TWO SYSTEMS OF LAW FOR CORPORATE GOVERNANCE: NONPROFIT VERSUS FOR-PROFIT

Henry Hansmann Yale Law School October 2006

Preliminary Draft This essay was first presented as the Waterman Lecture at the Vermont Law School, October 14, 2005.

I.

INTRODUCTION

The problem of corporate governance has been a conspicuous item on the agenda of public reform in recent years. Most of that attention has been focused on business corporations. But nonprofit firms have attracted attention as well. Some of this has been drawn by scandals, the most conspicuous of which actually preceded the Enron-era scandals of the business sector such as the scandalous behavior of William Aramony, CEO of United Way, and of Peter Diamandopoulos, President of Adelphi University. Some of the attention has also been drawn by the numerous conversions of nonprofit hospitals, insurance companies, and HMOs to for-profit status, which often resulted in a large fraction of the institutions value being captured by the for-profit acquirer. More recently, substantial scrutiny has been reflected on the nonprofit sector from the strong concern today with governance in business corporations. As one conspicuous example of the latter, the Senate Finance Committee has recently proposed a number of reforms to federal law that are designed to tighten up substantially the regulation of nonprofit corporate governance. Understandably, these proposals have raised concerns in the nonprofit sector, which has been busily preparing its own alternative proposals for corporate governance reform. The problems in the nonprofit and for-profit sectors are rather similar: selfdealing by those in control, and managerialism that leads to unresponsiveness. But the legal strategies that we use to control problems of corporate governance in the nonprofit sector are strikingly different from those we use to police corporate governance in business corporations. For business corporations, the relevant law is largely state law. Its the state business corporation statutes that are the basis of that law. Though this law is statutory at its base, it really doesnt have the character of a code. Rather, the key elements of the law are judgemade. The most important issues of corporate governance are dealt with under standards of fiduciary duty that leave broad discretion to the courts. The courts use this discretion to determine most of the operative constraints on corporate governance, and to refine and alter those constraints over time as seems appropriate. This body of law is enforced principally through private lawsuits brought by corporate shareholders or other interested private parties. For nonprofit corporations, everything is very different. First, the relevant law is largely federal law rather than state law. Although all states have nonprofit corporation statutes, theyre largely unimportant. Rather, the real corporate law of nonprofits is found in the federal tax code, which contains extensive provisions concerning nonprofit corporate governance. Second, as befits a tax code, the law takes the form of detailed statutory provisions that are refined over time, not through judicial decisions, but through detailed rules and regulations issued by the IRS, or adopted by the Congress as statutory amendments. Third, and

finally, the law is enforced, not by private lawsuits, but by suits brought by government prosecutors, and in particular by the IRS. The distinction between these two very different systems of enforcement isnt dictated by the nature of the organizations involved. It would be possible to control nonprofit managers using the methods we use for business corporations: we could rely on fiduciary duties set out in state nonprofit corporation statutes; we could develop that law primarily through judicially implemented standards rather than through codified rules; and we could enforce the law through private lawsuits brought by donors, beneficiaries, or other interested parties. Likewise, it would be possible to control managers of business corporations using the methods we use for nonprofit corporations: by relying on federal law rather than state law; by having detailed codification of the rules of fiduciary behavior, more or less as we have under the federal securities law now; and by having those duties enforced by actions brought by public prosecutors, such as the SEC or the Justice Dept, rather than by private lawsuits. In fact, thats largely how its done in Europe. Americans often compare the European approach to enforcing corporate law invidiously to our own. But in fact we effectively use the European approach in policing the managers of nonprofit corporations. This gives rise to two obvious questions: (1) Why have we chosen such different approaches to these two different types of corporations? (2) Have we chosen the right approaches, respectively, for nonprofits and for-profits? These are the questions I want to address here. Im not going to give definitive answers to either of these questions. Rather, in conventional academic fashion, Im simply going to try to frame the issues clearly, and offer some first thoughts on possible answers.

II.

MORE DETAIL

Before exploring the reasons for the different systems of lawmaking and enforcement, let me offer a few more details about these systems. A. Business Corporations

The basic law of business corporations is probably familiar to most readers. The basic substantive law of corporate governance is state law. The federal securities law, to be sure, plays an important supporting role. With a few exceptions, however, the securities law focuses mostly on matters of disclosure. Standards of conduct, and the rules for structuring corporations, are still largely governed by state law.

