New York attorney general offers proposed amendments to state's Not-for-Profit Corporation Law
New York Attorney General Eric Schneiderman’s long-awaited legislative proposal to amend New York’s Not-for-Profit Corporation Law (“N-PCL”), and related trust and other statutes has been formally introduced in the New York State Senate. The legislation, the “Nonprofit Revitalization Act,” was sponsored by Senators Carl L. Marcellino and Michael H. Ranzenhofer; introduction in the Assembly is pending. The bill is posted at http://open.nysenate.gov/legislation/api/1.0/lrs-print/bill/S7431-2011. It follows the introduction by Senator Marcellino of his own bill, S6930, on nonprofit executive compensation.
These recommended changes grew out of the report issued by the Leadership Committee for Nonprofit Revitalization the AG convened in 2011 (available here: http://bit.ly/Lb6lEd) and are expected to receive favorable consideration given their broad legislative support. The attorney general’s proposed changes to New York’s nonprofit law are expected to be a bellwether for potential legislation in jurisdictions throughout the country. The bill’s introduction paralleled the release of proposed regulations implementing the limitations on nonprofit executive compensation and administrative costs mandated in Governor Cuomo’s January 2012 Executive Order (see related link below).
New York nonprofit corporations and charitable trusts are well-advised to review closely the legislation and compare its requirements to their current practices. In many cases, the requirements of the proposal will echo the best practices that these entities already have adopted. But in many cases the requirements—once enacted—will require changes to existing procedures, demanding a keen understanding of both state and federal law requirements as well as industry best practices.
With its focus on board approval processes for executive compensation and audits, the legislation’s definition of “independent directors” is especially important. Following a general theme, the legislation uses a definition similar to that used by the IRS for disclosure on Form 990. However, organizations should review the definition carefully because, as drafted, it appears to be more expansive than that used for Form 990 reporting. Additional guidance from the AG would be helpful to determine whether an organization can rely explicitly on the guidance provided by the IRS in its regulations and publications for the application of this state law standard.
Financial reporting and the audit committee
An organization’s financial reporting is essential to ensure proper oversight and ongoing viability of the organization. The proposed legislation enhances board involvement through a mandated audit process for those entities that are registered to solicit in New York under the Executive Law and are required to include an independent accountant’s audit report with its annual filing. Recognizing that these new requirements may be burdensome for smaller organizations, the audit requirement threshold would be increased from $250,000 to $500,000.
Specifically, the proposed legislation envisions either the creation of a board audit committee or involvement of the full board. In either case, only independent directors could participate. The proposed legislation also contains specific audit oversight functions, consistent with best practices already adopted by many organizations, such as: retaining and evaluating an independent auditor; meeting with the auditor before and after the audit; reviewing the results of the audit, including significant risks and weaknesses in the organization’s internal controls and means of improvement; and reviewing the adequacy and timeliness of the corporation’s response to the auditor’s request for information. The proposed legislation also envisions situations where the audit committee provides this function for a group of controlled corporations. (A similar device is used for the compensation committee and controlled corporations.) We note that the proposed legislation does not require that individuals serving on an audit committee also serve as board members, which conflicts with current law that prohibits a board from delegating authority to bind the board to a committee of the corporation.
Executive compensation has become an object of close attention in the nonprofit world, particularly in New York State where proposals by the governor and the legislature would act to limit such compensation. In order to enhance public trust—and serve as a potential alternative to measures that function as salary caps—the proposed legislative amendments include enhanced board oversight relating to executive compensation. These changes reflect substantially, but not identically, the regulatory regime already in place for Internal Revenue Code (“Code”) Section 501(c)(3) and (4) organizations for excess benefit transactions under Code Section 4958.
The proposed legislation makes it clear that reasonable compensation to members, directors, or officers for services rendered to the entity is permissible. This leaves compensation decisions in the hands of the board, consistent with the new regulatory regime set forth in the proposed statute.
