In an extraordinary development, all fifty states, the District of Columbia, and the Federal Trade Commission filed a federal lawsuit in May 2015 against four charities and their operators, alleging that they had defrauded more than $187 million from donors. While the dollar amount was staggering, the most unusual aspect of the lawsuit was the incredible level of cooperation among state nonprofit regulators. This cooperation was evident not only in the bringing of the lawsuit but also in its successful settlement less than a year later, with the defendant charities and their principal officers surrendering substantial assets, agreeing to dissolution of the charities, and acquiescing to being banned from fundraising and management of charities and charitable assets in the future.

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This development highlights the growing sophistication and cooperation of state nonprofit regulators. And it is not an isolated incident. Building on seeds planted over the past several decades, state regulators are both individually and collectively increasing their oversight of nonprofits.

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This trend is fortunate for those who care about oversight of nonprofits, because it comes at a time when the Internal Revenue Service’s efforts in this area are atrophying. Even before the recent controversy related to the handling of exemption applications filed by politically active nonprofits, the IRS faced a tight budget and a growing list of responsibilities, including significant rule-making and administrative duties related to the Affordable Care Act, or Obamacare. These pressures, in turn, led to a growing backlog of applications for recognition of exemption, a decline in the already low audit rate for tax-exempt nonprofits, and limited new guidance for nonprofits seeking to comply with the complex federal tax rules applicable to them.

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The mess involving exemption applications filed with the IRS by Tea Party and other conservative-leaning groups worsened this situation in several ways, however. It accelerated the development of streamlined application procedures—including, but not limited to, the new Form 1023-EZ—that significantly reduce the level of IRS review for new organizations. It also gave Congress another reason to under-fund the IRS, forced a wholesale change in the leadership of the IRS Exempt Organizations Division, and almost certainly made employees throughout that division wary of pursuing all but the most egregious violations of federal tax law. IRS examinations of annual information returns (primarily the Form 990 series) are now at an anemic level of less than four-tenths of a percent annually. This is at a time when the number of tax-exempt nonprofit organizations has grown to over one and a half million—not including churches and other houses of worship that are not required to seek such recognition from the IRS.

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So, what have state nonprofit regulators been doing during this time of decline in IRS oversight? Individually, many of them have been working hard to review and improve their laws and procedures governing nonprofits, as well as increase efforts to reach the regulated community and those who advise that community.

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Individual State Initiatives

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In the wake of the Enron disgrace and other scandals that rocked the for-profit sector, California enacted the Nonprofit Integrity Act of 2004 to improve the governance procedures and enhance the filing requirements for charities, other nonprofits that hold funds for charitable purposes, and commercial fundraisers. Significant new requirements included in the act are a shortened period for registering with the attorney general (thirty days after the initial receipt of property); mandatory audited financial statements and detailed audit-committee requirements for charitable corporations with gross annual revenues of $2 million or more; mandatory board or board committee review of senior officer compensation; and numerous additional filing requirements for commercial fundraisers.

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In 2013, New York enacted the Nonprofit Revitalization Act based on recommendations from Attorney General Eric T. Schneiderman’s Leadership Committee for Nonprofit Revitalization, made up of representatives from the New York nonprofit community. The act sought to relieve burdens on that community by reducing the number of categories for nonprofit corporations under New York law, simplifying certain formation procedures, and increasing revenue thresholds for certain auditing requirements. It also imposed enhanced corporate governance standards—including those relating to conflicts of interest, related party transactions, whistle-blowing, and financial audits—and gave the attorney general increased enforcement authority. More specifically, the act requires a written conflict of interest policy (with certain provisions for boards of all nonprofit corporations), mandates certain procedures for related party transactions, and requires a whistle-blower policy for nonprofit corporations with twenty or more employees and over $1 million in annual revenue. New York also recently announced a project to systematically review its registration and financial filing procedures for charities and fundraising professionals.

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These efforts are in addition to the increasing availability of state nonprofit filings through Internet-accessible databases, prominent announcements of investigations into alleged wrongdoing by nonprofits, and required annual reports detailing the high fundraising costs of certain nonprofits. On the latter point, examples include California’s commercial fundraisers reports, Massachusetts’s Report on Professional Solicitations for Charity, and New York’s Pennies for Charities report. In addition, state regulators have been working to enhance the other information available on their websites, providing an increasing number of plain-language guides on topics ranging from formation to fiduciary duties to dissolution. State regulators have also become regular presenters at many conferences focused on nonprofit legal issues, including meetings of the Exempt Organizations Committee of the American Bar Association, Section of Taxation; the Georgetown Law Representing and Managing Tax-Exempt Organizations conference; and the Loyola Law School Western Conference on Tax Exempt Organizations.

