Business
Friday, 19 July 2013 15:44

GOOD FAITH FOUND HERE


Those of us routinely asked to draft or review letters of intent (LOI), memorandum of understanding (MOU) and initial term sheets have a new challenge.  The use of conventional text clearly stating “this is non-binding” to be sure a preliminary document memorializing negotiations does not give rise to the risk of unintended enforcement apparently is no longer sufficient.  As a result of the Delaware Supreme Court’s decision in SIGA Technologies v. PharmAthene, Inc., No 314, 2012 2013 Del. LEXIS 265, 1-2 (Del. May 24, 2013), it is now suggested that counsel negotiating LOIs, MOUs and even term sheets designated as final include a specific negation of good faith.  Text specifically stating the parties agree that neither party shall have a duty to negotiate in good faith is now considered appropriate.  Getting both sides to agree to include such a forbidding sentence, however, is a significant challenge.

In SIGA Technologies, the court held that expectation or “benefit of the bargain” damages (and not just out of pocket, reliance damages) were appropriate where (1) the parties had a term sheet; (2) the parties expressly agreed to negotiate in good faith in a final transaction in accordance with those terms; and (3) but for the breaching party’s bad faith in trying to improve the terms, the parties would have consummated a definitive agreement with the terms set forth in the term sheet.

The SIGA Technologies decision might have been appropriate in light of the specific facts before the court but it leaves transactional lawyers at a loss.  Business lawyers have been advising clients since the beginning of time that there is, and should be, a great difference between incomplete and preliminary letters, drafts and other communications clearly understood as non-binding (with the exception of specifically identified provisions, such as those relating to confidentiality and exclusivity) and  final, mutually executed contracts with an integration clause.  The former should have no legal effect other than as a basis to start the hard drafting process for definitive agreements. LOIs, MOUs and term sheets referring to the parties’ intent to finalize binding documents later are to be used as support for financing efforts and strategic planning and not evidence of a final oral or implied agreement between the parties.  Exceptions to this rule were, until recently, very narrowly applied and usually only if the parties made an effort to carve out the intended exceptions with clear language (non-disclosure, exclusivity or no-shop provisions).  Efforts by counsel for either party to impose a written duty of good faith and fair dealing on the other party are normally met with resistance with the better practice perceived to be silence on this point and text that allows either party to halt negotiations at any time for any reason as long as there is no breach of the binding confidentiality and/or exclusivity provisions.  Termination fees are sometimes added to encourage good faith negotiations and cover out of pocket costs incurred as a cost of freedom to abandon those negotiations.

To avoid imposition of a SIGA Technologies penalty, many corporate advisors are now insisting the only safe course is to explicitly refute the presence of good faith.  And yet, most clients do not want to suggest that they would ever negotiate in bad faith. Worse, most clients do not want to agree to allow the other party to the proposed transaction to abandon all pretenses of good faith and fair dealing.  Who wants to go to the dance with a partner who asks for permission to humiliate you while there and tells you of his or her plan to possibly leave you without a ride home?

Bad faith in the midst of negotiations has historically been perceived as bad form but not an exception to the “non-binding” rule and certainly not the basis for expectation (lost profits) damages. To make this area even more challenging, a judicial determination of one company’s bad faith (e.g., trying to improve terms if the circumstances have become more favorable for the company) can easily be deemed by the shareholders/members of the same company to be the exercise of management’s fiduciary duty to maximize equity holders’ return.  Failure to push for the best possible terms in the face of a non-binding term sheet could be found by another court to be a breach of that duty.

Whether bad faith should support an exception to the “non-binding” rule as a matter of law is an interesting question but the philosophy of law is rarely a topic businessmen and women wish to explore.  Any number of things can make a deal that seemed attractive at a given point unacceptable some time later.  Negotiations with respect to terms not included in the preliminary documents can be filled with real dispute; due diligence may reveal greater risks than anticipated; the industry-wide market may shift; or business may suddenly improve supporting more favorable terms for one party and less favorable terms for the other.  Where the risk of the business enterprise does not begin to shift until after the execution of a definitive document, why should either party get the benefit of a preliminary bargain when the facts and circumstances supporting the transaction have changed? 

