Non-Profit Board Best Practices
Nonprofit and tax-exempt organizations are under scrutiny like never before. At the federal level, the Internal Revenue Service (the “IRS”) has demonstrated a strong interest in good governance practices and in compliance with tax laws and regulations. At the state level, secretaries of state, through their responsibility to oversee charitable organizations, are concentrating a significant amount of energy on enforcing compliance statutes to ensure transparency and consumer protection.
Boards of directors of nonprofit corporations do not want any distraction from the achievement of their organization’s mission. Therefore, they too are setting higher standards for governance and financial practices. The responsibility for meeting the heightened expectations of today’s increasingly stringent climate falls directly on the organization’s board of directors and senior leadership. The following will summarize nonprofit corporate governance “best practices” that nonprofit corporations should consider when setting up its board of directors and after it begins its operations.
Best Practices
Independent Directors
A substantial majority of the members of the board of directors should be independent of the organization’s senior executive officers, both in fact and appearance. In implementing this recommendation, organizations that maintain an executive committee of the board of directors should not constitute the membership of the committee and confer authority upon it so as to evade the substance of this recommendation.
Duties of Directors
Duty of Care
The duty of care requires the director to be informed regarding the affairs of the organization and to exercise the care that a prudent person in his or her position would exercise, and to do so in a manner that the director reasonably believes to be in the best interest of the organization.
To fulfill his or her duty of care, at a minimum, a director should: (i) regularly attend meetings of the board of directors; (ii) be informed about the affairs and finances of the organization; and (iii) exercise his or her independent judgment with respect to issues under consideration.
Directors frequently rely upon staff members to provide information regarding the affairs and finances of the organization. In general, a director may rely upon information supplied by staff members, the organization’s legal counsel, public accountants or board committees, unless the director is aware that such information is not accurate or has other reason to believe that the information may not be reliable. If, however, sufficient information is not supplied, it is the director’s duty to request additional information. The director should read written information that is provided.
Although the director may rely upon information provided by staff, he or she should exercise independent judgment and should not hesitate to take a position differing from that of the staff should he or she believe that to be appropriate.
Duty of Loyalty
The duty of loyalty requires a director to exercise his or her duties in a manner that furthers the interest of the organization rather than his or her personal interest or the interest of another person or organization. Matters related to this duty include: (i) conflicts of interest; (ii) corporate opportunity; and (iii) confidentiality.
A director should reveal to the board of directors any conflicts of interest that he or she may have when those conflicts or potential conflicts may be relevant. For example, if the organization will be doing business with a company owned by the director or a family member, the board should be informed of that relationship. Similarly, if the director also serves as a director, committee member or employee of a competitor of the organization, the board should be so informed.
If the board will be making decisions that present a conflict or potential conflict of interest, the affected director should answer any questions that board members have about the conflict and should abstain from voting on the matter. It is usually appropriate that the affected director leave the room while the matter is being discussed or considered so that other directors will feel comfortable in addressing the matter.
It is often advisable to obtain comparable information so the board has evidence that the transaction is fair to the organization. The minutes should describe the disclosure of the conflict, any recusals and any comparable information on which the board relied.
It is good practice for a nonprofit corporation to have a written conflict of interest policy requiring each director, among other things, to complete and deliver an annual disclosure statement identifying potential conflicts of interest such as the director’s employer, entities owned by the director and organizations for which the director serves on a board or committee. Typically, the president of the nonprofit corporation reviews this information so that he or she will be generally aware of potential conflicts of interest.
A director is obligated to refer to the corporation business opportunities appropriate for the corporation prior to using them for his or her personal benefit. For example, a director desiring to purchase a parcel of real property that by its nature or location might be of interest to the corporation is required to permit the corporation the opportunity to acquire the property prior to purchasing it personally.
The director must not disclose to others confidential matters of the organization. Any question as to whether any corporate information is confidential should be addressed to counsel for the organization.
