Nonprofit organizations and their boards need to consider the ramifications of the current economic climate and the potential for increased government oversight.

The following outlines perspectives on how the governance of nonprofit corporations may be affected by the evolving economic conditions, and related regulatory responses.

Premium on Business Judgment

Although not a principal contributor to the current crisis, nonprofit corporations—and their governance—are unlikely to escape collateral damage from what appears to be an emerging climate of “finger pointing,” in which attempts to assess blame, and to attribute responsibility to the board, will be the order of the day. In this climate, charity regulators may be increasingly compelled to hold nonprofit boards more directly accountable than before for “preventable” harm/loss to charitable assets. This will place a premium on the exercise, and documentation, of business judgment by the board.

Executive Compensation

Adoption of the Emergency Economic Stabilization Act of 2008 (EESA) has opened “Pandora’s box” of executive compensation issues, all of which are likely to have a spillover effect on the nonprofit sector. The EESA has introduced into mainstream discourse such previously “taboo” subjects as: (a) ceilings on total compensation; (b) “clawbacks” on incentive compensation based on metrics later proven to have been merely inaccurate (an expansion of Sarbanes-Oxley principles); (c) restrictions on “golden parachutes” and other severance or retirement benefits perceived as excessive; and (d) limitations on compensation incentives tied to “unnecessary and excessive risks” that threaten the value of the organization. The nonprofit executive compensation committee will want to consider the policy implications of these provisions, together with other similar developments (e.g., the Care First, Grasso decisions).

Investment Management

Experience suggests that any downturn in the securities markets will prompt focus on investment practices by individual nonprofit organizations that result in investment losses, causing economic harm to the investing entity and, where applicable, to the operating charity that is to be supported. Extraordinary losses attributed in large part to investment strategies subsequently perceived as imprudent may be subject to scrutiny by state charity officials, notwithstanding the protections afforded by liberal state investment management laws (e.g., UPMIFA – the Uniform Prudent Management of Institutional Funds Act). The current volatility in the securities markets mandates greater attentiveness on the part of investment committees and governing boards of nonprofit organizations with respect to their fiduciary duty to invest prudently. Moreover, it will become increasingly important for investment decision makers to properly memorialize the processes and considerations by which investments decisions are made.

Tax Exemption Pressures

The likelihood of an increased individual income tax burden to finance the recent extraordinary government “bailout” measures may place additional pressures on nonprofit organizations to justify their tax exempt status. This comes as many in both the public and private sectors have begun questioning whether the public benefits that tax exempt organizations are providing are commensurate with such organizations’ resources and the tax subsidies they receive. This questioning is also consistent with an environment which is less willing than before to extend nonprofits the benefit of the doubt. Nonprofit boards must be sensitive to growing skepticism regarding whether they “deserve” tax exemption.

Governance Practices

Boards should expect additional scrutiny on the extent to which they have adopted the latest round of governance best practices (e.g., Panel on the Nonprofit Sector, Internal Revenue Service, Smithsonian). The current economic climate appears to be prompting a broad repudiation of the concept of self-regulation. This climate is being compounded by a perception that Sarbanes-Oxley may not have been the “magic elixir” of corporate responsibility it was intended to be. Practices relating to director qualifications and length of tenure (e.g., excessive), and frequency of board/committee meetings (e.g., too infrequent), may be areas of particular focus. Given this, more action may be expected from nonprofit boards in terms of governance oversight and controls.

Conclusion

A likely byproduct of this emerging climate of accountability is the avoidance of risk by the board; e.g., the perception that aggressive risk taking is primarily responsible for current conditions. Yet, fiduciary principles promote the taking of informed risk by the nonprofit corporation. The challenge going forward is how to balance liability avoidance in an unforgiving environment with assuming prudent risks on behalf of the charitable mission.