CALIFORNIA FORMS OF ORGANIZATION Morrison & Foerster LLP Susan Mac Cormac and Clare Reilly 1

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1 Last Updated: October 2013 CALIFORNIA FORMS OF ORGANIZATION Morrison & Foerster LLP Susan Mac Cormac and Clare Reilly 1 Table of Contents 1. Nonprofit Corporations 2. For-Profit Corporations 3. Limited Liability Companies 4. Flexible Purpose Corporations 5. Benefit Corporations 6. Low-Profit Limited Liability Companies 7. Joint -Ventures 8. Partnerships and Limited Partnerships 9. Sole Proprietorships 10. New Corporate Forms 11. Resources The most common legal form of organization utilized by the social sector is the nonprofit corporation although for-profit corporations, limited liability companies (LLCs), flexible purpose corporations, benefit corporations, joint ventures and various kinds of partnerships, including limited partnerships, are increasingly being used--typically to accommodate plans to earn revenues or access capital markets. Each of these forms of organization has advantages and disadvantages and sometimes, with the help of experienced counsel, they are used in combination to maximize strengths and minimize weaknesses of a particular form. The following chart provides a high-level overview of various organizational forms that can be used in the social sector. More detailed descriptions of each form follow in the subsequent text. 1 Previous reviews completed by Nancy White, Pat Derdenger and Ben Gardner of Steptoe & Johnson LLP.

2 Nonprofit 501(c)(3) Corporation For-Profit Corporation Formation File articles or certificate of incorporation (containing specific info required by IRS) with state and pay filing fee. File application on Form 1023 for tax-exempt status unless below gross receipts threshold. Recruit directors, draft bylaws and hold organizational meeting. Take steps to comply with license, tax and employment law/regs. File articles or certificate of incorporation with state and pay filing fee. Decide on board of directors, draft bylaws, hold organizational meeting and issue stock. Take steps to comply with license, tax and employment laws/regs. Management and Control Liability Tax Factors Capital and Loans Managed by directors Members, directors, who appoint officers officers and employees to run day-to-day are generally not liable operations as specified for debts and in bylaws. Some obligations of the nonprofit corporations corporation, including have members (like shareholders) who elect directors. Managed by directors that are elected by shareholders. Directors appoint officers to run day-to-day operations as specified in bylaws. for unlawful acts of others involved in the affairs of the corporation. They can be held liable for injuries due to their own misconduct but some states provide limited immunity to such persons and also to volunteers. Shareholders are generally not liable for debts and obligations of the corporation, including for unlawful acts of others involved in the business. Unless indemnified by the corporation, directors, officers and employees can be held liable for injuries caused by certain of their own acts or failures to act. Generally exempt from federal and state taxes if receive 501(c)(3) exemption. Liable for tax on unrelated business income, and other taxes such as property and sales (unless local and state exemptions apply). Donors can deduct contributions. A C Corporation is subject to corporate tax on net income. If net income is paid to shareholders as dividends, the individual shareholders are taxed. If a corporation elects to be an S corporation and meets several criteria, it can receive pass through taxation. Can accept charitable donations and grants. Eligible for program related investments (PRIs) by foundations. Can borrow money and issue debt instruments but cannot raise capital by issuing stock. Can raise capital by issuing stock (equity) and by borrowing money through loans or other debt instruments. Corporation may be able to accept PRIs from foundations in the form of loans or equity.

3 Flexible Purpose Corporation (California) Formation Management and Control Liability Tax Factors Capital and Loans See for-profit See for-profit See for-profit See for-profit See for-profit corporation, but must corporation. corporation. corporation. corporation. have a name that includes Flexible Purpose Corporation or an abbreviation thereof. Also must include the shareholder agreed special purpose in its articles. Benefit Corporation (California) See for-profit corporation, but must state in its articles of incorporation that it is a benefit corporation. Also must operate for a general public benefit and is permitted to recognize one or more specific public benefits, which must be included in its articles. See for-profit corporation. See for-profit corporation. See for-profit corporation. See for-profit corporation.. LLC File articles of organization or certificate of formation with state and pay filing fee. Negotiate and execute operating agreement. Take steps to comply with license, tax and employment law/regs. Flexible structure like a partnership with management responsibilities specified in operating agreement (usually management committee or single manager). Same as a corporation. Usually not taxed as an entity because most LLCs choose pass through treatment whereby the member/owners report profits and losses on personal tax returns. Tax-exempt member/owners treat their share of income as exempt or subject to unrelated business taxable income, depending on the character of the income. Can raise capital through contributions by member/owner. Otherwise, same as for-profit corporation.

4 L3C (low-profit LLC) (NOTE: Not available in California as of 2013) Partnership Formation Management and Control Liability Tax Factors Capital and Loans Similar to LLC but See LLC. Same as a corporation. See LLC. Same as for-profit must be formed for a corporation except L3C charitable or enabling legislation is educational purpose. written to comply with Only permitted in PRI regs and is thus certain states (e.g., VT, intended to attract IL, MI, UT, ME, WY). equity or debt investments by foundations. No filing requirements Partners have equal, Partners are personally Generally not taxed as Can raise capital unless limited full control unless liable for the debts and an entity. Partners through contributions partnership (LP) or otherwise specified obligations of the report profits and by partners and by limited liability in partnership partnership, including losses on personal tax borrowing money partnership (LLP), but agreement. for unlawful acts of returns. through loans or other partners should sign other partners and debt instruments. partnership agreement. employees. Risk can be Take steps to comply limited by creating an with name, license, and LP or LLP. tax and employment law/regs. Sole Proprietor No filing requirements. Has no legal existence apart from owner. Take steps to comply with d/b/a name, license, tax and employment law/regs. Owner has full control. Owner is liable for all debts and obligations, including for unlawful acts of employees. Not taxed as an entity. Owner reports business profits and losses on personal tax return. Owner provides funds for capital investment and owner can borrow money through loans or other debt instruments. 1. Nonprofit Corporations a. Overview The California Nonprofit Corporation Law (Cal. Corp. Code ) governs the formation, operation and dissolution of various types of California nonprofit corporations. The majority of California nonprofit corporations are one of the following types: (i) the public benefit corporation, (ii) the mutual benefit corporation and (iii) the religious nonprofit corporation. Each of these subtypes of nonprofit corporations differs from the other in the following respects: the purposes for which each is organized, the manner in which its assets may be distributed, and the manner in and extent to which it is regulated. Public benefit corporations may be formed for any public or charitable purpose and may be used by foundations, community chests and hospitals. Public benefit

5 corporations are governed by Cal. Corp. Code and are subject to extensive governmental regulation and supervision. Public benefit corporations may not make distributions of corporate assets to members at any time. Mutual benefit corporations may be formed for any lawful purpose and are often the corporate form of choice for societies, fraternal orders, trade and homeowners associations, clubs and similar organizations conducted for their members benefit. Mutual benefit corporations are regulated by Cal. Corp. Code and are subject to less comprehensive state regulation and supervision than the public benefit corporation. Assets may be distributed to members only upon dissolution of the mutual benefit corporation and, subject to certain requirements set forth in the California Nonprofit Corporation Law, in connection with the purchase or redemption of a membership. Religious corporations may be formed primarily or exclusively for religious purposes such as churches, seminaries and other religious organizations like hospitals and schools if the organization s primary purpose is religious in nature. Religious corporations are regulated by Cal. Corp. Code and are subject to less comprehensive state regulation and supervision than the public benefit corporation. Religious corporations may not make distributions of corporate assets to members at any time. Note also that some religious organizations may wish to consider a unique form of organization called a corporation sole as an alternative to a religious corporation(see Cal. Corp. Code ). For a more detailed discussion and comparison of these various forms of organization, please see Advising California Nonprofit Corporations (3 rd ed. Cal CEB 2013). In addition to the three major nonprofit corporations outlined above, there are several minor types of nonprofit corporations recognized by California law including, without limitation, the corporation sole, and other special purpose corporations such as the consumer cooperative corporation, societies for the prevention of cruelty to animals, chambers of commerce and boards of trade, small business development corporations, and nonprofit cooperative agricultural marketing associations, which are also subject to General Corporation Law. Because it is the most common type of California nonprofit corporation, the discussion in this Chapter 1 is generally focused on the public benefit corporation, unless otherwise specifically indicated.

6 All activities and affairs of a nonprofit corporation in California are conducted and all corporate powers exercised by or under the discretion of its board of directors. The board of directors may delegate the management of the activities to the corporation s officers and employees. Instead of shareholders, a nonprofit corporation may, but is not required to, have members. Nonprofit corporations can make a profit, but cannot be designed primarily to earn profits. Rather, a nonprofit corporation exists primarily to fulfill its public or charitable purpose as described above. No part of the income or surplus of a California nonprofit corporation may be distributed to its members, directors or officers; however, reasonable compensation may be paid for services rendered. A nonprofit corporation has an existence of its own, independent of the terms of office or employment of members, directors or officers. Among other powers, a nonprofit corporation can sue or be sued in its own name, carry on a business at a profit and apply any profit that results from the business activity to any activity in which it may lawfully engage, and can own real estate in its own name. b. Advantages of Incorporation: Pros and Cons of Nonprofit vs. For-Profit The principal advantage of incorporation, either as a nonprofit or a for -profit corporation, is that it protects the shareholders or members from personal liability for the obligations and liabilities of the corporation, including unlawful actions of officers, directors and staff acting on behalf of the corporation. In addition, incorporation establishes continuity of existence which may be for a set period of time or perpetual unless earlier terminated or dissolved as described herein. Corporations (both nonprofit and for-profit) are subject to a body of statutes that provide very specific guidance as to their formation and operation; and incorporation brings stature to the organization and implies stability. Where profit is not a goal and the enterprise can be funded without the need for access to capital, the nonprofit corporation is the preferred vehicle for pursuing social objectives. Although nonprofit corporations are not prohibited from engaging in commercial activities, the directors of a nonprofit are duty-bound to devote primary attention to the promotion of the social mission of the corporation rather than the production of net income or profits. On the other hand, if access to capital markets is needed, a for-profit corporation (or limited liability company, discussed below) is likely to be the preferred option because nonprofit corporations cannot issue capital stock. The directors of a for-profit corporation, however, owe strict duties to the shareholders to maximize profits and value. Therefore, unless the directors and managers can tie the social

7 mission of their for-profit corporation directly to its business purpose, they can be sued for breach of their duties to shareholders and for misuse of corporate assets if they focus too much on the social mission and forego profits. This problem can be avoided where all shareholders agree to pursue a social mission or devote a percentage of revenues to charitable causes. Such agreements may be temporary because a change in control or a drop in earnings can lead to amendment or termination of shareholder agreements with stated social mission purposes. This problem can also be avoided by forming an entity using a new corporate form, such as the flexible purpose corporation, which provides flexibility to form corporations that may pursue both economic and social objectives. This corporate form is discussed in greater detail below. c. Formation A nonprofit corporation attains its separate legal status through the filing and approval by the California Secretary of State of its articles of incorporation. This document is in essence a contract between California and the nonprofit corporation to which California grants individual legal status in exchange for the corporation s commitment to follow its rules. One or more persons may form a nonprofit corporation by filing articles of incorporation in the form required by the California Secretary of State. If initial directors are named in the articles, each must sign and acknowledge the articles; otherwise, the articles shall be signed by one or more incorporators. One additional fully executed copy of the articles must be provided to the Secretary of State for delivery to the California Attorney General. The following discussion is directed to the most common type of California nonprofit corporation, the public benefit corporation. The articles must include the following information: the name of the corporation; the following statement: This corporation is a nonprofit public benefit corporation and is not organized for the private gain of any person. It is organized under the Nonprofit Public Benefit Corporation Law for (public or charitable [insert one or both]) purposes. The articles must also include the initial street address of the corporation, the initial mailing address of the corporation if different from the initial street address and the name of the corporation s initial agent for service of process (an individual or entity located in California appointed by the corporation to accept service of process on behalf of the corporation if an individual, the articles must also include the agent s street address in California). The statutory agent agrees to accept official documents such as pleadings in a law suit or legal proceeding and deliver them to the officers and directors of the corporation. The articles may set forth other provisions such as a limitation on the duration of existence, classes

8 of members, if any, voting rights and any other provision for the conduct of the affairs of the corporation not in conflict with law. A nonprofit corporation may not use, and the Secretary of State will not file, articles which set forth a name which is likely to mislead the public or which is deceptively similar to the name of another California corporation or any non-california corporation which is authorized to do business in California or which has registered its name with the California Secretary of State, unless that existing corporation consents in writing and the Secretary of State finds that under the circumstances the public is not likely to be misled. The availability of a name may be checked by accessing the website of the California Secretary of State at It is possible to reserve a name, if available, by payment of a fee for a period of 60 days. There are further limitations on name choices for California nonprofit corporations in that such names may not contain the words bank, trust, trustee or related words. If the nonprofit corporation intends to obtain exemption from federal and state income taxation, the articles of incorporation must conform with applicable statutes and regulations (discussed in the Recordkeeping, State Reports, and State Taxes section below). Samples of articles of incorporation and related materials can be found at: The California Secretary of State s office (California nonprofit, public benefit) Insight Center for Community Economic Development (California model articles of incorporation for nonprofit public benefit corporation (and includes a model cover letter for filing and with model name reservation request) on.pdf. d. Management and Control Once the nonprofit corporation has been established, the initial board of directors should meet (in person or/by written consent instead of a board meeting) to ratify the acts in connection with the initial formation of the corporation and adopt bylaws, which set forth the rules and procedures governing the decision-making process of the board of directors and the general operation and management of the corporation consistent with the applicable California statutes and the corporation s articles of incorporation.

