New Social Hybrid Legal FormsWhat Matters to State Regulators?

Victoria B. Bjorklund, Esq.Simpson Thacher & Bartlett LLPNew York, NY

October 1, 2012

Robert Keatinge, Esq.Holland & Hart LLPDenver, CO

AgendaTopics for Discussion

A Changing Landscape

Why do social hybrids matter?

What are the main social hybrid forms?

Who is advocating these social hybrid forms?

Low-profit Limited Liability Companies (L3Cs)

Program-related Investments and the L3C

Risks and Criticisms

Theory v. Reality

Benefit Corporations

Related forms: B-Corps and Flexible-purpose corporations

Conclusion

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States Adopting Social Hybrid Legislation (as of June 2012)

Benefit corporations - 9Flexible purpose corporations - 2

Low-profit limited liability companies (L3Cs) - 9

Timeline of Social Hybrid Legislation2008-June 2012

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2008•L3Cs: VT

2009•L3Cs: MI, UT and WY

2010•L3Cs: IL, NC and LA•Benefit corps: MD and VT

2011•L3Cs: ME and RI•Benefit corps: CA, HI, NJ, NY and VA•Flex purpose corps: CA

2012 (as of June)•Benefit corps: LA and SC•Flex purpose corps: WA

IntroductionWhy have this discussion?

Recent legislation As of June 2012, 17 states have enacted specific

legal forms for for-profit, non-exempt entities intending to generate social benefits; legislation is pending in many other states

Two major forms: Low-profit limited liability companies (L3Cs) and benefit corporations, each with different aims and advocates There are also flexible purpose or social purpose

corporations, related to benefit corporations, further discussion to follow

Efforts have come from outside organizations, led by Americans for Community Development (L3C advocates) and B Lab (Benefit corporation advocates)

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IntroductionWhy have this discussion?

General concerns New hybrid forms may be unnecessary; existing for-profit

forms (the LLC and corporate forms) are flexible and can be used by socially beneficial for-profit organizations

New hybrid forms may be overly restrictive relative to the ordinary LLC and corporate forms

New forms with built-in social benefit requirements may weaken legal arguments in favor of corporate philanthropy and social consciousness among ordinary for-profits

While new forms create obligations on the leadership, most statutes prescribe no government oversight and few transparency requirements, and any oversight may burden state regulators

L3Cs in particular may carry risks for established non-profit organizations seeking to partner with socially conscious for-profits without alleviating the burdens associated with such co-ventures

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IntroductionWhy have this discussion?

Concerns for state regulators New hybrid forms are not monitored by government

entities to ensure compliance with their statutory mandates

Lack of transparency and accountability may later result in greater oversight by state regulators

Abuses of new forms do not have clear methods of resolution, which may require state regulators to become involved in resolving disputes in the future

Inherent restrictions may require creation of new areas of state law to govern L3C or flex-purpose corporation compliance; benefit corporations ceding oversight to B Labs may be undesirable

Potential weakening of legal arguments in favor of corporate philanthropy and social consciousness among ordinary for-profits may require state regulators to become involved in corporate law

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Social Hybrid FormsWhat are they?

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Benefit corporation L3C

Focus on social benefits in organization and governance

Focus on joint investment by nonprofits and for-profits

Ensure that organization remains dedicated to social benefit goals alongside profit motives

Finance high-risk, low-return socially beneficial ventures with tranched investment from foundation PRIs

Approx. 100 nationwide, in California, Hawai’i, Louisiana, Maryland, New Jersey, New York, South Carolina, Vermont and Virginia

Approx. 600 nationwide, in Illinois, Louisiana, Maine, Michigan, North Carolina, Rhode Island, Utah, Vermont and Wyoming

States with L3C statutesStates with benefit corporation statutes

Social Hybrid FormsWho are the advocates?

