Social Enterprises Legal Society in the News

The Social Enterprises Legal Society was highlighted in Sarah Stankorb's article for American Today, Social Enterprises Have a Triple Bottom Line. After discussing social enterprises and their legal structures generally, the article continues on to discuss the implications for law students, giving a great background on Karina Sigar, Professor Walter Effross, and the formation of the Social Enterprises Legal Society. The article also highlights the emerging collaboration between the Social Enterprises Legal Society and the Social Enterprise Program at School of International Service. Go check it out!

In other news about the Social Enterprises Legal Society, we will go up before the Student Bar Association for funding on April 17, 2012. Stay tuned...

The Paradigm Project and the L3C

The Paradigm Project, mentioned briefly in a prior article, is a perfect demonstration of the immense flexibility of the L3C structure and an example of what the right hands can do with this new tool. This organization subsidizes the sale of stoves to communities in need, reducing the amount of fuel, time, and energy required to cook. The reduction in fuel consumption results in the creation of carbon offsets, which are then bulk packed and sold to entities in Europe or the United States. Unlike Vestergaard-Frandsen, the Project was created with social benefit as a primary objective. A group of Wall Street veterans ― individuals with intimate knowledge of the challenges they would face creating a commercial entity ― wanted to create a positive social impact and saw an opportunity in the L3C structure. One of the first 10 L3C’s to register when Utah passed legislation permitting the structure, the Paradigm Project wanted to avoid the pitfalls of the 501(c)(3) structure, avoid the cannibalization of their core entity for project funding, and stand out as something different to investors who wanted to make a sustained and significant impact. They are achieving these goals with a tiered corporate structure.

Their primary L3C operates as a parent company. The Board of this organization oversees the development of subsidiary L3C’s to manage each of their regional efforts. There are currently three of these operations. Two are in development, and one is fully operational. This structure insulates the parent company and allows for freedom in capitalization. The L3C structure enables the subsidiaries to receive contributions from charitable organizations as well as private capitalization. The charitable contributions can only be used for program related investments (PRIs), but access to these funds is one of the primary differences between an LLC and an L3C. To this end, the Paradigm Project has established a 501(c)(3) to take donations and funnel them to different regional projects according to the donor’s desires. The donors can deduct charitable donations made to the 501(c)(3) and the non-profit entity then converts these donations into program related investments.

The subsidiary projects establish organizations according to the domestic laws of their host countries and operate as businesses in those locations. They train workers to market and sell the stoves that they provide at subsidized rates. This involves the community and stimulates economic growth in other ways. The stoves they provide create carbon offsets through a significant reduction of fuel needed for cooking. They also decrease the time necessary for cooking and through the diminution in fuel needs reduce the time devoted to gathering wood. The benefits to the community manifest as rapidly as the stoves can be distributed. The Paradigm Project handles the 3rd Party verification and registration of the Gold Standard offsets they create, and then Blue Source, an affiliated entity, markets and sells those offsets to American and European organizations seeking to reduce their respective carbon footprints. Blue Source keeps a commission, but the net proceeds are then returned to the Paradigm Project for distribution to the subsidiaries.

They plan to begin distributions to their investors once the project in question breaks even. Each investor purchases a 10-year equity position with an anticipated 15 to 20% return over the 10-year span. The Project just delivered its first set of offsets approximately a month ago and they expect to have a solid picture of sustainability and profitability within three years. Gregory Spencer, a co-founder of the Project noted in a phone interview on February 29th that it is “tough to find the balance between social and environmental impact and company sustainability,” but as the Board of the Project seems to be on the same page, no serious hiccups have occurred.

The Gold Standard carbon offsets the Project is marketing require the most rigorous registration process available currently, so they command a premium on the voluntary market. Image conscious corporations―those looking to make a difference and establish a reputation at the same time―pay top dollar for these particular offsets, and the future for this organization looks bright indeed.

The Project has created a time-savings for fuel gatherers and cooks, generated a cost savings for the same group, helped to establish local business and fuel economic growth in some of the neediest areas in the world, reduced the number of trees cleared for fuel, and figured out how to profit in a manner that is non-extractive. This should serve as a demonstration of the significant value of this corporate form and the remarkable potential it has for global impact given the right combination of cognitive capacity and capital.

