| Overbearing Oversight?
Improving Accountability for Public Charities
Although almost none of the provisions of Sarbanes-Oxley apply to
public charities, both state and federal authorities have heightened
scrutiny of nonprofit governance and the trend is toward increased
regulatory oversight.
by Ellen W. McVeigh
and Eve R. Borenstein
A
recent article in the online version of Minnesota Lawyer1 notes that more than a hundred business lawyers
have signed up to provide pro
bono legal assistance to smaller charitable organizations2 through
the Minnesota State Bar Association’s LegalCORPS
program, launched a year ago. This
program is laudable and we applaud the effort to increase the pool
of attorneys available to consult with low-income clients and particularly
with charitable organizations. Many charities need substantial information
and coaching about the rules that govern the charitable sector. Now more than ever, with increasing oversight
by federal and state regulators of the sector on the horizon, managers
of all charitable organizations (and the practitioners who represent
those organizations), must have up-to-date information about what
is expected of them in the area of governance.
The number of charitable organizations
in America
has nearly doubled over the last 20 years.
These organizations currently employ 11.5 million people. This sector is composed predominantly of small
organizations; 64 percent of 501(c)(3) nonprofit
organizations have annual operating budgets of under $500,000 per
year. Americans donate approximately $201 billion
annually to charitable organizations, and corporate and foundation
donors contribute an additional $40 billion toward the operations
of charities.3
Maintaining public trust in
the nonprofit sector is essential to its continued growth and vigor. Most charities operate in a responsible and
ethical manner. However, some
charitable organizations have abused the public trust, similar to
for-profit organizations such as Enron, Tyco, WorldCom and others.
Several states’ attorneys general, including Minnesota’s
Mike Hatch, have launched highly publicized investigations of local
charities that they believe have violated state statutes with respect
to fiduciary management of charitable assets.
In the wake of the significant changes brought about in the
oversight of publicly traded entities by the Sarbanes-Oxley Act,4
and spurred on by two well-publicized reports harshly critical of
how charity managers fail to guard against insider benefit, Congress
began an investigation in 2003 of charitable organizations’ practices,
particularly with respect to excessive compensation of “insiders”
and use of charitable assets to serve private interests.5 The results of that investigation are discussed
further below.
Mark Everson, commissioner
of the Internal Revenue Service, summed up the expectation of the
irs about the importance of good governance
in charitable organizations in a recent letter to Sen. Charles Grassley,
the chair of the U.S. Senate Finance Committee. Everson outlined what he saw as one of the most
significant issues facing the charitable community and noted, “An
independent, empowered and active board of directors is the key to
insuring that a tax-exempt organization serves public purposes, and
does not misuse or squander the resources
in its trust.” The commissioner’s keywords — “independent,”
“public,” and “trust” — echo the themes that have emerged strongly
over the past several years in this area.
Practitioners must understand, and then convey clearly to their
charitable clients, that regulators increasingly value accountability,
transparency, and good governance and that clients should institute
policies and procedures to be sure that their fiduciary responsibilities
in these areas are fulfilled.
This article will outline the
duties owed by the members of a board of directors of a Minnesota
charitable organization to that organization, and discuss recent changes
proposed by regulators. We will end with some practical guideposts
for practitioners advising charities.
Fiduciary Duties
Duty of Care. Minn. Stat. §317A.251
sets out the standard of care for directors, requiring a director
to discharge his or her duties “in good faith, with the care that
an ordinarily prudent person in a like position would exercise under
similar circumstances and in a manner the director
reasonably believes to be in the best interests of the corporation.”6
A parallel provision applies to nonprofit corporate officers.7
The duty of care embodied in these statutes (including duties of loyalty
and obedience) generally requires these individuals to carry out their
responsibilities by staying informed about the organization’s activities
and acting to ensure that their decisions are made in good faith and
with the intent to further the organization’s purposes.
