Dare To Be Visionary: Using Social Impact Corporate Forms To Implement ESG and Social Impact Values
Corporate executives and board members should be visionary in implementing ESG and social impact values in their enterprise.
Corporate leaders should consider utilizing alternative corporate structures, including hybrid structures, that can help align legal responsibilities of a corporate board with the common good. This article discusses a variety of legal models that both traditional for-profit enterprises and social enterprises can consider in meeting ESG and social impact needs.
Why Care About ESG and Social Impact?
Present concerns surrounding ESG and social impact build on the years of research and advocacy related to social enterprise and sustainable investment, but with even stronger calls for actions. Specifically, ESG seeks to integrate environmental, social, and governance (ESG) factors as affirmative undertakings by an enterprise, on par with the need to create a profitable business.
There are several reasons why businesses should care about ESG and positive social impact:
Promoting a public good makes financial sense. A company’s brand as well as market position are likely to improve with investments in ESG and social impact. A 2019 report from McKinsey & Company concluded that, “A strong ESG proposition correlates with higher equity returns, from both a tilt and momentum perspective. Better performance in ESG also corresponds with a reduction in downside risk, as evidenced, among other ways, by lower loan and credit default swap spreads and higher credit ratings.” In May 2020, Blackrock noted that companies with higher ESG scores proved more resilient in and through the economic uncertainty caused by the pandemic, and that higher ESG scores “were material in differentiating between leaders and laggards across global markets.”
Promoting a public good helps retain and keep inspired and talented employees. A 2020 report from Deloitte concluded that, “Purpose-oriented companies have higher productivity and growth rates along with a more satisfied workforce who stay longer with them.” Research showed that “companies report 30 percent higher levels of innovation and 40 percent higher levels of workforce retention than their competitors.” Results of a 2016 Cone Communications study concluded that 83% of millennials “would be more loyal to a company that helps them contribute to social and environmental issues (vs. 70% U.S. average),” and 64% will not take a job with an employer that does not have strong corporate social responsibility values. These benefits alone are powerful reasons to care about social impact.
Promoting a public good changes the language of business and helps promote a more sustainable, civilized marketplace. Our shared global prosperity depends on the creation and maintenance of marketplaces that are stable and sustainable. For many years, businesses have been able to take the existence of such marketplaces for granted, but those days may be over. Like any public commons, our global marketplaces need proper maintenance for prosperity to continue. A company that promotes a public good can change the language of how we all do business, and can also direct attention towards continuing flaws in the marketplace that government may not have the capacity or political will to address.
Using a corporate form dedicated to the public good creates a legal expectation and market signal that ESG concerns and social impact are prioritized. The internet and social media have made it increasingly difficult for businesses to withstand close scrutiny of their purported values that lack concrete implementation. This makes it important for companies to consider the use of specific corporate forms that are dedicated to social impact. This article discusses several such options below.
Delaware’s Public Benefit Corporation
Key Takeaway: Consider a Delaware public benefit corporation to obtain the usual benefits of Delaware corporate law combined with social impact.
Delaware’s public benefit corporation (“PBC”) statute was enacted in 2013 and provides the flexibility and ease-of-use that Delaware entities are known for, while also promoting ESG values and positive social impact.
Delaware defines a PBC as any “for-profit corporation” that “is intended to produce a public benefit” and which operates “in a responsible and sustainable manner.” DGCL § 362(a). The corporation must be managed in a manner that balances “stockholders’ pecuniary interests” with the “best interests of those materially affected by the corporation’s conduct” and the public benefit or benefits identified in the certificate of incorporation. Id.
To file as a Delaware PBC, an entity must (i) identify one or more specific “public benefits” that it intends to promote and (ii) describe that public benefit in its articles of incorporation. DGCL § 362(a)(1). The public benefit must produce a positive effect (or reduction of a negative effect) on one or more categories of persons, entities, communities, or interests, and could include (without limitation) artistic, economic, environmental, scientific, or cultural effects. DGCL § 362(b).
The Delaware PBC alters the duties of the board of directors in significant ways. DGCL § 365. The board is required to manage the PBC “in a manner that balances the pecuniary interests of the stockholders, the best interests of those materially affected by the corporation’s conduct, and the specific public benefit or public benefits identified in its certificate of incorporation.” DGCL § 365(a). A director can fulfill this duty by making decisions that are “both informed and disinterested and not such that no person of ordinary, sound judgment would approve.” DGCL § 365(b). Practically, this statutory language thus permits a corporate board to make a business decision that may prioritize the public benefit over profit maximization.