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At least one state has taken a more innovative approach to combating what it perceives as unduly high fundraising expenses: An Oregon statute now disqualifies charities from eligibility to receive contributions that are tax deductible for purposes of Oregon’s income tax and corporate excise tax if program expenses fall below 30 percent of total annual functional expenses for the most recent three-year period. In December 2015, the Oregon Department of Justice announced the first three nonprofits to fall afoul of this rule; it remains to be seen whether any of them try to challenge their disqualification in court.

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States and localities have also become increasingly active in challenging the often very valuable property tax exemptions enjoyed by many nonprofits. These disputes have involved Princeton University; the Shrine of Our Lady of LaSalette, in Attleboro, Massachusetts; dozens of hospitals; and property owned by numerous other types of nonprofits.8 With no relief in sight for many state and local government budgets, these challenges show no signs of ebbing

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At the same time, state nonprofit regulators appear to have mostly avoided or backed away from getting involved with the regulation of political activity by nonprofits. While California and New York have been particularly active in this area, those states ultimately passed new election laws expanding disclosure of political activity by all types of entities, not just nonprofits, and disclosure of funding sources for such activity.  By doing so, they avoided any need to modify the laws specifically covering nonprofits. In New York, the attorney general actually revoked previously issued proposed regulations that would have targeted for disclosure political activity by tax-exempt organizations, on the grounds that the election law changes made the proposed regulations largely redundant.

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This is almost certainly a positive development, given the IRS’s experience with regulating political activity by tax-exempt organizations, as it keeps this difficult and risky task in the hands of the state agencies that administer state election laws and thus are better suited to oversee such activity. That risk is illustrated by the ongoing litigation challenging California’s attempts at requiring tax-exempt nonprofits to submit to the state attorney general the list of donors they file with the IRS. The U.S. Court of Appeals for the Ninth Circuit has upheld on its face the attorney general’s ability to demand this information, but a federal district court has barred this demand with respect to one particular, politically active nonprofit: the Koch brothers–funded Americans for Prosperity.

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Collective State Efforts

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State nonprofit regulators have also been increasing their communication and coordination across state lines. While such efforts can be traced back to occasional projects under the auspices of the National Association of Attorneys General (NAAG), they gained a more formal structure with the launch of the National Association of State Charity Officials (NASCO) in 1979. In particular, NASCO’s annual conference, which includes both public and regulator-only sessions, provides an ongoing opportunity for state regulators to meet each other, share their experiences, and learn about new developments. NASCO has also played a critical role in helping develop the Unified Registration Statement for nonprofits engaged in charitable solicitation, and the more recent Single Portal Initiative, which seeks to develop a one-stop Internet platform for charitable solicitation registration and reporting for all states that require such filings. NASCO has also begun to show a willingness to critique IRS oversight efforts—not just behind the scenes but also publicly, as shown by the concerns it recently raised about the new IRS Form 1023-EZ.

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The Single Portal Initiative is a good example of how long it can take for such collective efforts to bear fruit. The Initiative can be traced at least as far back as 2003, when the U.S. Department of Commerce provided initial funds for the project to GuideStar, which was working in partnership with NASCO. Almost thirteen years later, the Initiative published an official Request for Information, seeking input on the pilot website that NAAG and NASCO plan to launch by the end of 2016.

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In 2006, the National State Attorneys General Program at Columbia Law School developed the Charities Regulation and Oversight Project directed by Program Executive Director and Senior Counsel Cindy Lott. The project provides an opportunity for state regulators to gather together to learn about various topics of common interest, including conservation easements, fraud in the charitable sector, and future trends in state regulation of charities. It also supports in-depth research into state regulation and enforcement of the charitable sector, in cooperation with the Urban Institute’s Center on Nonprofits and Philanthropy.

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Finally, NAAG recently formed its Charities Committee, which joins a dozen other NAAG special committees that focus on topics ranging from agriculture to federalism to substance abuse. This move is significant, because it institutionalizes attorney general–level attention to the oversight of charities. Consisting of eight attorneys general, the committee’s description highlights the breadth of its role:

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The NAAG Charities Committee mission is to assist and enable attorneys general concerning charities registration and enforcement issues and matters by providing information, communication and support; to facilitate cooperation among the various areas of attorneys general offices that handle charities registration and enforcement through open dialogue and communication; to plan, organize and conduct training and annual seminars in coordination with the National Association for State Charities Officials and its assistant attorney general members for the exchange of ideas and information on matters relevant to charities registration and enforcement; and to promote the development of effective charities registration and enforcement programs and education for the protection of citizens and increasing awareness of our duties to our citizens.

