Nonprofit Ethics--Chapter 7 of The Nonprofit Handbook

by Gary Grobman

Nonprofit organizations, especially those qualified under section 501(c)(3) of the Internal Revenue Code, occupy a special and unique place in American society. Their uniqueness has many attributes.

All such organizations are supported by the nation’s taxpayers: they are exempt from federal and state income taxes; contributors, for the most part, can deduct their contributions from their federal income tax (and from their state income taxes in most states); they are eligible to have their postage subsidized by the federal government; and many are exempt from state and local sales and property taxes.

Among the general categories of ethical conflicts that are endemic to the nonprofit sector are accountability, conflict of interest, and disclosure. Specific issues of interest are relationships between board members and the staff; board members and the organization (such as business relationships); self-dealing; charitable solicitation disclosure; the degree to which donations finance fundraising costs rather than programs; the accumulation of surpluses; outside remuneration of staff; the appropriateness of salaries, benefits, and perquisites; and merit pay. For example, pay based on income received rather than mission accomplished is considered unethical. Staff members of charities are under more of an obligation not to exploit their position on staff for personal gain (such as charging a fee for outside speaking engagements on their own time) than their for-profit counterparts. Unlike their for-profit or government counterparts, charities generally are under an ethical, if not legal, obligation not to accumulate large surpluses. Salaries, benefits, and perquisites must be “reasonable,” and prior to the promulgation by the IRS of regulations relating to this and other “excess benefit” transactions, the legal requirements applying to these issues were in a gray area.

The following are some issues relating to ethics that are appropriate for nonprofit boards and staff to consider:

1. Accountability

Accountability often is overlooked in discussions about ethics. Because of the unique status of 501(c)(3) organizations, they have a special obligation to the public to be accountable for the results of their activities that justify their tax exemptions and other privileges. Organizations should continually challenge themselves by asking if the outcomes produced are worth the public investment.

Nonprofit boards of directors have a special obligation to govern with integrity. Governing with integrity means that the organization recognizes that it is accountable to the public, to the people it serves, and to its funders. Accountability includes the concept that nonprofit organizations exist only to produce worthwhile results in furtherance of their missions.

In addition, accountability encompasses a core system of values and beliefs regarding the treatment of staff, clients, colleagues, and community. Yet, organizational survival needs too often undercut core values. Although everyone in the organization is responsible, it is the board’s ultimate responsibility to assure that its values are not compromised, and that the activities are conducted within acceptable limits.

A more subtle issue of accountability is seldom discussed when staff will sometimes pursue grants and contracts, or engage in direct solicitation campaigns, for the primary purpose of growing. Boards sometimes ask whether the executive director “grew the organization” as the primary criterion for measuring success. Boards have an obligation to ensure that all activities support the organization’s mission.

2. Conflict of Interest

A potential conflict of interest occurs any time organizational resources are directed to the private interests of a person or persons who have an influence over the decision. Examples might include the leasing of property owned by a relative of the executive director or a board member, the board awarding itself a salary, the organization hiring a board member to provide legal representation, or the executive director hiring a relative or a board member’s relative.

A conflict also can occur when the person (or persons) making a decision expects something in exchange from the person in whose favor the decision is made. One example is the case in which an executive director retains a direct mail firm, and the executive director’s spouse is hired by that direct mail firm shortly thereafter.

With regard to board members, the cleanest approach is to adopt a policy that does not allow any board member to profit from the organization. It is the duty of every board member to exercise independent judgment solely on behalf of the organization. For example, suppose a board member who owns a public relations business successfully argues that the nonprofit needs a public relations campaign and then is hired to conduct the campaign. The board member’s self-interest in arguing for the campaign will always be subject to question.

Suppose in the above example the board member offers to do the campaign “at cost,” and that is the lowest bid. It may be that even at cost, the board member’s firm benefits because the campaign will pay part of the salary of some staff members or cover other overhead. It may be perfectly appropriate to accept the board member’s offer, even though it is a conflict of interest. However, it is absolutely essential that the board have a procedure in place to deal with these types of issues.

Some organizations permit financial arrangements with board members, provided that the member did not vote on that decision. Given the good fellowship and personal relationships that often exist within nonprofit boards, such a rule can be more for show and without substance.

