NON-PROFIT GOVERNANCE.
FUNCTIONING, FAILING OR JUST A FORMALITY?
by
Samantha Meulenberg
A Master Thesis submitted in partial fulfilment of the requirements for the degree of
MSc Business Economics, Finance Specialization
AMSTERDAM BUSINESS SCHOOL
UNIVERSITEIT VAN AMSTERDAM
Date __________________________________________________ 7 July 2016 Thesis Supervisor_________________________________Dr. Torsten Jochem
STATEMENT OF ORIGINALITY
This document is written by Student Samantha Meulenberg who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
ABSTRACT
A thesis presented on the influential effects of non-profit governance on performance. The research explores the unique setting of non-profits and how traditional corporate governance systems are transformed to adapt to non-profit needs. The research seeks to identify whether existing governance constructs are achieving their function or failing to do so. The notion that governance in the non-profit realm is simply a formality is further investigated. Using U.S. IRS Form 990 data, five governance indices are created representing five features of non-profit governance. Similarly, six aspects of non-profit performance are identified and used as dependent variables in the examination. The study uses Ordinary Leased Squares (OLS) regression techniques as the main analyses, and further addresses endogeneity through Instrumental Variable (IV) estimation on two separate aspects of governance. The results allude to the inference that governance does in fact play an integral role in the performance of non-profits, however not in the hypothesized manner and not conclusively without study limitations. The implications from these findings are useful to non-profit organizations, donors, society and the economy at large and state and federal policy makers.
TABLE OF CONTENTS
Chapter I: Introduction ... 2
Chapter II: Relevant Context ... 5
Non-profit Organizations ... 5
The Non-profit Sector ... 6
Non-profit Governance ... 7
Legal Environment ... 9
Challenges Facing Non-profits ... 11
Research Questions ... 15
Chapter III: Literature Review... 17
Relevant Theory ... 17
Non-profit Organizational Performance... 23
Linking Boards, Governance and Performance ... 25
Research Focus and Hypotheses ... 29
Chapter IV: Methodology ... 35
Contingencies & Controls ... 35
Identifying Non-profit Performance ... 38
Measuring Non-profit Governance ... 48
The Intersection between Non-profit Performance and Governance ... 55
Addressing Endogeneity ... 63
Chapter V: Data ... 69
Sources ... 69
Stratification and Sampling Process ... 70
Descriptive Statistics ... 72
Chapter VI: Results and Discussion ... 76
H1: Agency Hypothesis ... 76
H2: Compensation Hypothesis ... 78
H3: Efficiency Hypothesis ... 79
H4: Long-term Stability Hypothesis ... 81
H5: Output Hypothesis ... 82
H6: Accounting & Transparency Hypothesis ... 83
Instrumental Variable Analyses ... 85
Chapter VII: Robustness Check... 88
Combined Governance Index ... 88
Alternative Measures of Non-profit Performance ... 90
Subsequent Non-profit Performance ... 91
Chapter VIII: Conclusion ... 93
Main Findings ... 94
References ... 100
Appendices ... 125
Appendix A: Variable Definitions ...125
Appendix B: Governance Indices Correlation Matrix ...137
Appendix C: Summary Statistics and Comparison to Population ...138
Appendix D: Regression Analysis Results ...142
C h a p t e r I
INTRODUCTION
“No subject provokes more heated debate in the non-profit world than that of governance” - Drucker (1990 p.8)
For more than 25 years the governance of non-profit organizations has been of interest to many scholars in fields of not only finance but accounting and economics alike. The non-profit sector is increasingly playing an integral role in the U.S. economy. List (2011) finds that from 1968 to 2011, growth in charitable gifts of money roughly doubled the growth of the Standard & Poor’s 500. With the absence of shareholders overseeing management and organizational wide activity in the non-profit realm, the responsibility of governance systems via their guiding and monitoring role is even more crucial. Moreover, there is a widespread societal logic and expectation of non-profits to act morally, adhere to their charitable purpose and fulfil mission objectives to the best of their abilities. This external societal pressure emphasizes the greater need for non-profits and their management to act in the interests of the organization and on behalf of its stakeholders. Meeting these key duties is essential for non-profits long-term success. These distinctive elements within the non-profit sector call for a modified and unique governance system which must be adapted to a non-profit setting.
Within non-profit literature, the topic of governance is easily the most controversial and murky area of research. A plethora of theoretical studies attempt to explain the phenomena of where, who and why individuals serve on non-profit governing boards. Similarly in more recent literature, how the composition of the governing board influences the direction, activity and subsequent performance of non-profits has gained increasing attention. The non-profit sector is ever changing and adapting, creating the constant need for extended research on non-profit governance. Recent trends depict the non-profit sector as becoming more ‘business-like’ and adopting for-profit strategy and business-models. There is
additionally growth in for-profit firms to take on traditional non-profit activity, and vice versa, with non-profits increasingly taking on commercial for-profit activities. As a side effect recent public scrutiny has heightened, particularly following the use of government funds and growth in delivery of public services by non-profits (Cornforth and Brown, 2013). The legal context of non-profits is also adapting to these industry changes, driving new regulation and forcing non-profits to become more accountable and transparent. Some requirements, such as those under the 2002 Sarbanes Oxley Act are traditionally targeted at for-profit enterprises. However, some capture non-profit organizations under their jurisdiction, with the side-effects still unclear on these organizations. Nonetheless, innovation in governance in the non-profit sector is gaining traction. This research seeks to examine the effects of varying features of governance on the performance and ‘success’ of non-profit organizations. Are contemporary non-profit governance systems functioning, failing or simply a formality?
The governance features identified are categorized into five groupings including Governing Policies, Firm Independence, The Governing Board, Compensation Policies and lastly Accountability and Transparency. Unlike related literature, this analysis considers a variety of aspects at play in governance, not just the role and composition of the board. The data harnessed stems from the U.S. Internal Service Revenue (IRS) Form 990s, and is of recent interest due to the newly mandated (since 2008) ‘Governance, Management, and Disclosure’ section detailing governance and management information previously unavailable to the public. A sample of 450 non-profits with three firm-year observations from 2011 to 2013 and a relatively large asset base are randomly selected from the IRS 990 database.
