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Conflict Resolution in Social Purpose Corporations

King County Bar Association
December 10, 2012


Last year, Washington adopted a statute allowing social purpose corporations. These are corporations that are allowed to have objectives other than profit. Application of RPC 1.13 may become an important monitoring mechanism for these new organizations.

Directors of for-profit, not-for-profit and social purpose corporations all have similar duties of good faith to the corporation. When officers or directors take bad-faith actions contrary to the for-profit corporation's ultimate goal of maximizing shareholder profit, corporate counsel has a clear duty under RPC 1.13 to report such malfeasance to the highest authority.

Directors of not-for-profit corporations are similarly prohibited from taking actions contrary to the corporation's charitable purpose, and although it is the attorney general who protects the public from not-for-profit malfeasance, counsel has a similar duty under RPC 1.13 to report.

Although the application of the "up-the-chain" reporting requirements of RPC 1.13 is unusual and extreme, such application to Washington's new social purpose corporations ("SPC") might become more common because the path of enforcement of the organizations' dual purposes is not clear under Washington's statute. A lawyer's ethical duty to potential shareholders and to the corporation's social purpose may be an important defense of the SPC's stated purposes.

Growing Popularity of SPCs and Similar Entities

An SPC is a Washington corporation that has organized itself to pursue one or more social purposes. An SPC requires:

  • A corporate name that contains the words "social purpose corporation" or "SPC;"
  • A statement that the corporation is organized as a social purpose corporation governed by the Social Purpose Corporation Chapter of Title 23B RCW;
  • A statement setting forth the general social purpose or purposes for which the corporation is organized pursuant to Section 3 of the Act (Section 3 says, "Every corporation governed by this chapter must be organized to carry out its business purpose under RCW 23B.03.010 in a manner intended to promote positive short-term or long-term effects of, or minimize adverse short-term or long-term effects of, the corporation's activities upon any or all of (1) the corporation's employees, suppliers, or customers; (2) the local, state, national, or world community; or (3) the environment.").
  • A provision stating the following: "The mission of this social purpose corporation is not necessarily compatible with and may be contrary to maximizing profits and earnings for shareholders, or maximizing shareholder value in any sale, merger, acquisition, or other similar actions of the corporation."

Other states offer similar not-solely-for-profit corporations, commonly called an "L3C" for limited liability low-profit corporation. Vermont was the first state to enact social purpose corporation legislation in 2008; since that time, Michigan, Wyoming, Utah, Illinois, Maine, Louisiana, North Carolina, Rhode Island, the Oglala Sioux Tribe and the Crow Indian Nation of Montana have adopted similar legislation.1

How Is Good Governance by the Directors and Officers Enforced?

In Washington, directors and officers of for-profit corporations have fiduciary duties of care, loyalty and good faith.2 While directors of for-profit companies are primarily tasked with maximizing shareholder wealth, the business judgment rule provides directors with wide latitude in how they go about attempting to achieve this end.

For example, under Washington law, a court will not substitute its judgment absent evidence of bad faith.3 In Washington, plaintiffs may bring a general claim of breach of fiduciary duty against directors as long they show that the directors' acts or omissions involved: (1) intentional misconduct; (2) a knowing violation of law; (3) conduct violating RCW 23B.08.310 (which includes discharging duties in good faith under RCW 23B.08.300); or (4) any transaction from which the director will personally receive a benefit in money, property or services to which the director is not legally entitled.4

The nonprofit world is similar. Directors and officers of a nonprofit corporation are not liable to the corporation or members except for: (1) intentional misconduct; (2) knowing violation of the law; or (3) a transaction from which the director will receive a benefit to which the director is not legally entitled.5

In some jurisdictions, a focus on charitable purposes is embodied in the "duty of obedience." The duty of obedience does not have a counterpart in the law governing for-profit organizations and has been said to be key to holding directors legally accountable to their organization's charitable purpose and to donors' legitimate expectations.6

There are no Washington cases adopting or applying the "duty of obedience." There are very few cases and no Washington cases in which a director sues the nonprofit for failure to adhere to the organization's charitable goals. It is the attorney general who brings an action on behalf of the public to enjoin, correct or otherwise remedy a breach of a charitable trust. Few such cases exist.

Under the requirements of RCW 23B.08.300, SPC directors must serve the organization in good faith and carry out directorial duties, just as in a for-profit corporation. But directors and officers of Washington SPCs have neither the task of maximizing shareholder wealth nor any duty of obedience to the corporation's social purposes. This is due to the SPC's hybrid nature; SPCs were created to serve, at least to some extent, both masters (profit and charity).

Application of RPC 1.13 to the Social Purpose Corporation

SPCs lack the clear duties to shareholders that govern for-profit corporations, and do not have any implied duty of obedience to a not-for-profit corporation's purposes. Because it serves two masters, the SPC organization appears less amenable to standard governance and oversight, making the protection of RPC 1.13 all the more important.

Application of the attorney's duties to the corporation, regardless of form, remains clear. In the case of SPCs, application of a lawyer's duties under RPC 1.13 is not only required by the rules of ethics, but also provides necessary oversight, as the following example illustrates.

Assume you are counsel for a new SPC that sells widgets with stated purposes of preserving seaweed in its natural environment and keeping a happy workforce. For a time, things go swimmingly; seaweed is protected from harvest, employees are happy and the SPC has investors that are pleased with its financial numbers.

But over time, widget sales fall. Desperate to keep the corporation going, some of the SPC officers to whom you report institute a secret seaweed harvest, selling the seaweed to supplement producers. With this secret program in place, the investors remain pleased with the SPC.

As corporate counsel, you now know of the seaweed harvest. Seaweed harvesting is not illegal. The investors remain satisfied. The attorney general will not be interested in the officers' legal activity. But the SPC has violated one of its purposes. Application of RPC 1.13 provides the mechanism for correction.

Under RPC 1.13(b), if a lawyer for an organization knows that an officer is engaged in action that is likely to result in substantial injury to the organization, the lawyer must refer the matter to the highest authority that can act on behalf of the organization. Will continuing the seaweed harvest likely result in substantial injury to the organization? Yes, because it violates the organization's stated purpose. The rule requires the lawyer to report the officers' secret harvesting program to the board.

The authors of Model Rule 1.13 stress that invoking this rule is expected to be extremely rare. That was in the context of a for-profit corporation with normal structures of corporate oversight.

SPCs are provided with the defense against some methods of oversight, such as shareholder derivative suits for failure to maximize profits. In this context, it may be more realistic to expect RPC 1.13 to be invoked in an SPC than in an ordinary for-profit corporation.

1 See J. Haskell Murray & Edward I. Hwang, "Purpose with Profit: Governance, Enforcement, Capital-Raising and Capital-Locking in Low-Profit Limited Liability Companies," 66 U. Miami L. Rev. 1, 4 n.12 (2011).

2 See Grassmueck v. Barnett, 281 F. Supp. 2d 1227, 1230 (W.D. Wash. 2003).

 3 In re Spokane Concrete Prods., Inc., 126 Wn.2d 269, 279, 892 P.2d 98 (1995); see RCW 23B.08.300, .420 (requiring directors and officers to act reasonably and in good faith).

4 Grassmueck, 281 F. Supp. 2d at 1233; RCW 23B.08.320.

5 RCW 24.06.035.

6 Murray & Hwang, note 1, at 37.

As published, Bar Bulletin, King County Bar Association, December 2012.