After Madoff: What Should Charities and their Stakeholders Be Doing in a New World of IRS Transparency?

May 2009Newsletters Staying Well within the Law

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This article first appeared in HealthNewsDigest.com and is reprinted here with permission.

One of the most perplexing and disquieting group of investors/victims of the infamous Ponzi scheme of Bernard L Madoff is the long list of charitable organizations, many of them large and well-respected, that have reportedly lost many millions of dollars through investing with him. A number of the charitable entities that are tax-exempt under Section 501(c)(3) of the Internal Revenue Code have even been forced to abruptly cease their operations.

This article will examine some of the unique aspects of 501(c)(3) tax-exempt charities that made them attractive targets for Madoff, some of the mistakes that were made by those with responsibility for charitable assets, and opportunities for all charities and their stakeholders to better protect themselves in the future.

These matters coincide with the new and far more comprehensive and transparent annual reporting obligations of 501(c)(3) organizations on Form 990 with the Internal Revenue Service. While many charities will view the new Form 990 as a burden and extra work, the Form 990 can be a useful vehicle to repair charitable images damaged by Madoff or other events and to bolster charitable governance and compliance practices and reputations. Filed Forms 990 are universally available for review and copying from the internet. Later in this article information will be provided about how the new Form 990 can be used advantageously by charities and how anyone can obtain copies of them.

Who are the Stakeholders that were affected by Madoff?

A charity has many stakeholders. For example, a non-profit hospital’s stakeholders may include donors, patients, physicians, employees, vendors, the governing board, the community, government, among others. The primary stakeholders that will be a focus of this article are its donors, the intended beneficiaries under its mission and the governing board or other management that is charged with the fiduciary duty of enabling it to achieve its stated mission. The presence of a mission, such as the provision of charity care by a tax-exempt hospital, distinguishes a 501(c)(3) organization from a profit-oriented business entity.

Why Were Charities Such Attractive Targets for Madoff?

In order to identify mistakes that charities made and suggest proactive responses, it is important to understand some of the reasons why they were primary objectives for Madoff to assist him in lengthening the life span of his Ponzi scheme. They include the following:

  • For 50 years Madoff enjoyed the status and reputation of being a leader and innovator in the investment industry and had served as Chairman of the NASDAQ Stock Market.
  • Madoff created an aura of trust by appearing to be the epitome of the “Three W’s” that are most desirable attributes sought by charities in their board members and supporters: generosity from Wealth, sharing of Wisdom and performance of Work.
  • Madoff’s reporting of consistently high, stable “returns” over years would encourage charities to limit distributions in favor of rolling over their purported returns to augment revenues and balance sheet assets; if endowment funds were needed, they would use other funds first.
  • Charities with large endowments have consistently adhered to policies that have limited their spending to a small percentage of their endowment funds in a given year.
  • Tax-exempt charities did not need to take any distributions from the Madoff investments to pay income taxes on their returns.
  • The fact that respected charities appeared to have been making high returns with Madoff over a long period led to a desire by other charities to share in the “profits”.
  • Madoff operated in a cunning fashion to convince investors that his acceptance of their money made them members of a special select group.
  • Boards of charities in recent years feel under enormous pressure to generate investment returns that exceed those of recognized benchmarks and are not less favorable than their peers.

What Mistakes Did the Charities Make in Investing with Madoff?

The actions of boards, investment committees and advisers of charities in investing with Madoff were questionable in a number of aspects. Volunteer members of boards of charitable organizations with a mission are fiduciaries that should generally discharge their duties in good faith; in compliance with law and prevailing business ethics; with the degree of diligence, care and skill that an ordinary, prudent person would exercise under similar circumstances; and without undue conflict of interest.

