DATELINE: October 22, 2007, Chicago
Last Friday (Oct. 19, 2007), the Superior Court for the County of San Francisco issued its tentative findings of fact and conclusions of law in Network for Good v. United Way of the Bay Area. Coming in at 87 pages, the opinion is not only too long, but it is treacherous going, relying on highly technical interpretations of accounting entries and presentations. It would be easy to dismiss this opinion as involving a unique set of facts that are unlikely to repeat themselves. That would be...
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a mistake. The opinion holds some important lessons for corporate boards.
Here are the players and the basic facts: Network for Good (NFG) is a charity that operates a Web site permitting members of the public to research and donate to specific charities. NFG subsidizes the donations made through its site by, among other things, covering the credit card processing fees and other transaction costs associated with the contributions. It was the plaintiff in the lawsuit. [Paragraph 1].
United Way of the Bay Area (United Way) was the defendant in the lawsuit. Initially, United Way processed its donations internally. In the early 90's, United Way formed United Nonprofit Operations (United Operations), which it treated as a subsidiary. United Operations processed all donations to United Way and it handled pledge processing for other companies around the country. [Paragraph 2].
On July 1, 2000, United Way purportedly spun off United Operations, renaming it PipeVine. In addition to the back office and pledge processing services provided by PipeVine to United Way, PipeVine also performed pledge and donations processing for other corporate customers, including NFG. [Paragraph 4]. Although the opinion does not state so, PipeVine was a Section 501(c)(3) tax-exempt entity.
On May 23, 2003, PipeVine's board of directors met and decided to close PipeVine because it was "seriously under water," with "major losses" according to its acting CFO. As of April 30, 2003, PipeVine had checks outstanding that were almost $1 million in excess of the balance in its cash accounts. In addition, PipeVine owed $4.5 million to charities for donations that PipeVine had processed but not disbursed. [Paragraph 5]. A receiver was appointed at the request of the California Attorney General. After conducting an extensive investigation into PipeVine's books and records, the receiver determined that PipeVine had received $17.7 million in donations that had not been disbursed to thousands of charities. [Paragraphs 6 and 143].
The court's opinion goes through accounting entries in detail, examining debits and credits. We leave it to you accounting fanatics to read that discussion for pleasure in the coming days. [Paragraphs 20 through 37]. When you cut through the numbers, the problems and issues are relatively straightforward. The court concluded that PipeVine was undercapitalized when it split off from United Way, with the result that PipeVine was forced to use new contributions to meet its obligations to remit amounts attributable to older contributions. [Paragraphs 38, 48, 51, 52, 103, 173, 188, 193, 212, 213, and 223] The court also concluded that Pipeline's financial statements, as a result of an adjusting entry, hid these facts by overstating PipeVine's worth. [Paragraphs 24, 152, and 194].
The court held that United Way was PipeVine's alter ego. [Paragraph 218 through 227]. During the course of the trial, NFG demonstrated a unity of interest and ownership between United Way and PipeVine. It demonstrated that United Way didn't consider issues of PipeVine's capitalization or liquidity prior to the spinoff; that Pipeline was undercapitalized when it was spun off; that PipeVine had insignificant assets to meet its liabilities when it was spun off; that United Way manipulated PipeVine's accounting records to conceal PipeVine's financial problems; that PipeVine and United Way operated as a single entity following the spinoff; and that the two entities had overlapping officers, directors, counsel, and auditors, as well as commingled assets, accounts, and records. [Paragraphs 97 through 98, and Paragraph 228].The court concluded that United Way was liable for the damages suffered by NFG. [Paragraph 231]. Somewhat surprisingly, the court rejected NFG's request for punitive damages. [Paragraph 292].
Here are some lessons from the case for all boards and officers:
LESSON 1. Do Due Diligence on Third Party Processors. Charities constantly are being offered new ways to collect and process donations by third party processors. Many of these are Web-based. Naturally, charities want to maintain the goodwill of their donors. That means charities should make sure that money turned over to an intermediary by a donor is ultimately remitted to the charity. To protect itself, a charity should know who it is dealing with, do a thorough background check, and insist on audited financial statements. It should require funds to be remitted within a short time following receipt by the intermediary. [Paragraphs 123 and 124]. The charity should consider requiring some sort of bond to assure ultimate payment. Although not an issue in this case, charities should also monitor security for Web-based credit card processing in order to make sure that no one can obtain the charity's list of donors and their credit card numbers by hacking an inadequately secured system maintained by the intermediary.
LESSON 2. Don't Focus on Efficiency Metrics. The court's opinion notes that one of the reasons for the spinoff was the expectation that it would improve United Ways' fundraising metrics, making it look more efficient in terms of converting dollars raised into mission (rather than being used for fundraising and administrative expenses). [Paragraphs 3 and 170]. We don't understand that logic. True, United Way showed these expenses on its books when the fundraising operation was part of its operation. But moving processing into a separate and independent entity wasn't, alone, going to improve United Ways' metrics. It was now going to pay a fee for those services. [Paragraph 126]. This, however, is a perfect example of how the focus of charities on efficiency metrics can lead to what appears to be inexplicable behavior.
The court also notes that United Way expected that PipeVine would gain efficiencies that would reduce fundraising costs. Maybe so, but there is nothing in the record that suggests that PipeVine was going to gain any particular competitive advantage simply by creating a new entity. In short, shifting assets among different corporate boxes doesn't create efficiencies.
