Legal Dimensions of International Grantmaking
CHARITY GOVERNANCE AFTER SARBANES-OXLEY
By Joshua Mintz and John P. Vail
The following article is taken from a longer publication entitled Governance of Not-for-Profit Organizations in 2003. An electronic version of this article may be found at http://www.usig.org/SarbanesOxley.pdf .
1. INTRODUCTION
It is a challenging time for the directors, managers and advisers of charitable organizations. During a period when poor markets have damaged endowments and the economy has hampered fundraising, charities also have had to grapple with the fallout from scandals that have beset the for-profit world. At the same time, charitable foundations-both public and private-that make grants internationally have faced the added challenges of rethinking their grantmaking procedures to take into account the War on Terrorism. Are there lessons to be taken from the upheaval in the for-profit world? Or is this just another frenzy of media interest that will pass with little lasting change?
This article looks mainly at the governance changes that Congress has required for public companies - those whose shares are traded on the stock exchanges - and considers which might be appropriate for international grantmakers. Of course, no cookie cutter approach will address the needs of all international grantmakers with their different resources, needs and exposures. Changes that might suit a large, well-funded private foundation may not work as well for a small public charity. Accordingly, institutions can pick and choose from the suggestions made, but charities that ignore the current landscape do so at their peril.
Corporate scandals have substantially eroded the confidence of shareholders and regulators in the capacity of management to govern public companies. The debacle at Enron began the erosion of faith, but problems went well beyond Enron. Tyco and Adelphia, Worldcom and HealthSouth, quickly followed. Reacting to public outrage, Congress quickly passed the Sarbanes Oxley Act of 2002 ("Sarbanes Oxley") seeking to restore the confidence of investors in public companies.1 Prosecutors used their power to force leading executives to do "perp walks" in full view of media that were called to the scene by the prosecutors. Plaintiffs' lawyers quickened the pace of filings of shareholders' suits at the first suggestion of earnings restatements.
Charities have not been immune from scandal. Over the last several years, the white-hot glare of media and prosecutorial interest fell on a number of institutions, from Allegheny Health and Allina in the health care field to the Bishop Estate of Hawaii in the educational sector. More recently, charitable organizations ranging from The Nature Conservancy to the laundry list of private foundations identified by the Boston Globe have played starring roles in news accounts of charities that allegedly have transgressed legal or ethical standards.
A consequence of these reports is that foundations and other charities are facing much greater scrutiny from the media, Congress, state legislatures, and federal and state regulators, many of whom are suggesting that Sarbanes-Oxley type reforms be mandated for charitable institutions. New York Attorney General Eliot Spitzer, for example, has introduced a charity governance bill in New York based in part on Sarbanes-Oxley principles.
How should grantmakers respond? The first step is to look at their operations and decide whether additional steps are needed to bring their practices into line with the best practices of the sector. This article is designed to help grantmakers analyze their current practices and think about what additional safeguards might help boards and the public rest easy and trust their institutions.
2. THE GOVERNANCE PROBLEMS
Reports2 by the many committees and commissions that have reviewed Enron and other business scandals reflect a consensus that the fundamental problem in corporate America was one of fiduciary failure. Boards of directors allowed their companies to engage in high risk accounting, inappropriate conflict-of-interest transactions, extensive undisclosed off-the-books activities, and excessive executive compensation practices, all to the detriment of shareholders, employees and business associates. Boards failed to actively oversee management actions, were compromised by members' financial ties with the company, and failed to ensure the independence of outside auditors.3
Some company CEOs said that these issues did not exist in most companies and that the extent of the problems was overblown.4 But the perception that problems were sufficiently widespread to affect public trust in the marketplace nonetheless led Congress to enact sweeping reforms in the governance of public companies.
Several years of news accounts point to similar problems in the governance of some charitable organizations. Like their corporate counterparts, many charity CEOs argue that the problems exist in only a small group of institutions. However, like their corporate counterparts, charities may see Congressional action if they do not act voluntarily to improve their governance.
