Profits of the right sort
Cecile Gillard takes a closer look at social enterprise and reviews the practicalities of how community interest companies (CICs) operate
New reasons for doing business, as well as new ways of doing it, are essential to a sustainable economic and social recovery from the recession. Social enterprise (SE) offers both, so the law reforms now providing greater freedoms for community interest companies (CICs) are timely.
SEs are businesses with primarily social objectives whose surpluses are principally reinvested for that purpose in the business or in the community. The concept’s long and positive heritage ranges from the ‘grow and share’ healthy eating schemes for factory workers in the mid 19th century to today’s dynamic and diverse businesses with social aims.
Scale of SEs
Where CICs fit in
SEs are found in a wide variety of legal forms, from traditional co-operatives and industrial and provident societies to companies limited by guarantee and, more recently, some 3,300 CICs.
CICs are a special optional corporate legal form, specifically designed for SE and community-related activities. Introduced some five years ago, they were intended to offer a flexible and attractive vehicle for both small owner-managed local initiatives and larger scale community focused businesses. In either case, it was understood that outside investors would be important to the funding of some CICs, through loans or share capital investments. So, it was agreed from the outset that those willing to give such support to a CIC ought to be permitted to receive some return on their investment. However, a degree of nervousness about this bold new corporate legal vehicle led to some over zealous and over complex restrictions in the original CIC legislation [3].
The issues demanding attention
The legal issues demanding attention were:
- Changes necessary to ‘dovetail’ CIC company law with the charity and company law changes.
- Removal of some restrictions on CICs that were widely agreed to be unnecessary or confusing.
- Solving the apparent reluctance of some investors to fund CICs, due to the complexities of the legal controls on dividends and performance related interest payments on loans.
The legal and governance context
Governance controls in the legislation include:
- Limits on remuneration of and benefits for directors.
- Disclosure requirements about the board’s reward packages and dealings between CICs and their directors.
- Strict requirements for particular controls in the CIC’s memorandum and articles. Besides the ‘asset lock’ and the community interest test, the major financial restrictions on CICs are:
- Limits on dividends payable on shares (applicable to dividends for private investors in CICs limited by shares).
- Limits on performance-related interest payable on loans (applicable to all CICs).
These are known as ‘caps’. The cap levels imposed by the regulations can be changed from time to time by decision of the CIC Regulator [4]. Such a change would affect shares issued or loans made after the change date (but not pre-existing arrangements).
The dividend ‘cap’ imposes a limit on the sum payable per share (5 per cent above Bank of England base rate, i.e. Repo Rate), plus a maximum aggregated dividend on all shares as a percentage of distributable profit (35 per cent of profit) and a five-year limit for carrying forward unused dividend capacity. The per share cap attaches as a share is issued and remains fixed for the life of that share.
For performance related interest payments to lenders, the cap is a percentage of the average amount outstanding on a loan or debenture (currently 4 per cent). The level is fixed at the date the loan agreement is entered into. Loans with other interest arrangements are not subject to this control.
Financiers and professional advisers experience confusion and anxiety on the part of both entrepreneurs and potential funders due to the complexities of these rules. Because of the date when the cap attaches, the resulting limit clearly may not reflect market conditions prevailing when actual payments are made. There are also practical administrative complications if investments are staged over time, as different cap levels may apply to each successive investment. Adjustment of a cap, as market conditions and the CIC’s own trading performance change during the term of the loan or the life of the share, is not possible because the cap is fixed. So, the rules also lack flexibility and perhaps require a rather larger gamble on the future than some CICs or investors are willing to take.
Reforms introduced
- A more flexible and readily understandable definition of ‘section of the community’ for the community interest test is now based on a common distinguishing characteristic that a reasonable person would understand to identify a relevant group of people.
- CICs can convert to the asset locked form of community benefit society (a type of industrial and provident society) and vice versa.
- A Scottish charity can also convert to a CIC, though in practice that will be a rarity (and there are, naturally, safeguards in relation to the charitable assets).
- Important practical changes relating to the Companies Act 2006 prevent the chairman of a general meeting having a casting vote and alter requirements for the constitution of new CICs to reflect the new ‘single constitutional document’ articles now needed for incorporation.
Further changes to facilitate CIC funding
- The per share cap is a particularly significant deterrent to investors, with 95 per cent of fin-anciers stating it unduly limits incentives to po-tential investment and 50 per cent of organisations that opted for non-CIC legal form regarding it as too restrictive to encourage their use of a CIC.
- Similar comments were made about the performance-related interest controls, with 69 per cent of financiers and 67 per cent of non-CICs considering it a deterrent to investment.
- As a future simpler control, 58 per cent favour a single cap related to Bank of England base rate.
What next?
- The per share cap for shares issued on or after the commencement date will be 20 per cent of paid up value.
- The interest rate cap will no longer relate to Bank of England base rate. The new limit will be 10 per cent of the CIC’s average debt over the preceding 12 months before the interest payment date. This applies to loan agreements and debentures entered into on or after the commencement date.
Author: Cecile Gillard
Cecile Gillard is the legal manager at Burton Sweet, chartered accountants. She specialises in legal, constitutional and governance advice for charities, social enterprises and ‘not-for-profit’ organisations. She is a general editor of Charities Administration Service and co-author of Company Secretarial Precedents (published by Jordans).
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