| L3Cs: Trying to Play Both Ends Against the Middle |
| Author: Doug Sauer, CEO, NYCON Originally Published in the New York Nonprofit Press Monday, 29 November 2010 Charities rely tremendously on our socially- and community-minded for-profit supporters. They assist us in our work through cash and in-kind contributions, sponsorships, board leadership, influence, business guidance, paying taxes, and the list goes on. Businesses exist, however, to make money and they can do so in socially responsible ways if they choose. Unlike for-profits, charities exist for a specific, government approved public purpose. As such, we face ever increasing regulatory standards for accountability and transparency designed to demonstrate that our organizations and the individuals involved are not gaining private inurnment. Why this basic primer on the difference between for-profits and nonprofits? Well, there is a recent national craze that seeks to create a “fourth sector” made up of Low-Profit, Limited Liability Companies (L3Cs) that are legally for-profit businesses, but which are supposed to put their primary focus on social good rather than profit. This movement is both misguided and potentially dangerous. Vermont was the first state to enact legislation in 2008 establishing L3Cs as a legal business entity. Since then Michigan, Wyoming, Utah and Illinois have followed suit, along with the Crow Indian Nation and the Oglala Sioux Tribe. Several other states are considering similar proposals. Earlier this year, the New York Council of Nonprofits (NYCON) was surprised to see an L3C bill authored by Senator William T. Stachowski (D-Buffalo), suddenly advance out of its original committee of jurisdiction and proceed through several legislative steps before being passed by a vote of 50-11 on the Senate floor – amazingly, all on the same day. A companion bill AB-10414 introduced by Assemblyman Richard L. Brodsky (D-Westchester) remained under consideration in the Assembly Committee on Corporations, Authorities and Commissions. With the current legislative session at an end and their sponsors leaving office, these bills appear to be dead, at least for the moment. We at NYCON believe that is a good outcome and we are hopeful that there will be no effort to re-introduce L3C legislation for New York in the future. Here’s why: Supporters argue that L3Cs innovatively combine the best of both the for-profit and nonprofit worlds. Since they may legally generate a profit – albeit a yet to be defined “low profit” – L3Cs supposedly are capable of attracting new private sector capital in support of ventures with a broader social purpose. Supporters also hope that the IRS will change regulations to allow L3Cs to receive Program-Related Investments (PRIs) from private foundations. Those investments currently are not automatically eligible for inclusion as part of the grants to charities that foundations must make in order to meet their own IRS requirements. I am sure that the core thinkers and entrepreneurs behind the L3C movement are sincere folks who seek improvements in our society. That said, supporters fundamentally seek three things that are unacceptable to NYCON and many in the nonprofit sector: 1. Access to private foundation dollars for risk leveraging purposes. There are two problems with this. The funding which L3Cs seek comes from resources that would otherwise be available to the good work and achievements of legitimate charities. Secondly, the scheme put forth is that the L3Cs will be take in investments in separate “tranches”, or layers, each with its own level of securitization and risk. Foundation PRI’s, they maintain, would be most helpful in providing the early-round and highest risk financing, thereby attracting for-profit, private sector investors during subsequent rounds when the risk is lower and chances of a return are greater. NYCON believes that any investment model where funds from foundations take on the highest risk in order to protect private investors is totally inappropriate. It goes against the traditional fiduciary responsibility which boards of directors, officers and fund managers of foundations have to safeguard their charitable assets. Since the L3C is a private business, the entrepreneur owners themselves do not have any fiduciary responsibility and, moreover, are personally protected by being in a limited liability corporation. 2. Avoidance from the charitable regulatory and accountability environment. The L3C model is an effort to find a legal and tax “space” with the least amount of public oversight and scrutiny possible. L3C entrepreneurs are accountable first and foremost to their investors and certainly don’t want to be restricted by the federal and state governance, financial, and compensation reporting and rules that charities live by. This accountability to investors who expect a financial return as opposed to donors who solely expect mission return and regulators who are working to protect the public’s interest is a fundamental and fatal flaw in the L3C model. Many of the contemporary regulations concerning nonprofits are due to private inurnment abuse and are critical to maintaining public trust. Currently, a number of State agencies such as the Offices of Mental Health (OMH) and People with Developmental Disabilities (OPWDD) are working hard to prevent such excessive executive compensation through regulation and auditing. Limited liability companies (LLCs) in New York are not required to have Boards of Directors or to make any kind of public disclosure of their organizing documents. Without these and other requirements, there is a high risk that L3Cs will be fertile ground for excessive executive compensation and conflicts of interest, something which is prohibited by the Internal Revenue Code and regulated in charities by the IRS. 3. Intentional “blurring” of the charitable definition and marketplace . The public doesn’t understand the workings of C3’s much less that of an exotic, legal contrivance that is similar in name (L3C) and purports to not be what it appears. Charities are working hard and continually to build the confidence of donors, organized philanthropy, consumers and the public at a time there is growing anger and distrust in the integrity of corporate and government institutions. Creating a so-called fourth sector that relies on blurring, legally and in brand, the historic line separating for-profit from charitable organizations is a dangerous long term threat to the sector and public good will. Concern with L3C’s is growing. The New York Times recently explored examples of potential conflicts-of-interest at existing L3Cs in other states. (“Hybrid Model for Nonprofits Hits Snags”, October 26, 2010.) Daniel Klienberger, a Law Professor at Mitchell College of Law in St. Paul, MN, has also outlined an extensive series of legal concerns. (“The Fatal Design Defects of L3Cs”, Nonprofit Quarterly, June 21, 2010). The creation of these entities in New York State will create a regulatory nightmare as there is no regulatory framework for them to operate within at the state or federal level. The Internal Revenue Service has yet to rule on whether PRIs in L3Cs would be viewed as a legitimate use of charitable funds under legal guidelines established for private foundations. Until such a ruling, any legislative action to establish L3Cs clearly would be premature. Current IRS and State regulations provide ample opportunities for charities to responsibly engage in revenue and mission generating enterprises. NYCON itself is the sole shareholder of a successful for-profit insurance brokerage firm that has served and benefited the charitable sector for a dozen years. NYCON is fully confident that the legislation passed by the NYS Senate and introduced in the Assembly was intended to promote charitable causes and support the wide range of critically important work that nonprofits perform. Unfortunately, we believe that the passage of legislation creating L3Cs as a legal entity in New York was ill advised and would have precisely the opposite effect. Doug Sauer is CEO of the New York Council of Nonprofits (NYCON). |
