5A. Governance: Conflicts of Interest: Sitting On a …. Governance: Conflicts of Interest: Sitting On a Barbed-Wire Fence CAPLAW 2011 National Training Conference Friday, June 17,

5A. Governance: Conflicts of Interest: Sitting On a Barbed-Wire Fence

CAPLAW 2011 National Training Conference

Friday, June 17, 2011 9 a.m. - 10:30 a.m.

Minneapolis, MN

Mr. Jack Siegel, Esq., CPA CEO Charity Governance Consulting LLC 3400 North Lake Shore Drive Chicago, IL 60657 773-325-2124 [email protected]

Handouts:

1. Siegel PowerPoint Slides 2. Preliminary questionnaire

Jack B. Siegel

Charity Governance Consulting LLC

June 17, 2011

SITTING ON A BARBED WIRE FENCE*(Conflicts of Interest)

*Bob Dylan, Sitting on a Barbed Wire Fence, originally unreleased outtake from Highway 61 Revisited sessions (June 15, 1965)

Caveats

Copyright 2011, Jack B. Siegel, All Rights Reserved. Do not copy, redistribute, or excerpt.

2

� This is not legal, tax, or accounting advice. Organizations should always seek legal counsel, tax advice, and accounting services from qualified professionals rather than relying on PowerPoint presentations

� This is a general description, with a focus on spotting issues. The law differs among state jurisdictions

� Each organization must address the issues covered in this presentation by taking into account its unique circumstances and requirements. This presentation cannot anticipate or account for such circumstances or requirements.

� The views expressed herein are those of Jack B. Siegel. They do not necessary represent the views of CAPLAW.

Circular 230


3

Internal Revenue Service - Circular 230 Disclosure: As provided for in Treasury regulations, any advice (but none is intended) relating to federal taxes that is contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

Copyright and Intellectual Property Rights4

� These materials are copyrighted May 16, 2011, Jack B. Siegel. These materials may NOT be reproduced or distributed (including as e-mail forwards or attachments) in any form without prior written permission

� These materials may not be used by someone else to develop or make a presentation

� These materials may not be excerpted

� To report a violation, call 773.325.2124


Biographical Information5

Jack Siegel is an attorney (Illinois and Wisconsin) and CPA(Wisconsin), holding an LLM in Taxation from New York University and a Master’s of Management from Northwestern University. Jack provides consulting services through Charity Governance Consulting LLC. He focuses on training, governance, financial management, and special projects. Jack is the author of A Desktop Guide for Nonprofit Directors, Officers, and Advisors: Avoiding Trouble While Doing Good (Wiley 2007), a 750-page book addressing the legal, financial, tax, and governance issues facing nonprofits. He just completed a three-year term as a member of the IRS’s Advisory Committee on Tax Exempt and Government Entities (ACT). He is currently authoring a book on the charitable sector and another on the law of photography. Jack is the author of the Charity Governance blog.


Contact Information6

� Jack Siegel can be contacted at:� Tele: 773.325.2124 (United States)

� E-Mail: [email protected]

� Follow Jack on Twitter: Charitygovern

� Jack is located in Chicago, Illinois

� Web site and Blog: http://www.charitygovernance.com


May 16, 2011

Conflicts-of-Interest

MY ROLE AND POSITION

7


I Am a Realist8

� I live in the real world

� As long as we have boards, we will have conflicts of interest� Some Say “It’s how you manage them that counts”

� That is too glib

� Some conflicts can’t be managed

� My objective today� Sensitize you to the problems that conflicts pose

� Make you think twice before entering into or approving conflicts-of-interest transactions


May 16, 2011


OVERVIEW

9


Policies 10

� Our focus today� Conflicts of interest and related policies

� Others policies worth considering� Whistleblower

� Record retention

� Investment

� Gift-acceptance

� Employment practices


Why Today11


State Law12

� Section 8.31 of the Revised Model Nonprofit Corporation Act:� Defined: A conflict-of-interest transaction is a transaction between

the nonprofit and a director who has a direct or indirect interest in the transaction

� Validation: A conflict of interest transaction can be validated if:

� The transaction is approved in advance

� The material facts of the transaction and the director’s interest are disclosed or known

� The directors approving the transaction do so in good faith with the reasonable belief that the transaction is fair to the nonprofit

� The approval is from a majority of the directors who have no direct or indirect interest in the transaction


OMB13

� OMB Circular A-110, Procurement Standards� Paragraph _.42: Codes of Conduct, provides as follows:

The recipient shall maintain written standards of conduct governing the performance of its employees engaged in the award and administration of contracts. No employee, officer, or agent shall participate in the selection, award, or administration of a contract supported by Federal funds if a real or apparent conflict of interest would be involved. Such a conflict would arise when the employee, officer, or agent, any member of his or her immediate family, his or her partner, or an organization which employs or is about to employ any of the parties indicated herein, has a financial or other interest in the firm selected for an award. The officers, employees, and agents of the recipient shall neither solicit nor accept gratuities, favors, or anything of monetary value from contractors, or parties to subagreements. However, recipients may set standards for situations in which the financial interest is not substantial or the gift is an unsolicited item of nominal value. The standards of conduct shall provide for disciplinary actions to be applied for violations of such standards by officers, employees, or agents of the recipient.


IRS14

� Redesigned Form 990� Core Form, Part VI, Line 12

� Does the organization have a conflicts-of-interest policy?

� Is disclosure of potential conflicts required at least annually?

� Does the organization regularly monitor and enforce compliance with the policy?


