The recent controversy involving American University, its board of trustees and its former president/chief executive officer has thrust into the spotlight a series of difficult oversight and compensation issues that have broad implications for the nonprofit community. For American University and nonprofit organizations in general, it is the wrong issue (board oversight of executive compensation) at the wrong time (in the midst of intense scrutiny of nonprofits) in the wrong place (Washington, D.C.).
The core issues raised by the American University situation are the appropriate levels of discretionary expenditures incurred by a chief executive expected to be working "24/7" on behalf of the nonprofit organization; the required degree of board oversight of the executive compensation process; and the appropriateness, manner of review, and reasonableness of executive severance arrangements. The high-profile nature of this controversy, coupled with the lack of clear regulatory guidance on many of the implicated issues, have combined to attract broader attention of the Congress, the Internal Revenue Service and state charity officials. In particular, the American University dispute is likely to reinforce the concerns of legislators, regulators and the general public that stronger measures may be necessary to prevent waste of nonprofit assets devoted to executive compensation.
The roots of the American University controversy begin in an anonymous letter delivered to its board of trustees this past spring. The anonymous letter alleged various compensation and expense abuses by the CEO (i.e., charging the university for a variety of expenses allegedly incurred by the CEO for personal, not business purposes). Upon review of the letter, the board of trustees authorized an independent investigation under the direction of outside counsel. Upon completion of its investigation, the outside counsel delivered a written report to the board of trustees that called into question the business purpose of almost $500,000 in expenditures authorized by the CEO and his spouse over a period of several years. No records were identified that might have supported the business nature of any of the challenged expenses.
The controversy, however, extends beyond the questionable expenditures to include the reasonableness of the CEO’s base compensation and the process by which it was determined. Reportedly, the CEO’s $800,000 salary was substantially in excess of that of his peers at comparably sized institutions. Perhaps more significant were suggestions (by the chair of the board’s audit committee) that the CEO inappropriately sought to limit board access to elements of his compensation package and that the reporting of compensation in the Form 990 was incomplete. Concerns with respect to board oversight of the CEO also surfaced. For example, the former audit committee chair expressed concern that "the Board reported to [the CEO] rather than the reverse." The board of trustees of American University consists of experienced and sophisticated executives/leaders from corporate, financial, legal and religious institutions.
Upon review of the report’s conclusions, the board suspended the CEO. The report also recommended that the CEO reimburse the university for more than $115,000 in personal expenses and report more than $350,000 in additional income over a period of three years. Only recently, the board entered into a severance agreement with the CEO, providing him with a one-time payment of $950,000, relief from repayment of almost $1 million in premiums on a life insurance policy, and the right to receive $1.75 million in deferred compensation, to which he (reportedly) would not have been entitled had he been fired. In announcing the severance agreement, the board vice chair reportedly described the arrangement as beyond what the CEO was entitled to receive.
Continued controversy followed with the receipt of an October 27, 2005 inquiry letter from Senator Charles F. Grassley, chair of the Senate Finance Committee, addressed to the board’s acting chairman. The letter announced the committee’s intention to review the compensation-related decisions of the university and its board, and requested substantial related documentation.
The board’s resolution of the issues presented in the report was made significantly more difficult by the presence of a number of complicating factors. First was the discovery
of a supplemental employment agreement negotiated between the CEO and the board chair in 1997 that was intended to replace the original 1994 CEO employment agreement. A significant dispute arose as to whether the full board had authorized the chair to negotiate the 1997 agreement (and, in fact, was even aware of its existence). Significantly, the 1997 agreement contained provisions that, from the perspective of the CEO and many board members, authorized the CEO to incur many of the challenged expenses.
A second complicating factor was the offer of certain concessions by the CEO in order to resolve the dispute, including reimbursement of certain disputed expenses, and the engagement of an independent accountant to resolve specific tax reporting matters. A third complicating factor was the unauthorized release to The Washington Post of the entire report, which allowed the board’s deliberations to be played out in the national media on a daily basis. A fourth complicating factor was the CEO’s assertion that university policy required the destruction of receipts after one year.
It is important to note that there has been no determination of any violations of law nor breach of fiduciary duty in connection with the American University matter. Indeed, the CEO and several board members have presented a series of arguments challenging the accuracy of the report and many of its conclusions. Nevertheless, the entire unpleasant episode is of enormous significance to the larger nonprofit community to the extent that it deals with the thorny issue of how to effectively and equitably distinguish between expenses fairly incurred by the CEO or his/her spouse in the course of employment, and expenses that are purely personal in nature. This issue has become increasingly important for many nonprofit organizations and their chief executives, particularly when there is an expectation that the CEO’s employment obligations extend beyond the fundamental management of corporate affairs to being a larger "symbol" of the organization in terms of charitable solicitation and public presence. In such a situation when, indeed, is the CEO acting on personal, as opposed to business, matters? American University thus focuses attention on the following important exempt organization corporate, compensation and tax issues:
Board Oversight of Executive Compensation
Issues include (i) use of appropriate industry comparables; (ii) satisfaction (as a basic board practice) of all requirements for satisfaction of the "Rebuttable Presumption of Reasonableness" under the Intermediate Sanctions rules; (iii) the "link" between intermediate sanctions violations and loss of tax-exempt status and (iv) the importance of good faith efforts to remediate excess benefit transactions before IRS intervention.
