Two New Corporate Forms to Advance Social Benefits in California

Posted by John F. Olson, Gibson, Dunn & Crutcher LLP and Georgetown Law Center, on Thursday November 17, 2011 at 10:23 am
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Editor’s Note: John Olson is a founding partner of Gibson, Dunn & Crutcher’s Washington, D.C. office and a visiting professor at the Georgetown Law Center. This post is based on a Gibson Dunn alert by David M. Hernand and Stewart L. McDowell.

On October 9, 2011, California Governor Jerry Brown signed into law competing bills that create two new corporate forms in California — a “flexible purpose corporation” and a “benefit corporation” — intended to allow entrepreneurs and investors the choice of organizing companies that can pursue both economic and social objectives. The new corporate forms differ from traditional for-profit corporations that are organized to pursue profit (and not social purposes) and non-profit corporations that must be used solely to promote social benefits. These laws will take effect on January 1, 2012.

The flexible purpose corporation is created by California Senate Bill 201 (“SB 201″), which adds Division 1.5 to Title 1 of the California Corporations Code (the “Code”) and amends other related sections of the Code, and the benefit corporation is created by California Assembly Bill 361 (“AB 361″), which adds Part 13 to Division 3 of Title 1 of the Code. State Senator Mark DeSaulnier authored SB 201, and a full copy is available here. AB 361 was authored by Assemblyman Jared Huffman, and a full copy is available here. Both new laws take effect January 1, 2012.

Background

The new laws offer two versions of a solution to an identified gap in the Code and the corporate laws of many states. Existing law in California permits formation of for-profit corporations that operate within a construct that places interests of shareholders, and specifically return to shareholders, as the primary, if not sole, objective of the corporation and its various agents. A corporation might engage in philanthropy, act in an environmentally conscious manner and promote employee- or community-friendly policies, to name a few, but such pursuits ultimately are rationalized in the corporate governance context as being acts taken to promote long-term value growth for shareholders, and directors of a corporation could face exposure if they lean too far in favor of social objectives at the expense of shareholder returns. In contrast, a non-profit corporation in California is mandated to serve public interests and is specifically prohibited from pursuing private gain. A non-profit corporation that strays too far toward profit-producing activities risks action by the State Attorney General and loss of tax-exempt status (if applicable). This has left a gap for some entrepreneurs and investors that desire a business vehicle which can pursue both profits and social objectives.

SB 201 and AB 361 are the result of efforts by two groups working over the last two years to introduce a new “hybrid” corporate form in California. SB 201 originally was written by a group of corporate attorneys from major law firms in California, including this firm, who sought to create a new “flexible” form of corporation in California that would allow shareholders to devise their own mix of economic and social corporate objectives, ensure that future investors would have adequate notice of the purposes pursued, and provide protections to ensure that the new corporate form is not easily foisted upon shareholders of traditional corporations. AB 361 resulted from efforts of B Lab, a non-profit organization that offers certification of corporations as “B corporations” (which B Lab describes as “a new type of corporation which uses the power of business to solve social and environmental purposes”) and promotes adoption of benefit corporation legislation in states across the country. Enactment of AB 361 follows the adoption of similar benefit corporation legislation in Hawaii, Maryland, New Jersey, Vermont and Virginia. The fact that both SB 201 and AB 361 were enacted is likely to create confusion going forward among entrepreneurs, investors and lawyers as they try to understand differences among the new entities and traditional for-profit and non-profit corporations (as well as limited liability companies and limited partnerships). Both of the new entities will be taxed the same as for-profit corporations under current tax law.

Flexible Purpose Corporations

A flexible purpose corporation will be set up much like a traditional for-profit corporation, with shareholders and a board of directors, but its articles of incorporation and share certificates must state that it is organized as a flexible purpose corporation, and its articles must identify a “special purpose” from the following list:

  • (1) One or more charitable or public purpose activities that a nonprofit public benefit corporation is authorized to carry out; or
  • (2) 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 society; or
    • (c) The environment.

The obvious breadth of potential purposes was intended by the drafters of SB 201 — to allow shareholders to define their desired special purposes without regard to what third parties might deem to be valid or desirable societal objectives.

A flexible purpose corporation can amend its “special purpose” by amending its articles of incorporation. If the amendment would materially alter any special purpose stated in the articles, such amendment must be approved by the affirmative vote of at least two-thirds of the outstanding shares of each class of the corporation’s stock, or a greater vote if required in the articles, regardless of whether a class is entitled to vote, and a majority of the outstanding shares of all classes entitled to vote. A similar vote is required for a flexible purpose corporation to amend its articles to convert into a traditional California corporation (which can be done by amending the articles to eliminate the special purpose provisions). A unanimous vote of all shareholders, regardless of whether shares are entitled to vote, is required to amend a flexible purpose corporation’s articles to convert it into a non-profit corporation.

