Nonprofit Law and Ethics

Nonprofits are subject to laws with which they must comply or face the possibility of legal penalties. But they are also subject to ethical expectations from their key stakeholders. Certainly, many ethical standards are codified in the law. For example, compensating an executive of a charity an excessive amount may be considered both unethical and unlawful (e.g., under Internal Revenue Code Section 4958). However, other ethical standards are not contemplated by the law. For example, investing in fossil fuel companies is not illegal for an environmental organization advocating for alternative forms of energy but may be considered unethical by its staff, volunteers, donors, and other important stakeholders.

For risk management purposes, nonprofit boards and executives must consider compliance with both applicable laws and applicable ethical standards. Failure to comply with the organization’s ethical standards may not only harm its reputation inside and outside the organization, but it may also elevate its legal risks. For example, failure to have a written conflict of interest policy (which is generally not a violation of law), may lead the organization to enter into an unlawful transaction with an interested director. Similarly, failure to set a compensation policy that aligns with the values of the organization may lead to dissatisfied, underpaid employees, which could increase the risks of fraud.

The first step in achieving compliance is identifying and understanding the applicable laws and ethical standards. In this respect, legal compliance may be simpler because of the number of resources available and the relatively uniform application of laws (though there will be variations among state and local laws and among different types of nonprofit and tax-exempt entities). An organization’s ethical standards may be unique to its circumstances. For example, ethical standards related to compensation may differ among different types of nonprofits. A modest charity serving low-income beneficiaries may be much more sensitive to compensation issues than a billion-dollar private foundation whose principal activity is funding large institutional charities. Accordingly, nonprofit leaders must devote time and resources to identifying, developing, and educating their employees and volunteers on their core values and ethical standards. Memorializing these standards in internal policies and codes will be the next step.

Code of Ethics

A code of ethics is a document that typically articulates the organization’s core values and establishes principles and standards in applying these values to the organization’s governance and activities. Some of these standards may align with applicable laws and therefore require strict compliance. Others may serve more as guide posts requiring consideration and judgment in their application.

One core value selected by an organization may relate to trust and confidentiality. This value may result in principles of keeping certain discussions (including those in the board room) confidential to facilitate more open and participatory communications. This ethical principle may align with the board members’ fiduciary duties of loyalty to act in the best interests of the organization. So, breach of the principle may not only violate a core value and ethical principle adopted by the organization, it may also be a violation of law. However, absent egregious circumstances, it may be exceedingly rare for a board member to be held liable for such a violation of their fiduciary duty. Nevertheless, the board member may be held accountable internally (e.g., through removal from the board) for violating the ethical principle.

Read what Vu Le (Nonprofit AF) has to say about organizational values here. And check out the resource page – Code of Ethics for Nonprofits – from the National Council of Nonprofits.

Fundraising Solicitations

Laws typically require that (1) charitable fundraising solicitations are carried out by only qualified organizations or their authorized agents, (2) the solicitations do not mislead donors or the general public, (3) the promised use of the funds raised is consistent with the organization’s stated charitable purpose and tax-exempt status, and (4) the content of the solicitation does not otherwise infringe on any other person’s privacy or property rights. But a charity’s code of ethics related to its fundraising may go far beyond the legal requirements. For example, the Donor Bill of Rights, the International Statement of Ethical Principles in Fundraising, the Association of Fundraising Professionals (AFP) Code of Ethical Standards, each of which has served as a model for many charities’ code of ethics, address areas that go beyond legal compliance in the interests of establishing and maintaining donors’ respect and trust.

One area that implicates both nonprofit law and ethics is fundraising commissions. We are often asked whether it is legal for a charity to pay an executive director or development director a percentage of the amount she or he raises on behalf of the organization. An experienced lawyer will likely start her answer by stating, “It depends.” This is the fundamental answer we’re taught in law school where there is no bright line answer. On the other hand, the AFP Code of Ethical Standards unequivocally states:

Members shall:

21. not accept compensation or enter into a contract that is based on a percentage of contributions; nor shall members accept finder’s fees or contingent fees.

22. be permitted to accept performance-based compensation, such as bonuses, only if such bonuses are in accord with prevailing practices within the members’ own organizations and are not based on a percentage of contributions.

24. not pay finder’s fees, commissions or percentage compensation based on contributions.

While these ethical standards may not be recitations of law, they make good sense from a legal risk management perspective. The charity’s risk of payment  of unlawful compensation arises if the payment (1) is to an employee and makes the employee’s total compensation excessive or (2) is to an independent contractor and is excessive relative to the services provided in return. The latter may be the case where relatively little time, effort, and resources are expended by the contractor to establish and run a campaign which, by good fortune, coincided with a very large charitable contribution from a long-term donor who would have made the gift regardless of the campaign. Among the potential legal problems with fundraising commissions are payment of a prohibited private benefit (possibly an excess benefit transaction) and diversion of charitable assets.

The following added on July 28, 2019:

Operating an Unrelated Business

Federal tax laws limit a charity’s ability to engage in unrelated business activities. The 501(c)(3) Operational Test generally provides that a charity must be engaged primarily in activities that accomplish exempt purposes specified in section 501(c)(3). An organization will not be so regarded if more than an insubstantial part of its activities does not further an exempt purpose. While the wording does not precisely match the “unrelated trade or business” definition in Section 513 of the Internal Revenue Code, it’s close enough to raise concerns if the charity is operating an unrelated business for which it devotes more than an insubstantial amount of its resources.

Operating an unrelated business also raises ethical issues. Is the business consistent or in conflict with the charity’s exempt purposes and values? Will the deployment of organizational assets to further the business diminish the organization’s ability to advance its mission? Will it have a beneficial or detrimental impact on staff? Will it be perceived by other stakeholders in a positive or negative manner, and how will communications strategies need to respond? How will such communications be made in a manner consistent with the organization’s values?