Achieving Balance in Nonprofit Governance

Here’s some excerpts from an article in a from Harvard Business School about achieving some sort of balance between scrutiny of nonprofit organizations and maintaining some degree of freedom from the rigors of compliance. The new forced transparency was triggered by recent abuses by boards in both the for-profit and nonprofit sectors. Now there’s a lot of the usual throwing various kinds of legislation out there at state and federal levels—legislation with differing agendas and impacts.

In this atmosphere, the challenge to nonprofit charitable organizations, their fiduciaries and their managers is to frame and support an appropriate balance between regulation that is effective in preventing abuses, with preservation of the freedom we have traditionally afforded to nonprofit organizations to carry out their public purposes without government interference.

The federal government’s interest in the operation of charities, unlike that of the states, arises not from an inherent duty to protect charitable funds for the public, which is the ultimate beneficiary of them, but from the federal interest in protecting the integrity of the tax system….The federal law also explicitly prohibits charities from participating in political campaigns and from expending more than an insubstantial amount on lobbying, requirements not explicitly present in state law, but to which all charities conform on pain of loss of tax exemption.

Until 1970, the role of the federal government in the enforcement of the federal requirements for tax exemption was limited, and enforcement was largely aimed at determining whether they were subject to the unrelated business income tax. A major limitation on federal enforcement was the fact that the only sanction available to the IRS was revocation of exemption, a sanction that served only to diminish the funds available for charitable purposes, while doing nothing to stop nonprofit managers and fiduciaries from continuing to run the organizations they had used for their own benefit or managed without due care.

I [professor Marion Freemont-Smith] am not advocating changes in the traditional division of the roles of a board and of management. A recent trend, however, has been to place greater responsibility on management and, by requiring independent audit committees, assume that this will be an effective way to policy an organization. Instead of having the CEO and CFO sign off on financial statements (they are already required to sign and certify federal information returns), I would like it to be common practice for all board members to review these returns together with the organization’s financial statements, and in all events to act on compensation of management.

Finally, I believe too many charities ask only limited involvement from their board members, in some cases no more than attendance at one or two meetings a year, if that. Greater use should be made of advisory or honorary boards or committees, with board positions occupied only by those who will actively govern the organization. These are general precepts, however. If we want to protect the diversity of the sector, we must refrain from imposing limits that will constrain innovation and stifle experiment, even in the area of governance.

There are also efforts underway in several states to tighten the laws governing nonprofit organizations by imposing restrictions similar to those applicable under the Sarbanes-Oxley Act to publicly traded business corporations. Among them are requirements that larger organizations establish audit committees, obtain certified financial statements, limit the size of their boards, or be subject to stricter standards of care. Legislative proposals that include these suggested rules have been circulated in New York, Massachusetts, and California, and there are a number of other states in which they are being considered. In addition to these initiatives, the American Law Institute has a new project to develop Principles of Nonprofit Law, and the Restatement of Trusts provisions dealing with charities are being revised, as is the Uniform Management of Institutional Funds Act.

As mentioned in my earlier responses, nonprofit executives should be following these developments and, regardless of their assessment of the likelihood of passage of any of the specific recommendations, should assume that there will be increased scrutiny of their operations by members of the general public, as well as increased audit activity by the IRS and the active state attorneys general. They would do well to review their governance structures and internal policies to assure compliance not only with current law, but in the expectation that there could well be more stringent limits on self-dealing transactions, and expanded audit and governance requirements.