Designing Business Forms to Pursue Social Goals

Ofer Eldar is an associate professor at the Duke University School of Law. This post is based on his recent article, forthcoming in the Virginia Law Review.

In recent years, there have been efforts to encourage firms to pursue social goals. This imperative, however, is very vague. What range of permissible non-pecuniary goals should companies be encouraged to pursue? This question reflects a much re-hashed debate regarding the role and purpose of corporations. Many studies view this topic as a matter of corporate governance. That is, the key question is whether policies that seek to create social impact—often referred to as “CSR” (for corporate social responsibility)—maximize shareholder value in the long term. If the answer is yes, then it is a win-win situation for all because such policies are assumed to benefit society.

In a new article, Designing Business Forms to Pursue Social Goals (forthcoming, Virginia Law Review), I argue that rather than focusing on shareholder value, the pressing question should be, “Does the pursuit of social missions by for-profits actually benefit the intended beneficiaries?” Even if CSR policies are associated with shareholder value, it does not follow that they achieve their putative purpose of helping stakeholders and society at large. Without a mechanism for ensuring that CSR actually benefits the stakeholders, companies can easily use it to enhance their reputations and increase their profits, without providing tangible public benefits.

The problem in creating such a mechanism is that it is extremely difficult to verify companies’ social impact. Existing measures of social impact tend to be vague, include metrics that are difficult to quantify, and typically rely on self-reporting (see Fisch, 2019). But if measurement is rarely available, how do we know that firms are pursuing social goals effectively? The legal approach to addressing these questions has been to introduce legal hybrid forms—in particular, the benefit corporation. These forms are supposed to communicate to investors, consumers, workers and society at large that firms’ activities benefit society. These forms, however, have been largely ineffective in clarifying the actual impact of companies’ social goals, and many of the companies that adopt these legal forms have little or no social impact.

Why have these forms failed? Just like CSR policies, the forms are simply not structured in a way that makes companies more likely to pursue social goals effectively. An effective legal form must meet two conditions. First, the form must give firms incentives to pursue social missions effectively. Ideally, the firm should have a financial stake in the accomplishment of the social mission. Second, the firm should have the competence to pursue such missions. Social goals, such as unemployment or access to capital, tend to be complex, and accomplishing these goals requires the firm to tailor its social programs to the specific attributes and needs of the beneficiaries.

The issues of incentives and competence are very similar to standard issues in corporate governance. Broadly stated, the main goal of corporate governance policy is to ensure that managers have both (i) the incentives to maximize shareholder value and (ii) the competence to make decisions on behalf of the corporation (see Goshen & Squire, 2017). What complicates things when it comes to social responsibility is that a firm that purports to pursue CSR not only makes profits on behalf of the investors, but it also serves as a conduit for a subsidy or a donation. These subsidies are usually latent in the sense that they reflect premium prices paid by consumers or below-market returns from investors. For policy makers, the main design issue is how to assure those who provide subsidy-donations that they will be used effectively. Thus, legal hybrid forms must give managers the incentives and competence to accomplish this.

The policy I propose is modeled on the structural elements found in social enterprises that transact with their beneficiaries (e.g., as consumers or workers), which I have developed in The Role of Social Enterprise and Hybrid Organizations and more formally in The Organizations of Social Enterprises: Transacting versus Giving. The transactional relationship with its beneficiaries gives the firm a stake in helping them develop, and also enables the firm to observe beneficiaries’ abilities and needs. Thus, such firms have both the incentives and competence to serve certain social goals. The proposal further builds on the regulatory regime for community development financial institutions (“CDFIs”), which certifies financial institutions as firms that serve low-income populations, and essentially extends this regime from financial services to other contexts, such as employment.

In essence, the proposal is to introduce a new social enterprise (“SE”) legal form. Firms organized under the SE legal form would be required to obtain a government certification as a “Social Enterprise” if they commit, in their charters, to transacting with one or more carefully defined classes of beneficiaries. These beneficiaries will include workers, borrowers, consumers, etc. Beneficiaries will be divided into different classes in accordance with certain criteria of need (e.g., level of income). To maintain the certification, firms must commit to having a minimum percentage of their business associated with beneficiary transactions.

The main goal of this proposal is to facilitate the flow of subsidized capital and income to social enterprises. This legal form is necessary to attract subsidies from dispersed subsidy-providers, such as investors and consumers. Currently, investors and consumers mainly rely on costly contractual and ownership mechanisms to ensure that relevant firms transact with their beneficiaries. The proposed law would reduce the transaction costs of contracting and monitoring for altruistic investors and consumers by giving them notice that the firm transacts with beneficiaries before they purchase shares or products. In this respect, its role would be similar to the basic role of the nonprofit form which is to reduce the transaction costs for donors in ensuring that the firms’ managers are subject to certain legal constraints (in this case, the prohibition on distributing profits; see Hansmann, 1980). Thus, the proposal is likely to unlock capital to scale social enterprises and increase social impact.

The ability of the SE legal form to source subsidies from a wider range of subsidy-providers could serve two additional complementary objectives. First, it could help facilitate the process for allocating subsidized investments (known as program-related investments or “PRIs”) from foundations. While most policy initiatives seek to attract institutional shareholder investment to channel capital for social goals, the best candidates for investing in social impact are foundations. Paradoxically, foundations often resist making PRIs in for-profit social enterprises because such investments could expose them to tax penalties if they cannot verify the social mission of their investees. Currently, such verification is cumbersome and subject to legal uncertainty. Thus, making certified firms eligible for PRIs would facilitate the process for allocating such investments.

Second, more ambitiously, the proposal has the potential to meet a long-awaited goal of social entrepreneurs: facilitating their access to capital markets. Attempts to establish social exchanges for firms that combine profit and missions have largely been futile, primarily due to the difficulties of measuring social impact. A new legal form could help by providing adequate assurance to the investors who are expected to subsidize such impact.

Finally, one objection to this proposal might be that a legal hybrid form based solely on firms’ transactional relationships with their beneficiaries is too narrow. Shouldn’t a legal hybrid form capture the universe of social missions, such as the protection of the environment, diversity and human rights? These objectives are indeed laudable, but it does not follow that legal forms can adequately address them. In the absence of credible certification mechanisms and clear metrics of social impact, legal forms for organizations with broad social purposes are not likely to signal that these firms pursue social missions effectively. Furthermore, the class of organizations that transact with disadvantaged persons is large and highly consequential; they range from microfinance institutions to firms that provide eyeglasses in developing countries. Concentrating on these firms could transform legal hybrid forms from a marginal phenomenon to a remarkable vehicle for promoting development.

The complete article is available for download here.

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