At least biennially, the PBC must provide its stockholders with a statement about the PBC’s activities, which include a statement regarding the PBC’s objectives, how the board is promoting the public benefit or benefits, the standard it uses to measure these effects, “objective factual information” based on these standards regarding meeting the PBC’s objectives, and an “assessment” of the PBC’s overall success. DGCL § 366.
Any shareholder owning at least 2% of the outstanding shares (or in the case of a publicly traded PBC, owning the lesser of 2% of the outstanding shares or the percentage of shares with a market value of at least US $2,000,000) can bring a derivative suit to “enforce the balancing requirement” imposed by Delaware law. DGCL § 367. In theory, this permits a stockholder to obtain injunctive relief against a corporation and/or its board members if the public purpose is not being promoted. This remains a largely untested accountability mechanism, in large part because PBCs have not yet had widescale adoption. However, Delaware appears committed to the PBC model, and in 2020, the Delaware legislature amended the DGCL in a variety of ways to encourage PBC conversions.
California’s Public Benefit Corporation
Key Takeaway: California’s PBC offers a different take on the public benefit corporation model, with specific enumerated considerations that a board must consider prior to making a corporate decision.
California has two different types of for-profit entities that can potentially be used as social impact corporate vehicles, depending on the circumstance.
One is the California version of the Public Benefit Corporation. Like its analogue in Delaware, the California PBC’s chief insight is to amend traditional duties of the board of directors to go beyond profit maximization and to consider the impact of the corporation’s business on society as a whole.
Thus, a California PBC must “have the purpose of creating general public benefit” and may also “identify one or more specific public benefits that shall be the purpose or purposes of the benefit corporation,” which does not “limit the obligation of a benefit corporation to create general public benefit.” Cal. Corp. Code §§ 14610(a), (b). The creation of general and specific public benefit “shall be deemed to be in the best interests of the benefit corporation.” Cal. Corp. Code § 14610(c).
In contrast to the Delaware PBC authorizing statute, California law specifically identifies seven (7) concrete groups and interests which must be considered in any corporate decision:
(1) The shareholders of the benefit corporation.
(2) The employees and workforce of the benefit corporation and its subsidiaries and suppliers.
(3) The interests of customers of the benefit corporation as beneficiaries of the general or specific public benefit purposes of the benefit corporation.
(4) Community and societal considerations, including those of any community in which offices or facilities of the benefit corporation or its subsidiaries or suppliers are located.
(5) The local and global environment.
(6) The short-term and long-term interests of the benefit corporation, including benefits that may accrue to the benefit corporation from its long-term plans and the possibility that these interests may be best served by retaining control of the benefit corporation rather than selling or transferring control to another entity.
(7) The ability of the benefit corporation to accomplish its general, and any specific, public benefit purpose.
Cal. Corp. Code § 14620(b).
Directors “shall not be liable for monetary damages for any alleged failure to discharge the person's obligations as a director” in performing their duties to evaluate the above factors. Cal. Corp. Code § 14620(g).
A California PBC must prepare and issue a report annually to its stockholders describing its efforts and successes and failures in creating a general public benefit. Cal. Corp. Code § 14630. This must include an assessment based on a third-party standard “of the overall social and environmental performance of the benefit corporation.” Cal. Corp. Code § 14630(a)(2). This annual report must also be placed on the company’s website. Cal. Corp. Code § 14630(c). As in Delaware, shareholders, directors, and anyone else specified in the Articles of Incorporation or the Bylaws can initiate a “benefit enforcement proceeding.” Cal. Corp. Code § 14623.
California’s “Social Purpose Corporation”
Key Takeaway: A California SPC offers a different take on the public benefit corporation model, with greater flexibility to corporate boards in making decisions but also with more robust reporting requirements.
The alternative corporate form designed for social impact in California is known as the “Social Purpose Corporation” (SPC), the outcome of a competing proposal before the California legislature related to social impact corporate forms. In contrast to creating a general public benefit, an SPC is more narrowly authorized to carry out any activity that a nonprofit public benefit corporation is authorized to carry out, or it must promote the positive effects of (or minimize the adverse effects of) the corporation on the SPC’s employees, suppliers, customers and creditors; the community and society; or the environment. Cal. Corp. Code § 2602.
