September 27, 2016 - Corporate Form, Deal Structures

From “To B or Not To B”

 1. A “B Corporation” is Not a New Corporate Form

A “B Corporation” or “B Corp” is a certification mark – like a “Good Housekeeping” seal of approval or “LEED” certification.  B Labs has done a very good job of creating a framework for companies to evaluate their business and operations on ESG factors and to then receive a score or ranking.  To become a “B Corp,” such companies then enter into a license agreement with B Labs and pay a licensing fee of between $500 and more than $50,000 depending on the structure of the applicant.  B Labs does review the evaluations and often schedules calls for follow-up questions – but such review falls short of a full audit to ensure accuracy and completeness.  This means that there have been – and will continue to be – companies which license the “B Corp” mark and are promoted as part of the B Corp community but whose operations do not live up to the standards espoused by B Labs.  I believe that this is one of the reasons for the change in licensing requirements that I describe below.

       a.  When should a Company become B Certified?

Let me offer a few recommendations for companies who are deciding whether or not to become “B Corp” certified.  First, you don’t need to hire a consultant or lawyer to help you fill out the questionnaire and become certified.  The fact that there is now a cottage industry of “experts” willing to charge high fees to provide such assistance is a sign that B Corps are here to stay.  But the B Labs guys have done a good job at making the certification process user-friendly.  The survey can be downloaded, you can use it to determine areas of improvement before submission and their staff is willing and able to help if and when questions arise.

Second, I strongly advise that management take and score the survey before making a decision regarding certification.  While years of good work have gone into developing the survey and standards, one area of weakness is that the survey does not divide respondents by industry-area.  This can yield unhelpful results – like a recycling company whose mission is to reduce waste having a lower score (because of carbon emissions among other factors associated with heavy manufacturing) than a developer of social media applications in SoMa, San Francisco (with little output of social value).

Also, the survey was not designed for public companies – so when Etsy went public, quite a bit of work had to be done (and improvements continue to be made) so that publicly listed companies can actually and accurately respond to the questions.  Further, acquired companies are not able to retain B Corp status post sale or merger unless the target remains a stand-alone subsidiary (e.g., Plum, New Chapter Vitamins, Ben & Jerry’s) or the acquiring company itself becomes B certified (e.g., Danone/WhiteWave).  The issue with the former is obviously that both the survey process and compliance are in the hands of a corporate entity (e.g., Campbells, Procter & Gamble, Unilever) that does not have any legal requirement to retain the mission alignment associated with B certification.

Finally, just like any marketing campaign, it is very important to test with all constituents in your market – investors, consumers, community – to determine whether and how the B Corp brand will be beneficial to your company.

I note that the vast majority of “B Corps” are normal C corporations or LLCs and are not legally required to advance their social and environmental goals.  However, I believe that many of these companies (e.g., Etsy, Plum, RevFoods) are as or more mission-aligned than those that employ the new corporate forms (see below).  Further, B Labs has, over time, changed the provisions of its license agreement and is now requiring B Corps to change (within a reasonable period of time) their underlying corporate form to the benefit corporation.  Unfortunately, there appears to be a failure to recognize that there are effective mechanisms that can require corporations and LLCs to stay true to their impact goals – with enforcement measures that are just as (or more) effective than those afforded to the new corporate forms, including the benefit corporation.

        b.  Other Performance Metrics.

In addition to B certification, there are many other methods for rating a company’s performance based on ESG factors.  According to SustainAbility, there are over 110 such rating systems and many include both a description of the ESG factors that should be measured and data to provide a benchmark for measurement.  In addition to B Corps, the Global Reporting Initiative (GRI), Sustainalytics and MSCI provide evaluations across the full environmental, social and governance spectrum while the Carbon Disclosure Project and CarbonTracker focus on measuring carbon emissions and risk.

