Nonprofit Organizations’ Cost Allocations

The Implications of Madigan

By Daniel Tinkelman

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While most charities use donor money wisely, sometimes abuses come to light. Some charities are merely inefficient; a rare few are basically fronts formed to raise money for the enrichment of their organizers or consultants. State and local governments have tried a variety of methods to protect the public from inefficient or unscrupulous solicitations. Various states are now considering stricter rules—incorporating some aspects of the Sarbanes-Oxley Act’s rules—for nonprofit organizations, and the Senate Finance Committee has held hearings on possible changes in federal regulations.

The Supreme Court has frowned upon attempts to legislate against inefficiency. Some states presumed that high fundraising costs, as a percentage of donations, were in some ways a fraud on the public. These states forbade organizations from soliciting if they spent more than a specified percentage of donations on fundraising. In two decisions, Schaumberg v. Citizens for a Better Environment (444 U.S. 620, 1978) and Maryland v. Munson (467 U.S. 947, 1984), the U.S. Supreme Court struck down such laws as unconstitutional restrictions on freedom of speech. The Court noted in Munson that “there is no necessary connection between fraud and high solicitation and administrative costs. A number of other factors may result in high costs; the most important of these is that charities often are combining solicitation with dissemination of information, discussion, and advocacy of public issues, an activity clearly protected by the First Amendment.” In a third decision, Riley v. National Federation of the Blind of N.C. (487 U.S. 781, 1988), the Court noted that small or unpopular charities would tend to have higher fundraising cost ratios. In Riley, the Court held that a state could not compel charities or professional fundraisers to include a statement about their fundraising cost percentages in their solicitations.

While in these three decisions the Court struck down laws it considered overly broad, it showed some sympathy for states’ desires to protect the public. It noted that states could require charities and fundraisers to make certain information, such as financial information, publicly available, so that donors could compare charities. It also noted that states had the ability to prosecute cases of fraud. In Riley the Court said: “We do not suggest that States must sit idly by and allow their citizens to be defrauded. North Carolina has an antifraud law, and we presume that law enforcement officers are ready and able to enforce it.” In Madigan v. Telemarketing Associates (538 U.S. 600, 2003), Illinois took the Court at its word.

Madigan v. Telemarketing Associates

Telemarketing Associates, Inc., had a series of contracts from 1987 to 1995 to conduct telemarketing campaigns for VietNow National Headquarters, a nonprofit organization whose stated purpose was to aid Vietnam veterans. Telemarketing Associates also performed some other services for VietNow, such as producing a magazine with about 2,000 subscribers. As compensation for its efforts, the contracts provided that Telemarketing Associates would keep 85% of all funds raised in Illinois. Telemarketing Associates also acted as a broker for fundraising efforts by other telemarketing firms in other states. Telemarketing Associates was entitled to keep between 70% and 80% of all funds raised by these firms. After considering these commissions, VietNow was, by contract, entitled to receive only 15% of Illinois donations and 10% of out-of-state donations. VietNow had to cover its administrative costs and other fundraising costs out of this share, leaving very little money for its programs.

In 1991, Illinois filed a complaint against Telemarketing Associates and other defendants. As amended, the complaint charged that Telemarketing Associates had misrepresented to donors how the money was being used. The state obtained affidavits from donors that claimed they had been told their contributions would be used for such purposes as paying “bills and rent to help physically and mentally disabled Vietnam vets and their families” and for “job training.” An individual who asked what percentage of donations would be used for fundraising was told that “90% or more goes to the vets.” Illinois claimed that these statements were material misrepresentations, because by one calculation only 3% of the donations were actually spent on program activities. In essence, the state claimed that donors were led to believe that their money would be used for specific purposes, when in fact all but a nominal amount was being spent on other things.

The defendants moved to dismiss the charges, claiming that high fundraising costs could not be used as grounds for a fraud action, based on the Supreme Court’s Schaumburg, Munson, and Riley decisions. The Illinois courts were sympathetic to the defendants, and dismissed the case. The Illinois Supreme Court concluded that the action was primarily based on the Illinois Attorney General’s judgment that the amounts spent on fundraising were excessive, and that this was an improper basis for a fraud action. The Illinois Supreme Court noted that high solicitation costs could arise from various factors, including the range of services Telemarketing Associates provided. The Illinois Supreme Court also warned that if this case was allowed to go forward, there would be a chilling effect on fundraising activities. The state appealed the dismissal to the U.S. Supreme Court.