A hurdle encountered within this research is that of defining non-profit performance. Since non-profits do not operate for profits and to maximize shareholder wealth, long-standing corporate performance measures cannot simply be transferred to the non-profit realm. Non-profits are characterized as having some sort of social orientation and operate for the benefits of their desired beneficiaries or members. They simultaneously juggle a magnitude
of stakeholders and must cater to a variety stakeholder needs. The type of stakeholder who takes interest in a particular non-profit, originate from the non-profits charitable purpose and reason for existence. Many other factors influence non-profit stakeholder groups, such as their predominant source of revenue, if they are established for the purpose of specific members, whether they partake in large fundraising schemes requiring a number of volunteers or whether they concentrate on and target their efforts for a particular niche of the population such as those who belong to a religion, suffer from the same illness, study in the same field or participate in the same interest activities. The performance measures in which these parties are interested in vary. As a result the metrics used to capture ‘success’ and performance in this study cover a range of aspects including, agency costs, executive management compensation levels, efficiency, long-term financial stability, charitable giving and public support levels. Unlike related literature in non-profit governance, this study takes on multiple views of non-profit performance and includes some alternative metrics aside from financial, to capture performance.
Finally, to substantively add to relating literature on this topic, governance is seen to be unique to each organization. Thus this study does not presume an ultimate measure of good governance, but seeks to verify it via exploration and research. This analysis uses a series of theoretical underpinnings discussed over recent decades in non-profit literature as the basis for the hypotheses and resulting empirical examinations. The following paper is detailed as follows; a brief overview of the contextual setting of the non-profit sector, a literature review discussing non-profit relevant theory, defining performance and related research, the methodology implemented to facilitate this analysis including definitions of the contingencies, performance and governance variables, an overview of the data, a discussion of the main findings and robustness check, and to conclude a discussion of the main limitations within the study and suggestions for further research.
C h a p t e r I I
RELEVANT CONTEXT
This section enacts as a guide to non-profit organisations, the current economic influences in the non-profit realm and the governing constructs manifested from these unique elements. The latest issues and difficulties which face the non-profit realm are brought forward. The side effects and subsequent questions from these concerns are translated into the research questions addressed in this study.
Non-profit Organizations
The first important distinction to make regards the definition of a non-profit organisation and the entities studied. Firms with non-profit status and tax-exempt designation are two different classifications. The granting of non-profit status is done by the U.S state, while applying for tax-exempt designation is granted by the federal government through the entity’s filing of a Form 990 to the Internal Revenue Service (IRS). To apply for federal tax-exemption, you need to have been granted profit status first, however not all non-profits are eligible to be tax-exempt. Furthermore, there are many organizations that are engaged in activities and perform the same services as tax-exempt organizations but remain unincorporated. This study captures entities under tax-exempt designation. Therefore, some unknown but apparently quite large numbers of non-profit organizations (Smith 1997a, 1997b) are not included in this (or any) database founded on the Form 990’s for tax-exempt organisations.
The term non-profit organisation referred to in this study captures entities classified by the IRS as “501(c) tax-exempt non-profit organisations”. An immense number of organizations qualify under this definition including churches, soup kitchens, charities, political associations, credit unions, business leagues, fraternities and sororities, sports leagues, colleges and universities, hospitals, museums, television stations, symphonies, and public
interest law firms. The most common type of tax-exempt non-profit falls under category 501(c)(3) for Charitable Organisations, with 73.57% of the sample comprising of these non-profits. These differ from all the others for two reasons, firstly donations made to 501(c)(3)s may be deductible from the donor’s taxable income as charitable contributions, and secondly 501(c)(3)s are eligible to receive foundation grants.
In general, there are three fundamental and distinguishing characteristics of non-profit organisations. Firstly, non-profit organisations cannot be owned via shareholders or other traditional corporate constructs. Executive management therefore evade market disciplines as the market for corporate control is non-existent in the non-profit sector. Because of this detail, it is commonly argued for-profit corporations outperform their non-profit peers in terms of efficiency. Secondly, non-profits are orientated towards the accomplishment of social objectives as part of their mission statement (Oster 1995; Brown and Slivinski 2006). Whether via activities carried on by the organisation itself, or through supporting other entities, non-profits essentially distribute their raised revenues to undefined beneficiaries to support their charitable purpose. This is in direct contrast with their for-profit equals, whose main goal is to maximize shareholder wealth. Furthermore, as non-profits serve some public purpose, they are often actively supported by the state through favourable tax treatments or public funds (Salamon and Anheier 1997). Because of this and the lack of shareholder ownership, non-profits are consequently bound by a legal non-distributional constraint (Hansmann 1980). They cannot distribute surplus revenues as profits or dividends but must reinvest them into the organization to ensure mission accomplishments (Sandler and Hudson 1998).
The Non-profit Sector
Historian Alexis de Tocqueville identified the non-profit sector in the U.S. with its myriad of organizations and associations as one of the most vibrant and distinctive features of American life. In Salamon (1992 p.3-4)’s view, the non-profit sector “contains some of the most prestigious and important institutions in American society… it engages the activities
and enlists the support of literally millions of citizens, providing a mechanism for self-help, for voluntary assistance to those in need, and for the pursuit of a wide array of interest and beliefs… this sector has helped give rise to a distinctively American version of the modern welfare state”. Despite its name, the non-profit sector as a whole represents a major economic force that controls billions of dollars in property, assets, and investments, provides and purchases goods and services, offers employment and creates new job opportunities (Wing, Pollack and Blackwood, 2010). For instance, the non-profit sector contributed an estimated $905.9 billion to the U.S. economy in 2013, contributing to 5.4% of the country’s gross domestic product (GDP). 25.3% of U.S. adults volunteered with a non-profit organization in 2014, contributing an estimated 8.7 billion hours (Current Population Survey’s Volunteer Supplement). The non-profit sector clearly plays a dynamic role in American society subject to not only economic consequences but also a heightened ethical responsibility. Sullivan (2002) estimates that 89% of Americans give to at least one charitable cause per year, illustrating a vast scope of stakeholders and judgment the non-profit sector is accountable and subject to.
Non-profit Governance
The term ‘Governance’ has its roots in a Latin word meaning to steer or give direction. To give direction or steer the interests of an organization, one must first decide the firm direction, how one can guide the organization on that path, and who will ensure that path is followed. This can be achieved through a governing board of directors overseeing the activities and direction of an organization. Early on, observers of non-profit organizations viewed governance as a general term for describing the governing actions of the board. With the IRS deeming the governing body to bear the ultimate responsibility for setting ethical standards throughout the organization. However, observing the governing board alone is not sufficient to capture other aspects of governance at play. The board determines the direction of the organization and guides it through its lifetime. The mechanisms in which it does so, reinforces the movement of the non-profit in the right direction. These policies and procedures integrated into each level of operation are therefore an integral
aspect of governance which must be considered. The assortment and efficiency of such policies varies across non-profits and essentially reflects the method of governance adopted by the board of directors. The definition of governance in this research subsequently encompasses both the structure of the governing board and the array of policies and procedures in place to help guide the organization.
