How to be a Responsible Nonprofit Director: Do s and Don ts Avoiding Punishment for Good Deeds

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1 November 2005 ALBANY AMSTERDAM Do s and Don ts Avoiding Punishment for Good Deeds ATLANTA BOCA RATON BOSTON CHICAGO DALLAS DELAWARE DENVER FORT LAUDERDALE HOUSTON LAS VEGAS LOS ANGELES MIAMI NEW JERSEY NEW YORK ORANGE COUNTY ORLANDO PHILADELPHIA PHOENIX SACRAMENTO SILICON VALLEY TALLAHASSEE TOKYO TYSONS CORNER WASHINGTON, DC WEST PALM BEACH ZURICH The well-publicized scandals involving Enron, WorldCom and Adelphia moved corporate governance to the forefront. Scandals have also affected the public s perception of nonprofits and recent studies indicate that the public has lost confidence in charitable organizations. The public will be looking to directors of nonprofits to act as responsible stewards, which will require directors to have knowledge of the duties they are expected to carry out. As a result, directors of nonprofit organizations should be aware that expectations are changing. To date, compensation has been the focus of much of the enforcement activity. Excessive compensation was involved in problems at the United Way of the Capital Area and Adelphia University. The Nature Conservancy was the subject of a Congressional investigation and an IRS audit. Problems in the nonprofit sector led to the enactment of Intermediate Sanctions, legislation that focuses on excessive compensation. In September, 2005, the IRS issued new regulations on the possible impact of excessive compensation on an organization s exempt status. Congressional reaction includes the passage of the Sarbanes-Oxley Act ( SOA ) in 2002, addressing accounting and corporate compliance issues. While most of SOA is applicable only to public companies, certain provisions of SOA are applicable to nonprofits, including setting forth comprehensive standards for directors. A number of state attorneys general have proposed that states should adopt laws similar to SOA regarding nonprofits. Legislation for this was introduced, but not enacted, in the New York State legislature in California enacted in 2004 a law requiring large organizations to prepare audited financial statements and create an audit committee....the recent congressional hearings on tax-exempt organizations may produce legislation that will have significant impact on the non-profit sector. Though congressional action on charity governance reforms in the near future now seems unlikely, the recent congressional hearings on tax-exempt organizations may produce legislation that will have significant impact on the nonprofit sector. The report presented to the Senate Finance Committee by The Panel on the Non-Profit Sector earlier this year aims to help tax-exempts increase accountability and integrity by outlining steps to ensure that directors understand and can fulfill their ethical and financial duties in promoting the charitable mission of the organization they serve. What follows is a refresher course on what is expected of the directors of non-profits. 1. Duties of Directors What a Director Must Do. Directors must fulfill the duty of care. To fulfill this obligation directors must be reasonably informed and must participate in decisions in good faith with the care of a prudent person. Directors must regularly attend meetings of the Board. Sporadic attendance should be grounds for removal of the individual as a director.

2 Each director must exercise his or her independent judgment. A director should not base his or her vote solely on the positions of others. Decisions must be in the best interests of the organization even in the case where a director represents another entity. A director may not permit the interests of even other charities to enter into the process. Directors must comply with the duty of loyalty. A director may not take advantage of a corporate opportunity by using the information for personal gain. A director who does so has breached the duty of loyalty. As part of this duty, directors must disclose conflicts of interest. Many states have laws codifying some or all of these common law duties. The statutes contain similar provisions on the standard of care required of a director. The statutes generally provide that duties must be discharged in good faith, with the care 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. A director who acts in accord with the statute can preclude personal liability. 2. How does a Director Fulfill these Duties? There are some concrete items that a director can focus on to fulfill these obligations. For example, the directors should establish a mission for the organization. The directors should not only determine the mission of the organization, but also how the organization can accomplish the mission. This must include determining if the organization has resources adequate to meet the mission. The planning must include considerations for the sustainability of the organization. This requires consideration of whether the goals are within reach of the organization in light of available resources. If the answer is they are not, then the directors must consider if the goals should be reduced to make them attainable. This may also involve allocating resources between current users and future users. This is a topic of great current interest as some prominent organizations have recently chosen to spend down their assets for current charitable needs, leaving future beneficiaries to the generosity of generations to come. The directors must also establish governance policies. These policies should include a statement of the duties and responsibilities of the individual directors, including the expectation of time and financial commitments, qualifications for membership on the board of directors, and policies to evaluate directors performance. The directors should also create a conflict of interests policy and make sure that the policy is enforced. The directors should establish necessary committees, including an audit committee. California law now requires charities with revenues of $2,000,000 or more to establish audit committees. Governance policies should determine what level of responsibilities should be delegated to executives and other staff. Directors should prescribe policies and responsibilities required for the staff to carry out day-to-day duties. Directors, other than executives of the organization, need not be involved in supervising day-to-day activities, but they should maintain oversight of staff activities through frequent periodic reports. 3. Liability Shields. Many state statutes provide limitations on liability of volunteers who provide services to, or on behalf of, a charitable organization. Statutes provide an exemption from civil liability for any act, or omission to act, which results in personal injury or property damage if: (a) The volunteer was acting in good faith within the scope of the volunteer s duties, (b) The volunteer was acting as a reasonably prudent person would have acted under similar circumstances, and Do s and Don ts Page 2

