Legal Structures for Social Enterprises in New Zealand
A challenge for change (or, how to beat Roger Federer)
03 Apr 2017 Post by:
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Alice: Would you tell me, please, which way I ought to go from here?
The Cheshire Cat: That depends a good deal on where you want to get to.
Alice: I don't much care where.
The Cheshire Cat: Then it doesn't much matter which way you go.
Lewis Carroll in Alice in Wonderland
New Zealand has an abundance of creative people with ideas for interesting businesses that often have social purposes at their core. Whether they know it or not, they probably fit in the definition of “social enterprises”. The number of individuals starting such social enterprises is growing. This will only continue as the next generation increasingly looks for meaning in work beyond simply returning a profit to shareholders. However, one thing New Zealand lacks in this space is a legal entity structure designed specifically for the implementation of those social enterprises.
The Cabinet paper released on 9 December 2016, “Social Enterprise and Social Finance: A Path to Growth”, is welcomed. However, more is needed than a cross-agency working group, the collection of statistics for further analysis and encouragement of investment. Instead, serious discussion of a new legal structure should be more firmly placed on the agenda. Failing to do that at this critical time represents a missed opportunity to proactively lead the way in this area.
The UK, Canada and the United States have all developed new types of social enterprise entities in the last decade. The key paper that started the process in the UK was issued in 2002, 16 years ago, so this is by no means a new concept. The lack of a legal structure in New Zealand is a real deficiency and we should not let the ‘number 8 wire’ mentality take over and mean that we simply make do and work within the existing frameworks.
If Roger Federer were given a cricket bat to play tennis I might have a chance at beating him. We use the right equipment that has been crafted specially for the particular game we are in. He could try and make do (after all, both a cricket bat and a tennis racquet are used to hit a ball) but despite being one of the best players ever he just won’t be as effective at playing the game. In the same way we can make do with existing structures for social enterprises that have some of the characteristics that we want. However, they do not recognise the key differences that distinguish social enterprises and set them apart. We need to ask for more.
In Part 1 of this paper we move beyond what exists currently and dare to dream big about what we would one day like to see. In Part 2 we discuss working within the existing constraints and what the current options are. A lot of time and energy is being spent on ways to create a better ecosystem for social enterprises. While that is important the hope is that this paper will generate discussion about the more fundamental point of the form of legal structure. If that were changed it would result in many other benefits for social enterprises which are now being focussed on as distinct issues at present (such as the ability to raise capital and a better profile and understanding of what social enterprises are).
Part 1: What could be (… the dream)
“I think there is a world market for maybe five computers.”
Chairman of IBM Thomas Watson in 1943.
There is real value in social enterprises because they do not rely on government funding or donations and instead operate as a business which employs people. However, their goals are not traditionally profit driven and instead may work to advance cultural, environmental, educational, social or other goals. They may also employ marginalised people and build locally based businesses which can contribute to particular geographic areas more than mass market or franchise models.
There are many barriers for social enterprises to overcome before they can flourish. It is easy to become distracted by all of those important issues (lack of specialised incubation, mentoring, funding options, financial and business experience, and immature support networks). The list is a long one although it is getting better. One could well argue that those issues need to be addressed prior to focussing on any development of a new legal structure. However, if we do not make changes now it will be even harder to do so in the future once more social enterprises, that have not even been thought of yet, have had to twist themselves around in order to fit into the current legal structures.
Instead of making do with what we have, a bold and innovative new approach is now required. This would place the debate about social enterprise and what it is at the top of the list for discussion. It would raise awareness and ensure this was also front of mind for those who are creating such businesses, as well as the broader community and traditional “for profit” businesses which could be challenged in their thinking and assumptions about their own business as well. Most important, it would result in a new form of legal entity tailored specifically for social enterprises.
Other countries have adopted legal structures specifically with social enterprises in mind. In the UK these are “Community Interest Companies” and in the United States there are “Benefit Corporations” and in Canada there are “Community Contribution Companies”. As this discussion progresses each of those will need greater analysis of how they work and what are the positives and negatives that can be learned from. The point for now is that they do exist and are a distinct form of new legal structures in those jurisdictions.
The fact that there is not a greater cry out for a change is a symptom of people facing other more pressing day to day challenges and not knowing that there might even be another option. And yet if another structure were available that might also be a way to address those pressing concerns regarding sourcing investors and funding, explaining the vision of a social enterprise and raising awareness of this sector.
To be specific, what we would like to see here in New Zealand is a new form of legal entity introduced which has the following key elements:
- Clear name: A name for the new form of entity which makes it clear it is not a traditional limited liability company but also not a trust or incorporated society. This would assist to alert investors and others as to what type of entity it is.
- Purposes: Requirement for clear articulation of the purposes (social, environmental, cultural etc) which show how they align with the social good while wrestling with the tension of also being a business.
- Capped dividends: Restrictions in place on returning profits to investors to ensure that profit making is not the ‘primary’ objective.
- Tax exemptions: Make the structure flexible enough so that for those who wanted to do so, and meet criteria, they could still apply for tax exempt status (this is not really a change since it can be done now).
- Reinvestment: Profit/surplus to be reinvested into the purpose. Consider if there is a guideline or percentage fixed of what must be reinvested or it is left as a dynamic tension.
- Reporting: Include a requirement for reporting not just on profit making goals but also on other social benefit goals.
Many of these concepts are foreign to traditional “for profit” business models and will take time to be discussed and understood. That there could be something more than maximising the dollar amount a company earns will take time to penetrate into the consciousness of society but it is something to be aimed for.
