Interest in corporate governance has waxed and waned for more than 50 years, driven by recurrent cycles of “big business” scandals. Against the backdrop of this battlefield is a seemingly more serene landscape of non-profit institutions. However, despite outward appearances, non-profits often present splendid dramas of spoiled and conflicting ambitions.
Non-profits consist of all organisations that provide services or products to a community or association without the purpose of distributing a profit. This innocent definition poses a myriad of trivial to major complications and implications. The definition is sufficiently broad to cover not only classic non-profits, such as private schools and universities, hospitals and charities, but also co-operatives and mutuals, non-governmental organisations and industry associations. Despite the stipulation of “no profit distribution”, the potential still exists for profit-like payments to be captured by various groups – for example management, workers, suppliers and board members – or that ineptitude may waste the volunteered time and money.
These dangers are surely cause for concern in the context of the massive outpourings of generosity in response to disasters, such as the donations to non-profits in the wake of the recent tsunami. How do donors know if their contribution will reach the needy? How efficient is the organisation to which they are giving? And how does the non-profit make decisions?
A standard treatment of governance for the profit organisation is the principal-agent model. For publicly traded companies, owners are the principals and employees (including the CEO) the agents. However, this model is highly contested in the sphere of non-profits. I isolate three constituencies in non-profits: donors, volunteers and employees, and customers. In an environment where donors are often members of boards, employees and volunteers have active voices in decision-making and “customers” care deeply about the rendered services, who is the principal, who is the agent and whose benefit should we care about?
Donors and taxes
The literature on governance for profit-seeking organisations can often be summarised by the advice to “follow the money”. However, this advice can seem ill-placed amid the many life-critical services provided by non-profits. For this reason, it is arguably all the more valuable to travel along this trail in order to understand how governance in non-profits works.
A starting place for tracing the money trail in a non-profit begins with the tax treatment of a donation. In many countries, donations are deductible for donors and can be offset against income. For example, in the US, the deductible is generally 100 per cent, whereas in India, it is usually 50 per cent. The tax deduction can be further leveraged by, for example, donating appreciated stock to a non-profit. In this case, the donor realises a tax deduction (by deducting the total donated value from income) plus avoids capital gains tax on the appreciated value.
Although the donor benefits from tax deduction, in many countries the non-profit itself does not gain directly from its non-tax status (an exception is the UK, where the Gift Aid scheme provides benefits for both non-profit and higher-rate taxpaying donors). Consider, for example, a non-profit in France, which must pay approximately 20 per cent value-added tax on non-salary expenditures. The organisation recovers the tax it paid on its purchases by treating it as an expense, pays the government a value-added tax and charges the consumer the price that includes the cumulative tax.
However, if the non-profit does not pay taxes, it can neither charge the consumer for the VAT nor recover the VAT it paid on its purchases. Here is the rub: since corporate income tax is on profits but VAT is on non-salary expenditures, it is easily conceivable that a non-profit in such an environment ends up paying more tax than a for-profit company. In general, all the talk about the unfair advantage of tax advantages of non-profit organisations obscures the basic observation: tax deductibility is more pertinent for the donor than for the non-profit.
The donor benefits even more if the effect of the donation is to lower prices for services that he or she consumes. For example, in most countries, private tuition or museum entry fees are not tax-deductible, because the public does not want to encourage private education or subsidise consumption of luxury cultural goods. If the effect of a donation is to lower tuition prices or to allow for membership benefits, such as free entry to museums, then non-profit status in this way represents a veiled instrument to provide tax deductibility for services that generally do not receive public favour.
The conventional wisdom is that a non-profit board should consist of those who give generously and have the time, competence and wisdom to donate. All too often, however, boards consist of neither major donors nor competent workers; or if they do, they consist of donors who are individually and collectively dysfunctional. Incompetence or negligence are commonly justified by the excuse that “We are volunteers after all”. Removal of board members is difficult for all the reasons found in profit businesses: election dates are staggered, voters are poorly informed and do not vote, and members are social acquaintances and, therefore, hard to evict.
Volunteers and employees
The importance of donations to non-profits varies widely by the type of organisation. In the US, donations make up 10 to 15 per cent of the budgets of educational and health establishments, but the vast bulk of the budgets of religious and charitable organisations. It is a logical corollary that a significant form of giving in the case of the latter organisations will also be “in kind”, namely through volunteer labour. If they are paid, many workers will accept lower wages than they would normally expect given their qualifications and experience.
