Are charities legally permitted to make impact investments with their funds? Yes, but, getting to “yes” is not straightforward, and depends on the circumstances.
Impact investing is the use (mainly, but not exclusively) of money to simultaneously realize a financial return and a public or social good. A 2016 survey published by the Responsible Investment Association in Canada reports that in 2015 more than $9.2 billion in assets under management were identified by the survey respondents as being impact investments. A 2017 report by the Global Impact Investing Network reveals US$114 billion in impact investments worldwide in 2016. These investments are in sectors ranging from housing and energy to microfinance, education, and arts and culture. The investment instruments include debt (e.g., loans, bonds), equity (both private and public shareholdings or units in partnerships), and real assets (in other words, tangible assets such as real estate or commodities, rather than financial capital).
Increasingly, charities are looking at using their funds and other resources to contribute to positive social, economic, cultural and environmental change (“social impact”), as well as to obtain a financial return. But does the law permit them to do so?
Legal challenges to impact investing by charities
The law poses three challenges to charities’ ability to make impact investments: the power to invest that charities have; the duties that directors of charities have when deciding whether to make impact investments; and private benefits that may flow to others as a result of making impact investments.
1. Investment powers
An overarching legal rule applies to all charities: they are required to use their money and other assets to further their charitable objects. To achieve this, charities — and their directors — rely on powers. Charities obtain their powers from different sources. For example, a charity that is a corporation will look to its incorporating document (articles of incorporation or letters patent) for its powers, including its power to invest. If the articles or letters patent are silent about the charity’s power to invest, then it needs to look to legislation. A charity incorporated under the Canada Not-for-profit Corporations Act would find that it may invest its funds as its directors think fit. On the other hand, a charity that is an Ontario corporation is permitted to make investments that a “prudent investor” would make, and must consider a number of prescribed factors.
Does the notion of “investment” include an “impact investment,” though? This is not clear. Nineteenth-century English court decisions, at least in the area of trust law, held that an investment had to produce income, as well as preserve the capital. A more contemporary view is that investments include assets that don’t produce income, but where there is capital growth.
But impact investments are sometimes made where it is anticipated that there will be a negative financial return. May a charity make an investment where it is not expected to obtain either an increase in capital or produce any income — in short, there will be no financial return? In that situation, is it not more accurate to characterize the charity as simply spending its money? You can see, then, the outline of the problem. If a charity whose purpose is to operate social housing invests in an environmental project where it is doubtful that there will be a financial return at all, then the charity will have spent its funds on a purpose that is unrelated to its charitable object, which it is not legally permitted to do.
What about the situation where the same charity (social housing provider) anticipates a partial return of the capital invested (still a negative return, though)? There is at least one high court decision from New Zealand that takes a particularly expansive approach, concluding that partial financial returns, together with social impacts, constitute an investment. Based on this decision, it is arguable that, because of the social impact from the investment, a charity could rely on its power to invest to make an impact investment — for example, an interest-free loan — that expects repayment of only some of the initial amount invested. And in that situation, it should not matter that the project in which the charity made the investment is unrelated to the charity’s objects — it would, or at least should, be considered an investment. Does this give directors of charities enough to work with when considering whether they are permitted to make an impact investment? This brings us to the second challenge, the duties that directors of charities are under when making investment decisions.
2. Duties of directors
Directors of a charity must first make sure their charity is authorized to make an impact investment, and make any investment decision within the scope of such authority. This means abiding by any condition or restriction in the charity’s investment power, and ensuring that the exercise of the power is for proper purposes.
The core duty of every director of a charity is to make decisions in the best interest of the charity. In the context of impact investing, directors must consider both the anticipated social impact of, and the expected financial return from, the investment. It’s entirely possible that an impact investment will have no anticipated financial return. What then? Directors of charities have a duty to be careful in making investment decisions, which includes managing the risk associated with investing by diversifying the investments and considering the suitability of the investments given the needs of the charity. Unfortunately, this duty creates a difficulty for directors considering making an impact investment. While some impact investments may be suitable for a charity to make, directors may feel that they are unable to make them because they are too risky (given the expected financial return) or they may constitute too large a portion of the charity’s portfolio or the financial return is not the best available. In point of fact, however, there is no legal rule that requires directors of a charity to make investments that obtain the best possible financial return.
The issues of risk management and diversification remain, and, as discussed in part two of this column, a 2017 amendment to the Charities Accounting Act (Ontario) is intended to address these issues for Ontario charities.
3. Private benefit
Charities must be set up for exclusively charitable purposes and be operated for the benefit of the public. A corollary of this requirement is that charities are prohibited from delivering unacceptable private benefits to others. Court decisions have established firmly that if a private benefit is part of an organization’s purpose, then the organization is not a charity at law. On the other hand, if a private benefit is a consequence of an organization’s activities, then that will not prevent the organization from being a charity. The courts have also held that a private benefit is acceptable if it is ancillary or incidental to achieving a charity’s charitable purposes, or if it is an inevitable and necessary step in achieving the charity’s charitable purposes.
In the investment context, private benefits can include dividends or capital gains to other shareholders of companies in which a charity invests, or commissions to investment fund managers, or payments to third-party management companies retained to manage the project or enterprise in which the charity is investing. The traditional focus on what is “necessary and incidental” for determining whether a private benefit is acceptable or not is limiting for charities in the context of making social investments, however. This focus creates uncertainty about what charities can provide to investors in the charity, as well as with respect to what charities can invest in. For example, the Canada Revenue Agency’s (CRA) published policy about private benefits being delivered by charities is that such a benefit is only acceptable if it is minor and a necessary by-product of the charitable purpose of the charity.
When considering private benefits that may flow from a charity’s impact investing, a more practical and enabling approach is to ask whether such benefits are reasonable and proportionate in the circumstances. A charity’s impact investment involves it seeking to simultaneously realize a financial return and a public or social good, including, possibly, furthering the charity’s charitable purpose(s). Therefore, factors such as (but not limited to) the following should be examined:
- any financing, assets, guarantees or services that the charity provides as part of its investment are provided at market rates, or if below market, the discount is proportionate to the social impact anticipated from the investment;
- investments by way of loans are commercially reasonable, having regard to interest rates, security, length of term of the loan, adjusted according to the anticipated social impact from the investment;
- compensation and other terms in management contracts associated with the investment are commercially reasonable and fair;
- allocation of risk among the investors, including the charity, is fair and reasonable (that is, the charity is not assuming a disproportionate amount of the risk relative to the upside social impact and financial potential of the investment).
Ultimately, directors of charities must give consideration to private benefit when engaged in impact investing (as they must in regular investing). Private benefits that are reasonable and proportionate in the circumstances of a proposed impact investment should be considered acceptable, taking into account the twin aims of achieving a financial return and a public or social good at the heart of an impact investment.
This is part one of a two-part series on the law surrounding impact investing by charities. Read part two, on the regulation of charities, here.
Edward Hyland is partner at Iler Campbell LLP, Toronto, Ontario. Iler Campbell LLP is a full service law firm serving co-opertives, not-for-profits, charities and socially-minded small businesses and individuals in Ontario.
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