Commentary on ECFA Standard 6

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Conflicts of Interest

"Every member shall avoid conflicts of interest. Transactions with related parties may be undertaken only if all of the following are observed: 1) a material transaction is fully disclosed in the financial statements of the member; 2) the related party is excluded from the discussion and approval of such transaction; 3) a competitive bid or comparable valuation exists; and 4) the member's board has acted upon and demonstrated that the transaction is in the best interest of the member."

While most of ECFA's Standards require external evidences of financial accountability, such as distributing financial statements, Standard 6 deals primarily with internal behavior and decision-making. This is appropriate in the sense that compliance deals with personal and usually private intent and integrity.

This Standard provides additional assurance to donors and other supporters of the member organization that financial transactions are conducted fairly and are in the best interest of the organization and its ministry. As with other Standards, compliance with Standard 6 does not guarantee that all activities are in the best interest of the organization. It does provide for a more impartial environment, supporting fairness in decision-making. Another goal of this Standard is to provide to member organizations some good business principles, helping them to achieve the best long-term results while bringing honor to the Lord.

Anyone who has been involved in the leadership of a nonprofit enterprise or church has most likely experienced a situation in which a donor, board member, or other influential person has tried to conduct business with the organization in such a way as to gain some personal benefit. This can include such things as trying to "pass-through" gifts to individuals while obtaining a tax receipt, or promising future gifts if the organization conducts business with a particular individual or company. Experienced leaders can agree with the maxim that mixing business with charity or other pursuits does not work. Standard 6 assists leaders in withstanding such efforts by helping them make the right decision for the organization and themselves.

Related-party transactions and conflicts of interest. Standard 6 makes a distinction between related-party transactions and conflicts of interest. While some may argue that all related-party transactions are conflicts of interest, ECFA believes a useful contrast can be made to provide organizations with good decision-making guidelines. First let’s take a brief look at what constitutes a conflict of interest.

Conflicts of interest are situations in which a person has a responsibility for promoting one interest, but has a competing interest at the same time. When one exercises a competing interest over a fiduciary interest the conflict is realized. Examples of a realized conflict of interest include the following:

An organization's purchasing manager owns an interest in a travel agency through which the organization purchases airplane tickets and lodging reservations solely at the manager’s volition.

An organization’s board member also acts as legal counsel for the organization, recommending legal courses of action that will generate fees to the personal benefit of the board member's firm without the challenge of a competitive bid or second opinion. To mitigate this somewhat, the organization can prohibit the board member from voting on or approving such engagements. The difficulty in managing and controlling attorneys' time charges for only necessary work still presents the organization a major challenge in ultimately removing a conflict of interest. This example can apply to other professionals such as accountants, insurance agents, and architects.

An executive selects the airline and frequency of travel while personally accruing frequent flier miles on the selected airline. The conflict of interest is not in personally accruing frequent flier miles, but in acting without review or higher approval on the need for travel and on airline selection—especially if other carrier schedules and fares are more advantageous to the organization.

An employee, especially at a managerial level, pursues extracurricular activities—such as membership on boards and committees or other leadership roles in industry-related associations—so that substantial amounts of time, energy, or resources are diverted from the primary organization in which he or she is employed. In this situation, excessive amounts of extracurricular involvement are driven more by personal ambition than by benefit to the employing organization. While a conflict of interest is not always readily perceived, this type of situation can have serious implications for the employing organization; i.e., lost resources and dissemination of confidential information as a result of frequent contact with peers from other organizations.

These examples demonstrate that conflicts of interest are both obvious and subtle. The determining factor in each situation is the potentially inappropriate use of an organization's resources to benefit some competing interest. ECFA expects that member organizations will avoid conflicts of interest in their financial transactions.

Related-party transactions are transactions that occur between two or more parties (individuals, businesses, organizations, etc.) with inter-linking relationships. Sometimes these relationships can be benign: an organization buys a computer from a company that employs the wife of an organizational staff member—a staff member with no decision-making ability regarding the purchase. A more serious related-party transaction might occur if an organization purchased insurance coverage through a brokerage firm controlled by an organization’s board member. Additionally, if the purchase was not disclosed, was not approved appropriately, was not made at the best possible price or in the best interests of the organization, this example would also constitute a conflict of interest.

If an organization's board member or employee speaks at a function related to the organization, or speaks on behalf of the organization and receives an honorarium, this is a related-party transaction. While the precise facts and circumstances may assist in determining whether a conflict of interest has also occurred, it may be helpful for the organization to adopt a policy regarding the ownership of honoraria.