CEO Employment Contracting
Issues include (i) the need for detail and expression of specific expectations concerning business-related discretionary expenditures of the CEO and his/her spouse; (ii) board approval vs. board ratification of CEO employment agreements and (iii) the potential for regulatory-prompted limitations on the ability of a committee with board-delegated powers to implement executive compensation decisions.
Board Fiduciary Duties
Issues include (i) whether the duty of loyalty is violated by disclosure to the media of a confidential report to the board; (ii) whether the duty of care is violated by a failure to closely monitor discretionary spending by the CEO; (iii) which party—the CEO or the board—is obligated to raise for consideration application of the Intermediate Sanctions Rules and (iv) whether governing board members with background/experience in the specific issues at controversy (e.g., law, accounting, compensation) may be held to a higher standard of conduct with respect to their individual duty of care.
Issues include (i) what is the appropriate spending authority of a chief executive officer expected (essentially) to serve the institution on a "24/7" basis, especially when fundraising and donor solicitation duties are included; (ii) in such circumstances, what is the distinction between personal and business-related expenses; (iii) what are appropriate business-related expenditures of the CEO’s spouse; (iv) what are proper reporting and recordkeeping procedures with respect to such expenditures; (v) what is the proper board oversight of discretionary spending and (v) what are the related intermediate sanctions and individual income tax implications.
Executive Severance Arrangements
Issues include (i) under what circumstances are executive severance arrangements appropriate; (ii) what is outside counsel’s role in the process of negotiating and reviewing executive severance arrangements; (iii) what are board members’ responsibilities and duties if they disagree with proposed executive severance arrangements and (iv) how best can parties address the intermediate sanctions and tax exemption issues raised by such arrangements.
Federal Income Tax Reporting
Issues include (i) what is the potential impact from an income tax standpoint for failure to report taxable income; (ii) what are the possible income tax withholding and FICA obligations; (iii) when does unreported income become an automatic excess benefit transaction and (iv) when should a previously filed Form 990 be amended to correct errors found subsequent to filing.
The American University controversy is noteworthy to the nonprofit sector for three principal reasons.
- It is consistent with the current, extraordinary level of Congressional, regulatory/IRS and general public focus on nonprofit executive compensation issues and what constitutes proper board oversight of the process by which compensation is determined and monitored.
- It increases the potential that regulators will expand their scrutiny of chief executive officers and governing boards with respect to their respective roles in the compensation process, based upon the perspective that discretionary spending abuse may be widespread in the nonprofit community.
- Like earlier controversies with prominent organizations such as the United Way of the National Capital Area and the Nature Conservancy, it may serve as a "home town" (e.g., D.C.) reminder to those legislators who believe that greater Federal oversight legislation is needed to correct perceived abuses in the nonprofit sector.
Recommended Action Items
To better position the organization to address similar types of compensation, discretionary spending and board oversight concerns, nonprofit boards and CEOs may wish to work collaboratively to do the following:
- Confirm specific organizational expectations regarding discretionary spending by the chief executive officer, the presence of limitations thereon and a vehicle by which the parties can resolve open related questions.
- Ensure the CEO employment agreement (or any amendments) accurately reflects the parties’ understanding regarding discretionary spending.
- Review the executive compensation determination process for (i) compliance with recognized "best practices," (ii) satisfaction of the rebuttable presumption of reasonableness criteria, (iii) the appropriate role of the compensation consultant, (iv) appropriate limitations/involvement of the role in the process of the chief executive officer and (v) transparency with the full governing board.
- Identify a workable recordkeeping process that will enable the CEO to promptly and efficiently record the business purpose of discretionary expenses incurred in the conduct of executive affairs.
- Periodically (e.g., every other year) conduct a board audit of the discretionary spending practices of the CEO (and spouse, if necessary and appropriate).
- Apply appropriate Federal income tax reporting guidelines for expenses deemed "personal" in nature.
- Qualify executive-compensation-related decisions for the rebuttable presumption of reasonableness wherever possible.
This On the Subject is based in part upon articles appearing in The Washington Post, The New York Times, The Chronicle of Philanthropy and Tax Notes Today during September and October 2005.