Some Unanswered Questions About Benefit Corporations, L3Cs, and Social Enterprise More Generally

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At a conference co-sponsored by Georgetown University Law School and Independent Sector last week, the text and subtext about the forms of social enterprise revealed challenging issues that for-profit social entrepreneurs and, more importantly, nonprofits should ponder. Without providing a comprehensive pro or con on social enterprises, we offer here the most interesting issues that surfaced at this conference, which included speakers such as Jonathan Greenblatt from the White House, Phil Buchanan of the Center for Effective Philanthropy, Rich Leimsider from Echoing Green, Anthony Bugg-Levine who heads the Nonprofit Finance fund, Elizabeth Grant from the Oregon Attorney General’s office, Erik Trojian from B Lab, and attorneys Matthew Elkin and Robert Wexler, just to name a few of the very knowledgeable experts gathered by Georgetown Law.

To be clear, the promoters of social enterprise, but for a couple dyed-in-the-wool acolytes, were much more reflective and self-critical than one might suspect from a movement that is heavy on marketing, branding, and promotion, and the critics were hardly dismissive of the potential positive dimensions of social enterprise. These comments, therefore, draw on the issues that seemed to be unresolved at the event and unresolved in the nonprofit sector writ large about the meaning, substance, and impact of for-profit social enterprise in the space of public and community benefit that has historically been the province of charity and government.

The focus of this report: B Corps and L3Cs

Worldwide discussion of “social enterprise” is very broad, but in the U.S., it has tended to focus on a few forms. In this report, we are skipping over the topic of social impact bonds. They aren’t bonds, and only four of these highly touted projects even exist. Almost all of them revolve around the issue of recidivism of formerly incarcerated people, and not one has reached its first payment point. Although heavily promoted in the social enterprise press, SIBs don’t exist in enough numbers or substance to dominate the social enterprise space. This article is explicitly a discussion of the evolution of forms such as benefit corporations, B corps, and low-profit limited liability corporations (L3Cs).

Can—and should—social enterprises self-regulate?

Even the nominal critics of social enterprise at the Georgetown Law program all attested to a faith in free-market capitalism. This mom and apple pie sentiment revealed itself in the debate over regulation. With amazingly minimal governmental regulation from the states that have authorized and validated some forms of social enterprises, the social enterprise movement is predicated strongly on self-regulation. For L3Cs, states require next to nothing in terms of application material and virtually nothing in terms of annual reporting. For benefit corporations, the states require little or no reporting on their financial transactions. Benefit corporations turn to purportedly disinterested third-party evaluators to verify their social benefit, although in the case of B Corporations certified by the nonprofit B Lab, the disinterested aspect of their reviews is open to debate, but the third-party reviews are conducted largely without government involvement and verification.

Speakers cited the unfortunate precedent of Independent Sector’s “Nonprofit Panel,” which tried to minimize as much government regulation of 501(c)(3)s as possible, in part through the promulgation of 33 principles of good governance. As self-regulatory principles, they are fine guidelines for determining the right thing to do, but they lack the core principle of accountability: a lack of enforced consequences. As Elizabeth Grant, in charge of the Charitable Activities Section of the Oregon Department of Justice, pointed out on one panel, “If there aren’t consequences, there’s a lack of accountability.”

But do social enterprises such as L3Cs and benefit corporations warrant government oversight and regulation? As conceived in a belief that underlies much of social enterprise and was articulated by a couple of panelists, because social enterprises are not 501(c) tax-exempt entities, they are somehow freed from the kind of regulation that nonprofits have to endure. Taking the risk of operating without tax exemption, they argue, they are rewarded without having to subject themselves to public disclosure and other forms of government oversight.

It is truly a minimal-government dream of sorts: a sector of the economy that is all but freed from government oversight and trusted to regulate itself, but motivated to do good by virtue of articulating and pledging commitments to social benefit in their corporate articles, with mechanisms for external assessments. In the world that followed not just the examples of Enron and Tyco, but the collapse of the entire economy brought on by Wall Street banks that needed oversight, it is hard to believe that the good intentions of the people founding and running benefit corporations, much like the good intentions of those running nonprofits, might not warrant some form of government regulation to ensure that the public or community benefit they promise and that their evaluators attest to is really occurring.

