FEGS: A Lesson for the Sector

10 Sep 2017

Federation Employment & Guidance Service, Inc. (“FEGS”), one of NYC’s largest nonprofit health and human services organizations, with more than 3,900 employees, an annual budget of over $200 million, 350 locations, and an estimated 120,000 individuals served annually, filed for bankruptcy on March 18, 2015 and closed its doors soon afterwards. So how could an organization that had been in existence since 1934 and grown to be a behemoth in the nonprofit sector, go out of existence almost overnight? The reasons FEGS gave for filing bankruptcy were:

  • Inadequate financial systems and revenue cycle management (as well as general and administrative inefficiencies);
  • A failure to adequately reserve and plan for the repayment of significant regulatory and governmental advances and contract termination costs;
  • Unallocated and vacant space – they had office leases for space they were not using;
  • An overly prohibitive administrative cost structure, significantly more than industry standards; and,
  • Numerous unprofitable agreements.

Wait … FEGS produced audited financial statements, were regularly reviewed by their funders, and had a management team and board overseeing the organization, right? How could this happen? This is an interesting case, that is a result of failures and poor decision making on multiple levels, and if you peel back the layers, should be somewhat of a wake-up call to the sector.

If you look at FEGS from the outside, they seem to be doing a lot of the right things. They had size, which helped to defer administrative costs; they had a certain level of diversification of revenue streams; they had jumped into the social entrepreneurism area, with several for-profit subsidiaries that were generating over $20 million of revenue per year, all good right? Unfortunately, they also had a complex structure that made it hard to get a clear picture of their operations; they were highly leveraged with minimal inadequate cash flow; they had holes in their compliance program which resulted in government recoupments; and they relied heavily on government funding, which doesn’t provide adequate support to cover the infrastructure necessary to run FEGS effectively.

To better understand what happened to FEGS, you need to focus on both internal and external factors. This is important to understand because what happened to FEGS could happen to other nonprofit agencies, many of which are already sitting on the precipice, waiting for the wind to blow the wrong way. According to a study performed by the Human Services Council, an umbrella organization for human services organizations:

  • Human services nonprofits have a higher rate of insolvency than other nonprofit organizations.
  • Human services organizations tend to run lean, with inadequate working capital and cash flows (60% are financially distressed, with under 90 days of cash).
  • Human services organizations, especially larger ones, are heavily invested in government funding, with a proportionately low amount of their revenue coming from fundraising activities.
  • Underfunded government payment rates are the number one cause of the financial distress, as many government contracts do not provide sufficient resources to cover the cost of running the funded program.
  • Government funders dominate provider budgets but only pay about 80% of the cost of true program delivery costs, when considering all the costs to run these programs effectively. This leaves agencies with the need to bring in adequate discretionary funding to cover these shortfalls.
  • Shortfalls lead to low salaries, resulting in higher turnover, increased recruitment and training costs, and increased cost of supervision.
  • Underfunding also leads to deterioration of facilities, unsafe environments for consumers, increased repair costs not contemplated in budgets, etc.
  • Chronic delays in payments lead to increase borrowings at interest rates that add more costs to running programs that are already underfunded.
  • Multiple and redundant audits, along with unfunded mandates and other oversight mechanisms add up to staggering administrative costs and funding recoupments … all of which erode any level of fiscal viability these organizations have.
  • Human service providers have not been given a voice at the table, resulting in government regulations and funding changes that are not indicative of the operations of the underlying programs and service delivery.
  • Inadequate funding of administration and infrastructure has stripped agencies of the ability to perform effective and adequate risk assessment and controls implementation.
  • Shrinking government funding has agencies chasing after additional dollars resulting in mission creep and organizations taxing their already thin infrastructure.

Unfortunately with the move to managed care, the full implementation of EO-38 (with caps on administrative spending), the threat of a Medicaid block grant system, the continued emphasis on government audits with related recoupments, and the overabundance of changing regulations and reimbursement methodologies, these concerns are only going to become more acute.

The FEGS debacle, however, cannot be solely placed on the shoulders of government funders. Failure also occurred within the organization’s management and governance area. Improper understanding, failure to establish adequate controls, growth in programs without growth in capacity, improper communication and oversight, improper financial systems and information, yada yada yada… all were significant contributors in the downfall of FEGS.

