LAW AND SOCIAL ENTREPRENEURSHIP

THE ROLE OF SOCIAL ENTERPRISE AND HYBRID ORGANIZATIONS

This post, originally posted in on the Harvard Corporate Governance Forum, is a summary of the main claims I make in my recent paper, The Law of Social Enterprise and Hybrid Organizations, which was recently posted on SSRN as a Yale Law & Economics Research Paper. The goal of this paper is to advance an economic theory of social enterprise that can inform legal policy. I am also working now on a policy paper that will make policy recommendations in light of the theory.

In my paper, The Role of Social Enterprise and Hybrid Organizations, which was recently made available on SSRN, I advance a theory of hybrid organizations that combine profit-seeking and social missions.

Recent years have brought remarkable growth in hybrid organizations, including firms that pursue corporate social responsibility (“CSR”) policies, socially responsible investment firms, and environmentally-friendly firms. In addition, much attention has focused on a broad but vaguely defined group of hybrid organizations which are commonly referred to as “social enterprises”; these include microfinance institutions, businesses that sell fair trade products, work integration firms, and companies that sell affordable products in developing countries (e.g., eyeglasses and bed-nets). Despite popular enthusiasm for hybrid organizations, legal reforms to facilitate their formation and growth—including, in particular, special enabling statutes for hybrid firms (e.g., the Low-Profit LLC and the Benefit Corporation)—have largely been ineffective. This failure stems in large part from the lack of a theory that identifies the structural and functional elements that make some types of hybrid organizations more effective than others. Rather, legal and economic scholars tend to treat different forms of hybrids, especially social enterprises and firms implementing CSR policies, as essentially the same form of enterprise, i.e., firms with a mixed profit and social mission.

However, defining hybrids by reference to their mission is problematic because verifying and measuring social missions is virtually impossible. Instead, I define hybrid organizations, including social enterprises, as commercial firms that channel subsidies to a class of beneficiaries. If there is no subsidy, the firm is simply a standard profit-maximizing firm. In this respect, I take a broad view of subsidies, to include not only government subsidies and donations, but also premium prices and subsidized investments at below-market rates. For example, a consumer may pay a premium for products if the firm has a strong CSR agenda, or if its products are sourced from fair trade producers. To evaluate hybrid organizations, we thus need to ask what forms of organization utilize subsidies more effectively than others.

The theory in the paper focuses on social enterprises, such as microfinance institutions and work-integration firms, and distinguishes them from all other forms of hybrid organization. Social enterprises have been relatively effective in addressing complex development problems, such as increasing access to capital, improving employment opportunities, and enhancing consumer welfare. The key common characteristic of social enterprises is that they transact with their beneficiaries as patrons, i.e., the beneficiaries are either purchasers of the firms’ goods or services, or suppliers of input (including labor) to the firm. For example, microfinance institutions make loans to low-income borrowers, and work integration firms employ disadvantaged workers. Transactions with the patron-beneficiaries are costly either because of information asymmetries with respect to the beneficiaries’ abilities, or because beneficiaries lack sufficient abilities to transact with commercial firms; hence, the need for a subsidy.

The essence of the theory is that social enterprises perform a measurement role. The financial viability of social enterprises depends in large part on the performance of their patron-beneficiaries. For example, microfinance institutions are financially dependent on the ability of their borrowers to repay their loans. Thus, social enterprises have incentives to measure or gather information on their patron-beneficiaries’ attributes (e.g., workers’ skills or borrowers’ creditworthiness) in order to ensure that they are capable of performing their duties and tasks under their transactional relationship with the social enterprise firm. This information enables social enterprises to allocate subsidies (e.g., a training subsidy) to their beneficiaries (e.g., disadvantaged workers) effectively. In particular, social enterprises have the ability and incentives to tailor the form and amount of subsidies to their beneficiaries’ abilities and preferences as well as the commercial needs of their business.