For more information on the Paradigm Project, what they are doing and how they plan to accomplish their goals, please visit them at their web site.

Talk on Gender-Based Social Investments and the Role of Social Enterprises

In a talk I attended on March 7, 2012 entitled “How Big Business is Empowering Women and Girls,” I identified three kinds of social enterprises that are not exclusive to women-empowering businesses: (1) investment funds; (2) businesses that embark on separate social projects; and (3) businesses that integrate social purposes into their business models.

As for the first kind, the impact investor and investment fund at the event were Ikatu International and Women Effect Investments, an initiative out of Criterion Ventures. Ikatu invests in businesses that would create employment opportunities for the youth. Women Effect Investments empower a community of women investors to place their assets in a diverse group of vehicles and create new investment opportunities with a gender lens. Social investment funds, like other investment funds, pool capital from various investors and invest them in businesses and financial vehicles. However, unlike traditional funds, social investment funds invest only in those that have social impacts. Grassroots Business Fund, which organization I wrote about a few weeks ago, is also an example of such a fund. These types of investments typically attract impact investors, but they have become increasingly appealing to ordinary market investors who are looking to make good money out of their investments. 

For the second kind of enterprise―businesses that embark on separate social projects―the Coca Cola Company was one such example at the event. Large corporations nowadays typically have a corporate social responsibility (CSR) division or funds dedicated to conducting extra-curricular activities, such as Starbucks Coffee, Citibank, and Home Depot. Charlotte Oades, the global director of women’s economic empowerment at Coca Cola, spoke about their recent projects in helping female small business owners in countries like Brazil. Many have argued that the CSR model makes alternative forms of organizations, such as L3Cs and benefit corporations, unnecessary because companies could pursue social projects through a CSR division using allocated funds.

The last kind of enterprise―businesses that integrate social purposes into their business models as opposed to spinning it off into a separate entity―was represented by Vestergaard Frandsen (VF), a Switzerland-based, family-owned company that specializes in complex emergency response and disease control products, such as a mosquito net impregnated with insecticides and a water filter worn around the neck that makes filthy water safe to drink. VF did not start out as a socially driven company. For 40 years, VF was a textile company that made uniforms for hotel workers and retailers. When VF's founder’s grandson Mikkel Vestergaard-Frandsen took over the company, he transformed VF into a company that is “in the business of saving lives” and creates a business model that he calls humanitarian entrepreneurship―one that turns corporate social responsibility into its core business. One of VF’s projects is LifeStraw Carbon for Water that uses the carbon credit market to both fulfill a social mission and generate profit. 

All of the speakers agree that one of the most important and challenging issues for social enterprises is to align the values of the management and investors. Jackie Vanderbrug of Criterion Ventures states that there are two kinds of investors: (1) the social impact first investors and (2) financial first investors. To make things more complicated­, each investor usually brings in different theories of change and interests. The challenge for social enterprises is to accommodate all of the interests and priorities of the investors and channel their combined funds to investments that meet their needs and demands.   

Now, what should people in the legal field take away from all of this? First, I believe that a market-based or business approach to solving humanitarian problems is proving to be more and more popular and effective. But because such approach is still at an embryonic stage, this field needs creative lawyers who can come up with structured transactions, legal structures, and financial products that would facilitate the convergence between business and social impact. For example, L3Cs and benefit corporations are legal structures that many argue could play a very fundamental role in shaping the course of social enterprises. Second, with new structures come new legal questions. Can investments in L3Cs constitute charitable contributions and therefore qualify for a tax deduction? Should social enterprises only be allowed to consider stakeholder interests or should they be required to? In light of these issues, some organizations have found ways to accommodate their needs using existing tools provided by current laws. For example, the Paradigm Project L3C has a sister foundation that obtains donations from people, presumably to allow for tax deductions. Such tandem structure permits fundraising from different pools of individuals with different legal rights as to the legal entities, use of funds, and accountability mechanism. As the field of social enterprises is growing rapidly, so should the number of lawyers working in it.

California Benefit and Flexible Purpose Corporations: Small- and Mid-Size Corporations vs. Large Corporations

California recently enacted two new forms of business entities: benefit corporations and flexible purpose corporations. While arguments are made that the two forms are redundant and unnecessary, one relevant difference between the two forms may be their target companies.