B.

Nonprofit Corporations

The law of nonprofit corporate governance, in contrast, may be less familiar. Though nonprofit corporations, like business corporations, are formed under state corporation statutes, the state nonprofit corporation statutes have not, as a matter of fact, been an important constraint on matters of nonprofit governance. Rather, the federal tax code has for many decades been the principal means of disciplining persons who create and control nonprofit corporations. In particular, federal law has imposed various governance standards on nonprofit corporations as conditions of receiving the two big tax benefits for which nonprofits can qualify -- exemption from corporate income taxation, and deductibility of contributions by donors to the organization. For a long time those federal nonprofit governance rules were pretty general. The basic rules against self-dealing transactions were largely enforced under the general rule of non-inurement thats a condition for tax exemption. The courts set the criteria for what was improper inurement on a case-by-case basis, more or less as do the state courts that deal with the duty of loyalty imposed by state business corporation law. This was a relatively loose and lax system. Not only were the rules vague, but enforcement was limited, in substantial part because the principal sanction that was available loss of exemption seemed draconian and often punished the organizations innocent donors and beneficiaries more than the particular persons who engaged in selfdealing. Then, in 1969, the governance rules were made much more specific for private foundations. Private foundations are, for the most part, nonprofits that are set up by a particular individual or family as a vehicle through which they make charitable contributions. The concern was that the donors, who often retained control over the foundation directly or indirectly, would draw improper personal benefits from them. The 1969 private foundation rules set up a variety of hard rules to prevent abuses, including clear statutory criteria for what constituted a self-dealing transaction. They also set up a series of statutorilydefined fines to be levied on managers and donors who didnt comply. Subsequently, in 1996, this approach was extended from private foundations to most other nonprofit organizations by means of the so-called Intermediate Sanctions rules. These rules define a class of excess benefit transactions essentially involving what we would typically think of as improper self-dealing and apply statutory fines to any insider who benefits from such a transaction, or who knowingly participates in approving such a transaction. Theyre called intermediate sanctions because the sanctions they involve are intermediate between the drastic sanction of revoking exempt status on the one hand, and on the other hand doing nothing. These intermediate sanctions rules have relatively little to do with raising revenue. Rather, theyre detailed rules of corporate governance. But they exhibit the difference that, as with other tax

rules, they are highly codified and are elaborated in detailed IRS regulations and rulings.

III.

THE RATIONALE FOR DIFFERENT SYSTEMS

So what is the explanation for these two very different approaches to corporate governance? As a basic approach, Ill take the decentralized system for business corporations as the standard, and ask why we dont use the same system for nonprofit corporations. In the process, however, Ill also ask whether weve got the right approach for business corporations. A. Private versus Public Enforcement

Ill begin with the question of enforcement by private litigation, since I think this is the most fundamental choice involved. 1. Who Would Sue?

Standing doctrine at present doesnt permit suits, in general, by either donors or beneficiaries of nonprofit organizations. Why do we have private suits for business corporations? Presumably because public officials wouldnt have the incentive or the knowledge to prosecute. Of course, shareholders lack the incentive, and often the knowledge, to bring suit in publicly traded business corporations. So we incentivize the lawyers instead. We let lawyers collect contingency fees. This makes lawyers the real parties in interest. If we were to have private suits for charities, it would presumably have to be organized the same way. This is because public charities are, for these purposes, like publicly held business corporations: individual donors or beneficiaries would seldom have an incentive to sue. We see this in the experience in Wisconsin and New Jersey in the past. Both states granted universal standing to beneficiaries. Yet there was subsequently virtually no litigation in either jurisdiction. So, though theres evidently great fear among charities that granting standing to private parties would open the floodgates to a mass of nuisance litigation, theres no evidence that this would happen. To get lawsuits, wed need to allow lawyers to collect fees. But that, of course, might succeed in opening the floodgates. So the question is, would private litigation get out of control so much that the costs would exceed the benefits? 2. Diffuse Objectives