In what direction the organization is being steered is what differentiates these entities from their for-profit counterparts. The purpose of non-profit organizations is clearly outlined in their mission statements, and tends to have a social, ethical or ‘greater-good’ orientation. On the other hand, the for-profit realm is characterized by a devotion to profit and maximizing shareholder wealth. According to Hansmann (1980), non-profits tend to behave more responsibly towards stakeholders than their for-profit equivalents, who are incentivized to do what is most profitable rather than what is considered most responsible. For-profit incentives simply do not translate into the non-profit realm, as the non-profit approach of governance is tainted with heightened ethical concern. Complementary, governance is frequently defined in terms of the economic interests of the participants. Corporate governance in the for-profit realm aims to protect shareholder value and restrain opportunistic behaviours (Daily, Dalton and Cannella, 2003). Dissimilarly, the function of non-profit governance is to protect charitable assets for the welfare of its beneficiaries and public stakeholders. Most commonly, it is argued that the function of the non-profit board is to promote the mission and, in doing so, it has responsibilities to a range of stakeholders including donors, clients, the public taxpayer, and even the staff (Oster, 1995).
The ultimate utility of governance is its ability to reduce the principle-agent problem when agent’s interests differ from principles. It can do so by decreasing asymmetric information or incomplete monitoring. Much governance research has centred on the efficacy of such mechanisms, such as providing sufficient oversight and monitoring activities in order to protect stakeholder interests and value from opportunistic and self-serving behaviour (Huse, 2007). Directors may want to gain reputations or monetary value from the non-profit entity,
therefore undertake activities which serve their self-interests but may not entirely align with the non-profits charitable mission (Glaeser 2003). Actives which gain such suspicions include stealing the companies’ money, technology or business information, granting themselves excessive compensation or other perks, taking on excessive risk, loafing or shirking responsibilities, engaging in ego trips that destroy money and using insider knowledge to derive personal benefits. These actions result in severe agency costs marring the potential utility of the organization to reaching mission accomplishments. Governance’s primarily utility is to restrain these costs from occurring.
Common folklore is that the board of directors should bring to an organization the three W's, wealth (donations and fundraising), wisdom (monitoring and oversight), and work (operational duties), a much broader set of responsibilities than with for-profit boards. The third W plays an extended function in non-profit boards, who must additionally assume the supervision role of principles, which are typically present in the for-profit realm as shareholders. In the absence of important governance mechanisms like monitoring by external owners or performance based pay, other mechanisms like regulation, reputation and transparency come to the foreground. Consequently the purpose of governance plays a doubly as important role in protecting the non-profits charitable assets and aligning the interests of management with the organizations mission. This research conclusively summarizes Harris, Petrovits, Yetman (2014 p.1) definition of non-profit governance as “the set of internal and external mechanisms designed to ensure that managers are working to fulfil their organizations charitable mission and fiduciary responsibilities, and in turn to minimize the misuse of charitable assets.”
Legal Environment
Collectively, state regulators represent the primary governance authority over non-profit organizations in the United States (Fremont-Smith 2004). Oversight is by the attorneys general of state, and state specific laws which recite the usual requirements of bylaws, regular meetings, elections of officers and other old standards. A primary objective of
existing state trust laws is to detect and prosecute instances of asset theft and asset misuse. Many states attempt to achieve this through the implementation of governance and accountability regulations. California stands out for having enacted higher governance requirements under its Nonprofit Integrity Act of 2004. For large non-profits with gross revenues exceeding $2 million per annum, they must have a separate audit committee, annual audited financial statements, and the directors or a board committee to determine the CEO’s and CFO’s compensation is ‘just and reasonable’. Several other states also impose some requirements usually requiring audited financial statements.
Federal jurisdiction over non-profits begins with the 1974 ‘Sibley Hospital’ Case, where Judge Gessell clarified the standards of legal responsibilities of non-profit boards that are still applied today. Those responsibilities are summarized as the concepts of care, loyalty and obedience. “Care” relates to boards paying attention and exercising due diligence in monitoring the organizations finances and supervising the actions of its management. The duty of loyalty means that members of the board put the interests of the organization above their own personal financial interests or that of another organization with which they may also have a formal relationship. “Obedience” requires that the board makes sure that the organization is complying with the law and, in addition, that any decisions or actions taken are consistent with the organizations mission and governing documents.
The federal government via the IRS has recently adopted a more stringent governance role and gained increasing power over the years. IRS regulations require that charitable non-profits may not be “operated for the benefit of private interests”. This prohibition is the foundation of the “public benefit” requirement, and the legal, as well as ethical, guiding principal for all charitable non-profits. Before 1996, this was the IRS’s only jurisdiction over non-profit organizations and could only punish disobedient entities by completely revoking their tax-exempt status. Today the IRS can impose intermediate sanctions, that instead of penalize the non-profit organization, penalize the individual who benefit from improper transactions. Generally the IRS focuses on transactions involving payments to key vendors
and compensation of officers and directors, stating “executive compensation continues to be a focus point in our examination program”. According to Treasury Regulations section 53.4958-4(a), an excess benefit transaction generally includes “any situation in which an individual or entity received an economic benefit from a tax-exempt organization that exceeds the value of the benefit provided, encompassing payments to key vendors”. A public charity must also not “provide to its leadership more than reasonable compensation, as measured against the amount that comparable organizations would pay for comparable services in comparable situations” (IRS 2004).
Lastly in the wake of corporate governance scandals in the early 2000s, including the demise of Enron and WorldCom, the Sarbanes-Oxley Act was passed in 2002. Two provisions of this act apply to non-profit organizations, including those regarding the destruction and retention of documents and protection for whistle-blowers. As a result of the Act (and questions posed on the IRS Form 990) most non-profits are now aware of these regulations of having a board-approved whistle-blower protection policy and a document retention and destruction policy. However surprisingly, only approximately 50.78% of the sample indicates having a whistle-blower policy and 59.58% of the sample indicates having a document retention and destruction policy.
