A guide to business entity compliance and governance

Every business entity, regardless of its organizational form, its size, who owns it, what business it is in, or how successful it is, is subject to at least some compliance requirements. Some business entities are subject to a great many compliance requirements.

The topic of compliance has been heavily talked about, debated, and regulated since the financial disclosure scandals of the early 2000s. The same can be said of the related topic of business entity governance. These two topics – business entity compliance and business entity governance – are the subjects of this article.

A comprehensive discussion of compliance and governance is beyond the scope of this article. Instead, we will look at just a few aspects of these topics. The compliance section will look at some of the many requirements facing corporations and LLCs, focusing mainly on those imposed by state corporation and LLC statutes and to a lesser extent other state laws with filing or reporting requirements. It also looks at the reporting requirement imposed by the federal Corporate Transparency Act. The governance section examines the roles played in ensuring compliance by corporate directors, officers, and shareholders, and by LLC members and managers.

In discussing these topics, references will be made to provisions found in most state laws. However, no two-state business entity statutes are exactly the same. Therefore, before taking any actions related to compliance or governance it is necessary to research and follow the requirements of the specific governing laws.

C. Compliance requirements regarding internal governance

Corporations and LLCs also have to comply with requirements regarding how the entity is governed. These requirements may be imposed by the governing statute or the internal documents.

Corporations are subject to more of these statutory requirements than LLCs. LLCs tend to have to deal with more self-imposed compliance requirements than corporations. Below are some of these requirements.

1. Record-keeping and mandatory inspection

Domestic corporations and LLCs are generally required by their governing statutes to maintain certain books and records. While there are differences from state to state, statutorily mandated records generally include (1) organizational documents such as a corporation’s articles of incorporation and bylaws and an LLC’s articles of organization and operating agreement; (2) a list of corporate shareholders and LLC members; and (3) copies of recently filed tax returns, annual reports, or financial statements.

Most of the statutes require the corporation or LLC to allow shareholders and members to inspect the maintained documents. Upon a failure to comply the shareholder or LLC can go to court, and if the court grants the inspection, the corporation or LLC may have to pay the shareholder’s or member’s costs.

2. Meeting requirements

The corporation statutes require an organizational meeting to be held after the articles of incorporation are filed, in order to complete the organization of the corporation. They also require board of directors’ meetings. The LLC statutes do not require the holding of organizational or manager meetings, although the members may require meetings to be held in their operating agreement.

In addition, every state corporation act requires a corporation to hold an annual shareholders’ meeting. A corporation is required to notify shareholders of the date, time, and place of each annual meeting. An annual meeting may be ordered by the court if the corporation fails to comply with this statutory requirement. LLCs are generally not required by statute to hold an annual meeting. However, an LLC may require meetings to be held and may impose record date, notice, quorum and other requirements in its operating agreement. The operating agreement may also impose penalties if the LLC fails to comply.

3. Indemnification

Most corporations and LLCs will pay the expenses and liabilities incurred by their managing officials who are sued for actions taken in their official capacity.

Every state corporation law provides for statutory indemnification. These provisions generally require a corporation to indemnify directors or officers who are wholly successful in defending themselves.

Many LLC laws also have a provision dealing with indemnification. Some have provisions similar to those found in the corporation acts. Others leave it up to the members to decide if they want indemnification and if so to provide for it in the operating agreement.

4. Dissenter’s rights

Every corporation statute provides shareholders with dissenter’s rights. This obligates the corporation to pay shareholders the fair value of their shares in the event of certain mergers, amendments, and other corporate actions that the dissenting shareholders oppose and that result in a fundamental change in their shares. There is also a statutory procedure that the corporation and shareholders must follow.

Some LLC acts address dissenter’s rights as well. However, even in the absence of a statutory provision the LLC can give this right to its members in its operating agreement and set forth the procedure for the LLC and members to follow.

5. Miscellaneous compliance requirements imposed by governing documents

There are a variety of compliance requirements that may be included in a corporation’s or LLC’s internal documents. For example, a corporation may provide that upon a merger preferred stock will be redeemed for a specific price. An LLC’s governing documents may require the LLC to make distributions to its members to cover their income taxes. A failure to comply can be considered a breach of contract.

