Welcome to Our 2005 Seminar Series:

Your Not-For-Profit Board Service: Do’s and Don’ts

October 18, 2005

Speakers:

Victoria B. BjorklundDavid A. ShevlinDavid Saltzman,

Robin Hood Foundation

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Agenda

• Accountability of Directors of Not-for-Profit Corporations

• Legal Duties of Directors of Not-for-Profit Corporations

• Compensation Issues• Director Liability and Indemnification Issues• A Changing Regulatory Environment • Questions

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Accountability of Directors of Not-for-Profit Corporations

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What are the essential characteristics of a not-for-profit?

• May be formed as a corporation, trust, or unincorporated association

• Must further a “501(c)(3)” purpose (i.e., charitable, educational, etc.)

• May not have private inurement• May not engage in [substantial] lobbying• May not intervene in any election for public office

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To whom are directors accountable?

• Charitable Class• Members (if any)• Donors • General Public• Regulatory Authorities

• IRS• State Attorney General

• Others

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Charitable Class

• Not-for-profit organizations must serve a charitable class.

• Examples of a charitable class:• Needy or distressed• Victims of domestic violence• Inner-city youth• New York’s hungry

• DO: Understand the identity and nature of the charitable class that the organization has been formed to benefit.

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Members

• Not-for-profit corporations may have members who have a particular stake in the activities of the corporation.

• Voting members will typically have the right to elect and remove directors and to approve fundamental corporate changes such as the amendment of the corporation’s Certificate and By-Laws and the dissolution of the corporation.

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Donors

• Accountability may arise under the terms of any contract or agreement that governs a donor’s gift.

• DO: Be sensitive to donors’ concerns and expectations.

• DON’T (Managers): Accept a restricted gift without first determining whether the organization can comply with the restrictions.

• Example: Smithers v. St. Luke's-Roosevelt Hospital Center

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General Public

• Directors do not owe legal duties to the general public but must be sensitive to the public’s perception of the organization.

• Directors should be aware that the “public face” of the organization is seen by the public and the press through:

• Fundraising materials

• IRS Forms 990/990-PF (publicly available on the GuideStar website)

• Organization’s Website

• DO: Check that fundraising materials, IRS Forms 990/990-PF and website are consistent with the organization’s purposes and operations.

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General Public

• Example – Cabot Foundation• On its IRS Forms 990-PF on GuideStar, the Paul and

Virginia Cabot Trust had reported paying annual compensation to Paul Cabot, one of its trustees, in excess of $1 million. In 2001, Mr. Cabot reported increasing his compensation by $400,000 to $1.4 million in order to, among other things, pay for his daughter’s wedding.

• The Boston Globe included the Trust as an example in its articles on charity abuses.

• In a 12/04 settlement with the Massachusetts Attorney General, Paul Cabot paid back more than $4 million to the Trust.

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Regulatory Authorities

• Internal Revenue Service• Has ongoing oversight over the organization

through review of the organization’s IRS Forms 990/990-PF and the examination/audit process

• State Attorney General• Represents the charitable class and has the right

to bring suit against the organization on behalf of the charitable class

• Oversight varies state-by-state

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Legal Duties of Directors of Not-for-Profit Corporations

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What are the legal duties of directors of not-for-profit corporations?

• Duty of Care• Duty of Loyalty• Duty of Obedience

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Duty of Care

• The duty of care imposes a standard of conduct on directors as they oversee the activities of the not-for-profit corporation.

• In New York, the duty of care standard that applies to not-for-profit directors under N-PCL Section 717 is similar to the standard that applies to directors of business corporations.

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Duty of Care

• “Ordinary Director” Standard in N-PCL Section 717:• Act in good faith; and• With the degree of diligence, care and skill that

ordinarily prudent men in a like position would exercise in similar circumstances

• In a July 2005 case, Consumers Union of U.S., Inc. v. The State of New York, a majority of the New York Court of Appeals presumed that the business judgment rule applied to a decision of not-for-profit directors.

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Duty of Care

• What Does This Mean For a Director?• DO: Be informed• DO: Be active• DO: Exercise independent judgment• DO: Ask questions

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Duty of Care

• Example of a Violation of the Duty of Care• In a 1997 proceeding, The Committee to Save Adelphi v.

