Originally published in Current, Sept. 20, 2004
By Gary P. Poon

With both Congress and the Internal Revenue Service showing interest in tightening the rules for nonprofits to restore the public’s trust, public broadcasting stations, among others, almost inevitably will face some kind of reform in the next few years.

Station leaders may find it timely to review their governance systems and begin planning for changes that may be required or otherwise desirable.

The Senate Finance Committee held hearings in June to determine whether new regulations of nonprofits are required to address abuses publicized in recent years in both the for-profit and nonprofit sectors. The hearings raised a broad range of issues, including additional financial disclosures, increased regulatory oversight and improved corporate governance.

Internal Revenue Service Commissioner Mark W. Everson told senators that “stronger governance procedures are needed for exempt organizations” and described IRS plans to combat alleged abuses in nonprofits. Everson indicated, for instance, that the agency was developing a “plain-language brochure” to promote “good governance, ethics, and internal oversight.” (At this writing, the brochure is not yet available.)

In August, the IRS announced a comprehensive enforcement effort “to identify and halt abuses by tax-exempt organizations that pay excessive compensation and benefits to their officers and other insiders.”

Several state legislatures, including New York, Massachusetts and California, also are considering reforms, which cannot be covered in this space.

While many of the reforms likely to be considered will leave nonprofits healthier and reassure the public that they are still trustworthy stewards of the public interest, other proposed rules appear to be more burdensome than warranted and some could even prove to be ineffective.

Congress began pursuing nonprofit reforms many months ago. The House passed the Charitable Giving Act of 2003 (H.R. 7) in April 2003, and the Senate passed the CARE Act of 2003 (S. 476) the following September, though reconciliation of the bills stalled in the conference committee at the end of the last legislative session.

Media reports prompted some of the activity. Beginning in October 2003, the Boston Globe alleged financial abuses at a handful of private foundations. The newspaper charged the groups with excessive compensation for directors and executives, self-dealing, conflicts of interest and some apparent instances of outright fraud. While the vast majority of nonprofits are run by honest and dedicated individuals, the unfortunate reality is that allegations such as these have inspired growing concern on the Hill. Earlier this year, Sen. Charles E. Grassley (R-Iowa), chairman of the Senate Finance Committee, vowed to tighten rules for private foundations and nonprofits in general.

The call for reforms of nonprofits echoes the government response to the many corporate scandals that dominated the business pages for many months. The Sarbanes-Oxley Act of 2002, the most extensive legislative response, pertains largely to publicly traded companies, though legal commentators, trade associations and lawyers have advised nonprofits to consider voluntarily adopting many of its provisions—particularly those that seek to ensure auditor independence, promote corporate responsibility and enhance financial disclosures.

Longtime public broadcasters Bob Ottenhoff and Cindy Browne, among others, have argued that greater transparency is good practice for public broadcasters and other nonprofits in any event (Current, Sept. 8, 2003, and Jan. 19, 2004). A few provisions of the act apply generally to nonprofits as well as publicly traded companies.

Everson’s remarks in the Senate hearing and a discussion draft released by the Senate committee’s staff serve as useful summaries of the range of reforms being considered for 501(c)(3) nonprofits.

Directors’ fiduciary duty

State law generally requires directors or trustees of nonprofit organizations, like their for-profit counterparts, to act in "good faith,” with a “duty of care” expected of an ordinary prudent person similarly situated. The board members must act in a manner that they reasonably believe to be in the "best interest” of the organization. State law generally holds them liable for willful breaches of duty.

The Senate discussion draft proposes the addition of federal liability for such breaches, with detailed suggestions of remedies, including vesting the U.S. Tax Court with broad equity powers to remedy any detriment to a philanthropic organization and allowing such proceedings to be brought by directors/trustees of a nonprofit organization and the IRS.

While the proposed rules may raise a number of legal issues relating to the delicate balance between federal and state law, providing an additional enforcement mechanism may help deter corporate abuses.

Rules proposed in the discussion draft would force directors of a nonprofit organization to pay closer attention to their duties as directors by requiring oversight efforts, which it described only in general terms:

• creating and overseeing a compliance program to address regulatory and liability concerns,
• establishing basic policies and procedures, including a review process for deviations from such policies,
• developing, reviewing and approving program objectives and performance measures, and
• assuring proper management.

Excessive pay and conflicts of interest

To address alleged excessive compensation for corporate executives, consultants and other insiders, the discussion draft proposes that compensation consultants to the nonprofit organization be hired by and report to the board of directors and remain independent. Boards would have to approve annually, publicly and with written justification all management compensation except for routine inflation adjustments.

Everson explained in August that the IRS study of compensation at nonprofits seeks “to enhance compliance by learning what practices organizations use to set compensation; learning how organizations report compensation to the IRS; and creating positive tension for organizations as they decide on compensation arrangements.”

Despite well-established rules prohibiting conflicts of interest, some nonprofit organizations have engaged in inappropriate transactions involving their directors, officers and other insiders. The discussion draft proposes that every nonprofit board would need to establish a policy on conflicts, disclose it and summarize conflicts found during the year on their annual tax returns, IRS Form 990.

Financial transparency

To address the “off-the-books” financial activities that occurred in Enron, the discussion draft proposes that nonprofits disclose a number of new financial details on Form 990. While it could be argued that current law already requires some of the disclosures to make the form “complete and accurate,” the discussion draft would impose uniform “enhanced” disclosure requirements “to ensure accurate, complete, timely, consistent, and informative reporting by [tax-] exempt organizations.”

For example, a nonprofit would not only disclose financial interests of 50 percent or more in taxable corporations or partnerships, as the law now requires, but it would also have to list all partnership interests and its role in those partnerships. (For a discussion of proposed disclosure reforms, see my article on the topic at www.poonlaw.com.)

