Dissecting the ISOC/PIR/Ethos Transaction
Professor Benjamin Leff
February 21, 2020
Significant concern and confusion has been generated by the relatively recent announcement by the Internet Society ("ISOC") that it will "sell" its subsidiary, Public Interest Registries ("PIR"), to the private equity firm Ethos Capital for more than 1.1 billion dollars. Among other things, PIR operates the .ORG domain registry, which generates tens of millions of dollars of revenue every year. ISOC is a nonprofit charity under section 501(c)(3) of the Internal Revenue Code, as is PIR.
Because I teach nonprofit and charity law at American University's Washington College of Law, I recently appeared on a panel about the proposed transaction. Other panelists were more qualified than I to address the concern being generated, but I was there in order to address some of the confusion, and this post is an attempt to distill the key points I tried to make. In this post, I answer some basic questions about this transaction.
Can a non-profit organization really be sold off to the highest bidder?
The answer to this question is a resounding "no." As discussed below, under nonprofit law a nonprofit can be the "sole member" of another nonprofit, but a nonprofit member does not own the other nonprofit and cannot sell it.
But ISOC is not technically trying to sell PIR the nonprofit, and, because I'm a professor, I made a very cluttered and messy slide to illustrate what exactly is happening (as far as I can tell from the materials I've reviewed).
That is a complicated slide. Can you explain it further?
Part of what makes this complicated is that we have a set of rules that governs nonprofit corporations based on the state in which the organization is incorporated. But, then, in addition nonprofit organizations that qualify for an exemption from income tax under the federal tax law are bound by that body of federal law.
PIR is incorporated in Pennsylvania. Under Pennsylvania law, a charitable nonprofit corporation is permitted to convert itself into a for-profit entity:
(i) so long as the full value of the charity's assets remain "in the charitable stream," and
(ii) so long as its board of directors determines that the conversion does not prevent the charitable purposes from being adequately served.
How can those commitments to charitable mission be met if the new organization is for-profit?
This "conversion-in-place" process means that the charitable entity (PIR Inc.) ceases to be charitable but continues to exist (as PIR LLC, a for-profit entity). Some other charitable entity must continue after the conversion of PIR to make sure that the value of PIR's assets stay locked in the charitable stream and are used to advance PIR's charitable purposes.
So, this transaction requires creating a new nonprofit?
Yes, theoretically any new charitable entity could be created to carry on the charitable purposes of PIR. In this case, a new charitable entity, Connected Giving Foundation ("CGF") is being created for that purpose. As soon as PIR converts to a for-profit LLC, all of its shares (called membership interests for LLCs) will be owned by CGF. Then, CGF will sell its membership interest for about $1.13 billion to a newly created for-profit entity, Purpose Domains LLC, which is in turn owned by Ethos Capital.
A nonprofit cannot be directly sold, but if a nonprofit owns stock in a for-profit then the nonprofit can sell the stock?
Yes, this happens all the time when nonprofits that own shares of stock in for-profit companies sell those shares. But, here, there are still those ongoing commitments to PIR’s charitable purpose that have to be met.
After CGF sells its shares in the new for-profit version of PIR (PIR LLC), CGF (the charity) will have a little more than $1.13B to pursue the charitable purposes formerly served by the nonprofit version of PIR (PIR Inc.). Purpose Domains LLC will be the sole owner of PIR LLC, and therefore have the sole right to operate the .ORG registry. Under nonprofit law and federal tax law, CGF will now have the obligation to pursue its charitable purposes as the successor of PIR's charitable assets.
What obligations does the for-profit version of PIR have in running .ORG?
Assuming all the requisite approvals take place, PIR LLC can pursue profit unconstrained by either state corporation law or federal income tax law. However, the right to run .ORG is subject to the terms of the registry agreement with ICANN, and those terms could impose ongoing obligations about how .ORG is administered.
