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Giving in LA Giving in L.A. is a go-to source, an aggregator for strategies and points of view about trends and issues in giving, challenges for philanthropists and philanthropic organizations, tools and techniques for individuals or families, insights and opinions from experts, and more – all centered on Los Angeles County.

April 27, 2015 ~ 0 Comments

Nonprofit Governance: Directors Held Personally Liable for Mismanagement

Gavel-squareBy Ofer Lion, Douglas M. Mancino and Christian G. Canas

A recent court ruling highlights the need for robust governance practices for nonprofits. The Third Circuit Court of Appeals affirmed an award of $2.25 million in compensatory damages against former directors and officers of a bankrupt nonprofit corporation – personal liability for breach of fiduciary duties and “deepening insolvency.”[1]  The case indicates that nonprofit directors may not be able to rely on the “business judgment rule” if they fail to comply with the corporation’s bylaws and exercise reasonable diligence (including by showing up for board meetings) or to act once they are aware of mismanagement by the nonprofit’s officers or employees.

The Case: Lemington Home for the Aged

The Lemington Home for the Aged was a Pennsylvania nonprofit that operated a nursing home dedicated to the care of African-American seniors.  Its decades-long financial difficulties became particularly acute during the early 2000s, under the management of its directors and two officers: the chief executive officer and “Administrator” and the chief financial officer.

The directors allowed the Administrator to run Lemington for six years in the face of abnormally high deficiency findings and independent reports documenting her shortcomings and recommending that she be replaced.  Even after she ceased working at Lemington full-time, the directors allowed her to continue in her role (in violation of state law) and collect her full salary.  In addition, they relied on the advice of the CFO, even after discovering that he was not maintaining Lemington’s financial records and had failed to bill Medicare for at least $500,000.

The board was also in disarray.  Minutes of board meetings, including those involving compensation decisions, were incomplete or non-existent.  Board attendance was often below fifty percent, and at least one director failed to participate in a single meeting over several years.  Although Lemington’s bylaws required a finance committee with a treasurer as chairperson, this committee was not established, and the position of treasurer remained unfilled.

Duty of Care and the Business Judgment Rule

The standard of conduct for directors of nonprofits generally requires that a director perform the duties of a director in good faith, in the best interests of the corporation and with such care as an ordinarily prudent person would use under similar circumstances.

The “business judgment rule” insulates directors from judicial intervention and liability, in the absence of fraud or self-dealing, if the directors exercise reasonable diligence in reaching decisions and honestly and rationally believe that their decisions are in the best interests of the corporation.  Thus, its successful use depends on whether the directors’ reliance upon the information provided by one or more officers (or others) is in good faith and on whether there is a reasonable basis for relying upon such officers.

The court in Lemington Home for the Aged held that the evidence supported a finding that the directors breached their duty of care by failing to take action to remove the officers once the results of their mismanagement became apparent.  In other words, the directors did not exercise reasonable prudence and care in continuing to employ the two officers.  Furthermore, the board’s failure to follow its own bylaws and continued reliance on the information provided by the two officers, in the face of numerous red flags, supported a conclusion that the directors did not exercise reasonable diligence.  As a result, the court found that the business judgment rule should not shield the directors from liability.

Responsible Governance

The board of directors is ultimately responsible for management of a nonprofit.  The following recommendations are examples of strong governance practices that seek to ensure that the board’s duty of care is fulfilled.

