Contextualizing and Understanding the California Benefit Corporation

I. FOUNDATIONAL ENTITY ELECTION CONSIDERATIONS

A foundational consideration for any business and its shareholders is the kind of legal entity that best serves the company's intended purpose when considering a myriad of factors. Generally, these include factors such as governance structure, compliance requirements, capital raising potential, taxes, and no shortage of other factors. State legislatures, and relevantly the California legislature, are tasked with authorizing and defining compliance requirements for various forms of legal entities. Commonly, these include corporations, nonprofit corporations, limited liability companies, partnerships, etc. Such legal entity forms are generally known amongst clients and practitioners. However, somewhat lesser known are the various permutations of these common legal entities. In any case, each kind of legal entity is intended to solve some practical set of business issues, and each carries its own unique set of governance and legal compliance rules.

Increasingly, whether in formation or ongoing operations, business management is weighing factors that fall under the umbrella term ESG, standing for environmental, social, and governance issues. For those entity principals who weigh such ESG factors more heavily than others and for the practitioners who advise such clients, forming and operating a permutation of the traditional corporation, the benefit corporation, may be advisable. As such, the rest of this article serves to (a) generally and contextually discuss the issues that the benefit corporation seeks to resolve and (b) provide the practitioner with an overview of the applicable, unique legal compliance requirements when forming and operating a benefit corporation.

II. THE PURPOSE OF THE CORPORATION AND FIDUCIARY DUTIES

a. The Purpose of a Corporation and The Friedman Doctrine

In lieu of an extensive economic, moral, and legally theoretical discussion, suffice it to say that the purpose of the corporation remains a source of continued discussion and argument amongst legal practitioners, economists, businesspeople, politicians, and others. Importantly, much of the present public discourse regarding ESG and the purpose of the corporation is rooted in personal sentiments (for and against), not legal bases. Accordingly, this article aims to focus on and remain tethered to factual and legal bases for relevant consideration.

In 1970, famed economist Milton Friedman wrote an essay for the New York Times in which he argued (greatly summarized here) that the purpose of the corporation is solely to act in response to the desires of its shareholders (generally meaning to maximize profits), so long as the market was free, without deception or fraud, and without the corporation having any other social or societal responsibility whatsoever. While not the first or last purveyor of such an idea, the Friedman Doctrine has largely come to define the corporation, the corporate law, and the fiduciary responsibilities of the principals in managing and operating the corporation in California and elsewhere.

b. Fiduciary Duties of Directors in California

In California, directors, and generally officers, owe to the shareholders and/or the entity the duties of (1) loyalty and (2) care. The codification of such duties is contained within §309 of the Corporations Code. Management is also afforded additional protection under the business judgment rule. Each of the fiduciary duties and the business judgment rule are further interpreted according to case law.

The duty of loyalty generally requires that management conduct itself loyally to the corporation and its shareholders. Generally, this means putting the interest of the corporation and its shareholders first before any other consideration and not engaging in any self-dealing that is detrimental to the corporation's or the shareholder's interests. The duty of care generally requires that management make decisions in the best interest of the corporation and its shareholders. Generally, this means making decisions and conducting business operations in a way that maximizes shareholder profits and prevents waste.

The business judgment rule in California generally protects management from liability for their business decisions, particularly in any shareholder derivative action, so long as management acts in good faith after a reasonable inquiry into the matter engaged and such actions are generally in line with the fiduciary duties of loyalty and care as indicated above. For additional reference, a shareholder derivative action is a suit by the shareholders on behalf of the entity against the management of the entity to remedy and prevent further mismanagement, self-dealing, and/or waste of corporate assets.

III. EXTERNALITIES AND ESG ADOPTION AND ASSOCIATED RISK

a. Externalities

Regarding the Friedman Doctrine, there are certainly worthy points for consideration when thinking about the purpose of a corporation. But, an associated and worthy criticism of the Friedman Doctrine is the general absolving of management of an entity for failures to account for real-world externalities caused by business operations and decisions. Externalities are costs or benefits caused by a producer or entity that are not borne or enjoyed by such producer or entity.