While no one should be conducting negotiations in bad faith, the imposition of an implied duty of good faith and fair dealing in preliminary “non-binding” documents unless the parties specifically negate that obligation seems problematic.  In contrast, once agreements are fully negotiated and signed, the covenant to act in good faith and engage in fair dealings is appropriate between business partners of all kinds. As found in other Delaware decisions, even where the contracting parties appear to have agreed to limit the scope of their common law and statutory fiduciary duties in a final document, good faith and fair dealing have an important role that should be implied and enforced by the courts.  But, only after a final document is signed and sealed, however, should we be insisting a party trying to maximize their position “Did a bad, bad thing.”

From time to time, a client asks about when and why a corporate seal is necessary. Even some attorneys (particularly from out of state) question during contract negotiations whether the phrase “executed under seal” should be removed from a contract as an archaic concept. Historically, seals were affixed to a document as a formality to attest to the parties’ intention to be legally bound by the promises contained in the document. In several states, however, the execution of an agreement under seal continues to have specific legal significance that is not always understood or intended by the parties.

As a general rule, the Pennsylvania Judicial Code provides that the statute of limitations for actions based on a contract is four years. For instruments that are executed under seal, however, the statute of limitations is twenty years. The guarantor of a commercial loan recently learned the hard way that his guaranty was subject to the extended statute of limitations. In Osprey Portfolio, LLC v. Izett, the lender confessed judgment under Mr. Izett’s guaranty nearly five years after the loan went into default. Mr. Izett argued that the action was precluded because it was filed after the four-year limitation period. While acknowledging that the document was executed “under seal”, Mr. Izett maintained that the twenty-year limitation period did not apply because the guaranty agreement was not an “instrument”, which he defined as instruments under Article 3 of the Uniform Commercial Code. Article 3 defines “instrument” as a “negotiable instrument”, namely “an unconditional promise to pay a fixed amount of money.” Because his guaranty related to a line of credit (not a loan for a fixed sum) and was conditional upon the default of the borrower under the note, he reasoned that it did not meet this definition of “instrument.” The Pennsylvania Supreme Court disagreed and affirmed the lower courts’ rulings. It held that the term “instrument”, as used in the Judicial Code,  should be interpreted using its ordinary meaning: a written document that defines the rights and obligations of the parties, such as a contract, will, promissory note, etc. Using this broader definition, the guaranty in question clearly qualifies as an instrument. Since the instrument was executed under seal, the twenty-year statute of limitations applied and the action was allowed to go forward.

It should be noted that the Judicial Code section providing for the twenty-year statute of limitations is due to expire on June 27, 2018. Of course, the sunset date for this provision has been extended in the past, so only time will tell whether the execution of contracts and other writings “under seal” will continue to have special legal significance in Pennsylvania.

Four years ago, the Home Improvement Consumer Protection Act (HICPA) went into effect, forcing home improvement contractors to register with the Commonwealth and to comply with various contracting requirements (for more information, see our Client Alerts on the subject https://www.ammlaw.com/general/articles.html). We have found that unfortunately many contractors remain unaware of this law. Failure to comply with HICPA could result in civil and criminal penalties. But does non-compliance also mean that a contractor is prevented from receiving payment from its customer for completed work? Not necessarily, held the Pennsylvania Superior Court, which recently gave hope to contractors when it concluded that a contractor who does not comply with HICPA may nevertheless recover the value of its services from the customer.