Leimsider from Echoing Green warned, “If we start to overregulate this form, we’re going to no one going into this.” That is the all-too-pervasive sector response toward regulation—certainly from private corporations, but from nonprofits, too. Any movement toward more regulation, no matter how small, is an opening toward the fear of overregulation. Regulation is always good for someone else, but we, appropriately motivated by public benefit concerns (or charitable concerns) can be relied on to regulate ourselves.

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“We don’t want to hinder the growth of benefit corporations,” he went on, “because they are taking investment dollars, not philanthropic dollars.” Are benefit corporations and L3Cs, of relatively recent vintage, really a different sort of corporate entity, run by high-minded people who can be trusted to self-regulate, or is this a willful blindness about the behavior of corporate entities? Some observers and critics think there are good reasons why Sarbanes-Oxley, and more recently Dodd-Frank, were enacted—and, similarly, why corporations have fought both so vigorously, chipping away at the one and probably doing the same to the other were Elizabeth Warren not in the U.S. Senate sitting on the banking committee.

The entities associated with corporate misdeeds time after time have been big corporations, while social enterprises appear, for the moment, to be small businesses, unlikely to bring down the economy on their own. The same goes for nonprofits, which also are typically small entities. But is small so beautiful, to echo the iconic phrase of economist E.F. Schumacher, that social enterprises should get a pass from regulation by virtue of size? As nonprofits promise adherence to charitable goals, social enterprises promise commitment to community and public benefit, in many cases authorized by states that have enacted benefit corporation legislation. The argument that social enterprises that make public affirmations of their social objectives should be somehow exempted from the oversight that government gives nonprofits—and should be giving the corporate sector—is still less than fully persuasive.

Are social enterprises superior to nonprofits?

Nonprofits themselves are often victims of magical thinking in the form of the idea that wrapping oneself in the mantle of a 501(c)(3) imparts a superiority of some sort, the angel wings of goodness.

For-profit social enterprises are also wrapped and presented in a magical world of elevated entities attacking social problems out of constant pressure for grants and knocking on the doors of private foundations. That is clearly one of the attractions of social impact bonds, a multi-year financial commitment with regular payment points predicated on achieving some sorts of interim measures of progress.

One of the defining elements of social enterprises promoted by their advocates is the rigor and discipline of the markets. Somehow, it is purer to earn revenues than to get them from grants and donations. On one of the panels, the CEP’s Buchanan noted the obvious, that most of the income of human service nonprofits is actually earned income, not foundation grants or charitable donations. The notion that nonprofits are predicated on a financial model of negative financial returns is truly silly. No nonprofit that we know tries to operate in the red, and doing so is a step toward financial problems. Buchanan pointed out that hospitals, universities, museums, and others have long built strong revenue-generating programs, but one doesn’t have to use the big nonprofits to make the point.

Listening to the public presentations and promotions of social enterprises, perhaps experts can distinguish the operational and tax differences of for-profit social enterprises and nonprofit public charities, but for the public, they sound increasingly similar. For L3Cs, the language built into their authorizing legislation tracks IRS definitions of charity for the purposes of qualifying L3Cs for foundation program-related investments. That benefit corporations also carry out activities and programs in the public interest sounds charity-like to the public, but is presented as in some ways superior to nonprofits, including by some panelists, who suggested that nonprofits (and government) purportedly have trouble with or actually don’t evaluate their programs. The third-party assessments of public and community impacts for benefit corporations can come off as sounding like a superior brand of nonprofit.

Speakers generally glossed over the creation of L3Cs laser-focused on accessing foundation PRIs, a form of nonprofit-oriented subsidy. But they also largely skipped evolving efforts to give social enterprises some sorts of public subsidies—for example, the Philadelphia program of tax credits for benefit corporations—and only mentioned in passing the possibility that government entities might accord procurement preferences to them, as has been proposed in California and elsewhere.

To think that for-profit social enterprises won’t follow the less-than-free-market model of other corporations seeking multiple government subsidies is to fall for the halo effect, that these for-profit entrepreneurs will abjure the tax incentives and funding subsidies that other corporations have typically sought no matter what kind of endeavor. The federal government alone annually provides subsidies to for-profit corporations to the tune of well over $100 billion, mostly at the request or lobbying of corporate interests. Our analysis of articles describing state and local subsidies for corporations (for example) suggests that that number could be easily doubled. There isn’t a free market in this nation, but a highly subsidized system of corporate welfare. Will benefit corporations choose not to follow the lead of other corporations and reject government-provided advantages and subsidies?