A classic example of a negative externality is an apparel-producing entity's use of a foreign textile supplier who may be engaging in human rights abuses or subjecting its own workers to generally substandard health and safety conditions. In this example, profits would likely be boosted for the entity since material costs from the supplier here are likely to be lower than, say, from a U.S.-based supplier, who must expend additional capital to comply with U.S. employment and other laws. But, by engaging this foreign supplier for its textiles or services, the entity here, and by further extension the entity's customers, are indirectly supporting potential human rights abuses. Such an externality may not be clearly enumerated on the entity's balance sheet or other financials, but nevertheless is a real consequence of its operations. The workers of the foreign supplier here would be deemed to collectively be “stakeholders” of the entity in that while they may not be part of the entity or its customer base, they are nevertheless affected by the decisions of the entity and its management. Other externalities, both negative and positive, may include environmental pollution, degradation, and resource exploitation (the tragedy of the commons issues); workforce and third-party health and safety; corruption; human rights abuses; social issues; etc.

b. ESG Adoption and Associated ESG Risk

Generally, what many ESG-focused or interested business managers want to better account for are the above-explained externalities, either generally or specifically, while still pursuing a profit-driven operation. Other entity forms, such as the nonprofit corporation, allow an entity to focus on some identified externality and/or stakeholder in some fashion, but at the express prohibition of economic profit in exchange for certain tax benefits. But for management interested in pursuing both profit and some other purpose, they are necessarily on somewhat shaky legal ground, particularly in light of the aforementioned fiduciary duties of management in an entity. Unless there is a direct, financially beneficial implication in pursuing any such societal or environmental good, there exists some level of risk of a shareholder derivative suit, which applies to both public and private entities.

Still, the pursuit of ESG in the market in for-profit entities continues to proliferate. According to a recent study by KPMG, each of the top 100 companies in the U.S. reports on their ESG initiatives, whether voluntarily or as they determine to be requisitely implicated under the existing financial disclosure regime (as the link between some ESG matters and financial performance grows ever more illuminated). Further, 96% of the top 250 global companies provide some sort of ESG disclosure reporting on their ESG initiatives, and 70% of polled U.S. chief executive officers believe that their ESG pursuits improve their entity's financial performance. Generally, the consensus appears to be shifting since many, though not all, ESG factors are really just an extension of enterprise risk management, and such coordinated business actions are firmly in line with the long-term interests of shareholders. Responsively, a general survey of the largest law firms in the U.S. and the world will also clearly identify the allocation of resources law firms are investing towards ESG advising for their clients.

As the reader may imagine, however, many market participants pursue ESG initiatives without the advice or review of counsel. Such endeavors, often leading to claims of "greenwashing," meaning an overstatement of an entity's ESG initiatives, may and often do lead to potential legal liability. Re-referencing the apparel industry, for example, certain high-profile apparel manufacturers have recently made strong sustainability claims about their products that were patently untrue, leading to various bases of liability. As with anything in life, law, or business, undertaking ESG initiatives should be taken with due care, analysis, and diligence. Many of the aforementioned issues can be rectified by knowledgeable and engaged legal counsel. Such advice and review of counsel becomes quite important then and a client who may want to pursue ESG initiatives may be well-served by considering a permutation of the traditional corporation, the benefit corporation.

IV. THE CALIFORNIA BENEFIT CORPORATION

The California Benefit Corporation is a relatively new corporate form in California. Its unique compliance requirements, as adopted by the California legislature, are codified in §§14600-14631 of the Corporations Code. Many of the legal compliance requirements of the benefit corporation are common to that of the traditional corporation. Thus, compliance and governance requirements of the benefit corporation should largely be familiar to legal practitioners, clients, and investors. Additionally, approximately 40 states now authorize some form of benefit corporation. Some of the relevant, additional compliance requirements of the California Benefit Corporation relative to a traditional California corporation are detailed below.

a. Corporate Purpose and Public Benefit

All corporations are required to have a "corporate purpose," as indicated in their Articles of Incorporation. Practically, this is a somewhat antiquated legal element. Lawyers usually draft standard language to satisfy this compliance requirement, which essentially allows the corporation to act in any legal way it wishes in the market. In addition to the standard corporate purpose, a benefit corporation must have the purpose of and must endeavor to create a "general public benefit," and such language must also appear in the articles. A general public benefit is a "material positive impact on society and the environment, taken as a whole, as assessed against a third-party standard." Additionally, though not in lieu of the general public benefit, a benefit corporation may also specify "specific public benefits." The statute provides examples, such as preserving the environment, improving human health, and increasing the flow of capital to entities with a public benefit purpose, among others. A benefit corporation may also indicate some other non-enumerated specific public benefit, if it so chooses. For example, Patagonia, a prominent California benefit corporation, enumerates six specific public benefits in its articles. Among them are (a) contributions of 1% of their profit to 1% for the planet, a nonprofit entity; (b) transparency as to the environmental impact of its products and disclosure thereof on its website and print catalogs; and (c) conducting its operations to cause no unnecessary harm by seeking to reduce its carbon footprint, water use, energy use, greenhouse gas emissions, and other similar aims. Each of the six specific benefit purposes adopted by Patagonia are voluntarily imposed legal mandates regarding their operations.