(continued)15

� Form 990 Implications� It is clear: Putting these policies in place is not a condition for tax-

exemption

� The Service’s view: The presence of these policies is relevant

� Is the organization operated in furtherance of its exempt purpose?

� Has there been private inurement (insiders)—intermediate sanctions?

� Has there been private benefit (outsiders)?

� What will the Service do?

� Auditors likely will look at responses

� Computer programs for audit selection likely will take responses to these questions into account

� Decision for boards

� Is it advisable to adopt policies, if for no other reason, than as window dressing?


The ACT16

� Advisory Committee on Tax Exempt and Government Entities (ACT)

� June 11, 2008—The Appropriate Role of the Internal Revenue Service with Respect to Tax-Exempt Organization Good Governance Issues

“In fact, superior board governance may have much more to do withthe values, active engagement, and accountability of those in charge than with the adoption of procedures and policies…. Many of the good governance indicators upon which the IRS has focused call for policies to be adopted, but do not examine the practices in which an exempt organization engages in adhering to those policies, or inotherwise meeting the underlying objectives of the policies. Unless implemented and applied in circumstances that warrant that application, those polices may be no more than pieces of paper left in a file cabinet.”


May 16, 2011


THE INNATE KNOWLEDGE THAT

EVERY BOARD MEMBER IS BORN

WITH (THE “DANCE”)

17


What Every Board Member Knows18

� For some inexplicable reason, every board member, no matter how inexperienced, believes that conflicts of interest are permissible if:� The person with the conflict leaves the room during the discussion

� The person with the conflict leaves the room when voting

� The person with the conflict doesn’t vote

� The organization obtains comparables (or believes that it is getting the goods or services at a 50% discount—tongue in cheek)

� I hope to convince you that there are other considerations. In short, just because something is legal (assuming it is) doesn’t mean it is a good idea or problem free


May 16, 2011


TYPES OF CONFLICTS

19


Common Conflicts20


21

TYPE 1: LOANS BETWEEN THE NONPROFIT AND INSIDERS


Loans22

Charitable Organization

Officer/DirectorIOU

$


One State Statute23

� One U.S. state statute:“Except as permitted by subsection (e) of Section 108.75, no loan shall be made

by a corporation to a director or officer except that a loan may be made to a director or officer who is employed by the corporation if authorized by a majority of the non-employed directors and either (a) in the case of a corporation organized for and holding property for any charitable, religious, eleemosynary, benevolent, educational or similar purpose, the purpose of such loan is to provide financing for the principal residence of the employed director of officer upon receipt of adequate collateral consisting of marketable real estate or securities readily capable of valuation or (b) the loan is otherwise in furtherance of the purposes of the corporation and in the ordinary course of its affairs. The directors of a corporation who vote for or assent to the making of a loan to any non-employed director or non-employed officer of the corporation, or otherwise prohibited by this Section, and any other person knowingly participating in the making of such loan, shall be jointly and severally liable to the corporation for the amount of such loan until the repayment thereof.”


Other States24

� Other State Statutes: The Chronicle of Philanthropy ran a feature on insider loans in 2004. It indicated that the following states had provisions that prohibited or regulated loans between a nonprofit and its insiders: Alabama, Alaska, Arkansas, Colorado, Florida, Hawaii, Idaho, Illinois, Indiana, Iowa, Minnesota, Mississippi, Montana, Nebraska, New Hampshire, New York, North Carolina, Oregon, Rhode Island, South Carolina, Tennessee, Texas, Utah, Vermont, Washington, and Wyoming. Organizations should review applicable state laws rather than relying on this list.

� Harvy Lipman and Grant Williams, Assets on Loan: Nonprofit Groups Lend Millions to Officials, Chronicle Study Finds, CHRON. OF PHILANTHROPY (Feb. 5, 2004).


When Regulated25

� Some states that regulate loans between nonprofits and insiders limit these to mortgage loans used to finance a principal residence

� Question for the Board: If a bank will not make the loan, why is it prudent for the nonprofit to make the loan, particularly if the nonprofit is not in the business of lending money?


IRS View26

� IRS View: Based on attendance at a lecture by two IRS officials� Related party

� Loans are:

� Highly suspect

� Raise questions that go to tax-exemption• An isolated mortgage loan so that the executive director can relocate

may not be a problem

• Multiple undocumented loans to insiders for no business purpose is viewed as a potential problem

� One IRS official

� Wants to see credit card rate of interest charged if the loan isunsecured (not the right answer—should be a market rate)

� Reviews the underlying security


Below-Market Rate Loans and Taxes27

� A nonprofit that enters into a below-market rate loan with a nonprofit employee or independent contractor should examine the below-market rate loan provisions, which impute compensation income to the borrower

� Section 7972 imputes compensation income to the recipient:� Does the recipient have funds to pay the taxes?

� Employee-relocation loans are exempted from Section 7972 treatment, but only if they meet three requirements outlined in Treasury Regulation Section 1.7872-5(c)(1).

� Income tax withholding is not required, but FICA withholding applies. Treasury Regulation Section 1.7872-11(d)


28

TYPE 2: CONFLICTS INVOLVING THE PROVISION OF SERVICES


Services29

Provide Legal Services

Bank Makes Loan

Spouse Fundraising Contract

Law Firm PartnerDirector

VP DevelopmentOfficer

Bank PresidentDirector

Social ServicesAgency



FundraisingConsultant


General Observations30

� Conflicts involving the provision of services should be evaluated not just under state law validation statutes, but also under the Section 4958 intermediate sanctions if the service provider is an officer, director, key employee, substantial contributor or other disqualified person

� When evaluating these conflicts, the organization should consider price and quality

� The media features these conflicts prominently whenever a nonprofit finds itself embroiled in controversy


Lawyers: A Special Case31

� Under most, if not all, codes of professional conduct, a lawyer can serve as both a director and as outside counsel. See ABA Comm. on Ethics and Prof’l Responsibility, Formal Op. 98-410

� Potential non-financial conflicts when operating in a dual capacity� In providing legal counsel, is the attorney objective, or is he subtly couching his

legal advice so that other board members support the attorney’s preferences as a board member?