  • FEGS received severe audit finding by the Office of Medicaid Inspector General (“OMIG”). Of the $81 million that Medicaid reimbursed to FEGS Home Attendant Services from 2006 through 2009, OMIG estimated that the agency had overcharged Medicaid by $21 million. OMIG reported with very high confidence that the overpayment was at least $14 million, the amount they requested in reimbursement. FEGS did not have the financial wherewithal to repay this amount. This is indicative of poor quality assurance procedures in place. FEGS should have been performing internal compliance/internal audit procedures to identify weaknesses in its compliance with documentation, delivery, and billing systems.
  • FEGS continued to fund its for-profit subsidiaries; All-Sector Technolgy, HR Dynamics, SinglePoint, etc. These entities were created to provide much needed discretionary resources. Instead, they utilized much-needed resources, with investments by FEGS in these entities reportedly in excess of $20 million in the five years leading up to FEGS closure. This was the result of lack of proper financial reporting and board oversight.
  • To build up its housing portfolio, FEGS routinely had gone to a variety of city and state funding sources over the past decade, seeking millions of dollars’ worth of advances on construction and capital costs for their new facilities, taking out low-interest loans that it didn’t have the means to pay back, as its funding streams did not generate sufficient cash flows.
  • FEGS owed $90 million in leases in future years and was in technical default on three bond issues, one being a $12 million bond. Even so, FEGS continued in its expansion mode, rather than focusing its energy on building infrastructure, tightening controls, developing strategies to improve financial condition, understanding its risks, and reviewing its operations for fiscal improvement.
  • Between 2013 and 2014, salaries grew by 14% while revenues only grew by 4. During the same period, FEGS wrote off $8 million of bad debts. Once again, tell tale signs that no one was paying attention to what was happening within the Organization.

In the case of FEGS’ implosion, there’s plenty of blame to dish out, both from an internal and external perspective. However, it shouldn’t be about blame; it should be about the lessons we can all take from FEGS:

  • The government does a poor job of funding administrative costs. This is a given, and it looks like it is only going to get worse. If you’re going to play in the government sandbox, you need to remember:
    • You need to make an assessment of how administrative shortfalls will be made up.
    • You need to determine if you have the capacity for increased fundraising.
    • You need to assess whether or not your organization has adequate reserves and access to cash flow, as lack of reserves, coupled with increasing loss contracts create growing instability within an organization.
  • Organizational growth brings with it risks:
    • More programs mean a greater likelihood of government audits.
    • Growth increases the need for oversight and quality assurance.
    • The need for stronger record-keeping, staying abreast of changing regulations, and the potential of costs rising faster than contract amounts.
  • Boards need to be better informed about the organizations they manage:
    • Create regular fiscal reporting that includes ratio analysis such as days in cash, liquidity, expendable net assets, debt ratios, etc.
    • Make sure the audit committee and Board have adequate time to sit with the auditors to review financial results. Don’t just dedicate 10 minutes to this, make sure there is ample time to really discuss the organizations operations and concerns.
    • Make sure your internal reporting can drill down revenue and costs by program, contract, location, etc. to help make more informed decisions. It is often difficult for a Board to understand a financial statement that includes multiple layers of consolidation.
    • Provide board education to help them be more effective in their governance role within the organization.
    • Perform strategic planning and monitor, with the Board, your progress along that plan.
    • Make sure that there are regular reports to your Board from your compliance director.
  • Organizations need to be forward thinking and stay ahead of potential risks:
    • Make sure that you project into the future. Do we have adequate resources to pay debt when it matures? What impact does rent escalations have on our operations? If a grant was cut or revenue was below budgeted levels, do you know which costs could be cut quickly to mitigate the potential impact on your organization?
    • Understand your exposure. Invest in compliance. Perform regular internal audits/risk assessments of your government funding streams to identify potential exposure. Review OMIG, OSC, and other websites to understand what funders are looking at.

The nonprofit sector is in a tenuous place. The need for its services is growing, while the funding streams are shrinking. This is a dangerous combination, as FEGS learned the hard way. In order to be successful, nonprofits need to make the right decisions, have proper oversight, understand and focus on their finances and compliance, and strategically plan. These are often skill sets that don’t exist in agencies. Nevertheless, FEGS has taught us that size and reputation alone are not enough, you need to have your house in order and practice sound financial practices if you are going to thrive in the nonprofit sector. While the government provides many organizations with the lion share of their funding, they are not strong in running a business … something that nonprofit leadership needs to be adept at.

Ken Cerini, CPA, CFP, FABFA
Managing Partner
Eric Gonzalez, CPA
Senior Accountant

This article was also featured in the NFP Advisor Vol. 16.