In Shafer Electric & Construction v. Mantia, an out-of-state contractor entered into a written contract with a Pennsylvania homeowner (who also happened to be a contractor) to build an addition to the homeowner’s garage and provided services valued at over $37,000. The contractor did not register with the Commonwealth under HICPA. After the homeowner failed to pay the amount due, the contractor sued to recover its fees. The homeowner asserted that the complaint was legally insufficient because the underlying contract was not enforceable under HICPA. The contractor countered that even if the contract were unenforceable, the contractor should be able to recover its fees under the equitable doctrine of quantum meruit, a theory which allows a party to recover the reasonable value of its services so as to avoid unjust enrichment of the other party. Unfortunately, although HICPA preserves a contractor’s right to recover its fees under a quantum meruit theory, the language of the statute appears to require compliance with HICPA as a prerequisite to recovery. The lower court, strictly interpreting the statute’s plain language, ruled in favor of the homeowner. The Superior Court reversed, holding that the plain language of the statute impermissibly limits the purpose of the provision allowing recovery under quantum meruit. It reasoned that to require the contractor to comply with HICPA before recovering under a quantum meruit theory made no sense because a compliant contractor can recover its fees under a breach of contract theory and does not need an equitable remedy such as quantum meruit.

While Shafer Electric provides reassurance for home improvement contractors doing work in Pennsylvania, the prudent contractor will not rely on it to ensure collection of its fees. Because of the hefty fines and possible criminal penalties that may be imposed for violations, we strongly encourage contractors to register and comply with the other requirements set forth in HICPA.

Monday, 01 July 2013 14:47

The Perils of Equity-Based Compensation

Employers frequently want to attract new, super-talented management to an existing Company, or potentially worse, have already promised to give one or more trusted and loyal current employees equity as part of their compensation package as soon as the time is right.  Unfortunately, this is easier said than safely done. 

Clearly, equity can be a powerful, seemingly low-cost form of compensation and motivation.  Having your most valued employees vested in something beyond their pay check certainly seems like a fine idea.  If the Company does well, the employee shares in that growth in the form of annual distributions or a buy-out upon death, disability, retirement or other termination of employment.  So, what do I have against such an idea?

Monday, 06 May 2013 14:08

Rules Applicable to Summer Internships

With summer just around the corner, employers are inundated with requests by students for summer internships. If your company offers such opportunities, taking a few moments to review the applicable regulations will help assure that the program complies with the law.

It goes without saying that a paid intern is an employee and subject to all applicable state and federal employment laws including those pertaining to minimum wage and overtime. Even if the internship is unpaid, failure to follow Department of Labor guidelines could lead to legal liability under the Fair Labor Standards Act.

Department of Labor Guidelines

The Fair Labor Standards Act (the FLSA) provides, of course, that individuals in an employment relationship must be paid for services performed. When is an unpaid intern an employee? According to guidelines published by the Department of Labor, if the following factors are met, there is no employment relationship and the intern need not be paid:

The internship, even though it includes actual operation of the facilities of the employer, is similar to training which would be given in an educational environment;

The internship experience is for the benefit of the intern;

The intern does not displace regular employees, but works under close supervision of existing staff;

The employer that provides the training derives no immediate advantage from the activities of this intern;

The intern is not necessarily entitled to a job at the conclusion of the internship; and

The employer and the intern understand that the intern is not entitled to wages for the time spent in the internship.

If all of these factors are met, the Department of Labor will conclude that an employment relationship does not exist under the FLSA. In such circumstances, minimum wage and overtime provisions do not apply to the intern.

Different rules apply for governmental agencies and non-profit organizations. Internships offered by governmental agencies, private non-profit food banks and non-profit organizations providing religious, charitable, civic, or humanitarian services are generally permissible so long as the intern volunteers his or her time freely and without anticipation of compensation.

A permissible unpaid internship will include some or all of these features:

  1. It is structured around a classroom experience as opposed to the employer’s actual operations;
  2. Academic credit is offered by a sponsoring institution;
  3. The internship provides the intern with skills that can be used in multiple employment settings as opposed to specific training in the employer’s operations;
  4. The intern does not perform the routine work of the employer;
  5. The employer is not dependent upon the work of the intern;
  6. Job shadowing opportunities that allow an intern to learn certain functions under the close and constant supervision of regular employees, but the intern performs no or minimal work.
  7. The internship is of a fixed duration established at the outset of the internship.

