Corporate Governance in Private and Not-for–Profit Organizations

Corporate Governance in Private and Not-for–Profit Organizations Chapter XIII

Chapter Objectives: • Discuss the purpose and roles of NPOs. • Evaluate SOX and its potential application to private companies and NPOs. • Present the corporate governance principles, mechanisms, and functions found in public companies in a comparable structure for use in private companies and NPOs. • Elaborate on the duties of the audit committee of NPOs. • Reiterate the importance of an effective internal control structure for entities of all types and sizes.

Key Terms Articles of Incorporation charter Development/fundraising committee Executive committee Finance committee Nonprofit Integrity Act of 2004 Not-for-profit organization Personnel committee Program committee Society of Corporate Secretaries and Governance Professionals Whistleblower programs

Should private companies and not-for-profit organizations and their executives care about the provisions of SOX? Definitely yes. Section 209 of SOX opens the door to possible state actions. State regulators have adopted many provisions of SOX (e.g., audit committees, internal control reporting) as part of their “best practices”. • Private companies may choose to comply with provisions of SOX because: (1) they may go public or sell their business to a public company; (2) they may desire to make their business more effective and efficient through SOX compliance; and (3) their suppliers, customers, or even their government may require compliance with SOX provisions. • Regulators in several states including New York, California, and Virginia are applying provisions of SOX to NPOs. • NPOs are adopting provisions of SOX to improve their corporate governance, financial reporting, internal controls, and audit activities. 13

SOX Impacts on Private Companies Private companies, like public companies, are subject to the requirements of state law and these corporate governance best practices: • Establishing an appropriate “tone at the top” promoting ethical, legal, and professional conduct throughout the company • Developing and maintaining adequate and effective internal controls in general, and internal control over financial reporting to ensure operational effectiveness and efficiency, reliability of financial reports, and compliance with applicable laws, rules, and standards 14

SOX Impacts on Private Companies • Establishing antifraud programs to prevent, detect, and deter misappropriation of assets and misstatements of financial reports • Using best practices and provisions of SOX to improve governance, transparency, and accountability • Establishing whistleblower programs • Establishing independent board committees to oversee financial reporting of internal controls, audit activities, and governance matters 15

SOX Impacts on IPOs Examples of reforms that can be planned in advance of the IPO process are: • Formation of a board composed of a majority of independent directors • Formation of board committees (audit, compensation, nomination/governance) that contain all independent directors • Designation of one of the members of the audit committee as an audit committee financial expert • Establishment of financial relationships with directors and officers that comply with SOX (e.g., no personal loans to directors and executive officers) • Internal control reporting 16

Types of NPOs There are a variety of NPOs created for philanthropic purposes. State and Local Governments Health Care Organizations Colleges and Universities Charitable Organizations

Characteristics of NPOs • They do not attempt to make a profit and are often exempt from income taxes. • They are owned collectively by their constituents in which ownership is not evidenced by equity shares that can be sold or traded. • Their policy and operating decisions are normally made by a majority vote of an elected or appointed governing body. 18

Similarities between NPOs and FPOs are: • Both are integral parts of the same economic system and use financial, capital, and human resources to achieve their objectives. • Both obtain and convert scarce resources into goods and services. • Both are required to have a reliable accounting system and effective internal control system. Differences are: • Organization Objectives: FPOs seek to create shareholder value while NPOs seek to expend their financial resources for the benefit of their constituencies. • Evaluating Performances and Operating Results: Budget authorizes and limits the amount that may be expended for specified purposes. • The SEC regulates public companies to protect investors and the capital markets. The IRS regulates NPOs for compliance with conditions for the laws regarding tax exemption in order to protect constituencies. 19

Nonprofit Integrity Act of 2004 • Initially known as Senate Bill 1262 • Authored by Senator Byron Sher (D.-Stanford) • Bill sponsored by Attorney General Bill Lockyer • Gov. Arnold Schwarzenegger’s support of the bill

Nonprofit Integrity Act of 2004 • 30 Day deadline to register and file articles of incorporation • Independent audit required for organizations with gross revenues >$2 million • Requires establishment and maintenance of an audit committee

Nonprofit Integrity Act of 2004 • Review and approval of executive compensation by the authorized board committee • Disclosure of any solicitation campaign to the Attorney General • Written contract requirement

Nonprofit Integrity Act of 2004 • Organizations are authorizedto void or cancel commercial fundraising contracts • Specified obligations for fundraising • Prohibited misrepresentation of information when soliciting donations • Maintain archives of solicitation campaigns for at least 10 years

Governance Measures of NPOs Mission statement. A mission statement sets an appropriate tone for directors, management, and volunteers to direct their activities toward achieving the organization’s objectives. Code of conduct. The organization’s code of conduct is currently required by law for NPOs. Charter. An organization’s charter, which is also referred to as articles of organization or certification of incorporation, is a legal document that should be filed with each secretary of state. Bylaws. Bylaws spell out the basic operating procedures and the way an organization is structured and governed. Bylaws establish rules and procedures for selection of directors, appointment of officers, meetings, voting, and indemnification. 17

Public Trust in NPO NPOs, particularly charities, have been under extensive scrutiny regarding their governance, financial integrity, stewardship of resources, and appropriateness of their compensation schemes. The IRS has also increased its efforts in reviewing about four hundred foundations regarding their tax-exempt status and compensation decisions. Example: According to California’s Nonprofit Integrity Act, it requires charities reporting more than $2 million in revenue to have audit committees and their financial reports audited.

