1. business and industrial
2. business operations
3. human resources
4. compensation and benefits

Title
of is On…
The Heat
Webinar/Roundtable
Developments
in Nonprofit
Executive Compensation
Date | Time
December 19, 2014
This webinar is sponsored by
This webinar is sponsored by
Faculty :
Faculty :Date|Time
Name
T.J. Sullivan
Company/Firm,
City, State
Drinker, Biddle & Reath,
Washington, D.C.
Email address
TJ.Sullivan@dbr.com
This webinar is sponsored by
Martin
Name L. Katz
Frederic
W. Cook &City,
Co.,State
San Francisco, CA
Company/Firm,
Company,
firm,
city,
state, email address
mlkatz@fwcook.com
Email address
LaVerneCompany,
Woods firm, city, state, email address
Name
Davis Wright Tremaine, Seattle, WA
Company/Firm,
City, State
lavernewoods@dwt.com
Email address
Marta
(moderator)
NameHoffman
(moderator)
Plunkett Cooney, City,
Bloomfield
Company/Firm,
State Hills, MI
Mhoffman@plunkettcooney.com
Email address
Summary of Contents
• The Heat is On! – Context for Nonprofit Executive
Compensation
• T.J. Sullivan: Background of IRC Section 4958 and
Rebuttable Presumption
• Marty Katz: Case Study: People v. Help
Hospitalized Veterans
• LaVerne Woods: Best Practices in Corporate
Governance
• Q&A
2
Executive compensation scrutiny is at
all- time high.
MASS. OAG Releases
CEO Comp Review
 Deferred compensation
“risk” due to large lump
sum payments
 SERPs hard to justify
 Challenges severance
SEIU Ballot Initiative
 Health care provider pay
to be limited to $450,000
 Followed Oregon model
 Docs & BCBS plans
excluded
IRS Study of Major
Universities
 400 universities examined
CAL. DOJ settles
 20% failed RP process
People v. HHV
 $35 million in taxable wages  Board removed
uncovered
 Execs terminated
 $3.5 million in penalties
and wage disgorgement
Executive
NY Nonprofit
Compensation
Revitalization Act
Environment
 Emphasizes board
independence
 Financial oversight >$1M
 Whistleblower and COI
policies required
3
When things go wrong…it gets UGLY
fast!
December 2009, Chronicle of Higher Education reports recent allegations of
executive corruption at the Stevens Institute of Technology. The Institute’s
president is accused of excessive compensation and inappropriate borrowing from
the institution to maintain vacation homes. The New Jersey AG claims to have
found “extensive misconduct” by the president and the Institute’s board of
trustees, while the IRS is investigating matters relating to the president’s
compensation.
4
IRC SECTION 4958
• Background of IRC Section 4958 and
Rebuttable Presumption
• Case Study: People v. Help Hospitalized
Veterans
• Best Practices in Corporate Governance
• Q&A
5
EO Guiding Principles
• Private Inurement
– No part of the net earnings inures to the benefit of any
private shareholder or individual
– Applies only to “insiders” (disqualified persons)
– No minimum threshold
6
EO Guiding Principles, cont.
• Private Benefit
– Must be “incidental”
• Qualitatively and quantitatively
– Must be balanced against public benefit
– Not limited to insiders
7
Intermediate Sanctions
• Code Section 4958 (1996)
• Applies to 501(c)(3)s and (c)(4)s
– “Applicable tax-exempt organizations”
– “Excess benefit transactions”
– “Disqualified persons”
– “Rebuttable presumption”
– “Penalty excise taxes”
8
Avoiding Intermediate Sanctions
•
•
•
•
It’s All About Reasonableness
It’s All About Process
It’s All About Documentation
It’s All About Reporting
But, once in a while, it’s about the money…
9
Excess Benefit Transactions
• Non-Fair Market Value (“FMV”) Transaction
• Unreasonable Compensation Transaction
• Automatic Excess Benefit Transaction
– Unreported compensation
– PPA Transaction
10
Penalty Excise Taxes
• Disqualified Person
– 25% tax and additional 200% if the transaction is
not timely corrected
• Organization Manager
– Approved transaction, knowingly, willfully and
without reasonable cause
– 10% tax (to a maximum of $20,000)
• No Penalty on the EO
– Regulations address interplay with revocation
11
Disqualified Persons
•
•
•
•
Identify up front! (Need for 990)
Voting members of Board
CEOs, COOs, Treasurers and CFOs
Person, at any time during the previous five
years, in a position to exercise substantial
influence over the affairs of the organization
• Family members
• 35% controlled entities
12
Disqualified Persons, cont.
