The Impact Of Sarbanes-Oxley On Not-For-Profit Companies - Part II

Wednesday, March 1, 2006 - 01:00

Following a string of corporate and accounting scandals, Congress passed
The Sarbanes-Oxley Act of 2002 ("SOX") to regulate corporate governance.
While most of SOX applies specifically only to public companies, SOX raised the
expectations as to all companies, including not-for-profit companies
("NFPs"). In Part I of this Article, we discussed SOX generally and made
suggestions as to how certain of these provisions are applicable to NFPs and how
an NFP might implement SOX-related reforms as a best practices matter. In this
Part II, we discuss SOX-type requirements currently imposed (or proposed to be
imposed) on NFPs by the U.S. federal government and various states.

NFPs' Voluntary Governance Efforts

Many NFPs have voluntarily undertaken corporate governance reforms in
response to SOX, and, in fact, NFPs may be more likely to voluntarily implement
such reforms than for-profit companies. One survey showed that a higher
percentage of NFPs than for-profit companies have implemented or plan to
implement governance reforms, although the likelihood of implementing reforms
varies depending on the NFP's size. Large NFPs (i.e., NFPs with annual
revenue or budgets above $300 million) may be significantly more likely to
implement such reforms.

Certain non-profit trade associations (for example, the Better Business
Bureau Wise Giving Alliance) and advocacy groups have issued standards and
guidelines that refer to concepts stressed in the SOX rules as a best practices
matter. In 2002, the United States Treasury Department published a guide to
voluntary best practices for NFPs, which guide covers many of the SOX topics.
Certain NFP sectors have been subjected to more governance efforts than others;
for example, the healthcare sector has many standards to which it can look for

NFPs In The Regulatory Scheme

The U.S. federal government and some state governments have adopted or
proposed SOX-type requirements for NFPs.

Federal Government

IRS Forms 990. The IRS already requires NFPs to file annual
financial information in its Forms 990 (for public charities) and 990-PF (for
private foundations), including on gross receipts such as charitable
contributions, direct and indirect public support, and information on
compensation payable to the NFP's directors or trustees. Forms 990 and 990-PF
are public documents and most such returns are available online; NFPs must make
the three most recent Forms 990 available to anyone requesting access in person
or in writing (immediately if a request is made in person, and within 30 days if
the request is made in writing). The U.S. federal government also requires
organizations which have annual expenditures over $500,000 in federal funds to
undertake an annual audit. As a matter of practice, NFPs often undertake audits
only when this operating budget is over $500,000. Thus, many smaller NFPs do not
have annual audited financial statements, because, for them, annual audits are
prohibitively expensive. Congress has considered adding corporate governance
items to the disclosure requirements on Form 990. This would be accomplished
through legislation, introduced in the U.S. Senate Finance Committee and, as
discussed below, that would add SOX-type certification requirements to Form 990.
In addition, private foundations must comply with various restrictions on their
transactions with interested parties ("disqualified persons") in order to
maintain their qualification as an exempt operating foundation. Transactions in
violation of the IRS restrictions are subject to excise taxes applicable to both
the private foundation and the counterparty to the transaction, despite the
general tax-free status of the private foundation.

U.S. Sentencing Guidelines. In November 2004, the U.S. Sentencing
Guidelines placed increased emphasis on the role of directors, trustees and
senior management of companies (without regard to their for-profit or NFP
status) in preventing criminal misconduct through development of and adherence
to ethics and compliance programs. Implementation of successful ethics and
compliance programs may be considered in reducing criminal penalties levied
against a for-profit or non-profit entity when individuals acting under the
entity's authority engage in criminal misconduct. Thus, since 2004, the
Sentencing Guidelines have considered the quality of an NFP's corporate
governance when assessing appropriate criminal penalties.

Proposed Federal Legislation. In mid-2004, the U.S. Senate Finance
Committee convened a roundtable of experts to propose legislation designed to
reform perceived NFP entity abuses. The proposed legislation encountered
substantial criticism from across the non-profit sector, including that it
applied a "one-size-fits-all" approach to NFPs whose needs and resources vary
greatly and that its requirements would be too costly and administratively
burdensome in comparison with the potential benefits to be derived therefrom.
The U.S. Senate Finance Committee has not proposed any legislation on this

State Governments

Several states have also increased their focus on NFP corporate
governance, with many requiring or considering requiring independent audit
committees and, for large NFPs, audits performed by independent public
accountants. Several state legislatures are also considering increased
restrictions on payments by NFPs to employees and related parties. Recent new
and proposed state SOX-type legislation for NFPs include:

New York. In April 2005, legislation proposed in the state Senate
and referred to committee would:

  • Allow designation of an executive committee consisting of three or
    more members, if the charter or bylaws so provide (and would require designation
    of such a committee by an NFP with more than 25 Board members, unless the NFP
    has chosen to elect in its charter or bylaws to "opt out" of this requirement);

  • Require an NFP with audited financial statements of $2 million or
    more in revenues to:
  • º Create an audit committee consisting of three or more directors (but
    allow the NFP to elect in its charter or bylaws to "opt out" of this

    º Require the audit committee (or the entire board if an audit committee
    is not created) to be responsible for oversight over the accounting firm chosen
    to do the audit;

    º Have Board or audit committee whistleblower procedures for receipt,
    retention and treatment of complaints relating to accounting, internal auditing
    controls or auditing matters;

    º Require audit committee members to be Board members and prohibit
    members from accepting certain fees and compensation;

  • Prohibit self-dealing between an NFP's officer or director and the
    NFP in certain cases;