Are social enterprises not charities? By legal structure, they aren’t. By soliciting investment and support for their pursuit of IRS-defined charitable purposes (as L3Cs) or public and community benefit (as benefit corporations), they are advertising themselves as carrying out a kind of activity that ought to signal regulators that the message social enterprises are presenting to the public and to investors that they are meeting government standards of charitable purpose warrants the kind of consumer protection that state charity officials offer the consumers regarding nonprofit charitable solicitation. If you walk and talk like a charity in the public’s view, given the public’s generosity to charities, then AGs might have an important consumer protection role to play, regardless of the social enterprises’ tax status.

For L3Cs, the game of soliciting foundation PRIs may be over. Despite the support of the Council of Foundations and some of the nation’s top tax lawyers working for L3C promoters, foundations haven’t turned to L3Cs to make PRIs. That result has been surprising, even though top foundation leaders have been making “sector-agnostic” pronouncements on behalf of the foundation community. The very few examples of PRIs awarded by foundations to L3Cs are unusual, in that at least three of the tiny handful occurred as PRIs from a foundation to two L3Cs both created and controlled by the head of the foundation itself (the Kay Family Foundation of California which invested in the Univicity and Project Bonfire L3Cs in 2010 and 2011), hardly a great statement of foundations supporting independently structured and led L3Cs. The foundation community’s support of proposed federal legislation to somehow make it even easier to make PRIs for L3Cs reveals the success of the relentless advocacy of the promoters of L3Cs and their contracted tax experts. Foundations could have been equipping themselves much more aggressively for PRIs to nonprofits or to nonprofit/for-profit partnerships and collaborations, as opposed to devoting energies to lobbying Congress for easier PRIs to unproven and generally unregulated L3Cs.

Benefit corporations and L3Cs could be easily supported with investment dollars through foundations’ Mission Related Investments (MRIs) as opposed to PRIs, the latter which count toward private foundations’ mandatory payout requirements. Although much more flexibly made than PRIs, foundation MRIs still warrant a connection of the investment to the foundation’s mission. Foundations should be making more MRIs, much more than the tiny percentage currently done, rather than investing the bulk of their tax-exempt assets with corporations of all sorts, generally because they offer reliably high rates of investment returns. But MRIs really don’t need benefit corporations. MRIs could be made toward a number of interests, as has already been demonstrated by the success of the FB Heron Foundation’s MRI track record investing in corporations that improve society and divesting from those that move our nation backwards environmentally and socially. If benefit corporations are achieving third party-validated public and community benefits, that should begin to show itself not in foundations shoving PRIs in their direction, but in a flow of MRI dollars.

Do social enterprise structures protect against an all-consuming focus on profit maximization?

The specter of Milton Friedman has been conjured by promoters of benefit corporations, manifest in the idea that the benefit corporation structure protects the entities from shareholder actions suggesting that they aren’t mindlessly aiming to maximize profit. It is an argument rooted in old caselaw that says the primary purpose of a corporation is to maximize shareholder value and that any deviation from that subjects corporations and their managers to serious legal jeopardy. Modern corporations, even those lacking the clothing of a benefit corporation, engage in socially responsible and philanthropic activities, partly because doing so helps them achieve strategic (and profit) objectives. While there are undoubtedly shareholders who view corporate philanthropy as anathema and that charitable recipients should not be receiving pennies of corporate philanthropic largesse, most of the investing public has warmed to the idea that corporate philanthropic expenditures, whether above or below the line regarding tax treatment, aren’t violations of corporations’ raison d’être. Critics might actually suggest that much of corporate philanthropy and corporate social responsibility is self-serving, hardly a reason for investors and shareholders to complain.

The ghost-of-Milton-Friedman argument is truly dubious in today’s world of corporate strategy. Are shareholders so unhappy with their investment in Coca-Cola (a corporation cited a couple of times at the Georgetown Law program), whose end-of-the-year stock price rose from $36.25 in 2012 to $41.31 in 2013 and who has been paying dividends of over $1.00 per share for the past decade, that they are going to legally challenge Coke’s philanthropic activities in Vietnam and Myanmar to support Pact’s efforts in women’s economic empowerment or, closer to home, its historic commitment of grantmaking to Emory University in Atlanta? To our knowledge, Coke faced some big challenges from shareholders this year around executive compensation, but nothing of consequence challenging whether the soda maker should drop its philanthropic or social responsibility investments.

