A Nonprofit with Shareholders? The Koch Brothers’ “Hostile Takeover” of Cato Institute

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March 2, 2012; Source: Washington Post

Like Matthew Iglesias in Slate, we don’t get it either. How is it that the nonprofit Cato Institute has shareholders—that is, people who own shares of stock in a nonprofit organization?

Here is the odd story of the structure of the nation’s most well known libertarian think tank and the crisis that that structure has helped create.

David Weigel writes that the Cato Institute was established in San Francisco in 1977 and moved to Washington, D.C. in 1985. Upon the move to D.C., the nonprofit Cato established itself as “owned” by four shareholders, each owning 16 shares of stock at $1 per share. The four shareholders were the executive director, Ed Crane, the conservative money man Charles Koch, and two other people (George Pearson and William Niskanen). In 1991, Charles Koch’s brother, David Koch, joined the ownership group and purchased another 16 shares. 

More than twenty years later, the place is in turmoil. Pearson has given back his shares, so he is out of the picture. Niskanen died last October and left his shares to his wife, but the Koch brothers are claiming that she has no right to the shares. Rather, the Koches argue that Niskanen’s shares should either be purchased back by Cato or made available to the remaining shareholders (Crane and the two Koches). 

Crane is referring to the Koches’ suit as “an attempt at a hostile takeover.” Currently, the Koch brothers control half of the stock. If Niskanen’s widow has to forfeit her shares back to the corporation or make them available for sale to the Koches and Crane, the Koches would own a controlling interest in the organization. Reportedly, they haven’t been pleased with Cato’s direction and long ago, despite their “ownership” of the nonprofit, shifted their funding to other organizations such as Americans for Prosperity.

A nonprofit with four shareholders? Former IRS official Marc Owens declared the Cato ownership structure as “completely at odds with the requirements for [a nonprofit]” and as putting Cato “at risk of retroactive revocation of its tax-exempt status back to 1977.” Cato’s own federal tax lawyer, Bruce Hopkins, acknowledged that the IRS doesn’t like this kind of ownership arrangement, but says that the shares are a “strange breed of stock that doesn’t have any economic advantage to it.” He said that despite the nomenclature of stock, the structure “is more of a control mechanism and in practice it’s not much different than a membership.”

Is Cato a public charity? How can it be a public charity if it is individually owned by four people who possess the limited number of shares of stock issued by the corporate entity known as the Cato Institute? If the stock is really only a substitute for the category of the Cato Institute’s membership, how can Niskanen’s widow inherit the Cato shares? If they are regular corporate-type shares, they can be inherited. Given the strong comments of Marc Owens, who should know the “ownership” issues of nonprofits since overseeing nonprofits was his job at the IRS’s tax exemption division, how has the IRS allowed this situation to proceed over the course of the past 27 years?—Rick Cohen

  • Michael Wyland

    There seems to be a rush to judgement here. Just because Cato Institute’s structure is unusual doesn’t necessarily make it illegal.

  • Michael Wyland

    Look at the state corporation laws for the state in which the Cato Institute was formed. The article indicates the nonprofit was formed in California and moved to DC. Is it incorporated in DC, in CA, or elsewhere?

    Unlike tax-exempt recognition, corporate status is a state issue. What are the applicable state laws governing the issuance of shares of stock in a nonprofit corporation? Was/is Cato formed in compliance with applicable statutes in effect at the time? Is it still in compliance, or was it “grandfathered” when changes to statutes may have been made?

  • Michael Wyland

    The next step is to look at Cato’s Form 1023, if it’s available. Was the stock ownership structure disclosed in the application? This would likely have been included in the Articles of Incorrpoation, By-Laws, or constitution (Cato is old enough that a constitution may have been used). If so, and the IRS approved the application, there is a prima facie case that Cato’s structure was deemed appropriate by the IRS.

    The next step is to look at any changes made to governing documents and the governing structure for the Cato Institute. Some changes are required to be reported to the IRS – were they? Even though many charities and nonprofits neglect to file the appropriate notices with the IRS, the IRS could take advantage of any missed filings by Cato as an opportunity to examine its tax-exemption.

    It will be interesting to see how questions like these are answered and how they inform any contemplated action by regulators,watchdogs, and others.

  • Ken Swanson

    This article confuses all 501(c)(3) organizations with those that are charities. There are eight different categories of nonprofit organization under Code Sec. 501(c)(3), one of which is charitable, and another of which is educational – which is the category under which the Cato Institute was granted its exempt status (the others categories are religious, scientific, literary, prevention of cruelty, consumer product testing, and amateur sports). The Cato Institute qualifies as an educational organization because it’s primary purpose is the instruction of the general public on subjects that are useful to individuals and beneficial to the community (from Reg. §1.501(c)(3)-1(d)(3)(i)).

    Bruce Hopkins is going to have a tough time arguing that the shares are nothing more than an evidence of membership given that they were assigned dollar values. But Mr. Hopkins is also extremely knowledgable in this area, so I wouldn’t count him out automatically.

  • Gena Rotstein

    I think there is a larger question being asked here. That is, if we as society are encouraging charities to operate like businesses, put in place structures that allow for this but then when the organization fails and the structure collapses what are the solutions?
    1. If this is a public charity not a private foundation, then the buck stops with the board of directors not with the shareholders. The shareholders may have a vote on who is on the board, but it is ultimately the board that decides on the organizational structure and handling of this situation.
    2. If this is a private charity and the board is also the shareholders, then this is a “private matter.” The question that is then raised is who is representing public voices, if the public contributed financially to this organization by way of donations. That goes back to the board’s policies on donor stewardship and fundraising.

  • Gena Rotstein

    Part 2 of my comment because it was too long…

    There are several organizations with shareholders who are the founding members of organizations that retain their shares, but are no longer part of the board. This model was established for a number of reasons (of which are here are a few):
    – For the organization to generate revenue outside of traditional fundraising
    – For the organization to have extra time to raise capital before acting on its charitable purposes
    – For the organization to have the time to build a team that could lead it effectively
    – Because they were advised, based on their objects, that this was the right structure

    It would be great to have a charity lawyer speak to this further before jumping to conclusions that the public is not being represented or that this is a hostile take-over.

  • Randall Burns

    I can see why this kind of structure might be useful for a tribe or clan that wants a charitable branch. What makes the issue important here is just how politically influential the Cato Institute has become and how large their throughput is. I get the impression their endoment per faculty member is not huge–but they have a cozy relationship with other Koch influenced non-profits.

    In general I think there should be limits on donations or endowment funds a non-profit can have per voting member. If they exceed those limits, they should be subject to taxation like a trustee/guardian for profit corporation. Non-profits should express the will of a real community not be the vanity press for a wealthy family.