The most salient difference between nonprofit and business corporations here is, arguably, the difference in their objectives. It isnt that one is dedicated to the public interest and the other to private interests. Rather, I think that the important distinction is that business corporations have a single clear goal the

maximization of share price. All shareholders share that single goal as their legitimate objective. The duty of corporate managers and controlling shareholders is to pursue that goal. And its often pretty clear what does and doesnt serve that goal which is, after all, measurable. This means that, when any given shareholder brings a derivative suit against corporate managers, his interests are probably shared by the other shareholeders too. More important, it means that a judge in a fiduciary duty suit has a clear standard by which to evaluate the conduct of the defendant corporate managers. Nonprofits, meanwhile, have no such clear single goal. Rather, theyre dedicated to a broad group of rather ill-specified goals that are all hard to measure. This means that different donors or beneficiaries might have different views of what goals should be pursued. Thus theres room for much more dispute as to whether managers are pursuing those goals, or pursuing them effectively. And this leaves open the possibility that many suits will be brought by involved parties, such as beneficiaries or donors, or perhaps just by selfinterested lawyers seeking remedies or recoveries for actions that other patrons of the organization might not find at all objectionable. Now one might object that this cant be a serious problem. There are two fiduciary duties imposed on those who control corporations: the duty of care and the duty of loyalty. The duty of care requires that managers not be negligent in managing the firm. The duty of care, in turn, prohibits self-dealing by corporate managers. But the duty of care is largely irrelevant; the business judgment rule largely rules this out as a concern even for business corporations. The only place it really applies is where directors or managers negligently approve selfdealing transactions by other corporate managers or shareholders. That is, it only applies where theres an underlying breach of the duty of loyalty. So its really only the duty of loyalty thats important today. And that duty has little to do with the ends the organization is intended to pursue. Stealing is stealing, whether the corporation you steal from is nonprofit or for-profit. So why should the enforcement methods be different for nonprofit corporations? In particular, one might argue, it really doesnt matter who the plaintiffs are. The important thing is just to prevent self-dealing transactions. But this is a bit too simple. It isnt always easy to decide what constitutes improper self-dealing. Moreover, whether a transaction involves self-dealing often depends on judgments about the kinds of measures that are helpful in promoting the organizations purposes. We see that in the recent Disney corporation litigation, where the issue was whether it was or wasnt in the corporations interest to hire Michael Ovitz at $100 million a year, and then pay him in addition a huge premium when he was fired a year later for poor performance.

Consider, for example, a case in which the accomplished director of a nonprofit nursing home wishes to relocate to another town where his wife has been transferred by her employer, and proposes to relocate the nursing home facility in that town so he can continue as its administrator. The board of the home, having been handpicked by that administrator, supports him. Some donors and patrons, eager not to lose the administrator, also support the relocation. Others particularly relatives of a number of the patients, fearful of the consequences of taking the patients further from their families -- oppose it. Should private parties be given standing to challenge the decision to relocate? Should they be able to seek damages from the board afterward if the decision is judged ill-considered and overly tainted with self-interest on the part of the director? Obviously this is a situation where your view of whether theres impermissible self-dealing depends a lot on what you think best serves the mission of the nursing home. So perhaps allowing private litigants to challenge such transactions is inviting an unresolvable mess in the courts, and perhaps a lot of room for attorney-driven strike suits as well. Still, Im not convinced that the courts couldnt sort this out, and dismiss the inappropriate cases at the beginning. 3. Experience with Private Litigation in Business Corporations

On the other hand, theres something else that leads me to believe that the benefits of encouraging private actions for breach of fiduciary duties in nonprofits might not be worthwhile. This is that the experience with private suits against the managers of business corporations is not, in fact, very promising. Theres little evidence that its had a beneficial effect. Empirical studies examining that litigation find that if we put aside cases involving corporate mergers and acquisitions theres virtually no hard evidence that shareholder litigation has led to meaningful remedies or reform in individual firms, or in the corporate sector at large. We must largely take it on faith that theres been some deterrence. So we must wonder if things would be better in the NP world. Maybe, instead, we should abandon private enforcement in favor of public enforcement for for-profit firms, just as we have for nonprofit firms. Of course, whether were talking about business corporations or nonprofit corporations, we dont want to put up a high barrier to private enforcement, however bad it may be, unless were sure that public enforcement will be better. Ill come back to this later. First I want to focus on another factor here: thats the question of whether the law of nonprofit corporate governance should be state law or, as it largely is today, federal law. B. State versus Federal Law