Most public companies are suffering from disclosure “overload” related to ESG as they are continuously approached by new organizations asking them to complete surveys, provide data and help rate their performance on various social and environmental metrics.  Fortunately, the rise of integrated reporting with public companies should, over time, bring needed standardization and rigor to the sector.  Key leaders such as the Sustainable Accounting Standards Board, GRI and the International Integrated Reporting Council are identifying the ESG factors by industry that are material to operations and should therefore be disclosed in required reporting for public companies (10-K and 10-Q filed with the SEC).  The Bloomberg-Carney Task Force on Climate-related Financial Disclosures is working to harmonize standards related to climate risk.  All of the standard-setters are working with the Big 4 accounting firms to provide a framework for disclosure that can be audited or verified.  In the United States, the Nasdaq and NYSE have indicated a willingness to follow other stock exchanges from around the world whose listing standards are already including – or will soon include – certain ESG factors.

The movement toward reporting on material social and environmental factors in a way that can be audited and included with financial reporting to shareholders will certainly represent a big step toward improving accountability for companies around the major environmental and social issues that we are facing today.  Such reporting is also necessary for there to be a shift of the fiduciary duties of boards and management to include ESG goals, as contemplated by the new corporate forms.

2.   The new corporate forms come in many different shapes and sizes.

The branding genius of B Labs has most people, practitioners and press believing that there is only one new corporate form – the benefit corporation.  However, in fact, there are several different forms that have been conceived to chart a new path between non-profits (focused exclusively on mission) and for-profits (focused primarily on shareholder value).  Further, the benefit corporation form itself varies greatly from state to state; only a few states follow the “model” initially developed by B Labs, and that model itself has been modified substantially and improved over time.  There are two primary elements that are universal to the new forms. First, they all require boards and management to consider social and/or environmental goals in addition to financial returns.  Second, at least as of this writing, none of the new forms receive special tax treatment; investments and/or donations to the new corporate forms are not deductible, and revenue earned by the entities is taxed at normal rates.

       a.  The Low-Profit Limited Liability Company (L3C).

The first new form to arrive on the scene – the Low-Profit Limited Liability Company or L3C – was written into law in Vermont in 2008.  Since the Tax Reform Act of 1969, foundations have been permitted to make program-related investments (PRIs), which are investments in for-profit entities, so long as those investments are for the primary purpose of advancing the foundation’s charitable purpose and not generating financial returns.  However, the originators of the L3C noticed that utilization rates for PRIs remained (and still remain) very low over four decades.  The L3C was conceived to address this failure and help non-profits, and particularly foundations, deploy greater capital and have greater impact through investment in for-profit entities as an alternative to donations.  Specifically, the L3C is a form of limited liability company that requires managers and owners to articulate social and environmental goals and then prioritize such goals over financial returns.

Unfortunately, L3Cs have not garnered widespread support from entrepreneurs or funding from foundations.  This is in part because more significant IRS rule changes (anticipated at the time of originally conception) have not come to pass to afford special tax treatment for the L3Cs or obviate the need for tax opinion letters.  However, new regulations and guidance from the IRS as recently as 2016 have served to further de-risk PRIs (if they were ever in fact risky) and may spur further adoption of PRI investments if not L3Cs.  In addition, the L3C form does provide a viable alternative to “mission first” enterprises in the eight states (and two Indian tribes) with L3C legislation.  Further, for those of us who practice in states without L3C legislation (particularly California and Delaware), the forms offer good exemplars and ideas for incorporating social and environmental purpose into traditional LLCs.

       b.  The Social Purpose and Public Benefit Corporations (SPC/PBC).

Whereas the L3C can be viewed as an extension of the non-profit corporation, the second form was intended to introduce social and environmental focus to the traditional for-profit corporation.  The Flexible Purpose Corporation (renamed Social Purpose Corporation in 2015) was drafted over two and a half years by a non-partisan group of corporate lawyers (of which the author was a member) and was first introduced in 2009 in California.  In general, the SPC provides a safe harbor ‑ in addition to the business judgement rule – that requires boards and management to emphasize shareholder-agreed social and/or environmental purposes in the charter.  In addition, the SPC differs from a traditional corporation because of the fiduciary duty to the mission (and additional protection to the board and management in promoting such social and environmental goals), mission protection (2/3rds class vote to change the agreed purpose), increased accountability via reporting and detailed provisions for conversion, merger, sale and consolidation.

