Marion Fremont-Smith has few if any peers in the field of nonprofit law and regulation. She began her legal career in 1951 and has spent most of it working with nonprofits of all kinds. She began her work at the bar as a lawyer in private practice, then served in the 1960s as Assistant Attorney General and Director of the Division of Public Charities in Massachusetts. Next she became a research director for the Russell Sage Foundation, with whom she published two major studies in philanthropy, one dealing with Foundations and Government, the other, Philanthropy and the Business Corporation. The former book was the definitive treatment of its subject until this year, when it was superseded by her latest work, Governing Nonprofit Organizations: Federal and State Law and Regulation (Harvard University Press). This new book covers foundations and public charities, providing both a fascinating history of evolving laws and regulations and also a thoughtful critique of the “problems inherent in the present regulatory structure.”
For the last several years, she has continued writing, lecturing, and consulting from her post as senior research fellow at Harvard’s Hauser Center for Nonprofit Organizations. Before that, she spent over three decades as a lawyer specializing in nonprofits at Boston’s Choate, Hall and Stewart law firm. Since the 1960s she has been called upon by numerous private groups and public officials to offer her counsel, which has led to testimony before the U.S. Congress and state legislatures and to board service on such organizations as Independent Sector, the Foundation Center, the Exempt Organization Committee of the Bar Association, and many others.
Most recently, she was invited to submit expert comments on the Senate Finance Committee’s controversial “discussion draft,” detailing possible new regulations on foundations and charities. (For more on the discussion draft, see our special July/August issue, “Philanthropy and the Law.”) She spoke with Philanthropy about the discussion draft and other legal changes on the horizon.
PHILANTHROPY: You’ve just had published your history of the regulation of foundations and charities. Are you surprised how little has been written about the field?
MRS. FREMONT-SMITH: That’s one reason I wanted to write the book. What surprised me as I finished it was how timely it had become, thanks to the recent Senate Finance Committee hearings.
PHILANTHROPY: Your book shows that congressional criticism of the nonprofit sector is frequent, whereas the passage of legislation tends to be rare. Do you think we’ll see many legal changes in the near future?
MRS. FREMONT-SMITH: No, I don’t think much will happen soon.
PHILANTHROPY: You spent part of your career in the Massachusetts’ state attorney general’s office and you follow carefully what the state legislatures are doing—
MRS. FREMONT-SMITH:— which is practically nothing. I’m not surprised, but I am disappointed. When I first looked into this in the 1960s, only a handful of states were actively supervising the nonprofit sector—New Hampshire and Massachusetts were the first with registration and reporting statutes, and therefore attorney general oversight of charities. As time went on, however, other states began to follow suit, including Illinois, Ohio, Michigan, New York, and California. It looked as if we would see a groundswell, but the trend ended, and Washington and Iowa went backwards, repealing their laws. For decades now there has been no significant increase in the number of states actively regulating fiduciary behavior—it remains fewer than 15.
PHILANTHROPY: Do those states regulate both public charities and private foundations?
MRS. FREMONT-SMITH: Yes, for the most part. Rhode Island only looks closely at trusts, which means largely foundations, and the extent of a state’s supervision will vary, depending on who the attorney general is and what the budget is. To be fair, things aren’t quite as bleak as it might appear, because the supervision of charities is most active in the states where most charitable assets reside. Also, most states do actively regulate charitable fundraising, but that isn’t what Congress is looking at now and it’s not where we see the worst abuses today, which are the kind of abuses that have always been around and probably always will be around.
PHILANTHROPY: What abuses do you think most need to be confronted?
MRS. FREMONT-SMITH: Let me put them into two categories. The first involves what I call the regulation of fiduciary duties, which is what my present book deals with. The book I’m currently writing is on the regulation of fundraising, which is a second category of problems. Regarding fiduciary duties, I think the worst abuses have been the payment of excessive compensation and the provision of benefits or perquisites to insiders. Here neither the federal government nor the states have been paying sufficient attention.
PHILANTHROPY: What would be the best way to try to improve the situation? Do we need new laws and regulations?
MRS. FREMONT-SMITH: I think parts of the law could be improved, but in the statement I was asked to submit to the Senate Finance Committee this summer, I began by saying I think that if there had been adequate funding for enforcement by the states and the IRS, and if the two groups had been able to communicate well with each other, we would have seen far fewer abuses. As the number of foundations and charities has burgeoned, the IRS especially has not received proper funding. The IRS hasn’t even been given funds for a decent computer system, which is why it can’t provide the kind of tax information on nonprofits that the Urban Institute and Guidestar provide.
