Redefining Good Governance

Charities make big changes to improve accountability

Leaders at many of the nation’s charities and grant makers have started to make sweeping changes in how they

manage financial audits, protect whistle-blowers, keep their books, and run their boards.

The moves come as lawmakers in Congress and regulators in several states, including California, Massachusetts, and New York, have begun calling for tighter financial management and governance at nonprofit organizations along the lines of a landmark federal law, commonly referred to as the Sarbanes-Oxley Act, that was enacted two years ago to regulate publicly traded companies.

Among the proposals being considered by the Senate Finance Committee: a requirement that tax-exempt organizations with more than $250,000 in annual gross receipts commission an annual independent audit of their financial statements.

Just as the Sarbanes-Oxley Act was prompted by scandals at some of the nation’s biggest companies, many nonprofit leaders now believe that a series of charity scandals in recent years — including controversial fund-raising practices at the American Red Cross after the September 11, 2001, terrorist attacks and reports of foundations giving lavish perks to executives and board members — will prompt new requirements. Some nonprofit leaders say they felt the ideas in the Sarbanes-Oxley Act were worth adopting regardless of whether Congress or the states force charities to do so.

“The law has unquestionably galvanized the attention of anyone who serves on a nonprofit board or is a senior manager responsible for running nonprofit organizations,” says Hugh Price, a former president of the National Urban League who advises charities on regulatory issues. “Collectively, those at the helm of these groups are taking a much more rigorous look at how well their organizations are run.”

Adds F. George Davitt, a Boston corporate lawyer and charity board member: “A nonprofit board and executive director would be an ostrich — would have their head in the sand — if they did not see that what is going on in the corporate boardrooms across America is going to somehow impact the not-for-profit world.” Mr. Davitt, who chairs the finance committee of Volunteers of America’s Massachusetts organization, says, “Nonprofits have to be aware of this climate change.”

Expensive and Cumbersome

Yet while some charity leaders believe an overhaul of nonprofit governance is long overdue, others are perplexed by or aghast at the attempts by governments to apply some of the concepts of the Sarbanes-Oxley law to nonprofit organizations. They say that the proposals are expensive to put in place, difficult to enforce, and so strict that some board members and volunteers might be driven away in frustration. Small organizations, they say, are likely to find the rules especially cumbersome.

Florence L. Green, executive director of the California Association of Nonprofits, an umbrella group that represents more than 1,700 organizations in the state, says she has not seen charities rush to embrace the concepts of the Sarbanes-Oxley Act.

“I understand we have problems in our own nonprofit community,” says Ms. Green. “But to suggest that they can be solved through this Sarbanes-Oxley approach is wrong. It will just be onerous to the smaller, more typical nonprofit organizations and will not do a thing to catch the bad guys in the big nonprofits — or even in the small ones. It just doesn’t take us where we want to go.”

Even charity leaders who believe some elements of the federal law for companies should be applied to the nonprofit world urge caution. “There’s considerable anxiety over Sarbanes-Oxley because we don’t know what the unintended consequences will be,” says Diana Aviv, president of Independent Sector, a national coalition of nonprofit groups and grant makers. “We have encouraged organizations to follow the law voluntarily, so they can test it out.”

It is hard to tell how many nonprofit groups have made changes to follow Sarbanes-Oxley. A study released last fall by Grant Thornton International, an accounting and business advisory group, found that only one in five organizations of the approximately 300 surveyed had made such changes.

Some charity leaders say corporate executives who serve on their boards have helped convince them that changes might be needed. Others say the companies that audit their organizations have been stressing the need for change in the wake of corporate scandals.

When Mr. Davitt’s group, Volunteers of America of Massachusetts, changed auditors about two years ago, “it seemed like every auditor we interviewed wanted to talk about Enron,” says Thomas L. Bierbaum, the charity’s chief executive officer.

“You could just tell how engaged the auditors were with the subject,” he adds. “Not that they viewed us as an Enron-type client. But you could just tell it was right in front of their minds as they talked to us about different procedures and instruments that they’d be using to test our financial capabilities and so forth.”

Protections for Whistle-Blowers

Charities have taken a range of approaches to reconfiguring Sarbanes-Oxley to their needs, but the provision that has perhaps drawn the swiftest response involves whistle-blowers. Under the law, companies cannot punish workers who report suspected illegal activities and must establish procedures for handling complaints on financial matters from whistle-blowers, including anonymous ones.

