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This Report was approved by the Board of Directors of the New York County Lawyers’ Association at its regular meeting on April 9, 2007.
The Task Force on Corporate Governance (“Task Force”) of the New York County Lawyers’ Association (NYCLA) prepared this Report on Not-For-Profit Corporate Board Best Practices to assist not-for-profit (NFP) boards in considering and implementing governance policies and systems that conform to best practices and contribute to the transparency and effectiveness of non-profit operations.
In 2006, NYCLA President Edwin David Robertson charged the Task Force with the responsibility to create a useful and practical guide for lawyers, directors, officers, trustees, overseers, executives, managers and employees who serve NFP corporations. A precipitating factor was the myriad scandals that had rocked the NFP corporate world. Financial shenanigans at the American Red Cross, the New York Stock Exchange, Inc. and various 9/11 and Hurricane Katrina charities, among others, led state regulators such as the New York State Attorney General to redouble their efforts at scrutinizing NFP corporate operations.
Over the last year, the Task Force studied NFP corporate governance controls and structures, which differ somewhat from those in for-profit corporations. After this research the Task Force compiled the set of best practices described below that NFPs may consider implementing. However, the Task Force cautions those NFPs considering implementing these best practices to thoroughly review their current corporate governance controls and structure. This review may lead to the conclusion that these best practices are either not relevant, inapplicable, in whole or in part, or should be adapted to fit the particular NFP. Further, as described below, the extent to which any changes are made is truly a function of the size of the NFP and its ability to afford the cost of implementing changes. However, cost should not be a factor with the most basic corporate governance systems needed to operate and maintain an NFP. It is strongly recommended that any change in NFP corporate practice be considered in consultation with experienced legal and accounting counsel familiar with NFP corporate governance.
This Report discusses, among other things, corporate formalities and fiduciary duties; meetings and other governance considerations; the application of the Sarbanes-Oxley Act of 2002 (SOA) to NFPs; trends in this field and best practices. The Report may be a resource for NFPs taking an initial step in complying with ever-expanding regulation and seeking greater transparency and efficiency in delivering their services to the public.
A critical aspect of any NFP corporate governance control system and structure is its reliance on “corporate formalities.” These formalities are not bygone, anachronistic mechanisms. In fact, they may protect those who serve the NFP by ensuring a standard that can be relied upon when difficult decisions are questioned. However, the extent of the formalities the NFP actually implements will depend upon its particular situation and financial ability, as well as the regulations and statutes imposed on it by state law. In certain situations, NFP corporate governance and fiduciary duties may be nearly identical to those of for-profit corporations.
In NFPs, the role of the Board of directors/trustees/overseers (“directors”) in operations is extremely significant. The Board must be active and progressive─and not staid and reactionary. Essentially, the NFP Board must direct and implement all corporate controls over the NFP’s operations. To this end, the following characteristics of an effective Board are essential.
Initially, the NFP Board must be of a sufficient size to effectively manage the organization. The number of Board members should be set based on the organization size and structure. A critical component of Board composition, however, should be independent directors, that is, directors who are not affiliated with the NFP as, among others, an officer, executive or consultant. Independence is critical in assessing a director’s service to the NFP.
Additionally, the NFP Board should have a committee structure to assist in making difficult decisions independently. NFP’s should consider a separate audit committee, governance/nominating committee and compensation committee. Each committee plays an integral role in the operation of the Board. If it comprises directors who have such experience, an audit committee will provide financial expertise to an NFP Board. A governance/nominating committee ensures that corporate decisions are appropriately made in a timely fashion, and that the positions of directors are filled with competent people as terms expire. A compensation committee may be necessary to research and determine appropriate salaries for NFP executives, managers and directors.
Determining executive and director compensation is a critical obligation of any NFP board. Recent case law seems to suggest that the “reasonableness of compensation and benefits paid by nonprofit organizations is ordinarily determined on a case-by-case basis.” See David J. Samuels, “Non Profit Compensation Update,” New York Law Journal [December 22, 2006]. However, Professor Samuels cautions that regulators will seek to hold the NFP board to a high standard and require its involvement in these compensation decisions. Id.
