Monday, February 11, 2019
The thing that caught my attention last week regarding Florida Coastal School of Law's planned conversion to nonprofit status was the suggestion that after the conversion, Infilaw, the current owner, might continue its relationship with the school under a management agreement. A word of unsolicited advice is perhaps in order. When the owners of a for-profit entity decide or even consider converting to nonprofit status (with an application for tax exempt status as part of the conversion), its probably not a good idea to announce ex ante that the current for-profit owners will enter into a management contract with the soon to be formed exempt nonprofit. I am not even quite sure what law school operations a for-profit management company can actually and legitimately manage if the school is to operate in accordance with the accreditation standards. Will the management company select the Dean, hire faculty, set class sizes, make admissions decisions, determine curricular content or determine tenure and promotion standards? I can think of a host of accreditation concerns with regard to a for-profit management company doing any of those things.
Let's assume a privately managed tax exempt Coastal can get around the accreditation questions. Even so, and as Corso might say, "not so fast, my friend!" In the world of "big time tax exemption," management contracts are fraught with private benefit issues, especially when the management company has or had a financial interest in the exempt organization. Consider this excerpt from the analysis of Situation 2 in Revenue Ruling 98-15 (I have substituted Florida Coastal and Infilaw, respectively, for the principals named in Rev. Rul. 98-150):
The primary source of information for [Florida Coastal's] board members will be the chief executives, who have a prior relationship with [Infilaw], and the management company, which is a subsidiary of [Infilaw]. The management company itself will have broad discretion over [Florida Coastal’s] activities and assets that may not always be under the board’s supervision. For example, the management company is permitted to enter into all but "unusually large" contracts without board approval. The management company may also unilaterally renew the management agreement.
Maybe its safe to assume that Infilaw will do its homework before the conversion. Still, I really doubt that Old Florida Coastal can decide ex ante that Infilaw or an Infilaw controlled entity will serve as New Florida Coastal's manager, at least not without serious private benefit issues arising. Its hard to imagine a compensation structure for that management agreement that would not put the Infilaw owners in almost the same position they would have been in absent the conversion. Nor can I imagine any set of contractual terms that would require the former for-profit owners to manage new Florida Coastal in a manner that ensures charitable goals take precedence over profit making. As a matter of law, new [exempt] Florida Coastal would have to engage in serious due diligence, wholly independent from the thinking or plans of Infilaw, before awarding a management contract. Common law fiduciary duties and the tax law duties to conserve charitable assets and avoid private benefit mandate that the board select an independent management company with no incentives to relegate the charitable goal to the company's profit making goals. See below the fold for more on management contracts.
Darryll K. Jones and Harry Germeus
If I could point to one decision my clients almost always end up regretting, its the decision to enter into a comprehensive management contract. Some management companies prey on nonprofits, taking control over the nonprofit's operations and charging unreasonable fees for services of questionable value. While there are management companies that provide valuable services and it is possible to construct a fair, arm's length agreement, hallmarks of abusive management contracts include the following;
Lengthy Terms. Longer terms tend to benefit management companies while limiting the flexibility of nonprofits. It is always in the nonprofit’s interest to retain the flexibility to change or terminate management contracts if the relationship isn’t working.
Management Company Dictating Policy and Strategy. A nonprofit’s policies should be set by an independent board and not by a management company. By way of example, the board should establish and define the mission, goals, strategy, budget, operational procedures, financial policies and governance policies.
Services. Management contracts should specifically detail which responsibilities belong to the management company and which belong to the nonprofit. The failure to be specific can result in the nonprofit not getting the full benefit of all the services it is paying for. Management contracts should also clarify when the management company needs the nonprofit’s approval before performing specific services. This is especially important when the management company charges hourly fees, as opposed to a flat monthly service fee.
Personnel. Management contracts that rely on the management company to supply key employees or that includes anti-compete clauses that limit the nonprofit’s hiring to personnel affiliated with the management company tend to serve the interests of the management company while depriving the nonprofit of the opportunity to hire staff of its choosing. Relying too heavily on a management company’s staff can also make it harder to terminate a management company agreement that isn’t working.
Compensation. Compensation paid to the management company must be reasonable as compared to market rates for similar services. If the management company is a disqualified person (insider) with respect to the charity, excessive compensation could be deemed an excess benefit transaction. If the management company is not a disqualified person with respect to the nonprofit, then excessive payments could still result in a private benefit that threatens the nonprofit’s tax-exempt status.
Termination. Termination and default provisions should not unreasonably restrict the nonprofit’s option to terminate the contract. The ability to end the relationship is key to maintaining a healthy vendor/vendee relationship.
Access to Data. Permitting a management company to unilaterally control financial data, vendor information, donor information, program data, or to control websites and social media accounts can be disastrous in the event the nonprofit and the management company part ways. Ideally, both the nonprofit and the management company should be able to access company information and data.
Ownership of Intellectual Property. Licensing a name, trademark or other brand related intellectual property from a management company favors the management company and can leave the nonprofit without any goodwill of its own once the agreement is terminated. Also, management company agreements should specify that intellectual property created as part of the management company’s duties for the nonprofit are work made for hire that belongs to the nonprofit so the nonprofit can continue using such intellectual property after the agreement is terminated.