LESSON 3. Maintain Good Minutes. The court devoted several pages to reviewing the minutes from various board meetings. [Paragraphs 8 through 14]. It is unclear whether the minutes were incomplete or just that issues were raised without adequate follow up. The lesson here is simple: Courts read corporate minutes when bad decisions lead to lawsuits. Consequently, the person charged with preparing the minutes should do so with the understanding that the minutes are potential evidence. More importantly, board members should review minutes. Why did those board members who raised concerns fail to follow-up—or if they did, why didn't they demand that the minutes reflect their efforts?
LESSON 4. Have a Well-Thought-Out Business Plan for New Ventures. We hear a lot about the new philanthropy, with for-profit joint ventures, elaborate corporate structures, and the latest in whiz-kid business processes. That's all great, but when a nonprofit is contemplating creating or funding a new venture, it should have a documented business plan that addresses the many issues that come with joint ventures and other exotic arrangements. In discussing the particular arrangement before it, the court maintained a critical posture when it came to those who were behind the spinoff, including members of United Way's board. The court points out that they asked questions and raised concerns, but the court finds little evidence that they adequately addressed those issues before initiating the spinoff. [Paragraphs 8 through 14]. This may not have directly led to a finding of liability on United Way's part, but it certainly played into the court's negative view of the entire arrangement.
LESSON 5. Accounting Fixes Rarely Solve Business Problems. As described by the court, the accounting treatment for the arrangement bordered on the surreal. The court was not convinced by the explanations offered by the defense and its experts. The court was unable to see how the adjusting entries tracked reality. [Paragraphs 34 through 37] Accounting entries are supposed to reflect reality, not create someone's version of what they would like reality to be. Board members and senior management should be skeptical whenever the accounting treatment becomes so convoluted that nobody understands it. There are usually business reasons why people find the need to play with the numbers. The board's duty is to go beyond the numbers.
LESSON 6. Listen to Whistleblowers. About a year after the spinoff, George Chen became PipeVine's CFO. He was concerned about inadequate internal controls, the viability of PipeVine, and inter-company transfers. Chen tried to alert senior management, United Way's general counsel, and members of the board, but he appears to have been ignored. [Paragraph 71, 104, Paragraphs 106 through 108, Paragraphs 161 through 164, and Paragraphs 207 through 210]. Listen to whistleblowers, particularly when they are senior executives. There is a natural inclination to avoid making waves. When someone is screaming that their hair is on fire, it probably is.
LESSON 7. Deal at Arms-Length. Whenever charitable assets are transferred between two entities (particularly if the entity is a for-profit entity--not the case here), the parties should give serious consideration to obtaining a fairness opinion. That was particularly warranted in this case because United Way received unusual rights under the arrangement. [Paragraphs 73 through 76]. The court was disturbed by the fact that PipeVine did not have separate legal counsel and that it had overlapping officers, directors, counsel, and auditors. [Paragraphs 88 through 90, and Paragraph 93 through 96]. In fact, United Way's general counsel (also a director) appears to have also represented PipeVine, although eventually he withdrew as counsel to PipeVine. [Paragraph 93 through 96]. The outside accounting firm provided audit services to both United Way and PipeVine. [Paragraph 21]. In short, the transactions and arrangements were not at arm's length or independent. Those sorts of facts make a fairness opinion even more important.
LESSON 8. Don't Become an Alter Ego. Nonprofits need to make sure that they deal with affiliated entities at arm's length. Liability predicated on one corporate entity acting as the alter ego of another is often difficult to establish. This case adds little to the law because the facts were so bad. The new entity was undercapitalized, the same lawyers and accountants sat on both sides of the transactions and represented each entity. [Paragraph 21, and Paragraph 93 through 96]. There was also overlap when it came to United Way and PipeVine's CFO [Paragraphs 88 through 90]. United Way didn't follow formalities, but simply treated PipeVine as if it was still part of United Way when that was convenient. [Paragraphs 67 through 69, 71, and Paragraphs 79 through 82]. In the court's view, United Way did not pay its obligations to PipeVine. [Paragraphs 29, 30, 37, 54, 78, 114, and Paragraphs 116 through 118]. The tax return also contained evidence that PipeVine was not an independent entity. [Paragraph 70]. In short, this was an easy case when it came to holding United Way accountable for PipeVine's obligations. Nevertheless, there is a lesson here for those who are sloppy when it comes to affiliated entities and corporate formalities. Clean up your act unless you want a court to ignore the separate corporate structures that have been so carefully created.
LESSON 9. Don't Commingle Restricted Charitable Assets with Operating Funds. The court held United Way accountable in part because these were charitable assets. [Paragraph 218]. The California statutes impose special fiduciary duties on those who handle charitable assets. [Paragraphs 218, 239, 245, 266, 270, and 276]. In this case, PipeVine paid its overhead expenses out of the same bank account that it used to make payments to charities. [Paragraph 156]. In other words, assets designated for charities were commingled with operating funds. Any organization processing charitable contributions should segregate them into separate bank accounts. In fact, it should check with counsel about how it can place those assets beyond the claims of its creditors.
There are probably other lessons from this case, but our 9 lessons are a good start.
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