9 Typically, the bylaws of a nonprofit corporation contain provisions governing member, director and officer qualifications, powers, and duties; voting; filling of board vacancies; board and shareholder meetings; property holding and transfer; indemnification of directors and officers; committees; bank accounts; fiscal year audits and financial reports; conflicts of interest; and amendment and dissolution procedures. Samples of bylaws that may be adapted for California nonprofit corporations can be found at: Insight Center for Community Economic Development (California model bylaws for a nonprofit membership corporation) s.pdf Insight Center for Community Economic Development (California model bylaws for a nonprofit non-membership corporation) 20nonmembership%20bylaws% pdf American Bar Association, Business Law Section Pro Bono: ABC Toolbox (California bylaws for nonprofit non-membership public benefit corporation) /bylaws_cali.doc e. Liability of Members, Directors and Officers Because of the importance of attracting services of directors and officers of nonprofit corporations and the sometimes prohibitive cost of appropriate liability insurance, it is the public policy of the State of California to provide protections to individuals who perform these functions. Subject to certain exceptions, a nonprofit corporation has the power to indemnify directors, officers, employees and other agents who are party to, or threatened to be party to, any proceeding because of the fact that such person is or was an agent, against litigation expenses, if the person acted in good faith and in a manner he or she believed is in the best interest of the corporation. Indemnification cannot be provided in cases where the agent has breached his or her fiduciary duty of loyalty to the corporation by engaging in certain self-dealing transactions (that is, transactions to which the corporation is a party and in which the director has a material financial interest). There are other circumstances under which an agent cannot be indemnified, which are described in the California Nonprofit Corporation Law.

10 With specific exceptions outlined below, no law suit for monetary damages shall be recognized against a volunteer officer or director of a California nonprofit corporation (i.e., a person serving in such capacity without compensation) arising out of a negligent act or omission of such person while he or she is performing such duties so long as such person acted within the scope of his or her duties and in good faith, the act or omission was not reckless, wanton, intentional or grossly negligent, and damages caused by the act or omission are covered by a liability insurance policy or, if not covered, so long as the corporation and the volunteer had made all reasonable efforts in good faith to obtain available liability insurance. This limitation on liability applies to nonprofit corporations that are exempt from federal income taxation under Sections 501(c)(3) or 501(c)(6) of the Internal Revenue Code, provided that the nonprofit corporation maintains liability insurance policies with amounts of coverage sufficient based on the corporation s annual budget. To the extent an officer or director of a nonprofit corporation uses corporate funds to pay private debts, makes any distribution of corporate assets or fails to observe typical corporate formalities (recognizing the corporation as a separate legal entity), or as necessary to prevent fraud on creditors, the officers or directors committing such acts maybe personally liable for damages resulting for such acts. f. Mergers, Acquisitions and Dissolution The requirements related to mergers of California nonprofit corporations are in Cal. Corp. Code for public benefit corporations; Cal. Corp. Code for mutual benefit corporations; and Cal. Corp. Code 9640 for religious corporations. For sake of simplicity, and because public benefit corporations are the most common form of California nonprofit corporations, the following discussion is limited to public benefit corporations. A California public benefit corporation may merge with any domestic for-profit corporation, a foreign for-profit corporation or other business entity. However, subject to certain exceptions, without the prior written consent of the California Attorney General, a public benefit corporation may only merge with another California nonprofit corporation, foreign nonprofit corporation, or unincorporated association if such entity s governing documents state that its assets are dedicated exclusively to charitable, religious or public purposes. The merger process may be summarized in the following steps: i) The board of each corporation that wishes to merge must approve an agreement of merger which contains the following information:

11 The terms and conditions of the merger; Any amendments to the articles of incorporation or bylaws that are required for the corporation who will survive the merger or continue to exist after the merger is effected (the surviving corporation ); The name, place of incorporation and status of each corporation participating in the merger; The identity of the surviving corporation; The manner, if any, of converting memberships of the corporations into memberships, shares, or other securities of the surviving corporation, or the securities, cash, rights or other property that members are to receive in exchange for their memberships or securities; Any other provisions or details required by the parties; and Any other details required by the laws of the state of incorporation of one of the corporations, if not California. ii) The terms of the merger must be approved by members of the participating corporations and as may otherwise be required by each party s articles of incorporation; iii) The merger agreement must be signed by the authorized officers of the participating corporations; and iv) The surviving corporation must then file with the Secretary of State the agreement of merger with an officer s certificate from each participating corporation, setting forth specific facts relating to the voting and approval of the merger required by each participating corporation, and must pay the required filing fee. It is also possible for a California for-profit corporation and a nonprofit corporation to merge. The requirements for such merger (approval of the boards of the participating corporations, appropriate votes, execution and filing of a merger agreement) are detailed in the California statutes governing nonprofit and for -profit corporations. A nonprofit corporation may voluntarily dissolve and wind up its affairs by either approval of the board of directors or approval of a majority of the members of the nonprofit corporation. The board of directors alone may choose to wind up and dissolve a corporation, if the corporation: (i) has been the subject of an order for relief in bankruptcy; (ii) has not conducted business within the last five years and which has already disposed of all its assets; (iii) has no members; or (iv) is required to dissolve under the terms of the corporation s articles of incorporation providing for termination of its existence as of a specific date.

12 Once a corporation has decided to dissolve and wind up its affairs, it must file a dissolution certificate evidencing its intent to dissolve with the Secretary of State and the California Attorney General. The certificate must be an officer s certificate, or must be signed by a majority of the directors or by one or more members. It must recite the number of votes in favor of dissolution and whether the decision to dissolve was made by the board or by the members. Once the corporation initiates the dissolution process, it may no longer conduct its normal activities except as necessary to wind up its affairs and/or to prepare for a sale or disposition of its assets or both. Another notice of dissolution must then be provided to all members who did not vote in favor of dissolution, the California Attorney General and all known creditors and claimants whose names and addresses appear in the corporation s books and records. A corporation voluntarily dissolving must provide notice to creditors and claimants explaining how to make a claim against the dissolving corporations and provide a deadline no fewer than 120 days from the date of notice within which the corporation must receive a written claim submitted by such creditors. It is possible to seek court intervention and supervision of the dissolution of a California nonprofit corporation if requested by the corporation itself, the authorized number of members (or 5% of the voting power, unless there are 1,000 or more members), if any, the California Attorney General, or by three or more creditors. When a corporation has been wound up without court involvement, a majority of directors must sign and verify a certificate of dissolution which states, among other things, that the corporation has been wound up, that it has filed or will file its last franchise tax return, that it is dissolved, that all debts and liabilities have been paid, and, if there are known debts and liabilities for payment of which adequate provision has been made, a description of the provision made, the name and address of the person, corporation or governmental entity who has assumed or guaranteed payment of the corporation s liabilities. Before the certificate of dissolution will be accepted for filing by the California Secretary of State, the corporation must attach either a written waiver of objections to the distribution of the corporation s assets issued by the California Attorney General or a written confirmation issued by the California Attorney General that the corporation has no assets. In addition to voluntary dissolution proceedings, it is possible for an action for involuntary dissolution to be filed in the superior court of the proper county by any of the following: at least half of the directors then in office, a person(s) holding at least 1/3 of the voting power, any member if the ground for dissolution is that the period for which the corporation was formed has terminated without extension, the California Attorney General or any person authorized in the

13 corporation s articles to file such an action. The grounds for such a lawsuit include abandonment of corporate activities for more than one year; deadlock on the board with respect to ongoing management and operation or internal dissension among members such that the activities of the corporation can no longer be conducted to advantage or so that there is danger that its property or activities will be impaired or lost; fraud, mismanagement or misapplication of assets or corporate property; or expiration of the corporation s term of existence set forth in its articles. The California Attorney General may also bring an action to obtain dissolution on similar grounds set forth in Cal. Corp. Code 6511(a). The court may appoint a provisional director to break a tie or management deadlock, or it may appoint a receiver to take over and manage the orderly disposition of the corporation s assets. The powers of the court in an involuntary proceeding are set forth in Cal. Corp. Code 6516 and include, among other things, management of claims against the corporation and approval of payments of such claims and/or retention of assets to provide a fund for payment of claims. The mechanics for notice to creditors and claims payments are set forth in Cal. Corp. Code g. Recordkeeping, State Reports and State Taxes Every nonprofit corporation in California is required to keep a copy of its articles and bylaws at its principal office in California and to keep adequate and correct books and records of account and minutes of meetings of the members, board and board committees. It shall also maintain a record of its members names, addresses and class of membership. No later than 120 days after the close of its fiscal year, unless the corporation receives less than $25,000 in gross revenues or receipts during its fiscal year, the board is required to send an annual report to members. The annual report must contain a report of its assets and liabilities as of the fiscal year end, principal changes in such assets and liabilities, the revenues and receipts of the corporation for the fiscal year, its expenses and disbursements, as well as a statement of any indemnification payment of $10,000 or greater by the corporation to or on behalf of any officer or director or any corporate transaction or series of transactions with an interested director, officer or holder of more than 10% of the voting power involving over $50,000 in the aggregate. The obligation to report indemnification disbursements applies without regard to the corporation s gross revenues or receipts unless such indemnification is approved by the members. The annual report must be accompanied by the report of the corporation s

14 independent accountants or, if none, a certificate of an authorized officer that such statements were prepared without audit from the corporation s books and records. Corporations are also required to file with the California Secretary of State within 90 days of the filing of its articles of incorporation and every other year thereafter a Statement of Information containing the following information: (i) the name of the corporation and the Secretary of State s file number; (ii) the names and addresses (business or residence) of its chief executive officer, secretary and chief financial officer; (iii) the street address of its principal office in California; (iv) the mailing address of the corporation if different than that of its principal office or if its principal executive office is outside of California; and (v) if the corporation elects to receive notices from the Secretary of State electronically, a valid address for the corporation. The Statement of Information shall also include the name of the corporation s statutory agent and his, her or its business or residence address. The link to this form on the California Secretary of State website is In addition, upon the request of an assessor, a corporation must make available its business records relating to property it owns at its principal office in California or at a place mutually acceptable to the assessor and the corporation. A nonprofit public benefit corporation must also file an Annual Registration Renewal Fee Report (Form RRF-1) with the California Attorney General within four and a half months after the end of the corporation s accounting period, unless the corporation is exempt from the general requirements for registration with the California Attorney General, and both Form RRF-1 and IRS Form 990, Form 990-PF or Form 990-EZ, as applicable with the Registry of Charitable Trusts. California tax laws also apply to nonprofit corporations in unique ways. Primarily, qualifying nonprofit and charitable entities are exempt from state franchise tax (similar to an income tax ). Real and personal property held by a nonprofit corporation is generally subject to California property taxes, except that California law exempts from property tax property of a specific type or property owned or used by certain types of organizations, including the property a qualifying nonprofit organization uses for religious, hospital, scientific, or charitable purposes. California law also provides a broad property tax exemption for property used only for religious worship. On the other hand, California, unlike some states, does not generally exempt sales to or by nonprofit organization from sales tax or use taxes. However, some specifically enumerated exemptions that may apply to nonprofit organizations are interspersed throughout California s sales and use tax provisions. These

