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Consider the legal side of subsidiaries: Advance review of relevant legal issues can help ensure a successful for-profit venture.

MANY NOT-FOR-PROFIT ENTITIES ARE currently exploring or already have organized for-profit subsidiaries. The creation of such entities not only can generate new revenue streams, it also can increase membership rolls and provide meaningful products and services to your members. However, in addition to the many business issues requiring consideration, there are a number of significant legal issues to evaluate in determining whether the creation of a for-profit subsidiary is a wise choice for your organization. And while success is never a sure thing, associations and other nonprofit entities can significantly increase the likelihood of a profitable venture by understanding and addressing in advance several key legal issues. Because a large number of association for-profit enterprises are involved in insurance, securities, and other financial products, this article will focus largely oz those businesses and the issues unique to them. The following considerations are among the most important.

1. Carefully review the business model regarding the business activities identified for the for-profit subsidiary. Careful consideration of the type of business in which you intend your for-profit to engage is quite simply mandatory. Historically, not-for-profit entities have created for-profit subsidiaries to provide retirement, insurance, and other financial products and services to their memberships. Sales and marketing of these products is regulated in some instances by the states and in other instances by federal agencies. The role your for-profit will play in the sales and marketing process for regulated products and the manner in which your subsidiary is compensated will govern in many cases the regulatory requirements to be fulfilled. These regulatory requirements are discussed in more detail below.

2. Evaluate how strategic relationships will be structured, and determine what your role in the sales process will be. A foremost issue in the creation of a for-profit subsidiary is evaluating your risk tolerance. If your risk tolerance is low, you may want to limit the role of the employees of the for-profit entity to merely that of identifying strategic business relationships, negotiating sponsorship agreements, and monitoring the use of your association's trademarks--activities for which most strategic partners are willing to pay a fixed endorsement fee. Those with moderate risk tolerances may be willing to introduce members to the sales representatives of strategic partners, participate in joint speaking engagements and field visits, attend conferences and other meetings, and so on. In exchange for the performance of these types of services, strategic partners may pay a fixed fee as well as a revenue-sharing component. Those with a higher risk tolerance may wish for their employees to engage directly in t he sale of the strategic partner's products and services to their members. This type of arrangement carries with it the greatest legal risk to the entity, requires the greatest regulatory compliance, and can provide the most financial upside. In addition, direct sales of products and services can give your for-profit the most control over the customer relationship, including ownership of renewals, at the time a strategic alliance ends.

3. Determine the most desirable structure for your for-profit subsidiary. This requires evaluation of several factors, including the tax, accounting, and regulatory implications of the type of entity you select. For example, many parent entities prefer the limited liability model, which offers pass-through tax treatment, and if properly operated is treated as a separate entity for purposes of corporate law. The limited liability company also offers streamlined options for management. Rather than being managed by directors and officers, such companies generally are run by "managers," who function as quasi directors or quasi officers.

However, adoption of the limited liability entity may be disadvantageous from a regulatory standpoint. For example, if your new subsidiary must register as a federal broker-dealer, you will want to consider rules of the National Association of Securities Dealers (NASD), which may subject individuals designated as managers but who are not directly involved in your subsidiary's securities business to registration requirements not applicable to directors in a typical corporate structure.

4. Identify staffing requirements and other personnel issues. Part of your business plan must include specific identification of those individuals who can provide the skill and qualifications required for the activities you wish to undertake. For example, should you wish to engage in the direct sale and marketing of insurance and other financial products and services to your members, your subsidiary must employ individuals who understand these products and who are properly licensed with state and federal regulatory agencies to sell them. Depending upon the manner in which your for-profit subsidiary is operated, your compensation structure, and the activities your employees undertake, state regulators, as well as NASD and the U.S. Securities and Exchange Commission (SEC), may require licensing of the subsidiary and of those employees engaged in insurance and/or securities activities described above as "moderate-risk" activities. A few states may even require licensure for those activities described earlier in this article as "low-risk."

5. Recognize that operating a for-profit business carries with it issues not generally encountered in the operation of a nonprofit entity. Often appropriate staffing for your new subsidiary may require going outside your existing organizational structure. As a further step in your analyses of the manner in which you intend to deliver products and services to your members, you should consider that the employees necessary to operate your new business may not be accustomed to the compensation structure of a nonprofit entity. For example, many individuals who have been active in the sales and marketing of insurance, financial, and high-tech services are paid salaries plus a share of the commissions and/or other revenues generated by their employers. Failure to address the compensation objectives of the new employees of your subsidiary may lead to dissatisfaction and ultimately a lack of employee retention. And too much turnover in those employees who deal with your membership base will be detrimental to your for- profit endeavor.