Eight provisions of SOX that would be more appropriate and applicable to NPOs are: • More vigilant and independent directors • Audit committees • Improvements in the financial reporting process • Risk management and internal controls • Audit quality • Codes of conduct • Whistleblower programs • Document destruction 21

Corporate Governance Effectiveness of NPOs • Educate the board about the importance of effective corporate governance (e.g., importance of financial expertise for audit committee members). The IRS can encourage NPOs to educate their boards through educational programs. • Establish a set of best practices of corporate governance as a minimum requirement for eligibility for tax exemption. • Enact comprehensive federal regulation similar to SOX for NPOs to prevent financial scandals. • It is expected that the IRS will start distinguishing between good governance and eligibility for tax exemption (e.g., conflict of interest policy). 22

IRS Form 990: Governance and internal controls for NPO • There is a strong emphasis on transparency including disclosure about conflicts of interest, transactions with related parties, and compensation. • It enhances transparency, promotes tax compliance, and minimizes the burden on the filing organization. • It includes a new summary page; new governance section; enhanced reporting of executive compensation and an organization's relationships with insiders and other organizations; and new reporting for non-cash contributions, foreign activities, tax-exempt bonds, and hospitals. • The form's 15 schedules request information about a variety of areas from fundraising to political campaigning to international activities. • Are you operating within the law as a non-profit? Are proper policies and procedures in place and being adhered to? • The IRS now wants more detail: what is the relationship between board members—familial, business, and otherwise? Are there any special deals or business arrangements that may create undue influence between board members? • Now the IRS is requiring information on the cash and non-cash compensation of officers, directors, key employees, and any other "highly compensated individuals

Oversight Function of NPOS (Cont.) 1. Establish the organization’s mission and goals. 2. Develop strategies to achieve these goals. 3. Establish appropriate board committees. 4. Appoint officers and executives to run the organization. 5. Determine the compensation of executives, oversee their work, and evaluate their performance. 6. Review the organization’s programs and services. 7. Oversee financial reporting, internal controls, and audit activities. 8. Oversee compliance with applicable laws. 9. Promote ethical behavior and accountability. 10. Ensure adequacy and effective use of resources. 11. Evaluate the board’s performance. 12. Approve director/trustee compensation, if any. 13. Assess board vacancy and recruit new board members. 14. Ensure executives and staff provide the board with relevant and timely information to effectively carry out its fiduciary duties. 15. Set an appropriate “tone at the top”. 16. Establish fair whistleblowing policies to encourage employees to come forward in reporting wrongdoing without the fear of retaliation.

Board Duties Directors and trustees of NPOs have THREE MAJOR FIDUCIARY DUTIES: Duty of obedience, which requires directors and trustees to carry out their assigned responsibilities in accordance with the organization’s rules, standards, and procedures as specified in its articles of incorporation, bylaws, and mission statements. Duty of care, which requires directors and trustees to exercise due care, diligence, and skill that any ordinary, prudent person would exercise under similar circumstances. Duty of loyalty, which requires directors and trustees to carry out their activities in pursuing the best interests of the organization by avoiding self-dealing and self-serving activities. 24

Governance Structure of NPOs

Oversight Function of NPOS NPOs are typically organized as nonprofit corporations with either a board of directors or board of trustees, or as trustees or foundations with a board of trustees.

Attributes of Board Members The effectiveness of the organization’s board depends on the attributes, personal integrity, competence, dedication, insight, and professional qualifications of its members. Important qualities of an effective board member are: Vision Leadership Stewardship Skill Diligence Collegiality

Best Practices The suggested corporate governance best practices for NPOs consists of the following checklist of elements for good governance: Make ethical behavior central to a board’s culture Strengthen internal controls Review bylaws Use board committees Use the Internet to inform the public Review investment and spending policies Perform board training and evaluation

Internal Control in NPOs Internal controls pertaining to compliance with applicable regulations are essential in an NPO to ensure continuation of a tax-exempt status. Governance documents of NPOs consist of four major documents: two organization documents (mission statement and code of conduct) and two legal documents (charter and bylaws): Mission Statement Code of Conduct Charter Bylaws

Conclusion • Many private companies will eventually enter the public markets, and thus, their corporate governance practices will be publicly scrutinized. • There are a variety of NPOs for philanthropic purposes. • The primary purpose of NPOs is to serve the public rather than maximize shareholder wealth through earning profits. • The Panel on the Nonprofit Sector was organized to demonstrate the role of charitable organizations. • Many provisions of SOX are very applicable to private ns companies and NPOs, including requirements for (1) more vigilant and independent directors, (2) audit committees, (3) improvements in the financial reporting process, (4) risk management and internal controls, (5) audit quality, (6) codes of conduct, (7) whistleblower programs, and (8) prohibition of document destruction.

Conclusion (Cont.) • Corporate governance measures are as important and relevant to NPOs as to business firms. Specifically, some NPOs often use public funds, contributions, and grants, and are tax exempt. They must be monitored closely to ensure their budgets are spent on the intended philanthropic purposes. • Corporate governance principles of fairness, transparency, responsiveness, accountability, resilience, communication, and disclosures discussed in Chapter 2 for public companies are also relevant to private companies and NPOs. • NPOs must rely primarily on internal governance mechanisms to assess performance, reward good performance, and discipline poor performance. The primary governance mechanisms of NPOs are their governing and advisory boards.

Conclusion (Cont.) • Directors and trustees of NPOs have three major fiduciary duties: duty of obedience, duty of care, and duty of loyalty. • The important qualities of an effective board member are vision, leadership, stewardship, skill, diligence, and collegiality. • ICFR, operations, and compliance with applicable laws and regulations, particularly the tax exempt status of many NPOs, are important internal governance mechanisms.

Corporate Governance in Private and Not-for–Profit Organizations