A Cautionary Tale for Nonprofit Boards

Last year, the attorney general of New Jersey sued the Stevens Institute of Technology, in New Jersey, accusing it of financial mismanagement, excessive spending on the personal needs of executives, misuse of charitable funds, and breach of fiduciary duty. The action followed a three-year investigation by the attorney general’s office into the university’s financial practices. The kind of trouble the institution got into could face any nonprofit organization unless its board and top leaders are acting effectively, and the lessons of this case should remind all nonprofits to tighten their governance operations.

At Stevens, the attorney general alleged that the salary and benefits paid to the university’s president were excessive and that he received low-interest loans as well as other benefits that were overly generous for a nonprofit institution.

According to the state officials, the university’s president, along with a board member, effectively kept the full board in the dark about their “spending and borrowing practices and financial mismanagement.”

One committee of the board allegedly “buried” an independent consultant’s analysis concluding that the president’s compensation was excessive, and another board committee failed to adequately disclose warning letters from the institution’s original independent auditors. According to the attorney general, the original auditors “fired” the institute as a client due to the high risk the school posed to the accounting company. The college’s new accountants also repeatedly warned about weak internal controls.

A few months after the lawsuit was filed, Stevens agreed to make sweeping changes to its governance approach as part of a deal to end the dispute. It also announced that its president was stepping down. Stevens did not admit to any liability or unlawful conduct as part of the agreement, but it did agree to extensive changes in its governance arrangements.

Those changes deal with the organization of the board and administration of the institution, compensation of top college officials, and the power and duties of the board and all of the major board committees. Under the agreement, some board committees would be required to hire independent consultants, and Stevens must hire a lawyer to work on its staff. Stevens also agreed to retain the services of a former New Jersey Supreme Court judge for at least 24 months as special counsel to monitor and report to the board on the institute’s compliance with the terms agreed to in the settlement deal.

While the particular facts of the Stevens case may be unusual, the trap that apparently caught its board members and the administration is not.

By their very nature, the governing structure of large nonprofits makes them susceptible to the type of abuse and neglect alleged in the Stevens case. Most big nonprofits have very large boards that meet, at most, three times a year for two or three hours. There is always a tension between what should be brought before the full board and what should be handled by the organization’s leaders.

In fact, board agendas are normally very carefully scripted by the administration and the board chair. The tight agendas and somewhat formal proceedings do not normally encourage questions or scrutiny. This can often lead to a benign conspiracy of sorts in which top administration officials and a few key board members are the only ones with access to all of the information. These individuals try to deliver the important information to the full board in a concise format. Most of the time, these efforts are done in good faith and produce positive results. However, this type of insular process can also evolve into a “we know what’s best” attitude that can lead to decisions that have been unduly influenced by personal relationships and other inappropriate factors.

All board members have a fiduciary duty to the institution that they cannot uphold by a mere passive acceptance of what is presented to them. The challenge, from a nonprofit leader’s perspective, is to present the important issues when so much information must be conveyed in such a short time.

It helps to take a step back and look at the big picture. While much of what goes on in board meetings is important in terms of the direction of the institution, certain issues deserve particular attention due to their sensitive nature. To see what the Internal Revenue Service thinks is important, one need look no further than the newly designed informational tax return nonprofits must file with the IRS. The document, known as the Form 990, includes questions on governance, conflicts of interest, and whistle-blower policies. Following are a few key issues:

• Approved by the board or a committee that was free from any conflict of interest.
• Based on appropriate comparable data (such as a survey of colleges or health charities or museums of the same general size and mission).
• Documented in writing.

As the New Jersey attorney general made clear, the fact that the compensation of the Stevens president was only slightly higher than that of the president of the Massachusetts Institute of Technology is not helpful when MIT’s operating expenses were approximately $2.3-billion and Stevens’s was $158-million.

Compensation surveys, broken down by size, enrollment, and other factors, are becoming increasingly available.

Board members should know the details of compensation packages of the executives and how that compensation was determined. If the compensation is approved by a committee, IRS rules entitle each board member to ask for a copy of the comparable data and the other documentation used to determine whether pay was fair. If something does not look right, it may not be right. In the Stevens case, a compensation expert had raised questions about the president’s compensation, but the expert’s report never was shown to most of the board—at least not until the attorney general became involved.

Conflicts of interest. Conflict issues are difficult for several reasons. First, it is not always clear whether a conflict exists. An obvious example is a transaction between a board member and the institution. But what about a transaction between a business associate of the board member and the institution? Is that a conflict, or should it be treated as one? The question comes down to whether a nonprofit’s leaders would feel constrained in evaluating or dealing with the business associate knowing his or her relationship with the board member.

If there is a conflict, most state nonprofit laws (and most conflict policies) do not prohibit the transaction so long as the terms were fair and it has been voted on by trustees who don’t have any conflicts of interests. However, no matter how much diligence and vetting are done, if a problem occurs with a transaction that is tainted by a conflict of interest, it will look much worse than the same transaction that has no conflicts. There is simply no way to avoid doubts and second-guessing if a problem later arises. That is why some institutions simply prohibit any transaction with people or companies that have conflicts. Ultimately, resolving conflicts comes down to questions of disclosure, appearance, and judgment.

How does the institution find out about conflicts in the first place? The starting point is a comprehensive conflict-of-interest policy outlining which senior executives, trustees, and others are responsible for determining what is a conflict or potential conflict. Whether an institution has such a policy is just one of the questions the IRS asks in its new Form 990.

Board committees. Many boards do much of their work through a variety of committees such as an executive committee, a compensation committee, or an audit committee. While a healthy committee system can provide an efficient way for all of the board members to participate in some aspect of the operations, it is subject to abuse, especially when one committee dominates or when the committee chairs are part of an insular group. An executive committee is especially susceptible to this type of arrangement and in some cases acts as a mini-board with little or no accountability to the full board.

This may have been at issue in the Stevens case because one of the requirements of the agreement with the attorney general was that the executive committee serve only as an advisory group with no power or authority to act or approve on behalf of the full board.

As a general matter, the executive committee should only act in between board meetings or for other matters of emergency. The committee should not act as a substitute for the full board. As to the other committees, it is important to have a diversity of members in the leadership positions of those committees so that all of the power is not concentrated in a few individuals.

Most board members are used to having leadership positions, and they are good at it—it is an ideal way to get valuable board members involved in a meaningful way with the institution.

Scrutiny of nonprofits by the IRS, attorneys general, donors, and other constituents is likely to continue. Putting thoughtful procedures and policies in place, and applying them in a common-sense manner, can go a long way to attracting talented board members and protecting the legacy of a nonprofit institution.