D. Compliance requirements imposed on specific types of corporations or LLCs

Compliance provisions found in the state corporation and LLC acts generally apply to all corporations and LLCs formed or qualified under the act regardless of their purpose or activities. However, there are a number of compliance requirements that are imposed upon specific types of companies. Insurance companies, for example, may be required to file documents with the state insurance department. This may be in addition to, or instead of, the statutory filings required with the corporation department. A registered agent may be required, or the insurance company may have to appoint the insurance commissioner as its process agent and file a document providing a forwarding address where the commissioner can send process served on it on the insurance company’s behalf.

Benefit corporations are another example. A benefit corporation is a for-profit corporation that has, as one of its purposes, the creation of a material positive impact on society and the environment. Although a benefit corporation is incorporated in the same manner as any for-profit corporation it is subject to some special compliance requirements. For example, under many benefit corporation statutes, a benefit corporation must send each shareholder an annual benefit report, post its most recent benefit report on the public portion of its website, and deliver a copy of the benefit report to the Secretary of State.

E. Other state laws requiring compliance with filing or reporting obligations

There are many state statutes – other than the corporation and LLC acts – that impose compliance requirements and require the filing of documents with a state agency while imposing penalties for non-compliance. Below are a few examples.

1. Assumed name statutes

a. Requirement in general: When a corporation or LLC does business under an assumed name that means it is using a name other than the one set forth in its formation document (i.e., its true name). Most states have statutory provisions governing the use of assumed names. Some assumed name provisions are found in the state’s business entity statutes. Others are found in the state’s laws dealing with consumer protection or unfair trade practices. In general, these statutes require business entities doing business under an assumed name to make a public filing.

b. Filing procedures: The assumed name filing procedures vary by state. Most require the assumed name document to be filed with a state agency such as the Secretary of State. Others require filings to be made on the county level. There are also states that require a filing on both state and local levels.

c. Penalties for non-compliance: Most assumed name statutes impose monetary penalties on entities that do business under an assumed name without making the required filing. In addition, some assumed name statutes provide that a non-compliant business entity may not maintain a suit until it complies.

2. Other state statutes

a. Unclaimed property laws: Every state has an unclaimed property statute. Unclaimed property (also called abandoned property) is property that has been unclaimed by its owner for a statutorily set period of time called the dormancy period. Unclaimed property includes stocks, bonds, dividends, cash, uncashed checks, life insurance benefits, and other items. The statutes require business entities that are holders of unclaimed property to file a report with the appropriate state agency. In general, the report must be filed annually. The unclaimed property statutes provide for the assessment of interest and penalties for the failure to report and escheat unclaimed property to the state.

b. State securities (blue sky) laws - Every state has its own securities laws and rules. State securities laws are commonly known as “blue sky laws”. The blue sky laws require a security to be registered before it is offered or sold in a state, unless it is otherwise exempt. The registration of securities that are neither exempt nor federally covered is commonly made on a form entitled “Uniform Application to Register Securities” (Form U-1). The registration is accompanied by a “Uniform Consent to Service of Process” (Form U-2). The statutes also impose penalties for violations of the law.

F. Beneficial Ownership Information reporting under the Corporate Transparency Act

a. Requirement in general: All corporations and LLCs must file a beneficial ownership information (BOI) report with the Financial Crimes Enforcement Network (FinCEN) unless they qualify for an exemption.  Exempt entities include publicly traded corporations, financial institutions, insurance companies, public accounting firms, tax exempt entities, large operating companies, and inactive entities.

b. Content of report: A BOI report contains information about the corporation or LLC, its beneficial owners, and for corporations and LLCs created on or after January 1, 2024, its company applicant or applicants.

c. Filing procedure: BOI reports are filed electronically with FinCEN.  Updated reports must be filed within 30 days of a change in the information the corporation or LLC reported about the corporation or LLC or its beneficial owners.

d. Penalties for non-compliance – Civil and criminal penalties, including possible jail time, can be imposed for violations of the BOI reporting requirements.