15 exemptions include, for example, flags sold by nonprofit veterans organizations, sales by certain qualified youth organizations, and sales by certain charitable organizations engaged in the relief of poverty. Finally, nonprofit organizations will be subject to employment taxes to the extent that they meet the definition of employers and to the extent that they have persons meeting the definition of employees working for them. h. Insurance Nearly every type of activity by a nonprofit corporation can become the target of some kind of a claim by a firm or an individual that alleges damage or injury by the corporation or individuals responsible for it (i.e., directors, officers or employees). Even if the claim is without merit, the costs of defending against the claim can be very substantial. To encourage qualified individuals to accept positions as directors and officers, many nonprofit corporations purchase insurance to cover director and officer (D&O) liability. In addition, most responsible nonprofit corporations purchase a basic comprehensive general liability policy that covers liability for accidents in the corporation s offices, at sponsored meetings and the like. Liability insurance for nonprofit corporations is often a very complicated matter. Consultation with an experienced and knowledgeable agent or consultant is essential in order to obtain the right coverage at the lowest premium. i. Hybrid Structures Nonprofit corporations also can partner with for-profit corporations to accomplish their goals. For example, a nonprofit corporation may form a for-profit subsidiary or make an investment in a for-profit entity consistent with its public or charitable purpose. By owning a certain amount of stock or membership interests in the for-profit entity and having representation on the for-profit entity s board of directors, the nonprofit may be able to exert some measure of control over the operations of the for-profit entity, which is able to separately access capital markets to raise funds. Alternatively, an existing for-profit corporation may form a nonprofit foundation that pursues a charitable purpose separate from the business operations of the for-profit entity. One specific hybrid structure that may be used involves a for-profit entity setting up a separate nonprofit corporation (typically a private foundation) whose charitable purpose the for-profit entity otherwise supports or whose goals are aligned with the for-profit s social mission. The for-profit then contributes certain intellectual property assets (e.g., a valuable trademark) to the nonprofit, which, in turn, licenses such intellectual property back to the for-profit pursuant a license

16 that (i) is contingent on the for-profit using the intellectual property to pursue an agreed-upon mission and (ii) provides for revenue-based royalty payments back to the nonprofit. This structure allows the nonprofit and the for-profit to work together to pursue and preserve a social mission, while the royalty payments provide funds to the nonprofit that can be used to further pursue its own public or charitable purpose. Note that there are a number of important issues that must be considered when pursuing a hybrid structure, because a nonprofit entity risks generating UBIT (unrelated business income tax) and/or losing its status as a tax-exempt organization if it engages in activities that are not sufficiently related to its public or charitable purpose. For example, the IRS rules and regulations generally stipulate that any income or surplus of a nonprofit corporation cannot inure to a private individual, such as a member, director or officer. Similarly, the assets of a nonprofit cannot be used to benefit a for-profit corporation without reasonable consideration. For these reasons, it is important for a nonprofit corporation to consult with legal and tax advisors before setting up a hybrid structure to properly structure and document all transactions between the nonprofit and the for-profit and avoid losing its tax exempt status or inadvertently violating any other tax, corporate or other applicable laws. j. Alternatives to Nonprofit Corporations Nonprofit and charitable enterprises may also operate as unincorporated associations. (See generally Title 3 of the California Corporations Code.) A nonprofit association is defined by statute as an unincorporated association with the primary purpose other than to operate a business for profit. Unincorporated association is defined as an unincorporated group of two or more persons joined by mutual consent for a common lawful purpose, whether organized for profit or not. The applicable California law relating to unincorporated associations is set forth in Cal. Corp. Code Compared to other business entities, unincorporated associations are subject to relatively few statutory formation requirements and regulations. The primary disadvantages of using the unincorporated association form include uncertainty of the laws governing the association and its members (including such issues as personal liability for torts, standards of care for officers and directors, lack of express statutory authority giving officers, directors or members authority to act by and on behalf of the association). Given these uncertainties, the task of drafting organizational and operating documents that may relieve some of these uncertainties is more challenging. The California Secretary of State has provided a link to the appropriate form for reservation of an unincorporated nonprofit organization at: For a more detailed discussion of unincorporated associations and their advantages and

17 disadvantages in the nonprofit sector, please see Advising California Nonprofit Corporations (3 rd ed. Cal CEB 2013), Chapter 2, ) A nonprofit organization in California can also organize itself as a charitable trust. Charitable trusts are arrangements whereby one or more parties (individuals or corporations) agree to hold legal title to certain property for the benefit of a charity or for other religious, charitable, scientific, literary, educational or certain other purposes enumerated in the Internal Revenue Code. The applicable California law relating to charitable trusts is set forth in of the California Probate Code. Charitable trusts must be registered with the Attorney General s Registry of Charitable Trusts. See Supervision of Trustees and Fundraisers for Charitable Purposes (California Government Code ). See Chapter 2, of Advising California Nonprofit Corporations (3 rd ed. Cal CEB 2013) cited below for further discussion. k. Resources Oleck and Stewart, Nonprofit Corporations, Organizations & Associations (Prentice-Hall, 1994, Cum. Supp. 2002) Jacobs, Jerald A., Association Law Handbook (ASAE & The Center for Association Leadership 4 th ed., 2007) Nonprofit Governance and Management (American Bar Association and American Society of Corporate Secretaries, 2002) Guide to Nonprofit Corporate Governance in the Wake of Sarbanes-Oxley (American Bar Association Section of Business Law, 2005) Guidebook for Directors of Nonprofit Corporations (American Bar Association Section of Business Law 2d ed., 2002) Advising California Nonprofit Corporations (3 rd ed. Cal CEB 2013) 2. For-Profit Corporations a. Using For-Profit Corporations to Pursue Social Objectives The for-profit form of organization can and frequently is used as a vehicle for conducting a business that also has a social mission or objective. Although for-profit corporations are usually formed for the purpose of making profits and distributing them to shareholders, there is no reason why a for-profit corporation cannot include a social mission in the purposes clause of its articles of

18 incorporation or in a shareholders agreement. Although it is typically understood that the primary duty of a director of a for-profit corporation is to maximize shareholder value, this duty is not legally required in all cases. The primary fiduciary duties of directors of for-profit corporations are the duties of care and loyalty. The duty of care requires directors to use the same level of diligence and care that an ordinarily prudent person would use in similar circumstances this means that directors should inform themselves of all material information reasonably available and take the time and opportunity to carefully deliberate before making decisions. The duty of loyalty requires directors to act without self-interest, in good faith and in a manner reasonably believed to be in the best interest of the corporation. When courts are evaluating these fiduciary duties of directors, they are viewed in light of the business judgment rule, which creates a safe harbor for directors and provides considerable latitude so long as directors of a corporation are looking out for the long-term best interests of the corporation and its shareholders. It is not absolutely required that directors focus on short-term maximization of profits, so long as decisions (including decisions to promote social or environmental goals) are well informed and preceded by careful deliberation, the director did not engage in self-dealing and the decision benefits the corporation as a whole in the long term. While a social mission provision in the articles of incorporation would authorize the corporation to pursue social objectives, it would not require the corporation to do so only the shareholders/owners have this power. Unless all shareholders agree to pursue social aims, dissenters could potentially bring an action against the corporation s directors for failing to operate the corporation in the best economic interests of the shareholders. Although, as noted above, a court would most likely apply the deferential business judgment rule standard of review in any such action (again, so long as the directors had otherwise satisfied their duties of care and loyalty). Still, any litigation matter can be costly and time-consuming and may have negative reputational effects for the directors. Further, if the social mission is not tied at all to profitability, particularly in a change of control situation, there could be liability. Therefore, a shareholders agreement is probably the best way to address this problem, rather than including a social mission provision in the articles of incorporation. Such an agreement, entered into by all shareholders and the corporation, would require the corporation to be managed and operated so as to pursue specified social objectives thereby tempering to some degree the duty to maximize shareholder value and similar legal principles that govern typical behavior of for-profit corporations. Note, however, that even the most skillfully drafted shareholders agreement is not a perfect solution, because agreements can always be terminated or amended

19 by a vote of the parties to such agreement and the shareholders of a for -profit corporation may and often do change as a result of a sale, gift or inheritance. Moreover, a tightly drafted shareholders agreement that makes it difficult to respond to business changes over time may tend to render the for-profit corporation much less attractive to certain investors (potential new shareholders) who do not share the passion for the corporation s social mission. Another means by which a for-profit corporation can pursue and preserve its social mission is by creating and issuing separate classes of stock one class of stock is issued to the founders of the corporation, who established the for-profit corporation for the primary purpose of pursuing the social mission, and a separate class of stock is issued to outside investors. The founder stock is granted certain rights, such as protective provisions in the articles of incorporation that allow the founders to preserve the social mission. For example, the approval of the class of stock held by the founders would be required to change the purposes clause of the articles of incorporation or to merge the corporation with another entity, whose purpose may not be aligned with the corporation s social mission. As discussed above in Chapter 1 on nonprofit corporations, for-profit corporations can also establish a hybrid structure to pursue a social mission. This can be particularly effective if some valuable intellectual property is donated to the nonprofit and licensed back to the for-profit, which license includes requirements aligned with the social mission. b. Formation The General Corporation Law governs the formation, operation and dissolution of for-profit corporations in California. One or more natural persons, partnerships, associations or corporations may form a corporation by executing and filing articles of incorporation. If initial directors are named in the articles, each director must sign and acknowledge the articles. If initial directors are not named, the articles may be signed by one or more persons who initiate the formation activities ( incorporators ) who also sign the articles. The corporation begins to exist upon filing of the articles with the California Secretary of State and continues perpetually unless earlier terminated by law or as provided in the articles. The articles of incorporation must set forth the information set forth in Cal. Corp. Code 202, including, among other items, the purpose of the corporation (usually broadly stated to engage in lawful act or activity for which a corporation may be organized); the name and street address of an initial agent for service of process; if the corporation is authorized to issue only one class of shares, the total number

20 of shares the corporation is authorized to issue; if more than one class or series of shares is authorized, the number of each class or series of shares authorized to be issued or a statement that the board is authorized to fix the number of shares in any such class or series; and any rights, preferences, privileges or restrictions granted to and imposed upon each class or series of shares. The articles may set forth other provisions not inconsistent with California law, including limitations on the business in which the corporation may engage; a provision requiring shareholder consent for any corporate action ; or provisions eliminating or limiting personal liability of a director except for certain breaches of directors duties (intentional misconduct, or acts believed by the director to be contrary to the best interests of the corporation), among others. The articles may also eliminate the liability of directors to the fullest extent permitted by law. The Secretary of State shall not file articles which set forth a name that is likely to mislead the public, or which resembles closely the name of a domestic corporation or a foreign corporation registered with the Secretary of State and authorized to transact intrastate business, or a name that has been reserved with the Secretary of State. The availability of a name may be checked on the website of the California Secretary of State by accessing the following link: A specific name may be reserved for 60 days by an applicant by filing and paying the required fee. If the corporation is a close corporation (i.e., no more than 35 shareholders), the name must contain the words corporation, incorporated or limited or an abbreviation of such words. c. Management and Control A for-profit corporation has a hierarchical control structure. It is managed by or under the direction of a board of directors, who has the right to appoint its officers, although its shareholders vote on important corporate issues such as election of directors, mergers, sales of all or substantially all assets and dissolution. Similar to a nonprofit corporation, once the for-profit corporation has been established, the initial board of directors meets (in person or by a written consent instead of a meeting), ratifies the acts taken in connection with initial formation of the corporation and adopts bylaws, which set forth the rules and procedures governing the decision-making process of the board of directors and the general operation and management of the corporation consistent with the applicable California statutes and the corporation s articles of incorporation.