� Suppose the nonprofit’s executive director controls the selection of outside legal counsel. In his role as a director, will the attorney tend to side with the executive director or provide legal advice to the board that supports the executive director’s agenda?

� Who does the attorney represent—the board, the organization, or the executive director?

� Will communications with the lawyer be discoverable� If lawyer is deemed acting as a director, no� If lawyer is acting as counsel, yes (to extent the communication is otherwise

privileged)� Mixing roles can create troublesome ambiguities


(continued)32

� For one formulation of the lawyer’s allegiances, see Texas Disciplinary Rule of Professional Conduct 1.12, which provides:

(a) A lawyer employed or retained by an organization represents the entity. While the lawyer in the ordinary course of working relationships may report to, and accept direction from, an entity’s duly authorized constituents, in the situations described in paragraph (b) the lawyer shall proceed as reasonably necessary in the best interest of the organization without involving unreasonable risks of disrupting the organization and of revealing information relating to the representation to persons outside the organization


(continued)33

(b) A lawyer representing an organization must take reasonable remedial actions whenever the lawyer learns or knows that:

(1) an officer, employee, or other person associated with the organization has committed or intends to commit a violation of a legal obligation to the organization or a violation of law which reasonably might be imputed to the organization;

(2) the violation is likely to result in substantial injury to the organization; and

(3) the violation is related to a matter within the scope of the lawyer’s representation of the organization.


(continued)34

� Examples� Lawyer worked closely with nonprofit’s executive director for years.

The board decided to conduct an investigation. Executive director upset that lawyer was heading that investigation

� Board member who is a lawyer is asked to represent another boardmember in negotiating a gift to the institution

� Lawyer on board represents another board member’s business on a regular basis. Lawyer asked to vote on whether to remove that board member� Same as above, but lawyer as director asked to approve transaction

between nonprofit and the other board member’s business

� Board member who is a lawyer asked to conduct an internal investigation (as opposed to using outside counsel). Is that investigation protected by work product or attorney-privilege doctrine (assuming internal investigations are not otherwise protected)?


(continued)35

� For a general discussion of the issues facing a lawyer who serves both as a director and attorney for a nonprofit corporation, see William L. Boyd, III, Lawyers’ Service on Nonprofit Boards: Managing the Risks of an Important Community Activity, 18 Bus. L. Today 35 (Nov./Dec. 2008)


CPAs: A Special Case36

� Can a CPA serve as a director or officer and also as an outside auditor?

� Unequivocally, NO� SAS No. 1:

� It is of utmost importance to the profession that the general public maintain confidence in the independence of independent auditors… . To be independent, the auditor must be intellectually honest; to be recognized as independent, he must be free from any obligation to or interest in the client, its management, or its owners. For example, an independent auditor auditing a company of which he was also a director might be intellectually honest, but it is unlikely that the public would accept him as independent since he would be in effect auditing decisions which he had a part in making.


(continued)37

� There are instances where an outside auditor can maintain his independence and still have some involvement with the organization


(continued)38

� EXAMPLE 1: Auditor as Board Member. C is a CPA who provides audit services to a variety of clients. For the last five years, C has audited the financial statements of R, a social services agency. R’s board is engaged, but none of its board members have financial or accounting expertise. The board chairperson, at the behest of the board, has asked C to join the board so that C can add that expertise to the mix. C faces a simple choice: He can either continue to provide audit services or serve as a board member, but he cannot do both.


(continued)39

� EXAMPLE: Auditor as Honorary Director. The client relationship is the same as described in the prior example. R has a ten-member board comprised of community leaders. They ask C to become an honorary member of the board. C accepts the invitation. R changes its stationary and Web site, adding C to the list of directors. Rule ET 101-4 of the AICPA’s Code of Professional Conduct provides that C can continue to provide attest services to R if his position is “clearly honorary.”


(continued)40

� What does honorary mean?

� Can C attend board meetings (as a non-voting attendee)?

� Can C render advice? If the board does everything C suggests and C is always present, is he still an honorary member? Svengali, the CPA


Finance Committee

Bankers41

Large Community Cultural Institution

Major Local Bank

Board MemberCEO

$3 million line of credit

$2 million tax-exempt bond

Sue, the Banker


(continued)42

� Based on an actual series of events (facts changed)

� Everyone assumes that the nothing will go wrong

� Now: What happens when the cultural institution starts running large operating deficits that have not yet been disclosed to the public—the institution occupies public space under a $1 a year lease?

� What does Sue do when she learns one or more the following at a finance committee meeting� An outside lawyer’s recommendation about filing bankruptcy

� Projected deficits

� Unpublicized threats by government officials to cut government subsidies


(continued)43

� Who does Sue her loyalties to?� Does she return to the bank and remain silent?

� Doesn’t she owe a duty to the bank’s shareholders?

� Shouldn’t she advise the troubled-loan committee?

� Does she tell her troubled-loan committee all?

� Hasn’t she violated her duty of loyalty to the cultural institution if she reveals information to the troubled-loan committee?