Factors which indicate an employment relationship (and trigger the requirement to pay wages) include:

  1. The intern is engaged in the operations of the employer;
  2. The intern is performing productive work such as, for example, filing, clerical work or assisting customers;
  3. The employer uses interns in lieu of hiring additional employees or offering more hours to existing employees;
  4. The intern receives the same level of supervision as other employees;
  5. The intern is offered employment to begin immediately upon the conclusion of the internship, effectively transforming the “internship” into a trial period of employment.

Summer internships, paid or unpaid, provide valuable experience to students. Employers need only exercise some caution is structuring the internship to avoid running afoul of DOL regulations. The DOL Fact Sheet on summer internships is available at http://www.dol.gov/whd/regs/compliance/whdfs71.htm

My heart inevitably sinks when a client asks the ever popular question “What form of legal entity would be best for my for-profit enterprise?” The entrepreneur’s excitement is contagious but answering is never easy.  There are so many variables that determine where a start-up might end up no matter how researched the assumptions and projections might be.  And yet, a choice has to be made. 

For the growing number of social entrepreneurs, it has become even more nuanced.  There are three new legal forms emerging to satisfy the “Impact Investment Revolution” in our midst (the Flexible Purpose Corporation, the Benefit Corporation and the Low-Profit Limited Liability Company or L3C), and Illinois is considering the creation of a fourth, the Benefit L3C.  While each is designed to accommodate ventures that pursue social and environmental benefits attractive to impact investors, social entrepreneurs should consider a variety of factors before using the traditional LLC or corporation.

Summarizing the similarities and differences of each of the new legal forms is no straightforward task.  Each state that has adopted one or more of the alternative new forms has slightly different requirements and there is no real case law to date analyzing how state specific legislation is to be interpreted since these legal forms are so new. 

In general, the Flexible Purpose Corporation permits the founders of a for profit corporation to establish a blend of business and charitable or social objectives that are not profit maximization or asset growth oriented.  The board and management of the Flexible Purpose Corporation are then charged to act with those blended objectives in mind and to report to the shareholders on its success or failure in achieving them. 

The Benefit Corporation differs slightly in that it is a for profit entity that is required to advance a general public benefit in addition to any other purposes adopted as a business corporation.  The Benefit Corporation may also have as a purpose the creation of one or more specific public benefits.  The directors have an affirmative duty to consider the effects of their decisions on all of the corporation’s constituencies (shareholders, customers, suppliers, the environment, the community) and an annual benefit report prepared by an independent third party describing efforts to create the public benefit during the preceding year must be filed with the Department of State and distributed to shareholders.

In contrast, an L3C is usually formed to create a presumption of eligibility for program related investments (PRIs) from one or more foundations or to lock in a charitable mission when the founders have a set of investors who will support that mission.  See my earlier post “Private Foundations and New Regulations Regarding Program-Related Investments”.  The L3C is, by definition, a low-profit limited liability company which significantly furthers the accomplishment of one or more charitable or educational purposes within the meaning of Section 170(c)(2)(B) of the IRS Code of 1986, as amended.  No significant purpose of the L3C can be the production of income,  the appreciation of property or one or more political or legislative agendum within the meaning of Section 170(c)(2)(D) of the IRS Code of 1986, as amended. 

The L3C therefore goes further than the Flexible Purpose Corporation or the Benefit Corporation in that both of those are set up to be money-making enterprises that also have social or charitable mission(s). The L3C can operate a business but producing income or maximizing appreciation of assets cannot be a significant purpose of the venture and if it becomes clear after formation that income or appreciation is the focus, the L3C will immediately cease to exist as a low-profit LLC although it will continue to exist as a limited liability company.

Note that “B Corporations” are not a corporate form but rather a certification mark available to all three of the above forms and even traditional for profit corporations.  The certification or brand can be obtained from the nonprofit organization called B Lab and requires achieving a specific score after the B Lab evaluation of a variety of factors including the entity’s treatment of its employees and successful evaluation of socially responsible goals.  See http://www.bcorporation.net for more information on B corporations.  

