Nonprofit Governance Reforms

The advent of significant corporate governance reforms in response to the Sarbanes-Oxley law, as well as scandals involving several leading nonprofit institutions, has created a climate of uncertainty for the management and Boards of Directors of nonprofit organizations. Controversy has arisen as to the extent to which these entities should emulate the behavior of comparably sized public corporations, even though most of Sarbanes-Oxley does not apply to entities that do not have securities registered with the Securities and Exchange Commission.

Pressure is building for governance reform in nonprofit organizations from several quarters. Directors who serve in management or on the boards of public companies may insist on certain reforms they have enacted elsewhere, out of a concern for personal liability. Outside auditors are demanding broader representations in management letters and are assessing the quality of governance in the context of their reports on the adequacy of internal financial controls. Rating agencies, such as Fitch's and Moody's, have suggested that they will take “governance” into account in assigning ratings for tax exempt debt. Legislative proposals by the Attorneys General of California, Massachusetts and New York would impose specific governance and certification requirements on nonprofit organizations subject to charitable trust oversight. Finally, the IRS has recently announced its intention to weigh in on standards for corporate governance in the context of conflicts of interest, inurement and private benefit that may give rise to intermediate sanctions.

It is important that a nonprofit organization approach questions of governance reform in a deliberate and careful fashion, with due regard to its particular history, charitable mission and needs. There is no “one size fits all” model for ideal governance and many of the requirements of Sarbanes-Oxley, such as external financial certification, have no place in the charitable world. Nonetheless there are several areas in which progressive nonprofit organizations should devote attention and take prudent steps to improve governance and accountability.

Five Steps Toward Improved Accountability

Reconsider the Size and Composition of the Board

Many nonprofit corporations have boards that are considerably larger than the seven to twelve members common in the companies that make up the Standard & Poors 500. Historically, charitable organizations have relied heavily on directors to raise funds for the organization and have a desire to bask in the prestige that arises from attachment to distinguished local, or even national, personages. These considerations in selecting directors have often overwhelmed criteria such as whether a prospective director can devote appropriate time to his or her duties or has experience that will contribute to the Board's decisions. Large Boards tend to meet infrequently and, as a consequence, true oversight of management is de facto delegated to a small core group of directors or is nonexistent at the Board level. In addition, the group dynamic of a large Board tends to stifle individual dissent and diffuses individual responsibility for decisions, such that directors, while gaining comfort from siding with a large group of peers, have abdicated a meaningful fiduciary role. Nonprofit Boards should consider prudent reductions in membership, using advisory or honorary bodies to maintain ties with important, but less active, members, and the articulation of expectations for director participation. Good practices to adopt are a system for regular evaluation of director participation and performance (with removal as a consequence for poor performance or inactivity) and meaningful term limits, to assure fresh perspectives on management direction.

Strengthen Key Committee

In particular, the roles of the Audit Committee and the Nominating Committee are increasingly important to good governance. A nonprofit organization of significant size should create standing Audit and Nominating Committees, if they do not exist already. In addition, the directors who serve on the Audit Committee and Nominating Committee should be independent of management and have no financial ties with the entity, even if permitted by conflict of interest policies. Membership of the Audit Committee should include one or more directors who have sufficient experience with accounting and financial reporting issues to properly oversee the relationship with outside auditors and evaluate their financial reports. The Board should also review existing charters of these committees to be sure that their roles are properly defined and consistent with corporate policies including corporate compliance programs.

Reassess the Relationship with Outside Auditors

Nonprofit organizations with substantial assets or revenues should have an independent annual audit performed. The Audit Committee should periodically reconsider the engagement of its incumbent audit firm and request proposals from competing firms. It should also evaluate, with its auditors, the benefits of periodic rotation of the lead engagement partner. Further, the Audit Committee should specifically approve any proposals for consulting or other non-audit related work by the organization's auditors.

Enhance the Compliance Program

Many nonprofits in the health care sector have created compliance programs to detect potential liabilities under federal and state laws and regulations. However, these programs typically do not address the discovery of financial irregularities or financial disclosure issues. The Board should consider the creation of an internal compliance program focusing on financial issues, with appropriate oversight by the Audit Committee, and consider having the integrity of this system evaluated by its outside auditors. The Board should consider the benefits and detriments of consolidating such a financial compliance program with its existing compliance regime. Corporate document retention policies and procedures for handling whistleblower complaints should also be reconsidered, in that the provisions of Sarbanes-Oxley that sanction destruction of documents related to violations of federal law and retaliation against whistleblowers apply to all corporate entities.

Review Conflict of Interest and Ethics Policies

Many of the recent nonprofit corporate scandals were rooted in conflicts of interest on the part of management or key directors. While many nonprofit organizations have adopted conflict of interest and ethics policies in response to federal tax and state law charitable trust requirements, it is important that these policies be reviewed in light of recent IRS developments and the emerging views of state Attorneys General. An area that should be considered in evaluating existing policies, borrowed from the requirements of Sarbanes-Oxley, is whether key executive and financial officers are accountable for the detection, reporting and correction of financial irregularities.

Conclusion

While many of these recommendations may represent only extensions of current practices rather than novel approaches to governance, the process of revisiting these issues may cause management and directors to test old assumptions and consider principles and practices that my be relevant to the organization's activities. Every nonprofit corporation should, at a minimum, demonstrate an awareness of the changing environment and a willingness to undertake sensible reforms to further its charitable mission and assure continuing compliance with law.

