A Plea for Transparency: An Excerpt From a New Book on Philanthropy

In his new book, The Foundation: A Great American Secret — How Private Wealth Is Changing the World, Joel L. Fleishman, a professor at Duke University, offers ideas on how to make grant makers more accountable. Following is an excerpt from the book, which will be released next month by PublicAffairs:

Foundations have an overriding obligation to the public to perform their duties according to the highest standards of stewardship. That obligation arises from the tax deductibility of gifts to create foundations and the tax-exempt status granted to foundation assets and income once they are established. As a result of these benefits, United States taxpayers annually benefit United States foundations with foregone taxes in excess of $20-billion. For that reason alone, foundations must somehow be made accountable, preferably by means of voluntary action, but, failing that, through legally mandated regulation or through voluntary action.

Most foundations continue to do an excellent job of creating effective programs that benefit the general public and help to improve society. What they have not done is to create a climate of transparency, the lack of which both causes foundations to underperform their potential and creates growing public distrust. It would hardly be surprising if members of the public, whose attention to foundations has now been dramatically drawn by Warren Buffett’s $31-billion gift to the Gates Foundation, find it increasingly incongruous for foundations to operate at that scale while doing so in a secretive manner. So the foundation practices that concern me most include:

• The unwillingness of foundations to provide sufficiently detailed documentation about all their initiatives to permit unbiased outside appraisal.
• The failure of foundations to disclose, analyze, and call attention to their failed initiatives.
• The failure of foundations to communicate openly with grant seekers and the public about how foundation decisions are made.
• The infrequency of rigorous evaluation by foundations of their own grant-making initiatives and their unwillingness to make such evaluations available to the public.
• The infrequency of rigorous strategic planning analyses when foundations consider new programs, as well as their unavailability to the public.
• The general “fuzziness” and “mushiness” of many foundation initiatives that result from a failure to analyze them carefully in advance and to assess them after implementation.

Imperfections such as these inevitably lead the public to regard foundations as uninterested in what the public thinks about them, as nonresponsive at best, and as willfully arrogant at worst. And whether or not that judgment is fair, such practices are decidedly detrimental to the foundations themselves.

Scholars and skilled practitioners of organizational behavior know that organizations that are continuously subject to scrutiny, challenge, criticism, and competition from informed outsiders tend to make wiser, more effective decisions, while organizations that operate in a vacuum frequently commit serious blunders and waste resources unwisely. The only solution is to introduce a greater degree of transparency and accountability into the foundation world. But how can this be done without unduly limiting the freedom of foundation managers to pursue their objectives as they see fit?

Let’s consider some alternative possibilities.

American foundations are wealthier and more numerous than those in any other country, which makes our foundation sector unique. Nonetheless, it’s useful to mention some of the ways in which other nations have sought to assure foundation accountability to the public.

In most other countries, government regulation of the nonprofit sector is significantly stricter than in the United States.

In Germany and Japan, for example, government agencies painstakingly review every application to create a foundation, and exercise what Americans would regard as heavy-handed regulatory supervision. Under French law, every foundation is required to have a board member or director appointed by the government.

In the United Kingdom, a Charities Commission monitors and supervises all nonprofit organizations, including foundations. And the press has been full of news in 2006 about the Russian government’s placing restrictions on the creation and functioning of all nonprofits.

I am not at all suggesting that any of those approaches would be appropriate for the United States, and, indeed, I would oppose their adoption.

But I must note that in the United States, by contrast with all of the above countries and many others, the creation of a nonprofit organization, including a foundation, merely requires the filing of incorporation papers with a state’s secretary of state or the writing of a charitable trust agreement by a lawyer. Internal Revenue Service approval of the organization’s tax exemption as a 501(c)(3) is virtually automatic, valid for five years, and subject to little in-depth substantive review.

After creation and IRS tax exemption, foundations are required to file an annual 990-PF form report with the IRS (analogous to the form 990 required to be filed by other charities), but the reports are usually never read. The IRS admits that it lacks the personnel required to review such annual filings, to audit even 1 percent of them on an annual basis, or otherwise provide any serious oversight to civic-sector organizations.

The oversight provided by state charity regulators is no more effective or comprehensive. While some state attorneys general, especially those in New York, Massachusetts, and California, pay close attention to detecting serious legal infractions and ethical misbehavior by foundations and their trustees, most others do not. According to a recent count, there were fewer than 100 full-time charity supervisory officials among the 50 state governments.

Most observers agree that the present system of nonprofit oversight aimed at willful misbehavior is inadequate. But what kind of reform should be implemented?