Challenges Facing Non-profits
Enduring challenges confronted by the non-profit sector have shaped and influenced many issues which relate to non-profit governance, making them an important backdrop for this study. Non-profits share many conventional agency problems with their for-profit counterparts. However in the non-profit realm, the principal is not an external owner, but the organization as a whole, or in a more abstract sense its charitable purpose, which suffers from agency problems. The non-profit is marred by agency issues if individuals or management have divergent self-interested motivations ahead of the organizations charitable purpose. A Washington Post analysis of IRS 990 filings from 2008 to 2012 found more than 1,000 non-profit organisations indicating they had discovered a “significant
diversion” of assets, disclosing losses attributed to theft, investment fraud, embezzlement and other unauthorized uses of funds. One of many cases demonstrating blatant abuse of non-profits tax-exempt status and charitable assets is that of American Bureau of Shipping. The non-profit was accused of lavishing its executives with multimillion dollar pay packages and perks; and purchasing an offshore hedge fund in the Cayman Islands. A misuse of charitable assets can also occur through excessively high executive compensation. One reported example is that of two brothers and top executives of a Medicaid-financed non-profit organisation. They faced significant scrutiny for earning nearly $1 million a year in pay, driving state funded luxury cars and passing their children’s tuition bills onto the non-profit group.
A unanimous struggle which over 90% of the non-profit sector endures is the difficulty in recruiting adequately skilled and qualified management who are engaged in the non-profits mission. A recent study of over 5,000 non-profit organisations in the U.S. revealed that 70% report difficulty in finding qualified top management and 20% report it very difficult. Similarly, non-profits are often challenged when it comes to ensuring not only management but also the governing board has the right skills to fulfil its responsibilities (Spear, Cornforth, & Aiken, 2009). Larcker, Donatiello, Meehan and Tayan (2015) find that too many are not engaged within the organisation and do not understand their obligations. Most governing boards lack formal governance structure and processes and fundraising is seen as the central obligation. Above all, Larcker et al. find that most governing boards members are satisfied with the performance of their top management and of the governing board as a collective. This presumes that non-profits struggle to find adequate individuals to govern the activities and management to guide the orientation, of their organisations. Moreover, that these same individuals are ignorant to their inabilities. Commonly Chelliah, Boersma and Klettner (2016) interview governing board members about the prerequisites required to fulfil their positions. They found the process through which people become members, as dictated by the constitution or policies, resulted in a limited pool of candidates which limited the range of skills represented on the board.
Competition is also an undoubtable challenge within the for-profit and non-profit realm alike. It has been estimated that more than 90% of non-profits currently in existence have been created in the last 60 years, and every year tens of thousands new non-profits are granted U.S. tax exempt status (Reich, Dorn and Sutton, 2009). Competition amongst other non-profits exists in visibility, charitable donations and volunteers, customers or clients and also for talent (including management and board members). Notably, more and more non-profits have turned to the market to seek revenue through commercialization and earned income initiatives (Grønbjerg, 2001; Guo, 2006) leading to additional competition in for-profit activities. Conversely, the operations undertaken by the non-for-profit sector are not exclusive to non-profit organizations. In the mid-1990s welfare reform legislation opened up the opportunity for private firms to get involved into what many consider to be non-profit markets. As a result, an overriding concern is the increased competition from for-profits in traditional non-profit fields (Salamon, 2002). The overlapping of activities in the for-profit and non-profit sectors highlights the most significant implication of the competition challenge, which is increased pressure to become more “business-like” via for-profit competition, i.e. adopting activities “generally understood to be those characterized by some blend of profit motivation, the use of managerial and organization design tools developed in for-profit business settings, and broadly framed business thinking to structure and organize activity” (Dart, 2004 p.294).
The fact that individuals and entities voluntarily choose to support the non-profit sector, signifies a certain level of public trust in these organisations. Frumkin (2002) describes how simply being a non-profit is a way to build trust, legitimacy and public confidence as they are believed to be acting for the good of the public. However the legitimacy of an organisation can be broken with the slightest negative publicity, as demonstrated by some very public cases of charitable organizations mismanaging entrusted resources (Fremont-Smith and Kosaras, 2003). This also leads to the detail that non-profits are competitive amongst each other for public support and must prove their legitimacy over their peers. Increasingly these organisations are pressured to become more transparent in their
operations and to ‘open up their books’. Additionally they are questioned more frequently on how they make a difference rather than just being a passive and supportive helping hand. The effects of this legitimacy and accountability challenge are placed in the hands of the governing board, who are pressured to demonstrate their trustworthiness and bear the responsibilities of increased accountability.
Aligned with the pressure of accountability and legitimacy, is the stresses of non-profit organizations to be more effective and to demonstrate that effectiveness (Salamon 2002), specifically in short-term results. A common notion is that no one “gives” to non-profits, rather donors are investing in an opportunity to make a difference, and when they do, they expect organizations to demonstrate their impact on their charitable mission. However, non-profit effectiveness is riddled with controversy, including debates about the primary factors that constitute organizational effectiveness and questions about validity of measurements (Forbes 1998; Herman & Renz 2008). The board of directors are additionally short-term focused due to the public’s desire to see immediate impacts. There are difficult trade-offs when investing for the future, but if a board fails to do so, the corporation’s likelihood for survival and relevance are threatened. Non-profits have little choice but to attempt to address these challenges in order to meet public demands for performance and short-term returns.
Complementary, the non-profits focus to meet public demands is segregated across a magnitude of stakeholders. Unlike a commercial entity whose aim is to create profits for shareholders, a non-profit organization may have several competing aims for a variety of stakeholders. A board will have to choose among the needs and desires of different groups of beneficiaries, funders and managers. For example, donors can impose specific limitations on their donated funds for spending on designating activities, which may not be in the interests of all beneficiaries. This forces non-profits to ‘go where the money is’, thereby creating a situation where donor dependency can undermine the organization’s mission (Alymkulova and Seipulnik, 2005). Furthermore, balancing of stakeholder interests is
identified as one of the key challenges for non-profit boards in non-profit literature (Dawson & Dunn, 2006; Spear et al. 2009; Young 2011). A recent study of non-profit challenges discovers that many organisations indicate that the diversity of stakeholder groups and their differing expectations pose serious challenges for non-profit organisations (Chelliah, Boersma and Klettner, 2016). One interviewee explained the main challenge related to their stakeholder group is “Primarily the diversity of it. It is a constant challenge for this organisation to identify what business we are in and what our members and stakeholders expect of us, and how to respond to that. Our job is to identify that our stakeholders are diverse in their expectations and can change almost on a daily basis, but certainly on a weekly basis; to make prioritising decisions and strategic decisions about what we actually do and how we respond to our members and stakeholders’ expectations; what work we can do; and how much they have to pay for it.” (Chelliah et al. 2016, p.17)
Taken together the implications of these critical challenges, including the importance to mitigate the misuse of charitable assets, source skilled management and governing board members, maintain resources and visibility competitively, uphold the integrity and accountability of the agency, ensure short and long-term financial sustainability, whilst also meeting diverse stakeholder expectations are all governance related issues. Hence, these challenges provide a context and starting point for guiding this research’s focus on how governance and performance are uniquely interconnected in the non-profit realm.