In all cases, the compensation a nonprofit organization pays an employee must be “fair, reasonable and commensurate with services the employee provides to the corporation.” Furthermore, no person who stands to gain from a compensation decision may be present at any meeting or discussion concerning the compensation. To many this will be commonsense. Yet, it is a necessary addition to ensure boards are not influenced by those who will benefit from their decisions.
The proposed legislation goes a step further for certain organizations by requiring the establishment of a compensation committee (or imposing those functions on the full governing board) for organizations registered with the AG under the Executive Law and with revenues over $1 million. The compensation committee must be charged with reviewing and approving compensation paid to the organization’s officers and top five highest paid employees. While this review process is similar to that under Code Section 4958, there are some additional requirements that the proposed legislation would require a compensation committee or board to meet. Specifically, compensation reviewed by a compensation committee is subject to further approval by majority vote of the independent directors on the board; committee action by itself is insufficient. In addition, the CEO can no longer approve compensation of his or her direct reports, even after the compensation committee deems the amounts reasonable—the board must approve.
Enhanced oversight of related party transactions and conflicts of interest
Board independence is one of the most important issues relating to the public’s trust in New York’s nonprofit organizations. Even the perception that an officer or director is exploiting his or her position for personal gain will threaten the public’s trust in the organization—indeed, in the nonprofit sector generally. The processes contained within the proposed legislation addresses three critical areas relating to board governance and independence: conflicts of interest; related-party transactions; and whistleblower policies.
Conflicts of interest
Just because a director or officer has a conflict of interest with an organization does not automatically mean that any transaction with that person is invalid or meant to be avoided. However, in order to protect the organization from potentially damaging conflicts and to avoid even the appearance of impropriety, the entity should have a process to address potential conflicts. The proposed legislation would require nonprofits—whether charitable or not—to adopt a conflict of interest policy to ensure, on an ongoing basis, that its directors, officers, and key employees act in the best interests of the organization.
The proposed statutory standard reflects what is already a common practice in the sector, though the proposed legislation contains more explicit language about the need for an interested party to be absent from board or committee deliberation, thus better assuring independence of judgment.
The proposed legislation also would require each director, when newly elected and then annually thereafter, to provide a written statement indicating every organization with which he or she has a relationship and with which the nonprofit has, or is expected to have, a conflict of interest. This information will allow the organization to monitor for conflicts of interest on its own, as these statements are then made available to the board or audit committee. Again, many organizations already have such a process in place and, therefore, this should not be an onerous task for most organizations. New in the proposed legislation, however, is a requirement that certain organizations will now be required to provide a copy of their conflicts policy (as well as any amendments) to the AG.
A related-party transaction is any arrangement between a nonprofit organization and an insider—ostensibly someone who has the power to influence organizational decision-making for his or own benefit. While the federal tax law has a robust system for addressing such situations for both public charities and private foundations, current New York law has a statutory standard delineating when interested party transactions are void or voidable, and then relies largely on case law to establish appropriate standards.
The proposed legislation, again, is very similar to the standards imposed by Code Section 4958, which most organizations already have in place. However, it will be important for organizations to ensure that it has proper processes in place to approve such transactions because the AG will now have delineated powers to deal with transactions not in compliance with these requirements, including the ability to demand, in the case of willful conduct, an amount up to double the benefit improperly obtained from any person or entity involved. The expected result of these mandatory standards and increased enforcement powers will be to limit vastly the number of interested party transactions in New York. Board education will be needed to make the requirements clear to those involved, and the process for recruiting board members may need to be modified.
Another change intended to enhance board independence and accountability is one requiring every corporation with at least five employees and $1 million in revenue in the prior year to adopt a whistleblower policy. The purpose of such a policy is to protect employees, directors, officers, and volunteers from retaliation of any sort if they report illegal or fraudulent behavior by or within the corporation. This includes reporting a violation of any adopted policy of the corporation. That, in turn, requires a level of clarity and familiarity with corporate policies to which organizations may not have adhered in the past.
