The Flexible Purpose Corporation and Senate Bill 201
February 23, 2011
W. Derrick Britt (Working Group Co-chair), Partner, Doty, Barlow, Britt, and Thomas, LLP,
R. Todd Johnson (Working Group Co-chair), Partner, Jones Day,
Susan H. MacCormac (Working Group Co-chair), Partner, Morrison Foerster
The California Working Group for New Corporate Forms (the “Working Group”)[i] organized in the summer of 2008 to begin drafting a new division of the California Corporations Code designed to facilitate the organization of companies in California with greater flexibility for combining profitability with a broader social or environmental purpose (a “Special Purpose”). The self-appointed Working Group consists of a diverse collection of individual corporate lawyers in California – from academia, non-profit law firms, organizations fostering social entrepreneurship and large and small corporate law firms.
The “Frequently Asked Questions” (“FAQs”) and answers that follow are meant to accompany the proposed statutory changes circulated by the Working Group and introduced in the California General Assembly by Senator Mark DeSaulnier in 2010 as Senate Bill 1463, and reintroduced by Senator DeSaulnier in 2011 as Senate Bill 201. We note that SB 201 does not currently include any substantive changes from the original SB 1463. The FAQs provide insight into the Working Group’s purposes, rationale, and intentions in offering the proposed changes, as well as background on why the Working Group pursued this proposed statutory framework. Equally important, the FAQs provide a summary of comments received by the Working Group during its work and a summary of why it made its choices contained in the proposal.
As of February 23, 2011, SB 201 is under review, and amendments may be recommended on or after March 8, 2011. The bill will then be examined by both the Judiciary Committee and the Banking and Financial Institutions Committee of the California State Senate.
Who is part of the “Working Group” and How Were They Selected?
Originally convened by the three co-chairs, the members of the Working Group[ii] were invited based on their corporate law experience and reputation as well as their ability to represent a diverse set of views in resolving various “friction points” identified in creating hybrid organizations (embedding into a for-profit entity special purposes that are usually found in a non-profit entity). By consensus, the Working Group spent nearly 18 months deliberating and drafting the proposed new division of the California Corporations Code. The diverse background of the members of the Working Group and its advisors,[iii] together with the decision to produce a consensus outcome, were designed to ensure that the final work product represented no particular bias, no particular group or groups and no particular agenda other than a desire by ten individual California lawyers to fashion a proposal for meeting the needs for a corporate form where the ability to integrate profitability and a Special Purpose exists without the legal frictions inherent in California’s existing General Corporation Law (the “GCL”) and its non-profit alternatives.
Did the Working Group’s Process Include Transparency or Input?
From the summer of 2008 when the Working Group began its work, until November 2009, the Working Group crafted a proposal that would achieve consensus among the ten lawyers involved. Given the diverse backgrounds and interests of the members, this provided each member with veto power on any particular point. The resulting proposal engenders multiple compromises between ideals, but a proposal that the Working Group believes provides the best possible structure for a new corporate form in California.
In November 2009, the Working Group published a draft of its proposal and a first draft of this FAQ, soliciting advice, comments and feedback from an advisory committee comprised of members of the California legal community, as well as members of the business community. In the end, the Working Group received dozens of comments, including extensive comments from the Corporations Committee of the Business Law Section of the State Bar of California (the “Corporations Committee”) and from various businesses interested in the proposal. The Working Group considered all comments received and subsequently made changes that are reflected in the final proposal. A summary of the comments received together with the consensus view of the Working Group is included at the end of this FAQ.
What is the Name of the New Entity?
The Working Group considered various possible names for the new corporate entity and, for a time, used the working name of “H Corporation” (where the “H” stood for hybrids). Ultimately, the Working Group arrived at “Flexible Purpose Corporation” as most closely describing the final corporate form’s differences from the traditional corporation formed under California’s General Corporation Law. In addition, the name reflects the legislation’s provisions encouraging the employment of “best practice” standards in the preparation of public reports on impact.
Why Consider Alternatives to Traditional Corporations and LLCs?
The co-chairs initially convened the Working Group after the veto by Governor Schwarzenegger of California Assembly Bill 2944 in the summer of 2008. Assembly Bill 2944 would have included a provision applicable to all corporations permitting directors, when deciding what is in the best interests of the corporation and its shareholders, to consider, among other things, the long-term and the short-term interests of the corporation and its shareholders, the corporation’s employees, suppliers, customers, and creditors, community and societal considerations, and the environment.
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.[iv] Although the fundamental characteristic difference between these two options remains tax treatment,[v] 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.[vi] 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? 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.[vii] 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 legislative proposal produced by the Working Group with this FAQ represent a draft being considered as an amendment to Senate Bill 201. The introduction of Senate Bill 201 represents a great step forward and the Working Group appreciates the efforts of Senator DeSaulnier in championing this legislation. The Working Group is working with the bill’s sponsor and others seeking some amendments and ultimately passage of legislation. 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, the Working Group predicts that the Flexible Purpose Corporation proposal would not pass before the spring/summer of 2011 and may not be effective until January 1, 2012.
Can You Elaborate on the Comments Received By the Working Group?
The Working Group received dozens of written comments on its initial draft proposal. Some commentators provided technical comments on particular statutory language or ideas for changes. Most comments, however, can be classified into one of three categories: (1) those from individuals and businesses that viewed the proposal as a needed step in the right direction, but questioned whether the proposal went far enough, (2) those from individuals and businesses that were critical that the proposal was unnecessary or went too far, and (3) those from individuals and the Corporations Committee that offered constructive feedback on provisions that the Working Group should reconsider.
The Working Group summarizes below the broad categories where comments were received. In most cases, the points raised were considered at length by the Working Group, so the summary also provides a brief review of the internal considerations of the Working Group relating to those comments, as well as a summary of any countervailing comments received from other interested parties.
1. Fear of “greenwashing” and permissive (as opposed to mandatory) approach vs. “halo effect.”
Some commentators expressed concern that the approach adopted by the Working Group has a high potential for misuse and greenwashing. These commentators expressed concern that some companies could choose a small or narrow Special Purpose, serving solely a narrow “mitigation of evil,” for example, and benefit from the goodwill created by companies who adopt the form, but are far more substantive in their efforts to create a public benefit. Thus, some commentators expressed a fear that some companies that would otherwise be obvious candidates might avoid becoming a Flexible Purpose Corporation in order to avoid association with “greenwashers.”
This touches upon the first issue considered by the Working Group when it organized in the Summer of 2008: Should the proposal require a minimum level of behavior below which a company could not incorporate as a Flexible Purpose Corporation? After numerous discussions on this topic, the Working Group decided against the idea, in favor of the proposed permissive language. The Working Group’s decision was guided by the following thinking.
