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When Good Turns to Bad: An Examination of Governance Failure in a Not-for-Profit Enterprise

Introduction Governance failures in the private sector have received significant attention in recent years. The banking crisis has highlighted the lack of controls on institutional risk-taking which has echoes in earlier cases such as Enron where creditors and shareholders alike were misled (Clarke !!"#. Those involved in the governance function in the for-profit sector now effectively find themselves guilty until proven innocent. In contrast$ the not-for-profit sector retains a superior reputation despite enduring its own problems with financial mismanagement. This behavior tends to be analy%ed as almost accidental rather than willfully unethical (&unn and 'iley !!(#. Therefore$ although deficit in board ability does feature in the not-for-profit. )iterature (*b%ug and Galaskiewic% !!+, -rown !! #$ there is little in the way of a presumption of unethical behaviors being prevalent within the sector. This divergence in assessing and analy%ing governance in the for-profit and not for- profit sectors is echoed in academe. The literature on organi%ational governance suggests that organi%ations in each sector e.ist in parallel worlds. Corporate governance /ournals tend to have few articles focusing on notfor-profit governance (e.g.$ -art and &eal !!0, Turnbull !!1#. 2ost research is published in dedicated not-for-profit /ournals such as 34onprofit 2anagement and )eadership5. Therefore$ as a conse6uence of this separation$ papers seeking to compare governance in these different sectors are 3virtually non e.istent5 (-art and &eal !!0$#. The analysis of governance in each sector is driven by two distinct theoretical approaches. They can be broadly identified as shareholding and stockholding ()et%a et al. !!(#. 7or-profits tend to receive an analysis that has a shareholding framework at its foundation. This is guided by the assumption that shareholder interest is the primary aim of a firm8s e.istence (Child and 'odrigues !!(#. The stakeholder model of governance$ by contrast$ views the organi%ation as a means to serve the interests of numerous parties (ecovich !!"#. This in turn re6uires the board to focus on 3co-ordination with a fairly broad array of constituents5 compared to private sector boards which preoccupy themselves with 3securing access to capital and enhancing co-ordination5 (2iller-2illesen !!9#. *lthough some scholars believe that the stakeholder model applies e6ually to for-profits and not for- profits (-ouckaert and :andenhove +;;<#$ it would appear that the continued criti6ue of how for-profits act would raise a 6uestion over this (=utton +;;", >lein !!<#. 7ollowing these observations$ this paper aims to e.plore the potential for overlaps between governance in the two sectors$ guided by the following 6uestion? &o the for-profit and not-for-profit sectors share governance challenges$ including the threat of unethical behaviors@ The paper begins by mapping the principal challenges of governance in each sector. This combination of perspectives is then used to analy%e a case study of governance failure within a not-for-profit organi%ation. The final section discusses the implications of the findings

from this study when e.amining governance within the not-for-profit sector. Conclusions are drawn for further research and theory building.

When Good Turns to Bad: An Examination of Governance Failure in a Not-for-Profit Enterprise