A similar problem can cause a conflict in the awarding of contracts to non-insiders. There may be personal reasons for one or more members of the board or the executive director to award contracts to particular persons, such as enhancing their personal or professional relationship with that person.

There are instances in which it is appropriate to have a contract with an insider, such as when a board member offers to sell equipment to the organization at cost, or agrees to sell other goods or services well below market value. Here, too, the organization should assure itself that these same goods or services are not available as donations.

It is essential for the board to confront and grapple with these issues and adopt a written policy to govern potential conflicts of interest, to avoid the trap of self-dealing or its appearances. Many potential abuses are not only unethical, but also illegal as a result of the Taxpayer Bill of Rights 2 (see page 66). A sample conflict of interest policy can be found at: http://www.irs.gov/pub/irs-pdf/i1023.pdf (see page 25 of the form).

3. Disclosures

There is much disagreement within the nonprofit sector regarding how much disclosure is required to those who donate to charitable nonprofits. The first obligation of every organization is to obey the laws and regulations governing disclosure. Nonprofits have a legal and ethical obligation to report fundraising costs accurately on their IRS Form 990, to obey the requirement regarding what portion of the cost of attending a fundraising event is deductible, and to comply with state charitable registration laws and regulations.

Nonprofits face a more difficult ethical issue when deciding how much disclosure to make that is not required by law, particularly if the organization believes that some people may not contribute if those disclosures are made.

In the for-profit corporate world, the Securities and Exchange Commission demands full, written disclosure of pertinent information, no matter how negative, when companies are offering stock to the public. There is no comparable agency that regulates charitable solicitations by nonprofits. Nonprofits must be very careful to disclose voluntarily all relevant information and to avoid the kind of hyperbole that misrepresents the organization.

Another difficult issue is whether fundraising costs should be disclosed at the point of solicitation. The costs of telemarketing campaigns or of maintaining development offices are sometimes 80%, or even more, of every dollar collected. Some argue that people wouldn’t give if these costs were disclosed. Others argue that if the soliciting organization cannot justify these costs to the public (and in many cases they are not justifiable), then the organization is not deserving of support.

4. Accumulation of Surplus

If the funds of a charitable nonprofit are to be used for charitable purposes, what is a reasonable amount of surplus to accumulate? One national charitable watchdog agency, the Better Business Bureau’s Wise Giving Alliance, has suggested that a charity’s unrestricted net assets available for use should be no more than three times the size of the past year’s expenses or three times the size of the current year’s budget, whichever is higher.

Organizations should consider the circumstances under which it is appropriate to disclose to prospective donors the amount expected to be used to accumulate a surplus. Clearly, if a major purpose of the solicitation is to build a surplus, that should be disclosed.

5. Outside Remuneration

Executive directors and other staff often are offered honoraria or consulting fees for speeches, teaching, providing technical assistance, or other work. The ethical issue is whether the staff person should turn the fees over to the nonprofit employer or be able to retain them. Potential conflicts can be avoided if the policy is based on the principle that all reasonably related outside income belongs to the organization. Thus, an executive director’s honorarium for speaking to a national conference as a representative of the organization or as an expert in his or her field would revert to the employer, but a fee for playing in a rock band on weekends would be his or hers to keep.

An argument against this principle is that the employees’ usage of their spare time should be of no concern to the employer. The argument on the other side is that the line between the employer’s and personal time is not so easy to draw. Is it ethical for an employee to exploit the knowledge and experience gained on the job for personal gain? Are we buying only the employee’s time from our employees, or do we expect that we are getting the undivided professional attention of that person?

If the board or executive director is silent on this issue, the assumption is that earning outside income is a private matter. It makes sense to have a clear policy on outside income before an employee is hired.

6. Salaries, Benefits, and Perquisites

Determining an appropriate salary structure is perhaps the most difficult ethical issue in the nonprofit sector. Ethical considerations arise at both the high and low ends of the salary spectrum.

If an organization is funded by grants from foundations and corporations or by government contracts, the funders can and do provide some restraint on excessive salaries. However, if the nonprofit is funded primarily by individual donations or fees for service, such constraints (other than, perhaps, those relating to the intermediate sanctions regulations of the Internal Revenue Service―see below) are absent.