21 In general, the bylaws of a for-profit corporation contain provisions governing director and officer qualifications, powers and duties; voting; meetings of shareholders, directors and officers; filling of vacancies; board committees; property holding and transfer; indemnification of directors and officers; bank accounts; fiscal year audits and financial reports; conflicts of interest; and amendment, merger and dissolution procedures. d. Liability of Shareholders, Directors and Officers Directors of for-profit corporations have two primary fiduciary duties the duties of care and loyalty. Directors are required to perform their duties as directors (including as a member of a board committee) in good faith, in a manner each director reasonably believes to be in the best interests of the corporation and its shareholders, and with the care an ordinarily prudent person in a like position would use under similar circumstances. Directors may rely on information, opinions, reports and financial statements and other data provided by officers, counsel and accountants that a director believes to be reliable and competent in the matters presented, as well as board committees on which such director does not serve as to matters within such committee s authority or charge. Provided a director performs his or her duties in accordance with the foregoing standards, he or she shall have no liability for any alleged failure to perform his or her obligations as a director (as discussed above, when courts evaluate the fiduciary duties of directors, they are viewed in light of the deferential business judgment rule, which creates a safe harbor for directors so long as the directors have satisfied their duties of care and loyalty). The corporation s articles of incorporation may eliminate or limit the personal liability of directors for monetary damages in an action brought by or on behalf of a corporation for breach of the director s duties to the corporation and its shareholders. The articles may not limit liability of directors for acts or omissions that involve intentional misconduct or knowing violations of the law, acts the director believes to be contrary to the best interests of the corporation and its shareholders or that involve the absence of good faith on the part of the director, any transaction resulting in an improper personal benefit for the director, acts or omissions evidencing reckless disregard for the director s duties in circumstances in which the director should have recognized a risk of serious injury to the corporation and its shareholders or certain other enumerated exceptions described in Cal. Corp. Code 204(10). A corporation that intends to limit the liability of its directors as described above may include in its articles of incorporation the following: The liability of directors of the corporation for monetary damages shall be eliminated to the full extent permissible under California law.

22 Pursuant to the provisions of Cal. Corp. Code 316(a), directors of a corporation who approve the following transactions may be jointly and severally liable to the corporation for the benefit of the corporation s creditors and shareholders: (i) distributions to shareholders that leave the corporation with unreasonably small capital to operate its business or distributions otherwise in conflict with California laws regarding the amount of distributions that may be made to shareholders; (ii) distributions to shareholders in connection with the dissolution of the corporation without adequate provision for payment of known liabilities, or (iii) the making of an improper loan of money or property to, or guaranty of the obligation of, any officer or director of the corporation in violation of Cal. Corp. Code 315. Shareholders receiving an appropriate or illegal distribution may also be liable under certain circumstances to the corporation for return of such illegal distribution. In addition, to the extent shareholders, officers and directors have personally guaranteed the debts of the corporation, they may be held liable for such guaranteed obligations as a matter of contract law. Shareholders and directors of a corporation may also be held liable for the debts and obligations of the corporation in the event a court decides there are facts and circumstances that justify ignoring a corporation s separate legal existence apart from its shareholders. This is judicial doctrine called piercing the corporation veil. A court may elect to do this under certain circumstances, most usually to avoid an injustice to a third party dealing with the corporation (such as a creditor or the other party to a corporate contract), in cases where there is a unity of interest and ownership between the corporate and its shareholders, such that one is merely the alter ego of the other. For example, if corporate formalities are not followed (e.g., failure to keep separate books and records), if corporate funds are used by the shareholders or directors to pay personal debts, or if there is failure to adequately capitalize or fund the corporation in light of the business it undertakes, a court may decide to ignore the existence of the corporation as a separate legal entity and hold the responsible parties liable. A court may also choose to pierce the corporation veil to prevent fraud on third parties. A California corporation has the power to indemnify or pay the expenses, judgments or settlements of or against an officer, director, employee or other agent of the corporation who is a party to, or is threatened to be a party to, any proceeding (other than an action by the corporation against such person) by reason of the fact that such person was acting by or on behalf of the corporation. In order to qualify for such indemnification, the person must have acted in good faith and in a manner the person reasonably believed to be in the best interest of the corporation and, in the case of a criminal proceeding, with no reasonable

23 cause to believe such conduct was unlawful or illegal. Similarly, and subject to the same qualifications (good faith, best interests, and no basis for belief of unlawfulness of the conduct), a corporation may indemnify such person against expenses incurred in connection with the defense or settlement of such action. No indemnification shall be made in connection with claims or expenses with respect to any claim the officer or director is adjudged to be liable to the corporation, unless the court determines such person is fairly and reasonably entitled to indemnity and then only in the amount ordered by the court. Similarly, if a pending action is settled without court approval, the officer or director will not be entitled to indemnification of the costs of settlement or expenses made without court approval unless the agent is successful on the merits of the defense of such proceeding. If the agent of the corporation has been successful on the merits of the action, the agent shall be indemnified against its expenses reasonably incurred. If the agent has not achieved success on the merits, indemnification shall be made only if the agent has met the required standard of conduct (good faith, best interests, and no basis for belief of unlawfulness of the conduct) and if (i) a majority vote of a quorum of the directors not parties to the proceeding vote in favor of such indemnification; (ii) an independent legal counsel has issued a written opinion that indemnification is appropriate; (iii) upon approval of shareholders (not including shares owned by the person seeking indemnification) ; or (iv) upon approval of the court in which the preceding is pending. Expenses for indemnification may be advanced by the corporation prior to final disposition but only with the promise of the agent to repay the amount if it is ultimately determined that the agent is not entitled to indemnification. To the extent the articles of incorporation provide for more extensive rights of indemnification, the indemnification provided by California law shall not be exclusive of the additional rights provided for in the articles or the bylaws, or by agreement or vote of shareholders and disinterested directors. No indemnification may be made if inconsistent with articles, bylaws, resolution of shareholders, or if it is inconsistent with a condition imposed by the court approving a settlement of a lawsuit, notwithstanding any of the forgoing provisions. A corporation may purchase and maintain insurance against any liability asserted against the officer or director due to his or her status as agent of the corporation.

24 e. Raising Capital For-profit corporations (and LLCs) offer the most flexibility in raising capital, ranging from various kinds of equity (common stock, preferred stock, options and warrants) to numerous types of debt instruments (convertible notes, subordinated notes, bonds and commercial paper). Note that various forms of capital raising efforts require compliance with both state and federal securities laws, the discussion of which is beyond the scope of this outline. Note also that LLCs may be less attractive to investors because of the pass-through tax treatment. f. Recordkeeping and State Reports Every corporation in California is required to keep a copy of its articles and bylaws at its principal office in California and to keep adequate and correct books and records of account and minutes of meetings of the shareholders, board and board committees. It shall also maintain at its principal executive office a record of its shareholders names, addresses and number and class of shares held by each. No later than 120 days after the close of its fiscal year, unless the corporation has less than 100 shareholders and its bylaws specifically waive the report requirement, the board is required to send an annual report to shareholders. The annual report must contain a balance sheet as of the end of the fiscal year and an income statement and a statement of cash flows for the fiscal year, accompanied by any report thereon by independent accountants, or in the alternative, a certification of an authorized officer of the corporation that the statements were prepared without audit from the books and records of the corporation. In addition to the foregoing, corporations with 100 or more shareholders that are not subject to or are otherwise exempt from the reporting requirements of the Securities Exchange Act of 1934, must include in the annual report the following: (i) transactions involving amounts greater than $40,000 to which any officer, director or shareholder owning more than 10% of the outstanding voting shares of the corporation had an interest; and (ii) any indemnification or advances aggregating more than $10,000 made by the corporation unless approved by the shareholders. Corporations are also required to file with the California Secretary of State within 90 days of the filing of its articles of incorporation and annually thereafter a Statement of Information containing, among other items, the following information: (i) the names and complete addresses of its directors; (ii) the number of any vacancies on the board; (iii) the names and addresses of its chief executive officer, secretary and chief financial officer; (iv) the street address of its principal executive office; (v) the mailing address of the corporation if different than that of

25 its principal executive office; (vi) if its principal executive office is outside of California, the address of its principal business office in California; and (vii) a statement of the general type of business in which it engages in California. The Statement of Information shall also include the name of the corporation s statutory agent and, if the agent is a natural person, his or her business or residence address. The link to this form on the California Secretary of State website is The form, or a statement that no changes have been made since the last filing must be sent during the five calendar months before the anniversary of the filing of the articles. Publicly -traded corporations must provide additional information found at Cal. Corp. Code In addition, upon the request of an assessor, a corporation must make available its business records relating to property it owns at its principal office in California or at a place mutually acceptable to the assessor and the corporation. g. Taxation California imposes a tax on the income of corporations doing business or deriving income from within the state. Cal. Rev. & Taxation Code (franchise tax imposed on corporations doing business in the state). For-profit corporations in California are subject to double taxation; that is, first a corporation pays state income or franchise tax on the income it earns, and then the corporation s shareholders must also pay income taxes on the dividends they receive from the corporation in the state in which they are resident. Cal. Rev. & Taxation Code (adopting I.R.C. 301). In most states and at the federal level, S corporations, as opposed to C corporations, are not subject to double taxation as their income is not taxed at the entity level. Rather, the income and losses of the S corporation are usually passed through to the shareholders in relation to their ownership interests. In California, however, S Corporations are generally subject to an $800 minimum franchise tax or an income/franchise tax at a reduced rate (usually 1.5%, but 3.5% for financial corporations). Thus, the corporate double-tax is diminished for S Corporations in California, but not entirely eliminated as in most states. Shareholders of S Corporations are still subject to income tax on the distributions they receive. To be eligible for tax treatment as an S corporation, the corporation must elect S corporation status at the federal level. Not all corporations are eligible for the S corporation election. Among other requirements, an S corporation may not have more than 100 shareholders, may only have individual (and not entity) shareholders, may not have a non-resident alien shareholder, and may not have more than one class of stock.

26 h. Resources Friedman & Dallas, California Practice Guide (Corporations) The Rutter Group California Practice Guide, West Pub. Co. (2010) State Bar of California, Corporations Committee of the Business Law Section, 51 Marsh & Finkle, California Corporation Law and Practice, West Pub. Co Brea, Counseling California Corporations, State Bar of California, Continuing Education of the Bar (California Franchise Tax Board) Selecting and Forming Business Entities (2 nd ed. Cal CEB 2013) 3. Limited Liability Companies ( LLCs ) a. Using LLCs to Pursue Social Change The Beverly-Killea Limited Liability Act, Cal. Corp. Code , governs the formation, operation and dissolution of LLCs in California. Combining certain characteristics of both partnerships and corporations, LLCs are privately owned legal entities that can be formed for the purpose of earning profits, pursuing a social mission, or both, although some states require an LLC to be formed only for a business purpose. LLCs differ from for-profit corporations because they are formed and owned by members rather than shareholders; however, like S corporations and partnerships, LLCs are eligible for pass-through income tax treatment. This means that income and expenses are reported as though the members incurred them directly, and profits or losses are taxed at the ownership (member) level, rather than the entity (company) level. Members of LLCs can be individual investors as well as for-profit corporations and tax-exempt nonprofit corporations or other business organizations. For this reason and also because of pass-through taxation which eliminates double taxation (the effect of taxing income at the corporate level and again when it is included in the owner s income), LLCs are preferred over for-profit corporations as vehicles for social enterprise, especially for joint ventures between a tax-exempt nonprofit with a social mission and a for-profit business.