Diamandopoulos, the New York Board of Regents removed 18 of the 19 trustees of Adelphi University for neglect of the duty of care in, among other things, approving an excessive compensation package for the President.

• The Regents found that the trustees had violated the duty of care by failing to make informed decisions about the President’s compensation. This included failing to obtain and review salary comparables, failing to evaluate the President’s performance and failing to ask questions about the components of the President’s compensation.

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Duty of Care

• Delegation by Directors• Directors may delegate functions, such as the

day-to-day operation of the corporation, to others.

• However, the delegation must be in good faith and in compliance with the duty of care.

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Duty of Care

• Delegation by Nonprofit Directors• To whom may directors delegate authority?

• Officers or employees of the corporation who the directors believe are reliable and competent

• Counsel, accountants or other outside experts for matters that the directors believe to be within those persons’ professional or expert competence

• A committee of directors, so long as the matter is within the committee’s designated authority

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Duty of Loyalty

• Directors must have an undivided allegiance to the corporation and its mission when using the power of their position or information they possess concerning the corporation or its assets.

• The duty of loyalty requires directors to exercise their powers in good faith and in the best interests of the corporation.

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Duty of Loyalty

• What Does This Mean For a Director?• DO: Be conscious of potential conflicts of

interest• DO: Follow the corporation’s conflict of interest

policy

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Duty of Loyalty

• Examples of Violations of the Duty of Loyalty• In The Committee to Save Adelphi v.

Diamandopoulos, Adelphi University purchased insurance through a firm owned by a trustee who did not disclose that her firm was being compensated. The New York Board of Regents found that the trustee violated the duty of loyalty by putting her business interests over the interests of the University.

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Duty of Loyalty

• Examples of Violations of the Duty of Loyalty• In American Baptist Churches of Metropolitan

New York v. Galloway, a 2000 case in the New York Appellate Division, an officer of a not-for-profit hospital assisted in locating a site and obtaining permits for a new facility. Just before the closing on the facility site, the officer incorporated a new not-for-profit corporation and arranged for the new not-for-profit corporation to purchase the property before the hospital could act.

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Duty of Loyalty

• New York Law Regarding Conflict of Interest Transactions• Under N-PCL Section 715, a contract or

transaction between a corporation and one or more of its directors or between a corporation and any other entity in which one or more of its directors have a substantial financial interest presents a “conflict of interest.”

• DO: Disclose and abstain.

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Duty of Obedience

• Directors must be faithful to the mission and purposes of the corporation.

• What does this mean for a director?• DO: Know what the corporation’s Certificate of

Incorporation states as the purposes of the corporation.

• DO: Be aware that the corporation’s mission and activities must be consistent with the corporation’s stated purposes.

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Compensation Issues

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Federal Law – Private Foundations

• Internal Revenue Code Section 4941 (1969)• Prohibits payment of compensation (or

reimbursement of expenses) by a private foundation to a disqualified person

• Exception for compensation paid for personal services which are reasonable and necessary to carrying out the foundation’s purposes, if the compensation (or reimbursement) is not excessive.

• DO: Follow a procedure similar to the one used by public charities

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Federal Law – Public Charities

• Internal Revenue Code Section 4958 (final regs2002)• Directors, officers and others in a position to exercise

substantial influence over the affairs of the organization (such as the Executive Director and CFO) must repay and are subject to penalties on any excessive compensation they receive

• Directors who knowingly approve the payment of excessive compensation are subject to penalties

• Tax-exempt status can be forfeited in egregious or repeated cases. See 9/08/05 proposed regulations.

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Federal Law – Public Charities

• IRS has to rebut presumption that compensation is reasonable if:

• Approved by independent Board or committee

• Relied upon appropriate data as to comparability

• Process is adequately documented (ensure minutes of meeting record approval and details of transaction)

• These rules also apply to transactions other than compensation (e.g., contracts, sales, etc.)

• DO: Follow the procedure

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Compensation – Legal Considerations

• New York law -- Salaries of officers must be approved by a majority of the entire Board, unless a different procedure is set forth in the By-Laws. N-PCL Section 715(f).

