CDD vs EDD: Know When to Go Beyond Basic Due Diligence
16 April, 2025
6 minutes read
A clear understanding of what actually constitutes a legal entity and what its different forms are is crucial for financial professionals, business owners, and legal experts. It builds the foundation for how a business or a company will operate and the relevant legal requirements. A failure to identify the type of legal entity can lead to compliance failure.
In order to comprehend the concept, imagine a scenario where a corporation might not be aware of certain agreements that require shareholders’ approval. This can lead to invalid agreements. Similarly, misalignment of business operations or in line with the exact legal nature of an entity or a partner entity can lead to discrepancies in tax filings or other consequences, triggering tax penalties.
Whether you are an international financial institution dealing with international clients or a business with foreign trading partners, it is essential to know the legal status of the partner entities to accurately ensure compliance with various regulations, like KYC, AML, and sanctions compliance laws. Let’s explore the context of legal entities in businesses.
What is a Legal Entity?
A legal entity is defined as an organization, a business, or any structure recognized by law as having its rights and responsibilities distinct from those of its owners or members. It can enter into any contracts or own property and be held liable for debts or legal obligations.
Ascertaining the nature of Legal entities is fundamental to smooth business operations, as it helps determine the nature of liabilities that may arise. Laws governing the formation of legal entities dictate the types of business structures and tax applications accordingly. Moreover, choosing a particular type of legal entity during the formation of a business decides upon the level of liability protection and overall governance.
Financial institutions and businesses dealing with business entities must know about the relevant data that they need to look up in order to determine the authenticity of an organization.
In order to do the legal entity due diligence, look up names and official legal documents in relevant databases, one must know what these terms imply.
Legal Entity Name and Role of Documents
The official name of an organization registered with the relevant government authorities is known as a legal entity name. In this context, the name holds legal importance as it represents the entity legally. Furthermore, the name impacts liability and recognition.
Here’s a four-step process for naming a legal entity:
- Choose a name
- Check availability
- Register the name
- Acquire the trademark
Formation of a legal entity is accompanied by several legal documents depending on the type of entity being formed. Some of the documents listed below help outline the entity’s structure, operational procedure, and governance:
- Article of incorporation
- Operating agreement
- Bylaws
- Partnership agreement
Legal Entity Identifier(LEI) | A Global Alpha-Numeric Code
Introduced by the Office of Financial Research(OFR), LEI helps in risk management, data collection, and reporting efficiency in international trade and transactions involving foreign legal entities by enabling the smooth identification. Since its launch in 2014, the LEI has been widely adopted, with over 1.9 million issued globally by 2021.
Another nonprofit organization, the Global Legal Entity Identifier Foundation(GLEIF), established by the Financial Stability Board, oversees the adoption and implementation of the LEI system.GLEIF helps in supply chain due diligence and even streamlining the foreign financial transactions.
To be specific, a Legal Entity Identifier(LEI) is a global standard for determining legal entities in financial transactions. It enables risk managers and regulators to pinpoint the parties involved precisely. Moreover, the LEI enhances transparency, risk assessment, and data management across the financial system.
According to OFR, one of the lessons from the collapse of Lehman Brothers in 2008 was the lack of industry standards for identifying financial data related to entities involved in failed transactions. Similar to a barcode, the Legal Entity Identifier (LEI) precisely identifies parties in financial transactions, helping firms and regulators trace exposures and connections across the financial system.
However, regulators are encouraged to mandate LEI usage universally for improved efficiency and policymaking.
LEI, which is an international data standard, has the following benefits.
- It helps trace exposures and connections between entities
- It offers a consistent way to track transparency
- It reduces complexity in compliance
Types of Legal Entities
Under the business law, a legal entity means an organization (e.g., corporation, LLC, partnership) that operates as a separate legal unit from its owners. As a result, this enables the entity to perform actions such as entering into contracts, suing, or being sued.
| Partnership | Depending on the type (general, limited, or limited liability partnership), partners may have varying degrees of liability. It involves two or more individuals sharing ownership |
| Limited Liability Company (LLC) | LLC combines elements of partnerships and corporations, providing flexibility and limited liability to its owners. |
| Sole Proprietorship | Owned by a single individual, this structure doesn’t legally distinguish between the owner and the business, making the owner liable for business debts. |
| Corporations | A separate legal entity from its owners (shareholders), offering limited liability protection. Corporations can enter into contracts, own property, and be sued independently of their shareholders. |
Suggested Read:Business Structures Revealed | Understand Sole Proprietorship vs LLC
Legal Entity Meaning in Different Contexts
Here are some examples of legal entities from different sectors.
