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Financing of Not-for-Profit Organizations and Securities Laws

Written by: Dick A. Samuels

Not-for-profit organizations are in some ways financed much like business organizations.  Frequently, not-for-profit organizations borrow money and grant security interests in their property.  They also may generate revenue by charging fees for their services, which may support the organization’s operating expenses, but which also may be retained as internally generated capital.  More frequently than for-profit organizations, not-for-profits may be supported by grants, government funding, and tax-exempt borrowing through state government agencies. 

In some circumstances, not-for-profit organizations can also be financed by issuing memberships or, less commonly, shares, that can be resold to or redeemed by the organization.  This paper addresses problems that such financing can create under securities laws and suggests how to avoid those problems.

            1. New Hampshire Voluntary Corporation and Federal Tax Provisions.

RSA 292:8 authorizes New Hampshire voluntary corporations to generate funds through “issuance of membership certificates or stock certificates,” dues, fees, and by accepting “contributions to capital.”  Charitable not-for-profit organizations, if qualified under Internal Revenue Code §501(c)(3), are commonly supported by tax-deductible donations from supporters.  Such donations do not “purchase” an interest in the charitable organization, will not be returned to members or shareholders, and upon dissolution, the organization must distribute any net assets to another 501(c)(3) organization.  That is true even if the charitable organization provides for “membership” or issues membership certificates or stock in exchange for membership fees or dues.

Aside from the requirement that a §501(c)(3) organization distribute assets to another §501(c)(3) upon dissolution, can not-for-profit organizations return member or shareholder contributions as a means of financing?

The Internal Revenue Code prohibits most categories of §503(c) tax-exempt organizations from allowing any part of their net earnings to inure to the benefit of any private shareholder or individual or require them to devote all net earnings to their tax-exempt purpose (except as a recipient of the services of the organization).  However, the Code does not generally prohibit §503(c) organizations from returning the contributions, membership purchase payments, or share purchase prices (in contrast to “net earnings”) to members or shareholders. 

Of course, not-for-profit organizations, including 501(c)(3) organizations, frequently borrow money and in exchange issue notes, bonds, and other evidences of indebtedness.  As discussed below, those instruments are securities.

Under New Hampshire law, the only limitation contained in RSA 292 is found in 292:9 IV, which prohibits the distribution to a member or shareholder of amounts greater than the member’s or shareholder’s capital contributions of share purchase price upon dissolution of a non-for-profit corporation.

Though the prospect of financing any not-for-profit organization through refundable “equity” contributions could arise with any sort of not-for-profit venture, as a practical matter, the return of contributions or share purchase consideration rarely arises in connection with non-charitable non-for-profit corporations.  The context in which it frequently arises is in the financing of recreational organizations (§501(c)(7)), and it is here that there is an intersection of tax and securities law.

            2. Financing Not-for-Profit Organizations and Redeemable Contributions.

A complication that will arise if an organization sells shares or memberships with a promise or prospect of returning funds or other value to the member or shareholder is that the “sale” of that share or membership must comply with both federal and state securities laws.  Generally, those laws prohibit the sale of securities unless the offering is registered with the appropriate securities regulator.  Rarely will an organization want to tackle such a registration, due to cost and complexity.  The solution centers on making certain that the share or membership either does not constitute a security or, if it is a security, the issuance or sale of it exempt from registration.

How does this issue typically arise?  Let’s say that a golf, tennis, or swim club is financed in part by the purchase by members of shares or memberships.  The member is entitled to enjoy all of the facilities and benefits of membership and, in addition to the share purchase requirement, pays annual dues that go to support the operating expenses.  Upon termination of membership, the member is entitled to the return from the club of the original share purchase price.  May the club finance itself in that manner without running afoul of securities laws?  What if the member is entitled to redeem the shares or membership for the then-current share or membership price, or book value, either of which may be higher or lower?  Does it matter whether the redemption is mandatory or at the election of the club?  Is there a difference if the interests are simply memberships rather than shares? 

            3. State and Federal Securities Law Framework.

While state securities laws vary from state to state, many states, including New Hampshire, follow the Uniform Securities Act approach to not-for-profit organization interests. 

                        a. Interests in not-for-profit corporations may be securities.

Under the New Hampshire Uniform Securities Act, the laws of other states, and federal law, it will often be the case that shares or membership certificates issued by a not-for-profit organization will constitute “securities”—or at least not clearly fall outside of the definition of securities.  The approach to the definition of “security” that all of those statutes take is to present a broad laundry list of instruments and arrangements.  Under the New Hampshire Act (RSA 421-B:1-102(53)), securities are defined to include, unless the context otherwise requires:

…any note; stock; …bond; debenture; evidence of indebtedness; certificate of interest or participation in a profit sharing agreement; … transferable shares; investment contract; …or, in general, any interest or instrument commonly known as a security, or any certificate of interest or participation in, temporary or interim certificate for, receipt for guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

             Similarly, under the federal Securities Act of 1933 (§2(a)(1)), securities include:

unless the context otherwise requires, …any note, stock, …bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, …transferable share, investment contract, …or, in general, any interest or instrument commonly known as a "security", or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

In light of those definitions, if a not-for-profit organization intends that its membership interests not be considered a security, certainly it should not give the interest a title that coincides with one of the instruments named in the state law definition, for instance, stock.  However, even if a redeemable contribution to a not-for-profit entity is not labeled “stock” or “bond,” it may nonetheless constitute a security.

Given the similarities between the state and federal law definitions, the analysis of whether membership interests are securities, within the meaning of RSA 421-B:1-102(53), is essentially identical to the analysis under federal securities law.   An instructive example of a not-for-profit membership that was determined not to be a security is addressed in Bear’s Paw Country Club, (SEC 1980) 1980 CCH Dec. ¶ 76,426.  In Bear’s Paw no distributions would be made to members, and memberships would not be transferable or assignable but could be repurchased by the club for a price that might represent a gain to the resigning member.  The club was not required to repurchase the memberships.  The members were not promised and appear to have been told that they should not expect any economic profits from their memberships.  In numerous subsequent no-action letters, the SEC staff has consistently agreed that memberships that entitle the members to no share in the profits and are not transferable do not constitute securities under the Securities Act.  In many of these no-action letters, although purchasers were not assured that their memberships would be repurchased and were not promised any "profits" from memberships, they had an opportunity to sell the membership upon termination at a repurchase price that might be higher or lower than the original purchase price (for instance, all or a large portion of the then-current membership purchase price at the time of a member’s termination).  See Black Diamond Club, Inc. (October 20, 1986); Jacaranda Country Club, Inc. (October 30, 1986); Spruce Creek Country Club, Inc. (March 7, 1986); The Martin Downs Country Club, Inc. (December 20, 1985); Palm-Aire Country Club at Sarasota, Inc. (September 17, 1985); The Haig Point Club, Inc. (August 30, 1985); Boca West Club, Inc. (February 26, 1985); La Salle Club (October 11, 1984); Twin Herons Golf Club, Inc. (May 31, 1982) Boca Lago Country Club, Inc. (October 14, 1981).

Note that in California, a different test has been applied, with a different result.  In Silver Hills Country Club v. Sobieski, 361 P.2d 906, 87 ALR.2d 1135 (1961), the California Supreme Court fashioned a “risk capital” for determining whether an investment constituted an “investment contract” and therefore a security.  The risk capital test  requires only that an investor has risked his capital with a fair chance of realizing an objective, without reference to any expectation or return.  (In contrast, the SEC v. Howey, investment contract analysis under federal securities law requires an expectation of profit through the efforts of others,)  Accordingly, in Silver Hills, the Court held that country club memberships could be securities even where a member had no rights in the income or assets of the club.  Prior to the 2015 amendment to RSA 421-A, there was little reason to believe that the risk capital test would be adopted in New Hampshire, although it had not been rejected.  Regrettably in my view, RSA 421-A:1-102(29) now includes a modified “risk capital” definition of “investment contract.”

            b. Exemptions for not-for-profit organization securities.

