April 25, 2011

'Three Cups of Tea' Scandal Offers Lessons for Charities and Trustees

PRNewsFoto/Central Asia Institute, Dierdre Eitel/AP Images

Greg Mortenson, his son Khyber, and daughter, Amira Mortenson, with students at Gultori War refugee school, Bromolo Colony, Karakoram mountains. These students escaped massive Indian artillery bombardment during the 1999 Kargil crisis on the Pakistan - India border.

At a time when trust in charities has eroded, the scandal over the Central Asia Institute, the nonprofit founded by Greg Mortenson author of Three Cups of Tea, threatens to cause even more questions for organizations of all kinds.

Among the key issues facing the Central Asia Institute: whether the money the organization raised from supporters was channeled mainly to schools in Afghanistan and Pakistan, as it said was the case and in keeping with its mission, or whether it went primarily toward promoting sales of Mr. Mortensen’s books and helping him snare lucrative speaking fees.

To his credit, Mr. Mortensen and his colleagues have agreed to cooperate with investigators—and the charity has issued a few defenses for its actions.

Charities are under a magnifying glass like never before. Advances in technology have created an era of transparency. No longer can charities rely on just the good will of their name and historical record. Now they must continually justify their relevance and nurture and protect their credibility. Public trust is of paramount importance, and to lose it may mean losing everything.

To be sure, the problems at the Central Asia Institute are unusual, but the controversy should serve as a cautionary lesson for all nonprofits.

Following are key steps every nonprofit should take in the wake of the controversy that erupted after the “60 Minutes” exposé on the Central Asia Institute.

Consider public expectations in every report and publication.

One of the biggest questions surrounding the Central Asia Institute has to do with the amount of money it spent domestically versus overseas to construct and pay for the operations of schools in Afghanistan and Pakistan.

It came as a surprise to many supporters that most of the institute’s spending on charitable programs was categorized on its tax form as “domestic outreach” (such as paying for Mr. Mortenson’s speaking engagements and advertising for his books).

The shock over the institute’s spending is due in part to the mixed messages contained in its informational tax return and on its Web site. For example, the tax form for fiscal 2009 lists domestic outreach and education as the charity’s largest program expense. However, the “program” section of the institute’s Web site fails to even mention domestic outreach and lists only the programs it conducts abroad.

Charities should exercise care with the information they produce about the organization and monitor their sources for consistency and transparency. Every piece of information disclosed to the public contributes to how a charity builds a relationship and trust with its supporters and donors.

That’s why supporters may feel upset, betrayed, or disappointed when a charity is inconsistent or unclear about its intentions or actions, and that anger might motivate them to report their concerns to legal authorities or the news media.

Organizations should use the sources of information within their control—such as the informational tax return, known as the Form 990, the Web site, and publications—to connect the dots for anyone who wants to learn about the organization rather than leaving it open to interpretation. The public, legal authorities, and the news media may all hold charities accountable for their words.

View the informational tax return as a public-disclosure document, not just an Internal Revenue Service form.

More than just an information return intended for the IRS, the Form 990 has become an easily accessible public document that charities should expect to come under scrutiny.

Allegations of inappropriate use of charitable funds by Mr. Mortenson and the Central Asia came in large part after charity watchdogs and journalists reviewed the organization’s Form 990.

Diligent nonprofit leaders should have their organization’s Form 990 prepared or at least reviewed by marketing experts as well as those with financial expertise.

Particularly since its recent redesign, the Form 990 should be considered an important part of the charity’s public-relations strategy. It may be wise to ask one member of the board or a committee charged with reviewing the Form 990 to approach it from a critic’s perspective. That would allow for revisions that could help prevent or mitigate attacks against the organization.

Watch for potential conflicts of interests involving top executives and board members.

A conflict of interest exists when a director or officer of an organization has a personal financial interest in a transaction with the charity. While not all conflict-of-interest transactions are illegal or ill-advised, they should be allowed only after the charity has undertaken careful review.

Mr. Mortenson, a board member and executive director of the Central Asia Institute, had a conflict of interest because the charity’s activities also helped him sell his books and generate speaker’s fees

Regardless of whether he appropriately abstained from any vote approving activities that involved his own financial interests, the remaining two members of the institute’s board should have considered how the public would react to the disclosure of this conflict, particularly in light of the substantial benefits received by Mr. Mortenson in advertising and travel.

Charities should adopt and observe conflict-of-interest policies that meet federal and state legal requirements and also take into account any special circumstances facing their organizations. In cases in which a board member stands to receive royalties and other income as the result of a charity’s activities, the board must be particularly aware of how the public will perceive it (and how critics may characterize it). Even if such transactions would be fair to the charity and further the charity’s mission, it may be best to avoid them.

Prevent sweetheart deals that benefit a charity’s officials or board members.

A charity must serve a public interest rather than a private one, and any financial benefits provided to an individual must be incidental compared with the amount spent to advance a charity’s tax-exempt purposes.

If a charity’s directors and officers, as well as other “insiders” in a position to exercise substantial influence on the organization, receive a financial benefit that exceeds the value of the services or goods they provide to the charity in return, they may be subject to a penalty tax for what the IRS calls an “excess-benefit transaction.”

It is at best problematic that Mr. Mortenson earned money from a sale to the charity of thousands of copies of his books, the charity’s advertising of his books and personal speaking engagements, and the charity’s payment of his travel costs in support of sales of his books and speaking engagements.