Responsibilities of Directors
Before his or her term begins, the new director should undertake to become knowledgeable about the organization. The director should review the following: (i) articles of incorporation and bylaws, (ii) determination letter from the IRS, (iii) most recent tax return, (iv) most recent audited financial statements or year-end statements if audited financial statements are not available, (v) most recent annual report, (vi) list of the current officers and directors of the organization, (vii) summary of applicable insurance, (viii) mission statement, and (ix) chart showing the relationship among the organizations, if the organization is part of a system of affiliated organizations.
The board of directors is charged with defining and overseeing the implementation of the organization’s mission. The board is responsible for: (i) developing and overseeing implementation of a strategic plan; (ii) protecting the organization’s long-term values and mission against sacrifice for short-term gains; (iii) assuring that the programs operated by the organization are consistent with its mission; and (iv) preserving the organization’s assets against waste or abandonment.
The board of directors approves the organization’s annual budget (capital and operating) as well as modifications to the budget throughout the year. While staff can prepare and make recommendations regarding the budget, ultimately it is the directors who must make decisions regarding the addition of new programs and the making of capital expenditures. Should the organization experience financial difficulty, it is the board that must make difficult decisions such as the elimination of programs for the overall welfare of the organization and balancing the immediate needs of the organization’s programs with the long-term financial well-being of the organization.
Finally, it is the responsibility of the board to oversee the management and investment of the organization’s endowment and investments so as to assure the long-term viability of the organization and the availability of its resources, when needed. The board must assure that donations are invested and used in the manner required by donors and otherwise as required by law. In addition, in many organizations, it is expected that directors will actively assist in the organization’s fund-raising efforts, by donating to the organization as well as assisting the organization in obtaining donations from others. Indeed, many foundations and other organizations that typically make donations to charities are disinclined to support a charity where its directors do not contribute to the organization.
Board Operations
The board of directors should consider and determine appropriate action on the following matters: (i) processes for setting agendas and distributing information; (ii) policy concerning expected time commitments of directors, and the extent to which other directorships or other factors (such as health) may impair a director’s ability to satisfy such commitments; (iii) policy concerning rotation of the chair and membership of the board of directors and its corporate governance, audit and compensation committees; and (iv) whether to appoint a “lead” independent director or an independent director to serve as chair of the board of directors or to preside at meetings of non-management directors.
The board of directors also should consider establishing and maintaining training and education programs for all directors, in regard to (i) their legal and ethical responsibilities as directors, (ii) the financial condition, the principal operating risks and the performance factors materially important to the business of the corporation and (iii) the operation, significance and effects of compensation incentive programs and related party transaction.
Finally, the board of directors should decide how to conduct periodic evaluations by the directors of (i) the effectiveness and adequacy of meetings of the board of directors and its committees, (ii) the adequacy and timeliness of the information provided by management to the board of directors, (iii) the diversity of experience of individual directors and (iv) the contributions of each director.
Ethical Issues
In recent years, nonprofit organizations have been subjected to increased scrutiny as a result of scandals in the nonprofit world and business world and the passage of legislation commonly referred to as Sarbanes Oxley. With the exception of its provisions relating to document destruction and reporting of violations of law, most of Sarbanes Oxley’s requirements do not apply to nonprofit corporations.
However, some commentators believe that the standards set by Sarbanes Oxley will eventually become the accepted practice for nonprofit corporations. In some states, legislatures are considering adopting Sarbanes-like requirements for nonprofit organizations. In that light, nonprofit corporations may wish to consider the following actions:
Establishing an audit committee separate from the finance committee. The audit committee, which would be composed of persons not employed by the nonprofit and who are knowledgeable about financial matters, would make recommendations regarding the selection of the auditors, oversee the auditors, and establish processes for addressing complaints regarding accounting and internal control issues.
Establishing a nominating/governance committee composed of directors who are not employees. The committee would assume responsibility for nominating qualified candidates for directors, monitoring corporate governance, and monitoring compliance with ethical standards.
Establishing a policy regarding the retention and destruction of documents.
Establishing a procedure that allows employees to alert management and/or board to ethical issues and violations of law without fear of retaliation.
Establishing a conflict of interest policy.