The Social Purpose Corporation is substantially similar to the Delaware Public Benefit Corporation (PBC), introduced in 2013 and adopted in 2015, with only two material exceptions.  The PBC requires a broad public purpose in addition to the specified social and/or environmental goals, while the SPC only requires at least one shareholder-agreed social or environmental goal.  And the SPC requires greater accountability and reporting than the PBC.  B Labs initially supported the SPC before deciding to introduce a second form in California in 2011.  Ironically, when B Labs rejected the SPC in favor of the California benefit corporation, they provided an open letter with objections to five provisions of the SPC – and all five provisions are now incorporated into the Delaware PBC.  Specifically, the Social Purpose Corporation and the Public Benefit Corporation:

  • both have shareholder-agreed social and environmental goals that must be articulated in the charter of the corporation (instead of itemizing all goals in the state statute itself);
  • do not require external validation or audit of the reporting to shareholders on the public benefit (the SPC requires that such reporting be in accordance with “best practices” while the PBC allows the board/management to simply describe the standards that have been used for reporting);
  • do not have an identified “benefit director” with what arguably gives rise to conflicting fiduciary duties for directors of benefit corporations in other states;
  • do not have a “special proceeding” to enforce the social/environmental mission; both provide additional protection from liability for boards and management and rely on traditional corporate enforcement mechanisms, specifically the right of shareholder action for breach of duties and the right to remove directors; and
  • both offer dissenters rights on conversion from an existing corporate entity to the new form (allowing shareholders the right to object to the conversion and take action to have their shares reduced).

Ironically, given that the SPC is often referred to as the “benefit corporation light,” the SPC has more robust reporting requirements than the PBC – with annual reporting for the SPC (as opposed to biannual for the PBC), required reporting to the public as well as shareholders for the SPC (no public reporting for the PBC) and 8-K type reporting for the SPC if there are material changes in between annual reports (no reporting other than biannual for PBC).

Both the SPC and PBC have been designed for use by both small social enterprises and by larger public companies.  The first PBC (Laureate Education) filed an S-1 with the SEC to go public in October 2015 (but has yet to list its shares and start trading).  A second PBC will result from the closing of the $10.4 BN merger of Danone and WhiteWave Foods.

Finally, both the SPC and the PBC can garner support from liberals and conservatives as an “extra-governmental” solution to the current crises.  They can be vehicles for economic growth and job creation in addition to advancing social and environmental goals which are approved by the owner shareholders (as opposed to legislators) and can be in the best interests of the corporation’s long-term financial well-being.  When introduced in California, the SPC was the only bill that year that received 100% support from both Democrats and Republicans in the Senate.

       c.  The Benefit Corporation.

The first benefit corporation was written into the Maryland statute in 2010.  Since that time, various versions of the benefit corporation legislation have been adopted by 30 states plus the District of Columbia (according to B Labs as of August 2016).  Note that many states use different names for the new form – including Benefit Corporation, Public Benefit Corporation (e.g. CO), Social Purpose Corporation (e.g. WA, FL) and Sustainable Business Corporation (e.g. HI).  Further confusing the issue is that, in some states, the benefit or public benefit corporation is a form of non-profit corporation while in others it is a form of for-profit corporation (and we are obviously discussing the latter in this article).

It is also important to note that benefit corporations vary greatly state by state and have evolved significantly since first introduced and advocated by B Labs in Maryland and Vermont six years ago.  In fact, many are much more similar to the SPC and PBC than to either the first legislation or to the “model” statute promoted by B Labs.  However, in general, unlike the PBC and SPC, these statutes bake “goodness” into the legislation – as a benefit corporation, a company’s board and management have a fiduciary duty to a long list of social, environmental and governance goals (borrowed from the “B Corp” certification survey) in addition to financial goals.  The successful lobbying efforts of B Labs have made the benefit corporation approach far more prevalent when measured by state adoption (not by company incorporation) – although not in Delaware (or CO, WA, FL).  However, it remains to be seen which policy approach will have greater positive impact on the world – companies which have affirmative fiduciary duties to selected social and environmental goals or those that are required to focus on a laundry list of objectives (thereby diluting the effect).