So PIR goes from nonprofit to for-profit, CGF gets over $1 billion, what about the Internet Society?
So far, I haven't mentioned the Internet Society (ISOC). From a nonprofit organizational point of view, prior to any conversion, ISOC is PIR Inc.'s "sole member," which means it has the exclusive power to appoint PIR's board of directors, which is ultimately responsible to insure that PIR pursues its charitable mission. Sometimes, nonprofit lawyers refer to a sole member as the "parent" of a "child" entity.
How does this relationship affect how PIR accomplishes its charitable purposes?
PIR has a federal tax status as a "supporting organization," which effectively means that it doesn't have to be treated as a private foundation because of the fact that it is controlled by, and provides support to, its parent ISOC. So, PIR is controlled by ISOC and one of its fundamental purposes -- in many ways its most important purpose -- is to provide financial support to ISOC to permit ISOC to pursue its own charitable purposes.
Is PIR’s only job to hand the money it makes from .ORG over to the Internet Society?
No. Under nonprofit corporate law, PIR Inc. has its own board of directors, and each of them has an independent fiduciary "duty of obedience" to use their best judgment in good faith to advance the charitable purposes of PIR. These purposes are described in PIR's "articles of incorporation," and, I made a slide that quotes the language from the articles of incorporation describing the charitable purposes of PIR other than providing support to ISOC. These purposes include to: “provide support for and stimulate the involvement of the non-profit community, and others, in the continuing growth and evolution of the Internet”, “To educate the non-profit community and the public at large about technology and the Internet, and to encourage others to do the same;” and “To stimulate and facilitate effective use of the Internet by non-profit organizations and others.”
Thus, supporting ISOC financially is not PIR's sole obligation.
Is this an all-or-nothing choice about the future of .ORG?
It doesn't have to be an all-or-nothing choice. First of all, the .ORG registry is operated under an agreement with ICANN, and that agreement can require commitments from PIR LLC, the for-profit firm that will continue PIR Inc.'s operation of the .ORG registry. But if it's not possible for those contractual agreements to be strong enough or enforceable enough to protect the charitable purposes of PIR the charity, then the parties could build in more fundamental structural protections of the .ORG registry.
What other options are there to meet the charitable purposes of PIR?
For example, CGF (the successor to PIR's charitable purposes) could take an ownership interest in PIR LLC, along with Purpose Domains LLC (the for-profit created by Ethos Capital to own PIR LLC). Just as CGF can sell off its ownership of a for-profit entity, it also has the ability to acquire or continue to own interests in a for-profit.
An LLC is a limited liability corporation that is governed by a membership agreement. The membership agreement that governs PIR LLC could then give CGF specific control rights, like veto power over certain identified fundamental policy changes. CGF, as a charitable owner of PIR LLC (even if an owner of only a tiny share of the revenue generated by PIR LLC), could then use its authority to protect the .ORG registry. Obviously, that would be a significant change to the transaction as it is currently envisioned, but there's no legal barrier to it happening.
One could even imagine PIR LLC having a charitable owner other than CGF or two charitable owners. This second charitable owner could be constituted to be better equipped to make sure that PIR LLC operates the .ORG registry in a way that advances the charitable purposes for which PIR the charity was formed; it could help ensure that PIR’s 2002 commitments, including providing for, educating and “stimulating” the non-profit community online, and supporting the .ORG registrant and user communities in a variety of ways.
Ultimately, the decision about what's best for the charitable purposes of PIR has to be made by the board of directors of PIR. But under Pennsylvania law, any conversion of a non-profit to a for-profit has to be approved by a court. And the Pennsylvania Attorney General has standing to appear at that court proceeding to represent the public's interest in the charitable purposes of PIR. Effectively, the State of Pennsylvania has the power to intervene to block the conversion if it thinks the conversion would not serve the public interest.
From both the nonprofit law perspective and from the domain name system perspective, this is a pretty unique transaction that deserves careful attention from all the relevant actors.