501(C)(3) Organizations: Common Guiding Principals for Effective Boards

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November 28, 2018
Author: Anita L. Pelletier, Esq.

A. Stated Goals
Effective governance requires that goals are clearly stated. Board accountability begins with the charitable, educational or social mission of the organization. The mission is the reason why the organization exists and has been granted favored status as a charity by the IRS. The mission should be the organization’s “polestar” in that it provides a measure of success and guides the organization’s conduct. (This can be compared to the for-profit world “polestar” of maximizing shareholder value through the efficient production of goods and services.)

The board is charged with ensuring that managers further the mission, without wasting assets or engaging in self-dealing. Therefore, as a starting point, the board needs to:
- understand the entity’s mission, as stated in its governing documents;
- develop with management a strategy for carrying out that mission; and
- monitor and assess management’s efforts to carry out that strategy in line with the mission.

B. Clear Delineation of Responsibility and Authority and the Line Between Oversight and Management

All directors need to understand the role of the board as an entity, as well as their individual duties as fiduciaries and the distinct role of management. The role of the board is one of oversight – directors “direct” – while the role of management is to carry out the day-to-day activities of the organization – managers “manage.” Often members of a board cross the line between oversight and management by becoming overly engaged in the operating activities of the entity, such as the day-to-day work required to fulfill programmatic goals. Board involvement in operating activities can lead to tensions between the board and management/staff. Boards should consider the extent to which their involvement in operating – as opposed to strategic – activities benefits or hinders the ability of management to perform. The board may wish to consider discussing and defining the respective roles of the board and management with respect to strategic and operational activities in a formal “delegation of authority” that addresses the specific matters reserved to the CEO and those reserved to the board. For example, the board typically delegates the execution of policies and strategic objectives to management. Creating a formal delegation of authority can also help the board identify and communicate expectations about what issues are worthy of board consideration and in what time frame decisions are expected to be made.

C. Monitoring and Measuring Performance
Active board oversight requires that management performance be evaluated against the specific operational goals that the board has determined will further the agreed strategy in line with the organization’s mission. The board should then define with management the specific benchmarks (both long-term and short-term) that would indicate successful performance and monitor results achieved by management against those benchmarks. If performance goals are not being met, the board should consider where adjustment may be necessary; for example, improve performance, adjust the strategy and replace management where necessary. Management changes are inevitable and the board should ensure that a succession plan for key executives is in place. The board should utilize its evaluation of management performance in designing and implementing an executive compensation scheme that will compensate executives fairly and includes appropriate incentives for performance. It may also be appropriate to compensate directors for their contribution to the organization.

D. “Following the Money”
Overseeing the finances of the organization is a critical part of the board’s role. Fulfilling this oversight responsibility begins with ensuring that the organization has an effective Chief Financial Officer or equivalent (such as a bookkeeper or outside accounting firm); recruiting such a person can be challenging, particularly as salaries are generally lower than in the for profit sector. The board should establish open lines of communication with the CFO to facilitate the exchange of information. The board should work with the CFO in developing and approving budgets and financial plans, and should test management assumptions that may be embedded within budgetary analysis. The board is also responsible for monitoring and ensuring the integrity of the organization’s financial reporting processes (including recordkeeping), internal control systems and audit, and should hire the independent auditor (if any) after assuring itself of the auditor’s lack of significant relationships that might impair objectivity.

E. Determining Board Focus & Information Needs
The board’s ability to govern effectively depends on how it focuses its time and attention and the information it has available to it. The board should take charge of its own agenda by identifying, articulating, prioritizing and scheduling the issues that the board will address. Usually, board attention – and therefore the board’s agenda – is best focused on “following the money,” setting strategic direction and long-term goals, monitoring management’s progress and results to achieve those goals, and ensuring satisfactory compliance with ethical standards and the law.

Board meetings should be structured to make the best use of board time. Meetings should be scheduled well in advance – for example, via an annualized schedule to address foreseeable issues – with additional meetings called when board review with respect to other issues is required. The bulk of the board’s meeting time should be reserved for discussion of the issues it considers to be most important; these issues should be dealt with before administrative and housekeeping-type matters are addressed. Management presentations at meetings should be kept to a minimum, as most of this information should be capable of being transferred to the board for its consideration in advance of the meeting.

