Conflicts of Interest - Key Issues for Foundations

With Congress and the media focusing on corporate governance and foundation administration, now is the time to make sure that all grantmakers have a strong conflict of interest policy in place. Both private foundations and public charities (such as community foundations) should have clear guidelines on financial or other interests that must be disclosed and transactions that must be scrutinized or avoided. The policy should cover both board members and foundation staff. A robust conflicts policy can not only help a grantmaker stay on the right side of the law, but can also keep the organization from engaging in behavior that gives even the appearance of conflict.

While the Tax Code does not require that a charitable organization have a conflicts policy in place, it would be difficult to achieve or demonstrate compliance with applicable provisions of the law without such a document.

The Law on Conflicts

Board members or trustees of a charity have fiduciary duties to the organization. This means that they must be careful stewards of the charity's assets and must put the charity's interests first. On occasion, however, a board member's other involvements–business interests, family relationships, or political or other charitable activities–may make it impossible for him or her to provide disinterested advice to the charity. Especially when the matter affects the financial interests of a board member, this duality of loyalties may become a conflict of interest.

In addition, for private foundations, Section 4941 of the Tax Code prohibits a variety of financial transactions between the foundation and "disqualified persons." This category includes substantial contributors to the foundation and its managers, plus members of both those groups' families and businesses in which they have a large stake. Specifically barred transactions include rent payments to a disqualified person and loans from the foundation to a disqualified person, even when the terms of the deal would benefit the foundation substantially.

There's also a general prohibition on the use of a private foundation's income or assets "by or for the benefit of” a disqualified person. That means that a foundation's grants and other expenditures must not provide tangible economic benefits to disqualified persons. An exception to the bar on self-dealing allows foundations to pay disqualified persons reasonable compensation for very limited personal services that are necessary to the foundation's operation.

For public charities such as community foundations, financial transactions between the charity and its board members, as well as other "insiders,” are covered by the intermediate sanctions rules in Section 4958 of the Tax Code. Insiders also include major donors, charity executives, and their families. If any payments to such insiders, including salaries and payments for goods or services, exceed fair market value, the insiders, and possibly members of the organization's board, will be subject to penalty excise taxes.

In addition to those federal rules, some states have laws that regulate whether a board member or other charity official may participate in voting or other actions when the board member has a financial interest in the outcome.

Getting into Compliance

Legal rules help shape the outlines of the conflicts policy that a charity should have. Both private foundations and public charities should have written rules, approved by the board, that require board members and executives to disclose business or other ties that may result in a conflict of interest or bias (for or against) making a particular grant or investment. Ideally, this disclosure happens on a regular basis, say, at the beginning of the year or when a director's term begins. At the very least, foundation managers must be required to make full disclosure when a relevant matter is under consideration by the foundation.

Depending on what the manager's conflict is, it may be appropriate for him or her to abstain from voting on or even discussing the matter. For example, if a partner in the foundation's investment management firm serves on the board, he or she should not vote on any resolution to retain or dismiss the firm. The minutes of the board or committee meeting should note this abstention.

Foundation staff, too, should be required to disclose positions or interests that may give rise to conflicts. Does the program officer have a spouse who works at a potential grantee? Does the program officer personally receive consulting fees from nonprofits that may apply for funds? Depending on the size and activities of the foundation, it may be wise to have a parallel conflicts policy for staff members.

In addition, foundations should prepare themselves for situations where there may be no legal conflict but there may be the appearance of conflict. A board member's printing firm, for example, might seek the contract to produce the community foundation's annual report. One approach is to bar board members from doing business with the foundation. Another approach is to mandate a rigorous bidding process so that foundation managers can be confident that the best bid, even if it comes from a foundation insider, will win.

The stronger and more comprehensive a foundation's conflict of interest policy is, the easier it should be to spot conflicts and address them before they become a problem. Furthermore, when a foundation has evidence that it has gone through the procedures required by its conflicts policy, it will more easily be able to defend its actions to the media or government authorities.

Some conflicts, once disclosed, turn out not to be conflicts at all. Where a foundation board member serves on the board of an organization seeking a foundation grant, the foundation may generally make the grant without penalty. Disclosing this tie provides other board members with an opportunity to learn about the applicant charity from their colleague. Foundation policy may require that the board member abstain from voting on the grant, although there is no federal legal requirement that he or she do so. Because the board member's dual role has been disclosed, other board members may weigh his or her comments appropriately.

But some conflicts cannot be cured by disclosure. Where a community foundation proposes to pay above-market rates to a fundraising firm operated by the executive's spouse, no amount of disclosure can make the problem go away. Where a private foundation's investment manager uses foundation assets to manipulate the price of a stock held by disqualified persons, there's a genuine conflict (and probably an act of self-dealing, too).

Feeling Conflicted?

Conflicts of interest often give rise to interesting questions for the legal staff at the Council on Foundations. Members with a particular situation that they are uncertain of should not hesitate to contact Council legal staff at legal@cof.org.