• Not Disqualified Persons
– Organizations described in § 501(c)(3)
• Caution re PPA
– Other 501(c)(4) organizations
(for (c)(4)s only)
– Employees receiving total economic benefit
less than $115,000 (full or P/T)
13
Initial Contract Rule
• “Fixed” payments
– Can include variable amount per formula
• Can be useful to protect new hires until
material change
• IRS sabre rattling in Hospitals report—
eliminate?
14
Automatic Excess Benefit Transactions
• (FY 2004 CPE Text)
– Unreported compensation
• Statutory (PPA)
– Loans by 509(a)(3)s to any DP (full amount of
loan)
– Payments by 509(a)(3)s to a substantial
contributor (full amount)
– Payments by donor advised fund to donor or
donor-advisor (full amount)
15
Rebuttable Presumption of
Reasonableness
• Applies If:
– The arrangement was approved by board or
committee composed entirely of individuals who do
not have a conflict with respect to the arrangement;
– The board or committee obtained and relied on
appropriate data as to comparability; and
– Adequately documented the basis for its
determination (by later of next meeting or 60 days).
16
Authorized Body
• Who counts on the committee?
• What is a conflict?
• What do you do to avoid conflict?
– Excuse members subject to direction or control of
executive being reviewed
– Excuse members receiving payments subject to
approval by executive being reviewed
17
Determining Comparability
• Appropriate Data as to Comparability Includes:
– Compensation levels paid by similarly situated
organizations, taxable and tax-exempt;
– Independent compensation surveys compiled from
independent firms;
– Actual written offers from similar institutions;
– Independent appraisals of the value.
• IRS skepticism growing
18
Determining Comparability
• The approving body is protected in relying on a
consultant’s written reasoned analysis, if the
consultant certifies that it:
– Holds itself out to public as compensation
consultant,
– Performs these valuations regularly, and
– Is qualified to perform these valuations.
• These certifications should be in every comp opinion
19
Timely Documentation
• Meeting minutes should contain all the
following:
– Intent to qualify for R.P.
– Terms of compensation/benefits arrangements
approved
– Date of approval
– Comparability data relied upon and how
obtained
– Who was present, who voted, actions taken to
address any conflict of interest
20
Timely Documentation, cont.
• Meeting minutes should contain all the
following:
– If the body decides that approved pay and
benefits exceed data range presented, basis for
decision on reasonableness.
– Minutes prepared within 60 days and approved
within a reasonable time thereafter.
• Best practice is approval individual by
individual.
21
Executive Compensation
•
•
•
•
•
Growing focus of IRS exams
IRS more likely to challenge EO decisions
IRS skeptical of peer groups
Skeptical of use of for-profit data
Will steer EO/exec to Fast Track Settlement
22
CASE STUDY – PEOPLE v. HHV
• Background of IRC Section 4958 and Rebuttable
Presumption
• Case Study: People v. Help Hospitalized
Veterans
• Best Practices in Corporate Governance
• Q&A
23
Setting the Stage...
• HHV founded in 1971 by Roger Chapin; with
Michael Lynch as Exec Director/COO
• Supports injured veterans in VA hospital rehab
• Craft kits provided by “Craft Care Specialists”
• Kits cost ~$20 to “manufacture”; leather crafts,
hook rugs, paint by numbers, etc.
