Why the Impact Sector Needs New Legal Structures: Guru Arthur Wood Talks to Maximpact

Arthur Wood,social finance pioneer and founder of Total Impact Advisors, is an impact sector leader with new legal structures in his sights. A former banker with years on the financial “dark side” (as he calls it) Wood left banking to become the head of social financial services at Ashoka. Today he’s back in the private sector as one of the founders of Total Impact Advisors but he hasn’t given up his role as an advocate for sector development.

“What we’re trying to do,” Wood told Maximpact in a recent interview, “is to create mechanisms whereby you can apply for-profit capital market tools, create cross-subsidization and layer financing structures in a simple, replicable,modular manner.” His commitment to this end lead him to become one of the chief architects of the social impact bond, an innovative financial arrangement designed to secure funding for social benefit outcomes. He is also a driving force behind a new legal structure for social benefit companies, the Social Enterprise Limited Liability Partnership or SELLP.

But why do legal structures matter to the impact sector? And why do they matter today more than ever?

A time of convergence

We are living through a process of “fundamental convergence and reconfiguration of the social and commercial sectors from completely separate fields to a common space”according to a much-quoted article in a recent issue of the Stanford Social Innovation Review. That sounds radical; and it is. It’s also welcome news for many of our readers who support this shift to common ground.

And yet this time of convergence raises fundamental issues for the sector. As one result, the very shape of the social benefit organization is undergoing a transformation.The days when were only two kinds of organizations, for profit and nonprofit,are gone for good. Today there’s a need for new kinds of organizations where players from different sectors are able to collaborate in new ways. Complex hybrid organizations that blend philanthropy, business and government; and that, significantly, draw their capital from a variety of sources; already emerging, though not without difficulty.

Early solutions

One early solution to the convergence challenge has been to establish two organizations,a for-profit and a non-profit, linked in a joint venture. Commonly the non-profit owns equity in the for-profit, giving it the power to control the activities of the joint venture while pursuing its mission. Another approach is to create complex collaborative structures using contractual frameworks to establish new kinds of relationships within existing legal structures. Once controversial,such entities are becoming more commonplace today as the charitable sector,government and the private sector try to find ways to work together.

Yet these arrangements have limitations. Experience shows that they can throw up significant structural, cultural and governance challenges as mission-driven organizations try to cope with the world of business and satisfy government demands for accountability. They are expensive to set up, too, because each one must be tailor-made with the help of specialist legal advice. Finally,although they are capable of functioning, they don’t easily accommodate the development of the kind of complex, multi-layered, multi-stakeholder organizations that are emerging today.

“What we’ve traditionally done is to create these entities one by one and try to force not-for-profits into a for-profit contractual frameworks,” says Wood.”Cross-subsidization between social and economic mission in a for-profit/not-for-profit environment is very difficult without a proper legal structure. Firstly, it’s expensive to set up and hard to replicate. Secondly,when it’s done within a contractual rather than a regulatory framework, the better-resourced partner always has an advantage; and this is not usually the social benefit collaborator. Thirdly, doing it outside of a regulatory framework makes it difficult for governments to help achieve scale, compliance or replication. Finally, the status quo frameworks don’t include social mission as a primary requirement.”

According to Wood, the challenge is facilitating the “cross-subsidization of social and economic mission” in a more efficient, scalable way. That means establishing off-the-shelf legal structures like the 501(c)(3) in the US, that are easy to adopt without specialist advice, straightforward to manage in practical terms and transparent vis-vis government regulators.

Emergent legal structures

Wood is part of a group of like-minded leaders, some from the charitable side, others from the worlds of banking and business, who are trying to establish just such structures. They are having some success; new legal forms are starting to emerge:

In the US

• The Low-Liability Limited Company or L3C has been made by adapting an existing legal form to meet social investing needs. Developed specifically to encourage investment by foundations, the L3C is now being used to form new kinds of entities. New IRS guidance released in April 2012 provides more clarity about the tax status of L3C type structures and increases their appeal to investors. The L3C has passed in eleven US jurisdictions, nine states and two Indian Nations and a federal bill has been tabled.
• Certified B Corporations or B Corps are the invention of the nonprofit certification body B Lab. B Corps go through a certification program that ensures they meet standards of purpose, legal accountability and transparency. Today B Corps are recognized in 11 US states with legislation pending in 16 more. There are currently some 600 B Corps organizations operating in 15 countries.
• Flexible Purpose Corporations are recognized in the state of California; the outdoor gear company Patagonia was an early adopter. This legal structure allows corporations to pursue a specific mission in addition to profits. Directors choose a “special purpose” that benefits society, establish strategy to meet its goals and report on its performance to shareholders.

