California Mutual Water Company Training Course

1. California Mutual Water Company Training Course California Health & Safety Code §116755(a) Corporations Code §14301.2

2. Required Topics • Pursuant to Health & Safety Code §116755(a), the required topics include, but are not limited to: • Fiduciary duties of mutual water company (“MWC”) board members; • Avoiding conflicts of interest; • Duties of MWC’s to provide clean drinking water under the federal and California Safe Drinking Water Acts; and • Long-term maintenance of public water systems.

3. Topics we will cover • Corporate governance, state regulation and taxation of MWC’s, including: • Incorporation rules; • Governance by board of directors; • Role of officers; • Contents of articles of incorporation and bylaws; • Specific statutes governing MWC’s; • Securities regulations pertaining to MWC’s; • Public Utility Commission (“PUC”) regulation of MWC’s; and • Taxation of MWC’s

4. Topics we will cover, cont.: • Fiduciary duties of board members • The duty of care; • The duty of loyalty (which includes avoiding conflicts of interest); and • The duty of good faith and fair dealing. • Overview of the federal Safe Drinking Water Act (“SDWA”) • Overview of the California SDWA; and • Long-term maintenance of public water systems.

5. Governance of MWC’s

6. Governance of MWC’s The term “mutual water company” is defined as: “Any private corporation or association organized for the purposes of delivering water to its stockholders and members at cost, including use of works for conserving, treating and reclaiming water.” (Cal. Pub. Util. Code (“PUC”) §2725.

7. Governance of MWC’s, cont. • Incorporation of MWC’s • Mutual water companies, unlike common interest developments, must be incorporated– i.e., they must be formed as a corporation under California law. • Under California law, a MWC is organized as a non-profit mutual benefit corporation (not to be mistaken with a non-profit public benefit corporation). • Shareholders of mutual benefit corporations, just like shareholders of for-profit corporations enjoy limited liability protection.

8. Governance of MWC’s, cont. • The rules governing mutual benefit corporations are found in the Corporations Code §§7110, et seq. • These rules are supplemented by general corporate law found in Corporations Code §§100, et seq. • In other words, MWC’s are governed by the nonprofit mutual benefit corporation law; however, if the mutual benefit law does not address an issue, general corporate law will prevail. • The only corporate code provisions which expressly discuss MWC’s (as opposed to mutual benefit corporations in general) are found in Corporations Code §§14300, et seq., and §§14310, et seq.

9. Governance of MWC’s, cont. • The Board of Directors (“BOD”) • MWC’s are managed and its activities are conducted through the BOD. • All MWC’s must have a board of directors (which must include at least on BOD member). • Absent a provision in the bylaws requiring shareholder approval, all “activities and affairs of a corporation shall be conducted under the direction of the board.” (Corp. Code §7210.) • Restrictions can be placed in the bylaws requiring member approval (including super majority approval). The goal is to balance two competing concerns: • The need to check the powers of the board; and • The problems associated with management by a large group. • Bottom line – nothing can happen unless the BOD directs it to happen.

10. Governance of MWC’s, cont. • Officers of the MWC • All MWC’s must have the following officers: a president, a secretary and a treasurer. (Corp. Code §7213(a).) • One person may serve in more than one capacity as an officer. (Id.) • Officers are appointed by the BOD to run the MWD at the direction of the board. • “Except as otherwise provided by the articles or bylaws, officers shall be chosen by the board and serve at the pleasure of the board.” (Corp. Code §7213(b).) • Bottom Line – officers are responsible for running the MWC, subject to the direction and oversight of the BOD

11. Governance of MWC’s, cont. • Governing Documents • All MWC’s must have two documents: • Articles of Incorporation; and • Bylaws.

12. Governance of MWC’s, cont. • Articles of Incorporation (“AOI”). • AOI must include the following (Corp. Code §7130): • The name of the corporation; • The following statement: This corporation is a nonprofit mutual benefit corporation organized under the California Nonprofit Mutual Benefit Corporation Law. The purpose of this corporation is to engage in any lawful act or activity, other than credit union business, for which a corporation may be organized under such law. • The name and address of the MWC’s agent for service of process

13. Governance of MWC’s, cont. • Specific AOI Requirements for MWC’s • MWC’s formed for domestic water supply must include a provision in the AOI (or the bylaws) that the water must be supplied only to the shareholders of the MWC. (Corp. Code §14300.) • For MWC’s formed after 1998 in connection with the sale of property in a subdivision, Corporate Code §14312(a)(13)(A)-(L) contains a detailed list of additional required provisions. These provisions closely mirror those required for a permit from the Department of Corporations (10 CCR §260.140.71.2) • These rules can be adopted by MWC’s formed prior to 1998, and in many instances it would be “best practices” to do so.

