Does the 501(c)3 have legitimate brand power?

For a long time, consumers, donors, and, generally, members of the public have presumed that nonprofits are trustworthy public servants and stewards of the public good.

This essay questions the legitimacy of those assumptions by posing a hypothetical set of circumstances, contemplating how those circumstances would be treated under the IRS’s regulatory regime for nonprofits, and then contemplating how those same circumstances would be treated under the statutory accountability requirements imposed by the new benefit corporation legislation.

The circumstances

Sell tshirts to raise $ for cancer patients. Tshirts made in sweat shop, with chemicals that pollute the environment.

The mission of XYZ nonprofit is to provide t-shirts for homeless children who have no clothes. XYZ will not rest until every homeless child has one or several of its beautiful blue t-shirts. It funds its t-shirt provisions from donations from the community in which the homeless children live.

Things are good. Donations are growing because everyone wants a homeless kid to have a t-shirt. XYZ buys more t-shirts to clothe more and more homeless children. The mission is being accomplished.

But the number of homeless children continues to grow and the need for t-shirts correspondingly increases. XYZ’s executive director, Linda Leader, decides she can’t see another homeless child go without a shirt when the kid needs it. With demand outpacing donation growth, all Linda can think to do is cut costs (assume that, because of the increased t-shirt buying to match demand, XYZ has a low level of liquidity and no investment portfolio) to make its t-shirt service more efficient, save money on purchasing, and thus allow XYZ to buy more t-shirts at decreased per-t-shirt cost.

In order to cut costs, Linda proposes a strategy of finding cheaper t-shirts and cutting the wages of some staff XYZ members. XYZ staff member Busy Barry hunts down the best deal he can find on t-shirts online and orders t-shirts from the cheapest online retailer he can find. Great news: XYZ will save 75 cents per t-shirt, meaning XYZ will be able to clothe 8,000 more children this year than it did last year. Mission is being achieved, the organization’s primary service is operating more efficiently, and that efficiency will allow XYZ to put more resources towards accomplishing its mission.

But there’s just one little problem. Barry did no research into the online retailer’s employment practices, or the t-shirt manufacturer’s supply chain. The retailer, Evil Inc., which sells the t shirts, pays minimum wage to its staff of all part-time employees, and thus gives no stock options or benefits. Evil Inc. sources its t-shirts from a manufacturer, Slave Co., which is located in an industrial region of a city in India. Slave Co. employs 200-300 eleven year olds who are plucked from their families to go work in its t shirt factories for 80-110 hours per week, brush their teeth with their fingers and ashes from the factory incinerators, are given only unsanitary water to drink, are forbidden to talk, and are regularly beaten into submission if they take too long in the bathroom, and are paid 6.5 cents per hour for their services. Of course, all machinery at the factory is diesel powered and factory waste is released into the local river, which is the water supply for downstream farms and villages. The processed t-shirts are then shipped on a boat that emits thousands of gallons of pollutants into the ocean during its cross-Atlantic voyage.

But, XYZ is a nonprofit. Efficiencies are improved. Revenues are increased. Mission is accomplished. So things are just dandy.

Treatment of nonprofits under the federal and state regulatory regimes

Nonprofit 501(c)3 organizations are subject to both state and federal law. When an nonprofit organization decides to incorporate as a nonprofit corporation, it does so under state law. Most states provide property and income tax exemption to corporations so formed. When those corporations apply to the IRS to seek federal tax exemption by gaining 501(c)3 status, they apply in accordance with federal laws promulgated by the IRS in the Internal Revenue Code, and by the Treasury in the Treasury Regulations.

State laws determine the legitimacy of the corporation as a recognized legal entity. In other words, the state has the power to decide whether the organization is actually a corporation – or just an association of individuals that does not have the limited liability and tax benefits ascribed to nonprofit corporations. Private citizens cannot sue to enforce the covenants of the nonprofit corporation’s charter document, which always specifies that the organization will be operated exclusively for charitable purposes. So the only way for a nonprofit corporation’s actual status as a nonprofit to be challenged under state law is by the filing of a lawsuit by the Attorney General him or herself. But, as Yale Law Professor Henry Hansmann has remarked, “most states in fact make little or no effort to enforce this prohibition.” This is because “government regulators (and most particularly attorneys general, to whom the law confides the principal role in policing charities) tend to allocate their scarce regulatory resources to other more politically potent portions of their domains. In most states, the Charity Bureau of the Attorney General is inactive, ineffective, overwhelmed, or some combination of these.” And, after all, “an accountability system is only as good as its enforcement mechanism.”