Duty
of Loyalty. Included within the above reference
to “the best interests of the corporation” is a general duty of loyalty. Overall, this duty requires that corporate directors
and officers8 act in good faith and in a manner reasonably believed
to be in accordance with the best interests of the corporation. Minn. Stat. §317A.255 provides a procedure for
boards of directors to follow when “conflicts of interest” between
a director’s personal and organizational interests arise. Practitioners should understand the possible
areas of conflict set out in Minn. Stat. §317A.255, in order to prevent
voiding of corporate transactions that involve:
1. a director or a member of the family of
its director;
2. a director of a related organization,
or a member of the family of a director of a related organization;
or
3. an organization in or of which the corporation’s
director, or a member of the family of its director, is a director,
officer or legal representative or has a material financial interest.9
Directors and officers are
also required to keep charities’ information confidential to the extent
that that the information is privileged or that release of it would
compromise the corporation’s opportunities.
Directors and officers must refrain from taking an opportunity
of the corporation. Note that Minn. Stat. §317A.255 addresses only
a narrow range of possible conflicts of interest that are regulated
by law. Federal tax law includes
a larger pool of “insiders” whose possible conflicts of interest must
be managed by the charity’s fiduciaries.
Practitioners must become familiar
with a relatively new system of sanctions the irs
uses in situations in which charities’ “insiders” receive unearned
or excessive compensation or other benefits (“excess benefit”) from
the charitable organization. Under
Section 4958 of the Internal Revenue Code and its implementing regulations,
the irs may determine whether an “insider,”
as defined in the regulations, has received “excess benefit” from
a charitable organization. If
so, the recipient must return the “excess” and pay an excise tax that
ranges from 25 percent to 200 percent of the excess benefit received.
Directors of the organization who approved the transaction
resulting in the excess benefit may also be held personally liable
for a 10 percent excise tax. Section
4958 contains “safe harbor” procedures that charities should follow
to show that they have conducted sufficient due diligence before entering
into compensation or other benefit transactions with any insider.
Duty
of Obedience. While the duty of obedience is not
specifically addressed by a stand-alone statutory section, directors
and officers (and their legal advisors) must be aware of it. In its publication, “Fiduciary Duties of Directors
of Charitable Organizations,” the Minnesota Attorney General’s Office
lists the duty of obedience separately from the duties of care and
loyalty, and includes the following as specific obligations under
it:
1. State and Federal Statutes. Directors should be familiar with state
and federal statutes and laws relating to nonprofit corporations,
charitable solicitations, sales and use taxes, fica
and income tax withholding, and unemployment and workers’ compensation
obligations. They should also be familiar with the requirements of
the Internal Revenue Service. Directors should see to it that their
organization’s status with state and federal agencies is protected.
2. Filing Requirements. Directors must comply with deadlines for tax
and financial reporting, for registering with the attorney general,
for making social security payments, for income tax withholding, and
so on. Additionally, if an organization is incorporated under the
Minnesota Nonprofit Corporation Act, its directors have a duty to
maintain its corporate status by submitting timely filings to the
Secretary of State’s Office.
3. Governing Documents. Directors should be familiar with their organization’s
governing documents and should follow the provisions of those documents.
Directors should be sure proper notice is given for meetings, that
regular meetings are held, that directors are properly appointed,
and that the organization’s mission is being accomplished.
4. Outside Help. Where appropriate, directors
should obtain opinions of legal counsel or accountants.10
The attorney general is the
state official with enforcement authority over charitable organizations
in Minnesota. Recent enforcement efforts by Mike Hatch, Minnesota’s
attorney general, against larger charitable organizations such as
Health Partners, Allina, and the Minnesota
Partnership for Action Against Tobacco have made it clear that the attorney general
believes that boards of directors of charitable organizations need
to pay more than lip service to fiduciary duties set out in Minnesota
statutes.
The Minnesota Attorney General’s
Web site displays a series of policies for charities to consider when
developing standards to govern their operations and the conduct of
board members, officers, directors, and employees.11 According to
the Attorney General’s Office, its policies are offered as guides,
but text at the site explains that board members, officers and management
employees owe the public a fiduciary duty, a duty that carries with
it “a broad and unbending duty of loyalty and fidelity.”
