The nonprofit millionaires

Randy Whiting stunned his employees just over a year ago when he rolled into the parking lot of their office complex in a brand-new canary-yellow Ferrari - price tag: US$144,000. He offered them a spin, and a couple of people took him up on it, but most were more put off than impressed. "He wasn't getting any of the 'oohs' that he was looking for," says one former employee who was there. Another says people were disgusted, and adds, "It was surreal."

Such brazen displays of wealth weren't unusual in January 2000, when Internet IPOs (initial public offerings) were minting new millionaires every day. What set this scene apart was that Whiting had struck gold by working for a nonprofit trade group, CommerceNet, and he admits that almost all of his colleagues there - including those who happened to catch him in his Ferrari that day - had not shared in the riches.

Whiting and just two other CommerceNet executives became millionaires via an increasingly common practice in which nonprofits invest in for-profit ventures. The gains from those investments generally go into the nonprofit's coffers; sometimes, though, they also go to a select few executives who oversee the investments. Whiting and his friends used the tactic to make their nonprofit very profitable indeed.

This is how Whiting did it. In early 1997, CommerceNet spun off a for-profit consulting firm, later called Veo Systems, and gained a stake in the venture in return for providing $100,000 in support, he says. During that time, Whiting, then CommerceNet's chief executive officer (CEO) and president, helped channel $2.4 million in federal grant money to Veo for an ambitious research and development project. In early 1999 Veo was sold to b-to-b software company Commerce One, (CMRC) and CommerceNet's stake in Veo became a stake in Commerce One. Five months after Commerce One went public in July 1999, CommerceNet sold most of its stake for about $60 million. Whiting confirms that his compensation package promised him 20 percent of that sale - giving him about $12 million of the windfall.

The story gets more tangled: Two of Veo's founders were both top officials at CommerceNet. Jay "Marty" Tenenbaum, in fact, preceded Whiting as the group's CEO until early 1997 and remained its chairman and chief scientist for the rest of that year, while CommerceNet was helping to arrange Veo's government funding. (The other founder, Asim Abdullah, resigned his post as executive director while the grant was being sought.) Today, Tenenbaum's stake in Veo is worth about $70 million in Commerce One stock, not including the $88 million he has already sold, according to InsiderScores.com, a company that tracks the holdings of corporate officials. That's not a bad return on an investment of $2.4 million in taxpayer money.

While not strictly illegal, the actions of Whiting and Tenenbaum raise eyebrows among tax experts. The group's investment returns fall into a gray area of the law, these experts say, and pose a troubling question: Is it appropriate for a nonprofit's executives to take advantage of their organization's tax-exempt status to reap huge rewards for themselves?

SPINNING GOLD FROM IDEALISM

Tenenbaum was among the first Silicon Valley techies to see the Internet's future as a commercial mass medium. Back in the early 1990s, when the Net claimed a mere 20 million users, mostly in government and academia, he dedicated himself to proselytizing his vision of an interconnected business world that would hatch a new economy. "He was the rah-rah boy," says Dan Lynch, a computer scientist whose research in the 1970s and 1980s helped lay the foundation for today's Net.

Tenenbaum's vision held great appeal for the Clinton administration, which had earmarked millions for new R&D programs. The government awarded Tenenbaum and several others a $6 million grant, and in April 1994 they launched CommerceNet. Its mission was to encourage the building of an open infrastructure that would allow companies to do business over the Internet. Its membership roster read like a who's who of commerce and technology, including Bank of America (BAC) , Hewlett-Packard (HWP) , IBM (IBM) and Sun Microsystems (SUNW) . Membership dues ran as high as $50,000 a pop, Whiting says.

CommerceNet preached the religion of compatibility, helping establish standards for everything from credit-card processing to privacy. Its greatest achievement so far may be the widespread adoption by businesses of extensible markup language, or XML, which it began pushing in 1997; XML is fast becoming the foundation of the huge electronic marketplaces that are expected to revolutionize commerce.

Tenenbaum's group gained credibility in part by putting its goals above the interests of any individual members. "CommerceNet hosted meetings where the combatants would air issues," says Lynch, who served on the group's board. "These were open meetings, so no one could claim there was a backroom deal." When Visa and MasterCard disagreed over measures for protecting card numbers online, CommerceNet helped convince the companies to accept a common protocol. CommerceNet persuaded encryption company RSA Data Security to give away its software for preventing the interception of sensitive information, a needed component for the development of today's Web browsers. And when the world clamored for privacy online, CommerceNet and the Electronic Frontier Foundation created TRUSTe, which now sets and enforces rules for the collection of data about Web users.

Among the early converts to CommerceNet's mission was Whiting. In 1995, he was director of Internet marketing and commerce services at Hewlett-Packard. He saw CommerceNet's pitch - demonstrating how a company might use the Internet to provide an online catalog, take orders and then process them - and presented it to his colleagues."All of a sudden, you could see these VPs and execs say, 'Oh, this is going to change the way we do business, isn't it?'" recalls Whiting. He had been at HP for 15 years, ever since making an unsuccessful attempt to start his own business, Autofax Systems, straight out of the University of Nebraska business school. By 1996 he was working at CommerceNet, and a year later he was its CEO.

