Megan Rowe

Social and Environmental Enterprises

Spring 2014
April 24, 2014
Solution
The Committee on Corporate Law should integrate into its Model Business Corporation
Act provisions creating a social enterprise form. These Social Enterprise Amendments will
address two problems facing this rapidly growing sector: first, although social enterprises
provide a public good, just as nonprofit corporations do, they still endure a the tax burden as
traditional corporations under federal and some state laws; second, the public and social
enterprise stakeholders need to be able to hold social enterprises and their governing bodies
accountable to pursue their social mission but there is a lack of legal enforcement mechanisms.
The proposed solution is amendments to the MCBA allowing for:
1. Initially incorporating a business as a social enterprise by establishing that the primary
business activities further a 'charitable purpose' as defined by the Federal Internal
Revenue Code;
2. Requirement for a social enterprise to annually establish that its primary business
activities further its charitable purpose;
1
3. Later re-qualifying an existing social enterprise's newly realized charitable purposes;
4. Fiduciary duties to shareholders to pursue both profits and charitable purpose;
5. Maintenance of the charitable purpose through mergers and acquisitions; and
6. Conversion of a traditional corporation into a social enterprise after incorporation by
qualifying a charitable purpose, and conversion of a social enterprise into a traditional
corporation.
The proposed amendments are organized in such a way that they can be easily integrated
into relative sections of the MBCA. In the following paper, however, they will be discussed
topically.
Introduction
Social enterprises are a hybrid of corporations and nonprofits. They both generate profits
like corporations and seek to perform a public good like nonprofits. There are three main players
involved in the form: the social enterprise itself, investors, and government. A social enterprise
reduces the burden on the government by providing a public service and just as in the case of
nonprofits the government should compensate the social enterprise by reducing its tax burden.
In order to hold the social enterprise accountable in exchange for preferential tax treatment, the
government needs to be able to oversee the social enterprise to ensure that it is performing a
public service.
1
The investors provide the social enterprise with patient capital and in exchange
1 Week 2, page 27.
2
the social enterprise should be held to a fiduciary duty to perform its purported social purpose.
Currently, however, publicly social enterprises cannot enjoy lesser tax liability under
federal law and in some states.
2
Also state statutes and judiciaries do not consistently uphold
social enterprises' duty to shareholders to further their social purpose.
3
Although both of these
issues can be best resolved by government action (i.e. the creation of federal and state tax
exemptions for social enterprises and statutory recognition of a social enterprise's duty to
investors), advocates must first create cohesive model legislation to gain uniform state
acceptance and eventually federal recognition in tax codes.
4
The Proposed Social Enterprise Amendments
1. Initially incorporating a business as a social enterprise by establishing that the
primary business activities further a 'charitable purpose' as defined by the Federal
Internal Revenue Code.
One of the biggest hurdles facing advocates of social enterprises is the fact that there is so
much inconsistency between the states in their hybrid statutes. A lack of uniformity both scares
of investors, who may be unsure even what a social enterprise is, and the federal government,
which probably worries about businesses declaring phony social purposes to evade corporate
2 Week 8, page 18-19.
3 Week 4, page 36.
4 Week 12, page 11.
3
taxation. Developing a uniform definition for social purpose and a standard for how much of a
social enterprises business activities must be directed toward this purpose is imperative to
gaining wide state acceptance of the amendments and federal recognition of the form. Luckily,
there is jurisprudence already in place that both defines social purpose and sets a benchmark for
'primary business activities.'
Currently, several various hybrid forms with material differences: Delaware's public
benefit corporation, Maryland's benefit LLC, California's flexible purpose corporation, and
Washington state's social purpose corporation.
5
Additionally, nine states and two Indian nations
have adopted the L3C form, low-profit limited liability company, and benefit corporation has
been adopted by eighteen states and Washington D.C. and thirteen others are in the process of
adopting it.
6
Further, some social entrepreneurs have set up traditional LLCs and contracted
around profit maximization.
7
Each of these hybrid forms has a different definition of qualifying
social purposes. For example, Vermont's benefit corporation statute defines public benefit as a
material positive impact on society and the environment, as measured by a third-party standard,
through activities that promote some combination of specific public benefits. 11A V.S.A.
21.03(a)(4). Even within Vermont, standards for 'social purpose' can vary depending on which
third-party certification is received.
8
On the other hand, some states use the the L3C form, which
form borrows the 'charitable purpose' standard from federal tax law.
9
Thus, a material difference
5 Week 4, page 22-23, 4.
6 Week 4, page 3-4.
7 Week 3, page 19.
8 Week 4, page 26.
9 Week 6, page 15.
4
between state hybrid forms is on a foundational level: how they define social or charitable
purpose.
Although one commentator argues that 'social purpose' is a broader term than 'charitable
purpose,' the latter term in fact is very broad and had been developed in jurisprudence for
hundreds of years.
10
Charitable purposes recognized by the Federal Internal Revenue Code
include those: organized and operated exclusively for religious, charitable, scientific, literary, or
educational purposes, or to foster national or international amateur sports competition or for
the prevention of cruelty to children or animals[.] 26 U.S.C. 170(c)(2)(B). Under this
umbrella, nonprofits have been set up for environmental protection, civil rights advocacy,
economic development, the arts, and cancer research, just to name a few. The legal definitions
of 'charitable purpose' are broad enough to include any social purpose. Thus, the first of the six
proposed amendments is to adopt the federal standard of 'charitable purpose'.
Also, nonprofit law has already established standard for what constitutes a businesses
'primary' activities. Nonprofits are similarly held to a standard that their primary business
activities must be charitable to maintain their tax exemption. The estimated range of charitable
activities can be anywhere from seventy to eighty percent. This standard can merely be extended
to social enterprises under the proposed amendments.
Therefore, the in creating a social enterprise, the MBCA should merely reference long-
established nonprofit law. The law is already accepted by the federal government, has been tried
and tweaked over hundreds of years, and is broad enough to accommodate many potential social
10 Week 1, page 2.
5
purposes.
2. Requirement for a social enterprise to annually establish that its primary business
activities further its charitable purpose.
and
4. Fiduciary duties to shareholders to pursue both profits and charitable purpose.
The second and fourth proposed amendments both concern holding the social enterprise
accountable to pursue its charitable purpose. The second amendment requires a social enterprise
to annually report to the government about its pursuance of charitable activities, while the fourth
holds a social enterprise responsible to shareholders by providing them a cause of action for
breach of duty to pursue the promised social purpose.
Currently, it is difficult for both investors and the federal government to hold social
enterprises accountable for their alleged social purpose and both are hesitant about making deals
with the social enterprises. On one hand, investors lack confidence because it it unclear whether
directors will be legally held to their promises to promote social good or whether they will
exploit the generous, patient funds for their own interests.
11
Current corporate statutes lack
mechanisms to enforce social purpose yet there is ample authority to enforce nonprofits'
charitable purpose. This ample authority needs to be extended to shareholders of social
11 Week 10, page 2.
6
enterprises formed under the proposed amendments.
12

