How Social Purpose Entities ("SPE's") Can Make Free Trade More Fair
Disclaimer: this article generally discusses state corporate law and IRS rules and regulations. Although the author of this article is a licensed attorney, Camino Aztlan is not a provider of legal, financial, or accounting advice or services. We encourage you to seek the advice of a licensed attorney or Certified Public Accountant (“CPA”) if you are interested in pursuing a social-purpose venture. If you need help finding a professional, please submit an inquiry on our Contact Us page and we will do our best to point you in the right direction.
Introduction
In recent years, companies have tried to change their image to appear less profit driven and more conscious of health, environment, and labor practices. This is largely the result of demand from a new generation of consumers who don’t necessarily seek the cheapest or most efficient product but also consider whether their products meet standards like “Organic” or “Fair Trade.”
This trend is not limited to socially-conscious companies like Patagonia or REI. Exxon Mobil, America’s largest petroleum company, prepares an annual Sustainability Report that discusses the impact of human-made climate change even while a large portion of Americans still deny its existence. When all the biggest multinationals tout their commitment to “sustainability”, how can conscious-minded consumers know what is genuine and what is superficial “greenwashing?”
Social Purpose Entities (“SPE’s”) may provide some clarity for consumers, investors, and regulators. These entities, including Benefit Corporations and Low-Profit Limited Liability Companies, are relatively new corporate forms that combine aspects of traditional for-profit companies and tax-exempt nonprofit organizations. In the little over 10 years since their inception, there are already thousands of SPE operating across America and attracting a significant chunk of the Impact Investment market estimated to exceed $500 Billion.
This article is Part 1 of a multi-part series discussing SPE’s and how they may be an ideal option for sustainable cross-border ventures. Future articles in the series will go into greater detail about how specific SPE’s operate and provide examples of what forms may be appropriate for specific ventures like migrant-support organizations and Fair Trade importers and producers.
The Shareholder Is Always Right
In 1916, Ford Motor Company had a huge cash surplus after the success of the Model T automobile. Henry Ford proposed to suspend dividends and reinvest the surplus into the company with the goal of lowering prices to consumers and raising wages for employees. Mr. Ford proclaimed the following in support of his plan:
My ambition is to employ still more men, to spread the benefits of this industrial system to the greatest possible number, to help them build up their lives and their homes. To do this we are putting the greatest share of our profits back in the business.
Sounds amazing, right? Not everybody thought so. The Dodge brothers, who owned 10% of the company’s stock, sued Ford Motor Company, arguing that Ford was not placing their interests as shareholders at the forefront. The court agreed, stating:
A business corporation is organized and carried on primarily for the profit of the stockholders. The powers of the directors are to be employed for that end.
[I]t is not within the lawful powers of the board of directors to shape and conduct the affairs of a corporation for the merely incident benefit of shareholders and for the primary purpose of benefiting others.
Dodge v. Ford Motor Co. 170 N.W. 668, 684 (Mich. 1919). The principle enunciated by the Michigan court is known as the “shareholder primacy doctrine,” which generally means that directors of a corporation must take measures that provide the greatest profit maximization, even if those measures are harmful to non-shareholder stakeholders like employees, the environment, or the general public. The doctrine has been heavily criticized over the years, with many legal scholars questioning whether it is still a binding doctrine. One prominent critic of the doctrine is Marc J. Lane, a pioneer of the low-profit limited liability company. In his article Is Shareholder Primacy Dead?, he argues that shareholder primacy is not supported by U.S. Supreme Court precedent. He also notes that the business community appears to be (at least publicly) leaning away from the doctrine, as shown by the Business Roundtable’s recent position statement that a company’s pursuit of ethical business practices and consideration of various stakeholders is good for business and ensures long-term shareholder value.
Despite the criticisms of shareholder primacy, it is still a widely accepted principle, and corporations continue to act cautiously to avoid derivative lawsuits by shareholders who may challenge a particular business decision of the board of directors.
Ben & Jerry’s learned this lesson when Unilever bought the company in 2000. Ben & Jerry’s was an early pioneer of placing social purpose ahead of profit, paying its producer farmers above market, providing environmentally-conscious packaging, and providing benefits to same-sex unions. When Unilever tried to acquire the company, Ben & Jerry’s founds Ben Cohen and Jerry Greenfield placed a competing bid for control of the company to guarantee that it adhered to its social causes. Despite the existence of a governing Vermont statute that allowed a board to consider the interests of different stakeholders in its business decisions, the Ben & Jerry’s board approved the sale to Unilever, the highest bidder, on the advice of its attorneys. Although this takeover could have easily undermined the company’s social purposes with new ownership, the company fortunately maintained most of its social practices and is currently a certified B-Corporation (our next article will delve further into B-Corps.). See Antony Page & Robert A. Katz, Freezing Out Ben & Jerry: Corporate Law and The State of a Social Enterprise Icon, 35 VT. L. Rev. 221, 223 & n. 90 (2010).