Governance Challenges within the 7or-Arofit and 4ot-for-Arofit Bectors Theoretical Underpinnings of the Not-for-Profit Sector The observation was made above that each sector has its own discrete theoretical underpinning. To reiterate$ shareholding is the dominant model within for-profit governance$ while the not-forprofit sector has stockholding as its focus. The shareholding model is preoccupied with the issue of agency and how the board and senior management can be incentives to act in the interest of shareholders ()et%a et al. !!(#. This problem emerged from the separation of ownership and control which was brought about by the creation of the limited company form -erle and 2eans +;9 C+;;+#. The issue rests on why a senior manager$ as an agent of the shareholder$ will be as careful with shareholder assets as the shareholder would be themselves. 7riedman (+;1!# took great pleasure in emphasi%ing that we are most likely to be irresponsible when spending other people8s money. *lthough other issues feature within this theory of corporate governance$ it is still the agency problem that dominates. 2onks and 2inow ( !!<# believe that this problem is the 3single ma/or challenge5 of governance$ especially given that shareholders 3grant managers enormous discretionary power over the conduct of the business while holding them accountable for the use of that power5. This was illustrated by the Enron case where the board was /udged to have failed in its fiduciary duties to the large number of small shareholders who ended up losing much of their life savings (Clarke !!"#. )ittle attention is paid to the agency problem in not-for-profit research. The underpinning assumption appears to be that a not-for-profit organi%ation which claims to serve its stakeholders will be ethically guided (2ason et al. !!1# and so directors will not act in their own selfinterest. This rather optimistic view is 6uite prevalent within the literature (=ayden !!0#. =owever it is becoming more widely recogni%ed within the literature that not-for-profits are increasingly seeking profit-making opportunities through trading activities and so appear to becoming more like for-profit organi%ations (&art !!(#. *nother reason that agency is not a dominant issue is that both theoretically and legally not-for-profit organi%ations are owned by the community and as a result they have no shareholders (earce !!9#. 4obody has a claim on the organi%ation8s assets which are held in trust for the benefit of the community (&unn and 'iley !!(#. This means that it is difficult to identify which principal an agent would act on behalf of (*b%ug and Galaskiewic% !!+#. This does raise 6uestions over transparency (=ayden !!0# and accountability (&unn and 'iley !!(#. In contrast to for-profits$ this also means that financial demands are not the only ones that stakeholders may demand from an organi%ation. 2anaging

hese demands is the key challenge of governance within the stockholding model ()et%a et al. !!(, )ow and Cowton !!(#. Stakeholder Involvement 'esearchers make both a moral and an instrumental case for stakeholder involvement in governance (&onaldson and Areston +;;", *b%ug and Galaskiewic% !!+#. The moral view is that not-for-profits have a democratic ethos that places a duty on them to take into account a broad range of community interests (Iecovich !!"#. To facilitate this$ the board membership should be diverse and composed in a way that reduces the likelihood of it being dominated by long-serving local elites (Aarker !!1#. The instrumental case is more pragmatic in that the claim is made that there will be gains in the efficiency and effectiveness of decision making if stakeholders are involved in governance ()et%a et al. !!(#. This view has been critici%ed on the grounds that involving stakeholders is not feasible and nor is it desirable (Bternberg !!!#. Even stockholding advocates accept that there are difficulties in meeting stakeholder needs simultaneously (Goodpaster +;;9, 2ason et al. !!1#. *s *b%ug and Galaskiewic% ( !!+# note$ 3there is no one community interest, there are many5. &iversity of board membership has also become a prominent issue in for-profit studies. The ob/ective of such diversity is different though. It is primarily concerned with how the conduct of boards might be improved by ensuring that there is a reduced likelihood of the 3cost boardroom ties5 (=ayden !!0# that have been linked to a lack of attention to shareholder interests. There is also an e6uality dimension to this agenda. *s =iggs ( !!9# noted$ 6uestions will be asked of an organi%ation8s commitment to diversity if the board itself appears to be homogenous. 7urther studies have attempted to evaluate progress on the e.tent to which board membership has been opened up to broaden the gender and ethnic mi. ('uigrok et al. !!1, Grosvold et al. !!1#. The preceding section has identified two issues to e.plore within the research conte.t? agency$ which is dominant within the shareholding model$ and involvement$ which is a preoccupation of the stockholding model. The case study that is e.amined in the ne.t section offers a not-forprofit research conte.t in which each of these issues is to be e.amined. * brief description of the methodology employed is followed by the case study. The two issues are then e.amined and conclusions drawn

When Good Turns to Bad: An Examination of Governance Failure in a Not-for-Profit Enterprise