• Specialists were NOT nurses, therapists, or HC
providers; no licensure requirements; minimal
training required; VA hospitals supported mission
• Funds raised primarily by direct mail
• Board members and “consulting” attorney all good
friends of Mr. Chapin
24
Setting the Stage, cont.
• 70’s – Rev. <$2M; salaries ~$30,000, all is well
• 80’s – Rev. grows to $10M; salary grows to $60k (no salary
from 1978 – 1985, but $5-6,000 car allow.)
• 90’s – Rev. hits $19M; HHV profile grows; salary grows to
$254k + $15k bonus; 75% DBPP adopted & $82k accrued
• 00’s – Salary frozen (2001) at $250 in exchange for 100%
DBPP, plus $20k bonus; $80k - $154k DB accrued annually
– Chapin testifies to Congress; CNN.com picks up story
• 10’s – Wheels come off; AG sues for lack of fiduciary duty
and excessive comp, among other things
• 2013 – HHV settles on eve of trial; ship was sinking due to
inability to defend actions
25
What Went Wrong…
• Problem # 1: “The disappearing salary freeze”
– Chapin “negotiated” a 100% FAP pension in exchange
for salary freeze at $250,000 in 2001
– Salary magically unfrozen in ‘07; $50k bonus paid in ‘06
to increase TCC to $300k; pension accrual hits $154k
– Board approved 6.1% annual salary adjustment to “what
it would have been” had freeze not been in place
– Chapin testified that “this was the deal”; unfortunately,
no one bothered to write it down
• Valuation consultant hired to report annual salary
inflation, supporting 6.1% average increase
26
What Went Wrong, cont.
• Problem # 2: “The Magical Mushroom SERP”
– SERP first approved at 75% in ’98, after age 65,
amended in ‘01 to 100% of FAP based on salary freeze
– Salary later increased from $250k to $300k, then to
$400k in ‘08 just prior to retirement
– Chapin reduces FAP pension benefit back to 75%
– Lifetime 2.5% COLA anyone?
– Plus 100% J&S annuity for spouse….unreduced!!
• 75% of FAP ($300,000) now more that 100% of his
prior salary and clearly excessive in design features
– Bonuses added to pay in 2006 and 2007 to increase TCC
so that $300,000 pension would be less than final pay
27
What Went Wrong, cont.
• Problem # 3: “Who am I really?”
– Chapin had advisors compare HHV to acute care
hospitals, rehab hospitals, retirement homes and SNFs
• We compared HHV to social and human services orgs,
employment prep, vocational counseling, veterans groups
– HHV typically raised $20 - $30M annually, and hit $50M
twice (based on nonrecurring contributions)
• One “peer group” provided by Chapin’s lawyer was $84M $232M in revenue, averaging $148M, about 5x HHV
– Assets, fund balance, program services expenses all
<P25; revenue and operating expenses P50; comp
expense apprx. 120% of P90
• Bad comps, not adjusted for scale, roles inflated….
other than that it was perfect
28
What Went Wrong, cont.
• Problem # 4: “I’ll do anything for you Roger”
–
–
–
–
75% pension… no problem; but let’s make it 100%
Salary freeze?... just kidding!
What the heck… Let’s cover 2 lives for the price of one!
I see you’re retiring next year… let’s raise your salary
from $300k to $400k (75% x $400 = $300…coincidence?)
– Here’s an idea…how about a lifetime cost of living
escalator for you and Mrs. Chapin?
• Review of minutes indicated not one instance where
the Board declined to act, asked for more information,
or challenged any proposal
29
What Went Wrong, cont.
• Problem # 5: “Trust me, this is all ok”
– Chapin’s attorney gathered relevant comparability data
and presented same to the board
• Advised that pensions were commonplace, and hospitals and
health systems were comparable to HHV
– He also advised that “while he could find no evidence of
COLA’s in the market data”, they are reasonable… Why?
… because the government uses them!