The measurement function makes social enterprises relatively efficient vehicles for allocating subsidies to promote development goals. For example, microfinance institutions have grown substantially in the last few decades and now provide financial services to millions of low-income customers in developing countries. The relative success of microfinance contrasts with the limited effectiveness of traditional donative organizations, including governments and aid agencies, in spurring development. This paper argues that a possible reason for this is that donative organizations transfer subsidies to external beneficiaries rather than transact with them as patrons. Thus, they have limited incentives and means to gather information on the effectiveness of the subsidies they allocate. Social enterprises should also be contrasted with other forms of hybrid organizations, especially firms that engage in CSR policies. Similar to donative organizations, CSR initiatives typically involve the allocation of subsidy to external beneficiaries. In fact, firms that engage in CSR not only have limited means and incentives to measure the social impact of their policies, but they also have incentives to exaggerate it to enhance their reputations.

The article also describes the various types of commitment devices that social enterprises adopt in order to commit to transacting with their beneficiaries. Social enterprises may form as both for-profits and nonprofits. When social enterprises form as for-profits, there is a risk that their owners will expropriate the subsidies they receive to address a development mission. Commitment devices generally involve a nonprofit or a government agency assuming responsibility for ensuring that the for-profit social enterprise transacts with a class of patron-beneficiaries, such as borrowers or workers. Commitment devices may take the form of certification by a nonprofit in accordance with certain standards (e.g., Fair Trade certification), a contract with a nonprofit, or control by a nonprofit through ownership or voting rights. These commitment devices seem to work well due to their simplicity. Whereas social rating mechanisms, such as the Global Reporting Initiative or B-Corp certification, attempt with questionable success to measure the overall social impact of corporations, these commitment devices verify structural elements (i.e., transactions with patron-beneficiaries) which can be observed at relatively low costs. The transactions with their beneficiaries ensure that social enterprises haveincentives to utilize subsidies effectively.

Finally, the measurement function of social enterprises may serve the basis for designing a new social enterprise legal form and reforming corporate subsidy programs to promote development, including the Small Business Act and the Work Opportunity Tax Credit. In future work, I consider the policy implications in greater depth; this article focuses on laying out the structural and theoretical underpinnings of social enterprises and other hybrid organizations.

The full article is available for download here.

Any comments are welcome.

 

FELLOWSHIP: WVU’S LAND USE AND SUSTAINABLE DEVELOPMENT LAW CLINIC

Folks that follow this blog may be interested in the following fellowship announcement from WVU’s Land Use and Sustainable Development Law Clinic:

West Virginia University College of Law’s Land Use and Sustainable Development Law Clinic is now accepting applications for the Land Use and Sustainable Development Law Fellowship. The fellowship combines the opportunity to work with attorneys, planners and students at one of the leading Land Use Clinics in the United States with the opportunity to obtain the WVU Law LL.M. degree in Energy and Sustainable Development Law. The LL.M. program provides a uniquely deep and balanced curriculum in perhaps the nation’s richest natural resource region.

LL.M. in Energy and Sustainable Development Law

The WVU College of Law LL.M. in Energy and Sustainable Development Law is the only LL.M. program in the United States that provides a balanced curriculum in both energy law and the law of sustainable development. Working with WVU College of Law’s Center for Energy and Sustainable Development, LL.M. students will develop the expertise to advise clients and provide leadership on matters covering the full range of energy, environmental and sustainable development law.

The LL.M. in Energy and Sustainable Development Law provides a broad and deep offering of courses, experiential learning opportunities, and practical training for every part of the energy sector. Our broad spectrum of courses allows our students to prepare to be lawyers serving energy companies, investors, environmental organizations, landowners, utilities, manufacturing companies, lawmakers, policymakers, regulators and land use professionals.

More info here: http://law.wvu.edu/energy-llm/land-use-llm-fellow.

TEXAS A&M CLIP CONFERENCE INSIGHTS: BEING AN ENTREPRENEURIAL LAWYER

I just returned from a wonderful conference at Texas A&M School of Law, sponsored by the Center for Law and Intellectual Property (CLIP) and Startup Aggieland. Megan Carpenter, director of CLIP, did a wonderful job of organizing the conference, entitled “Innovation Summit: Shaping the Future of Law & Entrepreneurship”. As I listened to the speakers (of which I was one), I was inspired to gather a list of what exactly it means to be a lawyer for entrepreneurs, or an entrepreneurial lawyer. My list is below; what have I missed?

