Presentation Regarding Incorporation and Corporate Governance of

Report
California Health & Safety Code §116755(a)
Corporations Code §14301.2
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.
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
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.
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.
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 nonprofit public benefit corporation).
 Shareholders of mutual benefit corporations, just like
shareholders of for-profit corporations enjoy limited liability
protection.
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.
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.
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
Governance of MWC’s, cont.
 Governing Documents
 All MWC’s must have two documents:


Articles of Incorporation; and
Bylaws.
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

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.
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.
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.”
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.
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).
The Department of Corporations, the Department of Real
Estate, the Public Utilities Commission
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).
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.
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:



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15 representations and assurances;
A detailed engineer’s report;
Certification of compliance with water supply, distribution
and fire protection design standards; and
Other information.
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.)
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.
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.)
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).
Regulation of MWC’s, cont.
 Sales to non-shareholders
 Think very, very carefully before selling water to nonshareholders (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).
Internal Revenue Code §501(c)(12)
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.)
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.
The Duty of Care and the Duty of Loyalty
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:

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

Attorney / client
Real estate agents and brokers
Partners in a partnership
Employees to employer
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.
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.
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.
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.
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.
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).)
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.
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,s provided 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.
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 BJR to
protect the BOD members.
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.
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”).
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.
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.
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 secondary to the obligations of the D&O
insurance.
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.
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.”
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.
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).
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).)
Fiduciary Duties –
Conflict of Interest Transactions
 All conflict of interest transactions are void or voidable (at the
election of the MWC) unless:
The material facts of the transaction and the BOD member’s
interests in the transaction are fully disclosed or known to the
BOD; and,
 The transaction is approved in good faith by a vote of the
disinterested BOD members. (Corp. Code §7233(a)(1), (2).)
 If there is no disclosure, and no approval by a disinterested BOD,
the transaction is not void if the interested BOD member proves
that the transaction was “just and reasonable as to the corporation
at the time it was authorized, approved or ratified.” (Corp. Code
§7233(a)(3).)

 If the transaction is one which must be approved by the shareholders (as
provided in the bylaws), the same disclosure must be made to the shareholders,
and the transaction must be approved by a vote of the disinterested
shareholders.
Fiduciary Duties –
Conflict of Interest Transactions
 Analyzing conflict of interest transactions:
 Procedural Aspects:


Were all material facts concerning the interested BOD member
disclosed;
Was the transaction approved by a vote of the disinterested BOD;
 Substantive Aspects:
 Was the approval in good faith – this inquiry may delve into
substantive areas (e.g., the approval of a grossly unfair transaction
strongly suggest collusion and an absence of good faith);
 Was the transaction “just and reasonable” at the time it was
approved.
 If the disinterested BOD’s approval is not in good faith, or if the
transaction was not “just and reasonable,” the interested BOD
member has breached his or her duty of loyalty, and the
disinterested BOD members have likely breached their duty of
care.
Fiduciary Duties –
Conflict of Interest Transactions
 The bylaws should contain provisions directly addressing conflict of
interest transactions.
 The bylaw provisions may be more stringent that the minimum
standards in Corp. Code §7233 (e.g., they may eliminate the “safe
harbor” for undisclosed conflict of interest transactions which are “just
and reasonable”).
 The MWC should also have a written conflict of interest policy (either
in the bylaws or a separate document) which addresses the following:
 Defining what constitutes a conflict of interest transaction (which may
be broader than §7233);
 Setting forth procedures for determining the existence of, the
disclosure of, and the approval of a conflict of interest transaction;
 Setting forth procedures for adequately recording the conflict of
interest transaction in the corporate minutes (without this there is no
proof of any disclosure).
Fiduciary Duties –
Corporate Opportunity Transactions
 A fiduciary is generally prohibited from competing
with the company.
 In the for-profit world, this would mean that a Google
executive cannot simultaneously work for Apple.

