A New Measure for Accountability

Many nonprofit leaders probably sighed with relief this summer when Congress passed the most far-reaching corporate-accountability legislation in decades. Not only would the legislation restore confidence in the stock market and therefore, they hoped, help battered endowments, but it seemed that only businesses — and not nonprofit groups — would face the imposing burden of changing policies to comply with the new law.

But in reality, nonprofit groups will need to pay close attention to the corporate-responsibility measure. States that have experienced large nonprofit bankruptcies or public scandals are likely to consider adding provisions similar to the federal law so that they cover charitable organizations. For instance, the bankruptcy of the Allegheny Health Education and Research Foundation, in Pennsylvania, which collapsed with $1.3-billion in debt, could well prompt the state to take serious measures to prevent the same kinds of abuses that foundation officers, managers, and their accountants have been taken to court over.

What’s more, whether or not the states act, many nonprofit groups will probably decide voluntarily to follow some of the requirements of the federal corporate-responsibility law, both to maintain donor goodwill and to distinguish themselves from competitors who may elect not to adopt such provisions.

Few nonprofit groups will want to be seen as being more lax in their governance and accounting standards than the nation’s major corporations. Not only are accounting and governance on the public’s mind because of the corporate scandals, but the topics were made even more prominent by the questions that have been raised about how the September 11 charities distributed funds, and how organizations like the United Way in the District of Columbia, now the subject of multiple federal investigations, ensure they are accountable for the donations they raise.

Here are some of the key areas where nonprofit groups are likely to look very closely at the federal law and adopt its spirit at the very least, and maybe some of the specifics:

Board audit committees. Companies must create audit committees that are directly responsible for retaining and supervising outside auditors. Audit-committee members must be directors and must be independent; thus the chief executive, chief financial officer, or other senior managers cannot be part of the committee. To further ensure independence, audit-committee members cannot be paid for consulting or other services provided to the corporation outside of their service as directors.

The corporation must also disclose whether the audit committee has at least one member who is a financial expert and if not, why not. In addition, the committee must establish procedures for receiving whistleblower complaints about the company’s accounting practices, and is responsible for determining which consulting services can be provided by the company’s audit firm.

Nonprofit boards that don’t have audit committees may well decide to create them, and those that now have them may want to make changes in the composition of their committees to ensure they are independent. It is not uncommon for a nonprofit organization’s chief executive officer and chief financial officer, or other directors who have financial expertise and connections, to serve on the audit committee. One consequence of the independence standard is that it may be hard for charities to find enough trustees with the right mix of financial expertise.

Certifying financial statements. Full disclosure and, more important, efforts to carry out procedures to ensure accurate reporting have now become the gold standard against which all corporations — both for-profit and nonprofit — will be measured.

Chief executives and top financial officers must certify in their audits and corporate annual reports that they have reviewed the document, that it doesn’t contain any untrue statements or omit anything material to understanding the financial report, and that the report fairly presents the financial condition of the corporation. In addition, they must swear that they designed and evaluated internal-control systems to ensure they were made aware of material information concerning the corporation’s operations, and that they have disclosed to the company’s auditors and audit committee deficiencies in the controls as well as any fraud involving management or other key employees.

Corporate donors, especially those that are themselves subject to the new federal reporting laws, are certainly more likely to give to charities that can guarantee they have strong internal systems to assure all donated funds are used properly. In addition, accounting firms (which are subject to increased scrutiny under the legislation) are likely to insist that all of their nonprofit clients provide proof that they have internal controls. That means annual audits will be more detailed, be more expensive, and probably have an increased focus on internal controls and processes.

Loans to top executives. The new legislation also prohibits, with certain exceptions, personal loans from a company to any director or executive officer. Some states now allow nonprofit groups to make loans to senior managers. For example, it is not unusual for a charity in a city with a high cost of living to make a loan to a newly appointed chief executive so he or she can move from a lower-cost city and be able to buy a house in a good neighborhood. Since such loans won’t be allowed in the for-profit world, it won’t be easy for charities to justify why they need to offer such perks to recruit the best talent.

Code of ethics. Companies must disclose to the Securities and Exchange Commission whether they have adopted a code of ethics for their senior financial officers. Nonprofit groups will be expected to do the same or risk being seen in a negative light by their donors, the news media, and their liability insurers. If so, contributions could drop and insurance premiums could increase.

Removing trustees. Board members of corporations now can be removed by the Securities and Exchange Commission for unfitness — a broader standard than the previous requirement of “unsubstantial fitness.” Although state attorneys general have in the past sought the removal of directors of nonprofit organizations in proceedings brought to enforce charitable trusts, this remedy may be sought more frequently now that the standard has changed.

Nonprofit groups would be well advised to become familiar with the new governance provisions and to make an assessment of the wisdom of adopting some or all of the requirements before donors, regulators, insurers, and the press begin to question why charities hold themselves to a lesser standard of governance than their for-profit peers.

Patrick K. O’Hare is a lawyer in the Washington office of Ober, Kaler, Grimes, & Shriver.