Of critical importance is the fact that the publicity around the new form of legal entity would raise awareness of social enterprises in New Zealand. As a result they would gain a new level of legitimacy and become better known. In addition, investment would be encouraged so they can grow because investors would understand what it was that they were supporting.
Part 2: What is (… the reality)
Door: It's simply impassible!
Alice: Why, don't you mean impossible?
Door: No, I do mean impassible. (chuckles) Nothing's impossible!
Lewis Carroll in Alice in Wonderland
In New Zealand those who have a good idea for a social enterprise do not have a tailored legal entity structure that can be used. This means that when setting up here existing structures need to be adapted for use. Of course, as the quote says, “nothing is impossible”, and this section outlines the different models most commonly used. It also serves the purpose of illustrating why a new legal structure would be beneficial.
The most common approach we see is to set up an incorporated charitable trust or society which has a charitable purpose (so it is a “not for profit”). This approach can limit the scope of what such an entity does since it is constrained by staying within those purposes. We often see that the charity sets up a limited liability company which then operates as a trading entity making income and which ultimately seeks to maximise profits for its parent charity.
Other social enterprises adopt a direct limited liability company structure with charitable components, but operate in a manner consistent with their social enterprise purposes.
So, turning to the options in brief:
Incorporated charitable trust: The Charitable Trusts Act 1957 provides the framework for trusts and societies to incorporate. The entity needs to have a charitable purpose at its core (relief of poverty, advancement of education, advancement of religion or purposes that benefit the public). Profit is not distributed to private individuals. Provided its purposes are charitable it can also register with Charities Services under the Charities Act 2005. This type of entity can also apply for donee status (under the Income Tax Act 2007) so that donations are not taxed.
Limited liability companies: The Companies Act 1993 provides for companies to be registered where there is at least one director and one shareholder (they can be the same person). Profit is typically distributed to shareholders. It is possible to “write in” (by restrictions on activities) some social enterprise purposes in the Constitution of a company. Note that companies can also register under the Charities Act 2005.
Incorporated societies: The Incorporated Societies Act 1908 provides that members can form a society which requires a minimum of 15 members. The constitution or rules must set out its objectives.
Limited partnerships: Under the Limited Partnership Act 2008 there is a general partner and limited partners. This form of entity is slowly growing in popularity in New Zealand as it allows both commercial and charitable entities to work together without compromising their tax status. While it could be potentially used we do not think it is commonly considered as the other options are less complicated.
Co-operative companies, Maori land trusts and industrial and provident societies: We will not go into these in detail as we have only seen them used rarely and in specific situations but we simply note that they do exist and could potentially be structures that are used. The framework for them is the Co-operative Companies Act 1996, the Industrial and Provident Societies Act 1908 and the Te Ture Whenua Maori Act 1993.
We believe that the scenario we outlined above (a charitable trust which eventually incorporates a limited liability company as a subsidiary to run its trading arm) is most common and that is borne out by both anecdotal discussions and the limited research on this. The Department of Internal Affairs in 2013 published a paper on this topic and pointed to 421 respondents which it had surveyed. Of those 52 per cent (218 responses) were set up as charitable trusts. Incorporated societies made up 37 per cent while limited liability companies made up only seven per cent.
One of the main factors for any new business is access to capital. If a charitable trust structure is adopted then that lends itself to approaching individuals and groups for philanthropic grants or donations (particularly if it has tax exempt status). However, it is more difficult to attract private investors who share the risk since these entities do not return profits to shareholders and remain “charitable” under the Charities Act 2005. On the flip side of this dilemma, a limited liability company may struggle with attracting such private funding since there is an assumption that it is “for profit” because of the form of entity which is being used – in fact it has other objectives beyond returning a profit. Even if charitable purposes are built into the constitution this is still something which needs to be explained and automatic assumptions will need to be clarified.
Change is the law of life. And those who look only to the past or present are certain to miss the future.
John F. Kennedy
Where are we, and where do we want to be. Any new change will be difficult to understand at first - see an amusing example here. But we owe it to future social enterprises to try and make things better. This paper has outlined the currently available legal structures in New Zealand used by social enterprises. It has also set out the dream of what we would like to see some day in the future. We need change in this area. We need to request the right equipment to play the game.
In the foreword to the UK report “Private Action, Public Benefit: A Review of Charities and the Wider Not-For-Profit Sector” published in 2002, Tony Blair (it is long enough ago that he was the Prime Minister), commented as follows and about 17 years later these statements still resonate here and now for New Zealand:
“Much of the legal context for charity and voluntary action is now outdated … law and regulation have not kept pace with developments … There is also insufficient recognition in the legal system of the particular needs of social enterprises, a rapidly growing group of businesses carrying out a wide range of activities for the benefit of society rather than the individual. This report sets out a package of measures which will modernise the law …”
The result in the UK was the introduction of a new form of legal entity more than a decade ago. It is hoped that this paper will promote discussion about the possibility of turning the dream of such an entity for New Zealand into a reality sooner rather than later. Doing so would ensure that social enterprises are given a new framework in which to operate and succeed. That will ultimately benefit all of New Zealand and ensure that we continue to be forward looking and encourage even greater growth and investment in social enterprises.
Not unlike Alice in the quote at the start we need to work out where we want to go. How we get there will be complicated as there are many competing interests and points of view. Our intention in preparing this paper is to promote further discussion and engagement on this issue so that New Zealand can show real action in the area of social enterprises. With the social enterprise world forum being hosted in Christchurch in 2017 it is the right time to consider this issue and take action now.
This article is not a substitute for legal advice and you should talk to a lawyer about your specific situation. Reproduction is permitted with prior approval and credit being given back to the source. Contact Steven Moe at firstname.lastname@example.org to request this or for any other questions. Copyright © Parry Field Lawyers 2017.