A Cautionary Tale for Trustees

American University was chartered by an act of Congress. Will it take another kind of action by Congress to get the university’s Board of Trustees to do the right thing?

The board hoped that its decision last month to provide a $3.75-million severance package to Benjamin Ladner, who served as president for 11 years, would put to an end to much of the controversy that has embroiled the university in recent weeks.

Allegations that Mr. Ladner was paid too much and spent too much of the university’s money on his own expenses have reverberated across the campus and attracted nationwide attention in the press. Now the Senate Finance Committee has weighed in, with a letter characterizing the American University board as the “poster child for why review and reform (of charities) are necessary.”

Only those involved at American University know the truth about what really happened in the boardroom and elsewhere on campus. But the implications of the scandal at American University reach far beyond this one institution.

Will stories of this university’s governance problems add to the unwelcome and unjustified impression that the nation’s more than one million charitable organizations are rife with boards that do not know their responsibilities or do not care enough to live up to them? Instead, the events at American University should prompt everyone in the nonprofit world to examine what good governance means and the consequences of its absence.

Decisions by nonprofit boards, especially those about spending, should be made with the board’s fiduciary responsibilities, the organization’s mission and values, and the public trust in mind.

Questions about whether American University’s money was being spent appropriately began with allegations that Mr. Ladner made personal use of a limousine and a chef provided for university business, traveled in a first-class manner on the institution’s dollar, and was compensated too highly.

The decision by American’s trustees to offer a multimillion-dollar severance package to a man who allegedly failed to pay taxes on nearly $400,000 in income over the past three years, who was forced to reimburse the university $125,000 for inappropriate expenses, and who left the university under a cloud of allegations of personal greed and questionable expenditures compounded the public’s concern.

The inactions and actions of American University’s board have left many people in Washington, universities across the nation, and the Senate Finance Committee reeling.

With chief executive compensation under scrutiny at the Internal Revenue Service and the governance practices of nonprofit organizations under public review by the Senate Finance Committee, how could this have happened?

The relationship between a nonprofit board and its chief executive is a critical and complex one. Basic governance principles hold that both boards and chief executives are driven by the nonprofit organization’s mission, with boards in charge of setting policy and chief executives responsible for day-to-day management.

That framework, however, does not tell a nonprofit board what to do or how to do it. Nor does it reflect the increasing imbalance of power between volunteer boards, uncertain of their responsibilities, and professional managers, often knowledgeable, strong-minded, and purposefully in charge.

Good governance begins with the board and the chief executive agreeing to annual performance expectations. Boards are then in a position to make decisions about the compensation of the chief executive with one eye focused on performance and the other on what is fair and justifiable.

To be sure, chief executives should be paid — and paid well — for their services. The nonprofit world has grown ever more complex and its executives ever more professional. With organizational success at stake, nonprofit boards must take care to hire the best people they can find and find ways to reward them for jobs well done.

Boards are penny-wise and pound-foolish if they fail to set appropriate compensation levels for high-performing executives who can easily find work elsewhere.

To help figure out just what compensation is appropriate, the Internal Revenue Service has issued guidelines, the so-called intermediate-sanctions regulations, that identify appropriate ways to set and vet executive compensation. They call for independent board members at nonprofit groups to review salary and benefits paid to similar executives at comparable organizations and to document the basis of their compensation decisions. Did the American University board know about and follow those procedures?

Decisions about appropriate compensation levels and severance payments are made all the more complex when chief executives are rewarded with increasingly common deferred compensation arrangements.

According to the American University board, the $3.75-million severance package included a one-time payment of $950,000 and $1-million present cash value of a split-dollar insurance policy, as well as account balances in two deferred compensation trusts valued at about $1.75-million.

In a memorandum sent to American University faculty members, administrators, students, and others, members of the American University board said they made their decision about Mr. Ladner’s severance primarily based on “the risks, costs, and delay inherent in litigation.”

In the face of those kinds of allegations and in light of American University’s special status as a charitable organization, was it right for the board to favor the expediency of resolution over the opportunity to demonstrate leadership and commitment to a higher principle? Sometimes it is better to do the right thing than the easy thing.

Questions have also been raised about the extent to which Mr. Ladner’s compensation arrangements were disclosed to every member of the university’s board.

When it comes to assessing and rewarding the chief executive’s performance, good governance requires the entire board to participate in the process. While it can be appropriate for a board chair, executive committee, or compensation committee to negotiate the CEO’s compensation, its terms should be shared with and, in most cases, approved by the entire board.

Concerns about personal privacy pale in comparison with the importance of each director’s fiduciary obligations. Besides, salaries, benefits, and other compensation agreements are made public through the organization’s annual informational return that it is required to file with the Internal Revenue Service. So, why didn’t American University’s entire board know about, and vote on, Mr. Ladner’s compensation?

Good boards are also characterized by their ability to focus on matters of importance, ask hard questions, and seek diverse views.

When the chief executive is a member of the board, as was Mr. Ladner, the board must hold regular executive sessions without the chief executive present. Doing so underscores the fact that the chief executive is not just another member of the board and ensures independent decision-making by the board as a collective whole. Was American University’s board independent and engaged enough when it came to scrutinizing its chief executive’s actions?

Board composition also makes a difference. Recent corporate governance scandals have focused attention on the need for board members with financial expertise. But nonprofit groups need more than business acumen in the boardroom. They need board members who believe in the mission and who will do what is right, not what is easy. They need board members who open doors and wallets.

And, as so clearly demonstrated in the American University case, they need board members who understand and are willing to live up to the requirements of federal law and the fiduciary obligations established by state law.

Mr. Ladner should have done his part as well. As a leader of a major university, he was required to do more than attend to university business and fund raising; he needed to live up to the values of the institution, the faith of its donors and constituents, and trust from the public that granted preferential tax status.

At a nonprofit organization, a key quality of leadership is the willingness to subsume personal wealth and advantage to a higher calling of mission and service. What happens next in this seemingly never-ending saga remains to be seen.

The memorandum from the American University board commits to further actions by its governance committee, but the Senate Finance Committee’s letter promises a bigger and more extensive review of the governance of the university.

The Senate Finance Committee has asked for copies of all contracts and compensation arrangements with Mr. Ladner, compensation studies and other documentation relied on by the American University board in setting Mr. Ladner’s compensation, no-bid contracts that exceed $100,000 in the past 11 years, all transactions with “disqualified persons” (which includes board members, chief executives, and other university insiders), conflict-of interest policies, biographies of trustees, and more.

The board of American University may have thought that a $3.75-million severance agreement was big enough to end the controversy and permit the university to return to business as usual, but they were sorely mistaken.

The health of our civil society depends on nonprofit success and the public’s trust in their management.

As most recently seen in the wake of Hurricanes Katrina and Rita, nonprofit groups are essential threads in the fabrics of our communities. They feed the hungry and shelter the homeless; they educate our children; they provide those at risk with safe places to play and caring mentors; they ensure we have clean air to breathe and water to drink; they find cures for illnesses and treat those who are sick; they inspire us with beautiful art and thoughtful entertainment, and so much more.

For all those reasons, good governance is not optional, it is critical.

Deborah S. Hechinger is chief executive officer of BoardSource, an organization in Washington that seeks to make nonprofit boards more effective.