With the above in mind, reverting to the age old “Who”, “What”, “Where”, “When” and “Why” analysis is probably the best way to analyze the alternatives.  Throwing in a “How” or two will help even more.

Looking at the “who”, entrepreneurs, investors and consumers each have characteristics that may make one choice unavailable or at least inappropriate.  For example, if the founding principals consist of one or more non-profit corporations rather than individuals, a Benefit Corporation may be desired although such an entity would be unable to elect pass through “S” status which may prompt a closer examination of the L3C model.  If attracting foundation PRIs is a large part of the business plan, that too might suggest that the L3C is the proper vehicle. In contrast, if the initial or anticipated future investors articulate the desire to consistently build profits along with a material positive impact on society or the environment, the L3C requirement for “low-profit” expectations will be violated and the L3C status possibly challenged.  The Benefit Corporation would be a better choice for such investors especially where enough time has simply not elapsed for anyone to determine how low the “low profit” requirement really is.

The “what” and the “where” is a close examination of the intended business activities and cross border implications, if any.  Some activities are more fundamentally socially or environmentally beneficial than others and some are clearly charitable at their core.   At the same time, while you can form a legal entity anywhere that the chosen structure is permitted and file for authority to do business in any state of operation, PRIs, bonds and grant programs are often geographically specific. 

“When” is a determination of the planned exit of either the founders or specific staged investors which may suggest starting out as one kind of entity and evolving over time into another kind of entity which is permitted in most states if the requisite shareholder/member consent is obtained. The transition is not intended to be as difficult as a non-profit to for profit transformation (which, in Pennsylvania, require Attorney General and Orphans’ Court participation).   “Why” is really another examination of the social/environmental/charitable mission and the expectations of all principals along with the individuals or programs the principals intend to benefit with the new endeavor.  And, finally, an old fashioned projection of just “how” much money is needed at different junctures of the anticipated growth cycle is key. 

LawForChange at http://www.lawforchange.org  features some interesting content on the variety of legal structures available on a state by state basis.  There are certainly pros and cons of using each structure and I sincerely wish you well in your efforts to choose which will be best.  Forget what I said at the beginning of this post and feel free to call me if I can be of any help. 

Friday, 15 March 2013 19:53

Simple Subpoenas 1.0

Why does it seem to take so long to solve simple problems?  For years litigators have had to resort to the use of the cumbersome and needlessly expensive procedures to compel the attendance of a witness in interstate litigation pending in state court.  The problem arises, of course, where the testimony of a witness located in Pennsylvania is needed in connection with litigation pending in another state, or when the witness is located out of state and his testimony is needed in connection with a Pennsylvania case. 

In 2007, the National Conference of Commissioners on Uniform State Laws promulgated the Interstate Depositions and Discovery Act (the “Act”) which simplified the entire process.  In October 2012 the Act was adopted in Pennsylvania and became effective December 24. It is codified at 42 Pa.C.S. § 5331.

The Act requires the Prothonotary to issue a Pennsylvania subpoena, upon the submission of a foreign subpoena.  The Pennsylvania subpoena must incorporate the terms used in the foreign subpoena and provide the names and contact information for all counsel of record and unrepresented parties in the foreign proceeding.  Service and enforcement of the subpoena are governed by the Pennsylvania Rules of Civil Procedure. 

Need to subpoena a witness in another state for a Pennsylvania case?  If the witness is located in any of the thirty two states and territories that have adopted the Act, the procedure is just as simple.  Issue a Pennsylvania subpoena; send it to your local counsel on the ground in the discovery state and off you go.  The Act is the law in Alabama, Arizona, California, Colorado, Delaware, District of Columbia, Georgia, Hawaii, Idaho, Indiana, Iowa, Kansas, Kentucky, Maryland, Michigan, Mississippi, Montana, Nevada, New Mexico, New York, North Carolina, North Dakota, Oregon, Pennsylvania, South Carolina, South Dakota, Tennessee, U.S. Virgin Islands, Utah, Vermont, Virginia, Washington.  It is on the legislative agenda in New Jersey.

