At Cutting Edge Capital, we think a lot about the possible legal strategies that can advance community capital. There are the often-used (if not well-known) strategies like crowdfunding, direct public offerings, and charitable loan funds. But then there are strategies that have been on the books for decades but have seldom, if ever, been used as a vehicle for community capital. Sometimes innovation isn’t about doing something new, but rather doing something old in an innovative way.
Years ago, I helped a charitable organization set up a pooled income fund (a “PIF”). The idea of a PIF is that a contributor puts money or assets into a trust, where it is pooled with the contributions of other contributors and jointly invested. Income from the investments is distributed to the contributors (and often their spouses or other beneficiaries) for their lifetimes. Upon the death of each life beneficiary, the pro rata value of the fund at that time is removed from the trust and given over to the charity that sponsors the trust. A portion of the amount contributed is tax deductible to the contributor in the year of the original contribution, based on a formula that measures the actuarial value of the remainder interest that will eventually go to the charity.
Many foundations, universities, and other (usually large) charities have established PIFs as a planned giving device. From the point of view of these sponsoring charities, the purpose is to eventually receive the remainder interest upon the death of each contributor, though the charity may have to wait years, and sometimes decades. But with enough contributors in a PIF, it is inevitable that one by one they will pass on over the years, and those assets will come into the charity, as planned.
Meanwhile, the assets of the PIF are typically invested as most charitable assets are – in Treasuries, bond funds, perhaps some socially screened equity funds, but nothing that looks too risky. Big charities are a pretty conservative bunch. From the sponsoring charity’s point of view, the goal is to preserve and grow principal, while generating just enough income to fulfill the promises made to contributors.
So we went to work at this charitable organization, thoroughly researching the topic, developing a plan for how we wanted the PIF to work, and carefully crafting all the necessary legal documents, including a declaration of trust, a contribution agreement, and a disclosure document that explained everything. There was no discussion of using the PIF to make place-based investments – by which I mean investments in small ventures rooted in a local community that could contribute to a healthier and more resilient local economy. But I’ll come back to that in a moment. This PIF, like others, was to invest its assets fairly conservatively. And the charity would take a fee off the top for managing the fund.
When it was all finalized, we put it out there. And it flopped. The feedback was that anticipated annual returns, after deducting the charity’s management fee, just weren’t enough to make it attractive. Ultimately, the PIF attracted only a small handful of contributors before the organization pulled the plug and went through another hassle to unwind the PIF. It seemed like a lot of wasted effort.
Fast-forward to the present. Recently we at Cutting Edge Capital have focused on community investment funds as a critical tool for moving the needle forward significantly toward a more inclusive and equitable society. (We wrote about that here.)
But there are gaps in the legal landscape for community investment funds – a landscape dominated by the Investment Company Act of 1940. That law imposes a heavy regulatory burden on any investment fund that doesn’t qualify for an exemption, a burden so heavy that it is not financially feasible for a community-scale fund.
But, the 1940 Act includes a number of exemptions. It’s fairly simple to set up a charitable loan fund or a community-owned real estate fund, because each of those is exempt from the 1940 Act. However, there is no simple exemption strategy for a fund that makes equity investments in small businesses and is open for investment by the non-wealthy. There are a handful of exemption strategies that could work, but each of those strategies requires a fund to squeeze into a business model that may not align with what is needed.
In that context, we think the humble PIF deserves another look. The PIF fits within the charitable exemption from the 1940 Act because of the charitable remainder component. But even so, it can do what no other type of investment fund can do: It allows any number of investors of any level of wealth to pool their resources into a community-scale fund that can make equity investments in local businesses (along with any other kind of investments), with profits from those investments shared among the investors. No regulatory review is required, because of the securities law exemptions, which makes it efficient to set up. It’s like a local mutual fund without the regulatory burden.
There is, of course, the downside that the investors can’t get their money back because of the charitable remainder element. But that charitable remainder also brings a tax deduction, along with the knowledge that contributions will eventually go to a charitable cause. And depending on how the fund is invested, the years or even decades of income from a PIF may be far more valuable than the remainder interest. If the need arises, that life income stream can be transferred to another beneficiary.