In fiscal year 2009, the Central Asia Institute reported that it spent more than $1.7-million in “book-related expenses” and nearly $1.4-million in travel expenses and did not get any book- or speaking-event-related revenue in return. Mr. Mortenson certainly benefited financially from these expenditures in the form of royalties and speaker’s fees. Whether he donated some of this money back to the charity is beside the point from a legal perspective.

The board of the Central Asia Institute defended its actions by saying that the institute received a greater financial benefit than it provided—presumably suggesting that it raised a lot in private donations from people who were moved to give after reading the book or listening to Mr. Mortenson talk.

However, that is a misreading of federal law.

The value of Mr. Mortenson’s books and public speaking may be very different from their benefit to the charity.

For example, if he charged speaking fees to similar organizations for $30,000, Central Asia Institute’s payment to Mr. Mortenson of more than such amount, whether through cash or noncash benefits such as travel subsidies, for the same services would be excessive regardless of whether the benefits the charity received from a speaking engagement was greater than what it paid.

Charities should make sure that board members, top officials, and others who are in a position to exercise substantial influence over an organization understand the rules designed to prevent excess-benefit transactions.

The IRS can levy financial penalties on the people who approved such transactions, and serious violations of the law could cause the tax agency to revoke an organization’s charity status.

Structure the board to engender public trust.

The Central Asia Institute’s Web site identifies three people who serve on its board of directors, including Mr. Mortenson.

While it is legally permissible for a charity to have only three directors, such a small board can be a problem for an organization of this size—after all, it collected $14-million in revenue in 2009. The board’s makeup in this case may cause even more suspicions because Mr. Mortenson is also the executive director. That means only two other people were operating as a check on his activities.

Charities with very small boards should strive to add members who are committed to the mission and who would act in the charity’s best interests. The additional directors may bring different perspectives, skills, and other resources.

That not only would result in improved governance but it may also bolster the credibility of the organization. In addition, boards would be wise to consider whether a paid executive of the organization should also be a board member because of the inherent conflict of interest.

Conduct independent audits regularly to avoid trouble.

A charity’s board is supposed to ensure that the organization’s resources are deployed efficiently and are focused on the charitable mission.

For organizations with sufficient resources and substantial financial activities, like the Central Asia Institute, an independent audit is strongly recommended (and may be required by law). The Central Asia Institute did not have an audit even in 2008 when its net assets exceeded $10 million, it spent more than $5-million, and it generated a surplus of more than $8-million.

The board’s decision to forgo an audit until fiscal 2009, combined with the problem of the small size of the board and the financial self-interest of the charity’s founder and executive director, raise suspicions that it failed to exercise appropriate oversight and might have misused charitable assets.

An independent audit can assure a charity’s board and others that the financial statements provide an accurate reflection of the organization’s financial health and performance.

Self-reported numbers by staff members are less trustworthy because they may contain errors that might otherwise be corrected by an audit and can easily be manipulated to further an individual’s personal interests.

With the public’s increased scrutiny and skepticism of nonprofits, charities, particularly those with annual revenues of $2-million or more (the legal threshold for a required audit in California), would be wise to consider the value of an independent audit.

Adopt clear and fair travel policies.

The Central Asia Institute’s spending on travel has attracted criticism because it covered first-class and charter travel as well as travel for companions.

Even at the institute itself, people seem to hold different views about whether it was appropriate for the charity to pay for these trips

Mr. Mortenson has said he has covered his travel costs since mid-January to avoid potential conflicts of interest; the institute has explained that it had covered Mr. Mortenson’s travel expenses because these activities are “integral to the mission and operations.”

Charities must be sensitive to donor and public expectations of how charitable assets are used, especially when it comes to travel. For an organization that serves poor people in Afghanistan and Pakistan, first-class and chartered jet travel for insiders and their non-work-related companions can just look wrong. It may be wiser to pay a compensated employee a higher salary than to provide him or her with this type of fringe benefit.

Draft an emergency-response plan long before any problems arise.

The saying goes that there are two sides to every story. Unfortunately, anyone searching for the story from the perspective of the Central Asia Institute, its board, or Mr. Mortenson in the week following the “60 Minutes” exposé was left only with a handful of short statements posted on the institute’s Web site and Mr. Mortenson’s blog and a transcript of an interview published by Outside magazine.

Although those statements were released within two days of the “60 Minutes” segment about the scandal, most readers were probably left feeling unsatisfied with the institute’s defenses, particularly compared with the widespread and voluminous criticisms of the charity’s operations. Even as the news media and public have come knocking with a loud bang for answers, so far the institute has responded with a whimper.

Charities that find themselves in the middle of a news-media nightmare should not underestimate the importance of strategic damage control.

Especially in today’s increasingly connected world, it is impossible to stop the fast pace and extended reach of information.

Time is of the essence, and public-relations situations like these demand quick thinking, rapid responses to questions, and reaction to eleventh-hour surprises—all of which can contribute to poor decision-making, especially for the inexperienced or unaware.

In these situations, charities should consider hiring a specialist who handles emergency public-relations responses.

Even before everything hits the fan, charity officials should consider devising an emergency-response plan. This can be especially important for an organization in which a key individual influences much of the public perception about the organization. Charities depend on public support and trust. Even if a charity comes out unscathed legally, a damaged reputation and loss of good will can be equally—if not more—damaging.

Emily Chan and Gene Takagi are lawyers in San Francisco who specialize in advising nonprofits.