REPORT ON PROPOSED REVISIONS TO THE NEW YORK NOT- FOR-PROFIT CORPORATION LAW

 

PREPARED BY THE NEW YORK COUNTY LAWYERS’ ASSOCIATION NON-PROFIT ORGANIZATIONS COMMITTEE

 

THIS REPORT WAS APPROVED BY THE BOARD OF DIRECTORS OF THE NEW YORK COUNTY LAWYERS’ ASSOCIATION (NYCLA) AT ITS REGULAR MEETING ON JUNE 13, 2011.

 

Executive Summary

 

The New York Not-for-Profit Corporation Law, frequently referred to as the “NPCL,” has not seen thorough revision since it was enacted over forty years ago. Because of the difficulties created for non-profit1 corporations by outdated and idiosyncratic provisions in the NPCL, many New York practitioners now choose to incorporate non-profit organizations in other jurisdictions, even though such corporations will be required to register with the New York State Attorney General and file an application for authority with the New York Department of State to conduct fundraising and other activities in New York.

 

In the last few years, there has been a growing call for reform of the NPCL. Because of the extent of the energy and resources that would be required to overhaul the law, a comprehensive revision of the NPCL is unlikely to take place in the near future. However, there are more discrete changes that could bring greater clarity, simplicity and relevance to the law. This report provides a summary of some of the proposals for reform of the NPCL that have been advanced recently, in particular the exceptional proposal of the New York State Bar Association’s Corporation Law Committee, and recommends several changes to the law that address some of the more urgent needs of New York’s non-profit sector.

Introduction

 

In 1970, the NPCL became effective and replaced the New York Membership Corporations Law, which was enacted in 1895. The NPCL was the product of a substantial and comprehensive legislative effort. In 1956, the New York legislature established a joint legislative committee to study New York’s law pertaining to corporations. After the joint committee undertook an extensive review of the law regulating business corporations, New York enacted a new Business Corporation Law in 1961. The committee then undertook a similar review of New York’s Membership Corporations Law. The committee adopted a “study approach” to drafting, producing eighty-two research reports and seeking extensive comments and input from a diverse group of parties. The result of this process was the NPCL. In contrast to the resources expended in producing the NPCL, the law has not been thoroughly revised since its enactment.

 

In May 2007, the Corporation Law Committee of the New York State Bar Association proposed a comprehensive revision of the NPCL (the “State Bar Proposal”). In drafting the State Bar Proposal, the Corporation Law Committee sought to conform the NPCL to New York’s Business Corporation Law and to eliminate many of the NPCL’s idiosyncratic provisions that create undue complexity in the formation and operation of non-profit corporations in New York State. Former Assemblyman Richard Brodsky and State Senator John Flanagan first introduced bills in the New York State Assembly and Senate to enact the State Bar Proposal in 2008. Mr. Brodsky did not seek reelection to the Assembly in 2010, but his successor, Tom Abinati, has expressed interest in resubmitting the State Bar Proposal bill. As of the date of this report, Senator Flanagan has not elected to resubmit his bill.

 

The State Bar Proposal is a pivotal effort in the movement to reform the NPCL and opens a much-needed dialogue on the current state of non-profit regulation in New York. This report will highlight several areas of reform addressed by the State Bar Proposal that are especially worthy of attention because they address urgent needs of the New York non-profit sector. In particular, the New York County Lawyers’ Association Non-Profit Organizations Committee (the “Committee”) recommends that the reforms enumerated below be adopted immediately.

• Eliminate the Type C classification for non-profit corporations.

 

New York regulates non-profit corporations according to a unique system of statutory “Types.” Under the NPCL, non-profits are classified into one of four Types, labeled A, B, C and D. Type A corporations may be formed for “any lawful non- business purpose or purposes,” including “civic, patriotic, political, social, fraternal, athletic, agricultural, horticultural, animal husbandry, and for a professional, commercial, industrial, trade or service association.” Although not entirely clear from the face of the statute, the Type A classification was ‘“intended to cover the usual member type organization where the support of the organization is derived from a limited class called “members” and where the non-pecuniary benefits flow primarily to such limited class.’” Type B corporations are those formed “to benefit a broad class of society or society in general, as distinguished from a group of members” and for purposes that generally overlap with the purposes listed in section 501(c)(3) of the Internal Revenue Code (the “Code”). Type C corporations can be formed for “any lawful business purpose to achieve a lawful public or quasi-public objective,” and thus include “commercial” non- profits that engage in activities similar to those of for-profit businesses. The NPCL introduced the Type C category to fill a previously existing gap between for-profit business corporations formed under the Business Corporation Law and non-business, non-profit corporations formed under the Membership Corporations Law: the corporation that performed commercial activities in furtherance of a non-profit purpose. The Type D category is for non-profit corporations that are authorized under other laws and is designed to eliminate the need to set forth in such laws basic provisions for meetings and other corporate activities that are found in the NPCL.