An entrepreneurial lawyer needs to have an entrepreneurial spirit and business mindset. By that, I mean:

1. The entrepreneurial lawyer must be able to assess both risks and opportunities. The entrepreneurial lawyer should not be risk averse or focus on the negative effects of every option. The entrepreneurial lawyer should recognize that risk is tolerable where there is opportunity for reward.

2. The entrepreneurial lawyer should aim to be part of the business team and be invited into business meetings, not kept outside. If the client simply hands the lawyer a term sheet to draft the deal after the business terms have already been settled, the lawyer has failed to be entrepreneurial. To be part of the team, the entrepreneurial lawyer must know the client’s business and have a solid business and financial understanding. It also helps if the lawyer is not a naysayer and can assess both risks and opportunities (see #2).

3. The entrepreneurial lawyer must be able to help her client’s “lean start-up” strategies, which includes avoiding high sunk costs when the start-up is in its early stages (e.g., avoiding high legal fees, potentially avoiding high legal costs such as patent and trademark filings and incorporation fees, at least at the pre-concept phases).

4. The entrepreneurial lawyer must be willing to find non-legal solutions to her client’s legal problems.

5. The entrepreneurial lawyer needs to break from the mechanical confines of traditional legal representation and be creative.

6. The entrepreneurial lawyer should not have a litigious mindset.

I plan to write a paper exploring the notion of an “entrepreneurial lawyer” further and how to teach such entrepreneurial skills to law students. That paper will be presented at Lewis & Clark Law School’s Fall Forum in October 2014, organized by Susan Felstiner, director of the Small Business Legal Clinic there.

NONPROFIT IPO: A GOOD IDEA BUT ONLY IF YOU WANT MEMBERS

I have recently read more than one article about nonprofit IPOs as a capital-raising method. Of course, a nonprofit does not have shareholders and cannot distribute its profits. Instead of an initial public offering, “IPO” stands for “immediate public opportunity.” An IPO in the nonprofit context means that a donor receives a “social innovation share” in the nonprofit: every X amount of money the donor donates entitles the donor to cast one vote for board director elections. Using the term “IPO” is certainly a way to grab attention and solicit donations in a sector that increasingly prizes innovation. However, there is one legal issue (and possibly more) of which nonprofit directors and officers should be well-advised. Under Delaware law, where the certificate of incorporation of the corporation is silent with respect to members, individuals who have the right to vote for board members of a nonprofit are considered to be “members.” (DGCL Section 102(a)(4)). Therefore, in conducting a nonprofit IPO, a nonprofit may be inadvertently anointing the IPO participants as legally-defined members with certain default statutory rights . It is also unclear what would happen in Delaware if a corporation that has members (and therefore references those members in its certificate of incorporation) then conducts an IPO that allows donors to participate in director elections. Are those new donors considered “members” with the same rights of members stated in the certificate of incorporation?

To resolve this, any nonprofit thinking of engaging in an IPO would be well-advised to first think through the ultimate fundraising objective and closely analyze whether the IPO participants will be considered members under state law. If the nonprofit decides to move forward with the IPO, the nonprofit should amend its certification of incorporation to clearly define who constitutes a member, whether participants in the IPO will be considered members, and what rights these members have.

WHITEWASHING & THE PUBLIC BENEFIT CORPORATION: AN EXAMPLE

Rasmussen College recently converted to a Delaware public benefit corporation. For those who don’t follow the blog regularly, a Delaware public benefit corporation is a for-profit entity “intended to produce a public benefit or public benefits and to operate in a responsible and sustainable manner.” “‘Public benefit’ means a positive effect (or reduction of negative effects) on one or more categories of persons, entities, communities or interests (other than stockholders in their capacities as stockholders) including, but not limited to, effects of an artistic, charitable, cultural, economic, educational, environmental, literary, medical, religious, scientific or technological nature.”

What raises red flags for this corporate conversion is the fact that the U.S. Senate Health, Education, Labor and Pensions Committee (HELP) issued a damning report in July 2012 on for-profit colleges including, specifically Rasmussen College. The report, titled For-Profit Higher Education: The Failure to Safeguard the Federal Investment and Ensure Student Success, can be found here. The report is the result of a 2-year government study on for-profit colleges.