Finding new ways to encourage whistle-blowers to come forward was one of the first acts taken by Marsha Johnson Evans after she became chief executive of the American Red Cross in August 2002. Ms. Evans said she knew that encouraging people to report wrongdoing would be essential as she sought to restore confidence in the charity, which had been heavily criticized for how it handled donations after the September 11 attacks.

The Red Cross already operated a telephone hotline that employees or anybody else could call if they saw that donated blood was improperly handled.

But Ms. Evans saw a need for a second toll-free hotline, one that would be answered by a third-party contractor and that would allow employees, volunteers, and other people to report incidents of illegal, unethical, or unsafe behavior at the charity’s headquarters in Washington and its 896 chapters in the United States.

The second hotline began operating last year. People who call it can choose to remain anonymous while they describe their complaint. They are then given a tracking number and are told to call back within a certain amount of time to learn the results of an independent investigation. So far, tips to the hotline have resulted in 850 investigations.

“I was brought in to increase accountability and transparency,” says Ms. Evans. “Once we looked into how to do that, we saw that a ‘concern line’ could be a valuable tool to achieve it.” The protection of whistle-blowers at the Red Cross guarantees that employees will not be fired or punished for reporting problems, Ms. Evans says.

Term Limits, Other Policies

Many charities have carefully reviewed other standards and provisions in the Sarbanes-Oxley law to make a variety of major changes in their operations.

At Pace Academy, an Atlanta school with about 1,000 students, officials conducted a yearlong review of its board practices and other operations using Sarbanes-Oxley principles as a guide, says Rick Miller, an Atlanta corporate lawyer who is chair of the school’s governance committee.

Among the changes Mr. Miller says the organization put into place as a result of the review: The number of board committees was slashed from 17 to 4; term limits for board members were imposed (which meant the departure of one person who had served 27 years and another with 18 years’ experience); a conflict-of-interest policy was adopted; and board committees were required to start submitting an annual written statement of goals.

While Mr. Miller says the changes have been beneficial — including a policy that has trustees evaluate their own performance — figuring out just what the various aspects of Sarbanes-Oxley mean is a complex process. “It’s like trying to stick your hand into a plate of spaghetti and not get any sauce on it,” says Mr. Miller, who first reviewed them in his role as counsel to companies. “It’s a mess.”

Audit Committees

Some charity leaders say that the heart of the Sarbanes-Oxley standards is the law’s requirements that give audit committees important new powers.

Under the law, the audit committee — not the company’s chief financial officer or staff members — is responsible for selecting external auditors. The company must disclose if its audit committee has at least one financial expert or explain why it does not. The partner of an auditing firm who has primary responsibility for an audit must be rotated every five years to bring in a fresh eye. And the auditing firm generally is prohibited from providing any nonaudit services, such as bookkeeping and actuarial services.

Officials of the Public Policy Institute of California, in San Francisco, first started thinking about adopting the audit standards a few months after the Sarbanes-Oxley law was enacted in 2002 after getting a call from the institute’s lawyer. The policy institute, which produces and disseminates research related to California, already had an audit committee, but it decided to spell out the committee’s independent authority from the full board in several ways. For example, in the organization’s newly reworked bylaws, the audit committee is officially in charge of choosing the organization’s auditors.

“That was kind of fuzzy before,” says Andy Grose, a longtime chief financial officer of the group. In the past, he says, the audit committee had largely looked to staff members for recommendations.

Direct Authority

Now, the policy institute’s audit committee consults with the auditor directly regarding the scope of audits; reviews the audit report; accepts the report on behalf of the board; and reviews the performance of the auditor. The audit committee is authorized to retain outside lawyers, consultants, or other experts to assist in any investigation that it might decide to conduct.

In addition, the policy institute decided to make sure it always has a financial expert on its audit committee.

One principle guided the organization as it made its changes. “We’ve got the philosophy that if something is related to good governance, we’ll do it,” says Mr. Grose.

“The effort came in getting the changes into place,” he says. “After that, we have not experienced any additional workload as a result of doing this. It is more a matter of organizing your efforts and routinizing them so that you’re making sure you kind of check off boxes once a year.”