Research Questions
The non-profit sector is clearly faces its own unique challenges, and founders, beneficiaries and the general public need assurance against them, particularly organizational charitable misconduct, which can damage the reputation of the entire sector. The governance function has long been considered a facilitator to tackling this challenge and an integral factor in non-profit success (Renz 2011), however as Glaeser (2003) discovers, the governance structures in the non-profit realm have been labelled as being much weaker relative to their for-profit counterparts. Thus outlining the driving motivation of this study. As alluded to by the
research title, this study address the questions of how governance plays a role in the performance of non-profit organizations. Is the non-profit governance construct fulfilling its function in reducing agency costs, increasing public legitimacy and ultimately maximizing chartable mission accomplishments? Or is it blatantly failing to address these issues altogether, turning non-profits into pencil-sharpening, box-checking bureaucracies with no energy left to actually pursue their charitable purpose? Or is it merely formality, adopted out of obligation to depict a certain ‘ethical’ imagine of the organisation, but viewed with no other value-adding purpose?
C h a p t e r I I I
LITERATURE REVIEW
The following section guides the pathway through existing theories attempting to explain the determinants of non-profit success and the broad and controversial debate on how to capture non-profit performance. Finally the link between governance and these elements is summarized and made clear, whilst accompanied by the research hypotheses.
Relevant Theory
The most significant and empirically tested theories in non-profit governance literature are outlined below. Stakeholder and agency theory together explain how multiple stakeholders can substitute as principles in traditional for-profit agency-principle relationships. Alternatively, stewardship theory provides a contrasting perspective to this notion, suggesting agents already act in the interests of principles. Resource dependency and intuitional theory outline other factors contributing to non-profit governance quality by explaining other determinants of organizational direction and activities. Finally, conformance and performance theory inter-relates these concepts and outlines the underpinning theory justifying this researches direction and hypotheses on non-profit governance.
Stakeholder Theory
The need to involve stakeholders of non-profit organizations in governance processes has been increasingly recognized in recent research (Freiwirth, 2013). In these cases, stakeholder theory is relevant to governance, as it states that the board’s role is to mediate among stakeholders and balance their interests (Freeman & Evan, 1991). The term stakeholder refers to “any person or group that is able to make a claim on an organization’s attention, resources or output or who may be affected by the organization” (Lewis, 2001, p. 202). In a recent study on non-profit organizations, Van Puvelde, Caers, Du Bois and Jergers (2012)
identify donors, consumers, clients, and members as principals for these organizations. Stakeholder theory posits that by including diverse stakeholders on boards, organizations are more likely to address broad societal interests rather than the interests of a single group (Hung, 1998). Furthermore, Hill and Jones (1992) suggest argue that the principal–agent relationships can be seen as a sub classification of the more general class of stakeholder relationships. Therefore the stakeholder theory perspective shows the importance of a governance framework considering multiple principals or stakeholders in an agency-principle relationship.
Agency Theory
In line with for-profit organizations, most non-profit organizations are characterized by the separation of ownership and control. The principal–agent framework describes a principal– agent relationship as “a contract under which one or more persons (the principal[s]) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent” (Jensen and Meckling, 1976, p.308). Agency theory suggests that agents and principals are rational, behave opportunistically, suffer from information asymmetries and have (to a varying degree) conflicting goals (Fama and Jensen, 1983). However, a key limitation of agency theory when applied to a non-profit organisation is that it is not clear who the principle is, hiring the agent. The goals between “the owners” of a non-profit and its agents cannot be defined as conflicting if they have no clearly defined owner, and answer to multiple stakeholders. Hence, assessing whether mangers are indeed fulfilling the owners expectations becomes difficult (Miller 2002).
According to stakeholder theory, the ‘owners’ of a non-profit are interested parties who have some sort of interest or investment in the organization and whose utilities are affected by the non-profit’s activities or the lack thereof (Jegers, 2008). Or alternatively and all encompassing, the charitable cause itself in which the organisation was established for. Previous non-profit literature has focused predominately on internal stakeholders in agency
problems of non-profit organizations. However, non-profits are usually also accountable to external stakeholders such as their donors and clients. In support, Hill and Jones (1992) argue that these kinds of stakeholder relationships can also be modelled as principal–agent relationships. Furthermore, with a lack of definable ownership, there is an absence of ‘principles’ overseeing corporate decisions made by agents in non-profit organisations. Past research claims that the non-distribution constraint brought about by a lack of definable ownership is the cause of agency problems that leads non-profits to be less efficient than for-profits (Alchian and Demsetz, 1972; Fama and Jensen, 1983). Ultimately agency problems are not only of a different nature typically characterised in for-profit firms but are more prevalent in the non-profit sector.
A divergence in the interests of managers and the non-profits mission, causes managers to take actions that are costly to the organisation and non-profit stakeholders. Such actions are most often characterized as the consumption of perquisites on the job (such as lavish office equipment), but also refer to other means by which managers may exercise discretion to benefit themselves at the non-profits expense, such as shirking responsibilities. Evidently the mission and objectives of non-profit organisations are at risk from managers pursuing their own interests or not managing the organisation efficiently and effectively. A key role of the governing body is therefore to monitor management and ensure their compliance in furthering the organisation’s objectives. Agency theory suggests developing formal control (and incentive) mechanisms and the assignment of a formal monitoring role to the governing board to handle these conflicting interests.
Stewardship Theory
In contrast to agency theory, stewardship theory (Donaldson and Davis, 1991; Muth and Donaldson, 1998) is grounded in a human relations perspective (Hung, 1998) and assumes that in general managers are motivated by more than their own narrow economic self-interest. It theorizes that even when the interests of management and stakeholders are not aligned, the agent can gain more benefits such as achievement, affiliation, and
self-actualization by acting in the principal’s interest (Davis et al., 1997; Tosi et al., 2003). Or it alternatively assumes that managements goals are coincidently perfectly aligned with those of the stakeholders (Sundaramurthy & Lewis, 2003). In the non-profit realm this is even more plausible, as Thomsen (2014) argues non-profit managers and board members are less financially incentivized than their for-profit colleagues. Likewise, Inglish & Cleave (2006) recognize members of non-profit organizations, be it management, the governing board or volunteers are motivated by non-monetary means. Their motivations could include enhancement of self-worth, learning through community, helping community, developing individual relationships, unique contributions to the board and self-healing. Hence, stewardship theory hypothesizes managers want to do the best for the organization, and will act as effective stewards of the organization’s resources. A flaw of stewardship theory is that it assumes agents have a high identification with the mission of the organization, but as Larcker, Donatiello, Meehan and Tayan (2015) find, one of the major issues facing non-profits is that many members of management do not understand their obligations, and have low engagement within the organization. Additionally, Caers et al. (2006) suggest that stewardship theory should not be viewed as an opposing framework, but more as a limiting case of agency theory. As a result, this theory is not assumed as a major determinant of either non-profit success or governance in this research.
