The work of a charity's trustee, board member, or volunteer officer comprises prestigious acts of public service, but their duties are not to be taken on lightly. The author describes significant federal and state regulation, and deals with investments, delegation of authority, conflict of interests, and unrelated business income. Findings of significant court cases are summarized. Appropriate reading for a CPA either as auditor or trustee, member of the board, or officer.

Trustees of charitable causes once believed they were performing a service simply by lending their names to some worthy organization. This was perceived as a help to the charity's fund-raising efforts. While a trustee might have attended few, if any, meetings and paid little or no attention to day-to-day operations, he or she did contribute, often generously. The trustee thus would have been indignant if called upon to account for mismanagement of the organization--after all, he or she had nothing to do with day-to-day operations. I can assure you, those days are long gone. Now every trustee is responsible for management of the organization and personally liable for mis- or non-management. What has happened? Actually, what happened was long overdue and is a formal recognition of duties and responsibilities that were always there.

Over the past 25 years, legislative bodies at all levels, regulatory agencies, and, in particular, the courts, have clarified and defined the degree of diligence expected of trustees. This interest by officialdom in the duties and responsibilities of trustees reflects, I think, the extraordinarily broad and pervasive position of private philanthropy in this country.

REGULATION OF CHARITIES

In broad terms, there are three levels of regulation: federal, state, and internal or self-regulation. At the federal and state level, a definite standard of conduct is imposed by law or regulation upon trustees of charitable funds.

My discussion deals with regulation of charities from the federal and state level. It is important that there also be appropriate self- regulation through bylaws, operating procedures, officers and committees with specific duties, and internal controls. The absence of self- regulation can result in federal or state action against the trustees. Specific recommendations about self-regulations are not dealt with herein.

Federal Government: Internal Revenue Service

Although the IRS was structured as the tax collecting arm of the federal government, it is in fact its chief regulatory arm for charities. There is considerable regulatory ammunition at the disposal of the IRS, including the Internal Revenue Code, Treasury Regulations, the IRS rulings, Information Releases and Bulletins. The IRS has the duty of seeing that each organization that has been granted exemption from federal income tax and the right to receive tax-deductible contributions, is both organized and operated exclusively for the purpose for which established. The key provision, out of which the regulatory structure grows, is IRC Sec. 501(c)(3). Considering the array of organizations this provision impacts, it is deceptively brief. It provides that the following shall be exempt from taxation:

"Corporations, and any community

chest, fund, or foundation, organized

and operated exclusively for religious,

charitable, scientific, testing for public

safety, literary, or educational

purposes, or to foster national or

international amateur sports

competition . . . or for the prevention of

cruelty to children or animals, no part

of the net earnings of which inures to

the benefit of any private shareholder

or individual, no substantial part of

the activities of which is carrying on

propaganda, or otherwise attempting,

to influence legislation . . . and which

does not participate in, or intervene in

(including the publishing or

distributing of statements) any political

campaign on behalf of (or in opposition

to) any candidate for public office."

A statement of duties and responsibilities of charitable trustees--at least in outline form--begins to emerge in Sec. 501(c)(3), without reference to the standards imposed by other federal statutes, state laws or the decisions of various courts. That statement imposes the following duties on trustees:

* The exempt entity must be both organized and operated exclusively for proper purposes; * It cannot be used in such a way as to benefit a private interest; * It cannot, in a "substantial" manner, involve itself in legislative activities; and * It cannot participate in political campaigns.

Since TRA 69 the IRS has had considerable regulatory power--generally by way of taxes--over certain philanthropic organizations. This has firmed up the standards applicable to trustees of charitable funds. There are three types of Sec. 501(c)(3) organizations resulting from TRA 69: 1) private foundations, which are subject to considerable statutory control; 2) private operating foundations, which are subject to somewhat less control; and 3) public charities, which continue to enjoy the loose regulation--at least at the federal level--applicable to all Sec. 501(c)(3) organizations prior to TRA 69.

Private Foundations. These foundations are prohibited from:

* Self-dealing with trustees; * Jeopardy investments (discussed later); * Excess business holdings; and * Lobbying or attempting to influence the legislative process. This rule does not apply to "public charities."

