Nancy P. Lee joined McDonough Holland & Allen PC in 1985 and is a senior member of the Business Services Practice Group. She is an AV-rated lawyer.
Ms. Lee's transactional practice focuses on business, commercial, and health care law, with an emphasis on acquisitions and sales of businesses, business counseling, contract negotiation and preparation, corporate mergers, joint ventures and secured financing transactions. With a masters degree in business administration, Ms. Lee has been distinctively positioned to build her practice with an understanding of a business person's perspective and an appreciation of business issues.
She serves as general counsel to a number of California corporations, both for-profit and nonprofit organizations. Her advice to nonprofits, principally trade associations and charitable organizations, focuses on formation, governance, tax-exemption and compliance matters, and relationships between affiliated for-profit and nonprofit entities.
Q: There seems to be an emerging trend of prominent individuals and for-profit entities becoming involved in large-scale philanthropy. The Bill and Melinda Gates Foundation, Warren Buffett, and google.org are some examples. What are some of the reasons, incentives, and pros and cons behind this trend?
A: Within the last twenty years or so, individuals and organizations have amassed a large amount of capital and other assets-whether in high tech, real estate or other areas of business. At some point, I think individuals decide that their needs for having a certain amount of money have been satisfied and they turn to the opportunities that philanthropy can provide to affect our society and, in the case of some of the largest foundations, to affect the world in which we live. For for-profit organizations, it is not only a chance to give back to the community, but also to engage employees in community endeavors. Of course, tax benefits are an incentive to doing so. One of the main benefits is that private monies are going to fund charitable, educational, scientific, religious, and similar types of endeavors when public funds may otherwise be lacking.
Another important benefit is that it encourages others-organizations large and small and individuals wealthy and of more limited means-to think about ways in which they can engage in philanthropy. It is hard to think of any downside to the increase in funds when they are earmarked for charitable purposes. If anything, Warren Buffett's announcement that he would give approximately $30 billion to the Bill and Melinda Gates Foundation caused people to stop and think about not only the sheer size of what he was doing, but also about the reciprocal goodness the foundation could do with that money. The money will be combined with the Gates Foundation initiatives to fight infectious diseases and reform education. It was good to see that Buffett decided to contribute to an existing foundation rather than set up yet another foundation to do potentially the same kind of work.
Q: The founders of Google said, "We hope that someday [google.org] will eclipse Google itself in overall world impact by ambitiously applying innovation and significant resources to the largest of the world's problems." So far, Google has committed 1% of its profits and equity to google.org and $90 million to Google Foundation. What is unique about Google's philanthropy, and do you think it will influence the giving strategies of other entities?
A: I think that Google has several advantages over other types of organizations. The fact that Google is engaging in such large-scale philanthropy generates a great deal of goodwill both for its founders and for its stockholders when they might otherwise be interested in keeping the money within the entity to increase shareholder profits. These days, people understand that public funding is not enough to deal with public or social issues, and that government funds are being used for other purposes. So when folks see a need out there, even if it is just to give $25 to the victims of Hurricane Katrina, for example, they feel a societal responsibility to respond to the needs of others.
In Google's case, not only does it engender a great deal of goodwill, but it also constitutes good business practice. Google's giving spreads the goodwill beyond their shareholder ranks and employee ranks, to Google customers around the world. To see that an organization like Google is willing to make such a large commitment to the community and the world-$90 million is a great start and more money will be forthcoming-is almost mind-boggling. A lot can be done with such a large sum of money. I can say that because I work with a spectrum of nonprofit organizations, some large and some very small.
I also think that Google's action sets a good example for other large companies to think strategically about philanthropy. Google can do more to influence other companies with $90 million as a start, than by encouraging its stockholders or employees to contribute $50 or $100 or $1,000 to their own charities. With this mass of money and with strategic planning about particular philanthropic objectives, the company can truly make a difference. I am not suggesting that the smaller donations or smaller organizations cannot also make a difference, but at some point, the size of the charitable trust that Google is creating can go a long way toward having either a greater impact or a quicker impact on the activities or areas they seek to influence.
Q: Many of the large-scale acts of philanthropy we are discussing, namely Warren Buffett's $31 billion donation to the Gates Foundation and Google's donation of 1% of its profits and equity to google.org, come in the form of shares of stock. What are the advantages to both donors and recipients of this unique kind of giving?
A: For the donor, the advantage really depends on their basis in the shares. A gift of appreciated securities may carry some advantageous tax consequences; then again it may not. For the organizations that receive appreciated securities, there can be a risk because of fluctuations in the value of the securities. Some boards have policies about divesting themselves of those shares and taking the cash value of them shortly after the shares are received. Others decide to hold on to them for a while in anticipation of their appreciation. My answer returns to the good governance discussion where it is so important these days for boards to really be informed in order to make decisions for the organization that they believe to be in the best interests of the organization.
