Enterprise Foundations
Who ensures a nonprofit parent pursues public benefit rather than profit through its control of a taxable corporation?
A recent article in the Financial Times raises an interesting question regarding the American version of “enterprise foundations.” Enterprise Foundations are feeders, essentially. Normal business owned or controlled by a charity, the profits from which are devoted to the parent’s charitable purpose. They are more common in Europe than they are in the United States, where feeders are not entitled to tax exemption, and the excess business holding tax applies.
In the U.S. an enterprise foundation is usually not entitled to tax exemption. But must an exempt parent exercise its control over the enterprise in a manner consistent with the reason for its tax exemption, or does it owe fiduciary duties to the other shareholders who are in it for the money? In Europe it doesn’t matter because its the destination of income that counts, not the way its earned. A charitable parent can be just as ruthless and exploitative as the best capitalist.
It probably doesn’t matter with a public benefit corporation either when the charity sacrifices profit for public benefit. The PBC charter permits the corporation to pursue public benefit rather than or just as much as profit. Stockholders signed on when they acquired stock in the public benefit corporation and therefore have no derivative complaint.
Should it matter, though, when the charitable parent causes the enterprise to pursue profit at the expense of public benefit? The charitable parent has a state and federal obligation to pursue public benefit and disdain private profit. As a controlling shareholder, may it cause or permit the corporation to pursue profit at the expense of public benefit anyway? The FT article recounts the story of the Hershey Charitable Trust and offers some cautious speculations regarding OpenAI’s planned 4th quarter IPO.
OpenAI is preparing for what could be one of the largest initial public offerings in history — and one of the oddest. When the world’s most valuable AI start-up goes public it will be under the control of an American charity.
Following a contentious restructuring last year, OpenAI converted its for-profit arm into a public benefit corporation. This is controlled by the OpenAI Foundation charity, which despite owning only about 26 per cent of the company has special governance rights, including the power to appoint and remove directors. The foundation’s stake makes it one of America’s wealthiest non-profits, larger than the Gates Foundation’s endowment.
American tax law discourages private foundations from controlling businesses. But OpenAI is structured as a public charity — a different legal form with greater leeway. There is no reason a charity-controlled company cannot succeed for shareholders and the public alike. On paper, the charity’s mission to create safe artificial general intelligence will come ahead of business priorities. But the OpenAI Foundation board is made up of mostly the same people as the company’s board, including co-founder Sam Altman.
There is, however, an external complication: in the US, state attorneys-general are responsible for supervising how charities use their tax-exempt assets. This supervision can unfold in unpredictable ways. For the closest American analogue consider the Hershey Company — yes, the chocolate company.
The article tells the story of how the Hershey Charitable Trust sought to sell its controlling interest in Hershey Foods Corporation. The Pennsylvania attorney general sued alleging that the sale violated the Trust’s nonprofit obligations to the community:
Pennsylvania's attorney general, Mike Fisher, sought to block any sale in the Dauphin County Orphans Court, which oversees charitable trust activities, arguing that court approval was needed for any deal and contending that a sale could devastate the town, where about 6,200 people work for the company.
The Trust board eventually backed out of the sale that experts say would have generated a lot more value for profit-seeking shareholders and maybe for the Charitable Trust beneficiaries as well.
Shortly after the Attorney General obtained a preliminary injunction, the trustees abandoned the sale and the [Hershey Food] Company's stock dropped to $65.00. Using standard event study methodology, we find that the sale announcement was associated with a positive abnormal return of over 25% and that canceling the sale was followed by a negative abnormal return of nearly 12%. Our findings imply that instead of improving the welfare of the needy children who are the Trust's main beneficiaries, the Attorney General's intervention preserved charitable trust agency costs of roughly $850 million and foreclosed salutary portfolio diversification. Furthermore, blocking the sale destroyed roughly $2.7 billion in shareholder wealth, reducing aggregate social welfare by preserving a suboptimal ownership structure of the Company.
The FT articles speculates that AG oversight of the controlling nonprofit shareholder generates economic risks for shareholders, particularly when AGs are responding to a public outcry pitting shareholders against stakeholders.
Recall that OpenAI Foundation, a 501(c)(3) public charity has a 26% controlling stake in OpenAI Group PBC, the corporation hoping to raise at least $60 billion with its IPO. When they approved OpenAI’s sale to and control over the PBC, the Delaware and California AGs nevertheless retained statutory and contractual authority to ensure OpenAI Foundation controls the PBC in a manner that puts public benefit over private profit. Theoretically, the AGs, and perhaps the IRS, can force OpenAI to control the PBC in a manner conducive to public benefit (decreasing or eliminating the social costs of artificial intelligence at the expense of profit, for example).
There is a thoroughly written comparative analysis of this and other questions in the current issue of the Yale Journal on Regulation. I mentioned the article before, but without context. Here, once again, is the abstract to “The Anatomy of Nonprofit Control of Business:”
Nonprofit control of operating businesses has long been a feature of European corporations such as Novo Nordisk, Ikea, Carlsberg, and Rolex, which are governed by enterprise foundations—nonprofits with charitable missions explicitly permitted to hold controlling stakes in businesses. In the United States, nonprofit control is becoming more prominent due to recent legal developments, with companies like Patagonia and OpenAI under nonprofit ownership. Despite this growing interest, the economic rationale behind nonprofit control remains poorly understood: why would nonprofits with social missions choose to control businesses that sell products and services?
We identify two primary models of nonprofit control. The income-generating for-profit is controlled by a nonprofit to generate funding for the nonprofit’s charitable mission, ensuring steady long-term cash flows and mitigating systematic risk. The socially oriented for-profit is controlled to ensure the operating business adheres to the nonprofit’s mission. Unlike simplistic accounts that treat all nonprofit-controlled businesses as uniformly purpose-driven, our analysis clarifies the benefits and risks of these models and provides a framework for evaluating legal regimes governing them.
Our comparative analysis of legal systems in Europe, the United Kingdom, and the United States highlights significant differences in how nonprofit control is regulated. European and U.K. laws support income-generating for-profits through enterprise foundations and trading companies while incorporating oversight to ensure socially oriented for-profits remain mission-driven. U.S. law, by contrast, imposes strict limits on private foundations while allowing other nonprofits to control businesses with few safeguards against outside-investor influence.
We propose an optimal legal framework to facilitate income-generating for-profits where mission drift risks are relatively low while also imposing stronger safeguards on socially oriented for-profits to prevent outside investors from undermining those for-profits’ social missions, as seen in the recent OpenAI controversy. Rather than focusing on independence from donors or founders, legal reforms should prioritize independence from investors with economic interests in the for-profit subsidiary. Our proposal ensures that nonprofit-owned businesses remain both financially sustainable and committed to their stated social purposes.