3. GRANTMAKER GOVERNANCE IN A POST-ENRON WORLD
Whistleblowers and Document Retention
Although most Sarbanes-Oxley reforms apply only to public companies, two key aspects of the legislation - whistleblower protection and document destruction - pertain to everybody. Changes adopted in Sarbanes-Oxley make it a lot easier for the government to prosecute cases where individuals and organizations have obstructed justice by retaliating against whistleblowers or destroying documents. Because these changes in the criminal law apply to any "person," a term that can include charitable institutions and their managers, foundations should review (or adopt) document retention and whistleblower policies. International grantmakers should pay particular attention to these issues, given the possibility of criminal penalties if a foundation is found to have provided financial support to terrorists or the organizations that support them. A solid whistleblower policy - one that allows direct access to the board or the audit committee and that includes appropriate provisions for anonymity - makes it more likely that management will learn of any attempt to divert grant funds to the support of terrorism.
Some Best Practice Suggestions for All Grantmakers
Grantmakers considering whether to modify their corporate governance structures to incorporate Sarbanes-Oxley reforms should keep the big picture firmly in mind. Most grantmakers, and especially smaller ones, should spend less time trying to understand the details of Sarbanes-Oxley and more time understanding the problems that triggered the need for reform and how those problems might be reflected in their own operations.
The genesis of Sarbanes-Oxley was in lax corporate governance and fiduciary failure. Stakeholders found that they could trust neither the companies' financial reports nor the process that should have operated to ensure that those reports were reliable and trustworthy. Grantmakers in a post-Sarbanes-Oxley world need to examine their own operations to look for areas of vulnerability that can undermine the confidence of their stakeholders, including regulators, grantees, and employees, to decide what they can do to improve levels of trust. They should consider the following principles of good governance that were lost in the for-profit world:
·Governance by boards that take an active interest in governance and that hold management to standards of accountability.
·Transparency with respect to financial conditions and operations.
·Avoidance of transactions with insiders that provide them with improper benefits at the expense of the organization.
·Access to good advice that is not affected by any conflict of interest.
With these principles in mind, grantmakers should ask themselves the following simple questions:
1. What can the organization do to increase the quality of director candidates? What is the current process for nominating and selecting directors? Should there be additional efforts to find directors with business acumen and financial expertise to assist the organization and show third parties that the organization is concerned about proper governance?
2. Should grantmakers make additional efforts to educate directors about governance and their fiduciary duties? This effort is one that generally will be well worth making. Not all organizations will be able to find new, highly-experienced, businesspeople to serve on their boards. However, they can increase the expertise of their boards through education.
3. Is the board devoting adequate time and effort to governing the organization? More frequent or longer meetings may be needed to increase the board's ability to provide adequate oversight to management and exercise its duty of care. Grantmakers with large boards should consider establishing and using board committees.
4. Is the board holding management accountable and demanding sufficient information from management to enable it to do its job well? This is a critical area for attention in any organization. Management often is in the best position to have information on all operations of the organization. Unless critical information makes its way from management to the board, the board will not be able to do its duty or act as a check on managerial excess. Boards need to develop clear expectations of their managers and hold them to the expectations.
5. Do the chief officers understand the financial statements of the organization to a degree that they could certify them as true and accurate if ever called upon to do so? Many charitable organizations are finding that their chief officers - their CEOs and their CFOs - must know more about the details of the financial condition of the organization and must be comfortable that controls are in place that can ensure that financial statements can be accurately prepared. Even if Congress or state legislatures never act to apply Sarbanes-Oxley to charities, bond-rating agencies or other lending institutions may be asking for Sarbanes-Oxley style certifications of financial information.
6. Is the organization's conflict of interest policy current and adequate to address the organization's issues? Although it may be difficult for many grantmakers to put new policies in place in the vast number of governance areas being discussed today, attention should be given to critical ones such as the conflict of interest policy. Public pronouncements by the Internal Revenue Service, the Council on Foundations' Principles and Practices for Effective Grantmakers and the Treasury Anti-Terrorist Financing Guidelines all stress the importance of adopting and implementing a conflict of interest policy.
7. Can donors, beneficiaries and regulators understand the financial condition of the organization and the risks that it faces in its operations? Trust by constituencies can only be engendered if an organization is sufficiently transparent to them. Grantmakers should consider their vehicles for dispensing information, such as websites, tax returns, annual reports, financial statements, brochures, and other public communications, to determine whether they can improve the quality, quantity, and understandability of information about the foundation's resources and expenditures.