That’s all there is to it! In the words of the Commission:

The Act requires minimal judicial oversight and eliminates the need for obtaining a commission or local counsel in the discovery state, letters rogatory, or the filing of a miscellaneous action during the discovery phase of litigation.  Discovery authorized by the subpoena is to comply with the rules of state in which it occurs.  Furthermore, motions to quash, enforce, or modify a subpoena issued pursuant to the Act shall be brought in and governed by the rules the discovery state.

The solution is so simple one wonders why it took so long to come up with it and, once the Act became available, why it took five years to enact it in Pennsylvania?  Enact it we have and litigators, their clients and the Courts will benefit from its simplicity.  


Restrictions against competition are frequently included in employment agreements and agreements for the sale of business assets or stock.  The restriction against competition is designed to secure a time period for the employer or buyer of business assets, as the case may be, during which the employer/buyer is free from competition for a departed employee or seller so as to facilitate the transition and better protect their own business assets and customer relationships.  If properly drafted and implemented, restrictions against competition are enforceable under Pennsylvania law.

The primary method of enforcement in the event of breach is a preliminary injunction in equity.  In order to prevail on a petition for preliminary injunction, a petitioner must demonstrate several factors including (1) the need to prevent irreparable harm which cannot be compensated by money damages, (2) that more harm will result from the denial of the preliminary injunction than from granting same, (3) that the injunction will restore the parties to the status quo, (4) the likelihood of success on the merits, (5) that the injunction is designed to abate the offending activity, and (6) that the injunction will not negatively impact public policy.   In most cases the issues of likelihood of success on the merits and irreparable harm incapable of compensation with money damages represent the contested issues.

In Bucks County, the petition for preliminary injunction must be accompanied by a verified complaint and an order for hearing.  The petition is often, though not always, heard by the initial pre-trial judge assigned to the case at the time of filing.  Court administration reviews all petitions for preliminary injunction and assigns the presiding judge, courtroom and date for evidence to be taken.  The order for hearing is an essential aspect of the petition; without it, no hearing will be scheduled.

The petitioner in any injunction matter bears a heavy burden.  Adequate evidence as to the need for enforcement of the covenant, the potential irreparable harm and right to relief must be presented.  Because the entry of injunctive relief is an extraordinary remedy, the evidence must be clear and persuasive.  In employment and business asset transfer cases, the language of the restriction in the applicable agreements must be constrained to those aspects of competition which are reasonably necessary for the protection of the employer/buyer.  For example, a covenant which is overbroad in terms of geography, time or scope will not be enforced.

Preliminary injunctive relief may be acquired in the Bucks County Court of Common Pleas if supported by the underlying agreement and if properly perfected under the practices and procedures employed in the County.

Just when minority owners of Delaware LLCs thought that the Delaware Limited Liability Company Act (the “Act”) protected them from overreaching managers, along comes the Delaware Supreme Court to say “better get it in writing.” It appears that practitioners longing for certainty will have to wait until the Delaware legislature steps in and revises the statute.

The Delaware Supreme Court recently published an opinion in a case involving a Delaware LLC (Gatz Properties, LLC) that was the manager of another LLC (Peconic Bay, LLC). Gatz Properties is managed and controlled by William Gatz, and the Gatz family and their affiliates owned controlling equity interests in Peconic Bay. They also owned real estate that was leased to Peconic Bay, which in turn subleased the property to a national golf course operator. The golf course proved to be unprofitable because it was poorly managed, and Mr. Katz anticipated that the sublease would be terminated. He decided to acquire the sublease and Peconic Bay’s other assets for himself. Consequently, he foiled the efforts of a third party to buy the sublease rights. He then engaged a valuation expert to appraise the property but did not provide the expert with information about the prior third party offers or tell the expert that the golf course’s unattractive financials were the result of its being mismanaged. Not surprisingly, the resulting appraisal showed that Peconic Bay had no net positive value. Next, Mr. Katz hired an auctioneer with no experience in the golf course industry to sell the golf course business. After lackluster advertising for the auction, Mr. Katz was the sole bidder and acquired the property for $50,000 plus the assumption of debt. Peconic Bay’s minority members brought suit in the Delaware Court of Chancery, alleging that Mr. Katz had breached his fiduciary duties to them. The Court of Chancery held that Gatz had breached both his contractual and statutory duties to the minority members, and Gatz appealed to the Delaware Supreme Court.

