Sarbanes-Oxley for Nonprofits

January 2006:  The following is the NPCC Government Relations Committee's input during 2003 into the then-proposed NYS Sarbanes-Oxley-type legislation for nonprofits.  That proposal has now evolved into a new proposal called the Nonprofit Accountability Bill.  To read the status of the current proposal, please go to www.npccny.org/gov_rel_080105b.htm, and scroll down to Nonprofit Accountability Bill.

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As an umbrella group whose purpose is to promote the effectiveness of the nonprofit sector in the New York metropolitan area, the Nonprofit Coordinating Committee of New York (NPCC) stands for accountability and transparency in the activities of nonprofits. Our work relating to legislation and regulations affecting nonprofits is done primarily through our Government Relations Committee. The Committee views any new proposed regulation or legislation through a dual lens of whether it promotes accountability and transparency or whether its provisions are unduly burdensome, considering the expected results.

Original Legislative Proposal

The original proposal contained five major elements. First, it required an audit committee (or having the full board serve as an audit committee). Second, it required the creation of an executive committee unless the by-laws prohibit the creation of such a committee.

Third, it revamped the current rules relating to “interested party” transactions (transactions between a nonprofit and a director doing business with the nonprofit). It did this by giving the Attorney General new powers to challenge transactions that had been approved by a board after full disclosure, and it set up procedural rules for how boards should address interested party transactions in order to create a presumption that the transaction was “fair and reasonable.”

Fourth, it required verification of financial information in various ways. In the case of organizations with revenues of under $250,000, it required a simple verification of the accuracy of the financial information presented to the board (as required by Section 519 of the New York Not-for-Profit Corporation Law). In the case of organizations with paid staff or revenues in excess of $250,000, it required considerably more extensive certifications of the accuracy of the financial data and it required that the “president” and “treasurer” certify that they had reviewed the corporation’s financial controls and that they had reported any problems to the audit committee.

Fifth, the proposal would have reduced somewhat the permissible scope of indemnification that nonprofits could offer to their officers and directors in the event that they were sued for inappropriate conduct.

For an organization like NPCC, these proposals raised some questions. The Attorney General’s original proposal struck the Committee as having both desirable and undesirable elements, and as having some components that needed to be altered in order to make them effective as contemplated, but less burdensome.

NPCC submitted four major sets of comments on the proposal to the Attorney General’s office and had several meetings with its representatives. The Attorney General’s office responded favorably to a great many of the comments we made and altered the proposal significantly. In its most recent form—the revised form in which it was introduced in the State Senate—the bill included the following provisions, many of which are supported by NPCC’s Government Relations Committee.  (As noted at the beginning of this article, the bill--then called S4836-- is no longer pending as it has effectively been superseded by the new Nonprofit Accountability Bill discussed as the third item at www.npccny.org/info/gov_rel_080105b.htm.)

Revised Legislative Proposal

NPCC strongly recommended that nonprofits create an audit committee of disinterested directors (i.e., directors who are not doing business with the nonprofit). The job of the audit committee, in essence, is to meet with the auditor and to satisfy themselves that the financial affairs of the organization are in order. The revised proposal kept the requirement of an audit committee (except that, if an organization does not want to have a separate audit committee, it is free to amend its by-laws to prohibit the creation of such a committee, in which case its full board functions as the audit committee). In supporting this proposal, we noted that it is clearly constructive in intent and can only lead to improved financial oversight.

The revised proposal required that an executive committee be created if, and only if, a board has more than 25 members. This is clearly a response by the Attorney General’s office to numerous instances in which it has appeared that very large boards have not had a sufficient number of directors who felt responsible for the affairs of the organization. If an organization feels strongly that it does not want to have an executive committee, it is free to amend its by-laws to prohibit the creation of such a committee. Thus, this provision is effectively optional, though clearly encouraged by the legislation.

While NPCC’s Government Relations Committee had some concerns about interfering with the autonomy of nonprofits in deciding how to manage themselves, we concluded that the executive committee provision, as proposed, is one we should support because it tends to focus board attention on the need to have a responsible group of directors. The board can do that through using an executive committee or it can avoid an executive committee, but the message of board responsibility is clear. It is noteworthy that the proposal did not require the executive committee to perform any specific functions. Thus, if a board does not want to function through an executive committee, it is free to do so. Most nonprofits already have an executive committee, which they use either regularly or on special occasions when it is not easy to convene a full board meeting and the matter at issue requires prompt board action.

On the topic of interested party transactions, we are very pleased that our suggestions relating to this issue were adopted virtually in their entirety in the revised legislation. The Committee has become convinced, through discussions with the Attorney General’s office, that there are too many instances in which supine boards approve transactions after full disclosure that reasonable people, including the public at large, would find inappropriate. It is our belief that this is really the area in which the worst nonprofit board conduct occurs. Thus, NPCC has supported, since 2000 (when an earlier version of the current proposal was made), the idea that the Attorney General should have the ability to challenge in court interested party transactions it considers objectionable, even if they have been approved by the board after full disclosure.