� Suppose Sue learns at the same finance committee meeting that the cultural institution may have a White Knight donor? Does that reduce Sue’s dilemma?


Investment Advisors44

Investment Committee

Committee votes to invest in HedgeFund Manager’s Hedge Fund. He recuses

himself from the decision


(continued)45

� Rationale� It is the only way we can obtain Hedge Fund Manager’s

expertise

� We know Hedge Fund Manager so we feel comfortable with him

� Hedge Fund Manager is the best in the industry so why should we deny ourselves his expertise?

� We owe it to Hedge Fund Manager because he is a volunteer

� Hedge Fund Manager waived half of his fee (is that permissible?)


(continued)46

Investment Committee

Committee votes to invest in HedgeFund Manager’s Hedge Fund. He recuses

himself from the decision


(continued)47

� The loss was initially reported at somewhere around $110 million. Invested cash was reported to be somewhere around $14 million (plus opportunity cost)

� The publicity hurt donor relations. At least one donor to an affiliated organization wrote a rather firm letter, indicating that he would honor his pledge, but the implication was that there had better be changes

� Moody’s put $177.2 million of Yeshiva debt on a watchlistfor possible downgrade, according to the Chronicle of Higher Education. A Moody’s press release stated (in part):


(continued)48

Moody's Investors Service has placed Yeshiva University's Aa2 underlying rating on watchlist for possible downgrade. The rating action impacts $177.2 million of rated debt, including the University's fixed-rate Series 1998, 2001, and 2004 bonds. We expect to conclude our next review of the rating within a 90 day timeframe. The rating action reflects Moody's concerns about the University's governance, investment management and oversight, pressure on liquidity due to investment losses and a relatively small amount of the investment portfolio invested in equities, bonds, and other readily marketable securities. The University has also increased debt levels, including use of a line of credit to purchase properties and plans for future borrowing

• Usually board members are the ones that the Development Department is cultivating for large future gifts. This sort of scandal can damage relations with these donor/board members

o May be forced to resigno May want to resigno May become angry that they were put in an embarrassing position


(continued)49

� There were a number of reports that other organizations steered clear of Madoff (who also had affiliations with them) because of their conflicts-of-interest policies

� Closing Thought:

“Of all the gin joints in all the towns in all the world, she walks into mine”

Humphrey Bogart (Rick) from CASABLANCA (1943)


50

TYPE 3: SOCIAL ENTREPENEURSHIP


For-Profit Venture51

Mary

JeffLinda

For-Profit

College Prep, Inc.

26% Interest

Leases

Board of Directors

26% Interest

48% Interest

Joe, CEO

Youth After-School Inc.

Helen


(continued)52

� The facts (which are embellished, but were inspired by a newspaper report):� Management agreement with Joe and Helen

� Joe and Helen refuse to turn over financial statements

� Teachers stop working for nonprofit; devote time to for-profit

� Computers are used without compensation—OMB audit uncovers

� The for-profit does not reimburse the nonprofit for utilities

� The for-profit is named as an insured on the nonprofit’s insurance policy, but does not reimburse the nonprofit for any portion of the premium


(continued)53

Wall St. Journal

Reporting (Nov. 24, 2007)Distribute 150 million

low-cost laptop computers in

developing countries

Intel involved in project Chip supplier


(continued)54

� The head of the One Laptop project asked Intel to stop marketing the Classmate in developing companies, apparently because it competed with the One Laptop Per Child computers.

� A spokesperson for Intel told the WSJ that Intel could not accommodate that request. The reason: Intel had already sold tens of thousands of its Classmates oversees and discontinuing overseas sales would disrupt relations with overseas manufacturers and supplies. It is also notable that the One Laptop Per Child project tried to compensate for its own lackluster market penetration by selling the laptops in the United States. Those sales may have posed issues for Intel.


(continued)55

� Concerns with Social Entrepreneurship� Potential conflicts:

� Could preclude grant of federal tax-exemption� Could result in loss of federal tax-exemption� Could affect property tax exemptions

� Tax issues:� Private inurement� Private benefit (are the for-profit interests aligned with the nonprofit’s

interests and mission), or will the nonprofit’s interests become secondary to private benefit

� Intermediate sanctions

� Similar state law concerns� L3C—Low-Profit Limited Liability Company. Several states

have adopted enabling legislation, but IRS hasn’t adequately addressed yet


56

TYPE 4: CHANGE OF STATUS


Case 4: Volunteer Director to Employee57

Social Services Agency

Fred George

Mary

Board

Sue

Employee

SueChange of Status from Board Member to

Employee


(continued)58

� Steps that should be taken before a director changes status to paid employee� Validate the decision

� Director is not counted for purposes of the quorum determination

� Director is not in the room for the discussion or vote (except to answer questions)

� Director doesn’t vote

� The nonprofit and the director are represented by separate counsel

� The compensation is based on comparables

� No backscratching affiliations

� Should director resigns from the board first?

� Should there be a cooling off period?


59

TYPE 5: DUALITY OF INTERESTS


Dualities60

Cases 1 and 2:

Community Action

Low-income community

City Government X

MayorJoe

Appoints Fred to Board Appoints Mayor Joe

Fred


(continued)61

� Conflict 1: Does the low-income representative act in the best interests of the low-income community or does he act in best interests of Community Action despite status as low-income representative?� If the community insists that Community Action should

borrow money to provide more services even though it will likely bankrupt Community Action, must Fred say Yes?


(continued)62

� Conflict 2: Does Mayor Joe act in the best interests of the City or does he act in best interests of Community Action when he serves on Community Action’s board?� Suppose Mayor Joe concludes that Community Action is

ineffective and he decides to push for CSGB grant to be awarded to Community Action Upstart, Inc.?