 

The regulation of a non-profit corporation under the NPCL depends on its Type. Type B corporations are generally subject to the heaviest regulation under the NPCL, while Type A corporations tend to be subject to the lightest. Type B corporations are not currently required to have any members, while Type A, C and D corporations are. Despite the importance of a corporation’s Type, the distinction between Types can be unclear, especially that between Type B and Type C corporations. One organization might be classified as a Type B corporation while a similar organization might be classified as a Type C corporation. For example, a dance company or other performing arts non-profit could be viewed as an educational organization benefitting the public at large (a Type B corporation) or as a non-profit benefitting the public that engages in the business of putting on performances (a Type C corporation). Organizations that submit certificates of incorporation for Type B corporations frequently have their certificates rejected on the basis that an enumerated purpose that has commercial overtones causes the organization to be a Type C corporation. Upon deletion of the offending provision, the certificate is approved as describing a Type B corporation. Such a devotion to form over substance is an indication of the flimsiness of the distinction between the two types.

 

An early critic of New York’s scheme labeled it ‘“a nightmare for state and federal regulatory agents.’” The system has also been described as “awkward and ambiguous.” At the request of the Department of State, State Senator Bill Perkins introduced a bill in the Senate that would eliminate the Type C classification from the NPCL and designate as Type B corporations all non-profits formerly classified as Type C corporations. The sponsor’s memo for the bill notes that

 

the ‘Type’ classification system….unnecessarily complicates the formation and regulation of not-for-profit corporations….Additionally, the Department of State has been advised by practitioners that not-for-profit corporations classified as ‘Type C’ frequently encounter difficulties in receiving an IRS tax exemption as a result of such classification. This proposal would simplify the current classification system by combining the ‘Type C’ and ‘Type B’ classes of not-for-profit corporations into a new ‘Type B’ classification. Elimination of the ‘Type C’ classification will encourage and simplify the formation of not-for-profit corporations in New York State.

 

The State Bar Proposal would go a step further by eliminating the Type classification system completely and instead treating all non-profit corporations equally. For example, the State Bar Proposal would make membership optional for all non-profit corporations. Under the State Bar Proposal, the purposes for which a corporation is formed and assets are received would replace Types as markers of the need for Attorney General or judicial oversight. The State Bar Proposal retains for any Type of non-profit corporation the existing requirement in the NPCL that the non-profit not conduct activities “for pecuniary profit or financial gain, whether or not in furtherance of [the non-profit’s] corporate purposes, except to the extent that such activity supports or is incidental to its other lawful activities then being conducted.”

 

Although the elimination of the Type classification system would bring simplicity and clarity to the law, the State Bar Proposal does not address the complications that will arise from such a sudden and complete overhaul. Completely eliminating the Type classification system without distinguishing between organizations that primarily benefit the public and those (such as social clubs) that primarily benefit their members could produce unfortunate results, by, for example, holding mutual benefit organizations, which are formed as Type A corporations under current law but which do not benefit from the same beneficial tax rules as public benefit organizations, to the same standards as public benefit organizations. Retaining the distinction between mutual benefit corporations currently classified under Type A and other non-profit corporations would produce a sensible classification scheme that is used in a number of other states. Retaining the current Type D classification would also provide needed continuity for non-profit corporations formed under laws other than the NPCL that look to the NPCL for basic rules of corporate governance.

 

Although the distinction between Type A and B corporations is rooted in fundamental differences between the segments of the population served by those corporations, the distinction between Type B and C corporations is not. It is questionable whether a Type C corporation that meets the requirements in the NPCL that it not conduct activities “for pecuniary profit or financial gain” and that it be formed “to achieve a lawful public or quasi-public objective” is sufficiently different from a charitable, Type B corporation to justify different classification and treatment merely because the former engages in “commercial” activities. The only special non-profit corporation expressly designated as a Type C corporation in the NPCL is a local development corporation, which is operated “for the exclusively charitable or public purposes” of relieving unemployment, improving job opportunities, training individuals and lessening the burdens of government, among others. These purposes easily fall within the scope of what are generally considered to be charitable or public purposes. Given the flimsiness of the distinction between Type B and C corporations, it is questionable whether Type C corporations should be subject to less strict regulation than Type B corporations, as is currently the case.