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Ramifications for Nonprofits

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So, what do these developments mean for nonprofits? There are several important takeaways:

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• The IRS is not the only sheriff in town. Especially for charities, state regulators have the authority and willingness to pursue wrongdoing. Like the IRS, they face budget pressures and competing priorities, but state regulators are showing an ability to manage these pressures through both innovation at the individual state level and coordination with other states and federal agencies at the national level. Forums such as NASCO, NAAG’s Charities Committee, and the Charities Regulation and Oversight Project will only continue to enhance state regulators’ ability to do more with their limited resources and to work together.

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• For compliant nonprofits, increased state innovation and cooperation is (mostly) good news. A primary goal of the ongoing state efforts is to reduce the regulatory burdens on nonprofits that are in good faith seeking to comply with applicable state laws. For example, New York’s Nonprofit Revitalization Act amended New York’s Not-for-Profit Corporation Law to raise revenue thresholds for certain audit requirements and to simplify the classification of nonprofit corporations. The Single Portal Initiative’s stated goal is to significantly reduce the administrative burden on nonprofits and professional fundraisers that solicit charitable contributions in multiple states, by providing a single online system for required registration and reporting. At the same time, however, these initiatives often impose additional governance requirements on all or some nonprofits, as exemplified by some of the recent changes to New York law and California’s Nonprofit Integrity Act of 2004.

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• For noncompliant nonprofits, there is less room to fly below the radar. As states update and revise their laws governing nonprofits and the procedures for enforcing those laws, fewer out-of-compliance nonprofits will be able to escape scrutiny. And increased communication between the states means less opportunity for out-of-compliance nonprofits to avoid oversight by simply ending activities in a given state or relocating to a different state. For example, one aspect of the Single Portal Initiative is to bring together IRS Form 990 data with state registration data, making it easier for state regulators to identify nonprofits that are operating in their jurisdictions without having properly registered or reported, as well as to spot fraudulent activity. These developments are good news for the nonprofit sector as a whole—they should reduce bad behavior, such as that highlighted in the FTC/50-State & DC Lawsuit, that damages the sector’s reputation. At the same time, however, less sophisticated and less well-resourced nonprofits that, while otherwise acting properly, have been able to ignore at least some state legal requirements with relative impunity, may no longer be able to do so—including with respect to both charitable solicitation and property tax exemption.

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The bottom line is that nonprofits need to be aware that even as IRS enforcement of the federal requirements for tax-exempt organizations continues to be battered by limited resources and congressional criticism, the states have quietly laid the groundwork for more effective individual and collective oversight of nonprofits. That groundwork is starting to bear fruit, as illustrated by the recent multi-state lawsuit, the renewed Single Portal Initiative, and the NAAG Charities Committee, as well as the addition of increasing governance obligations to the nonprofit laws of California and New York.

Nonprofits, therefore, must be sure to treat compliance with their state legal obligations as seriously as compliance with their federal tax obligations, as well as making sure to keep track of the ongoing state law developments that could impact them in numerous ways.

The creation of the Office of Foundation Oversight is just one example of the government/citizen cooperative to end nonprofit fraud.   Developed by Bruce W. Tucker, the director and founder of Tucker Global Initiatives, as extended investigatory resources to private citizens who files a complaint about a nonprofit, foundation or charity for suspected financial fraud.  

In dealing with the crime internally the fraud infects the whole organization  starting with the board of directors. Their participation in a cover-up and lack of disclosure to authorities and the general public makes them accomplices after the fact. Suddenly, what was an ethical and worthwhile charity has morphed into a deceitful sham.  To solve the problem we must examine the factors that influence moral conduct, the ethical issues that arise specifically in charitable organizations, and the best ways to promote ethical behavior within organizations.

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Public confidence in nonprofit performance is at risk and and all time low. In 2008 a Brookings Institution survey found that approximately one third of Americans reported having little to no confidence in charitable organizations, and 70 percent felt that charitable organizations waste a great deal of the donated money. Only 10 percent thought charitable organizations did a good enough job spending money wisely that they contributed; only 17 percent thought that charities made fair and economical decisions; and only one quarter thought charities fulfilled their mission of helping people well.   Similarly, a 2006 Harris Poll found that only one in 10 Americans strongly believed that charities are honest and ethical in their use of donated funds. Nearly one in three believed that nonprofits have lost sight of their mission statements. In the ten years since the statistical data was compiled, the situation has only gotten worse. The public perception is particularly troubling for nonprofit organizations that depend on continuing financial contributions. Without trust, there will be no trust.

