the states, variations exist in the timing, filing fee amount, issuer-dealer requirements, and method of filing from state to state.
For example, state filing fees could be a flat fee or variable based on the offering’s sales. The map below demonstrates the wide range in fees between the states, from $0 to $1,000+.
Ongoing Compliance
Adherence to state blue sky laws extends beyond the submission of initial notice filings. States often mandate annual renewal filings. In most states, the renewal is due one year from the date of the initial notice delivery to that state. However, Illinois requires a renewal filing one year from the qualification date. These nuances, while seemingly small, can affect whether an issuer complies with state securities laws.
In addition to meeting annual Reg A, Tier 2 renewal obligations, issuers must monitor their sales in each state to prevent “over selling.” This is crucial in states with variable fees, as these fees are contingent on the sales figures declared in the initial filing. If an issuer surpasses the sales initially reported in a specific state, they are required to amend their filing to reflect the updated projected sales amount.
Take for example Texas, where the filing fee for a state notice is 1/10 of 1% of an offering. When submitting an initial notice filing, an issuer could denote that they anticipate selling up to $75,000,000 in Texas, but that would land them with a $75,000 filing fee. This leads many issuers to try to provide a closer estimate of the amount they anticipate selling in Texas. If the issuer instead denotes that they anticipate selling $2,000,000 in Texas, they will have a $2,000 filing fee. However, if the offering goes well and it looks like there are investments totaling $3,000,000 in Texas, the issuer must amend their initial filing and pay an additional fee to avoid an over sale.
Navigating Compliance
While there is a lot of guidance available through the SEC, the nuances of compliance with federal and state securities laws are difficult for any issuer to navigate. Looking for assistance with launching and managing the compliance of your Regulation A, Tier 2 offering? Don’t hesitate to reach out to our team for assistance.
The Corporate Transparency Act (CTA), a United States federal anti-money laundering law, was enacted January 1, 2021, and came into effect on January 1, 2024. The CTA requires non-exempt reporting companies to report information about the reporting company and its beneficial owners to the Financial Crimes Enforcement Network (FinCEN). For a comprehensive overview of CTA compliance requirements, read our article.
On March 1, 2024, the U.S. District Court in the Northeastern District of Alabama ruled that the Corporate Transparency Act was unconstitutional (National Small Business United et al. v. Yellen et al.). The Court ultimately determined that the U.S. Constitution does not grant the government the authority to regulate entities as outlined in the law. This ruling complicates the path forward for many entities that have already begun to file or seek legal counsel.
Case Details
In defense of the Act, the Government contended that the CTA fell within the purview of several congressional powers, including the regulation of commerce, oversight of foreign affairs and national security, as well as the imposition of taxes and regulations. However, after an examination of each of these arguments, the Court determined that none provided a valid basis for the law’s enforcement.
Ultimately, the Court ruled that the CTA exceeded the constitutional boundaries of the legislative branch and that Congress failed to demonstrate a sufficient connection to any enumerated power to justify the CTA’s implementation as a necessary or proper means of achieving Congress’s policy objectives.
I. Foreign Affairs and National Security
The court began by examining whether constitutional authority for the CTA was within the well-known authority of Congress to regulate matters of foreign policy and national security. The Government argued that collecting beneficial ownership information is necessary to protect vital United States national security interests. However, the Court found that incorporation is an internal, rather than foreign affair, and that it has long been committed to state, and not federal regulation.
As such, the Court asked whether Congress’ Foreign Affairs powers justify the CTA’s regulation of “creatures of state law,” which are ordinarily within the purview of the States. The Court found that the answer was no because the CTA would convert traditionally local conduct into a matter for federal enforcement, which would substantially extend federal policing.
II. Commerce Clause
The Court then examined whether the constitutional authority for the CTA laid within congress’ authority to regulate interstate and foreign commerce. The court reiterated the three categories of activity that Congress may regulate under the commerce clause: 1) interstate commerce channels, 2) instrumentalities involved in interstate commerce, and 3) activities significantly impacting interstate commerce. The Court concluded that mandating the reporting of beneficial ownership information by most companies, not solely those engaged in commerce, did not fall within any of the categories.
The Court determined that the CTA exceeds the authority granted under the commerce clause because it regulates non-economic and non-commercial activity. This is because the CTA mandates the reporting of beneficial ownership information by most companies, including for example those that solely incorporated without engaging in further economic activities.
Additionally, the Court invoked a textualist argument, highlighting the absence of the word “commerce” or any reference to channels or instrumentalities of commerce within the CTA. The Court pointed out that Congress could have readily included such references if it had intended to, as it has done in numerous other legislations.
Lastly, the Court asserts that the CTA is “far from essential” in achieving Congress’ legitimate objective of reducing money laundering and terrorist financing, as evidenced by other constitutional efforts aimed at combating illicit activities.
III. Taxing Power
The Government contended that the collection of beneficial ownership information, coupled with its transmission to the Treasury Department, is necessary and proper to guarantee the accurate reporting of taxable income. However, the Court determined that, although the connection between disclosure provisions and the taxing authority is widely acknowledged (as evidenced in scenarios like an income tax return), the mere provision of access to the CTA’s database for tax administration purposes does not establish a close enough relationship in this instance. If that were the case, the Court said, “the Necessary and Proper Clause would sanction any law that provided for the collection of information useful for tax administration and provided tax officials with access” which would be a substantial expansion of federal authority.
What Does This Mean for U.S. Reporting Companies?
FinCEN released a notice on March 4th announcing that it is complying with the court’s order and will continue to do so for as long as it remains in effect. However, FinCEN’s statement implies that reporting companies not involved in the case are expected to follow through with their reporting obligations.
“As a result, the government is not currently enforcing the Corporate Transparency Act against the plaintiffs in that action: Isaac Winkles, reporting companies for which Isaac Winkles is the beneficial owner or applicant, the National Small Business Association, and members of the National Small Business Association (as of March 1, 2024). Those individuals and entities are not required to report beneficial ownership information to FinCEN at this time.”
In the long term, likely after a series of appeals, the constitutionality of the CTA will be determined. If deemed unconstitutional, the filings will not be required. If deemed constitutional, the filings will be required. It’s also important to note that if the Corporate Transparency Act is ultimately ruled by higher courts as unconstitutional, similar anti-money laundering and anti-fraud rules could develop to address present concerns.
Considering the uncertainty surrounding the constitutionality of the CTA and the significant consequences of non-compliance, it is advisable to encourage clients to fulfill the filing requirements stipulated by the CTA. Nevertheless, it’s important to acknowledge the potential scenario where compliance may not be essential in the end. Ultimately, individual companies must assess their own risk tolerance levels in making the decision to comply with the CTA at this time.
