Property rights and the nonprofit organization: the issue of separation of ownership and control

The nondistribution constraint is an important part of the legal definition of a nonprofit organization. It is an important economic characteristic as well. This legal requirement, whereby no residual claim may be made by any individual or group associated with the nonprofit organization, is interpreted in economic analyses to define a nonprofit as an organiza- tion with no apparent ownership. In property rights theory, lack of ownership creates a situation where there is no incentive for any individual or group to monitor the decision maker. In his analysis of nonprofits, Hansmann (1996) notes that ‘[a] nonprofit firm with a self- electing board of directors represents the ultimate in separation of ownership and control; the management is under no effective supervi- sion by anyone with an interest in residual earnings’ (p. 238). Alchian (1969) and Fama and Jensen (1983a) interpret ‘lack of ownership’ in nonprofits to be equivalent to the lack of a functioning capital market. Thus they conclude that while separation of ownership and control is not an issue for for-profit corporations, it is relevant to nonprofit man- agerial behavior. The usual implication of the lack of ownership and monitoring in a nonprofit organization is that the decision maker has an incentive to use resources in a socially inefficient manner

The assumed apparent lack of ownership (that is, residual rights) and the related incentives for inefficiency in nonprofit organizations are problematic for a number of reasons. First, while there is no legally authorized residual claimant, there may be effective ownership or resid- ual claimants, that is, individuals who are motivated to monitor the nonprofit manager. Second, the inefficient outcomes that have been predicted rely on strictly pecuniary incentive systems.

How might nonprofit ownership be defined? Clearly, nonprofit organ- izations do not and may not have legal shareholders as do for-profit firms. Nonprofit organizations do, however, have stakeholders as fund- ing sources (see also Fama and Jensen, 1983b, on this point). The stake- holders in nonprofit organizations take on many of the characteristics of shareholders or investors in firms, as well as some characteristics of legislators with respect to public sector organizations.

Consider grantors, donors, members, and volunteers as investors in a nonprofit organization. These groups include individuals and also foun- dations, government organizations, and private for-profit corporations.2 Each grant, gift, or donation of either money or time has attached to it some expectation on the part of the provider of some return. Unlike the return expected by shareholders in a corporation, however, the expected return for donors or grantors to a nonprofit is typically nonpecuniary. That is, the expected return to fund providers is in the form of prom-ised goods or services to be supplied to a third party, the clients or users of the nonprofit service. Expected returns from a donation or grant to a nonprofit are not necessarily nonpecuniary, however. There may be some expectation of pecuniary return, even if only indirectly from the goodwill generated by having its name associated with the contribu- tion, for example, by corporate sponsors of a nonprofit service, such as public television. The contribution in this case is much like a corporate investment in advertising. Investors in nonprofit organizations there- fore have an incentive to monitor managerial behavior in the funded organization.

An alternative view of the relationship between donors and nonprofit organizations has been proposed by Tullock (1971). He assumes that nonprofit organizations are selling satisfaction to donors via misinfor- mation that has positive utility for the donors. He also assumes that outcomes (that is, output of services) of nonprofits have no value to donors and are not a source of utility to them. He describes the donor’s attitude in this respect: ‘With charitable expenditures … defects in the product … will in any case, not directly affect me. If I make a contribu- tion … I will not be in any way injured by a successful fraud or by ineffi- ciency … [Nonprofits] are “selling” a feeling of satisfaction derived from sacrifice, whether the sacrifice does or does not improve the well-being of someone else is not of direct interest to the donor’ (p. 125, italics in the original). Tullock does not provide any evidence to support this assumption, however. Indeed, there is considerable evidence to the contrary as evidenced by requirements for audit reports that detail nonprofit activities and finances, donors concerns regarding the way their funds are used and reduced donations in response to fraud and mismanagement (Wolf, 1999 and Salmon and Cho, 2002).