In one or more respects the boards of charities that invested with Madoff fell short on these standards, including the following examples:

  • It has been published that Madoff’s purported investment vehicles were characterized by him as “split-strike conversion products using both index options and individual stock options, both with and without index puts.” It would appear that such obscure and exotic investments are not traditional types that are suitable for tax-exempt organizations with a mission other than making money and maximizing revenues. The volunteer board members of non-profits, who are generally earning only “psychic income” often lack the time, background, experience or inclination to be capable of evaluating such investments. Additionally, most states have granted higher levels of protection from personal liability for board actions to uncompensated board members of charities than to directors of profitoriented business entities.
  • One or more charities had actual conflicts of interest in that Madoff was a board member at the same time that the organization was investing funds with him for a generous fee. In other cases there may be “perceptual” conflicts of interest, e.g., where Madoff was not a board member of charities that invested with him, but was a contributor or had board members who were otherwise investors with him or social or business relationships.
  • A charity has a mission, which transcends merely generating money, that was the basis of its receiving taxexempt status,. Donors are not providing contributions as seed money for the board to take substantial and unquantifiable risks to increase endowments. They are giving to a cause that has meaning that they wish to support financially.
  • The improvident investment policies of a charity in investing with Madoff has subjected it not only to actual losses of investment value, but also the potential for “clawback” by the trustee for Madoff assets if the entity did take monetary distributions and received substantial and disproportionate payments as compared to the average cash return for all other investors.

What should charitable governing boards do to rehabilitate relationships with donors and beneficiaries?

The unfortunate experiences with Madoff of many charitable organizations should be poignant object lessons for all charitable organizations and their fiduciaries, whether or not victims of Madoff. It has become critical that all 501(c)(3) entities review, analyze and reform their operating policies and procedures in areas such as governance, investment policies, education of board members about financial and operational matters, avoidance of conflicts of interest, etc. Only by demonstrating their commitment to best practices in governance and operations can they succeed in the increasingly competitive environment for shrinking donor dollars in an adverse economic climate.

What is the Form 990 and how can it assist 501(c)(3) entities in achieving governance reforms and demonstrating these reforms to stakeholders?

For many years Form 990 was viewed as an annual financial report by a 501(c)(3) entity to the IRS for the prior fiscal year. The financial statements are an important part of the Form 990 and track very closely the annual audited financial reports of the organization. The Forms 990 for 2008 can be expected to be generally dismal because of declining contributions due to an adverse economy and significant losses in market values of charitable endowment funds during 2008, whether or not there were Madoff investments. Most 501(c)(3) organizations will have a need to explain clearly and carefully in their 2008 filings why losses were incurred and the steps to be taken to avoid or reduce a repetition of such losses. The IRS changes in the disclosure requirements of Form 990 for 2008 encourage that approach.

Form 990 is required to be filed with the IRS by the 15th day of the month following the end of a charity’s fiscal year, e.g., May 15, 2009 for a fiscal year ended on December 31, 2008. It must be understood that, unlike federal tax returns filed by business corporations, Forms 990 can be accessed anonymously by anyone in the world at any time. Websites, perhaps the most well known of which is www.guidestar.org, archive Forms 990 on line, ordinarily within two months after they are filed with the IRS. Potential donors, competitors, governmental agencies, beneficiaries and many others easily and routinely can access Forms 990.

A charity can have up to two extensions for filing a Form 990 that could delay its filing until November 15, 2009. It can be anticipated that many 501(c)(3) entities will try to extend their filing dates as long as they can in order to see what others are doing with the new Form, to delay disclosing adverse results in 2008 or to complete changes in governance and operating policies and procedures prior to filing. There are potential penalties for a 501(c)(3) entity that fails to file a complete and correct Form 990 with the IRS on a timely basis.

It is advisable for charities to file Form 990 for 2008 as soon as practicable, so that the initiative for building bridges to stakeholders can be maximized. An early filing of the 2008 Form 990 with positive answers to the new schedules and questions can disclose a strong commitment to a defined mission, appropriate governance and investment policies, involvement of the board in preparing the Form 990, a whistleblower policy, a modern and responsible conflicts of interest provision, appropriate policies for setting executive compensation, etc. The new changes to Form 990 will allow a charity to use the IRS items as a checklist of “best practices” and tell its story in its own words. Additionally, charities should post their Forms 990 on their own websites, together with principal governance documents that demonstrate their commitment to best practices.

Conclusion

The unfortunate Madoff scandal, an adverse economy and other events have combined to create challenging times for charities and their stakeholders. A properly prepared Form 990 that reflects recent proactive changes in governance and operations under the leadership of the governing board will go far in repairing the damage to the images of those that invested with Madoff and to enhance the reputations of those that avoided the Madoff morass. For more information about this topic, contact Michael Kline at 609.895.6635 or [email protected].