First, notwithstanding the complaint and concern that some companies may not adopt this newly proposed form out of a concern that a few companies might abuse it, the Working Group believes that its proposal will likely have a significant impact in California where there presently exists no alternative for companies seeking to accomplish a Special Purpose through a corporation. As a result of the earlier-mentioned long-arm statute, even companies incorporated elsewhere, but operating in California, cannot imbed social or environmental missions in their Articles without risk. In both cases, the California GCL does not permit such provisions. Thus, the proposal provides for a departure from the current prohibition in California corporation law by permitting, for the first time, the express statement of a corporate purpose other than making money. As a result the Working Group believes that this concern may be overstated and notes that the complaints of “greenwashing” that some commentators mentioned are likely built from current experience where competitors already make false “green” and “clean” claims. Although the Federal Trade Commission focuses on this issue today, only governmental investigative powers permit access to sufficient information to determine the truth of such claims. In this respect, the transparency requirements of the new proposal should significantly advance the cause of bringing light to fears of “greenwashing” claims.
Second, the Working Group agrees with those commentators who fear that a risk exists for misuse of the new corporate form. As one commentator noted, the proposal would not prohibit a company from using its minimal effort of “carbon emissions abatement presently pursued, as an excuse for reincorporating as a Flexible Purpose Corporation for the benefit of being known as doing good.” The Working Group does not, however, believe that this possibility of misuse argues for greater proscriptions or prescriptions, but rather, suggests a need for greater monitoring, reporting and certifying by outside organizations of whether a Special Purpose pursued by any particular company is or is not “green” or “good” and for greater transparency around the impact being achieved by corporations for claimed “green” or “good” results. As a result, the Working Group’s proposal includes the first-ever proposed, public reporting obligation for a for-profit entity relating to its impact, other than financial impact.[viii]
The proposal requires public disclosure of an annual management discussion and analysis of the Special Purpose that:
(1) identifies and discusses the short-term and long-term objectives of the Special Purpose and explains any changes made in those objectives during the fiscal year;
(2) identifies and discusses the material actions taken during the fiscal year to achieve its stated objectives, the impact of those actions (including the causal relationships between such actions and the reported outcomes) and the extent to which those actions achieved the objectives for such fiscal year and identifies the material actions, including the intended impact of such actions, that it expects to take in the short-term and long-term in an effort to achieve its objectives;
(3) describes the process for selecting, and identifies and discusses, the financial, operating and other measures used during the fiscal year for evaluating its performance in achieving objectives with an explanation of why it selected those measures, together with an identification and discussion of the nature and rationale for any material changes made during the fiscal year in its measures; and
(4) identifies and discusses any material operating and capital expenditures incurred by the company during the fiscal year to achieve the objectives, a good faith estimate of additional material operating or capital expenditures it expects to incur over each of the next three (3) fiscal years to achieve its objectives, and other material expenditures of resources incurred during the fiscal year, other than those identified above (including employee time) to achieve its objectives, together with a discussion of the extent to which such capital or use of other resources serve purposes other than and in addition to furthering the achievement of its objectives;
together with any other information that the officers and directors believe to be reasonably necessary or appropriate to an understanding of the flexible purpose corporation’s efforts in connection with the Special Purpose.
Ultimately, the Working Group favored transparency through reporting, and avoided establishing a minimal level of “goodness” for several reasons.
First, there existed the difficulty of determining what should and should not be included as part of the minimal requirement of “good” – environmental impact mitigation (only?), environmental remediation, living wage (only?), executive pay limits, charitable contributions (levels?) – and the equally thorny issue of determining who is qualified to pass judgment on such a decision. Concerns arose, too, of whether standards could be drafted specific enough to have meaning, but broadly enough to encompass any industry.
Second, the Working Group also considered whether specified behavioral standards might stifle innovation in the future, keeping some companies from adopting the form even if they were providing an incremental social benefit or might become quickly outdated depending upon social norms. For example, in considering this question, the Working Group hypothesized scenarios under social norms, such as whether a tobacco company could have qualified to use this form 30 years ago? Twenty years ago? Could a tobacco company qualify at all today, even if it utilized environmental “best practices” and provided positive social impact? What about a handgun company? In this respect, the Working Group struggled with whether product should matter to such a threshold, or should such a threshold be solely process focused? And if product were a consideration, then what products? And should they change over time? For example, could a marijuana shop qualify?
The Working Group’s deliberations led to the conclusion that such considerations simply devolve into a “back-door” means for regulating certain products or pursuing other controversial public policy objectives and, ultimately, would lead any discussion of such a legislative proposal into the turmoil of special interests. Thus, the Working Group determined to let the market decide this question, understanding that, like most things (especially most good things), it will inevitably be abused by some (making even more important the need for the gatekeepers, monitors, certifiers and the focus on transparency).
Third, the Working Group received expressions of opposition to its permissive proposal from those companies that believe the new corporate form goes too far in providing a “halo effect” for companies adopting the form, for actions that a traditional corporation might already be undertaking and might even be doing better than a Flexible Purpose Corporation could achieve under its Special Purpose. To this concern, the permissive “free market” approach of the proposal presents a powerful retort (when coupled with the innovative way in which many companies are seeking to do more than present statutes permit or make advisable). In essence, by adopting the “permissive” approach, we believe the proposal has the power of a “free market” argument to combat those who might oppose the legislation as providing an unfair competitive advantage, primarily because the proposal contains neither a prescription of minimal behavior, nor public benefits of any type (such as favored tax treatment).
Finally, we note that the proposal, as introduced during the last legislative session as Senate Bill 1463, received support from the Corporations Committee, which stated in their draft letter to the Working Group as follows:
In response to investor demand . . . we support providing consenting business owners a vehicle to structure their business affairs in a novel way to achieve their multiple purposes. We appreciate that some business owners desire their businesses to achieve some higher good, in addition to doing well. We think it is important that California law provide business owners and organizers flexibility to achieve their goals, provided that shareholders are adequately protected by procedural safeguards. (Emphasis added.)
The Working Group believes strongly, and unanimously, that the proposed approach provides the best manner for permitting what is now prohibited, in a manner that does not include the intellectual and technical complexity of defining “what is good,” and at the same time presenting a strong rebuttal for those who complain that the new corporate form could result in unfair competition. The wisdom of this approach seems underscored by the focus of the Corporations Committee on the flexibility provided by the proposal for the entrepreneur to achieve “their” goals. In addition, the proposal’s requirements for public transparency and reporting on its efforts and success towards achieving its Special Purpose provide the opportunity for more facts than previously included in the marketplace for determining the real impact of a company’s claims of achieving “green” or “good” results. Finally, the existing organizations and the new organizations being formed that are monitoring, measuring and publicizing corporate behavior, should serve as a strong regulator of abusive activity in this area.