Resource Dependency Theory
A central principle of Resource dependency theory is the notion of resource scarcity, resulting in multiple organizations competing for the same or similar sets of limited resources (Pfeffer and Salancik, 1978). Non-profits are significantly dependent upon the flow of resources from external providers and the ability to raise funds. Attracting resources is crucial for any non-profit wishing to succeed and sustain its mission-related activities (Froelich, 1999; Palmer and Randall, 2002). According to Miller-Millesen (2003 p. 533) “Resource dependence theory is the dominant theoretical approach used to guide research efforts focused on non-profit boards of directors”. The strong focus on governing boards dates back to early work by Zald (1967, 1969) and Pfeffer’s (1978). From a governance
perspective, organizations ought to find and bring “resource-rich” members into the organizations (Boyd, 1990). For instance, large donors are typically on the governing boards of non-profit organizations. In 2006, Warren Buffet pledged $30 billion to the Bill and Melinda Gates foundation and was subsequently appointed to its governing board. These early studies suggest that what matters is the type and composition of people governing the organization. Finally, Hillman, Withers and Collins (2009) recognize that much promise lies in integrating other theoretical lenses, such as institutional theory, with resource dependency theory to explore and provide new insights into how organizations interact with their environments.
Institutional Theory
The IRS (2008) makes explicit that “the public expects a charity to abide by ethical standards that promote the public good”. This notion links closely with institutional theory in the non-profit realm. Its central premise contends that actions and behaviour in companies are shaped by the institutional environment because organizations, seek legitimacy by adopting common practices, which improves their chance of success and survival (DiMaggio and Powell, 1983; Zucker, 1987). An example is explored by Christensen and Molin (1995). They suggest that the resilience of the Danish Red Cross was attributable to the manner in which they conformed closely to wider institutional requirements from the outset of its existence, thereby increasing their legitimacy, subsequent resources and survival capabilities (Meyer and Rowan, 1977). As a result, the adoption of values, norms, beliefs and expectations of operating environments aid non-profits in their goal for legitimacy. However, the institutional approach challenges rational and efficiency-based explanations of organizational behaviour. Instead, as Zucker (1987) noted, behaviours are simply undertaken because they have become the most common or accepted way of behaving. This suggests that governance practices and structures may be in place not because they are the most effective or best suited for the organization, but because these practices and structures are deemed the correct or appropriate way of conducting governance. A significant example of this is the plethora of best practices preached by
highly regarded non-profit aid agencies such as BoardSource, BBB Give Wise Giving Alliance, Charity Navigator, Charity Watch and Independent Sector. Even though these groups do not have any formal sanctioning authority over individual non-profits, they have significant influence over donor perceptions. In other words, by trying to assess and even rate non-profit effectiveness these outsiders, ultimately create pressure for non-profit to conform to the “right” level. Some suggestions include optimal levels of administrative costs or resources spent on programs (Szper & Prakash, 2011). The IRS (2008) even explicitly states non-profits “are encouraged to keep their fundraising costs reasonable and to provide information about fundraising costs and practices to donors and the public”. These organizations must additionally be responsive to the mandates and requirements of their legal environments. Law makers and government agencies do not just set rules and monitor non-profit behaviour but also have the possibility of punishing or sanctioning organizations that do not comply or violate these rules. The fear of sanctions is a major force that influences how non-profits act and thus must be taken into consideration when examining non-profit governance.
Also stemming under intuitional theory is the process by which organizations deal with uncertainty or ambiguity. This occurs when one organization copies actions, behaviours or practices from another organization because the imitating organization is uncertain about how to respond or act in a given situation (DiMaggio & Powell, 1983). For example, non-profits have become more interested in finding ways to use commercial revenue as a viable funding source, but often do not know how to successfully set up and run an earned income program. The organizations seek and copy the practices of those who know best how to generate commercial revenue, those from the for-profit sector. This tendency offers one way to explain the growing trend among non-profits to try and become more business-like and market-oriented. Ultimately, as Miller-Millesen (2003) concludes, institutional theory suggests that legitimacy is the main reason for non-profits to adopt and follow prescriptive best practices on governance systems.
Conformance and Performance Theory
One useful model that helps integrate the insights of these different theories is brought forward by Garratt (1997) drawing on an earlier model by Tricker (1980). Garret suggests there are two main roles of governing boards, ‘conformance’ and ‘performance’. Conformance involves two main functions, firstly external accountability, including compliance with regulatory requirements and accountability to stakeholders. Secondly, supervision of management through monitoring performance and making sure adequate internal controls are in place and followed. These conformance dimensions match closely with institutional theory regarding regulatory compliance, and stakeholder theory regarding accountability. In addition, agency theory aligns with the supervision of management aspect. The second dimension of this theory, ‘performance’ is about driving the organization forward to better achieve its mission and goals. This can be achieved by obtaining governing board members who bring the most valuable and diverse resources to the organization. The performance dimension is therefore in line with resource dependency and stewardship theory of non-profit governance.
Non-profit Organizational Performance
Success in for-profit firms is most commonly evaluated in terms of profitability and shareholder value (Seibel 1996; Calabrese et al. 2013; Chad et al. 2013). However, these traditional for-profit financial indicators cannot be completely transferred into measuring non-profit performance (Herman and Renz 2008). This notion is widespread throughout non-profit literature, with how to define it, measure it, and how to interpret it, remaining one of the most discussed and disputed areas in non-profit research (Kanter and Summers 1987; Herman and Renz 1997; Forbes 1998; Sowa, Selden and Standfort 2004; Barman, 2007). Because non-profits are mission rather than profit driven, Sawhill and Williamson (2001) propose the ultimate indicator of non-profit success as the realization of mission objectives. However, Forbes (1998) asserts many non-profits typically “have goals that are amorphous and offer services that are intangible”. Unsurprisingly, developing quantitative measures of non-profit performance is a challenging and highly controversial task, and
attempts to do so have created a fragmented collection of research (Cameron 1986, 2005). Non-profit performance also encompasses a magnitude of dimensions, with each aspect of equal importance and distinctive from the others. Hence, the terms success, performance, sustainability, viability, even efficiency and profit (Baruch and Ramalho 2006; Campbell 1977) are used interchangeably across non-profit literature.