3 (c) The injury or damage was not caused by any wanton or willful misconduct. The Federal Volunteer Protection Act of 1997 provides that no volunteer of a nonprofit organization is liable for harm caused by an act or omission if the volunteer was acting within the scope of his or her duties at the time and harm was not caused by willful or criminal misconduct, gross negligence, reckless conduct, or a conscious flagrant indifference to the rights or safety of the individual harmed. These limitations affect the personal liability of the volunteer director. A nonprofit corporation is not shielded from liability by these laws. Notwithstanding the statutory limitations on responsibility, a director should be familiar with any right to indemnification. Directors should review the articles of incorporation and bylaws of the corporation to determine the extent to which indemnification would be available. The board of directors of a nonprofit corporation should consider the need for directors and officers liability insurance. If there is insurance, a director should review the policy for policy limits, retention amounts, covered persons, definitions of a claim or loss and exclusions. 4. Intermediate Sanctions. Prior to the Taxpayer Bill of Rights enacted in 1996, the IRS s only weapon against private inurement was revocation of tax exempt status. In practice, the IRS rarely revoked the exempt status of a Section 501(c)(3) organization. For a number of years, the IRS sought authority to assess penalties against the recipients of excess benefits from Section 501(c)(3) organizations. Intermediate Sanctions legislation was enacted in 1996 as Section 4958 of the Internal Revenue Code. An excise tax is imposed on the excess benefit received by a disqualified person. In September, the IRS finally issued new proposed regulations to provide guidance on when revocation of exempt status should be considered by the Service, either (a) because excess benefit transactions are so extensive as to call into question whether the organization has a true exempt purpose or (b) because the organization operates for private, not public, benefit, even where no excess benefit transaction has occurred. Excess benefit is the receipt of compensation in excess of reasonable compensation, a purchase of property by a disqualified person for less than fair market value or a sale of property to a Section 501(c)(3) organization by a disqualified person for more than fair market value. A disqualified person is a person who has substantial influence with respect to the organization, including officers, directors and substantial contributors. The excise tax is initially imposed at a rate of 25% of the excess benefit. That tax is imposed on the recipient of the benefit. There is also a tax of 10% of the excess benefit imposed on the organization s managers, including directors, with a cap of $10,000 per incident. If the amount of the excess benefit, plus interest on the amount of the excess benefit, is not returned to the organization by the recipient of the excess benefit, an excise tax of 200% of the excess benefit is imposed. The Treasury Regulations provide for a rebuttable presumption that can be created that compensation is reasonable or a transaction is at fair market value. The rebuttable presumption arises if (1) the compensation or transaction is approved by a body of the organization of independent persons with no interest in the transaction, (2) the approval is made after comparability data has been reviewed, e.g., compensation surveys compiled by independent firms, information about what other persons are paid for similar positions, even by for-profit organizations, or independent appraisals, and (3) the Board or other body documents the basis of the decision in records that indicate the terms of the transaction, the members of the body that approved the Do s and Don ts Page 3

4 Detecting and correcting actions that could put the organization s exemption at risk should be done by the organization itself. transaction and the data that was used. Minutes of the meeting will serve this purpose. 5. Conflicts of Interest. The term conflict of interest describes two situations: (1) where a director has a personal interest in a proposed transaction or payment or (2) where a director has a duty of loyalty to two organizations, where the decision of the board of directors can benefit one organization and hurt another organization. If the non-profit organization is publicly supported, the job is not to eliminate persons with conflicts of interest, but to have the tools to handle the conflicts as they arise. If the organization is a private foundation, directors should be aware that many transactions that could otherwise be handled fairly under a conflict of interest procedure will still be prohibited by the more stringent self-dealing prohibitions contained in the Internal Revenue Code. The fact of the conflict should be disclosed to the board or the committee approving the contract or transaction and the transaction should be approved by a vote that is sufficient to approve the matter without counting the votes of the interested directors. In addition, the contract or transaction should be fair and reasonable to the organization. The IRS has published a model Conflict of Interests Policy for health care organizations. The IRS model policy requires that the policy be distributed to directors and that each director annually sign a statement that he or she has received a copy of the policy. The IRS model policy is more restrictive than some state laws, as it requires that the director with the conflict not participate in the discussions on the matter and precludes the conflicted director from voting. Good practice is to obtain information about conflicts in advance of problems. Directors should be required to annually submit information to the organization listing the other organizations in which they are involved and providing information about possible conflicts. A conflict of interests policy should be adopted and followed on a regular basis. 6. Checklist for the Responsible Nonprofit Director. Is each director actively involved? Do almost all of the organization s regular activities further its tax exempt purposes? Does the organization serve the general public rather than a limited group of individuals? Is the organization careful to ensure that officers and directors do not receive excess benefits or other benefits from the organization that are substantial and recurring? If excess benefits have occurred, have they been small relative to the size and scope of the organization s exempt activities, and been quickly and adequately corrected? Are there written and disseminated policies and procedures in place to prevent excess benefits and inappropriate uses of funds (including contract review)? If the answer to any of these questions is no, the responsible director should take action promptly to enlist fellow directors in the effort to protect the organization. Detecting and correcting actions that could put the organization s exemption at risk should be done by the organization itself. Waiting for the IRS to do so will simply not help the organization maintain its exemption. Do s and Don ts Page 4

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