This has less application to BOD members because:
 MWC’s do not usually “compete” with each other in the same
way for-profit corporations do; and
 MWC BOD membership is a part time job and other positions
will ordinarily not compete with the time the BOD member
owes to the MWC to fulfill its duties.
Fiduciary Duties –
Corporate Opportunity Transactions
 As opposed to competing by joining another
organization (or MWC), a BOD member may
“compete” by taking advantage of an opportunity
available to the MWC.
 The Corporate Opportunity Doctrine:
 A fiduciary may not take advantage of a “corporate
opportunity” without first offering the opportunity to
the corporation and disclosing any conflict of interest.
Fiduciary Duties –
Corporate Opportunity Transactions
 A “corporate opportunity” is an activity which the BOD
member becomes aware:
 in connection with the performance of her functions that
reasonably should lead the individual to believe that the
person offering the opportunity expects it to be offered to the
nonprofit;
 through the use of the organization’s information or property
and the individual should reasonably be expected to believe
the activity would be of interest to the organization; or
 any opportunity to engage in an activity of which a director
becomes aware of and knows is closely related to an activity in
which the nonprofit is engaged or expects to be engaged.
Fiduciary Duties –
Corporate Opportunity Transactions
 Examples:
 A BOD director knows that the MWC is looking to
purchase new water rights and becomes aware that
certain water rights are for sale; before buying those
rights for his or her own account, the opportunity must
first be offered to the MWC.
 A BOD member is approached about an opportunity to
invest in a PUC regulated utility which will acquire the
water system which provides water to the MWC; the
BOD director may have an obligation to offer this
opportunity to the MWC.
Fiduciary Duties – Summary
 Process generally trumps substance
 Duty of care –


If the process by which the BOD arrives at a position is attentive and
diligent, the BOD will likely have satisfied its duty of care, even if the
position turns out to have been misguided.
The BOD needs to be aware of the issues (legal and otherwise); it
can then delegate the task of answering or addressing those issues to
others. The BOD can even delegate the task of identifying the issues
to counsel or a compliance officer.
 Duty of loyalty – DISCLOSE, DISCLOSE, DISCLOSE.
 If you believe a transaction might pose a conflict of interest, always
assume that it is a conflict of interest:
 Disclose the facts;
 Don’t vote; and
 Don’t overreach or abuse your position of authority.
Federal SDWA (42 USC §§300f, et seq.)
California SDWA (Cal. Health & Safety Code §§116270, et seq.
Safe Drinking Water Act
 There are two applicable Safe Drinking Water Acts
(“SDWA”):
 Federal Safe Drinking Water Act (42 USC §§300f, et
seq.)
 California Safe Drinking Water Act (Cal. Health & Safety
(“H&S”) Code §§116270, et seq.)
Federal Safe Drinking Water Act
 The federal SDWA was passed in 1974, and amended in
1986 and 1996
 The federal SDWA is found in Title 42 of the US Code
(“Public Health & Welfare”). (42 USC §§300f, et seq.)
 Constitutional authority for federal regulation of
drinking water – the Commerce Clause allows the
federal government to regulate all “navigable waters”
within the United States – including man-made
navigable waters. (Kaiser Aetna v. United States (1979)
444 U.S. 164.)
Federal Safe Drinking Water Act
 The SDWA applies to “public water systems”.
 A “public water system” is “a system for the provision
to the public of water for human consumption through
pipes or other constructed conveyances, if such system
has at least fifteen service connections or regularly
serves at least twenty-five individuals” (§300f(4)).
 Private wells are generally exempt, unless they serve 25
or more people (however, the EPA has separate
standards for private wells).
 There is a key limitation to the applicability of the
SDWA which we will discuss later.
Federal Safe Drinking Water Act
 Overview of the SDWA
 The SDWA authorizes the Environmental Protection
Agency (“EPA”) to administer the SDWA and to set
federal safe drinking water standards. (§300g-1.)
 States are primarily responsible for the enforcement and
administration of the EPA’s standards, provided that the
state has adopted the EPA’s standards (or more stringent
standards of its own). (§300g-2.)