� Can Mayor Joe attend meetings of Community Action’s board where they plot a public relations campaign to retain the funding? Open meeting laws raise some interesting issues.


(continued)63

� Observations and Questions� If bylaws provided for removal of directors who violate their

duty of loyalty, could Community Action remove Mayor Joe?

� Are these legal problems, or business/management problems?

� The best way to deal with these issues is to get agreements and legal language settled at the outset


Montana Supreme Court64

� In Re Charles M. Bair Trust, Montana Supreme Court (April 29, 2008) addresses duality

“The Trust Agreement directed the Board to spend the necessary principal and income to establish, improve, and maintain the Museum, and the Trust Agreement granted the Board the decision-making power to close the Museum, subject to the standard set forth in the Trust Agreement. Though the Trust Administrator appears to have played a part in the Board's decision to close the Museum, the Board made the decisions regarding the Museum. The Board, not the Trustee, breached its fiduciary duties to the Trust by failing to spend ‘whatever principal and income’ of the Trust that was ‘necessary to establish, improve and maintain’ the Museum. The Board, not the Trustee, breached its fiduciary duties to the Trust by closing the Museum without determining that the Museum had ‘ceased to serve the purposes thereof so as to make it inadvisable to continue the museum for public and educational purposes . . . .’ We conclude that removing the Trustee from the Trust is unnecessary considering that the Trustee breached no duty to the Trust.”


May 16, 2011


HEAD START AND CONFLICTS

65


Head Start66

� Section 642(c)(1)(C) of the Head Start Act (42 USC 9837). Members of the governing body shall: � Not have a financial conflict of interest with the Head Start

agency (including any delegate agency);

� Not receive compensation for serving on the governing body or for providing services to the Head Start agency;

� Not be employed, nor shall members of their immediate family be employed, by the Head Start agency (including any delegate agency)….


Some Observations


67

� This is an absolute bar against financial conflicts of interest involving members of the governing board. There is no exception for:� Transactions priced at fair market value

� Transactions that follow an otherwise recognized validation procedure

� The prohibition extends beyond transactions involving just the Head Start program. It applies to financial transactions relating to other programs (i.e., weatherization, housing, etc). In other words, it is organization-wide

What is A Financial Conflict?


68

� There are the obvious financial conflicts, such as a director:� Selling goods to the organization—insurance, stationary,

computers

� Selling services to the organization—legal, accounting, architectural

� Renting property to the organization—lease of headquarters

� Lending money to or borrowing money from the organization

(continued)


69

� What is puzzling is that the statute doesn’t explicitly address conflicts carried out through parties related to the members of the governing board, such as a corporation wholly-owned by a director. Although the statute does bar the hiring of a director’s immediate family members, it does not explicitly address family members in the prohibition on financial conflicts

� Does that mean that the prohibition can easily be circumvented? � Keep in mind that the statute does not define the term “financial

conflict.” This means that the term has some elasticity built into it, with the result that transactions involving parties related to directors could easily be characterized as “financial conflicts”

(continued)


70

� Policy Statement on Program Governance from OHS defines a conflict of interest as follows:

A conflict of interest refers to a clash between the private interests and the official duties and obligations of a person occupying a position in a Head Start agency. The Head Start Act lists specific conditions as conflicts of interest that, unless eliminated, would prohibit anindividual from serving on a governing body. There are some other conditions where a conflict of interest may be of a limited nature and the conflict of interest may be addressed through the individual’s recusal from participation in discussions and votes on matters affected by the conflict.

This definition certainly can be read to include conflicts attributable to a director’s relationship with other persons and entities doing business with the agency.

(continued)


71

� Your organization’s relationship with OHS is not a one-time transaction, but it is ongoing. In other words, it is subject to review, with the possibility that your organization’s Head Start status and funding might not be renewed if OHS has problems with certain transactions. This has two implications:

� Your organization should be conservative in how it approaches financial conflicts, meaning that its focus should not be on technicalities, but on the broad policy reflected in the statute

� When in doubt, contact your organization’s legal counsel and OHS. Once again, remember that there are viable alternatives tovirtually all conflicts

Head Start Policy Councils


72

� Members of the policy council CANNOT:� Have a conflict of interest with the Head Start agency

(including any delegate agency), or

� Receive compensation for serving on the policy council or providing services to the Head Start agency

� Notice that phrase “conflict of interest” is not preceded by the word “financial”

� Is a meaningful distinction being drawn here, or

� Is this sloppy drafting?

Section 642(c)(2)(C) of the Head Start Act (42 USC 9837)

Implications for Bylaws


73

� Organizations operating Head Start programs should review their bylaws in terms of director qualifications and removal of directors

� Qualifications� The bylaws should state that a person is ineligible to serve as a

director if they have a prohibited conflict or if one arises

� People wanting to serve as a director of the organization have a choice to make if they otherwise want to do business with the organization

� Election� All postings for director openings should refer to the qualification

requirements, pointing out that an otherwise successful candidate will not be seated if he has a prohibited conflict

(continued)


74

� Removal� The bylaws should provide for a procedure that results in the

removal of the director if the director has a prohibited conflict. There may be room for a procedure that stops short of removal if the conflict is eliminated and other mitigating circumstances exist, but this should be reviewed with legal counsel.

� Notice� The bylaws should require directors to notify the board of any

prohibited conflicts as soon as the director becomes aware of a conflict

Concluding Thoughts


75

� The statute prohibiting certain conflicts is poorly drafted, creating lots of uncertainty

� One approach to the problem: When in doubt,� Begin with the organization’s legal counsel

� Do not hesitate to contact OHS and ask. If OHS gives the OK, get something in writing before proceeding.

