United Cancer Council, Inc. v. Commissioner

109 T.C. No. 17UNITED STATES TAX COURT
UNITED CANCER COUNCIL, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 2008-91X. Filed December 2, 1997.
Petitioner was organized in 1963. In a ruling letter
dated Mar. 31, 1969, respondent ruled that petitioner was
exempt from Federal income tax and was an eligible
charitable donee. Secs. 501(a), 501(c)(3), 170(c), I.R.C.
1954.
On June 11, 1984, petitioner entered into a 5-year
fundraising contract (the Contract) with a professional
fundraiser (W&H). During 1984 through 1989, W&H helped
petitioner conduct a nationwide direct mail fundraising
campaign. Petitioner received a total of about $2¼ million
in net fundraising revenue under the Contract. W&H received
more than $4 million in fees from petitioner, and in
addition derived substantial income from exploiting the co-
ownership rights in petitioner’s mailing list, which rights
had been granted to W&H under the Contract.
On Nov. 2, 1990, respondent revoked the favorable
ruling letter retroactively to June 11, 1984. Petitioner
initiated the instant action under sec. 7428, I.R.C. 1986,
for a declaratory judgment that it qualifies as an exempt
organization and as an eligible charitable donee.
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1. Held: W&H was an “insider” for purposes of the
inurement provisions of secs. 501(c)(3), 170(c)(2)(C),
I.R.C. 1954 and 1986.
2. Held, further, there was an inurement of net
earnings to W&H; petitioner fails to qualify as an exempt
organization or as an eligible charitable donee.
3. Held, further, respondent’s retroactive revocation
of the favorable ruling letter back to June 11, 1984, was
not an abuse of discretion.
Leonard J. Henzke, Jr., James W. Curtis, Jr., MacKenzie
Canter III, Theodore R. Weckel, Jr., and Joseph Greif, for
petitioner.*
Dianne I. Crosby, Deidre A. James, Sandra M. Jefferson, and
Chalmers W. Poston, Jr., for respondent.
TABLE OF CONTENTS
Page
Introduction and Statement of Issues ...................... 4
Findings of Fact .......................................... 5
Background and Summary.................................. 6
Direct Mail Fundraising................................. 14
*
After the trial was held and opening briefs were filed, but
before the parties filed their answering briefs, Theodore R.
Weckel, Jr., was given permission to withdraw from the instant
case.
Briefs amici curiae were filed by Thomas A. Troyer, Albert
G. Lauber, Jr., and Catherine E. Livingston, as attorneys for
American Heart Association, American Lung Association, American
Cancer Society, and Independent Sector (hereinafter sometimes
collectively referred to as American/Sector), and by Roger Warin
as attorney for Non-Profit Mailers Federation (hereinafter
sometimes referred to as Mailers).
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W&H; AICR............................................... 21
The Contract; Related Agreements ....................... 25
A. The Contract (June 11, 1984) ..................... 25
B. The Escrow Agreement ............................. 29
C. Petitioner's “Draw” Arrangement................... 32
D. Agreement To Continue At 50 Percent The Percentage
Of Net Housefile Mailing Income The Fundraising
Contract Required To Be Retained In The Escrow
Account To Reimburse W&H.......................... 36
E. April 1987 Addendum to the Contract............... 36
Direct Mail Fundraising Campaign: 1984--1989............ 40
A. In General........................................ 40
B. W&H’s Advances Of The Initial
Capital To Conduct The Direct Mail
Fundraising Campaign.............................. 44
C. Vendors Who Furnished Goods Or Services........... 45
D. Rentals Of Mailing Lists.......................... 46
E. Sweepstakes Mailings.............................. 53
F. Adverse Publicity ................................ 60
G. Petitioner's Escrow Account-Related Problems...... 64
1. Draws and Petitioner's Dispute with W&H
Over the Calculation of Cumulative
Net Mailing Campaign Revenue................... 64
2. W&H’s Purchase And Invoice Control
Procedures..................................... 68
H. Petitioner's Attempt To Obtain A Copy of
Its Housefile..................................... 76
Petitioner's and W&H’s Respective Accounting
Treatments Of The Direct Mail Campaign's
Revenue And Expenses.................................... 78
Petitioner's Allocation Of Expenses Between
Fundraising And Public Education........................ 80
Opinion..................................................... 85
I. Status Under Sections 501(c)(3) And 170(c)(2)........ 85
A. W&H As Insider ................................... 90
B. Did Any Of Petitioner’s Net Earnings
Inure To W&H?..................................... 98
II. Retroactivity Of Respondent's Revocation Of The Prior
Favorable Ruling Letter Issued To Petitioner......... 111
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CHABOT, Judge: Petitioner initiated this action pursuant to
section 74281 for a declaratory judgment that for all periods
beginning on or after June 11, 1984, it qualifies as an
organization described in section 501(c)(3) which is exempt from
tax under section 501(a) and that it qualifies as an organization
described in section 170(c)(2). The action was initiated after
respondent revoked a favorable ruling letter which had been
issued to petitioner. The revocation is retroactive to June 11,
1984. Petitioner has exhausted its administrative remedies and
satisfied the other statutory predicates (sec. 7428(b); Rule
210(c))2.
The issues for decision are as follows:3
(1) Whether petitioner is operated exclusively for
charitable, educational, scientific, or other exempt
purposes under sections 501(c)(3) and 170(c)(2)(B).
(2) Whether any part of petitioner’s net earnings
inured to the benefit of private shareholders or
1
Unless indicated otherwise, all section references are
to sections of the Internal Revenue Code of 1954 or the Internal
Revenue Code of 1986, as in effect for the period of time
referred to.
2
Unless indicated otherwise, all Rule references are to
the Tax Court Rules of Practice and Procedure.
3
In United Cancer Council, Inc. v. Commissioner, 100
T.C. 162 (1993), we denied petitioner’s motion for summary
judgment, holding that the due process clause of the Fifth
Amendment to the Constitution does not require respondent to
initiate judicial review before revoking the ruling letter issued
to petitioner.
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individuals, within the meaning of sections 501(c)(3) and
170(c)(2)(C).
(3) If the answer to issue (1) is “no”, or the answer
to issue (2) is “yes”, then whether the retroactive
revocation of the favorable ruling letter was an abuse of
discretion.
The parties have also raised ancillary issues, including the
following: (1) whether petitioner’s direct mail fundraising
arrangement with Watson and Hughey Company (hereinafter sometimes
referred to as W&H) constitutes a joint venture; (2) whether a
portion of the direct mail campaign expenses petitioner incurred
are properly allocable to public education; and (3) whether the
mailings made under petitioner’s nonprofit mail permits violate
United States Postal Service regulations as cooperative mailings
due to the nature of the fundraising arrangement between
petitioner and W&H, and to W&H’s co-ownership rights in
petitioner’s mailing list.
FINDINGS OF FACT
Some of the facts have been stipulated; the stipulations and
the stipulated exhibits are incorporated herein by this
reference.
On June 1, 1990, petitioner filed for bankruptcy under
chapter 7 of the Bankruptcy Code in the U.S. Bankruptcy Court for
the Southern District of Indiana, Indianapolis Division. On
January 28, 1991, the bankruptcy court granted petitioner’s
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motion to lift the automatic stay and permit petitions to be
filed in the Tax Court for purposes of initiating the instant
declaratory judgment action and a related deficiency proceeding.4
When the petition was filed in the instant case, petitioner
was a not-for-profit corporation in bankruptcy in Indiana.
Gregory Fehribach, the trustee in bankruptcy, maintained an
office in Indianapolis, Indiana.
Background and Summary
Petitioner was organized in 1963 as a Delaware not-for-
profit corporation. Petitioner is a membership organization.
Its members consist of local cancer agencies throughout the
country. By letter dated March 31, 1969, respondent ruled that
petitioner was exempt from Federal income tax under section
501(c)(3) and that donors may deduct contributions to petitioner
under sections 170, 2055, 2106, and 2522.
Petitioner’s founding members had previously been local
chapters of the American Cancer Society (hereinafter sometimes
referred to as the ACS). These founding members separated from
the ACS because (1) they wanted to participate in United Way
fundraising campaigns, which ACS prohibited at that time; and (2)
they wanted to concentrate on cancer prevention and alleviation
of pain and suffering of cancer victims, rather than research to
develop a cure for cancer.
4
The related deficiency proceeding, docket No. 2009-91,
involves deficiencies determined for 1986 and 1987. The parties
have agreed to hold that case in abeyance until after the
resolution of the instant case.
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From 1963 until 1984, petitioner acted as a support
organization for its “affiliate member agencies”. It published a
quarterly newsletter, offered access to cancer educational
materials, and held an annual meeting of its membership each
fall. Petitioner was an umbrella organization, coordinating its
affiliate member agencies which met the direct needs of cancer
patients through the providing of medical supplies, cancer
research, and public education about cancer prevention,
detection, and treatment. Petitioner was supported primarily by
the membership dues paid by its affiliate member agencies.
Petitioner also received contributions in small amounts as a
result of direct solicitations of individuals who were members of
petitioner’s board of directors or of the boards of directors of
petitioner’s affiliate member agencies. Until 1984, petitioner’s
annual budget never exceeded $50,000.
In 1983, some affiliate member agencies indicated they
intended to withdraw from petitioner. This precipitated a budget
crisis for petitioner. Its board of directors realized that
petitioner might have to be dissolved unless other sources of
funding could be secured for petitioner. The board directed
petitioner’s executive director to conduct a search for a
professional fundraiser that could assist petitioner in
conducting fundraising to meet its increased need for funds,
without the necessity of petitioner’s contributing initial
capital for the fundraising effort.
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As a result, during 1983 and 1984, petitioner and W&H
discussed their possible entry into a fundraising contract. As
of March 12, 1984, petitioner estimated it would have an
operating deficit for 1984 of $13,000, without additional
fundraising income. In addition to providing the initial capital
to conduct petitioner’s direct mail fundraising campaign, W&H
offered to furnish funds with which petitioner could continue to
operate.
On June 11, 1984, petitioner and W&H entered into a “Full
Service Direct Response Fundraising Agreement” (hereinafter
sometimes referred to as the Contract) for a term ending May 30,
1989. As of the date the Contract was entered into, petitioner
was on the verge of insolvency; petitioner did not have money to
start a direct mail or other fundraising program on its own. The
Contract was amended by an addendum on April 8-9, 1987. Unless
the context indicates otherwise, references to the Contract are
to be taken as including both the Contract entered into in 1984
and the 1987 amendment. The Contract expired in May 1989, and
was not renewed.
In conjunction with the formation of the Contract, W&H
agreed to advance money to petitioner in order to cover the
initial costs of the mailings. W&H also agreed to give to
petitioner an immediate advance, or “draw”, against petitioner’s
projected future earnings from the Contract.
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From 1984 until its bankruptcy in 1990, petitioner
maintained its principal office in either Carmel or Indianapolis,
Indiana. As part of the direct mail fundraising campaign
petitioner conducted from 1984 through 1989 pursuant to the
Contract, a Washington, D.C., office mailing address was
maintained for petitioner. Contributors were directed to send
their donations to the Washington, D.C., office mailing address.
During 1984 through 1989, about 79.6 million fundraising
letters were mailed under the Contract. Of the 79.6 million
letters, about 51.8 million were “prospect letters” and 27.8
million were “housefile letters”. The terms “prospect letter”
and “housefile letter” are discussed more fully infra. The
Contract provided that W&H was to receive as compensation, among
other things, mailing fees of $.05 per prospect letter mailed and
$.10 per housefile letter mailed. However, the Contract was a
“no-risk” contract for petitioner, in that petitioner was liable
to pay fundraising expenses only to the extent proceeds were
raised. If insufficient proceeds were raised to cover the
fundraising expenses, then W&H was liable to pay the excess
fundraising expenses. During the term of the Contract, W&H
advanced funds to conduct petitioner’s direct mail fundraising
campaign and, generally, was paid its fees only after other
fundraising expenses had been paid. Under the Contract,
petitioner was further guaranteed that, for the first 2 years of
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the Contract, petitioner would receive at least 50 percent of the
cumulative net income produced from its housefile mailings; after
the first 2 years, petitioner would receive at least 70 percent.
In April 1986 petitioner agreed to keep the guarantee at 50
percent in exchange for W&H’s reducing its “creative” package fee
on housefile mailings and capping its mailing fee on any
housefile mailing of more than 500,000.
Petitioner generally maintained its books under an accrual
method of accounting. For 1984 through 1989, petitioner received
the amounts of total annual contributions set forth in table 1.
Table 1
Year Total Contributions
1984 $240,380
1985 5,087,453
1986 7,869,015
1987 10,740,045
1988 3,883,352
1
1989 943,142
Total 28,763,387
1
An analysis of petitioner’s financial statements, prepared by
petitioner’s counsel and assumed to be true by petitioner’s
expert witness Richard S. Steinberg, indicates that $644,627 of
the 1989 contributions were produced under the Contract.
For 1984 through 1989, petitioner incurred at least the
amounts of total annual expenses in fundraising and in its
mailing campaign set forth in table 2.
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Table 2
Year Total Expenses
1984 $241,251
1985 4,980,949
1986 7,255,744
1987 9,734,233
1988 3,229,425
1989 1,082,315
Total 26,523,917
The amounts in table 2 include mailing campaign expenses from
petitioner’s “Donor Development Fund” that petitioner concluded
were allocable to its public education activities, as
distinguished from its fundraising activities. The amounts in
table 2 do not include other management and general expenses that
petitioner incurred as a result of carrying out its fundraising
activities and mailing campaign.
Petitioner received a total of about $2¼ million in net
fundraising revenue under the Contract. In 1984 through 1989,
petitioner paid to W&H the amounts for fundraising shown in table
3.
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Table 3
Year Amounts Paid
1984 $43,965
1985 143,196
1986 842,219
1987 1,974,247
1988 999,527
1989 115,406
Total 4,118,560
The amounts in table 3 do not include list rental fees and
commissions paid to Washington Lists, a division of W&H, or
income derived by W&H from exploiting its rights in petitioner’s
housefile.
For 1984 through 1989, petitioner paid to Washington Lists
the amounts for mailing list rentals shown in table 4.
Table 4
Year Amounts Paid
1984 $39,813
1985 907,594
1986 868,763
1987 1,756,964
1988 328,070
Total 3,901,204
After the end of the term of the Contract, petitioner
entered into a fundraising contract with another fundraising
consultant. Under this second contract, petitioner was liable
for all fundraising expenses. However, when petitioner was not
able to pay certain debts to vendors, the new fundraiser paid
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those debts. The fundraising efforts conducted under the new
contract were not successful, and petitioner suffered a
substantial financial loss on the mailings done, and was unable
to pay all of the fundraising expenses.
On November 2, 1990, respondent issued to petitioner a final
notice of revocation of the favorable ruling letter retroactive
to June 11, 1984. The notice of revocation states, in pertinent
part, as follows:5
We have completed our review of your activities, and
examination of your Forms 990 for the years ending December
31, 1986 and December 31, 1987.
By a determination letter dated March 31, 1969, we
recognized your exemption from Federal Income tax under
section 501(c)(3) * * *.
As a result of the examination of your activities and
financial records for the years noted above, we had
unresolved questions concerning your mailings and your
exempt status. On July 12, 1989, we requested technical
advice from our National Office in order to resolve these
questions.
In response to the request for technical advice, our
National Office ruled that your exemption from income tax
should be revoked effective June 11, 1984.
* * * * * * *
This letter constitutes formal notification of revocation of
your exemption from Federal income tax effective June 11,
1984.
* * * * * * *
5
There are some slight differences between the notice of
revocation letter identified by both sides in the pleadings, and
the one that the parties have stipulated in the administrative
record; these differences appear to be irrelevant to any matter
in dispute. In these findings we have used the letter that is in
the administrative record.
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Contributions to you are no longer deductible as provided in
section 170 * * * .
On November 2, 1990, respondent also issued a notice of
deficiency to petitioner, determining income tax deficiencies for
1986 and 1987.
On January 30, 1991, after the bankruptcy court lifted the
automatic stay, petitioner filed its petition initiating the
instant declaratory judgment action pursuant to section 7428. On
January 30, 1991, petitioner also filed its petition initiating a
proceeding for review of the notice of deficiency issued to it
for 1986 and 1987, United Cancer Council, Inc. v. Commissioner,
docket No. 2009-91. The parties have agreed that the deficiency
proceeding should be held in abeyance pending the resolution of
the instant declaratory judgment action.
Direct Mail Fundraising
W&H operated with the understanding that direct mail
solicitation allows an organization’s marketing and solicitation
efforts to directly focus on and target specific individuals. In
W&H’s view, in comparison to direct mail solicitation,
solicitations conducted through the print media or radio will
generally reach a nonspecific and less targeted audience. W&H’s
advice to petitioner and actions under the Contract were based in
part on these understandings.
In a direct mail fundraising campaign, a “prospect letter”
is a letter mailed to an individual who has not previously
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contributed, or otherwise responded, to the mailing organization.
A “housefile letter” is a letter mailed to an individual who has
contributed to the organization or has responded favorably to a
communication, typically as the result of a prospect letter. An
organization’s housefile mailing is a mailing sent strictly to
that organization’s housefile.
An organization’s housefile, containing the names,
addresses, and other pertinent information with respect to that
organization’s previous contributors, can be a valuable asset in
that organization’s present and future fundraising efforts.
Typically, in a direct mail fundraising campaign, practically all
of an organization’s net mailing revenue will be generated from
its housefile mailings. As a result, a usual primary goal of a
direct mail fundraising campaign is to develop a productive
housefile of contributors for use in the organization’s
fundraising efforts.
In contrast to housefile mailings, an organization will
usually lose money or, at best, break even in conducting prospect
mailings. However, an organization typically first develops and
establishes a productive housefile through conducting prospect
mailings. Moreover, over the course of time, a housefile will
suffer from attrition. Not all previous contributors will
continue to contribute to the organization. As a result, even
after an organization has built up a productive housefile, the
organization will periodically conduct prospect mailings to
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refresh and add new names to its housefile.
An organization’s housefile can also be of considerable
value to other organizations in their fundraising or solicitation
efforts. Accordingly, an organization may be able to profit
economically from its housefile by using its housefile to produce
rental income or by exchanging its housefile for another
organization’s housefile, thereby reducing its fundraising
expenses. Before the late 1970's there were few mailing lists on
the market, and most that were available were exchanged list for
list, rather than rented for a fee. By the late 1970's and early
1980's a rental market for mailing lists had developed. The
rental market has expanded since the mid-1980's because there are
more lists being made available for rent and more list rental
brokers. However, some organization that have mailing lists did
not rent or exchange their lists.