  1. Bylaws.  To ensure that directors can fulfill their duty of care and thereby reduce their risk of personal liability, a board’s practices should remain consistent with the nonprofit’s bylaws (e.g., establish all required committees, ensure that the number of directors in office accords with the number or range called for in the bylaws, etc.), which should be reviewed regularly and amended when necessary.
  2. Term Limits and Turnover.  Short term lengths and limits on the number of consecutive terms a director may serve (as opposed to total number of terms) can help prevent board stagnation while reducing the artificial loss of qualified and experienced board members. In addition, staggered terms may ensure that experienced directors’ terms do not expire at the same time.  Vacancies in either director or officer positions should be filled as soon as possible, and directors who consistently fail to attend meetings should be reevaluated and replaced if necessary.
  3. Meetings and Minutes.  Board and committee meetings should be carefully planned and facilitated to foster full attendance, participation and thoughtful decision-making in the best interests of the nonprofit.  Minutes of all meetings should be taken and retained with the corporation’s records. Aside from being required by law, they may also provide evidence that directors faithfully discharged their various fiduciary duties. Minutes should include the names of all attendees, what votes were taken and how each director voted, including any objections or abstentions.  When the board or a committee acts on any matters for which there are specialized voting rules, such as where there is or may be a conflict of interest or in setting executive compensation, the minutes should note how those rules were met.  In many cases, information or documents the directors relied on when making their decision should also be appended to the minutes.
  4. Officer Evaluations.  Officers serve at the pleasure and under the supervision of the board, and their evaluations should be a significant component of a board’s responsibilities.  Evaluations are critical to ensuring officers are meeting the board’s expectations and fulfilling the duties delegated to them by the board in managing the nonprofit’s operations and finances.  If the board becomes aware that an officer is not fulfilling his or her duties, immediate corrective action may be in the best interests of the nonprofit.
  5. Director Compensation.  Board and committee members are expected to keep informed with respect to organizational, industry and regulatory developments, be prepared in advance of meetings and contribute their expertise and judgment in advising management.  Because personal liability is a real concern, even when reduced by statutory protections and insurance, an increasing number of nonprofits, particularly those primarily funded with program services revenue (e.g., healthcare, higher education, etc.), are paying directors’ fees in order to attract and retain qualified and experienced directors.  Director fees may also serve as a sort of moral deterrent to complacency.  Once they are being paid, even if the amount is relatively insignificant, directors may feel bad if they don’t diligently prepare for and attend meetings.  You get what you pay for, and paid directors may feel like they have to give nonprofits their money’s worth.

Conclusion

The award of $2.25 million in compensatory damages against former directors and officers of a nonprofit corporation is a stern reminder that both directors and officers of nonprofit corporations may be held personally liable for breaches of their fiduciary duties.

Nonprofit boards should regularly review and update their governance practices to ensure directors are meeting their fiduciary duties and reduce the risk of personal liability.

[1] In re Lemington Home for the Aged, No. 13-2707 (3d Cir. Jan. 26, 2015).

Ofer Lion, Douglas M. Mancino, and Christian G. Canas, attorneys at Seyfarth Shaw LLP, represent tax-exempt organizations and nonprofits on a wide spectrum of tax, corporate, governance, and fiduciary issues. For more information, please visit http://www.seyfarth.com/Tax-Exempt-Organizations. The contents of this blog are for general information purposes only, and should not be construed as legal advice. You are urged to consult an attorney for legal advice concerning your or your organization’s specific situation.

 

 

 

March 30, 2015 ~ 3 Comments

Ten Things We Don’t Know About Nonprofit Systems

Top-10-sizedBy Denise Tom

The nonprofit system in Los Angeles County has an identity problem. If you Google it, you won’t find much there. In today’s digital world, if Google can’t find you, you’re not “trending” and therefore not worth people’s attention. So here is a list, a la BuzzFeed, of the 10 things we don’t know about nonprofit systems, in no particular order:

1. What impact does the nonprofit sector have on the economic and social well-being of the society it serves? We’re not sure, because marketing itself is not a high priority of a sector that is too entrenched in the challenging work that government can’t do. Some in the sector also feel that marketing contradicts a mission directed at something more than self-interest.

2. Why isn’t systemic change part of every nonprofit’s mission? If it was, that premise alone might propel them to collaborate more to find solutions. They would look for interdependencies and partner up more with other nonprofits and across sectors to find leverage points to help create change.