Charitable Mission, Vision and Tax Exemption
Many, but not all, nonprofit corporations qualify for exemption from federal income tax because they are described in one or more provisions of Section 501(c) of the Internal Revenue Code (the “Code”). In most cases, to be afforded the benefits of tax exemption, the nonprofit corporation must apply to the IRS for recognition of exemption. The most common status is that of a charitable organization described in Section 501(c)(3) of the Code, which affords both exemption from federal income tax and deductibility of charitable contributions to the organization. Generally, 501(c)(3) status is available to charitable, religious and educational organizations. Qualification under other provisions of Section 501(c) affords exemption from federal income tax, but generally does not afford deductibility of contributions to the organization.
A 501(c)(3) organization is presumed to be a private foundation unless it qualifies as a public charity. When the IRS recognizes an organization as exempt under Section 501(c)(3), it also characterizes it as either a private foundation or a public charity. For the reasons discussed below, ordinarily it is preferable to qualify as a public charity.
An organization described in Section 501(c)(3) may be classified a “public charity” if it is a hospital, church or school, meets a financial test demonstrating that it has broad public support or supports one or more publicly supported organizations.
Section 501(c)(3) public charities are subject to a variety of limitations on their operations, including prohibitions on: (i) certain political activity; (ii) any substantial amount of lobbying; and (iii) allowing the assets or income of the organization to inure to the benefit of private persons.
A 501(c)(3) public charity is not permitted to engage in any political campaign activity in support of or opposition to any candidate for public office. Accordingly, directors who are inclined to involve themselves personally in such activity must be careful not to undertake such activity in their capacity as directors of the 501(c)(3) organization. For example, they should not conduct meetings at the organization’s office space or use the letterhead for political correspondence or purport to be speaking on behalf of the organization.
A 501(c)(3) public charity may engage in lobbying only if the amount of the lobbying is not substantial. Unfortunately, the Code does not define either “substantial” or “lobbying” for the purposes of applying the substantial part test. Lobbying by directors for its causes is usually attributed to the nonprofit organization, even when the directors volunteer their efforts.
A 501(c)(3) public charity is expected to operate for the benefit of the public and the charitable class served by the organization, rather than the benefit of private persons. Transactions between directors (and other private persons as well) and the exempt organization must be structured in a manner that does not improperly benefit the private person. Such improper benefit to private persons is referred to as “private inurement.” Private inurement can occur in numerous different ways. For example, the organization may not loan money to a key employee or an affiliated business corporation unless the terms are arm’s-length. Ordinarily, this would mean that the organization has determined that the loan is a sound business decision, the loan bears interest at a commercially reasonable rate and is properly secured. Similarly, the exempt organization cannot pay excessive compensation, pay for services that are not provided or provide free or below-market price goods or services to private persons other than members of the charitable class the organization serves. This prohibition on private inurement frequently raises significant issues for 501(c)(3) organizations desiring to participate in partnerships with taxable entities or individuals.
A “disqualified person” who engages in an “excess benefit transaction” with a 501(c)(3) organization that is a public charity or with a 501(c)(4) organization can be subject to an excise tax of 25% of the excess benefit, and, if correction of the excess benefit is not timely made, to an excise tax of 200% of the excess benefit. Officers and directors who knowingly participate in such a transaction may be subject to an excise tax of 10% of the excess benefit. These excise taxes are commonly referred to as intermediate sanctions.
“Disqualified persons” are persons with substantial influence on the exempt organization. They include officers and directors of the public charity and persons in positions of authority with the public charity during the previous five years, as well as their family members and companies owned by them. In an “excess benefit” transaction, the value of the economic benefit conferred by the exempt organization exceeds the value of the consideration it receives. Potential excess benefit transactions include (but are not limited to) compensation decisions affecting officers, directors and key employees, and transactions involving the sale of property between a public charity and one of its managers or employees.
A transaction may be presumed not to involve any excess benefit if: (i) it is approved by a committee or board comprised entirely of disinterested directors; (ii) when valuing the benefit conferred by the charity, the directors used comparable information as a guide; and (iii) the directors documented their decision-making process.
