​The Madoff Scandal and Charities and Foundations: The Need for All 501(c)(3) Entities to Improve Their Governance and Conflicts of Interest Policies in Advance of Reports for 2008 on Form 990 to be Filed With the IRS – Installment 5

February 23, 2009Articles White Collar Compliance & Defense Blog

This is the fifth in a series of Installments on this blog that will discuss some of the threshold issues that face the manifold stakeholders who have been materially affected by the Bernard L. Madoff scandal, allegedly the longest, most widespread and financially devastating Ponzi scheme on record. All potential stakeholders should consult professional advisors promptly to have their positions evaluated.

We will continue the discussion of charitable entities and foundations that were affected by the Madoff scandal. However, we believe that the unfortunate experiences of too many charitable organizations and foundations (collectively, “501(c)(3) Entities”) that were directly involved in enormous losses from the Madoff morass should be poignant object lessons for all charitable organizations and their fiduciaries, whether or not victims of Madoff, especially in the year 2009, which is the first year of the expanded Form 990 that 501(c)(3) Entities must file with the IRS.

Potential Tax Penalties for Private Foundations that are 501(c)(3) Entities and Their Fiduciaries

On February 11, 2009, Lynnley Browning wrote an incisive article in The New York Times entitled, “For Investing with Madoff, Private Foundations Could Face Tax Fines.” In the article, Browning explains clearly the massive penalty excise taxes of 10 percent to which 501(c)(3) Entities that are classified as private foundations and their fiduciaries on a personal basis can be subject. Browning points out the following:

Under an obscure tax rule, private foundations can be penalized for failing to vet their investments properly, to heed red flags or to diversify properly. While foundations are exempt from federal income taxes, they are subject to excise tax,
intended to keep them from taking outsize risks that could threaten their very survival.

Browning goes on to explain that, “The foundation’s officers, directors and trustees also face a 10 percent penalty, and a 5 percent additional penalty if they ignored red flags or did not thoroughly vet Mr. Madoff’s investments and proposals.”

As indentified by Browning, the tax penalties for foundations can be monumental, especially when added to the basic losses that they incurred with Madoff directly. It is not clear, however, that the IRS would invoke the provisions, across-the-board, according to Browning.

Implications of Private Foundation Penalties for Governance Principles for All 501(c)(3) Entities

While the potential tax penalties that may flow to private foundations from Madoff investments is serious, the matter is not the primary thrust of this installment. Irrespective of whether or not private foundations are penalized for their investing with Madoff, the are numerous significant governance and compliance principles that may be extrapolated from the experience of 501(c)(3) Entities that invested with Madoff. The need to vet investments properly, heed red flags and diversify properly is mandatory for public charities as well as private foundations, even though public charities do not have the looming specter of IRS excise taxes for themselves and their fiduciaries.

This need for 501(c)(3) Entities to exercise appropriate care in its investing policy is heightened by the fact that 501(c)(3) Entities have a mission and a societal goal that was the basis for their receiving tax exempt status in the first place. The earning of income should only be a means to achieving the mission, not an end in itself. Losing sight of the mission and failing to maintain the highest standards can subject the 501(c)(3) Entities to harmful media publicity, public embarrassment, loss of donor support or even lawsuits by donors or regulatory authorities in flagrant cases of mismanagement.

The 501(c)(3) Entities and their boards are entrusted with the monies of donors that they have the obligation to safeguard reasonably. Such 501(c)(3) Entities must demonstrate their commitment to standards of appropriate governance with sufficient up-to-date compliance and governance codes, charters and/or programs that will provide protection for the 501(c)(3) Entities and guidance for their fiduciaries.

An Outline of Obligations of Fiduciaries of 501(c)(3) Entities and Some Failures with Respect to Madoff

Every officer, director and trustee of a 501(c)(3) Entity has a number of obligations and standards that are imposed upon them by statute or common law principles and business ethics. Such obligations and standards have become increasingly burdensome for uncompensated volunteers who serve as fiduciaries of 501(c)(3) Entities and in effect earn only “psychic income.” They are held to as standard of conduct that encompass many of the same principles and potential liabilities as fiduciaries of major corporations who are highly compensated. These principles and obligations include the following:

Honesty – the so-called business judgment rule that is the presumption that the fiduciary acted in the honest belief that actions taken were in the best interest of the 501(c)(3) Entity

Integrity – the obligation of a fiduciary to act consistently, reasonably and in good faith and to maintain confidentiality of proprietary information of the 501(c)(3) Entity

Loyalty – the obligation of a fiduciary to avoid conflicts of interest with the 501(c)(3) Entity

Responsibility – a fiduciary has a duty to exercise such diligence, care and skill which ordinarily prudent people would exercise under similar circumstances in the position

Citizenship – compliance with laws and understanding of the need for carrying on activities with ethical awareness

Fairness - relatively recent adoption in many states of “stakeholder” principles that encourage fiduciaries to take into account not only the interests of the direct beneficiaries of the 501(c)(3) Entity but also the interests of many constituencies, e.g. employees, customers, suppliers, the community, the government and others

A number of these principles were apparently not complied with by a number of 501(c)(3) Entities and their fiduciaries in the course of their investing with Madoff. Perhaps the most egregious case reported to date was of a highly respected Eastern university that invested, by its own admission, many millions of dollars with Madoff for years when he was a member of the board of trustees and an officer of the university. Madoff himself clearly violated virtually all of the obligations for fiduciaries listed above.

What is more concerning, however, is the fact that the other trustees of the university also did not comply with many of the obligations in the foregoing list, intentionally or because they were not sufficiently clear on their fiduciary duties. The obligations that such board members may have breached arguably include many elements of the list when appropriate questions are raised. For example, even if Madoff was investing in the exotic vehicles that he stated he was, were these the types of investments that a board charged with overseeing donations from the public should be condoning or even approving? Did the board members even understand or have the background or experience to understand the nature of the investments? Would they have invested in these vehicles for their own accounts? Did they have sufficient knowledge of the facts or ask Madoff legitimate questions to make a determination on the quality of the investments? Did the board members ever concern themselves with the potential appearance of impropriety of investing with Madoff when he was a fiduciary of the university? Did the board ask for an accounting as to how much Madoff or his affiliates earned in fees or other income from his relationship with the university? If they did ask any or all of these questions, is it sufficiently documented in the minutes of university board or committee meetings or other records?

As discussed in Installment 4, Madoff preyed upon the various business and tax advantages that many 501(c)(3) Entities saw in an investment with him. Then the 501(c)(3) Entities became subject to the glare of adverse publicity and embarrassing questions as to how and why the staggering losses that they suffered had taken place. This blog will continue the discussions as to how 501(c)(3) Entities should be dealing with lessons learned from the Madoff scandal, especially in preparing to meet their obligations in filing Forms 990 with the IRS for 2008.

[To be continued in Installment 6]