Some may also argue that the assets of a PIF, being in a sense charitable assets, must be invested in a conservative way that does not accommodate the kind of small business equity investments that we are contemplating here. However, this argument is rooted in a false myth that fiduciary standards require charitable assets to be invested for capital preservation or for maximum financial return. While state laws vary, the general rule, as spelled out in the Uniform Prudent Management of Institutional Funds Act, is that charitable funds should be invested in a manner appropriate to the organization’s purpose – which could mean investing in local businesses, even if there is a higher risk of loss. The IRS recently underscored this point in a 2015 release on mission-related investing.
So a PIF can be much more than just a planned giving device that will eventually benefit the charitable sponsors. It can truly be an engine for local economic development that offers the benefits of investment to anyone in the community in an equitable and inclusive way. To date we are not aware of any PIF that is actually being used as a vehicle for community capital – that is, as a way for anyone to invest in the success of local businesses. However, in recent conversations that we’ve had, this idea has sparked significant interest, and we expect to see such a reimagined pooled income fund in action soon. So stay tuned.
Of course, nothing written here should be taken as legal, investment, or tax advice. If you would like to schedule a consultation with one of our principals at Cutting Edge Capital, click here.
Elizabeth Warren’s recently proposed Accountable Capitalism Act (“ACA”) has ignited a lot of controversy, with supporters hailing it as the way to save capitalism, while others argue that it will destroy capitalism. In my view, while it is a step in the right direction, there is a better way to solve the problem – more effectively and with less controversy.
But first, let’s take a quick look at what the Accountable Capitalism Act would do. Most significantly, it would require any corporation with over $1 billion in revenue to obtain a charter from a newly-created Office of US Corporations. This charter would expressly require the corporate board of directors to consider the interests of all the corporation’s constituents, including shareholders, customers, employees, and the communities in which they operate.
As our friends over at B Lab have reported, the ACA would essentially require that large corporations become benefit corporations. The benefit corporation is a new type of corporation authorized in recent years by legislation in several states. A benefit corporation is much like a regular corporation except that its management is explicitly empowered to consider the interests of constituencies other than its shareholders, it must provide an annual report to shareholders based on a third-party standard, and its managers are protected from liability when they do consider those other constituencies.
Both of these solutions — the benefit corporation and this proposed new federal corporate charter – are attempts to fix what Forbes describes as a “source code error in the operating system of capitalism” – the notion of shareholder primacy.
Shareholder primacy, sometimes referred to as shareholder value maximization, refers to the idea that a corporation’s sole purpose is to maximize profits for its shareholders. It has been cited as supposedly requiring that a corporation disregard the impacts of its actions on its employees, on the environment, and on the broader community in which it operates if any of those are in conflict with the maximization of profits. And, it is believed, a corporate director or manager who acts in a way that benefits some other constituency but doesn’t maximize profits may be personally liable to shareholders.
It’s easy to see how the notion of shareholder primacy can lead corporations to act in a sociopathic way, with single-minded devotion to profit at the expense of all else. Stock-based compensation to corporate managers incentivizes this myopic focus on shareholder profit, and fear of personal liability for doing otherwise strikes fear into their hearts. Given the enormous wealth and power held by corporations, it is also easy to see how this could cause great harm to all other constituencies, including employees, communities, and the environment.
Not surprisingly, the notion of shareholder primacy has been widely criticized. The late Cornell law professor Lynn Stout, in her 2012 book The Shareholder Value Myth, explains how putting shareholders first not only harms the public, but also harms corporations and their investors. Jack Welch, the former CEO of GE, famously described it as “the dumbest idea in the world.” It is frequently cited as the main reason wages have been stagnant for the past four decades, even as the wealthy have become far wealthier.
So what is the solution? The benefit corporation and Elizabeth Warren’s proposed federal corporate charter both seek to solve the problem by creating a new type of corporation that isn’t saddled with the myth of shareholder supremacy. And yet, while I applaud the good intentions behind both fixes, they share one critical flaw: They implicitly acknowledge that shareholder primacy is the law of the land. But is it?
