governance practices of nonprofit boards forever changed by Sarbanes-Oxley

Editor’s note: IOUs aren’t the only electric companies that have to worry about SOX regulations. While SOX does not apply to exempt organizations, except for some provisions, it has dramatically changed the governance practices – and public expectations of – exempt organizations. That means the impact of SOX can be felt, for instance, in the boardrooms of electric membership co-operatives.

Paul D. Gilbert, Esq., Waller Lansden Dortch & Davis, LLP

As the fourth anniversary of the enactment of the Sarbanes-Oxley Act of 2002 approaches, it is absolutely clear that SOX-a law passed to prevent public company disasters such as those at Enron and WorldCom-has dramatically changed the governance practices of, and public expectations with respect to, exempt organizations.

This fact is remarkable given that SOX does not apply to exempt organizations, except for provisions dealing with document retention and whistleblower protections. It’s worthy of close attention as applicable “best practices” place an ever-increasing emphasis on procedural matters, transparency and board accountability.

How SOX, a law designed to prevent and punish public company abuses, came to dictate public expectations of exempt organizations is an interesting example of the power of national media attention, the ability of the U.S. Congress to force change through the bright light of legislative oversight, and the sensitivity of large exempt organizations, especially those that seem to be engaged in a business rather than a charitable pursuit, to public perception and best governance practices.

high-profile failures

To place the application of SOX-like expectations to exempt organizations in the proper context, it is important to remember that exempt organizations have had their share of governance and oversight failures. In the early 1990s, for example, the reputation of the United Way of America was severely damaged by the conviction of its president, among others, for embezzling donations. The Allegheny Health, Education and Research Foundation bankruptcy in 1998 was another high-profile failure. Thought at the time to be the largest healthcare-related bankruptcy filing ever, the case included numerous allegations that financial failure resulted from poor management decisions and a lack of board oversight. Finally, following the tragic events of Sept. 11, 2001, the American Red Cross faced tremendous public criticism after it was revealed that the organization intended to retain for other purposes up to half of the money raised for the victims of the attack.

In the immediate aftermath of Sarbanes-Oxley, after the Securities and Exchange Commission had met the many deadlines to promulgate rules set forth in the law and a sense that the public markets had stabilized somewhat, attention turned to the governance, transparency and accountability of exempt organizations. This was true, in part, because of the unthinkable pre-SOX failures discussed above and because exempt organizations continued to be plagued by visible, and widely reported, failures. In early 2003, The Washington Post ran a series of articles regarding alleged improprieties at The Nature Conservancy. In response to these articles, Sen. Charles Grassley (R-IA), chairman of the U.S. Senate Finance Committee, requested on July 16, 2003, that The Nature Conservancy provide detailed responses to a number of questions, including a number of questions relevant, according to Sen. Grassley, to whether the organization should maintain its tax-exempt status. Only a few months later, national attention turned to the practices of certain tax-exempt hospitals when dealing with uninsured patients. As with The Nature Conservancy, the Senate Finance Committee held a number of public hearings regarding tax-exempt hospitals, their perceived failures and steps that might be taken to prevent such failures from continuing.

In response to this scrutiny, a survey recently published by The Governance Institute (a nationally recognized source of governance advice to not-for-profit hospitals and health systems) clearly indicates that boards are voluntarily adopting a number of the most important best practices developed under, or in response to, Sarbanes-Oxley. A recent survey of the National Association of Corporate Directors supports the view that the governance practices of leading nonprofits are converging with those practices of for-profit companies subject to Sarbanes-Oxley.

the Panel on the Nonprofit Sector

With the knowledge that most leading exempt organizations have determined that various changes to their governance practices are in their best interests, the question then becomes which “best practices” should be adopted and why. Among other things, SOX obligates public companies to maintain audited financial statements certified by their CEOs and CFOs, create independent audit committees with a financial expert, adopt a code of ethics for financial officers and their CEOs (unless the company discloses otherwise), ensure auditor independence, refrain from loans to directors and officers, and certify the adequacy of their internal controls for financial reporting. These practices may or may not be realistic for any particular organization and, when considering changes, exempt organizations should know that governance reform is not a “one-size-fits-all” proposition.

At the request of the Senate Finance Committee in connection with its ongoing scrutiny of exempt organizations and how they are governed, the Independent Sector, a nonpartisan coalition of more than 500 leading exempt organizations, convened the Panel on the Nonprofit Sector. The panel’s express purpose was to make “recommendations to Congress to improve the oversight and governance of charitable organizations.” From the beginning, it was clear that the panel’s recommendations would be informed by the requirements of SOX, the best governance practices that have developed as a result of SOX, and the underlying principles of transparency, accountability and independence. As a result, the panel’s recommendations should be reviewed by any organization considering changes to its governance policies and practices.

In June 2005, the panel delivered its final report to the Senate Finance Committee. Just recently, on April 24, 2006, the panel supplemented its final report. Although the final report contains 15 categories of recommendations and more than 120 specific actions to be taken by nonprofits, Congress, the IRS and others, the recommendations contained in the final report have not, as of April 24, 2006, been incorporated in any significant way in any legislation proposed by the Senate Finance Committee.

states paying attention too

Notwithstanding the fact that Congress has not yet implemented significant charitable reform legislation, various states have passed relevant legislation and, in light of attention being given to nonprofit governance, many state attorneys general have become quite aggressive in asserting their authority over the operations of exempt organizations when they feel that boards have abdicated their responsibility. In this context, exempt organizations should, at the very least, consider whether to amend their current governance practices.

Under various state laws, directors of nonprofit organizations, like for-profit directors, must provide oversight in a manner consistent with their fiduciary duties of care and loyalty. Nonprofit boards must also meet a fiduciary duty of obedience (or duty of loyalty) to the nonprofit organization’s mission. The duty most often questioned, the duty of care, generally requires that directors act in good faith, with the care an ordinarily prudent person would exercise in like circumstances, and in a manner believed by the director to be in the organization’s best interests. If the board meets these duties, the board’s decisions, whether good or very bad, should not be subject to judicial review.

Against this standard, many tax-exempt boards have decided to voluntarily adopt certain requirements of Sarbanes-Oxley-especially those that require certified financial statements, independent audit committees and certifications of the adequacy of their internal controls for financial reporting. To do so is certainly consistent with the common desire of mission-based organizations to avoid even the appearance of impropriety. To be clear, however, an exempt organization cannot, under current federal law, be found to have violated Sarbanes-Oxley (unless it violates one of the few provisions applicable to nonprofits). Given all that has happened in the world of corporate governance over the last few years, however, the “reasonably prudent person” would likely demand more than he or she would have demanded in the past. It is likely, at least in hindsight, that a court may well determine that the ordinarily prudent person would have adopted certain minimal standards set forth by Sarbanes-Oxley.

This article should not be read to suggest that boards of exempt organizations should rush into full compliance with Sarbanes-Oxley. This is neither required by law nor feasible for most nonprofit organizations. A “one-size-fits-all” approach to corporate governance is unrealistic and inappropriate. Nonprofit boards would be well-advised, however, to review the state of their corporate governance standards and implement whatever improvements may be needed.

Paul Gilbert is a partner in the Nashville office of Waller Lansden Dortch & Davis, LLP. His practice areas include mergers and acquisitions and securities and corporate finance. You may contact him at Paul.Gilbert@wallerlaw.com

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