All states except Wyoming have adopted their own standards
Generally, California’s standards are more stringent that the
EPA’s
Federal Safe Drinking Water Act
 Overview of SDWA, cont.
 The EPA sets guidelines for:





Safe drinking water standards (including variances and exemptions);
Monitoring procedures;
Procedures for certification of operators of public water systems;
Setting technical, managerial and financial capacities for public
water systems formed after 1999;
Grants and funding for implementation of the SDWA.
 In general, the SDWA lays out topics for the EPA to regulate;
the “substance” of the rules are therefore found in the EPA’s
regulations which are codified in 40 C.F.R. §§141, et seq.
Federal Safe Drinking Water Act
 Safe Drinking Water Standards
 The EPA has a list of 90 contaminants.
 These contaminants are:





Microbial contaminants, such as viruses and bacteria, that may come
from sewage treatment plants, septic systems, agricultural livestock
operations, and wildlife.
Inorganic contaminants, such as salts and metals, that can be naturallyoccurring or result from urban stormwater runoff, industrial or domestic
wastewater discharges, oil and gas production, mining, or farming.
Pesticides and herbicides, that may come from a variety of sources such
as agriculture, urban stormwater runoff, and residential uses.
Organic chemical contaminants, including synthetic and volatile organic
chemicals, that are by-products of industrial processes and petroleum
production, and can also come from gas stations, urban stormwater
runoff, agricultural application, and septic systems.
Radioactive contaminants, that can be naturally-occurring or be the
result of oil and gas production and mining activities.
Federal Safe Drinking Water Act
 Safe Drinking Water Standards, cont.
 The EPA then sets standards for each of the
contaminants by:


Setting Maximum Contaminant Level Goals (“MGLC”);
Setting Maximum Contaminant Levels (“MCL”), or, if there is
not method of measuring a MCL, by setting a Treatment
Technique (“TT”) for the contaminant.
Federal Safe Drinking Water Act
 Safe Drinking Water Standards, cont.
 The MCLG is non-binding – it is a “goal.”


The MCLG is level of a contaminant in drinking water below which there
is no known or expected risk to health.
Under the California SDWA the MCLG is called the public health goal
(“PHG”).
 The MCL is binding.


The MCL is the highest level of a contaminant that is allowed in drinking
water
In some instances, the EPA or the state may issue a variance or an
exemption from the MCL.
 Generally the MCL level is set as close as economically and
technologically possible to the MCLG.
 The TT is a required process intended to reduce the level of a
contaminant in drinking water (used where there is no reliable
means of measuring the MCL).
Federal Safe Drinking Water Act
 Safe Drinking Water Standards, cont.
 The EPA sets both primary and secondary water
standards
 Primary drinking water standards include:



MCL’s for contaminants that affect health;
Monitoring and reporting requirements; and
Water treatment requirements.
 Secondary drinking water standards include:

MCL’s for aesthetic characteristics (e.g., color, taste and odor)
which may affect the consumer’s acceptance of their water
supply.
Federal Safe Drinking Water Act
 Two key portions of the SDWA are the “Consumer
Confidence Report” (§300g-3(c)(4); 41 CFR §§141.151, et
seq.), and the “Public Notification Rule” (41 CFR
§§141.201, et seq.)
 These requirements in California are found at 22 CFR
§66480 (the Consumer Confidence Report) and
Health & Safety Code §116450, et seq. (the Public
Notification Rule).
Federal Safe Drinking Water Act
 The Consumer Confidence Report (“CCR”)
 Public water systems are required to issue by mail an
annual report (due July 1 for the prior calendar year).