27 LLCs are akin to partnerships because the members have broad discretion to allocate profit and loss and management powers among themselves (via an operating agreement ). On the other hand, as with the shareholders of corporations, the members of an LLC can be divided into classes, each with its own economic and voting rights. The personal liability of members is limited, as more particularly discussed below. Two states, Tennessee and Kentucky, specifically authorize the formation of nonprofit limited liability companies (nonprofit LLCs). The statutes of numerous states, including California, have language that permits nonprofit LLCs to exist. Assuming state laws permit formation of nonprofit LLCs, the IRS will recognize such an LLC as exempt under Section 501(c)(3) if it elects to be treated as a separate legal entity for tax purposes and its operating agreement includes the language mandated by the organizational test (purposes, distribution of assets upon dissolution, etc.) and it meets numerous requirements largely designed to guard against inurement and private benefit. However, even a standard for-profit LLC can have a social mission. The operating agreement for the LLC may include its social mission as one of the purposes of the entity. Because LLCs are governed primarily by contract (i.e., the operating agreement), there is more flexibility to adjust or eliminate traditional fiduciary duties to allow for a primary focus on a social mission. Under both California and Delaware law, it is permissible for the purpose in the articles (i.e., the social mission, if the LLC should so choose), to take priority over the pursuit of economic value for members. In addition, there is flexibility in the ownership structure and distribution requirements of LLCs. In the same way that corporations can create separate classes of stock, LLCs can create separate classes of membership interests to which different rights may be allocated. LLCs can structure the separate classes of membership interests according to the ultimate goals of different types of investors. For example, if a nonprofit invests in the LLC, the nonprofit s primary focus may be pursuing the social mission, while other members may be focused on economic gains. The operating agreement can structure the distributions from the LLC in such a way that profits flow first to the nonprofit and then to the economically-focused members (however, the inverse would not be possible). Further, an LLC can distribute profits to a nonprofit that is not a member or otherwise affiliated with the LLC. The nonprofit may also be granted certain approval rights with respect to any changes in the social mission of the LLC or any potential sales or mergers.

28 b. Formation California limited liability companies may engage in any lawful business activity whether or not for profit except for banking, insurance, or trust company business. California LLCs have all the powers of a natural person in carrying out its business activities, except as limited by its organizational documents (articles of organization and operating agreement). To form an LLC, one or more persons must execute and file with the Secretary of State articles of organization. Thus, single member LLCs are expressly permitted and the term person is defined broadly to include an individual, partnership, trust, estate, association, corporation, LLC or other entity, whether domestic or foreign. The articles of organization must set forth the name of the LLC; the name and address of the initial agent for service of process who must meet certain requirements (set forth in Cal. Corp. Code 17061(b)) and a statement to the effect that the LLC is to be managed by one or more managers (who need not be members of the LLC) and not all of the members, if that is the case. If the LLC is to be managed by one or more managers and not all the members, the articles of organization shall contain a statement to that effect. In addition, the articles must contain the following statement: The purpose of the limited liability company is to engage in any lawful act in authority for which a limited liability company may be organized under the Beverly-Killea Limited Liability Company Act. Articles of organization may contain other provisions not inconsistent with California law including, without limitation, restrictions on the business in which the LLC may engage or the power the LLC may exercise or both, admission of members, events causing dissolution, date of dissolution and limitations on the authority of managers, etc. The name of each California LLC must be set forth in the articles and must contain the words limited liability company (which may be abbreviated by using ltd. or co. ) or the abbreviations L.L.C. or LLC as the last words of the name of the LLC. Like other entities, California LLCs must not use a name likely to mislead the public and must not use a name that is the same as, or resembles so closely as to tend to deceive, any California or registered foreign LLC, or any reserved name. The availability of names may be checked on the website for the California Secretary of State at It is possible to reserve a name, if available, by payment of a fee for a period of 60 days. The reservation may be renewed for an additional 60-day period, but not

29 consecutively by the same person or entity that made the initial reservation. There are further limitations on name choices for California LLCs in that such names shall not contain the words bank, trust, incorporated or corp, among others. The California Secretary of State provides samples of articles of organization at c. Management and Control Typically, an LLC operating agreement among the members governs the management of an LLC. The operating agreement which is like the articles of corporation, bylaws and a shareholder agreement all in a single document may contain provisions requiring adherence to a social purpose, and such purpose and the values it embodies may be incorporated throughout the operating agreement. Unless the articles of organization include a statement delegating management of the LLC to a single manager or a board of managers, the members of the LLC will manage its business and affairs, subject to the provisions of the articles of organization and the operating agreement which may restrict or enlarge management rights or duties of any member or class of members. Absent such provision each of the members shall have management duties and obligations. If the LLC is managed by its members, every member has authority to act on behalf of the LLC if he, she or it is carrying out the business and affairs of the LLC unless such member has no authority and the other party has actual knowledge of such member s lack of authority. If management of the LLC is vested in a board of managers (as evidenced by a statement to that effect in its articles of organization), decisions are made by a majority vote of the managers if at a meeting or by unanimous written consent if made outside of a formal meeting of managers of the LLC. An act of any manager of an LLC, in connection with conducting the LLC s business and affairs, binds the LLC unless such manager has no authority in the particular matter and the party with whom the manager is dealing actually knows the manager has no such authority. However, any note, mortgage or other contract signed by at least two managers of an LLC may not be invalidated by the LLC unless the other party actually knew the two managers lacked authority to sign. One way to preserve the social purpose of an LLC is to provide some measure of control at the manager level (either a single manager or a board of managers) to individuals who are mission-aligned. For example, the managers may be specifically designated by a member whose primary focus is the social mission (such as a nonprofit that has invested in the LLC).

30 d. Operating Agreement A written operating agreement may provide for the appointment of officers (such as a chairperson, or a president, or both, a secretary, a chief financial officer, and any other officers) with such titles, powers and duties as shall be defined in the articles or operating agreement, or determined by the managers or members. The operating agreement may also provide for indemnification of managers, members, officers, employees or agents of the LLC against judgments, penalties, fines and expenses incurred as a result of acting in their official capacities. Decision-making mechanics may also be set forth in the operating agreement. If the members have appointed more than one manager, decisions of the managers shall be made by majority vote of the managers if at a meeting, or such higher percentage as specified in the operating agreement, or by unanimous written consent. e. Membership After formation of an LLC, a person may acquire a membership interest directly from the LLC or if the articles or operating agreement do not so provide, upon vote of a majority in interest of the members, provided such person becomes a party to the operating agreement. There is a difference between an assignment of a mere economic interest in an LLC and a membership interest in an LLC (which requires approval of a majority in interest of the non-assigning members, and which confers upon the recipient having economic interests and rights to participate in management of the LLC) and an assignment of an economic interest which merely entitles the assignee to distributions of income, gains and losses. Unless and until the assignee becomes a member, the assignor continues to be a member and has the power to vote on matters coming before the members. f. Limited Liability of Members and Managers Members of LLCs generally establish the operating rules governing their conduct among themselves and in relation to the company in the articles of organization and the operating agreement. There are certain statutory provisions that may not be altered by agreement of the members set forth in the operating agreement (for example, certain voting rights, fiduciary duties owed by a manager to the members and the company, etc.). No person who is an LLC manager or officer or both shall be personally liable under a court judgment, or for any debt, obligation or liability of the LLC solely because of such manager s or officer s status. An LLC manager may agree to be personally liable for the debts and obligations of the LLC if (i) the articles or

31 written operating agreement so provide, making specific reference to Cal. Corp. Code 17158(b), or (ii) pursuant to a written guarantee or contract executed by the manager other than the operating agreement. An LLC may provide for indemnification by the LLC of judgments, settlements, penalties and fines of any kind incurred by the LLC s manager, member, officer or employee if such undertaking is set forth in the articles of organization or a written operating agreement. Indemnification will not be available if a manager breached its fiduciary duties to the LLC. LLC s may also purchase liability insurance to cover such risks. g. Merger, Dissolution and Term of Existence If the LLC did not conduct business within the first 12 months of its existence, it is possible for members, managers or the person(s) who signed the articles to execute a certificate of cancellation on a form prescribed by the Secretary of State and file it with the Secretary of State. A certificate of cancellation may be found through this link: An LLC will be dissolved upon the earlier to occur of (i) a time specified in the articles of organization or upon the happening of specific events set forth in a written operating agreement; (ii) the vote of a majority of the members (or a higher percentage if specified in the articles or written operating agreement); or (iii) entry of a judicial dissolution decree described below. A court may order dissolution of an LLC if one of the following reasons exist: (i) it is not reasonably practicable for the LLC to carry on its business in accordance with its articles and operating agreement; (ii) dissolution is necessary to protect the interests of certain members who have sought judicial protection; (iii) the business of the LLC has been abandoned; (iv) the management of the LLC is deadlocked and unable to resolve their differences; or (v) the members or managers managing the LLC have been guilty of or have tolerated fraud, mismanagement, or abuse of authority. It is possible for members to avoid dissolution by taking certain actions described in the statute involving a buyout or purchase of the membership interests of the parties seeking dissolution for cash at fair market value. There are certain requirements and procedures that must be followed regarding, among other things, notice to creditors and claimants and payments to creditors and members in accordance with the statute.

32 h. Raising Capital An LLC offers the same flexibility in raising capital as a for-profit corporation. However, many investors are hesitant to invest in LLCs, because of the pass-through income tax treatment. Also, the flexibility available to LLCs with respect to structuring the rights of members can raise issues for minority investors who may have fewer rights relative to investors with larger ownership stakes. i. Recordkeeping and State Reports A California LLC is required to maintain in its office in the State of California the following: a current list in alphabetical order of the full name and last known address of each member and each holder of an economic interest in the LLC, including the contribution and share of profits of each member or holder of an economic interest; copies of six years of the LLC s federal, state and local income tax or information returns and reports; a copy of the LLC s written operating agreement and any amendments thereto; financial statements for the most recent six fiscal years for the LLC; and books and records of the LLC as they relate to the internal affairs of the LLC for at least the current and past four fiscal years. The LLC s office must also maintain a copy of the articles or organization and all amendments, together with the powers of attorney by which these documents were signed, if any. In addition, the LLC is required to make available to an assessor, at the LLC s principal office in California or at a mutually acceptable place, business records relevant to the amount, cost and value of the property it claims it owns, claims, possesses or controls. Within 90 days of the original filing of its original articles of organization and every two years thereafter, the LLC must file with the Secretary of State a statement of information (the Statement of Information ) containing the following: the name of the LLC and the Secretary of State s file number (and in the case of a foreign LLC, the state under the laws of which it is organized); the name and address of its agent for service of process; the street address of its principal executive office, the mailing address of the LLC, if different from the street address of its principal executive office, and in the case of a domestic LLC, its office in California where it maintains the company records required by Cal. Corp. Code 17057(a); the name and address (business or residence) of any manager(s) and its chief executive officer; if no manager is elected or appointed, the name and address of each member; if the LLC chooses to receive renewal notices and any other notifications from the Secretary of State by , the LLC shall include a valid address for the LLC or its designee to receive those notices; and the general type of business conducted by the LLC.

33 If there have been no changes since the last filed Statement of Information, the LLC may so indicate by filing on a form prescribed by the Secretary of State that no changes have occurred during the reporting period. The filing period for the Statement of Information is the calendar month during which its original articles were filed (and in the case of a foreign LLC, the month during which its application for registration as a foreign LLC was filed) and the immediately preceding five calendar months. The Secretary of State will provide notice to the LLC to its last known address or via , if notification is elected by the LLC, approximately 3 months prior to the required filing date. The notice will contain the due date for compliance. Failure to receive the form does not exempt the LLC from the filing requirements. The Statement of Information may be found at: LLCs with more than 35 members are required to send an annual report to each of the members not later than 120 days after the fiscal year, which shall contain a balance sheet as of the end of the fiscal year and an income statement and statement of cash flows for the fiscal year. Periodic (interim) balance sheets and income statements must be provided upon the request of members representing at least 5 percent of the voting interests of members or three or more members. All financial statements described herein shall be accompanied by the report of the LLC s independent accountants, or if none are so engaged, the certificate of the manager of the LLC certifying that the reports were prepared in accordance with the LLC s books and records. j. Taxation Unless it elects to be treated for federal and state purposes as a corporation, an LLC is generally not subject to separate entity-level taxation of its income under state and federal tax laws, although it is required to file an informational return. In California, however, an LLC is generally still subject to the annual minimum tax of $800. In addition, if the LLC s total income attributable to California is greater than $250,000, it must pay an additional annual fee ranging from $900 to $11,790 depending on the amount of income. Unless a member is exempt from income taxation, its distributive share of membership income and loss is treated as income or loss to the member and reported on his, her or its return, regardless of whether the member actually receives the income. Regs (b)-3(c) (following federal check-the-box rules and allowing LLCs to be treated as partnerships). LLCs that have one owner are generally disregarded as entities separate from their owners.