Tenenbaum and Whiting formed an effective team - the scientist and the salesman. Tenenbaum's associates describe him as brilliant but eccentric, known for wearing flared collars and walking around the office with a loaf of bread under his arm, leaving crumbs on his colleagues' desks. Whiting, they say, is articulate and charming. A stylish dresser, he's a bass player in a jazz band and a connoisseur of wine and sports cars. Tenenbaum would constantly spout new ideas, Whiting says. His job, he adds, was to keep the group focused on a few of these ideas and then sell them to the world.

In 1997, the two men embarked on a project - dubbed eCo - that would prove pivotal, not only for CommerceNet but also for the future of e-commerce. With a new $4.8 million federal grant, the nonprofit and partnering companies set out to create an electronic system that would help businesses work together with an ease that had never been possible. Until then, e-commerce systems functioned like phones, strictly one-to-one. ECo set out to create a universal framework that would let a business describe its goods, prices and other product information to thousands of businesses - so they could conduct e-commerce instantaneously and with no prior agreements. "Digital anarchy is threatening the explosive growth of Internet commerce," Tenenbaum declared at the project's launch. "Markets will be closed if they are built on proprietary e-commerce software and applications that cannot communicate or interoperate."

To develop the software needed to support eCo, CommerceNet - with Whiting's enthusiastic endorsement - recommended that roughly half the federal grant go to Veo, the consulting firm in which CommerceNet owned a stake. Under the grant's terms, Veo was transformed into an XML software company dedicated to creating the eCo platform. Tenenbaum received founder's stock in the company while he was drawing a salary of nearly $137,000 from CommerceNet. While Veo could have applied for federal funds on its own, the relationship with CommerceNet gave it a leg up, says Whiting.

Intel (INTC) , Microsoft (MSFT) , Sun Microsystems and about 30 other companies were also working on eCo, with Veo serving as the project manager. The joint effort produced several papers laying out the framework and source code for an "interoperable" transaction platform. That universal platform is still being developed, but by 1999, when the grant expired, CommerceNet had changed its focus to new projects and left eCo behind. Now Tenenbaum's dream of a nonproprietary transaction platform was in the hands of the private sector. Commerce One's Common Business Language, produced with Veo technology, is one such project. Another is a joint effort by Ariba (ARBA) , IBM and Microsoft called Universal Description, Discovery and Integration.

But some ex-eCo participants are bitter, saying CommerceNet walked away from eCo too soon. "They dropped the ball," says Murray Maloney, the former project manager for eCo. Other critics worry that Microsoft, Commerce One and the others will build features into their programs that favor their interests. "Any time you have Microsoft leading anything you have to watch it carefully," says Peter Kacandes, an e-commerce strategist at Sun Microsystems. (Microsoft says it plans to submit the specification for its platform to a neutral standards body by 2002.)CommerceNet insists it didn't abandon eCo. The group guided the project as far as possible, executives explain, but CommerceNet was not suited to administering and updating Internet software standards. What's more, the execs say, the project's influence can be found in all the major XML efforts under way. "We carried through the grant [and] executed it, and our member companies - IBM and Microsoft among them - have carried through," says Mark Resch, who succeeded Whiting as CEO in January 2000. "That doesn't sound like dropping the ball to me."

Perhaps it was inevitable that eCo would dissolve, but Tenenbaum's decision to sell Veo in January 1999 to Commerce One for $23 million in stock certainly guaranteed that eCo would fall apart. Tenenbaum took on new duties as Commerce One's chief scientist, developing a set of proprietary Internet software products that would form the core of Commerce One's product offerings.

When Commerce One went public in July 1999, it was one of the most successful IPOs in market history: By the end of the year its stock had increased to 35 times its offering price. By December, when Commerce One stock was near an all-time high, CommerceNet liquidated most of its holdings, which were worth about $60 million. While a for-profit company would have been heavily taxed for such a windfall, as a nonprofit, CommerceNet faced virtually no tax bill. The group and its most influential insiders had hit the jackpot.

AN ACCIDENTAL BOUNTY

CommerceNet insists its windfall was a fluke. "It turns out it was a lotto ticket, and a winning one," says Resch. "There was no big plot - it was an accident."

Still, the situation is by no means unique. Over the last few years, a number of nonprofits and their executives have prospered from investments. In 1998, Minnesota Public Radio sold a for-profit catalog subsidiary for $120 million, putting $4 million into the pockets of two of the nonprofit's executives. In the same year, Citizens Energy, a Massachusetts nonprofit founded by Joseph Kennedy II, reportedly paid three executives tens of millions of dollars from stock options and other compensation connected to for-profit companies linked to Citizens Energy. (The company declined to comment on the reports.)In both instances, as with CommerceNet, the individuals who benefited can offer good legal arguments in their favor. But there's still the question of propriety. And it becomes even more urgent as an increasing number of trade groups invest in for-profit startups that aim to go public. A survey by the American Society of Association Executives released in June revealed that nonprofit trade groups such as CommerceNet are relying less on dues from members and more on investment income. At the same time, the ASAE survey pointed out that a small but growing number of groups are opting to change over to for-profit status, because of the increase in revenues from activities unrelated to the group's original mission.

