Legally Binding: How the Law Can Ensure Impact Outcomes

Last fall, Wharton Social Impact Initiative announced a collaborative project with Penn Law’s Entrepreneurship Legal Clinic. In collaboration with Anne Tucker, an associate professor of law at Georgia State University, and supported by four Penn Law students through the Social Impact Fellowship, this cross-campus collaboration aimed to advance our ongoing impact investing research and provide new insights into impact targets, legal structures, and performance of private equity funds with a social or environmental mission.

This week we will publish a series of blog posts from these students, reflecting on their experience and what we’ve learned thus far. Tune in each day for new updates from the team. In today’s update, law student Lacey Nemergut explains what impact investors can learn from benefit corporations. 

Infographic: Map of states with benefit corporation legislation as of Oct. 2015. Source.

Investors are struggling to define the recently discovered space between traditional funds—driven primarily for the highest return—and impact funds, which operate with the dual mandate of financing social change and profit.

This gap mirrors the growing space in entity formation between strictly for-profit corporations and nonprofit corporations, which has grown to include benefit corporations, social enterprises, companies that focus on the triple bottom line and companies that practice the principles of conscious capitalism.

Currently, legislators have only definitively spoken on benefit corporations, providing statutory guidance for benefit corporation formation and requirements. The advent of benefit corporation legislation primarily served as a mechanism to allow directors to focus on a social benefit at the potential expense of additional profits without the threat of shareholder litigation; however, the actual focus on and achievement of social impact can vary greatly depending on the directors’ willingness to be bound by a focused, measurable social mission.

The contrast between Delaware and New York public benefit corporation (PBC) requirements is an excellent example of this variation in the social impact space.

In New York, PBCs must declare a “general public benefit,” requiring a material positive impact assessed by a third-party standard and release an annual benefit report detailing the third party assessment.

In Delaware, the standard for defining a public benefit is much broader, giving directors greater flexibility. Directors are only required to release a benefit report biennially and they are permitted to use a standard of their own invention. Choosing to incorporate a benefit corporation in Delaware allows directors significant leeway in declaring a broadly defined social benefit, permitting them to adjust with minimal procedure if necessary. However, from the standpoint of a socially conscious investor, Delaware does not have the same strength as New York does in binding directors to their stated social purpose.

Infographic Source: B The Change

The competing tensions of a company’s desire to attract investors for the purpose of advancing a social impact and a company’s hesitation to be legally bound to a specific stated purpose are playing out in the impact investing space in a similar manner.

A careful review of fund level documents, including limited partnership agreements and private placement memorandums, shows that while managers will highlight their intentioned social impact, they are reluctant to explicitly define it, provide precise measurements or standards to meet, or tie any sort of compensation to the achievement of the social impact.

There are too few operational, actionable clauses in fund documents binding managers to a specific social impact or outcome compared with the uniform presence of financial clauses that do so. While benefit corporation standards for portfolio companies doesn’t necessarily mean the same standards for funds, the existence of third party standards required by New York PBC statutes would suggest that there could be possible benchmarks to use.

“When investors stop settling for this broad definition, we will likely see clauses with more teeth and specificity, binding managers to a higher standard.”

In the investing space, it is likely that investors have not yet demanded specificity in the fund level documents regarding stated missions. Given the novelty of the impact investing industry, investors are likely just getting used to the idea that their capital can not only provide returns but also target a social benefit. When investors stop settling for a broad definition, we will likely see clauses with more teeth and specificity, binding managers to a higher standard.

Download a Report of All Of Our Research Insights From This Series

Lacey Nemergut is currently a third year law student at Penn Law and a candidate for the Wharton Certificate in Business Economics and Public Policy. She graduated from Bentley University with a major in Economics-Finance, a liberal studies major in Global Perspectives and a minor in Psychology. Lacey currently serves on the boards of the Youth Advocacy Project and the Urban Ventures Project through the Toll Public Interest Center at Penn Law. She is currently the Symposium Editor for the Journal of Business Law and planned a conference focusing specifically on transactional pro bono and impact investing. Lacey will start work at Freshfields Bruckhaus and Deringer, where she worked as a summer associate after her second year of law school, as a transactional attorney in New York in the fall. She is originally from New Jersey and enjoys traveling and planning trips for time off.