� Recognize that even without the specific prohibition, conflicts are not a good idea. Therefore, the organization should not proceed with a transaction posing what is potentially a prohibited conflict. Instead the organization should find a third-party who is not tainted

May 16, 2011

Conflicts-of-Interest Policies

THE TRUE COST OF CONFLICTS

76


Incurable Conflicts77

Major Cultural Institution

Well-Know Bus.

Person

Arch.Son-in-

Law

Chairman of theBoard and Potential

Big Donor:Claims to Have No

Knowledge of The Award

MAJOR ADDITION TO

FACILITY

Exec. Dir.

The Board

Award ContractTo Son-in-Law


(continued)78

� Three questions:� Does recusal (or no knowledge) cure the potential conflict?� Does competitive bidding cure the conflict?� Does the high-profile nature of the transaction cure the conflict?

� Answer: No!� Other architects might not have bid because they believed the

process would favor the son-in-law� Does awarding to the son-in-law eliminate a fundraising opportunity

that comes with using an internationally-known architect?� Is the executive director independent? Doesn’t the chairman of the

board have influence over the executive director’s salary? Is it appropriate to view the executive director as a proxy for the board chair?

� Received bad press coverage


May 16, 2011


POLICY TERMS AND PROVISIONS

79


Basic Provisions80


81

PURPOSES CLAUSE


Example 182

� Example 1: Purposes: The purpose of the conflict of interest policy is to protect this tax-exempt organization's (Organization) interest when it is contemplating entering into a transaction or arrangement that might benefit the private interest of an officer or director of the Organization or might result in a possible excess benefit transaction. This policy is intended to supplement but not replace any applicable state and federal laws governing conflict of interest applicable to nonprofit and charitable organizations. (IRS)


Example 283

� Example 2: Purposes: The purpose of this policy is to provide guidance in identifying and handling potential and actual conflicts of interest involving the foundation. In most instances, conflicts of interest can be avoided simply by continuing to exercise good judgment and, indeed, the foundation relies on the sound judgment of its employees to prevent many such conflict situations.

The foundation is committed to the highest levels of integrity. Employees of the foundation are expected to conduct their relationships with each other, the foundation, and outside organizations with objectivity and honesty. The general rule is that: foundation employees are obligated to avoid and disclose ethical, legal, financial, or other conflicts of interest involving the foundation, and remove themselves from a position of decision-making authority with respect to any conflict situation involving the foundation. (Gates Foundation)


Example 1: IRS Example 2: Gates

� Tax focused

� Focus is on everyone

� Reason for the clause

� For all purposes

� Focus is on employees

� Overarching rule

84

Comparison


85

COVERED PERSONS


Example 186

� Example 1: Interested Person. Any director, principal officer, or member of a committee with governing board delegated powers, who has a direct or indirect financial interest, as defined below, is an interested person. (IRS)


Example 287

� Example 2: This statement is directed not only to directors and officers, but to all employees who can influence the actions of the organization. For example, this would include all who make purchasing decisions, all persons who might be described as "management personnel," and anyone who has proprietary information concerning the organization. (Minnesota AG)


Who88

� Who—Direct � Officers

� Directors

� Employees

� Volunteers

� Independent Contractors

� Contractors

� Members of the Charitable Class?

� Who—Indirect � Family members

� Ownership (related entities)

� Interlocking boards and position


Family89

� Possible Definitions:� IRS: The family of an individual includes only his or her

spouse, ancestors, brothers and sisters (whether by the whole or half blood), children (whether natural or adopted), grandchildren, and spouses of brothers, sisters, children, and grandchildren

� Section 404 of Sarbanes-Oxley: Child, step-child, parent, step-parent, spouse, sibling, mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-in-law, and any person (other than a tenant or employee) sharing the household of the covered person

� Gates Foundation: The listed members include “domestic partners”


Related Entities90

� An entity in which the covered individual or a family member owns more that a certain percentage of the equity interests� Entities

� Corporation

� Partnership (are limited partners treated differently than general partners)?

� Limited liability companies

� Sole proprietorships

� What percentage?

� Any interest (may want to except out publicly-traded corporations)

� More than 50% is certainly a logical percentage

� Other (maybe 5% if closely-held business)


(continued)91

� Base for measurement

� Voting control;

� Value; or

� Both?

� Attribution of ownership

� Could refer to Sections 267 and 318 of the Internal Revenue Code

� Gets at the question of direct ownership of an interest in an entity and indirect ownership in the same entity. When is indirect ownership added to direct ownership to determine whether the percentage threshold has been met


Interlocking Boards and Positions92

� Is an entity covered by reason of the fact that someone with the organization has a relationship with the entity

Organization Other Entity

OfficerDirector

EmployeeVolunteer

OfficerDirector

EmployeeVolunteer


Balancing the Breadth of Coverage93


94

COVERED TRANSACTIONS


Example 195

� IRS Form 990, Schedule L� Loans to or from the organization

� Grants or assistance benefiting interested persons

� Business transactions: Include but are not limited to contractsof sale, lease, license, and performance of services, whether initiated during the organization’s tax year or ongoing from a prior year.

� IRS Conflicts of Interest Policy: “Transaction or arrangement”


Example 296

� A conflict of interest may arise through:

1. Owning stock or holding debt or other proprietary interests in any third party dealing with the Organization.

2. Holding office, serving on the board, participating in management, or being otherwise employed (or formerly employed) with any third party dealing with the Organization.