The argument of the social enterprise folks is that while the corporations are protected against shareholder actions regarding profit maximization, shareholders do have a private right of action to challenge benefit corporations on their public and social benefits. The third-party assessments generated for benefit corporations would be the measure, as opposed to profit margins, stock prices, and dividends. How many shareholder actions have there been against benefit corporations to date? Zero, according to a speaker from B Lab. Are benefit corporations so pristine in their achievement of public benefits that not one shareholder has a concern that might warrant a challenge to corporate management and strategy?

There are five categories or dimensions of benefit corporation behavior assessed by B Lab: suppliers, community, employees, the environment, and then the specific niche or focus of the corporation. According to the B Lab panelist, the “average company” would get a score of 30; for a B Lab certification, the minimum is 80 out of a potential score of 200.

On the B Lab website, of the four general rating categories, the one with the smallest difference between B Corps and whatever the control group of “ordinary” businesses was in the category of employees or workers, with 56 percent to 48 percent of total sectoral points. The comparison is based on benchmarking a little over 500 certified B corporations against over 1,000 “other sustainable businesses” and a smaller number of “other businesses.” The benchmarks on workers/employees are in the chart below:

Besides the fact that some of these metrics are dependent on public policy (such as health insurance premiums), some depend on external economic factors (such as job growth) and entirely missing is any dimension of labor organizing, arguing for the ability of workers to advocate for their rights against the perspectives of owners/investors. The B-corps on the current list of honorees are there for their social and environmental scores, not because of their labor ratings.

What is the future direction of the for-profit social enterprise movement?

What explains the creation of hundreds of L3Cs and over a thousand benefit corporations (the latter including benefit corporations in other countries)? In the Georgetown session, several speakers cited demographics, that social enterprise makes young people more excited than other options. It may be the MBA-ization of the U.S. economy. The millennials creating new social enterprises are highly motivated to use their business educations for social good, but are opting to create their own new for-profit, ostensibly market-driven entities rather than opting for nonprofits or, for goodness sake, public service in government.

If it really is a product of a demographic, it is truly one of concern, especially with headlines promoting the advocates of benefit corporations, such as this article in Salon(on B Corporations) titled “Corporations with a Conscience: Disillusioned with the baby boomers’ all-encompassing greed, young people are building a different kind of business.” The breathtaking hubris of the statement is no aberration, but it might not be warranted by the facts. A Forbes review of research comparing the attitudes of millennials versus Baby Boomers suggested that the vision of millennial community feeling versus Boomer greed might not hold.

“The younger generations were, on average, less interested in ‘intrinsic’ goals and more interested in ‘extrinsic’ ones—especially the millennials,” wrote Forbes columnist Alice Walton. “They viewed ‘money, fame, and image’ as being among the more important life-goals, whereas they saw aspirations ‘concerned with self-acceptance, affiliation, and community as less important.’” The efficacy of the market for achieving social good may be a matter of belief and ideology, perhaps especially among people who have gone to business schools, but it doesn’t mean that people in their 40s, 50s, or even 60s might not cotton to social enterprise.

Nonetheless, the young MBAs, the promoters of social enterprise, and the Georgetown students who were well represented in the audience of this program have to answer to the challenge that they themselves are creating. They are arguing for market differentiation—that, based on their third-party assessments and benchmarks, social enterprises are fundamentally inherently different from and, in terms of community benefit, superior to Walmart, Southwest Airlines, and Whole Foods. They have to understand if they are going to make such claims, particularly under the cover of government legislation establishing L3Cs and benefit corporations, they have to expect to be held accountable for them. Counting on the “crowd” plus “caveat emptor” to determine which social enterprises truly live up to their social benefit, especially when the third-party assessments are conducted by parties committed to the advancement of the form (as in B Lab), ignores the documented reality of the importance of external, governmental oversight and regulation.

