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Sep 30, 2019

Charities Behaving Badly

Laura Solomon, JD, following up on her presentation from PICPA’s 2019 Not-for-Profit and Government Accounting Conference, discusses charities behaving badly. She highlights major changes to corporate governance over the past year, commonly neglected fiduciary duties, the risks facing charities with outdated governing documents, and much more. Solomon is the founder of Laura Solomon & Associates in Ardmore, Pa., a law firm devoted to representing charitable and other tax-exempt organizations and philanthropic individuals.

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By: Jim DeLuccia, PICPA Communications Manager


Podcast Transcript

Laura Solomon, Esq., has been a frequent speaker at PICPA conferences where she's discussed corporate governance of nonprofits. She spoke about charities behaving badly at PICPA's 2019 Not-for-Profit and Government Accounting Conference on July 22. And she joins me today for a recap of what she discussed, including fiduciary responsibilities and other critical legal factors associated with leading a nonprofit organization. Laura is the founder of Laura Solomon & Associates in Ardmore, Pa. It is a law firm devoted to representing charitable and other tax-exempt organizations and philanthropic individuals.

Laura, thanks for joining me on the phone today.

[Solomon] You're welcome, Jim. It's a pleasure.

As we look back here a little bit, at your presentation from July 2019, what's one major change you can highlight that has affected corporate governance of nonprofits over the last year or so?

[Solomon] I think the biggest change is really tax reform, Jim, believe it or not. The 2017 Tax Cuts and Jobs Act, which went into effect on Jan. 1 of 2018, had a number of provisions that affect charity directors and really forced them to focus in different ways on governance and on the mission. The act had, what I think of as two groups of changes that affected charities. One group affected charities directly. Some of them, a narrower group, for example, there's an excise tax now on certain university endowments. Or on larger organizations that pay key executives $1 million or more. There's also a change for charities that pay tax called unrelated business taxable income.

But perhaps even more importantly there is a series of changes that affect donors to charitable organizations and those changes really impact charities across the board. And interestingly, the data out of Giving USA came out recently and we can really see what happened in 2018 as a result of tax reform. And what we see is a jump in giving to donor advised funds, which are kind of opaque to development professionals. We see drops in individual giving, which is really serious.

On the flip side, we see a certain bump in giving from corporate foundations, which can be a good thing, but the kind of bunching of charitable contributions by individuals in particular, which is from the doubling of the standard deduction for individuals and couples who itemize. That's resulting in kind of an uneven giving pattern. Directors of charities need to be thinking about whether their development team understands this and is preparing for it, but even more particularly, they need to take it into account when they're budgeting and doing their financial planning. Because charities that maybe have had smooth funding from a certain mix of donors probably saw it in 2018 and will expect to see a more, I would say, kind of a wavy pattern of giving, a more unpredictable funding stream.

Tax reform really cast a wide net, didn't it?

[Solomon] It really did. And I think a lot of people are understandably focused on how it affects their own taxes of course, as we all should. But really directors and officers of charities need to think about it as well, even if they're not on the board of a university because every charity that gets contributed income, which is really like 99% of them, is going to be affected by this.

I see. Well what's one fiduciary duty commonly neglected by nonprofit organizations that you've seen?

[Solomon] So this is an easy one, at least to me, just because I go to so many board meetings and spend so much time talking to and advising charity directors and officers. And that is a subset of the duty of care. There are three fiduciary duties: care, loyalty and obedience. And the duty of care in essence says, you need to be reasonable and exercise the level of care that a reasonable person would in doing his or her job. So that all makes sense. But there's a kind of corollary to the duty of care called justifiable reliance. And that is the idea that directors and officers are entitled to rely in good faith on information, opinions, reports, statements, including financial statements and other data prepared or presented by other directors, officers, employees, lawyers, accountants, and even board committees. And boards often times forget this. They will solicit the legal advice or an opinion from a lawyer or get information from an appraiser on the fair market value of their building, but they forget to document it.

I think one of the most important bits of advice for our clients is to remind them that if they ask for advice, if they pay for advice, if they plan to rely on that advice when they are making a decision at a board meeting, that advice should be in writing and it should be made a part of the minutes of the meeting. So that if anyone ever questions later, why did the board sell the building for that price? Why did the board approve a business plan to begin a new activity that looks unrelated? The board can go back to its own minutes and with confidence say, we did our job. We exercised our duties of care, loyalty, and obedience. We solicited outside professional help, we relied on it. And here it is.