Some have suggested that all that is required is making additional financial resources available to the IRS to beef up its Exempt Organization Division, and that certainly should be done.

I doubt, however, that such a step alone would make the difference between today’s inadequate governmental oversight and what is required for everyone to have confidence in its future effectiveness.

From the IRS’s point of view, nonprofits are not “where the money is.”

The fines for willful, illegal misconduct likely to be recoverable from foundations, other nonprofits, or their officers as a result of IRS supervision will always represent a mere drop in the bucket compared with the financial return from enhanced oversight of individual and corporate taxpayer returns, which amounts to hundreds of millions of dollars annually. The IRS, therefore, has less incentive to focus its attention on the nonprofit sector.

Moreover, aside from that lack of financial incentive for the IRS to focus adequate attention on charities, including foundations, the bureaucracy of the IRS makes it unlikely that it could ever become the means of effective accountability for the nonprofit sector.

For example, the decades-long effort to reform the 990 and 990-PF forms so that they are both filer-friendly and comprehensible to members of the public who seek to read them must discourage anyone who is tempted to believe that the IRS could possibly be the right place for nonprofit oversight.

And the IRS’s culture, heavily oriented toward the privacy of individual and corporate tax information, discourages it from facilitating the transparency obligations of nonprofit organizations and deters it from exchanging information on nonprofit misdeeds with state regulatory authorities.

To create an effective oversight system for all civic-sector organizations, including foundations, one in which the public can be confident that willful misconduct is detected, deterred, and punished, I am persuaded that we must either place some government agency other than the IRS in charge or invent a new arrangement whereby the IRS’s role in the oversight process is significantly transformed.

Of all the oversight possibilities that have been suggested for dealing with willful misconduct by nonprofits, including foundations, the one proposed by Marc Owens, former director of the IRS Exempt Organization Division, is the only one that promises to be effective and also unlikely to infringe on the indispensable freedom of nonprofits.

Owens concludes that the IRS is not the best home for charities’ supervision as currently structured, and calls for the creation of a new Congressionally chartered, private, not-for-profit organization that would be related to but independent of the IRS to discharge that function.

Owens’s suggested new agency would be modeled on the National Association of Securities Dealers, which regulates brokers and brokerage firms.

Like its sister organizations, the Municipal Securities Rulemaking Board and the Public Company Accounting Oversight Board, the NASD assists the Securities and Exchange Commission in carrying out its responsibilities.

As Owens notes, “All three entities share the common characteristics that they are not structurally part of the federal government, yet all exercise oversight authority by virtue of their relationship with the SEC, including the ability to sanction those who transgress their rules, including the levying of fines.”

Owens urges creating an NASD-like agency for tax-exempt organization oversight that would be related to but independent of the IRS in much the same way that the NASD is related to the SEC, and would be financed by allowing foundations to obtain a tax credit against their federal foundation tax obligations for payments to support the agency’s operations.

I believe that Owens’s analogy to the NASD is exactly right.

The financing scheme he proposes is ingenious in that it both essentially costs foundations nothing and also succeeds in refocusing on nonprofit-sector oversight at least some of the revenues yielded by the foundation tax, which was the original rationale given for its imposition in 1969. In fact, that tax has yielded anywhere between $300-million and $700-million, depending on the year — only about $50-million of which has ended up in the IRS Exempt Organization budget.

My strong recommendation, therefore, is that the first important action to increase foundation accountability be the establishment by Congress of such an NASD-like private, nonprofit organization related to the IRS in much the same way that the NASD is related to the SEC, with sufficient resources, personnel, and investigative powers to oversee the entire U.S. civic sector, including foundations.

The new entity’s powers should be carefully circumscribed to prevent it from intruding on substantive foundation and nonprofit decision making, and to limit it to the enforcement of laws and regulations specifically targeting such matters as nonprofit fidelity to conflict-of-interest, insider self-benefit, transparency, and comparable procedural standards enforced by law.

How best can foundations create a climate of transparency? The answer to that question seems obvious — by taking action themselves. That would be a far more satisfactory solution than to have transparency forced upon them by government action.

Would they be willing to do so? So far, they have not manifested much enthusiasm for any collective, energetic effort to that end, but perhaps the greater public attention to the existence of foundations and the rapid growth in their assets attracted by the 2006 Warren Buffett gift, coupled with the recent increased level of criticism by public officials and the press, will build up some momentum for doing so.

I therefore urge foundations themselves to create a transparency-enforcing mechanism that could be implemented in short order by a foundation-sector infrastructure organization.