Those who believe it is the law of the land may be surprised to learn that the notion has never been codified into any statute; and no court has ever ruled that it is the law in any general sense. Quite to the contrary, the well-established business judgment rule explicitly protects managers of a corporation for actions taken in good faith pursuit of the corporation’s best interests – even if those actions don’t necessarily maximize profit for shareholders. It is important to recognize that there are many things that may be in the corporation’s best interests but don’t maximize profits (at least not in the short term), such as R&D, new product development, employee training, community engagement, reductions in environmental footprint, and supporting local charities.
And yet, the notion that a corporate manager’s sole obligation is to maximize profits has become so widespread that it has become the de facto standard for corporations across America since the 1990s. In other words, even though it is not the law, the widespread belief that it is the law has contributed to the concentration of wealth, the impoverishment of workers, and environmental harm – as well as reduced long-term profitability of American corporations, as we’ll see in a moment.
In this context, a solution that implicitly validates this dangerous and destructive myth of shareholder primacy is a solution that just might do more harm than good. A better solution is to explicitly reject the myth altogether, and not just for certain kinds of corporation, but for all corporations.
While this may sound revolutionary, it is not. In fact, the notion of shareholder primacy only gained widespread acceptance in recent decades; it was not always that way.
The corporation as a type of legal entity came into existence as a means of achieving social purposes. The Hudson Bay Company, for example, was chartered in 1670 for the purpose of promoting trade, not for the purpose of enriching shareholders. Early corporations did pay dividends to their shareholders, but that was because investors needed some incentive to invest the capital that corporations needed. The dividend was a means to an end; it was never the primary purpose.
Shareholder primacy as we know it only came into prevalence in the 1980s and 1990s. Milton Friedman, probably its most famous proponent, preached that a narrow focus on maximizing profits would lead to improved corporate performance. And yet, history has shown otherwise. Author and economist James Montier has compared average corporate performance during what he terms the era of managerialism (1940 to 1990 – that is, before shareholder primacy took hold) and the era of shareholder primacy; and he has shown empirically that the single-minded focus on profit in recent decades has led to lower corporate performance. He points to several mechanisms for why this is so, including reduced funding for research and development (because more of a corporation’s profits are paid out to investors), lower employee satisfaction (because compensation is reduced and because their idea of the purpose for why they are there has become confused), and more focus on short-term results rather than long term results (because both corporate lifespans and manager tenures have gone down).
Black Rock, the biggest private asset manager in the world (with over $6 trillion under management), understands this, perhaps better than anyone. Its CEO Larry Fink penned a letter this past January to corporate CEOs explaining that it is time for all companies to make “a positive contribution to society.”
So how do we bring about a repudiation of the myth of shareholder primacy? It would be nice if there was a Supreme Court case confirming that shareholder primacy is not and never was the law of the land. That would lay the matter to rest. But it is unlikely that a case of that sort will work its way through the appellate process and reach the Supreme Court. Another solution would be for state legislatures to amend their corporation laws to explicitly state that managers will not be liable for actions taken in good faith after balancing the interests of all the corporation’s constituencies.
But we should remember that the pickle we are in is not because of bad laws, but because of widespread, albeit mistaken, beliefs about the law. In other words, it is a cultural problem. That being the case, there are ways in which we can all help bring about the demise of the shareholder primacy myth without waiting for any laws to change. We can write about it and speak about it. We can remind corporate managers that they can and should consider the interests of all constituencies. Business owners and managers can ensure that their own businesses adopt a more balanced perspective. We can include an express statement of corporate purpose in charter documents for our legal entities even if they are not formally organized as benefit corporations.
Running a business is never easy, and raising capital is typically even harder – made more so because investors have come to expect that shareholder primacy is the law of the land, and some work hard to insert priority rights to protect the financial investments they manage. While that may lead to quicker short-term profits, it does not lead to a healthy company. Our collective challenge is to help investors and corporate managers to understand that a balance must be struck that honors intellectual capital, human capital, stakeholder capital, and financial capital. When any one of those takes precedence, there are unintended consequences that damage the entire ecosystem of capital.