In the UK

• Community Interest Companies (CICs) are limited companies with additional features created to encourage business for community benefit. The company’s money and equipment can only be used for its social objectives and there is a cap on shareholder dividends; a limitation currently being challenged by Stephen Lloyd, one of the architects of the form. CICs are regulated by the UK Charity Commission.
• Similar to the L3C in the US, the Social Enterprise LLP is adapted from the existing Limited Liability Partnership form, or LLP. Still awaiting approval by Government, it’s been designed as an off-the-shelf structure for social enterprises, providing a form for collaborative partnerships that may involve a number of for-profit and not-for profit-stakeholders. The SE LLP is transparent for tax purposes, has a charitable golden share to ensure social mission lock and, like the CIC, may provide a cap on returns. It is regulated by the CIC regulator.
• Charitable Incorporated Organisations (CIOs) are incorporated charities that are not companies. Members and trustees are personally safeguarded from the financial liabilities the charity incurs. The charity has a legal personality of its own, which means it can conduct business in its own name, rather than the name of the trustees. Like CICs, CIOs are regulated by the UK Charity Commission.

Worldwide

• Finland, Norway, France and Luxembourg have all created new legal structures to facilitate the establishment of hybrid organizations, often by adapting existing structures.

But is it enough?

Despite these advances, change isn’t happening fast enough for those who want to see more structural options available to social benefit organizations. As the sector continues its rapid growth and an ever wider range of players get involved, the need for new structures becomes more pressing.

Yet there’s inertia when it comes to changing old ways. Foundations, the target investors for L3Cs, have been slow to take up the opportunity to put their money into socially beneficial entities; in a recent blog for Pioneers Post, Wood points out that some 98% of the capital of US foundations is still unaligned with social mission. Meanwhile, the SELLP is stalled as the UK Government mulls over its tax implications, a situation that frustrates Wood.

“There are numerous examples of these types of structures accepted by the IRS in America today,” he points out. “In this sense it is not a legal question but one of scaling, replication and marketing. The contentious issue is the compliance framework and how complex that needs to be. An LLC framework is of course extremely flexible, with an extensive body of existing law surrounding it,including precedents for creating internationally collaborative frameworks. In this sense the L3C and the SELLP are not new but simply iterations of the existing LLC and LLP codes but with a social purpose built in.”

Beyond legal structures

The delay leaves Wood and his collaborators looking for other strategies to bolster the sector while the gears of government slowly grind. Currently they are discussing ways to tweak the social impact bond framework to make it more broadly useful and cheaper to adopt.

“With a little more social and financial engineering we will be able to create a standardized product that is applicable to any social issue,” says Wood. “What most people overlook is that by securitizing the cash flows of a social impact bond you can create quasi-equity. This has a clear financial value as a function of the achievement of the tangible social outcome by a number of collaborating stakeholders. Thus social equity actually has financial equity value.”

That’s good news for a burgeoning sector looking for more ways to make impact investing work, but it raises other questions. One of them regards oversight: Who will manage the partners in a social bond’s collaborative framework. How will they do it?

For Wood, this is a strong argument for establishing legal structures. “Social bonds are certainly useful, but there still needs to be a strong regulatory (legal)framework for these interactions,” he argues. “As a society, we think it’s right to regulate grant-making because philanthropy effectively receives a subsidy though the tax code. How much more do we need regulation when we have contingent for-profit cash flows to various parties and the allocation of equity as the function of meeting a shared social goal? Without a legal structure, the alternative is just to trust the bankers who set up these deals and hope for the best.”

Total Impact Advisors is currently listing impact deals on Maximpact.com. Check out their deals and many others.

Interview by Marta Maretich