Non-profit organisations succumb to a peculiar tension between generating revenues and adherence to activities supporting their mission. For example, a non-profit may devote their time and resources to fundraising revenues, which in turn facilitates mission supporting activities. However, the non-profits mission may include feeding the homeless, which is inherently a loss-making endeavour. The organisation must divide its energies and resources between either direct mission supporting activities, or tasks which raise net revenues such as selling a profitable service or fundraising. Many studies have supported this notion empirically (Schiff and Weisbrod 1991) and argue its unanimousness across the non-profit sector (James 1983). However, this begs the question, are non-profit expenses indicators of waste or measures of its charitable giving? With this conflicting notion of organisational spending, one researcher queries “What is the bottom line when there is no bottom line?” Drucker (1990, p. 107).
In early non-profit literature, a mission accomplishment view was the dominant logic to capturing non-profit success. Organizations are ‘‘deliberately constructed… to seek specific goals’’ (Etzioni 1964, p. 3) and thus are successful to the extent to which they accomplish their organizational objectives (Price 1972). Oster (1995) and Sawhill & Williamson (2001) equally argue mission accomplishments measured in terms of short-term outputs and long-term impact should be the ultimate indicator of organizational success. However, the mission accomplishment approach has its downfalls for various reasons. To evaluate the accomplishment of organizational goals, they must be clearly stated and measurable (Miles 1980; Robbins 1987). However, publicly communicated goals may differ from actual firm goals (Katz and Kahn 1966). Additionally, companies may pursue multiple, even conflicting
goals, which may complicate which goal should be used as an indicator of success (Molnar and Rogers 1976; Quinn and Cameron 1983). Furthermore, the accomplishment of organizational objectives is only a partial measure of organizational success. Organizations should also be judged on their ability to acquire resources and transform these resources into chartable mission supporting activities. Only when enough resources are acquired can the transformation process be efficiently achieved. Similarly, only when relationships with key stakeholders are upheld can non-profits accomplish their ultimate objectives (Robbins 1987). Another aspect of non-profit performance is their growth. Pfeffer (1973), in studying non-profit hospitals, used the percentage increase in the number of beds and the percentage increase in budget over a five-year period as measures of organizational effectiveness. In research on human services non-profits, Provan (1980) used the extent as well as the percentage change (in a three year period) of United Way funding and other funding.
Callen et al. (2003) states “The literature advocating a multiple constituency approach to understanding non-profits has suggested that there is no single organizational or board effectiveness criterion that all stakeholders perceive similarly. Rather, each group measures effectiveness on the basis of criteria and impressions most relevant to it.” Therefore this study identifies a variety of key dimensions of non-profit performance, encompassing the identification of agency issues, excess compensation, efficiency, long-term financial stability, public support and charitable giving. These aspects are described in detail as part of the methodology section.
Linking Boards, Governance and Performance
One of the central themes within non-profit governance research deals with the questions of whether, how and why governance makes a difference for non-profit performance. Early work by Hansmann (1980) and Fama and Jensen (1983) demonstrates governance having a heightened role in the non-profit realm compared to the for-profit sector, providing the foundation for following research in non-profit governance. In a review of related U.S.
literature in in the areas of human services and health, which has tended to dominate the field, Ostrower and Stone (2006) suggest that the main topics for research have been centred solely on the role of boards the link with organizational effectiveness. Additionally, recent studies (Brown and Guo 2009; Kreutzer 2009; Ostrower and Stone 2010) have identified the most studied aspects regarding non-profit governance covers the role of governing boards and the challenges they face. As well as current and suggested best practices for board size, composition and diversity, performance accountability procedures and transparency, compensation, and conflict of interest policies.
The IRS (2008) ascertains “Successful governing boards include individuals who not only are knowledgeable and engaged, but selected with the organization’s needs in mind (e.g. accounting, finance, compensation, and ethics). In the board composition strain of research Callen, Klein, and Tinkelman (2003) highlight the importance of a non-profit’s governing board and the inclusion of donors on boards leading to potential efficiency improvements. In later years, Jegers (2009) also finds that donor representation on non-profit boards tends to reduce administrative costs. Jegers study additionally points to evidence that management representation on non-profit boards can undermine governance effectiveness, although some studies suggest otherwise (Werbel and Carter 2002; Wang and Coffey 1992). Brickley, Van Horn and Wedig (2010) use data from hospitals to test the hypothesis that management representation on non-profit boards leads to “excessive” CEO pay. They document a relatively small, but statistically significant, positive association between CEO pay and “insider” boards that include the CEO and other employees as members. Regarding board size, the IRS (2008) suggest “very small or very large governing boards may not adequately serve the needs of the organization”. While Aggarwal, Evans, and Nanda (2012) report a positive association between board size and donations for a large cross-section of organizations from 1998 to 2003, although they attribute this result to larger boards achieving better board fundraising rather than better board oversight.
In a more general view of non-profit governance and performance, Nobbie and Brudney (2002) report a significant association between non-profit effectiveness (represented by measures of goal achievement, financial ratios, resource acquisition, internal processes, and CEO job satisfaction) and the adoption of governance practices recommended by the Policy Governance model (Carver, 1990) and other non-profit watchdogs. Some studies solely focus on governance from a legal standpoint, by paying attention to how boards fulfil their legal and fiduciary duties (Chisolm 1995). In the same area, Desai and Yetman (2005) later question in the absence of owners, how effective are the constraints imposed by the state in promoting effective firm governance? From this perspective they discover that stronger provisions aimed at detecting managerial misbehaviour are associated with significantly greater charitable expenditures, increased foundation payouts and lower insider compensation. Similarly, Alexander and Lee (2006) demonstrate via empirical evidence that improvements in governance quality can lead to more efficient operations.
In the for-profit realm Opler, Pinkowitz, Stulz Williamson (1999) establish the positive link between excess cash holdings and agency problems. Adapting this to the non-profit sector, Fisman Raymond and Hubbard (2005) present a model of non-profit governance built on two assumptions, firstly organizations wish to hold precautionary savings in order to smooth expenditures, and secondly it is relatively easy for managers to divert these funds for personal use. They demonstrate that organizations in U.S. states with poor government oversight have managerial compensation that is more highly correlated with inflows of donations and allocate a smaller percentage of donations to the endowment for future expenditures relative to organizations in strong oversight states. On the same token, Core, Guay and Verdi (2006) show a positive association between executive pay and excess liquid asset levels (a proxy for ‘agency problems’) in non-profit organisations.