6. Identify key regulatory issues involved in pursuing your identified business opportunities. Many not-for-profit organizations elect to pursue relationships with third parties to provide employee benefits for members of their respective associations. Among the more typical are retirement benefits and other investment services, various forms of insurance, and other financial products and services. However, the nature of these products and services can provide pitfalls for the unwary. Consider the following:

Insurance licensing requirements. The sale of variable annuities and insurance products is regulated by the states. While you may believe that merely endorsing an insurance company and allowing this company to use your name to make its products and services available to your members does not constitute selling, some states take a different view. Many states now have enacted legislation that may eliminate the requirement for licensure of entities solely because they accept compensation (commonly in the form of commissions) based upon the amount of premiums generated by an insurance company for sales of products and services to their members. And in other states, structuring the compensation arrangement in a manner that ties the amount to be paid to something other than the premiums paid can avoid the need for licensure. But, even if this pitfall is avoided, the nature of the activities in which the employees of the for-profit entity engage may of itself require licensure. Additionally, if you intend to offer p roducts in more than one state, you must fulfill the licensing requirements of all states in which you will offer products or services. Fortunately, however, the days of prohibiting nonresident licensure have disappeared, and all states now license nonresident agents and brokers (most granting reciprocal credit for purposes of continuing education).

Broker-dealer licensing requirements. In addition to the licensure requirements described so far, variable annuities and mutual funds are considered to be securities for purposes of the laws of the United States. Therefore, if you intend to provide these products and services to your members, you must evaluate whether registration as a federal broker-dealer is required. There are some exemptions from registration, and you will of course want to consider whether the activities you wish to undertake will qualify. If not, then advance preparation for the registration process is critical. Unlike the registration of investment advisers, which as discussed below is undertaken in certain instances by the states, the NASD and the SEC are responsible for the registration of broker-dealers. To register, you will be required to submit a detailed application to NASD and to submit to an on-premises interview with NASD personnel. Registration as a broker-dealer carries with it many continuing responsibilities, such as subs tantial employee supervision, continuing education, detailed record keeping, and the filing of periodic financial and other reports, and will require diligence in order to comply. Note that in addition to the federal registration requirements, most states require some type of filing (often quite simple) to conduct a broker-dealer business.

Investment adviser licensing requirements. To the extent your subsidiary is compensated on a percentage of assets under management or your employees are engaged in providing investment advice, you must determine whether registration under state or federal investment advisory statutes is required. The regulatory terrain for registration of investment advisers is different from that which is applicable to broker-dealers, in that the states regulate smaller investment advisers (i.e., those with less than $30 million in assets under management, or those with $25 million in assets under management and who operate in fewer than 25 states). Therefore, if you determine your activities may require registration, you also must determine whether you will fall under the state or federal regulatory scheme. The SEC currently allows exemption from registration as an investment adviser in certain circumstances, as do many state regulatory agencies. Among these, a registered broker-dealer is not required to separately register as an investment adviser if its investment advisory activities are "solely incidental" to its broker-dealer activities. In addition, under limited circumstances the SEC permits registered investment advisers to pay cash referral fees without requiring recipients of such fees to register as investment advisers. Some states have adopted similar rules and also have exemptions based on activities with a small number of customers and in situations where customers are all institutional, a designation which is defined differently depending on applicable state law. Whether exemption from registration as an investment adviser is possible requires a technical analysis and a fact-specific review of your business. Therefore, you will want to work closely with a professional adviser skilled in the area of securities law in evaluating the regulatory requirements applicable to your new business venture.

7. Consider privacy issues and the Graham-Leach-Bliley Act. Whether the privacy provisions of the Graham-Leach-Bliley Act will apply must be considered in connection with any entity collecting what is defined under the act as "nonpublic personal" information. The act establishes federal rules for disclosure of such information--rules that are administered and enforced through the SEC as they relate to the activities of broker-dealers, and through the Federal Trade Commission for other entities deemed to be financial institutions. The definition of a financial institution is broad, and encompasses an association or a for-profit subsidiary if it is significantly engaged in financial activities. If applicable, the act requires development of policies and procedures for use and disclosure of nonpublic personal information collected, and for appropriate notification to customers. Additionally, many states have adopted legislation relating to the use and disclosure of such information, and consideration of this leg islation also is required in connection with the activities of your for-profit entity.

