Enhanced scrutiny for nonprofit compensation

Beware the Attorney General: Scrutiny of Director Compensation on the Rise

Recent California Attorney General (“AG”) audits should make every nonprofit board beware the Attorney General. This charity regulator appears to be doubling down on its scrutiny of director compensation.

Under the California Nonprofit Corporation Law (the “Nonprofit Law”), the AG has the authority  to look into virtually every aspect of a charity’s operations. This broad regulatory power extends over any entity holding charitable assets that operates in California. It also applies whether or not the charity is based in California.

Rules for Transactions with Directors

A particular focus of the AG is director compensation. The Nonprofit Law governs that ALL transactions between a nonprofit corporation and any of its directors (or their family members), or one in which the director has a financial interest. Among other things, the Nonprofit Law requires that all such arrangements be approved by the board. That approval requires making the following determinations that must be documented in the minutes of the board meeting at which the compensation was approved:

  1. The compensation is to be provided for the charity’s interests (not those of the director);
  2. The compensation is fair and reasonable to the charity;
  3. The director fully disclosed their interests in the transaction; and
  4. The arrangement was the most advantageous the charity could reasonably obtain under the circumstances.

These determinations must be made by a majority of the directors without counting the votes of any directors with a financial interest in the transaction.

AG Audits of Nonprofits

The California AG audits thousands of nonprofits each year. Audits may be triggered by a variety of causes including annual reporting, news stories and consumer complaints. During an audit, the AG focuses on any payments made by the charity to any director or family member of a director, among other things. In several audits we have seen over the last year, the AG has scrutinized every such payment, even those as little as $25. Our clients have had to show how the board approved each such payment. When that documentation doesn’t exist, the AG can and does demand that those payments be reimbursed. For this and other reasons, audits are often the scariest thing a nonprofit will ever have to face.

Good Intentions Are Not Enough

The AG is charged with protecting charitable assets. When defending anaudit, a charity’s good intentions are not enough. I once asked a supervising deputy attorney general, “don’t you see the forest for the trees?” His reply was, “what forest?” The lesson for every charity is to be scrupulous about following the rules cited above. If you do not, be concerned that the AG will audit your organization and the ramifications may be significant.

The best way for directors to be on notice of these requirements is for them to be spelled out in the nonprofit’s bylaws. Do your organization’s bylaws specifically instruct directors on the proper process for approving payments to directors? If not, have an expert help your organization amend its bylaws so that directors are aware of this duty. Doing so may save the organization and its directors big money and big headaches.

NOTE: The information contained herein is not intended to be legal advice and the reader should know that no Attorney-Client relationship or privilege is formed by the posting or reading of this article which is also not intended to solicit business.

Casey Summar, Partner, The Law Firm for Non-Profits, 4705 Laurel Canyon Blvd, #306, Studio City, CA 91607

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