In discharging his or her duties, a director of a flexible purpose corporation “may consider those factors, and give weight to those factors, as the director deems relevant, including the short-term and long-term prospects of the flexible purpose corporation, the best interests of the flexible purpose corporation and its shareholders, and the purposes of the flexible purpose corporation as set forth in its articles.” SB 201 specifically states that there shall be no private right of action created for members of the public to sue a flexible purpose corporation for failure to pursue or achieve its special purposes, and directors are not responsible to any parties other than the flexible purpose corporation and its shareholders.

A flexible purpose corporation’s board of directors is required to send an annual report to shareholders each year that includes a management discussion and analysis (MD&A) concerning the short-term and long-term objectives of the entity relating to its special purpose or purposes, the material actions taken during such year to achieve such objectives, the impact of such actions, and the causal relationships between the actions and outcomes, future material actions expected to be taken in the short-term and long-term to achieve the entity’s special purpose objectives, the measures used to evaluate the entity’s performance in achieving its special purpose objectives, and any expenditures incurred in achieving these objectives. The entity’s board of directors also must make the annual flexible purpose MD&A publicly available by posting it on the entity’s website or providing it through similar electronic means. Flexible purpose corporations also must send to shareholders and make publicly available current reports summarizing (i) any expenditure or group of expenditures that are likely to have a material adverse impact on the entity’s results of operations or financial condition for a quarterly or annual fiscal period or (ii) any decision by the board or action by management to (a) withhold expenditures that were to have been made in furtherance of the entity’s special purpose where the planned expenditures were likely to have a material positive impact on the entity’s impact in furtherance of its special purpose objectives or (b) determine that the special purpose has been satisfied or should no longer be pursued. The shareholders of a flexible purpose corporation with fewer than 100 shareholders can elect to waive the requirement for the entity to send and publish annual and current reports, and the disclosure requirements are deemed satisfied for any corporation with securities registered under Section 12 of the Securities Exchange Act of 1934 if the corporation includes the required disclosure in its periodic reports.

A flexible purpose corporation can merge with any other California or non-California entity in the same manner as for-profit corporations, except that if the disappearing corporation in a merger is a flexible purpose corporation and the surviving corporation is not, or the surviving corporation in a merger is a flexible purpose corporation with materially different special purposes than a disappearing flexible purpose corporation, then in addition to other approvals typically required the merger must be approved by the affirmative vote of at least two-thirds of the outstanding shares of each class of stock of the disappearing flexible purpose corporation, or a greater vote if required in the articles, regardless of whether a class is entitled to vote. If the disappearing corporation in a merger is a California for-profit corporation and the surviving corporation is a flexible purpose corporation, the merger must be approved by at least two-thirds of the outstanding shares of each class of stock of the disappearing corporation, or a greater vote if required in the articles, and all shareholders of the disappearing corporation not voting in favor of the merger must be afforded the opportunity to sell their shares to the surviving corporation for cash at their fair market value (i.e., exercise dissenters’ rights). Essentially the same requirements apply if a California for-profit corporation chooses to convert to a flexible purpose corporation. If a flexible purpose corporation merges with a non-profit corporation and the surviving entity in the merger is the non-profit corporation, the merger must be approved by all shareholders of the disappearing flexible purpose corporation, regardless of whether shares are entitled to vote.

Benefit Corporations

A benefit corporation also will be set up much like a traditional for-profit corporation, but its articles of incorporation must state that it is a “benefit corporation” and it must be organized to pursue a “general public benefit” and, if it chooses, one or more other “specific public benefits.” A general public benefit is defined as a “material positive impact on society and the environment, taken as a whole, as assessed against a third-party standard.” The optional specific public benefits can include any of the following:

  • (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 ordinary 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.
  • (7) The accomplishment of any other particular benefit for society or the environment.

The “third-party standard” utilized by a benefit corporation refers to a “standard for defining, reporting, and assessing overall corporate social and environmental performance to which all” of a long list of requirements apply. B Lab, the original proponent of AB 361, reportedly has developed such a standard and offers its certification services at fees ranging up to $25,000 per corporation per year.

Any traditional for-profit corporation can become a benefit corporation simply by amending its articles to state that the entity is a benefit corporation, and likewise a benefit corporation can terminate its status as a benefit corporation simply by amending its articles to delete such statement. In either case, the amendment requires approval of at least two-thirds of the outstanding shares of each class or series of stock of the corporation, regardless of any limitation stated in the articles or bylaws on the voting rights of any class or series. In addition, the corporation changing its status must provide dissenters’ rights to all shareholders not voting in favor of the proposed change. A benefit corporation may amend, add or delete any additional, specific public benefits identified in its articles by amending its articles with approval of at least two-thirds of the outstanding shares of each class or series of its stock (or higher threshold if specified in its articles).