Investors in nonprofits monitor managerial behavior in a number of ways. First, nonprofits compete for funding from alternative institu- tional sources. Large grantors (private individuals, foundations, corpo- rations, or government agencies) typically require a formal detailed proposal of expected outcomes and budget requirements as part of the competitive process. Salamon (1999) notes that ‘government grants and contracts typically contain formal stipulations and monitoring requirements that necessitate professional action of [nonprofit] mana- gerial structures’ (p. 357). Smith (1999) terms this the ‘administrative or procedural’ category of regulations related to government contracts (p. 189). He notes that this process has become increasingly in use by private institutions that are sources of nonprofit funding as well. Salamon also notes that in the US contracts are short term and offered for rebidding at the end of the contract term, although the nonprofit organization currently under contract has a high probability of having the contract renewed. In Europe, on the other hand, contracts with nonprofit organizations are long term relationships.

In the contracting process, once the grant is awarded the contributor requires the funded nonprofit organization to provide periodic finan- cial and progress reports. Some nonprofits are subject to formal profes- sional audits. These reports indicate the allocation of the granted funds to expenditures and measurable accomplishments by the nonprofits. The reports are expected to be consistent with the original proposal. Nonprofits that do not meet financial or service performance criteria may be penalized through loss of future funding or possibly rescission of the remainder of the current grant (see Young, 1987, for both theo- retical and empirical exposition of this point). Kearns (1994) and Campbell (2002) note a number of situations where effective measures of accountability have been devised for use by by public and private sources of nonprofit funding.

The benefits to a small individual contributor of monitoring a non- profit organization are likely to be significantly lower than the cost of monitoring.  Therefore,  small  donors  have  less  economic  incentive to monitor the nonprofits they fund. However, options exist that serve to mitigate the benefit–cost problem of monitoring faced by small donors. One option is the availability of financial information that may be supplied by the nonprofit organization in solicitation mailings or on request, or via the nonprofit organization’s website. Nonprofit organi- zations also provide information through these sources on the number and types of specific services that they have provided in relation to the organization’s mission or goals. Lower search costs for this information through the availability of the internet allow small donors to adjust their funding portfolio, such as by moving contributions away from nonprofit organizations with relatively high overhead or fundraising costs to those where a larger percentage of the contribution goes to the provision of the desired service.

Another option available to small individual donors is that of provid- ing funds through the larger context of an umbrella organization, such as Catholic Charities or the United Way. Umbrella organizations act as a screening device for the donor by admitting those nonprofit organi- zations that have a reputation for service, thus increasing potential benefits relative to cost (the contribution) to small donors. Umbrella organizations also capture scale economies in fund raising, reducing these costs and permitting a larger percentage of the donor’s contribution to go to provision of the desired service (Young, 2001). In addition, the option to small donors of contributing to an umbrella organization through their employer provides an additional source of monitoring on behalf of the small donor. If the umbrella organization is considered to be either inefficient or ineffective, the donor’s affiliated group (employer or religious organization) may choose to not participate in a fundraising campaign through the offending umbrella organization. This provides some protection to the potential investments of small donor-employees or donor-members.3

Paid and volunteer employment in nonprofit organizations has increased from 8.4 percent of the total labor force in 1977 to 11.7 per- cent in 1996. Volunteer time  has  consistently  accounted  for  nearly 60 percent of the employment in nonprofit organizations (Steuerle and Hodgkinson, 1999, p. 87). Volunteers at nonprofit organizations, while usually analyzed as a form of labor input, may also be considered as investors in nonprofit organizations. Volunteers invest their time. The esti- mated value of adult volunteer time in nonprofit organizations in the US in 1998 was $225.9 billion (The Independent Sector, 2001). Unlike mone- tary donations, however, donations of volunteer time are not tax deductible in the US. Accordingly volunteers have an incentive to monitor the nonprofit organization where their investment of time is provided.

