UNITED CANCER COUNCIL, INC.,
Petitioner
v.
COMMISSIONER
OF INTERNAL REVENUE,
Respondent
Tax Ct. Dkt. No.
2008-91X
UNITED STATES TAX COURT
1997 U.S. Tax
Ct. LEXIS 70; 109 T.C. No. 17
December 2, 1997,
Filed
DISPOSITION:
[*1] Decision will be entered for
respondent.
SYLLABUS:
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 $2-1/4 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.
1. HELD: W&H was an "insider" for purposes of the inurement provisions of secs. 501(c)(3), 170(c)(2)(C), [*2] 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.
COUNSEL:
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.
JUDGES:
CHABOT, JUDGE.
OPINION BY:
CHABOT
OPINION:
* 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).
CHABOT, JUDGE: Petitioner initiated this action pursuant to section 7428 n1 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 [*7] 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)). n2
n1 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.
n2 Unless indicated otherwise, all Rule references are to the Tax Court Rules of Practice and Procedure.
The issues for decision are as follows:
n3
n3 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.
(1) Whether petitioner is operated exclusively for charitable, educational, scientific, or other exempt [*8] 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 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 [*9] 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 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. n4
n4 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.
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 [*10] 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.
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 [*11] 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.
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 [*12] 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.
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 [*13] 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 [*14] further guaranteed that, for the first 2 years of 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
n1 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,
indi- cates 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 [*15] its mailing campaign set
forth in Table 2.
Table
2
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
$2-1/4 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.
Table 3
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 [*16] amounts for mailing list
rentals shown in Table 4.
Table
4
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 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: n5
n5 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. [*17]
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.
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 [*18] 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 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 [*19] 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 [*20] has built up a productive housefile, the organization will periodically conduct prospect mailings to 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 [*21] 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.
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 [*22] 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 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 [*23] 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 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 [*24] of the proceeds to be used by the charitable organization to pay fundraising expenses. n6
n6 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.
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- [*25] 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 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. [*26] 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 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. [*27] 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 [*28] case, W&H maintained
its offices in the Washington, D.C., area, in Alexandria,
Virginia. (In July 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 [*29] 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 that covered the period from AICR's inception through December 31, 1989. n7 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.
n7 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. [*30]
Table 5
Date
of
Contract
Provision
of
Contract
2 cents therafter
1 cent next 5 mil.
0.5 cents next 3 mil.
Free after 18 mil.
1 cent next 250,000
Free after 500,000
0.9 cent next 5 mil.
0.45 cents next 3 mil.
Free after 18 mil.
1 cent next 250,000
Free after 500,000
0.9 cent next 5 mil.
0.45 cents next 9 mil.
Add'l letters--
price to be arranged
1 cent next 250,000
Free after 500,000
0.9 cent next 5 mil.
0.45 cents next 9 mil.
Add'l letters--
price to be arranged
1 cent next 400,000
2/4/83
2/4/83 n2
1/1/84
1/1/85
1/1/86
1/1/87
$1,500/mo.
$1,500/mo.
$1,500/mo.
No
No
No Joint - W&H, AICR
Sole property of AICR
Sole property of AICR
Sole property of AICR
Sole property of AICR
Sole property of
AICR
Table Continued
of Contract
6/1/82
$3,000/mo.
Capital List --forever
n1 Payment to be applied to AICR's debt to
W&H, not a separate "package fee".
n2 Contract signed Aug. 10, 1983, retroactive to Feb. 4,
1983. [*31]
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 [*32] 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, 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 [*33] 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 obligation 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 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 $ [*34] 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 names and addresses developed by W&H for no purpose other than in direct connection [*35] 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 [*36] 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.
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 [*37] 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 [*38] the
Contract. The Escrow Agreement, which W&H provided to
petitioner and WIB, is essentially the same 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.
n8
n8 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.
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, [*39] 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 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. n9
n9 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. [*40]
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 [*41] Fund, commence an action in the nature of interpleader and seek to deposit the disputed portion in a Court of Competent Jurisdiction.