2. Dissenter’s rights and super-majority vote.
Nearly eighteen months ago, as the Working Group began its work, the question of merging or converting into or out of an alternative form was discussed. At that time, several goals emerged: (1) it should be easy for companies that want to adopt the form or convert into a Flexible Purpose Corporation to do so, (2) a change in form should cause no harm to shareholders who dissent, and (3) the mission of a Flexible Purpose Corporation needs to be anchored, so that rejecting or materially altering the Special Purpose would be difficult (whether done by merger, conversion or changing the Articles). To accomplish this latter principle, the Working Group determined to require a super-majority vote of each class of stock for any proposed material change in the Special Purpose (whether done by merger, conversion or changing the Articles). Achieving the first two goals, however, proved more difficult.
For purposes of parity, it seemed appropriate to require a super-majority vote to adopt the new form, if the proposal required a super-majority to materially alter or abandon the Special Purpose. Although not immediately obvious, the conclusion of the Working Group to require a super-majority vote to move into or out of the Flexible Purpose Corporation status (or to materially change the Special Purpose) results from a belief that, as a result of the Special Purpose, the Flexible Purpose Corporation is a significantly different corporate form from the standpoint of shareholders and investors. Unlike the combination of other entities, the change into a flexible purpose corporation presents a potentially substantive change for shareholders and investors’ expectations (i.e., potentially trading off value maximization, in favor of the Special Purpose). For this reason, the Working Group believes that changing into a Flexible Purpose Corporation should require a vote higher than that required for combining two other business entities. As one member of the Working Group noted:
There are numerous reasons a company may desire flexible purpose corporation status. Regardless of the company’s Special Purpose, however, the Working Group must protect the investor who believes (rightly or wrongly) that the Special Purpose provides benefits other than monetary benefits, but at a cost to financial performance, and possibly at a significant cost.
In this manner, the Working Group sought to protect both the shareholder who believed that giving up a Special Purpose would be wrong, and the shareholder who believed that adopting a Special Purpose would be costly, but was willing to proceed with the change if a super-majority of shareholders agreed. Ultimately, as noted above, the Working Group concluded that either shift resulted in a substantive change to the corporation’s objectives and results, different from any other combination of two business entities, in which both entities would be bound to pursue, primarily, a maximization of shareholder return. As a result, and in light of California’s traditional policy of protecting shareholders, the Working Group determined to require a super-majority vote for any change.
For this same reason, the Working Group decided to include dissenter’s rights in its proposal – a requirement that dissenting shareholders could be cashed out at fair market value rather than participate in a substantive change in form that might affect the performance of the business. Dissenter’s rights seemed particularly important in achieving the second goal of ensuring that a change in form should cause no harm to shareholders or investors, particularly where the company involved is a private company with no liquidity for shareholders.
In some respects, the Working Group’s conclusion acknowledges the special shareholder provisions unique to California law, primarily because it remains home to significant amounts of the private equity and venture capital money. The super-majority vote and dissenter’s rights serve as an acknowledgment that the proposal changes the rules of the game in a substantial manner, so much so that the Working Group believes that dissenting shareholders should not be dragged into the new form against their will. Without the dissenter’s rights provisions, companies would not be required to pay out shareholders when they change form, but they would likely pay for such a change later as a result of shareholder litigation in the future.
The Working Group recognizes that these requirements could be a barrier to adoption, in opposition to the first goal above. Obviously, the Working Group understands that its proposal means that objecting shareholders might be entitled to cash-out if a present California GCL corporation (or other existing business entity) proceeds with a change into a Flexible Purpose Corporation. But those seeking to convert into a Flexible Purpose Corporation account for only one subset of those seeking to use the proposed new statute – the other being entrepreneurs seeking to start a business. With respect to the latter, the Working Group believes that the proposal achieves its goal, meaning that the issue for the former group presents a short-term, not a long-term, deficiency. With respect to companies seeking to convert, the Working Group erred in favor of protecting shareholders and investors in a state where public policy weighs heavily in that direction.
With respect to the proposal’s standards for disclosure, the Working Group received multiple questions and objections, most recommending that the Working Group adopt one of the existing standards for reporting a “social return on investment” or “SROI.” Unfortunately, commentators encountered the same problem the Working Group first encountered when attacking this issue – “which standard?” Following discussions with many in the field, the Working Group concluded that there existed no single accepted, well-established standard for measurement of SROI, but rather multiple emerging standards. The Working Group reviewed many of the measurement tools that presently exist and ultimately determined that flexibility seemed to be the right approach, as the proposal (if adopted) will apply to large companies (who might well be able to apply the standards of the Global Reporting Initiative (or “GRI”)) and smaller companies (for whom GRI standards would prove financially and logistically difficult, if not impossible). Further, adopting a standard in the proposal risked continual updating and amendment or obsolescence. Given that some commentators have already expressed tepid support for the proposal, with grave concern that the legislative process could result in amendments that turn them into opponents, the Working Group determined that any provision that risked continuous amendment seemed unadvisable.
Ultimately, the Working Group adopted a carrot and stick approach to transparency. The disclosure requirement (with shareholder enforcement and director replacement as the threat) represents the stick for the corporation. Proposed Section 3502(b) provides the carrot in the form of a presumption if they use “best practices.” This permits the statute to live and breathe through court decisions of whether or not a particular reporting standard represents a “best practice,” an approach often taken in statutory drafting and for which courts are well suited to discern through the adversarial process.
Finally, the proposal includes a public reporting requirement around the Special Purpose reports. The Working Group believes strongly these requirements will provide a strong incentive for better reporting, greater detail, and better explanation of efforts undertaken, permitting far better monitoring of greenwashing than is possible today. We should note that the Working Group made changes to some of these provisions in response to comments received. Some commentators expressed concern that the original proposal (which would have required public disclosure of other matters, including balance sheets and income statements of a Flexible Purpose Corporation) would inhibit use of the form. Ultimately, the Working Group agreed, and its final proposal being recommended to Senate DeSaulnier would make changes to Senate Bill 201 consistent with the Working Group’s final proposal.
Some commentators asked why the proposal does not include a special right of action for enforcement of the Special Purpose. In contrast, the Corporations Committee expressed some concern that the new Special Purpose reports required by the proposal would be subject to the GCL’s existing liability standards for material misstatements or omissions of a material fact, including the right to attorney’s fees.
The question of a special right of action was not as difficult for the Working Group to decide as the mandatory threshold issue discussed above, given the general view that a critical element of any successful proposal must include greater latitude for directors to make trade-offs between the Special Purpose and the economic mission of the company. As explained above in “What are the Issues of a Traditional Corporation?,” we note that one of the primary reasons for this alternative form rests with providing better protection to directors under the “business judgment rule.” After acknowledging the need for this protection, the idea of then permitting a new special right of action for enforcing the mission (outside of what is presently available to shareholders) became opposite to the goal of providing directors with greater discretion.