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Addressing these ethical concerns requires a deeper understanding of the forces that compromise ethical judgment and the most effective institutional responses. Investigative techniques and expertise in financial crime enforcement can reveal the how-- an equal amount of well-hone criminal psychology will help explain the why.  

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Causes of Misconduct

Ethical challenges arise at all levels in all types of organizations—for-profit, nonprofit, and government—and involve a complex relationship between individual character and cultural influences. Some of these challenges can result in criminal violations or civil liability: fraud, misrepresentation, and misappropriation of assets fall into this category. More common ethical problems involve gray areas—activities that are on the fringes of fraud, or that involve conflicts of interest, misallocation of resources, or inadequate accountability and transparency.

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Research identifies four crucial factors that influence ethical conduct:

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• • • • • • • • • Moral awareness: recognition that a situation raises ethical issues

                • Moral decision making: determining what course of action is ethically sound

                • Moral intent: identifying which values should take priority in the decision

                • Moral action: following through on ethical decisions

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People vary in their capacity for moral judgment—in their ability to recognize and analyze moral issues, and in the priority that they place on moral values. They also diff er in their capacity for moral behavior—in their ability to cope with frustration and make good on their commitments.

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Cognitive biases can compromise these ethical capacities. Those in leadership positions often have a high degree of confidence in their own judgment. That can readily lead to arrogance, overoptimism, and an escalation of commitment to choices that turn out to be wrong either factually or morally.

As a result, people may ignore or suppress dissent, overestimate their ability to rectify adverse consequences, and cover up mistakes by denying, withholding, or even destroying information.

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A related bias involves cognitive dissonance: People tend to suppress or reconstrue information that casts doubt on a prior belief or action.9 Such dynamics may lead people to discount or devalue evidence of the harms of their conduct or the extent of their own responsibility. In-group biases can also result in unconscious discrimination that leads to ostracism of unwelcome or inconvenient views. That, in turn, can generate perceptions of unfairness and encourage team loyalty at the expense of candid and socially responsible decision making.

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A person’s ethical reasoning and conduct is also affected by organizational structures and norms. Skewed reward systems can lead to a preoccupation with short-term profits, growth, or donations at the expense of long-term values. Mismanaged bonus systems and compensation structures are part of the explanation for the morally irresponsible behavior reflected in Enron Corp. and in the recent financial crisis.

In charitable organizations, employees who feel excessive pressure to generate revenue or minimize administrative expenses may engage in misleading conduct. Employees’ perceptions of unfairness in reward systems, as well as leaders’ apparent lack of commitment to ethical standards, increase the likelihood of unethical behavior.

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A variety of situational pressures can also undermine moral conduct. Psychologist Stanley Milgram’s classic obedience to authority experiment at Yale University offers a chilling example of how readily the good go bad under situational pressures. When asked to administer electric shocks to another participant in the experiment, about two-thirds of subjects fully complied, up to levels marked “dangerous,” despite the victim’s screams of pain. Yet when the experiment was described to subjects, none believed that they would comply, and the estimate of how many others would do so was no more than one in 100. In real-world settings, when instructions come from supervisors and jobs are on the line, many moral compasses go missing.

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Variations of Milgram’s study also documented the influence of peers on individual decision making. Ninety percent of subjects paired with someone who refused to comply also refused to administer the shocks. By the same token, 90 percent of subjects paired with an uncomplaining and obedient subject were equally obedient. Research on organizational behavior similarly finds that people are more likely to engage in unethical conduct when acting with others. Under circumstances where bending the rules provides payoff s for the group, members may feel substantial pressure to put their moral convictions on hold. That is especially likely when organizations place heavy emphasis on loyalty and off er significant rewards to team players. For example, if it is common practice for charity employees to inflate expense reports or occasionally liberate office supplies and in-kind charitable donations, other employees may suspend judgment or follow suit. Once people yield to situational pressures when the moral cost seems small, they can gradually slide into more serious misconduct. Psychologists label this “the boiled frog” phenomenon. A frog thrown into boiling water will jump out of the pot. A frog placed in tepid water that gradually becomes hotter will calmly boil to death.