  • For any NFP that files an annual report with the Attorney General,
    mandate the NFP to have a system of internal financial controls, and require
    officers to disclose to the auditors (if any) and the audit committee (or the
    full Board, if there is no audit committee) any significant deficiencies and
    material weaknesses in the design or operation of such internal financial
    controls, any fraud and any other material information that indicates that the
    financial information included in any Section 520 report does not fairly present
    in all material respects the financial condition and results of operations;

  • Modify the indemnification provisions applicable to NFP officers and
  • The proposed legislation currently remains under consideration in

    Connecticut. On June 7, 2005, Connecticut passed the Solicitation
    of Charitable Funds Act, which is now effective and requires NFPs that solicit
    funds (or anything of value) to submit a financial report annually to the
    Connecticut Department of Consumer Protection and, if the NFP's gross revenues
    exceed $200,000, also file an audited financial statement. The statute also
    prohibits any person engaged in the conduct of the NFP's affairs from engaging
    in any financial transaction unrelated to the NFP or appropriating any NFP
    property for private use ( i.e., from engaging in private inurement), and
    makes individuals who misuse charitable assets personally liable.

    New Jersey. Currently, a New Jersey NFP with gross revenue of
    $100,000 or more may be required to submit audited financial statements to the
    Attorney General under certain circumstances. A proposal introduced in June
    2003, which was not renewed in the fall 2005 legislative session, sought to
    raise that threshold to $150,000. The existing Charitable Registration and
    Investigation Act currently requires NFPs to disclose, in their registration
    statements with the Attorney General, any relationships of their principals with
    each other or with the NFP.

    Massachusetts. In October 2004, Massachusetts began requiring NFPs
    with annual revenues of at least $500,000 to submit to the Division of Public
    Charities a full audit performed by an independent accountant, and NFPs with
    revenues between $100,000 and $500,000 to submit a financial review conducted by
    an independent accountant.

    In addition, in May 2005, the Massachusetts Attorney General proposed the
    Act to Promote the Financial Integrity of Public Charities, and on November 3,
    2005, the Massachusetts House of Representatives held a public hearing regarding
    the proposed Act (but as of January 1, 2006, the Act had not been passed). This
    corporate governance bill would (i) require NFPs to pay compensation to its
    employees that is fair and reasonable, (ii) prohibit insiders from receiving
    excessive benefits, (iii) permit only appropriate related party transactions,
    (iv) require adherence to auditor independence standards as to non-audit
    services performed by auditors, (v) require officers and board members to review
    and accept financial filings submitted to the state's Division of Public
    Charities, (vi) require a Board member to verify the accuracy of the NFP's
    audit, (vii) require officers to establish controls over financial reporting and
    (viii) prohibit NFPs from retaliating against employees who submit complaints to
    the audit committee about the misuse of charitable assets. The Act would also
    require NFPs with revenues over $500,000 or with $5 million in assets to have
    their financial statement audited and to have audit committees composed of at
    least three persons, a majority of whom must be Board members and be
    independent. The Act would incorporate certain requirements set by the IRS,
    discussed above. The proposed Act remains under legislative consideration.

    California. Effective January 1, 2005, California
    implemented the Nonprofit Integrity Act of 2004, a SOX-type statute for certain
    large NFPs. Under this Act, NFPs with revenues over $2 million must: have an
    annual audit performed by an independent accountant (where such independence is
    defined under federal law); make that audit available to the public and the
    Attorney General; and have an audit committee whose membership may not include
    staff and may not overlap with more than half of the finance committee's
    members. All NFPs also must make their audits available to the public and the
    Attorney General on the same basis as their IRS Form 990 if they prepare
    financial statements that are audited by a CPA.

    Other. Other states have enacted or proposed governance-type
    statutes for NFPs. For example, the Ohio legislature has been considering a
    proposal introduced in May 2005 which would impose record-keeping, audit and
    other requirements on entities that receive money from governmental entities for
    the provision of certain services. In the 2005 legislative session, Texas
    considered proposals requiring that NFP Boards complete a financial report
    within 180 days after the fiscal year end and that NFPs with gross revenues of
    $250,000 or more have an audit committee and have their financial statements
    audited by an independent public accountant, with the audit to be made available
    to the Attorney General and the public. Kansas passed a law, effective in July
    2005, that requires all NFPs whose contributions total $500,000 or more to
    submit an audited financial statement. New Hampshire and Maine each passed laws
    in 2004, with the New Hampshire law requiring every NFP with annual revenues of
    at least $500,000 to submit an audited financial report along with its IRS Form
    990 and the Maine law requiring NFPs renewing their charitable registration to
    submit an audited financial statement and IRS Form 990.


    Recent regulatory and legislative actions and proposed actions have
    placed an increased focus on NFP corporate governance, mandating many SOX-type
    provisions, or at least providing incentives to follow them as a matter of best
    practices. Indeed, NFPs should consider adopting many of the SOX-type governance
    concepts for a variety of reasons, perhaps, most importantly, to assure their
    supporters of their commitment to serving their constituents and achieving their
    purposes with integrity and transparency.

    M. Ridgeway Barker is Chair of the Corporate Finance
    & Securities Practice Group of Kelley Drye & Warren LLP. Randi-Jean
    G. Hedin is a Partner in the Corporate Finance & Securities Practice
    Group. Acknowledgement is given to Jeanne R. Solomon and Jeffrey
    A. Letalien
    , Associates at Kelley Drye & Warren LLP, for their
    efforts in the preparation of this article. For footnotes, see our Website,

    Please email the authors at or with
    questions about this