What are a few risks facing charities that have outdated or inconsistent governing documents?

[Solomon] I would say that there are three primary risks and the first is not a legal risk. But I think that if you have inconsistent or outdated governing documents, they could be an obstacle to your ability to raise funds. For example, if you put in a grant application to a reputable private foundation for environmental education, but your articles of incorporation limit your activities to land preservation, a good funder will review the grant application, will review your underlying organizational documents and have a big question mark. At worst, they're going to reject the grant, right? Because it appears to be outside of your purposes. And even at best, even if they give you the grant, they may come away with an impression that you don't know your own legal documents, you don't know your own purposes and you're really not a well-run organization. I think that's a problem.

Turning to potential legal repercussions, I would say that in the event of a claim or litigation involving a breach of fiduciary duties, the board's failure to comply with its own documents creates exposure. There's no question. For example, if you discover that a key employee of the organization was embezzling and your bylaws require a finance and audit committee to monitor among other things, internal controls. But the board actually never appointed people to that committee and therefore it's not functioning, in that situation when the attorney general comes in to review what happened and they will, along with law enforcement. And they particularly take a look at the fiduciary duties of the board, which they also will, the AG's office could conclude that the board breached his duties. It violated its own bylaws. It failed to populate a board committee whose expressed responsibility was internal controls and oversight, thereby creating an environment where this could happen.

If you want to adopt policies, that's fine, but make sure you follow them. Similarly, you want to make sure that you're following your own articles of incorporation and bylaws. And even stepping back from those two examples, I would say that in general, outdated and inconsistent governing documents suggest a board that is not really paying attention to the details and fully engaged and therefore a noncompliant organization. They're not the cause of problems necessarily, but they're typically symptomatic of bigger issues. And I think ones that should be addressed, if you really want to maintain a culture of compliance with an engaged board doing their jobs.

Can you share a real-world example of a charity behaving badly?

[Solomon] Oh yes. That's an easy one, Jim.

I'm sure.

[Solomon] I mean, first of all, we could open up the newspaper this morning and probably find one, but here I want to talk about one that got a lot of press recently, which is the Varsity Blues scandal.

If you recall, that was a huge scandal, primarily focused in California in which Hollywood A-listers paid an unscrupulous consultant named Rick Singer to help, and I'll put help in quotes, get their kids into college by, among other things, falsifying SAT and ACT results and bribing college officials. Rick Singer had, and some people don't know this, a related charitable organization called Key Worldwide Foundation and that foundation was actually critical to this whole scam. The foundation, interestingly, if you go on GuideStar, lists its mission as and I can't believe this, providing educational access to underprivileged students. Which of course makes you wonder how they define underprivileged.

Really?

[Solomon] But in all seriousness, the foundation was used as really a conduit. It was misused for the entire scheme. What happened was parents of famous people, or I'm sorry, parents of children who are famous, right? They're trying to get their kids into college, made questionable gifts to the foundation, got a tax deduction for their gifts, and then the foundation used that money to make "bribes or grants" to bribe college officials under the guise of getting their kids onto the lacrosse team or the crew team. The foundation had a board which included Rick Singer. And I would say that clearly this board breached their fiduciary duties. They were on the board. I'm not sure how involved they were or not, but this organization clearly engaged in tax fraud, right? By accepting these contributions, by using them for legal purposes.

And even if you were to say that the directors and officers, I don't know, maybe didn't know about it, didn't come to meetings. Well that in and of itself is a breach of fiduciary duties, right? Because if you are on a board, you need to be engaged and you need to be exercising that oversight. The focus of the news reports and I think the prosecutions to date have been on Rick Singer, but I think we can expect and anticipate that the IRS and possibly the Attorney General in California will be going after the other directors who sat or sit on the board of that foundation as well.

Yeah, I had a feeling that question was going to be a layup for you. Right, there's always so much going on in this area.

[Solomon] I know, I know. Really. And I get calls from reporters on certainly a weekly basis if not more often asking questions about cases like this.