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L3Cs Advocacy led by a non-exempt entity, Americans for

Community Development, and its leader, Robert Lang

Benefit corporations Advocacy led by B Labs, a Philadelphia-based § 501(c)(3)

public charity that describes itself as promoting social and environmental consciousness in business ventures

Additional projects by B Labs include the B-Corp designation, a private certification by B Labs of a company’s commitment to social or environmental goals (similar to Fair Trade USA)

L3CsThe Basics

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Structure Variant on the flexible LLC form; includes LLC requirements

Differences from the LLC Entity must further an IRS-recognized charitable purpose Mirrors program-related investment (PRI) standards to

ostensibly ease investment from private foundations

Purposes Encourage tranched investment by private foundations

and for-profit investors by seeking foundation PRIs to generate capital

“Brand” entities with a social purpose

L3CsPRIs and L3Cs

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What is a PRI? I.R.C. § 4944(c) allows foundations to make below-market grants

or loans when they are program-related Primary purpose must be charitable under § 170 No significant purpose can be the production of income No purpose can be campaign or lobbying activities

Regulation examples, including new examples, leave grey area Foundations without experience in PRIs may be reluctant to

make PRIs; foundations with experience perform significant diligence prior to making a PRI

How do L3Cs relate to PRIs? L3Cs are structured to mirror the three PRI requirements with the

intent to make PRIs to L3Cs simpler than other PRIs But L3Cs do not automatically comply with PRI requirements

(especially charitable purpose); thus, IRS has not given blanket approval of PRIs to L3Cs

L3C advocates are no longer pushing for blanket IRS approval Federal legislation to mandate a process whereby L3Cs seek IRS

endorsement has stalled and is unlikely to be enacted

L3CsCriticisms

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State regulation In most states, L3Cs lack transparency, and their activities are

not monitored to ensure they further their stated charitable purpose

Except Illinois, where L3C directors and managers are charitable trustees by law and subject to monitoring by state charities bureau

Illinois-type monitoring may become more common in other states, or alternatively a new monitoring system may develop

State regulation, to the extent it exists, is dependent on an understanding of federal rather than state charitable definitions

Alternative LLC form would require less regulation

Other issues L3Cs do not reduce PRI costs to foundations; complacency risks Improper private benefit to for-profit investors may result from

tranched investment (significant uncertainty in the area) PRI-based structure limits activities to those federal law

considers charitable when other activities may have merit and prevents lobbying or political activities when they may be appropriate

L3CsTheory v. Practice

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L3Cs in practice L3Cs have not been used primarily by individuals seeking

PRIs, and we are unaware of any PRIs made by foundations to L3Cs

May partially result from relative lack of appeal of L3Cs as PRI targets due to recent vintage, small size and less sophisticated leadership

According to a study of L3C early adopters in Vermont, leaders were primarily interested in a for-profit entity with social goals

Connecting theory to practice The L3C form in particular has significant problems; however,

appetite exists among some entrepreneurs for “branding” PRIs ought not to be the focus of future social hybrid reforms State regulators may be concerned by relative inexperience of

L3C operators with charitable forms if called upon to regulate

Benefit CorporationsThe Basics

Structure Variant on corporate form; existing corps can elect in Certification by B Labs, advocates of benefit corporations Provides some oversight as certification must be kept up-

to-date and B Labs publishes some details, though certification is private and outside of ordinary political regulatory system

Difference from exempt and non-exempt forms

Unlike non-profit corps, permitted to distribute profits Unlike for-profit corps, requirement that Board consider

social and environmental goals is built into legal structure Annual report to shareholders based on “a third-party

standard” (typically the B Labs standard) to state social goals

Shareholders have right of action to enforce social goals

Must include a Director and an Officer who are oriented toward benefits

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Benefit Corporation Purposes (Cont.)

Purposes (Model Benefit Corporation Legislation (“MBCL”) § 201)

General public benefit purpose. – A benefit corporation shall have a purpose of creating general public benefit. This purpose is in addition to its purpose under [cite section of the business corporation law on the purpose of business corporations].

Optional specific public benefit purpose. – The articles of a benefit corporation may identify one or more specific public benefits that it is the purpose of the benefit corporation to create in addition to its purposes under [cite section of the business corporation law on the purpose of business corporations] and subsection (a). The identification of a specific public benefit under this subsection does not limit the obligation of a benefit corporation under subsection (a).

Effect of purposes. – The creation of general public benefit and specific public benefit under subsections (a) and (b) is in the best interests of the benefit corporation.

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Benefit Corporation Purposes (Cont.)