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Moral blinders are especially likely in contexts where people lack accountability for collective decision making. That is often true of boards of directors—members’ individual reputations rarely suffer, and insurance typically insulates them from personal liability. A well-known study by Scott Armstrong, a professor at the Wharton School of the University of Pennsylvania, illustrates the pathologies that too often play out in real life. The experiment asked 57 groups of executives and business students to assume the role of an imaginary pharmaceutical company’s board of directors. Each group received a fact pattern indicating that one of their company’s most profitable drugs was causing an estimated 14 to 22 “unnecessary” deaths a year. The drug would likely be banned by regulators because a competitor offered a safe medication with the same benefits at the same price. More than four-fifths of the boards decided to continue marketing the product and to take legal and political actions to prevent a ban. By contrast, when a different group of people with similar business backgrounds were asked for their personal views on the same hypothetical, 97 percent believed that continuing to market the drug was socially irresponsible.

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These dynamics are readily apparent in real-world settings. Enron’s board twice suspended conflict of interest rules to allow CFO Andrew Fastow to line his pockets at the corporation’s expense.15 Some members of the United Way of the National Capital Area’s board were aware of suspicious withdrawals by CEO Oral Suer over the course of 15 years, but failed to alert the full board or take corrective action.16 Experts view the large size of some governing bodies, such as the formerly 50-member board of the American Red Cross, as a contributing factor in nonprofit scandals.

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Other characteristics of organizations can also contribute to unethical conduct. Large organizations facing complex issues may undermine ethical judgments by fragmenting information across multiple departments and people. In many scandals, a large number of professionals—lawyers, accountants, financial analysts, board members, and even officers—lacked important facts raising moral as well as legal concerns. Work may be allocated in ways that prevent decision makers from seeing the full picture, and channels for expressing concerns may be inadequate.

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Another important influence is ethical climate—the moral meanings that employees give to workplace policies and practices. Organizations signal their priorities in multiple ways, including the content and enforcement of ethical standards; the criteria for hiring, promotion, and compensation; and the fairness and respect with which they treat their employees. People care deeply about “organizational justice” and perform better when they believe that their workplace is treating them with dignity and is rewarding ethical conduct. Workers also respond to moral cues from peers and leaders. Virtue begets virtue, and observing integrity in others promotes similar behavior.

Ethical Issues in the Nonprofit Sector.

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These organizational dynamics play out in distinctive ways in the nonprofit sector. There are six areas in particular where ethical issues arise in the nonprofit sector: compensation; conflicts of interest; publications and solicitation; financial integrity; investment policies; and accountability and strategic management.

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Compensation.

Salaries that are modest by business standards can cause outrage in the nonprofit sector, particularly when the organization is struggling to address unmet societal needs. In a March 23, 2009, Nation column, Katha Pollitt announced that she “stopped donating to the New York Public Library when it gave its president and CEO Paul LeClerc a several hundred thousand-dollar raise so his salary would be $800,000 a year.” That, she pointed out, was “twenty times the median household income.” Asking him to give back half a million “would buy an awful lot of books—or help pay for raises for the severely underpaid librarians who actually keep the system going.” If any readers thought LeClerc was an isolated case, she suggested checking Charity Navigator for comparable examples.

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The problem is not just salaries. It is also the perks that officers and unpaid board members may feel entitled to take because their services would be worth so much more in the private sector. A widely publicized example involves William Aramony, the former CEO of United Way of America, who served six years in prison after an investigation uncovered misuse of the charity’s funds to finance a lavish lifestyle, including luxury condominiums, personal trips, and payments to his mistress. Examples like Aramony ultimately prompted the IRS to demand greater transparency concerning nonprofit CEO compensation packages exceeding certain thresholds.

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Nonprofits also face issues concerning benefits for staff and volunteers. How should an organization handle low-income volunteers who select a few items for themselves while sorting through non-cash contributions? Should employees ever accept gifts or meals from beneficiaries or clients? Even trivial expenditures can pose significant issues of principle or public perception.

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Travel expenses also raise questions. Can employees keep frequent flyer miles from business travel? How does it look for cash-strapped federal courts to hold a judicial conference at a Ritz-Carlton hotel, even though the hotel offered a significantly discounted rate? The Panel on the Nonprofit Sector recommends in its Principles for Good Governance and Ethical Practice that organizations establish clear written policies about what can be reimbursed and require that travel expenses be cost-effective. But what counts as reasonable or cost-effective can be open to dispute, particularly if the nonprofit has wealthy board members or executives accustomed to creature comforts.

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Conflicts of Interest.

