Director Compensation
At Not-for-Profit Organizations

It’s no secret that Board compensation at publicly-traded companies is on the rise.  As the accountabilities and liabilities of Board members have increased (in large part due to off-shoots of the 2002 Sarbanes-Oxley legislation), a director’s job has become considerably more difficult and time consuming.  This has made the recruitment and retention of directors a much more important and challenging task, often resulting in greater pay.

However, increased Board responsibilities are not unique to directors of publicly-traded companies.  Not-for-profit board members also are finding themselves with significantly more responsibility.  While these organizations have not historically paid their directors, many are asking whether Board pay is not only appropriate, but necessary.  In the increasingly stringent environment for not-for-profit Board governance, these director roles are getting harder and carry more weight.

The Environment for Not-for-Profit Board Pay

The past few years have seen not-for-profit Board membership shift from risk-free public service to time-consuming stakeholder accountability.  These directors now have much greater responsibilities that include the same types of tasks that publicly-traded directors face, including those related to audit, fiduciary matters, and executive compensation.  Clearly, not-for-profit Board governance has changed, as Sarbanes-Oxley accountabilities are starting to be seen as “best practices” for these Boards.  As an example, we note the recent announcement of Fitch Ratings, the global credit ratings agency, which stated its support for holding not-for-profit healthcare organizations accountable to Sarbanes-Oxley regarding audit and governance practices.  As the responsibilities and accountabilities of not-for-profit Boards have grown, a debate has emerged over whether or not it is appropriate to pay not-for-profit directors for their services.

Past Practices.  There often is a perception that paying not-for-profit directors is inappropriate, ant that the practice runs counter to the mission of such organizations.  In fact, in June 2005, the U.S. Senate Finance Committee commissioned an Independent Sector report formally discouraging any compensation for not-for-profit Board members unless the complexity, time commitment, or skill requirements of the Board so warrant.  In practice, Board pay has been far infrequent across the overall non-profit universe; a BoardSource survey conducted in 2000 found that only 2% of more than 1,000 organizations surveyed compensate their directors.

A Changing Environment.  There is a growing sense that as the role of the not-for-profit Board evolves, Board pay may not only be appropriate, but rather necessary to attract and retain needed directors.  In  general, Board compensation is permissible as long as the organization’s bylaws allow it and the payment does not violate standards relating to private inurement.  For tax-exempt organizations, the compensation also must be “reasonable” within the standards of Section 4958 of the Internal Revenue Code.  Essentially, this requires the pay not to exceed the amount that would ordinarily be paid for like services by like enterprises under like circumstances.  Also, many not-for-profit directors have opportunities to serve on for-profit boards that pay significant director fees.  If particular not-for-profit organizations are competing with their for-profit brethren for top talent, paying directors may be a necessity.

Factors to Consider

The decisions on whether to pay and what to pay to not-for-profit directors should be considered very carefully and be driven by a number of factors unique to each organization.

•           Complexity of the organization.  Does the organization have various moving parts or particularly difficult issues, whether strategic, regulatory, or optical?  If so, the added complexity may furnish support for paying directors. 

•           Time commitment required.  Are directors spending significant amounts of time either in the Boardroom or otherwise performing Board duties and responsibilities?  If so, it may be appropriate for directors to be paid for their time. 

•           Level of direct operational involvement and special skills required.  Do directors have any direct operational involvement in the organization?  Is the organization involved in a situation that requires a specialized skill set?  If so, then this is an indication that the director talent may have a substantial impact on the organization’s success, and there may be greater justification for paying them. 

•           Competitive market for director talent.  With what types of organizations does the Board compete for director talent?  Are these organizations compensating their directors?  If so, these organizations may provide a reasonable benchmark for pay practices.  In particular, not-for-profits that directly compete with for-profit companies may determine they need to compensate their directors or lose out on certain candidates.

•           Affordability.  Can the organization afford to pay its directors?  Would director pay limit programmatic offerings of the organization in any way?  Simply put, directors should only be paid if the organization can afford to do so.

One type of organization that tends to meet these criteria is the healthcare provider.  These employers are perhaps the most complex not-for-profit organizations, as they are highly regulated, are publicly and legally accountable, require specific skill sets, and may compete with large for-profit healthcare systems for Board talent.  As a result, many such organizations may be strong candidates for director pay.  Conversely, organizations that do not meet most of these criteria generally would not be suitable for director pay.

Components of Director Pay

If an organization, after evaluating itself against these factors, decides to pay its directors, it has various alternatives for delivering that pay.  The typical components of director pay include:

•           Annual retainers.  Similar to base salary, this is normally a guaranteed cash amount, although some for-profit employers deliver all or a portion in stock.

•           Board meeting fees.  Similar to annual incentives, these are fees for every Board and/or committee meeting attended.  Some committees, like audit, pay a premium relative to other committees for increased importance and accountability. 

•           Chairperson fees.  A member who chairs a committee may receive a special retainer for his or her services in the form of an additional or additional meeting fees. 

•           Committee membership fees.  Those who serve on a board committee may receive an additional retainer for membership.  

•           Equity-based awards.  This is typically a guaranteed grant in the form of stock options or another equity vehicle like restricted stock.  Since not-for-profit organizations generally do not have stock, these awards generally are not available.

In keeping with the “pay for performance” philosophy that our clients increasingly are adopting for their executive compensation strategies, not-for-profit organizations may decide to structure their pay packages heavily toward a “time commitment” orientation.  While it is common in general industry to maintain a significant portion of the overall pay package in the form of a guaranteed retainer, at some non-profits it may be more appropriate to limit the guaranteed component in favor of meeting fees, which only pay members for the time they spend in the Boardroom.

Prepare for Scrutiny

Any not-for-profit organization that chooses to compensate its directors should be prepared for scrutiny of the practice.  While we believe not-for-profit Board pay will continue to increase in prevalence as these Board accountabilities grow, some constituencies will continue to see Board service as a public service, and will understandably be opposed to the practice.  The Internal Revenue Service recommends that tax-exempt organizations maintain transparency of process for, and full documentation of, all pay decisions related to an organization’s leadership---executives and directors included.  For this reason, we suggest that all not-for-profit Boards, regardless of their tax classification:

•          Abide by IRS standards for process and documentation laid out for the Code sections 501 (c)(3) and (c)(4); and 

•          Prepare a written rationale, either in the form of a policy or a formal philosophy, regarding its decision on payment of its directors, taking into account the factors discussed in this paper.