– Of course, the board approved the 75% FAP pension,
100% J&S benefit, with 2.5% COLA for both lives
– When they hired a consultant to demonstrate what
comp “would have been” during the freeze, the salary
growth rate over that period was found to be 6.1%
• Impacted only the SERP, not actual pay
30
Unreasonable Compensation - Cash
• Cash compensation above P75 was determined to be
unreasonable based on HHV character and condition
and Executives’ skills and experience
• Compensation for 2005, one year of eight (‘03 – ’10)
under examination, is reported below:
– HHV assets, fund balance and program expenses all below P25
2005 Comp
($000s)
HHV
P 50
P75
P90
Excessive
Chapin, CEO
$300
$149
$198
$255
$102
Lynch, E.D./COO
$280
$124
$161
$202
$119
Top 2 Combined
$580
$273
$359
$457
$221
Prog. Exp./Total
61%
90%
94%
97%
N/A
31
Unreasonable Compensation - SERP
• SERP was evaluated separately and found to be
unreasonable based on multiple design features:
– DB plans are extremely rare for smaller public charities
– Market typical plan is DC with 8 – 12% annual contribution in
aggregate
HHV
Market
Defined Benefit
Defined Contribution
FAP Replacement Ratio
75% FAP
50% - 60% FAP
Accrual Period
10 years
25 – 30 years
7.5% per YOS
2.5% - 3% per YOS
Payment if not Lump Sum
100% J&S Annuity1
Single-life annuity
Cost of Living Adjustment
Yes
No
Offsets for Other Plans
No
Yes
Type of Plan
Accrual Rate
Note 1 - 100% J&S Annuity NOT reduced to actuarial equivalent of a lump sum or single-life annuity.
32
Ouch!!
• Case settled on eve of trial; defense counsel did not
want comp consultant to testify
• RC passed away; ML removed; Board forced to
resign, never again to serve as officers or board
members for a CA charity
• Penalties:
–
–
–
–
$500,000 paid to OAG for litigation costs & expenses
$500,000 paid to OAG as a penalty
$2 million paid by RC estate to HHV (return of SERP)
ML stepped down as CEO, forfeited SERP, but able to
keep Q plan benefit of $168,000 per year
– Board paid $450,000 to HHV out of D&O coverage
33
What We Learned…
• Significant majority of Board should be
independent, not friends of founder
• Board advisors should not be working for CEO
• When hiring experts….hire an expert
– Counsel acted as comp consultant
– “Comp” consultant had no relevant experience
• It’s all about the mission
– Nothing wrong with high pay for high performance, but
no room for greed
– Good governance essential
– Keep eye on the ball (mission)
34
BEST PRACTICES IN GOVERNANCE
• Background of IRC Section 4958 and Rebuttable
Presumption
• Case Study: People v. Help Hospitalized
Veterans
• Best Practices in Corporate Governance
• Q&A
35
GOVERNANCE BEST PRACTICES
• Who should approve executive compensation?
– Full board or delegation to a committee
– Some state Attorneys General take the position that the
full board should approve President/CEO’s
compensation
– Delegation to a Committee
• Advisory to Board or authorized to provide final approval?
• If committee approves, make sure the committee satisfies
state law requirements (e.g., appointed by the Board, not the
Chair)
• Recommendation: Compensation Committee that
reports to and advises the Board; full Board has
ultimately approval authority
36
GOVERNANCE BEST PRACTICES, cont.
• Adopt a Compensation Philosophy
– Alignment with mission and goals
– Identify peer group
– Market data to be used
– Position pay compared to the market
– Purpose/appropriate goals for incentive plans
37
GOVERNANCE BEST PRACTICES, cont.
• Adopt Board or Committee Charter setting out
procedure to follow in approving executive
compensation
– Regular compensation reviews; e.g., every two years
– Identify roles for Legal and Human Resources
• Legal is too often excluded from the process, or HR fails to
communicate with legal
• Result is often failure to satisfy the rebuttable presumption
– Identify who is covered by procedures
• CEO, COO, CFO, voting members of governing board
• Persons with “substantial influence”: when in doubt, include
– Require that arrangements be approved before
compensation is paid
38
GOVERNANCE BEST PRACTICES, cont.