Practical experience reinforces this conclusion. As noted above, officers and directors are not presently prohibited from pursuing objectives other than financial return. Rather, the real and perceived limitations of the “business judgment rule” innovative, as well as market forces and compensation structures contribute to continued emphasis on shareholder value and a lack of innovation around blended value. The greater protection of the proposal seeks to unlock creative opportunities, by eliminating this risk (with the protection of greater transparency on how pursuit of the Special Purpose might be impacting financial objectives) – an impact that would be significantly undercut by a special right of action.
In addition, we believe that current law will permit shareholders to enforce the Special Purpose in several ways. First (and perhaps most strongly), with the additional transparency requirements, shareholders will now possess important information for determining whether a company is working in a manner and with appropriate efficacy to achieve its stated Special Purpose (or for deciding that if a company is reporting little or nothing, perhaps they are doing nothing and directors should be replaced), or for deciding that the Special Purpose serves only as an excuse for lower shareholder returns. Most academic studies conducted in this area show this type of transparency to be extremely effective in changing behavior, even corporate and governmental behavior. Second, the law always permits shareholders to file suit for a director’s breach of fiduciary duties, something that will now include (equally and in the same manner) a failure to adhere to the agreed Special Purpose as it currently applies to failures to sufficiently emphasize financial returns. Thus, the Working Group believes no change is necessary and that a special right of action would be unadvisable and counter-productive to other goals of the proposal.
In contrast, the comments suggesting that the Working Group consider exempting the proposal’s special purpose reports from the GCL’s existing provisions produced the opposite conclusion from the Working Group. As noted above,
“the proposal’s requirements for public transparency and reporting on its efforts and success towards achieving its Special Purpose provide the opportunity for more facts than previously included in the marketplace for determining the real impact of a company’s claims of achieving “green” or “good” results . . . [providing information for] the new organizations being formed that are monitoring, measuring and publicizing corporate behavior, [which] should serve as a strong regulator of abusive activity in this area.”
Excepting these reports from the enforcement standards already imposed on the disclosures of GCL corporations seems akin to making the reporting requirements voluntary, thereby denuding the provisions that the Working Group have used to justify a proposal that requires no mandatory provisions regarding minimum required behavior.
Why not Use an L3C?
The L3C represents another alternative for pursuing profitability together with a Special Purpose mission. However, the L3C is primarily designed for a different type of user – a for-profit entrepreneur with primarily a charitable purpose wishing to attract PRI investments from foundations, as opposed to a for-profit entrepreneur seeking to avail herself of traditional capital market investments.
First, an L3C is a statutory type of LLC that has been considered in 21 states, with legislation currently pending in 12[ix] states and, so far, has been adopted in eight states and by sovereign nations of the Crow Nation and the Oglala Sioux Tribe.[x] All of these jurisdictions have adopted identical changes to state LLC statutes permitting an LLC to be organized for both producing income and wealth accumulation for investors, and performing a socially beneficial purpose that is not earning money for the LLC. The statutory changes were specifically written to dovetail with the United States Internal Revenue Service regulations regarding Program Related Investments (“PRIs”) by foundations.[xi]
But the L3C goes further. As noted by the authors of this form on their website:
The L3C concept provides that the primary purpose of the organization must be charitable, with the production of income permitted to be a secondary purpose. As with a tax-exempt charity that must have a charitable purpose by law, yet also must, from an economic standpoint, have sufficient revenue to conduct operations, institutional decisions must be made with the L3C’s overarching charitable purpose in mind. Thus, the L3C brings together foundations’ PRIs and investments by non-exempt parties to accomplish L3C’s primary charitable purpose through a business that, because of its inherent risk and low likelihood of profit, simply would not be attractive solely to for-profit investors.
Thus, it is important to recognize that in order for an entrepreneur to gain the advantage of potentially receiving PRIs on an easier basis, the L3C trade-off means that it is much closer to a public charity or foundation, than to a for-profit business, at least during the life of the PRI.
Second, the L3C continues to have the same issues of an LLC for institutional investors – namely tax concerns, additional time, effort and cost, due to a lack of uniformity and limited capital market acceptance. See, Can’t I Organize an LLC with the Same Results as a Flexible Purpose Corporation?
Finally, although it could be addressed in the operating agreement, there exist no forms for the operating agreements of L3Cs that address holistically the problems facing entrepreneurs and investors in a blended value company. Specifically, the model forms prepared for L3Cs lack mission anchoring mechanisms, decision-making protection for managing members balancing mission and profitability, and transparency reporting obligations around the charitable or special purpose. Thus, although the L3C provides a solution similar to the Flexible Purpose Corporation for those seeking to establish for-profit entities with a primary charitable purpose, those seeking to use the L3C will need to consider other issues, as well as the disadvantages of deploying an LLC form.
How is a Flexible Purpose Corporation Different from a B Corporation?
The “B Corporation” is not a new corporate form, but rather a certification standard developed by B Lab to differentiate between “good companies” and those that are simply “good marketers” and are involved in “greenwashing” products or processes. A “B Corporation” represents a for-profit entity that meets B Lab’s certification process, much as the “Fair Trade Certified” mark signifies a product that meets TransFair USA’s certification process. In both cases, certification provides those companies willing to pay a royalty to license the mark for display on products and materials with a third-party verified certification distinguishing their company and its products from others.
In many respects, the “B Corporation” certification process remains agnostic as to the form of the entity (although it only certifies for-profit organizations). Thus, a corporation, a partnership, an LLC, an L3C and (presumably) a Flexible Purpose Corporation could all qualify as “B Corporations.” Unfortunately, traditional California corporations formed under the GCL are not able to amend their articles to “embed” a Special Purpose mission, without considerable risk, thereby creating an issue for California corporations seeking “B Corporation” status.[xii] (Of course, there is more flexibility for LLCs as described above.) Therefore, the Working Group believes that the Flexible Purpose Corporation should serve as an enabling statute for B Corporations in California.
Is the Flexible Purpose Corporation a “For-Benefit” Corporation?
The term “For-Benefit” corporation describes an aspirational organizational concept developed by the Fourth Sector Network. It does not identify any particular statutory form of corporation currently in existence, but rather provides guidance on the design of new corporate forms using prototypical characteristics. According to the Fourth Sector Network, neither the Flexible Purpose Corporation nor the Benefit Corporation (discussed below) meets all of the aspirational characteristics of the “For-Benefit” model, but through the specification and anchoring of a Special Purpose, the discretion granted to directors to make trade-offs between the Special Purpose and economic value, and the transparency requirements, the Flexible Purpose Corporation moves in the direction of the “For-Benefit” model.
How Is the Flexible Purpose Corporation Different Than a “Benefit Corporation”?