It is common practice to use monitoring or “dummy” names
(sometimes called “seed names”) in a housefile, to guard against
unauthorized use of the housefile and to monitor the patterns of
mail drops across the United States. Both petitioner and W&H
maintained their own, separate, monitoring names with regard to
the mailing lists developed under the Contract. The parties have
not presented us with illustrations of how this dummy name
monitoring works in practice, or how much effort or funds are
expended in such monitoring programs generally, or were expended
under the Contract.
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By industry custom, if a rented name responds favorably to
the mailing made by the lessee of the mailing list (i.e., by
sending a contribution, making a purchase, or entering a
sweepstakes contest), then the lessee is entitled to add that
name to its own housefile. The lessee thereafter may use the
name as its own and will not have to pay a further rental fee.
W&H had Wiland Associates (described infra as a services
vendor) provide management information reports to petitioner.
Among these reports was one that evaluated individual
contributors on mailing lists, based on an analysis of the
following three factors: (1) recency (i.e., how recently the
last donation by that contributor was made), (2) frequency (i.e.,
how frequently that contributor has made donations to the
organization), and (3) size of the gift. All other things being
equal, a contributor who made a donation within the past 6 months
is considered more valuable than a contributor who last made a
donation 3 years ago. Similarly, all other things being equal, a
contributor who made 10 donations is considered more valuable
than a contributor who made just one donation. Lastly, all other
things being equal, a contributor who made a $100 gift is
considered more valuable than a contributor who made a $5 gift.
In the 1960's and the 1970's, the use of computers
revolutionized the operation of the direct mail fundraising
industry. Using the electronic data processing capability of
computers, mailing lists could be analyzed, compiled, and
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utilized much more efficiently than previously was possible.
Before the use of computers, mailing lists were maintained on 3-
by-5 cards or on metal plates.
Richard Viguerie (hereinafter sometimes referred to as
Viguerie) was an early pioneer in the contemporary direct mail
fundraising industry. By the late 1970's, Viguerie and his
company, Richard Viguerie and Associates (hereinafter sometimes
referred to as the Viguerie Company), had received considerable
press and publicity as a result of their ability to successfully
conduct direct mail fundraising campaigns for “conservative”
political candidates and causes. The Viguerie Company reportedly
had a master mailing list comprising the names and addresses of
millions of contributors. The Viguerie Company also conducted
nonpolitical direct mail fundraising campaigns for charitable
organizations exempt under section 501(c)(3).
As of the early 1980's, Viguerie and the Viguerie Company,
which maintained offices in the Washington, D.C., area, had
several competitors who offered similar fundraising services.
Some of these competitors were former employees of the Viguerie
Company.
By the 1980's, many States enacted charitable solicitation
statutes. Generally, such statutes require most charitable
organizations to register with a State governmental regulatory
agency before soliciting contributions from members of the
general public within that State. Some State charitable
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solicitation statutes further prohibited or restricted charitable
organizations from soliciting contributions, unless a prescribed
minimum percentage of the proceeds raised would be expended in
the charitable organization’s charitable program, thereby
limiting the percentage of the proceeds to be used by the
charitable organization to pay fundraising expenses.6
The Council of Better Business Bureaus (hereinafter
sometimes referred to as the CBBB) and the National Charities
Information Bureau (hereinafter sometimes referred to as the
NCIB) established certain guidelines for organizations that
solicit charitable contributions from the public. The objectives
of the CBBB as to these matters are to (1) encourage self-
regulation of charities and (2) assist potential donors by
helping them to make better-informed gift-giving decisions. The
objective of the NCIB is to promote informed giving by providing
to the public information that will help potential donors to
evaluate charities. The CBBB is exempt under section 501(c)(6)
as a business league; its activities in the charitable area are
conducted by a division called the Philanthropic Advisory
6
Ultimately, the United States Supreme Court held
unconstitutional, on First Amendment grounds, several State
charitable solicitation statutes that limited the amount or
percentage of the proceeds raised that could be expended by
charitable organizations to pay fundraising expenses. See Riley
v. National Federation of Blind, 487 U.S. 781 (1988); Secretary
of State of Md. v. J.H. Munson Co., 467 U.S. 947 (1984);
Schaumburg v. Citizens for Better Environ., 444 U.S. 620 (1980);
see also, United Cancer Council, Inc. v. Commissioner, 100 T.C.
at 174-177.
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Service. The CBBB and the Philanthropic Advisory Service were
formed in 1971, as the successors to the National Better Business
Bureau and its Solicitations Control Division, respectively. The
NCIB is exempt under section 501(c)(3) as a charity; it was
founded in 1918. CBBB and NCIB also prepared and issued reports
on whether particular charitable organizations met CBBB’s and
NCIB’s respective fundraising and operational guidelines.
Typically, a report on a particular charitable organization was
prepared as a result of CBBB’s or NCIB’s receipt of inquiries
with respect to that charitable organization.
Among its guidelines, CBBB generally recommends that (1) a
charitable organization’s fundraising costs not exceed 35 percent
of related contributions, and (2) total fundraising and
administrative expenses not exceed 50 percent of its total
income. However, CBBB recognizes that a charitable organization
that does not meet these percentage limitations may provide
evidence demonstrating that its use of funds is reasonable. In
particular the CBBB pamphlet on standards states as follows:
The higher fundraising and administrative costs of a newly
created organization, donor restrictions on the use of
funds, exceptional bequests, a stigma associated with a
cause, and environmental or political events beyond an
organization’s control are among the factors which may
result in costs that are reasonable although they do not
meet these percentage limitations.
The overwhelming majority of the charities that the CBBB reviews
meet all 22 of the CBBB’s guidelines.
Similarly, among its guidelines, NCIB generally recommends
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that not more than 30 percent of the contributions, grants, and
bequests a charitable organization receives should be spent on
fundraising. NCIB suggests that, where more than 30 percent was
spent on fundraising, then the prospective contributor should
further analyze the charitable organization’s operations and ask
the charitable organization for an explanation regarding the
percentage of proceeds spent in fundraising. In particular,
NCIB’s contributor’s checklist pamphlet states as follows:
Some fund-raising practices are always expensive--
acquisition of new donors through direct mail or
telemarketing, for example--and yet they may be the
only methods available to an organization if it hopes
to reach the general public. Some charities which rely
heavily on bequests will have fundraising costs that
vary considerably from year to year. New
organizations, organizations with causes that are
little known or controversial, organizations with a
contributor base made up of many smaller contributions
rather than a few large grants--are all likely to have
relatively high fund-raising costs, and yet they may be
quite well managed.
W&H; AICR
W&H began business in late 1981 as a two-person partnership
owned 50 percent each by Jerry Carroll Watson (hereinafter
sometimes referred to as Watson) and Byron Chatworth Hughey
(hereinafter sometimes referred to as Hughey). As of the time of
the trial in the instant case, Watson and Hughey have been W&H’s
only two partners. Before forming W&H, Hughey was employed at
the Viguerie Company from 1978 to 1981. From 1983 through the
time of the trial in the instant case, W&H maintained its offices
in the Washington, D.C., area, in Alexandria, Virginia. (In July
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1992, W&H changed its name to Direct Response Consulting
Services; herein we continue to refer to it as W&H.)
W&H is engaged in the direct mail and fundraising services
business and has had up to about 20 to 22 employees. Its clients
primarily have been nonprofit organizations. Over the years, W&H
began to specialize in offering direct mail fundraising services
to nonprofit health organizations. In 1984, W&H had one or two
clients in addition to petitioner which were nonprofit health
organizations. Over the years, more and more of W&H’s clients
were in health-related areas. In 1987, W&H received 65 percent
of its income from three major clients and petitioner accounted
for 26 percent of W&H’s gross income for that year. In 1987, W&H
had a total of 12 clients.
American Institute For Cancer Research (hereinafter
sometimes referred to as AICR), which has been recognized by
respondent as tax-exempt under section 501(c)(3) since its
incorporation in September 1981, was one of W&H’s first nonprofit
health clients. Watson and Hughey are the two sole “founding
members” of AICR. AICR’s articles of incorporation provide that
only its founding members have the right to vote. The articles
also provide that no changes may be made with respect to the
founding members who were designated at AICR’s initial board
meeting and that no other founding members may be added, unless
all the founding members are dead.
AICR and W&H entered into successive fundraising contracts
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that covered the period from AICR’s inception through December
31, 1989.7 When W&H did its first mailings for AICR, Watson and
Hughey consulted an attorney. The attorney advised them that
they and AICR would have to be careful that section 501(c)(3)’s
prohibition against inurement was not violated, in light of
Watson’s and Hughey’s status as founding members of AICR. As a
result, W&H reduced its fees “drastically”, W&H relinquished all
ownership in AICR’s mailing lists, and other changes were made.
Table 5 summarizes certain features of W&H’s fundraising
contracts with AICR.
7
Petitioner does not object to respondent’s proposed
finding of fact to this effect. We note that the first of the
contracts that respondent listed in support of this finding was
executed on Jan. 20, 1983; this contract states that it “is
effective the 1st day of June 1982”; but AICR had been
incorporated in September 1981. Similarly, the last of the
contracts that respondent listed states that “The term of this
Agreement is two (2) years beginning Jan. 1, 1987”; thus, the
last contract appears to have expired 1 year before the date
specified in the agreed-to proposed finding. We have treated the
agreed-to proposed finding as, in effect, an additional
stipulation between the parties.
- 24 -
Table 5
Mailing Fees
Effective Prospect--cents Housefile--cents
Date of No-Risk Term of per letter, per letter,
Contract Provision Contract letter per year letters per mailing Retainer1 List Ownership
6/1/82 Yes 1 yr. 4 cents 8 cents $3,000/mo. Capital List--
forever
2/4/83 Yes 1 yr. 4 cents 8 cents 1,500/mo. Joint--W&H, AICR
2/4/832 No 1 yr. 2 cents 4 cents 1st 250,000
2 cents thereafter 1,500/mo. Sole property
of AICR
1/1/84 No 1 yr. 2 cents 1st 10 mil. 4 cents 1st 250,000
1 cent next 5 mil. 1 cent next 250,000
0.5 cents next 3 mil. Free after 500,000
Free after 18 mil. 1,500/mo. Sole property
of AICR
1/1/85 No 1 yr. 1.8 cents 1st 10 mil. 3 cents 1st 250,000
0.9 cents next 5 mil. 1 cent next 250,000
0.45 cents next 3 mil. Free after 500,000
Free after 18 mil. No Sole property
of AICR
1/1/86 No 1 yr. 1.8 cents 1st 10 mil.
0.9 cent next 5 mil.
0.45 cents next 9 mil. 3 cents 1st 250,000
Add’l. letters--price 1 cent next 250,000
to be arranged Free after 500,000 No Sole property
of AICR
1/1/87 No 2 yrs. 1.8 cents 1st 10 mil. 3 cents 1st 400,000
0.9 cent next 5 mil. 1 cent next 400,000 No Sole property
0.45 cents next 9 mil. of AICR
Add’l. letters--price
to be arranged
1
Payment to be applied to AICR’s debt to W&H, not a separate “package fee”.
2
Contract signed Aug. 10, 1983, retroactive to Feb. 4, 1983.
- 25 -
Later, as a result of advice by another attorney, changes
were made regarding Watson’s and Hughey’s control over AICR.
Under AICR’s original articles of incorporation, directors are
elected by, and may be removed without cause by, AICR’s founding
members, Watson and Hughey. Under amendments filed May 4, 1984,
any founding member is forbidden to elect or remove directors
“during any period in which such founding member has a commercial
relationship with the Corporation [AICR] and for a period of three
years thereafter.” For these purposes “the term ``founding member’
shall be deemed to include any * * * partnership * * * in which a
founding member has a material interest.” These amendments also
provide as follows:
During any period that all founding members are
prohibited, or are abstaining, from exercising their
rights with respect to the election and removal of
Directors, Directors shall be elected and removed by the
affirmative vote of a majority of the entire Board of
Directors.
The Contract; Related Agreements
A. The Contract (June 11, 1984)
The Contract provides that, during its 5-year term, ending
May 30, 1989, W&H would be petitioner’s exclusive fundraising
consultant and adviser in petitioner’s conduct of its direct mail
fundraising solicitations. Petitioner agrees not to “retain or
use the services of any other person or company to provide counsel
and advice to [petitioner] in conducting its direct mail
solicitations.” W&H agrees to furnish its services and to advise,
- 26 -
counsel, and make recommendations concerning all aspects of
preparing petitioner’s direct mail fundraising and membership
solicitations, and to be responsible for implementing all of the
work required, either directly or through affiliates or other
suppliers, “subject to the approval of CLIENT [petitioner].” W&H
further agrees to maintain petitioner’s housefile and to perform
all follow-up correspondence.
The Contract further provides that all mailing campaign
materials prepared and recommended by W&H, including the proposed
numbers of letters to be mailed, would be subject to petitioner’s
approval “and no such material shall be mailed or made available
to the public without such approval.”
The Contract additionally provides that a bank or “caging
company” (described below) would be hired to act as cashier and
escrow agent for the funds generated under the Contract. The bank
or caging company would process receipts and disburse payments
under an agreement to be entered into by it, petitioner, and W&H.
The Contract requires W&H to promptly furnish to petitioner
copies of invoices received from suppliers of goods and services
used in fulfilling W&H’s obligations under the Contract. The
Contract also requires W&H to make reasonable efforts, where
market conditions and time permit, to obtain competitive bids or
rates for work subcontracted to suppliers. W&H affiliates would
be allowed to perform such subcontract work, subject to this
competitive bid and rate requirement. No markup was to be added
- 27 -
by W&H on the supplier or subcontractor invoices billed to
petitioner.
The Contract provides that W&H would be paid, as compensation
for its services, mailing fees of $.05 per prospect letter mailed
and $.10 per housefile letter mailed, as well as certain creative
fees for each housefile mailing package mailed. On a housefile
package mailed to under 50,000 previous contributors, W&H would be
entitled to a $2,500 creative fee. On a housefile package mailed
to 50,000 or more previous contributors, W&H’s creative fee would
be $5,000. Petitioner would pay a retainer of $1,500 per month to
W&H as a draw against these fees. During the term of the
Contract, all materials, packages, and ideas developed by W&H on
behalf of petitioner would remain the sole property of W&H, and
all such material could be used by petitioner only with W&H’s
written consent.
With respect to petitioner’s mailing list, the Contract
provides that W&H and petitioner would have respective co-
ownership rights as follows:
Section 14. List Ownership. It is expressly
understood, covenanted and agreed upon * * * that any
and all names and addresses and amounts contributed, if
any, of persons, firms, associations or corporations
which are obtained, developed, compiled or otherwise
acquired for CLIENT by or through the direct or indirect
efforts of W&H in connection with any services rendered
by W&H to CLIENT pursuant to the terms hereof shall at
all times be and constitute the property solely and
exclusively of W&H and CLIENT. These names and
addresses and the amounts of contributions, if any, can
be used at any time by CLIENT in any manner, for any
purpose for its own account. CLIENT shall use these
- 28 -
names and addresses developed by W&H for no purpose
other than in direct connection with CLIENT’S own
projects. CLIENT shall not at any time during the life
of this Agreement or any time thereafter rent, exchange,
lease, sell or give away these names and addresses
developed as the result of the efforts of W&H to any
other parties for any purpose whatsoever. However, W&H
shall be free to use the names and addresses referred to
in Section 14 in any way it so desires and for any
purpose it may so determine.
The Contract also states that “It is expressly understood and
agreed upon that * * * Section 14 [the list ownership rights
provision] shall survive” the termination of the Contract. The
Contract also requires that, during the Contract’s term, any
computer work that petitioner wants to have done with respect to
the names developed as a result of the Contract “must be done at
W&H or at a company designated by W&H.”
The Contract provides as follows with respect to its “no-
risk” nature:
Section 9. Payments to W&H and Suppliers. W&H
assumes full obligation and responsibility for the
payment of all vendor, suppliers and W&H invoices
arising out of the fulfillment of W&H’s obligations
hereunder, said invoices to be subsequently reimbursed
by CLIENT only under the terms and conditions set forth
in this Section. CLIENT shall reimburse W&H only to the
extent that W&H has raised such funds. W&H shall have
no right or claim upon any other funds or accounts of
CLIENT. W&H shall be reimbursed for money owed to it
only out of funds obtained as a result of W&H’s efforts.
However, if CLIENT raises additional funds through their
own efforts from names that W&H has generated, these
funds shall be considered in the same category as funds
raised by W&H. People who are members of UCC or prior
donors to UCC are excluded from the provisions of this
section. In other words, W&H is liable for all expenses
connected with this contract to the extent that W&H has
not raised funds to cover those costs. This section
applies throughout this agreement.
- 29 -
CLIENT shall make monthly payments to W&H to the
full extent that W&H has raised funds to pay the costs
incurred by W&H in carrying out its obligations under
this Agreement.
For the first two years of this Agreement, up to
50% of net income from * * * [house] file mailings may
be applied to the cost of * * * [prospect] mailings.
After two years and for the remainder of this Agreement,
up to 30% of net income from * * * [house] file mailings
may be applied to the cost of * * * [prospect] mailings.
CLIENT will only utilize * * * [house] file net income
for its projects under the terms and conditions set
forth in this Section.
For purposes hereof, net income received pursuant
to this Agreement by CLIENT shall hereby be defined as
all contributions received, less all expenses incurred,
pursuant to the terms hereof, including supplier
invoices, postage, W&H charges and all other items
described in this Agreement.
The Contract provides that it “is automatically renewable for
Five (5) Years if either Party does not in writing specify the
canceling of this Agreement at least Three (3) Months prior to the
expiration of this Agreement.” Apparently this provision was
intended to give each party to the Contract a veto over the
Contract’s automatic renewal. However the Contract does not
include a provision permitting termination for cause.
B. The Escrow Agreement
On June 19, 1984, petitioner, W&H, and Washington
Intelligence Bureau (hereinafter sometimes referred to as WIB)
entered into an escrow agreement (hereinafter sometime referred to
as the Escrow Agreement), whereby WIB would provide escrow
services in connection with the Contract. The Escrow Agreement,
which W&H provided to petitioner and WIB, is essentially the same
- 30 -
agreement that W&H uses in all of the escrow arrangements that W&H
has with WIB. During the term of the Contract, WIB was at all
times the escrow agent and did most of the caging.8
WIB began to deal with W&H in 1982 or 1983. WIB has been the
escrow agent for most of W&H’s clients. WIB’s first W&H-related
client was AICR. In 1984, about 15-20 percent of WIB’s business
pertained to W&H’s clients. By 1989, this had grown to 30-35
percent. Thereafter, the percentage dropped to about 25 percent.