3. Receiving remuneration for services with respect to individual transactions involving the Organization.

4. Using the Organization’s time, personnel, equipment, supplies, or good will for other than Organization -approved activities, programs, and purposes.

5.Receiving personal gifts or loans from third parties dealing or competing with the Organization. Receipt of any gift is disapproved except gifts of a value less than $50, which could not be refused without discourtesy. No personal gift of money should ever be accepted. [Minnesota AG Policy]


97

NOTIFICATION


When to Notify98

� Annually through a standard questionnaire� A matter or routine

� Before the potential conflict ripens� The director is going to enter into a contract with the

organization

� When becomes aware of the conflict� The director learns that his brother purchased a 40% interest

in a company that does business with the organization


Who to Notify99


100

VALIDATION


Head Start101

� CAA’s with Head Start programs cannot validate financial conflicts of interest when the other party to the transaction is a member of the board or a member of the policy council. For the specific limitation, see Sections 642(c)(1)(C) and (2)(C) of the Head Start Act (42 USC 9837)


Typical Validation Procedures102


(continued)103


104

CONSEQUENCES FROM VIOLATING THE POLICY


References105

� If a director can be removed for violating the conflicts-of-interest policy,� The procedure for removal under the policy should be recited or

integrated with the articles of incorporation or bylaws

� Be particularly diligent about integration if the organization is a membership organization

� If an employee can be terminated for violating the conflicts-of-interest policy,� The policy should be recited in or integrated into the employee

handbook

� Employment contracts should reflect the policy

� Disciplinary procedures that stop short of termination must should be reflected in the policy


May 16, 2011


IRS FORM 990

106


The Form 990107

� The Form 990 is a public document, readily available on GuideStar

� The legislative history underlying the public disclosure requirements is clear: Congress viewed the Form 990 as promoting the administration of the tax laws and assuring public accountability

� The legislative history to the provision expanding public availability provides:

In the case of charitable organizations, the committee believes that increased availability of information will help assure that the double tax benefits of deductibility of contributions and exemption from income tax are limited to organizations whose assets are devoted exclusively to charitable purposes, as required by the tax law. Also, because most such charities regularly solicit contributions or receive other support from the public, the public should have ready access to current information about the activities of these organizations…

H.R. Rep. No. 100 391, 100th Cong. 1st Sess. (1987)


The Gift That Keeps Giving108

� In 2007, the IRS redesigned the Form 990

� The redesigned Form 990 first applies to taxable years beginning in 2008

� It is comprised of:� An 11-page Core Form

� 16 schedules. The facts and circumstances dictate which schedules a particular organization must complete

� The package (including instructions in excess of 200 pages—available on the IRS website


(continued)109

� The package is a treasure trove of information� We easily could spend 4 hours discussing it

� The media and watchdog groups are thrilled with the information that it will provide

� We only have time for some of the highlights. Jack Siegel has written a 80-page guide to the form which is included in the updated version of White, New York Business Entities (LexisNexis)


Conflicts and a Tax Return: Huh?110

� The IRS is very interested in conflicts of interest from a tax administration standpoint� Conflicts may indicate that the organization isn’t operated for

charitable purposes

� Relatedly, conflicts may be indicative of private benefit, whichprecludes Section 501(c)(3) status

� Conflicts can result in unreasonable compensation, triggering the intermediate sanctions


Highlight 1: The Questionnaires111

� Several important sets of questions require detailed information that is known by board members, managers, and others� The organization can discharge its obligation to collect this

information by circulating an annual questionnaire to directors, managers, and others

� If you are director or officer of a tax-exempt organization, this may explain why you received a 12-page questionnaire


Highlight 2: Conflicts Policy112

� Part IV of the Core Form: Governance, Management, and Disclosure

� Vital information� Line 1a: Number of voting members

� Line 1b: How many of those voting members are independent?

� Line 2: Did any of the directors, officers, or key employees have business or personal relationships with each other?

� Conflicts

� Lines 12a: Does the organization have conflicts of interest?

� Line 12b: Are officers, directors or trustees, and key employees required to disclose annually interests that could give rise to conflicts?

� Line 12c: Does the organization regularly and consistently monitor and enforce compliance with the policy?


Highlight 3: Schedule L113

� Schedule L, Transactions with Interested Persons� Excess benefit transactions (violations of the intermediate

sanctions)

� Loans to or from interested persons

� Grants or assistance to interested persons

� Business transactions between the organization and interested persons

� Definitions and exceptions are important, but lots of important information will be disclosed


Highlight 4: Schedule R114

� Schedule R requires all related entities to be listed

� This permits outsiders to piece the pieces together

� Hiding conflict transactions by using separate entities will be much more difficult


Highlight 5—Schedule O115

� Schedule O is where all the supplemental disclosures are made. It is a good place to defuse controversy by explaining transactions that may be appropriate, but that have the taint of conflict


The Facts116

� The Form 990 is filed under penalties of perjury� See United States v. Mubayyid, 2008 U.S. Dist. LEXIS 56090. (D. Mass. 2008); � Ben Gose, Three Convicted of Lying in Charity Terrorism Case, CHRON. OF

PHILANTHROPY (Jan. 24, 2008).

� Refusing to provide all required information can result in regulatory action� Commonwealth of Pennsylvania v. The Declaration Foundation, Docket No.

0011-98-0-6: Consent Agreement and Order (Aug. 18, 2006) available at http://www.dos.state.pa.us/char/lib/char/consent_agreements/declaration_foundation,_inc._06-98-04601.pdf.