Volunteers are heterogeneous in their motives. For cultural organisations, people may volunteer because they enjoy art or music and they want to be near the objects they love and to those who share their interest. Volunteers may also be motivated by political and social passions, by deep sympathies for the less fortunate, or by the desire to consort with the wealthy or “society”.
Regardless of whether the reward is found in the act of volunteering or in the acquisition of social status, volunteering is a donation of time. The difference is that a donation of money leads to the eventual parting of donor and gift, whereas a donation of time always accompanies the volunteer.
This generosity endorses a culture of giving that stands in opposition to the culture of business. It is passion that generates the governance problem in this domain. Since volunteers care, they may be too motivated. They will disagree and not be reconciled to compromise. Convinced they are right, they may obstruct or appeal to external donors for support. These are the people whose passion powers the organisation and whose passion can often destroy it.
Consider, for example, the International Federation of the Red Cross (not to be confused with the Swiss Red Cross). The Federation consists of 178 national societies whose general assembly elects a governing board. The board comprises the president, five vice-presidents, 20 national societies and the chairman of the finance commission, all elected for a four-year term. The board meets only twice a year and yet has the formal authority to govern the Federation in between sessions of the General Assembly. Speaking multiple languages, with few meetings, it cannot be a very effective instrument of governance. Nor can it legitimately respond to the arguments of national organisations that are far more knowledgeable of local conditions.
The Federation may appear an unusual case, but the issues are common to many non-profits. Consider the second example of Pratham, a trust set up by the government of Maharashtra, the municipal corporation of Greater Bombay, and Unicef, to provide educational opportunities for almost 200,000 children. It has a similar structure to the Federation, since it is also a federation of local organisations. The central company, consisting of 20 to 25 professionals, provides three services: it helps set up proper auditing and accounting processes; formalises objectives and establishes central programmes; and raises funds. Given that it can only succeed through the active participation of teachers, Pratham’s leadership has sought to decentralise power to local communities. It took the view that, while the top-down control of governments often lacks accountability, local control assures accountability by giving decision-making rights to communities.
The cost of this delegation is a lack of focus. With an estimated 70m Indian children either illiterate or semi-illiterate, there are overwhelming choices concerning where to spend the money. In this environment, passion speaks for a policy of a little everywhere; the governance problem is to persuade teachers and fieldworkers to focus resources to assure quality results without losing legitimacy for neglecting the poor.
This conundrum between passion and reason is echoed throughout non-profits: in hospitals where routine decisions are made regarding the allocation of vital resources; in universities that can no longer support all disciplines; and in museums that cannot serve all constituencies.
All too often, however, the real governance problems emerge as non-profits become richer. According to one school of thought, growth leads to capture by specialised employees, such as doctors in hospitals, teachers in schools, or professors in universities, who become the de facto principals given the very weak governance capabilities of non-profit boards. Thus, passion becomes rationalised, and the principals establish the professional rules by which to evaluate the agents, who happen to be themselves.
The customer
No doubt, many non-profits would protest to label those whom they service as customers, yet every one serves a community of users, and it is their welfare that should be the goal of governance. A non-profit receives its legitimacy from its claim to provide a trusted service. In many cases, it provides a service whose quality is hard to measure, such as education, health delivery or prison “care”. For-profit organisations are often not allocated these services because they are not trusted to maintain quality or to make the “right” decision if faced with a trade-off against profits.
The credibility of the non-profit is based around the compassion of constituents: donors who give money to a cause; volunteers who donate their services; or employees who provide high levels of commitment. Yet, as we have seen, passion engenders its own governance problems. In many cases, the social entities that are best placed to judge quality are the users or customers themselves.
Through her detailed studies of the management of water resources in California, Sri Lanka and elsewhere, Elinor Ostrom, a professor at Indiana University, concludes that the best-governed facilities utilise users as monitors. In an entirely different context, communities of “open source” computer programmers, such as Apache (which is organised as a non-profit foundation), rely upon users to write and debug code.