The report notes that the revenues of for-profit colleges come almost entirely from federal taxpayers (to the tune of $32 billion a year) but that the retention rate of students is low, the colleges are not held accountable for ensuring student success, the colleges have seen large increases shareholder returns in recent years, the colleges spend more money on recruiting than education, and that the quality of education provided is abysmal.

I cannot repeat the findings of the 250-page HELP report in total on this blog, but here are some figures from the part of the report that discusses Rasmussen College (full report on Rasmussen here).

• Approximately 80% of Rasmussen’s revenue comes from federal funds (approximately $185 million in 2010).
• Compared to public colleges offering the same programs, the price of tuition is higher at Rasmussen. A Bachelor’s degree in Business Management from Rasmussen College costs $68,668. The University of Minnesota costs $56,240 for a Bachelor’s in Business.
• Rasmussen spent $4,801 per student on instruction in 2009, compared to $6,261 on marketing and $9,017 on profit.
• Rasmussen’s student retention rates were among the lowest of the for-profit colleges surveyed.
• In 2010, with 17,090 students, Rasmussen employed 448 recruiters, 30 career services employees, and 303 student services employees. That means each career counselor was responsible for 570 students and each student services staffer was responsible for 56 students. Meanwhile, the company employed one recruiter for every 38 students. (Recruiting high volumes of students is part of the profit model).

The HELP report on Rasmussen College report concludes:

“Like many others in the sector, Rasmussen’s enrollment increased rapidly over the past decade.
Much of this growth came after the company’s 2003 acquisition by the private equity company
Frontenac. Additionally, Rasmussen has received increasing amounts of Federal financial aid dollars, at least $185 million in 2010, and realized significant increases in profit. However, the company’s programs are costly and students attending Rasmussen have some of the worst retention rates of any company examined by the committee, with more than 63 percent of students leaving with no degree. While Rasmussen has made some minor improvements, including an orientation program, and makes a greater investment in spending on instruction and student services than many for-profit colleges examined, it is unclear whether taxpayers or students are obtaining value from their investment in the company.”

And now, Rasmussen College is a public benefit corporation. This is exactly the type of “whitewashing” or “greenwashing” that lawyers and scholars predicted would occur as the benefit corporation legislation has been passed into law in 19 states and the District of Columbia. Any company can become a public benefit corporation; and the public benefit produced is only enforceable by shareholders. Quite unfortunately, I predict that we’ll see a lot of this in the years ahead.

This is a prime example of how the corporate form—whether a traditional corporation, benefit corporation, or even a nonprofit corporation—does not tell us much about the actual shared value (or lack thereof) that a firm creates. Socially- and environmentally-beneficial firms create shared value because they have investors and managers that pursue shared value and eschew opportunistic, greedy behavior, not because of a state statute governing corporate form. I still think that there are societal benefits to the benefit corporation and hybrid forms like it, but one should not mistake corporate form for actual corporate performance. Even a nonprofit corporation can engage in vice. To assess corporate performance, you need accounting and outcome measurements, and someone or something to hold companies accountable. Rasmussen would presumably fail miserably on GIIRS ratings or SASB standards.

THE BENEFIT CORPORATION’S RIGHT TO THE FREE EXERCISE OF RELIGION

Recently posted on SSRN (hat tip to Steven Bainbridge) is an article analyzing whether a benefit corporation organized for a religious purpose has the right to the free exercise of religion in context of the Hobby Lobby case:

Blurring Lines between Churches and Secular Corporations: The Compelling Case of the Benefit Corporation’s Right to the Free Exercise of Religion by Marc Greendorfer

Abstract:
The United States Supreme Court will soon hear oral arguments on two cases, Sebelius v. Hobby Lobby Stores, Inc. and Conestoga Wood Specialties Corp. v. Sebelius. Both cases present similar questions with regard to the applicability of the First Amendment’s “Free Exercise Clause” to corporations. In Hobby Lobby, the Tenth Circuit found that Free Exercise rights existed for a corporation, without regard to its status as a non-church, profit-seeking entity. In Conestoga, however, the Third Circuit agreed that a corporation could have Free Exercise rights, but such rights did not apply if the corporation happened to be “secular” and “for-profit”, defining characteristics which appear nowhere in the Constitution and which are contrary to recent First Amendment jurisprudence and other precedent, including the seminal case of Citizens United v. Federal Election Commission.