Governance

A. What is corporate and LLC governance?

Governance, as that term is used in this white paper, refers to how a corporation or LLC is managed and controlled. More specifically it refers to the allocation of power and decision-making authority within each corporation and LLC, in particular, when it comes to compliance-related decisions and actions.

The typical governance structure for a corporation consists of (1) shareholders who own the corporation, (2) directors who select and oversee management, and (3) officers who run the day-to-day operations.

The typical governance structure for an LLC consists of either (1) members who own the LLC and run the day-to-day operations or (2) members who own the LLC and managers who run the day-to-day operations. Members may be both owners and managers.

Governance is regulated mainly by the state corporation and LLC statutes. Internal documents and case law also play a role.

B. The relationship between governance and compliance

Corporations and LLCs are artificial persons that act through real persons who hold certain positions and perform certain roles within the company.

In general, there will be one or more persons in each company responsible for establishing a procedure to ensure compliance with reporting, registered agent, and other requirements and for making sure that procedure is being followed. There will also be someone responsible for making compliance-related decisions – such as whether to qualify in a foreign state - and for taking the steps to comply – such as by filing a certificate of authority. There are also people in a position to prevent non-compliance or to seek compensation on the corporation’s or LLC’s behalf for the harm suffered due to non-compliance. Although it may differ from entity to entity, in general, these are the people holding the positions of corporate directors, officers, and shareholders, in-house counsel, and LLC managers and members.

C. Corporate directors

1. Director’s role in general

Every corporation statute provides that management of the business and affairs of a corporation is vested in a board of directors. The state laws do not regulate the composition of the board or require directors to have special qualifications.

Directors owe the corporation and its shareholders the fiduciary duties of loyalty and care. The duty of loyalty requires directors to place the corporation’s and shareholders’ interests above any personal interests. The duty of care requires directors to stay abreast of corporate issues and make informed decisions. Directors must also act in good faith.

The state corporation statutes allow the board of directors to delegate to officers, employees, or agents the authority to exercise powers and perform functions not required by law to be exercised or performed by the board of directors itself. And, in general, it is these officers, employees, or agents who are directly responsible for taking compliance-related actions such as implementing a process to ensure that Annual Reports are filed and for making decisions such as whether to qualify to do business in a foreign state.

2. Director’s role as compliance monitor

A director’s primary role when it comes to compliance is overseeing and monitoring the actions of those officers and others to whom they have delegated power and authority. Some state statutes provide that in the case of a public corporation, the board's oversight responsibilities include attention to policies and practices to foster the corporation's compliance with law and ethical conduct.

D. Corporate officers

1. Officer’s role in general

The state corporation laws allow corporations to designate any offices and officers they choose. The designation may be made in the bylaws or by the board of directors consistently with the bylaws. The functions of each officer are generally set forth in the bylaws.

Officers, like directors, owe fiduciary duties. These duties may be set forth in the statute or may be judicially created.

2. Officers and compliance

A corporation’s day-to-day business is typically run by officers - or employees and agents acting under the authority of officers. As a result, it is often officers who are directly responsible for whether a corporation complies with its legal obligations.

Because officers have a more direct responsibility for compliance than directors, officers also face a greater risk of personal liability in cases of non-compliance. Officers may face personal liability for their corporation’s non-compliance if the statute the corporation failed to comply with provides for personal liability. And even in the absence of a statute an officer can be held personally liable under common law theories such as the “responsible corporate officer doctrine”.

Under the responsible corporate officer doctrine, personal liability may be imposed if (1) the officer held a position of responsibility such that he or she could influence the corporation’s policies or activities, (2) the officer’s position was such that he or she could have influenced the corporation’s actions that constituted the statutory violation, and (3) the officer’s actions or failure to act facilitated the violations.

Under the Corporate Transparency Act, senior officers of a corporation or LLC that willfully fails to file a required BOI report may be held accountable for that failure.

E. Shareholders

1. Shareholder’s role in general

Shareholders are the owners of a corporation. And although ownership is usually accompanied by control, when it comes to owning a corporation this is not the case. In a corporation there is a separation of ownership from control. The basic model, particularly for public corporations, has (1) shareholders who are passive investors who provide capital for the purpose of profiting from the increase in value of their investment, and (2) managers who have expertise in the business who direct and control the corporation for the purpose of increasing its value.

