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					Welcome to Our 2005 Seminar Series:



Your Not-For-Profit Board Service:
Do’s and Don’ts

October 18, 2005
Speakers:



Victoria B. Bjorklund
David A. Shevlin
David Saltzman,
     Robin Hood Foundation
Agenda

    • Accountability of Directors of Not-for-Profit
        Corporations
    • Legal Duties of Directors of Not-for-Profit
        Corporations
    •   Compensation Issues
    •   Director Liability and Indemnification Issues
    •   A Changing Regulatory Environment
    •   Questions




3
    Accountability of Directors of
    Not-for-Profit Corporations




4
What are the essential characteristics of a
not-for-profit?


    • May be formed as a corporation, trust, or
      unincorporated association
    • Must further a “501(c)(3)” purpose (i.e., charitable,
      educational, etc.)
    • May not have private inurement
    • May not engage in [substantial] lobbying
    • May not intervene in any election for public office



5
To whom are directors accountable?

    •   Charitable Class
    •   Members (if any)
    •   Donors
    •   General Public
    •   Regulatory Authorities
        • IRS
        • State Attorney General
    • Others


6
Charitable Class

    • Not-for-profit organizations must serve a charitable
      class.
    • Examples of a charitable class:
       • Needy or distressed
       • Victims of domestic violence
       • Inner-city youth
       • New York’s hungry
    • DO: Understand the identity and nature of the
      charitable class that the organization has been
      formed to benefit.

7
Members

    • Not-for-profit corporations may have members
      who have a particular stake in the activities of the
      corporation.
    • Voting members will typically have the right to
      elect and remove directors and to approve
      fundamental corporate changes such as the
      amendment of the corporation’s Certificate and By-
      Laws and the dissolution of the corporation.




8
Donors

    • Accountability may arise under the terms of any
      contract or agreement that governs a donor’s gift.
    • DO: Be sensitive to donors’ concerns and
      expectations.
    • DON’T (Managers): Accept a restricted gift without
      first determining whether the organization can
      comply with the restrictions.
    • Example: Smithers v. St. Luke's-Roosevelt Hospital
      Center




9
General Public
     • Directors do not owe legal duties to the general public but
       must be sensitive to the public’s perception of the
       organization.
     • Directors should be aware that the “public face” of the
       organization is seen by the public and the press through:
        • Fundraising materials
        • IRS Forms 990/990-PF (publicly available on the
          GuideStar website)
        • Organization’s Website
     • DO: Check that fundraising materials, IRS Forms 990/990-PF
       and website are consistent with the organization’s purposes
       and operations.

10
General Public

     • Example – Cabot Foundation
       • On its IRS Forms 990-PF on GuideStar, the Paul and
         Virginia Cabot Trust had reported paying annual
         compensation to Paul Cabot, one of its trustees, in excess
         of $1 million. In 2001, Mr. Cabot reported increasing his
         compensation by $400,000 to $1.4 million in order to,
         among other things, pay for his daughter’s wedding.
       • The Boston Globe included the Trust as an example in its
         articles on charity abuses.
       • In a 12/04 settlement with the Massachusetts Attorney
         General, Paul Cabot paid back more than $4 million to the
         Trust.
11
Regulatory Authorities

     • Internal Revenue Service
        • Has ongoing oversight over the organization
          through review of the organization’s IRS Forms
          990/990-PF and the examination/audit process
     • State Attorney General
        • Represents the charitable class and has the right
          to bring suit against the organization on behalf
          of the charitable class
        • Oversight varies state-by-state



12
     Legal Duties of Directors of Not-
     for-Profit Corporations




13
What are the legal duties of directors of not-for-
profit corporations?

     • Duty of Care
     • Duty of Loyalty
     • Duty of Obedience




14
Duty of Care

     • The duty of care imposes a standard of conduct on
       directors as they oversee the activities of the not-
       for-profit corporation.
     • In New York, the duty of care standard that applies
       to not-for-profit directors under N-PCL Section 717
       is similar to the standard that applies to directors of
       business corporations.




15
Duty of Care

     • “Ordinary Director” Standard in N-PCL Section
       717:
        • Act in good faith; and
        • With the degree of diligence, care and skill that
          ordinarily prudent men in a like position would
          exercise in similar circumstances
     • In a July 2005 case, Consumers Union of U.S., Inc. v.
       The State of New York, a majority of the New York
       Court of Appeals presumed that the business
       judgment rule applied to a decision of not-for-
       profit directors.