In addition, many states have passed statutes protecting officers and trustees of nonprofit organizations to an extraordinary extent. In some states, the articles of incorporation can provide that directors will not be liable for anything except the most flagrant abuses—gross negligence and bad faith. The rationale for these statutes was a fear that if volunteers were not protected from lawsuits, they would not serve. This view has now culminated in a federal statute that provides protection from tort liability to volunteers if it is not already available under state law. I understand the concern, but unfortunately these laws suggested to people who want to take advantage of their positions in nonprofits that nobody would go after them. Even if you operate in a state in which charities are actively regulated, if its laws also afford broad protection from lawsuits, the chances of an attorney general going after your misbehavior are slight because he won’t launch a suit he thinks he can’t win. In short, the combination of these protective statutes, and the ability of the corporations to indemnify officers and purchase insurance to cover the expenses of their litigation, reduce the likelihood that there will be much prosecution of wrongdoing.
Of course, as I told the committee, it makes no sense to increase the IRS’s burden with new legislative provisions if additional funds are not appropriated to provide the Service with the personnel and resources needed to enforce them.
PHILANTHROPY: The high costs of insurance for directors of foundations and charities suggest lawsuits may be more of a danger than you suggest.
MRS. FREMONT-SMITH: I think that if you try to identify suits against directors and officers, you will find that there have only been a handful. Remember, except in rare instances, members of the public can’t sue a charity. There are two things to distinguish here. On the one hand, there’s tort liability, which I’m not talking about. I’m referring to instances in which individuals benefit at the expense of the charity—what the law considers breaches of fiduciary duty. Prosecution of these acts takes the form of a civil suit that a state attorney general would bring, with the posible sanctions including imposition of fines, undoing arrangements that harm the organization, and removal of the fiduciary. I see no reason to excuse wrongdoers from liability merely because they are volunteers—as some individuals, and even some courts, believe should be the case.
PHILANTHROPY: The Senate Finance Committee staff recently released a “discussion draft” that gave a long list of possible new regulations. Which ones do you think would be most useful, and which are you most skeptical of?
MRS. FREMONT-SMITH: I think the easiest way for me to discuss this is to approach it as I did in my submission to the committee, where I divided the proposals into three categories. The first category involves proposals that extend the limits that already exist on private foundations and public charities. The second group of proposals would expand the IRS’s role from its traditional function of protecting the tax system to policing the internal practices of tax-exempt organizations—imposing “best practice” requirements on their day-to-day activities and making the IRS a certifying agency for the field. The proposals in the third category would increase the powers of the federal and state governments to supervise nonprofits and extend some enforcement powers to individuals.
I support most of the recommendations in the first category. These are mostly technical revisions; for instance, expanding the definition of disqualified persons, increasing penalties for misbehavior, improving the quality of the information on nonprofits’ Form 990 tax returns, and increasing public disclosure. However, I do not support the proposal to repeal “intermediate sanctions” and instead to extend to public charities the absolute prohibition on self-dealing that the law imposes on private foundations. It’s too early to scrap the intermediate sanctions rules (which are “intermediate” in that they stop short of removing a nonprofit’s tax-exemption). They were well thought out, and we should give them a chance to work.
PHILANTHROPY: If the self-dealing ban were extended to public charities, that would hamper the voluntary sector’s good works in, say, small towns in Iowa, wouldn’t it?
MRS. FREMONT-SMITH: Exactly. I gave the example of a hospital in a town where there’s only one oil dealer. The owner of the company would make a great trustee for the hospital, but his dealership also happens to be the only oil company in the vicinity. Should the owner be forbidden to serve on the board of trustees, even though his company charges the hospital the same price as all its other customers?
Another provision I’m skeptical of that falls in the first category of proposals is one to prohibit the payment of any compensation to trustees of private foundations. I’m not persuaded that the abuses are so widespread that a ban is needed. I’d rather see better enforcement of existing rules that are based on a standard of reasonableness, possibly coupled with expanded requirements to disclose greater details of compensation and related-party transactions.
PHILANTHROPY: What about the second category of proposals?
MRS. FREMONT-SMITH: These would greatly expand the role of the IRS. It would be required to police such internal practices of exempt organizations as the maximum size of a board and would generally set up the IRS as a certifying agency similar to groups that accredit universities or hospitals. I think this is an inappropriate role to assign to the IRS. It is a tax collection agency, and it has taken many years and much effort for it to put together a group of specialists within the Service who understand that regulating the nonprofit sector does not mean looking merely to collect unpaid taxes. This proposal would drastically expand their powers in a manner they are not equipped to handle.
If conditions ever become so bad that we need to have federal regulations that go into this degree of minutiae—and conditions would have to become very bad indeed—then Congress should consider creating a separate regulatory agency similar to the Securities and Exchange Commission that regulates public corporations.
