In this e-mail interview with HBS Working Knowledge, Marion R. Fremont-Smith, Senior Research Fellow, Hauser Center for Nonprofit Organizations, Harvard University, talks about the role of government in the life of a nonprofit, shares proposals for change from recent hearings by the Senate Finance Committee, and gives advice on how members of nonprofit boards can improve the efficacy of their participation.
Manda Salls: What do you see as the greatest challenges facing nonprofits?
Marion R. Fremont-Smith: Since mid-2003 there has been a proliferation of charges of wrongdoing in the nonprofit sector. Nonprofit watchdog organizations, academics, and the press have reported instances of tax benefits provided to insiders, overvaluation of tangible property contributed to charities, payments of excessive compensation, and provision of unearned perquisites to directors and trustees of nonprofit organizations. Legislators and federal and state regulators have responded to the allegations with proposals to expand drastically the scope of regulation, including granting the IRS and the federal courts unprecedented powers to control the behavior of charities and their fiduciaries. The situation is to a degree similar to that which preceded and led to passage of the provisions in the Tax Reform Act of 1969 significantly restricting the activities and programs of private foundations.
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.
| In one sense, the greatest current challenges to the sector have arisen from their new transparency. |
Traditionally, the purpose of federal and state regulation has been to assure that charitable fiduciaries—officers, trustees, and directors—do not benefit personally at the expense of their organizations and to refrain from acting recklessly. I believe we do need to tighten some existing laws. Even more important, we need to improve enforcement so that fiduciaries will understand that they will be held to account. This means supporting appropriations for the IRS to institute an effective audit program. It means vastly increasing the funds available to state attorneys general to assure compliance with fiduciary standards. At the same time, we should resist efforts to control the manner in which private individuals are permitted to determine the best manner in which to carry out the charitable public purposes which they are charged with fulfilling.
Q: What is the role the federal government plays in the life of a nonprofit?
A: We have a dual system for regulating charities. In order to answer this question, I must also describe the role of the states. Nonprofit charities are creatures of the states in which they are organized. State laws govern the procedures under which they come into existence and are terminated. They impose on charitable fiduciaries duties of loyalty and care, standards that in essence require them to carry out the purposes of the organizations while prohibiting them from reaping any private benefit at the expense of the organization and further proscribing speculation and negligence in the administration of the organization's assets.
The attorney general in each state has virtually exclusive power to call trustees and directors to account in the courts, and the courts in turn have broad powers to correct wrongdoing, including the ability to compel accountings, remove fiduciaries, impose fines, require restitution of funds, and dissolve charities and transfer their assets to other similar organizations. The powers of the states are broad; the extent to which they are exercised is exceedingly limited. Only ten states require charities to register and file financial reports. An additional twenty-nine states impose these requirements on charities that solicit contributions from the general public, but regulation of solicitation, while important, has as its goal the protection of consumers, not the protection of charitable funds from misuse by fiduciaries. The greatest limit, however, is that even the most effective state regulatory programs are grossly underfunded, making enforcement uneven and in many instances ineffective.
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. Thus, the IRS has the power to determine whether an organization is entitled to exemption from federal income tax and is eligible to receive contributions which are deductible for federal income, estate, and gift tax purposes. Thus, once created under state law, a nonprofit will apply to the IRS for a ruling that it meets the requirements for tax exemption, requirements that in the first instance follow the same concepts found in state laws as to the definition of charitable purposes and the constraints against private benefit and private inurement.
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. In addition, since 1950, there has been a tax on otherwise exempt charities imposed on any of their activities that are not directly related to the carrying out of their exempt purposes.
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 question whether an audit committee is the panacea for all charities. |
The shortcomings of this approach were recognized in 1969 with passage of limits on the operations of private foundations, the sanctions for violation of which were imposed on fiduciaries that knowingly approved of the prohibited transactions and, in the case of self-dealing, on the interested parties who dealt with the charity on their own behalf. This concept of sanctioning the wrongdoers and not the charity was extended in 1996 to the entire universe of tax exempt charities in regard to certain self-dealing transactions in which "excess benefits" were received by persons in positions to exercise substantial influence over the charities, thereby making federal regulation better suited to correcting abuses while preserving charitable assets.
In addition to these requirements, all private foundations and tax exempt charities which normally have gross receipts in excess of $25,000 must file information returns with the federal government and make these returns available to the public. Until recent years, it was difficult to obtain these returns. Now, however, they are posted on a Web site by a nonprofit organization, GUIDESTAR. This transparency has led to greater scrutiny of nonprofit activities, broader questioning of their practices and finances, and ultimately renewed assessments of their contributions to the public and the justification for their privileged status. In one sense, the greatest current challenges to the sector have arisen from their new transparency.