An effective board requires accurate, relevant and timely information relating to the organization and the context in which it operates to enable it to fulfill its role. The board should identify what information it needs and work with management to ensure that it obtains such information. Information should be distributed in advance of meetings to enable directors to review the material and reflect on it.

F. Board Size and Composition
Size and composition influence the ability of a board to be effective. Most decision-making groups function best with between seven and ten members. Boards are often much larger, due to their fund-raising nature. For a very large board, if downsizing is not practical, the board may wish to consider whether there are ways to facilitate efficient decision-making through the use of committees; for example, some very large boards create an executive committee or advisory board that has authority to make decisions on behalf of the board where appropriate.

Board candidates should be selected with a set of criteria in mind that are specific to the needs of the particular organization. The board should reflect, as far as possible, an appropriate balance of independence, sound judgment, business specialization, technical skills, diversity, fundraising ability and/or willingness to make personally meaningful gifts, geographic representation and other desired qualities.

The board should be comprised of directors who are committed to the organization’s mission. Directors should ensure that they are interested in and understand the activities of the organization, the environment in which it exists and the risks facing it. They should learn about the structure of the organization by reviewing its governing documents, policies and minutes of board and committee meetings from the past year, as well as any literature produced as part of the organization’s programs. Directors should seek out information from management where required to gain this understanding.

G. Board Independence
Independence is the foundation for objective judgment. The board should be comprised and organized in a manner that encourages directors to be engaged and to form and express objective judgments about issues involving inherent conflicts with management such as:
??evaluation of management performance, compensation and succession planning;
??oversight of audit, accounting and financial reporting; and
??determination of board composition and governance processes.

The board should include a number of persons who lack material business relationships to the entity and also lack material business and family relationships to senior management and key constituents.

H. Board Leadership
The leadership of any organization is critical and board leadership is especially so. An effective board leader is highly engaged, independent, capable of developing a strong working relationship with management and in guiding the board to consensus after free and open discussion of viewpoints. An independent board leader is especially important for:
??organizing the board agenda with input from management and helping to identify the board’s information needs;
??leading board discussions of management performance and compensation in sessions at which management is not present (“executive session”); and
??encouraging frank but collegial discussions both at the board level and as between the board and management.

The board should not be led by management, either in name or in spirit.

I. Policies and Guidelines
The board plays a key role in setting the tone of the organization. It sets the tone through establishing policies and guidelines that set forth expectations for behavior within the organization and by assessing whether senior management is promoting an appropriate ethical culture within the organization. These policies could include the following:

- Board guidelines that set forth expectations of directors, which may include board functions, processes and structures, as well as requirements to make personally meaningful gifts and/or contribute to fundraising efforts;
- Ethics and business conduct codes applicable to the board, management and employees requiring fulfillment of responsibilities in a manner that furthers the mission of the organization and complies with law, regulations, ethical standards and policies adopted by the organization;
- “Whistleblowing” procedures to receive, investigate and take appropriate action regarding fraud or non-compliance with law or organizational policy, and to protect “whistleblowers” against retaliation; and
- Document retention policies to ensure that documents are retained pursuant to applicable laws and that documents that may be relevant to legal proceedings or governmental investigations are not.

The board sets the tone for the entire organization; it does so best by adopting a governing style that emphasizes:
- strategic leadership rather than a focus on administrative detail;
- focus on the future rather than on the past;
- anticipation and preparedness rather than reactivity;
- collegiality, with respect for diverse viewpoints, and not divisive;
- consensus building, not “majority rule;” and
- conflict avoiding (and disclosing).

J. Committee Structure & Operations
Appropriate structure and use of board committees can enhance the efficiency and effectiveness of the board. Board committees may be particularly useful with respect to board responsibilities that require independent judgment and that may involve a conflict of interest for management; such committees should – where possible – be comprised of directors who are independent from management and should be provided for in the organization’s bylaws. Key board committees include:

- Audit committee – responsible for hiring and assuring the independence of the independent auditor (if any), and providing oversight of internal controls and related processes designed to assure the reliability of financial data;
- Compensation committee – responsible for determining and reviewing the compensation of the CEO and other senior managers in accordance with objective, documented and comparable information, and for ensuring that compensation is tied to the achievement of predetermined performance goals that are keyed to mission-related accomplishments rather than financial results; and
- Nominating and governance committee – responsible for nominating board candidates, ensuring that the size, leadership and composition of the board are appropriate, and overseeing governance structures and policies (including committee structure, conflicts of interest policies and bylaws).