It is useful to think of related-party transactions as having the elements of an "arm's-length" transaction, while retaining a relationship of common control or interest among the parties. If true "arm's-length" elements do not exist in a related-party transaction then a conflict of interest occurs. In other words, a conflict of interest is a subset (only a part) of all the possible related-party transactions. While ECFA member organizations are to avoid conflicts of interest in their financial transactions, related-party transactions are permissible if they meet certain minimum criteria.

When evaluating minimum criteria, an organization should carefully examine all aspects of the transaction to ensure that no conflict of interest exists, even in subtle forms. The organization should also ensure that the financial transaction makes economic or sound business sense. Indeed, some related-party transactions are clearly advantageous to the economic benefit of an organization. Using the previously cited example of purchasing insurance coverage through a brokerage firm controlled by a board member, contracting with the firm may financially benefit the organization. If the coverage provisions are independently or competitively determined, and if the brokerage firm controlled by the board member elects to eliminate or significantly reduce its commission well below competitors’ bids, then it would be in the organization’s best interest to contract with the related party.

ECFA believes that related-party transactions may be appropriate in certain circumstances, if they can meet certain tests to ensure objectivity and are carefully evaluated to avoid conflicts of interest.

Criteria for allowing related-party transactions. Before undertaking a related-party transaction, an ECFA member organization must meet all of the following criteria established in Standard 6 for material transactions (those transactions that would be considered consequential to an objective third party):

Organizations are to avoid related-party transactions that are conflicts of interest.
Related-party transactions must be disclosed to decision makers and resource providers. The primary vehicle for disclosing related-party transactions to external constituents and resource providers is through the audited financial statements. In fact, disclosure of related-party transactions is also required by accounting principles generally accepted in the United States of America (GAAP). One of the benefits of requiring disclosure through the financial statements (at least to external readers of the financial statements) is that they have to be reviewed and verified by an independent accountant for completeness and veracity.

Obviously, related-party transactions should be disclosed to executive staff and the governing board (see criteria #4). An essential part of this internal disclosure process is a written and distributed conflict of interest policy within the organization. Often this conflict of interest policy is part of the corporate bylaws.
To help ensure that the decision to approve a related-party transaction is made in an objective and fair manner, the party that has a related interest should not participate in the discussion or approval of the transaction. The other members of the board or staff involved in making a decision should have the freedom to discuss and act on the transaction without any degree of pressure or reticence generated by the related party's involvement in the entire process. For instance, ECFA expects board decisions involving a related party who is also a board member or executive staff member of the organization to be adequately and appropriately discussed without the attendance or participation of the related party.
A related-party transaction can only be undertaken if there is evidence that the resource commitment (e.g., cost to the institution) is the best that can be obtained for the goods or services being procured. While competitive bids are the most common form of determining cost and benefit relationships, they are not always available or appropriate. For example, consider the situation of a chief executive officer asked to serve on an important board in a distant city. This would thrust the CEO into the national spotlight, could be personally rewarding to the CEO, and could require a substantial investment of time and travel cost to the member organization. While competitive bidding has no meaning in this situation, the governing board still needs to make a cost and benefit evaluation to determine whether this situation is ultimately in the best interest of the organization.

The primary point of this criterion is to ensure that the member organization performs the necessary evaluation, documenting its decision to support the reasonableness of the related-party transaction. Since independent accountants will review the transaction in order to make proper disclosures in the financial reports, a formal internal procedure and record is needed to show that a thorough cost and benefit evaluation was conducted. Normally this would include the governing board’s review of the information before making a decision.
Although more subjective in nature, the final criterion is just as important as the previous four. After the governing board has disclosed all relations, discussed the transaction openly and without bias, and conducted cost/benefit evaluations, it needs to look at the transaction as a whole and determine the overall wisdom of entering into it. The board should ask such questions as: Will the transaction, when disclosed, raise more questions with external (and internal) constituents or regulatory groups than we can adequately answer? Will we set a precedent, making it difficult to respond negatively to future situations? Does this decision ultimately have the best long-term interests of the organization at heart, or will it give short-term gains only? Since the governing board will be held responsible for the outcome of the transaction, it must exercise the utmost prudence in its evaluation and decision.

In determining independence in the auditor-client relationship, the general approach is to recognize both the appearance and reality of independence. Even if independence is the reality, this may mean little if appearance says otherwise. A member organization should always give substantial weight to the appearance of things before deciding to enter into a related-party transaction.

Summary. While guidelines and practices can help an organization avoid a conflict of interest or determine whether to undertake a related-party transaction, this is rarely an issue with clear contrasts. Instead, it is often a subjective determination involving personal intent, individual integrity, and conscience. To the extent that the board and leadership of an organization continually exhibit and practice sensitivity to these issues in all areas of decision making, the organization itself can develop a general atmosphere of high accountability. The best way for an organization to cultivate a pervasive sense of integrity and accountability is for the governing board and officers to give continuous attention to openness about their intentions and decision.