As mentioned in an article by Aman Singh on Forbes Corporate Social Responsibility Blog, benefit corporations have largely been limited to small- and mid-size corporations. One explanation for this may be the mandate for benefit corporations to consider certain other constituencies and use a third-party standard to assess the benefits to these other stakeholders. Such a mandate may scare off large corporations, either for implementation purposes or because large corporations cannot get all its shareholders on board.

Flexible purpose corporations, however, offer a slightly more tenable solution to large corporations. Flexible purpose corporations allow a corporation to specify one or more charitable or public purposes. Directors are then enabled to consider and weigh the short- and long-term prospects of such purposes in performing their duties. As the name entails, flexible purpose corporations provide flexibility in pursuing specific charitable or public purposes, allowing corporations to put one toe in the untested waters of for-profit social enterprises rather than diving head first in considering the numerous stakeholders required under benefit corporations.

While both benefit and flexible purpose corporations require a two-thirds vote of each class of shares in order to amend their articles to adopt a certain purpose, large corporations may find it easier to obtain the necessary shareholder approval for a single purpose rather than the mutli-stakeholder approach of benefit corporations. Moreover, flexible purpose corporations can pursue those charitable or public purposes that shareholders themselves are demanding without bringing in other considerations into the mix.

Heart of a Development Investor, Discipline of a Lender

Takeaway: Grassroots Business Fund’s investment in social enterprises throughout developing countries enforces discipline investing using patient capital from impact investors.

Investing in social causes has for a long time remained an oxymoron. But with companies like Grassroots Business Fund (GBF), such investments are becoming real, abound, and very much desirable.

GBF was founded in 2008 by the International Finance Corporation of the World Bank initially as a Grassroots Business Initiative. As way of background, the IFC was created in 1956 as an institution through which private investors can invest in developing countries. Similarly, GBF intends to mobilize private capital from developed to developing countries. Unlike IFC, however, GBF’s investments are in a much smaller scale involving small start-up social enterprises.

In the talk about GBF I attended on February 24, 2012 at John Hopkins University, Harold Rosen, GBF’s CEO, very eloquently shared the company’s business structure and investment strategy. GBF is essentially an investment manager that invests in high impact businesses, which are for-profit businesses that create economic opportunities for people at the base of the economic pyramid. Unlike traditional venture capital firms, GBF incorporates both financial and social metrics to assess its investments, which Rosen stresses to be one of the main challenges in investing in social enterprises. The funds managed by GBF come from various institutions, including Overseas Private Investment Corporation (OPIC), DEG (German Development Bank), FMO (the Netherlands Development Finance Company), and Deutsche Bank. GBF charges a 3% management fee, and its average investment size ranges between $500,000 and 2 million with an average investment span of 6 to 9 years. GBF has investments in Kenya, Ghana, Tanzania, Indonesia, India, Bolivia, and Peru.

Rosen stressed the importance of obtaining patient capital for investment with an eye on development. GBF strives to identify nontraditional investors who are willing to wait for returns to finally kick in. This requires investors who believe in the underlying cause of creating positive impact in the enterprises’ surrounding communities. Such investors are now popularly known as impact investors. Factors that signify “impact” include the numbers of people employed and family members supported.

However, GBF’s typical investment structure in these social enterprises combines equity with debt, which Rosen refers to as quasi-equity or hybrid securities. These investments are debt-type instruments with equity features, such as convertible loans or redeemable structures, that incorporate a current income component. Unlike equity, quasi-equity holders have a known cash flow. GBF distinguishes itself from other sources of funding that Rosen refers to as “soft money”―grants and equity, investors of which do not care much about returns―by characterizing its investment as discipline investing. Through the current income component, these social entrepreneurs are obligated to bring steady investment returns to the investors. The reason for such a structure is to discipline the investees to allocate income on a steady basis, which would thereby affect their business planning, enhance investment accountability, and consequently strengthen their financial viability.

In addition to, or part of, its investment, GBF also provides technical assistance in areas of corporate governance, financial management, operations and supply chain management, environmental and social impact, and human capacity. GBF builds the portfolio companies’ capacity to create, maintain, and use simple management dashboards. By having the skills to build such dashboards, these entrepreneurs can leverage their data to obtain future financing for their high impact businesses.

