Health Law Advisory
July 2‚ 2013
Transforming Not-for-Profit Governance and Oversight in New York:
The Nonprofit Revitalization Act and Executive Compensation Reform Act
The New York State Attorney General (AG) has teamed up with lawmakers to introduce two new bills that propose an overhaul of the Not-for-Profit Corporation Law (N-PCL), which has not seen significant change in more than 40 years. The two bills, known as the Nonprofit Revitalization Act and the Executive Compensation Reform Act, are the byproduct of a year-long effort by the AG and nonprofit leaders to improve nonprofit organizations’ governance and oversight functions, increase their transparency to the public, ensure reasonable executive compensation, and mitigate administrative burdens associated with nonprofit transactions. While the Executive Compensation Reform Act was not voted upon by the legislature at its recently concluded session, as of this writing the Nonprofit Revitalization Act has passed the Senate and the Assembly, and is on Governor Cuomo’s desk. If signed into law as expected, the changes to the N-PCL will go into effect on July 1, 2014.
Nonprofit reform has been considered long overdue by regulators and industry insiders alike for a number of reasons. From a regulatory perspective, New York not-for-profit corporations — which generate annual revenue in the billions — are in need of greater internal protections against fraud and self-dealing by, among other things, tightening rules on related party transactions and mandating whistleblower protection policies. Nonprofit leaders view the legislation favorably because it eliminates or simplifies certain bureaucratic processes that made running nonprofit businesses burdensome and costly, such as the two-step (AG and Supreme Court) approval process for nonprofit mergers and acquisitions, and at the same time incorporates modernized board procedures, such as email and video technology for notices and meetings.
Key provisions of the Nonprofit Revitalization Act and the Executive Compensation Reform Act are summarized below.
- Internal Controls. With the economic downturn, reductions in staff and budgeting have no doubt led to greater incidents of fraud, theft, and other corporate misconduct than before. The likelihood of such transgressions is often exacerbated in the nonprofit industry, which historically has lacked effective internal controls. According to the AG, one of the goals of the proposed legislation is “to revitalize New York’s charitable organizations and, at the same time, put a stop to the financial abuses that have come to light.” Some of the proposed changes to the N-PCL intended to address these concerns include:
- Board Chair. In order to ensure proper oversight of and independent leadership in nonprofit management, the law will prohibit any employee of the organization from also serving as Chair of the organization’s Board of Directors.
- Related-Party Transactions. If a related party — defined as any director, trustee, officer, or “key employee”1 of the organization, or any of their respective relatives, or any entity in which they have a 35% or greater ownership or beneficial interest of an organization — has a financial interest in a transaction (a “related party transaction”), the Board will have to consider alternative transactions, affirmatively determine that any alternative transaction would not be more advantageous to the organization, approve the transaction by a majority vote of the Board, and contemporaneously document the decision. The AG may bring an action to void a related party transaction.
- Mandatory Auditing. The N-PCL will require that each organization designate an audit committee of the Board, consisting of independent directors, or require independent directors of the Board to perform auditing functions. Some of these responsibilities include the requirement to annually retain an independent auditor, review and discuss with the independent auditor results of the audit, and oversee the implementation of the conflict-of-interest and whistleblower policies that the new provisions of the N-PCL will require.
- Mandatory Conflicts of Interest Policy. Each nonprofit organization must adopt a conflict of interest policy that includes a description of what constitutes a conflict of interest, and procedures for disclosing and documenting the resolution of conflicts and related party transactions. The policy also must prohibit a conflicted director from attending or participating in deliberations, from voting on the matter, and from otherwise influencing the vote. The policy must indicate that directors, prior to election and annually thereafter, must complete disclosure statements identifying entities in which the director is affiliated (either as an officer, director, trustee, member, owner or employee) and with which the corporation has a relationship, and any transaction of the corporation in which the director may have a conflicting interest.
- Mandatory Whistleblower Policy. Organizations with 20 or more employees and annual revenue in excess of $1 million must adopt a whistleblower policy to protect against retaliation for persons who in good faith report suspected improper conduct, including fraud, illegal conduct or violations of company policy. The policy must include procedures for reporting suspected misconduct, a designee to administer the policy, and a requirement that the policy be distributed to all officers, directors, employees and volunteers.