Conflicts of interest arise frequently in the nonprofit sector. The Nature Conservancy encountered one such problem in a “buyer conservation deal.” The organization bought land for $2.1 million and added restrictions that prohibited development such as mining, drilling, or dams, but authorized construction of a single-family house of unrestricted size, including a pool, a tennis court, and a writer’s cabin. Seven weeks later, the Nature Conservancy sold the land for $500,000 to the former chairman of its regional chapter and his wife, a Nature Conservancy trustee. The buyers then donated $1.6 million to the Nature Conservancy and took a federal tax write-off for the “charitable contribution.”

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Related conflicts of interest arise when an organization offers preferential treatment to board members or their affiliated companies. In another Nature Conservancy transaction, the organization received $100,000 from SC Johnson Wax to allow the company to use the Conservancy’s logo in national promotion of products, including toilet cleaner. The company’s chairman sat on the charity’s board, although he reportedly recused himself from participating in or voting on the transaction.

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These examples raise a number of ethical questions. Should board members obtain contracts or donations for their own organizations? Is the board member’s disclosure and abstention from a vote enough? Should a major donor receive special privileges, such as a job or college admission for a child? In a recent survey, a fifth of nonprofits (and two-fifths of those with more than $10 million in annual expenses) reported buying or renting goods, services, or property from a board member or an affiliated company within the prior two years. In three-quarters of nonprofits that did not report any such transactions, board members were not required to disclose financial interests in entities doing business with the organization, so its leaders may not have been aware of such conflicts.

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Despite the ethical minefield that these transactions create, many nonprofits oppose restrictions because they rely on insiders to provide donations or goods and services at below-market rates. Yet such quid pro quo relationships can jeopardize an organization’s reputation for fairness and integrity in its financial dealings. To maintain public trust and fiduciary obligations, nonprofits need detailed, unambiguous conflict of interest policies, including requirements that employees and board members disclose all financial interest in companies that may engage in transactions with the organization. At a minimum, these policies should also demand total transparency about the existence of potential conflicts and the process by which they are dealt with.

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Publications and Solicitation. Similar concerns about public trust entail total candor and accuracy in nonprofit reports. The Red Cross learned that lesson the hard way after disclosures of how it used the record donations that came in the wake of the 9/11 terrorist attacks. Donors believed that their contributions would go to help victims and their families. The Red Cross, however, set aside more than half of the $564 million in funds raised for 9/11 for other operations and future reserves. Although this was a long-standing organizational practice, it was not well known. Donor outrage forced a public apology and redirection of funds, and the charity’s image was tarnished.

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As the Red Cross example demonstrates, nonprofits need to pay particular attention to transparency. They should disclose in a clear and non-misleading way the percentage of funds spent on administrative costs—information that affects many watchdog rankings of nonprofit organizations. Transparency is also necessary in solicitation materials, grant proposals, and donor agreements. Organizations cannot afford to raise funds on the basis of misguided assumptions, or to violate public expectations in the use of resources.

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Financial Integrity.

Nonprofit organizations also face ethical dilemmas in deciding whether to accept donations that have any unpalatable associations or conditions. The Stanford Institute for Research on Women and Gender, for example, declined to consider a potential gift from the Playboy Foundation. By contrast, the ACLU’s Women’s Rights Project, in its early phase, accepted a Playboy Foundation gift, and for a brief period sent out project mailings with a Playboy bunny logo. When Stanford University launched an ethics center, the president quipped about what level of contribution would be necessary to name the center and whether the amount should depend on the donor’s reputation. If “the price was right,” would the university want a Ken Lay or a Leona Helmsley center on ethics?

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Recently, many corporations have been attempting to “green” their image through affiliations with environmental organizations, and some of these groups have been entrepreneurial in capitalizing on such interests. The Nature Conservancy offered corporations such as the Pacific Gas and Electric Co. and the Dow Chemical Co. seats on its International Leadership Council for $25,000 and up. Members of the council had opportunities to “meet individually with Nature Conservancy staff to discuss environmental issues of specific importance to the member company.”

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There are no easy resolutions of these issues, but there are better and worse ways of addressing them. Appearances matter, and it sometimes makes sense to avoid affiliations where a donor is seeking to advance or pedigree ethically problematic conduct, or to impose excessive restrictions on the use of funds.

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Investment Policies. Advocates of socially responsible investing argue that nonprofit organizations should ensure that their financial portfolio is consistent with their values. In its strongest form, this strategy calls for investing in ventures that further an organization’s mission. In its weaker form, the strategy entails divestment from companies whose activities undermine that mission. The issue gained widespread attention after a Jan. 7, 2007, Los Angeles Times article criticized the Bill & Melinda Gates Foundation for investing in companies that contributed to the environmental and health problems that the foundation is attempting to reduce.