To make financial activity more transparent, the discussion draft puts forward various additional obligations for a nonprofit’s board of directors. The board would review and approve the nonprofit’s budget, financial objectives and any “significant” transactions, investments, joint ventures and business transactions.

Auditor independence

The Enron scandal and similar abuses have taught the painful lesson that outside auditors must remain truly independent.

To that end, the discussion draft proposes that nonprofits with more than $250,000 in annual gross receipts would need to commission an independent audit of its financial statements, with the auditor certifying whether and to what extent the nonprofit is liable for unrelated business income tax. Smaller nonprofits with revenues between $100,000 and $250,000 would need a financial review by a certified public accountant. Nonprofits’ boards would have to establish, review and approve auditing and accounting principles and practices for preparation of financial statements. The chief executive would need to declare, under penalty of perjury, that the financial statements are complete and accurate.

Moreover, the discussion draft suggests that nonprofits would have to change independent auditors every five years.
I believe mandatory rotation of auditing firms goes too far, however. This would demand nonprofits do more than the Sarbanes-Oxley Act requires for publicly traded companies and would impose undue expenses on nonprofits without assuring measurable benefits. In debating Sarbanes-Oxley, Congress had considered whether to impose a mandatory rotation of auditors but decided to require only the rotation of the partner in charge of a company’s audit.

In view of the loss of institutional knowledge that would occur if audit firms were changed every five years, mandatory rotation of firms “may not be the most efficient way to enhance auditor independence and audit quality,” a General Accounting Office study concluded in November 2003. The study found that educating a new audit company every five years could increase costs by more than 20 percent without totally removing undesirable pressures on auditors, while yielding benefits that are difficult to predict and quantify.
If Congress doesn’t see a need to require audit firm rotation for publicly traded companies, why should it mandate it for nonprofits?

Board independence

The discussion draft envisions substantial changes in many nonprofit boards by requiring that they have no less than three members and no more than 12, although a higher number may be permitted in “limited cases.” If enacted, this may require many stations to reduce their board size significantly. While this requirement may make some boards less unwieldy, it may hurt stations that have a large number of generous donors and influential community leaders on their boards.

Further, a nonprofit could not directly or indirectly compensate more than one of its board members, and the compensated member could not serve as the board’s chair or treasurer.

Finally, the discussion draft would mandate that at least one director — or one-fifth of the board (whichever is greater) — be “independent.” To be considered independent, a director would have to be “free of any relationship with the corporation or its management that may impair or appear to impair the director’s ability to make independent judgments.”

This is a very high — and, some may argue, overly broad — standard. While it may be appropriate to impose a strict standard, requiring a large number of directors to be independent may be unworkable for many nonprofits.

Drafters of the proposed reforms may want to recognize, if they do not already, that nonprofit boards generally seek out new board members who have become important to their organizations in various ways, helping to further its mission and raise revenue. If the law required too many directors to be free of any relationship with the organization or its management that may impair the director’s ability to make independent judgments, the organization may be unduly restricted in building a board. The rule could be especially damaging if it has no grace period or materiality standard, potentially disqualifying board candidates who have made significant donations to the station or underwritten programs from serving as “independent” board members.

In comparison, the New York Stock Exchange sets a narrower definition of “independence” for publicly traded companies, while requiring that a majority of a
listed corporation’s board members be independent. First, the exchange’s Listed Company Manual contains a "materiality” standard: To qualify as “independent,” a director must have no “material” relationship with the listed company, including “commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships.” The exchange recognizes that the materiality standard relies on specific facts and thus requires a listed company’s board to assess each board candidate individually and disclose the basis for its determination.

In addition, the stock exchange gives a grace period after which a non-independent director could become independent again under various objectively verifiable situations. In other words, a director who has had a prior relationship with the company would not be considered independent only if, within the past three years, the director:

• is an employee (or whose immediate family member is an executive officer) of the company,
• receives (or whose immediate family member receives) more than $100,000 per year in direct compensation from the company,
• is affiliated with or employed by (or whose immediate family member is affiliated with or employed in a professional capacity by) a present or former internal or external auditor of the company.

In debating nonprofit reforms, Congress would have a trade-off to consider: whether to propose a very high (and potentially vague) standard of independence covering fewer directors or a lower (and perhaps more objectively defined) standard covering more directors.

Another option would be to recognize that nonprofits come in many varieties and that a “cookie-cutter” rule would be inappropriate for this industry. Under this alternative, the law would allow each nonprofit the flexibility to strike its own balance between “independent” versus non-independent directors, but require it to justify its board composition annually in IRS Form 990.

While it may take quite some time for the government to settle on reforms for nonprofit governance, nonprofits would be well-advised to assume Congress and/or the IRS will act in the not-too-distant future. Accordingly, it is not too early for station boards and managers to begin thinking about how they will prepare for possible reforms. For example, they could ask an independent party to review their internal compliance policies and risk management procedures.

Taking such steps will not only ease the transition to new rules but also minimize potential liability in the future. A nonprofit that follows sound governance procedures would be more likely to prevent abuses from occurring in the first place—or at least be able to detect any fraudulent conduct in its ranks and deal with it properly through a system of checks and balances. Sound corporate governance also means being financially transparent, which helps restore the public’s confidence that nonprofits are indeed worthy stewards of the public trust.

Gary Poon, a former PBS attorney, practices law in Washington, D.C., concentrating on nonprofit, foundation and media issues. He served as PBS’s executive director of digital strategic planning and has been working on digital transition topics as a consultant to such organizations as the Ford Foundation. Before joining PBS in 1995 he was a lawyer at Arnold & Porter. He prepared this commentary for informational purposes only; it should not be construed as providing legal advice.

Copyright 2004 by Current Publishing Committee
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