Boards fall into an ethical trap if they reward executive directors based on the amount of income received, rather than on how well the mission is accomplished. A board can consider many criteria when setting the salary of the executive director. These include the size and complexity of the organization, what others in similar agencies are earning, and whether the salary is defensible to the public. Some nonprofits include proportionality in their salary structures by limiting the highest paid to a factor of the lowest paid (e.g., the highest can be no more than three times the lowest).

As a result of enactment of the Taxpayers Bill of Rights 2, there are now legal as well as ethical restrictions about paying excessive compensation. Ethical management of employees requires that each person be treated with dignity and respect, paid a salary that can provide a decent standard of living, and given a basic level of benefits, including health coverage. A potential, critical conflict arises when a charitable organization working to spread its social values treats its staff in a way that conflicts with its organizational values.

7. Personal Relationships

Nonprofit organization executives and board members must be careful to avoid sexual harassment or behavior that makes an employee feel uncomfortable at best or threatened and intimidated, at worst. Employees should be treated fairly, which among other things, means that no favoritism should be permitted with respect to work assignments. Discrimination should not be permitted even if it doesn’t meet the threshold required for legal violations.

Nepotism―the hiring of family members―should be prohibited. Nonprofit executives and board members should seek to keep personal friendships from influencing professional judgment. Managers shouldn’t make it difficult for employees to maintain an appropriate work-family balance. Privacy and confidentiality of workers should be respected. A diverse workforce means that cultural differences among staff should be respected to the maximum extent possible.

In 1998, the Maryland Association of Nonprofit Organizations initiated an ethics and accountability code for the nonprofit sector entitled Standards for Excellence. Along with the code, the program includes educational components and a voluntary certification process whereby charities can receive certification that they meet basic ethical and accountability standards. As a result of two major grants, the program has been expanded beyond Maryland to include nine other states (Florida, Georgia, Idaho, Louisiana, North Carolina, Ohio, Oklahoma, Pennsylvania, and West Virginia). Launched in July 2004, a national institute (http://www.standardsforexcellenceinstitute.org) now provides nonprofit organizations access to the educational tools to support implementing the Standards. The 55 performance standards required for an organization to be certified by the program are grouped in eight areas:

• Mission and Program

• Governing Board

• Conflicts of Interest

• Human Resources

• Financial and Legal Accountability

• Openness and Disclosure

• Fundraising

• Public Policy and Public Affairs

Participating charities may demonstrate that they adhere to the standards by participating in a peer review process. They submit an application, document their compliance with the standards, and pay a fee. If the peer-review panel affirms that the organization meets the standards, the organization receives a Seal of Excellence, with the expectation that having the Seal will provide the organization with increased credibility with donors and grantmakers. The full set of standards can be found at:

http://www.standardsforexcellenceinstitute.org

Among the standards are:

• On average, over a five-year period, a charity should assure that fundraising revenues as compared with expenses have a greater than a 3:1 ratio.

• Fundraisers, whether or not they are employees or independent consultants, should not be compensated based on a percentage of the amount raised or some other commission formula.

• Nonprofit organizations should have a conflict of interest policy and a procedure to provide board, staff, and volunteers with an annual opportunity to submit a conflict-of-interest statement, to disclose actual and potential conflicts of interest.

The Taxpayer Bill of Rights 2 was signed into law by President Clinton on July 30, 1996. The principal purpose of this law is to punish individuals affiliated with charities and social welfare organizations who are participating in financial abuses, and to provide the government with a sanction other than simply revoking the charity’s exemption status. The law also includes expanded public disclosure requirements for annual federal tax returns.

Previous law required charities to make their 990 tax returns available for public inspection, but did not require that copies be provided. The law was changed to require that if a person requests a copy of the 990 in person, it must be immediately provided for a reasonable copying fee. If the request is made in writing, it must be provided for a reasonable copying and postage fee within 30 days. Organizations that make these documents “widely available,” such as posting them on the Internet, are exempt, although they still must make the document available for public inspection. The law expands the disclosure that must be made on the 990, adding information about excess expenditures to influence legislation, any political expenditures, any disqualified lobbying expenditures, and amounts of “excess benefit” transactions.