On the other hand, the federal government refuses to provide tax breaks to social
enterprises because they do not want to exchange much needed tax dollars for social impacts
which are less certain than those of nonprofits due to lack of oversight.
13
It is ironic that the
federal government is so stingy with tax dollars and suspicious of social entrepreneurs declaring
phony charitable purposes to evade taxes when many large traditional corporations do not pay
taxes.
14
Although some argue that if more businesses received tax breaks then the burden on
individuals would increase, it seems more reasonable that the government should eliminate tax
loopholes for corporations.
15
These arguments aside, the federal government is more likely to be
persuaded to recognize the form if social enterprises are required to report annually their
furtherance of a social mission.
In sum, despite the fact that there is a high and ever-increasing demand for social
investment opportunities, this demand is not being met because investors lack confidence in
whether the courts will enforce social purpose.
16
Uniform enforcement of shareholder rights
would increase confidence and thus attracting more capital to meet these demands, and of course
social enterprises could always use more capital.
17
Further, the federal government is more likely
to accept the social enterprise form if these businesses are held to uniform standards, eliminating
the possibility of fraud. In the end, the government and investors will benefit from social
12 Week 10, page 9-11.
13 Week 2, page 27.
14 Week 8, page 30-31.
15 Week 8, page 1.
16 Week 1, page 21, 26-27.
17 Week 7, page 41.
7
enterprises fulfilling these duties to the public and to shareholders. Social enterprises will benefit
from higher investments and lighter tax burden so they can simultaneously compete against for-
profit business with limitless incomes or nonprofits free of tax liability and provide a public
service.
18

