Dateline: January 22, 2007, Chicago--GO BEARS
Now-former California Attorney General Bill Lockyer announced late last year (December 27, 2006) that he had entered into an agreement with the American Red Cross (ARC) over its Donor Direct program and the way the ARC determines executive compensation. In the past we have defended the ARC against certain attacks made by the media and elected officials, but even we are beginning to wonder: This is a major charitable organization with hundreds of millions of dollars flowing through its coffers. Why...
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all the controversy all the time? Yet, in fairness to the ARC, this settlement agreement seems to reflect a little bit of political grandstanding on the part of the California Attorney General. Could it be that the ARC suffers from a tin ear? In the end, although probably not intended, this settlement raises far more questions than it answers.
The California Attorney General's investigation stemmed from allegations of improper handling of relief funds raised for victims of the 2001 Alpine-Viejas Fire, excessive executive compensation and deceptive solicitation practices by both the ARC and the San Diego and Imperial Counties chapter (SDIC). According to the California Attorney General:
the ARC and SDIC failed to properly restrict certain donations made to aid victims of the Alpine-Viejas fire; the ARC’s Donor DIRECT fundraising program misled contributors by not informing them that, if they wanted their money earmarked for victims of a particular disaster, they had to specifically declare that intent; the ARC’s policies and procedures governing executive compensation were wholly inadequate and provided virtually no national oversight of local chapters; and Dodie Rotherman, former CEO of the SDIC, was substantially overpaid during fiscal years 1997-2001.
The settlement agreement specifically provides that it does not constitute an admission of any wrongdoing, fault, violation of the law, or liability of any kind.
Donor Direct: As for the Donor Direct program, the facts are unclear. It appears that the ARC or SDIC initially did not distribute all the money that had been donated for the victims of the Alpine-Viejas fire to those victims. The ARC and SDIC subsequently made a supplemental distribution to clear out the $55,000 remaining in the account. It agreed to adopt the following language as part of its Donor Direct campaign:
You can help the victims of thousands of disasters across the country each year, disasters like [insert name], by making a financial gift to the American Red Cross Disaster Relief Fund. This Fund enables the Red Cross to provide shelter, food, counseling, and other assistance to victims of disasters. The American Red Cross honors donor intent. If you wish to designate your donation to a specific disaster please do so at the time of your donation.
We must confess, this language surprised us because it is the language that we would have expected to have been associated with the Donor Direct program as we already understood it. What changed? We suspect the California Attorney General was concerned with the problem (cy pres) posed when designated gifts for a particular disaster exceed the needs of victims. The new language seems to encourage donors to make general contributions rather than designating for a particular disaster. If that is the case, we can think of far better language to use, such as the following:
We understand your desire to help victims of a particular, highly publicized disaster, but we often receive designated donations for a particular disaster that far exceed the needs of the particular victims. This creates a number of problems for the ARC. Although you can still designate your donation to a specific disaster at the time of your donation and we will honor that designation, please remember that there are many victims of less publicized disasters that also warrant assistance. An undesignated donation provides us with the greatest flexibility to meet many needs, including those of the [publicized disaster]. Thank you.
Setting Compensation: The settlement agreement also focused on the determination of executive compensation. Exhibit I to the agreement contains a very detailed set of procedures for hiring executives and setting compensation. It is clear some international consulting firm made a fortune preparing this scheme, but we are not at all convinced that this window dressing accomplishes much. We fear that the California Attorney General is micro managing a bit too much if his pressure was the impetus for all of this boilerplate nonsense. We prefer a more basic approach: An engaged board of directors that works through a compensation committee. A compensation committee that identifies and reviews comparables, permitting it to obtain the best candidates possible. Independence on the part of all involved.
Impact of Indemnification Clause: What is most interesting about the settlement is the decision of the California Attorney General to forego litigation against the ARC, the SDIC, current and former directors and officers of the SDIC (including the executive who the California Attorney General believed was overpaid), and certain ARC board members. The settlement agreement notes that the ARC has adopted an indemnification policy permitted under California law. As a consequence, if the California Attorney General were to sue and recover from these folks, they would be entitled to indemnification, unless they acted in bad faith and not in a manner they believed to be in the best interests of the ARC, or they acted with malice, dishonesty, or recklessness. In other words, anyone contesting the right of the officers and directors to indemnification has a heavy burden to carry. Moreover, if the officers and directors were entitled to indemnification, the Red Cross would simply be using charitable assets to reimburse the officers and directors.
We find this result to be very ironic. Every board should take note. By adopting an indemnification provision, the ARC apparently (and possibly inadvertently) erected a fence, making it more difficult for the California Attorney General to pursue more aggressive action. This strikes us as an odd. Assuming, for the sake of argument, that the compensation was excessive, we are troubled that those who authorized and received such compensation escape sanction because of a provision that they are in position to put in place.
D & O Insurance: Moreover, there is the question of D & O insurance. If the ARC has D & O insurance, the ARC and the officers and directors would look to the D & O policy to cover any damages sought by the California Attorney General. In other words, if the ARC had to indemnify the officers and directors, wouldn’t it be able to look to its D & O policy for reimbursement? Consequently, the California Attorney General's refusal to pursue the directors and officers becomes ever more perplexing to us. We assume an organization of the size of the ARC has D & O insurance. So why does the settlement ignore that likelihood? Second, the California Attorney General’s refusal to pursue officers and directors because of the likely impact of the indemnification provision discourages charities from putting D & O insurance in place as a funding mechanism. This makes no sense to us. Moreover, aside from providing a funding mechanism, D & O insurance provides a fresh review of corporate practices as part of the underwriting process. The insurance carrier therefore serves as an "auditor," acting on behalf of the California Attorney General. The carrier is in a position to demand changes if it sees poor governance practices.
Internal Affairs Doctrine: We should also note that the settlement agreement raises questions under the emerging internal affairs doctrine. Clearly a state has authority to regulate the business practices of any foreign entity doing business within the state. However, there is a longstanding question of how much authority, if any, a state has to regulate a foreign corporation’s internal governance. Yet, here we have the California Attorney General asserting some sort of jurisdiction over the internal affairs of the ARC. In this particular case, we suspect the California Attorney General’s hook is California’s charitable trust doctrine. It appears that the California Attorney General is taking the position that if compensation is excessive, charitable assets are being diverted from the charitable mission that caused donors to make charitable contributions, resulting in a fraud. We don’t know enough about ARC's chapter structure to comment further, but this is an interesting aspect of this settlement.
ARC's and SDIC's directors and officers should not sleep too comfortably. The settlement may have ended the matter as far as the California Attorney General is concerned, but the IRS can always take another crack at those folks through the intermediate sanctions.
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