Vermont as the Delaware of low profit: A skeptic’s view

Editor’s note: This commentary is by Donald M. Kreis, an associate director/assistant professor of law at the Institute for Energy and the Environment, Vermont Law School.

Consider your favorite nonprofit organization, and whatever virtuous objectives it pursues. Then ask yourself whether the whole thing should be owned, operated and governed by Bill and Melinda Gates.

That possibility – or, more generally, the notion that big foundations like the one the Microsoft founder and his wife head up should own organizations that work for the greater good – was the subject of a two-day conference at Vermont Law School on February 18 and 19. Entitled “Corporate Creativity: The Vermont L3C and Other Developments in Social Entrepreneurship,” the confab was intended to help cement Vermont’s status as the Delaware of a new kind of corporate entity known as the “Low Profit Limited Liability Company,” or L3C.

Most traditional mega-corporations are incorporated in Delaware because over time that state has emerged as the one with the most favorable and predictable legal rules for starting and governing such entities. In 2008, Vermont became the first state to enact a law authorizing the incorporation of L3Cs.

An L3C is a “for-profit venture that under its state charter must have a primary goal of performing a socially beneficial purpose not maximizing income,” according to an organization known as L3C Advisors. Itself the first L3C to be incorporated in the U.S., L3C Advisors was started by Robert Lang, CEO of the Mary Elizabeth and Gordon Mannweiler Foundation in suburban New York.

Lang, who spoke at the conference at VLS, also happens to be the guy who dreamed up the L3C in the first place. Whatever its relation to Vermont, the L3C is not a home-grown phenomenon.

At the theoretical level, an L3C is an intriguing idea. A cross between an LLC (limited liability corporation, itself a relatively new but up-and-coming form of business enterprise) and a nonprofit organization, an L3C is intended as a vehicle for so-called social entrepreneurship.

LLCs and other kinds of traditional corporations are with few exceptions obligated by law to make as much money as possible to the exclusion of all other objectives. Conversely, nonprofits are not allowed to make money or even have owners in the traditional sense. L3Cs are supposed to bridge the gap by giving social entrepreneurs a vehicle for doing the good deeds that nonprofits do, potentially sacrificing profits along the way, but without losing the ability to make at least some money.

But here’s the catch. It turns out that Lang dreamed up the whole idea as a way for charitable foundations to make so-called program-related investments (PRIs). To understand why that is potentially a Faustian bargain, one has to learn a bit about charitable foundations and their role in the economy.

Bill Gates is only the most recent person to make (or inherit) a fortune and then vest a chunk of it in a tax-exempt charitable foundation that he and/or his family controls. Henry Ford, Andrew Carnegie, tobacco heiress Doris Duke, various Rockefellers, J. Paul Getty, Howard Hughes, Andrew Mellon, Robert Wood Johnson (one of the Johnsons of Johnson & Johnson) and cereal magnate W. K. Kellogg are only some of the other prominent people who have opted to use eponymous foundations to wield power in this manner.

Through much of the 20th Century, abuse was rampant in the form of foundations that essentially engaged in no charitable activities while still enjoying an exemption from taxes. In other words, they were just big tax shelters. The tax reform act of 1969 addressed this problem by requiring charitable foundations to devote at least five percent of their endowments every year to actual charity. In most instances, this means making grants – outright donations – to nonprofit organizations.

But here’s the rub, for present purposes. Foundations can also comply with the five-percent rule by making PRIs – program-related investments, in any kind of entity as long as making money is not a “significant purpose” of the investment. That’s where the “low profit” part of “low profit limited liability corporation” comes in. Moreover, like any other investor in an L3C, a foundation can demand seats on the L3C’s governing board and other organizational concessions that effectively put the foundation in control of the enterprise.

The result, from the foundation’s perspective? While still complying with the five-percent rule, “you have a continuing asset rather than just a thank-you letter,” Duke University law professor Richard Schmalbeck told the VLS conference. And a previous speaker, general counsel John Tyler of the Ewing Marion Kauffman Foundation, made clear what “continuing asset” means in this context. Tyler said that when a foundation makes a program-related investment in an L3C, it should insist on at least a certain amount of veto power over the affairs of the organization.

Should low profit morph into high profit, unabashed capitalism can emerge from the L3C chrysalis and takes wing, without so much as a glance backward at the tree that formerly sheltered it.

Philanthropy is good. Tyler said his foundation wields its veto power so as to discharge its legal obligation to hold the L3C to its beneficent purposes.

But democracy and public accountability are also good. Traditional nonprofits, eligible for grants from foundations, are legally considered community assets – nobody ‘owns’ them in the traditional sense. Their directors have a fiduciary duty to keep faith with their organization’s charitable purposes, for which they are accountable to state authorities. L3Cs are only accountable to their owners.

Tyler praised another aspect of L3Cs that is arguably troubling. “Success is a good thing,” he noted, defending the idea that an L3C can shed its “low-profit” status by proclaiming its charitable work complete and converting to a garden variety LLC. In effect, this is heads-I-win-tails-you-lose public policy. It allows entrepreneurs to act like charities, and indirectly take advantage of the public subsidies that foundations enjoy through their tax exemption, to help through the lean times. But should low profit morph into high profit, unabashed capitalism can emerge from the L3C chrysalis and takes wing, without so much as a glance backward at the tree that formerly sheltered it.

Professor Schmalbeck circulated an article he’d written in which he proclaimed himself “a middle-aged professional who has looked forward to a retirement of long mornings enriched by coffee and newspapers.” He figures his coffee supply is secure but concedes that the newspaper industry is probably in a “hopeless” state because such publications were “well-suited to nineteenth and twentieth century life, but not to an age in which electronic media to enjoy strong competitive advantages.”

Schmalbeck is therefore promoting the L3C as an excellent vehicle to save the newspaper, given that it has become the classic low-profit but socially important phenomenon that traditional investor-owned companies can no longer be counted upon to provide. Though superficially attractive, it is an idea that merits especially skeptical scrutiny.

Schmalbeck and other promoters of L3Cs as newspaper publishers argue that their idea is better than direct government subsidies because journalists are supposed to expose what the government is up to but are unlikely to bite the hand that feeds them. Of course this ignores the historic success of public radio and public TV, both funded in part by the taxpayer-supported Corporation for Public Broadcasting.

Moreover, if government is undesirable as a funder of aggressive journalism then foundations are even less suitable. Social commentator Peter Finley Dunne famously observed more than a century ago (through his fictional mouthpiece Mr. Dooley) that the purpose of a newspaper is to “comfort the afflicted and afflict the comfortable.” The people who make or inherit sufficiently large fortunes to pour them into foundations are, if nothing else, comfortable in precisely the sense Mr. Dooley meant.

Long before Robert Lang invented the L3C and delivered it, Moses-like, to the people of Vermont, the state already had a vibrant economic sector based on a corporate form that allows for the promotion of the greater good as distinct from profit maximization. Vermont has two electric coops, 28 credit unions, food co-ops that collectively comprise one of the state’s top 25 employers, and farmer co-ops like Cabot Cheese that are the backbone of Vermont’s agricultural economy. Co-ops are democratically controlled by their users and sometimes their employees. L3Cs are designed for control by wealthy foundations.

Both may have their place in Vermont’s future, but one is clearly more attractive for those who truly want to put wealth in the service of the greater good.

Disclosure: Donald Kreis is Board Vice President of the Cooperative Fund of New England and a board member of the Hanover Consumer Cooperative Society.