Another example is the Grameen Bank, a for-profit entity set up to provide microcredit loans to the rural population of Bangladesh. The loans are generally made through non-profit organisations or organisations owned by the borrowers. Founded in 1976, the Grameen Bank now has 4.35m customers, 96 per cent of whom are women. It is currently self-sufficient and does not accept donations. Despite charging close to market-rate interest rates, the bank has low rates of default due to intensive education and the use of co-operative groups to provide help, monitor finances and facilitate collection.
This model has been adopted by many other organisations, such as the Self-employed Women’s Association (Sewa), an Indian trade union that offers microcredit to more than 250,000 women through a co-operative bank.
However, relying upon local initiatives and monitoring for governance may not be enough. The Women’s World Banking is a non-profit financial institution that consists of a network of affiliates and partners, such as Sewa, that are engaged in microlending to women. Funding and advising the network are a few national governments, international institutions and qualified individuals. Implicitly, the network is engaged in diffusing self-regulatory guidelines by establishing success and performance factors, because local governance by mutual monitoring does not seem sufficient, at least to large donors.
Social entrepreneurship
The Grameen Bank represents a hybrid of for-profit and non-profit organisations and is more correctly an example of social entrepreneurship than the classic non-profit. It is easy to understand why social entrepreneurship is in vogue. The past decade has generated considerable wealth through venture capital and new businesses, and many of the founders of these businesses, keen to “give something back”, feel at home funding organisations that understand their language. At the same time, the many governance problems that plague non-profits are easier to control in for-profit companies pursuing social objectives.
Why should this claim be true? There are several reasons. One is that for-profit companies are constrained by a more tested body of law and regulations that require greater transparency. Economic performance measurement focuses the attention of the board and management on achieving self-sufficiency and establishes a culture that attends to efficiency and to the analysis of trade-offs among objectives. And perhaps most importantly, it encourages the employment of professionals, paid appropriately for their services, who are rewarded for innovative solutions to social ills.
These new hybrid organisations pose their own unique governance problems. The most obvious conflict is the potential that social entrepreneurial enterprises will attract capital investment donations aimed at improving social welfare, but that passion will eventually succumb to profit and permit “excessive” remuneration. Whether such an evolution is intrinsically bad so long as the “job gets done” will be the explosive question of this organisational form.
Summary
A surprising fact about non-profits is that they largely work without major scandals. One study found only 152 cases of alleged criminal wrongdoing by the primary fiduciary individual among US charitable non-profits between 1995 and 2002. Given the many governance problems noted above, this figure is either encouraging or a reason for scepticism.
There are many governance practices that should be standard policies among non-profits. In general, there should be a strong bias towards transparency. Since non-profits pursue social objectives, they are under greater moral obligation to reveal relevant information. Although non-profits often rightfully care about competition, the resistance to release information due to competitive pressures is relatively harder to justify.
Board members should be rigorously scrutinised and easily replaced should the need arise. It is particularly important that practices such as staggered elections are curtailed, and that there should be transparency around board appointments and expenditures. External board members who donate neither money nor time and competence should quickly exit. Boards should meet standards of competence in audit and compensation committees, or lacking such competence, they should pay for the appropriate counsel. They should establish quantitative and qualitative performance measures, tied to social objectives, and report the success annually.
The weakness of boards provides ample opportunity for management and specialised employees to operate without oversight. For this reason, it is critical to declare top management compensation relative to total compensation, and also to relate compensation to the achievement of strategic goals, such as educational or achieved health quality, or charitable payouts.
It is often forgotten that a primary purpose of governance is not simply control, but to provide inspiration with guidance. A great enterprise is marked by vibrancy at all levels, and the mark of a good governance system is a balance between control and inspiration, oversight and innovation. To some sceptical observers, it is surprising just how well non-profits generally succeed in delivering cultural, welfare, and co-operative services, despite many obstacles. Perhaps the governance advantage of non-profits is nothing other than the stubborn passions of wanting to contribute and to change the world for the better. In this case, the best metaphor for good governance of the non-profit is the sensitive plumber who installs a few pipes and regulators here and there without wasting a reservoir of passion on the kitchen floor.
Bruce Kogut is the Eli Lilly professor at Insead. A member of boards in Europe and India, he co-chairs the United Nations Economic Commission for Europe working group on corporate governance and is the editor, with Peter Cornelius, of “Corporate Governance and Capital Flows in a Global Economy” (Oxford University Press, 2003).