• DO: Ensure that approval of compensation complies with state and federal requirements, as well as the organization’s governing documents.

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Director Liability and Indemnification Issues

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Director Liability

• Liability for Violation of Legal Duty• Tort Liability• Adverse Publicity

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Violation of Legal Duty

• Action may be brought by• State Attorney General• Director• Members representing at least 5% of the

membership• Remedies – removal of directors, requirement to

restore benefits improperly received

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Tort Liability

• Liability to third parties for actions committed against them (e.g., accidents, employment claims)

• Under New York law, a volunteer director or officer is not liable to third parties unless• Actions constitute gross negligence or• Director or officer had an intent to cause harm

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Indemnification

• New York law provides for indemnification, that is, the right of directors and officers to receive reimbursement for costs associated with litigation against them and the authority of the corporation to provide reimbursement. See N-PCL Sections 721-726.

• New York law is nonexclusive, meaning the corporation may provide indemnification beyond what the statute requires and permits, as long as certain standards are met. See N-PCL Section 721.

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Indemnification - Mandatory

• Indemnification of judgments, fines, amounts paid in settlement and reasonable expenses is mandatory if the director is successful on merits. See N-PCL Section 723.

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Indemnification - Permissive

• Indemnification is permitted even if director is unsuccessful in defense or where there is a settlement if the director acted in good faith, had a reasonable belief that he or she acted in the best interests of the corporation and, in a criminal proceeding, had no reasonable cause to believe that his or her conduct was unlawful. See N-PCL Section 722.

• Indemnification in these situations may be provided by a provision in the Certificate, By-Laws, Board resolution or contract.

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Indemnification - Prohibited

• Indemnification is prohibited –• If there is an adverse final adjudication that the

directors acted in bad faith, with active or deliberate dishonesty or gained a personal profit or other advantage. See N-PCL Section 721.

• In a derivative action, the corporation may not indemnify for fines or judgments imposed on a director. See N-PCL Section 722(c).

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Delaware Indemnification

• Substantially similar (DCGL Section 145):

• Non-exclusive; similar standards for permissive, mandatory and prohibited indemnification; and advancement of expenses with undertaking.

• Delaware corporations doing business in New York.

• N-PCL Section 1320 expressly applies N-PCL indemnification provisions to foreign corporations.

• N-PCL Section 725 prohibits indemnification if inconsistent with home state’s provisions.

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Directors’ and Officers’ Liability Insurance

• DO (Directors): Inquire about the corporation’s policy on indemnification and the scope of its insurance coverage.

• Do (Managers): Inquire whether• Subsidiaries, affiliates and related corporations

are covered? The costs of the corporation itself are covered?

• Correct titles are used?• Expenses of investigations and excise taxes

covered are?• Defense costs are included as part of loss?

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A Changing Regulatory Environment

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A Changing Regulatory Environment

• WHY?• Arguments regarding the applicability of

“Sarbanes-Oxley” principles to not-for-profit organizations and an increased emphasis on corporate governance.

• Highly-publicized examples of alleged abuse, particularly in the areas of compensation and expenses, which have drawn the attention of regulators, press, donors, etc.

• Example: 10/2005 articles on dismissal of the President of American University

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Key Elements of Sarbanes-Oxley

• Auditor independence requirements• Audit committee requirements

• Duties, composition• Officer certification of financial reports• Penalties for document destruction***• Whistleblower protection***

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Listing Standards

• NYSE and NASDAQ also adopted corporate responsibility rules, including director “independence” requirements.• Example: NYSE rules include required proxy

statement disclosure and consideration of material relationships.

• Example: In re Oracle Corp.

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Application of Sarbanes-Oxley to Charities?

• Whistleblower protection and document destruction provisions do apply by their terms.• DO: Consider the adoption of whistleblower

protection and document retention procedures.

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Application of Sarbanes-Oxley to Charities?

• Some states have taken steps to apply other provisions of Sarbanes-Oxley to charitable organizations.• The California Nonprofit Integrity Act of 2004

includes corporate responsibility provisions: financial audits, audit committees, public disclosure of audited financials, approval by the Board of compensation of the CEO and CFO.

• May apply to organizations that solicit in California.

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New York State Attorney General’s Proposals

• Encouraging boards to designate executive committees if they have 25 or more members;

• Encouraging boards to designate audit committees if the organization has more than $2 million in revenue and support;

• Requiring certain organizations to maintain a system of internal financial controls designed to reasonably ensure the identification of incorrect financial information in annual reports and the reporting of fraud; and

• Revising the conflict-of-interest provisions in N-PCL Section 715 to establish a presumption of fairness where appropriate disclosures are made and due diligence is performed.

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New York State Attorney General’s Proposals

• Audit committee’s duties would include:• Establishing whistleblower procedures• Appointment, fixing of compensation and

oversight of the independent auditor• Audit committee members may not accept fees

from the organization nor have participated in any “interested party” transactions within the previous year.

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Senate Finance Committee “White Paper”

• In June 2004, the Senate Finance Committee held hearings and issued a “White Paper” on best practices and potential legislative reforms for charitable organizations.

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Senate Finance Committee “White Paper”

• The White Paper contains a number of proposals regarding transparency and governance of not-for-profit organizations.• Five-year review of exemption• Increased reporting obligations• Limits on compensation• Limits on travel and other expenses

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Panel on Nonprofit Sector

• In October 2004, Independent Sector convened the Panel on the Nonprofit Sector to provide recommendations for strengthening the governance, ethical conduct, and accountability of not-for-profit organizations.

• The Panel issued a Final Report on Strengthening the Transparency, Governance and Accountability of Charitable Organizations on June 22, 2005 (see www.nonprofitpanel.org).

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Panel on Nonprofit Sector

• The Final Report contains over 120 recommendations for action by Congress, the IRS and the charitable sector to strengthen the sector’s transparency, governance and accountability.

• The recommendations cover fifteen subjects, including financial audits and reviews, non-cash contributions, board compensation, executive compensation, travel expenses and audit committees.

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Panel on Nonprofit Sector

• The Final Report recommendations include:• A proposal that Congress enact legislation

requiring audits of not-for-profit organizations with annual revenue of $1 million or more, and an independent accountant’s review of charitable organizations with annual revenue of between $250,000 and $1 million.

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Panel on Nonprofit Sector

• The Final Report recommendations include:• A proposal that Congress enact legislation to

increase the penalties on board members who approve and executives who receive excessive compensation, that the IRS revise Forms 990 and 990-PF to make the total compensation of executives clearer to the public and regulators, and that boards of not-for-profit organizations approve executive compensation annually.

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Panel on Nonprofit Sector

• The Final Report recommendations include:• A proposal that Congress enact legislation

requiring not-for-profit organizations to disclose on IRS Forms 990/990-PF whether they have a travel policy.

• A proposal encouraging not-for-profit organizations that pay for or reimburse travel expenses of Board members, officers, employees, etc. to adopt and follow clear policies for the payment or reimbursement of travel expenses.

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Regulatory Updates

• On July 28, 2005, Senator Grassley, Chairman of the Senate Finance Committee, stated that new legislation to reform the charitable sector would be forthcoming in the fall (delayed by Hurricane Katrina issues).

• IRS Commissioner Mark Everson has identified increased charities enforcement as one of his highest priorities.

• DO: Be aware of regulatory developments.

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Evolving GOOD Practices

• What are the Do’s and Don’ts?• DO: Self-evaluate governance and other

procedures to ensure that the organization operates in accordance with “GOOD practices.”

• DON’T: Assume that there is a “one size fits all” approach.

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Evolving GOOD Practices

• Considerations for discussion• Role of committees and the adoption of

committee charters• Review and approval of senior management’s

compensation• Proper procedures for handling potential and

actual conflicts of interest• Ensuring independent financial reviews and the

accuracy of financial reporting• Is there a need/role for “independent” directors?

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Your Questions

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Simpson Thacher Speakers

Victoria Bjorklund New Yorkvbjorklund@stblaw.com 212.455.2875

David Shevlin New Yorkdshevlin@stblaw.com 212.455.3682