American University students came back to school this Fall greeted by headlines about University president Benjamin Ladner’s “lifestyle”—compensation package. There is a dispute as to whether many of the expenditures that Mr. Ladner allegedly incurred were reimbursable under his contract with American University.
Well, only students at American University’s Washington College of Law would be interested in the niceties of contract interpretation. We suspect most of the other students will give serious consideration to switching their majors to whatever will put them in line to become a university president. One thing is for sure: American University isn’t serving....
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purple & neon cauliflower soup, parmesan tuile, crème fraiche & caviar, little neck clam gratin, baked beausoleil oysters, and white truffle & porcini egg custard & American sturgeon caviar in the school cafeteria, unless there were some leftovers from the New Year’s Eve dinner that Mr. Ladner allegedly served to celebrate the engagement of his son. The Washington Post reported the full menu in its September 25, 2005 edition--Controversy on the Menu.
The details of Mr. Ladner’s alleged extravagances are well documented in a series of articles appearing in the Washington Post. According to a September 20, 2005 article in the Post, the U.S. attorney’s office in Washington, working with the FBI, is investigating the matter. See, V. Strauss and S. Kinzie, Federal Officials Scrutinize Ladner. According to that same article, the IRS has also contacted American University, but apparently is not conducting an active investigation. The faculties of five of the six schools that comprise American University have rendered votes of no confidence. See, S. Kinzie & V. Strauss, Au Faculty Members Vote No Confidence In Ladner: Information Lacking, Suspended Leader Says, Washington Post (September 27, 2005). According to all accounts, the board of trustees is split over whether to retain Mr. Ladner. We would have thought that he would have been long gone, but according to the Post, Mr. Ladner has his supporters on the board. See, S. Kinzie & V. Strauss, Once Friendly AU Board Splintered Into Factions (September 27, 2005), with some members working on a new contract for Mr. Ladner
For the time being, Mr. Ladner has been placed on administrative leave with pay. See. Letter to Alumni. He has strongly disputed many of the allegations made about his compensation and perks, asserting the vast majority of expenditures are appropriate and permissible under the terms of his contract. According to an article appearing in the Chronicle of Higher Education, Mr. Ladner has acknowledged that several personal expenses were mistakenly submitted for reimbursement, but asserted that those mistakes have now been corrected through repayments. P. Fain, American U. President Fires Back While Faculty Groups Vote No-Confidence; Dismissal Could Be Costly (September 28, 2005). What caught everyone’s attention is Mr. Ladner’s personal chef. Mr. Ladner contends that a personal chef was quite appropriate because of the amount of entertaining that came with Mr. Ladner’s position. Others view a personal chef as a bit over the top, particularly given American University’s relatively small endowment. S. Kinzie & V. Strauss, [Chef's] Layoff Amid Proble of AU Head's Spending (September 16, 2005); and S. Kinzie & V. Strauss, $500,000 in Ladner Spending Itemized, Washington Post (September 22, 2005).
No doubt the truth will come out over the next several months. But already there are governance lessons emerging from what is presently known.
Lessons For Boards. One of the primary functions of any board of directors is to set the compensation of the organization’s chief executive. According to all published reports, Mr. Ladner began his tenure at American University in 1994. Somewhere around 1997 his contract was renegotiated. What is unclear is who was involved in the re-negotiation. By some accounts, the full board of trustees did not approve the terms of Mr. Ladner’s contract. According to one article, the negotiations occurred between Mr. Ladner and the then chairman of the American University’s board of trustees. See, S. Kinzie & V. Strauss Washington Post. Another article indicates that the compensation committee may have had some involvement. See, M. Janofsy, Suspended College President Offers to Accept Lesser Pact, N.Y. Times (September 24, 2005). According to the Washington Post, the University’s Vice President of finance repeatedly asked Mr. Ladner if he could see the contract, but was denied a peek until several years had passed. See, S. Kinzie & V. Strauss, $500,000 in Ladner Spending Itemized, Washington Post (September 22, 2005)
We are disturbed that this apparently was a decision that was made without full board involvement. We would be very interested to see the charter for the compensation committee. Once again, we have a case where the focus on highly-charged and unseemly allegations has obscured basic questions: Where was the board of trustees in the decision process? Why weren’t the trustees asking questions about the president’s compensation? Did no one read the Form 990, on which Mr. Ladner’s compensation must be reported?
Quite apart from board decision process, what sort of internal controls were in place? Why was Mr. Ladner apparently not accountable to someone within the organization that reviewed the expenses he submitted for reimbursement? At best, the board appears to have been an enabler by not asking tough questions. Too often executive directors like a passive board, but as this case may prove, in the long, the failure of a board to serve as a check on executive director can be costly to the executive director. Sometimes somebody needs to say “No.”
