Congress enacted the American Competitiveness and Corporate Accountability Act (commonly known as "Sarbanes-Oxley") in response to widely reported corporate and accounting scandals. Sarbanes-Oxley's principal purpose was to restore public confidence in the financial reporting of publicly traded companies. With limited exceptions, Sarbanes-Oxley did not apply to nonprofit organizations.
As time has passed, however, nonprofits have begun to consider adopting management procedures reflecting the requirements of Sarbanes-Oxley. A study conducted in late 2003 found that approximately 20 percent of the surveyed nonprofits had made some changes to their governance in response to Sarbanes-Oxley, and the trend is expected to continue.
Such voluntary measures should come as no surprise, considering the recent high-profile controversies relating to the financial practices of a few charitable organizations. As a result, donors, state and federal regulators, and charities themselves have called for transparency in charities' financial affairs. All of these players have a very real stake in the financial integrity of nonprofits and a deep interest in eliminating and preventing the types of abuse and problems addressed by Sarbanes-Oxley.
The recently introduced "Nonprofit Integrity Act of 2004," now under consideration by the Legislature, echoes many of the provisions of Sarbanes-Oxley and would apply to charitable corporations, associations and trusts that do business in California.
A summary and comparison of the salient provisions of Sarbanes-Oxley and the proposed nonprofit act follows.
- Independent audit committee. Sarbanes-Oxley requires public companies to establish and maintain an independent audit committee to serve as the primary contact with the auditor. Membership on the audit committee is limited to directors. To maintain the committee's independence, none of its members may receive any consulting, advisory or other compensatory fees for services performed for the company.
The nonprofit act would require charitable corporations (but not associations or trusts) having annual gross revenues of $500,000 or more to have an audit committee. The act parallels Sarbanes-Oxley in limiting committee membership to those directors who do not receive compensation from the corporation.
Under the act, directors having any material financial interest in any entity doing business with the corporation would also be barred from membership. If the corporation has both an audit committee and a finance committee, the act precludes dual membership. Finally, members of the corporation's staff, including its president (or chief executive officer) and treasurer (or chief financial officer), may not serve on the audit committee. Committee members are responsible for retaining and terminating the auditor, setting the auditor's compensation, conferring with the auditor to satisfy themselves that the company's financial affairs are in order, and reviewing and approving the audit.
- Independent auditor. Sarbanes-Oxley creates parameters to ensure the independence of auditors from their clients. Auditors may not provide nonaudit services to the company (bookkeeping, appraisals, fairness opinions). Tax preparation services may be provided by auditors but only if preapproved and disclosed by the audit committee. The lead auditor and reviewing partner must rotate off the company's audit every five years.
The California bill would require every charitable corporation, association or trust whose gross annual revenues are $500,000 or more to obtain an annual independent audit. As under Sarbanes-Oxley, auditors may not provide nonaudit services other than tax return preparation. The California bill, however, does not require auditor rotation.
- Chief executive officer-chief financial officer certification. Under Sarbanes-Oxley, the company's chief executive officer and chief financial officer are required to certify the financial statements and disclosures prepared by the auditors. This provision has no counterpart in the nonprofit act.
- Insider transactions. Sarbanes-Oxley generally prohibits loans to directors and executives. No such provision exists in the nonprofit act, likely because California law already regulates loans to directors by requiring a charitable corporation to secure the attorney general's preapproval of such loans.
Loans to executives are regulated by the "intermediate sanctions" provisions of the Internal Revenue Code. The nonprofit act goes beyond Sarbanes-Oxley, however, by requiring annual board review and approval of compensation for a charitable corporation's president and treasurer.
- Disclosure. Sarbanes-Oxley requires disclosures, including information on internal control mechanisms, corrections to past financial statements and material off balance sheet transactions. Further, companies are required to disclose to shareholders on a "current" basis information on material changes in their operations or financial position.
The California bill would impose a duty to make the audited financial statements available for inspection by the attorney general and the general public. This disclosure duty applies not only to charitable organizations with at least $500,000 in annual gross revenues but also to those with revenues less than $500,000 if they prepare audited financial statements.
- Whistle-blower protection. Sarbanes-Oxley protects individuals who report suspected illegal activities in either for-profit or nonprofit corporations and imposes criminal penalties for retaliatory actions. No counterpart provision exists under the nonprofit act.
- Document destruction. Sarbanes-Oxley criminalizes actions by for-profit or nonprofit corporations to alter, destroy, mutilate or conceal any document to prevent its use in federal investigations or proceedings. Violations are punishable by fines and up to 20 years in prison.
The California bill requires charitable organizations to retain all records regarding their activities for at least 10 years but is otherwise silent with respect to issues of document destruction.
Several of the provisions of the nonprofit act are of concern, particularly the relatively low threshold of $500,000 in gross revenues per year that triggers the audit requirements; the fact that members of the audit committee may not serve on the finance committee (for small organizations, it may be very difficult to find more than a very small number of people with the requisite background to serve on such committees); and the requirement of an annual review and approval of chief executive officer and chief financial officer salaries, particularly in the context of multiyear contracts. Although likely to pass, it is unclear at this early stage whether and how the California bill may be amended before its final passage.
Jill S. Dodd is a partner in the business and tax practice of San Francisco's Steefel, Levitt & Weiss.