Pay for Success: Pay for Success Calls for Innovation in Non-Profit, Contract and Securities Law

By: John Grossman and Marcia Chong*

Pay for Success (PFS) is a groundbreaking, bi-partisan, public-private movement that drives resources toward high-performing social service programs. In so doing, PFS measurably improves the lives of people in need. PFS replaces traditional cost reimbursement government contracts with performance-based contracting where outcomes and impact are rigorously measured and government pays only if measurable results are achieved. In PFS projects, funders provide flexible, upfront capital for service providers to scale interventions for a high-need population. An independent evaluator reviews the service provider’s performance and informs all project parties of the service provider’s achieved outcomes by the end of the project. If outcomes have been achieved according to levels agreed to in the PFS Contract, the government will pay for those outcomes. In early 2012, there were no launched PFS projects in the United States. Today there are seven launched PFS projects actively delivering services and, depending on who’s counting, over 75 projects in various stages of development.

By anyone’s measure, PFS represents a bold new approach to addressing society’s most persistent problems. Despite tremendous growth in the sector over the last three years, these are still uncharted waters, and the field we’re creating doesn’t always fit neatly into existing structures. In the same way personalized medicine forced the insurance and legal systems to examine law and ethics, or the digital age necessitated a critical reexamination of media and privacy laws, we are now seeing that PFS could benefit from a reexamination of Nonprofit and Tax Law, government contracting, and Securities Law.

In the following sections we look at each of these areas in more detail, highlighting the reasons why innovation and fresh thinking may be called for.

1. Nonprofit and Tax Law: In PFS projects, there is typically a Special Purpose Vehicle (SPV) that sits at the center of the project: receiving grants, taking out loans, disbursing funds to project parties, receiving success fees, and disbursing success fees to project participants. There are a number of issues that drive the structure of the SPV but broadly speaking, it can either be some form of a 501(c)3 or an LLC.  Where it is a 501(c)(3), there are number of issues that arise:
   • Should there be a tax benefit for loans made to social enterprises at below risk-adjusted rates?
   • How does the Private Benefit Doctrine, which (appropriately) prohibits tax exempt entities from conferring benefits on an individual that are “more than more than incidental, quantitatively and qualitatively, to the furthering of its exempt purposes” square with the idea of disseminating government success fees to impact funders?

2. Government Contracting: PFS requires governments to enter into multi-year contingent social service contracts. Government is only obligated to pay if outcomes are achieved and often, we don’t know if those outcomes are achieved until months, or even years, after the service is delivered. Funders involved in PFS require assurance that government won’t just walk away. In Massachusetts, the legislature backed their Pay for Success commitments with the full faith and credit of the Commonwealth. In other places, the government has created a sinking fund and promised to make annual appropriations.
   • Each of these measures is imperfect–What is the best mechanism to do this?
   • How else can governments address the counter-party risk?

3. Securities Law: In November 2014, the SEC issued a No Action Letter suggesting that, in some circumstances, the activities surrounding PFS projects do not implicate federal securities law.
   • When does an impact loan made in the context of a PFS project become a security?
   • What rules will allow PFS and other forms of social innovation finance to thrive without putting funders and the public at risk?

PFS is still in its nascent stages, but the recent surge in government interest portends a tipping point for the sector. Now is the time to reexamine and adapt the systems that will encourage (or constrain) the vast potential of this exciting field.

*John Grossman is the Co-President and General Counsel of Third Sector Capital Partners, Inc. Marcia Chong is a Senior Analyst at Third Sector Capital Partners, Inc.