The case attracted tremendous attention in the nonprofit community. Numerous parties filed amicus briefs with the Supreme Court. The Federal Trade Commission, the U.S. Solicitor General, the Council of Better Business Bureaus (CBBB), and the Attorneys General of 45 states filed briefs supporting Illinois’ right to bring a fraud action. Briefs opposing Illinois were filed by several coalitions of nonprofit organizations and professional fundraisers.

In May 2003, the U.S. Supreme Court unanimously reversed the judgment of the Illinois Supreme Court and allowed a fraud action to proceed under Illinois law. Justice Ginsberg, writing for the Court, stated that “High fundraising costs, without more, do not establish fraud. … And mere failure to volunteer the fundraiser’s fee when contacting a potential donor, without more, is insufficient to state a claim for fraud. … But these limitations do not disarm States from assuring that their residents are positioned to make informed choices about their charitable giving. States may maintain fraud actions when fundraisers make false or misleading representations designed to deceive donors about how their donations will be used.”

Implications of Madigan

The Madigan decision is one of several recent developments that emphasize the materiality of information on the allocation of expenses. The fraud action was premised on the fact that donations were actually spent in ways other than those the organization described to donors. This means that organizations can be legally held to account for intentionally misallocating expenses in order to mislead donors into believing more money is spent on programs than is actually the case.

Ratios of amounts spent on programs, on fundraising, and on administration are commonly reported. The CBBB and the BBB Wise Giving Alliance, in their brief, cited evidence showing that many donors want to know what percentage of donations goes to the charity’s program.

Some organizations may be under intense pressure to present the best possible fundraising ratios. Many websites and other sources of information for donors provide data on organizations’ spending ratios, so organizations face competitive pressures to “look good.” Adding to this pressure, in 2002 the CBBB Wise Giving Alliance tightened its standards of acceptable governance procedures for nonprofit organizations. It now requires organizations to spend at least 65% of total expenses on program-related activities. The prior standards only required organizations to spend 50% of total income on programs. Some organizations will struggle to meet the new standard. According to the New York State Attorney General’s 2004 “Pennies for Charities” report, the 592 telemarketing campaigns in New York State in 2003 transmitted only 34% of the $187 million they raised to charities, meaning the telemarketing firms kept 66%. Even if some of the funds retained by the telemarketers could be considered to have been used for program expenses, it appears these charities will have difficulty meeting the 65% target.

The great attention being paid to fundraising cost ratios has brought to light weaknesses in the definition and consistency of application of the accounting standards. Two briefs in the Madigan case strongly challenged the representational faithfulness of reported fundraising costs and cost ratios. Public Citizen, Inc., and 175 other nonprofit organizations said, “The percentage of charitable contributions used to defray fundraising costs, is not ‘factual,’ ‘verifiable,’ or even meaningful.” Their brief noted the discretion that charities have in allocating expenses under GAAP and IRS rules. A second brief, from a coalition of fundraisers and nonprofit organizations headed by the Association of Fundraising Professionals, noted that “there is no uniform, rational, objective manner by which the fundraising ratio can be calculated. No one, including … fundraising experts, government regulators, tax authorities, consumer advocates, [and] Attorneys General, has defined the fundraising ratio in a uniform fashion or in such a way as to make it a useful or reliable indicia of fraud or philanthropic efficiency.” The briefs considered such problems as inconsistencies of cost allocation methods across organizations, and potential mismatches between the time periods over which solicitation costs are recorded and donations are received.

Accounting standards-setters should carefully consider the issues raised by these briefs, which were prepared by major groups of financial statement users. The consistency, transparency, and accuracy of cost allocations need to be addressed. The issue of whether the costs of assembling a donor list can be capitalized, rather than being immediately expensed, should be reexamined. Standards-setters should also consider whether the accounting rules for allocation of joint costs of fundraising and educational activities, which now treat costs incurred internally differently from costs incurred using an outside fundraiser, produce comparable data across organizations.

The increased attention on fundraising costs also has implications for accountants and auditors. Intentional misrepresentation of the amounts spent for fundraising can be the basis of a fraud action. The cost allocation process should be approached and checked with great care. Accountants should be familiar with all applicable professional standards governing cost allocation. They should document their review of the allocation procedures carefully, to provide a defense against charges of unreasonable allocations.

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