2004 Summer, 46. Sarbanes-Oxley and the Impact Upon New Hampshire Nonprofit Organizations.

AuthorBy Attorney Michael S. DeLucia

New Hampshire Bar Journal


2004 Summer, 46.

Sarbanes-Oxley and the Impact Upon New Hampshire Nonprofit Organizations

NH Bar JournalSummer 2004, Volume 45, Number 2Sarbanes-Oxley and the Impact Upon New Hampshire Nonprofit OrganizationsBy Attorney Michael S. DeLucia"Always do right. This will gratify some people and astonish the rest."

- Mark Twain

"CEOs do not need a business ethicist to tell them right from wrong. What they need is the character to do the right thing . . . ."

- The Wall Street Journal July 2002


The corporate scandals that emerged with such ferocity during the past three years caused the United States Congress to enact Sarbanes-Oxley, a piece of legislation that addresses financial practices and board governance in the for-profit sector.(fn1) Questions are now being asked about the applicability and implications of Sarbanes-Oxley for the nonprofit sector. Do provisions of Sarbanes-Oxley apply to both for-profit entities and nonprofit entities? If not, should nonprofit organizations use Sarbanes-Oxley as a guide for good governance and "best practices" in the hope of avoiding the scandals and humiliation that bedeviled for-profit corporations, their public auditors, the CEOs and other senior executive officers that stood accused of manipulating shareholder assets, and individual board members? There is much commentary in the nonprofit sector about all of these issues.

This article asks three major sets of questions. First, what was at the core of the original scandals that led to the enactment of Sarbanes-Oxley? What wrong-doing was Sarbanes-Oxley intended to address? Second, does Sarbanes-Oxley apply in a technical sense to nonprofit organizations? Or, does it serve a broader purpose? Is it best viewed as a wake-up call to nonprofits, prodding them to reexamine their governance structure, the independence of their board members, the potential for excessive compensation and the fiduciary duty of board members to monitor the nonprofits they serve? Third, what does New Hampshire law require in terms of "good governance" for nonprofits? What are the "best practices" that are emerging? Finally, this article also comments upon the major vulnerabilities or deficiencies in the nonprofit sector: (i) the absence of shareholders to hold governing boards accountable, (ii) the inability of the Internal Revenue Service to monitor a rapidly growing sector, and (iii) the limited role that auditors play in the nonprofit sector.

The author is expressing his own perspective on these issues and his opinions are not necessarily those of the Attorney General's Office. As this article goes to press, Senator Charles Grassley (R-Iowa), chair of the U.S. Senate Committee on Finance, has announced that his committee will hold hearings on tax-exempt organizations, with a focus upon "governance and best practices of charities . . . "(fn2) Senator Grassley expressed concern over transactions that "may be unfairly enriching individuals and corporations." In addition, Steve Miller, the head of the IRS Exempt Organization Section, has announced a new enforcement initiative that will focus upon compensation at nonprofit organizations this year.(fn3)


The most prominent corporations at the center of the original corporate scandals included WorldCom, Tyco, Enron, and Adelphi Communications.(fn4) The common thread among these original entities was the alleged financial manipulation of corporate assets on a grand scale by CEOs and senior executive officers -- i.e., the "looting" of shareholder assets for personal gain. The names associated with these entities are L. Dennis Kozlowski, Mark H. Swartz and Mark A. Belnick (Tyco), Bernard Ebbers and Scott Sullivan (WorldCom), John J. Rigas (Adelphia Communications), and Kenneth Lay, Andrew S. Fastow and Jeffrey Skilling (Enron).(fn5) Each week, however, brings still additional announcements from corporations about the discovery of major financial problems. Nortel Networks, for example, announced recently the termination of three senior executive officers in what has become almost standard form.(fn6) Its announcement stated that its CEO had been terminated, that its financial statements had to be restated, and that steps were being taken to "restore investor confidence in the company leadership and in its financial reporting."(fn7)