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Many nonprofit leaders have resisted pressure to adopt socially responsible investing principles on the grounds that maximizing the financial return on investment is the best way to further their organization’s mission, and that individual divestment decisions are unlikely to affect corporate policies. Our view, however, is that symbols matter, and that similar divestment decisions by large institutional investors can sometimes influence corporate conduct. Hypocrisy, as French writer François de La Rochefoucauld put it, may be the “homage vice pays to virtue,” but it is not a sound managerial strategy. To have one set of principles for financial management and another for programmatic objectives sends a mixed moral message. Jeff Skoll acknowledged as much following his foundation’s support of Fast Food Nation, a dramatic film highlighting the adverse social impacts of the fast-food industry. “How do I reconcile owning shares in [Coca-Cola and Burger King] with making the movie?” he asked. As a growing number of foundations recognize, to compartmentalize ethics inevitably marginalizes their significance. About a fifth of institutional investing is now in socially screened funds, and it is by no means clear that these investors have suffered financial losses as a consequence.

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Accountability and Strategic Management. By definition, nonprofit organizations are not subject to the checks of market forces or majoritarian control. This independence has come under increasing scrutiny in the wake of institutional growth. In 2006, after a $30 billion gift from Warren Buffet, the Gates Foundation endowment doubled, making it larger than the gross domestic product of more than 100 countries. In societies where nonprofits serve crucial public functions and enjoy substantial public subsidies (in the form of tax deductions and exemptions), this public role also entails significant public responsibilities. In effect, those responsibilities include fiduciary obligations to stakeholders—those who fund nonprofits and those who receive their services—to use resources in a principled way. As a growing body of work on philanthropy suggests, such accountability requires a well-informed plan for furthering organizational objectives and specific measures of progress. A surprising number of nonprofits lack such strategic focus. Many operate with a “spray and pray” approach, which spreads assistance across multiple programs in the hope that something good will come of it. Something usually does, but it is not necessarily the cost-effective use of resources that public accountability demands.

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Money held in public trust should be well spent, not just well-intentioned. But in practice, ethical obligations bump up against significant obstacles. The most obvious involves evaluation. Many nonprofit initiatives have mixed or nonquantifiable outcomes. How do we price due process, wilderness preservation, or gay marriage?

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Although in many contexts objective measures of progress are hard to come by, it is generally possible to identify some indicators or proxies. Examples include the number and satisfaction of people affected, the assessment of experts, and the impact on laws, policies, community empowerment, and social services. The effectiveness of evaluation is likely to increase if organizations become more willing to share information about what works and what doesn’t. To be sure, those who invest significant time and money in social impact work want to feel good about their efforts, and they are understandably reluctant to spend additional resources in revealing or publicizing poor outcomes. What nonprofit wants to rain on its parade when that might jeopardize public support? But sometimes at least a light drizzle is essential to further progress. Only through pooling information and benchmarking performance can nonprofit organizations help each other to do better.

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Promoting Ethical Decision Making

Although no set of rules or organizational structures can guarantee ethical conduct, nonprofits can take three steps that will make it more likely.

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Ensure Effective Codes of Conduct and Compliance Programs. One of the most critical steps that nonprofits can take to promote ethical conduct is to ensure that they have adequate ethical codes and effective compliance programs. Codified rules can clarify expectations, establish consistent standards, and project a responsible public image. If widely accepted and enforced, codes can also reinforce core values, deter misconduct, promote trust, and reduce the organization’s risks of conflicting interests and legal liability.

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Although the value of ethical codes and compliance structures should not be overlooked, neither should it be overstated. As empirical research makes clear, the existence of an ethical code does not of itself increase the likelihood of ethical conduct. Much depends on how standards are developed, perceived, and integrated into workplace functions. “Good optics” was how one manager described Enron’s ethical code, and shortly after the collapse, copies of the document were selling on eBay, advertised as “never been read.”

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A recent survey of nonprofit organizations found that only about one third of employees believed that their workplace had a well implemented ethics and compliance program. This figure is higher than the corresponding figure for the business (25 percent) and government (17 percent) sectors, but still suggests ample room for improvement.  Part of the problem lies with codes that are too vague, inflexible, or narrow. Only about half of nonprofit organizations have conflict of interest policies, and fewer than one third require disclosure of potentially conflicting financial interests. A related difficulty is compliance programs that focus simply on punishing deviations from explicit rules, an approach found to be less effective in promoting ethical behavior than approaches that encourage self-governance and commitment to ethical aspirations. To develop more effective codes and compliance structures, nonprofit organizations need systematic information about how they operate in practice. How often do employees perceive and report ethical concerns? How are their concerns addressed? Are they familiar with codified rules and confident that whistle-blowers will be protected from retaliation? Do they feel able to deliver bad news without reprisals?