14. Governance of MWC’s, cont. • Additional provisions (in AOI and/or blyaws) required for permit from Department of Corporations (10 CCR §260.140.71.2(b)): • A statement to the effect that the mutual water company shall provide water to all members or shareholders. • A general description of any activities other than the delivery of water in which the water company may engage. • A proviso directing the board of directors to establish a rate structure which will result in the accumulation and maintenance of a fund for the repair and replacement of the water supply, distribution and fire protection system (the “repair and replacement fund”). The rate charged, moreover, must bear a reasonable relationship to the cost of furnishing water. • A reasonable relationship between each unit of the securities to be issued and each unit of the area to be served; e.g., one share of common stock issued for each subdivided lot purchased. • A statement prohibiting the issuance of fractional shares or securities. • Adequate provision must be provided for transfer of the securities, voting rights of the security holders, inspection of books and records by security holders, necessary or contemplated expansion of the facilities of the mutual water company, and further subdivision, where applicable, of the area to be served. • A reasonable limitation on the salaries paid to the persons operating, or employed by, the mutual water company including officers and directors. • A provision for annual meetings of the security holders accompanied by a provision for adequate notice. • A provision for distributing to each security holder annually fiscal year-end financial statements within 105 days of the close of the fiscal year. • In the case of a mutual water company purchasing water for distribution from a public utility, municipal water company or water district, a provision for charging all security holders a pro rata amount of the cost of water supplied to an entity providing fire protection service.

15. Governance of MWC’s, cont. • AOI – Additional (Optional Provisions) • Number, qualifications, term and duties of the BOD and/or officers; • In the case of non-profit mutual benefit corporations, prohibitions against certain transactions which would terminate the corporation’s tax exempt status; • A limitation on or clarification of the corporation’s powers and purposes (in the absence of such a limitation, the corporation has all the powers enumerated in Corp. Code §7140). • E.g., Corporations Code §14301 provides that “A corporation, including a nonprofit corporation organized for or engaged in the business of developing, distributing, supplying, or delivering water for irrigation or domestic use, or both, may provide in its articles, or may amend its articles to provide, that its only purpose shall be to develop, distribute, supply, or deliver water for irrigation or domestic use, or both, to its members or shareholders, at actual cost plus necessary expenses.”

16. Governance of MWC’s, cont. • Bylaws • Bylaws govern the governance and operation of a MWC. • Required provisions (Corp. Code §7151(a)) • The number of directors (must be 1 or more). • They should include rules and procedures concerning, at the least: • The purpose of the MWC; • Rules pertaining to membership (e.g., who is a member, transfers of membership interests, requirements for membership, removal of members, etc.); • Member meetings (including notice, rules for regular and special meetings); • Rules pertaining to the BOD, including: • Powers of the board; • Limitations on the board (e.g., super-majority or member consent actions); • Election, removal and BOD vacancies; • BOD meetings and meeting requirements; • Standards of care; • Power to delegate authority to commissions; • Rules pertaining to the selection and powers of the officers; • Indemnity and insurance requirements; • Rules for amending the AOI and/or bylaws; • Books and record keeping requirements; and • Prohibitions against distributions (except upon dissolution). • See also, Corp. Code §7151 for more optional provisions.

17. Governance of MWC’s • Corporations Code §§14300, et seq.specifically address MWC’s. • MWC’s organized to supply domestic water may only deliver water to their shareholders. (§14300.) • (Notwithstanding the above or any language in the AOI or bylaws, a MWC may sell water to the state, schools, any public agency or another MWC; in addition, in the event of emergency, the MWC may sell water at cost to any person. Id.) • MWC’s may not distribute profits or assets to their shareholders except upon dissolution (§14301(b).) • MWC’s have the power to levy assessments on their shareholders; if the shares are appurtenant to the land, water may be denied and the shares forfeited. (§14303.) • Unlike a common interest development, the MWC forecloses upon the shares themselves (thereby terminating the right to water).

18. Regulation of MWC’s The Department of Corporations, the Department of Real Estate, the Public Utilities Commission

19. Regulation of MWC’s • MWC’s formed before 1998 are subject to the jurisdiction of the Department of Corporations; • MWC’s formed after 1998 (where shares are sold in connection with subdivided lands) are subject to the jurisdiction of the Department of Real Estate (“DRE”). • As a general rule, most of the regulatory work is done (or should have been done) by the original incorporator (who is usually the developer).

