New York State Association of Independent Schools

A Time for Reform:

Nonprofit Sector Issues Draft Principals for Self-Regulation

Mark E. Brossman

Meghan E. Siket

Schulte Roth & Zabel LLP


In October 2004, at the request of the U.S. Senate Finance Committee, the Panel on the Nonprofit Sector (the "Panel") was created to make recommendations to Congress to improve the oversight and governance of charitable organizations.  In June 2005, the Panel, which is comprised of 24 nonprofit and philanthropic leaders, issued its Final Report, entitled "Strengthening Transparency, Governance, Accountability of Charitable Organizations."  Last year, the Panel supplemented its Final Report.  This winter, after examining the standards and principles of more than 50 self-regulation and accreditation systems that monitor charitable organizations, and after reviewing more than 125 suggestions it received, the Panel released "Draft Principles for Effective Practice" (the "Principles"). 

The goal of the Principles is to offer suggestions for strengthening self-regulation within the charitable community.  The Principles address four areas of nonprofit oversight and operations:  legal compliance, nonprofit governance, financial oversight, and fundraising practices.  The Principles suggest significant changes to self-regulation of nonprofit organizations.  The Panel recommends that all charitable organizations aspire to follow the Principles, and all major public charities with at least $1 million in annual revenues and private foundations with at least $25 million in assets should implement the Principles. 

A summary of the Principles is set forth below.

A.        Facilitating Legal Compliance

1.         Knowledge of Applicable Laws and Regulations and International Conventions:  Board members should be familiar with the basic rules and requirements applicable to their charitable organization.

2.         Governing Body:  A charitable organization must have a governing body that is responsible for reviewing and approving the organization's mission and strategic direction, annual budget, and key financial transactions, compensation practices and policies, and fiscal and governance policies of the organization.

3.         Conflict of Interest Policy:  A conflict of interest arises when a board member or staff person's duty of loyalty to the charitable organization comes into conflict with a competing financial or personal interest that he or she may have in a proposed transaction.  Every charitable organizations should establish a conflict of interest policy that requires full disclosure of all potential conflicts of interest within the organization and that explains how the organization will handle conflicts of interest.

4.         Whistleblower Policy:  Every charitable organization should have clear policies and procedures--generally known as a "Whistleblower Protection Policy"--that that allow staff, volunteers, or clients of the organization to report suspected wrongdoing within the organization without fear of retribution. 

5.         Business Record Policy:  A charitable organization must establish and implement policies and procedures regarding document retention and destruction to protect and preserve the organization's important documents and business records (for example, applications for employment, payroll records, tax forms, organizational documents, and board materials and policies). 

6.         Transparency:  A charitable organization must make information about its operations, including its board members, finances, programs and activities, and methods used to evaluate the outcomes of work, widely available to the public.  The Panel recommends not only providing the documents required by law (for example, an annual information return Form 990, application for recognition of tax exemption and tax returns), but also offering additional information about its operations, governance, and finances.

B.        Effective Governance

1.         Regular Meetings:  The board of a charitable organization must meet regularly enough to conduct its business and fulfill its duties.  The Panel recommends that a board of trustees should hold at least three meetings per year.

2.         Size and Structure of the Board:  The board of a charitable organization should have a sufficient number of members to allow for full deliberation of governance matters and for diversity of thinking in areas such as conflicts of interest and self-dealing.  The Panel recommends the board should have a minimum of five members.

3.         Composition of the Board:  The board of a charitable organization should include members with diverse skills, backgrounds, expertise, and experience necessary to advance the organization's ability to fulfill its mission.  For example, the Panel recommends a board include or have access to individuals with expertise in budget and financial management, investments, personnel, fund raising, public relations and marketing, governance, advocacy and leadership, as well as knowledge about and insights into the charitable organization's area of expertise or programs, or a special connection to the organization's constituency.

4.         Independence of the Board:  The Panel recommends that a substantial majority of the board of a public charity should be independent, that is, individuals (i) who are not compensated by the organization as an employee or independent contractor; (ii) whose own compensation is not determined by individuals who are compensated by the organization; (iii) who do not receive, directly or indirectly, material financial benefits from the organization except as a member of the charitable class served by the organization; and (iv) who are not related to (as a spouse, sibling, parent or child) or do not reside with any individual described above.

5.         Evaluating and Compensating the Chief Executive Officer:   The board is responsible for hiring, supervising, and evaluating the performance of the chief executive officer of the organization, as well as approving annually (unless there is a multi-year contract) and in advance the compensation of the chief executive officer.  The board must comply with Internal Revenue Code rules prohibiting the payment of excessive compensation to executives and other disqualified persons (i.e., individuals who have substantial influence over the organization's affairs), and their family members.  For public charities, the federal "intermediate sanctions" regulations encourage organizations to follow procedures designed to peg compensation to what is being paid to individuals in like positions at comparable organizations.  Significant penalties apply to both the disqualified person who receives excessive compensation and to board members and other managers who approve such excessive compensation.