For public water systems with fewer than 10,000 customers,
the CCR may be published in a local newspaper.
 Purpose:

“Improve public health protection by providing
educational material to allow consumers to make
educated decisions regarding any potential health
risks pertaining to the quality, treatment, and
management of their drinking water supply.”
Federal Safe Drinking Water Act
 The Consumer Confidence Report, cont. – Required Content
 Water system information (name of contact person);
 Source of water (describe where the water comes from);
 Definitions (e.g., MCL, MCLG, TT);
 A table summarizing all detected contaminants, including:



The MCL’s and MCLG’s for those contaminants;
Known sources of the contaminants; and
Health effects of the contaminants
 Information on monitoring for Cryptosporidium, Radon, and other
contaminants (if detected);
 Compliance with other drinking water regulations;
 Whether there are any variances or exemptions in place; and
 Certain educational information (including an explanation of
contaminants in drinking water and bottled water; information to
vulnerable populations about Cryptosporidium; statements on nitrate,
arsenic, and lead.
Federal Safe Drinking Water Act
 The Consumer Confidence Report, cont. –Optional
Content
 An explanation or diagram of the treatment process;
 Source water protection efforts;
 Water conservation tips;
 The costs of making water safe to drink;
 Information to educate customers about taste and odor
issues;
 Information about opportunities for pubic participation.
Federal Safe Drinking Water Act
 The Public Notice Rule (“PNR”)
 Public water systems must notify consumers if the
public water system violates a national primary drinking
water regulation or has a situation posing a risk to public
health.
 Notice must be provided to all persons served.
 Purpose:

To notify the public about violations and situations which
may pose a risk to public health.
 When the notice must be provided depends on the tier
to which the violation is assigned.

There are 3 tiers
Federal Safe Drinking Water Act
 PNR, cont.
 Tier 1 Violations


Requires public notice immediately (within 24 hours).
 Notice must be issued via radio, TV, hand delivery, posting or
some other method to ensure that everyone is notified.
Applies to:
 Samples containing fecal coliform or E. coli;
 The presence of nitrate or nitrite above the MCL level;
 Chlorine dioxide maximum residual disinfectant level
(“MRDL”) level violation;
 Any waterborne disease outbreak; and
 The detection of E. coli, enterococci or coliphage in ground
water source samples.
Federal Safe Drinking Water Act
 PNR, cont.
 Tier 2 Violations


Require public notice as soon as practicable (within 30 days).
 Notice must be issued by mail, posting or direct delivery.
Applies to:
 All MCL, MRDL and TT violations (unless Tier 1 notice is
required);
 Certain monitoring violations;
 Failure to comply with variance or exemption conditions;
 Failures to comply with certain corrective action plans imposed
by the state or EPA.
Federal Safe Drinking Water Act
 PNR, cont.
 Tier 3 Violations



Requires annual notice (usually provided in the CCR).
 Notice must be issued by mail, posting or direct delivery.
Applies to:
 All monitoring or testing procedure violations (unless they are
Tier 2 violations);
 Whether a system is operating under a variance or exemption;
Also required to provide notice for availability of unregulated
contaminant monitoring results (i.e., the contaminants which
are technically not regulated by the EPA or state).
Federal Safe Drinking Water Act
 PNR, cont.
 Each notice give pursuant to the PNR must contain:









A description of the violation or situation, including the
contaminant(s) of concern, and (as applicable) the contaminant
level(s);
When the violation occurred;
The population at risk (including subpopulations which may be
particularly vulnerable);
Whether alternative water sources should be used;
Actions consumers should take;
What the public water system is doing to correct the violation;
When the public water system expects to return to compliance;
The name of the contact person; and
A statement encouraging recipients to distribute the notice to
others.
Case Examples:
1.
The 2011 Vallejo CCR;
2.
2005 EPA Administrative Order to Vallejo
for SDWA violations.
California SDWA
 California SDWA is codified in the Health and Safety Code
(“H&S”) §§116270, et seq.
 For the most part, the California SDWA works like the
federal SDWA
 The SDWA grants authority to the Department of Health
Services (“DHS”) to promulgate regulations.
 The lengthy and complex regulations are found in Title 22 of
the California Code of Regulations, primarily in the
“Waterworks” regulations found at 22 CCR §§64551, et seq.
 DHS may delegate primary administrative and enforcement
responsibility to a local health officer authorized by a county
board of supervisors.
California SDWA
 Public water systems subject to SDWA must obtain a
permit from DHS. (H&S §116525.)
 The permit application must include a technical report
including:




Detailed plans and specifications;
Water quality information;
Physical descriptions of the existing or proposed system; and,
Financial assurance information (H&S §116530.)
 This permit is in addition to the permit required by the
Department of Corporations and/or the DRE.
California SDWA
 All public water systems subject to SDWA must(H&S
§116555):
 Comply with DHS primary and secondary drinking water




standards;
Not be subject to backflow under normal operating
conditions;
Provide a reliable and adequate supply of pure, wholesome,
healthful and potable water;
Employ or utilize only water distribution operators who
have been certified by DHS; and
Place the direct supervision of the water system (both
treatment and distribution) under the charge of an
operator holding a valid certificate from the DHS.
California SDWA
 Operator requirements apply to:
 Water treatment operators; and
 Water distribution operators.
 The type of certification required depends on the
classification of the treatment and/or distribution facility
classification.
 The classification of water treatment facilities depends on the
number of “points” pursuant to 22 CCR §64413.1. There are 5
classifications ranging from T1 (smallest) to T5 (largest).
 The classification of water distribution facilities depends on
the population served (§66413.3), and ranges from D1 (under
1000 population) to D5 (more than 5 million).
California SDWA
 Each public water system must designate:
 Water treatment operators:

One “chief operator”, and one “shift operator”, one of whom
must be on-site or able to be contacted within one hour.
(§64413.5.)
 Water distribution operators:

One “chief operator”, and one “shift operator”, one of whom
must be on-site or able to be contacted within one hour.
(§64413.7.)
 All operators must be certified.
California SDWA
 Certification of Treatment Operators (22 CCR §63775.)
 Operators must take and pass an exam. (§63800; see also,
§§63785-95 for more exam information.)
 In order to take an exam (for a T1 certificate), the operator
must:

Have a high school degree (or GED), and either:
 Complete the “Basic Small Water Systems Operations” course
provided by DHS; or,
 Have one year as an operator of a facility that required an
understanding of chemical feeds, hydraulic systems, and pumps.
 For certificates above T1, the operators are required to take a
number of “specialized training courses” (depending on the
system classification).
California SDWA
 Certification of Distribution Operators (22 CCR §63780.)
 Operators must take and pass an exam. (§638805; see also,
§§63785-95 for more information on exams.)
 In order to take an exam (for a D1 certificate), the operator
must:

Have a high school degree (or GED); and either:
 Complete the “Basic Small Water Systems Operations” course
provided by DHS; or,
 Have one year as an operator of a facility that required an
understanding of chemical feeds, hydraulic systems, and pumps.
 For certificates above D1, the operators are required to take a
number of “specialized training courses” (depending on the
system classification).
California SDWA
 All required sample collections and field tests must be
performed by:
 DHS;
 A laboratory certified by DHS; or
 A certified water treatment operator (22 CCR §64415).
 All required analyses must be performed by
laboratories certified by DHS (id.)
California SDWA
 Certified distribution operators must be utilized for the
following decisions (22 CCR §63770(b)-(d)):
 To install, disinfect, test and connect water mains;
 Shutdown, repair, disinfection and testing of broken water mains;
 Overseeing the flushing, cleaning and pigging of existing water





mains;
Stand-by emergency response duties;
Drain, clean, disinfect and maintain distribution reservoirs;
Operate pumps and related flow and pressure control and storage
facilities;
Maintain or adjust system flow and pressure requirements; and
Investigate water quality problems in the distribution system.
Application of SDWA
 As mentioned earlier, there is an important limitation to
the applicability of the federal and California SDWA’s.
 Even if a system is a “public water system”, the SDWA does
not apply to systems which meet all of the following
criteria:
 Consists only of distribution and storage facilities and does
not have any collection and treatment facilities;
 Obtains all of its water from a public water system to which
the SDWA applies; and
 Does not sell water to any person or user.