The law increases the fine for failure to file a timely 990 from $10 per day to $20 per day, with a maximum of $10,000. Higher fines apply to organizations with gross receipts over $1 million.

Both state and federal law have prohibitions against “private inurement”― permitting a charity’s income to benefit a private shareholder or individual. Legislation at the federal level to define what constitutes a prevalent form of private inurement and to refine the definition of a private shareholder was enacted. It aims to respond to alleged financial abuses by some organizations that were perceived as providing unreasonable compensation to organization “insiders.”

To curb financial abuses, the law authorizes the IRS to impose an excise tax, 25% in most cases, on certain improper financial transactions by 501(c)(3) and 501(c)(4) organizations. The tax applies to transactions that benefit a “disqualified person,” defined as people in positions who exercise substantial influence over the organization, their family members, or other organizations controlled by those persons.

Disqualified persons include voting members of the board, the president or chair, the CEO, the chief operating officer, the chief financial officer, and the treasurer, among potential other officers and staff. The benefit to the disqualified person must exceed the value that the organization receives to be subject to the tax. To avoid problems, tax experts are advising organizations to treat every benefit to a director or staff person as compensation, and reflect these benefits in W-2s, 1099s, and budget documents. Seemingly innocent benefits, such as paying for the travel and lodging expenses for a spouse attending a board retreat or a health club membership for an executive director, may trigger questions about excess benefit. Luxury travel could be considered an excess benefit.

Compensation is considered reasonable if it is in an amount that would ordinarily be paid for similar services by similar organizations in similar circumstances. The term “compensation” is defined broadly, and includes severance payments, insurance, and deferred compensation.

Most of the provisions relating to intermediate sanctions apply retroactively to September 14, 1995, the date the legislation was first introduced. Steep additional excise tax penalties, up to 200% of the excess benefit plus the initial 25% excise tax, apply for excess benefit transactions that are not corrected in a reasonable amount of time. An excise tax may also be applied to organization managers (a term that is meant to include an officer, director, trustee) who approve the excess benefit transaction in an amount of 10% of the excess benefit, up to $10,000 maximum per transaction.

Although these excise taxes apply to individuals and not to the organizations themselves, there is nothing in this law that prohibits organizations from paying the tax or purchasing insurance to cover an individual’s liability for the tax penalty. However, if the organization does purchase this insurance, the premium must be considered compensation to the individual. This insurance could become the basis for an excess benefit if total compensation to the individual, including this insurance, exceeds the fair market value that the person provides to the organization in exchange for the total compensation that person receives from the organization. It makes sense to consult an attorney who is knowledgeable about the Taxpayer Bill of Rights 2 if there are any unresolved issues that would make an organization’s directors and staff vulnerable to an IRS audit.

The Internal Revenue Service published draft regulations on this section of the Revenue Code in the Federal Register on August 4, 1998. Final regulations were published in the Federal Register on January 10, 2001 that were temporary. Permanent final regulations were published in the January 23, 2002 issue of the Federal Register.

The final regulations provide more examples of situations that might be faced by charities. One change included in the final regulations is the safe harbor for organizations to rely not only on the advice of their attorneys (as was a feature of the draft regulations), but also on the advice of other outside consultants, such as their accountants.

Ethics in organizations are enforced through the use of codes of ethics, codes of conduct, staff ethicists, ethics committees, policies and procedures relating to ethical dilemmas, and ethics training.

As explained by Dr. Jeremy Plant of Penn State University, a code of ethics is a systematic effort to define acceptable conduct. It may be general or specific, aspirational or legalistic. The code may be a simple list of ten golden rules, or a long, detailed, codified system of procedures and ideals. In the context of an ethics code, it may have the force of law (such as a statutory ethics code for public officials), be a collection of principles that are not law but are morally binding, or simply contain a system of symbolic principles for meaningful communication.

Unlike government (which has the taxing power) and for-profit business (which generates revenue through market transactions), charities generate much of their revenue through nonmarket mechanisms such as seeking donations (in the form of contributions from the public and grants from foundations and government). This form of revenue generation is a ripe area for fraudulent practices, and many of the ethics-related principles that differentiate nonprofit organizations from their government and private sector counterparts focus on this area.