 

An organization that conducts substantial trade or business activities can qualify for federal tax exemption under Code section 501(c)(3) so long as such activities are in furtherance of an exempt purpose and the primary purpose of the organization is not to carry on a trade or business unrelated to an exempt purpose. Because New York State generally relies upon a determination of federal tax exemption in granting state tax benefits, the arbitrary classification of a corporation as a Type C corporation prior to a determination of the corporation’s federal tax status creates unnecessary confusion, as indicated in the sponsor’s memo for Senator Perkins’s bill. The reliance of New York State on federal determinations of tax-exempt status is another fact favoring the elimination of the Type C classification, as the Type classification system does not track federal tax classifications.

 

The Committee recommends the elimination of the Type C classification from the NPCL. A provision automatically re-designating as Type B all corporations previously classified as Type C should be included to eliminate confusion over their regulation going forward. Because laws other than the NPCL refer to a non-profit corporation’s Type in subjecting it to regulation, transitional rules may be required by the elimination of the Type C classification. Eliminating the Type C classification will bring clarity to the law and will simplify and streamline the process of incorporating and obtaining tax- exempt status for non-profits in New York.

• Limit the scope of organizations currently required to seek the consent of the Department of Education to various filings.

 

In addition to its unique Type classification system, New York has burdensome agency consent requirements that have also long been the subject of criticism. Under the NPCL, a non-profit corporation must generally obtain consent to its Department of State filings from the state agency or other governmental entity that regulates the kinds of activities conducted by the non-profit.Such consents are currently required for a variety of filings, including certificates of incorporation, certificates of merger, certificates of dissolution and applications by foreign corporations to conduct activities in New York. This process demands significant time and resources from both non-profits and the governmental bodies from which such consents are required. The consent requirements are in addition to any required agency regulation, such as that of schools by the Department of Education or of hospitals by the Department of Health. However, the consent requirements can also affect organizations that are not otherwise subject to such special regulation. The lack of such requirements in other states has led many practitioners to incorporate non-profit organizations in other jurisdictions. A particularly popular alternative is to form a non-profit corporation in Delaware, where non-profit incorporation can be accomplished with the same ease as for-profit incorporation.

 

The State Bar Proposal would largely eliminate the requirement of agency consents to various corporate filings. New provisions would clarify that non-profit corporations remain subject to the regulatory authority of state agencies and governmental entities created in any other statute, rule or regulation. Under the State Bar Proposal, non-profit corporations would still be required to provide notice of any filing previously requiring consent to the relevant state agency within thirty days after the filing is made. Such agencies would thus continue to be notified of the activities of non-profit corporations that operate in areas over which they have jurisdiction.

 

At the time of the statute’s enactment, the provisions of the NPCL requiring agency consents represented a movement away from an onerous and subjective system of judicial review, the legitimacy of which had been undermined by First Amendment challenges to rejections of applications for incorporation. State agencies, however, quickly began to exercise a similarly problematic amount of discretion in granting and withholding consents. The New York Court of Appeals ultimately limited that discretion. The wholesale elimination of the agency consent requirements would thus represent another step in a gradual trend towards deregulation.

 

Although the current system of agency consents can, in many instances, be characterized by a lack of substantive agency review, the prospect of the wholesale elimination of the system raises a number of issues. The Committee recognizes that the elimination of the requirement of agency consents to certain filings, such as certificates of merger and certificates of dissolution, may raise substantive concerns, including concerns about the appropriate use of charitable assets. The Committee also recognizes that the regulation of many of the organizations specified in the NPCL as requiring agency consents, such as hospitals, day care centers and non-profit insurance companies, relates to concerns over public health and safety and consumer protection. The elimination of the application of the NPCL’s agency consent requirements to such organizations would also not necessarily affect their regulation, as the consent requirements are in some cases duplicated in other laws.