Recent Federal Action
Within the past year, the irs has begun serious efforts to
enforce Section 4958 of the Internal Revenue Code governing “excess
benefit transactions.” Charities are required to flag transactions
in which “excess benefit” may have occurred on their annual federal
filing, the Form 990. Line 89b of Form 990 asks 501(c)(3) and 501(c)(4)
filers whether the reporting organization engaged in any “excess benefit
transactions” during the reporting year, or whether it became aware
of any “excess benefit transaction” from a prior year during the reporting
year.
Based on charities’ responses
to this line and other information submitted on the Form 990, the
irs began a new “executive compensation”
initiative, and had contacted approximately 1,800 charities as of
May 2005. The
IRS said that it would
ask these charities for clarification about errors in their Form 990
filings or for information on how executive compensation and/or terms
for transactions with insiders was set.
While the IRS’
commissioner announced that the agency’s focus would be aimed at transactions
and organizations who willfully flaunt the tax rules, this initiative
and others implemented this spring are designed to reach — and will
touch — the more common and pedestrian charities, whose errors, if
that, are inadvertent or sloppy,
but certainly not malevolent. Altogether,
with other Form 990 filing error contacts, the IRS
has so far made 16,000 contacts with charities in 2004 and 2005. These efforts were undoubtedly designed not
only to show that “the sheriff is back in town” but also to educate
and motivate those who have been sloppy or imperfect in complying
with charity mandates (particularly in managing compensation and insider
transactions). The goal of these efforts is to have errant
charities undertake reforms and move faster to adopting best practices.
Indications that Congress is
contemplating further regulatory emphasis on charitable governance
first emerged in testimony and preliminary legislative proposals that
were discussed at a hearing held on June 22, 2004 before the U.S.
Senate Finance Committee.12 A bipartisan “Staff Draft,” coauthored
by the chairman of the Senate Finance Committee, Sen. Charles Grassley
(r-ia) and the ranking
member, Sen. Max Baucus (d-mt)
harshly criticized current nonprofit practices in three areas: tax
evasion, governance and operations, devoting most of its attention
to governance.
Chairman Grassley spoke of
the various failings witnessed (or awaiting disclosure) at charities
where “poor governance or failure to abide [by] best practices” occurs.13 Sen. Baucus criticized “inflated salaries” and
“insider deals.”14 IRS
Commissioner Everson (speaking for the White House) started his testimony
by addressing “the need for enhanced governance.”15 Invoking recent problems in the corporate
sector, he said:
In recent years there have been a number of very
prominent and damaging scandals involving corporate governance of
publicly traded organizations. The
Sarbanes-Oxley Act has addressed major concerns about the interrelationships
between a corporation, its executives, its accountants and auditors,
and its legal counsel. Although Sarbanes-Oxley was not enacted to address issues in tax-exempt
organizations, these entities have not been immune from leadership
failures. We need go no further
than our daily newspapers to learn that some charities and private
foundations have their own governance problems.
Specifically, we have seen business contracts with related
parties, unreasonably high executive compensation, and loans to executives
... . All these reflect potential issues of ethics, internal
oversight, and conflicts of interest.16
Everson went on to specifically
criticize “the governing boards of tax-exempt organizations [who]
are not, in all cases, exercising sufficient diligence as they set
compensation for the leadership of the organizations.”17
The Staff
Draft proposed a number of regulatory changes related to exempt organization
governance. While these proposals
have not yet been introduced in legislation, they provide insight
into the breadth of the changes that Congress may contemplate and
demonstrate that Congress is considering the need to extend the authority
of the IRS into areas
of nonprofit governance that have only been subject to state oversight
in the past. Some of the proposals
would:
(a)
Change governance practices:
Require charities’ boards to establish
and oversee: basic organizational
and management policies; program objectives and performance measures;
the conduct of business, including approving significant transactions;
accounting and auditing practices (including retaining of an independent
auditor); and review and approval of budgets.
