Bates Wells & Braithwaite London LLP: Social Business 01/23/2012
A quirk in UK company law and a steer from the US could lead the way to truly harnessing the power of capitalism in the service of society, suggests Luke Fletcher
A Social Business could be the legal form of choice for social entrepreneurs and social investors seeking to balance the downside risks of failure with the upside rewards of success.
In recent years, efforts have been made to give definition and cohesion to the growing social enterprise movement in the UK, notably through the development of the Social Enterprise Mark.
In contrast, little attention has been given to delineating the more specific concept of a social business, by which I mean a sustainable business that operates for a social purpose but without any prescribed asset lock or reinvestment requirements (a “Social Business”).
A Social Business is more than simply a business that seeks to act responsibly – it is a business that trades for a social purpose by providing socially or environmentally beneficial goods and services and, in the process of so doing, produces returns for shareholders. Think, for example, of Cafédirect, Divine Chocolate, Good Energy, Traidcraft and Ecotricity.
If we want social enterprise to go mainstream, we need to get the message out that businesses are able to trade for a social purpose – and that an asset lock and express limits on dividends are not absolute requirements. To do this, company law should be developed to create a new legal identity for mainstream businesses which trade for a social purpose.
Building on the community interest company
In the UK, we are privileged to have a legal form in the shape of the community interest company (CIC) which is dedicated to social enterprise. Many jurisdictions are not as advanced.
However, a budding social entrepreneur might reasonably expect upside from the personal investment of sweat equity and will often balk upon hearing that an increase in the capital value of the business will be captured by the CIC asset lock for a social purpose. Similarly, social investors looking to invest for financial and social returns might find it hard to generate returns in the present UK social economy, as the CIC form limits equity upside.
The CIC has many advantages and is often the perfect form for those social enterprises that may require some degree of state or philanthropic subsidy to survive. The CIC limited by shares is also likely to be the vehicle of choice for many of the pioneers setting up new public service mutuals coming out of the state, as the asset lock provides a safe haven for the transfer of public assets and the share structure allows for employee ownership.
There are already approximately 6,000 CICs and take-up is set to continue at a rapid pace. Nonetheless, for many social entrepreneurs and social investors putting substantial time and capital at risk, the CIC asset lock and limits on profit distribution may be seen to restrict unfairly the rewards which are justified by the placing of time, effort and capital at risk.
Making the most of a gap in company law
A natural next step in the development of the UK social economy is to provide a legal form for Social Businesses which do not have express asset locks or profit distribution caps.
A curious quirk in the Companies Act 2006 provides a glimpse of how a Social Business form could be created in law. The 2006 Act states that the duty of a company director is to “promote the success of the company for the benefit of its members”. There are also a number of additional factors to which directors must have regard, namely the long-term consequences of decisions, the interests of employees, relationships with suppliers, customers and others, the impact on the community and the environment, maintaining a reputation for high standards of business conduct and the need to treat members fairly.
However, there is an exception to the general rule that a company exists for the benefit of its members or shareholders where the purposes of a company “consist of or include purposes other than the benefit of its members”. In the case of a company which has a social purpose in its Articles, the directors are therefore obliged under the 2006 Act to promote the success of the company by advancing its social purpose.
This exception makes sense in the context of a company limited by guarantee which is a charity or a not for profit organisation. Interestingly, the exception also extends to companies limited by shares, which form the majority of mainstream businesses. Unhelpfully, the 2006 Act does not give any clue about how the social purpose of a company limited by shares is to be reconciled to its ability to return profits to shareholders. Yet...
A new legal identity for Social Businesses
It would be perfectly possible and relatively easy to clarify company law in this area and to create a new legal identity for mainstream businesses which trade for a social purpose.
1. Social Purpose: To qualify as a Social Business, a regulator, presumably an empowered CIC Regulator, would need to agree that the social purpose set out in the Articles of the company is for community benefit and, if the regulator agrees, it would be registered as a Social Business. The test of whether a purpose is for community benefit could be the same as for a CIC. It would not be enough for a company to show that it operates in public service markets – a company would need to be able to demonstrate an overarching and primary social purpose.
2. Directors’ Duties: Once registered, directors would be subject to specific duties applicable to a Social Business. The key would be to define how, in the context of a Social Business, a director’s duty to advance the social purpose is related to the ability of the business to return profits to shareholders. It is possible to imagine a number of formulations and wide consultation would be needed to get to the most appropriate formulation of the directors’ duties.