34 k. Resources Humphreys, Thomas, Limited Liability Companies and Limited Liability Partnerships (Incisive Media, 2009) 4. Flexible Purpose Corporations a. Overview The Corporate Flexibility Act of 2011 (Cal. Corp. Code ) establishes a new corporate entity in California called the flexible purpose corporation ( FPC ). Whereas the primary objective of a standard for-profit corporation is to maximize shareholder returns, and the primary objective of a standard nonprofit corporation is to further some charitable cause or social benefit, an FPC is permitted to devote itself to both of these objectives simultaneously. Therefore, the directors of an FPC may consider either profitability or the furtherance of a predefined special purpose, or both, when making business judgments, and yet remain insulated from the liability risks that would normally attach to such diverse motivations if they were directors of standard for-profit or nonprofit corporations. Additionally, incorporating as an FPC allows an entrepreneur to anchor the social mission of an early-stage company, by means of certain voting requirements, while still presenting to investors the familiar for-profit corporate form necessary to access larger capital markets. Note that the Delaware public benefit corporation and the Washington social purpose corporation are substantially similar to the FPC. Aside from the explicit adoption of a special purpose in its articles of incorporation, and the protections afforded to directors who consider that purpose in their decision-making, a typical FPC will differ from a typical for-profit corporation in a few other respects: An FPC must periodically issue reports to its shareholders regarding material actions it has taken in furtherance of or relating to its special purpose. An FPC may not alter its adopted special purpose without approval of at least two-thirds of each class of shares outstanding. An FPC must attain supermajority or unanimous approval of its outstanding shares in order to effect certain mergers. Additional differences will be described below, but where the Corporate Flexibility Act is silent, FPCs are governed by the General Corporation Law (Cal. Corp. Code ), and therefore enjoy advantages similar to those of for-profit corporations (e.g., limited liability).

35 b. Formation One or more natural persons, partnerships, associations, flexible purpose corporations, or domestic or foreign corporations may form an FPC by executing and filing articles of incorporation with the California Secretary of State. The filing fee is $100, and the articles must include: The name of the FPC, which must include the words flexible purpose corporation or an abbreviation thereof; Statements of purpose and type of entity in accordance with Cal. Corp. Code 2602(b); the typical FPC must: o State a business purpose in furtherance of the short-term and long-term interests of the corporation and its shareholders; and o State (i) a charitable or public purpose that a nonprofit public benefit corporation is authorized to carry out, (ii) a purpose of promoting the positive effects of, or minimizing the adverse effects of, the FPC s activities upon the corporation s employees, suppliers, customers, and creditors, the community and society, or the environment, or (iii) both; The name and street address in California of the FPC s agent for service of process; The street address (and the mailing address, if different than the street address) of the FPC; and Information regarding the number of shares the FPC is authorized to issue, as well as the rights and restrictions granted to or imposed upon those shares. The articles may, but need not, include a number of other provisions enumerated in Cal. Corp. Code , including limitations of director liability (to the extent permitted under California law) for breaches of fiduciary duties, requirements that shareholders approve certain corporate actions, and a limitation on the FPC s existence to a specified date. Further guidance can be found in the Business Programs portal of the California Secretary of State s website at An FPC may also be formed by incorporation of a trust, or by the conversion of a for-profit or nonprofit corporation.

36 In order amend the special purpose stated in its articles, an FPC must obtain the approval of at least two-thirds of each class of shares outstanding. This supermajority requirement cannot be removed so long as the company remains an FPC, and is intended to anchor the social mission of the company as it develops from an early-stage startup to a mature corporation with diverse shareholder constituencies. The requirement thus answers concerns that entrepreneurs and initial stakeholders may have regarding the possibility that, after incorporation, public investors will shift the company away from its special purpose to focus exclusively on profitability. To the extent that they do not interfere with the furtherance of the FPC s special purpose, the bylaws of an FPC may mirror those of a standard for-profit corporation, with provisions for shareholder meetings and voting, director elections, and recordkeeping. c. Management and Control As with a standard corporation, the business and affairs of an FPC are managed, and all corporate powers are exercised, by or under the direction of a board of directors, subject to any limitations in the Corporations Code or the FPC s articles of incorporation. The directors may delegate the day-to-day management of the FPC to officers or other persons, but ultimate responsibility lies with the board. Furthermore, subject to compliance with the Corporations Code or any other applicable law and the FPC s articles of incorporation, and subject to consistency with its special purpose, an FPC may exercise the same corporate powers available to a standard corporation, which include all the powers of a natural person in carrying out business activities. d. Liability of Directors Like the directors of a for-profit corporation, the directors of an FPC are bound by fiduciary duties of care and loyalty to the corporation, and in normal circumstances enjoy the judicial presumption that their business decisions are motivated by adherence to those duties (i.e., the business judgment rule ). Unlike the directors of a for-profit corporation, however, FPC directors continue to enjoy that presumption even when they openly and directly consider an alternative, special purpose in their routine management decisions, or even in situations (such as those involving a change in corporate control) where for-profit directors would be bound to consider only the immediate maximization of shareholder returns.

37 Additionally, an FPC can choose to eliminate or limit, by provision in its articles of incorporation, the personal liability of a director in suits brought for breach of fiduciary duties. However, such a provision cannot eliminate or limit the director s liability for: Acts or omissions that involve intentional misconduct or a knowing and culpable violation of law; Acts or omissions that the director believes to be contrary to the best interests of the FPC or its shareholders and its corporate purposes as expressed in its articles, or that involve the absence of good faith on the part of the director; Any transaction from which the director derived an improper personal benefit; Acts or omissions that show a reckless disregard for the director s duty to the FPC in certain high-risk circumstances; Acts or omissions that amount to an abdication of the director s duties to the FPC; and Certain self-dealing or improper financial transactions. By a similar provision, an FPC can indemnify a director or other corporate agent for breach of fiduciary duty (except of the type for which it may not eliminate or limit the director s liability, as described above), or purchase insurance on behalf of a director or other corporate agent against any liability for breach of fiduciary duty (regardless of whether the FPC may eliminate or limit liability for such a breach). e. Reports Reports to Shareholders. FPC reporting differs from that of a for-profit corporation primarily in that an FPC must update its shareholders regarding its actions in furtherance of, and other developments relating to, the FPC s special purpose. The purpose of this requirement is twofold. First, because the Corporate Flexibility Act does not provide a mechanism by which shareholders may enforce an FPC s specific purpose, concerns were raised that such corporations would engage in greenwashing that is, presenting a public face of furthering some social benefit while, in reality, taking few or no tangible steps toward that end. The transparency resulting from special purpose reporting allows the public and shareholders to independently determine the social value added of an FPC s operations. Second, it is intended that, over time, a standardized form of special

38 purpose reporting will develop, similar to the current standardization in reporting financial results. This development would allow investors, both those primarily interested in social benefit and those primarily interested in monetary returns, to compare between FPCs. i) Annual reports: An FPC must send to its shareholders an annual report, including: o A balance sheet as of the end of the fiscal year and an income statement and statement of changes in financial position for that fiscal year; o A special purpose MD&A, including, among other items: Identification and discussion of the short-term and long-term objectives of the FPC relating to its special purpose or purposes, and an identification and explanation of any changes made in those special purpose objectives during the fiscal year; Identification and discussion of material actions taken by the FPC during the fiscal year to achieve its special purpose objectives; Identification and discussion of material actions expected to be taken in the short term and long term with respect to achievement of its special purpose objectives; A description of financial, operating, and other measures used by the FPC for evaluating its performance in achieving its special purpose objectives; and Discussion of any material expenditures incurred during the fiscal year in furtherance of achieving its special purpose objectives and a good-faith estimate of additional material expenditures expected to be incurred over the next three fiscal years to achieve its special purpose objectives; o If the FPC has 100 shareholders or more and is not subject to or is otherwise exempt from the reporting requirements of the Securities Exchange Act of 1934, the following information: Transactions during the fiscal year involving amounts greater than $40,000 in which any director or officer of

39 the FPC or any holder of more than 10% of the outstanding voting shares of the FPC had an interest; and Any indemnification or advances aggregating more than $10,000 paid during the fiscal year to any officer or director of the FPC in accordance with the Code (see Cal. Corp. Code 317). ii) Special purpose current reports: An FPC is required to send to its shareholders special purpose current reports, including information regarding: o Any expenditures in furtherance of the FPC s special purpose objectives, where the expenditure has or is likely to have a material adverse impact on the results of operations or financial condition for a quarterly or annual fiscal period; o Any decision by the board or management to withhold expenditures that were to have been made in furtherance of the special purpose as contemplated in the most recent annual report, where the planned expenditure was likely to have had a material positive impact on the furtherance of its special purpose objectives; and o Any decision by the board or action by management to determine that the special purpose of the FPC has been satisfied or should no longer be pursued, whether temporarily or permanently. The Corporate Flexibility Act expressly provides that, where best practices emerge for providing the information required to be included in an annual or special purpose report, use of those best practices will create a presumption that the FPC caused all the required information to be included. An FPC may exclude from its annual report the special purpose MD&A, or nullify the requirement that special purpose reports be sent to shareholders, if: (i) the FPC has fewer than 100 shareholders; and (ii) holders of two-thirds of the FPC s outstanding shares vote to waive the requirement that the special purpose MD&A be included, or vote to waive the requirement that special purpose reports be sent, as applicable. Reports to the State of California. An FPC is required to file a Statement of Information, Form SI-200, with the State of California annually. This requirement also applies to all other California corporations. The initial Statement of Information must be filed with the California Secretary of State

40 within 90 days after the filing date of the FPC s articles of incorporation. Additional Statements of Information must be filed every year during the calendar month in which the original articles of incorporation of the FPC were filed, or during the preceding five calendar months. The Statement of Information may be filed online at f. Taxes FPCs are subject to the same tax treatment, both at the state and federal levels, as standard for-profit California corporations. In this respect, an FPC differs substantially from a nonprofit corporation that seeks to further some public benefit, because an FPC cannot offer tax deductions to its investors. Some municipalities may offer tax breaks to FPCs devoted to a particular special purpose, but this will vary by jurisdiction. Importantly, to institutional investors, the standard tax treatment of an FPC stands next to the familiarity of the corporate form as one of the FPC s more attractive qualities as compared to an LLC. While an LLC is a product of contract and thus could also be devoted to pursuing both financial returns and some special purpose, it is normally taxed as a pass-through entity. Since many institutional investors invest through funds that are themselves pass-through entities, the result could be that an LLC s earnings are imposed as tax burdens on the investors despite their not receiving any actual cash distributions. g. Mergers and Sales of Assets An FPC may merge with one or more other FPCs, corporations, or business entities, including foreign corporations. The terms, amendment, recording, abandonment, and implementation of a merger between an FPC and another entity are governed by Cal. Corp. Code If the disappearing corporation in a merger is a for-profit corporation and the surviving corporation is an FPC, the merger must be approved by at least two-thirds of each class of shares outstanding in the for-profit corporation. If the disappearing corporation is a close FPC (i.e., no more than 35 shareholders), and the surviving corporation is not a close FPC, the merger must be approved by at least two-thirds of each class of shares outstanding in the close FPC. The close FPC s articles of incorporation may provide for a lower threshold, but not less than a majority. If the disappearing corporation is an FPC and the surviving corporation is not an FPC, or is an FPC with materially different purposes, the merger