20. Regulation of MWC’s, cont. • MWT’s under jurisdiction of Department of Corporations • MWT’s are corporations; • When a corporation offers shares, it is selling a “security” (Corp. Code §25019) and it must comply with federal and state securities laws; • Exemptions: • Shares sold to a MWT regulated by the Public Utilities Commission (“PUC”); • Shares sold in connection with the sale of subdivided lands after 1998 (or corporations which elect to comply with §14310, et seq.) • In order to issue and sell shares, all non-exempt MWC’s must obtain a permit from the Department of Corporations (10 CCR §260.140.71.2.

21. Regulation of MWC’s, cont. • MWC’s under jurisdiction of DRE • Applies where: • Shares issued in connection with sale of subdivided land after 1998; and, • MWC’s that elect to comply with Corp. Code §§14310, et seq. • Requirements (Corp. Code §§14310, et seq.): The subdivider must submit an application containing: • 15 representations and assurances; • A detailed engineer’s report; • Certification of compliance with water supply, distribution and fire protection design standards; and • Other information.

22. Regulation of MWC’s, cont. • Pursuant to AB-54 (the same legislation requiring this class), all MWC’s which operate pubic water systems (defined later) must submit to their local agency formation commission (LAFCo) a map depicting the approximate boundaries of the property that the MWC serves. (Corp. Code §14301.1.)

23. Regulation of MWC’s, cont. • Regulation by California PUC • The PUC regulates “public utilities” • Not all MWC’s are public utilities. • There are two test for determining whether a MWC is a “public utility” and therefore subject to regulation by the PUC. • The bright line test; and, • The facts and circumstances test.

24. Regulation of MWC’s, cont. • The bright line test: • “Any corporation or association which is organized for the purpose of delivering water solely to its stockholders or members at cost, and which delivers water to others than its stockholders or members, or to the state or any department or agency thereof or any school district, or to any other mutual water company, for compensation, is a public utility and is subject to Part 1 (commencing with Section 201) and to the jurisdiction, control, and regulation of the commission.” (PUC §2702.) • The facts and circumstances test: • “whether or not those offering the service have expressly or impliedly held themselves out as engaging in the business of supplying water to the public as a class, not necessarily to all of the public, but to any limited portion of it, such portion, for example, as could be served from its system.” (Samuel Edwards Associates v. Railroad Comm. (1925) 196 Cal. 62, 72.)

25. Regulation of MWC’s, cont. • Regulation by PUC, cont. • Exceptions (PUC §2705) – a MWC may sell water to the following persons and entities without being a “public utility”: • Sales at cost to lessees of a shareholder’s shares; • Sales at cost to lessees of a shareholder’s land; • Transfers of water or water rights to any entity under state or federal law (not subject to the “at cost” limitation); • In the event of an emergency; • Pursuant to a court order or settlement; or • Pursuant to a contract made in exchange for water rights (or an easement for water distribution purposes).

26. Regulation of MWC’s, cont. • Sales to non-shareholders • Think very, very carefully before selling water to non-shareholders (at cost or for a profit). • By doing so you may: • Become a public utility and subject yourself to the jurisdiction of the PUC; • Lose your tax exempt status (and/or have taxable UBIT); and • Subject yourself to federal and state drinking water rules and regulations (discussed later).

27. Taxation of MWC’s Internal Revenue Code §501(c)(12)

28. Taxation of MWC’s • MWC’s obtain their tax exempt status under §501(c)(12) of the Internal Revenue Code (“IRC”). • §501(c)(12) exempts from taxation “mutual ditch and irrigation companies” but only if 85% of more of the income consists of amounts collected from members for the sole purpose of meeting losses and expenses. • Reserves –Despite the “sole purpose” a MWC “may be entitled to exemption, although it makes advance assessments for the sole purpose of meeting future losses and expenses, provided that the balance of such assessments remaining on hand at the end of the year is retained to meet losses and expenses or is returned to members.” (Treas. Reg. §1.501(c)(12)-1(a).) • Limitation – “Reserves may not be accumulated beyond the reasonable needs of the organization's business. Whether there is an improper accumulation of funds depends upon the particular circumstances of each case.” (Rev. Rul. 72-36.)

29. Taxation of MWT’s, cont. • Unrelated Business Income Tax (“UBIT”) • If more than 85% of a MWC’s income is derived from the shareholders, it will retain its tax exempt status; • However, income not derived from the MWC’s shareholders may be subject to UBIT. • UBIT is imposed on the net income of any (1) trade or business that is (2) regularly carried on by an exempt organization, and (3) which is not substantially related to the organization’s exempt purposes. (IRC §511.) • Purpose is to prevent unfair competition between for-profits and not-for-profits.