Finance
Legal entities in the context of finance include banks, NBFIs(Non-Bank Financial Institutions), payment service providers, credit institutions, and insurance companies. While these distinct types of entities may be based on the above-mentioned three legal structures, they may have more sub-sector specific regulatory bodies, and hence, dealing with them may require specific due diligence.
International Trade
A legal entity in this context can be a trading enterprise based on the legal structure of a corporation, limited company, or any entity involved in joint ventures, import/export, or trade of goods and services across borders.
Government Entities
Public corporations, local government bodies, and government-owned enterprises(GEOs) are the legal entities under governments. Legal entities coming under the influence of the government may have some distinct regulations and scope of operations, with their official status presenting a higher risk of money laundering for proximity to power.
Juridical Persons
Entities such as corporations or associations, which have legal capacities defined by law, are juridical persons. More examples include non-profit organizations, trusts, and cooperatives – organizations owned and operated by a group of individuals for mutual benefits. While Legal Entity is a broader term, it is to be noted that in some cases, legal entities and juridical entities are used interchangeably.
How do Legal Entity Structures Vary Across Countries?
Different countries may have their local business laws governing the structure of the business entities.
| Australia | Legal Entity structures in Australia include LLP(limited liability partnership), ILP(incorporated limited partnerships), sole traders, and a trust. |
| UK | UK entities’ structure includes limited company, LLP, community interest company(CIC), a charitable incorporated organization(CIO), an industrial and provident society, or a financial mutual, among others. |
| Brunei | Brunei includes sole proprietorship, partnership, and company. |
| Canada | In Canada, legal entities are generally formed under sole proprietorship, general partnership, limited partnership, or joint venture. |
| South Africa | Legal entities in South Africa include business trust, partnership, closed corporation, and sole proprietorship. |
| Denmark | In Denmark, entity structure includes sole proprietorship, general partnerships, private limited company startups with limited equity capital, etc. Using 25% of profit to collect enough equity capital to become a private limited company is a must. |
Why Is There a Need to Identify a Legal Entity?
Legal entity identification is crucial for several reasons in order to assess risks, ensure due diligence for compliance with Anti-Money Laundering laws, sanctions regimes or supply chain laws, and operate the business within legal boundaries. Some of the significant and primary reasons include sanction compliance, adhering to trade and export control regulations, ESG laws, and supply chain due diligence. Legal entity identification ensures that proper reporting will provide transparency and help track financial transactions.
How Can The KYB Help a Business Verify the Legal Entities
No matter where your business operates, you can now empower your due diligence efforts and AML compliance program with The KYB’s advanced legal entities screening solution.The KYB’s legal entities data, sourced from official business registries, helps businesses do the necessary due diligence about their legal entity partners across various sectors.
The KYB’s business screening not only offers details about directors, shareholders, and official documents of a legal entity but also screens names against sanctions lists and warnings, as well as regulatory enforcements. The smart platform provides detailed insights into the entity structure and its legal standings.
It doesn’t matter who your compliance partners are, be it complex contracts or ensuring regulatory adherence, the KYB simplifies the process, saving time and reducing risk.
Frequently Asked Questions
1. What is a Legal Entity Identifier?
A Legal Entity Identifier (LEI) is a unique 20-character code assigned to legal entities engaged in financial transactions, enabling precise identification and risk management.
2. What is Considered a Legal Entity?
A legal entity is an organization or individual recognized by law as having distinct rights and responsibilities, separate from its owners or members. It can enter into contracts, own property, and be held accountable for legal obligations.
3. What is The Legal Entity Name Example?
An example of a legal entity name is “Technovate Solution LTD,” the official name registered with the government for legal and business purposes. This name is used in official contracts, official documents, and under tax filings.
4. What Are The 4 Types Of Entities?
The four primary types of entities are sole proprietorships, partnerships, corporations, and limited liability companies (LLCs). Each type differs in terms of liability, ownership structure, and legal requirements.