Committee Organization
Corporate Governance Committee
The board of directors should establish a corporate governance committee composed exclusively of independent directors with responsibility for the identification and nomination (or recommending to the full board of directors the nomination) of independent members of the board of directors, and for extending invitations to prospective independent board members. The corporate governance committee should appoint (or recommend to the full board of directors the appointment of) the persons to serve on each of the other standing committees of the board of directors.
The corporate governance committee should adopt a corporate code of ethics and conduct that includes the establishment of one or more mechanisms through which information concerning violations of law by the corporation or its management personnel, or breaches of fiduciary duty to the corporation which could have a material effect on the corporation, not appropriately addressed by corporate officers, can be freely transmitted to more senior officers and, if necessary, to a committee consisting solely of independent directors.
Audit Committee
The board of directors should establish an audit committee, composed exclusively of independent directors. Audit committees typically consist of three to five members.
The audit committee should meet regularly outside the presence of any senior executive officer and should be: (i) authorized to engage and remove the corporation’s outside auditor (or if legally permissible, to recommend such engagement or removal to the board of directors), and to determine the terms of the engagement of the outside auditor; (ii) authorized and afforded resources sufficient to engage independent accounting and legal advisers when determined by the committee to be necessary or appropriate; and (iii) responsible for recommending or establishing policies relating to non-audit services provided by the corporation’s outside auditor to the corporation and other aspects of the corporation’s relationship with the outside auditor that may adversely affect that firm’s independence.
Finally, the resolution of the board of directors creating the audit committee should specify whether the foregoing decisions are to be made exclusively by the audit committee or by the full board of directors (or by the independent directors) upon recommendation of the committee.
Compensation Committee
The board of directors should establish a compensation committee, composed exclusively of independent directors. Compensation committees typically consist of three to five members.
The compensation committee should meet regularly outside the presence of any senior executive officer and should be: (i) responsible for determining, or making a recommendation with respect to, the compensation (including executive benefits) of the senior executive officers of the corporation; and (ii) authorized and afforded resources sufficient to engage independent executive compensation and legal advisers when determined by the committee to be necessary and appropriate.
In determining or recommending the amount, form and terms of compensation of senior executive officers, the compensation committee should (i) evaluate the performance of such officers, and (ii) be guided by, and seek to promote, the long term interests of the corporation and its shareholders.
The resolution of the board of directors creating the compensation committee should specify whether the foregoing decisions are to be made exclusively by the compensation committee or by the full board of directors (or by the independent directors) upon the recommendation of the committee.
In deliberating on the compensation of the chief executive officer, the compensation committee should meet outside the presence of any senior executive officer; the chief executive officer may, if the compensation committee chooses, participate in the deliberations on the compensation of any other officer.
Special Committee for Interested Director/Executive Transactions
In addition to approvals required by law, a committee composed exclusively of independent directors and appointed for the purpose by or on the recommendation of the independent directors or a committee composed exclusively of such directors, should review and approve any material transaction between the corporation and any director or senior executive officer of the corporation (and any person or entity controlling or controlled by such director or officer, or in which such director or officer has a direct or indirect material financial interest), including a loan or guarantee by the corporation.
Such review and approval should include: (i) an explanation of why the transaction is in the best interests of the corporation without regard to the interest or desire of the individual (or related person or entity); (ii) a documented rationale for engaging in the transaction with a related party rather than with a third person; (iii) a specific determination of the fairness of the transaction; and (iv) a review of the public disclosure that may be appropriate for the transaction.
Legal Compliance Committee
The board of directors should establish a legal compliance committee composed exclusively of independent directors. The legal compliance committee should be charged with obtaining and evaluating regular reports from the corporate officers responsible for implementing the corporation’s internal controls, codes of ethics and compliance policies, including general counsel, the chief financial officer, the chief internal auditor and the chief compliance officer.
These regular reports should contain information about the corporation’s legal and compliance affairs including, at a minimum, information about violations or potential violations of law and breaches of fiduciary duty by an executive officer or director that could have a material adverse effect on the corporation.
Ideal Board of Directors Make-Up
A nonprofit corporation generally should seek to have a wide range of experience and knowledge on its board of directors. An organization’s goal should be to bring in diligent, honest, independent directors that maintain an attitude of constructive criticism, ask probing questions and require accurate answers.