41 must be approved by at least two-thirds of each class of shares outstanding in the disappearing FPC. If the disappearing corporation is an FPC and the surviving corporation is a nonprofit corporation, the merger must be approved by all shares outstanding in the FPC. An FPC may sell, lease, convey, exchange, transfer, or otherwise dispose of all or substantially all of its assets, but such a transaction requires the approval of the board and at least two-thirds of each class outstanding. h. Reorganization A reorganization or share exchange tender offer must be approved by the board of: Each FPC in a merger reorganization; The acquiring FPC in an exchange reorganization; The acquiring FPC and the FPC whose property and assets are being acquired in a sale-of-assets reorganization; The acquiring FPC in a share exchange tender offer; and The FPC in control of any constituent or acquiring domestic or foreign FPC or other business entity in a merger reorganization, an exchange reorganization, or sale-of-assets reorganization, and whose equity securities are issued, transferred, or exchanged in the reorganization. Typically, the principal terms of a reorganization must also be approved by the outstanding shares of each class of FPC whose board is required to provide approval. The exceptions to this requirement are enumerated in Cal. Corp. Code i. Resources W. Derrick Britt, R. Todd Johnson & Susan H. Mac Cormac, Frequently Asked Questions: Proposed Amendments to the California Corporations Code for a New Corporate Form: The Flexible Purpose Corporation and Senate Bill 201 (2012) Selecting and Forming Business Entities (2 nd ed. Cal CEB 2013) Susan Mac Cormac & Heather Haney, New Corporate Forms: One Viable Solution to Advancing Environmental Sustainability, J. Applied Corp. Fin., Spring 2012, at 49

42 B Lab Benefit Corp Information Center pdf California Secretary of State, Two New Types of Corporations effective January 1, 2012, pdf 5. Benefit Corporations a. Overview A benefit corporation is a new form of for-profit corporation recognized in a number of states. Although requirements vary significantly by state, a benefit corporation, generally, is required to recognize a public benefit as one of its corporate purposes. In most states, the impact of the corporation s public benefit must be measured by a third-party standard, which is defined by statute. In California, benefit corporations were established in January 2012 and are governed by Cal. Corp. Code The General Corporation Law (Cal. Corp. Code ) also applies to these corporations, except where the General Corporation Law provisions are in conflict with or inconsistent with the provisions specific to benefit corporations. The following discussion in this chapter will focus on the California benefit corporation. A benefit corporation is required to operate for a general public benefit (i.e., a material positive impact on society and the environment, taken as a whole, as evaluated against a third-party standard, from the business and operations of a benefit corporation ). A benefit corporation also is permitted, but not required, to recognize one or more specific public benefits, which includes 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, and (7) the accomplishment of any other particular benefit for society or the environment. The specific public benefit(s), if any, must be set forth in the benefit corporation s articles. Note that the identification of a specific public benefit does not limit the obligation to create general public benefit. Also, any addition, deletion or amendment to the specific public benefit(s) set forth in the articles must be

43 approved by at least the minimum status vote, which means that in addition to any other approval or vote required under the General Corporation Law, both of the following shall apply: (i) shareholders of every class or series shall be entitled to vote on the corporate action to amend the articles regardless of any limitation on the voting rights of any class or series stated in the articles or bylaws and (ii) the corporate action shall be approved by the outstanding shares of each class or series by at least two-thirds of the votes entitled to be cast, or a greater vote if so required by the articles. b. Formation A benefit corporation is formed in the same manner as a for-profit corporation under the General Corporation Law, except that the articles of incorporation must explicitly state that it is a benefit corporation. Other than this specific requirement, the articles must include the same items that are required in the articles of a for-profit corporation. The filing fees are also the same. If an existing entity wishes to become a benefit corporation, it must amend its articles to include such a statement and such amendment must be approved by at least the minimum status vote. If a benefit corporation wants to terminate its status as such, it must amend its articles to delete the provision stating that it is a benefit corporation and, again, such amendment must be approved by at least the minimum status vote. In connection with the approval of an amendment to the articles to either become a benefit corporation or to terminate such status, any shareholder that did not approve of such amendment, by complying with certain provisions of the General Corporation Law, may require the corporation to purchase the dissenting shares of such shareholder at their fair market value. c. Management and Control As with a standard corporation, the business and affairs of a benefit corporation are managed, and all corporate powers are exercised, by or under the direction of a board of directors, who may delegate the day-to-day management of the corporation to officers or other persons. In some states, though not in California, the benefit corporation statutes call for a designated benefit director, who has certain duties to the mission and specific to the preparation of annual benefit reports.

44 d. Liability of Directors The directors of a benefit corporation are bound by the same fiduciary duties of care and loyalty as directors of a for-profit corporation. In discharging these duties, and in considering the best interests of the corporation, the directors of a benefit corporation are required to consider the impact of any action on the following: (1) its shareholders, (2) its employees and workforce and its subsidiaries and suppliers, (3) the interests of customers as beneficiaries of the general or specific public benefit purposes of the corporation, (4) community and societal considerations, including those of any community in which offices or facilities of its or its subsidiaries or suppliers are located, (5) the local and global environment, (6) the short-term and long-term interests of the corporation, and (7) the ability of the corporation to accomplish its general and specific public benefit purpose(s), if any. The directors are also permitted, but not required, to consider (1) the resources, intent, and conduct of any person seeking to acquire control of the corporation and (2) any other pertinent factors or the interests of any other person or group. Note that the directors are not required to give priority to any particular factor or the interests of any particular group over any others unless the benefit corporation s specific public benefit purpose states that it will do so. Officers of a benefit corporation shall also consider the same factors as directors, in the same manner as described above with respect to the required versus permitted considerations, when the officer has discretion to act with respect to a matter, or when it reasonably appears that the matter may have a material effect on the creation of a general or specific public benefit by the corporation or any of the interests or factors referred to above. Directors and officers will not be liable for monetary damages for any failure of the benefit corporation to create a general or specific public benefit. Similarly, any director or officer who performs his or her duties in accordance with the provisions of the statute will not be liable for monetary damages for any alleged failure to discharge his or her obligations as a director or officer. Additionally, a benefit corporation can choose to eliminate or limit, by provision in its articles, the personal liability of a director in suits brought for breach of fiduciary duties in accordance with the provisions of the General Corporation Law that are applicable to for-profit corporations. The California benefit corporations statute expressly provides a right for certain parties to bring an action against the benefit corporation for (i) failure to pursue the general or specific public benefit purposes of the corporation, (ii) a violation of the standards of conduct for the directors and officers or (iii) failure to deliver an annual benefit report (described below) (such actions are referred to in the

45 statute as benefit enforcement proceedings ). Such proceedings can be brought directly by the benefit corporation itself or derivatively by a shareholder, a director, a person or group that owns 5% or more of the equity interests of a parent entity of the benefit corporation and other persons identified in the articles of bylaws. Note, however, that the benefit corporation will not be liable for monetary damages for any failure to create a general or specific public benefit. e. Third-Party Standards and Reports As noted above, under most states benefit corporations statutes, the impact of the corporation s public benefit must be measured by a third-party standard. In California, the third-party standard is defined as a standard for defining, reporting, and assessing overall corporate social and environmental performance that is: (1) comprehensive because it assesses the impact of the business and its operations on the considerations that directors are required consider when discharging their fiduciary duties (described above), (2) developed by an entity with no material financial relationship with the benefit corporation or any of its subsidiaries (and that meets certain set forth in the statute see 14601(g)), (3) developed by an entity that accesses necessary and appropriate expertise to assess overall corporate social and environmental performance and uses a balanced multi-stakeholder approach, including a public comment period of at least 30 days to develop the standard, (4) transparent and makes publicly available all of the following information: the criteria considered when measuring social and environmental performance of a business, the weightings assigned to such criteria, the identity of persons and processes involved in developing, controlling and revising the standards, and any sources of financial support for the third-party entity. A benefit corporation must update its shareholders annually regarding its general and specific public benefit purposes. The annual report must be prepared and delivered to each shareholder within 120 days following the end of the fiscal year (or at the same time that other annual reports are delivered to shareholders) by delivery free of charge and also by posting the report on its website. The annual report must include a narrative description of (i) the process and rationale for selecting the third-party standard used to prepare the benefit report; (ii) the ways in which the benefit corporation pursued a general public benefit and, if applicable, specific public benefit, during the applicable year and the extent to which that general public benefit and, if applicable, specific public benefit, was created; (iii) any circumstances that have hindered the creation of a general or specific public benefit; (iv) an assessment of the overall social and environmental performance of the corporation, prepared in accordance with the third-party standard selected by the corporation applied consistently with reports

46 from prior years, and an explanation of the reasons for any inconsistent applications of the standard (note that the report does not have to be audited or certified by the third party); (v) the names of each person owning 5% or more of the outstanding shares; (vi) an opinion of the board as to whether the corporation failed to create a public benefit and an explanation of why and how; and (vii) a statement of any connection between the entity that established the third-party standard and the benefit corporation, or the directors, officers, and material owners of either. f. Taxes Benefit corporations are subject to the same tax treatment, both at the state and federal levels, as standard for-profit California corporations. g. Mergers, Reorganizations and Sales of Assets If a corporation that is not a benefit corporation is a constituent corporation in a merger, share exchange, conversion, reorganization or other transaction pursuant to which the surviving corporation will be a benefit corporation or the non-benefit corporation s articles will be revised to provide that it will become a benefit corporation, then such transaction must be approved by the non-benefit corporation by at least the minimum status vote. Similarly, if a benefit corporation is a constituent corporation in a transaction pursuant to which the surviving corporation will not be a benefit corporation or the benefit corporation s articles will be revised to terminate its status as such, then the benefit corporation must approve the transaction by at least the minimum status vote. For the sale or other disposition of all or substantially all assets of a benefit corporation, unless the transaction is in the ordinary course of business, the corporation must approve the transaction by at least the minimum status vote.

47 h. Resources B Lab Benefit Corp Information Center pdf California Secretary of State, Two New Types of Corporations effective January 1, 2012, pdf 6. Low-Profit Limited Liability Companies (L3Cs) a. Overview The L3C, or Low-Profit Limited Liability Company, is a new type of corporate entity that is a cross between a nonprofit and a for-profit corporation. L3Cs are not eligible for tax-exempt treatment by the IRS. Rather, they are intended to be profit-generating entities with charitable and educational (including positive social change) missions as their primary objectives. Building upon the LLC structure, the L3C has thus far been enacted in Vermont, Michigan, Utah, Wyoming, Illinois, North Carolina, Maine, Louisiana and Rhode Island, as well as the Crow Indian Nation and the Oglala Sioux Indian Nation. L3C legislation is also being considered in other states, such as Georgia, Missouri, Arkansas, Colorado, Kentucky, Maryland, Massachusetts, Montana, New York, North Dakota, Tennessee, and Virginia. The California legislature has not passed any legislation authorizing L3Cs as of August However, all states must recognize LLCs formed in other states and the L3C as a variant form of an LLC. For more information about the status of L3C legislation please visit: L3Cs are similar to LLCs in that they have the liability protection of a corporation, the flexibility of a partnership and membership shares can be sold to raise capital just like common stock. However, unlike the LLC, the L3C must be formed for a charitable or educational purpose, it cannot have a significant goal of producing income or capital appreciation and it may not accomplish political or legislative objectives. L3Cs are intended to be vehicles which can both attract capital investment from for-profit enterprises and investment by foundations. Nontraditional for-profit

48 investors who are willing to sacrifice market-level returns in exchange for social impact are prime candidates to provide capital investments or loans to L3Cs. Similarly, private foundations that wish to provide support in the form of a loan or equity rather than a grant may find an L3C to be attractive because the enabling legislation is written in such a way as to comply with the IRS program related investment or PRI regulations. PRIs can be attractive to foundations because they count toward its 5% minimum payout requirement, just as if they were grants. But if the investment is successful, the foundation could recapture the full amount of the investment, plus a reasonable rate of return, which it then must pay out again in the form of grants or more PRIs. Existing nonprofit corporations may be able to utilize the L3C structure in at least two ways. First, if the nonprofit generates enough earned income to qualify as low profit, it could reincorporate as a stand-alone L3C. Second, it could establish a subsidiary as an L3C to conduct low-profit earned income activities. It is too early to tell whether L3Cs will proliferate and whether they will attract significant investments from non-traditional investors and foundations. Some experts have predicted that since PRIs comprise a relatively small amount of foundation grants and capital, the L3C will not succeed in attracting significant funds from foundations and thus this form of organization will not become the preferred vehicle. b. Resources Chan, Emily, The L3C 3 Years Later, available at How-to: An Insider s Look at the L3C and What it Could Mean for you and your Social Enterprise. Social Earth, available at s-look-at-the-13c-and-what-it-could -mean-for-you-and-your-social-enterprise. Lang, Robert, Charitable Returns, Worth Magazine, April osures.philanthropy.charitable.returns.asp Lang, Robert. Overview. Americans for Community Development.

