Wednesday, February 08, 2012

Fair Profit Company: Making Case for a New Type of Entity for Social Enterprises

Increasingly a lot of dissent has been rising towards Capitalism that the system doesn’t contribute enough to the welfare of society at large. The reason behind this is that businesses are viewed (most often rightly) as the primary cause for social, environmental, and economic problems which different societies are facing. To put it simply, businesses and businessmen are now being widely perceived to be prospering at the expense of society at large.

The fiduciary duty of companies to maximize shareholder value only at the expense of everything else (otherwise they could be held legally liable) and the short term outlook followed by the companies are cited as the underlying causes for this loss of legitimacy for the Capitalism as a system. At the same time, governments and civil society organizations also try to solve the problems faced by the society at the expense of business. The trade-off between economic efficiency and welfare of the society at large has been taken as given, and guides the interventions by the government and civil society actors.

Here is a simplified take on what happens:
· Capitalism was the outcome of an attempt to create a system for efficient allocation of capital in the projects/ideas with highest possible returns.

· This lead to race among the investors to increase their returns on capital, which in turn demanded faster returns too. This quest for ever increasing and faster return got institutionalized with the advent of stock markets and VC funds.

· The narrow focus of investors in the return on their capital alone, meant that they and the businesses they had invested in started ignoring the broader influences which determine their success in long-term.

· This resulted in negative externalities for the environment and society, costs of which they were not supposed to pay and hence with economic growth the costs of these externalities have started weighing more day-by-day due to accumulation effects.

· One of the core strength of Capitalism is competition for promoting innovations to keep an economy vibrant. But the excessively myopic pursuit of returns on capital started meaning that companies needed to maintain their competitive advantage

· This in turn leads to big companies trying to make sure that competition dies out by using their money and other advantages to deter the entry of new players in the industry, which means decrease in innovation.

It is established that private ownership and efficient allocation of capital by markets i.e. Capitalism as we know today, is probably the most powerful, flexible, and robust system for growing society’s prosperity. At the same time, we know that the economy is just an aspect/part (probably the most vital one) of the society and the purpose of every society/ civilization is the welfare of its citizens. So economy and its constituents i.e. businesses should also serve that greater cause. But as interests of Capitalism are increasingly getting pitted against the broader interests of our society, Capitalism has to evolve to meet all the objectives of the society. Fortunately, this evolution of the role business in society has been happening albeit slowly over time, but the big push has come from increasingly growing number of social enterprises.

Rise of Social Enterprises
Social enterprises or socially responsible businesses try to solve this problem of negative externalities by internalizing the costs associated with them. This mean, shareholder value maximization is a part of the broader agenda for such enterprises. Their agenda could be to reduce environmental footprint, increase the welfare of the local communities, empowerment or focus on marginalized sections of the society, and in general a longer term outlook for the business ecosystem as a whole in the industry and locality they are working in. This means long term welfare and interests of all stakeholders in the business like consumers, employees, community, suppliers or other stake holders from the value chain has to be kept in mind while making decisions, and not just the interests of investors/shareholders.

Rise of social enterprises will go down as the characteristic transformation of our times in the economic history to be written in future. Governments and other influential bodies supporting this transition in the business is conducted would be hailed as the pioneers. The reckless pursuit of shareholder value maximization in turn got translated into making of GDP and the growth rates as the only criteria for measuring development of societies and countries. Other dimensions of development of society just got ignored, which has given rise to or increased the extent of many of our societal problems. Therefore the renewal or evolution of capitalism as a more inclusive system, would serve as a systemic intervention of bottom-up nature to solve the problems we have in our world today by promoting a nurturing environment for the innovations for this purpose.

Various structures and models are being tried by social entrepreneurs for achieving a balanced growth along with the welfare of public or fulfillment of other social goals like livelihoods security, health, education, empowerment of marginalized, etc. Some of these efforts have been highly successful but on the whole social enterprise ecosystem is not in the shape it should be to make it possible for new social enterprises/innovations to get into in the market and scale-up fast enough. While there are many dimensions of this ecosystem that require attention and support from the government, we would focus here on three very specific and heavily inter-related aspects.

1. Our current laws don’t provide for an alternative to pursue the society’s interests as a whole through sustainable models or mission driven businesses. Company law doesn’t provide for scope to pursue a second or third bottom-line beyond profits, though some entrepreneurs have tinkered with existing structure of a company to suit the needs of socially responsible business. Many new social enterprises get torn between their social commitment for which the business was started and their fiduciary duty.