In the event that an interest issued by a not-for-profit organization constitutes a security, for the reasons discussed above, it is important that the interest issued by the organization come within an exemption from registration.  The relevant New Hampshire exemption is found in RSA 421-B:2-201(7), which exempts:

A security issued by a person organized and operated exclusively for religious, educational, benevolent, fraternal, charitable, social, athletic, or reformatory purposes, or as a chamber of commerce or trade or professional association, and not for pecuniary profit, no part of the net earnings of which inures to the benefit of a private stockholder or other person, or a security of a company that is excluded from the definition of an investment company under section 3(c)(10)(B) of the Investment Company Act of 1940; provided that such issuer shall have filed with the secretary of state a notice, on a form prescribed by the secretary of state, together with a copy of all offering material used in such offering of such security, at least 30 days before the first issuance under such offering. With respect to the offer or sale of a security offered under this exemption, upon the receipt of such notice of such an offering, the secretary of state may require that the availability of this exemption be limited by classifying securities, persons, and transactions, imposing different requirements for different classes, specifying the scope of the exemption and the grounds for denial or suspension, and requiring the issuer to file a notice specifying the material terms of the proposed offer and sale and copies of any proposed sales and advertising literature to be used. The exemption shall become effective if the secretary of state does not disallow the exemption within 30 days of the filing of such notice and other required information.

What exactly does the “exclusively for” requirement mean, and is it similar to the Internal Revenue Code requirement that “no part of the net earnings of which inures to the benefit of” requirement?  Unfortunately, there is no New Hampshire case law on the topic.  However, the exemption under Section 3(a)(4) the Federal Securities Act of 1933 is worded similarly to the state securities law exemption for securities issued by religious, charitable, social or athletic organizations.  Section 3(a)(4) of the Securities Act reads:

Any security issued by a person organized and operated exclusively for religious, educational, benevolent, fraternal, charitable, or reformatory purposes and not for pecuniary profit, and no part of the net earnings of which inures to the benefit of any person, private stockholder, or individual, charitable and fraternal organizations…. 

Note that the federal exemption does not expressly include “social” or “athletic” purposes, and “fraternal” has been construed by the SEC not to include athletic or recreational purposes, regardless of the absence of a profit motive.  See Western American Communities (SEC 1981) 1981 CCH Dec ¶ 76,844. 

In SEC v. American Foundation for Advanced Ed. of Arkansas, 222 F.Supp. 828, 831 (W.D.Louisiana, 1963), the court held that "the existence of a single non-educational purpose will destroy the exemption...if it is of a substantial nature" (emphasis added) and determined that debentures issued by an not-for-profit corporation were not exempt from securities registration requirements because profits were returned to debenture purchasers and therefore the "exclusively for" requirement was not met.  In SEC v. Children's Hospital, 214 F.Supp 883, 888 (D. Arizona, 1963), the court wrote that the federal registration exemption is not available "when, in essence, the issuing institution is either organized or operated for what is substantially a non-charitable purpose" (emphasis added).  The Children's Hospital court discussed the construction of the "exclusively for" requirement and determined that there must be a substantial non-charitable (or non-fraternal, etc.) purpose for the exemption to be inapplicable.  Id. at 889. 

From these cases, one may conclude that the "exclusively for" language in the New Hampshire exemption would not be read literally such that an insubstantial non-for-profit or private benefit would render the exemption inapplicable.  But note that the New Hampshire exemption is not self-executing and requires filing with the Bureau.

Finally, note that a determination of whether or not membership interests are securities is important because if they are, the anti-fraud provisions of the state Securities Act apply to them, regardless of whether or not they are exempt from registration under the Act.  As a practical matter, the anti-fraud provisions, if they apply, will require that an organization not make any material misrepresentations in connection with the sale of the memberships nor omit any material facts needed to make any representations that are made not misleading. 

Also have in mind that if membership interests are being offered or sold to residents of states other than New Hampshire, the securities laws of those states will also apply.  The New Hampshire exemption for securities issued by social or athletic organizations comes from the 2002 Revised Uniform Securities Act, which has been adopted in one form or another in many states.

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