One final but very enlightening point raised by Rosen: there is more capital out there than social enterprises. It took me several minutes to really understand and agree with him. My guess is that Rosen was not referring to simply any business ventures that call themselves social enterprises; rather, he was probably referring to social enterprises that directly benefit the communities while creating profit, or what our business friends would call reaching scale. The smooth and successful marriage between profits and philanthropy remains a mystery to most.

For the talk’s power point slides and taped talk, visit http://www.sais-jhu.edu/academics/functional-studies/international-development/events/index.htm.

Expanded and Rigidified Duty of Reasonable Care for Directors of California Benefit Corporations

As codified in section 309 of California’s General Corporation Law, which applies to benefit corporations, directors of California corporations are protected by a business judgment rule. This broad protection of directors in performing their duties, however, is subject to certain limitations, including the duty of reasonable inquiry. The duty of reasonable inquiry requires directors to “not close their eyes to what is going on about them in corporate business, and must in appropriate circumstances make such reasonable inquiry as an ordinarily prudent person under similar circumstances.” Gaillard v. Natomas Co., 208 Cal. App. 3d 1250, 1265 (Cal. Ct. App. 1989). As the court in Gaillard noted, “[t] he term ‘under similar circumstances’ requires a court to consider the nature and extent of a director's alleged oversight or mistake in judgment in the context of such factors as the size, complexity and location of activities involved, and to limit the critical assessment of a director's performance to the time of the action or nonaction and thereby avoid harsher judgments which can be made with benefit of hindsight.” Id.

Despite the facts and circumstances application of section 309, the duty of reasonable inquiry appears to have been expanded and rigidified for directors of benefit corporations. In order to pursue a general public benefit, directors of benefit corporations are required to “consider the impacts of any action or proposed action upon all of the following:

1. The shareholders of the benefit corporation.
2. The employees and workforce of the benefit corporation and its subsidiaries and suppliers.
3. The interests of customers of the benefit corporation as beneficiaries of the general or specific public benefit purposes of the benefit corporation.
4. Community and societal considerations, including those of any community in which offices or facilities of the benefit corporation or its subsidiaries or suppliers are located.
5. The local and global environment.
6. The short-term and long-term interests of the benefit corporation, including benefits that may accrue to the benefit corporation from its long-term plans and the possibility that these interests may be best served by retaining control of the benefit corporation rather than selling or transferring control to another entity.
7. The ability of the benefit corporation to accomplish its general, and any specific, public benefit purpose.” Cal. Corp. Code § 14620 (emphasis added).

Although subsection (d) explains that directors do not need to give priority to any particular stakeholder, section 14620 presumably requires a reasonable inquiry into the impact to each stakeholder for each and every decision made by directors. By not considering all listed stakeholders, directors may face potential liability. And while the statute is not clear as to what consideration directors should give to each stakeholder, the bar would probably be set rather low, especially given that directors cannot be held liable for the failure to create a general public benefit. Directors seeking to avoid potential liability, however, will want to, at the very least, document their consideration of each of these stakeholders, whether through their own investigation or by relying on certain other persons allowed by subsection (e) of section 14620. 

Ultimately, section 14620 makes directors accountable for at least considering the broader impact of their decisions on stakeholders, which is what was intended by the statute. Directors, however, should be aware of the practical consequences of section 14620’s language, and should take the necessary steps to satisfy their new duties in order to avoid messy litigation over whether consideration was given to the listed stakeholders.

Testing and Welcome

Testing out the new blog for the Social Enterprises Legal Society, made up of students of the Washington College of Law. We met for the first time as a group on February 9, 2012 and are hoping to be formally accepted as a student group at WCL shortly. In the meantime and going forward, we have set up this blog as a way to enter the discussion on the growing trend of social enterprises as students of the law.

We have many ideas for what this blog could be used for:

• Posts discussing the numerous legal issues surrounding social enterprises, and what that means for social entrepeneurs
• Case studies of social enterprises, with a specific focus on why the company was formed as a social enterprise in an effort to understand whether the law helps or hinders that goal
• Journal the process of forming a social enterprise (e.g., benefit corporation)
• Collaborations with other groups, both academic and professional, including the Social Entrepeneurship Masters Program at American University and Law For Change
• Announcing any events, including our own, relevant to those interested in social enterprises

Hopefully much more to come on the blog.