WIB has always been unrelated to W&H in ownership.
The Escrow Agreement provides, in pertinent part, as follows:
WHEREAS, the Client [petitioner] agrees to pay all
costs for direct mail fund raising services as well as
cost for others providing services and supplies for the
direct mail fund raising program.
IT IS, THEREFORE, agreed:
1. ESCROW FUND. The Agency [W&H] and the Client hereby
agree that returns from the direct mail fund raising
programs shall be received by the Escrowee [WIB] and the
sum so received shall be known as the Escrow Fund.
2. PAYMENT OF CREDITORS. The Escrow Fund shall be held
by The Escrowee separate and apart from the other funds
of the Escrowee. The Agency shall present the Escrowee
with invoices of creditors, including invoices of the
Escrowee, which the Escrowee shall pay from said Escrow
Fund. All invoices paid from said Escrow Fund shall be
8
Caging involves receiving, opening, and processing the
return mail generated by a direct mail campaign. A caging
company generally performs such functions as depositing the
return mail receipts with a bank, providing to the client an
account of these receipts, verifying and correcting name and
address information with respect to contributors, recording
pertinent information with respect to contributors, and relaying
such contributor information to a computer company selected by
the client.
- 31 -
approved by the Agency and submitted to the Escrowee
promptly for payment.
3. MAIL CHARGES. The Escrowee may transfer all sums
necessary to pay charges by the United States Postal
Service for the Client’s Business Reply Mail without
approval of the Agency or Client.[9]
4. ESCROWEE’S COMPENSATION. The compensation of the
Escrowee shall be established by the Agency, the Client,
and Escrowee. The Escrowee shall render billings for
Escrowee services to the Client, in care of the Agency,
and shall be paid on a priority basis. If approved
invoice is not received from the Agency by the Escrowee
within 30 days from the date of invoice, the Escrowee
shall be authorized to pay such billing without the
approval of the Agency.
* * * * * * *
6. ACCOUNTING. The Escrowee shall provide the Client
and Agency an accounting as to each payment or
disbursement made from the Escrow Fund. Those
disbursements shall only be upon the written approval of
the Agency. The Escrowee shall be provided compensation
for these services.
7. DISPUTES. In the event of any dispute with respect
to disposition of all or part of the Escrow Fund, The
Escrowee shall not be obligated to disburse the disputed
portion thereof nor shall the Escrowee be required
affirmatively to commence any action against the Client
or Agency, or defend any action that a creditor might
bring. In his [sic] sole discretion, the Escrowee may,
in the event of a dispute as to the disposition of all
or part of the Escrow Fund, commence an action in the
nature of interpleader and seek to deposit the disputed
portion in a Court of Competent Jurisdiction.
9
The Business Reply Mail postage referred to represented
postage on the return mailing envelopes provided to the persons
solicited in the direct mail fundraising campaign for purposes of
making contributions to petitioner or otherwise responding.
Unlike the outgoing fundraising letters and materials which were
mailed under petitioner’s nonprofit mail permits at the lower
nonprofit mailing rate, postage at the regular United States
Postal Service rate was required on the return letters mailed by
recipients of the fundraising letters.
- 32 -
Pursuant to the Escrow Agreement, WIB opened a bank account
(hereinafter sometimes referred to as the Escrow Account) in which
to maintain the escrow fund. Only authorized employees of WIB
could withdraw funds from the Escrow Account. The money deposited
into the Escrow Account came primarily from the following sources:
(1) The money W&H advanced to pay for petitioner’s fundraising
expenses and operational expenses, and (2) the contributions made
by the general public in response to the fundraising letters
mailed under the Contract. All of the revenues from petitioner’s
direct mail campaign, not merely the profits from the mailings,
went into the Escrow Account.
C. Petitioner’s “Draw” Arrangement
As indicated above, during its discussions with petitioner
about entering a possible fundraising contract, W&H offered to
provide funds with which petitioner could continue to operate.
W&H furnished such funds to petitioner after the Contract was
executed.
A December 17, 1984, letter agreement between petitioner and
W&H provides, in pertinent part, as follows:
In order to meet your cash flow needs for administration
and program, you [petitioner] plan to transfer funds from the
escrow account that were generated from * * * [prospect
letter mailings]. To date $5,000 was transferred on November
1, $5,000 was transferred on December 1, and you plan to
transfer another $5,000 on January 1, 1985.
This letter acknowledges the fact that these transfers *
* * are made in such a manner from * * * [prospect letter
mailing] revenues will be replenished from UCC’s income from
* * * [housefile letter] mailings within six months of
- 33 -
making such a transfer.
Contrary to what is suggested in the above letter agreement,
as of December 1984, no net mailing revenues had yet been produced
from either the prospect letter mailings or housefile letter
mailings conducted. Only losses or relatively small amounts of
net mailing revenues were produced by the housefile letter
mailings up until June or July 1985. It was not until about July
1985, that the cumulative net revenue produced from housefile
letter mailings began to somewhat approach the cumulative amount
of funds W&H provided to meet petitioner’s operating expenses.
Initially, some of the funds used to meet petitioner’s operating
expenses were advanced by W&H to the Escrow Account. Also, W&H
deferred receiving payment of its fees.
Later, as the net revenue produced from mailings began to
increase, W&H authorized and permitted petitioner to “draw”
increasingly larger monthly amounts of funds from the Escrow
Account to finance petitioner’s larger annual operating budgets.
Up until about the execution on April 8-9, 1987, of an addendum to
the Contract, petitioner was fully liable to repay the draws it
had taken, to the extent the draws exceeded the 50 percent of
cumulative housefile income guaranteed to petitioner under the
Contract. The draws petitioner received were to be repaid within
6 months, regardless of the direct mailing campaign’s
profitability. The events leading up to and culminating in the
execution of the April 1987 addendum to the Contract are discussed
- 34 -
more fully infra.
Once the mailings had become sufficiently more profitable, in
deciding the amount of petitioner’s monthly draws, W&H considered
petitioner’s budget plans and the future net mailing revenues
expected to be produced. W&H based its decisions, in large part,
on its calculation of the current monthly net housefile mailing
revenue being produced and the 50 percent of the cumulative
housefile income that petitioner, in all events, was guaranteed
under the Contract.
Monthly draws from the Escrow Account were taken by
petitioner over the period from October 1984 through May 1989, as
shown in table 6.
Table 6
Monthly Cumulative
Month Draws Draws
10/84 $5,000 $5,000
11/84 -- 5,000
12/84 5,000 10,000
1/85 10,000 20,000
2/85 -- 20,000
3/85 6,000 26,000
4/85 14,000 40,000
5/85 10,000 50,000
6/85 10,000 60,000
7/85 18,000 78,000
8/85 20,000 98,000
9/85 -- 98,000
10/85 22,000 120,000
11/85 33,000 153,000
12/85 25,000 178,000
1/86 40,000 218,000
2/86 40,000 258,000
3/86 40,000 298,000
(Cont.) Table 6
- 35 -
Monthly Cumulative
Month Draws Draws
4/86 40,000 338,000
5/86 40,000 378,000
6/86 40,000 418,000
1
7/86 40,000 453,000
8/86 40,000 493,000
9/86 40,000 533,000
10/86 40,000 573,000
11/86 40,000 613,000
12/86 40,000 653,000
1/87 50,000 703,000
2/87 50,000 753,000
3/87 50,000 803,000
4/87 50,000 853,000
5/87 50,000 903,000
6/87 50,000 953,000
7/87 50,000 1,003,000
8/87 50,000 1,053,000
9/87 50,000 1,103,000
10/87 50,000 1,153,000
11/87 50,000 1,203,000
12/87 50,000 1,253,000
1/88 60,000 1,313,000
2/88 60,000 1,373,000
3/88 60,000 1,433,000
4/88 60,000 1,493,000
5/88 60,000 1,553,000
6/88 60,000 1,613,000
7/88 60,000 1,673,000
8/88 60,000 1,733,000
9/88 60,000 1,793,000
10/88 60,000 1,853,000
11/88 60,000 1,913,000
12/88 60,000 1,973,000
1/89 60,000 2,033,000
2/89 60,000 2,093,000
3/89 60,000 2,153,000
4/89 60,000 2,213,000
1
So shown in the stipulated exhibit. Evidently, there is a
$5,000 error in either the July 1986 monthly draw amount or the
cumulative draws. This discrepancy does not affect our analysis
or conclusions.
- 36 -
D. Agreement to Continue at 50 Percent the Percentage
of Net Housefile Mailing Income the Fundraising
Contract Required to be Retained in the Escrow
Account to Reimburse W&H
As indicated above, the Contract originally provided that,
after 2 years, the percentage of net housefile mailing income that
petitioner was required to retain in the Escrow Account be lowered
from 50 percent to 30 percent. In March and April 1986, Watson
proposed to petitioner that this percentage remain at 50 percent,
rather than be lowered, because of higher prospect mailing
expenses resulting from an increase in postal rates. In exchange
for petitioner’s agreement to this, W&H would reduce its creative
fee on housefile package mailings from $5,000 to $2,500 and cap
its mailing fee at $50,000 for any housefile mailing done in
excess of 500,000 letters. On April 26, 1986, petitioner’s board
of directors accepted Watson’s proposal.
E. April 1987 Addendum to the Contract
The certified public accounting firm that examined
petitioner’s annual financial statements issued a qualified
opinion, dated April 18, 1986, as to petitioner’s 1985 financial
statement. The certified public accounting firm elaborated on its
concerns in a management letter dated May 23, 1986, to the
executive committee of petitioner’s board of directors. This
management letter states, in pertinent part, as follows:
General Fund
1. Continued Existence of the Agency [petitioner].
Our gravest concern is the viability of the
- 37 -
organization. It is our understanding that the
1986 budget totals $520,000 including grant
commitments of $100,000. You expect to fund this
ambitious budget with the excess of revenues over
expenses from the direct-mail campaign. What will
the Council [petitioner] do if the excess of
revenues over expenses does not materialize at the
level expected?
The General Fund must borrow heavily from the
Donor Development Fund [Escrow Account] to finance
the budget, and if required to repay such
borrowings it is doubtful the General Fund would
have the ability to make the repayments.
Over a 7- to 8-month period beginning in or about July 1986,
petitioner discussed with W&H its concerns regarding petitioner’s
full recourse liability to repay the excess draws taken and
petitioner’s inability to receive unqualified opinions from the
certified public accounting firm with respect to petitioner’s
future annual financial statements. On October 23, 1986, Watson
sent a letter to petitioner’s executive director stating W&H’s
position with respect to petitioner’s repayment of the excess
draw liability, stating in pertinent part, as follows:
This letter is to confirm our discussion relating
to program draws from the UCC escrow account.
* * * * * * *
As we understand it, UCC’s concerns surround the
procedure by which this [50 percent of] net income
[from housefile mailings] is transferred to your
regular operating account.
Rather than receiving the exact amount as
determined by the 50% formula, UCC, with W&Hs
knowledge, is taking a fixed amount each month. When
the final net income figure becomes known some months
later, UCCs draw from the escrow account can be greater
than it should be.
- 38 -
Your question is Will UCC be required to pay the
escrow account back for this excess draw?
According to the terms of the agreement, I suppose
that technically you would have to do this.
However, since W&H does have knowledge that these
transfers are taking place, we currently have no
objection to this in light of our hope that we can
overcome the deficits. W&H would not request UCC to
repay any overdraws unless we objected to a specific
draw at the time it was taken or in the event that UCC
would unreasonably interfere with W&H’s efforts to
continue the mailing campaign to recover the deficits.
The worst thing that could happen is that should
the deficits continue to grow or can not be reduced,
and if UCC substantially overdraws its 50% program
allocation, it could become necessary to reduce the
draws to bring them back into balance.
Should we determine this situation to be
developing, I would like for us to sit down well in
advance of such time and create plans so that a
reduction would not adversely impact UCC’s operation.
After reviewing Watson’s October 23, 1986, letter, petitioner’s
executive committee and executive director concluded that the
letter was not satisfactory for petitioner’s purposes and did not
relieve petitioner from having full recourse liability with
respect to excess draws.
Petitioner’s executive committee asked petitioner’s
executive director “to contact * * * Watson to ask that he
rewrite it [i.e., the October 23, 1986, letter] in time for our
auditors review.”
Watson sent a new letter to petitioner’s executive director
on November 19, 1986. The November 19, 1986, letter is
substantially the same as the October 23, 1986, letter, except as
- 39 -
follows: (1) The November 19 letter omits the October 23, 1986,
paragraph that states “According to the terms of the agreement, I
suppose that technically you would have to do this [i.e., repay
the excess draw]”; and (2) the November 19 letter replaces the
phrase “the draws” by the phrase “future draws” after “reduce” in
the October 23 letter clause “it could become necessary to reduce
the draws to bring them back into balance.”
On December 12, 1986, petitioners executive director sent a
letter to Watson about the treatment of general and
administrative costs under the Contract. In the course of this
letter, he pointed out that the auditors “were in the office to
begin preliminary work on the 1986 Financial Statements.”
Petitioner and W&H executed an addendum to the Contract on
April 8-9, 1987. The addendum provides that, beginning with
1986, petitioner would not have to repay draws taken in excess of
its 50 percent of its housefile income, to the extent sufficient
net fundraising revenue was not raised. The addendum states that
such excess draws would be treated in the same manner as prospect
mailing debts for purposes of the Contract. The addendum further
provides that petitioner’s monthly draws would be agreed to in
writing by W&H and petitioner, and requires W&H to give 90 days’
prior written notice to petitioner in order to effectuate any
reduction in the monthly draws. Petitioner’s then-chairman
believed that W&H agreed to the April 1987 addendum--especially
the nonrefundability of the draws--because W&H hoped that it
- 40 -
would improve relations with petitioner’s board of directors and
increase the likelihood that the Contract would be renewed.
As a result of the addendum provision regarding monthly
draws, petitioner received an unqualified opinion for 1986. That
is, the certified public accounting firm’s report no longer
included qualifications or reservations about petitioner’s
practices or potential liabilities.
Direct Mail Fundraising Campaign: 1984-1989
A. In General
From June 1984 through May 1989, W&H conducted a nationwide
direct mail fundraising campaign for petitioner. Mailings were
eventually sent throughout all 50 States. However, petitioner
directed W&H not to make mailings to areas serviced by certain of
petitioner’s member agencies, as those member agencies received
annual funding from the United Way campaign and a condition of
their receipt of such funding was that they not be involved in
competing fundraising efforts.
W&H created and developed direct mail fundraising packages
with petitioner’s assistance and input. Before each direct mail
package was mailed, petitioner received from W&H all materials to
be included in the package, as well as the names of all mailing
lists to which W&H proposed to send the package and the estimated
numbers of names from each mailing list to be used in the
mailing. Petitioner, through its staff and a committee of its
board, reviewed and revised the package and the mailing list and
- 41 -
gave instructions as to the mailing list numbers, the copy, the
dates of mailing, and the total number of letters to be sent.
Petitioner received from W&H a monthly status report of the
cumulative costs and revenues of each direct mail package mailing
and a proposed schedule of future mailings. Petitioner was also
advised with regard to test mailings, typically of 5,000 letters,
that W&H had done of proposed mailing packages. If a test
mailing was successful, then W&H generally recommended that more
mailings of that package be “rolled out” in greater quantities.
W&H issued purchase orders on behalf of petitioner with
respect to all of the goods, services, and other expenditures
required for the various mailings. This was done on an on-going
basis and involved such items as computer work, mailing house
expenses, mailing list rentals, and printing. When petitioner
approved the making of a mailing, W&H and petitioner considered
petitioner to have authorized W&H to order and arrange for all of
the related goods, services, and other expenditures required to
effectuate the mailing.
Petitioner accrued the amounts shown in table 7 as its
expenses for (1) postage and shipping, (2) printing and
publishing, (3) fundraising fees,10 and (4) mailing list rentals.
10
Compare the accruals shown on the fundraising fees
column in table 7, with the payments shown supra table 3. When
adjusted for the W&H reimbursements pursuant to the Contract, the
net accrual amounts are fairly close to the actual payment
amounts, except for 1986, where the difference is about $275,000.
(continued...)
- 42 -
Petitioner allocated about 45 percent of each of these categories
of expenditures--other than fundraising fees--to “program
services”, rather than “donor development and fundraising”.
10
(...continued)
- 43 -
Table 7
Postage Printing Professional (Reimbursable) Net Professional Mailing
and and Fundraising or Not Fundraising List
Year Shipping Publications Fees Reimbursable1 Fees Rentals
1984 $60,171 $74,224 $30,092 -- $30,092 $50,201
1985 1,480,719 1,445,431 798,092 $(641,920) 156,172 1,034,711
1986 2,079,059 1,513,599 1,521,101 (403,772) 1,117,329 1,133,254
1987 2,678,137 1,824,517 1,259,798 730,228 1,990,026 1,475,299
1988 936,627 675,605 659,179 237,444 896,623 229,684
1889 263,514 439,479 115,406 65,890 181,296 14,529
Totals 7,498,227 5,972,855 4,383,668 (12,130) 4,371,538 3,937,678
1
Expenses (reimbursable), or no longer reimbursable, by W&H under the Contract. The
amounts are taken from petitioner’s Forms 990. The parties have not explained why these
amounts net to ($12,130), rather than -0-.
- 44 -
B. W&H’s Advances of the Initial Capital to
Conduct the Direct Mail Fundraising Campaign
As indicated above, the Contract was a “no-risk” contract
with respect to petitioner’s payment of fundraising expenses.
For the first 2 years or so under the Contract, W&H advanced
money to the Escrow Account to pay for postage. Postage was an
“upfront” expense, while other expenses generally were billed
“after the fact”, when petitioner had already received the
revenue generated by the mailing. For a while, W&H continued to
advance money to pay for postage even when there were substantial
amounts in the Escrow Account. W&H did this because its people
believed that there was not enough money in the Escrow Account to
pay both the postage and the other vendors, and because of the
draws that W&H paid to petitioner.
W&H’s last advance of funds to petitioner for postage
occurred on March 9, 1987. Thereafter, petitioner earned
sufficient profits from its mailings to cover its postage
expense.
The Contract does not specify how much capital W&H would
provide to fund petitioner’s direct mail fundraising campaign.