The Delaware Supreme Court agreed with the Court of Chancery that the LLC agreement’s clear language prohibited self-dealing without the consent of 2/3 of the minority owners, and Mr. Gatz testified on several occasions that he understood that Gatz Properties owned fiduciary duties to the minority members. The Court also upheld the lower court’s finding that Gatz breached this duty.

Moving on to whether Gatz breached a statutory duty under the Act, the Court noted that it was “improvident and unnecessary” for the Court of Chancery to decide that the Act imposed “default” fiduciary duties on managers where the LLC agreement is silent because, in the case at bar, the issue could be decided by interpreting the text of the LLC agreement. Additionally, no litigant asked that the lower court resolve the issue by interpreting the Act. Another concern for the Court was the lower court’s suggestion that its statutory interpretation should withstand scrutiny because practitioners rely on its rulings. The Court remarked that, as the highest court in Delaware, it was not bound to follow the lower court’s decisions. The Court rebuked the lower court for using the case at hand as a “platform to propagate [its] world views on issues not presented.” The Court concluded its reprimand by stating that because the issue of whether the Act imposes default fiduciary duties is one on which reasonable minds can differ, the matter should be left to the legislature to clarify.

Following the decision in Gatz Properties, equity holders in Delaware manager-managed LLCs would be prudent to clearly identify in the LLC agreement which fiduciary duties are intended to apply to their managers. Given the Court’s position that the issue is a matter for the legislature (not the courts) to decide, practitioners will be monitoring the activities of the legislature to see if it takes up the gauntlet.

As the calendar year comes to a close, all corporate entities, profit and nonprofit, look to their books and make end of year decisions to best avoid the pitfalls of the clear and concise (NOT!) Internal Revenue Code (the “Code”).  Private foundations have a unique challenge in their efforts to avoid excise taxes which are imposed on them, as well as their managers, in accordance with Section 4944(a)(1) of the Code if it is found that such foundations made investments that jeopardize the private foundation’s exempt purposes.  Such “jeopardizing investments” generally occur when foundation managers fail to exercise ordinary business care and prudence, under the facts and circumstances prevailing at the time of making the investment, in providing for the long and short term financial needs of the private foundation.

On May 21, 2012 the Service published proposed regulations that provide nine new examples of types of private foundation investments that qualify as Program Related Investments (“PRIs”).  PRIs are not classified as investments which jeopardize the carrying out of exempt purposes of a private foundation because they possess the following characteristics:

    a. have as the primary purpose the accomplishment of one or more charitable or educational purposes defined by Section 170(c)(2)(B) of the Code;
    b. do not have as a significant purpose the production of income or the appreciation of property; and
    c. do not further one or more of the purposes described in Section 170(c)(2)(D) of the Code (relating to prohibited political activities and lobbying).

To be certain both the foundation and the recipient of the PRI are on the same page (and to also prove the foundation is exercising “expenditure responsibility” to the Internal Revenue Service), a private foundation must secure a written commitment from the recipient of the PRI which specifies the purpose of the investment and contains an agreement by the organization:

    a. to use all amounts received only for the purposes of the investment and to repay any amount not used for these purposes back to the foundation, provided that, for equity investments, the repayment is within the limitations concerning distributions to holders of equity;
    b. to submit, at least once a year, a full and complete financial report together with a statement that it has complied with the terms of the investment;
    c. to keep adequate books and records and to make them available to the private foundation; and
    d. not to use any of the funds to carry on propaganda, influence legislation, influence the outcome of any public elections, carry on voter registration drives or make grants that do not comply with the requirements regarding individual grants or expenditure responsibility. 

