by R. Todd Johnson*
[The following piece was drafted as part of a "Frequently Asked Questions" piece to be distributed by the co-chairs of the California Working Group on New Corporate Forms, which should be published within the next several weeks.]
Why Consider Alternatives to Traditional Corporations and LLCs?
Over the past decade or more, the previously episodic examples of company’s pursuing both returns for investors and the achievement of some other Special Purpose has become a regular occurrence. As a result, many organizations both in the non-profit and the for-profit worlds have been “bending the arcs” of their respective corporate forms to achieve multiple or blended objectives or value. These approaches produce unsatisfactory results and create risks and potential liability for managers with either shareholders (in the case of for-profits) or with the IRS (in the case of non-profits).
Entrepreneurs seeking to create and scale business models by raising traditional investment capital (including venture capital and other forms of private equity, venture and other types of debt, and ultimately in the public markets), have historically been limited to two primary corporate vehicles – the corporation and the limited liability company.[i] Although the fundamental characteristic difference between these two options remains tax treatment,[ii] two other differences make both forms difficult for the entrepreneur seeking to meld profitability with a Special Purpose.
The use of a traditional corporation portends potential risk for directors making decisions on the basis of a Special Purpose, if done at the expense of maximizing financial returns for shareholders and outside the presumption of the business judgment rule. Although case law does not present a clear picture of exactly when and how liability arises (based on the facts and circumstances of each case), prudent counsel (responding to risk-averse directors) tend to draw conservative lines on how far a board might take a corporation in pursuit of a Special Purpose, at the expense of financial returns. Corporations, as a product of trust law, typically do not permit entrepreneurs to alter this dynamic through the articles of incorporation, because the rules are either statutorily embedded or judicially created as a part of a director’s fiduciary duties to the shareholders and the corporation.
In the alternative, the LLC is a product of contract law and entrepreneurs can theoretically write into the operating agreement the ability for managing members to make the trade-off of financial returns in favor of a Special Purpose.[iii] However, LLCs are not favored forms for institutional investors.
Why Don’t Institutional Investors Like LLCs?
Institutional investors strongly prefer that funds in which they invest avoid making portfolio investments in LLCs or partnerships primarily as a result of tax considerations. Many limited partners in venture and private equity funds seek avoidance of imputed taxable income from the trade or business income that is generated by portfolio companies. Unless an LLC has elected to be taxed as a corporation, LLCs are pass-through entities for tax purposes. As limited partnerships, the funds into which limited partners invest are also pass-through entities for tax purposes. As many limited partners are not otherwise taxable (being pension funds, non-U.S. persons for federal income tax purposes or sovereign wealth funds, either domestic or foreign), the deemed receipt of income imposes an undesirable tax burden on the limited partners and could produce the most undesirable result – taxable income without the distribution from the fund of cash to pay the taxes.
For a tax-exempt pension fund, endowment, foundation, or similar entity, the United States Internal Revenue Code of 1986, as amended, (the “Code”) typically views this imputed income as “unrelated business taxable income” (“UBTI”) that is subject to tax at regular corporate rates. Income of this type may also be characterized by the Code to constitute “effectively-connected income” (“ECI”), which, if imputed to a foreign investor, may be subject to U.S. regular corporate tax, as well as branch profits tax, and, at a minimum, triggers a requirement to file a U.S. tax return. Finally, imputed income of an operational or commercial nature (as arises from the deemed receipt of trade or business income) can constitute income from commercial activity (“CAI”), and thus cause sovereign wealth funds to completely lose certain U.S. tax exemptions to which they would otherwise be entitled. Typically the institutional investors sensitive to any of UBTI, ECI or CAI seek contractual covenants from a fund ensuring that the fund avoids investing in any entity not deemed to be a Subchapter C corporation for U.S. federal income tax purposes.
Further, the public capital markets have not favored public offerings of equity by LLCs, other than those involved in real estate or pipeline businesses. For example, between 1998 through the first half of 2009, there were more than 2,700 initial public offerings and only two of them were LLCs. LLCs are disfavored as an entity choice for widely held companies primarily because the markets favor the standardization of entities formed by statute. In particular, the cost and effort of understanding the nuanced differences of operating agreements, and the cost and risk of drafting a prospectus that captures those nuances and fully discloses the risk factors to be considered by potential investors, each represent a difficult and time-consuming effort that companies and investment bankers would be required to undertake on each individual LLC, compared to the standardization of the statutory approach and a standard set of articles of incorporation, that facilitates a smooth functioning of the markets, rather than the need for company-by-company review of operating agreements.