Professor Samuels’s sage advice is not only reserved for compensation. An NFP Board must monitor adherence to control and compliance systems, as well as investigate complaints that arise from the NFP’s operation. The Board must adopt policies and procedures to provide guidance in responding to these complaints. Finally, the Board must ensure that the NFP retains all appropriate documents and business records. Of course, as the usefulness of records wane, these records may be disposed of but only in accordance with a written record-retention policy adopted by the Board.
Although this corporate board and committee structure provides an appropriate form for an NFP, it would be meaningless if those who serve it do not preserve its integrity. That is, NFP boards, like those in for-profit corporations, should engage in a pattern of appropriate and conspicuous disclosure about possible conflicts and other issues that might compromise the NFP’s integrity. To comply with this dictate, the NFP should promulgate written ethics and business conduct codes. Copies of all the governance policies NYCLA has adopted attached to this Report as Appendix A.
Generally, an NFP’s director owes the NFP four duties:
Duty of Care: This requires the NFP director to fulfill his/her corporate duties in good faith with informed decision-making in the NFP’s best interests. Typically, a director must exercise the same amount of care that an ordinarily prudent person would use in similar situations. In arriving at decisions, a director may rely on professional advice from legal counsel, accountants and consultants, as well as upon the NFP’s books and records and other business documents. As part of the duty of care, a director should actively participate in the NFP’s management and committee structure, attend NFP board meetings, familiarize himself/herself with the NFP’s books and records, and protect the NFP’s assets. (Regarding a charitable trust, trustees may be subject to an enhanced duty of care to protect the charitable trust’s assets as well).
Duty of Loyalty: This duty forbids self-dealing and usurpation of corporate opportunities. It extends to avoiding conflicts of interest whenever possible (discussed below in greater detail). The mechanism for satisfying this duty as it relates to conflicts is timely, candid and complete disclosure of such conflicts to the Board or NFP membership.
Duty of Candor: A director must disclose all material information about any corporate transaction requiring NFP Board or member approval.
Duty of Obedience: A director must obey the principal non-profit mission of the organization, as well as the particular charitable purposes of any donors. A director may not act in contravention of those purposes.
For-profit corporations typically seek to indemnify or limit the potential liability of their directors for various corporate activities. NFPs are no exception and may limit or eliminate a director’s duty of care. NFPs may consider obtaining directors and officers insurance to protect its Board members. However, the NFP may not relieve directors from any breach of loyalty, knowing breaches of law or receipt of improper personal benefit. Accordingly, in forming and/or in the operation of the NFP, a Board must be ever mindful of its responsibilities.
Meetings are the lifeblood of any NFP. It should comply with all statutory meeting requirements for director/trustee/overseer and member meetings. Moreover, these meetings should not be viewed as mere perfunctory, ritualistic occasions, but rather as occasions where the NFP’s business is transacted.
Any NFP meeting should begin with the statutorily proscribed notice or a waiver of notice. Some meetings may be waived on consent, and the actions undertaken prepared in written form to be approved by individual members or directors. If meetings occur, written minutes should be kept and approved by those present. This is very important because the creation of the record is evidence that director or member duties were performed. This step is not necessarily expensive and should be followed by even the smallest NFP.
Compliance with this recordkeeping function may also facilitate the financing of projects as it legitimizes the NFP’s corporate history. Prospective lenders or donors often seek to review these corporate records to establish the bona fides of the NFP.
Conflicts of interest are, in all likelihood, the single biggest issue facing directors serving on NFP boards. Many conflicts arise when directors attempt to engage in business activities that relate to the NFP’s work. Thus, the adoption of a clear conflict of interest policy should be an NFP Board priority.
Contracts or transactions between an NFP and a director or directors, or between the NFP and an entity controlled by such a person(s), are not inherently void or voidable. The NFP director must, however, follow a specific procedure to ensure that he/she is protected. The director may, upon full disclosure of the interest to the NFP Board, have the entire contract or transaction ratified by the Board if at least one NFP director is disinterested. If there are no disinterested directors, and there should be, the NFP membership may also vote to ratify the contract or transaction once the interest has been disclosed. As a note of caution, although these conflict situations may be waived, there may still be adverse consequences for the NFP under the Internal Revenue Code.