 

Of the agencies currently required to consent to the filings of non-profit corporations, however, the Department of Education is notable for the incredible scope of organizations that fall under its jurisdiction. Under the NPCL, corporations that include in their certificates of incorporation “a purpose for which a corporation might be chartered by the regents of the university of the State of New York” are required to obtain consents from the Department of Education. The Department of State has read this provision broadly to include corporations that do not run schools or other formal institutions of learning but include education of some kind in their stated purposes. Unlike other provisions of the NPCL that require agency consents from organizations conducting specific activities that raise the concerns, such as public health, discussed above, this provision affects a startling array of non-profits whose activities do not raise such concerns. As a result, New York non-profits, including arts and cultural organizations, often find themselves burdened with an additional layer of regulation because “education” is an important part of their missions. A significant number of non- profits have education of some kind as a part of their mission even if they do not run schools or other formal educational institutions. These organizations are generally not otherwise regulated by the Department of Education and would not be regulated by a similar agency if they were incorporated in another state.

 

The Committee recommends that the scope of organizations required to obtain consents from the Department of Education be limited to those seeking to operate a school (whether a primary or secondary school or a college or university), library or museum or certain other specifically described institutions. Adopting this change to the NPCL would relieve a significant segment of the New York non-profit sector from needless regulation and would relieve the Department of Education of the need to provide countless consents to organizations that would not otherwise come across its path.

• Provide greater protection for volunteer directors.

 

Another deterrent to incorporating non-profits in New York is the state’s limited protection for non-profit directors. The NPCL currently only limits the third-party liability of directors and officers of section 501(c)(3) organizations who serve without compensation and who have not acted in gross negligence or with the intent to cause harm. The NPCL does not limit liability in actions brought by the Attorney General or the non-profit or for directors and officers of non-profit corporations that are not exempt from tax under Code section 501(c)(3). The NPCL also does not limit the liability of directors or officers in actions brought on behalf of the corporation involving claims of neglect of, failure to perform, or other violations of a director’s duties. The lack of protection for directors in New York is one reason why many non-profits that would otherwise choose to incorporate in New York do so in Delaware.

 

The State Bar Proposal would allow a non-profit certificate of incorporation to include a provision eliminating or limiting director liability to the corporation or its members for damages for breaches of duty in the absence of bad faith, intentional misconduct or a knowing violation of the law or personal gain by a director to which he or she is not entitled. The provision is also similar to one added to the Business Corporation Law in 1987. In the absence of such protection, organizations that cannot afford directors and officers insurance can have difficulty in recruiting volunteers to serve on their boards.

 

The Committee recommends the adoption of a provision similar to that in the State Bar Proposal. As the inclusion in a certificate of incorporation of a provision eliminating or limiting director liability would be voluntary, non-profit corporations could choose not to include such a provision. The Committee does not support expanding the protections described above to paid directors at this time. Non-profit corporations that pay their directors are more likely to have the resources to pay for insurance and may have less difficulty in recruiting directors. Such organizations are also subject to concerns relating to the appropriate compensation of and incentives for directors.

• Permit electronic communications with members.

 

The NPCL does not currently permit electronic notice of meetings of members; notice of such meetings may only be given personally or by mail. The State Bar Proposal would bring the NPCL into the 21st century by permitting electronic notice of meetings and electronic waivers of notice of meetings of members and also by clarifying that corporations may provide information required to be presented to members in any format in which such information is maintained by the corporation. The Committee recommends that these aspects of the State Bar Proposal be adopted immediately.

 

In contrast to the NPCL, Delaware law currently permits meetings of members of non-profit corporations to be held by means of remote communications technology and allows written consents of members to be transmitted electronically. Including such provisions in the NPCL would facilitate the operation of membership corporations in New York and the Committee recommends that such provisions be adopted.

Conclusion

 

Non-profit organizations are increasingly mobile and able to locate themselves where it is convenient to do so. New York’s archaic and troublesome regulatory scheme for non-profit corporations deters many practitioners from incorporating organizations in New York. Reform of the NPCL is needed to protect against the erosion of New York’s vital non-profit sector.

 

Although any major overhaul of the NPCL would require significant public dialogue and consideration, the adoption of the few, discrete reforms described in this report would provide significant relief to many organizations without raising a number of the substantive concerns that would be involved with more comprehensive change. These particular reforms represent some of the more urgent needs of New York’s non- profit sector, and the Non-Profit Organizations Committee encourages the New York State Legislature to adopt such reforms to maintain and enhance the vibrancy and diversity of that sector.