In relation to transparency and accountability, Tassie, Murray and Cutt (1998) used institutional theory to explain how some non-profit organisations conduct certain evaluations for symbolic rather than useful analysis purposes because external donors
demanded it. Kitching (2009) documented a positive association between a non-profits use of the Big 5 auditors and donations received. Finally, Saxton, Neely and Guo (2014) reported a positive relationship between web disclosures, as measures of transparency, and donations for a sample of 400 U.S. non-profit organisations.
In more recent years, the spotlight has focused on governance arrangements and whether they are adequate to ensure that non-profit organizations are effective, responsible, and accountable for their actions, especially in their role in mitigating the misuse of charitable assets and excess managerial compensation. A handful of recent and closely related literature to this study utilise newly available governance data under the “Governance, Management, and Disclosure” section in the updated IRS990 Forms. Firstly Newton (2013) investigates the intersection between CEO pay, financial performance and governance quality. He finds a significant negative relationship between the CEO-to-employee pay ratio and multiple measures of non-profit financial performance. Newton confronts one issue posing non-profits; the misuse of charitable assets through excessive CEO compensation and suggests that excessively high CEO compensation deteriorates financial performance. Harris, Petrovits and Yetman (2014), examines whether donors reward non-profit organizations that report better governance. They find a positive and statistically significant connection between stronger governance and higher donations. Harris, Petrovits and Yetman’s approach focuses on only one specific benefit of corporate governance, enhanced donations. Furthermore, Balsam and Harris (2014) show that charitable organisation supporters reduce donations to non-profits subsequent to disclosure of high executive compensation. Through empirical evidence, they consistently establish that large, sophisticated donors actively seeking out and react to compensation information made available in IRS Form 990s, while smaller donors react to compensation disclosures in the media.
Research Focus and Hypotheses
In research which identifies limitations and downfalls in existing non-profit governance literature, Cornforth (2012, p.1117) argues “implicitly equating governance with what boards do has led to an overly narrow conceptualization of non-profit governance that largely ignores the influence of the wider governance system”. Within this research, the governing board is not taken in isolation and is incorporated as only part of the entire construct of non-profit governance. This however has been the key focal point for many governance related studies. The other four elements of non-profit research including Governing Policies, Firm Independence, Compensation Policies and Accountability and Transparency cover a variety of alternate features of non-profit governance. Additionally, unlike research on corporate governance in the for-profit sector, surprisingly little research has been devoted to the influence of audit and reporting requirements on non-profit organizations. On top of analysing governing constructs interplaying together, this study pinpoints specific state legal audit and accounting requirements for examination on non-profit performance. Many other studies limit the scope of non-non-profit performance, such as Harris, Petrovits and Yetman’s recent related research which only focuses on one specific benefit of corporate governance, enhanced donations. As a result, other potential outcomes of increased governance are not studied and further research is needed to comprehensively capture these costs and benefits. This study aims to fill this gap by assessing a vast array of effects on organisational performance, than simply donations as the only facet.
Furthermore, The IRS (2008) believes that “a well-governed charity is more likely to obey the tax laws, safeguard charitable assets, and serve charitable interests than with poor or lax governance”. In support of this belief, previous discussions of stakeholder, agency, resource dependency and institutional theory indicate at least the potential, if not the practice, for boards through their policies and procedures, to exert considerable influence on the performance of the organisation in which they govern. With the help of "good practices" drawn from experience of practitioners and consultants, case studies and surveys by
researchers (Herman and Renz 1999; Axelrod 2005) the following hypotheses are formulated in anticipation for examination:
H1: Agency Hypotheses
Higher non-profit governance quality via a multi-factor approach should help protect the interests and charitable assets of the organization, and align
management’s motivations with the overall mission of the firm.
As in-line with agency theory, a key role of the governing body is to monitor management and ensure their compliance in furthering the organization’s charitable objectives. Therefore the presence of better governance, as indicated through increased governance indices, should mitigate excess liquid assets portraying the level of agency problems conflicting with non-profit operations. Specifically, board members owe their organization a duty of loyalty which requires them to act in the interest of the non-profit rather than act on their own conflicting motivations. The duty of loyalty requires board members to avoid conflicts of interest that are detrimental to the non-profit. As a result, a more independent board should be unbiased and act in the interests of the non-profit. Young (2011) outline one of the strengths of non-profit governance is the relative independence of the volunteer board from the paid management and staff. Therefore it has a greater capacity to execute fiduciary responsibility to evaluate, reward, punish, or dismiss misbehaving or inadequate management. This is in-line with Fama and Jensen (1983)’s suggestion that insiders should not sit on governing boards of not-profit organizations. The IRS (2008) further strongly advocate “a governing board should include independent members and should not be dominated by employees or others who are not, by their very nature, independent individuals because of family or business relationships”.
To emphasize the potential rewards in accomplishing board independence, the difficulty in achieving and maintaining this level of independence must firstly be understood. Inglish & Cleave (2006) suggest in order to function efficiently, non-profit organisations must adopt vigorous resource recruitment and retention practices, particularly with respect to their suppliers, donors and volunteers. In order to attain such connections, many non-profits
offer related parties positions on their governing board. Hence donors or beneficiaries of non-profit missions tend to also sit on governing boards, with many non-profits finding it challenging to attain high board independence. This indicates that the harder it is to obtain board independence and the more sought after and recommended it is in the non-profit realm, the more likely it is due to the expected increased performance rewards.
H2: Compensation Hypothesis
A higher level of independence throughout non-profits and more effective compensation policies should result in adequate levels of employee and
management compensation.
This hypothesis is similarly in-line with agency theory, claiming that higher overall independence of governing boards and limited firm related party transactions should lower the likelihood of any possible conflict of interests marring the judgement of board members, in particular regarding the compensation of employees and top management. The IRS (2008) strongly recommends compensation levels “should be determined by persons who are knowledgeable in compensation matters and who have no financial interest in the determination” and should include a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision. Best practices advocate for a three-step process to determine appropriate compensation (Charity Lawyer Blog 2009). Firstly, the board should arrange for an "independent body" (which means that the person receiving the compensation should not be part of the review process) to conduct a "comparability review". Secondly, the independent body should take a look at "comparable" compensation data, such as data available from salary and benefit surveys, to learn what employers of a similar mission focus, budget size and location pay their senior management. Lastly, the review should be documented, detailing who was involved and the process used, as well as the disposition of the full board's decision to approve the management compensation.
Adequately setting compensation levels helps reduce the misappropriation of charitable assets, while also having an additional effect on non-profit performance. Non-profits can