Profit or Social Purpose? A Dilemma.
The extent to which a for-profit company needs to emphasize shareholder value largely depends on the way it is organized. Publicly-traded corporations will come under the most scrutiny because of their large variety of shareholders, stakeholders, and regulators. Single-member LLC’s would likely have the most leeway to pursue a variety of purposes other than the pursuit of profits. The following is a brief review of the main legal forms a company may take in the United States and why the limitations of traditional entities led to the creation of hybrid entities.
For-profit organizations can be organized in a number of ways, mostly falling within the broad categories of partnership, corporation, or limited liability company. To illustrate a general partnership, two partners agree to contribute their resources into a company and split profits and losses equally or subject to their partnership agreement. If a creditor wants to sue the company, it could sue the partner directly and, under many circumstances, even sue the other partner who may have had little involvement with the acts giving rise to the claim.
On the other end of the spectrum are corporations, separate entities that exist apart from their owners. This means that creditors who sue the corporation can only look to the corporation’s assets but can generally not pursue individual shareholders or managers in their individual capacity.
There is also a key tax distinction between partnership and corporations. Corporate income is subject to double taxation, once against the corporation at the corporate tax rate and again against shareholders when they receive distributions like dividends. Partnerships are subject to “pass-through” treatment, meaning that partnership income flows down to the individual partners, who are taxed at their individual rates. Among corporations, there is a further distinction between C Corporations and S Corporations, the latter of which is able to enjoy a limited degree of “pass-through” treatment similar to partnerships.
Limited Liability Companies (“LLC’s”) developed to simplify the corporate structure and eliminate some of the more burdensome features of a corporation, including formalities like electing a board of directors and holding regular board or shareholder meetings. LLC’s can also choose to be taxed as partnerships, with each owner taxed at the individual tax rate. If a multi-member LLC makes this election, it will need to file Form K-1, the tax return for partnerships.
Partly because of the complexity of Subchapter K of the Internal Revenue Code and the uncertain tax status of LLC’s, the LLC form did not take off right away when the first legislation was enacted by Wyoming in 1977. It took nearly two decades for the new form to be recognized by all 50 states, and the IRS did not officially recognize the tax treatment of LLC’s until 1997.
Regardless of how a for-profit entity is organized, investors and owners will generally expect the business to turn a profit. Even though many companies seek to pursue social purposes other than profits, there is always a risk that initial values can be changed or undermined under a different leadership or business climate.
For organizations seeking to emphasize social or charitable purposes rather than profit, the preferred legal entity has been the 501(c)(3) non-profit organization. In order to receive tax-exempt status, the organization must show that it is pursuing at least one of eight charitable purposes such as religious or educational goals and that no profits will be distributed to any individual members.
Two limitations of the tax-exempt structure are (1) limitations in securing funding, as they must rely on donations, grants, and limited commercial activity; and (2) the cost of compliance and risk of penalties from the IRS and state charitable entity regulators.
The conflict between the shareholder-primacy doctrine of for-profits and the charitable-purpose requirement of nonprofits makes it difficult for organizations to fully purpose both goals. For this reason, people have traditionally chosen one or the other. Although there is a possibility of creating a joint-venture or parent-subsidiary relationship to combine a for-profit and nonprofit, these structures are complex and may not be financially viable for small operations.
Enter the Low-Profit Limited Liability Company (“L3C”)
In the early 2000’s, a group of lawyers and entrepreneurs proposed a new alternative to address the dilemma between choosing profits or social purpose. In 2008, Vermont enacted the first legislation establishing the low-profit limited liability company (“L3C”), designed to retain the flexibility of a traditional LLC but allow for a stated charitable purpose that did not place profit-maximization as the company’s primary mission. Whereas LLC’s emerged to provide a simple alternative to a traditional corporation, the L3C was developed as a hybrid between a traditional LLC and non-profit company.
As discussed above, Marc J. Lane was a pioneer of the L3C form and helped draft legislation that allowed for L3C’s in the State of Illinois. In a recent conversation we had with Mr. Lane, he expressed two key benefits of the L3C; (1) the ability to secure a wide-range of investments, including from non-profit foundations; and (2) social-purpose branding to attract the growing market of conscious-minded consumers and impact investors.
A key feature of the L3C is its potential to facilitate securing Program-Related Investments by IRS-recognized foundations (“PRI”). To keep their tax-exempt status, foundations must allocate 5% of their assets to charitable purposes. These allocations often take the form of grants, but can also be used for PRI’s to entities with a charitable or educational purpose that aligns with the foundation’s mission.