16
Duty of Care

     • What Does This Mean For a Director?
        • DO: Be informed
        • DO: Be active
        • DO: Exercise independent judgment
        • DO: Ask questions




17
Duty of Care
     • Example of a Violation of the Duty of Care
        • In a 1997 proceeding, The Committee to Save Adelphi v.
          Diamandopoulos, the New York Board of Regents
          removed 18 of the 19 trustees of Adelphi University for
          neglect of the duty of care in, among other things,
          approving an excessive compensation package for the
          President.
        • The Regents found that the trustees had violated the duty
          of care by failing to make informed decisions about the
          President’s compensation. This included failing to obtain
          and review salary comparables, failing to evaluate the
          President’s performance and failing to ask questions
          about the components of the President’s compensation.

18
Duty of Care

     • Delegation by Directors
        • Directors may delegate functions, such as the
          day-to-day operation of the corporation, to
          others.
        • However, the delegation must be in good faith
          and in compliance with the duty of care.




19
Duty of Care
     • Delegation by Nonprofit Directors
        • To whom may directors delegate authority?
           •   Officers or employees of the corporation who
               the directors believe are reliable and
               competent
           •   Counsel, accountants or other outside experts
               for matters that the directors believe to be
               within those persons’ professional or expert
               competence
           •   A committee of directors, so long as the
               matter is within the committee’s designated
               authority

20
Duty of Loyalty

     • Directors must have an undivided allegiance to the
       corporation and its mission when using the power
       of their position or information they possess
       concerning the corporation or its assets.
     • The duty of loyalty requires directors to exercise
       their powers in good faith and in the best interests
       of the corporation.




21
Duty of Loyalty

     • What Does This Mean For a Director?
        • DO: Be conscious of potential conflicts of
          interest
        • DO: Follow the corporation’s conflict of interest
          policy




22
Duty of Loyalty

     • Examples of Violations of the Duty of Loyalty
        • In The Committee to Save Adelphi v.
          Diamandopoulos, Adelphi University purchased
          insurance through a firm owned by a trustee
          who did not disclose that her firm was being
          compensated. The New York Board of Regents
          found that the trustee violated the duty of
          loyalty by putting her business interests over
          the interests of the University.




23
Duty of Loyalty

     • Examples of Violations of the Duty of Loyalty
        • In American Baptist Churches of Metropolitan
          New York v. Galloway, a 2000 case in the New
          York Appellate Division, an officer of a not-for-
          profit hospital assisted in locating a site and
          obtaining permits for a new facility. Just before
          the closing on the facility site, the officer
          incorporated a new not-for-profit corporation
          and arranged for the new not-for-profit
          corporation to purchase the property before the
          hospital could act.



24
Duty of Loyalty

     • New York Law Regarding Conflict of Interest
       Transactions
        • Under N-PCL Section 715, a contract or
          transaction between a corporation and one or
          more of its directors or between a corporation
          and any other entity in which one or more of its
          directors have a substantial financial interest
          presents a “conflict of interest.”
        • DO: Disclose and abstain.




25
Duty of Obedience

     • Directors must be faithful to the mission and
       purposes of the corporation.
     • What does this mean for a director?
        • DO: Know what the corporation’s Certificate of
          Incorporation states as the purposes of the
          corporation.
        • DO: Be aware that the corporation’s mission
          and activities must be consistent with the
          corporation’s stated purposes.




26
     Compensation Issues




27
Federal Law – Private Foundations

     • Internal Revenue Code Section 4941 (1969)
        • Prohibits payment of compensation (or
          reimbursement of expenses) by a private
          foundation to a disqualified person
        • Exception for compensation paid for personal
          services which are reasonable and necessary to
          carrying out the foundation’s purposes, if the
          compensation (or reimbursement) is not
          excessive.
        • DO: Follow a procedure similar to the one used
          by public charities

28
Federal Law – Public Charities

     • Internal Revenue Code Section 4958 (final regs
       2002)
        • Directors, officers and others in a position to exercise
          substantial influence over the affairs of the organization
          (such as the Executive Director and CFO) must repay and
          are subject to penalties on any excessive compensation
          they receive
        • Directors who knowingly approve the payment of
          excessive compensation are subject to penalties
        • Tax-exempt status can be forfeited in egregious or
          repeated cases. See 9/08/05 proposed regulations.


29
Federal Law – Public Charities

     • IRS has to rebut presumption that compensation is
       reasonable if:
           • Approved by independent Board or
             committee
           • Relied upon appropriate data as to
             comparability
           • Process is adequately documented (ensure
             minutes of meeting record approval and
             details of transaction)
        • These rules also apply to transactions other than
          compensation (e.g., contracts, sales, etc.)
        • DO: Follow the procedure


30
Compensation – Legal Considerations

     • New York law -- Salaries of officers must be
       approved by a majority of the entire Board, unless
       a different procedure is set forth in the By-Laws.
       N-PCL Section 715(f).