Private foundation trustees must see that each year the foundation pays out 5% of the market value of its portfolio in grants or other "qualifying distributions." In certain cases the foundation must exert expenditure responsibility over the grants made to others. The foundation must pay an excise tax of 2% on investment income, which may be reduced to 1% if it makes sufficient qualified distributions. Private foundation trustees are subject to tighter regulation than trustees of other organizations and in meeting their responsibilities are subject to greater scrutiny.

Private Operating Foundations. TRA 69 created this class of private foundation. They tend to conduct their own programs rather than make grants to other organizations, but for various reasons fail to meet the tests necessary to claim public charity status. Private operating foundations and their trustees are subject to most of the same limitations as private foundations.

Public Charities. Finally, the IRC classifies all Sec. 501(c)(3) organizations that do not fall into either the private foundation or private operating foundation categories as "public charities." They are of two types: those granted public charity status by virtue of what they do and those accorded such status by virtue of the sources of their support. The former category includes churches, educational institutions and voluntary hospitals. The latter includes organizations that enjoy substantial financial support from the general public; from grants from other public charities and from governmental grants; organizations that generate substantial receipts from activities related to their exempt purposes; and organizations with the sole purpose of supporting other public charities.

The regulatory scheme with respect to private foundations and private operating foundations is inapplicable to public charities. At the time of TRA 69 it was believed that certain organizations in the public eye-- whether because of what they did or because of their dependence on public support--did not require the regulation proposed for private foundations. This means that federal regulation over such organizations is limited and the only effective tool available to the IRS is revocation of their exempt status.

State Governments: Attorneys General

At the state level, regulation of philanthropies rests primarily-- though not entirely--with the Attorneys General. Other state agencies, particularly those with their own legal staffs, may exercise additional supervisory powers. For example, in New York State, hospitals are subject to supervision by many city and state agencies, as well as federal agencies; educational institutions are supervised by the Board of Regents and the State Education Department. The conduct of trustees of public charities--as opposed to private foundations--is primarily a state law matter.

Perhaps the best way to illustrate regulation at the state level is to focus on New York law and discuss the regulatory process as it affects charities; many other states tend to adopt or follow New York practices.

The establishment of a charitable corporation in New York under the Not-for-Profit Corporation Law requires a Certificate of Incorporation that sets forth appropriate not-for-profit purposes.

Once in operation, the corporation will be subject to continuing review by the Attorney General as well as other state agencies to which it must make reports. Under New York law trustees of charitable funds must register with the office of Attorney General and must file, annually, a report containing substantially the same information required in annual information returns filed with the IRS. In addition, the trustees may be required to file reports with other agencies. In this way the authorities have some idea of whether the corporation is operating properly.

I consider the ever-present authority of the Attorney General and other agencies to act, rather than the infrequent actions actually taken, to underlie state regulatory schemes. In most instances, authorities are able to correct abuses without recourse to remedies-- some of them drastic--that the laws permit them. The point is that standards of conduct exist at the state level; agencies charged with seeing those standards are followed do exist; and those agencies have full authority to act when standards are not being met.

DUTIES AND RESPONSIBILITIES OF TRUSTEES

Improprieties by trustees are nothing new and startling. Even prior to legislation, common law had developed a keen sense of proper conduct by a fiduciary. The principle of fiduciary responsibility was perhaps best stated by Justice Cardozo.1

"Many forms of conduct

permissible in a workday world for those

acting at arm's length, are forbidden

to those bound by fiduciary ties. A

trustee is held to something stricter

than the morals of the market place.

Not honesty alone, but the punctilio of

an honor the most sensitive, is then

the standard of behavior."

To paraphrase the provisions of the New York Not-for-Profit Corporation Law: Trustees have primary responsibility for management of the organization and are liable for consequences of negligent or willful mismanagement. Trustees are required to discharge their duties in good faith and with that degree of diligence, care and skill that ordinarily prudent people would exercise under similar circumstances in like positions.

Determinations by Courts

The following cases illustrate the current extent of trustee liability.