In contrast to the PBC model, the SPC does not mandate that directors consider any public purpose; rather, the SPC requires directors to “consider those factors, and give weight to those factors, as the director deems relevant, including the overall prospects of the social purpose corporation, the best interests of the social purpose corporation and its shareholders, and the purposes of the social purpose corporation as set forth in its articles,” leaving it up to the director as to how much weight to give to the social purpose in any corporate decision. Cal. Corp. Code § 2700(c). This appears to give wide latitude to corporate boards as to how they can make business decisions—perhaps “giving weight” to profit maximization for some decisions, while prioritizing the purpose of the SPC for others. In contrast, the PBC models discussed earlier generally require that the public benefit be considered for every business decision (for example an express balancing of social impact with profit in Delaware, or an affirmative evaluation of specific factors in California).
The SPC has significant and extensive reporting requirements. The SPC must produce an annual report that contains a “management discussion and analysis (special purpose MD&A) concerning the social purpose corporation’s stated purpose.” Cal. Corp. Code § 3500. This MD&A requires a discussion of the SPC’s social purpose objectives, “material” actions already taken and which the SPC intends to take in the short and long term for achieving its special purpose, a discussion of financial, operating and other measures used by the SPC during the fiscal year for evaluating its performance in achieving its special purpose objectives, and a discussion of capital expenditures. Cal. Corp. Code § 3500(b).
In addition to the MD&A, a special purpose “current report” must be sent to SPC shareholders if (i) the SPC undertakes any expenditures made in furtherance of the special purposes that is likely to have a “material adverse effect” on the SPC’s financial condition, (ii) withholds expenditures designated for the special purpose if that expenditure was likely to have had “a material positive impact on the social purpose corporation’s impact in furtherance of its special purpose objectives,” or (iii) the board determines that “the special purpose has been satisfied or should no longer be pursued, whether temporarily or permanently.” Cal. Corp. Code § 3501. Both the MD&A as well as the current report must be posted on the internet. Cal. Corp. Code §§ 3500(b); 3501(a).
A shareholder may sue for special purpose reports if they have not been generated. Cal. Corp. Code § 3502(j). SPC shareholders may also maintain a derivative action to enforce the directors' duties to act in accordance with the SPC's prospects and purposes; however, given that the SPC statute gives considerable flexibility to directors with respect to decision making, it seems uncertain the extent to which a court would overrule a decision to place less emphasis on social impact by a director.
Establishing a Corporate Foundation
Key Takeaway: A private foundation offers the most control to a corporate sponsor, but there are restrictions on the relationship between the corporate sponsor and the foundation that will have to be maintained.
A longstanding strategy used by businesses to generate a positive social impact has been the establishment of an affiliated private foundation. Private foundations can be set up under Internal Revenue Code § 501(c)(3).
A private foundation is generally the best vehicle where grant-making is the primary purpose of the non-profit and maintaining long-term control over the foundation is important. If grant-making will not be the focus, and if long-term control is not necessary (or can be obtained through continued giving), then other types of non-profit structures may make more sense.
In exchange for having significant funding control over the foundation, IRS rules require strict boundaries between the sponsoring corporate entity and the foundation. Specifically:
Foundations are subject to heavy restrictions on self-dealing. There is a total ban on business dealings with “disqualified persons.” The financial sponsor is almost always a “disqualified person,” and different officers/employees at the sponsoring foundation may also be disqualified persons and might be prohibited entirely from economic dealings with the foundation.
Rules on disqualified persons generally prohibit mixing staff. However, a sponsoring foundation could pay its employees directly, and then lease them or grant them time to work on the foundation. That is permitted and is a typical way that a corporate foundation shares staff.
Generally speaking, under IRS rules the foundation has to distribute 5 percent of its assets to grant-making activities.
Direct charitable activities can be undertaken by the foundation, subject to the above considerations.
Establishing a Charitable Organization
Key Takeaway: If a sponsoring corporate entity wants a multi-purpose, charitable affiliate, a 501(c)(3) public charity offers the most flexibility, but it cannot be legally required to maintain perpetual affiliation with the sponsor and will need to maintain at least 1/3 non-sponsor sources of support.