In Internal Revenue Service (IRS) parlance, CommerceNet is known as a 501(c)6, a tax-exempt status bestowed on chambers of commerce, trade groups and other associations that promote business in a particular industry or geographic location. While tax laws governing trade groups are less defined than those applied to charities, they nonetheless prohibit the "inurement" - the unjust enrichment - of insiders and require that all money coming into the organization be spent in a way that is consistent with the group's mission. But what constitutes unjust enrichment?

CommerceNet's current and former executives defend the arrangement with Veo, saying its support of high-risk ventures like Veo falls squarely within the nonprofit's mission. That CommerceNet principals made money in the process is only natural. "We turned the world on to XML," Tenenbaum says. "The people who worked at CommerceNet had very strict ethical codes, and certainly everything I did had the full knowledge and approval of the board." All funding decisions were also approved by outside auditors and government reviewers.

Whiting also remains unapologetic. "Never, ever, did we make any decision or take any actions that would preferentially benefit either me or the company based on our investment in Veo Systems," he says. He notes that his compensation package was approved by CommerceNet's board before Commerce One purchased Veo. And he explains that he earned his money because under his watch CommerceNet didn't need to rely on federal grants. "Yeah, I got lucky," he adds, "but I would have made a lot more money if I'd gone other places."

Still, nine tax law experts interviewed by The Standard say the nonprofit's situation is troubling. Bruce Hopkins, an attorney specializing in nonprofit tax law at Polsinelli, Shalton and Welte in Kansas City, Missouri, says the law requires compensation to execs be "reasonable" and "necessary." Of the $12 million that went to Whiting, Hopkins says, "These are large enough numbers to raise questions about what is reasonable."

Whiting's compensation was not the only troubling aspect of CommerceNet's involvement with Veo, say several of the tax experts. Marcus Owens, the former head of the IRS division that polices tax-exempt organizations, says he's also concerned about CommerceNet's decision to help funnel $2.4 million in government funds to a company controlled by people closely connected to the nonprofit and who clearly benefited as a result. "These seem to be unusually large transactions involving closely related parties," says Owens, now in private practice at Caplan & Drysdale in Washington. "Those kinds of facts traditionally raise red flags."

Terry Davidson, an IRS agent who monitors tax-exempt groups, agrees that the arrangement would warrant an investigation. "They can get some investment income, but the tail is not supposed to wag the dog," he says.

WHAT ABOUT THE REST OF US?

In 1998 and 1999, when stock options at dot-coms were making even receptionists wealthy, CommerceNet lost a steady stream of employees to Internet startups. Seven former employees say CommerceNet tried to stem the exodus by dangling the chance to share in the profits that came from Veo or other companies the group might incubate. "We were told that we would be able to participate in any stock options that came out of Veo," says Corinne Moore, a CommerceNet marketing manager who left the group in late 1999. "It never happened." Whiting says he did not make such a promise.

Adding insult to injury, say these former CommerceNet workers, was the absence of any holiday bonuses at the end of 1999. In fact, the group was so short of money that year that it needed to get a bridge loan to cover expenses. Still, in the final days of the year, the group liquidated most of its Commerce One shares and gave 20 percent of the cash to Whiting. Within weeks, he resigned.

Since then, CommerceNet's nest egg has done little to keep the nonprofit's influence from waning, say people familiar with the group. According to Jonathan Brill, CommerceNet's former business-development manager, marquee supporters such as Ariba, Sun Microsystems and others had allowed their memberships to lapse by the time he quit in March 2000. Skip Folds, Ariba's manager of supplier marketing who used to be Ariba's point man with CommerceNet, explains, "The game plan seems to have changed from the early days, and [we're] unsure what it is." That was echoed by Stacey Bressler, the group's former VP of marketing and business development. "There was definitely a feeling among the members that they had lost their advocate," she says.

Tenenbaum, Whiting and other CommerceNet officials, former and current, insist that CommerceNet is still a player. CEO Resch says major companies remain active in CommerceNet, though the group no longer needs to charge dues. He adds that CommerceNet has reinvented itself several times over the years and is now in the midst of such a metamorphosis. The organization has drafted a new agenda that he says will put it back on the cutting edge. It includes helping companies develop applications that will run on the next-generation Internet; overseeing research by 30 companies that will enable government agencies to pay contractors electronically; and improving the way the Social Security Administration provides services via the Internet.

Underlying these efforts, however, is a commitment to finance startups that offer the promise of more big returns. CommerceNet has sunk at least $300,000 into three such firms in the last year. If any of these hit it big, Resch stands to get a piece of the action, though he says that the board has not yet determined what cut he would get. In the meantime, the group is looking to expand its other activities in order to double the $50 million it has in the bank, says Ron Parsons, a former CommerceNet manager who left late last year. Whiting disputes that CommerceNet is looking to double its reserves through expansion.

So it wouldn't be surprising if the group and its leaders score some more windfalls in the next few years. It's got the money, the connections and the smarts. And it all seems to be OK with the federal government - at least so far.

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