6.         Avoiding Concentration of Authority:  The Panel cautions against concentrating authority for the organization's governance and management practices in one or two individuals.  It recommends that the positions of chief executive officer, board chair, and treasurer are held by separate individuals.

7.         Education of the Board:  The board should establish an effective, systematic process for educating and communicating with board members to ensure that the board carries out its oversight functions and that individual members are aware of their legal and ethical responsibilities.

8.         Terms and Removal of Board Members:  Board members should evaluate their own performance as a group and as individuals no less frequently than every three years.  The board should establish clear policies and procedures on the length of a board term of service and the number of terms an individual may serve, as well as on the removal of board members.

9.         Board Review of Governing Instruments:  The Panel recommends that the board must review organizational and governing instruments (e.g., the articles of incorporation and bylaws) no less frequently than every three years to ensure that they reflect its current practice.

10.       Board Review of the Organization's Mission:  The board should establish or review goals for implementing the organization's mission on an annual basis and evaluate programs, goals, and activities to be sure they are consistent with the mission no less frequently than every three years.

11.       Compensation of Board Members:  Board members are generally expected to serve without compensation, other than reimbursement for expenses incurred to fulfill their board duties.  Charitable organizations that provide compensation to board members must make available to anyone, upon request, relevant information that will assist in evaluations of the reasonableness of such compensation.

C.        Strong Financial Oversight

1.         Investment of Funds:  Board members must exercise their "duty of care" by providing careful oversight of the organization's assets and financial transactions to protect the interests of the organization and its charitable purposes.  The board must institute policies and procedures to ensure that the organization and, if applicable, its subsidiaries, managers and invests its funds responsibly and prudently.  The full board must review and approve the organization's annual budget and should monitor actual performance against the budget.

2.         Annual Audit:  A charitable organization must keep complete and accurate financial records and should have a qualified, independent financial expert audit or review them annually in a manner appropriate to the organization's size and scale or operations.  The Panel has previously recommended that Congress revise federal laws, which currently do not require audits of charitable organizations, to require that exempt organizations with total annual revenues of $1 million or more have their financial statements audited by an independent certified public accountant and that exempt organizations with revenues between $250,000 and $1 million have their financial statements reviewed by an independent public accountant.

3.         Loans to Board Members:  The Panel recommends that charitable organizations must not provide loans (or the equivalent) to board members. 

4.         Administrative Expenses:  A charitable organization must incur reasonable and necessary "administrative expenses" to further its charitable mission.

5.         Reimbursement of Expenses:  A charitable organization must establish and implement policies that provide clear guidance on its rules for paying or reimbursing expenses incurred when conducting business or traveling on behalf of the organization, including the types of expenses that can be paid for or reimbursed and the documentation required.  Board members and executives who approve or receive excessive travel benefits are subject to penalties under existing law.

D.        Responsible Fundraising

1.         Solicitation Materials:  Solicitation materials and other communications with donors and the public must clearly identify the organization and be accurate and truthful.

2.         Use of Contributions:  Contributions must be used for the purpose described in the relevant solicitation materials, in the way specifically requested by the donor, or in a manner that reflects the donor's intent.

3.         Written Acknowledgement of Contributions:  Charitable organizations must provide donors with appropriate and timely acknowledgements and recognition of all contributions.

4.         Ethics of Accepting a Gift:  Charitable organizations should implement clear policies, based on the organization's exempt purpose, to determine whether accepting a gift is in the best interests of the organization based on any associated costs or other consequences.

5.         Training of the People Soliciting Funds:  A charitable organization may be legally responsible when those who solicit on its behalf engage in illegal or fraudulent practices.  Thus, the Panel recommends that a charitable organization should provide appropriate training and supervision of the people soliciting funds on its behalf to ensure that they understand their responsibilities and applicable federal, state and local laws, and that they do not employ techniques that are coercive, intimidating, or intended to harass potential donors.

6.         Compensation of Fundraisers:  Organizations should not compensate internal or external fundraisers based on a commission or a percentage of the amount raised.  According to the Panel, basing compensation on a percentage of the money raised can encourage fundraisers to put their own interests ahead of those of the organization or the donor and may lead to inappropriate techniques that jeopardize the organization's values and reputation and the donor's trust in the organization.

7.         Protecting the Privacy of Donors:  A charitable organization must respect the privacy of individual donors and must not sell or otherwise make available the names and contact information of its donors without prior permission, except where disclosure is required by law.