DATELINE: July 22, 2008
Yeah, baby, when the whip comes down
When the whip comes down
(I'll be running this town, I'll tell you)Rolling Stones, When the Whip Comes Down from Some Girls
Talk about a surge. It seems like the entire staff of the San Diego Union-Tribune has been covering what is a clear crisis for the Southeastern Economic Development Corp (SEDC). For the last six days, the newspaper has posted at least one article each day, with graphs, charts, and supporting documentation also posted on the newspaper’s Web site. Reporters Helen Gao, Matthew T. Hall, Jeff McDonald, and Jeanette Steele have all contributed to the overall story.
So here are the facts: SEDC is charged with handling redevelopment of a 7.2 square mile area east of downtown San Diego. Government officials have raised a series of questions about...
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administrative costs, salaries, and conflicts of interest. Mayor Jerry Sanders wants to know why SEDC President Carolyn Smith was paid $206,328 for fiscal 2005-06 when only $158,000 had been approved for pay. Jeanette Steele, Nonprofit's President Paid More Than Approved Amount, Union-Tribune, July 9, 2008.
Reporter Jeff McDonald put some perspective on the numbers in his July 19, 2008 article entitled Agency Paid 15 Workers More than $1 Million Extra, Union-Tribune. According to McDonald, President Smith revealed that SEDC "had paid its 15 employees more than $1 million above their approved salaries over five years." One schedule shows that for FY 2007-08, the employees received $315,047 on top of their $854,852 base salaries. In an e-mail that might come back to haunt SEDC board chair Chip Owen and President Smith, the two told the SEDC's board that:
The budget/compensation process has been the same at SEDC for over 20 years.
The e-mail then goes on to state:
In 1994, the SEDC Board of Directors delegated the details of SEDC's president's compensation to the Chair of the Board of Directors. However, just recently, the current SEDC Chairman has expanded this compensation discussion to include the entire Board of Directors. This was promulgated in the June 20, 2008 memorandum to SEDC Board of Directors…
Earlier, in the e-mail, there is a statement that every year the staff did make a formal presentation to the SEDC board which included an explanation of all the various categories in the administrative budget.
Subsequent investigations likely will reveal the extent of the full board's involvement in setting the compensation for President Smith and other key employees, but the e-mail doesn't suggest that there was a robust process involving the full board. We can only speculate, but at best, it sounds like the board was given some idea about compensation as part of the budget presentation. Normally executive compensation is a separate determination, particularly because it should take executive performance into account.
What is particularly notable is a July 17, 2008 letter from San Diego City Attorney Michael J. Aguirre to Board Chairperson Owen. City Attorney Aquirre points out that Owen is subject to State of California conflict-of-interest rules. The letter goes on to point out that Owen was paid for "brokerage services rendered in real estate development earned in calendar year 2002 for PDP Imperial Partners LLC ("PDP")." The letter continues:
Because PDP has been paying you annually since 2002 for services rendered that year, you are financially interested in every contract made between PDP and the SEDC Board because the more money that PDP makes from projects results in greater likelihood of you continuing to receive your installment payments.
When section 1090 is applicable to one member of the governing body of a public entity (in this case the SEDC Board), the prohibition cannot be avoided by having the interested board member abstain; the entire governing body is precluded from entering into the contract…A contract that violated section 1090 is void and unenforceable…The prohibition applies regardless of whether the terms of the contract are fair and equitable to all parties.
Obviously the position of City Attorney Aguirre places SEDC and Chairperson Owen in a difficult position. But the difficulties continue to mount. In a July 17, 2008 letter, California Attorney General Edmund G. Brown Jr. advised SEDC's directors, trustees, and officers that SEDC had failed to file registration/renewal fee (RRF-1) reports and the applicable fees for the six preceding years. SEDC also apparently failed to provide the California Attorney General with federal tax returns (most likely the Form 990) for the same six years. The letter advises that the California Attorney General plans to notify the Franchise Tax Board so that the board can disallow SEDC's tax exemption. The letter is not entirely clear, but it indicates that the officers, directors, and trustees have exposure to personal liability for such failures. SEDC was given the opportunity to demonstrate that it has filed the returns, but it is hard to imagine that the reports were lost in the mail six years in a row. See Jeff McDonald, Redevelopment Arm Hasn't Filed Paperwork, Union-Tribune, July 18, 2008.
There must have been suspicion about the goings on at SEDC. In May 2007, San Diego City Councilman Tony Young requested an audit. Matthew T. Hall, Development Arm Facing Questions, Union-Tribune, July 20, 2008. Notably, the audit has yet to be completed. Hall reports that the audit is already $48,000 over a $125,000 budget. Hall also notes that the December 2007 completion deadline kept slipping, until it slipped past what Hall describes as last month's bitter mayoral election. Mayor Jerry Sanders denies that the election had anything to do with the delays, but Hall reports that the audit is overseen by a top mayoral aide. Last Friday, the mayor called for President Smith to resign.