30. Fiduciary Duties of Board Members The Duty of Care and the Duty of Loyalty

31. Fiduciary Duty • What is a fiduciary? • “One who is required to act for the benefit of another person on all matters within the scope of their relationship.” (Black’s Law Dictionary). • In lay terms – an agent is a fiduciary of his or her principal for all matters within the scope of the agency. • Examples: • Attorney / client • Real estate agents and brokers • Partners in a partnership • Employees to employer

32. Fiduciary Duty, cont. • What is “fiduciary duty” • “A duty of utmost good faith, trust, confidence and candor owed by a fiduciary; a duty to act with the highest degree of honesty and loyalty toward another person and in the best interests of the other person.” (Black’s Law Dictionary”.) • Fiduciary duty generally encompasses two separate, but related duties: • The Duty of Care; and • The Duty of Loyalty.

33. Fiduciary Duties, cont. • To whom are fiduciary duties owed? • Board members and officers owe fiduciary duties to the MWC. • But what about the shareholders? • Fiduciary duties apply to agents, and the BOD is not necessarily the agent of the shareholders. • This issue is less than clear (although there is support for it in the case law). • Generally, if a board member breaches his or her fiduciary duties, the cause of action belongs to the MWC. • If the MWC does not enforce its rights, the shareholders may bring what is called a “derivative action” against the board member in the name of the MWC.

34. Fiduciary Duties, cont. • Does it matter if the BOD is not compensated? • No! • Section 7230 of the Corporations Code provides that “Any duties and liabilities set forth in this article shall apply without regard to whether a director is compensated by the corporation.” • This obviously creates some unfairness – BOD members owe fiduciary duties and may be held personally liable even though they are volunteers.

35. Fiduciary Duties, cont. • The Corporations Code does contain one section designed (allegedly) to shield against this unfairness. Section 7231.5 provides that: There is no monetary liability on the part of, and no cause of action for damages shall arise against, any volunteer director or volunteer executive officer of a nonprofit corporation subject to this part based upon any alleged failure to discharge the person's duties as a director or officer if the duties are performed in a manner that meets all of the following criteria: (1) The duties are performed in good faith. (2) The duties are performed in a manner such director or officer believes to be in the best interests of the corporation. (3) The duties are performed with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances. • This is the same protection available to paid BOD members in for-profit corporations! A small, illusory consolation.

36. Fiduciary Duties – The Duty of Care • Although not always discussed this way, a careful reading of the applicable case law shows that the duty of care has two aspects: • Procedural, and • Substantive. • We will address these aspects in connection with the fiduciary duties owed by the BOD (and the officers) to the MWC.

37. Fiduciary Duties – The Duty of Care • Procedural Aspects of the Duty of Care • The “duty of attention”: • Must hold and attend meetings; • Must oversee the affairs of the corporation and supervise its activities (including the activities of the other board members); • Must understand how MWC’s operate. • Must be aware of the legal issues and rules governing MWC’s and pubic water systems (if the MWC is also a public water system). • Ignorance of the law is no defense (although the task can be delegated to an attorney or compliance officer); BOD members need to know the “issues” – but not necessarily the answers. • The BOD may delegate its powers, but it must exercise that power prudently and must supervise the people it has delegated power to. • The BOD may rely on others for information, but only if doing so is reasonable. (Corp. Code §7231(b).)

38. Fiduciary Duties – The Duty of Care • Substantive Aspects of the Duty of Care • BOD members are held to a general negligence standard (Corp. Code §7231(a).): A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances. • This imposes 3 requirements. The BOD must: • Act in good faith; • In a manner believed to be in the best interests of the MWD; and • With the care and reasonably inquiry an ordinarily prudent person would exercise.

39. Fiduciary Duties – The Duty of Care • To satisfy (or more accurately shift) the BOD’s duty of care, the board may rely the opinion, reports, and statements of: • The officers; • Counsel and other professionals (e.g., a CPA); • Other people who have “professional or expert competence”; or • Committees on which the director does not serve which is composed exclusive of the above (Corp. Code §7231(b).) • A BOD member may conclusively reply on the opinions, reports and statements of other,sprovided that the procedural duties of care are followed – i.e., • The persons relied upon are believed by the BOD to be reliable and competent; • The delegation is made in good faith; and, • There are no facts which would justify the BOD not to rely.