In most states, the benefit corporation provisions are an “add on” to the corporations code – not creating a new and distinct legal entity but fashioning a new designation for “normal” corporations.  For many states, this has resulted in unintended conflicts between corporate law and benefit corporate law that apply to the same entity.  For example, most state benefit corporations have a “benefit director” responsible for oversight and accountability with respect to the public purpose and a requirement of independent verification (which either by design or by default comes courtesy of B Labs for a fee).  Corporate law experts often cite a recurring issue state-by-state between the conflicting duties of a benefit director whose new duties must be viewed in light of his or her pre-existing fiduciary duties of care and loyalty to the shareholders.  They also point to issues with the “enforcement proceeding,” a feature of most benefit corporation laws, which can yield increased risk and liability for boards and management.  It is therefore not a surprise that many benefit corporations have difficulty securing director and officer insurance.

Provided that you have waded through the confusing detail on corporate form above – which is likely at odds with the articles and press releases written by biased advocates of one form or another (many of whom benefit financially from promotion of a certain form) – what does all of this mean for both private social enterprises and for public companies?  Should boards and management consider either incorporating as – or converting into ‑ one of the new corporate forms?

Let me stress that I believe that requiring all corporations to change form – imposing fiduciary duties on boards and management in favor of shareholder agreed social and environmental goals – is critical as a tool to address the issues ranging from social inequality to climate change.  However, we do not yet have an agreed form (much less an agreed name) for the new corporate form – although most experts (myself included) agree that the Delaware Public Benefit Corporation is currently the best model.  Further, the weighting of fiduciary duties has not yet been tested in court.  In other words, if a company is increasingly profitable in its operations and successful in emphasizing the agreed social or environmental goals, there is little risk of litigation.  If, on the other hand, a company becomes unprofitable and therefore must make choices between adherence to the public purpose and financial stability, risks will increase.

So, some concrete advice on whether to adopt a new corporate form (to “B” or not to “B”):

  • If the good or service that your company produces has a positive social or environmental impact in and of itself (e.g. solar, education, healthy school lunches), there is much less risk associated with the “weighting” issue above and therefore incorporation/conversion into a new form.  For these companies, there is often no trade-off between high profits and high positive social/environmental impact.
  • If the good or service that you produce is output agnostic (e.g. social media application, coffee tables, baseball bats), then you must consider the interplay between the public purpose and your profitability before you convert.  This does not necessarily mean there is a trade-off.  Positive focus on ESG goals could increase profitability for the maker of baseball bats that emphasizes employee relations and contributes financially to the building of little league parks in underserved communities.
  • If you are a start-up and introducing an innovative new product with a new management team, the new corporate form may be one “new” too many.  If you and your board really want to try one of the new forms, I suggest waiting 6-18 months after incorporation, possibly asking your investors to agree to convert to a new form (conversion is easy) after certain milestones are met.
  • In all of the cases above, it is critical that you not only get your board to embrace the new form, fully understanding the risks and rewards (not just the latest PR spin), but that your investors are fully comfortable as well.  In the early stages, commitment to convert ahead of investor support can significantly increase the likelihood that your venture will fail.
  • Your board and investors will need to understand not only the impact of the new fiduciary duties on daily operations but also exits – IPOs and sale transactions (although there are more alternative forms of exits being utilized by social enterprises).  We do not yet know how the market will price these new entities (although we are waiting for two concrete examples – Laureate Education and Danone/WhiteWave).  There is some evidence that the market will view the public purpose as a net positive, specifically for companies where the product or service produced is good for the environment, community or society.  However, this belief faces strong headwinds from mainstream capital markets that have long held that “impact” or focus on social/environmental purpose will necessarily generate lower returns.
  • Finally, if your company – with board and shareholder support – is serious about embracing a public purpose and having a positive impact, as described above, there are many very effective tools to implement such goals for traditional corporations.