Lessons For Chief Executives. As noted at the outset, we will have to await a full airing of the facts, but based on what has come out so far, one has to really question Mr. Ladner’s judgment. The Chronicle of Higher Education reports that one trustee indicated that the chef was sent to Europe for professional development. This is apparently defensible because Mr. Ladner used his own frequent flyer miles to pay for the chef’s airfare. See, P. Fain, Troubles Deepen for AU President, as Reports of Lavish Spending Spur Trustee to Demand his Ouster (September 26, 2005). According the article, the University only reimbursed the chef’s meals and lodging. If Mr. Ladner believes that just seeking reimbursment for food and lodging eliminates the overall issue regarding European trips for his chef, it certainly places into question Mr. Ladner’s judgment, or as one trustee has said, “his moral compass.” The fact that something is arguably reimbursable does not mean that it is necessarily a wise expenditure.
Lessons For the IRS. We hope that the IRS decides to take a look at this matter from the standpoint of the intermediate sanctions in Section 4958 of the Internal Revenue Code. The case presents a number of interesting questions.
We have read one article pertaining to the American University scandal that suggests that whether there is an excess benefit depends on whether the compensation is reasonable. That is true as a general proposition. Recall that the intermediate sanctions are designed to "encourage" boards to make sure that compensation and other arrangements with insiders are fair and reasonable, reflecting market values. If a transaction is not fair and reasonable, the intermediate sanctions are designed to force the insider to pay back the unreasonable portion of compensation (a correction). The sanctions may also result in the imposition of penalties on both the insider and the members of the board that approved the transaction.
There are instances where a particular payment will automatically be deemed to constitute an excess benefit regardless of whether it is reasonable. For example, to be considered compensation for services, the organization must indicate its intent to treat a payment as compensation. Failure to so indicate can result in automatic application of the intermediate sanctions to that payment. As a general rule, this indication is deemed to have been made if the organization provides written substantiation that is contemporaneous with the transfer of the economic benefit. See, Treasury Regulation Section 53.4958-4(c)(2).
Mr. Ladner can look to other written contemporaneous evidence, which could include an approved written employment contract or written evidence that the appropriate body approved the transfer. See, Treasury Regulation Section 53.4958-4(c)(3)(ii). Here we enter a feedback loop, faced with the question as to whether Mr. Ladner’s second employment contract was approved by the appropriate body. Does approval by the chairman of the board or the compensation committee suffice? More facts are needed before that can be determined.
Because the amounts
at issue in this case appear to center around expense reimbursements,
Mr. Ladner’s best argument may be that the reimbursements
were pursuant to an accountable plan described in
Treasury Regulation Section 1.62-2(c). See, Treasury Regulation Section
53.4958-4(a)(4). If made pursuant to such a plan, the payments would be taken out of the analysis under the intermediate sanctions altogether. Without more facts, it is impossible to determine
whether the reimbursements satisfy the requirements for an accountable
business plan, but to so qualify, the expenses must be incurred while
the recipient performs the services as an employee and they must
otherwise be business-related. That could turn out to be problematic
with respect to some of the expenses if the various accounts in the press are accurate.
If the plan is not an accountable one, but there is contemporaneous evidence, Mr. Ladner must then demonstrate that his compensation package was reasonable. No doubt he would like the benefit of the rebuttable presumption that his compensation was reasonable. See, Treasury Regulation Section 53.4958-6(a). Once again, it is not at all clear that he will have the benefit of that presumption, which requires the arrangement to be approved in advance by the authorized body, that the authorized body adequately document the transaction, and that in making the decision, the authorized body rely on appropriate data as to comparability before making that the decision. Assuming the chairman of the board or the compensation committee are considered to be the authorized body, we can only wonder whether they obtained comparables. The Chronicle of Higher Education article contains several quotes suggesting the compensation may have been high when compared to comparable institutions, particularly a golden parachute, which one experienced lawyer described as "precedent-breaking."
The IRS will also have to struggle with the appropriate period for measuring any excess benefits, if there are any. Normally, one would think that the relevant period would be three years, but one commentator has indicated that it could be six years. See, E. Brody, Administrative Troubles for the Intermediate Sanctions Regime, Tax Notes (July 16,2001). See, Treasury Regulation Section 301.6501(e)-1(c)(3)(ii), for a starting place for the analysis.
But note what the intermediate sanctions have really done in this case and potentially in all cases: The board may now be split over the reasonableness of Mr. Ladner's arrangement, but the board no longer controls everyone's destiny. Instead, if the the IRS chooses to intervene, it will be the IRS and judicial fact finders who determine whether Mr. Ladner's compensation was reasonable. Moreover, the IRS is arguably in a position to economically force Mr. Ladner to return amounts in excess of amounts that he and the board might voluntarily agree should be repaid. Of course, this hinges on if and how much the IRS determines that the compensation is unreasonable or fails to be in exchange for services (automatic impositions).
As we said, this matter could truly be precedent setting, providing the tax bar with clear cut guidelines for advising clients regarding future contracts. If any good comes out of the case, that could be it. Good luck to all involved.
Lessons for the Students. We wonder whether the student body, which held a protest yesterday, will consider filing a lawsuit against the trustees and Mr. Ladner for recovery of what was in part their tuition payments. If they do, it will be interesting to see how the courts handle the standing issue.
A former student of American University is maintaining a website focused on the issues posed by Mr. Ladner.
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