Circling back to Elizabeth Warren’s Accountable Capitalism Act, I note that it includes some other excellent ideas. For example it would:
- Require that at least 40% of the board of directors of these new US corporations be elected by the corporations’ employees – thus putting more control in the hands of those who care most deeply about the corporation’s purpose.
- Restrict sales of company stock by its directors and officers for three to five years – which is intended to better align their interests with long-term shareholders rather than short-term shareholders.
- Prohibits US corporations from spending any money on lobbying without 75% approval by both its board of directors and its shareholders.
Yet even if the ACA does not actually become law, our hope is that it furthers a very important conversation about the role and purpose of corporations in our economy. We can no longer take bad ideas for granted as simply the way things should be. We need to envision a better way.
Naturally, nothing here should be considered legal, investment, or tax advice. If you would like to like to discuss capital raising or entity structuring with one of us at Cutting Edge Capital, click here
Since 2015, a bipartisan coalition of lawmakers has advocated for tax incentives for those who invest in low-income communities, recognizing that the benefits from the economic recovery have largely bypassed those communities. Their efforts were rewarded when their proposed opportunity zone program was included as Subchapter Z of the 2017 tax law overhaul that was passed in December. While Subchapter Z wasn’t specifically tailored to community capital, it offers tax incentives that will apply to some kinds of community investment funds.
First, here’s how the new law works: A taxpayer with capital gains can defer capital gains tax if they sell their appreciated assets and, within six months, roll over the profits into a “qualified opportunity fund.”
But it gets better. Investors in the qualified opportunity fund who hold their investment for at least 5 years will have their basis bumped up by 10% of the deferred gain (thus reducing their capital gains tax), and by another 5% if they hold it for 7 years. In 2026, there will be a realization event (in which investors are taxed on the other 85% of the original profit invested in the fund, assuming the investment has been held for 7 years). But if they continue to hold their investment for at least 10 years, their basis is bumped up to the market value of their investment, which means any further capital gains tax is eliminated completely.
A qualified opportunity fund is a partnership or corporation with at least 90% of its assets consisting of qualified opportunity zone property (and acquired after 12/31/2017), which can include:
- Equity interests in a corporation or partnership that is an opportunity zone business (and issued directly by the corporation or partnership, not acquired in secondary sales); or
- Tangible property (real or personal) located in the opportunity zone that is either first used by the fund or is substantially improved by the fund (the latter meaning that additions to its basis exceed its original basis).
A business is an opportunity zone business if:
- Substantially all of its tangible property is located in the opportunity zone;
- At least 50% of its gross income is derived from operations in the opportunity zone;
- A substantial portion of its intangible property is used in its operations in the opportunity zone; and
- Securities comprise less than 5% of its total assets by tax basis.
While this new law provides tax incentives to invest in funds that serve low-income communities, it does not provide any new strategies under the securities laws. It is probably inevitable that the vast majority of qualified opportunity funds will be open to accredited investors only, like nearly all private funds.
However, there are at least three strategies that allow a qualified opportunity fund to be open to its entire community, including non-accredited investors:
- Real estate fund: A fund whose primary business is investing in real estate and 90% of whose assets consist of real estate in an opportunity zone will be a qualified opportunity fund and will be exempt from the burdensome regulations of the Investment Company Act of 1940 (the “1940 Act”), which paves the way for the fund to raise capital via a direct public offering – making it a true community investment fund.
- Small business holding company: This type of fund is exempt from the 1940 Act if most of its assets comprise controlled or majority-owned subsidiaries – the idea being that the fund is in whatever business its subsidiaries are in, rather than in the securities investment business. Again, if 90% of its holdings are businesses in opportunity zones, it will also be a qualified opportunity fund.
- Intrastate fund: A closed-end fund of up to $10 million, all of whose investors reside in the same state, is eligible to seek an exemptive order from the SEC that allows it to raise community capital via a direct public offering and while avoiding all or most of the 1940 Act’s regulations. Such a fund could invest in either business or real estate in opportunity zones and thereby also become a qualified opportunity fund.