W&H’s decisions to advance additional capital were based, in
substantial part, on its evaluation of the results from the
mailings that had already been done and on its conclusions about
the mailing campaign’s profits prospects. Where W&H and its
clients entered into no-risk fundraising contracts similar to the
- 45 -
Contract, W&H’s practice was to stop advancing funds to finance a
client’s direct mail fundraising campaign if the initial mailings
were unsuccessful and W&H concluded that reasonable prospects for
conducting a profitable mailing campaign did not exist. If W&H
decided to stop advancing funds, W&H then advised that client its
mailings would be curtailed, unless that client paid the expenses
of the further mailings that the client wanted to do. On the
other hand, if W&H concluded that strong prospects for conducting
a profitable mailing campaign existed, W&H then might
substantially increase its advancements of funds in order to
finance larger mailings for that client.
In this manner W&H effectively limited the risk that it had
apparently assumed in any no-risk fundraising contracts similar
to the Contract
C. Vendors Who Furnished Goods or Services
In the course of petitioner’s direct mail fundraising
campaign, goods and services were obtained from a number of
vendors. As indicated above, WIB was the escrow agent and
provided most of the caging services with respect to the return
mail received in response to petitioner’s mailings. Wiland
Associates (hereinafter sometimes referred to as Wiland) was
retained by W&H and performed the computer services required in
connection with the Contract.
Several other vendors at various times furnished goods or
services in connection with petitioner’s direct mail campaign.
- 46 -
W&H did not own or have any interest in the vendors who furnished
printing, mailing, telemarketing, or data processing services
under the Contract, nor did W&H own or have any interest in WIB
or Wiland.
The Art Department Company, a corporation owned by Watson
and Hughey, prepared mock-ups and layouts and performed other art
work-related services for W&H’s clients and for other customers.
Petitioner was billed at the rate of $25 per hour for the Art
Department Company services.
Washington Lists, a division of W&H, performed list
brokerage services for petitioner.11 A list broker represents an
organization that wants to rent a mailing list from another
organization. One of Washington Lists’ functions as a list
broker was to arrange for petitioner to use as lessee certain
mailing lists. Washington Lists arranged these mailing list
rental transactions for petitioner through standard industry
channels for such transactions.
D. Rentals of Mailing Lists
As indicated above, Wiland was retained by W&H to perform
the computer services required in connection with the Contract,
including maintenance of a computer list of petitioner’s
housefile. Wiland also maintained computer lists which W&H owned
11
In 1986, Washington Lists changed its name to Capitol
List. Hereinafter, use of the term Washington Lists includes,
where applicable, reference to Capitol List.
- 47 -
or co-owned with its other clients. Wiland, as instructed by
W&H, automatically merged and added to W&H’s masterfile on a
monthly basis all new names and donor information that had been
added to petitioner’s housefile. W&H’s masterfile included the
names and donor information that was owned by W&H or was jointly
owned by W&H and its clients. W&H had joint ownership rights in
most of the client housefile mailing lists developed under the
fundraising contracts it entered into with its nonprofit clients;
W&H did not have such an arrangement with respect to AICR.
In conducting petitioner’s prospect mailings, prospect
mailing packages were mailed to the following categories of names
and addresses (hereinafter for convenience referred to as names):
(1) Names that W&H, as lessor, rented to petitioner from the W&H
masterfile, (2) names that Washington Lists arranged for
petitioner to rent as lessee from outside list owners unrelated
to W&H, (3) names that W&H, as lessor, rented to petitioner
through Washington Lists which names W&H obtained from outside
list owners in exchange for petitioner names, and (4) names that
W&H, as lessor, through Washington Lists rented to petitioner
which names W&H obtained from outside list owners in exchange for
non-petitioner names on W&H’s masterfile.
The Contract forbids petitioner to exchange or to rent as
lessor its housefile list names. When petitioner as lessee used
names from W&H’s masterfile, W&H charged petitioner W&H’s
advertised rental rate for the names published in the current
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“Standard Rate and Data” publication (hereinafter sometimes
referred to as SRD). SRD is a direct mail industry advertising
publication that sets forth the characteristics of a number of
mailing lists available for rental, the rental rates, and the
name and telephone number of the particular list owner or list
owner’s agent to contact. When petitioner as lessee used names
that W&H obtained from outside list owners either through
exchanges of petitioner’s housefile list names or exchanges of
non-petitioner names on the W&H masterfile, W&H charged
petitioner the outside list owner’s currently advertised SRD-
published rental rate for the names furnished to petitioner or,
if no current SRD-published rental rate existed for the names
furnished to petitioner, W&H’s currently advertised SRD-published
rental rate for the names W&H gave up in the exchange
transaction.
Generally, by engaging in an exchange transaction, a list
owner is able to obtain additional names at a significantly
cheaper cost than it would otherwise incur to use the names as a
lessee in a rental transaction. For instance, in a typical
exchange transaction, the two list owners involved might agree
that each would furnish to the other 10,000 of their respective
housefile list names that meet certain prescribed specifications.
The two owners would not pay one another any cash fee; the only
costs an owner would incur include computer-related production
costs for a computer tape or mailing labels containing the 10,000
- 49 -
names that owner furnishes, postage to ship the tape or labels,
and a list broker’s fee or list manager’s fee12 for arranging the
exchange transaction.
When W&H exchanged for petitioner names it owned jointly
with petitioner, the cost to W&H of acquiring the third party’s
names included charges for computer processing, postage, and a
list broker’s or list manager’s fee. W&H did not pay a rental
fee to the owner of the third-party names in these situations,
because W&H was providing names to the third party that normally
rented for $60 per thousand names.
Table 8 shows the amounts petitioner as lessee paid to
Washington Lists by way of mailing list rental fees for renting
mailing lists which W&H owned or mailing lists to which W&H
claimed mailing list rights. The payments petitioner made to W&H
include payments for names that W&H acquired by exchanging
petitioner’s names for names owned by unrelated third parties.
Table 8
Payments for Names W&H
Payments for W&H Obtained by Exchanging
Year Masterfile Names Petitioner Names
1984 -0- $1,450
1985 $6,448 57,349
1986 44,645 119,436
1987 122,747 219,896
1988 32,408 24,660
12
In the direct mail industry, a list manager functions
as a sales agent who represents a list owner in marketing the
list owner’s mailing list to others. The list manager promotes
the mailing list and arranges for rentals and/or exchanges of the
mailing list to other parties.
- 50 -
1989 -0- -0-
Totals 206,248 422,791
When W&H obtained names for petitioner to use as lessee,
including non-petitioner names from W&H’s masterfile and third-
party names for which W&H exchanged petitioner names, W&H charged
or passed on any direct out-of-pocket costs of obtaining those
names to petitioner. These out-of-pocket costs included
computer-processing charges and mailing charges.
W&H’s masterfile had numerous subparts or discrete “list
selects” that could be selected via computer processing. For
example, list selects of all donors to sweepstakes contest
appeals, all donors to health causes, all donors to cancer-
related health causes, or all donors to a particular W&H client,
could be obtained through computer selection.
During 1984 through 1989, W&H exchanged segments of
petitioner’s housefile list between 200 and 300 times. These
exchange transactions involved as few as 5,000 petitioner names
or as many as 300,000 petitioner names.
For each of these exchanges, W&H charged petitioner the
published SRD rental fee of the names received in the exchange;
if no published SRD rate existed, then W&H charged petitioner the
published SRD rental fee of petitioner’s names that were given up
in the exchange. UCC’s payments to W&H on account of these
charges constituted income to W&H.
- 51 -
W&H also rented as lessor the names on its masterfile to
third parties, including other W&H clients and W&H-controlled
entities. Petitioner’s names could be separately selected from
the W&H masterfile and were occasionally rented by W&H to third
parties as a discrete, separate list of petitioner names.
Petitioner’s names were also contained in lists rented by W&H to
third parties mixed together with non-petitioner names. On the
record in the instant case, it is virtually impossible to
determine how often any particular petitioner name was rented as
part of a mixed list.
From 1984 through the time of the trial in the instant case,
W&H as lessor rented discrete segments of petitioner’s housefile
names about 50 to 80 times. These rental transactions may have
involved as few as 5,000 petitioner names or as many as 300,000
petitioner names.13 From 1984 through the time of the trial, in
the instant case, W&H as lessor rented segments of the W&H
masterfile more than 2,000 times. Any such rental may have
involved no petitioner names, one petitioner name, or a
substantial number of petitioner names. On at least one occasion
as many as 300,000 petitioner names were contained on a rented
13
For example, a list rental order dated Jan. 1, 1990,
submitted on behalf of the Norris Hospital at the University of
Southern California to W&H, reflects that an 8,500-name
“representative cross section” of certain petitioner names was
being ordered. The order indicates that the segment of
petitioner names selected consisted of donors who had made a
donation of $5 or more to petitioner within the past 24 months.
Note that the Contract had expired more than 7 months earlier.
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segment of the W&H masterfile.
W&H as lessor rented petitioner names at rates that were
common in the list rental market. A typical rate was $60 per
thousand names.
The Contract did not require W&H to, and W&H did not, notify
petitioner before renting parts of the W&H masterfile including
petitioner’s names to third parties. Pursuant to the Contract,
W&H retained all rights to approve a mailing sample of what would
be mailed by the third parties renting parts of W&H’s masterfile.
W&H also retained all rights to control the mailing dates when
these third parties using parts of W&H’s masterfile would make
their mailings to the rented list names.
During the term of the Contract, some of petitioner’s
directors and staff became aware that W&H was exchanging
petitioner housefile names for other names, and then charging
petitioner full regular rental rates for the use of the other
names. Some of petitioner’s directors and staff also became
aware that other W&H clients, including certain nonprofit cancer
organizations, were mailing fundraising packages similar to
petitioner’s. They were further aware that W&H possibly could be
renting or otherwise providing petitioner housefile names to the
W&H clients that were mailing fundraising packages which were
similar to petitioner’s. In fact, W&H did so use petitioner’s
housefiles and did mail similar sweepstakes packages for
petitioner’s “competitors”. Petitioner did not try to have W&H
- 53 -
stop such activities, as petitioner concluded that W&H was acting
within its rights under the Contract.
Under the Contract, it would have been improper for W&H to
impose a markup on charges made by suppliers. Thus, if W&H
secured a desired mailing list for petitioner as lessee, and the
lessor charged $55 per thousand, then it would have been improper
for W&H to pass a cost of $60 per thousand on to petitioner. W&H
and petitioner operated in accordance with the Contract.
However, when W&H “paid for” the desired mailing list by
exchanging one of petitioner’s mailing lists for it, so that the
lessor imposed no monetary rental fee, then, as petitioner’s
staff understood the Contract, it was appropriate for W&H to pass
on to petitioner a rental fee in the amount that the lessor would
have charged for the desired mailing list if the lessor had not
instead received petitioner’s mailing list in exchange. In
exchange situations, then, W&H received as its own revenue the
“as if” rental that the lessor had not in fact charged, as well
as W&H’s regular fees under the Contract.
The bar against petitioner’s exchanging its own names
extended past the term of the Contract. Because petitioner could
not exchange its own names, petitioner had to pay the greater
costs associated with renting names from others.
E. Sweepstakes Mailings
The first sweepstakes contest mailing that W&H conducted was
done under the Contract. W&H then used sweepstakes contest
- 54 -
mailings extensively with most of its other clients. Before they
formed W&H, both Watson and Hughey had experience with the use of
sweepstakes contests on behalf of either their employers or their
clients.
As part of its initial program of prospect mailings for
petitioner, W&H tested various packages. A “check” package
performed best and became petitioner’s “control” package--a
package that is mailed until a later package can net more money.
In November 1984 a sweepstakes (sweeps) package was tested and
also performed well. As Watson put it in an October 15, 1985,
memorandum to several of petitioner’s directors and its executive
director, “At this point UCC had two control packages, the check
package which could be mailed to the traditional donor market;
and a sweepstakes offer which could be mailed to markets that
respond to sweepstakes.”
A January 1985 major prospect mailing was planned using the
check package. However, although the package had been approved
by petitioner, petitioner’s board of directors then urged that
the check package be replaced by a different package. That
different package then lost $110,000.14
14
The record reflects that petitioner’s directors
directed the check package not be used, because they believed
certain representations contained in the package were inaccurate.
Recipients of the package were informed that if they made a
contribution, petitioner then essentially would receive a
matching donation from another party. In actuality, at the time
the solicitation was made, petitioner had not yet secured a
(continued...)
- 55 -
In August 1985 an “annual fund” package was successfully
tested. As a result, petitioner again had two control packages.
An annual fund package was first mailed out in substantial volume
(almost 500,000 letters) in December 1985.
Apart from the foregoing, for petitioner every substantial
volume prospect mailing and almost every test prospect mailing in
1985 was a sweeps package. Five of these 1985 sweeps prospect
mailings each lost more than $100,000; one lost $228,569.
However, from mid-1986 to mid-1987, sweeps packages produced
14
(...continued)
commitment from another party to make matching contributions.
In his letter dated Feb. 19, 1985, to petitioner’s executive
director, Watson complained that the projected $70,000 loss on
the Jan. 1985 poll package mailing (excluding at least another
$45,000 due W&H in fees) done at petitioner’ directors’ urging
was the largest single loss W&H ever experienced. He stated that
it was essential that what happened not occur again and formally
requested that once petitioner approved a mailing package that
petitioner be committed to the package’s use, unless it was
“obvious and conclusive” that the package’s continued use would
result in irrevocable harm to petitioner. His letter concluded,
in pertinent part, as follows:
I’m sure you are disappointed in what has happened in
regard to this Poll package mailing. But, I assure you, no
one is as concerned as I am. I hope it has been a lesson
for us all.
I had the hope, and still have the dream, that UCC
could be made financially strong within a relatively short
time. And, I pray this setback doesn’t postpone that day
too long into the future.
Copies of this letter to the executive director were also sent by
Watson to three of petitioner’s directors.
- 56 -
the greatest percentages of responses to prospect mailings.
Also, contrary to the usual experience with prospect mailings,
some sweeps packages produced substantial profits.
Although the sweeps packages were often profitable for
petitioner, they had their drawbacks. Sweeps packages generally
worked on individuals who were primarily interested in playing
the contest, as opposed to being interested in supporting
petitioner. In his memorandum dated July 9, 1986, to
petitioner’s executive director, Watson, in generally commenting
on petitioner’s direct mail campaign, made the following
observations about the sweeps package donors who contributed to
petitioner:
UCC basically has two donor files--one being sweepstakes
donors and the other being regular or straight donors.
The Sweepstakes file makes up 80% of all donor names and the
straight file has the balance of 20%.
Although sweeps names have a higher conversion rate into
second and third donations, the life span of these donors is
less than straight donors.
We are continuing to try to expand the straight file which
is a true donor base and is the one that can be tapped for
future major gifts. * * *
* * * * * * *
In summary, it appears that the UCC direct mail
fundraising program is healthy and shows signs of continued
improvement. As the straight donor file expands, it should
lend stability to the monthly income for UCC. The
sweepstakes housefile mailings should continue to provide
the buffer needed to provide the minimum revenues to help
UCC make its monthly budgetary commitments.
In addition to the problem that Watson noted, some of the
- 57 -
sweepstakes contest mailings generated adverse publicity for
petitioner, because some individuals who received the mailings
believed the solicitations were misleading. The adverse
publicity petitioner experienced in conducting its direct mail
campaign is discussed more fully infra.
Although W&H attempted to convert some of petitioner’s
sweepstakes donors into straight donors by sending them non-
sweepstakes mailing packages, the conversion efforts were not
successful. W&H concluded that the only way to obtain further
contributions from sweepstakes donors was to continue to send
them sweepstakes contest mailing packages.
During 1985 through May 1989, sweepstakes contests mailings
were used heavily in petitioner’s direct mail fundraising
campaign. Beginning in late 1987 or early 1988, petitioner
sharply reduced the numbers of sweepstakes contest prospect
letters it mailed, because petitioner realized the sweepstakes
contest prospect mailings were not helping petitioner to develop
a strong housefile. In his letter dated January 28, 1988, to the
W&H executive who handled petitioner’s account on a daily basis,
petitioner’s executive director responded as follows to the W&H
executive’s prior argument that petitioner should not reduce the
level of its 1988 prospect mailings so greatly below the level of
the 1987 prospect mailings, because the 1987 prospect mailings,
the W&H executive claimed, had added 1 million new names to
petitioner’s housefile:
- 58 -
Your reference to the 1 million names added in 1987
housefile is interesting. Why were we continuing to
mail to only 300+ thousand with housefile packages
given this million “new” names? My opinion is that we
both knew those names wouldn’t produce due to their
acquisition from sweeps. And if they did work, their
lifespan was a matter of weeks, not months. We wish to
see greater cultivation of housefile names with new
packages and straight packages. If we only get 180,000
names or less, but they have been generated via quality
straight packages, we will be better off than adding
another 1 million sweeps players.
In November 1988 petitioner stopped conducting prospect
mailings. During 1984 through 1988, a total of 90 prospect
mailings were done in petitioner’s direct mail fundraising
campaign. Of the 90 prospect mailings, 71 involved the use of
sweepstakes contest mailing packages. The total number of
prospect letters mailed in petitioner’s mailing campaign was
51,771,026, of which 37,546,124 involved the use of sweepstakes
contests.15
15
So stipulated. The parties stipulated as an exhibit
W&H’s July 1, 1989, status report to petitioner. In that
exhibit, the listing of the 90 prospect mailings occupies three
pages. The stipulated number of letters is the total of the
prospect mailings listed on the first two pages of this portion
of the exhibit. The total for the prospect mailings listed on
all three pages is 57,758,533. Only 48 of the prospect mailings
are identified in the status report with the word “sweeps”; these
48 involve 32,671,489 letters. We cannot clearly identify which
23 of the 42 other prospect mailings are among the 71 stipulated
sweeps prospect mailings. Based on the descriptive terms used in
the status report, our best estimate is that the status report
shows that the 71 stipulated sweeps prospect mailings involved
about 41-43 million letters.
Similarly, the parties have stipulated that the status
report shows 75 housefile mailings, of which 47 were sweeps
letters, and a total of 27,849,216 housefile mailings letters of
(continued...)
- 59 -
As of May 19, 1989, near the end of the term of the
Contract, petitioner’s housefile contained a total of 2,084,019
donor names, of which 1,165,153 were “active names” and 918,866
were “inactive names”.16 As of May 8, 1989, petitioner’s
housefile contained 1,164,698 “active donor names”, which had
been produced from the sources indicated in table 9.
Table 9
Source Number of Names
Sweepstakes Mailings 810,411
15
(...continued)
which 19,915,212 were sweeps letters. The stipulated status
report shows 75 housefile mailings, but a total of only
21,849,216 letters. The 47 sweeps housefile mailings that we
were able to identify involved 17,313,153 letters.