In discharging their respective duties, the board of directors, committees of the board and individual directors of a benefit corporation are required to “consider the impacts of any action or proposed action upon all of the following”:

  • (1) The shareholders of the benefit corporation;
  • (2) The employees and workforce of the benefit corporation and its subsidiaries and suppliers;
  • (3) The interests of customers of the benefit corporation as beneficiaries of the general or specific public benefit purposes of the benefit corporation;
  • (4) Community and societal considerations, including those of any community in which offices or facilities of the benefit corporation or its subsidiaries or suppliers are located;
  • (5) The local and global environment;
  • (6) The short-term and long-term interests of the benefit corporation, including benefits that may accrue to the benefit corporation from its long-term plans and the possibility that these interests may be best served by retaining control of the benefit corporation rather than selling or transferring control to another entity; and
  • (7) The ability of the benefit corporation to accomplish its general, and any specific, public benefit purpose.

Having to consider all these factors for every issue that comes before a board of directors may be a tall order. AB 361 specifically provides that directors are not required to give particular weight to these specific factors or interests unless the corporation’s articles of incorporation state a preference for particular factors or interests. While this approach provides much flexibility, the new law does not make clear what standards directors should follow in making decisions, resulting in some commentators expressing concern that directors of benefit corporations may have too much discretion and lack accountability to shareholders.

AB 361 limits directors’ liability for monetary damages for failure of a benefit corporation to create a general or specific public benefit and states that directors shall owe no fiduciary duties to beneficiaries of the benefit corporation’s general or specific public benefit purposes. Nevertheless, AB 361 expressly contemplates that a “benefit enforcement proceeding” may be brought against a benefit corporation or its directors or officers by the corporation itself or derivatively by shareholders, directors, persons who hold more than 5% of the equity of a parent entity or other persons specified in the articles or bylaws of the corporation. AB 361 also specifically requires an officer of a benefit corporation to consider the same interests and factors that board members must consider (as described above) whenever an officer has discretion to act and an action may materially impact such interests or factors, and the officer shall be deemed not to have violated his duties when he or she so acts.

Similar to the reporting regime required for flexible purpose corporations, a benefit corporation is required to deliver to each shareholder and make publicly available on its website (if it has one) an annual benefit report that (i) details for the applicable year the process and rationale for selecting a third-party standard used to prepare the report, the ways in which it pursued a general public benefit and any specific public benefits and any circumstances that have hindered the creation of such public benefit purposes, (ii) assesses the social and environmental performance of the benefit corporation according to the third-party standard, (iii) identifies any person that owns five percent or more of the corporation, (iv) includes a statement of the corporation’s board of directors regarding whether the corporation failed to pursue its public benefit purposes in all material respects during such year, and (v) identifies any connections between the corporation (or its directors, officers or material owners) and the entity (or its directors, officers or material owners) that created the third-party standard used by the corporation to assess its pursuit of its benefit purposes, in any case that might “materially affect the credibility of the objective assessment of the third-party standard.” There is no mechanism for a benefit corporation or its shareholders to opt out of these annual reporting and disclosure requirements.

Anticipated Usage

It remains to be seen whether entrepreneurs and investors will embrace these new forms of corporate entity in California. Organizing a flexible purpose corporation or benefit corporation will require more initial thought and work than forming a traditional for-profit corporation, particularly in 2012 as practitioners come up to speed on the requirements for the new entities. As between the two forms, the flexible purpose corporation offers greater flexibility in terms of defining the special purposes to be pursued by the corporation and less onerous governance requirements, while the benefit corporation offers the advantage of being used and recognized in a handful of other states.

  1. In my opinion, the AB 361 (which provides for “Benefit Corporations”) is greatly inferior to AB 201 (which provides for “Flexible Purpose Corporations”). AB 361 was opposed by the Corporations Committee of the Business Law Section of the California State Bar, the Nonprofit and Unincorporated Organizations Committee of the Business Law Section of the California State Bar, and the California Association of Nonprofits.

    AB 361 was promoted by an entity that will directly benefit from the fees (which can be significant) that it charges to Benefit Corporations. AB 361 was introduced as a “spot bill” so that its true purpose was not immediately disclosed to the public.

    AB 201 in contrast was the product of a working group that actively sought public input and comment.

    Comment by Keith Paul Bishop — November 18, 2011 @ 11:50 am

 

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