The world is changing. Today, environmental consciousness permeates into
nearly every aspect of our society. The food we eat, the products we buy,
and the way we go about out daily lives have an impact on our environment
and our fellow human beings. While corporations jumped on the environmental
bandwagon some time ago, the financial services industry has lagged behind
a little bit.
Social impact bonds are investments that are geared towards providing funds
to an entity that looks to make a social impact or facilitate environmental
awareness. “Impact Securities” are debt securities or bonds
that indicate they have a tie to environmental concerns but are different
from green bonds in that the proceeds are not directed towards an individual
green project. The term “Social Impact Bonds” give the impression
to investors that the proceeds are used to promote environmental change,
yet the returns from impact bonds stem from various investments made from
bond proceeds, and may have no measurable ties to environmental impact projects.
How Securities Law Affects Social Impact Bonds
The U.S. Securities Act of 1933 provides an exemption from registration
for securities that are issued by and organization that is operated solely
for philanthropic or charitable reasons and not for a monetary profit.
Of course, the entity applying for the exemption will have to demonstrate
that it is eligible for registration exemption, under Section 3(a)(4),
as a non-profit, or not for profit organization. This requirement also
means that none of the company’s net earnings may are distributed
for the benefit of members or shareholders.
The law is clear that it is acceptable to claim a registration exemption
if a firm is indeed a non-profit enterprise; however, many companies will
obtain a no-action letter from the SEC to ensure that they will have a
guarantee of relief from any oversight or enforcement action based on
the offering of unregistered securities. An entity can claim the exemption
only if they are a non-profit with 501(c)(3) tax status, although their
status with the IRS does not guarantee exemption. If there is a commingled
part of the company’s business that is for profit, they may not
have the exemption available to them. The no-action letter provided from
the SEC typically has a single reason for issuance, and based on an organization’s
tax-exempt status will offer a level of assurance that allows the company
to issue impact securities without much scrutiny.
Since 1995, the government has made it easier for philanthropic companies
to operate in such a way that allows them to engage in charitable activities
without restrictive regulations. The Philanthropy Protection Act of 1995
makes it clear that a non-profit that issues securities based on environmental
or social impact concerns is not considered an “investment company”
under the Investment Company Act.
How Organizations Claim an Exemption
When companies register as a 501(c)(3) tax-exempt entity, they typically
express the organizational attributes in their business’s charter
that demonstrates they undertake the activities of a non-profit. If a
company is going to engage in the issuance of social impact bonds, it
must pay particular attention to exactly how their charter and bylaws
limit activities to include only charitable projects, and that there are
no net earnings distributed to stockholders or executive members. Another
important aspect for non-profit companies to focus on is their bookkeeping
and recordkeeping. Impeccable records will ensure that if the IRS or SEC
ever comes knocking, they will be able to provide proof they do not engage
in activities that can muddle their exemption status with either the SEC or IRS.
How Social Impact Offerings are Formed
A company relying on a SEC exemption to offer impact security instruments
primarily structures the public offering as an LLC or LP entity, presented
as a private placement investment. This type of investment relies on accredited
and institutional investors for participation. Since there are restrictions
on the kind of marketing that is utilized for these securities, impact
bonds are typically offered through foundations, government agencies,
or government-sponsored organizations. If there were to be some revisions
with regards to current SEC regulations would allow for issuers of impact
securities to engage with a broader range of investors willing to participate
in environmental or social impact investments.
How Impact Securities are Structured
Regardless of its intention, an impact security is a debt instrument, meaning
it is issued under an indenture agreement. Although the charitable organization
is the entity offering the security to investors and offering is often
conducted with the assistance of a financial intermediary who will act
as underwriter. The instrument is presented to potential investors as
a profitable venture that will meet criteria about certain environmental
or social goals.
While there are no set requirements that bind an organization to socially
relevant goals, impact bonds are issued to promote the philanthropic mission
of the company. The proceeds raised from the sale of the security are
to be used for the company’s operations and to achieve socially
important objectives. To ensure that certain social or environmental impact
goals are met, a payer or donor guarantees principal and interest payments
to the holder of the impact security, or makes payments on behalf of the
issuing entity. A security holder’s return is based on variable
outcomes of socially impactful projects. The projects are designed to
preserve principal while providing enough returns to pay interest to the
holder. Therefore, the performance of the instrument is tied to the management
and oversight of the non-profit’s philanthropic endeavors and is
paramount for enticing future investment.
Instruments will be issued based on a paying agency agreement and with
underwriting undertaken by an established financial intermediary. This
level of industry standard practices and protections helps pique the interest
of more accredited investors and institutions, prompting them to seek
out participation with more social impact investments.
The level of environmental activism is growing tremendously, with most
indicators demonstrating a renewed commitment to non-governmental socially
beneficial programs. The SEC must do its part to ensure that the marketing
and offering process becomes easier so that a wider base of investors
is developed in a way that helps promote this evolving financial undertaking.
In turn, private organizations will need to expand the issuance of social
impact securities, and ensure viable returns are offered to investors
so to achieve more growth in the impact investment market.
Contact Geraci Law Firm at (949) 298-8050 today, or contact
Kevin Kim directly
for more information.