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Calculating Beneficial Ownership: Applying the Failsafe Rule

In some prior posts (The Capital Calculation Rule, The Partnership Capital Rule and The Corporate Capital Rule), I described the logical operation of FinCEN’s Reporting Rule.

The Reporting Rule creates a standard for determining whether the reporting company should calculate percentage ownership under the Partnership Capital Rule or the Corporate Capital Rule.

The Partnership Capital Rule is a means for measuring an individual’s percentage ownership of the aggregate capital and profit interests of the reporting company.

The Corporate Capital Rule provides that an individual’s percentage ownership is equal to the greater of (a) the individual’s percentage of aggregate voting power in the reporting company, or (b) the individual’s percentage of the aggregate value of the reporting company.

This post describes the “Failsafe Rule” that applies when the Partnership Capital Rule or the Corporate Capital Rule fails to produce an outcome that is “reasonably certain.”

When to Apply the Failsafe Rule

Section 380(d)(2)(iii)(D) provides that “if the facts and circumstances do not permit the calculations described in either paragraph (d)(2)(iii)(B) [the Partnership Capital Rule] or (C) [the Corporate Capital Rule] to be performed with reasonable certainty, any individual who owns or controls 25 percent or more of any class or type of ownership interest of a reporting company shall be deemed to own or control 25 percent or more of the ownership interests of the reporting company” (emphasis added). 

Two key terms (emphasized above) drive the application of the Failsafe Rule.

First, a reporting company must apply the Failsafe Rule if the application of the Partnership Capital Rule or Corporate Capital Rule do not permit the calculations “to be performed with reasonable certainty.”

The Reporting Rule does not specify when calculations cannot be performed with reasonable certainty.

In its September 30, 2022 release of the Reporting Rule, FinCEN had relatively little say about what this phrase might mean.  In the only passage that might bear on interpretation, FinCEN wrote that “these challenges [referring to the challenge of calculating the present value of an interest] should be relatively infrequent because only a change that results in the individual moving above or below 25 percent of total ownership interest will change the reporting obligation.” 

Applying this logic implies that if the outcome of the Partnership Capital Rule or Corporate Capital Rule calculations will change based on the present value of the reporting company (or any individual’s interest in the reporting company), then that potential change is the circumstance that renders the calculations unable “to be performed with reasonable certainty.”

What kinds of circumstances could cause an individual’s percentage of a reporting company’s total value to change?  These circumstances include a capital structure in which distributions of profit or a capital event are distributed differently based on the total amount distributed.

For example, many LLC operating agreements have a “distribution waterfall” in which there is one distribution percentage for the return of investor capital and a second (and a third or a fourth) distribution percentage for the distribution of proceeds after all capital has been returned.

Likewise, many corporations have preferred stock structures where an initial tranche of distributions goes first to preferred shareholders, until a specified quantity is distributed, with subsequent distributions going to other classes of shareholders in different percentages.

Multi-tier arrangements like these can result in distributions to investors at different percentage rates based upon the amount to be distributed.  In the case of a hypothetical liquidation, the ultimate net percentage would depend on the proceeds resulting from the liquidation.

Consequently, a reporting company with a multi-tiered distribution arrangement (whether resulting from a waterfall provision in an operating agreement or the terms of preferred stock) will cause the calculation of percentage ownership to be no susceptible of “reasonable certainty,” thereby triggering the Failsafe Rule.

How to Apply the Failsafe Rule

The second provision that stands out is the Failsafe Rule’s reference to “any class or type of ownership interest” in the reporting company.

The Reporting Rule defines “ownership interest” in Section 380(d)(2)(i) with a lengthy five-part definition that covers (1) “any equity, stock or similar instrument,” (2) any “capital or profit interest in an entity,” (3) any “instrument convertible, with or without consideration, into” any of the two preceding categories, (4) any “put, call, straddle, or other option or privilege of buying or selling” any of the three preceding categories, and (5) “any other instrument, contract, arrangement, understanding, relationship, or mechanism used to establish ownership.”

While this fulsome definition arguably covers every form of “security” a reporting company might issue (referring to the open-ended definition used in the Securities Act of 1933 and its regulations), it does not guide the reader to a definition for “class or type” of security.

Because the CTA penalizes under-reporting (and does not penalize over-reporting) a conservative approach is to treat every potential distinction between one form of ownership interest and the other as a distinct “class or type.”

For example, if members of an LLC receive different percentages of distributions at different levels in a waterfall, a conservative approach would treat each level of the waterfall as a distinct “class or type” of ownership interest.

Likewise, if a share of one series of preferred stock would receive a different percentage of distributions that one share of a different series of preferred stock, a conservative approach would treat each series of preferred stock as a different “class or type” of ownership interest.

For reporting companies with multi-tier distribution arrangements, applying the Failsafe Rule will often result in a finding that an individual has a 25% or greater share of a particular class or type of security (even though that individual’s percentage share of the entire value of the company is less than 25%).  That is clearly the outcome that FinCEN intended in its drafting of the Failsafe Rule.


Reporting companies with multi-tier distribution arrangements, whether resulting from preferred stock or multi-level waterfall arrangements, will need to apply the Failsafe Rule (except in those rare instances when the reporting company’s liquidation value is known with certainty).  When it applies, the Failsafe Rule requires the reporting company to report as a beneficial owner any individual with 25 percent or more of any class or type of security in the reporting company.  Most reporting companies will need to coordinate with their legal or accounting professionals to calculate beneficial ownership in this way.