Federal law, on the other hand, determines whether or not a nonprofit entity (organized under state law, as mentioned above) is eligible to receive federal tax exemption for both the entity’s taxes and those of the donors who give to the entity. While this federal exemption matter presents an entirely separate set of legal issues, most nonprofit leaders would agree that, even if the entity is recognized as legitimate under state law, without federal tax exemption, the organization is as good as void because it will not be able to attract grants or donations. Thus, as state laws are severely under-enforced, and as federal laws are essentially determinative of a nonprofit’s financial wellbeing – and therefore existence – federal law is the primary legal enforcement tool used to ensure nonprofits are pursuing their charitable goals and being accountable to their charters.

Would federal or state nonprofit law preclude XYZ from sourcing its t-shirts from Slave Co. via Evil Inc.?

Probably not.

Under federal law, despite the multitude of IRS and Treasury regulations to which nonprofits are subject, none of the doctrines developed by the federal courts seems equipped to scrutinize and evaluate these sorts of external practices. They are treated as simply beyond the purview of the courts, which focus exclusively on the internal practices and operations of the organization in determining whether the organization is organized and operated exclusively for charitable purposes. The courts have evolved two tests: the organizational test, and the operational test. The organizational test is concerned only with the organizing documents of the entity and is thus satisfied quite easily by simply stating in the organizing documents that the entity is organized to serve only one or more exempt purposes, and no other purposes. If that organizational test is met, courts proceed to the operational test, which focuses on the actual purposes the organization advances by means of its activities. This test is used most often to consider whether an organization is pursuing an alternative economic purpose, and the Tax Court considers factors such as the commercial hue of the organization’s activities, and “the existence and amount of annual or accumulated profits.” The idea behind the organizational test is that a nonprofit cannot function as a profit-seeking business: its primary purpose must be the accomplishment of an exempt purpose enumerated in the IRS regulations. But there has been no inquiry into the sourcing aspects of an organization’s charitably-oriented activity. Courts do not declare exempt organizations non-exempt because they purchased t-shirts from the wrong supplier. The courts’ inquiry stops at asking whether or not the services were commercially oriented. Because XYZ’s t-shirts are given to the homeless youths and not sold to them at market rate, the organization would not be considered to be commercially oriented, and XYZ would thus remain exempt under federal law.

Moreover, even if XYZ weas scrutinized by the state Attorney General’s office, such externalities as t-shirt sourcing would not likely be considered in the state court’s treatment of the organization either. Most of the State Attorney Generals’ scrutiny is aimed at preventing fraud by ensuring the directors and executives of nonprofits are not siphoning off resources for private gain.

Finally, the modified cost-cutting employment practices of XYZ – lowering the wages of its employees and removing benefits – are emblematic of the normal labor standard in the nonprofit industry. Employees of nonprofits are expected to work for less money, for longer hours, and with fewer benefits, on the rationale that they are given the gratification of working towards a higher purpose beyond that of their own economic wellbeing. This fulfillment purportedly replaces the employees’ need for, e.g., dental exams and groceries.

Treatment of benefit corporations

Had XYZ been formed as a benefit corporation rather than a nonprofit corporation, things may have gone very differently. Benefit corporations are required to pursue a general public benefit: a material, positive, impact on society and the environment, measured by an independent, transparent third party standard. This means that an independent organization with transparent standards will evaluate the benefit corporation based on objective criteria; in the case of B Lab, the leading third-party certifier of benefit corporations, the company receives a score out of two hundred based on how it performs according to employee, community, and environmental metrics. Moreover, benefit corporations are required to report the results of this third party analysis in an annual report that is available to the public. Finally, benefit corporations are required to appoint a director that is specifically tasked with ensuring the company’s pursuit of the stated benefit, and the corporation is subject to a benefit enforcement proceeding in which any stockholder of the corporation may sue for failure to pursue the stated benefit. This stockholder right of action is an accountability mechanism that allows a significant body of stakeholders – anyone who owns stock in a benefit corporation – to ensure that the corporation is complying with the beneficial purpose stated in its governing documents.

Let’s now assume XYZ was formed a benefit corporation rather than a nonprofit corporation.

Would XYZ’s sourcing behavior be permissible if it were incorporated as a benefit corporation?

First, the concept of general public benefit as a legal matter has not yet been hashed out in the courts. But it is apparent that the concept need not be limited by the internal functions approach utilized by the IRS and Tax Court in determining whether a nonprofit pursues an exempt or non-exempt purpose. Because commercial activities are not only permissible, but expected in the case of benefit corporations, courts will not be constrained by the Tax Court’s motivation of ensuring that commercial activities do not predominate a nonprofit corporation’s operational purpose. The benefit corporation legislation does not require organizations so formed pursue exclusively or even primarily their stated beneficial purpose. Rather, inherent in the benefit corporation concept is the intimate and complex fusion of business with beneficial pursuits. Indeed, a primary reason for passing the legislation is that it permits the delicate and mixed interplay of benefit and profit, pursued in the best judgment of the directors, without a rigid statutory ordering of purposes. So the question of whether externalities like sourcing will be included in the benefit corporation concept turns on whether courts adopt the internal functions approach used for nonprofit organizations, or adopt an approach that includes externalities such as those considered in the B Impact Assessment. General public benefit, in the consideration of B Lab’s rating system, contemplates internal functions as well as external impacts. Courts will thus include such internal functions in their analysis if courts follow B Lab’s rating system metrics as guidelines for determining whether companies have pursued a general public benefit in good faith.