Sibley Memorial Hospital Case.2 In a most important judicial decision in this area, delegation of day-to-day investment and management decisions by a hospital board of trustees to two board members, who happened to be full-time employees of the hospital, resulted in considerable losses to the hospital. This prompted a District of Columbia court to issue standards for hospital trustees that appear equally applicable elsewhere. The court stated that a trustee violates his or her continuing fiduciary duty of loyalty and care in managing fiscal and investment matters if he or she:

* Fails, while assigned to a committee with investment or financial responsibilities, to use diligence in supervising and periodically inquiring into the actions of employees or outside experts who have been delegated authority to act on a day to day basis; * Knowingly permits the organization to enter into a business transaction with him-or herself or with another organization in which he or she has an interest, without fully disclosing the facts to everyone concerned; * Actively participates in a business transaction with the organization that results in personal benefit to him- or herself, without full disclosure; or * Fails to perform his or her duties honestly, in good faith and with reasonable diligence and care.

Tillman Case.3 The Fourth Circuit in this case set standards for imposing personal liability on trustees where an intentional wrong had been committed. This case involved a decision by trustees to uphold a racially discriminatory policy--that is, to go along with something illegal and that should have been known to be illegal. The Court stated that inasmuch as an overtly exclusionary policy was voted upon at a time when state and federal statutes prohibited such activities by such organizations, and thus involved an intentional wrong affecting third persons, the trustees who had voted in favor of the policy were held personally liable, and the Court therefore assessed damages against them. This finding was reached even though the trustees had consulted their own legal counsel and were advised that the exclusionary policy was legal. When read with the Sibley Hospital case, this case further refines trustee responsibility and establishes a clear line between intentional and unintentional acts causing harm.

More Recent Cases

Cases in which business corporations are involved in hostile takeovers have discussed standards that are applicable to non-profit corporations. They have established that the duty placed upon trustees is one of process rather than results. Two recent cases in particular illustrate this point.

Hanson Trust PLC Case.4 The Second Circuit held that directors of the defendant corporation had not made a sufficient effort to inform themselves of the facts before deciding to grant certain options in a bidding war. For this reason, they could not invoke the so-called business judgment rule in defense of their actions. That rule expresses the reluctance of courts to second-guess the governing board of a corporation as to the merits of a particular decision, but rather limits judicial review to whether the board acted in good faith and with due care. Of particular interest in Hanson is that the Court made its finding of inadequate information despite the involvement of investment experts at the meeting where the decision was made, who advised their clients that the options being considered were "within the range of fair value."

Van Gorkom Case.5 The Delaware Supreme Court held that directors of the defendant corporation had not adequately informed themselves prior to their approval of a merger. The court found the directors to be grossly negligent, even though the sale price was almost 50% above the stock's current market price, because they had approved sale of the corporation after a mere two hours consideration.

Lessons from Court Decisions

Both statutes and cases are calling, above everything else, for common sense. Trustees are expected to engage in a decision-making process that entails these elements:

* As demonstrated in Tillman and Hanson, a reasonable effort to become adequately familiar with the facts, subject to permitted but not unlimited reliance on advice of experts; * As demonstrated in Van Gorkom, a reasonable period of deliberation prior to making any decision; and * Good faith and reasonable belief that the decision so rendered is in the best interests of the organization being served.

SPECIFIC AREAS OF CONCERN

Finance and Investments

In these areas, there are two standards I call to readers' attention. New York law provides that trustees of charitable funds may invest them in such securities as would be acquired by prudent investors of discretion and intelligence in such matters who are seeking a reasonable income and, at the same time, preservation of capital. It requires trustees to avoid unreasonably speculative investments and to use good sense in drawing a line between what is prudent and what is not. It also requires trustees who lack investment experience and skill to obtain expert advice. The provision certainly does not require trustees to invest only in U.S. government securities, triple-A bonds or the like; it does require trustees to analyze each investment with care and to avoid those investments which, however attractive they may appear, present risks that are not reasonable in the circumstances.

The second standard is set forth in IRC Sec. 4944. The jeopardy investment rule prohibits a private foundation trustee from making investments that jeopardize the organization's exempt purposes by subjecting its funds to risks out of proportion to its long- and short- term financial needs. This standard may well be applicable to all trustees of charitable funds.

Delegation of Authority

The selection of a staff to handle day-to-day management of an organization is a key responsibility of trustees. The Sibley case is a good example of trustees selecting personnel, delegating full responsibility for day-to-day management of the organization, and then failing to supervise their activities. The fact is that trustees remain responsible. Because, as a practical matter, they cannot administer on a day-to-day basis, they must hire the most competent staff personnel available, they must delegate responsibility to the staff within clearly-developed guidelines, and must exercise supervisory control on a regular, ongoing basis.