8. Where are the temptations to understate or overstate the grantmaker's financial affairs and what internal controls are needed to prevent that happening? The Sarbanes-Oxley reforms were designed to protect against the use of financial chicanery to overstate earnings and understate expenses. While charitable organizations are not expected to return a profit, there is considerable public pressure to minimize administrative expenses and, for public charities, to keep fundraising costs low. Does the grantmaker have systems in place to assure that these expenses are fairly and accurately reported on its financial statements and Form 990 or Form 990-PF? Grantmakers also should consider whether internal controls are sufficient to monitor their handling of restricted gifts and endowments. The finance committee or other individuals playing a similar role should always have available an inventory of the organization's significant restricted gifts and have procedures in place to ensure compliance with such restrictions.
9. Are the compensation policies of the institution in line with those of similarly situated organizations? Are they adequate to compensate employees for the value they bring to the organization, but not excessive? Excessive compensation has been a primary factor that has eroded trust and confidence in for-profit CEOs. Trust in charitable organizations can similarly wither away unless boards and executives clearly communicate, through their compensation decisions as well as their words, their understanding of the basic principle that charities exist for the benefit of the public and not for the benefit of any private persons.
Some Best-Practices Considerations for Larger Grantmakers
Larger grantmakers may want to go beyond the general principles just enunciated and consider whether to adopt specific aspects of the Sarbanes-Oxley reforms. The remainder of this article provides a quick guide to the major changes that Sarbanes-Oxley required of public companies and how grantmakers might evaluate whether to adopt similar reforms.
1. Board Independence. Sarbanes-Oxley requires that independent directors make up a majority of the boards of public companies. Most public charity boards meet this standard - they have a majority of directors that are not tied to the organization through employment or other financial or familial relationships. Many large, older, private foundations also have independent boards; however, newer foundations and especially family foundations and those connected to businesses typically do not. Grantmakers should evaluate whether their boards should include a majority of members that are independent, keeping in mind that different organizations may reach differing conclusions on this point - after all, a family foundation with a majority of independent directors would cease to be a family foundation -- and that the government already strictly regulates the operation of private foundations.
2. Loans to Executives and Board Members. Because of abuses linked to unduly favorable lending practices, Sarbanes-Oxley prohibits personal loans or extensions of credit to directors or executive officers. However, federal and state law already limits the ability of grantmakers to lend money to their directors and officers. For private foundations, the federal self-dealing prohibition bars loans to directors, officers, members of their immediate families, and businesses they control. For public charities, many state nonprofit corporations laws bar loans to directors and officers, while federal law bars any loan that confers an undue benefit on such individuals. In situations where a loan is permissible, grantmakers should ensure that the loan is supported by good business reasons and is clearly and adequately documented.
3. Conflict of Interest Policy. Any grantmaker that does not have a conflict of interest policy should implement one and any organization that has one should review it for improvement.
4. Code of Ethics. Grantmakers already have codes of ethics for the conduct of their affairs and the management of their employees should review their codes to determine whether they are comprehensive and whether they are adequate to send the strong ethical message that is desired. Particular attention should be given to the implementation of codes of conduct and ethical standards for senior financial officers. Grantmakers that do not have an ethical code should consider adopting one.
5. Audit Committee. Many larger grantmakers already follow the practice of public companies in using an audit committee to oversee management with respect to financial matters, including the work of outside auditors. Grantmakers, particularly those that hold substantial assets or have large boards, should consider creating an audit committee to increase attention to the organization's accounting practices and financial reporting. Grantmakers should weigh carefully whether the audit committee should also supervise the foundation's investment activities or whether those functions should be clearly separate. Grantmakers with audit committees also should consider the following Sarbanes-Oxley reforms:
·Charter. The board should consider adopting a charter for the audit committee setting forth its powers and legal duties as well as the required qualifications of the audit committee members.
·Financial Expert. The board should consider whether the audit committee includes at least one "financial expert" and whether that expert is independent of management. Considerations in deciding whether an individual is a financial expert include whether the individual understands and can apply generally accepted accounting principles (GAAP), understands internal controls and financial reporting procedures, and understands the functions of an audit committee.
·Outside Experts. In order to obtain necessary or appropriate expertise and analysis of issues, audit committees should consider retaining professionals as needed for independent advice.
·Independence. SEC regulations require that all audit committee members be "independent." That is, they cannot accept any consulting, advisory or other fees (other than fees for serving as a director or on the audit committee) from the company or its affiliates. Grantmakers that establish audit committees should consider whether to adopt a similar independence standard for committee members.
