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Agency theory of nonprofits

23 Apr 2011

Last month Felix Salmon urged people not to donate to Japan in the wake of the earthquake, and if you do wish to do something, to make unrestricted donations to major charities like MSF. You should then trust MSF to allocate donations to countries and particular causes and to deliver help effectively or partner with a local organization that can do so. I guess the idea is that most people are unable to judge the relative merits of various causes, or don’t have enough information or are too biased to do so, and that if you just chase the latest cause célèbre a lot of your donations will be wasted.

This sounds quite reasonable, but it makes me wonder about the governance of nonprofits. Fama and Jensen (1983), the definitive work on separation of ownership and control, stress the importance of residual claims. Owners of residual claims on the firm—shareholders in the case of a corporation—are in the best position to monitor the firm because as residual claimants they stand to benefit, in most cases, from improved governance.

Nonprofits don’t have residual claimants. This is a more fundamental definition of “nonprofits” since many nonprofits actually have profits, but almost all nonprofits are subject to a non-distribution requirement, meaning that profits cannot be distributed to members or anyone else. There are no residual claims on nonprofits by design.

In nonprofits that are primarily funded by endowments, especially those with self-perpetuating boards as is common in the United States, governance is more or less hopeless because there is no external governance mechanisms. Governance will be good if the board members happen to behave well. Fama and Jensen point out that some nonprofits have very extreme bonding mechanisms, such as the poverty and celibacy vows in the Catholic Church, as additional governance mechanisms.

In the case of nonprofits without large endowments that are mostly funded by current donations, you might expect monitoring to be done by donors. If the nonprofit doesn’t behave well, donors will stop donating and the managers will lose their jobs (“private benefits” in the governance jargon), so managers will tend to behave well.

It seems to me that this model of governance would work best if donors actually earmark and target their donations quite narrowly. Maybe your favorite charity should spend more money in Haiti than Japan, or perhaps move resources away from Haiti to more worthy countries. You could trust that the charity’s managers will do this, but why not force their hand by earmarking your donations to the most worthy country (not Japan)? Donors, acting through the market for donations, will then have maximum control over how charity is directed and delivered.

What, then, is the agency theory of nonprofits that is consistent with Felix’s (and others’) recommendation that you give unrestricted donations to large, well-known charities? How can unrestricted donations be good for governance, and how can it be good simply to give to the most reputable large charity?

I think that first of all you need relatively large information acquisition costs at the individual donor level, so it’s costly to judge whether Haiti or Darfur or some third country is most worthy. Second, there has to be some mechanism (and enough information) for choosing the “best” charity, which right now seems to be MSF. I know that outfits such as Guidestar claim to do this. So the assumption is that Guidestar is able to tell you “give to MSF but not Yéle,” but not how to earmark your donation. Is this plausible? Is there a better theory out there?