Creating value and doing good: Governance solutions for sustainable enterprises

LJD

By Professor Andrea Zorzi, University of Florence


This blog is part of a special series exploring subjects at the core of the Human-Centred Business Model (HCBM). The HCMB seeks to develop an innovative – human-centred – business model
based on a common, holistic and integrated set of economic, social, environmental and ethical rights-based principles. Read more about the HCBM here, and check out an event about it here
The HCBM project originated in 2015 within the World Bank’s Global Forum on Law, Justice and Development and is now based at the OECD’s Development Centre.

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Charitable institutions are an established concept. So is the concept of cooperatives that advance some social goals through business activities. What is relatively new, however, are two related ideas: one is the idea that the pursuit of social goals is the business itself, and the other that the business pursuit of social goals does not mean giving up profits.

In the past decade, many initiatives burgeoned to give legal form to social business. It was necessary before to adapt the legal structures of for-profit companies to not-only-for-profit goals. Adapted standards, however, may not always be effective or may expose entities to legal risks. Now, many jurisdictions provide legal forms for ‘social enterprises’, which are generally expected to pursue only ‘social, environmental or community objectives’, rather than both for- and not-for-profit goals and to reinvest most of their profits.[1] The most important difference between social enterprises and other non-profits is that social goals are pursued by carrying out the business rather than giving out money, goods and services to the needy.

A more recent trend involves hybrid entities, or those that pursue both profit and not-for-profit goals. The most notable examples are benefit corporations and similar entities. Statutes envisaging these kinds of companies appeared in some U.S. states ten years ago, and the trend has since spread across both the United States and other jurisdictions, from Europe to South America. Directors in benefit corporations must pursue not only ‘shareholder value’, but also other goals set out in the charter.[2]

While the pursuit of profit is easily measurable (profits or losses) and detectable (even on a continuous basis, for publicly traded companies, through share value), pursuing the objectives and measuring the success of not-for-profit goals is not as easy. How do you make sure that directors comply with their promise to shareholders, creditors, interested stakeholders and the general public? How do you address breaches of this promise? Business organisations that were conceived to make profits, such as companies, or to serve selfish goals, such as cooperatives, have corporate governance mechanisms in place that are based on the assumption that directors will first and foremost serve the interests of shareholders. But pursuing mixed or hybrid goals complicates the picture. Firstly, beneficiaries of the organisation are no longer just one constituency, but at least two and often more. Secondly, non-profit rules – particularly those to avoid diverting funds from their charitable purposes – do not apply to hybrid organisations, thus requiring substitute rules. Indeed, various issues come to the forefront, such as:

  1. Capital, both equity and debt, raised by the company in light of the social nature of its business must not be diverted from its intended goals and perhaps even distributed to shareholders. If some distribution is allowed, the question becomes how best to calculate it and what measure to use.

  2. Measuring performance in non-financial terms is a big issue. Many important initiatives on reporting, both at voluntary and compulsory levels exist, but building a common standard that gives a quantitative picture is yet to come. [3]

  3. Managers and directors should be incentivised and constrained to pursue the goals their shareholders intend for them to pursue. On another level, shareholders must avoid changing their minds and pursuing only profit. Furthermore, managers and directors should not invoke the organisation’s not-for-profit goals to justify suboptimal and perhaps self-interested decisions. This requires significantly adapting classical governance devices used in company law, such as incentive compensation or liability rules.

These and many other issues arise when it comes to corporate governance of hybrid organisations. A growing body of literature, voluntary initiatives and, in some cases, rules and regulations are addressing them, but they should still be tested in practice and measured empirically.

Looking ahead, the risks of inadequate monitoring, underperformance in non-profit goals and mission drift (or ‘bait and switch’ marketing to investors) are significant. These could have serious and perhaps irreparable negative reputational effects on the whole sector if not credibly curbed.

What is also important to consider is whether some sort of ‘hybrid’ goal should become the norm for all companies, irrespective of shareholders’ will and choice. Whilst this may be a long-term legitimate objective, good reasons suggest that shareholders should voluntarily decide to introduce a hybrid goal. Ultimately, the law should set (high) minimum standards for companies, encourage them to act and behave in a sustainable manner, and may also favour a transition to hybrid models, but the final decision on the goals to be pursued should rest with shareholders. What is imperative is that once a company decides on a certain goal, the law sets the framework for that goal – and no other – to be pursued.


[1] See http://ec.europa.eu/growth/sectors/social-economy/enterprises_enUnder the EU definition, also ownership and governance should be democratic and participatory. The EU notices that most social enterprises concentrate in three areas: (1) work integration; (2) personal social services, such as health, well-being and medical care, professional training, education, health services, childcare services, services for elderly people, or aid for disadvantaged people; (3) and local development of disadvantaged areas.

[2] For a recent overview of ‘hybrid initiatives’ see Lenzi, Diletta and Zorzi, Andrea,
The Human-Centred Business Model and Hybrid Business Forms: A Primer and a Roadmap (April 2, 2019). Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3369644.  

[3] See, for example, the Global Reporting Initiative (GRI), the Integrated Reporting (IR) and the Directive 2014/95/EU on disclosure of non-financial and diversity information.

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