The 2005 National Association of Corporate Directors Not-For-Profit Governance Survey1 indicates that these key board committees are prevalent in not-for-profit organizations identified as “leading” based on size and established reputations:

Standing Committee Prevalence Fully Independent?
Audit 96.2% 92.0%
Compensation 75.0% 89.5%
Nominating/Governance 80.8% 75.6%
However, whether or not an would find it useful to establish a particular committee will depend on the needs and circumstances of the organization. For example, an organization with significant financial resources or complex financial arrangements may benefit significantly by establishing an audit committee. In contrast, a small organization with simple financial structures may decide that it would be efficient and effective to entrust responsibility for ensuring the integrity of financial reporting to the entire board. (In either case, some members of the board should be financially literate and at least one director should be sophisticated concerning financial reporting and accounting.)

Committee charters often help set forth the responsibilities of each committee and clarify whether decisional authority is delegated to the committee or whether the committee is to undertake the background work and make recommendations to the board for board approval. As discussed above, organizations with large boards may find it useful to organize an executive committee to take on a number of tasks that might otherwise fall to the full board, but can be achieved more efficiently in a smaller group. The boards often have a large number of committees that focus on operational or program aspects; for example, strategic planning, finance, fundraising and public relations. Care should be taken that these committees do not result in the board becoming over-engaged in operational matters and unduly hampering managements’ ability to perform effectively.

K. Board Health and Evaluation
The board should regularly evaluate its performance and seek to continually improve. The board may wish to consider evaluating its effectiveness against BoardSource’s “Twelve Principles of Governance that Power Exceptional Boards:”2

1. Constructive Partnership Exceptional boards govern in constructive partnership with the chief executive, recognizing that the effectiveness of the board and chief executive are interdependent.
2. Mission Driven Exceptional boards shape and uphold the mission, articulate a compelling vision, and ensure the congruence between decisions and core values.
3. Strategic Thinking Exceptional boards allocate time to what matters most and continuously engage in strategic thinking to hone the organization’s direction.
4. Culture of Inquiry Exceptional boards institutionalize a culture of inquiry, mutual respect, and constructive debate that leads to sound and shared decision making.
5. Independent-mindedness Exceptional boards are independent-minded. When making decisions, board members put the interests of the organization above all else.
6. Ethos of Transparency Exceptional boards promote an ethos of transparency by ensuring that donors, stakeholders, and interested members of the public have access to appropriate and accurate information regarding finances, operations, and results.
7. Compliance with Integrity Exceptional boards promote strong ethical values and disciplined compliance by establishing appropriate mechanisms for active oversight.
8. Sustaining Resources Exceptional boards link bold visions and ambitious plans to financial support, expertise, and networks of influence.
9. Results-Oriented Exceptional boards are results-oriented. They measure the organization’s advancement towards mission and evaluate the performance of major programs and services.
10. Intentional Board Practices Exceptional boards intentionally structure themselves to fulfill essential governance duties and to support organizational priorities.
11. Continuous Learning Exceptional boards embrace the qualities of a continuous learning organization, evaluating their own performance and assessing the value they add to the organization.
12. Revitalization Exceptional boards energize themselves through planned turnover, thoughtful recruitment, and inclusiveness.

L. IRS Guidelines for “Good Governance”
While the Code does not have specific requirements with respect to governance requirements, the IRS takes the position that without “good governance” a tax-exempt organization cannot operate consistently with Code Section 501(c)(3). Some governance areas that the IRS may review on audit include the following (many of these have already been noted above):

1. Executive compensation. A charity may not pay more than reasonable compensation for services rendered. According to the IRS, compensation payments are reasonable if the compensation arrangement is approved in advance by an authorized body composed entirely of individuals who do not have a conflict of interest with respect to the arrangement, the authorized body obtained and relied upon appropriate data as to comparability prior to making its determination, and the authorized body adequately documented the basis for its determination concurrently with making the determination. See discussion regarding Code Section 4958 above.

2. Conflicts of interest. The charity directors owe it a duty of loyalty. The duty of loyalty requires a director to act in the interest of the charity rather than in the personal interest of the director or some other person or organization. Specifically, the duty of loyalty requires a director to avoid conflicts of interest that are detrimental to the charity.