3. Why can’t nonprofits and funders get past the “power dynamic”? If they approached each other as equal partners, each needing the other to fulfill their missions, they would be able to find what Nancy Olson of Southern California Leadership Network calls a “triple bottom line,” the sweet spot that connects the two with the needs of the community.

4. Why do people still start nonprofits? If they knew that there are 30,000 nonprofits in Los Angeles County — most of them with annual operating budgets of $100,000 or less — competing for limited foundation and corporate dollars and with missions that cover the gamut of issue areas, they might instead serve on a board, volunteer, contribute financially or get involved in some other way.

5. Are funders  listening as much as they should to the nonprofit sector? Yes, funders hold the purse strings and regularly participate in panels at which they share their funding priorities and processes with nonprofit organizations. (See No. 4) But there needs to be more of an intentional effort to have real conversations about strengths, weaknesses, opportunities and threats to the nonprofit system, as well as how nonprofits and funders can work together on shared goals to solve a particular problem.

6. Can we better understand the business models of nonprofits, which are unique to each organization? Funders need to know not only the mission and goals of the nonprofits they support, but also their business strategies and the rationales behind how they create, deliver and track the value they provide to the community. Nonprofit leaders need to ensure their staff members are armed with that same knowledge, so that they understand how their business models lead to their missions.

7. What are the organizational cultures of nonprofits, each of which has its own set of values, norms, beliefs, assumptions and work habits? Understanding why and how nonprofits work will lead to a deeper knowledge about the challenges they face in effectively fulfilling their missions and sustaining their operations. Only then can funders and nonprofits work together to strengthen the sector.

8. Why do organizations spend so much time and effort solving the wrong problems? Is it because they have been in operation a long time and have not diverged from what is expected and what has worked in the past? Is it because they are focused on activities rather than outcomes?

9. What is a nonprofit system? Google aside, we still don’t really know. That’s because the nonprofit system doesn’t see itself as a system and therefore doesn’t see the whole picture of how it connects with and interacts with other systems, like government and business. And what are the right outcomes? Will they lead to systemic change? Perhaps the larger questions are: is the work they do relevant, and do they have the ability to evolve to stay relevant in rapidly changing times?

10. Finally, does the nonprofit system have the ability and the will to think in an increasingly systemic way about problems that need to be solved? Does it have the discipline to spend the needed time to diagnose problems rather than jumping straight to intervention and solutions?

The answer to all of these questions is “we don’t know.”

But here’s what we do know: organizations today are increasingly cooperating, coordinating and collaborating on their own across sectors — sharing thoughts, knowledge and expertise about problems that need solving. They are working together because they know that collaboration with a shared purpose, as muddled as it can be at times, promotes teamwork, deep listening and accelerates change.

And that’s worth knowing.

Denise Tom is the program manager for health care at California Community Foundation. 

March 11, 2015 ~ 0 Comments

What’s Your Nonprofit Start-Up IQ?

IQ

By John E. Kobara

For good reason, people today are seeing the status quo as unacceptable. Regardless of where you sit, there are tremendous challenges all around. Things that have to change if we want a more just and humane world. But when we have impulses to change something, we often fire first, then aim. We leap before we look; we act before we think; we over-simplify.

Many people have on their to-do list to start a nonprofit organization to enact change. It might sit on a list with writing a book, traveling the world and deepening proficiency in a hobby.

Over the years, I have encountered hundreds of executives, philanthropists and other well-meaning humans who see nonprofit work as the stuff of leisure and retirement. Softer, fluffier work that requires less rigor and brain power. “How hard can that be?” I have been queried hundreds of times.

They might have the best of intentions, but the label “nonprofit” gives some people the impression that it is a lower form of organization than its better-understood cousin, the “for-profit.” To the inexperienced eye, nonprofits can seem like quaint do-gooder organizations that are very easy to master.

But one must not be so quick to dismiss a U.S. industry with more than $1.65 trillion in annual revenues and more than 1.44 million employers (the third largest industry employer after retail and manufacturing). There are even more people employed in the nonprofit/non-governmental sector than in the entertainment industry in Los Angeles!