2. Shareholders and compliance

Despite this separation of ownership from control, shareholders – even in public corporations – can influence or impact governance and compliance in a number of ways, including the following:

a. Voting for directors: Shareholders have the right to vote for the directors who select and oversee the officers who directly impact governance and compliance. Every corporation must have at least one class of shares with voting rights.

b. Attending annual meeting: Every corporation is required to hold an annual shareholders’ meeting. Although the main purpose is to elect directors, the meeting also serves as the shareholders’ opportunity to raise issues that concern them such as whether the corporation is complying with state and federal laws. At one time the annual meeting gave shareholders the opportunity to face the directors in person.  However, most states now allow corporations to hold their annual meeting solely by means of remote communication.

c. Proxy contests for control: In public corporations, most shareholders vote by proxy. Corporations send shareholders proxy materials which contain the names of their nominees for director and which recommend the shareholders vote for their nominees. Shareholders can also solicit proxies and ask the other shareholders to vote for their nominees instead of the corporation’s. This does not occur frequently because a proxy contest is very expensive. However, a successful proxy contest can result in replacing some, or all directors of a corporation that may have suffered harm due to non-compliance. And even an unsuccessful contest can bring to management’s attention the importance of ensuring compliance in order to maintain good relations with shareholders.

d. Shareholder proposals: The federal proxy rules allow some shareholder proposals to be included in the corporation’s proxy materials. In these proposals the shareholder can request that the corporation take a certain action.

e. Derivative suit: A derivative suit is a civil action brought by a shareholder on behalf of a corporation. It is one of the principal methods of challenging allegedly illegal actions or breaches of duty by management. Derivative suits are used frequently today in cases where a corporation is fined or penalized for non-compliance with legal requirements. In these suits the plaintiff shareholders will generally claim the defendant directors and officers breached their fiduciary duties and will seek compensation on the corporation’s behalf.

F. LLC members and managers

The hallmark of the LLC is flexibility. Governance is one of the areas in which this flexibility is most evident. An LLC can be governed like a corporation, with the members electing a board of managers or directors, who select officers. It can be governed by all the members with each one having an equal say. Between those two extremes are LLCs where some of the members govern while others are passive investors.

LLC statutes do not regulate governance to the degree that corporation laws do. Instead, the legislatures have left it to the members of each LLC to decide, in their operating agreement, how they will be governed and by whom.

a. Members in manager-managed LLCs: In LLCs that are governed with a corporate-like structure, the members’ main impact on compliance may be in their right to elect the managers. However, even this right is not as clear as in a corporation. The election of managers is not subject to the statutory rules imposed upon corporations. Instead, the members’ voting rights, and much of the mechanics of the election, will probably be set forth in the operating agreement.

Another way members in manager-managed LLCs may be able to impact governance and compliance is by bringing a derivative suit seeking damages on the LLC’s behalf after it has been penalized for non- compliance.

b. Members in member-managed LLCs and managers in manager-managed LLCs: Members in member-managed LLCs and managers in manager-managed LLCs typically have roles analogous to that of corporate officers. They make business decisions for the LLCs and carry out the decisions themselves or hire employees to do so.

c. Liability: One issue facing member-managers and managers who control the day-to-day operations of an LLC is whether they may be held liable for the penalties assessed against the LLC, due to its statutory non-compliance. It may be reasonable to assume they can be, if the statute so provides, or under common law theories such as the responsible officer doctrine.

Another possible source of liability is the operating agreement. The members may set forth, in the operating agreement, each managing member or manager’s responsibility for compliance-related activities. For example, a certain member may be named as being responsible for the filing of all Annual Reports with the state filing departments. The operating agreement can also specify the penalties imposed upon the member if the responsibility is not met.

Conclusion

Corporations and LLCs must comply with a variety of state statutes and rules, and with their own internal governing documents. These statutes, rules, and documents require the filing of reports, the maintenance of registered agents, and various other actions that the corporation or LLC must take. They must also comply with the federal Corporate Transparency Act. Compliance with these statutes depends in large part upon the individuals governing those entities. And these individuals can ensure that the entities they serve are fully compliant corporate or LLC citizens.