L3C legislation tends to mirror the following PRI requirements: (1) its primary purpose is the accomplishment of a charitable purpose that is enumerated in Section 170(c)(2)(B) of the Internal Revenue Code; (2) neither the production of income nor the appreciation of property is a significant purpose of the investment; and (3) it does not have any prohibited purpose such as lobbying or political campaigning. I.R.C. 4944(c) (2017); Treas. Reg. Section 53.4944-3(a)(1)(i)-(iii).
In the first couple of years of L3C enactment, foundations’ PRI distributions accounted for less than 1% of the total qualifying distributions. Mr. Lane believes that this figure is now much higher and notes an increasing trend of foundations using PRI’s as a larger percentage of their authorized distributions. These include the Kauffman Foundation out of Kansas City and the Bill and Melinda Gates Foundation.
PRI’s will be discussed in greater detail in a subsequent article, but in general, they may provide much-needed funding for social-purpose companies that may have difficulty securing traditional funding if they are not placing profit at the forefront. PRI’s can take the form of grants, equity investments, loans, or loan guarantees.
Some scholars and proponents of L3C’s projected that PRI’s could provide initial seed funding for the company at a low rate of return. Once the company was funded and operating, it could then attract more traditional funding as part of a “tranched” investment structure in which different stages of investment would be subject to different risk and rates of return. Mr. Lane observes that PRI investments are increasingly coming in at later funding stages when the business has become “de-risked” by accumulating assets and operating successfully. He notes that foundations have been using PRI’s to invest in for-profit companies even before L3C’s were enacted, and that regardless of how a company is organized, foundations will still engage in a due-diligence process to ensure that their investments do not incur IRS penalties. L3C’s that have a strong social mission in their company charter and demonstrate their commitment to this mission will likely have an easier time securing funding from foundations and impact investors.
Should I Set up an L3C for my Fair Trade Business?
If you are looking for a low-cost way to set up a company that focuses on goals like sustainability or Fair Trade principles, the L3C may be the right choice for you. This is especially true if you reside in the following states and Indian Nations have enacted L3C legislation: Illinois, Kansas, Louisiana, Maine, Michigan, North Dakota, Puerto Rico, Rhode Island, Utah, Vermont, Wyoming, the Crow Indian Nation of Montana, and the Oglala Sioux Tribe. If you do not reside in one of these states, you could still form an L3C in another state, but this will likely require additional costs such as hiring a registered agent in the L3C state.
L3C’s may be particularly suitable for the Fair Trade organizations and emphasize goals like payment of fair wages, training and empowerment for producers, and sustainable practices. An illustration of the type of organization that could benefit is a Hometown Migrant Association (“HTA”), which was one of the first types of cross-border organizations created by Mexican migrants in the United States to raise funds and improve living conditions in migrant’s places of origin. For example, a Chicago based HTA formed by U.S. immigrants from Juchitan, Oaxaca to support their families and friends back home could set up an L3C to import hand-made artisan products from their hometown and resell them in Chicago. The L3C’s social-purpose statement could specify the company’s mission and ensure that it does not, for example, seek cheaper non-sustainable products from another city (or country) to increase its profits. The HTA could also use its mission and operations to solicit a PRI from one of the many foundations like the Ford Foundation or MacArthur Foundation that have donated millions to immigrant causes.
One potential weakness in the L3C is that there is currently not a strong mechanism to enforce the company’s stated social purpose. If the HTA in the preceding example took actions to enrich its owners to the detriment of the artisans in Juchitan, there would be limited remedies for any objectors and non-member stakeholders (not to mention the obvious hurdles the people in Oaxaca would face in suing the L3C owners in American courts). Mr. Lane observes that, at least in the case of Illinois, this risk is minimized because L3C’s are regulated by the state’s Charitable Trust Act and must report regularly to the State Attorney General. Nevertheless, Mr. Lane believes that people have been using L3C’s as intended, and he has not seen any notable instance in which there was a disagreement among L3C’s owners and stakeholders as to whether the company was fulfilling its social purpose. Still, L3C’s could benefit from having a well spelled-out charter and membership agreement and by voluntarily preparing a benefit or sustainability report to document how it is achieving its stated purpose.
Conclusion
Just like LLC’s took two decades to become a business norm, it will take some time for businesses, regulators, and consumers to come around to the L3C. As discussed above, there remain uncertainties regarding the L3C’s tax treatment and corporate governance. Nevertheless, we are seeing a changing tide towards sustainable and ethical practices in the business community and with consumers at large. Camino Aztlan is hopeful that SPE’s can become a new norm for cross-border trade and make the next phase of globalization a better deal for the greatest number of people, including the many marginalized people that have been hurt or left behind by rapid market changes.