A number of states[xiii] have introduced legislation creating “Benefit Corporations.”[xiv] In April 2010, Maryland adopted such legislation and Vermont followed suit with similar legislation in May 2010. The statutes in both states (and the legislation pending in other states) have been supported by B Lab, who also provided advice and feedback on the drafting of the Flexible Purpose Corporation legislation. The primary differences between a Flexible Purpose Corporation and a Benefit Corporation are detailed below, but may be summarized as follows:
(1) Benefit Corporations live under a legislatively prescribed standard that requires “a material positive impact on society and the environment, taken as a whole, as compared to Flexible Purpose Corporations that must include one or more of the previously described Special Purposes in their articles;
(2) Benefit Corporations require that the benefit being achieved be measured in accordance with a third-party standard, whereas the Flexible Purpose Corporations are provided added protection if they apply “best practices;”
(3) In determining what is in the best interests of the corporation, the directors of a Benefit Corporation must consider the impacts of any action or proposed action upon various constituents or stakeholders of the corporation, whereas the directors of a Flexible Purpose Corporation must consider the impacts of any action or proposed action on any Special Purpose,
(4) Benefit Corporation legislation requires the appointment of a Benefit Director and Benefit Officer who must certify compliance with the public benefit, whereas the Flexible Purpose Corporation legislation does not; and
(5) Benefit Corporation legislation creates a new right of action for enforcement of the benefit, whereas the Flexible Purpose Corporation legislation relies on the transparency requirements and seeks to provide the fullest measure of protection to directors in order to permit innovation and an unfettered application of their business judgment in making any necessary trade-offs between a Special Purpose and maximizing shareholder value, without fear of litigation;
Ultimately, the Working Group believes that Benefit Corporations are primarily designed for use by private companies focused on sustainability that avail themselves of socially responsible capital, as opposed to companies seeking access to traditional capital markets.
1. Special Purpose vs. General or Specific Public Benefit.
As previously noted, in order for a corporation to qualify under the proposed “Flexible Purpose Corporation” legislation, the corporation must include one or more of the following “Special Purposes” in its Articles: (a) one or more charitable, or public purpose activities that could be carried out by a California nonprofit public benefit corporation; or (b) 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: (i) the Flexible Purpose Corporation’s employees, suppliers, customers, and creditors; (ii) the community and societal considerations; or (iii) the environment. As discussed at length in the prior section “Can You Elaborate on the Comments Received by the Working Group: Fear of “greenwashing” and permissive (as opposed to mandatory) approach vs. “halo effect”” the Working Group favored transparency through reporting, and avoided establishing a minimal level of “goodness” for the reasons noted therein.
The Benefit Corporation legislation takes a decidedly different approach. First, the Benefit Corporation typically employs a “materiality” requirement for any benefit. Specifically, the concept of “General Public Benefit” requires a “material positive impact on society and the environment taken as a whole . . . from the business and operations of a benefit corporation.” Through this requirement, the Benefit Corporation would preclude use of the corporate form by companies seeking to make incremental changes “taken as a whole from its business and operations.” From the perspective of the Working Group, such an approach restricts the impact of the legislation by excluding larger corporations from participating in the new corporate form.[xv]
Second, the Benefit Corporation requires that this standard of material positive impact on society and the environment be in accordance with a third party standard. Although the Working Group acknowledges that numerous groups are working on developing better measurement standards for a “social return on investments” or “SROI,” following discussions with many experts in the field, the Working Group concluded that no single accepted, well-established standard for measurement or verification of SROI exists Instead, there are multiple emerging standards.[xvi] The Working Group reviewed many of the measurement tools that presently exist and ultimately determined that statutory flexibility represented the right approach, as the proposal (if adopted) will apply to large companies (who might well be able to apply the standards of the Global Reporting Initiative (or “GRI”)) and smaller companies (for whom GRI standards would prove financially and logistically difficult, if not impossible). See “Can You Elaborate on the Comments Received by the Working Group: Transparency.”
The Working Group also notes that some of those pursuing the Benefit Corporation legislation may possibly qualify as groups providing the independent “third-party standard” required by the legislation. In particular, the legislation in all nine states has been supported by B Lab, a non-profit organization and the owner and certifier of the “B Corporations” mark, which it licenses (for a fee) to those corporations who qualify under the B Lab certification and desire to display the “B Corporations” mark. The Working Group also notes that the “third-party standard” definition in the Benefit Corporation legislation includes an “independence” standard that excludes anyone that has a material relationship with the company, but one that does not presume that the use of a third party with a financial relationship with the company would violate the independence standard. Instead, the definition and use of a third-party standard relies on transparency with respect to a host of information about the “independent third party” that must be made available.[xvii]
Instead, the Flexible Purpose Corporation legislation adopts a carrot and stick approach to transparency. The disclosure requirement (with shareholder enforcement and director replacement as the threat) represents the stick for the corporation. Proposed Section 3502(b) provides the carrot in the form of a presumption if they use “best practices.” This permits the statute to live and breathe through court decisions of whether or not a particular reporting standard represents a “best practice,” an approach often taken in statutory drafting and for which courts are well suited to discern through the adversarial process. The Working Group firmly believes (as previously stated) that a system of third-party standards may well emerge as a “best practice” for companies seeking the full measure of impact from such a corporate form, but that such best practices could also come from other sources, including business competitors.
Finally, the Working Group avoided a prescriptive approach to the Special Purpose as a result of California’s unique environment for encouraging private investment in private companies (through venture capital and private equity). Ultimately, it was the judgment of the Working Group that prescriptive measures run the risk of thwarting the flow of capital to such companies, contrary to an overriding goal of the Working Group of creating a structural platform that would encourage capital investment in such companies.
Most of the states adopting or considering Benefit Corporation legislation have previously adopted “constituency statutes.”[xviii] Under the traditional constituency statutes, when directors consider what is in the best interests of the corporation and its shareholders, the directors “may” (or in some cases, “shall”) take into account various constituencies, including shareholders, employees, customers, suppliers, creditors, communities, society as a whole, and long-term interests. Benefit Corporation legislation requires directors and officers to consider the effects of any action on its shareholders, employees, suppliers, customers, community and societal factors, local and global environment, short-term and long-term interests, and the ability of the Benefit Corporation to accomplish its General Public Benefit Purpose and any Specific Public Benefit Purpose. Thus, the Benefit Corporation applies a new, more stringent constituency requirement for most of the states considering or adopting the statute, because the legislation broadens the list of constituents and requires that the board consider the impact of decisions on those constituents, whereas most of the affected states had a permissive standard, rather than a requirement, in their previous constituency statutes (to the extent they included such a provision).
