Media reports abound with cautionary tales of nonprofits providing massive financial benefits to insiders, arguably leaving less for charity. Recently, news sources reported that the attorneys general for all 50 states and the Federal Trade Commission have brought legal action against four cancer charities run by a single family. The charities are said to have spent 97% of funds raised on administration or professional fundraisers and only 3% to help cancer patients. Some reports further allege that closely knit leaders of the suspect charities spent charitable funds on such questionable expenditures as subscriptions to dating websites, jet ski rides, and couples’ cruises to the Caribbean.
The problem here is abuse of nonprofit resources. But what’s the underlying organizational issue? In a nutshell, significant conflicts of interest arise for paid nonprofit leaders. So what’s the solution? New York is a legislative trailblazer, seeking to curb this type of nonprofit abuse through new amendments to the state’s conflict of interest laws. While the intention is laudable, one proposed remedy lacks important clarity and the other is too restrictive. And while such legislation will apply only to nonprofits incorporated in New York, the measures may spur other states to take similar actions against nonprofit abuses.
New York’s Example: Wrestling with Insider Conflict of Interest Issues
Under newly enacted New York legislation, nonprofit employees are prohibited from serving as chair of the board of directors (or other titled officer with the same duties). This bright-line rule is set to become effective on January 1, 2016. Two bills have been proposed to modify this restriction, one originating from the New York Assembly and the other from the Senate. The bills take different directions. The Assembly bill would soften the prohibition to allow nonprofit leaders to work through conflict of interest issues on their own and document the process. By contrast, the Senate bill would make the new law even stricter, proposing a blanket prohibition on any paid nonprofit employees serving as voting members of their organizations’ governing bodies.
How Should Conflicts of Interest Normally Be Handled?
The question of whether a nonprofit leader may be both paid and allowed to serve as a voting director always raises conflict of interest concerns. Leaders owe a duty of uncompromised loyalty to the nonprofit corporation, to act in its best interest. An inherent conflict of interest exists when the paid leader serves on a board that makes decisions that affect the leader’s compensation, whether directly or indirectly.
Traditionally, the mere presence of this conflict of interest was not strictly prohibited. Rather, the law and best practices required the nonprofit to adhere to certain safeguards, such as through the use of conflict of interest policies, accompanying disclosure statements, and follow-through in actual practice. Such policies have long been part of the IRS’s and state charity regulators’ expectations for good governance, and they are now required under New York’s nonprofit law. (See our previous article.)
At a minimum, current law already mandates that the conflicted leader not be involved in any deliberation or vote regarding matters affecting his or her compensation. Further, the remaining independent board leaders who approve the transaction must determine through due diligence that any compensation provided is in the nonprofit’s best interest, as a quid pro quo payment at a customary rate for quality services rendered. The decision and rationale should be documented in the nonprofit’s minutes.
The New York Assembly’s Proposal: Documented Exceptions Allowed
The Assembly bill would provide for an exception from the new prohibition on employees acting as board chairs. An employee could be the board chair upon fulfillment of two conditions. First, a majority of the entire board would need to approve his or her selection as board chair. Second, the board would have to document contemporaneously why it made such a decision, specifically stating its consideration of other available options.
The bill currently provides that such an employee/chair would not be considered an “independent” director, but it is unclear what this means. For example, could the employee/chair never vote on any action? Or does this refer only to independence in the context of such decisions as employee compensation? The bill in its present form may be well-intended, but its lack of clarity creates a high degree of uncertainty for compliance.
The New York Senate’s Proposal: Prevent Abuse Through Absolute Prohibition
The Senate bill, on the other hand, does not allow for any exceptions. The new prohibition would be even stricter. An employee could be neither the board chair nor a voting director. This strict limitation could cause serious problems, particularly for new and small public charities.
For example, let’s say a passionate individual founds an organization and invites friends and family to help run it. The Senate bill would require the founder to choose between having any control over the organization’s affairs (through being a voting director, which is quite typical) and earning reasonable compensation for his or her services (through being an employee, which is also quite typical).
This proposed restriction could seriously impede well-intentioned, visionary leaders from starting such worthwhile endeavors, all because of this “one-size-fits-all” restriction. The restriction would apply even if the founder could find a highly qualified, independent group of nonprofit leaders to identify him or her as the best person for the job, having extensive skills, experience, and dedication, through an exercise in due diligence.
The Senate bill would additionally require approval of two-thirds of the board before any person related by blood or marriage to the chief executive or a director could be hired as an employee of the organization. It also would add a requirement that the corporation’s bylaws include provisions regarding employees serving on the board, the percentage of the board members who must be “independent of the organization,” the hiring of family members of employees and directors, and conflicts of interest covering business interests.
A Possible Compromise?
While the New York bills appear contradictory, one possibility for resolution is that they will be combined. New York legislators could determine that the stricter Senate rule should be the norm, as a general safeguard against abusive insider practices. The Assembly bill (preferably clarified) would provide the exception as an optimal solution for organizations that can successfully and appropriately work through conflict of interest issues.
Given that New York is the second largest state and home to many nonprofits, its legislative activity may broadly impact the nonprofit sector. Leaders of New York nonprofit corporations need to stay tuned for further developments, particularly with respect to potential changes needed for bylaws and leadership practices. Other states may soon chime in with their own legislative reforms. And in the meantime, all nonprofit leaders need to carefully follow their board-approved conflict of interest policies, especially with respect to any paid nonprofit leaders.