Next on the Griddle: Nonprofit Boards
from
November/December 2003
by Julie Connelly
The formula for becoming a member of a philanthropic board used to be simple. You had to give money (personally) or get money (from someone else). But now directors of charitable institutions have a new G-word to grapple with: governance. Listen to Brooke Mahoney, executive director of the Volunteer Consulting Group, a nonprofit organization in New York City that finds directors for other nonprofits: “We’re finally crawling out from under the Edwardian protocol that no one dared ask a director to be accountable.”
Now a chorus of strong voices is asking just that. Like their corporate counterparts, nonprofit directors have the fiduciary responsibilities of care and loyalty to the entities they serve. They must make sure donations are invested wisely and spent prudently to further an organization’s mission, without conflicts of interest. Some recent high-profile cases involving the misuse of charitable funds, particularly in the emotionally charged aftermath of the 9/11 terrorist attacks, are forcing directors to pay more attention to how money is disbursed. How it is invested is equally challenging, now that the weak economy has crimped donations and the stock market has sliced nearly a third off the value of endowments over the past two and a half years. Adding to the pressure is the landmark Sarbanes-Oxley Act, which imposes vast new responsibilities on corporate directors—and has obvious implications for nonprofit board members, even though it does not apply to them yet. Other demands to be more accountable are converging on philanthropic boards from the Internal Revenue Service, some state attorneys general, and, perhaps most important, major donors themselves.
The philanthropic world’s mind-focusing equivalent to the corporate implosions of WorldCom and Enron was the trauma of September 11, 2001. A stunned and grieving country donated more than $2 billion to the victims and their families. So much money flooded in to the charities, new and established, that some were slow in disbursing it and others found themselves victims of fraud. The Red Cross got nailed for redirecting donations earmarked for September 11 to future emergencies instead. Such failings, unfortunately, were not exposed and corrected quickly enough. According to a Chronicle of Philanthropy survey published a year after the disaster, 42% of Americans said they had less confidence in charities than before 9/11, and nearly 30% said they would be less likely to contribute. “I’d been telling nonprofit directors to be more engaged even before 9/11, but external events make people more willing now to pay attention,” says William Meehan, who runs McKinsey & Co.’s West Coast consulting practice and serves as chairman of the United Way of the Bay Area and as a director of GuideStar, a national database of charitable organizations. “There’s no question that corporate leaders on nonprofit boards are reading Sarbanes-Oxley.” Other board members should be too.
In this environment, it’s getting tougher to recruit directors for nonprofit boards. According to a 2002 study that the Volunteer Consulting Group commissioned from the consulting firm Booz Allen Hamilton, nearly 1.8 million nonprofit board seats become available each year. That’s an extraordinary number, but bear in mind that it includes innumerable small local charities as well as the local chapters of big national institutions. The vacancies have pushed the number of empty nonprofit board seats to about three million out of a total of approximately 13 million. “People are being more selective about what nonprofit boards they will join,” says Morris Offit, chairman of Offit Hall Capital Management in New York City and also of UJA-Federation of New York.
Until lately, a combination of lax regulation and the role of good guys bred a robust sense of entitlement in many of those who worked in philanthropy. “The sector used to get by on goodwill—these were good people doing good stuff, so don’t look too closely at them,” says Charles Dambach, a senior consultant at BoardSource, which educates nonprofit directors about governance. “The standard of good behavior wasn’t all that high.”
The law does cut a fair amount of slack for nonprofit directors who make a reasonable effort to stay on top of things. It typically allows them to rely on officers and staffers they believe are qualified to carry out particular duties. There is no federal law—yet—requiring nonprofits to have audited financial statements, though the IRS makes them file a tax return, form 990. As a practical matter, about 80% of charities do have audited financials, because these are a prerequisite to receiving federal funding and many states require them.
Since a nonprofit organization has no shareholders, directors are spared the threat of securities class-action suits. In fact, it’s difficult for private individuals to sue nonprofit directors for breach of fiduciary duties, according to Hazen Graves, head of the nonprofit practice group at Faegre & Benson, a Minneapolis law firm. “The underlying feeling,” he says, “is that once you make a gift to charity, you have given it up and the public is the one now interested in your gift. You need someone with the perspective of the public at large to sue—that is, the state attorney general.”
America’s most formidable (and most politically ambitious?) attorney general, Eliot Spitzer of New York, is poised to shake all this up. The man who made the financial industry separate investment banking from research and forced 10 securities firms to pay a $1.4 billion settlement wants to extend Sarbanes-Oxley practices and criminal penalties to Empire State charities with revenues exceeding $250,000. Such outfits—and there are more than 30,000 of them—get money not only from donations but also from federal, state, and local governments that provide support for charities. As Spitzer told the New York State Society of Certified Public Accountants last March, “We collectively need to ratchet up the intensity of our participation and examination of these organizations, or else we won’t be in the position to restore the confidence of the American public.”