8. Branding issues, and the use of your name, marks, and logos. Almost every strategic relationship upon which your new subsidiary embarks will include the use of your association's name, trademarks, and/or logos (collectively referred to here as your marks) by the strategic partner. Therefore, contracts with your strategic partners must address their rights to such use, including but not limited to (1) the type of materials on which your marks may be used, (2) your rights to review in advance all materials using your marks, and (3) when usage of your marks must cease. Prior to allowing anyone to use your marks, it would be prudent for you to undertake a legal review of your own rights to all such intellectual property. You may wish to take efforts to legally protect this property prior to allowing your strategic partners the right to use it. Many of your strategic partners will require that you indemnify them from third-party claims arising from their use of your intellectual property. In addition to enhanci ng the value of your entity, you will have greater comfort in providing this indemnity if your entity's intellectual property is properly protected.

Also remember that allowing your marks to be used in connection with the products and/or services offered by another company carries with it legal risks. Whether you call it an endorsement or use the arguably more limiting term sponsorship, the recommendation to your members of strategic partners and their products and services may subject your organization to liability for their actions and/or inactions. Therefore, due diligence of your strategic partners and the products and services they provide is required. Given the complex nature of some of these products and services, you may find it beneficial to use outside experts to assist in the due diligence process from time to time.

Last, carefully monitor the creeping endorsement, that is, the tendency of strategic partners to expand your endorsement to products and/or services not originally intended. Not only can this intrude on other sponsorship and/or endorsement relationships you may have, it can reduce your compensation and subject your organization to liability for products and services for which no due diligence investigation has been conducted.

9. Exercise of care in the selection of strategic partners. The exercise of care when selecting strategic partners cannot be overemphasized. While it may be tempting to select as a strategic partner the entity willing to pay the highest fixed endorsement fee or provide the richest revenue-sharing or commission structure, there are other salient issues requiring consideration. Among them, the reputation of a prospective strategic partner is important, as well as a demonstrated history of good customer service, and a good record for regulatory compliance--particularly if you must rely on your strategic partner to perform certain regulatory functions. Your member satisfaction will depend on your strategic partner's ability to perform well, and failure in the formative years of its existence could mean the death knell for your subsidiary.

Finally, careful negotiation and drafting of the contract documents between your subsidiary and your strategic partners will be material to your success. Items such as exclusivity requirements, exclusions from the customer base on which your for-profit entity is paid, post-termination compensation, ownership of customer information, and indemnification are among the many critical issues you must understand and address in your contract.

10. Review the tax issues involved with the creation and operation of a for-profit subsidiary. Clearly, you must understand the tax issues involved in creating a for-profit subsidiary. As a general rule, a for-profit entity will not qualify for tax-exempt status merely because it is owned by a tax-exempt parent, and therefore the earnings generated by the subsidiary will ultimately accrue to the benefit of a tax-exempt entity. Conversely, a tax-exempt parent will not lose its tax status merely because it is the owner of a taxable subsidiary that is engaged in business activities unrelated to the tax-exempt purpose of the parent. However, if a tax-exempt parent owns more than 50 percent of the stock of a for-profit subsidiary, and if the subsidiary pays interest, rent, royalties, or annuities to the parent, some or all of the amounts so received from the subsidiary may constitute unrelated business income, which is taxable to the parent. Moreover, a tax-exempt parent must also take care to observe the requisit e corporate formalities and to keep the activities of the subsidiary clearly separate from its own. Otherwise, there is a risk that the Internal Revenue Service might "pierce the corporate veil" and treat the parent and subsidiary as the same entity. This could jeopardize the parent's tax exemption. In general, however, with careful planning and operation, a for-profit subsidiary of a tax-exempt parent can conduct business to generate profits without risk to the parent's tax-exempt status.

The information provided in this article should serve as a roadmap for those interested in expanding their business opportunities to the for-profit arena. While the legal considerations may appear burdensome, those willing to invest the time and energy at the front end can often reap significant long-term rewards.

Sherri D. Way is a partner in the law firm of Krendl Krendl Sachnoff & Way, PC., Denver, and specializes in corporate, insurance, and securities law. Size serves as outside counsel to AHA Financial Solutions. Inc., a for-profit subsidiary of the American Hospital Association, Chicago. E-mail: SDW@Krendl.com. The foregoing article was written for general information purposes only and does not constitute legal advice.
COPYRIGHT 2002 American Society of Association Executives
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Author:Way, Sherri D.
Publication:Association Management
Geographic Code:1USA
Date:Apr 1, 2002
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