With any of these strategies, a community-scale fund can open up the opportunity for community ownership of community assets, with everyone able to participate on a level playing field, and everyone able to reap the profits from local ventures.
It should be noted that governors of each state had until late March to designate low-income census tracts as opportunity zones, but some have asked for a 30-day extension. However, only 25% of the low-income communities in each state may actually be designated as opportunity zones. It remains to be seen which communities will actually win that designation.
But community investment funds can be offered to the public in any community anywhere in the U.S. At Cutting Edge Capital we believe community investment funds are an effective way to significantly move the needle toward a more inclusive, democratic and decentralized economy.
If you would like to see this happen in your community, here are some steps you can take:
- Look at this map, which shows the census tracts that may be eligible for designation as an opportunity zone.
- If your community includes eligible census tracts, write to your governor, asking him or her to designate those tracts in your community as an opportunity zone.
- If you would like to see community investment funds serve your community, fill out our intake form to make an appointment with us to explore the kinds of funds that can be offered in your community.
“[T]his is a fundamentally pluralist vision, in which multiple forms of public, private, cooperative, and common ownership are structured at different scales and in different sectors to create the kind of future we want to see. The vision begins and ends with the challenge of community. If it does not meet the test of everyday life in the communities in which we Americans live, it does not meet the test of serious long term change.”
Gar Alperovitz writes these words in his introduction to Principles of a Pluralist Commonwealth – in which he shares his vision of a new political economy. In it, he explains how a transformation in the ownership of capital is at the very core of the changes that are needed on the path toward a system that works for all and not just for the wealthiest few.
At last week’s ComCap17 conference in Monterey, we collectively put these words into practice. We brought the ideal down to the ground level and worked through how to actually create these diverse forms of ownership. And indeed, perhaps the most important theme that emerged in the conference is that there are a variety of effective tools in our toolbox to help us get there.
To be sure, much of the discussion at ComCap17 was about one particular collection of strategies – state securities exemptions for intrastate crowdfunding, which is now available in some 37 states. But as pointed out by a number of speakers, including my team from Cutting Edge Capital, there are several other strategies available to raise community capital, including direct public offerings and community investment funds.
And clearly, there is no one-size-fits-all. Each strategy has its advantages and disadvantages, and each has a “sweet spot” where it is most effective. For example, where an enterprise wants to raise capital directly from its community:
- State-specific exempt crowdfunding can work well for small offerings where the investors are all within one state.
- Exempt crowdfunding under Reg CF (Title III of the JOBS Act) can be effective for offerings up to $1 million where investors are in multiple states.
- Intrastate direct public offerings are usually best for larger raises (i.e. any amount over the applicable exempt crowdfunding limit) where investors are all in one state.
- Rule 504 offerings are often best for offerings up to $5 million where investors are in multiple states.
- Regulation A offerings are best for offerings from $5 million to $50 million where investors are in multiple states.
Of course, these strategy choices are more nuanced than this, and a big part of our work at Cutting Edge Capital is helping our clients figure out which strategy among these and others best aligns with their values and strategic goals. (And then, together with our sister law firm Cutting Edge Counsel, we take our clients through the regulatory process until they have raised the capital they need.)
And yet, even these direct offering strategies are just the beginning. Indeed, most of them remain underutilized. It remains that case that a typical person living in a typical American town has virtually no local investment options; or if such options exist, they are hard to find. So how do we move the needle much faster toward a world in which community capital is truly ubiquitous and everyone has opportunities to invest locally in any town in America?
Community investment funds are the key to scaling up community capital and taking it from the fringe to the mainstream – whereby everyone thinks about local investing before they think of investing in Wall St. Besides scalability, community investment funds also have the advantages of diversification and greater efficiency in raising community capital, and they can typically offer more liquidity (that is, opportunities to get your money back) than a typical business can.