If Spitzer can persuade the New York legislature to go along with his proposed legislation, CEOs and CFOs of nonprofits will have to certify their financial statements’ accuracy and completeness, as well as adopt such other Sarbanes-Oxley requirements as independent audit committees and adequate internal controls. “The bar has been raised on acceptable corporate governance,” warns Jeannie Carmedelle Frey, a partner in the Chicago law firm of McDermott Will & Emery and an editor of the American Bar Association’s Guidebook for Directors of Nonprofit Corporations. “So a court looking at a nonprofit case might be more swayed by the argument that the board failed to have a process in place that would have detected the activities in question.”
Mike Hatch of Minnesota is another attorney general with oversight of nonprofits who is flexing his corporate governance muscles. His office has audited two of Minnesota’s nonprofit health maintenance organizations, Allina Health System and HealthPartners, and charged their boards with permitting excessive executive compensation. For example, before he decamped to the Kaiser Foundation Health Plan in May 2002, HealthPartners CEO George Halvorson received $5.5 million in pay and benefits. At Allina, several executives resigned and the board turned over as a result of Hatch’s audit, and now the attorney general is trying to get a director or two of his choosing onto the HealthPartners board.
One nonprofit has already embraced most Sarbanes-Oxley requirements, voluntarily. In February, Philadelphia’s Drexel University became the first major school to align its bylaws with the provisions of the act. “It is only a matter of time until nonprofit practices will reflect corporate practices, and we wanted to be ahead of the curve,” says Drexel’s president, Constantine Papadakis.
HomeAid America, a nonprofit based in Costa Mesa, California, that builds temporary shelters for the homeless, is also making changes inspired by Sarbanes-Oxley. Since 1989 the organization has built more than 75 shelters that it turns over to local charities to operate, and it has 35 more in the works. “For future growth we wanted an appropriately structured board,” says Ian McCarthy, CEO of Atlanta homebuilder Beazer Homes USA and chairman of HomeAid America’s national advisory board. Though an executive committee of five or six board members handled day-to-day organizational matters, “we didn’t have an audit committee or a governance committee, and we are establishing those now,” McCarthy says. Among those setting up the audit committee is Barbara T. Alexander, a senior adviser to the investment bank UBS AG and for many years Wall Street’s best-known construction-industry analyst.
The IRS is cracking down on conflict-of-interest dealings at nonprofits. The agency used to punish such infractions with its own weapon of mass destruction: removal of tax-exempt status, which effectively put an offending charity out of business. Then in 1996 Congress created so-called intermediate sanctions, less-than-lethal penalties that the IRS could impose on greedy officers and directors instead of, or before, taking away the tax exemption. In 2001 the Treasury Department issued the regulations pertaining to intermediate sanctions, which penalize nonprofits and their directors for what the IRS deems “excess benefit” transactions. Now every financial deal between any officer, director, or trustee and the nonprofit itself is subject to a 25% excise tax on the amount of the transaction exceeding its fair market value. If the excess benefit is not paid back or in some way reversed before the IRS assesses the first tax, that 25% tax will be followed by a second levy of 200%—yes, 200%—on the excess benefit. In addition, any officer, director, or trustee who knowingly approves such an arrangement will be personally liable for a tax of 10% of the excess benefit, up to a maximum of $10,000.
Last year, in a test case, the IRS went after Sta-Home Health Agencies in Mississippi, three nonprofit health-care providers run by members of the Caracci family. The Caraccis wanted to convert them to for-profit outfits by having new corporations purchase the assets. An appraisal by an accounting firm for the three agencies showed that because of operating losses, their assets were worth far less than their liabilities, so the new for-profit corporations had only to assume the liabilities of the old nonprofits. The IRS adamantly begged to differ, and when the case was finally tried in U.S. Tax Court, the value of the transferred assets was found to have exceeded the liabilities by roughly $5.2 million. Ultimately, the insiders were hit with $11.6 million in intermediate-sanctions excise taxes—the 25% penalty plus the 200%. As a client alert from the Chicago law firm of Gardner Carton & Douglas noted primly, “These developments suggest that transactions (including compensation) with exempt organization executives is an IRS enforcement area likely to heat up.”
Yikes!
And you thought you were just being a good citizen by joining that charitable board. Yet nonprofit boards have long been vulnerable to conflicts of interest and self-dealing. “You have to be able to recognize a conflict as a director,” says lawyer Hazen Graves, “and some organizations are not all that clued in.” People are often asked to join philanthropic boards precisely because they already have some connection with the organizations. In 1997 the New York State Board of Regents removed all but one of Adelphi University’s 19 trustees for sanctioning financial misdeeds. Among these were the university’s use of one trustee’s insurance brokerage business, the advertising services of another, and the law firm of a third without fully disclosing the arrangements. James Abruzzo, a member of the Alvin Ailey Dance Theater’s board and the executive director of the nonprofit practice at DHR International, an executive search firm in Short Hills, New Jersey, recalls that when he was the chairman of a museum, “I found out that a board member owned an insurance brokerage and we were doing business with him. When I asked why, I was told, ‘He gave us the best price.’ But when I looked into how we were covered, we turned out to be seriously underinsured.”