Examples of acceptable PRIs in the proposed new regulations are based on published guidance and on financial structures that had previously been approved in private letter rulings. The regulations do not modify the existing regulation but illustrate certain principles and current investment practices.  Where the examples in the older regulations focused on domestic situations principally involving economically disadvantaged individuals in deteriorated urban areas, the new examples include a broader range of opportunities that might be presented to a private foundation.

The new examples demonstrate that a PRI may accomplish a variety of charitable purposes, such as advancing science, combating environmental deterioration and promoting the arts.  Several examples also demonstrate that an investment that funds activities in one or more foreign countries, including investments that alleviate the impact of a natural disaster or that fund educational programs for individuals in poverty, may further the accomplishment of charitable purposes and qualify as a PRI.  One example specifically illustrates that the existence of a high potential rate of return on an investment does not, by itself, prevent the investment from qualifying as a PRI.  Another illustrates that a private foundation’s acquisition of an equity position in conjunction with making a loan does not necessarily prevent the investment from qualifying as a PRI and two examples illustrate that the private foundation’s provision of credit enhancement (such as a deposit agreement or a guarantee) can qualify as a PRI. 

As a result of the new examples, the Service has made it clear that the recipients of PRIs do not need to be within a charitable class if they are the instruments for furthering a charitable purpose. 
Thus, an investment in a for-profit that develops new drugs may qualify as a PRI if the for-profit business agrees to use the investment to develop a vaccine distributed to impoverished individuals at an affordable cost. Similarly, the purchase of equity in a benefit corporation or L3C that engages in the collection of recyclable solid waste or a below market rate loan to allow a social welfare organization formed to promote the arts purchase a large exhibition space may each also qualify for a PRI from the right foundation.

The new regulations should provide private foundation boards and managers in the second half of 2012 with the additional assurance they needed to make PRIs not only to traditional non-profits but to for-profit, benefit corporations and L3Cs with an articulated social enterprise consistent with the foundation’s exempt activities. Rejecting traditional boundaries between nonprofit and for-profit sectors, the PRI regulations can help encourage the most creative business minds achieve ‘double bottom line’ (financial and social) and sometimes ‘triple bottom line’ (financial, social and environmental) results.  By expanding the base for PRIs, we move beyond traditional conception of society as divided neatly into three sectors (business, nonprofit and government) help develop a new forth sector that encompasses elements of both business and nonprofit sectors. 

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    Joanne concentrates her practice in the areas of Business Law, Business Transactions,…
  • Jocelin A. Price Jocelin A. Price
    As an estate planning practitioner, Jocelin Price knows that the work of…
  • Lisa A. Bothwell Lisa A. Bothwell
    Lisa Bothwell counsels corporate/business clients on the formation, operation, acquisition, and sale…
  • Lynelle Gleason Lynelle Gleason
    Lynelle A. Gleason has spent her legal career in Bucks County, representing…
  • Megan Weiler Megan Weiler
    Megan Weiler is a skilled advocate dedicated to guiding clients and their…
  • Melanie J. Wender Melanie J. Wender
    Melanie J. Wender is a dedicated and supportive advocate for individuals and families…
  • Michael W. Mills Michael W. Mills
    Mike is devoted to helping businesses build value and improve working capital,…
  • Patricia Collins Patricia Collins
    Patty has been practicing law since 1996 in the areas of Employment…
  • Peter J. Smith Peter J. Smith
    Pete is a business lawyer and trusted partner to his corporate clients…
  • Stephen M. Zaffuto Stephen M. Zaffuto
    Stephen Zaffuto is a skilled and insightful Corporate and Real Estate attorney…
  • Susan Maslow Susan Maslow
    Sue concentrates her practice primarily in general corporate transactional work and finance…
  • Thomas P. Donnelly Thomas P. Donnelly
    Tom’s practice focuses on commercial litigation and transactions. In litigation, Tom represents…