49 Peeler, Heather, The L3C: A New Tool for Social Enterprise, Community Wealth Vanguard, Aug. 2007, Tozzi, John, Turning Nonprofits into For-Profits, Business Week: Small Business Financing (June 15, 2009), m 7. Joint Ventures a. Overview A joint venture is not a statutory entity or form of doing business in California. Rather, it is a contractual arrangement whereby more than one person or entity join forces to operate a venture. Many joint ventures operate by agreement only; the participants are not required to create a separate entity as the vehicle for a joint venture. Nonprofit corporations, for-profit corporations and LLCs can each function as the entity vehicle for joint ventures. However, when liability protection and maximum flexibility are required and the number of participants/investors is small, the LLC would be the preferred entity/vehicle for the joint venture. Thus, for example, a tax-exempt nonprofit corporation pursuing a social mission and a for-profit corporation operating a business can join together and form a joint venture using an LLC as the vehicle for the enterprise. The operating agreement would spell out the rights and obligations of each member. However, each member would be bound by the laws and rules governing its own existence, so that the nonprofit may not confer an undue economic benefit on the for-profit co-venturer, nor may the business corporation use the joint venture to do something that it could not do directly. The IRS has addressed the circumstances in which tax-exempt social and charitable enterprises may engage in joint ventures with for-profit entities, and has adopted rules that govern the kinds of benefits that tax-exempt enterprises can confer on for-profit entities in the context of joint ventures. The IRS rules are extremely complicated. A tax-exempt social enterprise should not enter into a joint venture with a for-profit entity without first seeking advice from tax counsel. b. Resources Sanders, Michael I., Joint Ventures Involving Tax-Exempt Organizations (John Wiley & Sons, 3d revised ed 2007)

50 8. Partnerships and Limited Partnerships a. Overview Partnerships and limited partnerships are forms of organization that can be used to pursue social objectives, provided that their organizational documents and partners so agree, and are recognized as statutory entities under California law. Partnerships provide almost unlimited flexibility in governance and management. Profits and losses are allocated according to the capital contributions of each partner. Unlike LLCs and nonprofit corporations, the total assets of each partner in a general partnership are at risk, not just the capital that has been put into the enterprise. Limited partnerships, contrary to general partnerships, permit the creation of a special class of partners, known as limited partners, who provide capital but do not participate in management. In limited partnerships, the limited partners are shielded from liability beyond their capital contributions, but the general partner who manages the affairs of the limited partnership does not have this liability protection. Limited partnerships are often used as financing vehicles where investors are to have no role in management and a simple or flexible governance structure is needed. b. General Partnerships General partnerships may be formed very informally and sometimes unintentionally. The association of two or more persons to carry on as co-owners of a business for profit forms a partnership, notwithstanding the intent of the parties. There are several rules that govern when or whether a partnership is formed. For example, joint ownership of real property even if the co-owners share profits, does not by itself create a partnership. A person who shares profits of a business is presumed to be a partner in the business unless the profits were received for (i) payment of a debt in installments; (ii) payment for services as an independent contractor or employee; (iii) in payment of rent; (iv) in payment of an annuity or other relevant benefit; (v) in payment of interest on a loan even if the loan payment amount varies based on the amount of profits; or (vi) in payment for the sale of the goodwill of a business or other property by installments or otherwise. Generally, the relationship among the partners and between the partners and the partnerships are governed by a partnership agreement. A partnership agreement is the agreement among the partners, which may be written, oral or implied, to engage in a business (which includes every trade occupation and profession). In the absence of a written partnership agreement drafted in compliance with law,

51 the partnership statutes will govern relationships among the partners and between the partners and the partnership. There are a number of restrictions on the terms of the partnership agreement provided by California law. For example, the partnership agreement may not unreasonably restrict the right of access to books and records available to partners under Cal. Corp. Code Further, the duty of loyalty a partner owes to the partnership cannot be eliminated. Finally, the partnership agreement may not eliminate the obligations of good faith and fair dealing. A statement of partnership authority executed by at least two of the partners may be filed in the office of the Secretary of State. The statement of partnership authority contains the following information: the name of the partnership; the street address of its chief executive office and its office in California, if any; the names and addresses of all partners or the agent appointed by the partners to exercise partnership authority (to enter into transactions, sign documents, etc.) ; and the names of partners authorized to execute transfers of real property on behalf of the partnership. The statement of partnership authority may also specify the authority, or limits on authority, of some or all of the partners to enter into transactions on behalf of the partnership. A partnership should also designate an agent for service of process. The agent must be an individual residing in California who has complied with Cal. Corp. Code All partners are jointly and severally obligated for the obligations of the general partnership unless otherwise agreed by the other party or as provided by law. Each partner is entitled to a proportionate share (based on such partner s capital contribution to the partnership) of the profits (and losses) of the partnership. A partner is not entitled to remuneration for services performed for the partnership, except for reasonable compensation for services rendered in winding up the business of the partnership. A partner has no right to receive a distribution in kind of partnership assets. Each partner has equal rights in the management and conduct of the partnership business. A majority of the partners decide matters in the ordinary course of the partnership s business. Matters outside the ordinary course, as well as amendments to the partnership agreements, may only be undertaken with the consent of all the partners. The books and records of the partnership must be kept in a form convertible into clearly legible tangible form at the partnership s chief executive office. California partnerships are required to provide partners and their agents and attorneys access to inspect and copy its books and records relating to the period such persons were partners of the partnership.

52 Partners of California general partnerships owe to the partnership and the other partners the duty of loyalty and duty of care. These duties include, among others, the duty to hold as a trustee the property of the partnership and profits derived therefrom; a duty of accounting for such property and profits; and the duty to refrain from competing with the partnership prior to dissolution. The partners are also obligated to comply with the partnership agreement and exercise rights consistent with a duty of good faith and fair dealing implied in all California contractual arrangements. The duties shift during the period of dissolution and winding up of the partnership. A partner does not violate a duty or obligation under California law or under the partnership agreement merely because the partner s conduct furthers the partner s own interest. A California general partnership may convert into or merge with, upon compliance with statutory requirements and the provisions of its partnership agreement, another legal entity such as a limited partnership, a limited liability company, a corporation, or a business trust. The mechanics and requirements are set forth in Cal. Corp. Code Any entity desiring to make such a change should consult with its business and tax attorneys and accountants before proceeding with such a transaction. c. Limited Partnerships A California limited partnerships is formed when a certificate of limited partnership in a form approved by the Secretary of State (found at is filed in the office of the Secretary of State. The Certificate must contain the following information: the name of the limited partnership which must comply with Cal. Corp. Code (the name must contain the words limited partnership or the abbreviation L.P. or LP ); the name must be distinguishable in the records of the California Secretary of State from existing limited partnerships or names reserved by others proposing to organize a California limited partnership and intending to use the name); the address of the office of the limited partnership in the state of California which need not be a place of its activity in California; the name and address of the initial agent for service of process in California; and the name and address of each general partner. The certificate of the limited partnership may contain other matters but may not be inconsistent with certain statutory provisions. For example, a partnership agreement may not eliminate the duty of loyalty or eliminate the obligation of good faith and fair dealing, or restrict the right of a partner to approve a conversion or merger. A limited partnership is required to have at least one general partner. A limited partnership is required to maintain at its designated office the current list showing

53 the full name and last known mailing address of each partner, separately identifying the general partners in alphabetical order and the limited partners in alphabetical order; a copy of the initial certificate of limited partnership and all amendments thereto; a copy of any filed certificate of conversion and merger; a copy of the limited partnership s federal, state and local tax returns and reports; a copy of the partnership agreement; a copy of the financial statements of the limited partnership for the last 6 years; a copy of any record made by the limited partnership during the past three years of any consent given or by vote taken of any partner, and unless contained in the partnership agreement, a record of the cash and agreed value of property contributed by each partner. d. Limited Liability Partnerships California law recognizes registered limited liability partnerships ( LLPs ) and foreign limited liability partnerships which must render services only through licensed persons (for example, architects, accountants, attorneys). Only persons licensed to practice law, architecture and public accounting in California or in another state may be partners in a California limited liability partnership or another jurisdiction, in the case of a foreign limited liability partnership. The name of any registered LLP must contain the words registered limited liability partnership or limited liability partnership or the abbreviations L.L.P., LLP, R.L.L.P. or RLLP as the last words or letters of its name. LLPs are required to file a registration with the California Secretary of State executed by one of the partners authorized to do so and providing the following information: the name of the partnership and the address of its principal office; the name and address of its agent for service of process; a brief statement of the business of the partnership; and a statement of intent to register as a registered limited liability partnership, accompanied by the statutory filing fee required by the applicable section of California Business and Professions Code relating to the profession practiced by the limited liability partnership. In addition to the formation and other statutory requirements set forth in Cal. Corp. Code , the limited liability partnership must comply with all the requirements of the applicable state board, commission or other agency that promulgates the rules and regulations of the profession in which the limited liability partnership plans to engage. To provide security for potential claims against a limited liability partnership, each limited liability partnership is required to maintain cash, cash equivalents, surety bonds or a policy of errors and omissions or professional malpractice insurance with statutorily required coverage. Annual certification signed by an authorizing person on behalf of the limited liability partnership of ongoing

54 compliance with these security requirements must be filed with the Secretary of State. Foreign limited liability partnerships must also comply with applicable California law before transacting business in California. 9. Sole Proprietorships Persons conducting a social enterprise alone in California without the protections afforded by incorporation are called sole proprietors. A sole proprietorship has no legal existence apart from its owner and may be formed without any expense or formality. Profits and losses are borne directly by the proprietor. The proprietor may operate under a trade name that is registered with the California Secretary of State which may be accessed through the following: Such registration provides limited protection for exclusive use of the name, absent trademark or service mark registrations. The main disadvantage of a sole proprietorship is that the owner is wholly liable for all debts and obligations of the enterprise. All of the personal assets and assets devoted to the social enterprise can be seized to make payments. A sole proprietorship itself cannot be sold since there is complete unity between the enterprise and its owner, but the assets used in the enterprise can be sold. A sole proprietorship terminates upon the death of its owner. 10. New Corporate Forms Leading thinkers in business, philanthropy and academia are studying the rapid growth of social enterprise which is taking root in the space between the for-profit corporate world, which is constrained by the duty to generate profits for shareholders, and the nonprofit world, which lacks the market efficiencies of commercial enterprise and does not have ready access to invested capital. A major legal question that has emerged from these studies is whether new laws and tax regulations are needed in order to nurture and support the growth of this new generation of corporate forms, such as the flexible purpose corporation, discussed in greater detail above, which provides flexibility in California to form corporations that may pursue both economic and social objectives. Starting with a meeting in 2007 titled Exploring New Legal Forms and Tax Structures for Social Enterprise Organizations, the Aspen Institute s Nonprofit Sector and Philanthropy Program has been bringing legal scholars and practitioners together to grapple with this question and related issues. Under the auspices of the Fourth Sector Network, many of the same individuals are also working on this question.

55 As of this writing, these groups have not achieved a consensus as to whether new or revised organizational and tax laws are needed to encourage and incentivize the growth of social enterprise. Indeed, some participants have suggested that existing legal and tax regimes already allow nonprofit social enterprise to operate broadly at the intersection of philanthropy and business and they express skepticism that any legal reform is needed. On the other hand, many participants advocate broad change, including revisions in federal tax and state corporate laws to accommodate new forms of social enterprise such as the Charitable LLC, B Corporations and the Socially Responsible Corporation. LawForChange will follow these groups and report significant developments as they emerge. 11. Resources Austin, James E., et. al., Capitalizing on Convergence, Stanford Social Innovation Review, Winter Billiteri, Thomas J., Mixing Mission and Business: Does Social Enterprise Need a New Legal Approach? The Aspen Institute, January f Searing, Jane M., Capital With a Conscience, Journal of Accountancy Online, July Wolk, Andrew, Social Entrepreneurship & Government: A New Breed of Entrepreneurs Developing Solutions to Social Problems, Root Cause, Structures at the Seam: The Architecture of Charities Commercial Activities, New York University School of Law and National Center on Philanthropy and the Law, conference materials, October 2008