California does not have a constituency statute and the Working Group believes it imprudent to adopt such a requirement for Flexible Purpose Corporations. Although 31 states have adopted constituency statutes, the Working Group notes that state courts have almost unanimously failed to interpret such provisions. See, Bainbridge, Stephen M., Interpreting Nonshareholder Constituency Statutes, 19 Pepp. L. Rev. 971 (1992). Mostly, the constituency statutes were adopted in the mid to late-1980’s as a response to hostile takeovers. The purpose, in nearly every case, was to provide directors with greater control in accepting or rejecting an offer to purchase a company by permitting consideration of other factors beyond maximization of shareholder value. Due to a lack of judicial decisions interpreting such statutes, the Working Group is not convinced that such provisions will effectively shield board and management from liability if the interests of certain stakeholders are promoted to the detriment of shareholder value.[xix]
The Working Group believes that the Flexible Purpose Corporation legislation accomplishes similar goals, through other, less risky means. First, a Flexible Purpose Corporation has the freedom to recognize various constituents within its Special Purpose or Purposes. Thus, a Flexible Purpose Corporation could adopt a purpose that requires the directors to consider decisions on the list of stakeholders noted in the Benefit Corporation, or it could alter that list by including additional or fewer such constituents.[xx] For example, a Flexible Purpose Corporation could adopt a purpose that requires that directors consider enumerated or described constituents as part of a Special Purpose, without subjecting the directors to an increased risk of lawsuits that simply diminish the assets of the corporation. Second, in the case of a Flexible Purpose Corporation, the shareholders are vested with the authority to determine whether a company should be sold or not to a company not intending to honor its Special Purposes, by requiring that two-thirds of each class of stock vote in favor of such a transaction. By placing the decision for such a sale in the hands of a supermajority of the shareholders (and providing for dissenters’ rights), the Working Group believes no increased risk of shareholder litigation would ensue, and that no risk of increased director liability would portend. In particular, the shareholder vote and dissenters’ rights requirements of the Flexible Purpose Corporation legislation should provide greater protection to directors and officers. As a result, the Working Group is of the view that such provisions of the Benefit Corporation legislation simply further the prescriptive nature of the Benefit Corporation, in contrast to the decision by the Working Group for a permissive standard as discussed above, with the risk that such prescriptions could result in unintended negative consequences.
3. Benefit Directors and Benefit Officers.
The Benefit Corporation legislation generally requires the appointment of a Benefit Director and/or Benefit Officer responsible for completion annually of a certificate of compliance with its General Public Benefit Purpose and any Specific Public Benefit Purpose.[xxi] The Working Group has rejected the idea of placing one director or officer in such a position, most importantly due to the potential conflicts of interest that may arise between such a director or officer’s constituency role and their fiduciary duties more broadly. See, Veasey, Norman E., and Di Guglielmo, Christine T., How Many Masters Can a Director Serve? A Look at the Tensions Facing Constituency Directors, 63 Bus. Law. 761 (2008).
As noted below, both the Flexible Purpose Corporation legislation and the Benefit Corporation legislation require far greater transparency on SROI through an annual report published, not only for shareholders, but made publicly available. The Working Group expressed concern that appointment of one director and/or officer with the compliance role serves to give those individuals a practical veto power on actions by the corporation, particularly where such director and/or officer believes that the corporate action would result in a decision of non-compliance. The Working Group expressed two concerns with such a system. First, the possible veto power of one director through the threat of a noncompliance determination risks a determination by a court that such an action usurps the fiduciary duties of other directors to exercise their best business judgment in all circumstances. Second, notwithstanding provisions in the Benefit Corporation legislation exonerating such individuals of any additional liability, as Chancellor Veasey notes:
Whether and how a constituency director can carry out his fiduciary duties is context-dependent. Many—probably most—board functions and decisions may not present a conflict issue. In a healthy, well-functioning company, for day-to-day business issues (i.e., “enterprise issues” as distinct from “ownership issues”), the interests of all constituencies may be generally aligned. That is, all constituencies generally should be interested in the long-term value of the company. Where that is the case, the corporate interest serves as a proxy for the interests of the stockholders. Indeed, the Delaware Supreme Court sometimes articulates directors’ fiduciary duties as owed to “the corporation” and sometimes articulates the duties as owed to “the corporation and its shareholders.”
Certain sponsors may sometimes have interests other than maximizing long-term financial returns on investment, even under normal, day-to-day circumstances. For example, an investor may be interested in seeing a company make environmentally favorable business decisions, even if doing so reduces financial returns. But such an investor could make a reasoned argument that operating a business in an environmentally sustainable way also makes good business sense and therefore increases long-term financial value. Thus, the existence of such interests does not necessarily undermine the general premise that stockholders usually are interested in the long-term value of the company. . . .
Where the interests of various constituencies do diverge—that is, where the corporation’s interests do not serve as well as a proxy for the interests of the stockholding body as a whole, as in some “end game” or “bet the company” scenarios—a constituency director may need to evaluate whether that divergence may subject the director to a conflict. And if so, the director will need to consider what the director’s course of action should be to “do the right thing” as well as to avoid liability. In undertaking that evaluation, the director must first consider to whom he owes fiduciary duties. That question underlies the potential tension that constituency directors face in fulfilling both their fiduciary duties and their obligations to their constituencies.
Id. 764-5 (footnotes omitted). The Working Group sees no reason to increase risk (even nominally) for such directors or officers, given the vigorous new transparency inherent in the annual reporting requirement of both legislative proposals.
As previously noted, both the Benefit Corporation legislation and the Flexible Purpose Corporation legislation require a significant level of transparency regarding accomplishments in relation to the relevant special purposes. Although both require the publication annually of a report that must be sent to shareholders and otherwise made publicly available, significant differences exist.
The Benefit Corporation report relies on the third-party standards previously mentioned. Not so for the Flexible Purpose Corporation report. Rather, the latter is fashioned in much the same way as a corporation would be required to fashion a management discussion and analysis under the Federal securities laws. Proposed Section 3502(b) provides a carrot in the form of a presumption if they use “best practices.” This permits the statute to live and breathe through court decisions of whether or not a particular reporting standard represents a “best practice,” an approach often taken in statutory drafting and for which courts are well suited to discern through the adversarial process.
The general guidelines for the Flexible Purpose Corporation report are more prescriptive than those of the Benefit Corporation report (in part because the former does not rely solely on a third-party standard), requiring disclosure publicly of information regarding objectives, goals, measurement and reporting of the impact or “returns” of actions vis-à-vis such Flexible Purpose Corporation’s Special Purposes.[xxii]
5. Adoption and Change of Form.
Like a Flexible Purpose Corporation, a company desiring to become a Benefit Corporation and a Benefit Corporation desiring to become a traditional corporation (regardless of the means for accomplishing such change) will require approval from two-thirds of each class or series of stock. Unlike the Flexible Purpose Corporation, however, the Benefit Corporation does not provide for dissenters’ rights. As previously noted in “Can You Elaborate on the Comments Received by the Working Group: Dissenter’s rights and super-majority vote,” dissenter’s rights seemed particularly important in achieving the goal of ensuring that a change in form should cause no harm to shareholders or investors, particularly where the company involved is a private company with no liquidity for shareholders.