Require boards to have conflict of interest policies and require annual
report on Form 990 about determinations made under the policy.
Require boards to establish and maintain a compliance
program, and include procedures for reviewing complaints against the
organization.
(b)
Increase transparency of board’s decision making with respect
to overseeing key staff and managing compensation:
Require organizations to report on Form
990 how often their board of directors met, including how often the
meeting occurred without the CEO
(or equivalent) present.
Require new safe harbors and ceilings for compensation
to certain insiders and require annual review by the board and public
disclosure of supporting materials considered in setting compensation.
(c)
Require review of every tax-exempt organization every five years,
to determine “whether the organization continues to be organized and
operated exclusively for an exempt purpose.”
(d)
Permit IRS to share confidential
taxpayer information with state regulators.
(e) Increase penalties for failing to file the Form 990
timely and completely, and create new penalties (including preparers’
penalties) for errors in reporting on the form.
(f)
Require a signed statement from the CEO of an exempt organization
affirming that procedures are in place to ensure that the organization’s
filings with the IRS
comply with the tax laws.
(g)
Establish new federal standards or “best practices” for the governance
of tax-exempt organizations.
The U.S. Senate Finance Committee
asked Independent Sector, a nonprofit, nonpartisan coalition of approximately
500 national public charities, private foundations, and corporate
philanthropy programs to respond to the Staff Draft.
It did so by convening a “Panel on the Nonprofit Sector,” comprising
24 leaders from public charities and private foundations, and advised
by an expert advisory panel and five work groups.
The panel was charged to consider and recommend actions to
strengthen governance, ethical conduct, and accountability within
public charities and private foundations.
In March, the panel reported its interim findings to the U.S.
Senate Finance Committee, with a final report to follow in June 2005.
Among other recommendations,
the Panel’s interim report proposed that:
(a)
Nonprofit groups should be required to:
Have the CEO
or CFO sign their tax
returns, under penalties of perjury.
Get an outside audit of their financial operations
if they have $2 million or more in annual revenue.
Hire an independent public accountant to review their
finances if they have $500,000 - $2 million in revenue.
Adopt and enforce a conflict-of-interest policy
Ensure that boards include members who are financially
literate.
Encourage whistleblowers to alert the organization
to violations of law and/or policy of organizations.
(b)
Congress and the IRS
should:
Require all charities to disclose if they
have a conflict-of-interest policy.
Suspend the tax-exempt status of organizations that
fail to follow federal requirements for disclosing information to
the IRS for two or more
consecutive years.
Enforce penalties on organizations that don’t file
complete or accurate returns.
Increase penalties on insiders of private foundations
who participate knowingly in “self-dealing” transactions.
Increase funding for enforcement of rules.
Encourage states to incorporate federal tax standards
for charitable organizations into state law.
Permit IRS
to share confidential taxpayer information with state regulators.18
Again, it is unclear what,
if any, legislative proposals will result from these ongoing discussions. It is likely, however, that some stricter regulation
of the charitable sector will be forthcoming. In an effort to stay “ahead of the curve,” practitioners
and their nonprofit clients should consider the following recommendations.
Recommendations forPractitioners
Duty of Care. Charitable organizations
would do well to review their governance practices to ensure that
they are compliant with the current regulatory focus. Several commentators have recommended specific
steps in this area.19 In particular, the authors recommend
that charitable organizations should:
Recruit knowledgeable board members with
skills in financial, programmatic and other substantive
areas relevant to the applicable organization;
Educate board members regarding their duties and encourage
them to actively question management and outside advisors on any “red
flags” they see;
Ensure that board members know and follow written policies
and procedures of the organization, and that they ensure that management
complies with these as well;
Educate potential board members about the commitment
and responsibilities that their service
will entail;
Develop internal controls that require management to
report significant events to the board, and that specify the size
or kinds of transactions that require board approval;
Develop a board self-evaluation mechanism (with the
opportunity for input from staff and management) to ensure effective
operation of the board, its committees, and its individual directors;
For larger organizations, consider the appropriateness
of an outside “independent” audit committee: “independent” meaning
composed of directors who are without ties to management or the auditor,
without conflicts of interest, and who are not compensated. This committee would be charged with reviewing
the audit in detail, hiring and supervising the auditor’s work with
the organization, and ensuring that complaint procedures are in place
for issues related to financial management of the corporation. They may also be responsible for risk management
oversight.
