Tuesday, December 5, 2023

New Empirical Work on Hansmann’s Contract Failure Theory

A couple of weeks ago, my fellow blogger posted the abstract for a new article that provides some empirical evidence about what I consider the core theoretical grounding for the law of the nonprofit sector: Henry Hansmann’s seminal work, The Role of Nonprofit Enterprise.  The abstract reports that the authors “assess whether consumers use nonprofit status to form purchasing preferences as Hansman predicted.” I do not have the expertise to evaluate particular empirical methods in the social sciences, and so have no opinion whether their findings are useful or not, but they do an excellent job of introducing Hansmann’s theory and “updating” it in an important way.

First, the introduction: at its most concise, the authors explain that Hansmann “argued that government regulated nonprofit status provides a valuable signal to consumers about the trustworthiness of an organization.” The “signal” of “trustworthiness,” according to Hansmann, is the “non-distribution constraint” – the governmentally-enforced requirement that nonprofits not distribute their residual value to any corporate insiders. The power of this signal is that it allows “patrons” (donors to and paying users of nonprofit firms) to simplify the very complicated process of determining which firms are more likely to provide the services they want at the highest quality. The traditional view is that profit-seeking firms have incentives to provide high quality services in the most efficient way, because their owners can profit from cost-saving practices. Hansmann’s work argues that removing this strong economic incentive for firms can, under certain circumstances, be more efficient than its operation. His hypothesis is that the nonprofit firm is generally more efficient when it is impossible or very expensive for patrons to assess the value of the services provided, that is, when there is a strong need for trust. In what Hansmann calls “donative” nonprofits, the difficulty in assessing value comes primarily from the fact that the person who pays for the service is not the person who consumes it, and the “buyer” may have very little direct access to the “consumer.” It also comes from the fact that the value of the service being provided (alleviation of poverty, for example) may be hard to measure well.

The primary implication of Hansmann’s work for nonprofit law scholars is the idea that the nondistribution constraint, which generally falls under the heading of “inurement” in our peculiar vocabulary, is at the heart of what nonprofit law must effectively define and police. If the nondistribution constraint is fake, or too weak, or illegible as a signal, then the whole nonprofit sector could lose its value to society. On the other hand, if the regulation of nonprofit organizations is too restrictive, the value of the sector could be unnecessarily limited, losing out on opportunities to provide socially beneficial services in their most efficient form.  It’s a powerful idea that has influenced almost all of my thinking on nonprofit law, and which I tried to treat head-on in my early work.

The theory is subject to a number of attacks. First, there is the question of whether any of it is actually true. Do patrons use nonprofit status as a signal of “trustworthiness” and does it deliver what it promises? Both of those are empirical questions, the first of which Silvia, Child, and Witesman attempt to address at least somewhat in their paper. But even if nonprofit status does function as a signal of trustworthiness, there is the possibility that there are other, better, signals that exist or could be developed. This paper’s attempt to test how two very common signals – customer ratings and third-party certifications – affect the “signal” of nonprofit status. For the purposes of nonprofit law, the question of whether third-party certifications could better advance some of the functions served (in their absence) by the nondistribution constraint is extremely important. In some ways, the whole Benefit Corporation movement is an attempt to substitute a general third-party certification process for the nondistribution constraint. I think that general certifications of social benefit are likely to be too vague and amorphous to work as well as the nondistribution constraint in most circumstances, but it is by no means a foregone conclusion that they have no value.  The problem, of course, is that if for-profit models (like Benefit Corporations) confuse the general public, they have the potential to reduce the value of the nonprofit signal.  And if Hansmann’s theory is correct, then reducing the clarity of the nonprofit signal could destroy significant social value.

Benjamin Leff


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