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New Year's Resolution 2011: Follow Through on Good Nonprofit Governance Practices

Davis Wright Tremaine's Profile

By LaVerne Woods and Thomas C. Schroeder

If there is a unifying theme among the key legal issues of 2010 for nonprofits, it is the importance of good governance practices. The impact of governance is pervasive. It affects an organization’s success in furthering its mission, its exposure to scrutiny by state and federal regulators, and the public perception of its worthiness. A review of important developments in 2010 sets the stage for organizations to follow through on good governance practices in 2011.

IRS to use governance data as basis for audits

The Internal Revenue Service has staked out a position that good governance practices by charitable organizations help promote compliance with the federal tax law, and that weaknesses in governance may be an indicator of compliance issues generally. While the rules regarding nonprofit corporate governance are a matter of state law and not federal tax law, the IRS has turned a spotlight on this area through its power to require disclosures on the publicly available IRS Form 990 information return.

The newly redesigned Form 990 brings a high level of accountability and transparency to nonprofit governance. It includes a wide variety of questions on governance issues, such as the number of “independent” directors on an organization’s board, the business and family relationships among board members, and financial transactions between the organization and its board members and related parties.

Reporting organizations must also describe the process they use to determine executive compensation, and must disclose whether they have a conflict of interest policy, a document retention and destruction policy, a whistleblower policy, and a policy on joint ventures with for-profits. Any organization that fails to examine its governance practices and policies in connection with completing the Form 990 invites a visit from the IRS. 

To support its position that good governance is an indicator of tax law compliance, the IRS has developed a “Governance Check Sheet” for IRS agents to use as a data-collection tool during audits. The Check Sheet questions follow closely the governance questions on the Form 990. IRS officials have emphasized that that they are not seeking to impose any particular governance practices on nonprofit organizations. Rather, the IRS has indicated that if the results of the Check Sheet questions show a correlation between governance and tax law compliance, such information will assist the IRS in selecting organizations for audit.

State regulators step up enforcement

The IRS is not the only agency taking a hard look at nonprofit governance. High-profile investigations at the state level have made headlines and seem to signal a willingness by state attorneys general to devote resources to policing charities. The New Jersey Attorney General, following a three-year investigation, brought a 16-count lawsuit against Stevens Institute (a technological university), its president, board chair, and members of its board of trustees. The suit alleged mismanagement of finances, misuse of endowment assets, excessive executive compensation, lack of board involvement in approving compensation, and improper forgiveness of loans to the president.

The university and the attorney general settled the lawsuit in 2010 through an agreement that required significant changes to Stevens’ governance policies and practices. The university agreed to amend its bylaws to set out the specific duties of the board members, to require the entire board to review important compensation and investment decisions and key financial information, to rotate appointments to board committees, to add a financial expert to the audit committee, and to improve the operation of board committees generally. The university’s president also resigned and agreed to repay loans.

Governance reforms in the corporate sphere may spill over to the nonprofit sector

The Sarbanes-Oxley Act of 2002 (SOX) significantly affected governance practices of nonprofit organizations, in spite of the fact that the vast majority of its provisions do not apply to them. By drawing attention to the importance of good governance practices in the corporate world, SOX caused many nonprofit boards to re-examine their policies and procedures.

The Dodd-Frank Act of 2010 seems likely to have a similar spillover effect. While Dodd-Frank applies only to publicly traded companies, many of its principles have equal validity in the nonprofit context. Dodd-Frank’s procedural requirements for establishing executive compensation in fact have close analogs in the procedural rules that charities may follow to create a rebuttable presumption that executive compensation is reasonable.

For instance, Dodd-Frank requires that compensation committees of public companies be comprised entirely of independent directors, and ensures that such committees have the authority to retain compensation consultants and legal counsel to enhance the soundness of compensation decisions.

Dodd-Frank also goes further than the federal tax law rules for exempt organizations, requiring disclosure of the ratio of median annual employee compensation to the CEO’s compensation. 

New Securities and Exchange Commission rules effective in 2010 could also affect disclosure practices in the nonprofit sector. The new rules require public companies to disclose specific information regarding the experience, qualifications, attributes, and skills that led to the board’s conclusion that a director or nominee should serve on the board, including whether the board considered a candidate’s specific risk assessment and financial reporting expertise.

The rules further require disclosure of whether and how the board considers diversity in identifying nominees for the board. While the rules do not define “diversity,” they do provide that companies may consider diversity to be more expansive than race, gender, and national origin, and may include differences of viewpoint, professional experience, education, skill, and other qualities.

A challenging investment climate exposes governance weaknesses

Countless nonprofits have suffered extraordinary investment losses in the difficult market of the last two years. A few have been the unfortunate victims of Ponzi schemes promoted by Bernard Madoff and others. These horror stories have focused attention on governance weaknesses that may make an organization more vulnerable to loss. All nonprofit organizations should re-examine their due diligence procedures for selecting investment advisors and making investments to ensure that they reflect prudent business practices.

Concentration of investment information and power in the hands of a few can be an indicator of inadequate oversight. All voting members of the board have a both a right and a duty to be fully informed concerning an organization’s investment policies. Any investment committee or similar body with board-delegated authority should report regularly to the full board regarding investment decisions and performance.

Most states now have adopted the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which requires boards to act as a prudent investor would in investing charitable assets, using a portfolio approach and considering risk and return objectives. (Please see our previous advisories on UPMIFA in Washington state and in California.) Boards are responsible under UPMIFA for incurring only reasonable investment and management costs, making a reasonable effort to verify relevant facts, diversifying investments, and disposing of unsuitable investments within a reasonable time. Any charity that has not revised its investment policy to reflect the UPMIFA standards should consider doing so.

Executive compensation approval procedures remain in the spotlight

Executive compensation has been near the top of the list of issues for scrutiny by both federal and state regulators for some years, and there seems to be no end in sight.

A group of prominent U.S. senators in 2010 challenged the Boys & Girls Clubs of America to justify its spending on executive compensation, perks, and travel. The senators expressed concern that the organization’s president was earning more than $900,000 in compensation while local boys and girls clubs around the country were closing their doors due to budget shortfalls.

Executive compensation was also a centerpiece of a questionnaire that the IRS sent to 400 colleges and universities. The IRS is following up now with audits of some of the responding schools, as well as audits of all 13 schools that failed to respond. Compensation of university presidents, coaches, and faculty appear to be key areas of inquiry in the audits.

Any charity that does not follow the procedural steps under the federal tax law to create a rebuttable presumption that executive compensation is reasonable—by having compensation approved by a board or committee comprised of individuals who have no conflict of interest, using appropriate market comparability data and documenting the decision in written minutes—may put its tax exemption at risk, and may put its executives at risk for intermediate sanctions excise taxes. State regulators also are looking to the federal procedures as a roadmap for appropriate compensation decisions.

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