Committees

Persons who sit on governing boards of philanthropies bring a wide variety of skills to their organizations. It makes sense, therefore, to establish different committees of trustees to take advantage of these skills. Putting trustees who are accountants on the audit committee is eminently sensible as long as none is associated with the CPA firm conducting an audit. Establishing an investment committee of trustees who have special investment skills, or a personnel committee composed of trustees with expertise in this area is also sensible. While all trustees share the same responsibilities at law, the risk of not meeting those responsibilities is lessened considerably where special tasks are assigned to trustees with appropriate experience to take them on.

The "Interested" Trustee. This is a continuing problem facing trustees of charitable funds. A trustee who stands to benefit personally from some arrangement between the charitable organization and either him- or herself or an organization with which he or she is affiliated, is a common problem. One situation is when a lawyer serves on the governing board, while his or her firm acts as counsel to the organization. There is nothing wrong with this, of course, but there are certain things that must be done if the relationship is to be a legal one.

In New York, there are a number of rules covering the interested trustee, applicable to all charitable corporations. First, the material facts as to the personal interest a trustee may have in a proposed arrangement involving the charitable organization must be known to other trustees charged with approving the arrangement. If the facts are not known they must be disclosed. Second, the transaction must be approved by a vote of the trustees that is sufficient without counting the vote of the interested trustee. That is, the interested trustee can be counted for quorum purposes, but his or her vote on the specific transaction cannot. If this procedure is not followed, the charitable organization may repudiate the transaction at a later point, unless it is affirmatively shown to be fair and reasonable as to the charitable organization at the time of approval. In most cases such a showing would be difficult--to say nothing of the embarrassment of the interested trustee--so the best course, clearly, is to have full disclosure before the fact. At least once each year trustees and officers should file with the Board of Trustees a written conflict of interest statement.

Special Responsibilities Under ERISA

It is, of course, entirely appropriate for trustees of charitable funds to establish reasonable fringe benefit and retirement plans for employees, and to set aside funds for this purpose. In most cases, however, the fiduciaries of such a plan will be subject to an additional layer of federal regulation, under ERISA.

ERISA standards of fiduciary conduct are similar to some of the state and federal standards discussed, although enforcement mechanisms are different.

Trustees should consider establishment of a committee of trustees charged with overseeing the compliance of a retirement plan and other benefits programs with ERISA and related requirements. Delegation of authority for day-to-day administration, investment and operational details of such programs should take place through this committee, and the committee should develop guidelines to monitor activities of persons to whom these duties have been delegated. These persons--appointees of the trustees--should be recognized experts in their fields, whether they be actuaries, investment advisers, lawyers, or accountants. Periodic review by the committee is required.

Unrelated Business Income

Trustees should be well aware of the unrelated business income (UBI) tax provisions of IRC Secs. 511 to 514. These provisions apply to all Sec. 501(c)(3) organizations, whether private foundations or public charities. The basic rule is simply stated: because the IRS has granted tax exemption to an organization which proposes to carry on charitable, educational, religious or other activities that the IRS exempts, the organization runs the risk of taxation if it carries on activities unrelated to its purposes, generally in competition with taxpaying businesses. UBI is income from any unrelated trade or business regularly carried on by the organization. An activity is related if there is a causal relationship between it and the accomplishment of an exempt purpose. If a university press is publishing scholarly works, its income is not taxable. However, if it publishes non-scholarly, popular works it runs substantial risk of taxation.

The reason is that it is unfair for a tax-exempt organization to engage in activities in competition with taxpaying business corporations. For the most part--although certainly not always-- activities that are truly related to exempt purposes do not involve competition with taxpayers. If they do, the chances are they will be subject to considerable scrutiny by the IRS to determine whether they are really related.

The real problem of unrelated business income that trustees must face has to do with its ramifications for the organization's tax exemption. An important duty of trustees is to preserve that exemption and to avoid anything that might jeopardize it. If income of an organization from an unrelated business activity becomes too great, there is a real risk that the IRS might question whether the organization's primary purpose has to do with activities for which it was granted tax exemption, or rather with generation of UBI. The argument that "it's all for charity" does not apply: if UBI looms too large, the exemption of the charity might be questioned.

