In this three-part series, TechSoup’s General Counsel provides an overview of "due diligence" in the charitable sector. Part I examines the meaning of the term, with an overview of how it applies specifically to U.S. funders and international grantees.
Part I: What Is Due Diligence?
Meaning and Historical Context
Among the handful of Latin phrases branded into the brains of U.S. law school students is caveat emptor, or "buyer beware." The term refers to a legal doctrine that limits a purchaser's ability to retract a purchase once the transaction is complete. "Buyer beware" might otherwise be stated as "do your due diligence."
The term "due diligence" derives from Latin for "owe" (debere) and "carefulness" (diligentia), meaning exercising the level of carefulness required for a given situation. As Merriam Webster describes it,
Due diligence has been used since at least the mid-fifteenth century in the literal sense "requisite effort.” Centuries later, the phrase developed a legal meaning, namely, "the care that a reasonable person takes to avoid harm to other persons or their property;" in this sense, it is synonymous with another legal term, ordinary care. More recently, due diligence has extended its reach into business contexts, signifying the research a company performs before engaging in a financial transaction. This meaning may also apply to individuals: people are often advised to perform their due diligence before buying a house, signing a loan, or making any important purchase.
In the U.S., the concept of due diligence as a business necessity was introduced via the Securities Act of 1933. The Act required that sellers of securities disclose pertinent information to potential buyers in a registration statement. Sellers could be liable for disclosing faulty information, unless they had, "after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true …."
In that situation, the seller itself was required to show that it exercised "reasonable investigation” or "reasonable diligence” with regards to its own securities. If the seller could prove that the information disclosed was conducted pursuant to reasonable investigation, it might avoid liability for failing to provide more accurate information.
The U.S. is not the only country with a traceable history of due diligence in law and business. Jonathan Bonnitcha and Robert McCorquodale write that
Under Roman law, a person was liable for accidental harm caused to others if the harm resulted from the person’s failure to meet the standard of conduct expected of a diligens (or bonus) paterfamilias – a phrase that translates roughly as a prudent head of a household. ... Elaborating in the 6th century AD, Justinian argued that an individual may be liable for harm where "what should have been foreseen by a diligent man was not foreseen." European Journal of International Law (citations omitted).
The authors point out that this particular history of the term links due diligence to a standard of conduct; whereas, "[i]n a business context, due diligence is normally understood to refer to a process of investigation conducted by a business to identify and manage commercial risks. …" Id.
Due diligence, as the term is currently used, extends far beyond commercial risks, including also reputational and legal risks. In the nonprofit world especially, due diligence will often serve to assess an organization’s mission fit, long-term sustainability, and likelihood of impact. For the purpose of this series, we will focus solely on the benefits, limitations, and distinctions of due diligence in the charitable sector. By "charitable sector" we mean charities, NGOs, and other public-benefit nonprofits (as opposed to nonprofits generally, a broader category that also includes trade associations, political committees, and labor unions, for example). We are also limiting the discussion to diligence for grantmakers around grantmaking and will not include the due diligence conducted by charities around activities such as mergers, acquisitions, or investments.
Due Diligence in Grantmaking
What constitutes due diligence will vary infinitely based on the individual circumstances, relevant laws, political climate, and risk appetite of the parties involved. In the grantmaking context, due diligence is primarily used to address one of four risks: (i) legal risks, (ii) mission alignment (or lack thereof), (iii) financial risk, and (iv) reputational risk. Below is a high-level summary of each.
(i) Legal compliance
U.S. funders are required to undertake a number of steps before transferring funds to a grantee, and these steps are principally driven by national and international laws. We have highlighted a few key examples below.
U.S. tax law
In the U.S., charities are subject to the Internal Revenue Code (the "tax code"), which regulates their operations to ensure that they merit exemption from federal income tax. Since non-tax-exempt entities, like for-profit companies, do not benefit from income tax-exemption, they are significantly less restricted in what they do with their funds.