With investment funds, there are strict legal limits on what can be done, but as with capital-raising strategies, there is an array of options – which my partner Kim Arnone and I described in our ComCap17 workshop on Wednesday morning. A few options that allow a community-scale fund to raise capital from the community include:
- Charitable loan funds, which raise debt investment and deploy it for some charitable purpose.
- Real estate funds, which could focus, for example, on urban revitalization, agricultural land preservation, or affordable housing.
- Supplemental funds that are an outgrowth of some other primary business, such as business services, co-working space, incubator, or grocery coop.
- Intrastate funds up to $10 million – though these require explicit SEC approval.
And that’s still not all; there are other innovative strategies not mentioned here that can be explored. The community capital movement is ripe for creative thinking about what could be, and what is possible under the law.
At ComCap17, there was much discussion about new laws or changes in the laws that would help our movement; and at Cutting Edge Capital we have our own wish list of changes we believe would help boost this movement. But let’s not let imperfections in the laws distract us from the fact that most of what is described here can be done in every state in the U.S. today. There’s no need to wait.
In the big picture, what we’re doing in this movement is taking back our economy, restoring economic power to communities, and leveling the playing field so that everyone of every economic class has an opportunity to participate fully and reap the benefits of our economy.
But at a deeper level, this movement is about more than just the economy. As Teddy Roosevelt said, “There can be no real political democracy unless there is something approaching an economic democracy.”
Community capital is about true democracy. Let’s make it happen!
These past few months have shown us an America more politically polarized than ever. Any proposed solution is viewed through a conservative vs. liberal lens, and each side vows to oppose any proposal by the other. So it may be worth asking where community capital fits on that spectrum.
As our readers know, the term “community capital” refers to community-focused investment opportunities that are open to anyone in the community, including both wealthy and non-wealthy investors; in other words, everyone can participate in community capital. But is that a liberal idea or a conservative one?
Our answer: Both. And neither.
You could say that community capital is conservative because that is the way capital was raised for centuries until economic power became concentrated on Wall Street in recent decades. But you could also say it is liberal because it defies the dominant Big Money-driven paradigm.
It is conservative because it is fundamentally pro-business. It is liberal because it reflects the belief that business can be a force for good.
It is conservative because it restores economic power to local communities. It is liberal because it restores economic power to local communities. Oh wait, what was that?
Maybe the traditional liberal vs. conservative distinction just doesn’t make sense when we’re talking about democratizing the economy and empowering everyone to invest, grow local businesses, and build wealth in their communities. Don’t we all want those things regardless of our political views?
It’s true that our firm is based in left-leaning Oakland, California.
we be able to all have a similar answer. I don’t think so. We as a whole have distinctive parts of it hotstar We cherish altogether different things to do with regards to engaging ourselves
But our work transcends the political divide. Our mission is to build an economy that works for all. The economy we envision offers opportunities for everyone, regardless of economic class, to participate in the economy, profit from investments, and thereby to build wealth, while financing the growth of local businesses and other values-aligned ventures. When this happens, everyone benefits.
In fact, we see our work as a way for liberals and conservatives to work together toward a common goal. Perhaps the distinctions between those two groups aren’t as important as our common interests. We all want a fair and equitable economy, with opportunities for everyone to achieve their full potential. And we all hope this results in a safe, prosperous, and cohesive community where we live and beyond. Maybe it’s time to forge a movement to democratize the economy and seek these common goals, a movement that includes both liberals and conservatives.
Strange bedfellows? Maybe not so strange.
At Cutting Edge Capital, we’re fortunate in that there is no real opposition to what we do. Our biggest challenge is simply the need for education: Entrepreneurs don’t realize it’s possible to raise capital from their own community. Regular people don’t realize it’s possible to invest in local businesses or in alignment with their values. They only know what Wall Street offers, and they have learned to live with those disappointing options. Because that’s just the way it is. Except that it doesn’t have to be.
We would love your help in getting the word out about what’s possible. How? Invest in local businesses, nonprofits, and community investment funds. Tell your friends about direct public offerings. Help start a community investment fund in your community if there isn’t one already. Little by little, we can together change the culture, and make community capital as ubiquitous as a corner convenience store. Are you in?