Duty
of Loyalty. To comply with the fiduciary duty of
loyalty, charitable organizations should identify meaningful ways
to encourage board members, officers and staff to embrace the variety
of resources they bring to the organization, but acknowledge at the
same time that these connections inevitably lead to divided loyalties
or “conflicts of interest.” The title “conflict of interest,” in the heading
of Minn. Stat. §317A.255, is too often read as defining the only situations
in which a director must provide notice of a “conflict of interest.”
A director’s withholding of information concerning a real,
or even potential “conflict of interest” that falls outside of the
statute’s narrow list of voidable transactions
may still constitute a breach of fiduciary duty to the extent that
it prevents the corporation from evaluating whether an undertaking
is in the true interest of the corporation.
The statute correctly underscores
that transactions between the corporation and directors, their family
members, or organizations that are related to directors, as well as
between organizations related to the corporation and directors, their
family and related organizations, are the most susceptible of conflict.
However, those are not the only scenarios in which a director may
have other interests that could be at odds with the charge to serve
the corporation’s “best interests.”
We recommend the following
specific steps in this regard:
(a)
Adopt a policy on substantive conflicts of interest that addresses
at minimum three types of transactions:
(1) Direct and (2) indirect related-party transactions
with officers and/or directors, including in this second tier of ‘indirect-related
party transactions’ those that occur with “close family members” of
officers and/or directors, or with individuals or noncharitable organizations with which officers and/or directors
or their close family members are affiliated; and
(3) Perceived conflict-of-interest transactions
(e.g., transactions with
close friends or former business associates of officers and /or directors).
(b)
Document, with respect to any such related-party transactions,
the pool of others who have been given consideration for the same
opportunity, along with relevant features of their offers, reasons
for choosing related party or party with whom perception of conflict
arises, and have the fact of that party’s involvement, along with
full facts thereof, disclosed along with the other information in
advance of the meeting in which the decision is to be made. (Practitioners should note that procuring additional
independent comparability data and following specific “safe-harbor”
procedures may be desirable in certain situations to avoid the risk
of excise tax under Internal Revenue Code §4958.)
(c)
Set a higher threshold for approving the transaction (for example,
requiring it to be approved by 2/3 of the uninterested directors,
rather than a majority), and document all votes yea or nay on the
transaction.
(d)
Have board members review regularly the organizations with which
they have a “material financial interest” and the pool of connections
their “close family members” (as the corporation’s policy has defined
those individuals) have with other individuals and/or organizations
in which they hold a “material financial interest.”
(e) Document, with respect to any compensation issues with
insiders, that compensation is reasonable based on objective data;
that only uninterested directors considered the data and how the board
arrived at a decision about it; and who was at the meeting approving
the compensation.
Duty
of Obedience. To ensure compliance with the duty
of obedience, the charitable organization should develop a method
by which directors are educated regarding the governmental filings
that are required, and understand what mechanisms are in place each
year to ensure that they are timely and accurately filed.
Of particular importance for fiduciaries in the current climate
is planning to bring appropriate review to the organization’s completed
Form 990, 990-EZ or 990-PF.
The authors anticipate from the clear trend of the law in this
area, as well as likely calls for increased disclosure of charities’
governance capacity on such filings, that fiduciaries of charitable
organizations will be expected to know what information is disclosed
about the organization’s activities and undertakings (including transactions
with insiders) on these filings. Undertaking educational initiatives now with
boards, as well as with internal reviewers and/or paid preparers of
the Form 990 series filings, would be a valuable proactive step, particularly
given that these filings are now the focus of both increased irs enforcement review and public scrutiny at www.guidestar.org
. c
Notes
1 Michelle Lore,
“LegalCORPS Has Strong First Year – and It Plans to Expand,”
Minnesota Lawyer, 04/25/05.