For this same reason, institutional investors typically require that LLCs in which they plan to invest, first convert to a corporation. Precisely because LLCs are a product of contract, rather than statute, and flexible to the point of individual tailoring, institutional investors are loathe to carry the cost of paying lawyers to review the diverse operating agreements of LLCs.
What Are the Issues of Using a Traditional Corporation?
A traditional corporation, as previously noted, creates risks for directors trying to make decisions involving trade-offs between a Special Purpose and profitability. Fiduciary duties of care and loyalty are usually viewed by courts in light of a presumption in favor of the business judgment of a disinterested director (often referred to as the “business judgment rule”) which, except in certain cases, permits some flexibility to consider Special Purposes in defining the long-term best interests of the corporation and its shareholders. However, the business judgment rule may not afford boards and management sufficient protection and flexibility to consider a “blended value” in all operating decisions and may not come into play in change of control situations when boards and management generally have a fiduciary duty to act solely in the interest of maximizing shareholder value. Because these rules are judicially created and interpreted, and because litigation is prevalent, even where judicial guidance exists, directors and their lawyers tend to apply risk-averse interpretations, resulting in the practical effect that consideration of “blended value” seldom succeeds in the boardroom if it threatens the maximization of short-term or long-term shareholder profitability.
Further, the traditional corporate form presents risks for the entrepreneur seeking to maintain the mission of a Special Purpose during the life of an early-stage corporation, without the possibility or probability that investors will shift the company away from the original Special Purpose over time (particularly at the time of a change of control), in favor of additional profitability instead. This difficulty in “anchoring the mission” represents a significant issue for entrepreneurs utilizing a blended value model. The typical vehicles for accomplishing such a “mission anchor” either tend towards over-breadth (e.g., a super-voting stock as used in Google or rumored for Facebook), meaning that investors are at risk of a “bad actor” on the part of the founders, or they result in overly narrow solutions (e.g., putting provisions in the articles, in states where that is possible, or in the bylaws) where they may be either ignored, if they conflict with a director’s fiduciary duty, or diluted or deleted by amendment. Obviously, investors seeking a reasonable internal rate of return focus both on appreciated value for their investments, and on the time period between the investing and realization of liquidity from the investment (typically through a sale of the company or a public offering of shares). This timing element (and a desire by institutional money to control the timing of liquidity events), places increased pressure on the methodologies for anchoring the mission.
Finally, even if the risk of director liability could be eliminated and an equitable means for anchoring the mission were possible, the traditional corporation statutes provide for disclosure of financial data of a company, but not data revealing performance in accomplishing a Special Purpose. Without transparency in this area, the risk for investors exists that directors waste corporate assets without accountability, under the auspices of seeking to achieve a Special Purpose. Of course, companies could choose to voluntarily report on such matters (much as companies began voluntarily reporting on carbon emissions and programs to reduce greenhouse gases before reporting requirements began to emerge). However, without a baseline of required disclosure, comparison among companies will likely prove impractical as a result of variations in qualitative and quantitative information voluntarily disclosed.
The proposed Flexible Purpose Corporation integrates the for-profit philosophy of the traditional corporation along with its statutory certainty and standardization, but seeks to address the issues noted above so that entrepreneurs and investors can avoid the difficult work of trying to integrate a Special Purpose mission within the scope of the business judgment rule and, instead, can work on building an organization from the start that integrates achieving profitability and accomplishing its stated Special Purposes without the traditional obstacles and considerations.
How is a Flexible Purpose Corporation Different from a Traditional Corporation?
The new form of for-profit corporation proposed, encourages and expressly permits companies to be formed or converted from other forms to pursue one or more purposes in addition to creating economic value for shareholders, pursuant to lawful acts or activities for which a corporation may otherwise be organized under the GCL. To some extent, entities taking this form may evince characteristics of both for-profit and non-profit corporations. They will, however, be subject to all provisions of the GCL, except as specifically provided in the new law. As a means of aligning corporate and investor interests, such Flexible Purpose Corporations will be required to specify in their Articles of Incorporation (“Articles”) at least one “Special Purpose” that directors and managers may consider in addition to traditional shareholder economic interests when determining what is in the best interests of the Flexible Purpose Corporation and its shareholders with respect to decisions about operations, policies and transactions.[iv] As further described in Section 3 below, decisions and actions of the directors and officers properly made that consider those multiple (and potentially competing) purposes will be protected from claims of waste or other breach of fiduciary duties, with offsetting requirements of transparency (as further described in Section 6).