Case Btudy? *-C

This case study was compiled based on the e.periences of a participant within *-C$ the focal not-for-profit organisation. It is acknowledged that participant observation may not provide an entirely unbiased perspective on organi%ational processes and events (Bilverman !!!#. =owever$ the position taken here is that an insider can help to reveal dynamics that would go undetected by an independent researcher using more ob/ective methods such as surveys (Aarker !!1#. 2ore specifically$ in this instance$ board processes and director behaviors were captured and analyses (Bamra-7redericks !!!#. The data collection e.ercise took place over five years and included participant observation alongside the ac6uisition and conse6uent analysis of internal documentation such as the organi%ation8s written constitution. This methodological approach was not the result of a planned and purposive e.ercise. It was the product of the participant conducting a rigorous retrospective analysis in the light of the organi%ational failure which resulted in the company8s bankruptcy in !!0. 4o claims are made$ therefore$ that this case should be viewed as one that is e.haustively validated. It is offered in the spirit of presenting an opportunity to begin a discussion of the possibility of connections being made between governance practices in different sectors. ABC *-C was established in =uddersfield$ England$ in Dctober !!! as a not-for-profit company limited by guarantee. It lasted si. years and was formally wound up in !!0. It was created to provide opportunities for young people to access creative arts activities. The young people it focused on were those e.hibiting anti-social behaviors. *lthough *-C was constituted as a worker co-operative$ it did not have provision to act as a member benefit organi%ation. It was specifically organi%ed to proscribe members receiving personal rewards$ as embodied in the constitution which stated that. the surplus of the Co-operative shall be applied as follows$ in such proportion and in such a manner as the General meeting shall decide from time to time? to a general reserve for the continuation and development of the Co-operative. The assets of *-C were similarly locked in to maintain community ownership through a further clause? If on the winding up or dissolution of the Co-operative any of its assets remain to be disposed of after its liabilities are satisfied$ these assets shall not be distributed among the 2embers$ but shall be transferred instead to some other common ownership enterprise$ or some other non-profit organi%ation$ as may be decided by the members. Driginally the organi%ation was run by four staff whose positions were supported by funding from the E> government through an employment creation scheme. Foung people were referred to *-C by local schools as well as parts of the criminal /ustice system such as youth offending teams. *-C subscribed to a model of anti-social behaviors that linked it with low educational attainment$ unemployment$ and crime. They believed that they could reduce the incidence of social e.clusion by offering positive alternatives to the usual activities of drug-taking$ alcohol$ and criminal behaviors. These alternative activities were predominantly workshop-based sessions in music technology$ break-

dancing$ and drama. These sessions were designed to increase confidence and motivation by providing young people with transferable skills. Initially *-C focused on *fro-Caribbean young people. There is a si%eable community within the =uddersfield area. Dver time the organi%ation e.panded its reach and engaged with white and *sian youths who were also e.hibiting anti-social behaviors. Githin one year *-C was in a position to establish its own premises within =uddersfield. They ac6uired space which enabled them to create a number of dedicated facilities including a recording studio$ dance studio$ training rooms$ and office space. Btaff was recruited on the basis of their creative talents and their pro.imity to the organi%ation. )ocal artists$ musicians$ and dancers became mentors who were seen by *-C to be capable of acting as positive role models for the young people on their programmers. *-C gradually became more established and received recognition for their work. 7or e.ample they won a regional award in !!( for being 3Dn the Ep5. -etween !! and !!($ annual turnover grew sharply from H9<$!!! to around H9!!$!!!. This was the result of trading$ funding awards$ and contracting with one government contract alone being worth H+"!$!!!. These contracts re6uire an organi%ation to create formal systems that can deal with monitoring$ evaluation$ and progression of participants. This meant that a perception grew within *-C that they were meeting the needs of their contractors rather than ma.imi%ing their effectiveness with regard to users of their service. This formality was making them less fle.ible and so less responsive to the young people on their programmers. *ccountability appeared to be moving away from the community which *-C were set up to serve as they had to meet the increasingly onerous demands of their contractors. *fter a series of events that shall be described in the following sections$ by Ianuary !!0 the organi%ation was in voluntary li6uidation. To identify which factors may have contributed to this swift decline$ agency and stakeholder involvement from the earlier theoretical discussion will now be e.plored in the conte.t of the case material. Agency * contributory factor to *-C8s failure was the agency problem which emerged in the establishment of a subsidiary trading arm focused on the music industry. This venture aimed to nurture those talented youngsters that had been discovered while attending *-C8s creative programmers. These local music artists were given recording opportunities and management support in return for a guaranteed share in future revenues from sales and performance commissions. This artist development programmed would therefore be financially supported by commercial trading income. *ny profit margin generated could then be invested back into *-C to help subsidies their main social purpose activity. * large amount of working capital was needed to set this programmed up and was raised through accessing the company8s reserves. *fter two years$ and with the support of two full-time members of staff$ it had still failed to generate any income. &irectors failed in their role as agents of both the organi%ation and the community. It is not uncommon for these types of venture to fail. The music industry is a notoriously difficult one in which to succeed due to its competitive nature. =owever$ the decision-making bears further analysis. Aerhaps the venture illustrates the difficulty of balancing the need for not-for-profits to