Well to that extent, what should CPAs with nonprofit clients or maybe CPAs working for nonprofits know about liability exposure?

[Solomon] Two key things, Jim. Number one, they should know and their clients should know that there is protection from exposure, primarily statutory protection that is built in to both the state nonprofit corporation laws for directors and officers of nonprofit corporations. And also at the federal level, the Volunteer Protection Act. And these laws are meant to, first of all, encourage good people to sit on nonprofit boards. And they do that by shielding volunteer directors and officers from liability. If those people are, number one volunteers and number two, they're doing their job. They're not in breach of their fiduciary duties, they're not engaged in self-dealing and they're not willfully engaged in misconduct or recklessness. We have all of these levels of statutory protections which are kind of vestiges of charitable immunity, which used to apply fully to charities but no longer does. We have all these protections built in to encourage people to serve on boards, right? We want people sitting in board meetings to be focused on the business at hand and focused on governing and not in the back of their minds distracted or worried about liability.

That said, even with those protections, liability exposure exists and it is not possible to make it go away entirely. Obviously as I said, if a director officer was engaged in self-dealing, willful misconduct or recklessness, they would face liability. Even if, I would point out, they have insurance and the best indemnification provision in the bylaws. Directors and officers bear exposure for any criminal liability as they should. Tax liability for certain taxes known as trust fund taxes. For example, withholding on behalf of employees. And harm resulting from situations where they breached their fiduciary duties.

And there was an interesting case called Lemington Home for the Aged, a number of years ago. It was in bankruptcy court, so it was at the Federal level and it involved a nursing home in Pittsburgh that went bankrupt. And in that situation the creditors sued the directors and officers personally alleging that they were personally liable. In that situation, they had good counsel and they referred to these statutory protections and the lawyer said, no, no, no. Our clients should not be held liable because they have immunity under state law and they have immunity under federal law. And interestingly on appeal, the court found that the directors and officers were liable and that was because they were negligent. They were not paying attention to what was going on at the home to such an egregious extent that people died. And the home really should have been wound up and closed earlier.

The big picture is this. In general, you're shielded from liability as you should. We want to encourage good, nice people to sit on boards, but if you misbehave there is liability and there is always a carve out from statutory protections, indemnification and insurance for criminal liability, tax liability and situations where you breach your obligations.

Wow, that certainly sounds really critical. I mentioned earlier that you obviously spoke at our 2019 Not-for-Profit Government Accounting Conference. What was some of the feedback you got from that session there? Can you share a little bit of that with us?

[Solomon] Yeah, absolutely. It was really interesting. It was loud and consistent. Many people come up to me after the event and some people connected via LinkedIn or even called or emailed to say that they wished all of their clients had had a training like that. Because they understand, and I do too, and I believe this deeply, that educated boards are better, more engaged boards. It is for that reason that I typically do these trainings for all of our clients. And of course I'd be happy to do it for other organizations that want to create a culture of educated, engaged fiduciaries. I think that as professionals, sometimes we overestimate the knowledge and skills of our clients’ boards and candidly sometimes the people sitting on those boards do the same thing. In other words, the people in the room assume, oh I've, you know, been sitting on various boards and serving nonprofits for decades.

And while that is commendable and of course is true in so many cases, it doesn't mean that people know about recent developments, whether it's the Key Worldwide Foundation or Lemington Home for the Aged. They may not have a sense of the sort of changed environment like tax reform, and they may not have a consistent understanding across the board of what fiduciary duties mean. Right? If you have a room of 10 people, I think you can bet that there is not a common understanding among those 10 people. By doing a training like this and talking about fiduciary duties, you are both educating everyone, you're putting them on an even playing field, and you are preparing them not only for day to day governance, but you're also preparing them to address more difficult situations like when a conflict arises or a crisis hits or a difficult decision needs to be made with respect to the organization. That was really the reaction. Wow, it was great and I wish all of our clients could have this.

Great, well Laura, thanks so much again for sharing this insight with our listeners today. I really appreciate it.

[Solomon] It's my pleasure, Jim. I love working with the PICPA. It was a pleasure to present and I look forward to working collaboratively with you all going forward for the good of our clients.

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Podcast transcripts are provided as a summary of the conversation and have been lightly edited for the written medium. The transcript is not a verbatim representation of the interview.
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