This proposed statute will require that the Articles specifically identify at least one such Special Purpose in addition to the general authorization to engage in any lawful business under the GCL, as further described in Section 1 below. Flexible Purpose Corporation directors and officers will honor investment decisions by shareholders by adhering to all of the purposes to which the corporation is dedicated. Thus, within prescribed limits, the new corporate form will permit directors and officers to promote one or more special purposes, even at the expense of economic value, provided that such purposes are clearly specified in the Articles and there is sufficient accountability and transparency (as further described in Section 6 below).
More specifically, the Flexible Purpose Corporation is different from a corporation organized in California under the current GCL in the following ways:
1. A Qualifying Special Purpose Must be Set Forth in the Articles. The Articles of a Flexible Purpose Corporation must set forth the following:
(a) A provision mirroring Section 202 of the GCL, to the effect that “The purpose of the corporation is to engage in any lawful act or activity for which a corporation may be organized under the General Corporation Law of California other than the banking business, the trust company business or the practice of a profession permitted to be incorporated by the California Corporations Code;” and
(b) An additional dedication of the organization to one or more of the following “Special Purposes:”
(i) one or more charitable, or public purpose activities that could be carried out by a California nonprofit public benefit corporation; or
(ii) The purpose of promoting positive short-term or long-term effects of or minimizing adverse short-term or long-term effects of the Flexible Purpose Corporation’s activities upon any of the following:
(A) The Flexible Purpose Corporation’s employees, suppliers, customers, and creditors;
(B) The community and societal considerations; or
(C) The environment.
The language of this Special Purpose is not designed with a view of creating a lowest common denominator, below which someone could not establish a Flexible Purpose Corporation. Nor is it designed to create a vehicle for outside policing, other than accountability to the investors and shareholders of a Flexible Purpose Corporation regarding compliance with one or more Special Purposes and the public reporting of efforts and resources devoted to realization of the Special Purpose. Rather, the Special Purpose requirement is designed to put shareholders and potential shareholders on notice that the corporation will pursue agreed interests that may (or may not) align with profit maximization, depending upon the business judgment of the directors, taking into account the Special Purpose.
2. The Special Purpose Mission is Anchored Until Two-Thirds of Each Class of Voting Shares Vote Otherwise. The proposed statute anchors the Special Purposes by requiring a supermajority vote of at least two-thirds of each class of voting shares held by the Flexible Purpose Corporation’s shareholders to materially alter or eliminate the Special Purpose.
3. Directors are Protected for Decision-Making Involving Trade-Offs between Profitability and the Special Purpose. As noted above, the Special Purposes must be clearly identified in the Articles filed with the Secretary of State. Once so set forth, directors and officers are afforded considerable flexibility in their decisions and actions, both within and outside of the ordinary course of business, subject to reasonableness and materiality standards of existing case law. Such decisions and actions need not necessarily favor any one purpose (including enhancing shareholder value) over any other. Rather, existing case law that imposes a reasonableness and materiality standard will also apply to the prioritization by directors and managers of one or more of the stated Special Purposes over others, including, in appropriate circumstances, favoring the achievement of a stated Special Purpose over the economic interests of the shareholders.
4. Change of Corporate Form Requires a Vote of at least Two-Thirds of Each Class of Voting Shares. New entities may incorporate using the Flexible Purpose Corporation form, and extant for-profit corporations may convert into Flexible Purpose Corporations. In addition, Flexible Purpose Corporations may convert into other California domestic or foreign legal entities. Flexible Purpose Corporations may also merge with other Flexible Purpose Corporations or with other extant forms whose laws permit such mergers, and either survive or terminate in such mergers. However, any merger or reorganization materially altering or eliminating an existing Flexible Purpose Corporation’s Special Purposes, and any decision by any other business entity to become a Flexible Purpose Corporation would require the same supermajority vote of at least two-thirds of each class of voting shares applicable to a material change of such Special Purposes, absent the reincorporation or merger.