It is hard to see how, in the case of XYZ, courts could uphold the sweatshop sourcing as a legitimate, good faith pursuit of a general public benefit. Failing to research and weed out such atrocious conditions from XYZ’s supply chain evinces a marked disregard for the general public benefit concept, and it seems clear that courts could indeed consider such a failure a breach of fiduciary duty to the corporation.

Thankfully, benefit corp proceeding overcomes demand traditionally required in corp law.

  • Finally, even if benefit corp does not legally include the internal functions, the independent standard will catch it and consumers and investors will be made aware by way of the publicly available annual report.
  • Nonprofits are not equipped to provide active buyer-market pressure against violative businesses. They are relegated to the realm of the nagging advocacy that perhaps important, but by no means sufficient.
  • with the same charitable mandate provide t-shirts for homeless children who have no clothes. XYZ will not rest until every homeless child has one or several of its beautiful blue t-shirts.
  • Benefit corp doing same mission with b corp stds.
  • The mission of ABC Benefit Corporation is to create and sell beautiful t shirts, to give as many of them to homeless youths as it can, to source its materials as sustainably as possible, and to provide full employee ownership of the company.

Holding the organization accountable: Nonprofit law and corporate law

The public’s presumptions of trustworthiness and responsible stewardship are based on filing and reporting requirements imposed by federal treasury regulations and the Internal Revenue Code, which permit an organization to acquire and retain 501(c)3 status if it complies with the requirements. The most important of these requirements is the private inurement doctrine, or nondistribution constraint, which means, essentially, that nonprofit organizations cannot distribute profits to employees, directors, or management – or anyone, really – and that nonprofit organizations cannot be run to directly or indirectly unduly benefit a particular individual. Although nonprofit organizations may earn profits, unlike for-profit businesses, nonprofits may not distribute those profits to individuals. Although this is an oversimplification, this is the key distinguishing factor of nonprofits that leads the public to entrust them with the public benefit of tax exemption, and to trust them with donations and volunteer support.

The enforcement mechanism for this constraint comes either from the law of contract and tort – for example, fraud for deliberately misleading a donor into donating to an organization that was illegitimately pocketing profits, or breach of contract for the same – or the law of corporations, for committing acts outside the scope of its articles of incorporation, or for violating the directors’ duty to uphold the terms of a nonprofit’s charter. In the former case, the donor has a private civil cause of action against the nonprofit; in the latter, only the state attorney general may sue to enforce the terms of the charter. The latter is another distinction between nonprofit and for-profit corporate law: in a for-profit context, private shareholders may sue the directors and executive officers for breach of their fiduciary duty to act within and pursuant to the articles of incorporation. Although nonprofit directors also possess fiduciary duties, enforcement of such duties in the for-profit sector is incomparably more common because the state attorney general’s office is too preoccupied with other matters such as organized crime to enforce nonprofit charters. But even in the traditional for-profit corporate law context, where enforcement is more common, there are numerous roadblocks to successfully litigating a breach of fiduciary duties case. For example, most states have a “demand requirement” in order satisfy the pleading requirements in a suit for breach of fiduciary duties. If the Real Plaintiff – usually a group of stockholders – does not make a demand for the corporation (the Nominal Plaintiff) to file a suit against itself for breach of its own fiduciary duties, courts out will throw the suit. To satisfy the demand requirement, Real Plaintiffs must essentially demand that the corporate directors, whom the Real Plaintiffs are suing for breach of fiduciary duty, approve a lawsuit for their own breach of their own fiduciary duties: Real Plaintiffs must demand that the directors sue themselves. When that demand is denied, some states allow the denial to stand so long as, in the independent business judgment of the court, the decision was made after a reasonable investigation, and in good faith in the interests of the corporation. Basically, if it is more profitable for the corporation to not sue itself the suit may be dismissed. Some courts place the burden on the corporation to prove that its dismissal of the breach of fiduciary duties action was made in good faith after objective investigation by independent and disinterested members. Moreover, Demand may be excused in certain circumstances, where the alleged facts support a reasonable doubt that the Board exercised good faith business judgment.

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