An NFP director may be sued by members, who may also challenge ultra vires acts by the NFP. An NFP director may also be liable to the NFP for concurring with certain corporate actions, including, among others, the improper distribution of assets, the improper dissolution of the entity and unauthorized loans to officers, directors, trustees or overseers.
In New York State, the Attorney General’s Office (“NYSAGO”) exercises broad oversight over NFPs. Their operations in New York are governed by the New York Not- for-Profit Law and regulations promulgated by the NYSAGO. For example, ultra vires transactions may result in a proceeding by the NYSAGO to dissolve the NFP. The NYSAGO could also seek to dissolve the entity when, among other things, (a) the entity fails to file the necessary annual reports; (b) the entity has exceeded its authority under law repeatedly; (c) the entity has conducted its business in an unlawful manner; (d) the entity has misused its powers and privileges; (e) the entity has violated its certificate of incorporation in its activities; (f) the entity is conducting its activities at a loss or prejudice to the interests of its creditors or members; or (g) the entity’s activities are causing great prejudice to the public. Of course, if there are allegations of skullduggery, the NYSAGO may bring actions against officers and directors of a NFP, as it did, for example, with Richard Grasso and the New York Stock Exchange.
Accordingly, NFP directors and executives are cautioned that the proper execution of their activities is essential to maintain the NFP’s integrity. The consequences of their actions may result in potential personal liability.
SOA Provisions Applicable to NFPs
Although the SOA seems to apply to the minutest application of corporate practice, its affect on NFPs is fairly limited. SOA Sections 802 and 1102 (imposing criminal penalties for the destruction of certain documents) and Section 1107 (imposing criminal penalties on anyone retaliating against whistleblowers) amend 18 U.S.C. §§§1512, 1513 and 1519. These provisions increase penalties for violations of Section 1107 (§1513) to ten years and Sections 802 and 1102 (§§1512 and 1519) to 20 years. Technically, these amendments alter current criminal statutes that affect public and private corporation, including NFPs. However, the vast majority of SOA provisions solely relate to corporations whose securities are registered pursuant to either the Securities Act of 1933 or the Securities Exchange Act or 1934. Thus, NFPs are not directly covered by SOA.
As discussed above, the SOA does not generally apply to NFPs. However, SOA is affecting NFPs because many accountants for NFPs are stressing the SOA’s merits and are pushing NFPs to comply even in the absence of any legal obligation. Further, the SOA offers critical and useful guidance for NFP management.
For example, a public company’s management is required to create a system of internal control, and disclose its effectiveness on every periodic report pursuant to SOA §302(a)(4)(B). See 15 U.S.C. §7241(a)(4)(b). This comprehensive system of internal controls was required because it was believed it would instill confidence in a company. Essentially, this system would provide comfort to potential lenders, investors and acquirers, as well as possibly prevent liability to passive equity holders, i.e., shareholders. Similarly, the SOA ushered in a new rigorous era, a regime that is stricter in its approach and application of accounting practices and auditing procedures. Financial statements issued in compliance with the SOA rules and regulations are now viewed more favorably by the marketplace.
Consequently, the SOA provisions have become the de facto standards or safe harbor provisions for private corporations as well. Many lenders are insisting upon internal controls and SOA-compliant financials as a condition of credit. If NFPs adopt these SOA practices and others, they may find it easier to obtain credit and attract donors and independent directors. Many disinterested directors will recognize the protections afforded to them if SOA procedures are in place, and may be more likely to accept the responsibilities of an NFP directorship.
The future of any NFP begins with installing a successful internal control and compliance program and instilling a culture of compliance. Altruism and best intentions of those involved in NFPs are simply not enough. Without strong NFP internal controls and compliance, NFP directors, officers and executives may find themselves subject to adverse actions brought by members or worse, by a state attorney general. The failure to implement effective corporate governance programs may even result in the dissolution of the NFP, and the loss of all its good work.