Important limitation – the “sale of water” does not include: the
sale of water, obtained from a public water system that is
subject to this chapter, through a submetered distribution
system if each user of the system is charged no more than the
rate the user would be charged by the public water system
Application of SDWA
 To summarize, the requirements of the SDWA do not
apply if:
 You only operate a distribution and storage system – no
water collection or treatment facilities;
 You get all your water from a public water system (e.g.,
the City of Vallejo); and
 You sell your water at cost through a sub-metered
distribution system.
Application of SDWA
 Has this entire exercise been a waste?
 Hopefully not.
 We can use all of the foregoing information to develop and
implement reasonable practices which should ensure safe
and reliable drinking water for our particular needs.
 With that, we now turn to long term maintenance of public
water systems.
 The goal of the next section is to cover some recommended
practices which can feasibly be done by small mutual water
companies which do not treat or collect water.
“Best Practices” for Small MWC’s
Long Term Maintenance of Public
Water Systems
 This class is designed for board members, not water
treatment or distribution operators.
 As discussed earlier, the board has a duty of care. That
duty includes the duty to be aware of the issues.
 Once the board is aware of the issues, it can delegate
responsibility to others who are trained in the subject
matter.
Long Term Maintenance of Public
Water Systems
 A major first step is to have a properly functioning MWC and to
know how MWC’s are managed and operated.
 We have discussed:








The management of a MWC by the board;
The role of the officers;
The rules governing mutual benefit corporations;
Some of the specific rules governing MWC’s;
The regulation of MWC’s by the Department of Corporations, the DRE
and PUC;
Taxation of MWC’s;
The fiduciary duties of board members and officers; and
The SDWA’s.
 Just being aware of these issues is a huge step. It allows you to ask
the right questions and seek answers from qualified professions.

Remember – the board must be aware of the issues; it can then delegate
responsibility to others.
Long Term Maintenance of Public
Water Systems
 Funding a MWC.
 Undercapitalizing your MWC is a sure way of breaching
your fiduciary duty.
 MWC’s are authorized to levy assessments on the
shareholders (Corp. Code §14303.)
 The assessments must be used to:


Pay for operating costs; and
Capital costs.
 Capital costs must be placed into a reserve account to meet the
long term needs of the MWC.
Long Term Maintenance of Public
Water Systems
 Unlike common interest developments, there are no
rules for creating reserves.
 Nevertheless, the rules for common interest
developments (found in Davis-Stirling, Cal. Civ. Code
§§1350, et seq.) are instructive and should generally be
adopted as “best practices.”
Long Term Maintenance of Public
Water Systems
 Reserve Studies (from Davis-Stirling):
 Prepare a reserve study every 3 years based on a “diligent visual
inspection” of the “major components” of the MWC.

Major components are components with a service life of 30 years of less
(although components with a life of 30 years or more may be included);
 The reserve study should include:





An identification of the major components;
A determination of the remaining useful life of the major components;
The cost of maintaining or replacing the major components over the
next 30 years;
An estimate of the annual contribution necessary to meet the costs of
maintenance and replacement; and
A reserve funding plan indicating how the MWC plans to fund the
reserves.
Long Term Maintenance of Public
Water Systems
 Reserve Studies (from Davis-Stirling), cont.
 Assessments levied to fund the reserves should be
placed in a separate account and not comingled with the
operating account of the MWC.
 Who should prepare the reserve study?