b. Additional Fiduciary Duty

In addition to the duties of care and loyalty described above, management in a benefit corporation owes another co-equal fiduciary duty. This additional, co-equal fiduciary duty does not yet have an agreed-upon name, though the relevant statute includes language about the impact of corporate decisions, so for the purposes of this article, this third fiduciary duty will be called the duty of impact.

The duty of impact requires management to weigh the impacts of their corporate decisions not only on the shareholders of a corporation but — concurrently and generally — upon that of its employees, its subsidiaries and suppliers, the community, the local and global environment, and other stakeholders, and, specifically, upon that of any specifically adopted benefit purpose, such as Patagonia's aforementioned specific benefit purposes. The co-equal nature of the respective fiduciary duties in a benefit corporation is what mandates yet affords management the ability to pursue ESG-focused initiatives along with profit without the accompanying risks of a shareholder derivative action.

c. Third-Party Standard and Annual Benefit Report

As an accountability mechanism, California requires that the general and/or specific public benefits identified by the benefit corporation be measured against a third-party standard. What qualifies as an acceptable third-party standard has its own requirements, which generally serve to ensure that the entity issuing the third-party standard is not affiliated with the benefit corporation, is fair and balanced in its standards, and that the rating methodology is available for public viewing.

Somewhat similar to the now common but voluntary practice of issuing corporate sustainability reports, benefit corporations are required to issue annual benefit reports to their shareholders. The annual benefit report must include a narrative that describes the process for selecting the adopted third-party standard, the ways the benefit corporation pursued its general and any specific public benefits, circumstances that hindered the pursuit of such benefits, the relative performance against the third-party standard, whether the benefit corporation failed to achieve its public benefit and if so why, and other information, such as a list of shareholders that own at least 5% of the benefit corporation.

There are a variety of third-party standards presently employed by active benefit corporations in California. Perhaps one of the most recognizable is the B-Corp certification. B-Corp certification is not in itself a legal entity. Rather, it is a privately created ESG-focused rating system promulgated by B Lab, Inc. For California entities, any corporation pursuing B-Corp certification, whether as the third-party standard for use in a benefit corporation or otherwise, is required to be or to become a benefit corporation.

d. Benefit Enforcement Proceeding

As an enforcement mechanism enacted to defend against the pervasive practice of greenwashing, a benefit enforcement proceeding is available to ensure that the benefit corporation's management is operating in accordance with its duty of impact. Attentive readers will notice that this sounds similar to a shareholder derivative action, and indeed it is. This is a type of legal proceeding that shareholders of a benefit corporation may bring against the management of the benefit corporation, alleging that such officers and/or directors are not acting in accordance with their fiduciary duty of impact, though monetary damages are not available in any such action.

e. Conversion

For already established corporations or other entities, conversion to a benefit corporation is authorized in California. To do so, each equity class of the converting entity must approve the conversion by a statutorily mandated two-thirds minimum status vote or greater voting threshold if adopted in the converting entity's governing documents.

V. FINAL THOUGHTS

While ESG remains to some as a political football, being lobbed back and forth and largely devoid of the practical and legal considerations involved, the case remains that there are hard law concerns implicated by the rapid and en masse adoption of general ESG principles by for-profit entities. As such, these entities can benefit from knowledgeable counsel. Perhaps it eventually becomes the case that the California courts definitively construe and interpret or the legislature legislates that the pursuit of general or specific public benefits falls in line with the duties of care and loyalty, and thus this source of potential risk for management is definitively mitigated. But until then, the benefit corporation becomes an attractive risk mitigation tool when a client wishes to pursue ESG in addition to the pursuit of profit. Counsel would be well served to understand the basics of the entity form.

Matthew D. Batista practices general corporate, M&A, real property, intellectual property, and entertainment law in the San Diego office of Klinedinst PC. He is a member of the Business Law Section, a co-chair of the emerging ESG Committee, and a member of the Member Engagement Committee of the California Lawyers Association. Any views and opinions contained within this article are expressly those of the author. They do not necessarily represent the views and opinions of Klinedinst PC or the California Lawyers Association.