Accordingly, NFPs should seek legal counsel to advise them on these significant issues. Counsel may advise on, among other things, compliance with governance norms and the creation of appropriate corporate records to memorialize the NFP’s actions and assist the directors in satisfying their duty of care. Without such advice, NFPs may find the regulatory seas choppy and hazardous.
This Report’s final section emphasizes best practices an NFP Board may consider for adoption as policies and procedures. These best practices should be modified to fit the particular NFP and only undertaken after a careful review as discussed above. This list is not intended to be exhaustive.
An NFP Board should discuss and adopt bylaws to, among other things, avoid conflicts of interest, that is, NFP Board members should not vote on matters where they have a personal interest; be composed of an odd number of directors or, at least, have the number required by law in the state of its incorporation; oversee the mission and programs of the organization; meet quarterly at a minimum; and keep minutes of these meetings and maintain other business records.
An NFP must have policies addressing conflicts of interest among directors that include disclosure, recusal and memorialization in the written minutes of the Board meeting. Further, this policy should be contained in a written code of conduct applicable to all Board members.
An NFP should not have paid staff members and consultants serve as voting members of its Board, and should avoid transactions with directors or where directors could, directly or indirectly, benefit from the contract or transaction being contemplated by the NFP. Additionally, a majority of the Board should comprise independent directors, that is, directors who are not paid staff members, consultants and/or founders.
An NFP’s bylaws should contain provisions regarding the election of directors, notice of board meetings, number of consecutive board terms and other integral NFP corporate governance issues. The Board should also establish a nominating committee to identify and develop new and replacement directors, including a mechanism to recruit and mentor younger directors.
An NFP Board should establish a compensation committee composed of at least one independent member of the Board. This committee should analyze and review annually the performance of the NFP’s staff and executives and determine their compensation and benefits. An NFP should not provide loans or credit to any NFP officer, director, employee or donor, and should ensure that NFP funds are not commingled with those of NFP founders or others associated with the NFP.
An NFP Board should establish an audit committee, comprising independent directors, to review all NFP financial operations, as well as its interactions with accountants and auditors. Additionally, the Board should hire independent certified public accountants to prepare annual financial reports, but may use the services of in-house personnel to prepare monthly financial statements. This financial information should be presented to the NFP Board prior to every meeting so that Board members may review the data and discuss and/or raise questions concerning the information at the Board meeting.
An NFP should hold an annual meeting for its members with the date of the meeting announced in advance and held as scheduled. An NFP should create and maintain the minutes for all member meetings and adopt a conflict of interest policy for members.
If practical, an NFP should consider having legal counsel (outside or in house) in attendance at all Board meetings to advise the Board on all appropriate matters.
An NFP must retain all organizational and other key documents and maintain a written record-retention policy. An NFP should also annually review its records and procedures to ensure that its programs are in compliance with all applicable federal, state and local laws. An NFP should maintain accurate and complete financial records, including, among other things, copies of bank statements, records of donations received and expenditures, correspondence and complaints. Further, an NFP Board must promulgate procedures that will ensure donor funds are used for the intended purpose of the donor. Finally, an NFP must ensure that its solicitation, promotional and financial materials are truthful and accurate.
An NFP should establish, design and advance effective compliance programs, including state-of-the-art ethics and control programs, as well as global compliance programs, if applicable, and offer practical advice on internationalizing ethics and compliance programs.
An NFP should engage in a risk assessment to determine various risk factors facing it. Upon completion of the risk assessment, an NFP should implement reforms to address and manage the present risks and those likely to occur in the future.
An NFP should establish guidelines for handling internal and governmental investigations, including attorney-client and work-product privilege issues.
NYCLA TASK FORCE ON CORPORATE GOVERNANCE
Ernest E. Badway, Esq. Chair
Suzanne E. Auletta, Esq. Scott M. Berman, Esq. Paula A. Bosco, Esq.
David DeGregorio, Esq. Morton J. Goldfein, Esq. Hillary H. Hughes, Esq. Rhea Kemble Dignam, Esq. Matthew S. Levine, Esq.
Susan B. Lindenauer, Esq. Paul W. Mourning, Esq.
Lester Nelson, Esq.