It may be that the status report misidentified mailings
totaling about 6,000,000 names. Although the discrepancy between
the stipulation and the stipulated exhibit is substantial (more
than 10 percent of the total), it does not affect our ultimate
conclusions.
16
The parties stipulated to these numbers of “active
names” and “inactive names”. An invoice dated May 19, 1989, to
petitioner from Wiland, the computer company that maintained
petitioner’s housefile, reflects that Wiland had prepared a
computer tape of petitioner’s housefile that contained 1,165,153
“active names” and 918,866 “inactive names”. According to Dan
Wells, an employee of Wiland who testified at trial, “active
names” were the names that petitioner had mailed most recently.
Interestingly, Watson, during his testimony, estimated that
petitioner’s housefile, as of the May 30, 1989, date petitioner’s
contract with W&H ended, contained approximately 250,000 to
300,000 “active names” and another 1 million “inactive names”.
Watson, however, defined “active names” to be names which, at
that point, would produce a profit if mailed to, and “inactive
names” to be names which, at that point, would not produce a
profit if mailed to. He elaborated that the actual
categorization of a particular name as “active” or “inactive”
results from applying a complex statistical aging formula.
- 60 -
Non-Sweepstakes Mailings 279,084
Miscellaneous 75,203
Total 1,164,698
F. Adverse Publicity
As a result of its direct mail fundraising campaign and its
association with W&H, petitioner received adverse publicity.
This adverse publicity began in or about November 1984 and
persisted through the term of the Contract.
In late 1984, some of petitioner’s directors and staff began
receiving complaints and inquiries about the direct mail
fundraising campaign petitioner was conducting. Adverse
newspaper articles concerning petitioner had been published. The
negative press came from all parts of the country to which
petitioner was mailing fund-raising letters. The areas of
concern raised in the complaints or inquiries included (1) W&H’s
control of another cancer charity, AICR, (2) the mailing packages
petitioner employed, (3) the adverse impact of mailings done in
certain areas covered by petitioner’s member agencies, and (4)
whether petitioner was spending a sufficient portion of its
receipts for charitable purposes, as distinguished from spending
for fundraising and administration.
At petitioner’s board of directors meeting on November 17,
1985, the board members viewed and discussed a videotape of an
unfavorable Dayton, Ohio, television news story about
petitioner’s direct-mail fundraising. The news story focussed on
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petitioner’s asserted high-pressure fundraising tactics and
sweepstakes contests.
Petitioner’s directors were divided concerning the course of
action petitioner should pursue as a result of the above adverse
publicity petitioner experienced. Some directors wanted
petitioner to discontinue its direct mail fundraising campaign
entirely. However, a majority of the directors decided that
petitioner’s direct mail fundraising campaign should be continued
and that the adverse publicity was a problem which could be
managed. Financial considerations were a controlling factor in
the majority’s decision to continue the direct mail campaign.
The fundraising arrangement with W&H accounted for substantially
all of petitioner’s operating funds. Additionally, at this time,
petitioner was fully liable on a recourse basis to W&H for the
excess draws petitioner had obtained from the Escrow Account.
Although petitioner had tried, at various times, to develop other
sources of funds, these efforts were not successful and
petitioner remained heavily financially dependent on its direct
mail fundraising campaign revenues throughout the term of the
Contract.
In early 1987, NCIB issued a report on petitioner that,
among other things, concluded petitioner’s fundraising expenses
for 1985 equaled about 97.7 percent of the related contributions
- 62 -
petitioner received.17 The NCIB report resulted in further
adverse publicity for petitioner.
In or about September 1986, petitioner began using a
sweepstakes prospect mailing package known as the Instant Cash
package. The Instant Cash package mailings were highly
profitable for petitioner--especially unusual for prospect
mailings. However, petitioner’s use of this sweeps package
resulted in adverse publicity for petitioner. After receiving
complaints from contributors who received the Instant Cash
Package,18 petitioner stopped using the package by about June
1987.
At petitioner’s board of directors meeting on June 13, 1987,
its executive director proposed that petitioner establish a
cancer patient assistance fund which it would fund with $2,000
per month. In discussing the proposed patient assistance fund,
17
As is discussed infra, table 10 and the text following,
NCIB did not accept petitioner’s allocation of a portion of its
direct mail campaign expenses to public education.
18
Recipients of the package were informed that they were
winners in a contest with a prize of $5,000, if they would enter
the contest. As applicable State laws generally prescribed that
the recipients of such sweepstakes contest solicitations be
allowed to enter the contest without making a contribution, they
were also asked, but not required, to make a contribution to
petitioner. Although the solicitation letter also indicated that
the actual amount won by a recipient would be decided in a later
drawing, the individuals who complained to petitioner believed
the package was deceptive. In actuality, the $5,000 prize money
awarded in the contest would be split evenly among all the
contestants who entered the contest, and these contestants
typically received about $.09. In some instances, petitioner
refunded the contributions it received from the complainants.
- 63 -
petitioner’s executive director stated that the direct mail
campaign is a form of public relations, some viewing it as a
negative form, but with a cancer patient assistance fund in place
it could be turned around to a positive form in the future.
In April 1988, petitioner retained a consultant to assist
petitioner in soliciting donations and grants from corporations
and foundations. The consultant reported to petitioner on the
May 6, 1988, meeting that took place between the consultant and
an executive with the Lilly Endowment, a large foundation in
Indianapolis.
The consultant advised that the Lilly Endowment’s
executive’s unfavorable reaction to petitioner during the meeting
indicated that petitioner’s continuance of its fundraising
contract with W&H would jeopardize petitioner’s efforts to obtain
funding from corporations and foundations. The consultant
advised that “It is doubtful that Lilly will ever fund UCC * * *.
Perhaps a case could be built three or four years after the
termination of the direct mail consultant contract.”
The consultant’s report was given to petitioner’s
Administrative Fundraising Committee, and mentioned by this
committee in its May 11, 1988, report to petitioner’s Executive
Committee.
Several of petitioner’s affiliate member agencies withdrew
from petitioner as a result of the adverse publicity petitioner
experienced.
- 64 -
In addition, investigative inquiries with respect to
petitioner’s direct-mail fundraising activities were begun by
various State attorneys general, including the attorneys general
for Alabama, Illinois, Maryland, Massachusetts, New York, and
Pennsylvania. Later, lawsuits were begun by some of the State
attorneys general, including the attorneys general for New York
and Pennsylvania.
G. Petitioner’s Escrow Account-Related Problems
1. Draws and Petitioner’s Dispute With W&H Over the
Calculation of Cumulative Net Mailing Campaign Revenue
Pursuant to its draw arrangement with W&H, petitioner
received monthly draws from the Escrow Account maintained by WIB.
See supra table 6 & preceding text. In late 1984 these draws
were $5,000 per month. W&H exercised final authority with
respect to approving and directing WIB to release the funds
petitioner sought. Even though the Escrow Account was in
petitioner’s name and WIB considered that the funds in the Escrow
Account belonged to petitioner, WIB paid money out of the Escrow
Account only in response to check requests submitted by W&H.
This was so whether the payments were (1) to vendors in
connection with petitioner’s fundraising activities (in which
events WIB also required the vendors’ invoices), (2) to W&H, or
(3) directly to petitioner.
Petitioner could not have obtained immediate possession of
the funds that WIB held in the Escrow Account by unilaterally
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revoking the Escrow Agreement between petitioner, WIB, and W&H.
If a dispute between petitioner and W&H had arisen with respect
to the disposition of the funds held in the Escrow Account, then
WIB would have frozen the account.
At petitioner’s executive committee meeting on July 19,
1986, the committee members directed petitioner’s staff to ask
W&H to increase petitioner’s monthly draw from $40,000 to
$64,000, beginning August 1, 1986. During the meeting,
petitioner’s executive director expressed his reservations about
petitioner’s increasing the amount of its monthly draws, unless
W&H provided written assurance that petitioner would not have to
repay the excess draws it received. However, the executive
committee member who proposed that petitioner should seek to
increase its monthly draw, responded that he wanted to have those
funds in UCC’s control and accounts despite the possible future
need to repay W&H. This member’s proposal was further supported
by another of the committee members.
At petitioner’s executive committee meeting held on
September 25, 1986, a W&H executive who attended a part of the
meeting advised the committee members that W&H was of the opinion
that petitioner should not increase its monthly draw beyond the
then-current $40,000, because of a decrease in petitioner’s
housefile mailing income. W&H suggested that petitioner wait
until January 1987 before increasing its monthly draw to $50,000.
Petitioner’s monthly draw was increased to $50,000 beginning in
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January 1987, and was again increased, to $60,000, beginning in
January 1988.
In his letter dated November 4, 1988, to Watson,
petitioner’s executive director advised Watson that there was a
substantial discrepancy between W&H’s calculation of petitioner’s
Escrow Account balance and what petitioner calculated its Escrow
Account balance to be. The executive director asked that W&H
authorize transfer from the Escrow Account of the entire
remaining $90,000 of petitioner’s draws for 1988.
In his letter dated November 23, 1988, to Watson,
petitioner’s executive director acknowledged petitioner’s receipt
of its mid-November, semimonthly draw of $30,000 from the Escrow
Account, and stated that he assumed petitioner would be receiving
its draws for 1988 as originally scheduled, rather than in the
lump sum he had asked for in his November 4, 1988, letter. He
further asked that W&H immediately transfer to petitioner half of
the proposed $300,000 it would draw from the Escrow Account for
the period January through May 1989.
In his letter dated December 28, 1988, to Watson,
petitioner’s executive director advised that petitioner’s
Executive Committee had decided petitioner should stop receiving
monthly draws of $60,000 from the Escrow Account, and instead
receive 50 percent of the housefile mailing income, based on
petitioner’s calculation of the net housefile mailing income.
Petitioner’s executive director stated that these transfers are
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to be made within 10 working days of petitioner’s calculations.
In her letter dated February 15, 1989, to Watson,
petitioner’s chief financial officer enclosed a copy of
petitioner’s tentative calculation reflecting, as of January
1989, a $92,358.03 positive balance of cumulative net income from
the direct mail campaign. As petitioner had not received all
invoices of mailing expenses in connection with the January 1989
mailings, petitioner’s chief financial officer asked that
petitioner be paid $75,000, which would leave another $17,000 to
cover any additional mailing expenses. Her letter stated that if
W&H had any questions regarding any of this, petitioner should be
contacted, otherwise petitioner would expect to receive its
requested check for $75,000 no later than February 21, 1989.
In her letter dated May 9, 1989, to a W&H executive,
petitioner’s chief financial officer noted that there was a
substantial discrepancy between petitioner’s and W&H’s respective
computations of cumulative housefile net income, as of December
31, 1988. Petitioner’s chief financial officer stressed that
petitioner’s figures were audited. Petitioner computed that, as
of December 31, 1988, its cumulative housefile income was
$1,930,909, its cumulative transfers from the Escrow Account
amounted to $2,078,200, and there was a resulting deficit of
$147,291. In contrast, W&H computed that the cumulative transfers
were only $1,973,000, but there was a deficit of $540,711. W&H
prepared a status report dated July 1, 1989, in which it took the
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position that, as of April 30, 1989, the cumulative transfers had
grown to $2,213,000 and the deficit had risen to $687,712.
In order to wind up the fundraising arrangement between
petitioner and W&H, the Escrow Account was kept open until at
least September 30, 1989, as petitioner’s last housefile mailing
under the Contract was sent out in early May of 1989. Petitioner
expected that W&H would render a final accounting to it on
September 30, 1989. However, no final accounting was ever made
or agreed to by petitioner and W&H.
Petitioner’s position is that all debts incurred for
prospect mailings had been paid for by the revenues produced from
the mailing campaign, and that petitioner did not owe any money
to W&H.
2. W&H’s Purchase and Invoice Control Procedures
Similar to the authority it exercised with respect to the
funds petitioner sought from the Escrow Account, up until about
1987, W&H generally exercised final authority with respect to
approving and directing WIB to release funds to pay the direct
mail campaign’s expenses. As indicated above in discussing the
Escrow Agreement, the sole exceptions to W&H’s authority
concerned WIB’s transfer of Escrow Account funds to pay “Business
Reply” postage and invoices for WIB’s own services. Beginning
about 1987, W&H generally obtained petitioner’s approval with
respect to the payment of certain vendor invoices, before issuing
payment instructions to WIB.
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During 1984 through 1989, W&H generally furnished WIB with
copies of all vendor invoices along with check requests and
payment instructions. WIB relied on W&H to tell WIB that
petitioner had approved the check requests. When WIB paid an
invoice, it promptly sent to petitioner a copy of the invoice,
the check request, and payment information. Any time that
petitioner called WIB to ask questions about an invoice, WIB
referred petitioner to W&H, because WIB did not review the
correctness or appropriateness of the invoices to petitioner.
Petitioner never asked WIB not to pay a vendor invoice. However,
on at least one occasion W&H authorized a payment without
petitioner’s approval; W&H finally agreed that it would pay that
bill.
In a memorandum dated October 15, 1985, Watson addressed and
discussed a number of matters raised during an October 8, 1985,
meeting between himself, two of petitioner’s directors, and
petitioner’s executive director. Among the matters dealt with in
the memorandum are W&H’s procedures with respect to its issuance
of purchase orders, processing of invoices, and issuance of check
requests to WIB to pay invoices. W&H’s asserted practice was to
send to petitioner copies of purchase orders for all goods or
work contracted by W&H. After completion of the work or delivery
of the goods and W&H’s receipt of an invoice from the vendor, the
W&H account executive reviewed the invoice for accuracy and
returned it to W&H’s accounting department. A check request was
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then prepared and sent to WIB, and a copy of that check request
was also sent to petitioner. In his memorandum, Watson stated
that “Should UCC wish to raise a question concerning any bill,
all they need to do is pick up the telephone and call the escrow
agent [WIB] and request that payment be held up until UCC is
satisfied.”
In his October 15, 1985, memorandum Watson also responded to
petitioner’s concern that W&H, as required by the Contract, make
reasonable efforts to solicit competitive bids from vendors,
where time and market conditions permitted. Watson explained
that W&H’s executives, in soliciting bids, prepared
specifications for the various goods and services needed on a
standardized 7-part purchase order form. The executives then
contacted prospective vendors, advised them of the specifications
for the goods and services sought, and requested bids. The bids
submitted typically were given to the executives over the
telephone, rather than in writing. However, the W&H executives
who received these bids recorded the bid, the name of the company
making it, and the date the bid was submitted, on the last page
of the purchase order. Watson maintained that requiring W&H to
obtain written bids, as petitioner wanted, would be too
cumbersome a procedure and might deter prospective bidders from
submitting bids. If petitioner wanted to audit a bid, Watson
suggested, then petitioner could contact various vendors and ask
them for their internal documentation on the bids they had
submitted to W&H.
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Among the concerns raised by petitioner’s certified public
accounting firm in its later management letter dated May 23,
1986, to petitioner’s board of directors and executive committee,
are the following:
2. W&H Responsibility for Documentation.
It is our understanding that certain procedures in the areas
of purchasing and cash disbursements are executed by W&H
personnel. We performed a limited test of such procedures
and have the following observations:
a. We could not locate a check request for each cash
disbursement. It was our understanding that at the
very minimum, each check issued is to have a
corresponding check request identified with it. The
check request is the only document which indicates W&H
approval of the cash disbursement.
b. During our testing, there were several instances where
we could not locate the invoice(s) associated with
specific checks. We recommend that Council personnel
perform a timely limited review of all cash
disbursements to insure that the proper supporting
documentation exists. One area that needs special
attention is postage. Although invoices are not issued
for postage disbursements, receipts are given to W&H
upon payment. We strongly recommend that the Council
request that the original postage receipt be sent to
the Council and if W&H requires the receipts for their
files, they could retain a copy of the receipt.
Although our testing did not indicate that any of the
checks written for postage were used for items other
than postage, the receipts would provide verification
of these substantial expenditures. [See supra table 7,
which shows that postage and shipping was petitioner’s
largest category of expenses for 1985, 1986, 1987, and
1988.]
c. W&H appears to be decidedly lacking in its adherence to
the stated procedures regarding obtaining competitive
bids on behalf of the Council. A number of the goods
and services are paid for on a contractual basis so
that the main items subject to purchase using
competitive bids are printing and mailhouse costs. Of
the items we examined on a test basis which should have
been subject to competitive bids, we could find
documentation that bids had been obtained only
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approximately 50% of the time. It is possible that
bids were obtained over the phone, but not documented.
In some instances, the documentation we reviewed stated
that a bid could not be obtained due to time
constraints. We do not understand how this could occur
as the mailing schedule is determined months in
advance. Another possibility which exists is that
competitive bids are not obtained but documentation is
provided that states bids were obtained to pacify
council personnel requesting adherence to the stated
procedures regarding obtaining bids. True compliance
testing of the procedures can only be achieved through
independent verification with the vendors involved.
3. Lack of Timely Information.
The final major item we would like to discuss concerns
the lack of adequate, timely financial information
summarizing the activities of the direct mail campaign.
It is our understanding that management decisions are
often based on financial information obtained from
reports generated by W&H and the modified cash-basis
monthly financial statements prepared by the Council’s
accountant. This could be a dangerous course. We have
made two attempts to reconcile financial information in
the W&H reports to the Council’s financial records and
have been unable to do so. We were then informed by
* * * Watson that these reports were not complete,
contain several estimates, and would probably not agree
with the Council’s books. Therefore, we strongly
recommend that the Board not rely quite so heavily on
the reports generated by W&H. The best course of
action would be for Council personnel to prepare the
monthly financial statements in the same manner as they
have been prepared at December 31, 1985. However,
given current circumstances, it would be impossible to
do this on a timely basis. One problem is that W&H can
take up to four months to record an invoice in accounts
payable, particularly W&H’s own invoices. With that
kind of time lag, the Council cannot determine the true
accounts payable at month-end until four months later.
* * *
Petitioner’s concern about W&H’s use of reasonable efforts
to obtain competitive bids from vendors continued throughout the
term of the Contract. During 1986 and 1987, petitioner further
discussed with W&H petitioner’s desire to exercise more control
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over the payment of its direct mail campaign expenses. However,
petitioner’s efforts to obtain full control over disbursements
from the Escrow Account ultimately were unsuccessful.
In his letter dated July 31, 1986, to Watson, petitioner’s
executive director confirmed that he and petitioner’s chief
financial officer would be attending a meeting at W&H’s offices
on August 12, 1986. As part of the agenda for their meeting, the
executive director enclosed for Watson a list of petitioner’s
“staff concerns”. Among the listed staff concerns, was one which
stated that the “EXECUTIVE COMMITTEE MOVED TO BRING ALL
ACCOUNTING FUNCTIONS IN-HOUSE EFFECTIVE JANUARY 1, 1987.
