How to Address Nonprofit Governance Failures

Governance failures at for-profit corporations are the topic of frequent media stories, judicial opinions, and academic analyses. Nonprofit governance, however, has received significantly less attention. This lack of attention is not because nonprofits are immune from governance failures, and recent allegations against the National Rifle Association may prove the point. In our paper, Nonprofit Governance in an Age of Compliance,  we identify the factors that give rise to critical nonprofit governance failures, and we offer attainable reforms to address them.

Most nonprofit governance failures stem from the key legal difference between nonprofit and for-profit corporations. By law, nonprofits are prohibited from distributing accrued earnings to private individuals. Nonprofits, therefore, have no owners in the traditional sense and by extension no discrete class of people with the financial motivation to monitor management. As a result, nonprofits have been vulnerable to corporate governance problems like self-dealing or fraud. And since the nonprofit sector accounts for $1 trillion of US GDP and 12 million jobs, the consequences can be severe.

We begin by analyzing why reform is necessary.  Although nonprofits have no owners, a host of other public and private entities could provide varying degrees of monitoring. Nevertheless, we show that each of these entities suffers from problems that make monitoring little more than a formality. State attorneys general, for example, are tasked under state law with oversight of charitable nonprofits that do business within their state. However, because state AGs represent the interests of citizens only from their state, they will invest few resources into monitoring larger nonprofits whose operations spill across state borders.

Likewise, research suggests nonprofit status has a “halo” branding effect that organizations would want to protect by avoiding fraud. The well-known nonprofits are in the best position to monitor the nonprofit sector, but because they have their own established reputations, they have little interest in protecting a halo whose benefits accrue primarily to competing new market entrants without a reputation of their own.

Additionally, we might expect well-intentioned private citizens who care about a nonprofit’s mission to monitor the nonprofit’s management. But under most state laws, private citizens lack standing to sue for managerial misconduct. Other potential monitors, like boards of directors, the IRS, or the media, suffer from similar difficulties that keep them from serving as effective checks on governance missteps.

We offer three possible solutions. The first relies on private ordering. We suggest a series of disclosures and private third-party certifications that would help nonprofit management identify potential governance failures and help patrons of the firm identify trustworthy nonprofits with top-notch governance. The second approach would be a federal nonprofit monitor, centralizing monitoring in a single entity to solve the coordination difficulties of the current state-based system.

The third option would leverage the existing state AG monitoring framework. Our proposal charges the state AG of the nonprofit’s incorporation state with overseeing nonprofit governance, regardless of where that nonprofit does business, monitoring for major governance failures. Coordination among the states would establish minimum monitoring standards. After this initial step, there would be no need to coordinate among various state offices to achieve efficient levels of monitoring because responsibility would be centralized within a single AG office. The resulting race to attract nonprofit incorporations could unfold like the race to attract incorporations, with robustly monitoring states offering commitments to patron protection that would reward incorporating nonprofits with more business and lower capital costs. The minimum monitoring standards would prevent the race from becoming a race to the bottom.

Nonprofits are bastions of the American economy, yet issues of nonprofit governance have received significantly less attention than they deserve. We hope our article stimulates a new discussion of innovative ways to manage the familiar governance problems that can result from delegating responsibility to an unaccountable and unmonitored management.

This post comes to us from professors Peter Molk and D. Daniel Sokol at the University of Florida’s Levin College of Law. It is based on their recent paper, “Nonprofit Governance in an Age of Compliance,” available here.