2 The authors
use the term “charity” and “charitable” to mean organizations recognized
as tax-exempt under Section 501(c)(3) of the Internal Revenue Code.
3 Panel on the
Nonprofit Sector, Interim Report presented to the Senate Finance Committee,
03/01/05, p. 9.
4 While almost
all of the provisions of the Sarbanes-Oxley Act do not apply to nonprofit
charitable organizations, many commentators have discussed the implications
of the act for the charitable sector.
See e.g. Suzanne Ross McDowell, “Should Nonprofit Organizations
Adopt the Rules of Sarbanes-Oxley?” 16 Tax’n
of Exempts 1, July/Aug. 2004;
BoardSource & Independent Sector, “The Sarbanes-Oxley Act and Implications for
Nonprofit Organizations (2003), at www.independentsector.org/pdfs/sarbanesoxley.pdf; Patrice
A. Heinz, “The Financial Reporting Practices of Nonprofits,” Alliance
for Child. and Fam’s
Sarbanes-Oxley Rep., Aug. 2003,
at www.alliance1.org/Home/sox_final_8-03.pdf; Thomas Silk, “Ten Emerging Principles of Governance
of Nonprofit Corporations,” 43 Exempt Org. Tax Rev. 35 (2004).
5 Christine Ahn et al., Georgetown Pub. Policy Inst., “Foundation Trustee Fees: Use and Abuse” (2003) available
at http://cpnl.georgetown.edu/doc_pool/TrusteeFees.pdf. Starting
in October 2003 and continuing into 2004, the Boston Globe ran a series of articles, many by Beth Healey,
spotlighting private foundation abuses.
6
Minn. Stat. §317A.251 (2004).
7
Minn. Stat §317A.361 (2004).
8 Minn. Stat. §317A.251 (2004)(directors);
Minn. Stat. §317A.361 (2004)(officers).
9
Minn. Stat. §317A.255 (2004). “Material financial interests” are commonly
understood to be those in which a remunerative or exchange return
is expected.
10 Minnesota Attorney General’s Office, “Fiduciary Duties
of Directors of Charitable Organizations: A Guide for Board Members”
(2003), available at www.ag.state.mn.us/charities/charDuties.html.
11
www.ag.state.mn.us/charities/Default.htm.
12 Charity Oversight
and Reform: Keeping Bad Things from Happening to Good Charities: Hearing
before the S. Fin. Comm., 108th Cong. (2004), http://finance.senate.gov/sitepages/hearing062204.htm.
13 Id. at http://finance.senate.gov//hearings/statements/062204cg.pdf.
14 Id.
at http://finance.senate.gov/hearings/statements/062204mb.pdf.
15 Id.
at http://finance.senate.gov/hearings/testimony/2004test/062204metest.pdf.
16 Id.
(emphasis added).
17
Id.
18 Panel on the
Nonprofit Sector, Interim Report presented to the Senate Finance Committee,
03/01/05, pp.5-10.
19 See e.g. Silk, supra note 4; BoardSource & Independent Sector, supra note 4. The authors further
acknowledge the benefit of the recommendations made by Nancy Evert in her address at the Minnesota Council of Nonprofits
Annual Conference (Oct. 2003).
This
article updates and recasts an article the authors published in Fall
2004,
vol. 31, no. 1, William Mitchell Law Review.
EVE ROSE BORENSTEIN,
a member of Borenstein and McVeigh Law Office
LLC, has practiced exclusively
with tax-exempt organizations since 1988 and teaches courses on exempt
organization tax.
ELLEN W. McVEIGH
is a member of Borenstein and McVeigh Law
Office llc. She
practices in the areas of corporate and employment law, and represents
charitable and small business clients.
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