I would suggest that directors should be obliged to "promote the success of the company through the advancement of its social purpose and, on a secondary and subsidiary basis, for the benefit of its members". This would make it clear that a Social Business is a social enterprise which exists wholly or mainly to provide benefits to society or the environment and does not exist to maximise returns to shareholders. The reworking of directors’ duties in this way should be enough to prevent businesses which are not genuinely pursuing a social purpose from seeking Social Business status. It is hard to see shareholders who are seeking maximum returns agreeing to mandate directors to pursue social purpose over and above the creation of profits for shareholders. To give the directors’ duties teeth, directors who act in breach of duty and undermine the social purpose of the company should be dismissed without compensation.
3. Reporting: A Social Business should be obliged to report to the regulator on its social impact.
The reporting requirements for a Social Business could mirror those which have been developed for flexible purpose corporations in the US. A Social Business would be required to set annual objectives for the advancement of its social purpose and to provide a social impact report stating:
- the nature of its short and long-term social purpose objectives and any material actions taken to achieve those objectives, the outcomes and impact of those actions and the causal relationship between the actions and reported outcomes and impact;
- any material actions the company expects to take in the short and long term to meet its social purpose objectives; and
- the basis on which the company selects metrics for evaluating outcomes and impact.
Obligatory social reporting would give stakeholders the chance to come to their own conclusions about the extent of any claimed social impact. To strengthen governance, there could be a requirement that a Social Business must have at least a quorum of independent directors and that the senior independent director must sign the social impact report. Shareholders would have the right to vote to require the social impact report to be independently audited and would retain the usual shareholder rights to dismiss directors.
It would be possible to buttress the regime further with a set of corporate social responsibility principles to which Social Businesses must observe.
4. Flexibility: Mainstream businesses should be able to choose to become Social Businesses or indeed to renounce Social Business status by means of a resolution of 75% of the shareholders.
B-corps (http://www.bcorporation.net/) provide a certification and franchise system for companies pursuing social mission alongside profit. As it is a contractual franchise, companies in different countries can become B-Corps and we will hopefully see some in the UK soon.
The difference between a Social Business legal form and a certification or accreditation system is that, with a Social Business, social entrepreneurs would:
1. have a ready-made social enterprise legal form;
2. have legally recognised socially focussed director's duties hard-wired into the structure;
3. remain free to choose their own impact reporting metrics; and
4. would not be tied into specific franchise terms and conditions.
However, a Social Business would of course remain perfectly free to sign-up to the B-Corp franchise and to use the B-Impact Reporting System if it wished.
5. Reputational Advantages: The new ranks of Social Businesses should be given the right to use the suffix “SB” for social business in place of the usual suffix for a company of “Ltd” or “limited” and businesses without the status should not be allowed to use the term social business at all.
The new legal status would give mainstream businesses which operate for a social purpose a perfect opportunity to self-identify as a Social Business. It would also enable commissioners, customers and social investors to identify those businesses which are expressly run for social benefit and from which financial and social returns are available.
Keeping the foot on the accelerator
In the US, hybrid legal forms such as the flexible purpose corporation, B-corporations and low profit companies, otherwise known as L3Cs, are gaining state-by-state support. Each of these legal forms facilitates the pursuit of wider social benefits alongside shareholder value and none of these legal forms have asset locks or express limits on dividend distributions.
In the US, what has become known as impact investing is more pro-business and more open to positive social impact being generated from the mainstream economy than is the case in the UK. In contrast, what we have come to call social investment in the UK is typically considered to be about investment into traditional civil society organisations, which are often only able to survive on subsidies. A Social Business legal form would enable mainstream businesses to espouse a primary social purpose, help to define the social enterprise movement at its outer margins and expand the horizons of social investment.
If the UK is to continue to be a world-leading jurisdiction for social innovation and social investment, we cannot afford to rest on our laurels – we need to keep the foot firmly on the accelerator. A Social Business legal form is a missing piece in the social economy puzzle.
Capitalism in the service of society
In essence, the idea of creating a new Social Business legal status is remarkably simple.
All that would be needed would be some amendments to the Companies Act 2006 and an extension to the powers of the CIC Regulator, which would presumably in turn need to be rebranded, perhaps as a Social Economy Regulator, to describe an expanded remit.
There are different ways for social enterprises to reconcile profits with social purpose. At the moment, we find we often need to achieve the right balance for clients through specific contractual arrangements, adding complexity and costs to social enterprise start-up.
A Social Business could be the legal form of choice for social entrepreneurs and social investors seeking to balance the downside risks of failure with the upside rewards of success. So, if we want to harness capitalism in the service of society, why not start here?
Luke Fletcher is an Associate in the Social Finance Group at Bates, Wells and Braithwaite and writes in a personal capacity.