General Public Benefit (MBCL §§ 102(a), 301(a))

A material positive impact on society and the environment, taken as a whole, assessed against a third-party standard, from the business and operations of a benefit corporation. This involves consideration of:

(i) the shareholders of the benefit corporation;

(ii) the employees and work force of the benefit corporation, its subsidiaries and its suppliers;

(iii) the interests of customers as beneficiaries of the general public benefit or specific public benefit purposes of the benefit corporation;

(iv) community and societal factors, including those of each community in which offices or facilities of the benefit corporation, its subsidiaries or its suppliers are located;

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Benefit Corporation Purposes (Cont.)

General Public Benefit (MBCL §§ 102(a), 301(a)) (Cont.)

(v) the local and global environment;

(vi) the short-term and long-term interests of the benefit corporation, including benefits that may accrue to the benefit corporation from its long-term plans and the possibility that these interests may be best served by the continued independence of the benefit corporation; and

(vii) the ability of the benefit corporation to accomplish its general public benefit purpose and any specific public benefit purpose

Benefit CorporationsCriticisms

Structural concerns Knock-on effects on boards of ordinary for-profit

corporations; may reduce courts’ sympathy towards consideration of social benefits or corporate philanthropy

Possibly redundant with charter amendments that can build social benefits into the corporate purpose

Less flexible and potentially less favorable tax treatment due to use of the corporate form over LLC form

Oversight and enforcement concerns Only shareholders and third-party standard creators can

enforce in pursuit of social benefits; no government monitoring Although, as with L3Cs, state regulators may be called upon to

enforce in the future if legislatures decide mechanisms are insufficient

Less reporting to state charities bureaus or IRS than non-profits, thus less transparency to non-shareholders (but also less burdensome on state regulators)

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Model Charitable Solicitations Act

Is a solicitation for investment in a Social Hybrid Organization a “Charitable Solicitation”?

MCSA § 1(c) “’Solicit’ and ‘solicitation’ mean the request directly or indirectly . . . on the plea or representation that such money, credit, property, financial assistance, or other thing of any kind or value, or any portion thereof, will be used for a charitable purpose or benefit a charitable organization.”

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Model Charitable Solicitations Act

Is a solicitation of a contribution to a Social Hybrid Organization a solicitation for a “charitable purpose”?

MCSA § 1(d)(2) “Charitable purpose means:

Any benevolent, educational, philanthropic, humane, scientific, patriotic, social welfare or advocacy, public health, environmental conservation, civic or other eleemosynary objective, or an objective that benefits law enforcement personnel, firefighters, or other persons who protect the public safety.”

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Model Charitable Solicitations Act

Is a Social Hybrid Organization a “Charitable Organization”?

MCSA § 1(a)(2) “Charitable Organization means:

Any person who is or holds himself out to be established for any benevolent, educational, philanthropic, humane, scientific, patriotic, social welfare or advocacy, public health, environmental conservation, civic or other eleemosynary purpose or for the benefit of law enforcement personnel, firefighters, or other persons who protect the public safety, or any person who in any manner employs a charitable appeal as the basis of any solicitation or an appeal which has a tendency to suggest there is a charitable purpose to any such solicitation.”

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Model Protection of Charitable Assets Act

Is property of a Social Hybrid a “Charitable Asset”?

MPCAA § 2(1) “Charitable asset” means property that is given, received, or held for a charitable purpose. The term does not include property acquired or held for a for-profit purpose.

MPCAA § 2(2) “Charitable purpose” means the relief of poverty, the advancement of education or religion, the promotion of health, the promotion of a governmental purpose, or any other purpose the achievement of which is beneficial to the community.

Benefit CorporationsRelated alternatives

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Flexible or social purpose corporation

Board may consider social benefits, but no third-party standard required

Criticized for potential “greenwashing” and misleading of investors due to lack of an independent standard

More need for state regulators to become involved because no third party standard exists heightens risk of abuse

States with flex-purpose corporation

statutes

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ConclusionWhat can we conclude?

Some appetite exists for legal forms “branded” as for-profits advancing social benefit goals, and legislators have quickly enacted social hybrid legislation

Existing hybrid forms, particularly L3Cs, are ill-suited for the purposes they purport to advance and may be redundant with LLCs and corporations

Although current law affords little oversight or transparency for social hybrids, state regulatory oversight may be expanded in ways that may distinguish social hybrids from standard for-profit forms

In general, legal structures at the state and federal levels as well as the socially conscious community are still adapting to the social hybrid

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WASHINGTON, D.C.

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