seek financial sustainability against the taking of reasonable risks to secure this sustainability. *nother interpretation is to view this venture as the board allowing their own personal interest in the music industry to cloud their /udgment. This demoted the social ob/ectives of the company into second place. This behaviors can be defended to some e.tent and suggest agency failure without 6uestioning the ethics of the board8s conduct. =owever$ the evidence from the following section on stakeholder involvement suggests a different conclusion. Involvement Btakeholder involvement is enshrined legally in the constitution of a co-operative. In theory at least$ it is possible for anyone to become a member. 7rom there$ any member is then entitled to put themselves forward for board membership. Therefore$ any stakeholder can become involved in the governance function. This is illustrated within *-C8s *rticles of *ssociation? 9. 2embership will be open. The *rticles also show their support for the involvement of employees with the clause stating$ (. *ll employees on taking up employment with the Co-operative shall be admitted to 2embership of the Co-operative$ e.cept that the Co-operative in General 2eetings may by ma/ority vote decide to e.clude from the 2embership? a. persons under eighteen years of age, b. newly appointed employees during such reasonable probationary period as may be specified in their terms and conditions of employment, provided that any such criteria for e.clusion is applied e6ually to all employees. These e.cerpts from the constitution suggest that *-C intended to offer the opportunity to new employees to become members of the organi%ation and$ further$ to become involved in governance if they so desired. This opportunity was to be available unless there were e.ceptional and transparent circumstances which would be determined through a ma/ority vote by the e.isting membership. =owever$ this clause ( was used to limit membership and keep it e.clusive to the founding members. This was achieved by e.tending the 3reasonable probationary period5 detailed in the clause to beyond the length of any e.isting employee8s service. This had the effect of keeping membership perpetually out of reach. The other implication of this was that there was no opportunity for an employee to /oin the board. Eventually$ the situation did become the sub/ect of a challenge from staff within the organi%ation as they became more aware of their legal entitlements. Employees began to insist upon the right to membership and hence also pushed for full voting rights at *nnual General 2eetings. Epon gaining these rights$ the membership decided to remove a director from his role against his wishes. =is conduct was 6uestionable not least because he had appointed himself both 2anaging &irector and 7inancial &irector. =e had also been identified by members as one of the key barriers to any inclusive practices being fully implemented. The other members of the board

received more favorable treatment and were granted the right to continue in their roles for another year before being sub/ected to a membership vote. Dnce the inclusive policy was in place$ *-C had an open route to membership. This continued for the si. months that remained of the organi%ation8s e.istence. The company continued to struggle in spite of these improvements being made to employee involvement in the governance function. -y the autumn of !!"$ the organi%ation was no longer financially viable and was effectively on the verge of collapse. The price was being paid for previous decisions by directors to award themselves hefty pay raises while their new ventures$ as with the e.ample above$ singularly failed to achieve business success. It fell to the newly elected board members to honor their legal obligation to instigate li6uidation proceedings following the holding of an Emergency General 2eeting of the membership. This decision was not supported by the original directors who demonstrated little understanding of the legal implications of trading whilst in the full knowledge that the organi%ation is insolvent. 7ortunately$ the newly empowered membership was able to impose their will over the old guard and administration and winding-up duly followed.