Q: What changes would you recommend to improve nonprofit governance? What issues should nonprofit boards advocate? Why?
A: The principal changes in nonprofit governance I would recommend relate to procedures and board participation, not legal structures or legal requirements. Many of the abuses that have come to light recently could have been prevented if charitable fiduciaries—directors, officers, and trustees—had been more attentive to their organization's operations—its finances, its operating principles—and paid more attention to their proper role in society.
I 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. I question whether an audit committee is the panacea for all charities. Such a structure may be appropriate for many, but certainly not for all, and may instill confidence in the remaining board members that may not be justified.
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.
As to the issues that nonprofit boards should be advocating, I believe they should be supporting efforts to improve regulation, federal and state, with particular attention to assuring adequate funding for the regulators. The proposals from the Finance Committee staff appear to have mobilized many within the sector to revisit efforts at self-regulation. While these initiatives will not deter individuals who form and use nonprofit organizations for their private gain, they can provide assurance to the general public and the government as to the overall integrity of the sector, and thereby forestall efforts to increase regulation in ways that will constrain their freedom of operation.
Q: Couldn't governmental oversight impede the agility of nonprofits? Isn't there an advantage in letting NGOs tackle these problems, thus removing the bureaucracy of government-run projects? Is there a way to balance this effect?
A: I have tried to emphasize my belief that the proper role of government is to assure that nonprofits are not being used as vehicles for private gain, nor being treated recklessly. It has never been, nor should it be the role of government to determine what programs nonprofits should undertake, nor the manner in which they will be carried out. This means that we tolerate a degree of inefficiency in the sector.
| My belief [is] that the proper role of government is to assure that nonprofits are not being used as vehicles for private gain, nor being treated recklessly. |
As a society, we have been willing to do this in order to encourage its broad diversity and create an environment in which experiment is not merely tolerated but encouraged. I think this is the balance that we need to preserve. Accordingly, I oppose proposals to make the IRS an accrediting agency that would promulgate standards for governance and best practices and condition tax exemption on compliance with those standards. We do need to assess from time to time whether the restrictions that are in the laws are effective to prevent wrongdoing. When, as now, there is evidence that the laws are too lenient in certain respects, or that there are loopholes that need to be filled, we must strive to adopt corrective measures that will be least intrusive on what you describe as the agility of the sector.
Q: Is there evidence of likely changes in the next few years? What should nonprofit executives be aware of?
A In June [2004], the Senate Finance Committee held hearings on proposed changes in the Internal Revenue Code and state laws to increase regulation of charities. In conjunction with the hearing, the Committee circulated a Discussion Draft prepared by its staff that contained some forty proposed reforms and requested comments from certain members of the exempt community on their effect. A roundtable discussion of the proposals and the comments was held on July 22, attended by some ninety persons. (Copies of the Staff Discussion Draft and the Responses are available at http://finance.senate.gov/sitepages/round.htm.)
Committee staff has announced that its next step will be to develop specific legislative proposals. At the same time the Oversight Subcommittee of the House Ways and Means Committee announced that it is examining a number of issues relating to tax exempt nonprofit organizations, particularly hospitals.
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.
Many, not most, of the organizations that represent the nonprofit sector are looking to enhance self-regulation, promoting adoption of codes of ethics and new standards for governance and administration. These efforts on the part of the sector are a most important response to the Congressional initiatives.
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.
Q: What are you working on next?
A: Since completing the manuscript for my book, Governing Nonprofit Organizations: Federal and State Law and Regulation, in the spring of 2003, I have been conducting a study of government regulation of charitable fundraising and expect to have a manuscript for a book completed in 2005. I also published a survey of press reports issued between 1998 and 2002 of allegations of wrongdoing by directors and officers of charities. We are continuing and expanding this survey and I will be presenting a paper in October summarizing press reports during 2003 of allegations of criminal activity by fiduciaries and employees of charities.
I am also organizing a study of governance practices of nonprofit organizations, looking at them by subsectors such as education, religion, health, social welfare, etc., to determine whether we can devise governance forms and models for procedures and administration better suited to certain groups of charities than the existing "one size fits all" model.
Another project that I hope to undertake next year is a survey of the effect of the IRC limits on excess benefits on the governance and practice of public charities, a study that has increased in importance in view of the Finance Committee staff recommendation to repeal these limits and substitute an absolute ban on self-dealing, a proposal that I believe, along with many others, is premature in that the current limits were well considered before enactment and more time is needed before we can assess their effectiveness.
My abiding interest since the early 1960s has been in improving regulation of nonprofits in ways that will enhance their ability to serve society. These new projects are designed to continue that effort.
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