As we noted earlier, business corporation law is, at its base, state law. But theres principally just one state thats involved so far as large firms are concerned: Delaware. There is, however, no Delaware for NP corps. They

incorporate in the state of their headquarters, generally. Why? Probably because theres not much to choose among states. The law everywhere is pretty much the same, and pretty empty, particularly given the lack of precedent thats developed under the statutes. And here we see the interaction with standing doctrine. Without private litigation, we may not see much precedent develop. Of course, one could try to change this. If the relevant law were state law, perhaps thered be some differences among the states. But that might not be a good thing. Opportunism in founders or managers choice of the state of incorporation for business corporations is constrained by the preferences of shareholders. This is conspicuous for closely held firms, and though the issue has been the focus of debate for decades -- probably true to a substantial degree for publicly traded firms as well. But its not so clear that there would be a sanction for choosing weak state law in the case of nonprofit corporations. The only real sanction would be in the choices of donors (for donatively supported nonprofits) and customers (for commercial nonprofits). But it isnt obvious that those persons would ever become sufficiently aware of the state of incorporation to do something about it. Consequently, relying on state law, whether its enforced by private plaintiffs or -- as is generally the case now -- by the state attorneys general, might just press nonprofit corporations to reincorporate in states where the corporate law is particularly lenient concerning corporate governance. One solution to this is to rely on federal law. But another is to change our choice of law rule for nonprofits. Perhaps, for nonprofit corporations, we should abandon the internal affairs rule whereby a corporation effectively has free choice of the state whose law will govern the fiduciary duties of its managers. Instead, for nonprofit corporations, we might require that nonprofits incorporate in the state where they have their principal place of business. While this would remove one degree of freedom in nonprofit corporate governance, it may be a necessary step if we wish to avoid the complete federalization of nonprofit corporate law. 1. Choice of Plaintiff

If we continue to be reluctant to use private plaintiffs to sue managers over corporate governance issues, this offers another reason to prefer federal over state law. Most state attorney general offices are tightly constrained for resources, and too small to be able to develop sufficient expertise in an area like nonprofit corporate governance. Moreover, state attorney general offices are often quite conflcted politically, not wanting to offend important persons who are board members or donors of nonprofit organizations. So theres something to be said for having enforcement taken care of by the IRS or a similar federal authority that benefits from much greater economies of scale and thats less easily subject to political capture in individual cases.

But this raises the question of which federal department or agency is going to be in charge of the litigation. The IRS has great expertise, but also some odd incentives. It has a strong incentive to go after private foundations. Theyre a great vehicle for tax evasion. But the impact on the public welfare, taxes aside, is virtually nonexistent. In striking contrast, the IRS has no material incentive to go after conversion transactions, since a successful challenge is likely to reduce tax revenues. But there, in contrast, whats at stake for the public is large often a huge reduction in the resources invested in the nonprofit sector. A better choice might be the SEC. But one wonders whether the Congress would ever give the SEC sufficient resources. It doesnt even begin to have enough resources to go after business corporations, and with those theres a constituency for enforcement. With nonprofits, on the other hand, theres very little political payoff to enforcement. As a political matter, it may be easier to get some enthusiasm for policing nonprofit corporate governance under the idea that were stopping tax evasion than that were just stopping nonprofits from bilking their donors and customers. Consequently, if were going to continue to use federal officials to enforce corporate governance in the nonprofit sector, we have some hard choices. Neither the IRS nor the SEC is really ideally suited to the task. C. Judge-Made versus Codified Law

Weve said so far that, though the issue is debatable, there may be good reasons for relying on public rather than private enforcement in the area of nonprofit corporate governance. And, given this, there are good reasons for having that enforcement take place at the federal rather than the state level. This pretty much means, in turn, that the law thats applied needs to be federal law. But does it have to be such heavily codified law, such as that which were now accumulating in the tax code provisions dealing with nonprofit corporate governance? The answer may be yes. Where enforcement is primarily by public officials, theres strong pressure for codifying the law rather than leaving it open to highly flexible standards. Constraint of prosecutorial discretion seems the principal reason. We generally arent willing to give individual public prosecutors, or whole agencies or governments, the discretion as to whom to sue and on what theories. And this is particularly true of law at the federal level.