The advent of significant corporate governance reforms in response to the Sarbanes-Oxley law, as well as scandals involving several leading nonprofit institutions, has created a climate of uncertainty for the management and Boards of Directors of nonprofit organizations. Controversy has arisen as to the extent to which these entities should emulate the behavior of comparably sized public corporations, even though most of Sarbanes-Oxley does not apply to entities that do not have securities registered with the Securities and Exchange Commission.

Pressure is building for governance reform in nonprofit organizations from several quarters. Directors who serve in management or on the boards of public companies may insist on certain reforms they have enacted elsewhere, out of a concern for personal liability. Outside auditors are demanding broader representations in management letters and are assessing the quality of governance in the context of their reports on the adequacy of internal financial controls. Rating agencies, such as Fitch's and Moody's, have suggested that they will take “governance” into account in assigning ratings for tax exempt debt. Legislative proposals by the Attorneys General of California, Massachusetts and New York would impose specific governance and certification requirements on nonprofit organizations subject to charitable trust oversight. Finally, the IRS has recently announced its intention to weigh in on standards for corporate governance in the context of conflicts of interest, inurement and private benefit that may give rise to intermediate sanctions.

It is important that a nonprofit organization approach questions of governance reform in a deliberate and careful fashion, with due regard to its particular history, charitable mission and needs. There is no “one size fits all” model for ideal governance and many of the requirements of Sarbanes-Oxley, such as external financial certification, have no place in the charitable world. Nonetheless there are several areas in which progressive nonprofit organizations should devote attention and take prudent steps to improve governance and accountability.

Five Steps Toward Improved Accountability

Reconsider the Size and Composition of the Board

Many nonprofit corporations have boards that are considerably larger than the seven to twelve members common in the companies that make up the Standard & Poors 500. Historically, charitable organizations have relied heavily on directors to raise funds for the organization and have a desire to bask in the prestige that arises from attachment to distinguished local, or even national, personages. These considerations in selecting directors have often overwhelmed criteria such as whether a prospective director can devote appropriate time to his or her duties or has experience that will contribute to the Board's decisions. Large Boards tend to meet infrequently and, as a consequence, true oversight of management is de facto delegated to a small core group of directors or is nonexistent at the Board level. In addition, the group dynamic of a large Board tends to stifle individual dissent and diffuses individual responsibility for decisions, such that directors, while gaining comfort from siding with a large group of peers, have abdicated a meaningful fiduciary role. Nonprofit Boards should consider prudent reductions in membership, using advisory or honorary bodies to maintain ties with important, but less active, members, and the articulation of expectations for director participation. Good practices to adopt are a system for regular evaluation of director participation and performance (with removal as a consequence for poor performance or inactivity) and meaningful term limits, to assure fresh perspectives on management direction.

Strengthen Key Committee

In particular, the roles of the Audit Committee and the Nominating Committee are increasingly important to good governance. A nonprofit organization of significant size should create standing Audit and Nominating Committees, if they do not exist already. In addition, the directors who serve on the Audit Committee and Nominating Committee should be independent of management and have no financial ties with the entity, even if permitted by conflict of interest policies. Membership of the Audit Committee should include one or more directors who have sufficient experience with accounting and financial reporting issues to properly oversee the relationship with outside auditors and evaluate their financial reports. The Board should also review existing charters of these committees to be sure that their roles are properly defined and consistent with corporate policies including corporate compliance programs.

Reassess the Relationship with Outside Auditors

Nonprofit organizations with substantial assets or revenues should have an independent annual audit performed. The Audit Committee should periodically reconsider the engagement of its incumbent audit firm and request proposals from competing firms. It should also evaluate, with its auditors, the benefits of periodic rotation of the lead engagement partner. Further, the Audit Committee should specifically approve any proposals for consulting or other non-audit related work by the organization's auditors.

Enhance the Compliance Program

Many nonprofits in the health care sector have created compliance programs to detect potential liabilities under federal and state laws and regulations. However, these programs typically do not address the discovery of financial irregularities or financial disclosure issues. The Board should consider the creation of an internal compliance program focusing on financial issues, with appropriate oversight by the Audit Committee, and consider having the integrity of this system evaluated by its outside auditors. The Board should consider the benefits and detriments of consolidating such a financial compliance program with its existing compliance regime. Corporate document retention policies and procedures for handling whistleblower complaints should also be reconsidered, in that the provisions of Sarbanes-Oxley that sanction destruction of documents related to violations of federal law and retaliation against whistleblowers apply to all corporate entities.

Review Conflict of Interest and Ethics Policies

Many of the recent nonprofit corporate scandals were rooted in conflicts of interest on the part of management or key directors. While many nonprofit organizations have adopted conflict of interest and ethics policies in response to federal tax and state law charitable trust requirements, it is important that these policies be reviewed in light of recent IRS developments and the emerging views of state Attorneys General. An area that should be considered in evaluating existing policies, borrowed from the requirements of Sarbanes-Oxley, is whether key executive and financial officers are accountable for the detection, reporting and correction of financial irregularities.

Conclusion

While many of these recommendations may represent only extensions of current practices rather than novel approaches to governance, the process of revisiting these issues may cause management and directors to test old assumptions and consider principles and practices that my be relevant to the organization's activities. Every nonprofit corporation should, at a minimum, demonstrate an awareness of the changing environment and a willingness to undertake sensible reforms to further its charitable mission and assure continuing compliance with law.