For example, a group of foundations could develop and promulgate such a “transparency and accountability code” on their own or under the auspices of the Council on Foundations.

Another scenario would have the Council on Foundations itself promulgate such a code and make it binding on all its members.

Whether or not the council can muster the courage to make this its own initiative, if the founding group of code members were sufficiently prominent and persistent, it could attract many others to join their number voluntarily.

As a marketing device, they could develop a “Seal of Public Accountability,” which any self-respecting foundation would want to display on its publications and Web sites.

The next step might be the creation of a foundation-supported transparency-enforcement board to which persons denied information could appeal for redress. This board would work with foundations in developing standard criteria for disclosure and agreed-upon procedures for appeal.

The third piece in this self-regulatory system would be a requirement that every foundation above a stipulated size employ an ombudsman charged with fairly and independently receiving, evaluating, and acting on complaints about foundation failure to disclose requested documents. If the existence of the ombudsman’s office were widely publicized, it could go a long way toward remedying the general perception that foundations are arrogant and indifferent to outsider complaints.

A fourth element would be a foundation-sector-initiated and -financed system that would publicly rate foundations on the extent to which they fulfill obligations of transparency.

Let’s call this the Foundation Transparency Rating Board. I am convinced that enough foundations are sufficiently concerned today about the risk of doing nothing that they would provide the financial and moral support for such an effort.

Coupled with such self-regulation, the foundation sector must support its own infrastructure. I cannot state the urgency of this issue too strongly.

For American foundations to continue to be the important influences on American society that they have been in the past, and to remain free from and unfettered by government, many more foundations must recognize that their own individual interests are increasingly at stake in the battles in behalf of foundations — in the public mind and in the arenas of public policy making — that are being waged by all components of the foundation community infrastructure, and they must back up that responsibility with cash support.

That means support for the strengthening organizations actively representing the interests of the foundation sector; support for other organizations that help foundations perform their responsibilities more effectively and efficiently; support for organizations that assess foundation performance and that provide information to the public about what foundations do and how they do it; support for universities and think tanks that conduct research on the functioning of foundations and for the scholars who do such research; and support for the development of new forms of executive education and development for foundation program officers and trustees, as well as for those contemplating the establishment of foundations.

After nearly a century of complaints about the lack of foundation transparency, anyone would be justified in being skeptical about the likelihood that the problem will be solved by foundation voluntary action alone. If, therefore, foundations do not grasp the nettle themselves, we should consider enacting legal requirements to create a culture of transparency among foundations.

It may well be that federal legislation to mandate foundation transparency will prove to be necessary to create the level of openness that the public rightly demands. It may well be, too, that only mandated disclosure can succeed in arming outsiders with sufficient information about foundation decision making to create the external accountability forces needed to drive foundations to higher levels of effectiveness and efficiency.

If we reach the point that government action is necessary, I suggest considering the enactment of a Foundation Freedom of Information Act, which would require foundations to make public all decision-process documents involving grant-making initiatives above a specified dollar limit. It could include such documents as I specified above in this chapter.

The freedom-of-information paradigm that permits outsider access to internal government documents seems easily applicable to foundation documents.

Many government agencies that award grants to individuals and institutions are required to make available certain decision-chain documents to anyone requesting them, with some statutory and regulatory exceptions.

The governmental nexus for such a federal requirement is certainly provided by the tax benefits conferred on foundations by federal tax policy. I see no reason that the same requirement would necessarily hamstring foundation decision making.

If it becomes clear that only government action will bring about transparency, my recommendation is that any foundation documents used in formulating, implementing, evaluating, and assessing grant-making strategies, grant clusters, or individual grants in excess of $1-million should be available to any individual requesting them from the foundation.

As with the federal FOI law, specified types of information — including personnel data, protected intellectual property, and national security data — would not be subject to disclosure. If a foundation were to fail to provide the requested documents within a reasonable period of time, the person requesting the information could bring an FOIA disclosure action in the federal courts.

Regulatory changes requiring greater public availability of internal foundation decision documents would help in informing and activating external critics, as well as provide much more information to scholars and practitioners.

While other legislation may well be needed to hold foundations to higher standards with regard to various process issues — such as insider self-benefit, required payout, salary levels, or travel expenses — I can imagine no way for legislation directly to deal in a productive and non-damaging way with the core issue of foundation program decisions, and would oppose any position regulating them.

— Reprinted with permission of PublicAffairs, a member of the Perseus Book Group © 2006.