The tax code divides 501(c)(3) charitable organizations into two primary types: private foundations and public charities. Public charities are organizations funded by a diverse subset of donors, including governments, individuals, and other charities. Their primary activity is to conduct charitable programs as opposed to merely making grants. Private foundations, on the other hand, are organizations primarily funded and governed by a single donor, family, or company. They are typically engaged in grantmaking as their primary activity. Because they are not dependent on the general public for funding, and thus viewed by the Internal Revenue Service (IRS) as less "accountable" to the public, private foundations are subject to more restrictions on the way they operate and transfer funds. Notably, donor-advised funds (DAFs) are something of a hybrid: while technically public charities, they are subject to many of the same restrictions as private foundations with respect to grantmaking.
Before making a grant, private foundations and DAFs must either ensure that the grantee is a recognized public charity (or its foreign equivalent) or exercise expenditure responsibility over the grant. A U.S. grantee’s charitable status may be verified by confirming that it is currently recognized by the IRS as a 501(c)(3) public charity and is not a private foundation. For non-U.S. grantees to be recognized as public charities by the IRS, the foundation or DAF might choose to conduct an equivalency determination, or "ED." An equivalency determination is a specific kind of due diligence conducted by a "qualified [U.S.] tax practitioner" for the sole purpose of determining whether a non-U.S. grantee is legally restricted in its operations to the same degree as a U.S. public charity. An equivalency determination is conducted prior to making the grant. Obtaining an ED for the grantee allows the funder to legally proceed without further assurances regarding the use of the funds (as long as it has no reason to believe the funds will be diverted). Alternatively, expenditure responsibility – which may be exercised on either a non-U.S. grantee or a U.S. non-charitable entity – requires that the funder conduct certain due diligence before, during, and after making the grant. This can happen in the form of a pre-grant inquiry, restricted grant payments, and the collection of reports on the use of the funds.
If a private foundation or DAF makes a grant to a non-charity (or a non-U.S. entity) without either exercising expenditure responsibility or obtaining an equivalency determination, the foundation or DAF is subject to penalizing taxes on the grant distribution. Repeated violations resulting in its funds being used for non-exempt purposes (meaning, purposes inconsistent with its tax-exempt status) could result in loss of tax-exemption.
Counterterrorism laws and regulations
Compliance with counterterrorism laws is an ever-growing area of legal risk for organizations of all types, nonprofit or otherwise. Although counterterrorism legislation existed long before the 9/11 terrorist attacks in the U.S., it is without question that the response to 9/11 kicked off an expansive set of regulations that continues to grow in scope and number. For example, the United Nations’ development of 19 international legal instruments to prevent terrorist acts spans back to 1963. And yet, almost half of them were adopted post-9/11.
In an excellent report published by the Overseas Development Institute, Counterterrorism laws and regulations: What aid agencies need to know, Jessica Burniske writes that
Broadly speaking, counter-terrorism law encompasses the body of laws adopted by inter-governmental bodies and states to deter and punish terrorist acts, and to prevent terrorist groups from accessing resources that support their terrorist acts. While counter-terrorism laws existed in many countries prior to 2001, the attacks of 9/11 and the immediate response by the international community served as a catalyst for states to develop new measures and strengthen existing laws.
According to Human Rights Watch, "[m]ore than 140 governments have passed counterterrorism legislation since September 11."
Counterterrorism laws and regulations serve multiple functions, principal among them financial and criminal penalties for knowingly or unknowingly supporting terrorist actors. To quote Burniske again:
Among certain leading humanitarian donor states, counterterrorism laws not only strongly condemn and penalise terrorist acts but also criminalise acts preparatory to or in support of terrorism. In the United States, for example, an act deemed in "material support" of terrorism is punishable by 15 years' imprisonment. The law applies irrespective of the nationality of the accused. The definition of "material support or resources" encompasses a broad range of activities, including the provision of lodging, training, expert advice or assistance, communications equipment, facilities, personnel, and transportation. An individual does not need to intend to further an organisation's terrorist activities to be found guilty under the material support statute, and only the provision of "medicine and religious materials" is permitted under the law. The law contains no general exemption for humanitarian action. In a case challenging the material support statute, the U.S. Supreme Court explained that a wide range of seemingly peaceful activities, such as training listed groups on the use of international law to resolve disputes, are prohibited under the law because any assistance offered to terrorists "frees up" resources for nefarious activities.