Why would there be such a distinction relating to a right as fundamental as the exercise of religion?

According to the Conestoga court, it all comes down to profit. A legal entity that exists to produce profits for those who organized it can’t exercise religion, but one that exists without an interest in profits miraculously is vested with the right to exercise religion. In Hobby Lobby, the court summarized (and subsequently rejected) the government’s position as being a black and white distinction between non-profit religious organizations, which have Free Exercise rights, and for-profit secular organizations, which have no such rights. The government made the same argument in Conestoga, and in that case the majority adopted the government’s position. Not only is the government’s distinction arbitrary and without logical or legal basis, it is utterly at odds with recent developments in corporate law.

The advent of the “Benefit Corporation” (or “B-Corp”) has formally established a gray area between the black of the non-profit religious organization and the white of the for-profit secular organization with respect to First Amendment rights generally and Free Exercise rights specifically. Indeed, a corporation organized as a B-Corp can be religious and formed for purposes other than the sole pursuit of profit. Such a creature was apparently beyond the knowledge of the Conestoga court. Well, not the entire Conestoga court. Judge Kent Jordan, in his meticulously argued dissent, touched upon the radical upheaval in the law occasioned by the recent establishment of the B-Corp in many states, pointing out that a B-Corp, like a religious non-profit corporation, is a legal entity that exists for purposes other than the solitary pursuit of profit; in fact, B-Corps can be formed in furtherance of religious purposes, much like a religious non-profit.

The purpose of this paper is to elaborate on Judge Jordan’s discussion of B-Corps in his Conestoga dissent and further, to argue that not only should Free Exercise rights apply to corporations that have a religious purpose, such as B-Corps, but also such rights should exist for what I refer to as “de-facto B-Corps.”

DELAWARE PUBLIC BENEFIT CORPORATIONS: THE FIRST 90 DAYS

I’ve just finished up a draft of an article that presents original research on the companies that opted into the Delaware public benefit corporation form within the first three months that the statutory amendments to the DGCL became effective. In the article I analyze the companies with respect to the following characteristics: (1) year of incorporation as a proxy for corporate age, (2) industry, (3) charitable activities, (4) identified specific public benefit, and (5) adoption of model legislation options not required by the Delaware statute. The article is forthcoming in the U.C. Davis Business Law Journal and a draft is available on SSRN here. The abstract follows.

Abstract

The Delaware legislature recently shocked the sustainable business and social enterprise sector. On August 1, 2013, amendments to the Delaware General Corporation Law became effective, allowing entities to incorporate as a public benefit corporation, a new hybrid corporate form that requires managers to balance shareholders’ financial interests with the best interests of stakeholders materially affected by the corporation’s conduct, and produce a public benefit. For a state that has long ruled U.S. corporate law and whose judiciary has frequently invoked shareholder primacy, the adoption of the public benefit corporation form has been hailed as a victory by sustainable business and social enterprise proponents. And yet, the significance of this victory in Delaware is premature. Information about the number and types of companies opting into the public benefit corporation form has been preliminary and speculative. This article fills that gap. In this article, I present original descriptive research on the 53 public benefit corporations that incorporated or converted in Delaware within the first three months of the amended corporate statute’s effectiveness. Based on publicly available documents and information, I analyze these first public benefit corporations with respect to the following characteristics: (1) year of incorporation as a proxy for corporate age, (2) industry, (3) charitable activities, (4) identified specific public benefit, and (5) adoption of model legislation options not required by the Delaware statute. My analysis returns the following results: 75% of public benefit corporations are likely new corporations in their early stages of operation; 32% of public benefit corporations provide professional services (e.g., consulting, legal, financial, architectural design), the technology, healthcare, and education sectors each represent 11% of public benefit corporations, 10% of public benefit corporations produce consumer retail products; approximately 40% of public benefit corporations could have alternatively incorporated as a charitable nonprofit exempt from federal income taxes. This article discusses these and other findings to assist in understanding the public benefit corporation and how it has been employed within the first three months of its adoption.