40. Fiduciary Duties – The Duty of Care • Substantive Aspects of the Duty of Care, cont.: • The Business Judgment Rule (“BJR”). • A BOD member will not be liable for exercising sound business judgment. • In other words, an imprudent substantive decision or an undesirable outcome is not sufficient to subject the BOD member to liability. • This gets back to the procedural aspects of the duty of care – assuming the decision was informed when made, the BOD will not be responsible if it later turns out that the substantive results were less than desirable. • All bylaws should have some provision reciting the BJRto protect the BOD members.

41. Fiduciary Duties – The Duty of Care • Substantive Aspects of the Duty of Care, cont.: • The BJR does not apply to transactions which arise: • From a breach of the BOD member’s duty of loyalty; • Conflict of interest transactions; or • Self-dealing transactions.

42. Fiduciary Duties – The Duty of Care • Assuming you have not already resigned your position on the BOD – what can you do to protect yourself from liability? • All bylaws should have the following provisions to protect its volunteer BOD from personal liability: • A BJR provision; • An exculpatory clause; • An indemnity clause; and • A requirement that the MWC obtain a policy of directors and officers insurance (“D&O”).

43. Fiduciary Duties – The Duty of Care • What do these provisions accomplish: • There are 2 goals • Raise the bar of actionable conduct; and • Shift the risk of loss to the MWC or an insurance carrier.

44. Fiduciary Duties – The Duty of Care • Raising the bar on actionable conduct: • The BJR provision raises the bar on actionable conduct, and protects the BOD from informed decisions which turned out poorly. • An exculpatory clause further raises the bar. A properly drafted exculpatory clause will limit the BOD’s liability to grossly negligent and intentional wrongdoing. • With a properly drafted exculpatory clause, a BOD member will not be liable for its active or passive negligence.

45. Fiduciary Duties – The Duty of Care • Shifting the risk of loss • Even after raising the bar on actionable conduct, an indemnity provision requires the MWC to defend and indemnify the BOD member. • Corporations Code §7237 contains limitations on when a MWC may indemnify its BOD members. (The BOD member must act in good faith, and in a manner believed to be in the best interests of the company.) • D&O insurance (like the indemnify from the MWC) is another level of protection. • D&O insurance is often preferable because: • The MWC will only pay premiums – it will not have to pay the actual cost of defending and indemnifying the BOD. • The carrier may defend and indemnify the BOD member for things that the MWC is prohibited from doing (e.g., acts not in the best interests of the MWC, or acts not undertaken in good faith). (Corp. Code §7237(i).) • It is recommended that all bylaws expressly set forth that the MWC’s indemnity obligations are secondaryto the obligations of the D&O insurance.

46. Fiduciary Duties, cont. • Many of the previous protections do not apply to transactions involving a breach of the BOD member’s duty of loyalty. • BJR does not protect against breaches of the duty of loyalty; • A knowing or grossly negligent conflict of interest, self-dealing of other breach of the duty of loyalty will expose the BOD to liability even with an exculpatory clause; • MWC’s indemnity may not apply (in many cases) since a breach of the duty of loyalty is not in good faith or the best interests of the MWC; • D&O insurance (depending on the policy exclusions) may not apply.

47. Fiduciary Duties – The Duty of Loyalty • The duty of loyalty is truly the heart of what is meant by fiduciary duties. • As explained by Judge Cardozo in Meinhard v. Salmon (1928) 249 N.Y. 458, 463-64, a fiduciary owes: “the duty of the finest loyalty. Many forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate.”

48. Fiduciary Duties – The Duty of Loyalty • Some examples of the duties of loyalty are obvious: • A fiduciary holds company property as trustee for the company (i.e., no embezzling!); • A fiduciary must hold confidential information in trust; • Insider advantages (e.g., the payment of exorbitant salaries or other compensation); • The use of company property for a private benefit on a more favorable basis that is offered to third persons.

49. Fiduciary Duties – The Duty of Loyalty • The duty of loyalty enters a “grey” zone when a fiduciary enters into a transaction with the company, or where the fiduciary competes with the company. • These are not necessarily prohibited – but you must tread carefully. • We will examine: • Transactions between a BOD member and the MWC (called “conflict of interest” or “self-dealing” transactions”); and • Transactions were a BOD member competes with the MWC (called “corporate opportunity” transactions).

50. Fiduciary Duties – Conflict of Interest Transactions • Conflict of interest rules apply to any transaction between the MWC and: • A BOD member; • A company in which a BOD member has a “material financial interest”; • A company on which the BOD member is also a BOD member. (Corp. Code §§7233(a), (b).) • A transaction where a BOD member approves the salary or compensation of another BOD member is not a conflict of interest transaction (even if the approving BOD member is also receiving compensation from the MWC). (§7233(a).)