How does a funder know whether it may be providing material assistance to terrorists? This is where due diligence comes in – although it is hard to know just how much due diligence is enough. The U.S. Treasury advises that foundations "confirm that the [grantee] organization or its controlling officers, directors, or trustees are not foreign persons whose property and interests in property are blocked pursuant to an Executive Order or regulations administered by the Office of Foreign Assets Control (OFAC). "
The fear of unknowingly funding terrorists or their affiliates brings uncertainty to charitable funders, particularly those giving in conflict zones and other high-risk regions. Due diligence cannot protect against all risks, but it can provide a degree of comfort and indication of compliance that may mitigate penalties should a violation occur. "OFAC may consider the existence, nature, and adequacy of an SCP [sanctions compliance program], and when appropriate, may mitigate a CMP [civil monetary fine] on that basis."
It is difficult to overstate the impact of counterterrorism regulations, and resultant bank de-risking, on the charitable sector. Later in this series we'll take a closer look at why and how these regulations are hurting charities, and humanitarian responders in particular.
ABC and AML compliance
ABC stands for "Anti-Bribery and Corruption," and AML stands for "Anti-Money Laundering." Similar to counterterrorism legislation, ABC and AML laws are enforced at both national and international levels (as well as at the local level, such as through state regulators in the U.S.). They can carry significant civil and criminal penalties if a funder makes a grant to an individual or entity engaged in bribery, corruption, or money laundering. As with anti-terrorism due diligence, the primary way to reduce the risk of ABC or AML violations is to screen grantees for past violations, which we'll highlight in Part II of this series.
Other U.S. sanctions
The U.S. Department of the Treasury, acting through OFAC, administers an array of sanctions pursuant to U.S. foreign policy. Sanctions are intended to limit support for actors whom the U.S. has deemed criminal or otherwise counter to U.S. security. Sanctions are in place "against targeted foreign countries and regimes, terrorists, international narcotics traffickers, those engaged in activities related to the proliferation of weapons of mass destruction, and other threats to the national security, foreign policy or economy of the United States." The OFAC website provides current information on sanctioned individuals, groups, entities, and countries to clarify how and to whom such sanctions apply.
(ii) Mission alignment
While a for-profit company's principal aim is to maximize profit, a charitable funder's principal aim is to further its charitable mission. Thus, before making a grant, a funder will want to identify the most effective and impactful vehicle for a grant. The following questions may be explored via due diligence prior to deciding on a grant beneficiary or amount: Is the grantee pursuing programs that align with the funder’s charitable goals? How likely is it that the grant will be used efficiently and effectively? Why select one grantee over another? How risk averse is the funder? Does it only want to fund entities with certain track records? Or support entities with proven commitments to diversity, for example?
(iiI) Financial security
Financial risk is typically of the least concern to charitable funders since there is no expectation of return on investment in the financial sense. However, financial risk does exist for grantmakers primarily in two ways: first, grantmakers want to ensure they are getting the most results from their charitable investment. Maximizing the potential impact of a grant, as well as the grantee’s own processes around value for money, are important aspects to explore in a due diligence exercise. Second, grantmakers want to ensure that their funds are not being diverted for inappropriate purposes, whether for criminal purposes or for purposes inconsistent with the grantmakers’ charitable status. For these reasons, the kind of financial risk that due diligence exercises address for charitable funders is closely linked to the legal and mission-alignment components described above.
(iv) Reputational risk
Reputational risk affects all entities in all contexts. From unsavory political positions to criminal behavior, no funder wants to be caught supporting an organization embroiled in scandal. The kind of due diligence one undertakes to mitigate reputational risk might include adverse media searches, conversations with other actors in the field, and review of the grantee’s own safeguards against fraud or abuse. We’ll review more of these mechanisms in Part II.
It is important to note that the above summary is not exhaustive: it does not address every potential risk that a funder faces when making a grant, nor every possible area of compliance. A grantmaker’s due diligence program should be tailored to the grantmaker's specific activities and risk appetite. This will vary greatly from one organization to another. In Part II of this series we’ll lay out a toolkit for grantmakers to begin thinking about a basic due diligence program they can apply to their grantees.