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Promote Effective Financial Management. Another step that nonprofits can take to foster ethical behavior and promote public trust is to use resources in a socially responsible way. In response to reports of bloated overhead, excessive compensation, and financial mismanagement, watchdog groups like Charity Navigator have begun rating nonprofits on the percentage of funds that go to administration rather than program expenditures. Although this rating structure responds to real concerns, it reinforces the wrong performance measure, distorts organizational priorities, and encourages disingenuous accounting practices. Groups with low administrative costs may not have the scale necessary for social impact. The crucial question that donors and funders should consider in directing their resources is the relative cost-effectiveness of the organization. Yet according to a 2001 study by Princeton Survey Research Associates, only 6 percent of Americans say that whether a program “makes a difference” is what they most want to know when making charitable decisions. Two-thirds expect the bulk of their donations to fund current programs and almost half expect all of their donations to do so. Such expectations encourage charities to provide short-term direct aid at the expense of building long-term institutional capacity.

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Moreover, the line these donors draw between “overhead” and “cause” is fundamentally fl awed. As Dan Pallotta notes in Uncharitable, “the distinction is a distortion.” All donations are going to the cause, and “the fact that [a dollar] is not going to the needy now obscures the value it will produce down the road” by investing in infrastructure or fundraising capacity. Penalizing charities for such investments warps organizational priorities. It also encourages “aggressive program accounting,” which allocates fundraising, management, and advertising expenses to program rather than administrative categories. Studies of more than 300,000 tax returns of charitable organizations find widespread violation of standard accounting practices and tax regulations, including classification of accounting fees and proposal writing expenses as program expenditures.

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To address these issues, nonprofit organizations need better institutional oversight, greater public education, and more transparent and inclusive performance measures. Ensuring common standards for accounting and developing better rating systems for organizational effectiveness should be a priority.

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Institutionalize an Ethical Culture. In its National Nonprofit Ethics Survey, the Ethics Resource Center categorizes an organization as having a strong ethical culture when top management leads with integrity, supervisors reinforce ethical conduct, peers display a commitment to ethics, and the organization integrates its values in day-to-day decision making. In organizations with strong ethical cultures, employees report far less misconduct, feel less pressure to compromise ethical commitments, and are less likely to experience retaliation for whistle-blowing. This survey is consistent with other research, which underscores the importance of factoring ethical concerns into all organizational activities, including resource allocation, strategic planning, personnel and compensation decisions, performance evaluations, auditing, communications, and public relations.

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Often the most critical determinant of workplace culture is ethical leadership. Employees take cues about appropriate behavior from those at the top. Day-to-day decisions that mesh poorly with professed values send a powerful signal. No organizational mission statement or ceremonial platitudes can counter the impact of seeing leaders withhold crucial information, play favorites with promotion, stifle dissent, or pursue their own self-interest at the organization’s expense.

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Leaders face a host of issues where the moral course of action is by no means self-evident. Values may be in conflict, facts may be contested or incomplete, and realistic options may be limited. Yet although there may be no unarguably right answers, some will be more right than others—that is, more informed by available evidence, more consistent with widely accepted principles, and more responsive to all the interests at issue. Where there is no consensus about ethically appropriate conduct, leaders should strive for a decision making process that is transparent and responsive to competing stakeholder interests.

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Nonprofit executives and board members also should be willing to ask uncomfortable questions: Not just “Is it legal?” but also “Is it fair?” “Is it honest?” “Does it advance societal interests or pose unreasonable risks?” and “How would it feel to defend the decision on the evening news?” Not only do leaders need to ask those questions of themselves, they also need to invite unwelcome answers from others. To counter self-serving biases and organizational pressures, people in positions of power should actively solicit diverse perspectives and dissenting views. Every leader’s internal moral compass needs to be checked against external reference points.

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Some three decades ago, in commenting on the performance of Nixon administration officials during the Watergate investigation, then-Supreme Court Chief Justice Warren Burger concluded that “apart from the morality, I don’t see what they did wrong.” That comment has eerie echoes in the current financial crisis, as leaders of failed institutions repeatedly claim that none of their missteps were actually illegal. Our global economy is paying an enormous price for that moral myopia, and we cannot afford its replication in the nonprofit sphere.

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