• Design an appropriate and transparent package
– Keep it simple (stupid); the Board needs to
understand it
– Consider ratio of base and incentive
– Incentive goals should be clear, appropriate, and set
in advance
– Avoid special “one off” arrangements
– Consider “internal equity,” i.e., ratio of CEO to
employee pay
39
GOVERNANCE BEST PRACTICES, cont.
• Establish Federal tax law rebuttable
presumption of reasonableness
– Independent board or committee approval
– Reliance on appropriate comparability data
– Contemporaneous documentation
40
GOVERNANCE BEST PRACTICES, cont.
• Independent Board or committee approval
– Who should and should not be present at the meeting
– Absence of conflict of interest
• No one under the supervision of the person to be
compensated
• No one who receives compensation subject to approval of the
person to be compensated
• No material financial interest in the compensation
arrangement
– Compensated person may be present to answer
questions but must leave for final discussion and vote
41
GOVERNANCE BEST PRACTICES, cont.
• Obtain appropriate comparability data
– Independent sources
– Who engages the consultant (hint: not the executive or
his/her subordinate)
– Consider working through legal counsel for privilege
purposes
– Caution regarding use of for-profit comparables
– Ensure that all elements of compensation are included in the
analysis of reasonableness
•
•
•
•
•
Supplemental Executive Retirement Plans (SERPs)
Stock in affiliates
403(b), 401(k) plans
Severance benefits
Spousal travel
42
GOVERNANCE BEST PRACTICES, cont.
• Document the decision contemporaneously
– Content: who was present, data relied upon and
how obtained
– State intention to satisfy federal tax law rebuttable
presumption
– Timing: prepared before the later of next meeting or
60 days, and approved within a reasonable time
43
GOVERNANCE BEST PRACTICES, cont.
• Option: Delegate authority to CEO for
approving compensation of direct reports who
are disqualified persons
– Follow “procedures specified by the governing
body”
– Parameters, e.g., within identified percentiles
– Contemporaneous documentation in writing
– Executive should not design a plan in which he/she
also participates without third party review and
board/committee approval
44
GOVERNANCE BEST PRACTICES, cont.
• Initial contract exception for new hires
– Consider using procedures even for new hires in
senior executive positions
– Form 990 Schedule J Part I questions 8 and 9: are
organizations following the rebuttable presumption
procedures for new hires?
– IRS dislikes the initial contract exception
45
GOVERNANCE BEST PRACTICES, cont.
• New approval of all changes
– Discretionary bonuses
– New benefits
– Amounts not calculated under a fixed formula or
objective outside source (e.g., CPI)
46
GOVERNANCE BEST PRACTICES, cont.
• Board should review Form 990 compensation reporting
before filing
– Publicly available on Guidestar.org
– All forms of compensation reported (other than “disregarded
benefits” such as nontaxable fringe benefits), including
deferred compensation, whether or not vested
– Compensation paid by related organizations
– Questions at Part VI Section B: Did the process include
review and approval by independent persons, comparability
data and contemporaneous substantiation of the
deliberation and decision?
– Schedule J disclosure of first class travel, companion travel,
tax gross-ups, housing allowance, expense account, health
club dues and services such as housekeeping, chef and
chauffeur
47
GOVERNANCE BEST PRACTICES, cont.
• Always consider how it will look on the front page
– Public perceptions of reasonableness
– Appearance of conflicts
48
Common Governance Pitfalls
• Failure to adopt a compensation philosophy and Charter
setting out approval procedures
• Failure to approve arrangements before payments begin
• Adoption of overly-complex and opaque compensation
arrangements that the Board does not understand
• Failure to have an independent person select the
compensation consultant or obtain comparability data
• Failure to include all elements of compensation in the
approval process
• Failure to involve legal counsel in review of
documentation prepared by HR
• Failure to obtain appropriate approval of changes
• Failure to document decisions adequately in minutes
49
Q&A
50
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51