With the Sarbanes-Oxley Act and its application to nonprofits, I now advise my nonprofit clients to adopt policies related to the Act's whistle-blower protection and document destruction provisions. That way, the organization will have it on paper, their employees know what the organization's expectations are, and others will know there are policies in place that deal with these very important concepts. On the investment side, it also is very important for nonprofit organizations to have an investment policy that addresses how they will invest any excess revenues they have. Additionally, such a policy should outline the establishment of a reserve account and the procedures for investing those reserve funds taking into account issues such as liquidity, risk aversion, and socially responsible investing.
An organization should determine, on a case-by-case basis, the level of risk it is willing to take and how much risk is associated with holding certain securities, depending on the nature of the securities or other kinds of appreciated assets. It should evaluate the security in the context of the investment policy adopted by the board. If the gift is stock of a high tech company that has just done its first Initial Public Offering, the organization may want to cash out earlier than if the gift is, for example, a blue-chip stock. Or, the organization may conclude that it wants to invest some of those funds in an index fund or a mutual fund for a combination of investments. In that scenario, the organization should assess whether the anticipated rate of return will be better than a treasury bill or a certificate of deposit and be comfortable with the level of risk presented. If a nonprofit entity is fortunate enough to receive appreciated securities or other appreciated assets, I think the organization should accept the gift, but whether or not it converts it into cash right away depends on that organization's financial situation.
Q: What are the current issues that nonprofit organizations face?
A: The issues that are faced by nonprofit organizations are similar to those currently being faced by for-profit, publicly-traded organizations: transparency, governance and accountability. Tax-exempt organizations, that is, those exempt from federal and state income taxes, are not only being scrutinized by the IRS and Franchise Tax Board (California's version of the IRS), but also by their own stakeholders and the public at large. Fundraising abuse is one area that led the California Attorney General to push for the passage of the Nonprofit Integrity Act of 2004 (NIA). It strengthens laws governing charitable organizations and commercial fundraisers and also broadens the Attorney General's supervisory powers over these groups. The NIA is similar to Sarbanes-Oxley in that it deals with governance issues and seeks to make boards of directors and management more accountable for the business and affairs of the organizations.
On the governance side, the NIA requires a review and approval of CEO and CFO compensation as just and reasonable and, for nonprofits with annual gross revenues of $2,000,000 or more, the NIA requires an audit committee, independent audits, and public disclosure of audited financial statements. The fundraising provisions of the NIA are very stringent and basically require written contracts with fundraisers for each solicitation or event. Specific provisions are required in the contracts, and fundraisers are required to pre-register with the Attorney General; otherwise those contracts are voidable by the organization.
Governance is about instituting and engaging in corporate practices that enable a board to not only be an effective overseer of corporate operations, but also be sound decision-makers in formulating corporate policy and achieving strategic goals. Governance is really at the heart of enabling an organization to deal effectively with legal issues whether they be organizational or governance matters, tax issues, contractual relationships, personnel practices or liability concerns.
Q: You mentioned that the three main issues affecting nonprofit organizations-transparency, governance, and accountability-are similar to the issues facing for-profit corporations today. What kind of effect do you think the scandals in the for-profit context have had on the nonprofit sector today?
A: Events in the for-profit context have had a big impact on the nonprofit sector. The Nonprofit Integrity Act was actually California's response for nonprofit organizations to Sarbanes-Oxley. As I mentioned, Sarbanes-Oxley actually has provisions that affect the nonprofit sector. Those are the whistle-blower protections and document destruction provisions. The American Bar Association has even published a booklet that discusses the effect of Sarbanes-Oxley on nonprofit governance. A lot of nonprofit organizations now-particularly those that look to service the nonprofit sector-have touted Sarbanes-Oxley as a good model for governance practices that should be followed or at least in some way incorporated into governance practices by nonprofit organizations.
The Enron, WorldCom, and Adelphia scandals triggered the creation of a new statutory scheme and various new legal requirements for publicly-traded organizations. It essentially served as a wake-up call for the nonprofit sector. Nonprofits are beginning to realize that as they grow as organizations, they need to function even more like business entities. Directors need to be informed, and they need to actively participate, ask questions, and obtain information from experts when necessary. Having a strong board that works well with a management team that effectively carries out board decisions is critical to the longevity of the organization.
Q: What kinds of situation do clients approach you with that leads you to advise (or advise against) forming a nonprofit organization? What factors are significant in your analysis of the situation?
A: The Warren Buffett example is a great one. Those of us who practice in the nonprofit sector -lawyers, accountants, consultants, executive directors of management services organizations serving the nonprofit sector-all believe that when somebody approaches us and says that they would like to form a nonprofit, one of the first things we think is, "Why?" and, "Perhaps you do not want to do so." The reason for this is that a nonprofit organization has an organizational component and a tax-exemption component. The organization must comply with the statutes of the particular jurisdiction in its organization as a legal entity, and to the extent it wants to be tax-exempt, it must apply to the IRS and to its state taxing authority for tax-exemption. The process does not stop there. There are ongoing governance obligations, corporate and tax compliance matters, reporting requirements both to the state and to the Attorney General, and so on.