In recent years, there has been a move toward turning nonprofit management into a recognized profession, with credentialing becoming available for fundraising executives, association managers, and nonprofit organization managers. Organizations such as the Association of Fundraising Professionals (AFP), the American Society of Association Executives (ASAE), and the National Council of Nonprofit Associations―and the state and local chapters of these organizations―have sought to professionalize their memberships.

Until 2003, there had been two major ethical codes focusing on fundraising standards for charitable organizations. The first, which was developed during the late 1980s and went into effect in 1992 (National Charities Information Bureau, 2000), is the National Charities Information Bureau’s (NCIB) Standards in Philanthropy. Almost all of these ethical standards would have been meaningless in anything other than a nonprofit context. The standards were not enforceable by law, but served as a guide to both donors and those who run the charities. The standards were grouped into nine areas:

1. Board Governance

2. Purpose

3. Programs

4. Information

5. Financial Support and Related Activities

6. Use of Funds

7. Annual Reporting

8. Accountability

9. Budget

The Council of Better Business Bureau’s Standards for Charitable Solicitations were first published in 1974. Two revisions were made, the last being in 1981. A process was initiated in the fall of 1999 to help develop a third revision of the standards. The purpose of these standards was to “encourage fair and open solicitation practices, to promote ethical conduct by charitable organizations, and to help sustain public confidence and support of charities.”

The fundamental goal of the revision effort was to create standards that were meaningful and relevant to donors, easily understood by users, and fair and not overly burdensome to charities; to instill public trust and support for philanthropy; and to be reasonable for the parent agency, the BBB, to administer.

In 2001, NCIB merged with the Foundation of the Better Business Bureau, and the new organization, the Better Business Bureau’s Wise Giving Alliance, developed an updated code, published in March 2003. The 20 standards that comprise this influential ethics code can be found at: http://www.give.org/standards/index.asp.

Among the most controversial aspects of this code is the provision that calls for charities to allocate at least 65% of their donations for program expenses, spending no more than 35% of related contributions for fundraising. This is a higher standard than either the NCIB (60%) or the BBB’s Philanthropic Advisory Service (50%) had enforced prior to the merger.

Other standards in this code provide for regular assessment of the CEO’s performance, establishment of a conflict-of-interest policy, the completion of a written assessment of the charity’s performance at least every two years, and standards protecting donor privacy. The new standard frowns upon accumulating unrestricted net assets available for use that exceed either three times the amount of the past year’s expenses or three times the current budget, whichever is higher.

In December 2009, the Wise Giving Alliance announced that it was temporarily loosening its standards because of the severe recession. For the fiscal years ending in June 2008-2010, organizations still qualified for the Wise Giving Alliance stamp of approval if the organization spends at least 55% of donations on program expenses and no more than 45% on fundraising.

The national professional association of fundraisers also has an ethics code. The Statement of Ethical Principles of the Association of Fundraising Professionals (AFP) was adopted in 1991 when that organization was known as the National Society of Fund Raising Executives (NSFRE). AFP “exists to foster the development and growth of fund-raising professionals and the profession, to promote high ethical standards in the fund-raising profession and to preserve and enhance philanthropy and volunteerism” (NSFRE, 1991). This code was amended in 2007 and expanded to 25 principles.

AFP’s ethics code consists of a set of general ethical principles, introduced by a preamble that recognizes the stewardship of fundraisers and the rights of donors to have their funds used for the intent they expect.

Many of these principles would be appropriate for any type of organization, such as to “foster cultural diversity and pluralistic values, and treat all people with dignity and respect” and “value the privacy, freedom of choice and interests of all those affected by their actions.” Some of the principles are appropriate for public organizations, such as having an obligation to “safeguard the public trust” and others are parochial to the profession, such as to “put philanthropic mission above personal gain,” and “affirm, through personal giving, a commitment to philanthropy and its role in society.”

One year after the adoption of the AFP principles, the organization adopted its “Standards of Professional Practice” and incorporated them into its ethics code. Its 25 principles are mostly in the form of “members shall” and “members shall not.”