In the sad annals of self-dealing among nonprofits, nothing approaches the rapaciousness shown by a quintet of trustees of the Bishop Estate in Hawaii. (For more, see the box on page 84.) Still, many charities are overly sanguine about conflicts of interest. In a 2000 report on New York City nonprofits, authors Ira Millstein (a partner at Weil Gotshal & Manges and a leading corporate reformer), Katherine O’Regan (a professor at the Yale School of Management), and Sharon Oster (an associate professor at New York University’s graduate school of public service) found that only 58% had conflict-of-interest policies for transactions with board members, and 29% of those permitted directors to do business with the charities on whose boards they sat. The Maryland Association of Nonprofit Organizations discovered in 2002 that only 47% of that state’s nonprofits had written conflict-of-interest policies, though the figure was up from 21% in 1996.
Since Sarbanes-Oxley, even responsible not-for-profit board members are concerned about liability. “Directors are asking about directors’ and officers’ insurance policies,” says Karen Horn, managing director of Marsh Inc., a risk-management consulting company in New York City, and a board member of the Chamber Music Society of Lincoln Center and the Acting Company. “What is the amount on my personal policy vs. what is the organization covered for?” Horn serves on the finance committees of her boards, and she notes that her fellow directors, people with no financial background, are starting board discussions about the role of the finance committee. “You can tie this to all the scandals in the corporate world,” she says.
Small wonder that director candidates, who don’t even get paid for the liabilities they are assuming, are becoming elusive. Bragging rights offset some of the downside; who wouldn’t want to tell the neighbors about being a director of New York City’s Metropolitan Museum of Art? But the local soup kitchen is a labor of love. “When the call comes to ask you to join a nonprofit board, what they’re saying to you is ‘We want you to attend meetings four times a year, give 50 hours of annual service to the organization, make a $10,000 contribution, and attend an annual three-day retreat,’” explains Barbara Alexander. “When that call comes, you may not jump up and down saying, ‘This is the call I’ve been waiting for.’”
But perhaps the greatest force for increased accountability is the big donor, who is starting to demand it. “There is serious talk from donors—they want to see results,” says Neil McReynolds, whose Seattle company finds directors for nonprofits and who himself sits on the board of the Fred Hutchinson Cancer Research Center. “They are beginning to ask questions about the boards and the roles they are playing.”
Case in point: Peter Lewis, who is the chairman of Progressive Insurance and a major benefactor to charities in Cleveland, his hometown, as well as board chairman and open wallet for New York City’s Guggenheim Museum. Lewis likes to encourage cutting-edge architecture, and in 1996 he gave $25 million to Case Western Reserve University in Cleveland to house the Weatherhead School of Management in the Peter B. Lewis Building, designed by architect Frank Gehry. That gift grew to $36.9 million, the single biggest donation in the university’s history, as the cost of the building escalated. But as the Cleveland Plain Dealer has detailed, Lewis didn’t take the cost overruns lightly and asked to meet with the trustees to discuss them. They refused. Lewis became so outraged that he announced in June 2002 that he would stop giving money to any Cleveland charity until Case
Western’s entire board, which he holds guilty of mismanagement, steps down. “I’m very clear about my objective,” he said. “Get a new board at Case Western Reserve.”
The trustees have adopted some governance reforms, adding term limits and cutting the board from 50 members to 44. And Case Western has a new president, Edward Hundert, who is obviously eager to smooth the ruffled feathers of the golden goose. In November he told the Associated Press, “Peter and I are in touch almost every week. Our ongoing conversations not only indicate a great working relationship, it [sic] involves some of the highest-quality advice I’m getting.” Nonetheless, in August Lewis’s charity boycott stood, as does the now-completed Gehry building.
Slowly, very slowly, nonprofits are beginning to wake up to the importance of good governance. “It’s shocking when a nonprofit misbehaves. The absolute no-no is falling down where you should be making a contribution to society,” says Morris Offit. “Most people remember you more in life for what you did in your leadership role for the nonprofit. If you succeed, you leave a significant legacy—the community is grateful.”
And your own reputation is enhanced. Two years ago Ross Dembling, a partner at the law firm of Holland & Knight in McLean, Virginia, was asked to join the board of the United Way of the National Capital Area. “The other members were like me—big supporters being thanked,” he recalls. “We weren’t there to ask good questions.” But Dembling did anyway, questioning an overall lack of transparency. He objected to the fact that directors never saw budgets in advance of a board meeting, to the appointment of a new CEO with a poor prior record, and to the presentation of a generous consulting contract to his predecessor. Surprise, surprise: When Dembling’s term expired in 2002, he discovered he would not be renominated.
But shortly thereafter he was asked to join the local executive board of the Jewish National Fund, a group that preserves land in Israel. “The people who recruited me said I was the kind of person they wanted because of my notoriety,” he says. Unlike members of the United Way board, “they kept asking me, ‘Do you have any questions?’ They said if I was satisfied, that would cement their credibility in the community.”
In the nonprofit boardroom, as in any boardroom, the only dumb question is the one unasked.