A second wave of corporate scandals engulfed the securities industry and raised questions about unfair and illegal treatment of mutual fund investors.(fn8) In this second wave, the core elements included "late trading," a practice that gives preferential treatment and advantages to favored clients to the detriment of all other investors.(fn9) Also unearthed were practices where shares of highly desirable initial public offerings (IPOs) were allocated to clients of firms as rewards for their business or in the expectation of new business. In 2002, Credit Suisse First Boston (CSFB) paid $100 million to settle civil matters relating to these improper allocations. In the usual manner, CSFB neither admitted nor denied wrongdoing.(fn10) New York Attorney General Eliot Spitzer took the lead in investigating and imposing penalties during this second wave, since many of the major securities firms are based in New York.

In addition to the enforcement actions taken by the SEC and the New York Attorney General, investors have also brought claims against investment banking companies for still a third component of the scandals, leading Citigroup to enter into a settlement agreement for $2.6 billion with investors who purchased stocks and bonds in WorldCom.(fn11) That case involves allegations about conflicts of interest between investment advice given by Jack Grubman, a former analyst with Citigroup's analysis unit, and the clients represented by Citigroup's investment banking section. As is the norm, Citigroup denied any wrongdoing. It then moved to capture the moral high ground by stating that it was "taking a leadership position in bringing to a close this difficult era . . . "(fn12) The litigation is still ongoing for other defendants, including J.P. Morgan Chase, Bank of America, and Deutsche Bank. The allegations are that bank officials offering WorldCom stock had expressed concern over WorldCom's viability and downgraded its stock in private but did not mention the downgrading of the stock in the public offering documents.(fn13) Citigroup is also involved in litigation relating to the collapse of Enron Corporation.

A critical segment of the scandals involved the failure of the Securities and Exchange Commission (the "SEC")(fn14) and the accounting industry to detect financial fraud and to monitor the sector adequately.(fn15) One extensive analysis in The Wall Street Journal asked the obvious question: "How could they have missed all the wrongdoing?"(fn16) The stories published about both the original wave and second wave of corporate scandals are numerous and the corporate manipulations have undermined public confidence both in the securities markets and in the agencies that regulate those markets.(fn17) In essence, the rigorous system of checks-and-balances that the public thought was in place to protect its interests did not function as intended.

Sarbanes-Oxley. Sarbanes-Oxley addresses the original wave of these scandals by focusing upon the failure of public accountants to detect fraud during the auditing process and the role of the senior executive officers in manipulating financial data to deceive auditors. Consequently, Sarbanes-Oxley is tightly focused upon the role of independent public auditors, the need for certifications by the CEOs and CFOs, and the need for independent directors to be involved in the auditing process.(fn18) It focuses upon three Achilles' heels of the for-profit world: (i) the failure of some auditors to be independent of their clients and to detect fraud; (ii) the failure of audit committees of the governing boards to be independent and rigorous; and (iii) the role of the senior executive officers in manipulating financial data.

Sarbanes-Oxley does not deal with general governance issues as much as it deals with the auditing problems and the financial manipulation that occurred. However, the public anger that produced Sarbanes-Oxley has caused for-profit corporations to reexamine their governance structures. The Walt Disney Corporation provides a good example of a corporation that has adopted codes of conduct and defined mandates for its audit, compensation, and governance committees. The 2004 proxy statement for Walt Disney Corporation is available online and provides a handy guide to the types of committee structures and committee mandates that corporations should be considering. In addition, the "revolt of the shareholders" at the 2004 annual meeting of the Disney Corporation, where 43% of the voting shareholders cast ballots against the re-election of Michael Eisner, who served as both the chair of the board as well as the CEO, opens up a second front (led by institutional investors) in the effort to achieve a more independent and rigorous governing board, one that truly oversees senior management.(fn19)

There are many provisions contained in Sarbanes-Oxley that are not addressed in this article, including the establishment of a Public Company Accounting Oversight Board. That new Board will enforce standards for public accountants that perform audits. Sarbanes-Oxley also...

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