2. Philanthropic donations, government programs and aid-money have tried to address the challenges of human development with a mixed record so far, and social enterprises are also a similar attempt which many believe to be having a great potential. For investors and anyone else to be assured that social returns expected on their investment are being reaped, a standardized system of measuring the social impact is not in place. So far people use proxies for the impact which can’t exactly be compared across different projects/ideas because of the differences in the methodology used and things measured. Profits or financial returns on capital are easy to measure and compare. A well developed social enterprise ecosystem would also require an equally good societal impact measurement system to compare different types of impact. Impact measurement methods used by development projects could definitely be of help here. Existence of a reliable standardized impact measurement system would also enable us to differentiate between false propaganda/claims by some corporations v/s the real impact.

3. Lack of reliable impact measurement keeps socially responsible investors suspicious and low on confidence to make investment decisions. This causes a slow investment rate which combined with lack of liquidity of such investments becomes a huge constraint for the social enterprises.

In order to solve the problems mentioned in above sections, many jurisdictions have been adopting different methods. Based on the ideas implemented internationally to tackle these problems, we recommend following strategies:

New legal structure: Allowing for new type of entities (let’s say Fair Profit Company or FPC) to be registered in which shareholder primacy gets diluted in favor of public welfare in general, with increased transparency and accountability is definitely going to encourage and support mission driven entrepreneurs. Such a legal structure would allow for shareholder value maximization after ensuring that the social mission of such a FPC doesn’t get compromised.

Here is a representative (and tentative) list of features of such a legal structure:
1. FPCs would give first priority to the explicit commitments to community welfare objectives mentioned in their charter or Memorandum of Association.
2. Cost of negative externalities created due to the business will get accounted into the financial statements of FPC to tackle these externalities by internalizing them.
3. Minimum fraction of ownership to be given to different stakeholders would get mandated e.g. 10% to blue-collar employees, 10% to the suppliers, 10-14% to the communities where FPC markets its offerings and 15% to the communities where the FPC is located.
4. Good corporate governance practices would be enforced with high penalty clauses
5. Explicit commitment to pursue long-term outlook has to be made in the charter and executives would be given flexibility and decision making power to achieve the goals set by shareholders
6. Commitment that fixed fraction of the profit (upto 25% max) will always get distributed as dividends, unless ruled otherwise in the General Body Meeting in that fiscal year
7. These corporations can take in grants with tax benefits to the donors, just as non-profits are allowed to accept grants
8. Foreign investments could easily be made without any restrictions and need of approvals, both in the form equity or debt i.e. easy FDI and ECB allowed through Direct route
9. Extra reporting requirements would be there to both ensure transparency and accountability, and to monitor progress on the social mission of the FPC

10. All tax liabilities for FPCs would be calculated just as it is done for the other companies registered under the Companies Act of India, 1956
11. Cost of measuring social impact can be reduced from the tax liability of an FPC within the permissible limits
12. Heavy penalty for fraudsters not fulfilling the community welfare objectives of FPC or compromising its social mission
13. To increase labor availability for FPCs, deduction in the income tax liability for the employees of FPCs could be provided
14. No license required or significantly eased requirements for getting license to provide goods and services which are highly regulated, including the provision of public goods i.e. power, water, education, health, security, mining, communication, public infrastructure, etc

Impact measurement standards: Setting up a government recognized Standard for impact measurement calculations in the Indian context is a must to be able accept the reports submitted by the FPCs for the purpose of monitoring progress on the social mission of FPCs.

FPC Impact Rating system based on both the absolute impact metrics, peer-rating by other FPCs, NGOs and the community, and/or standardized social audits should be given recognition by the government. Such a rating system would enable everyone to compare the performance of FPCs with each other.

FPC Stock Exchanges: To provide liquidity to the shareholders and FPCs an opportunity to raise capital from public, government should facilitate setting up of new stock exchanges where only FPCs of all sizes can be listed. Spot exchanges or share trading sessions for the trading of shares amongst the community members, employees, suppliers etc. should be organized regularly in the location where FPCs are located. FPC Impact Rating system would serve the purpose of providing the information required by such buyers and sellers for getting into the trade.

No comments: