THE BLOG
10/13/2010 01:43 pm ET Updated May 25, 2011

Nonprofit Governance: The Need for Tougher Regulations and Enforcement

The incidence among nonprofits of malfeasance, fraud, excessive compensation, conflicts of interest and poor governance appears to be increasing throughout the country, thereby potentially jeopardizing public confidence in the sector. Contrary to the claims of charity apologists, there are a huge number of "rotten apples" in the nonprofit barrel.

Yet charity regulators, federal and state, have taken insufficient steps to eliminate these abuses. Only the print media and investigative journalism have served in recent years as an effective accountability mechanism for the sector. Unfortunately, the impending demise of daily newspapers and their loss of investigative reporters means that charity regulators will have an even more challenging job in overseeing the sector.

While a lack of political will and excessively cautious approaches are some of the reasons for the regulators' shortcomings, their lack of resources is probably a more serious obstacle to their failure to regulate the nonprofit community. The Internal Revenue Services' tax exempt division has a staff of about 850 employees, almost half of whom are deployed in reviewing applications for nonprofit tax exempt status. The remainder are charged with overseeing the operations of some 1.6 million charities throughout the country. For the latter, it is an enormous, and indeed impossible, task.

State charity regulators are just as critically shorthanded. Probably no more than eight state Attorneys General offices have more than a handful of regulators supervising their large nonprofit communities. In many cases, nonprofits are a low priority for politically conscious Attorneys General who are usually interested in more popular issues such as consumer protection and serious criminal activities. State officials have been reluctant to "speak out" publicly about nonprofit abuses and to seek additional resources for their work. In New Hampshire, however, the Attorney General's office did just that, resulting in a substantial growth in staff and a marked increase in regulatory activities.

Both the Senate Finance and the House Ways and Means committees, which have jurisdiction over the charitable sector, have done nothing to" beef up" federal and state regulators. Although Senator Charles Grassley, minority chair of the Senate Finance Committee, has been a forceful voice for nonprofit accountability, his actions have not gone beyond sending strong letters of reproach to nonprofit abusers, holding hearings and staging press conferences. He and his Committee have never tried to persuade their colleagues on the appropriations committee to increase federal funding for the oversight and enforcement activities of the IRS. The House Ways and Means Committee has been dormant on issues affecting the charitable sector.

For its part, nonprofits in general, including some of the larger charities, have not pressed either the Congress or state legislatures for additional resources for charity regulators. Fearing government interference of any kind, they have tended instead to champion self-reform as the acceptable alternative to stronger government standards, regulations and enforcement. Useful perhaps as a supplementary strategy, self-reform measures have rarely worked. They are not the answer to what ails the sector.

The most difficult task for regulators will be their efforts to improve the governance of nonprofit institutions.

In most cases of abusive or fraudulent behavior, especially among our largest nonprofits, the indifference and irresponsibility of board members have been the major reason for these problems. From the Aramony scandal, to the troubles at the Nature Conservancy, to recent incidents at the Stevens Institute in New Jersey, to the demise of the Vanguard Foundation in San Francisco, most of the blame can be attributed to boards of directors who were unwilling or unable to exercise their fiduciary responsibility. Remarkable in these and other cases was the fact that board members responsible for these abuses were permitted to stay on as board members instead of being fired or forced to resign. Punitive actions against such irresponsible board members seem to be the rare exception.

Clearly, boards of directors need to be better informed about their legal and ethical responsibilities. They need firmer guidelines from charity officials about issues such as conflicts of interest, self dealing and excessive compensation. They require more and better training. And they need greater diversity in the composition of their members. Too many boards, especially those of large nonprofits, are composed largely of corporate or ex-corporate officials who bring with them corporate values, a shaky sense of ethics and a management style more fitting to business than to nonprofit operations.

If nonprofit governance is to be improved, charity regulators will have to tighten their regulations, clarify the standards they use in defining conflicts of interest and excessive compensation and be willing to penalize nonprofits and their leaders who abuse the system. Until they do, many nonprofits will be encouraged to continue their feckless patterns of behavior.

Here are some steps they could take.

Board Governance

Charity officials, at both the federal and state levels, should issue clear guidelines about the responsibility of board members. These could include the suggestion that board members serve on no more than three nonprofit boards and be diverse in composition; that major decisions (eg on executive compensation, investments, audits, etc.) should be made by the full board, not just the chair or executive committee; and that board chairs should be rotated after a limited, reasonable time of service.

Charity officials also should make it clear that they are prepared to force out or replace board members of nonprofits guilty of serious abuses.

Conflicts of Interest and Self-Dealing

Traditionally, board members of charities have not received any compensation for their services to these organizations. In recent years, this tradition has broken down; a rapidly growing number of nonprofits are now providing trustees with fees for serving on boards and compensation for services (eg. legal, accounting, fundraising and realtor transactions) to the charity, whether or not they are below or above market-rate. Such conflicts of interest and self-dealing are not healthy for the sector.

For this reason, both federal and state charity officials should prohibit board members from receiving either trustee fees or compensation for services to their nonprofit organizations, with the possible exception for nonprofits located in sparsely populated areas where expertise is hard to find.

Federal regulations currently ban self-dealing among private foundations, yet permit such actions when " reasonable, necessary and not excessive" . It is a huge loophole that should be eliminated. Moreover, trustee fees that currently amount to over $300 million a year -- money that could better be spent on grants -- should either be prohibited or limited to $5-7,000 a year.

Excessive Compensation

Nonprofit CEO salaries have been skyrocketing in recent years, especially in higher education, hospitals and medical centers, big arts institutions, nonprofit athletics, foundations and large social service organizations. The widening gap between charities' CEO salaries and their lowest paid staff is beginning to resemble the salary ratios in corporate America. Yet federal and state charity regulators have done little or nothing to stop this development.

Charity regulators should more clearly define what constitutes excessive compensation. They should not permit nonprofit search committees to use comparable data from private corporations as a basis for deciding reasonable compensation packages for their top staff. Nor should nonprofits be allowed to provide expensive subsidies for the purchase or rental of housing, or non-monetary contributions like valuable paintings or luxury cars to their top staff

Exorbitant salaries and benefits continue to be tolerated by charity regulators. They need to crack down on these excesses.

If they cannot or unwilling to do so, it may then be time to place a salary cap on nonprofit salaries. The U.S. President's salary of $400,000 a year has been mentioned as a suitable cap. In view of the perks he enjoys, such as free housing and other benefits, it could be raised to $600,000. To make the system flexible, nonprofits could exercise the right to pay their CEO's more than the cap, but they would be subject to a penalty. I would argue that a 100% tax on the amount above the cap would be a fair assessment, serving as somewhat of a deterrent to even higher salaries.

Embezzlement and Fraud

The growing incidents of embezzlement and fraud among nonprofits across the country call for stricter requirements by regulators. At a minimum, nonprofits with budgets over $500,000 should be required to have an annual audit, performed by independent auditors with no ties to the nonprofits they are examining.

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While clearer standards and guidelines, tougher regulations and more energetic action by regulators are keys to more effective enforcement, nothing is more important to regulating the sector than ensuring that the IRS and state attorneys general have the resources they need to do their jobs. Currently, they are vastly understaffed and under-resourced. The nonprofit community and the Congress must join together to increase the capacity of our regulators. There is no time to lose.