- Administrative Changes. In addition to the internal governance provisions summarized above, the law will make several significant administrative modifications intended to alleviate some of the procedural hurdles associated with corporate changes and decision making.
- Corporate Transactions. Chief among the administrative changes intended to reduce red tape is the elimination of the two-step approval process for nonprofit mergers, acquisitions and certain other transactions. Specifically, the new law will permit such matters to proceed with Attorney General approval as an alternative, rather than in addition, to Supreme Court approval. The same rule would apply to other current two-step approval requirements such as material amendments to an organization’s certificate of incorporation, the sale or purchase of real property, the sale of all or substantially all of the organization’s assets, and dissolution.
- Authorizations of Real Estate Transactions. The new law will lower the threshold required for Board approval of routine real estate transactions to a majority, rather than two-thirds, of the directors or a committee authorized by the Board. (The two-thirds voting requirement is maintained, however, for transactions involving property that constitutes all or substantially all of the organization’s assets.)
- Notice to the Education Department in Lieu of Consent. Currently, many not-for-profit corporations are required to obtain the advance approval of the State Education Department prior to incorporation. Instead, most of these organizations will only be required to provide notice to the Department within 10 days of incorporation, and only schools, libraries, museums, and historical societies will be required to obtain approval prior to incorporation.
- Elimination of Types. Rather than having the four “letter types” of not-for-profit corporations — Types A, B, C, and D — the law will be simplified to have two categories of nonprofits: charitable and non-charitable. Organizations formed with both charitable and non-charitable purposes will be deemed charitable corporations.
- Electronic Technology. Finally catching up with the laws governing general business corporations and other corporate entities, nonprofit organizations will be permitted to transmit notices, waivers and other communications via facsimile and electronic mail, and to participate in meetings via videoconference and other electronic modalities.
- Audited Financial Thresholds. The new law will raise the gross revenue threshold that triggers the requirement to obtain an independent CPA audit from $250,000 to $500,000.
New York not-for-profit executives and managers already familiar with the IRS Intermediate Sanctions regulations (and with the regulations issued by the New York State Department of Health dealing with executive compensation) will undoubtedly recognize the similarities between the Executive Compensation Reform Act — which did not move forward in the last legislative session — and the federal rules applicable to the determination of whether compensation by a tax-exempt entity constitutes an “excess benefit transaction” or qualifies for the “rebuttable presumption of reasonableness” under Section 4958 of the Internal Revenue Code.2
If revived, the new law generally would require that all nonprofit employee compensation be fair, reasonable and commensurate with the services provided to the organization. In addition, a compensation committee consisting of independent directors, or independent directors of the Board, must review the total compensation paid to the principal executive officer, and determine that it is fair, reasonable and commensurate with the services provided to the organization. Finally, for charitable organizations with more than $2 million in annual revenue, compensation to any member, officer, director or key employee in excess of $150,000 must be reviewed to ensure that it is fair, reasonable and commensurate with the services provided to the organization. The compensation determination must consider compensation paid to similarly situated employees, the employee’s performance, and the organization’s financial condition. A person who may benefit from the compensation may not participate in the compensation decision-making process, which must pass by majority vote.
The proposed amendments to the N-PCL take important steps toward creating more efficient, transparent, and accountable nonprofit organizations, and in so doing, responds to some of the economic complexities and challenges of our time. While there may be further fine-tuning to come, a more streamlined N-PCL will soon control.
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1 A key employee is any person in a position to exercise substantial influence over the affairs of the organization.
2 The Department of Health and other agencies that provide State funding to certain organizations promulgated regulations to implement Executive Order No. 38 (issued by Governor Cuomo on January 18, 2012), which limits the use of State funds for executive compensation paid by “covered providers.” The regulations became effective on July 1, 2013, and state that a covered provider may not use more than $199,000 per year of State funds or State authorized payments for compensation paid to a “covered executive,” unless the executive compensation meets the regulatory safe harbor, or the covered provider has obtained a waiver from the applicable State agency. The regulatory safe harbor closely tracks the tests that are required to be met in order to qualify for the rebuttable presumption of reasonableness under the Intermediate Sanctions regulations.