Many charities have adopted a written conflict of interest policy to address potential conflicts of interest involving their directors, trustees, officers, and other employees. The IRS encourages a charity’s board of directors to adopt and regularly evaluate a written conflict of interest policy that requires directors and staff to act solely in the interests of the charity without regard for personal interests. The IRS encourages organizations to require its directors, trustees, officers and others covered by the policy to disclose, in writing, on a periodic basis any known financial interest that the individual, or a member of the individual’s family, has in any business entity that transacts business with the charity. The organization should regularly and consistently monitor and enforce compliance with the conflict of interest policy. Organizations that file Form 990 will find that Part VI, Section B, Line 12 asks whether an organization has a written conflict of interest policy, and whether it regularly and consistently monitors and enforces compliance with the policy.

3. Investments. State law or organizational documents may require the organization’s governing body or certain other persons to oversee or approve major investments. The IRS encourages charities that make such investments to adopt written policies and procedures requiring the charity to evaluate its participation in these investments and to take steps to safeguard the organization’s assets and exempt. Organizations that file Form 990 will find that Part VI, Section B, Line 16 asks whether an organization has adopted procedures and policies regarding participation in a joint venture or similar arrangement with a taxable entity. In addition, Form 990, Schedule D, asks detailed information about certain investments.

4. Fundraising. The IRS encourages charities to adopt and monitor policies to ensure that fundraising solicitations meet federal and state law requirements and solicitation materials are accurate, truthful, and candid. Charities are encouraged to keep their fundraising costs reasonable and to provide information about fundraising costs and practices to donors and the public. Organizations that file Form 990 will find that Schedules G and M solicit information about fundraising activities, revenues and expenses.

5. Governing body minutes and records. The IRS encourages the governing bodies and authorized sub-committees to take steps to ensure that minutes of their meetings, and actions taken by written action or outside of meetings, are contemporaneously documented.

Organizations that file Form 990 will find that Part VI, Line 8 asks whether an organization contemporaneously documents meetings or written actions undertaken during the year by its governing body and each committee with authority to act on behalf of the governing body.

6. Document retention and destruction. The IRS encourages charities to adopt a written policy establishing standards for document integrity, retention, and destruction. The document retention policy should include guidelines for handling electronic files. The policy should cover backup procedures, archiving of documents, and regular check-ups of the reliability of the system. Organizations that file Form 990 will find that Part VI, Section B, Line 14, asks about whether an organization has a written document retention and destruction policy.

7. Ethics and whistleblower policy. The IRS encourages a charity’s board or trustees to consider adopting and regularly evaluating a code of ethics that describes behavior it wants to encourage and behavior it wants to discourage. A code of ethics will serve to communicate and further a strong culture of legal compliance and ethical integrity to all persons associated with the organization.

The IRS encourages the board of directors to adopt an effective policy for handling employee complaints and to establish procedures for employees to report in confidence any suspected financial impropriety or misuse of the charity’s resources. This policy is commonly referred to as whistleblower policy. Organizations that file Form 990 will find that Part VI, Section B, Lines 5 and 13 ask whether the organization became aware during the year of a material diversion of its assets, and whether an organization has a written whistleblower policy.

M. Other Sources for Good Governance
Other, private, organizations provide information on “good governance”. Some of these organizations also offer a process by which a charity can receive a certification or rating.

- BBB Charity Accountability Program – developed to assist donors in making sound giving decisions and to foster public confidence in charitable organizations. The standards seek to encourage fair and honest solicitation practices, to promote ethical conduct by charitable organization and to advance support of philanthropy. More information is available at http://www.give.org/for-charities/

- Charity Navigator – works to guide intelligent giving. By guiding intelligent giving, Charity Navigator aims to advance a more efficient and responsive philanthropic marketplace, in which donors and charities they support work together to overcome the nation’s and the world’s most persistent challenges. More information is available at http://www.charitynavigator.org/

- Guidestar – the most complete source of information about US charities and other nonprofit organizations. Searchable database of more than 1.8 million IRS-recognized organizations. More information is available at http://www.guidestar.org/Home.aspx

1 National Association of Corporate Directors (NACD), 2005 NACD Not-For-Profit Governance Survey (2006)
19. The NACD surveyed more than 200 non-for-profit organizations identified as “leading” based on their size
and established reputations and received 52 responses.

2 BoardSource, The Source: Twelve Principles of Governance That Power Exceptional Board (2005).


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