3. Later re-qualifying an existing social enterprise's newly realized charitable purposes.
and
6. Conversion of a traditional corporation into a social enterprise after incorporation by
qualifying a charitable purpose, and conversion of a social enterprise into a traditional
corporation.
The purpose of these amendments is to provide businesses flexibility in the rapidly
changing and often mercurial philanthropic sector. One commentator colorfully describes the
charitable marketplace: it exhibits a tendency to evolve through waves of exploding bubbles,
with some [businesses] collapsing into nothingness, others leaving signal tracts and a few
systematically reshaping how we think and act.
19
A problem encountered by California's flexible purpose corporation sand Vermont's
benefit corporations approach is that a business must elect a social purpose at incorporation and
it is unclear from the reading how these businesses go about changing the elected purpose down
18 Week 8, page 17.
19 Week 14, page 27.
8
the road.
20
These statutes are not flexible enough to allow hybrid entities to quickly change their
functions in response to turbulent economic disruptions that have a greater impact on charitable
businesses than those for-profit.
21

The idea for the third amendment came from the L3C model. Creators of the L3C form
used LLC as a governing framework because the latter is considerably more flexible than the
traditional corporate form.
22
One reason why the LLC has been such a popular form with social
enterprises and other businesses is because it allows such flexibility.
23
Further, some states have
considered the widely accepted benefit corporation legislation to be too rigid and have purposely
made their social enterprise statutes more flexible.
24
Thus, the third amendment similarly allows
for flexibility in the business form by allowing social enterprises to qualify a different charitable
purpose. The proposal overall prioritizes uniformity over flexibility, however, which is why
amendments to the widely-accepted MBCA are proposed instead of merely advocating for the
L3C form.
The sixth amendment similarly provides much needed flexibility to businesses seeking to
enter and exit the social market. A traditional corporation can become a social enterprise if it
provides adequate records of its business activities to prove that its primary purposes are
charitable. A social enterprise can become a traditional corporation after it revokes its
preferential tax status. Since the MBCA already contains provisions on corporate conversion to
20 Week 4, page 35.
21 Week 14, page 27.
22 Week 10, page 20; Week 4, page 10.
23 Week 10, page 20; Week 4, page 7; Week 8, page 4.
24 Week 4, page 4.
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other forms, a social enterprise would merely follow those steps to become a different entity, like
an LLC or partnership.
Both of these amendments include duties to shareholders when changing the charitable
purpose and upon conversion. A publicly traded social enterprise must get shareholder approval
before re-qualifying a new charitable purpose. In the event of a conversion, a social enterprise
must also get approve from shareholders and offer to buyout shares from those in the minority. A
social enterprise cannot merely ditch its social purpose without approval from or compensation
to investors still committed to the mission.
Both of these goals allow for a social enterprise to be adequately flexible in order to
response to market changes but also slows down their movements enough so they are unable to
breach their duties to the public and shareholders.
5. Maintenance of the charitable purpose through mergers and acquisitions.
Finally, the fifth proposed amendment to the MBCA ensures that a social enterprise will
maintain its social purpose after a merger or acquisition.
25
Just as in a traditional corporation,
shareholders and directors of a social enterprise must approve of a merger or acquisition. Even
after a hostile acquisition, a social enterprise under the proposed amendments retains its
charitable purpose unless the new board gets shareholder approval to qualify a new purpose or
25 Week 2, page 15.
10
convert into a different form.
26
Just as a for-profit company maintains its duty to maximize
profits through transitions, the directors of a social enterprise continue to be committed to the
double bottom line upon consolidations and sales.
Conclusion
The first step in getting these amendments accepted is to send them to the Committee on
Corporate Law. After the CCL writes them into the MBCA, social enterprise advocates can bring
the model legislation to states without hybrid forms, those with shaky hybrid forms, or those
seeking more uniform and consistent hybrid forms. After the amendments gain wide acceptance
on the state level, advocates will be able to persuade the federal government to allow for a
significantly reduced tax burden on social enterprises. In the end, social enterprises will receive
more capital from investors with increased confidence and lighter taxes, the public will benefit
from more charitable services, the government will enjoy a reduced burden, and investors will
appreciate greater stability in the social enterprise sector.
26 Week 10, page 31.
11