Volunteers, as direct participants in the organization, are in a position to observe organizational outcomes and procedures, and, therefore, the effectiveness of management decisions. In many cases managerial decision behavior may be directly observable. The decisions of volun- teers to commit their time to an organization are affected by their obser- vations and perceptions of organizational effectiveness. The incentive for volunteers to monitor is consistent with the finding of Menchik and Weisbrod (1981) in their study of volunteer labor supply. They suggest that a rationale for volunteer labor is to obtain experience that may lead to a potentially higher future wage or salary. This would be a form of expected pecuniary return.

Boards of directors of nonprofit organizations also serve as monitors of nonprofit managers.4 Some evidence suggests, however, that the monitoring role of nonprofit board members is limited. Members of nonprofit boards of directors appear to be supportive rather than criti- cal of nonprofit managerial decisions once the hiring decision has been made (Holland, 2002 and Miller, 2002). This is consistent with Simon’s (1957) suggestion that the interests of directors and managers of a nonprofit organization are likely to be aligned and face less conflict. It is also consistent with the finding that nonprofit managers self select into the nonprofit sector and into nonprofit organizations that have a mission consistent with their own preferences (Young, 1983).

The primary limitation of the monitoring system for nonprofits derives from the lack of tradable legal rights of donor-investors. If the nonprofit does not meet expected performance criteria, the investor may threaten to withhold future funding, as legislators do with respect to appropria- tions for public sector organizations. In some cases a grant contract may specify some payback due to lack of performance. Such situations are relatively uncommon, however, and certainly not relevant for small individual donors. In general, the investor may not easily rescind funds once committed. Coase (1993c) has noted the importance of reputation in long term contractual relationships. Reputational effects are impor- tant for nonprofit managers who must seek funding from existing and new sources (Wolf, 1999).

Ben-Ner and Van Hoomissen (1994) suggest that modifying nonprofit corporate law to provide legal standing to nonprofit members and/or donors would enhance their ability to monitor nonprofit managerial decision behavior. Although enhanced legal standing and regulatory oversight may increase the level of monitoring of nonprofit organiza- tions, the current grant process does provide some ability to monitor. The monitoring system that results is more like that of legislative mon- itoring than shareholder monitoring. The issue of nonprofit ownership, in the sense of residual claimant, however, is an important one and one that cannot simply be assumed away on the basis of the nondistribution constraint. Donors, grantors and volunteers, as stakeholders in the non- profits to which they invest their money and time, have an incentive to ensure that they obtain their expected return in the form of nonprofit performance. Unlike shareholders, and like legislators, donors, grantors, and volunteers have expected returns that may be either pecuniary or nonpecuniary. The nondistribution constraint is concerned with pecu- niary residual. The focus on pecuniary return is appropriate for investors in for-profit corporations; however, it provides an incomplete picture of motivation for investors in nonprofit organizations. I consider this point further in Chapter 8.

In addition to the monitoring systems for nonprofit organizations there is evidence of self-selection by managers and entrepreneurs into the nonprofit sector (Young, 1983). Self-selection is based primarily on organizational mission or goals, so that interests of nonprofit managers and the nonprofit organization are consistent. Managers choose non- profit organizations that have a mission or goal that is consistent with their own preferences, thereby increasing their satisfaction through organizational choice. Self-selection by nonprofit managers therefore reduces the separation of ownership from control. Self-selection serves to align principal–agent interests in nonprofit organizational perform- ance because contributions from donor/investors are also tied to the orga- nizational mission or goals. That is, the contributions of donor-investors, large or small, are designed to promote a specific service provided through the nonprofit organization, whose manager is also dedicated to the provision of that service. This characteristic of nonprofit managers also serves to mitigate the limitations of nonprofit boards of directors described above as monitors of nonprofit managers.

Source: Carroll Kathleen A. (2004), Property Rights and Managerial Decisions in For-Profit, Nonprofit, and Public Organizations: Comparative Theory and Policy, Palgrave Macmillan; 2004th edition.

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