Lobbying and Legislative Activities

Private foundations cannot engage in these activities. There are a couple of exceptions to this. For example, a private foundation with specialized knowledge in some areas can enter into the legislative process at the request of the legislative body concerned, and a private foundation directly affected by particular legislation that has been proposed has a certain scope within which to act on the legislative front. Similarly, making available to the general public the results of a non-partisan study or research project--even a controversial one--is not interpreted as an attempt to influence the legislative process. However, the general rule for private foundations remains; private foundations must avoid legislative activities altogether or else proceed very carefully within the narrow limitations permitted.

With respect to public charities, the rule had permitted legislative activities as long as they were "insubstantial." The latter term was never clearly defined. However, under the TRA 76 the permissible level of lobbying or legislative activities by public charities was clearly set forth. Under the statute the term "influencing legislation" means:

* Any attempt to influence legislation--whether at the federal, state or local level--through an attempt to influence public opinion; and * Any attempt to influence legislation through communication with any member of a legislative body, any employee of a legislative body or any government official participating in the legislative process.

Under the statute "influencing legislation" does not include making available the results of non-partisan research or analysis, providing technical assistance to a governmental body at the request of such body, appearances before a legislative body with respect to a decision affecting existence or tax-exempt status of the organization, communications between the organization and its members with respect to legislative matters of direct interest to the organization and such members, and any communication with a governmental official unrelated to the legislative process.

The basic permitted level of legislative expenditures is 20% of the first $500,000 of the organization's exempt purpose expenditures for the year in question, plus 15% of the second $500,000, plus 10% of the third $500,000 plus 5% of any additional expenditures--subject to an overall maximum of $1 million in one year. In the event that the organization exceeds these limits in one year, an excise tax of 25% is imposed on the amount above the limits. In addition, if over a four-year period the organization's legislative expenditures exceed 150% of the limits, it will lose its tax-exempt status. Quarterly returns disclose all legislative activities to the IRS. However, these standards apply only to a public charity that elects to be covered. An organization that chooses to engage in the legislative process under the old rules may continue to do so, provided its legislative activities are "insubstantial"--say, no more than 5% of its total activities.

Liability Insurance

Under New York law, organizations are permitted to indemnify their trustees and officers in legal actions brought against them for alleged misdeeds while in office. Indeed, in certain circumstances trustees may claim indemnification as a matter of right, even when the organization does not want to give it.

Furthermore, in response to recent increasing concern over directors' and officers' insurance "crisis," New York has most recently amended provisions of both the Business Corporation Law and the Not-for-Profit Corporation Law. As for charitable corporations, recent legislation provides that no director, trustee or officer, who serves without compensation will be liable to any third person (that is, other than the corporation itself), based on conduct while in office, unless he or she was grossly negligent or intended to inflict the harm complained of. Further, a director, officer or trustee will not be considered to be compensated "solely by reason of payment of actual expenses incurred in attending meetings or otherwise in the execution of such office."

Under existing law, an organization may purchase insurance against the eventuality of its trustees and officers being sued. However, neither the law nor any insurance policy will countenance indemnification for gross negligence, criminal neglect or willful wrongdoing proven in court. The best insurance, of course, is to have dedicated, hardworking and responsible trustees, rather than a group of prestigious names whose sole contact with the organization has to do with its letterhead.

PHOTO : As a member of the Board of Directors of the International Rescue Committee and a founding member of the Women's Commission for Refugee Women and Children, Liv Ullmann devotes a substantial part of her time to the cause of refugees. Here she is pictured visiting a Vietnamese boat refugee camp in Hong Kong last year. 1Meinhard v. Salmon, 249 N.Y. 458, 464, (1928). 2Stern, et. al. v. Lucy Webb Hayes National Training School for Deaconesses and Missionaries, et. al., 381 F. Supp. 1003, (USDC, D.C. 1974). 3Tillman v. Wheaton Haven Recreation Association, Inc., 517 F. 2d 1141, (4th Cir. 1975). 4Hanson Trust v. ML SCL Acquisitions, Inc., 781 F. 2d 264, (2nd Cir. 1986). 5Smith v. Van Gorkom, 448 A. 2d 858, (Del. Supr. 1985).

Robert L. Duncan is an attorney and a partner at the New York law firm of DeForest & Duer. Mr. Duncan was educated at Princeton, Magdalen College, Oxford, and Harvard Law School, and his expertise is in the field of tax-exempt organizations.