In some respects, the Working Group’s conclusion acknowledges the special shareholder provisions unique to California law, primarily because it remains home to significant amounts of the private equity and venture capital money. The super-majority vote and dissenter’s rights serve as an acknowledgment that the proposal changes the rules of the game in a substantial manner, so much so that the Working Group believes that dissenting shareholders should not be dragged into the new form against their will. Without the dissenter’s rights provisions, companies would not be required to pay out shareholders when they change form, but they would likely pay for such a change later as a result of shareholder litigation in the future. Given that an important goal of the Working Group in drafting the Flexible Purpose Corporation legislation was to encourage access by such companies to the traditional, mainstream capital markets, reduction of a litigation risk seemed prudent.
The Benefit Corporation legislation includes a new right of action that may be brought directly by the corporation or derivatively by a shareholder or director. Titled a “benefit enforcement proceeding,” the action could be brought to enforce the General Public Benefit Purpose or the Specific Public Benefit Purpose.
As noted above, in the case of a Flexible Purpose Corporation (as in the case of a Benefit Corporation), the Special Purposes must be clearly identified in the Articles filed with the Secretary of State. Once so set forth, directors and officers (in the case of the Flexible Purpose Corporation) 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.
The question of a special right of action was not difficult for the Working Group to decide, given the general view that a critical element of any successful proposal must include greater latitude for directors to make trade-offs between the Special Purpose and the economic mission of the company. As explained above in “What are the Issues of a Traditional Corporation?,” we note that one of the primary reasons for this alternative form rests with providing better protection to directors under the “business judgment rule.” After acknowledging the need for this protection, the idea of then permitting a new special right of action for enforcing the mission (outside of what is presently available to shareholders) became opposite to the goal of providing directors with greater discretion.
Practical experience reinforces this conclusion. As noted above, officers and directors are not presently prohibited from pursuing objectives other than financial return. Rather, the real and perceived limitations of the “business judgment rule” as well as market forces and compensation structures contribute to continued emphasis on shareholder value and a lack of innovation around blended value. The greater protection of the Working Group proposal seeks to unlock creative opportunities, by eliminating this risk (with the protection of greater transparency on how pursuit of the Special Purpose might be impacting financial objectives) – an impact that would be significantly undercut by a special right of action.
In addition, we believe that California’s current law will permit shareholders to enforce the Special Purpose in several ways. First (and perhaps most strongly), with the additional transparency requirements, shareholders will possess important information for determining whether a company is working in a manner and with appropriate efficacy to achieve its stated Special Purpose (or for deciding that if a company is reporting little or nothing, perhaps they are doing nothing and directors should be replaced), or for deciding that the Special Purpose serves only as an excuse for lower shareholder returns. Most academic studies conducted in this area show this type of transparency to be extremely effective in changing behavior, even corporate and governmental behavior. Second, the law always permits shareholders to file suit for a director’s breach of fiduciary duties, something that will now include (equally and in the same manner) a failure to adhere to the agreed Special Purpose as it currently applies to failures to sufficiently emphasize financial returns. Thus, the Working Group believes no change is necessary and that a special right of action would be unadvisable and counter-productive to other goals of the proposal.
The Working Group understands that many states are considering the adoption of a new corporate form within existing corporate codes in an effort to support and encourage the convergence of business profitability and “doing good.” In fact, there presently exists a moment in time for states to adopt unique, innovative ways to accomplish this objective. The federalist system of the United States often permits innovation and experimentation by the states that could not (or would not) be possible on a greater scale.
The Working Group believes that in California, the unique combination of public policy protecting shareholder rights, the long-standing efforts aimed at fostering capital growth and innovative deployment in a free, non-prescriptive market, and the fact that California remains home to more companies seeking to mix mission and money than any other state, produced a climate better suited for a Flexible Purpose Corporation statute than for a Benefit Corporation approach. We also believe that other states may find the Flexible Purpose Corporation approach superior to the Benefit Corporation for their particular state. Ultimately, we believe other states may develop approaches different from either of these two forms, particularly during this time when no effort at standardization exists within the American Bar Association or elsewhere.
With this as a backdrop, the Working Group offers the Flexible Purpose Corporation as its contribution to everyone working to further a new opportunity for the entrepreneurs and investors who are already seeking to use business to solve some of the world’s most intractable problems, particularly when solutions can be deployed in some of the world’s hardest places through “bottom of the pyramid” strategies. Making that opportunity real will likely require a period of experimentation with different solutions and will certainly foster differences of opinion or approach.
[i] Each member of the California Working Group for New Corporate Forms participated in the Working Group in his or her individual capacity and the information provided as to affiliation or other association with any organization is solely for purposes of identification and may not and should not be construed to imply endorsement or even support by such organization.
[ii] The members of the Working Group are W. Derrick Britt (Co-chair), Partner, Doty, Barlow, Britt, and Thomas, LLP, R. Todd Johnson (Co-chair), Partner, Jones Day, Susan H. MacCormac (Co-chair), Partner, Morrison Foerster, Keith Paul Bishop, Partner, Allen Matkins Leck Gamble & Mallory LLP, Edward A. Deibert, Director, Howard Rice Nemerovski Canady Falk & Rabkin, William P. Fitzpatrick, General Counsel, Omidyar Network, Steven K. Hazen, Retired, Former Vice-Chair for Legislation of the State Bar of California Business Law Section, David M. Hernand, Partner, Gibson Dunn & Crutcher LLP, Jay A. Mitchell, Director, Organizations and Transactions Clinic, Stanford Law School and former chief corporate counsel of Levi Strauss & Co., and Robert A. Wexler, Partner, Adler & Colvin.
[iii] As a self-appointed team, the Working Group sought input and guidance from a wide array of experts in business and law. In this respect, we are exceptionally grateful for the guidance, wisdom and input from individuals such as Marshall Small, R. Bradbury Clark, the California Commissioner of Corporations and his staff, members of the Corporations Committee of the Business Law Section of the State Bar of California, as well as business leaders such as Don Schaeffer, Penelope Douglas, Jeff Mendelsohn and Andrew Kassoy, to name a few.
[iv] 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.
[v] 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.
[vi] 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.
[vii] 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.
[viii] The original Flexible Purpose Corporation legislation was introduced in California in SB 1463, in February 2010. Since that time, the Benefit Corporation legislation has introduced a similar reporting requirement and one that has passed in Vermont and Maryland.
[ix] In addition to the states that have already adopted an L3C statute and others that have considered or are considering introducing legislation, the following states presently have L3C legislation pending: Arkansas, Arizona, Hawaii, Indiana, Iowa, Kentucky, Maryland, Montana, New York, Oklahoma, Oregon, and Rhode Island. For more information, please see www.AmericansForCommunityDevelopment.org.
[x] Illinois, Louisiana, Maine, Michigan, North Carolina, Utah, Vermont and Wyoming have all adopted L3C statutes.