     • DO: Ensure that approval of compensation
       complies with state and federal requirements, as
       well as the organization’s governing documents.




31
     Director Liability and
     Indemnification Issues




32
Director Liability

     • Liability for Violation of Legal Duty
     • Tort Liability
     • Adverse Publicity




33
Violation of Legal Duty

     • Action may be brought by
        • State Attorney General
        • Director
        • Members representing at least 5% of the
          membership
     • Remedies – removal of directors, requirement to
       restore benefits improperly received




34
Tort Liability

     • Liability to third parties for actions committed
       against them (e.g., accidents, employment claims)
     • Under New York law, a volunteer director or
       officer is not liable to third parties unless
        • Actions constitute gross negligence or
        • Director or officer had an intent to cause harm




35
Indemnification

     • New York law provides for indemnification, that is,
       the right of directors and officers to receive
       reimbursement for costs associated with litigation
       against them and the authority of the corporation to
       provide reimbursement. See N-PCL Sections 721-
       726.
     • New York law is nonexclusive, meaning the
       corporation may provide indemnification beyond
       what the statute requires and permits, as long as
       certain standards are met. See N-PCL Section 721.



36
Indemnification - Mandatory

     • Indemnification of judgments, fines, amounts paid
       in settlement and reasonable expenses is
       mandatory if the director is successful on merits.
       See N-PCL Section 723.




37
Indemnification - Permissive

     • Indemnification is permitted even if director is
       unsuccessful in defense or where there is a
       settlement if the director acted in good faith, had a
       reasonable belief that he or she acted in the best
       interests of the corporation and, in a criminal
       proceeding, had no reasonable cause to believe that
       his or her conduct was unlawful. See N-PCL
       Section 722.
     • Indemnification in these situations may be
       provided by a provision in the Certificate, By-Laws,
       Board resolution or contract.


38
Indemnification - Prohibited

     • Indemnification is prohibited –
        • If there is an adverse final adjudication that the
          directors acted in bad faith, with active or
          deliberate dishonesty or gained a personal profit
          or other advantage. See N-PCL Section 721.
        • In a derivative action, the corporation may not
          indemnify for fines or judgments imposed on a
          director. See N-PCL Section 722(c).




39
Delaware Indemnification

     • Substantially similar (DCGL Section 145):
         • Non-exclusive; similar standards for permissive, mandatory and
           prohibited indemnification; and advancement of expenses with
           undertaking.

     • Delaware corporations doing business in New York.
         • N-PCL Section 1320 expressly applies N-PCL indemnification
           provisions to foreign corporations.

         • N-PCL Section 725 prohibits indemnification if inconsistent
           with home state’s provisions.




40
Directors’ and Officers’ Liability Insurance

     • DO (Directors): Inquire about the corporation’s
       policy on indemnification and the scope of its
       insurance coverage.
     • Do (Managers): Inquire whether
        • Subsidiaries, affiliates and related corporations
          are covered? The costs of the corporation itself
          are covered?
        • Correct titles are used?
        • Expenses of investigations and excise taxes
          covered are?
        • Defense costs are included as part of loss?
41
     A Changing Regulatory
     Environment




42
A Changing Regulatory Environment

     • WHY?
       • Arguments regarding the applicability of
         “Sarbanes-Oxley” principles to not-for-profit
         organizations and an increased emphasis on
         corporate governance.
       • Highly-publicized examples of alleged abuse,
         particularly in the areas of compensation and
         expenses, which have drawn the attention of
         regulators, press, donors, etc.
          •   Example: 10/2005 articles on dismissal of the
              President of American University

43
Key Elements of Sarbanes-Oxley

     • Auditor independence requirements
     • Audit committee requirements
        • Duties, composition
     • Officer certification of financial reports
     • Penalties for document destruction***
     • Whistleblower protection***




44
Listing Standards

     • NYSE and NASDAQ also adopted corporate
       responsibility rules, including director
       “independence” requirements.
        • Example: NYSE rules include required proxy
          statement disclosure and consideration of
          material relationships.
     • Example: In re Oracle Corp.




45
Application of Sarbanes-Oxley to Charities?

     • Whistleblower protection and document
       destruction provisions do apply by their terms.
       • DO: Consider the adoption of whistleblower
         protection and document retention procedures.




46
Application of Sarbanes-Oxley to Charities?

     • Some states have taken steps to apply other
       provisions of Sarbanes-Oxley to charitable
       organizations.
        • The California Nonprofit Integrity Act of 2004
          includes corporate responsibility provisions:
          financial audits, audit committees, public
          disclosure of audited financials, approval by the
          Board of compensation of the CEO and CFO.
        • May apply to organizations that solicit in
          California.