A statement attached to the standards notes that violations “may subject the member to disciplinary sanctions, including expulsion, as provided by the (AFP’s) Ethics Enforcement Procedures.”

Some of these standards are perfunctory, such as “members shall comply with all applicable local, state, provincial, federal, civil and criminal laws.” Others are general and broad, with implications that are not easily subject to interpretation, such as “Members shall not exploit any relationship with a donor, prospect, volunteer or employee to the benefit of the member or the member’s organization.” Among issues raised by the standards are conflicts of interest, truthfulness, privacy, and financial accountability.

Another issue raised in the principles that is of current interest in a number of professions is the standard that “Members shall not accept compensation that is based on the percentage of charitable contributions.…” Some states have expressly prohibited lobbyists from signing contingency fee contracts in which they are paid only when they are successful in getting a bill or amendment passed by the legislature.

The theory is that such contracts encourage lobbyists to engage in efforts that go beyond the boundaries of acceptable behavior. On the other hand, contingency fees are routine for attorneys in civil cases. It is also not unusual for professional fundraisers to be paid a percentage of the amount they raise. Many in the field find that this practice promotes unethical solicitations (e.g., presentations that exaggerate facts, minimize disclosure, and other behaviors that intimidate and harass potential donors), and it is interesting that a major professional organization such as the AFP has taken an unequivocal position on this issue.

The standards are not enforceable by law, but serve as a guide to both donors and those who run the charities. For more information, contact:

Council of Better Business Bureaus

4200 Wilson Blvd.

Suite 800

Arlington, VA 22203

(703) 276-0100

http://www.bbb.org/us/Standards-Charity

A different set of ethical issues exists around disclosures to foundation and corporate funders. For instance, what is the obligation of disclosing changed circumstances after the proposal is submitted and before it is acted upon, such as when key staff members have announced plans to leave? If the organization knows that the changed circumstance might affect the decision, is it unethical not to disclose it?

In February 2004, Independent Sector adopted a Statement of Values and Code of Ethics for Nonprofit and Philanthropic Organizations, and recommended that it serve as a model. The statement identifies a set of values to which nonprofits may subscribe including commitment to the public good, accountability to the public, and commitment beyond the law. It also outlines broad ethical principles in the following areas: personal and professional integrity, mission, governance, legal compliance, responsible stewardship, openness and disclosure, program evaluation, inclusiveness and diversity, and fundraising. The full text can be accessed at:

http://www.independentsector.org/members/code_ethics.html

There are many excellent publications on the subject of ethics. A few of them are:

1. A series of articles by David E. Mason in Nonprofit World, published by the Society for Nonprofit Organizations.

The Society For Nonprofit Organizations

P.O. Box 510354

Livona, MI 48151

(734) 451-3582

(734) 451-5935 (fax)

http://www.snpo.org

2. Making Ethical Decisions (33 pages, $12.95 plus shipping and handling).

Josephson Institute of Ethics

9841 Airport Boulevard

#300

Los Angeles, CA 90045

(310) 846-4800

(310) 846-4858 (fax)

http://josephsoninstitute.org/MED/index.html

3. Ethics and the Nation’s Voluntary and Philanthropic Community.

Independent Sector

1602 L Street, STE 900

Washington, DC 20036

(202) 467-6100

(202) 467-6101 (fax)

http://www.independentsector.org

There are many other ethical issues that nonprofit organizations will confront on a regular basis, such as: personal use of office supplies and equipment; personal use of frequent flier mileage; the extent of staff and board diversity; and the use of private discriminatory clubs for fundraisers, board meetings, or other events. The list is endless.

What is important is that nonprofit organizations proactively engage in discussions about ethics and values on a regular basis, recognizing that the charitable nonprofit sector has a special obligation to uphold the very highest standards. Boards of directors of charitable nonprofits have an important role in this regard. Boards cannot play a more important role than assuring that nonprofits are accountable, and that they operate as mission- and value-driven organizations.

Many who choose to work in the nonprofit sector do so because the stated values of the sector and their personal values are in harmony. It is critical that such people be vigilant against the erosion of those very principles that attracted them to the work.

Only in this way can the public be assured that the charitable nonprofit sector remains worthy of its privileges and that the sector continues to occupy its special and unique place in our society.