Although not required, generally the reserve study should be
prepared by an expert, such as:
 An engineer;
 A licensed contractor; or,
 A certified water distribution or treatment operator.
Remember – the board must be aware of the requirement; it
can then delegate the task to qualified professionals.
Long Term Maintenance of Public
Water Systems
 Recommended “Best Practices”
 Review AOI and Bylaws




Make required changes;
Make non-required changes (which are now required for new
MWC). (See, Corporate Code §14312(a)(13)(A)-(L) and (10 CCR
§260.140.71.2.)
Include provisions for the protection of the BOD and the officers;
Adopt a conflict of interest policy for BOD members.
 Prepare reserve study
 Should be done by qualified professional (engineer, contractor,
distribution operator);
 Adjust assessments to ensure long term funding consistent with
reserve policy.
Long Term Maintenance of Public
Water Systems
 Recommended “Best Practices”, cont.
 Ideally, the MWC should have one member who gets a
D1 certification for operating the distribution system.

In the alternative, the MWC may contract with a qualified D1
operator as a consultant.
 To test or not to test?
 Testing under the SDWA is technically not required; however,
if you do test, you can possibly expose yourself to liability for
failing to correct violations or for failing to notify your
shareholders of the violations.
 If the MWC elects to test, it should have one member get a T1
certification and that member should perform the testing.
Long Term Maintenance of Public
Water Systems
 Recommended “Best Practices”, cont.
 If you test, what should you test for?


Ask your certified treatment system operator.
Following the “small water system” monitoring regulations as
a potential “safe harbor” (22 CCR §§64212-17):
 Test for coliform bacteria every 3 months;
 One test for fluoride, iron, manganese, chloride, total
dissolved solids and certain inorganic chemicals.
 All tests should be performed by certified laboratories in
accordance with EPA approved methods (22 CCR
§64415; H&S §116390).
What to take from this class?
Summary
 This class is designed to educate you as to the vast
array of legal issues facing a MWC, including:
 Its governing documents;
 Regulatory requirements for operating a MWC;
 Management and operation of a MWC;
 Monitoring and testing under the SDWA’s; and
 Funding a functioning MWC.
Summary
 Board members do not have to be (and cannot be
expected to be) “experts” on all or any of these issues.
 However, the biggest challenge of a BOD member is to
identify issues so that they may:
 Ask the right questions; and
 Seek answers from qualified people.
 Doing this generally will discharge the BOD’s
responsibility, and frankly, will make your small MWC
far more legally and operationally functional than the
vast majority of MWC’s.
Links
 Napa County LAFCo: http://www.napa.lafco.ca.gov/
 Solano County LAFCo: http://www.solanolafco.com/
 Certified Water Treatment and Water Distribution
Operator Information:
http://www.cdph.ca.gov/certlic/occupations/Pages/DWop
cert.aspx
 Certified Laboratory Information:
http://www.cdph.ca.gov/certlic/labs/Pages/ELAP.aspx
 California Drinking Water Information:
http://www.cdph.ca.gov/certlic/drinkingwater/Pages/defa
ult.aspx
 Private Water Law Blog (good for updates on water law):
http://privatewaterlaw.com/
Disclaimer
 The information contained in this class and material is provided for
informational purposes only, and should not be construed as legal advice on
any subject matter. The transmission of information from this class and
material and/or any other communication with us through this class or
material does not create an attorney-client relationship, nor is it intended to do
so. No recipients of content from this class or material, clients or otherwise,
should act or refrain from acting on the basis of any content included in this
website without seeking the appropriate legal or other professional advice on
the particular facts and circumstances at issue from an attorney licensed in the
recipient's state. This class and material contains general information and may
not reflect current legal developments, verdicts or settlements.
 IRS Circular 230 Disclosure: Any tax advice or commentary on this website is
not is not intended or written to be used or relied upon, and cannot be used or
relied upon, for the purpose of (i) avoiding penalties under the Internal
Revenue Code or (ii) promoting, marketing, or recommending to another party
any transaction or matter addressed herein.
Contact Information
Stephen M. Flynn, JD, LLM
Flynn | Williams | Riley LLP
1010 B Street, Suite 200
San Rafael, CA 94901
[email protected]
For more information, visit:
www.formation2liquidation.com

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