Independent Auditors

The Mayo Foundation, in Rochester, Minn., the parent organization of the medical research, education, and clinical practice known as the Mayo Clinic, was also quick to make key changes.

Among other things, the Mayo Foundation adopted a policy that it will not purchase consulting services from its outside auditor. “That’s to keep the auditor independently focused on one job: the auditing and integrity and transparency of our financial statements,” says Jonathan J. Oviatt, the Mayo Foundation’s general counsel.

He adds: “Many of the audit committee and outside auditor standards of Sarbanes-Oxley are becoming best practices that nonprofits will increasingly choose to apply.”

Need for Tact

Even so, charities that do apply them may sometimes find themselves in situations that will require tact and sensitivity. Such an occasion is sure to arise when a charity rejiggers its audit committee to include new members with appropriate financial expertise.

“You certainly don’t want to go to significant donors and longtime supporters on the committee and say, We have decided to take this responsibility away from you because we don’t feel like you know what you are doing, or because you don’t have the experience to do this even though we’ve been having you do this for 10 years,” says L. Robert Guenthner III, a Chicago corporate lawyer whose firm represents many nonprofit groups.

He advises organizations to explain such changes to board members and donors by tying them to a group’s charitable mission. “By showing them how the change protects the organization, people become not only willing participants but enthusiastic champions of change,” Mr. Guenthner says.

A charity could also soften the blow by asking audit committee members to simply switch to another panel, such as a fund-raising committee, says Mr. Guenthner, with the explanation that the new assignment would allow them “to really focus on the things they enjoy and where they can really help the organization even more.”

No Changes for Some

While many charity leaders are adopting or exploring such options, others say their organizations will not be able to follow any Sarbanes-Oxley provisions on auditing procedures because they simply don’t have the money or other resources.

For example, “small groups have a harder time establishing an independent audit committee because they frequently don’t have enough directors with financial expertise to form one,” says Deborah S. Hechinger, president of BoardSource, a Washington organization that offers advice and training to nonprofit board members across the country.

At the same time, some large and small organizations say that their operations and procedures simply do not need a Sarbanes-Oxley overhaul.

Don McDougald, national treasurer of the Salvation Army’s headquarters, in Alexandria, Va., says that the charity’s auditing company persuaded the organization’s leaders that putting Sarbanes-Oxley standards in place would not be a help.

“We already make sure that we disclose everything to auditors,” says Mr. McDougald. Taking further action, he says, such as forming an independent audit committee, would be redundant.

‘Starts a Discussion’

Some charity leaders say the most important result of Sarbanes-Oxley is that it prompted nonprofit boards to review their operations, even if they ultimately make no changes.

“The thing about Sarbanes-Oxley is that it starts a discussion on so many areas that nonprofits need to think about,” says David V. Allen, a corporate lawyer in Cleveland who specializes in real-estate transactions.

Mr. Allen says even the tiniest charities can benefit from such discussions. He says he recently used the provisions to help the Strongsville Community Theater, in a city near Cleveland, deal with a sticky problem on its board. The theater has no paid employees and a budget of just a few thousand dollars, and puts on its plays on borrowed stages at a local high school and other sites.

About 18 months ago, the charity’s nine-member board of trustees faced a problem when one of the trustees wanted to direct a play. The board thought it might need a procedure to follow when it selected people to direct plays so that no trustees would improperly benefit from their ties to the organization. (Directors of plays receive a small fee.)

The community theater’s board of trustees turned to Mr. Allen as a volunteer adviser. “We were all thinking, Does a board in a small town in Ohio really need to have a conflict-of-interest policy when it is just trying to put on a few plays?” Mr. Allen says.

After the board and Mr. Allen discussed governance policies and Sarbanes-Oxley standards, the trustees decided the answer was yes. “The board didn’t want to ever be accused of playing favorites to anybody, including people who are not on the board,” he says.

Mr. Allen drafted a “very simple one-pager” general conflict-of-interest policy that was adopted by the board. As a result of the policy, all potential directors must meet certain criteria; trustees who want to direct plays must recuse themselves from board votes that select play directors; and the entire process must be disclosed publicly.

Says Mr. Allen: “If you feel the need to put a policy in place, make sure that you tailor it to your specific situation. And, by God, follow it.”