Kauffman Foundation Announces Renovated and Expanded EshipLaw Website

Long a supporter of entrepreneurship, the Ewing Marion Kauffman Foundation has announced the renovation and expansion of its Entrepreneurship Law (“EshipLaw”) website. The improved website “includes a collection of resources on intersections of law with entrepreneurship and entrepreneurship education that can be relevant in several settings, whether you are an entrepreneurship educator, a student, an inventor, a business owner, or a lawyer or other advisor to entrepreneurs.”

The renovated and expanded EshipLaw website also hosts a brand new section focused solely on social enterprise law. This new section contains unique information and materials that law professors and other educators will find useful in connection with teaching social enterprise law in their classrooms and clinics. Check out the new social enterprise section of the EshipLaw website here.

Thanks to the Ewing Marion Kauffman Foundation for providing this terrific resource.

PS: Please forgive the shameless self-promotion, but yours truly is one of the new editors of the EshipLaw website. Suggestions for improvements to the website as well as contributions of new materials are welcome. Furthermore, in connection with the renovation and expansion, EshipLaw has published my essay entitled, “Gift Horses, Choosy Beggars, and Other Reflections on the Role and Utility of Social Enterprise Law.” I hope that you will find my essay an informative and entertaining read.

HYBRID BUSINESS ENTITIES IN 2014

Happy New Year from SocEntLaw! And, for my fellow academics, welcome back to school!

As we begin 2014, I decided to post on the current state of the law concerning hybrid business entities: benefit corporations, flexible purpose corporations, social purpose corporations, benefit LLCs, and low-profit limited liability companies (“L3Cs”). For more detailed information on these new entities (including citations to the relevant statutes), see my updated social enterprise entity comparison chart posted on SSRN here.

L3Cs: First, with respect to L3Cs, North Carolina conspicuously repealed its L3C statute effective January 1, 2014. Therefore, only eight states now authorize L3Cs: Illinois, Louisiana, Maine, Michigan, Rhode Island, Utah, Vermont, and Wyoming.

Benefit LLCs: The number of benefit LLC states remains at two. Only Maryland and Oregon authorize benefit LLCs.

Flexible/Social Purpose Corporations: Only one state, California, authorizes flexible purpose corporations, while only two states, Texas and Washington, authorize social purpose corporations.

Benefit Corporations: The current number of benefit corporation states is trickier to determine. Altogether, nineteen states and the District of Columbia have enacted some form of benefit corporation legislation; however, a couple of those states have delayed the effective date for their benefit corporation statutes. Jurisdictions with currently effective benefit corporation legislation include the District of Columbia and seventeen states: Arkansas, California, Delaware, Hawaii, Illinois, Louisiana, Maryland, Massachusetts, Nevada, New Jersey, New York, Oregon, Pennsylvania, Rhode Island, South Carolina, Vermont, and Virginia. Two states have passed benefit corporation statutes that (absent further action) will become effective at a future date. Specifically, Colorado’s benefit corporation statute becomes effective April 1, 2014—Really? April Fools’ Day?—while Arizona’s benefit corporation statute becomes effective January 1, 2015.

Predictions: What will 2014 bring with respect to hybrid business entity statutes? Only time will tell, but I’m willing to make a few reckless predictions. I believe that the count of states with benefit corporation legislation roughly will double in 2014. Therefore, I predict that by January 1, 2015, thirty-five or more states will authorize benefit corporations. I predict that the number of states authorizing flexible purpose and social purpose corporations will increase slightly in 2014, but I would be surprised if more than five or six states have flexible purpose or social purpose corporation statutes by January 1, 2015. Finally, I predict that no additional states will enact either L3C legislation or benefit LLC legislation in 2014. In fact, I would not be surprised if more states follow North Carolina in 2014 and repeal their L3C statutes.

Regardless of my predictions, there is one thing we absolutely can count on in 2014 with respect to hybrid business entities: CHANGE!

J. GREG DEES, SOCENT LEADER DIES AT 63

J. Greg Dees has passed away. Dees was a leader in social entrepreneurship and responsible for making social entrepreneurship an academic field. His important work will be remembered and continued. Social Enterprise Alliance has a touching tribute here.