6. Outside Auditor. Besides strengthening the independence of the audit committee, Sarbanes-Oxley reforms also address the independence of the outside auditors employed by public companies. Reforms include:
·Prohibiting Non-Audit Services. The drafters of Sarbanes-Oxley identified serious problems stemming from the conflict of interest that results when an organization allows its auditor to simultaneously provide other, more profitable, services to the organization and acted to prohibit such services. Audit committees should identify all non-audit services provided to the organization by its auditors and determine whether the services are prohibited under Sarbanes-Oxley or would materially impair the auditor's independence. The audit committee should then decide whether to allow any services to continue and, if so, under what conditions.
·Audit Partner Rotation. Sarbanes-Oxley requires that the lead and concurring audit partner must rotate off an audit client after five to seven years and be subject to a five-year "time out" period after rotation. Grantmakers should consider whether to adopt a similar requirement for their relationship with auditors, keeping in mind that frequent rotation may be more needed in public company settings because the necessity for quarterly reporting to the public promotes closer, more intimate, relationships between company officials and the auditors. Grantmakers also must take into account the supply of outside auditors with knowledge of not-for-profit issues and the increased costs associated with rotation.
7. Management Certifications. Sarbanes-Oxley requires a company's principal executive officer and principal financial officer to certify that the information contained in the company's financial reports is fairly and accurately presented. These individuals also must certify that the organization's disclosure controls and procedures are regularly analyzed and are effective in ensuring that material information is made known to appropriate officers. Finally, the certifications must state that these chief officers have disclosed to the auditors and the audit committee all significant deficiencies in internal controls and any fraud by any person that is significantly related to internal controls. A grantmaker's board could consider imposing a requirement that the two primary officers make certifications to them similar to the above. At a minimum the board should demand that its principal officers be in the position of providing such certifications if required by a third party.
8. Off-Balance Sheet Transactions. Sarbanes-Oxley requires that a company explain in its public reports all off-balance sheet arrangements and certain contractual arrangements (such as guarantees or contingent interests in assets) that have or are reasonably likely to have an effect on the company's financial condition. Grantmakers are unlikely to have similar arrangements but, if they do exist, should report them to the audit committee on a regular basis.
CONCLUSION
Discussions of the state of governance of not-for-profit institutions are not new. However, Sarbanes-Oxley, and its suggestions of new best practices, is a wake-up call to grantmakers, reminding them of the importance of engaging in self-examination of current governance practices. Reasonable reforms, willingly adopted, will increase trust in charitable institutions and begin to silence the field's harshest critics.
Additional Resources
The Council on Foundations' Statement on Principles and Practices for Effective Grantmaking
http://www.cof.org/Content/General/Display.cfm?contentID=156&
Recommended Best Practices in Determining Reasonable Executive Compensation http://www.cof.org/files/Documents/Governing_Boards/execcomp2003.pdf
Sample Conflict of Interest Policies
http://www.foundationnews.org/CME/articles.cfm?ID=1870&IssueID=2521
Notes
1. Sarbanes Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745, July 30, 2002.
2. Two of the more prominent committee reports were the Report of the Special Investigation Committee of the Board of Directors of Enron Corporation, Chaired by Dean William Powers, Jr. (Feb. 1, 2002) and the Findings and Recommendations of The Conference Board’s Commission on Public Trust and Private Enterprise on Corporate Governance and Audit and Accounting dated January 9, 2003.
3. See Report of the Special Investigation Committee, note 2 above.
4. See John Byrne, Restoring Trust in Corporate America, Business Week Online, June 14, 2002, quoting James F. Parker, CEO of Southwest Airlines Co.
About the Authors and Editors
Joshua Mintz is Vice President and General Counsel at the John D. and Catherine T. MacAurthur Foundation. John P. Vail is a partner and Coordinator of the Corporate Finance/Securities Group at the Chicago office of Quarles and Brady LLP. Janne Gallagher, Vice-President and General Counsel at the Council on Foundations, and Stephen Dau, Communications Coordinator in the International Programs Department of the Council, edited this article.
The Council on Foundations coordinates the Legal Dimensions in International Grantmaking series with assistance from the Day, Berry & Howard Foundation ("promoting positive developments in the law, legal scholarship and legal education"). Inquiries may be addressed to the Council's International Programs staff at 703/879-0600 or to Timothy R. Lyman, president of the Day, Berry & Howard Foundation, at 860/275-0329.
For more information, contact the International Dateline Editor.
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