The social enterprise movement promotes a narrow definition of stakeholders and investors. If they adopt the language and purposes of charitable endeavor, they have a larger onus of responsibility to the public than the shareholders who have a financial stake in the business enterprises. The notion that nonprofits have been so inordinately burdened by the minimum regulation imposed by the IRS and state attorneys general is a myth. Nonprofits are authorized by the IRS with minimal requirements and tests; witness the rapid growth in the number of nonprofits despite the imposition of regulations.

The panelist from Echoing Green said that half of the applicant pool for Echoing Green support pitches hybrid social enterprises, as opposed to strictly suggesting 501(c)(3) public charities. What motivates them, these largely young entrepreneurs looking for Echoing Green seed money and technical support? For those pitching social enterprise opportunities in the U.S., some often think that the for-profit model will open up growth capital in a much better way than adopting the nonprofit model with its limited access to the capital markets. Underlying that, perhaps among some applicants, is the MBA value structure that suggests, as described by one panelist, that “nonprofits are for suckers.”

The notion that nonprofits reflect a movement of shared ownership and a revival of the public space, the commons of economic and political life, isn’t part of the social enterprise movement. Social enterprise, even accounting for some elements of employee stock ownership, is a movement of entrepreneurship by individuals; in fact, Echoing Green invests in the person, not the corporate form, though it will ask applicants to justify why they have chosen a for-profit structure rather than the nonprofit. Chicago-based analyst Kelly Kleiman, one of the panelists, observed, “Poverty is not a market failure [but] the inevitable consequence of a capitalist economy.” She added, “you don’t treat that with more capitalism.” Will the social entrepreneurs behind the formation of benefit corporations and L3Cs explain how the failures of capitalism can be remedied by capitalism—albeit, as the advocates suggest, capitalism imbued with a social consciousness?

More than half of the states have adopted or plan to adopt benefit corporation legislation. While the L3C movement seems to have completely stalled, with no new legislation passed in a couple of years and one state actually repealing its L3C statute, benefit corporations are still an attractive tool for governors and mayors who are excited about a tool that will generate, they hope, new sources of capital. They accept, as do social enterprise advocates, the premise that government’s reduction of funding commitments in the social sphere is structural, inevitable, and basically irreversible. It is an ideological premise that accepts and builds from a reduced governmental commitment to the social good.

It isn’t, as one panelist remarked, that society has some challenges that don’t quite have a market mechanism to address them, compared to others in “our free market capitalist society” that do, in terms of jobs and innovation. As Kleiman noted, the social enterprise model “presupposes that in the current situation, it is impossible to raise taxes [or] that decisions not to underwrite social services cannot be changed.” Most of the panelists said that the solution of social problems requires the voluntary and incentivized mobilization of private capital, that the private capital flowing into arenas of social and human services is all but unavoidable and actually necessary because of the inevitable and irreversible absence of government from the table.

Is that a prediction or an ideologically comfortable analysis? For nonprofits, it should be unacceptable, untenable, and a violation of what nonprofits stand for. Nonprofits ought not lie down and accept the public sector’s withdrawal from vital human needs. If that is where nonprofits are today, making do with less and less because of government’s preordained abandonment of human services and the social safety net without mobilizing themselves and their constituents for change, that is a sad statement from those that talk about the importance of advocacy and policy change.

One panelist pronounced the social enterprise movement as “the intersection of market forces and social benefit.” Maybe that’s what it is. But business is always ready to commodify and make profit from almost anything, including social benefit. If there is anything that seems clear from all of the presentations at the program pro and con regarding social enterprise, it is the very successful branding that is occurring. While L3Cs seem to be fading off the map due to their lack of success in attracting PRIs, benefit corporations are still on the upswing, as are their numbers and the states that authorize them. The B Lab has certified nearly 1,000 B Corporations (regardless of the existence of state legislation for benefit corporations), some quite well known and admirable, such as Patagonia, Etsy, and Ben and Jerry’s. As for-profit social enterprises capture the public’s imagination (and that of the business schools) with forms and mechanisms designed to achieve social and community benefits, what will that mean to the future of nonprofits and public charities whose existence is predicated on public and community benefit?

Do for-profit social enterprises need government regulation? Can they self-regulate? Are they superior to nonprofits? Do corporations need the social enterprise form in order to pursue social objectives? The jury is out, but Georgetown Law’s program raised these important questions that ought to involve not just social entrepreneurs, but the national and state nonprofit associations articulating their vision of the relationship of for-profit social enterprise and 501(c)(3) nonprofits.