We note that New York law has long required a whistleblower policy for labor matters, but these proposed requirements are broader in their reach. Compliance with the specific mandates will require close attention should the legislation become law.
It is interesting that, while the N-PCL contains a specific statutory provision with respect to members’ access to corporate records, there is no corresponding statutory right for directors of the nonprofit. Given the increased access to information occasioned by these and other requirements in the legislation, an explicit provision as least as complete as that for members would seem appropriate.
No more “typing” and other relief
Since its inception, the N-PCL has used a “typing” system to segregate forms of nonprofits and regulate their behavior. This unique—and confusing—system has given way to one which distinguishes charitable nonprofits from all other (non-charitable) nonprofits, with the former subject to a higher level of regulatory scrutiny. In doing so, New York joins the vast majority of other jurisdictions in the country.
The statute also contains a clarifying provision that allows, but does not require, the Certificates of Incorporation of newly formed nonprofits (or Certificates of Amendment of existing entities) to list corporate activities in addition to purposes. The intent is to help avoid the high rejection rate of nonprofit filings with the New York Secretary of State.
The existing requirement for pre-incorporation agency consents, which is also an impediment to forming nonprofit corporations in New York, is also addressed at least for some of the pre-filing consent requirements.
Further, New York’s vestigial requirement for newspaper publication of information by private foundations would finally be excised.
Extraordinary corporate events
New York is more demanding than other jurisdictions in its required approvals for various “extraordinary” corporate events, such as mergers and consolidations. The proposed legislation attempts to relieve some of those burdens while still maintaining some level of oversight.
The N-PCL currently has a trap for the unwary with respect to the supermajority approval required for certain real estate transactions, including simple leases. The proposed legislation now allows delegation of such routine leasing and similar matters to a board committee, as well as reducing the approval requirement to majority vote.
The dissolution process in New York was simplified a few years ago and the proposed legislation now attempts to also simplify the merger/consolidation process and that for the sale of all or substantially all of an organization’s assets. Under the proposed legislation, a nonprofit corporation will now be able to seek AG approval as distinct from judicial approval, with court approval only being required if the AG does not (or will not) approve the proposed transaction. This procedure is expected to avoid the costs and delays related to petitioning the court, while still providing oversight of the use of public dollars.
For years nonprofit organizations and their advisors have struggled with New York’s arcane language on computing a quorum for the conduct of official business. The bill adopts the common convention of using a range of available board seats (e.g., 11–17) and calculates a quorum based on the number of seats actually filled at the most recent election or elections. This will remove the need for a board to annually “fix” its total number of directors.
The proposed legislation also clarifies the use of committees. Specifically, it makes clear that only committees of the board—comprised of board members and elected by the board—have the authority to bind the board. Other committees would not have that power. Current practice in the state will need to come into compliance with this structure.
The legislation addresses the issue of tempering the influence of organization CEOs (sometimes founders) by prohibiting them from also acting as chair of the board. The CEO would not be prohibited by law from serving on the board, but the board will need to exercise careful judgment relating to that individual’s role given the other independence requirements imposed by the bill.
The attorney general and his Leadership Committee had to choose from a long list of possible priorities in deciding how to revitalize New York’s N-PCL. Enhancing the public’s trust in board governance and accountability were two of the most important areas they could address through changes in the law. By requiring boards to follow certain processes or to develop policies, the revised N-PCL should provide both the guidance and uniformity needed to meet these goals. At the same time, the requirements are not so restrictive that a board is unable to govern in a way best suited for the purposes of the organization.
Nixon Peabody attorneys continue to monitor these important developments and are prepared to explain how these changes to New York law could directly impact your organization. Please join us for an upcoming informational webinar, “What’s your future bring? Nonprofit regulation in New York,” Tuesday, June 5 (see related events link).