Corporate Transparency Act’s Intersection with Diversity Jurisdiction Challenges
/Corporate Transparency Act’s Intersection with Diversity Jurisdiction Challenges
By David A. Gauntlett*
Introduction
This year, effected entities must make their first filings under the Corporate Transparency Act (“CTA”). Enacted in 2021, the CTA’s purpose is curtail illicit activity such as tax fraud, money laundering, and financing for terrorism by forcing disclosure of additional ownership information for certain U.S. businesses operating in or accessing the country's market. Under the new legislation, qualifying businesses must submit a Beneficial Ownership Information (BOI) Report to the U.S. Department of Treasury’s Financial Crimes Enforcement Network. The BOI reports must provide details identifying individuals who are associated with the reporting company. Several articles have already been written discussing compliance requirements. In this blog, we wanted to discuss a different angle—how will the CTA impact diversity jurisdiction?
Diversity Jurisdiction Requirements Can Be Complicated
Diversity jurisdiction, the most common path to appearing in federal court, requires that (1) the amount in controversy exceed $75,000 and (2) the plaintiff not be a citizen of the same state as the defendant.[1] The rule does not bend as you add more parties. Diversity is ruined if any plaintiff shares common citizenship with any defendant.[2]
A natural person has only one state of citizen—the state in which they are domiciled. Corporations have two: (1) the state in which they are incorporated and (2) the state of the corporation’s “principle place of business” where “where the corporation's high level officers direct, control, and coordinate the corporation's activities,” often referred to as the “nerve center.”[3] LLCs (and LLPs) are where diversity gets especially tricky since those entities are considered citizens of every state in which any member is a citizen.[4]
The CTA Will Not Solve All Problems
Although one might expect the “Corporate Transparency Act” to provide greater access to entities’ citizenship information, the CTA provides that the reported information “shall be confidential.”[5] The strict limitations on disclosure generally prevent anyone outside law enforcement from obtaining the information. That said, the filing requirement will make it difficult for an LLC to deny knowledge of its complete citizenship profile. While the actual reports are confidential, an LLC would have to admit its non-compliance to maintain an assertion of ignorance.
Because determining the complete citizenship of a defendant entity can be impractical or even impossible prior to discovery, courts have adopted a lesser pleading standard to accommodate the reality plaintiffs face. In Lincoln Benefit Life Co. v. AEI Life LLC, the Third Circuit explained that:
[M]embership of an LLC is often not a matter of public record. . . . Thus a rule requiring the citizenship of each member of each LLC to be alleged affirmatively before jurisdictional discovery would effectively shield many LLCs from being sued in federal court without their consent. This is surely not what the drafters of the Federal Rules intended. . . . [A] plaintiff need not affirmatively allege the citizenship of each member of a defendant LLC if it is unable to do so after a reasonable investigation. If the plaintiff is able to allege in good faith that the LLC's members are not citizens of its state of citizenship, its complaint will survive a facial challenge.[6]
Because the CTA will be of little help against a defendant LLC, the primary beneficiaries will actually be LLC plaintiffs. For larger LLCs, membership (and therefore citizenship) is often a complicated web of natural persons and corporate entities, each of which could have its citizenship shift from year to year. In the best case scenario, the information would be carefully tracked and maintained. More often than not, however, attorneys representing an LLC must scramble to determine citizenship and rely upon representations made by the LLC.
The CTA will force qualifying entities to maintain accurate records of citizenship.[7] This will enable attorneys representing plaintiff LLCs to easily, accurately, and completely address the issue of diversity jurisdiction in complaints. Failure to do so has, in the past, caused significant delays in resolution of disputes.
An Illustrative Example: SXSW v. Federal Ins. Co.
In SXSW, L.L.C. v. Federal Ins. Co., the entity that organizes the annual SXSW music festival sought insurance coverage for attorneys’ fees and a settlement payment made to resolve claims following the event’s cancellation during the COVID-19 pandemic.[8] After nearly two years of litigation, the Fifth Circuit identified a potential jurisdictional defect because “[i]n its complaint dated October 6, 2021, SXSW noted that it was a limited liability company. . . . Instead of alleging the citizenship of all of its members, SXSW only alleged its principal place of business.”[9] The case was remanded back to the district court to determine whether the parties were completely diverse and resolve three potential jurisdictional issues identified by the court:
First, there is a potentially important difference between LLC membership and LLC ownership. State law governs LLC formation and organization. Several states permit LLC membership without ownership. . . . If those LLCs have non-owner members, the citizenship of those members will trickle up to SXSW, potentially defeating complete diversity. In any event, the lack of clarity does not satisfy our requirement of “clear, distinct, and precise affirmative jurisdictional allegations.”