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: [*42]
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 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 [*43] 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 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 [*44] 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
10/84
11/84
12/84
1/85
2/85
3/85
4/85
5/85
6/85
7/85
8/85
9/85
10/85
11/85
12/85
1/86
2/86
3/86
4/86
5/86
6/86
7/86
8/86
9/86
10/86
11/86
12/86
1/87
2/87
3/87
4/87
5/87
6/87
7/87
8/87
9/87
10/87
11/87
12/87
1/88
2/88
3/88
4/88
5/88
6/88
7/88
8/88
9/88
10/88
11/88
12/88
1/89
2/89
3/89
4/89
$5,000
&emdash;
$5,000
$10,000
&emdash;
$6,000
$14,000
$10,000
$10,000
$18,000
$20,000
&emdash;
$22,000
$33,000
$25,000
$40,000
$40,000
$40,000
$40,000
$40,000
$40,000
$40,000
$40,000
$40,000
$40,000
$40,000
$40,000
$50,000
$50,000
$50,000
$50,000
$50,000
$50,000
$50,000
$50,000
$50,000
$50,000
$50,000
$50,000
$60,000
$60,000
$60,000
$60,000
$60,000
$60,000
$60,000
$60,000
$60,000
$60,000
$60,000
$60,000
$60,000
$60,000
$60,000
$60,000
$5,000
$5,000
$10,000
$20,000
$20,000
$26,000
$40,000
$50,000
$60,000
$78,000
$98,000
$98,000
$120,000
$153,000
$178,000
$218,000
$258,000
$298,000
$338,000
$378,000
$418,000
$453,000 n1
$493,000
$533,000
$573,000
$613,000
$653,000
$703,000
$753,000
$803,000
$853,000
$903,000
$953,000
$1,003,000
$1,053,000
$1,103,000
$1,153,000
$1,203,000
$1,253,000
$1,313,000
$1,373,000
$1,433,000
$1,493,000
$1,553,000
$1,613,000
$1,673,000
$1,733,000
$1,793,000
$1,853,000
$1,913,000
$1,973,000
$2,033,000
$2,093,000
$2,153,000
$2,213,000
n1 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.
[*45]
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 [*46] 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 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 [*47] 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.
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 [*48] 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, [*49] letter is substantially the same as the October 23, 1986, letter, except as 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, petitioner's 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 [*50] 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 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 [*51] 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 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 [*52] 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, n10 and (4) mailing list rentals. 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".
n10 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. [*53]
Printing 85
86
87
88
89
Total
$1,480,719
$2,079,059
$2,678,137
$936,627
$263,514
$7,498,227
$1,445,431
$1,513,599
$1,824,517
$675,605
$439,479
$5,972,855
$798,092
$1,521,101
$1,259,798
$659,179
$115,406
$4,383,668
($641,920)
($403,772)
$730,228
$237,444
$65,890
($12,130)
$156,172
$1,117,329
$1,990,026
$896,623
$181,296
$4,371,538
$1,034,711
$1,133,254
$1,475,299
$229,684
$14,529
$3,937,678
Table 7
Shipping
& Pubs
Fundraising
Fees
(Reimbursable)
or Not
Reimbursable n1
Fundraising
Fees
List
Rentals
84
$60,171
$74,224
$30,092
--
$30,092
$50,201
n1 Expenses (reimbursable), or no longer
reimbursable, by W&H under the contract. The amounts are
taken from petitioner's Forms 990. The parties have not
explained why these amounts net to ($ 12,130), rather than
-0-.
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
[*54] 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 [*55] similar to the 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 [*56]
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. 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. n11 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.
n11 In 1986, Washington Lists changed its
name to Capitol List. Hereinafter, use of the term
Washington Lists includes, where applicable, reference to
Capitol List. [*57]
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 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 [*58] 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 "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 [*59] 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 names that owner furnishes, postage to ship the tape or labels, and a list broker's fee or list manager's fee n12 for arranging the exchange transaction.
n12 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. [*60]
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 1985
1986
1987
1988
1989
Totals $6,448
$44,645
$122,747
$32,408
-0-
$206,248 57,349
$119,436
$219,896
$24,660
-0-
$422,791
Masterfile Names
Obtained by Exchanging
Petitioner Names
1984
-0-
$1,450
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 [*61] 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 5000 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.
W&H also rented as lessor the names on its masterfile to third parties, [*62] 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. n13 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 segment of the W&H masterfile.
n13 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. [*63]
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 thirdparties. 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 [*64] 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 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'smailing list in exchange. In exchange situations, then, W&H received as its own revenue the [*65] "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 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 [*66] 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. n14
n14 The record reflects that petitioner's directors directed the check package not be used, because they believed cer