PHILANTHROPY: You don’t see the need for that now?
MRS. FREMONT-SMITH: Absolutely not. Forgive me for being preachy, but one of the strengths of the nonprofit sector, the reason that we revere it and support it, is its diversity and its ability to respond individually and creatively to society’s problems. Government thus far has kept away from declaring how a nonprofit should conduct its internal affairs and carry out its programs. True, we’re always looking for a balance between this freedom of operation and the need to ensure that people don’t benefit at the expense of a nonprofit institution. But the moment you get into minute details of governance, I think you’re stepping into nonprofits in a way that would be disastrous to the sector’s long-term health.
PHILANTHROPY: What about the proposals in your third category?
MRS. FREMONT-SMITH: They have to do with enhancing enforcement, including increasing federal and state enforcement budgets. Although I have problems with some of the specific proposals, I would support almost all of them.
PHILANTHROPY: Any predictions of what is likely to come of the proposals in the next year?
MRS. FREMONT-SMITH: I think you will see some tightening of the code and increased disclosure requirements. Given the nature of the allegations of misbehavior, there will probably be stiffened penalties for self-dealing and some tightening of the excess benefit rules. I hope a way will be found to increase the funds going to enforcement. I’d be surprised if much else occurred in the near future.
I think perhaps the most important effect of the Grassley hearings and the Finance Committee staff proposals has been the way they have energized the nonprofit sector to reassess government regulation and self-regulation. National groups representing the nonprofit universe, the individual organizations, and donors are thinking about the sector as a sector, about what can be done to improve its performance. This is tremendously valuable, and I hope it will have some long-term positive results.
There will always be bad people who do bad things, but by and large, I think that we’re going to see improvements in self-awareness, which will lead to improvements in governance, and possibly some work in self-regulation, though I’ve never thought of self-regulation as a panacea.
PHILANTHROPY: What about actions at the state level?
MRS. FREMONT-SMITH: I don’t think anything’s going to happen if there aren’t adequate funds to support enforcement, and I don’t think the states are in a position to provide those funds. Significant actions by the states will only occur if the federal government provides monetary incentives to enhance existing programs and create new ones. I suggested this in the 1960s, and not until this spring has it been given any consideration, although I do not expect it to be adopted in the foreseeable future. In the Finance Committee staff’s discussion draft there is a proposal to give $25 million to the states to enhance state enforcement, but that amount is quite inadequate, although it would be at least a start.
PHILANTHROPY: The Senate staffers involved seem uninterested in boosting IRS enforcement.
MRS. FREMONT-SMITH: I think it’s unrealistic to imagine that funds raised through the excise tax on the investment income of private foundations will ever be allocated to enforce the charity laws, even though the tax was originally created for that purpose. Such a special allocation is not something the IRS can support openly, for to do so would invite other groups to press for a similar dedication of funds, thereby undermining the financing of the Service. This is undoubtedly why the Senate Finance Committee staff proposed special filing fees that would be dedicated to enforcement. Unfortunately, some of the proposed new fees would only increase foundations’ administrative expenses, which are already being called too high. In other words, this is a problem not easily solved.
PHILANTHROPY: For five years in the late 1980s, Congress temporarily limited the amount of administrative expenses that foundations could count toward their required 5 percent minimum payout. Why did that end?
MRS. FREMONT-SMITH: I describe more of the story in my book, but in brief the restrictions did not appear to accomplish what Congress wanted and compliance was difficult. The provision had a sunset date in 1990, and the Treasury, the IRS, and Congress agreed to let it expire. I’ve been surprised that this “experiment” has not been recalled, especially since last year’s H.R. 7 bill would have imposed similar limits on administrative expenses. I think it likely that we will eventually see some changes in the payout provisions, in part because it’s an easy issue for the press to run with. Sadly, it is an issue that has caused the sector to fight with itself. I am also concerned that pressure to reduce expenses pushes foundations toward poor practices, such as failure to follow through adequately on grants, yet I understand the tensions between the desire to increase grants and to provide good management.
PHILANTHROPY: If you could prevent one proposed alteration of the federal laws, what would it be?
MRS. FREMONT-SMITH: In general, I think any provision which has as its punishment the removal of tax-exemption is misguided, and that’s why intermediate sanctions were passed. I would like to see any penalties for violations of new regulations be imposed on the managers who committed or approved the prohibited acts, rather than on the nonprofits themselves. Removing tax-exemption is inappropriate because it diminishes funds that should be available for the public good, and it doesn’t affect the people who are responsible for abuses but just leaves them in place. I understand that revocation of exemption must remain a sanction for violating tax provisions; my hope is that its application can be restricted to situations where there are, in fact, no “charitable” funds involved.