Approval of all invoices and check requests shall come from the
UCC Headquarters, as well as the actual writing and
reconciliation procedures.”
In his letter dated August 21, 1986, to Watson, petitioner’s
executive director stated his understanding that, at the August
12, 1986, meeting with Watson, “It was agreed that when UCC
demonstrates the capability of assuming escrow authority and the
escrow account debt level is significantly reduced, then UCC will
become the escrow agent.”
In her letter dated January 14, 1987, to petitioner’s chief
financial officer, preparatory to a meeting scheduled for January
28, 1987, a W&H executive stated as follows concerning
petitioner’s previously expressed desire to take over management
of disbursements from the Escrow Account, beginning in early
1987:
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Concerning moving the Escrow Account Payable management
to the [petitioner’s] Carmel office early in 1987, you are
probably referring to the discussion we had concerning this
matter during the last visit by you and * * * [petitioner’s
executive director] to our offices in Alexandria. At that
time, we mentioned that only one of W&H’s clients handles
this function in that way. That organization maintains a
surplus cash balance in their accounts in excess of $2
million and a positive fund balance of over $400,000. It is
our policy that once a client is able to develop a positive
fund balance or the outstanding deficit can otherwise be
reduced to a reasonable level, we would be supportive of
such a move as we have been in the past.
Frankly, with nearly $500,000 in outstanding postage
loans to UCC on the books as of last week, it makes us
somewhat nervous to hear mention of this again for the
reasons outlined in your letter. Certainly those areas that
were brought up can easily be overcome. If, on the other
hand, there has been any serious discussion within your
organization which is outside the scope of what we have
already stated, I would appreciate your advising me so that
we can review this with * * * [Watson] and * * * [the W&H
executive who handled petitioner’s account on a daily
basis].
In her letter dated January 30, 1987, to Watson,
petitioner’s chief financial officer discussed her understanding,
from her meeting and discussions with Watson and two W&H
executives on January 28, 1987, of some actions W&H would take to
address petitioner’s concerns with respect to the conduct of its
direct mail campaign and the accounting for and disbursement of
funds to pay the mailing campaign expenses. Among these actions
to be taken by W&H, the letter states that Watson “will write an
addendum to the * * * [Escrow Agreement] which would allow the
Council to approve invoices paid by the Escrow Agent [WIB]. The
Council would be able to provide written requests for payment of
invoices without the approval of * * * [W&H].” With respect to
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petitioner’s desire to control the funds held in the Escrow
Account, the chief financial officer’s letter states as follows:
11. Again, the Council desires to obtain control of
Accounts Payable through a separate bank account which
would be funded by the current Escrow Account. Our
reason is the lack of control we currently have over
Escrow Account Funds. While I appreciate * * * [the
W&H executive who handled petitioner’s account on a
daily basis’] wish to shield us from the aggrevations
[sic] associated with Accounts Payable, I feel the
Council is quite capable of shouldering the
responsibility. If the other changes requested
previously in this letter occur within the next few
months, we will be willing to delay the transfer for a
period of time. Ultimately, the Council wants to
control all of its accounts.
In her letter dated March 10, 1987, to a W&H executive,
petitioner’s chief financial officer objected that the January
31, 1987, listing of accounts payable submitted by W&H that were
to be paid, contained invoices previously disapproved by
petitioner. Petitioner’s chief financial officer complained that
it appeared to her that W&H intended to circumvent the invoice
approval procedure that had been established. Her letter further
stated as follows:
This scenario only emphasizes the lack of control the
Council [petitioner] exerts over its own funds. * * *
[W&H] previously has expressed that the Council is incapable
of managing the Escrow Account, yet the recent activity has
been unacceptable to us and goes against standard accounting
principles. Just as * * * [W&H] insists on administering
the Council’s Accounts Payable, so will we insist that
standard accounting policy be followed, which includes
maintaining vendor correspondence and reviewing invoice
costs.
The proposed addendum to the Escrow Agreement discussed in
petitioner’s financial officer’s above letter dated January 30,
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1987, to Watson, was never executed by petitioner, W&H, and WIB.
In his letter dated June 1, 1987, to petitioner’s executive
director, Watson offered to revise the Escrow Agreement to
provide that petitioner would have the right to approve the
payment of all invoices, if petitioner agreed to an early renewal
of the Contract and entered the proposed new fundraising contract
he enclosed.
Petitioner eventually abandoned its efforts to obtain full
control over disbursements from the Escrow Account. In his
letter dated June 16, 1988, to petitioner’s certified public
accounting firm, petitioner’s executive director stated as
follows:
The Council [petitioner] chose not to bring all of the
record keeping for accounts payable and cash
disbursements in-house. W&H insisted that it would no
longer be responsible for the prospecting debt if such
action were taken. Mr. Watson explained that he did
not want his firm to be responsible for the debt, in
the event that the Council spent all of the proceeds of
the campaign on programs and did not pay the fund
raising expenses. Although we all agree that it would
be considerably easier and more efficient for the
Council to exercise direct control of the record
keeping, the decision was made not to jeopardize the
Council’s financial health by incurring a large
prospecting debt.
We hope these explanations help you understand the
Council’s position and actions during the past year.
H. Petitioner’s Attempt To Obtain A Copy Of Its Housefile
In July 1988, petitioner asked Wiland, the computer services
company that maintained petitioner’s housefile, to provide to
petitioner a complete computer tape of its housefile, as of June
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30, 1988. Petitioner stated that it would pay for the file.
Petitioner’s stated reason was that, “At the urging of our legal
counsel,” it wanted to have a copy of the housefile “to maintain
a ‘file copy’ * * * in the event some disaster strikes Wiland”.
Watson responded that Wiland has a file copy in the vault of a
bank in Fredericksburg, Va., and the safety procedures are
standard in the industry. Watson also pointed to the Contract
provision that “‘any computer work client desires to have done
with any names developed as a result of this contract with W&H
must be done at W&H or at a company designated by W&H during the
term of the agreement’”.
In September 1988, Watson told petitioner that petitioner
would receive a copy of its housefile after the Contract ended,
in May 1989.
Petitioner’s general counsel, James W. Curtis (hereinafter
sometimes referred to as Curtis), tried to get for petitioner a
copy of its housefile. Curtis was not successful in persuading
W&H to provide to petitioner a copy of its housefile. On January
19, 1989, Curtis formally notified Watson that petitioner was
invoking the arbitration provisions of the Contract and was going
to begin an arbitration action in order to obtain the copy of its
housefile. After an unsatisfactory response from W&H’s counsel,
on February 3, 1989, Curtis authorized another attorney to
prepare an arbitration petition for filing on petitioner’s
behalf. On February 9, 1989, Curtis spoke with Watson by
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telephone, concluded that Watson appeared to be cooperative, and
instructed the other attorney “to put the arbitration matter on
hold”. On February 16, 1989, Curtis followed up the February 9
telephone call, asked for the housefile tape and certain other
material needed to understand and use the housefile tape, and
assured that petitioner would respect W&H’s right to designate
the company that would do any computer work with the housefile
during the term of the Contract. On February 24, 1989, W&H
responded that it would direct Wiland to provide to petitioner a
sample tape containing donor information on 10,000 names from
petitioner’s housefile, together with the other material that
Curtis had asked for that was needed to understand and use the
housefile sample tape. W&H also agreed that “as soon as the
entire housefile is needed by whoever ends up working on it, we
can request that it be sent to them by Wiland.”
On February 27, 1989, W&H advised Wiland that petitioner
would transfer its housefile to another computer company after
the Contract ended in May 1989. W&H instructed Wiland to prepare
a sample tape containing donor information on 10,000 contributors
from petitioner’s housefile and to provide certain other
information about the housefile that would be useful to any other
company in deciding whether to become petitioner’s computer
house.
Petitioner’s and W&H’s Respective Accounting Treatments
of the Direct Mail Campaign’s Revenue And Expenses
On its financial statement and Form 990 for 1984, petitioner
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failed to treat the direct mail campaign’s expenses that exceeded
the direct mail campaign’s gross revenue as being its expenses.
In his letter dated December 20, 1985, to petitioner’s
executive director, Watson advised that petitioner’s accounting
treatment of the direct mail campaign’s 1984 expenses was
incorrect. Watson’s December 20, 1985, letter stated, in
pertinent part, as follows:
The proper way to account for all your funds and
expenses is to account for all of the income generated
from UCC mailings as UCC income and all of the expenses
related to all of the mailings must be recorded as UCC
expenses. If * * * [W&H], through its direct mail
assistance, raises $1,000,000 for UCC and spends
$900,000 doing it, then the financial statements must
reflect a gross income of $1,000,000 and $900,000 in
expenses. * * * If your accountants are overly
concerned about the * * * [Contract], I would recommend
that they list the contract as a contractual obligation
in the footnotes to the financial statement. And, they
may want to even indicate that * * * [W&H] is
potentially liable for any losses incurred in the
fundraising efforts. But most importantly, and I have
said this over and over again, * * * [W&H] is not the
keeper of UCC funds. * * * [W&H] does not dole out net
proceeds of fundraising campaigns to UCC.
On its 1985 through 1989 financial statements and Forms 990,
petitioner treated all of the direct mail campaign’s revenue and
expenses as its revenue and expenses.
On its partnership returns, W&H included in “cost of goods
sold” the postage advances it made and included in income the
subsequent reimbursements it received for these advances.
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Petitioner’s Allocation of Expenses Between Fundraising
and Public Education
On its financial statements for 1985 through 1988,
petitioner concluded that substantially all of its direct mail
campaign expenses were “joint expenses” allocable to public
education and fundraising. Its 1985 through 1988 financial
statements reflected that petitioner received total annual
contributions, and incurred joint expenses that it allocated to
public education and fundraising, as shown in table 10.
Table 10
1985 1986 1987 1988
Contributions $5,087,453 $7,869,015 $10,740,045 $3,883,352
Joint Expenses--
Education 2,301,260 3,843,907 4,306,377 1,463,432
Fundraising 2,647,470 3,390,012 5,399,344 1,693,333
Petitioner’s certified public accounting firm advised it of
certain factors to be considered in allocating its direct mail
campaign expenses between public education and fundraising. The
Accounting Standards Division of the American Institute of
Certified Public Accountants issued two Statements of Position
(hereinafter sometimes referred to as SOP), SOP 78-10 and SOP 87-
2, concerning the appropriateness of allocating fundraising
appeal expenses to a charitable organization’s exempt purpose
function. SOP 87-219 amended the earlier-issued SOP 78-10,
19
SOP 87-2, states in pertinent part, as follows:
(continued...)
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primarily by providing additional matters to be considered, and
had an effective date which made it applicable to petitioner’s
1988 financial statement.20 As petitioner’s chief financial
officer interpreted SOP 87-2, if the considerations set forth in
that SOP were applied--
to 1986 or 1987, we would have to show all expenses of the
Donor Development Fund as fund raising. This means that 96%
19
(...continued)
15. All joint costs of informational materials or
activities that include a fund-raising appeal should be
reported as fund-raising expense if it cannot be
demonstrated that a program or management and general
function has been conducted in conjunction with the
appeal for funds. However, if it can be demonstrated
that a bona fide program or management and general
function has been conducted in conjunction with the
appeal for funds, joint costs should be allocated
between fund-raising and the appropriate program or
management and general function.
16. Demonstrating that a bona fide program or
management and general function has been conducted in
conjunction with an appeal for funds requires
verifiable indications of the reasons for conducting
the activity. Such indications include the content of
the non-fund-raising portion of the activity; the
audience targeted; the action, if any, requested of the
recipients; and other corroborating evidence, such as
written instructions to parties outside the
organization who produce the activity, or documentation
in minutes of the organization’s board of the
organization’s reasons for the activity.
20
SOP 78-10 and SOP 87-2 address only whether allocation
of a charitable organization’s fundraising appeal expenses is
appropriate. SOP 87-2 states that “this statement of position
does not address the issue of how to allocate joint costs. A
number of cost accounting techniques are available for that
purpose.”
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of our total expenses (General Fund and Donor Development
Fund), would be allocated to Supporting Services.
Obviously, we cannot afford such a devastating report at the
end of 1988, and must correct any deficiencies in the direct
mail program immediately.
During 1984 through 1989, petitioner was well aware of the
guidelines CBBB and NCIB established for members of the general
public to use in evaluating charitable organizations that
solicited contributions. Petitioner planned and endeavored to
meet eventually all of the CBBB and NCIB guidelines, as
petitioner believed that doing so would enable it to gain more
support from corporations, foundations, and the general public.
Although petitioner, during 1984 through 1989, was never
able to meet all of the CBBB and NCIB guidelines, petitioner
concluded that it was in its interest to allocate as much of the
direct mail campaign’s expenses to public education as possible.
All of the mailing packages petitioner utilized during 1984
through 1989 contained some educational material. A list of the
“Nine Warning Signals of Cancer” was included with almost all the
housefile and prospect letters petitioner mailed. As its mailing
campaign progressed, petitioner tried to increase the educational
content of its mailings.
Petitioner’s 1986 financial statements, published as part of
petitioner’s Annual Report for 1986, contain the following
explanation of petitioner’s allocations of its 1985 and 1986
mailing campaign “joint expenses” between public education and
fundraising:
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NOTE 4--ALLOCATION OF JOINT COSTS OF MAILINGS:
Expenses related to both * * * [prospect mailings and
housefile mailings] are allocated to public education
and fundraising based on the relative content and
intent of all mailings. The content of each and every
mailing is evaluated to determine what percentage of
the mailing satisfies the goal of educating the public
and what percentage of the mailing deals with
fundraising. Public education includes any information
about cancer, its treatment and cures as well as
discussion of the Council’s [petitioner’s] programs in
research and cancer patient services. Fundraising
includes direct requests for money as well as emotional
appeals intended to solicit funds. The relative
content of individual * * * [prospect mailings and
housefile mailings] are summarized and a composite
percentage is determined which is then applied to total
costs. Since the goals of the direct mail campaign are
to educate the public and to raise funds, none of the
costs directly associated with the mailings are
allocated to management and general [expenses?].
Petitioner’s 1988 financial statement, published as part of
petitioner’s Annual Report for 1988, contain the following
explanation of petitioner’s allocations of its 1987 and 1988
mailing campaign “joint expenses” between public education and
fundraising:
NOTE 5--ALLOCATION OF JOINT COSTS OF MAILINGS:
In 1988, the Council [petitioner] incurred joint costs
of $3,156,765 for informational materials and
activities that included fundraising appeals. These
joint costs are expenses related to both * * *
[prospect mailings and housefile mailings] and have
been allocated as follows: $1,463,432 to public
education and $1,693,333 to fundraising. In allocating
the joint costs between public education and
fundraising, the Counsel evaluates the content or
message of the mailing and the intended audience. If
the content is information about cancer, its
treatments, cures and prevention and requests for the
reader to take some action other than sending a
contribution, then the public education function has
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been fulfilled. An audience selected because of its
interest in cancer and other health related issues also
indicates the reason for the mailing is public
education. Conversely, if the message is a direct
appeal for funds and sent to individuals based on their
ability to contribute money, then the fundraising
function has been fulfilled. All circumstances
surrounding a mailing with regard to content and
audience are examined together to arrive at the joint
allocation of costs for each mailing between public
education and fundraising.
In 1987, the Council incurred joint costs of $9,705,721
for informational materials and activities that
included fundraising appeals. Of those costs,
$4,306,377 was allocated to public education and
$5,399,344 was allocated to fundraising. Expenses
related to both * * * [prospect mailings and housefile
mailings] were allocated to public education and
fundraising based on the relative content and intent of
each mailing without regard to intended audience.
NCIB did not accept petitioner’s allocations of its 1985,
1986, and 1987 mailing campaign expenses to public education. In
preparing its reports on various charitable organizations, NCIB
generally accepted the financial information contained in a
charitable organization’s financial statements, except for the
charitable organization’s allocation of its fundraising appeal
expenses to exempt purpose activity. While aware of SOP 78-10
and SOP 87-2, NCIB examined the reasonableness of the allocations
made by the charitable organization. For example, as indicated
above, in a report it issued on petitioner, NCIB concluded that
petitioner’s fundraising expenses for 1985 equaled about 97.7
percent of the related contributions petitioner received.
With respect to petitioner’s 1988 mailing campaign “joint
expenses”, petitioner’s certified public accounting firm
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experienced considerable difficulty in applying SOP 87-2 and was
unable to conclude what portion of the 1988 direct mail campaign
expenses qualified as joint expenses. The accounting firm
essentially let petitioner itself decide how to categorize and
allocate the expenses.
The compensation that W&H received under the Contract by way
of direct payment by petitioner and by way of the value of W&H’s
use of the names generated by petitioner’s fundraising efforts,
exceeded reasonable compensation.
Respondent’s revocation of petitioner’s favorable letter
ruling retroactively to the start of the Contract was not an
abuse of discretion.
OPINION
I. Status Under Secs. 501(c)(3) and 170(c)(2)
Section 501(a) provides that “An organization described in
subsection (c) * * * shall be exempt from taxation under this
subtitle”.21
In order to be described in section 501(c)(3),22 an
21
Exceptions from this broad rule because of secs. 502
(relating to feeder organization), 503 (relating to prohibited
transactions by certain categories of transactions), 501(b)
(relating to unrelated business income), and various other
provisions of the Code do not appear to be issues in the instant
case.
22
Sec. 501(c)(3) provides, in pertinent part, as follows:
(continued...)
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organization must meet all of the following criteria: (1) it
must be both (a) organized and (b) operated, exclusively23 for
certain specified exempt purposes, including charitable,
educational, and scientific purposes; (2) no part of its net
earnings may inure to the benefit of any private shareholder or
22
(...continued)
SEC. 501. EXEMPTION FROM TAX ON CORPORATIONS, CERTAIN
TRUSTS, ETC.
* * * * * * *
(c) List Of Exempt Organizations.--The following
organizations are referred to in subsection (a):
* * * * * * *
(3) Corporations * * * organized and operated
exclusively for * * * charitable, scientific, * * * or
educational purposes * * *, no part of the net earnings
of which inures to the benefit of any private
shareholder or individual, no substantial part of the
activities of which is carrying on propaganda, or
otherwise attempting, to influence legislation, * * *
and which does not participate in, or intervene in
(including the publishing or distribution of
statements), any political campaign on behalf of (or in
opposition to) any candidate for public office.
