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
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
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 o
This article will outline the
duties owed by the members of a board of directors of a
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 unde
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:
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:
The attorney general is the
state official with enforcement authority over charitable organizations
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 o
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:
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:
(b) Increase transparency of board’s decision making with respect to overseeing key staff and managing 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:
(b) Congress and the IRS should:
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.
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:
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:
(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 .c
1 Michelle Lore,
“LegalCORPS Has Strong First Year – and It Plans to Expand,”
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,
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,”
5 Christine Ahn et al.,
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.
18 Panel on the
Nonprofit Sector, Interim Report presented to the Senate Finance Committee,
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).
article updates and recasts an article the authors published in Fall
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.