Governing Nonprofit Organizations: Federal and State Law and Regulation
by Marion R. Fremont-Smith
Harvard University Press, 2004
550 pp., $95.00
Few ideas are more deeply ingrained in the philanthropic world than the notion that nonprofit organizations compose a distinctive “independent” or “third” sector, separate from government and business, and thus free from both political and commercial constraints to serve the public.
In truth, the independent sector is not so independent. Much of its income comes from government grants, contracts, and reimbursements, or commercial transactions, including various kinds of partnerships with businesses, as well as sales of goods and services. Private donations ebb and flow with economic boom and bust cycles, as well as the shifting generosity of tax incentives for charitable giving.
Nonprofit organizations engaged in education, healthcare, and other kinds of activities often have to comply with publicly mandated standards for their programs. In addition, a complex set of federal and state laws directly affect how nonprofits are governed.
The doyenne of experts on the legal rules applying to tax-exempt organizations is Harvard’s Marion Fremont-Smith, who has written Governing Nonprofit Organizations as an outgrowth of her 1965 book on foundations and the law. Though her earlier work is an acknowledged classic, it has long been overtaken by developments in legislatures, the courts, and administrative agencies. Thorough, and detailed to the point of being mind-numbing, this new book does not disappoint as it ranges widely from the history of rules about establishing charitable trusts and corporations, to the intricacies of the Internal Revenue Code, and on to the crazy quilt of state regulations regarding the duties of donors and trustees.
The book should be essential reading and a reference for anyone responsible for—or just interested in—nonprofit governance, especially those trying to formulate new standards and regulations in response to the recent exposés of malfeasance in the sector.
Count Fremont-Smith among those who believe changes need to be made. “Philanthropy in the United States has been claimed by one writer to be ‘our freest enterprise,’” she observes. And with a few exceptions, she believes this is true. In recent years “the great body of legislation and court decisions has been directed toward the removal of restrictions on the charitable funds and toward the grant of almost complete freedom of action to the managers and directors of these funds.” Unfortunately, as she sees it, this has created problems in several areas.
One problem is that nonprofit directors have become increasingly insulated from liability for the misuse of funds set aside for charitable purposes. This stems from a willingness by the courts to allow business judgments, and not traditional fiduciary standards of “care” and “loyalty,” to set a nonprofit’s course. Instead of expecting those with authority over philanthropic funds to act cautiously and disinterestedly, courts and regulators have become more tolerant of actions taken on the basis of economic calculations, including those which are risky or where insiders may have a financial stake. Fremont-Smith acknowledges that these broader standards of conduct may benefit charities, but still believes “the most important change” that could be made to improve nonprofit governance would be to tighten them.
She’s also concerned about government’s ability to enforce existing laws and regulations. Under traditional legal rules, usually only a charity’s trustees or a state’s attorney general could sue, if they believed the charity were behaving improperly. Judging these recourses insufficient, courts have slowly expanded the rights of a charity’s donors and beneficiaries (including members of the community it serves) to take action. Fremont-Smith is wary of such steps, lest they produce too many frivolous complaints or, in the case of donors, allow them to exercise excessive control over gifts long after they have been made. Instead, she favors having an “active and interested [state] attorney general” who would not hesitate to intervene to correct abuses.
Similarly, she would like to see the Internal Revenue Service become more aggressive in carrying out its responsibilities. Not until 1969, Fremont-Smith notes, did the IRS have significant power to regulate how charities were governed (rather than just determine if they deserved special tax privileges), and not until 1996, with the enactment of penalties for private and excess benefits, did its authority extend to most of the nonprofit sector. But the unwieldiness of IRS bureaucracy, complicated by “inadequate funding” and restrictions on its ability to share information with state regulators, has actually produced a “dearth of guidance” and fewer audits of potential violators. Such inattentiveness, she warns, will give officers and directors of charities too many opportunities to seek private gains from money donated to charity, a problem that, judging from last summer’s Senate hearings, some lawmakers already feel is at hand.
Unfortunately, while Fremont-Smith explores the legal issues at length, Governing Nonprofit Organizations sheds little light on the actual extent of misbehavior in the nonprofit world. Admittedly, this is an area where almost no hard data exist. The best Fremont-Smith can manage is a study she conducted that looked for news stories about wrongdoing by “charitable fiduciaries” in over 13,000 publications between 1995 and 2002. The search turned up a grand total of 152 instances, many of which involved the misuse of grant funds from federal or state programs to nonprofit organizations, which suggests that politics, rather than standards of behavior in charities, may be the biggest problem. Even so, Fremont-Smith claims that her study “reinforces an initial impression that there is serious underreporting, and that privacy provisions in federal and state law prevent an untold number of incidents from coming to light.”
These criticisms of the nonprofit world were written before the Senate Finance Committee’s recent declaration that it was considering vast new regulations on the field. In her book, Fremont-Smith claims that her own preferred adjustments—greater liability for fiduciaries and increased IRS and state enforcement of existing laws—are sufficient, at least for starters:
Neither of these recommendations requires major changes in the behavior of the sector or in the role of government. They reflect, in fact, an affirmation of the rationale for the existing system, designed as it is to afford freedom to charitable fiduciaries to manage while assuring the public that charitable funds will not be diverted for private gain or used recklessly.
Skeptics may fear that Fremont-Smith’s suggested changes would not have consequences so limited and benign but would inevitably lead to still broader and counterproductive restrictions on tax-exempt organizations, including, potentially, a new “quasi-governmental” oversight body, of the sort Fremont-Smith has favored in the past.
In addition, Fremont-Smith pays little attention to the costs of the remedies she favors. Extra money for enforcement would be the least of these. Holding the directors and officers of nonprofits to stricter standards of liability, or increasing the likelihood that their actions could be second-guessed by federal and state regulators, is almost sure to encourage them to be more cautious, thereby restricting the social contributions they could make as innovators or champions of unpopular causes. Conversely, as Fremont-Smith suggests, making legal oversight by donors or beneficiaries more difficult may reinforce a charity’s independence, but perhaps at the price of diminishing donors’ willingness to give and charities’ willingness to be responsive. Requiring more stringent rules and more frequent audits would also give advantages to larger organizations over the multitude of smaller nonprofits that both compose the bulk of the nonprofit world and, arguably, are its most independent-minded members.
Those effects may, of course, be exactly what some lawmakers desire. While public policy has increasingly expanded the rights of individuals, it has become increasingly stingy where the freedom of associations they form is concerned. (That is by no means unprecedented; the Magna Carta, the 1215 proclamation of the rights of English citizens, placed restrictions on the amount of land held by charitable groups, at that time mostly religious orders.) Yet if private, voluntary groups lack sufficient autonomy, individual liberties will lose an invaluable safeguard in the face of a powerful government.
Fremont-Smith is correct that the influence of the “independent sector” depends on its perceived integrity, and that in turn may require restrictions on its independence. But admirable as her book is as a review of past and present legal strictures, it offers little help in deciding if more controls are necessary, or if, perhaps, we have already gone too far.
Leslie Lenkowsky is professor of public affairs and philanthropic studies at Indiana University.