IV.

NONPROFIT MERGER AND ACQUISITIONS LAW

Weve observed that there are strong considerations pressing the law of nonprofit corporate governance to be, for the most part, heavily codified federal law thats enforced by federal officials rather than private parties. So its not surprising that this is the way the law is going. Moreover, these same

considerations have some application to business corporations too. And, in fact, were increasingly seeing the law of corporate governance for business corporations come to be regulated by codified federal rules enforced by federal agents. Sarbanes-Oxley is just the most recent and most conspicuous of many steps taken in this direction in recent years. Still, I think its a mistake to entirely abandon private enforcement in the corporate governance of nonprofit corporations. And the area where that seems to me most true is the area where we find the most salutary effects of private enforcement for the governance of business corporations. Thats in mergers and acquisitions. The real problems with nonprofit corporate governance arent, I think, in simple self-dealing transactions. Cases like Mr. Aramonys self-dealing at United Way seem pretty rare. Rather, the real abuses come with conversion transactions in which a nonprofit sells its business operations to a for-profit firm. These transactions became commonplace in the 1980s among hospitals, health insurance companies, and HMOs. And there was strong evidence that, in the course of these transactions, a very substantial fraction of the nonprofits assets would end up in private hands. Some states responded to this by stepping up enforcement, sometimes with the benefit of new statutes enacted specifically to target these transactions. But this approach brought two problems. First, the state AGs often were neither well enough funded nor sufficiently expert to manage this litigation with sophistication. Second, an unfortunate result of this litigation was to significantly chill conversion transactions in general. Why should a director of a nonprofit hospital approve a sale of the hospital to a for-profit firm, after all, if the result is that the director is likely to be sued for breach of fiduciary duty? Its better just to say no to all such possible transactions. Yet these conversion transactions themselves are often very good things. The health care sector, in particular, has many facilities that would probably be much more productively managed by a forprofit firm. And a sale of the assets involved would bring cash to the selling nonprofit that could be used to fund other activities in the nonprofit sector that would have much greater social benefit than simply capitalizing a hospital or an insurance company. The important thing is to encourage conversion transactions, but make sure that large amounts of money dont end up in the wrong hands when they take place. For this purpose, its better to let the transactions be challenged by private parties. And those private parties should be competing bidders for the assets, whether nonprofit or for-profit. It is, after all, competing bidders that are the plaintiffs in nearly all the big merger and acquisition cases involving for-profit corporations. And theres good evidence that this is an area where private litigation has done very good things for corporate governance in the business sector. This is an area where you dont have to worry about awarding attorneys fees to incentivize litigation. Competing bidders have all the financial incentive they need to challenge an effort by a nonprofit to sell itself too cheaply.

But wont private suits, like suits by state attorneys general, just cause nonprofit boards to refuse to consider conversion transactions at all? I have an answer: I propose holding nonprofit managers and boards of directors to a very high standard when faced with a proposal to purchase the firm. I wouldnt let them just say no, as is roughly the situation with business corporations today. Rather, Id hold them to a duty to give serious consideration to any proposal to purchase the firms assets. And Id give the prospective purchaser standing to sue to enforce this duty by bringing a fiduciary duty suit against the reluctant nonprofits board of directors. Whats more, I think that whats sauce for the nonprofit goose is sauce for the for-profit gander: Id happily impose a similar rule on for-profit corporations. But such an aggressive fiduciary duty rule is less important for for-profit corporations, where the authority of embedded managers can also be challenged in a proxy fight. In contrast, for nonprofit firms, we often have only fiduciary duties with which to control managers. So its important that we get them right. And the right approach may be: expanded public enforcement under federal law to handle matters of internal malfeasance, and expanded private enforcement under state law to handle mergers and acquisitions. Moreover, I think that this is, overall, a pretty good prescription for enforcement of corporate governance in business corporations as well. It might be a good thing if our two contrasting approaches to corporate governance one for business corporations and one for nonprofits were to converge in the middle ground.

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