Making Charities' For-Profit Arms More Accountable
By Henry Goldstein
Reprinted with permission from The Chronicle of Philanthropy, March 1998

STATE ATTORNEYS GENERAL have labored for years to find effective ways to regulate fund raising. Meanwhile, real money is rushing out charities' back doors through their for-profit subsidiaries.

So far, relatively few charities have for-profit arms. Although abuse is not believed to be rampant, these activities receive too little oversight. And the potential for unchecked abuse is increasing.

In recent years, the once-clear line between “for-profit” and “non-profit” has been steadily eroding as charities of every type struggle with declining government support, the escalating costs of obtaining contributions, and the pervasive notion that they are supposed to run more like businesses.

To handle operations unrelated to their core missions, more and more charities are setting up for-profit subsidiaries, a long-standing and entirely legal practice. Hospitals, museums, colleges, and social-service organizations have been doing so for decades.

Under the law, if a subsidiary makes a profit on activities unrelated to the parent organization's main charitable function, it pays tax on those earnings.

Usually, the charity is the sole stockholder in the subsidiary. If the charity receives income from the subsidiary, that income is tax-free and can be used for the charity's operations or placed in an endowment or other reserve fund. However, at least three problems of great consequence are inherent in the relationship between non-profit organizations and their for-profit subsidiaries.

First, because a charity's audited financial statement does not require that all transactions between it and its subsidiaries be disclosed, a profitable subsidiary can cut its tax liability by shoveling income to the parent. Though clearly helpful to the charity, neither that transaction--nor others related to the subsidiary's activities--are generally disclosed to donors, clients, or others who have an interest in the charity.

Second, because the shares of stock in charity-owned for-profit companies are not publicly traded, the companies are not required to disclose their financial records. Charities must disclose their records, but they are not making it easy to uncover information. There may be clues in the footnotes, which even sophisticated people don't pick up. For example, chief executives and other top officers of a charity may hold equivalent-but much better paid-jobs at the for-profit subsidiary, with no one except the board and that executive knowing about it. In that way, restrictions on excessive compensation can be avoided.

Third, some of the directors of a charity may also sit on the boards of its for-profit subsidiaries but are essentially unaccountable either to donors or to those served by the non-profit organization. Even in membership corporations--where the directors ostensibly are elected by the members--public accountability is minimal. The “high fiduciary standard” to which for-profit trustees or directors are theoretically obligated is not precisely defined. In fact, the standard is no higher than the ethical sensibilities of each board member.

Since the United Way scandal six years ago--which was ignited by exactly the kind of improprieties that the non-profit/for-profit arrangement permits--the news media have properly covered philanthropy with greater attention and a critical eye. Just in the past few weeks, The New York Times raised questions about the sale of Minnesota Public Radio's for-profit catalogue company to Dayton Hudson--a deal that produced more than $6-million in compensation for leaders of the station and its catalogue subsidiary.

And The Wall Street Journal published an article harshly scrutinizing the lucrative pay awarded to employees of Citizen Energy, a Boston non-profit group founded by U.S. Rep. Joseph Kennedy II that also runs numerous subsidiaries.

What is troublesome about deals like Minnesota Public Radio's is that, in part, the organization built up the for-profit side of its operation through the subsidy provided by tax exemption and tax deductibility. Substantial personal gain has resulted, but the people involved took none of the normal business risk. That was left to taxpayers in general, and Minnesota Public Radio's donors, in particular. But until recently, few of them knew it.

It is only a matter of time before the public's already-waning confidence in the holiness of charity will impel federal and state governments to take necessary--if not always prudent--actions.

What, then, might be done to insure accountability? Here's how the law should be changed:

No charity should be permitted to own more than 49 per cent of the shares of a subsidiary. What's more, only the corporate form of organization should be permitted, so that real ownership can be tracked more easily. Limited partnerships, or other forms of organization that make ownership more difficult, or even impossible, to determine should not be permitted.

A charity should not be permitted to control its subsidiary's board. Instead, the board should be made up primarily of outside, independent directors. This does not remove entirely the possibility of sweetheart contracts or other conflicts, but at least it makes unethical behavior riskier.

All transactions between a charity and a for-profit company in which it has full or partial ownership--irrespective of the percentage--should be clearly stated in the charity's annual financial report and clearly disclosed to donors, not interred in footnotes. And if an employee of a non-profit organization also draws salary, bonuses, or benefits from a for-profit subsidiary, that beneficial relationship should also be clear.

In addition to changes in the law, non-profit groups--many of which are proud of becoming more businesslike--might emulate a new business practice:Several of America's biggest companies have appointed “ethics officers,” employees with direct access to the chairman's office. Essentially, they are there to blow the whistle on questionable practices.

Perhaps it is time for every board--of charities and their for-profit subsidiaries alike--to have one outside director who is responsible for questioning and enforcing the ethical behavior of other board members, as well as the organization's staff.

Of course, those groups willing to do that are probably the least likely to need it. Meanwhile, philanthropy's leaders need to call for complete accountability.

Henry Goldstein, president of the Oram Group, a fund-raising consulting company in New York, is a regular contributor to these pages. Click here to send an email.