Friday, November 02, 2007

Socially Responsible Investing (SRI), a primer for a Serbian magazine

At the media forum in Guatemala last week, I was asked by a Serbian editor if I would contribute something very short and general on socially responsible investing to a special issue on the subject of a Serbian business magazine. Something very readable for a general audience to explain what the idea is about and what kinds of laws and regulations you need to make it possible. Here's my effort - I am not very good at explaining things to general audiences, so I have encouraged him to simplify and shorten things.

What It Takes for a Society to Have Socially Responsible Investing

Socially responsible investing (SRI) is an increasingly popular mechanism by which individuals and organizations can engage in charitable activities. It is an especially growing activity of the nonprofit and nongovernmental organization sector in the United States and Western Europe, and has great promise to expand elsewhere in the world.

But SRI is a very special nonprofit activity, and for it to be successful in a society, SRI requires some crucial legal, regulatory, economic and social underpinnings – if these are present, then SRI can be an important tool in charitable and nonprofit work in a society, and in international philanthropy. If they are not, then there is a possibility of SRI backfiring and damaging the whole nonprofit sector. It is therefore very important to get the regulatory and legal rules right for SRI, and to understand that it is a specialized tool of nonprofit activity and not an answer for everything.

Stripped down to its essence, SRI is a practice by which either individuals or organizations – which might be regular for-profit businesses, such as banks or corporations, or non-profit organizations, such as charitable foundations – invest part of their funds in economic activities that are considered to be socially valuable but which might not ordinarily receive the funding from the market that is considered socially optimal. The basic idea is that the money is not donated in the ordinary sense of given to a charity, and then it is gone from the donor’s hands. The idea behind SRI responsible investing, on the contrary, is that it is an investment in a charitable activity, usually as a loan, which is to be repaid to the person who made the loan.

This socially responsible lender, rather than receiving the full market rate of interest, however, makes a conscious decision to accept either no interest on the loan or else a discounted interest rate – something less than the full market rate of interest. The money is intended to return to the lender, and so is not a donation. What is donated is the interest on the money that might have been charged.

In the case of individuals, that money can come from one or both sources. It might be money that the individual planned to contribute to charity anyway as an outright donation, and instead makes as a loan. People who do that – who planned to donate the money anyway to charity – frequently take the repaid loan and do another SRI loan, to the same organization or to another one. Alternatively, the money might come from funds that the individual planned to save – for a rainy day, for retirement, for all the reasons people save money. In that case, of course, the individual cares a lot that the money will be safely repaid – it is not money the individual planned to give away, but only to loan for a while.

In the case of for profit businesses, the legal rules in the United States and most other advanced economies permit the boards of directors of corporations to make reasonable contributions to charity in the name of the corporation. And so instead of making a straight donation, the business might instead loan the money at no or low interest rates. Alternatively, just as individuals might take some of their savings and put them into SRIs, a business might take some of its regular investment funds and put them into SRIs – and just like an individual, the business cares a lot that it get repaid.

Of course, all this means that the charity that receives the money must be the kind of charity that can repay a loan. Most charities are not like that, as a matter of fact. If you give money to a charity that uses the money to feed poor children or buy them winter clothes, the simple fact is that that kind of charity has no real possibility of earning money to pay back a loan. It's not (we hope) planning on charging the kids for the food or clothing. It is a charitable organization all about giving. It needs donations because its charitable activity is donating things. Think of it as an “intermediary” that takes donations from you, but knows better than you do who really needs that donation and why, and then makes sure it gets there. SRIs typically don’t make sense for those organizations – and they are most of the charities in the world – because those organizations don’t generate income apart from donations.

The organizations that can use SRIs are typically the specialized range of institutions that do generate their own funds, and can repay the amounts that are loaned to them. Examples would be schools that charge tuition – even if that tuition is very reduced, to subsidize the children, for example, still, over time there is an independent stream of income that can be used to repay SRI loans. What this means, really, is that an NGO that has a stream of income, from tuition payments, for example, can borrow at a zero interest rate through SRIs rather than financing itself – to build a new school building, for example – through loans on the market at full market interest rates.

This is a very valuable economic resource, but it only works with the kinds of charities that actually bring in their own money. But the numbers of charitable organizations in the world that do have their own streams of income from which they can, over time, repay SRI loans are increasing – especially as microfinance, which makes small, “micro” loans to poor people, especially women, in the developing world to create small businesses, grows. Those micro-businesses repay their loans, which in turn can repay the SRI loans.

If that is what SRI is all about, what kinds of legal, social, and economic structures make it possible?

In the first place, there has to be in place a solid social tradition of making charitable donations in the first place. In a lot of places, this is not true – all this work has traditionally been seen as the role of government, not charitable donations. But this view is gradually changing, to accept that although government has a large role to play, so do individual charitable donations. But to help persuade individuals and businesses to make charitable donations, there needs to be a reliable, stable set of government rules to make sure that donated funds are properly used, properly accounted for, go toward strictly charitable activities, and do not simply leak away in corrupt activities.

Second, once a society has in place a solid structure of legal rules for charitable contributions – straight out giving – it needs the special structure of rules for SRI loans. What makes this special and different from regular contributions to charity is that individuals and businesses who make these loans are genuinely looking to get paid back. There needs to be a regulatory and legal structure in place so that these loans really are treated, for legal purposes, as enforceable loans, even if they carry a zero or discounted interest rate.

Remember – often the most important source of SRI funds comes, not from money people were already planning on donating, but on people’s savings, money they are counting on having back, as part of their retirements and other reasons. They will not hand over the money for SRIs unless they have strong reasons to think they are legally protected that the loan will be repaid. Even if they are legally protected, technically, the difficulty of going through legal mechanisms - lawsuits, courts, etc. - mean that they must additionally feel comfortable that the organization will repay even without the threat of the law.

And so they will additionally require assurance that the money will be properly accounted for within the charitable organization. That requires legal rules ensuring that these loans are as legally enforceable as any other loan, although it is a loan made to a nonprofit charity. But it also means legal rules that ensure that nonprofits are monitored by neutral, objective government charity agencies to ensure that they are following proper accounting rules. Problems of unaccountable charities need to be caught before they turn into financial scandals, if possible. But that requires, of course, that the government agency really be about neutral, objective accountability - not a means of political control by the government. Governmental watchdogs over charities mean one thing in Britain and a whole other thing in Putin's Russia.

These are important legal and economic requirements in order that SRIs can work. But the benefits of SRIs are becoming increasingly clear in places where the rules work well. Money can be recycled in the charitable sector, and the fact that it is recycled and not simply donated helps force nonprofit organizations to be more efficient in their work. Many variations of these basic patterns exist - an SRI investor accepting greater risk, for example, that the loan will not be repaid for the sake of the activity. SRIs are not for every kind of charitable organization but, with the right governmental regulations, they are a new and important tool of the nonprofit sector.

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