The text includes an amendment made by sec. 10711(a)(2) of the
Omnibus Budget Reconciliation Act of 1987 (OBRA 87), Pub. L. 100-
203, 101 Stat. 1330, 1330-464. This amendment applies to
activities after Dec. 22, 1987, the date of the enactment of the
Act. This amendment relates only to political campaigns, and so
does not affect the instant case.
23
“Exclusively”, in this context, means that there is no
nonexempt purpose that is “substantial in nature”. Better
Business Bureau v. United States, 326 U.S. 279, 283 (1945);
Living Faith, Inc. v. Commissioner, 950 F.2d 365, 370 (7th Cir.
1991), affg. T.C. Memo. 1990-484; Stevens Bros. Foundation, Inc.
v. Commissioner, 324 F.2d 633, 638 (8th Cir. 1963), affg. on this
issue 39 T.C. 93, 109 n.10 (1962).
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individual; (3) no substantial part of its activities may consist
of lobbying efforts; (4) no part of its activities may constitute
intervention or participation in any political campaign on behalf
of, or in opposition to, any candidate for public office (sec.
501(c)(3)); and (5) its purpose must not be “contrary to a
fundamental public policy”. Bob Jones University v. United
States, 461 U.S. 574, 592 (1983). See generally, American
Campaign Academy v. Commissioner, 92 T.C. 1053, 1062-1063 (1989).
These requirements are stated in the conjunctive. Petitioner’s
failure to satisfy any of these requirements would be fatal to
its qualification under section 501(c)(3). American Campaign
Academy v. Commissioner, 92 T.C. at 1062; Stevens Bros.
Foundation, Inc. v. Commissioner, 39 T.C. 93, 109-110 (1962),
affd. on this issue 324 F.2d 633, 637-640 (8th Cir. 1963).
Donations to section 501(c)(3) organizations generally are
deductible for income tax purposes under section 170. Secs.
170(a), 170(c); Bob Jones University v. Simon, 416 U.S. 725, 727-
728 (1974). Section 170(c)24 defines the term “charitable
24
Sec. 170(c)(2) provides, in pertinent part, as follows:
SEC. 170. CHARITABLE, ETC., CONTRIBUTIONS AND GIFTS.
* * * * * * *
(c) Charitable Contribution Defined.--For purposes of
this section, the term “charitable contribution” means a
contribution or gift to or for the use of--
* * * * * * *
(continued...)
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contribution” to mean a contribution or gift to or for the use of
certain types of organizations enumerated thereunder. With a few
minor differences, the organizations and requirements listed in
section 170(c)(2) are virtually identical to those described in
section 501(c)(3). In view of the nearly identical statutory
language, the courts have applied many of the same standards in
interpreting section 170(c)(2) and section 501(c)(3). See Bob
Jones University v. United States, 461 U.S. at 586-587. For
24
(...continued)
(2) A corporation * * *--
(A) created or organized in the United States
or in any possession thereof, or under the law of
the United States, any State, the District of
Columbia, or any possession of the United States;
(B) organized and operated exclusively for *
* * charitable, scientific, * * * or educational
purposes * * * ;
(C) no part of the net earnings of which
inures to the benefit of any private shareholder
or individual; and
(D) which is not disqualified for tax
exemption under section 501(c)(3) by reason of
attempting to influence legislation, and which
does not participate in, or intervene in
(including the publishing or distributing of
statements), any political campaign on behalf of
(or in opposition to) any candidate for public
office.
The text includes an amendment made by sec. 10711(a)(1) of OBRA
87, Pub. L. 100-203, 101 Stat. 1330, 1330-464. This amendment
applies to activities after Dec. 22, 1987, the date of the
enactment of the Act. This amendment relates only to political
campaigns and so does not affect the instant case.
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convenience, we shall refer to section 501(c)(3), but our
analysis and conclusions, in the context of the instant case,
will apply equally to section 170(c)(2).
In the instant case, respondent contends only that (1)
petitioner was not operated exclusively for exempt purposes
because its “activities served private commercial purposes;” (2)
petitioner “operated in large part for the private benefit of
W&H;” and (3) petitioner’s net earnings inured to the benefit of
private shareholders or individuals. Respondent does not contend
that petitioner is an “action” organization (sec. 1.501(c)(3)-
1(c)(3), Income Tax Regs.), has not raised any contention that
petitioner has failed to satisfy any of the other requirements
discussed above for exemption under section 501(c)(3), and does
not dispute petitioner’s organization exclusively for exempt
purposes. Respondent further acknowledges that respondent bears
the burden of proof in establishing inurement, because
respondent’s notice of revocation did not indicate that inurement
was a ground for the revocation. Rule 217(c)(2)(B); Dumaine
Farms v. Commissioner, 73 T.C. 650, 659-660 (1980).
We note that while the inurement prohibition and the private
benefit analysis under the operational test of the Treasury
regulations may substantially overlap, the two are distinct
requirements which must independently be satisfied. American
Campaign Academy v. Commissioner, 92 T.C. at 1068-1069. However,
it is not clear that the first two of respondent’s contentions--
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activities serving private commercial purposes, and operation for
the private benefit of W&H--are meaningfully different
requirements, at least in the context of the instant case.
We consider first the issue of inurement.
In order for an organization to qualify for exemption under
section 501(c)(3), no part of the organization’s net earnings may
inure to the benefit of any private shareholder or individual.
Sec. 501(c)(3); sec. 1.501(c)(3)-1(c)(2), Income Tax Regs.
A “private shareholder or individual” is broadly defined as
any person having a personal and private interest in the
activities of the organization. Sec. 1.501(a)-1(c), Income Tax
Regs. Such private shareholders or individuals are sometimes
referred to for convenience as “insiders”. See American Campaign
Academy v. Commissioner, 92 T.C. at 1066; Sound Health
Association v. Commissioner, 71 T.C. 158, 185-186 (1978).
We consider first whether W&H was an insider with respect to
petitioner, and then whether there was an inurement of
petitioner’s net earnings to W&H.25
A. W&H As Insider
25
Petitioner does not make the argument that W&H cannot
be an insider under the statutory language because W&H is not a
shareholder in petitioner and is not an individual. Accordingly,
we do not consider that question. See Estate of Fusz v.
Commissioner, 46 T.C. 214, 215 n.2 (1966). In any event, sec.
501(c)(3) deals with whether there is an inurement “to the
benefit of any * * * individual”. If there were an inurement to
W&H, then it may well be that any such inurement would be “to the
benefit of” W&H’s owners--the individuals Watson and Hughey.
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Petitioner maintains that (1) “the inurement doctrine
applies only to insiders who receive an impermissible benefit
from the organization, not to third parties with whom the exempt
organization contracts for services” (emphasis in original); (2)
petitioner was independent of W&H, and the two entities “had no
common directors, officers or employees;” and (3) petitioner--and
not W&H--had “control” in that (a) petitioner directed its
charitable program, (b) petitioner “renegotiated the contract
with W&H in mid-stream, gaining an important financial
advantage,” (c) petitioner “diligently exercised its right of
review over all proposed mail copy, mailing lists, vendor’s
invoices, and volume and frequency of mailings”, and (d)
petitioner “exercised ultimate ‘control’ by terminating its
relationship with W&H.”
Respondent contends that “an ‘insider’s’ control consists of
a meaningful opportunity to influence any portion of the
organization’s activities that could readily be manipulated to
the benefit of the insider.” Respondent asserts that in the
instant case “the record clearly shows that W&H controlled most
of * * * [petitioner’s] income and assets, including controlling
most uses of (and all rental income from) * * * [petitioner’s]
donor and non-donor names, even after the five-year term of the
contract.”
Petitioner rejoins that its board of directors retained
ultimate control, and, to the extent that any control over any
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assets or activities was delegated to W&H, petitioner’s board of
directors exercised due diligence in supervising W&H’s actions.
Mailers contends that, if a charity and an “outsider”
negotiate a contract at arm’s length, then the contract does not
make that person an insider for inurement purposes with respect
to that contract. The contract between petitioner and W&H was
negotiated at arm’s length and was “market rate”, Mailers
asserts, and so W&H was not an insider and there was no inurement
to W&H.
American-Sector contends that “the case law often labors to
craft metaphysical distinctions between these requirements”--the
ban on “private inurement”, the ban on “private benefit”, and the
general requirement that a charity be organized and operated
“exclusively for an exempt purpose”.
We agree with respondent’s conclusion.
The term “private shareholder or individual” appears at
present in sections 170(c) (three places), 501(c) (eight places),
528(c)(1)(D), 833(c)(3)(A)(vi), 2055(a), 2522 (four places), and
4421(2)(B). This term has been unchanged since the Revenue Act
of 1924, Pub. L. 176, 68th Cong., 1st. Sess., ch. 234, 43 Stat.
253, 271, 282. The Revenue Act of 1921, Pub. L. 98, 67th Cong.,
1st Sess., ch. 136, 42 Stat. 227, 241, 253, used the term
“private stockholder or individual”, as did the prior Revenue
Acts back to the Tariff Act of 1913, Pub. L. 16, 63d Cong., 1st.
Sess., ch. 16, 38 Stat. 114, 172. The term “private stockholder
- 93 -
or individual” also appears in section 38 of the Tariff Act of
1909, commonly called the Corporation Excise Tax Act of 1909,
Pub. L. 5, 61st. Cong., 1st Sess., ch. 6, 36 Stat. 11, 113.
Neither the parties nor the amici have directed our attention to,
and we have not found, any statutory explanation of any of these
terms. Our examination of the legislative history of the Revenue
Act of 1924 has not turned up any explanation of the shift from
“stockholder” to “shareholder”. We note that the
Administration’s proposed bill leading to the Revenue Act of 1924
retained the word “stockholder”, while the bill as reported by
the House Ways and Means Committee used the word “shareholder”.
We note also that the term “private stockholder or individual”
appears in paragraph (2) of section 2055(a) (and its 1939 Code
predecessor, section 812(d)), while the term “private shareholder
or individual” appears in paragraph (4) of the same section
2055(a). We have not found any explanation of the intended
difference between “stockholder” and “shareholder”, nor any
reason why “stockholder” was replaced by “shareholder” in the
Revenue Act of 1924. See Western Natl. Mut. Ins. Co. v.
Commissioner, 102 T.C. 338, 354 (1994), affd. 65 F.3d 90 (8th
Cir. 1995).
Section 1.501(a)-1(c), Income Tax Regs., provides as
follows:
(c) “Private shareholder or individual” defined. The
words “private shareholder or individual” in section 501
refer to persons having a personal and private interest in
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the activities of the organization.
See sec. 1.501(c)(3)-1(c)(2), Income Tax Regs.
This definition is unchanged from Regs. 65, art. 517 (1924),
except that the older regulations use “individuals” and
“corporation”, instead of “persons” and “organization”,
respectively. Art. 517 of Regs. 65 is essentially similar to
Regs. 45, art. 517 (1920). In general, the case law appears to
have drawn a line between those who have significant control over
the organization’s activities and those who are unrelated third
parties. People of God Community v. Commissioner, 75 T.C. 127,
133 (1980).
We proceed to consider whether, and if so then to what
extent, W&H controlled petitioner’s activities.
On the one hand, neither W&H nor Watson nor Hughey was a
director or officer of petitioner, nor did any of them have a
formal voice in the selection of any director or officer of
petitioner.
On the other hand, in exchange for (a) funds to keep
petitioner operational and get it past its 1984 financial crisis
and (b) fundraising services, W&H received (1) compensation, (2)
effectively exclusive control over petitioner’s fundraising
activities, including supposedly separate computer activities,
and (3) substantial control over petitioner’s finances. The
amounts that W&H would advance for petitioner’s operational costs
and as capital for petitioner’s fundraising costs were not
- 95 -
specifically contracted for, but were essentially discretionary
with W&H.
Moreover, up until the execution of the April 1987 addendum
to the Contract, petitioner was fully liable on a recourse basis
to repay W&H for the excess draws petitioner received. This
repayment liability caused petitioner’s certified public
accounting firm to express serious concern about petitioner’s
continued existence and economic viability, in the accounting
firm’s management letter dated May 23, 1986, to petitioner’s
board of directors and Executive Committee.
Although petitioner had a longstanding existence before its
involvement with W&H, the position W&H occupied in relation to
petitioner, during 1984 and 1985, was in many ways analogous to
that of a founder and major contributor to a new organization.
Petitioner, which was on the brink of insolvency, was being
heavily financed and kept in existence by W&H pursuant to the
fundraising arrangement that petitioner and W&H entered.
Petitioner became dissatisfied with its lack of control over
the Escrow Account funds. In 1986 and 1987, petitioner made a
number of concerted efforts to obtain more control over the
Escrow Account. However, its efforts were unsuccessful as a
result of W&H’s refusal to give up control over the account. W&H
continued to retain control over the Escrow Account long after it
and petitioner knew the direct mail fundraising campaign was
financially successful.
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W&H’s control over petitioner’s fundraising campaign is
further manifested by petitioner’s unsuccessful efforts to obtain
a copy of its own housefile in July 1988, about 11 months before
the contract ended. W&H refused to provide to petitioner a copy
of its housefile until the contract was over. It instructed
Wiland, the computer company W&H selected to maintain
petitioner’s housefile, not to comply with petitioner’s July 1988
request. Despite the extensive efforts of its attorney,
petitioner was unable to obtain its complete housefile until
after the Contract ended.
From a practical standpoint, W&H exercised substantial
control over petitioner’s finances and direct mail fundraising
campaigns during the period from 1984 through 1989. In light of
W&H’s extensive control over petitioner and petitioner’s near-
insolvent financial condition when the fundraising arrangement
was entered into in June 1984, we conclude that W&H was an
“insider” with respect to petitioner.
Petitioner and Mailers contend that one cannot become an
insider merely by entering into an arm’s-length negotiated
contract. We are not aware of any such “one-free-bite” principle
in this part of the law. Whether the control thus transferred,
or shared, makes the transferee an insider depends on the
circumstances. The arrangement authorized by the Contract in the
instant case was not a “one-shot deal”, but a 5-year
relationship, involving many transactions during its term. The
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arm’s-length negotiations may have a significant bearing on the
fairness of the Contract, but they do not inoculate W&H against
insider status.
Mailers makes a further argument along this line by pointing
out that--
even the definition of self-dealing provides that the term
does not include ‘a transaction between a private foundation
and a disqualified person where the disqualified person
status arises only as a result of such transaction.’ Treas.
Reg. §53.4941(d)-1(a).
However, the cited regulation explains this rule in the very
next sentence, as follows:
For example, the bargain sale of property to a private
foundation is not a direct act of self-dealing if the seller
becomes a disqualified person only by reason of his becoming
a substantial contributor as a result of the bargain element
of the sale.
Thus, the cited regulation (which does not apply to public
charities anyway) focuses on the “one-shot deal” and does not
appear to immunize a substantial course of dealing merely because
the substantial course of dealing is pursuant to one contract
(and its amendments and extensions).
We conclude that the cited regulation, fashioned in an
environment of “disqualified persons” and “prohibited
transactions”, is distinguishable from what we face in the
instant case, viz, “insiders” and “inurement”.
We hold, for respondent, that W&H was an insider with regard
to petitioner.
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B. Did Any of Petitioner’s Net Earnings Inure to W&H?
Petitioner points out that respondent has the burden of
proof, and contends that respondent has failed to carry this
burden.
Respondent acknowledges having the burden of proof, but
contends that this burden has been carried because it was shown
that W&H received “excessive and unreasonable compensation (and
other private benefit)” from petitioner.
Mailers argues that private inurement does not result from a
third-party contract for fair market value and contends that the
Contract was at “Market Rate”, especially in light of all the
facts and circumstances when the Contract was executed.
We agree with respondent’s conclusion.
An organization’s payment of reasonable compensation to an
insider for services performed for the organization would not
constitute inurement of net earnings,26 but payment of excessive
compensation would. United States v. Dykema, 666 F.2d 1096, 1101
(7th Cir. 1981); Unitary Mission Church v. Commissioner, 74 T.C.
507, 514 (1980), affd. without published opinion 647 F.2d 163 (2d
Cir. 1981). Whether the compensation in question is reasonable
26
Neither side suggests that we should examine the
statutory term “net earnings”, and so we do not. See People of
God Community v. Commissioner, 75 T.C. 127, 132 n.5 (1980); Alive
Fellowship of Harmonious Living v. Commissioner, T.C. Memo. 1984-
87 n.21; see also discussion in B. Hopkins, The Law of Tax-Exempt
Organizations, sec. 13.4 (6th ed. 1992).
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is a question of fact. Founding Church of Scientology v. United
States, 188 Ct. Cl. 490, 412 F.2d 1197, 1200 (1969). Factors
similar to those considered in determining reasonable
compensation under section 162(a)(1) are examined. Founding
Church of Scientology v. United States, supra; B.H.W. Anesthesia
Foundation v. Commissioner, 72 T.C. 681, 686 (1979). In
determining whether there has been an inurement of net earnings
we are to consider all forms of compensation, and not merely
direct payments from the organization to the insider. Founding
Church of Scientology v. United States, supra; Unitary Mission
Church v. Commissioner, 74 T.C. at 512-513.
A cap or limit on the contingent compensation that may be
earned under a particular incentive formula, can be considered a
factor supporting the reasonableness of that contingent
compensation arrangement. See People of God Community v.
Commissioner, 75 T.C. at 132.
At trial, petitioner and respondent offered the testimony of
several expert witnesses on the issue of whether W&H received
more than reasonable compensation. As trier of fact, we are not
bound by the opinion of any expert witness and will accept or
reject expert testimony, in whole or in part, in the exercise of
sound judgment. Helvering v. Nat. Grocery Co., 304 U.S. 282, 295
(1938); Silverman v. Commissioner, 538 F.2d 927, 933 (2d Cir.
1976), and cases there cited, affg. T.C. Memo 1974-285.
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Petitioner offered the testimony of three expert witnesses:
(1) James Feldman (hereinafter sometimes referred to as Feldman),
a professional direct mail marketing and fundraising consultant;
(2) J. Curtis Herge (hereinafter sometimes referred to as Herge),
an attorney practicing in the Washington, D.C., area, who has
advised nonprofit organizations and professional fundraisers
about fundraising contracts and represented such clients in the
negotiation of their fundraising contracts; and (3) Richard S.
Steinberg (hereinafter sometimes referred to as Steinberg), an
economist who has specialized in the economics of nonprofit
organizations.