Meanwhile, San Diego City Controller Greg Levin sent what can only be described as an embarrassing letter to SEDC demanding that it confirm a number of calculations that the controller had made. Specifically, the letter asked for explanations for budget variances and verification of calculations that suggest that SEDC's financial metrics significantly understated administration expenses relative to budget/total expenditures.
And yesterday, Jeff McDonald and Helen Gao reported that prior to becoming chairperson, Owen and a company he managed purchased a property and immediately sold it to SEDC for a $500,000 profit. The transactions occurred in 2000. Current Chairman Made $500K Selling Parcel to SEDC, Union Tribune, July 21, 2008. We can't blame Owen. After all, at that point, he was acting as an independent person. The question: Why didn't SEDC buy the property directly from the original owner, particularly when their interest in the property dated to 1991, according to McDonald and Gao?
At the end of the day, SEDC and those in charge are facing some difficult days ahead of them.
Lesson 1. File the Paperwork. We don't in anyway condone what apparently happened at SEDC, but this is a case where those in charge are making it all too easy for government regulators to step in. There is no guarantee that the California Attorney General would have remained on the sidelines, but had SEDC filed what are perfunctory filings with the state, the California Attorney General might not have ever become aware of the underlying issues. Those issues are exactly ones that attorneys general are increasingly focusing on. As a consequence, what was a ministerial lapse could generate a full-fledged investigation of whether SEDC's board of directors discharged its duties of care and loyalty. We would not be at all surprised to read a story in six months or so reporting that the California Attorney General and SEDC entered into an agreement providing for SEDC governance reforms. That agreement, depending on what the California Attorney General finds if it does investigate further, could result in director resignations.
The simple fact is that it is hard to prove excessive compensation. It is easy to prove that papers weren't filed. Sloppy adherence by nonprofit boards and officers to legal formalities just makes the regulator's job easier; not that lessening the burden on regulators is a bad thing.
Lesson 2. Bring Yourself Within the Rebuttable Presumption to the Intermediate Sanctions. So far there is no evidence that the IRS has begun an examination, but with this much publicity, the IRS certainly will have the opportunity to stir things up further. As usual in these matters, we can't reach conclusions because we don't have all the facts. Nevertheless, the executive director and the chief financial officer, together with any employees who exercised substantial influence over the organization, should be nervous about an IRS investigation. If any of these people received compensation in excess of reasonable what would be reasonable, they may have to return the excess to SEDC if the IRS invokes the intermediate sanctions. This is where having the benefit of the rebuttable presumption under Section 4958 of the Code would come in handy. However, that requires the use of comparables, an independent board, and documentation of the transactions. The facts will carry the day, but the newspaper reports raise serious questions as to whether the rebuttable presumption will be available. Based on those reports, it is open to question whether compensation decisions were made by an independent board. The fact that there is alleged to have been at least $1 million of payments in excess of base compensation is particularly problematic because it does not sound like the board approved these payments.
Lesson 3. Know the Rules that Apply to Government Grants. The 2005 Form 990 for SEDC show that the bulk of the organization's money came from government grants. It will be interesting to see how the grantmakers respond to all the publicity. SEDC could find itself in trouble if the requests for reimbursement from the grant money (or the grant application and any submitted budgets) don't correspond with how the money was actually spent. This could lead grantmakers to demand return of the money. Furthermore, it could lead to a cut-off of funding from the grantmakers. As anyone familiar with the OMB Circulars and federal law knows, no organization wants to be accused of misclassifying expenses that are funded with government grant money. This is why is having someone on staff who knows the rules is so important when a nonprofit relies on government grant money.
Lesson 4. Adopt and Follow a Conflicts-of-Interest Policy. It will be interesting to see exactly how the board and the parties that have dealt with SEDC respond to City Attorney Aquirre's letter claiming that a number of transactions are void due to Chairperson Owen's conflict of interest. It is hard to imagine such a unyielding result, particularly if the someone has developed property that SEDC owns or sold. We assume SEDC will either appeal the conclusion or seek redress in the courts.
This problem demonstrates why simply adopting a conflicts-of-interest policy found on the Internet is problematic. SEDC's relationship with the City of San Diego subjected it to a number of requirements that don't apply to most nonprofits. If SEDC had a conflicts-of-interest policy, the policy needed to reflect these more stringent requirements so that the board and officers would clearly understand the restrictions. It is unlikely that the typical policy found on the Internet would identify the requirements that SEDC faces, let alone incorporate provisions to reflect those requirements. It will be interesting to see how this plays out.
Lesson 5. Watch What You Put in Writing. E-mail makes communicating with others so easy. We highly recommend full and open communication as part of the governance process. However, putting things in informal writings when an organization is facing investigations and possible regulatory action should be avoided, particularly if a lawyer has not reviewed the writing. As we noted, we found the e-mail to the board problematic. Although we don't in any way suggest that people lie or engage in a cover-up, we think they should be far more cautious and circumspect in putting things in writing once problems have surfaced and investigations have begun.
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