I think many people do not recognize, at least in the beginning, that forming a nonprofit is about more than just raising money or getting money to accomplish a goal. Fundamentally, it is about setting up a legal structure that allows one to pursue an organization's mission and goals while operating within a regulatory environment overseen by the state and federal government. These organizations are deemed to be performing a public or charitable purpose that is appropriate for exemption from tax.
To give a simple example, a client wanted to form a nonprofit to get grant money for a high school program. He found out that this grant money was available for the program, and thought that if he formed a nonprofit he could apply for the grant; be involved with the nonprofit; and do a lot of good for the community. Of course, this was in and of itself a noble purpose. However, very little due diligence had gone into the decision. For example, one question would be whether there was already a nonprofit within the community which could easily incorporate the work into their program. Somewhat secondarily, grantors are often less willing to make grants to entities with little or no operating history. Such entities have no track record, or there may be little accountability because the organization lacks infrastructure or staffing. It is somewhat a chicken and egg situation.
I hearken back to the expense, time, and effort involved in forming the legal entity and creating the structure and weigh it against those who view the process as simply trying to acquire some money to do some good works. In the example I discussed, there are already organizations like the local Boys and Girls Club, YMCA, and other community organizations that serve the local youth community. The solution seems to be that the person would be better served by joining existing organizations because they already have the staff and are serving the youth constituency.
Many types of individuals and organizations think about forming nonprofit organizations. Lately, I have been working with more individuals and companies who want to form private foundations. These are also charitable organizations, but they differ in that often they are funded from a limited number of sources such as an individual's or company's wealth as opposed to receiving support from a broad base of the general public. For example, a family who wants to make the decisions about where their money is distributed-and thus exert a little more control over the money-will form a private foundation. The family already possesses a source of funding that will last for a number of years. Contrast this with the more typical scenario of someone who has a charitable purpose, but recognizes that he or she will have to raise money through public donations or grants in order to engage in the charitable activity.
Q: In the twenty years that you have practiced for-profit and nonprofit counseling, what are the surprising shifts in law and business that have impacted your work? What tenets have remained the same?
A: We have talked a little already about the increased scrutiny imposed on nonprofit organizations by the IRS, and in the case of California, the Franchise Tax Board, and by the Attorney General.
Over the last five or ten years, the environment in which nonprofits operate, especially for charitable organizations, has changed dramatically. This is due in part to the shifts in sources of funding for these organizations. For many charities, grant funders are less willing to provide general operating support (including administrative overhead, staff salaries, etc.), and instead want to see their grants going toward identifiable programs benefiting the nonprofits causes. So an organization cannot necessarily cover the costs of the person who answers the phone and does the payroll. It can, however, provide funding for specific programs being run by the organizations, and somehow divide that administrative person's time into the various program areas. This shift in funding purposes has had a negative impact on a number of charitable organizations, such that some have needed to address the possibility of dissolving or otherwise merging with other nonprofits in order to cut their overhead costs.
Another change that I have seen in my practice involves the representation of trade associations. We have been talking about nonprofit organizations that are charitable; the common term for them is a "501(c)(3)" organization (referring to the pertinent section in the Internal Revenue Code). Trade associations are 501(c)(6) organizations; they also are exempt from income tax. The largest difference between the two types of organizations is that when people give money to trade associations, they cannot take a charitable deduction; the giving is not like donating to charity. The income received by a 501(c)(6) organization, however, is similarly tax-exempt.
I believe these organizations have taken on a much more prominent role in recent years. Trade associations are organizations which promote the interests of a particular business segment or industry and have members who operate or are otherwise interested in promoting that industry. The California Restaurant Association is an example. There are trade associations that may be limited in their geography or there may be national associations. The National Asian Pacific American Bar Association is a national trade association-it has members who are lawyers, judges, law professors and law students throughout the country. The activities of these associations often involve providing goods or services to their members such as technical publications and educational seminars, conferences, and third party vendor services at group rates (like insurance programs). They often engage in legislative advocacy on behalf of their members, and can do this to a greater extent than can charitable organizations. Charitable organizations are limited in the amount of lobbying activity in which they can engage.
As I mentioned, trade associations are tax-exempt. These associations often have a charitable foundation-a 501(c)(3) foundation-for which people can make donations, hold fundraising events, run scholarship programs, educate the public and encourage people to undertake careers in a particular industry; and they also can have for-profit affiliated entities. This is very much a growing part of the legal practice. Because Sacramento is the state's capital, many of these associations also have offices here so they are close to where the laws are being made that affect their membership.
I advise clients seeking to form a trade association the same way I advise those seeking to form charitable organizations-they should seriously consider whether there is already an organization out there doing what they want to accomplish. I can understand that trade associations may want to form because they are geographically distinct or their members' issues are different. In that case, the people who approach me are typically very business-minded, have done more due diligence, and approach it in more of a business-like fashion. They understand the nature of the organization and will have, by virtue of being a membership organization, a source of funding for their programs and activities.
The nonprofit world is changing, and with that change requires a governance approach more along the lines of what we see in the for-profit world. This does not mean that nonprofits need to forego their mission. On the contrary, it just means that they need to approach that mission and their activities in a more strategic and business-like way.