47
New York State Attorney General’s Proposals

     • Encouraging boards to designate executive committees if they
       have 25 or more members;
     • Encouraging boards to designate audit committees if the
       organization has more than $2 million in revenue and
       support;
     • Requiring certain organizations to maintain a system of
       internal financial controls designed to reasonably ensure the
       identification of incorrect financial information in annual
       reports and the reporting of fraud; and
     • Revising the conflict-of-interest provisions in N-PCL Section
       715 to establish a presumption of fairness where appropriate
       disclosures are made and due diligence is performed.
48
New York State Attorney General’s Proposals

     • Audit committee’s duties would include:
        • Establishing whistleblower procedures
        • Appointment, fixing of compensation and
          oversight of the independent auditor
     • Audit committee members may not accept fees
       from the organization nor have participated in any
       “interested party” transactions within the previous
       year.




49
Senate Finance Committee “White Paper”

     • In June 2004, the Senate Finance Committee held
       hearings and issued a “White Paper” on best
       practices and potential legislative reforms for
       charitable organizations.




50
Senate Finance Committee “White Paper”

     • The White Paper contains a number of proposals
       regarding transparency and governance of not-for-
       profit organizations.
        • Five-year review of exemption
        • Increased reporting obligations
        • Limits on compensation
        • Limits on travel and other expenses




51
Panel on Nonprofit Sector

     • In October 2004, Independent Sector convened the
       Panel on the Nonprofit Sector to provide
       recommendations for strengthening the
       governance, ethical conduct, and accountability of
       not-for-profit organizations.
     • The Panel issued a Final Report on Strengthening
       the Transparency, Governance and Accountability
       of Charitable Organizations on June 22, 2005 (see
       www.nonprofitpanel.org).




52
Panel on Nonprofit Sector

     • The Final Report contains over 120
       recommendations for action by Congress, the IRS
       and the charitable sector to strengthen the sector’s
       transparency, governance and accountability.
     • The recommendations cover fifteen subjects,
       including financial audits and reviews, non-cash
       contributions, board compensation, executive
       compensation, travel expenses and audit
       committees.




53
Panel on Nonprofit Sector

     • The Final Report recommendations include:
        • A proposal that Congress enact legislation
          requiring audits of not-for-profit organizations
          with annual revenue of $1 million or more, and
          an independent accountant’s review of
          charitable organizations with annual revenue of
          between $250,000 and $1 million.




54
Panel on Nonprofit Sector

     • The Final Report recommendations include:
        • A proposal that Congress enact legislation to
          increase the penalties on board members who
          approve and executives who receive excessive
          compensation, that the IRS revise Forms 990 and
          990-PF to make the total compensation of
          executives clearer to the public and regulators,
          and that boards of not-for-profit organizations
          approve executive compensation annually.




55
Panel on Nonprofit Sector

     • The Final Report recommendations include:
        • A proposal that Congress enact legislation
          requiring not-for-profit organizations to disclose
          on IRS Forms 990/990-PF whether they have a
          travel policy.
        • A proposal encouraging not-for-profit
          organizations that pay for or reimburse travel
          expenses of Board members, officers,
          employees, etc. to adopt and follow clear
          policies for the payment or reimbursement of
          travel expenses.


56
Regulatory Updates

     • On July 28, 2005, Senator Grassley, Chairman of the
       Senate Finance Committee, stated that new
       legislation to reform the charitable sector would be
       forthcoming in the fall (delayed by Hurricane
       Katrina issues).
     • IRS Commissioner Mark Everson has identified
       increased charities enforcement as one of his
       highest priorities.
     • DO: Be aware of regulatory developments.



57
Evolving GOOD Practices

     • What are the Do’s and Don’ts?
     • DO: Self-evaluate governance and other
       procedures to ensure that the organization operates
       in accordance with “GOOD practices.”
     • DON’T: Assume that there is a “one size fits all”
       approach.




58
Evolving GOOD Practices

     • Considerations for discussion
        • Role of committees and the adoption of
          committee charters
        • Review and approval of senior management’s
          compensation
        • Proper procedures for handling potential and
          actual conflicts of interest
        • Ensuring independent financial reviews and the
          accuracy of financial reporting
        • Is there a need/role for “independent” directors?


59
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60
Simpson Thacher Speakers


     Victoria Bjorklund        New York
       vbjorklund@stblaw.com   212.455.2875


     David Shevlin             New York
       dshevlin@stblaw.com     212.455.3682




61