Establishing a 501(c)(3) public charity is another alternative. This provides a significant degree of flexibility both to the sponsoring corporate entity as well as the affiliated non-profit. However, this type of non-profit cannot be completely controlled by the sponsor. A public charity will require some degree of independence from both a financial as well as a governance perspective. In addition to the well-known “public support” test (generally speaking, at least one-third of donations must be from the general public), the IRS will expect a governance structure that prohibits private inurement and self-dealing and does not allow the corporate sponsor to exercise control over the charity’s directors. While not as onerous as private foundation rules, private inurement is always prohibited.
A public charity may be able to engage in some of the following activities:
Providing an alternative low-cost “fee-for-service” model that could provide charitable support in activities similar to the services provided by the corporate sponsor.
Staff overlap and a relationship between the corporate sponsor and the charity is permissible, subject to appropriate restrictions that prevent value from flowing from the non-profit to the for-profit. Implementing a Master Services Agreement between the corporate sponsor and the non-profit is something that can be put together as part of the initial incorporation, which can help define sharing of staff, the services that the corporate sponsor can provide to the non-profit, shared office space, etc., in a manner that is consistent with IRS rules and which provides flexibility to the non-profit to rely on the corporate sponsor’s resources.
With respect to grant-making activities, a public charity can generally engage in such activities, so long as they are consistent with the mission of the charity.
The IRS will expect some degree of independence with respect to the public charity, particularly if a healthy amount of funding is coming from the corporate sponsor. Things that may need to be considered might be the right number of independent board members (including staggering the board), restrictions on changes to the non-profit’s mission and governing documents, and other such controls.
A public charity will require more mixed sources of donations (the corporate sponsor itself cannot donate more than two-thirds of the funding to the public charity, and may be subject to a lower threshold).
Adopting a Social Impact Subsidiary
Key Takeaway: Companies that are still exploring ESG practices could consider creating a subsidiary to test the market and the specific social impact model they wish to implement.
A for-profit business does not need to establish or convert into any of these entities outright. The business can always create a subsidiary that is dedicated to social impact, and which operates alongside the for-profit business. The subsidiary could have different branding, a different consumer audience, and even take in minority investment.
A business that is unsure of how to address its social impact could experiment with different business models in this way. Once a sustainable formula is found in the marketplace, the parent company could adopt the business of the subsidiary across the entire enterprise. This may be a good medium term (2-4 year) solution for businesses that want to make the leap into a full blown social impact enterprise, but have initial concerns about making such a model work in the current business environment.
Promoting Adoption of Social Impact and Social Purpose Companies
Governments, including state and local governments, could dramatically accelerate the adoption of the entities or structures discussed in this article by reducing franchise taxes or providing other tax incentives for corporations that promote a public purpose. In California, for example, all corporations, including PBCs and SPCs, must continue to pay an $800 franchise fee annually. Treating all corporations the same for purposes of taxation ignores that a social impact enterprise is designed to support and sustain a public good in a manner that a traditional corporation does not. A business may be more inclined to consider a social impact corporate form with proper tax incentives, particularly since social impact corporate forms carry added legal obligations and reduced freedom to maximize profit.
Corporate attorneys working with clients should endeavor to offer social impact approaches to their clients, which, if nothing else, helps to spread the word that these entities exist. Many businesses are currently reflecting on how to position themselves in the market in light of the growing importance of ESG and corporate social responsibility metrics, and may appreciate legal advice on how to architect or implement alternative corporate forms and structures in their organization chart.
Finally, CEOs, members of corporate boards, and other company leaders should evaluate the direction of their enterprise and consider aligning their businesses with social impact and social responsibility goals. This is as much a personal shift as it is a business shift. “Go fast and break things” has been the mantra of tech startups for some time, but the “things” that get “broken” under this model are actually real people’s lives—lives both inside and outside the enterprise. This type of business model is also producing social crises of unprecedented scale, crises that have economic, environmental, societal, and moral dimensions. It is absolutely possible to create and sustain for-profit enterprises that enrich and sustain the lives of employees, consumers, and a shared common good that exists beyond tribalist or partisan loyalties. In a more interdependent and connected world, corporate leadership should dare to be visionary and demand a better balance of profit-maximization with maintaining and sustaining a truly global marketplace that promotes civilization instead of chaos, sustainability instead of collapse, and the common good over factional interest.