Respondent offered the testimony of four expert witnesses:
(1) Nora Carrol (hereinafter sometimes referred to as Carrol), a
professional fundraising and marketing consultant, (2) John Kehoe
(hereinafter sometimes referred to as Kehoe), a professional
fundraiser who at the time of the trial specialized in mailing
list brokerage services, (3) William C. McGinly (hereinafter
sometimes referred to as McGinly), president of the Association
for Healthcare Philanthropy, a professional organization of
health care facility and hospital executives concerned with
fundraising, marketing, and public relations, for nonprofit
health care facilities and hospitals, and (4) Robert S. Tigner
(hereinafter sometimes referred to as Tigner), general counsel
for the Association of Direct Response Fundraising Counsel
- 101 -
(hereinafter sometimes referred to as ADRFCO), a professional
organization of professional fundraising companies that provide
direct response consulting services to nonprofit organizations.
Herge attached to his expert report copies of 21 fundraising
agreements for various nonprofit organizations filed with
Virginia’s Office of Registrations, Division of Consumer Affairs.
Herge asked the Virginia Office of Registrations to provide him
with copies of all fundraising agreements filed with it by up to
10 to 12 professional fundraisers during a specified time period.
From the agreements thus provided, Herge selected agreements
which he believed were representative and typical of the
agreements similar to petitioner’s found in the market place.
These 21 fundraising agreements were entered into during the
period from 1984 through 1992. They involve various professional
fundraisers and client organizations. Nineteen of the 21 client
organizations involved in these agreements have been recognized
by respondent as being exempt from Federal income tax either
under section 501(c)(3), 501(c)(4), or 501(c)(5). Four of the 21
agreements essentially provide that the nonprofit organization
client is fully liable on a recourse basis for the fundraising
expenses. The remaining 17 agreements are essentially “no-risk”
contracts for the nonprofit organization. However, a few of the
essentially “no-risk” agreements require the nonprofit
organization client to either contribute a specified amount of
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the initial capital to conduct the mailing campaign or bear
financial responsibility for certain specified types of expenses.
Without going into an analysis of each of these expert
witness’ testimony, we draw the following overall conclusions
from their testimony:
1. Contingent-fee charitable fundraising arrangements occur
with modest frequency. Although some in the fundraising field
regard such arrangements as being improper, others treat such
arrangements as an ordinary part of the fundraising landscape.
It is expected that a fundraising arrangement with a contingent-
fee element would present opportunities for greater total
compensation for the fundraiser than a similar fundraising
arrangement that does not have a contingent-fee element.
2. No-risk charitable fundraising arrangements occur with
less frequency. They may take various forms, most of which may
more appropriately be labeled as “limited risk”, rather than “no-
risk”. It is expected that a fundraising arrangement with a no-
risk or limited-risk element would involve greater total
compensation for the fundraiser than a similar fundraising
arrangement that does not have a no-risk or limited-risk element.
3. As petitioner’s experts Feldman and Herge point out, co-
ownership of mailing lists is typical in no-risk charitable
fundraising arrangements and is regarded as a method of enhancing
compensation to the fundraiser without requiring the charitable
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organization client to actually write checks. Although such co-
ownership is understood to be an element of compensation, it has
the side effect of making it more difficult to determine what is
the total compensation to the fundraiser. Note that petitioner’s
Form 990 did not report this as an element of compensation paid,
and respondent does not suggest that petitioner should have tried
to find out how much W&H earned as a result of this feature of
the fundraising agreement. In the instant case, the co-ownership
had features that significantly restricted petitioner’s use of
its own mailing list.27 Under section 18 of the Contract, all of
these restrictions even survive the term of the Contract. In
addition, W&H and petitioner interpreted the Contract to permit
W&H to exchange petitioner’s mailing list for another
organization’s mailing list and then require petitioner to
“reimburse” W&H for the expense that W&H did not in fact incur
because of the exchange of mailing lists. A side effect of this
feature is that in such a situation a payment by petitioner to
W&H which appeared to be a simple reimbursement of W&H’s out-of-
pocket expenses would in fact have been additional compensation
by petitioner to W&H.
27
See sec. 14 of the Contract, set forth supra. The
Contract expressly forbids petitioner to “rent, exchange, lease,
sell or give away” the names and addresses that W&H develops “to
any other parties for any purpose whatsoever.” On the other
hand, the Contract expressly permits W&H to use these names and
addresses “in any way it so desires and for any purpose it may so
determine.”
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4. Petitioner’s mailing fees under the Contract--$0.05 per
prospect letter and $.10 per housefile letter--were within, but
about the high end of the range of charges in what Herge
described as a representative group of fundraising contracts.
Petitioner was charged package fees for housefile mailings under
the Contract. In Herge’s group of contracts, package fees were
ordinarily found only in conjunction with lower mailing fees; in
only one instance in this group (The Viguerie Co.’s contract with
The Solidarity Endowment) was there both a package fee and a high
mailing fee. As Tigner points out, it is difficult to evaluate
the reasonableness of a particular mailing fee unless one
understands the volume of mailings that are anticipated. In
general, the greater the volume of mailings anticipated, the
smaller the mailing fees. This relationship was clearly
recognized in five of the fundraising contracts in Herge’s group
of contracts, involving four different fundraisers, which
provided graduated mailing fees, depending on the volume of
mailings actually sent. Thus, when the parties to a fundraising
contract do not have a basis for confidently estimating the
volume of mailings to be sent, a graduated mailing fee schedule
is a device that may be used to protect both sides. In April
1986 petitioner and W&H agreed to a cap on housefile mailing fees
in exchange for a reduction, from 70 to 50 percent, in the
cumulative net income from housefile mailings that petitioner was
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guaranteed to receive. The $50,000 cap applied to any single
housefile mailing of more than 500,000.
5. In almost all of Herge’s group of contracts the exempt
organization could terminate the fundraising contract with some
form of advance notice. The longest notice so required is 120
days and the shortest is 30 days. Often these contracts provide
that an exempt organization that terminates its fundraising
contract becomes liable for mail campaign losses. In contrast,
the Contract does not make any provision for petitioner to
terminate it by giving notice or for cause. On the contrary, the
Contract provides that, during its entire 5-year term, W&H would
be petitioner’s exclusive fundraiser, and specifically forbids
petitioner to “retain or use the services of any other person or
company to provide counsel or advice to [petitioner] in
conducting its direct mail solicitations.”
Thus, W&H had an effective way to limit its risk if the
Contract did not prove to be productive--W&H could reduce or
eliminate the monthly draws that it allows petitioner to take and
it could end the advances used to fund future mailings for
petitioner. Once petitioner had grown accustomed to this
lifeline, petitioner could not remain viable without continued
infusions; W&H could figuratively pull petitioner’s plug and
thereby effectively rid itself of future losses or insufficiently
profitable obligations. Petitioner, on the other hand, had no
exit. Presumably, petitioner could have refused to authorize
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more mailings, but petitioner could not use another fundraiser no
matter how unhappy it was with how the Contract was working out.
This suggests that the uncertainties normally attendant on a no-
risk contingent fee arrangement warranted less of a premium to
W&H under the circumstances of the Contract than might be
appropriate in the usual run of no-risk contingent fee cases.
The dollar amounts in some of the tables set forth supra in
our Findings of Fact in many instances do not properly match the
dollar amounts in other tables. This results from the
inconsistent and usually unreconciled exhibits that the parties
introduced in the extensive record in the instant case.
Nevertheless, the following conclusions may fairly be drawn from
the information we have:
1. W&H’s services under the Contract netted petitioner
about $2¼ million for its own uses unrelated to the
Contract. Tables 1, 2, and 10.
2. This net is less than 10 percent of what donors
contributed to petitioner in the fundraising campaign.
Tables 1 and 10.
3. Petitioner directly paid more than $4 million to W&H
as fundraising fees. Tables 3 and 7.
4. In addition, petitioner paid almost $4 million to
Washington Lists, a division of W&H, for list rental fees
and commissions. Tables 4 and 7.
5. More than 10 percent of petitioner’s payments to
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Washington Lists were for rentals of lists that W&H or
Washington Lists had obtained at little or no cost by
exchanging petitioner names. Table 8.
6. Although the record does not show how much W&H or
Washington Lists profited from being able to use petitioner
names for mailing list exchanges on behalf of W&H’s other
clients, it does show that about 5 percent of petitioner’s
payments to Washington Lists were for rentals of lists that
W&H or Washington Lists had obtained at little or no cost by
exchanging W&H masterfile names. Table 8.
At trial, Watson testified that the mailing fee rates that
W&H charged to petitioner under the Contract were equal to the
highest rates that he understood professional fundraisers in the
Washington, D.C., area charged their nonprofit organization
clients in no-risk fundraising contracts. In his letter dated
June 1, 1987, to petitioner’s executive director, Watson proposed
that petitioner and W&H agree to an early renewal of the Contract
and enter into a new proposed contract that would replace and
supersede the Contract. Under the proposed contract Watson
enclosed, W&H’s mailing fees would be reduced from $.05 to $.03
per prospect letter and from $.10 to $.07 per housefile letter.
When W&H entered into contracts with AICR on a no-risk
basis, AICR’s mailing fees were 20 percent less than what
petitioner had to pay, and AICR did not also have to pay package
fees. Supra table 5. The second 1983 AICR contract and the 1984
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AICR contract, both of which were entered into before the
Contract, showed W&H’s understanding of the uses of graduated
mailing fees.
The market, as exemplified by Herge’s sample of fundraising
contracts, provided two significant checks on excessive
compensation in no-risk situations--early termination rights for
the exempt organization (almost all the contracts) and graduated
mailing fee (five contracts). Until the April 1986 agreement,
the Contract did not provide either of these checks on the effect
of high mailing fees, thereby reducing the market justification
for charging what Watson acknowledged to be equal to the highest
rates in the Washington, D.C. area.
Although our inquiry in the instant case is to some extent
similar to that in section 162(a)(1) cases, this inquiry is
easier in one important respect--if we determine that there is
excess compensation in a section 162(a)(1) case, then we must set
a dollar amount on that excess, while in the instant case we
merely have to determine whether there is excess compensation and
need not then set a dollar amount. Airlie Foundation, Inc. v.
United States, 75 AFTR 2d 95-2068, 95-2070, 95-1 USTC par. 50279
(D.C. Cir. 1995); Orange County Agr. Soc., Inc. v. Commissioner,
893 F.2d 529, 534 (2d Cir. 1990), affg. T.C. Memo. 1988-380; see
Church of Scientology of California v. Commissioner, 823 F.2d
1310, 1316 (9th Cir. 1987), affg. 83 T.C. 381, 491-492 (1984);
Founding Church of Scientology v. United States, 412 F.2d at
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1202; Unitary Mission Church v. Commissioner, 74 T.C. at 513.
But see Carter v. United States, 973 F.2d 1479, 1486 n.5
(majority opinion), 1489-1490 (Tang, J., concurring in part and
dissenting in part) (9th Cir. 1992).
The instant case does not involve an insider’s embezzlement
or any other kind of theft or use of assets unbeknownst to the
other insiders. What we conclude to be excessive compensation
resulted from what petitioner and W&H apparently believed the
Contract permitted or required. The fact that the Contract was
bargained for is a significant factor pointing toward
reasonableness. Sec. 1.162-7(b)(2), Income Tax Regs. However,
even under the standards of section 162(a)(1) the bargaining
factor does not by itself conclusively protect an arrangement
from a determination that the compensation was unreasonable; we
are required to consider all the circumstances. Sec. 1.162-
7(b)(3), Income Tax Regs.
Our examination of the other contracts provided by Herge, of
the multiplicity of compensation sources that W&H had under the
Contract, of the open-ended nature of W&H’s charges under the
Contract even though graduated fees were already being used in
the industry--and specifically by W&H in connection with AICR--
convinces us that the initial risk that W&H bore did not justify
so high a level of compensation. We are not holding that an
arm's-length arrangement that produces a poor result for an
organization necessarily would cause the organization to lose its
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tax-exempt status. We conclude, and we have found, that the
compensation that W&H received under the Contract by way of
direct payment by petitioner and by way of the value of W&H’s use
of names generated by the fundraising efforts that petitioner
already paid for, exceeded reasonable compensation.
As a result, we conclude that, as of the June 11, 1984, date
on which the Contract started, the Contract was not a reasonable
contingent compensation arrangement, that W&H’s compensation
under the Contract exceeded reasonable compensation, and that
thus there was an inurement to an insider, in violation of the
restrictions in sections 501(c)(3) and 170(c)(2)(C).
It is suggested that the $2¼ million that petitioner cleared
during the course of the Contract may justify such high
compensation. However: (1) The $2¼ million is so small in
comparison to the amounts of contributions, of W&H compensation,
of postage and shipping costs, of printing and publications
costs, and of mailing list rental costs, as to be almost an
incidental product of the fundraising campaign; and (2) W&H was
supposed to provide a substantial asset to petitioner--a
housefile that petitioner could exploit in future fundraising
(see supra findings under Direct Mail Fundraising)--but W&H’s
services were a practical failure in this regard. Thus, the
magnitude of W&H’s compensation is not justified by adequacy of
results.
We hold for respondent on this issue.
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II. Retroactivity of Respondent’s Revocation of
the Prior Favorable Ruling Letter Issued to Petitioner
Petitioner contends that it was improper for respondent to
revoke the prior favorable ruling letter retroactively to June
11, 1984, the date on which petitioner entered into the Contract.
Petitioner contends that the retroactivity of the revocation (1)
violates its Fifth Amendment due process rights and (2)
constitutes an abuse of respondent’s discretion under section
7805(b). Petitioner’s constitutional arguments were considered
and dealt with in United Cancer Council, Inc. v. Commissioner,
100 T.C. 162 (1993), and in the hearing that preceded that
opinion. Petitioner asks the Court “to reconsider our previously
detailed arguments, and we also note our preservation of the
issues in the event of an appeal.” We believe that our earlier
rulings in this matter were correct and that there is no need to
restate them. We proceed to consider the abuse-of-discretion
issue under section 7805(b).28
28
Sec. 7805(b) provides as follows:
SEC. 7805. RULES AND REGULATIONS.
* * * * * * *
(b) Retroactivity of Regulations or Rulings.--The
Secretary may prescribe the extent, if any, to which any
ruling or regulation, relating to the internal revenue laws,
shall be applied without retroactive effect.
This provision was extensively revised by sec. 1101(a) of the
Taxpayer Bill of Rights 2, Pub. L. 104-168, 110 Stat. 1452,
1468 (1996), effective for regulations which relate to statutory
(continued...)
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The Supreme Court has held that respondent has broad
discretion under section 7805(b) and its predecessor, in deciding
to revoke a ruling retroactively, and that such a determination
is reviewable by the courts only for abuse of that discretion.
Automobile Club v. Commissioner, 353 U.S. 180, 184 (1957); see
Dixon v. United States, 381 U.S. 68 (1965). See generally,
Virginia Education Fund v. Commissioner, 85 T.C. 743 (1985),
affd. 799 F.2d 903 (4th Cir. 1986).
More recently, in a different but analogous setting, we
described review of exercise of discretion as follows:
Whether the Commissioner has abused his discretion is a
question of fact. Buzzetta Construction Corp. v.
Commissioner, 92 T.C. 641, 649 (1989); Estate of Gardner v.
Commissioner, 82 T.C. 989, 1000 (1984). In reviewing the
Commissioner’s actions, however, we do not substitute our
judgment for the Commissioner’s, nor do we permit taxpayers
to carry their burden of proof by a mere preponderance of
the evidence. Buzzetta Construction Corp. v. Commissioner,
28
(...continued)
provisions enacted after July 30, 1996, and so does not affect
the instant case. We note that present sec. 7805(b)(8) provides
as follows:
SEC. 7805. RULES AND REGULATIONS.
* * * * * * *
(b) Retroactivity of Regulations.--
(8) Application to rulings.--The Secretary
may prescribe the extent, if any, to which any
ruling (including any judicial decision or any
administrative determination other than by
regulation) relating to the internal revenue laws
shall be applied without retroactive effect.
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92 T.C. at 648; Mailman v. Commissioner, 91 T.C. 1079, 1084
(1988); Pulver Roofing Co. v. Commissioner, 70 T.C. 1001,
1011 (1978). Taxpayers are required to clearly show that
the Commissioner’s action was arbitrary, capricious, or
without sound basis in fact. Knight-Ridder Newspapers v.
United States, 743 F.2d 781, 788 (11th Cir. 1984); Mailman
v. Commissioner, 91 T.C. at 1084; Drazen v. Commissioner, 34
T.C. 1070, 1076 (1960). [Capital Federal Savings & Loan v.
Commissioner, 96 T.C. 204, 213 (1991).]
The Contract caused the inurement violation. It is not
“arbitrary, capricious, or without sound basis in fact” for
respondent to determine that the revocation of the favorable
ruling letter should relate back to the start of the Contract.
Neither the parties nor the amici refer to section
601.201(n)(6), Statement of Procedural Rules, nor to Rev. Proc.
90-27, 1990-1 C.B. 514, both of which provide, in pertinent part,
that “The revocation [of an exemption ruling] * * * may be
retroactive if the organization * * * operated in a manner
materially different from that originally represented”. The
start of the Contract marked a substantial change in petitioner’s
operations. This change was material with respect to inurement.
Petitioner has not suggested that there was any event after the
start of the Contract which marked a change in W&H’s actions, or
W&H’s rights under the Contract, such that there was an inurement
after that event or change but not before that event or change.
If the revocation, which occurred after the Contract expired, had
been made prospective only, then the revocation would have been a
meaningless act.
We conclude that (1) the retroactivity of the revocation to
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the start of the Contract is not an abuse of discretion when
tested by the usual standards, (2) petitioner does not maintain
that these standards have been modified as a result of section
601.201(n)(6), Statement of Procedural Rules, or Rev. Proc. 90-
27, and (3) the retroactivity would not be an abuse of discretion
even if the usual standards were so modified. See Capital
Federal Savings & Loan v. Commissioner, 96 T.C. at 217-219, 223.
We hold that respondent’s determination, that the revocation
be retroactive to the start of the Contract, was not an abuse of
discretion.
In light of our holdings for respondent, we do not consider
whether petitioner should be denied tax-exempt status for other
reasons, whether anyone’s actions violated postal regulations and
if so what effect that should have on petitioner’s exempt status,
whether petitioner and W&H engaged in a joint venture, whether a
portion of petitioner’s expenses is properly allocable to public
education, or whether any particular feature of the Contract
constituted a “per se” violation of any of the requirements of
sections 501(c)(3) and 170(c)(2). Finally, section 4958,
imposing an excise tax on “excess benefit transactions”, applies
only to transactions occurring on or after September 14, 1995,
and so does not apply to the instant case.
Decision will be entered
for respondent.
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