That’s hardly quaint.

The backbone of our social, educational, health and cultural programs are provided by public charities. Health clinics, child-care centers, YMCAs, arts programs, community gardens, food banks, Goodwill Industries, American Cancer Society and the Red Cross are all nonprofits we depend upon for critical services. And in many cases, the nonprofit infrastructure provides the vital safety net for the ever-increasing poor and underserved.

Too many people with time and/or money on their hands want to change the world–usually somebody else’s–by just jumping in. Anyone can file an IRS form to start a nonprofit and instantly become the change you envision.

Simple, right? Not so fast.

Years ago, I developed and administered my “Two-Question IQ Test to Run Nonprofits” to hundreds of people:

Instructions: Pass both questions below and you can run a nonprofit. Fail one or both, and you have to promise you will NEVER run a nonprofit.

Question #1: Do you know how your computer/laptop/iPad works? (“Is this part of the test? Why are you asking this?”) Because most nonprofits, and especially new ones, have no IT department! This surprises them.

Answer: “Yes, I think so.” (Always a bit shaky, but always yes.)

You’re halfway there. One more correct answer and you can run a nonprofit!

Question #2: Can you ask your friends, family and strangers for money to support your nonprofit over and over and over and over again? (Heads start shaking. “No, I would never do that. I would hire a fundraiser. I don’t want to fundraise.”) The head of the nonprofit has to fundraise. In fact, every employee and every Board member has to fundraise, too. At least 50 percent of your job is fundraising.

Answer: “No, no, no.”

Okay, raise your right hand and repeat after me, “I will never run a nonprofit!”

Having a business model that requires you to ask for donations to pay for everything is crazy hard. Of course, like for-profit businesses, unsophisticated leadership and poorly designed plans will also doom an organization. But growth is dependent on results and asking for more money. Growth does not bring in revenues, so scaling the nonprofit requires scaling fundraising.

I can hear some of you grumbling that we need a different business model. Yes, social enterprises, social impact bonds and several other income enhancers are helping on the margins, but all of the top nonprofits get the lion’s share of their income from individual gifts–about 75 percent of all revenues. And giving has remained flat for 12 years, so nonprofits are still in a recessionary mode.

The harsh reality is that we don’t need more nonprofits to try and raise money in a sea of other nonprofits. Most will struggle and fail. More than 272,000 tax exempt organizations lost their status in 2011. The number would be much higher if you couldn’t keep the shell of a nonprofit going almost forever while doing very little.

In Los Angeles alone, we have an estimated 35,000 nonprofits–the largest number of any county in the United States. The unfettered proliferation of nonprofits has created a glut in some places. Organizations competing with identical organizations.

So the California Community Foundation and 11 other organizations are leading one of the largest merger and acquisition programs in the country called the Nonprofit Sustainability Initiative (NSI). That’s right: it’s nonprofit M&A! NSI assists nonprofits to take serious and risk-free steps toward mergers and deep partnerships that will save money and increase impact. NSI pays for each phase of the process from exploratory to severance payments, if necessary. We are trying to reduce the number of nonprofits and increase efficiency.

When the urge hits you, think about joining and improving the best nonprofits you know or find, before setting up your own shop. Take a look around the community and you will find amazing and courageous organizations that are fighting the fight you are interested in. They are great resources on what has worked and what hasn’t. And they would love–and need–your innovation, energy, passion and resources to improve what they do. So join them before you compete with them.

Friends don’t let friends start nonprofits. If they fail the IQ Test and go ahead anyway, while they spend time trying to learn the business model and raise money, that change they envisioned may start to slip away.

John E. Kobara is Executive Vice President and Chief Operating Officer of the California Community Foundation, which has partnered with Grameen America to launch microfinance in Los Angeles. This article originally appeared as part of his blog on Huffington Post, in which he writes regularly on philanthropy and Los Angeles County. You can follow him on Twitter @jekobara.