Second, SXSW stated that Capshaw was a Virginia resident. But residency is not citizenship for purposes of § 1332. . . .
Finally, there is a timing issue. For diversity jurisdiction, we look to citizenship at the time the complaint was filed. . . . The complaint makes no allegations about the citizenship of SXSW's members. Federal's December 14, 2021 exhibit contains some additional information . . . as does SXSW's February 22, 2023 appellant brief. . . . But we have no way of knowing whether those later documents reflect SXSW's membership structure as of October 6, 2021. And we know from oral argument that SXSW's organizational structure has undergone significant changes in the last few years.[10]
After several weeks of investigation, SXSW was able to present an amended complaint that exhaustively listed the citizenship of every corporate entity and natural citizen that were part of the LLC’s complicated web of membership. In total, over 100 assertions of citizenship were required, making SXSW a citizen of “California, Connecticut, Delaware, Florida, Massachusetts, Michigan, Nevada, New York, North Carolina, Pennsylvania, Texas, Virginia, Switzerland, and the United Kingdom.”[11] Crucially, none of the members were citizens of Indiana or New Jersey, the two states of citizenship for Federal Insurance Company.[12]
As this case illustrates, a federal court can raise the issue of jurisdiction at any time, derailing cases just before the finish line after years of exhaustive litigation. In SXSW, the error was corrected with relative ease, but it still caused a delay of several months as the parties currently await a substantive judgment from the Fifth Circuit.
Conclusion
Despite its name, the CTA strictly limits who has access to reported information. Because of those restrictions, the act will have little impact on a plaintiff’s ability to determine the citizenship of a defendant entity. For purposes of asserting diversity jurisdiction, the biggest impact will be in facilitating the ability of attorneys representing complex LLCs to more easily and accurately plead the citizenship of their own clients. This increased accuracy should reduce the number of jurisdictional defects, which can be raised by a court at any time to derail an otherwise air-tight case.
*David A. Gauntlett is a principal of Gauntlett & Associates and represents policyholders in insurance coverage disputes regarding intellectual property, antitrust, and business tort claims, as well as in the underlying actions. Mr. Gauntlett can be reached at (949) 553-1010 by voicemail or dag@gauntlettlaw.com. For more information, visit Gauntlett & Associates at www.gauntlettlaw.com.
[1] There are other ways to satisfy the statutory requirements, which are found in 28 U.S.C. § 1332(a). This blog addresses the most common situation involving United States citizens.
[2] Lincoln Prop. Co. v. Roche, 546 U.S. 81, 89 (2005).
[3] Hertz Corp. v. Friend, 559 U.S. 77, 80–81 (2010).
[4] Kruglov v. Copart of Connecticut, Inc., 771 F. App'x 117, 118 (2d Cir. 2019) (“A complaint premised upon diversity of citizenship must allege the citizenship of natural persons who are members of a limited liability company and the place of incorporation and principal place of business of any corporate entities who are members of the limited liability company.”)
[5] 31 U.S.C.A. § 5336(c)(2).
[6] Lincoln Benefit Life Co. v. AEI Life LLC, 800 F.3d 99, 108–10 (3d Cir. 2015).
[7] 31 U.S.C.A. § 5336(b)(2).
[8] SXSW, L.L.C. v. Fed. Ins. Co., 83 F.4th 405 (5th Cir. (Tex.) 2023). For a discussion of the substantive issues of the case, see David A. Gauntlett, District Court Ignored Narrow Exclusion Construction Case Authority, https://www.gauntlettlaw.com/news/district-court-ignored-narrow-exclusion-construction-case-authority (Oct. 13, 2022).
[9] SXSW, 83 F.4th at 408.
[10] Id. at 408–09 (citations omitted).
[11] SXSW, LLC v. Fed. Ins. Co., No. 1:21-CV-00900-RP, 2023 WL 7276499, *3 (W.D. Tex. Nov. 3, 2023), report and recommendation adopted, No. 1:21-CV-900-RP, 2023 WL 7649389 (W.D. Tex. Nov. 14, 2023).
[12] Id.