What NPCC objected to are the originally proposed procedures for such board action on such transactions, which we considered to be overly cumbersome and considerably more burdensome than the rules applied under the federal “intermediate sanctions” rules for the same kinds of transactions. NPCC urged, in essence, that the procedures that deal with interested party transactions, and that create a presumption of fairness and reasonableness, follow those provided under the federal “intermediate sanctions” rules. Thus, to the fullest extent possible, nonprofits would be subject to a single set of procedural rules.

The key procedural issue with the Attorney General’s office has been whether interested party transactions must receive consideration by the majority of the entire board (a term which includes vacancies) as originally proposed, or whether those transactions can be reviewed by a board committee of disinterested persons, as is permitted under the “intermediate sanctions” rules. We were pleased that the legislation as proposed followed closely the “intermediate sanctions” rules, thus giving the Attorney General the power we believe is appropriate without imposing excessive burdens on nonprofits in the approval process for such transactions.

As to certifications of financial data, the proposed provisions remain complex in their revised form. But, we are happy to report that we have had some success in making them more reasonable in terms of their potential compliance costs and time to nonprofits.

Three major changes from the original proposal occurred. First, the more extensive certifications referred to above are now only imposed on organizations having revenues in excess of $1 million or assets in excess of $3 million. It is estimated that this increase in the threshold (from revenues of $250,000 or having paid staff) eliminates perhaps 60% or more of the “reporting nonprofits” in the New York City area (those that report to the IRS on Form 990). The second major change is that the certifications have been softened so that they are based on the “knowledge” of those certifying and, third, they can be made by paid staff members (essentially the executive director and chief financial officer) in lieu of the president and treasurer. This last point was viewed as being of considerable importance as it was felt that many board presidents and treasurers would not feel they had sufficient closeness to day-to-day operations to make the certifications comfortably and that those certifications, if they are to be required, are more reasonably called for by staff of the nonprofit.

NPCC’s Government Relations Committee had strongly recommended that these certifications be imposed only on larger nonprofits—those with revenues in excess of $5 million or assets in excess of $25 million—and is continuing to advocate that position. But it is noteworthy that the jump made by the Attorney General from a $250,000 to a $1,000,000 threshold represented significant progress in sparing smaller organizations from the burdens of these certifications.

As to those burdens, the main concern of the Committee is that the certifications will produce confusion and unease as to what they involve, and as to potential liability, and so will prompt nonprofits to hire outside “experts” to give them comfort as to the quality of their financial controls and as to the meaning of the statutory language on certifications. As nonprofits are already subjected to audits by their auditors, and filings with New York State and the IRS, and grant maker audits (particularly in the case of federal, city and state grants and contracts), there is a real question as to the likelihood that these additional reviews will find failures in financial controls that raise a material risk of losses to nonprofits. To the extent that these reviews simply show that the nonprofit’s financial controls are “fine,” the money spent on them is wasted—diverted to administrative costs and not available for programs.

Finally, the provision in the original proposal to reduce somewhat the permissible indemnification available to officers and directors was eliminated. NPCC’s Government Relations Committee urged this change because of a major concern that a reduction in indemnification, particularly in the context of the proposed legislation, whose purpose is to make sure that nonprofit board directors “straighten up and fly right,” would have the counterproductive effect of causing some of the best board members to say “thanks, but no thanks; I don’t want to continue to serve in this kind of environment.” However, New York’s rules on indemnification are extremely confusing and unclear and so it seems likely that the topic of clarifying them may be taken up by the Attorney General’s office at a later date.

Throughout this process, NPCC sought to comment on the proposal in such a way that, if it is enacted, it is most productive and the least burdensome for nonprofits. We know that some nonprofits will feel that any additional legislation is burdensome and should be opposed on the grounds that they have enough administrative burdens to deal with. While that is an understandable reaction from a busy executive, NPCC’s role as a sector-wide organization requires it to take into account how the sector is perceived by the public, government officials, and those it serves. That given, it seemed to NPCC’s Government Relations Committee that simply opposing the proposed legislation in total was not a desirable or appropriate way to proceed.

As a result of our having taken this course, the revised legislation is vastly better and less burdensome than the original version. NPCC is continuing to submit comments on the provisions it thinks require further work, and the prospect for passage of this legislation is unclear at this time.

NPCC’s Board of Directors has endorsed the course taken and recommendations made by the Government Relations Committee. As members know, NPCC’s Board consists primarily of executive directors and other senior officials of nonprofits, but, in its role for NPCC, it is functioning, as does NPCC, with the overall interests of the sector in mind and not with regard to the particular concerns of any one organization.

We feel that we have made a great deal of progress in improving this bill and we shall continue to comment in the interests of the sector.

(As noted at the beginning of this article, the bill--then called S4836-- is no longer pending as it has effectively been superseded by the new Nonprofit Accountability Bill discussed as the third item at www.npccny.org/info/gov_rel_080105b.htm.)

This article originally appeared in the August 2003 issue of New York Nonprofits, the monthly newsletter of The Nonprofit Coordinating Committee of New York, Inc. www.npccny.org.

modified 1/17/06