When Good Turns to Bad: An Examination of Governance Failure in a Not-for-Profit Enterprise


&iscussion This case analysis has attempted to support the central argument of this paper$ namely that forprofit and not-for-profit governance should not always be viewed in isolation of one another. Governance in these two sectors may actually e.hibit very similar behaviors in certain circumstances and so there is value in being open to this possibility. =owever these behaviors will only be identified by researchers if theoretical insights from research in each sector are combined in any framework adopted. &espite a handful of e.ceptions (2iller-2illesen !!9, -art and &eal !!0, Aarker !!1#$ there is still a tendency to focus on issues that have been revisited many times in the same sector. The case detailed here has focused on agency and involvement$ two key challenges of governance that are prominent within the for-profit and notfor-profit literatures respectively. -y making a link between agency failure and a desire by the board to restrict stakeholder involvement$ the case has shown how not-for-profits can be sub/ect to unethical conduct by directors who can undermine governance and so impact negatively on operational decision-making. *lthough the agency failure detailed above can be viewed as incompetence$ it takes on a more unethical character when taken together with the board8s behaviors with regard to involvement and governance. The willful e.clusion of employees took place through undermining the spirit if not the letter of the constitution of the company. -ouckaert and :andenhove (+;;<# suggest that an organi%ation that claims to be socially responsible must 3give due regard to the e.pectations and interests of the various stakeholders in determining and reali%ing the values and mission of

the company5. There is little evidence of this 3due regard5 in the case of *-C. This fact raises doubt around whose interests the board members were serving in their decision-making. &irector self-interest may be more common within the for-profit sector but it should not be ruled out in the not-for-profit arena (=ayden !!0#. It is not the intention to suggest that this case indicates a widespread malaise in the not-for-profit sector. It simply highlights that an organi%ation that is founded on a social principle may still display behaviors that is more usually associated with the for-profit sector. The organi%ation may still trumpet its values throughout its communications while acting in a way that undermines its claims. -etter governance procedures within the not-for-profit sector aim to balance e.perience with new ideas (+ Aarker !!1#. The case of *-C shows how this can be stifled by protecting the cost arrangements already in place (=ayden !!0#. )ack of openness to new board members may pose a threat to the 6uality of decision-making ()et%a et al. !!(# alongside being an issue of ethics. The agency failure of *-C may or may not have been avoided with a more diverse board membership. -ut at least the adoption of a more pluralistic approach would raise the probability of a more informed approach to the decision-making process. It becomes more likely that the board will be made more sensitive to the demands of stakeholders$ including potential consumers and contractors (*b%ug and Galaskiewic% !!+#. This field re6uires conceptual development alongside additional studies e.amining governance failure within the not-for-profit sector. It is assumed that the current preference will continue amongst governments for the not-for-profit sector to e.pand in its provision of public services (Aarker !!1#. Therefore$ it is not unreasonable to posit that the incidence of financial collapse will increase$ thereby presenting more research opportunities for research. Ghile increased failure is not a desirable scenario$ it re6uires greater scrutiny. Githout such scrutiny it is likely that future failures will continue to happen. Greater attention must be paid to the impact of the role played by director conduct and motivation in not-for-profit organi%ations. The for-profit 3scandal5 literature does a very good /ob of analy%ing this. To help bring this about$ more syntheses of the two literatures are needed (e.g.$ 2iller- 2illesen !!9#. This would then offer the possibility of developing a framework that builds upon the tentative model put forward in this paper