European Parliament Recommends Creating EU-Wide Social Enterprise Legal Status – A Misstep?

In July 2018, the European Parliament passed a resolution recommending to the Commission the creation of an optional EU-wide legal status for social enterprises. The Commission now has one year to respond to the recommendation. A social enterprise is a type of business entity (e.g. a company, cooperative or mutual) that pursues a social purpose by commercially providing goods and services for the market. It will typically also include limits on profit distribution to members, and will democratically involve other stakeholders affected by its activities (see e.g. Article 2(1) of Regulation (EU) No 1296/2013). 

It is estimated that there are upwards of 250,000 active social enterprises, and that they make important socio-economic contributions to the European economy. However, beyond aggregated domestic impact, the perception is that their participation in the internal market remains low. One of the reasons given for this is that Member States’ regulatory frameworks are largely disjointed. The argument goes that this non-harmonisation of policy impedes expansion abroad since the creation or operation of social enterprise entities is not envisaged – or is similarly restricted to only a few acceptable organisational forms and work integration activities – in several countries. This renders merging or opening up a new branch office in another Member State, on the whole, not possible. Further, until Member States’ regulatory frameworks allow social enterprises to add a cross-border dimension to their activities, it will act as a barrier to the EU providing supplementary developmental support (e.g. increased access to debt or equity financing).

Compared with previous vertical attempts to bore through Member States’ “armour of sovereignty” by introducing supranational organisational forms, the Parliament’s suggested solution represents a cautious departure in approach. Exacerbated by the implications of Brexit, this may stem from a climate of general hostility to new initiatives in areas where there have been calls for redistributing matters dealt with by the EU back to Member States. Similar to the Societas Unius Personae directive following the failure of the European private company project, the proposal would take the shape of a directive introducing partially harmonised rules. It would only concentrate on the “core” elements of social enterprises, leaving other aspects of regulation to the national law of each Member State. The legal status would be voluntarily conferrable on any private law entity. To be eligible, an interested firm would be required to include within its articles of association certain express provisions:

1. it must have a social purpose;
2. it must engage in a socially useful activity (e.g. work integration to combat labour market exclusion);
3. it must be subject to at least a partial constraint on profit distribution and have specific rules on the allocation of profits, with some profits made reinvested to achieve its social purpose;
4. its governance model must democratically involve stakeholders affected by its activities; and
5. it must incur extra reporting obligations.

The “European Social Enterprise” (ESE) legal status would be valid and recognised in all Member States, also extending to a certification label for social enterprises’ products. 

A strength of the recommendation is that it only contemplates mandatory rules that correspond with widely accepted social enterprise criteria that can be found across most Member States. It also mirrors a growing trend in Member States’ social enterprise regulatory techniques (e.g. Denmark), in that it would allow a firm to choose the organisational form under which it prefers to conduct its business by offering a flexible legal status. This can be contrasted with Member States that only offer a distinct organisational form and require firms to actually (re)incorporate (e.g. the UK). 

While this approach could reduce transaction costs, increase economies of scale and assist social enterprises in reaching a larger product market, a mixtum compositum directive of this kind could also create unfair competitive advantages and horizontal competition potentially leading to a “race to the bottom”. Despite the several areas of overlap between national definitions that the recommendation attempts to capture, there are still very important points of difference that would be left to Member States’ discretion in domestic implementation of any forthcoming directive. Notably, Member States would be left to fix the levels of distribution of profits and assets upon dissolution (or conversion back to a traditional “for profit” entity). 

For example, France and Luxembourg have already implemented their own legal statutes for social enterprises. Both regulatory frameworks account for all of the above criteria and likely meet the requirements of any forthcoming directive. Therefore, they would not necessarily need to undertake any extra legislative measures. Under the French law, a firm interested in registering as an Enterprise Solidaire d’Utilité Sociale (“social economy enterprise”) must include in its articles of association provisions to the effect that it is bound to maintain an on-going 50 percent capital reserve of retained earnings to support the selected social purpose. However, aside from this requirement, the state places no further condition on the distribution of dividends. Moreover, if the decision is taken to dissolve (or convert) the firm, the members may distribute the remaining assets between themselves even though the firm had been trading on a socially responsible and quasi-public platform. For its part, the French social enterprise concept is more entrepreneurial and situated closer to the fault line shared with the “for profit sector”. The legislation tries to temper this by requiring a democratic governance model that includes all the various stakeholders affected; but the firm participants are only shielded from the logic of profit maximisation to a limited degree. This ultimately means that there is a tension between creating social value and commercial survival. The registration rules in Luxembourg are far stricter. To become a Société d’Impact Sociétal (“social impact company”) the state must similarly verify that a firm’s articles of association feature the same 50 percent capital reserve to support the social purpose. However, different from the French law, dividends may not be distributed unless the social purpose, evaluated against agreed performance indicators, is affirmatively achieved. Moreover, in the event of dissolution (or conversion), members must transfer all assets to another social purpose entity, foregoing any personal benefits. 

The decision in Kornhaas suggests that, under the freedom of establishment, the stricter Luxembourgish registration rules could not be unilaterally applied to an incoming French ESE. This is because the rules relate to initial establishment and would force the French firm – otherwise willing to enter Luxembourg’s market – to reorganise involuntarily if it still wanted access. As the courts have made clear, “if the host State’s law makes it necessary to reorganize…and adapt to the host State’s rules…then this law restricts freedom of establishment and must be justified” (for an analysis of Kornhaas click here; see also the Uberseering and Inspire Art cases). Such a barrier would likely not be justifiable. It would necessitate additional costs for an ESE coming from a more relaxed jurisdiction like France. Namely, it would require changes to both the organisational structure and relationships with financiers not present in the outbound jurisdiction (on this see Case C-518/06, paras 64-71). Indeed, it would also cut across the underpinning policy of the recommendation that the ESE legal status is to be recognised in all Member States. 

To conclude, it may be possible for a firm to engage in registration arbitrage and subsequently set up a secondary establishment in a Member State with stricter registration rules to secure an unfair competitive advantage. Over time, the differences in regulation could engender a widespread evaluation on the part of Member States to relax their rules in favour of a closer relationship with aggressive trading practices. This is troubling since there is a growing concern, especially among academics, that social enterprises could lose their unique “public good” character. Thus, the Commission ought to bear in mind that Member States’ social enterprise organisational law is path dependent, and, for the time being, in a state of “Babylonian confusion”. It should not introduce even a semi-comprehensive directive. Rather, the Commission might choose a soft coordination device such as a recommendation and perhaps transition to a directive after a long period of “policy learning”.

J S Liptrap is a research associate at the Centre for Business Research at the Judge Business School, University of Cambridge.