By Stephanie Tsacoumis
Gibson, Dunn, and Crutcher LLP
Recent events involving the Smithsonian Institution testify to the continuing importance of governance practices at nonprofit organizations. In many ways, nonprofit governance is more complex than for-profit governance.
First, nonprofits have multiple constituencies: members, donors, those served by the organization, volunteers and others (such as state attorneys general).
Second, nonprofit boards must attend to business objectives as well as the organization’s mission and fundraising responsibilities.
Third, nonprofit organizations are diverse: labor unions, foundations, schools, social clubs, trade associations, sports leagues, religious, civic and health organizations, social service agencies, cultural and recreational institutions. Some are membership organizations; some are not. Some have large budgets and thousands of employees; some rely entirely on volunteers. Many employ a federated structure with a national organization and local affiliates.
While nonprofit governance reflects the great variety in nonprofits, some general themes have emerged.
- Fiduciary duties. Good governance is predicated upon the duties of care and loyalty. In the nonprofit context, a duty of obedience to pursue the organization’s mission is a component of the duty of care.
- Board role. The appropriate role of the board is one of oversight and policy direction rather than day-to-day management.
- Board size. Smaller boards generally are more effective; some experts advocate a maximum nonprofit board of 15 members. While some nonprofits prefer larger boards for fundraising or diversity purposes, large size can impair efficiency. The trend – as evidenced by recent developments at the American Red Cross, The Nature Conservancy and the United Way – is to reduce board size.
- Independence. Situations involving excessive compensation, corporate waste and “insider” transactions have placed a premium on independent boards. The Panel on the Nonprofit Sector – a coalition of nonprofit leaders convened with encouragement of the U.S. Senate Finance Committee to prepare recommendations to improve governance of nonprofits – recommends that nonprofit boards have at least one-third independent members.
- Conflicts of interest. Conflicts of interest should be disclosed and considered by disinterested directors against a rigorous standard. Consideration of interested party transactions should include comparable arms-length transactions and how the transaction furthers the organization’s mission and interests.
- Audit committee. Every nonprofit with significant financial resources or operations should establish an audit committee with independent, financially literate members; other nonprofits should seriously consider an audit committee. The California Nonprofit Integrity Act of 2004, specifically California Government Code, Section 12586(e)(2), mandates audit committees for large nonprofits, and other states have adopted or proposed similar requirements.
- Compensation committee. Excessive compensation for nonprofit executives can raise duty-of-care issues and jeopardize tax-exempt status. Executive compensation either should be approved by the full board or by an independent compensation committee. Compensation decisions should be informed by the example of compensation of similarly-situated executives and outside advice as appropriate.
- Whistleblower procedures. Many organizations have adopted whistleblower processes either as a Sarbanes-Oxley requirement, under the Federal Sentencing Guidelines or as good practice. Sarbanes-Oxley makes it a crime for any organization — nonprofit or for-profit — to retaliate against a whistleblower. Because whistleblower concerns may involve financial abuses or fraud, whistleblower processes often are overseen by the audit committee.
In the current environment, governance practices are just as important in nonprofit organizations as in the private sector. Nonprofit boards and management thus must be prepared to take a fresh look at their governance in light of current best practices.