In recent weeks, New York state courts have dismissed charges against Richard Grasso, former CEO of the New York Stock Exchange, and other officers of the NYSE, for the alleged “excess benefits” that Grasso received as head of the Exchange. Although the charges against Grasso were dismissed, the basis for the dismissal has more to do with the authority of the New York State attorney general to bring this action, particularly in light of the conversion of the Stock Exchange from nonprofit to for-profit ownership structure, than it does with the underlying issue of excess benefits. In fact, this case provides a roadmap for the IRS to prosecute nonprofit executives and board members under similar Internal Revenue Code provisions barring “excess benefit transactions for those executives.”1 It raises important questions for executives and board members of nonprofits, generally.

As CEO of the NYSE from 1995 to 2002, Richard Grasso was paid an annual salary of roughly $1.4 million, with bonuses escalating from $900,000 in 1995 to $10.6 million in 2002. In 2003, a new compensation agreement provided him with an annual salary of $12 million along with a single, lump-sum payment of $139.5 million.2 When the compensation package was revealed to the public, the negative reaction led to Grasso’s resignation, and eventually to New York’s attorney general bringing charges against Grasso and others. The charges alleged that the compensation package violated New York’s nonprofit law because it was “not reasonable or commensurate with the services preformed by Grasso.”3

The attorney general’s complaint also alleged that improper procedures and inadequate disclosure led to board approval of Grasso’s compensation package. The vote to approve the package occurred at an August 7, 2003 meeting of NYSE’s Compensation Committee, despite the fact that it was not on the agenda for that meeting. The complaint alleges that because it was not an agenda item, neither the NYSE’s independent counsel nor the package’s opponents on the committee were present at that meeting. The complaint also alleged that in previous years the Compensation Committee had approved bonuses for Grasso that exceeded NYSE’s own benchmark system, and that Grasso and others had consistently provided the Committee with misleading information regarding Grasso’s additional compensation from various benefits programs.4

On June 25, 2008, the New York Court of Appeals dismissed the four common law claims that the attorney general had brought against Grasso, as supplanted by the claims brought under the state’s nonprofit statute which require the state to carry a heavier burden of proving fault.5 On July 1, the statutory claims were dismissed as well, this time by the New York State Supreme Court Appellate Division, First Department. The basis of the appellate decision was that the attorney general no longer had standing to bring the claims because NYSE has converted to a for-profit entity. Therefore any judgment against Grasso would be paid to the Exchange, which would then be free to distribute the funds in any way that it wished.6 In light of these decisions, the New York attorney general’s office announced that “the Grasso case is over,” and that no further appeals would be taken.7

The Impact of Grasso

Although the case was dismissed, nonprofit entities should view the case, and parallel IRS regulatory action, as a harbinger of increased scrutiny of their executive compensation packages and policies. The public outcry over Mr. Grasso’s compensation package and other NYSE officials has already contributed to the rationale for the implementation by the IRS of new, highly detailed, reporting requirements for nonprofits.8 Using the information on executive compensation provided by nonprofits in the new Form 990, coupled with existing federal statutory provisions barring “excess benefits transactions” for nonprofit executives, the IRS has signaled that it intends to pursue more aggressively nonprofit executives and their boards of directors for receiving and approving compensation packages that IRS deems excessive.9

The new IRS Form 990 requires detailed disclosure of compensation packages provided to nonprofit executives, including salary, deferred compensation and benefits; as well as disclosure of the methods used by an organization to establish the compensation provided to its CEO. The IRS can use this information to bring claims against both “disqualified persons” (high-level executives) who receive “excess benefits” and the organization’s management, who approves such excess benefits. Executives receiving excess benefits can be liable for a tax equal to 25% of the perceived excess benefit, and an additional tax of 200% of the excess benefit if the problem is “not corrected within the taxable period.”10 The organization’s management, including board members who participated in the excess benefit transaction, can also be personally liable for a penalty tax of 10% of the excess benefit if management did not exercise due care in evaluating the reasonableness of the compensation package.11

Nonprofit Entities’ Response/Strategy

The most important step that nonprofit entities can take in dealing with executive compensation decisions in the wake of the Grasso case, and in response to increased scrutiny by the federal government, is to develop and document a transparent and detailed process for determining the amount of compensation to be paid to its high-level executives. The process should include the creation of a compensation committee of the board of directors, preferably with at least some members with knowledge in determining the appropriate level of compensation and benefits for executives’ services, including comparing the compensation packages of executives at similarly situated for-profit entities. Many organizations will also want to employ a compensation consultant, and/or independent counsel to obtain information about the compensation of similarly situated high-level executives at other nonprofits and to assist the board in the ensuring that there is an appropriate process for conducting and documenting its compensation decisions. Exercising due diligence and good faith in determining and documenting the reasonableness of compensation packages for high-level executives will go a long way toward protecting board members and the organization from IRS inquiry.

One interesting development as a consequence of this case was NYSE’s decision to convert to a for-profit corporation in order to avoid the scrutiny and potential liability associated with its nonprofit status. The process should include the creation of a compensation committee of the board of directors, preferably with at least some members with knowledge in determining the appropriate level of compensation and benefits for executives’ services, including comparing the compensation packages of executives with similar responsibilities at comparable not-for-profit and for-profit entities. We expect it is possible that other nonprofit organizations will re-examine the benefit of their tax-exempt status, particularly those without significant land holdings, in light of the increased disclosure, scrutiny and expense of complying with the new Form 990 and Form 990T (unrelated business income tax return) requirements, especially since these rules and disclosures may impinge on their business operations and their ability to attract top executives in their field.

If you have any questions or comments about this article, please contact any of the Arent Fox attorneys listed below:

Deanne M. Ottaviano
ottaviano.deanne@arentfox.com
202.775.5781

Dennis H. Blumer
blumer.dennis@arentfox.com
202.857.6068

Richard J. Krainin
krainin.richard@arentfox.com
212.484.3918

Marc L. Fleischaker
fleischaker.marc@arentfox.com
202.857.6053

Richard A. Newman
newman.richard@arentfox.com
202.857.6170

1 26 U.S.C. § 4958 (2000).

2 See The People &c., by Eliot Spitzer, Attorney General of the State of New York v. Richard A. Grasso, et al., decided June 25, 2008 by the New York State Court of Appeals (not yet published), p.2.  The opinion is available here.

3 Id., p. 2.

4 Id., p. 3-4.

5 Id., p. 8-10.

6 See Walder, Noeleen G., “Grasso Compensation Case ‘Over’ After Panel Throws Out Last State Claims,” Law.Com, July 2, 2008.  Available at http://www.law.com/jsp/article.jsp?id=1202422709675.

7 Id.

8 Discussed in a previous Arent Fox Client Alert, “Is Your Organization Ready for the New Form 990?,” by Joseph Rieser, et al., February 19, 2008.

9 26 U.S.C. § 4958(c)(1)(A) (2006).

10 26 U.S.C. § 4958(a)(1), (b) (2006).

11 26 U.S.C. § 4958(a)(2) (2006).  (Although this penalty is not to exceed $10,000 per transaction.  26 U.S.C. § 4958(d)(2) (2006).)