5. Shareholders Cannot be Forced Into or Out of a Flexible Purpose Corporation Without Dissenter’s Rights. Similarly, the proposed statute provides shareholders with dissenters’ rights (opt-in/opt-out opportunities with appraisal rights for those who opt-out) in the event of any material change in the Special Purposes set forth in the entity’s Articles. Unlike the GCL, as previously noted, the draft proposed statute only permits such a change to the Special Purposes if approved by at least a two-thirds vote of each class of voting shares. Shareholders also have such opt-out and appraisal rights in the event a two-thirds vote of each class of voting shares approves certain business combinations (particularly a merger with and into a non-Flexible Purpose Corporation) or a conversion of another legal entity into a Flexible Purpose Corporation or of a Flexible Purpose Corporation into another legal entity, in each case, following approval by at least a two-thirds vote of each class of voting shares.
6. A Flexible Purpose Corporation must Provide Annual Reports on its Impact Towards its Special Purposes and an Assessment of Future Expenditures Anticipated. To offset and compliment the expanded scope of directors’ and officers’ protected decision-making and actions, expanded requirements of transparency and shareholder communication (in particular as to Special Purposes) are included. The Flexible Purpose Corporation will be required to disclose publicly information regarding objectives, goals, measurement and reporting of the impact or “returns” of actions vis-à-vis such Flexible Purpose Corporation’s Special Purposes.
A Flexible Purpose Corporation’s shareholders will have the right to elect and remove directors, thereby enforcing the corporation’s adherence to its Special Purposes – but other parties will have no new rights of action as a result of these Special Purposes.
Are There Other Ways Flexible Purpose Corporations Differ From Corporations Organized Under California’s General Corporation Law?
No. In fact, the Flexible Purpose Corporation is a GCL corporation, except as to those matters noted above, as well as other non-substantive conforming changes, and the Flexible Purpose Corporation relies on the GCL for all other matters.
Can’t I Organize an LLC with the Same Results as a Flexible Purpose Corporation?
Yes. As previously noted, LLCs are a product of contract law and, as such, may include all of the proposed statutory requirements noted above in an LLC operating agreement. Yet LLCs are not favored by institutional investors for reasons previously noted and because investors typically do not appreciate the time and expense of performing due diligence on a company-by-company basis for the variations among operating agreements drafted by different lawyers, using different templates, and meeting the specific needs of different founders and entrepreneurs. Instead, investors prefer corporations where statutory requirements and case law provide greater certainty and the ability for standardization and market efficiency.
When Can I Form or Convert Into a Flexible Purpose Corporation?
The introduction of Senate Bill 201 by Senator DeSaulnier represents a great step forward. Obviously, the legislature would have to enact the legislation and Governor Brown would have to sign the adopted bill into law, before anyone could use the corporate form. If successful, however, some predict that the Flexible Purpose Corporation proposal would not pass before the spring/summer of 2011 and may not be effective until January 1, 2012.
[i] Other models, such as co-ops, employee-owned businesses and business-owned by trusts have clearly been tried, but have not gained a significant foothold in the traditional capital markets.
[ii] Limited liability companies (“LLCs”) are pass-through entities (for tax purposes), like a partnership, unless the LLC has elected to be taxed as a corporation.
[iii] In fact, an LLC need not pursue a business objective and is not required to be a profit-seeking enterprise, but rather, may be formed for “any lawful purpose.” Thus, an LLC may be used to achieve estate planning goals or to pursue charitable, religious or educational purposes.
[iv] As a proposed statute that would build on the GCL, nothing in this proposal is intended to take away from the latitude directors and officers of a corporation existing under the GCL are permitted in making decisions in the best interest of the corporation and its shareholders. Rather, it is envisioned that Flexible Purpose Corporation directors and officers would have that same latitude, in addition to the right to make decisions that specifically offset maximization of profit and the special purpose when, in their business judgment, such a decision is necessary and appropriate, even in the context of a sale transaction.
*Todd is a partner at the law firm of Jones Day, where he founded their Silicon Valley Office and runs their Renewable Energy and Sustainability Practice. The views expressed in this column are solely Todd’s personal views, not the views of Jones Day or its clients, and the information provided as to his affiliation with Jones Day is solely for purposes of identification and may not and should not be construed to imply endorsement or even support by Jones Day of the views expressed herein. © R. Todd Johnson, 2011. The thoughts, ideas and words expressed in this column are the property of R. Todd Johnson and may not be otherwise used or reprinted without express permission from Todd.
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