� Many organizations are required to file the Form 990 with state charity regulators. They also are beginning to challenge organizations that file incomplete or false Form 990s� For an alleged failure to file accurate and complete Form 990s, see complaint by

California Attorney General against L.B. Research and Education Foundation and several officers and directors (Sept 8, 2009)


The Solution117

� Build compliance into the organization’s accounting systems


May 16, 2011


OTHERS ARE WATCHING

118


Tone at The Top119

� Employees are watching� Former president of Philadelphia’s Independence Seaport

Museum stole at least $1.5 million from the museum and was sentenced to a 15-year prison term

� You always need to be skeptical of what a now-convicted felon has to say

� In a pre-sentencing letter to the judge, the former employee pointed to poor governance practices, writing:


(continued)120

“The Trustees routinely had large parties for themselves at museum expense.

Service contracts went to Trustees or friends of trustees (insurance, legal services, investment management etc) without bids.

The culture of the Board mentioned earlier hadn't changed much as a result of all this renewed activity on the Museum's part. During the refurbishment of the building several large contractshad gone out as "no bids" to people associated with Board members or actual members of the Board. Approximately 4-6 million of costs were farmed out in this manner despite the discouragement of me and the architect in charge. Insurance and legal were still handled by Board members or friends of Board members as were other contracts let from time to time.


(continued)121

The most egregious issue had to do with the management of the invested endowment funds. The outside investment managers we had, who were friends of Board members, began to fail badly in late 1998 as the stock market began to suffer. Repeatedly I and my in house business managers brought up the fact that as losses piled up something needed to be done.

Despite the above there still remains the questions of myself. As I allude to in the last paragraph I did convert museum funds, goods and service to my own use. I am not sure when this began, but probably around the late 1990's. Like all schemes it started outdiscreetly and grew I am ashamed and remorseful for these actions and offer no credible excuse for what I did. At some point I guess I began to feel that I should be getting my fair share, at least this is how I rationalized my use of museum resources.”


(continued)122

� Peter McCausland, the museum's board chair, did acknowledge that the museum had given board members contracts, but told the Philadelphia Inquirer that the members were "good people who have given of their time and a considerable amount of money to help the museum grow and prosper - on a volunteer basis.”

� Tone at the top and managing employee perceptions matters


The Media123

� I receive calls from the media on an almost weekly basis

� Most are doing investigative reporting or responding to a charity in trouble

� Almost to a person, the reporters have reviewed the Form 990 before they called me� Some reporters are very good

� Others don’t have a clue about how to read the Form 990

� Many reporters believe that executive compensation is too high and that conflicts are inherently corrupt and immoral


(continued)124

� No matter what the story is about, any conflicts disclosed in the Form 990 inevitably will find their way into the Form 990, usually toward the start of the article

� The story can be about an employee theft, a sexual harassment suit, a merger, or a donor who has reneged on a pledge. Seemingly nothing to do with conflicts. Nevertheless, the conflicts ended up in the story

� And most importantly, the public doesn’t like conflicts of interest


(continued)125

� It’s your choice, but those are the facts


May 16, 2011


CONCLUSIONS

126


You Can Do It


127

� The WSJ reported in an April 15, 2011 article that 15 members of the Boys and Girls Club of Northern Westchester left the charity during the last two years.

� The departures were attributable to differences over how “the charity was being run” and how money was being spent

� Some of the departing members apparently indicated concern that the organization was doing business with too many board members

� The WSJ reported that the latest tax return reported $412,000 in business contracts with board members

(continued)


128

� Group-term life insurance

� Health insurance

� Graphic design services

� Two boards members argued that the conflicts were disclosed

� THE LESSON: Board members have choices!

Conclusions129

� Organizations should avoid conflicts whenever possible

� Conflicts are not necessarily causative in terms of financial problems, poor governance, and failures to achieve mission, but there is a high correlation� Go figure


(continued)130

� There will be people sitting here who will go back to their organizations and engage in or approve transactions with conflicts

� I am a realist, but I hope I have made you realize that there is more to conflicts than the DANCE


JACK B. SIEGEL

SITTING ON A BARBED WIRE FENCE: CONFLICTS OF INTEREST

PRELIMINARY QUESTIONS FOR YOUR CONSIDERATION

Please answer the following questions before the presentation. There are no grades.

The questions are designed to make you think about some of the issues that will be

addressed during the presentation.

1. Does my CAA have any conflicts of interest? ______YES _____NO

2. Conflicts of interest are OK if properly managed. ______TRUE _____FALSE

3. There is no problem with a director providing goods or services to a CAA if

the CAA pays below fair market value for the goods or services. _____TRUE

____FALSE

4. A CAA with a Head Start program should be particularly concerned about

financial conflicts of interest involving the Head Start program, but the CAA

can have financial conflicts of interest involving other programs without

worrying about the Head Start implications. ______TRUE ____FALSE

5. Certain financial conflicts of interest must be disclosed on the IRS Form 990

_____TRUE _____FALSE

6. A member of a CAA's board who represents members of the low-income

community (he occupies a position on the board reserved for representatives

of the low-income community) need only focus on what is best for the low-

income members of the community when making decisions. _____TRUE

_____FALSE

7. A government official who is a board member owes a duty of loyalty to the

CAA when deciding whether government grants should be awarded to the

CAA. _____TRUE _____ FALSE

Documents

5A. Governance: Conflicts of Interest: Sitting On a …. Governance: Conflicts of Interest: Sitting On a Barbed-Wire Fence CAPLAW 2011 National Training Conference Friday, June 17,