[xi] It should be noted that foundations are presently permitted to make PRIs in traditional for-profit entities (e.g., traditional corporations and LLCs), so would also be able to make PRIs in Flexible Purpose Corporations. The L3C seeks to offer greater ease in securing PRIs, although some foundations have questioned whether that is true, or whether an L3C makes PRIs more difficult.
[xii] This is also true for corporations operating in California given the “long-arm” of Section 2215 of the GCL.
[xiii] In addition to the statutes adopted in Maryland and Vermont, the New Jersey legislature has adopted Senate Bill 2170, which is currently awaiting signature by Governor Christie, and Colorado, Hawaii, New York, North Carolina, Pennsylvania and Virginia have all introduced similar legislation.
[xiv] The Working Group has recently learned that Assemblymember Jared Huffman will be introducing Assembly Bill 361 in the California Legislature, seeking passage of the Benefit Corporation legislation.
[xv] The Benefit Corporation legislation also provides for the inclusion of a Specific Public Benefit Purpose that may be included in the company’s articles, which are defined to include (1) providing low-income or underserved individuals or communities with beneficial products or services, (2) promoting economic opportunity for individuals or communities beyond the creation of jobs in the normal course of business, (3) preserving the environment, (4) improving human health, (5) promoting the arts, sciences or advancement of knowledge, (6) increasing the flow of capital to entities with a public benefit purpose, and (7) conferring any other particular benefit on society or the environment. Such Specific Public Benefit Purposes are also encompassed in the concept of Special Purpose in the Flexible Purpose Corporation legislation, although not specifically enumerated.
[xvi] According to a recent report by SustainAbility, there are currently no fewer than 110 different organizations that have developed or are developing standards for the evaluation of products and companies.
[xvii] The Working Group does not mean to suggest or imply here that B Lab would not meet a more stringent standard of independence (for example, the rules employed by the Securities and Exchange Commission relating to auditor independence requirements), only that the independence standard employed by the Benefit Corporation legislation presumes that material employment relationships and material ownership relationships exclude a third-party from being considered independent, but lacks any explicit reference to a material financial relationship, even though such relationships (if material) would violate the overall rule excluding anyone with a “material relationship.” In contrast, the Working Group desires to allow and encourage the development of robust and verifiable standards through many providers through its “best practices” presumption – a presumption that will apply if third-party standards becomes a “best practice,” but that could also apply to many other ways of evaluating and reporting a company’s SROI, without legislating the cost or expense of using a third-party standard. The Working Group is also concerned that the independence test and the requirement that a General Public Benefit in the form of a “material positive impact on society and the environment, taken as a whole, as measured by a third-party standard” creates yet another source of potential litigation for companies.
[xviii] Only Colorado, North Carolina and Virginia have not.
[xix] Although both Flexible Purpose Corporation legislation and the Benefit Corporation legislation contain provisions granting greater protection for directors applying their business judgment when enforcing a special purpose, any such legislation must consider the judicially created presumptions that are contextually driven, where courts have been more than willing to make decisions based upon facts and circumstances that certain acts by a board constitute entrenchment and raise the specter of individual liability for breach of fiduciary duties.
[xx] For example, the Benefit Corporation legislation does not include creditors as one of the stakeholders that directors must consider when taking actions. In contrast, nearly half of the 31 states that have adopted constituency statutes include creditors in the list of stakeholders. Perhaps more importantly, there is considerable case law that suggests directors of corporations in a fragile financial condition (commonly referred to as corporations in the “zone of insolvency”) owe their duties to the corporation’s stakeholders, including its creditors. If and when a corporation becomes insolvent, the focus of the directors’ fiduciary duties changes to include as beneficiaries the corporation’s creditors, who must typically rely upon the terms of their debt instruments for the protection of their interests when the corporation is not financially distressed. For example, under Delaware law, once a corporation becomes insolvent, its officers and directors owe creditors a fiduciary duty. That duty requires the directors of the debtor to maximize the value of the enterprise for all constituencies, including unsecured creditors.
[xxi] Notably, the Maryland statute omits this requirement.
[xxii] In particular, See Chapter 11, Records and Reports, of the Flexible Purpose Corporation legislation, which requires publication of an Annual Report containing, among other things, (a) a balance sheet as of the end of that fiscal year and an income statement and a statement of cashflows for that fiscal year, accompanied by any report thereon of independent accountants or, if there is no report, the certificate of an authorized officer of the flexible purpose corporation that the statements were prepared without audit from the books and records of the corporation; and (b) a management discussion and analysis (the “Special Purpose MD&A”) concerning the flexible purpose corporation’s Special Purpose, which must include the following information:
(1) Identification and discussion of the short-term and long-term objectives of the flexible purpose corporation relating to the Special Purpose (the “Special Purpose Objectives”) and an identification and explanation of any changes made in the Special Purpose Objectives during the fiscal year.
(2) Identification and discussion of the material actions taken by the flexible purpose corporation during the fiscal year to achieve its Special Purpose Objectives, the impact of those actions, including the causal relationships between the actions and the reported outcomes, and the extent to which those actions achieved the Special Purpose Objectives for the fiscal year.
(3) Identification of material actions, including the intended impact of those actions, that the flexible purpose corporation expects to take in the short term and long term with respect to achievement of the process for selecting, and an identification and description of, its Special Purpose Objectives.
(4) A description of the financial, operating, and other measures used by the flexible purpose corporation during the fiscal year for evaluating its performance in achieving its Special Purpose Objectives (together, the “Special Purpose Measures”), including an explanation of why the flexible purpose corporation selected such Special Purpose Measures and identification and discussion of the nature and rationale for any material changes in such Special Purpose Measures made during the fiscal year.
(5) Identification and discussion of any material operating and capital expenditures incurred by the flexible purpose corporation during the fiscal year in furtherance of achieving the Special Purpose Objectives, a good faith estimate of any additional material operating or capital expenditures the flexible purpose corporation expects to incur over the next three fiscal years in order to achieve its Special Purpose Objectives, and other material expenditures of resources incurred by the flexible purpose corporation during the fiscal year, including employee time, in furtherance of achieving the Special Purpose Objectives, including a discussion of the extent to which that capital or use of other resources serves purposes other than and in addition to furthering the achievement of the Special Purpose Objectives.
The Flexible Purpose Corporation legislation also requires that the Special Purpose Current Report identify and discuss, in reasonable detail, any expenditure or group of related or planned expenditures, excluding compensation of officers and directors, made in furtherance of the Special Purpose Objectives, whether an operating expenditure, a capital expenditure, or some other expenditure of corporate resources, including employee time or otherwise, whether the expenditure was direct or indirect and whether the expenditure was made to a person or entity outside of the flexible purpose corporation or was made internally, where the expenditure has or is likely to have a material adverse impact on the flexible purpose corporation’s results of operations or financial condition for a quarterly or annual fiscal period.
*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, 2010. Business for Good.SM is a service mark of R. Todd Johnson. 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.