Confidence in the nonprofit sector through Sarbanes-Oxley-style reforms.

• Author: Mead, Joseph

Over the past several years, the nonprofit sector suffered a series of highly visible scandals that shook the public's confidence in charitable organizations. Concerned politicians and nonprofit leaders responded with a variety of reforms inspired by the Sarbanes-Oxley Act. The Note focuses on three such reforms: requiring nonprofit officers certify financial statements, mandating audits of nonprofits' financial statements, and imposing independent audit committees on nonprofit boards of directors. This Note argues that, contrary to the conclusions of many commentators, these reforms will provide a net benefit to the nonprofit sector by increasing donor confidence while imposing minimal costs.

TABLE OF CONTENTS INTRODUCTION I. THE "CRISIS IN CONFIDENCE" AND THE RESULTING REFORMS A. The Scandals B. The Reforms 1. Proposed Certification Requirements Mirror Sarbanes-Oxley 2. Proposed Audit-Committee Oversight of Auditing Work also Mirrors Sarbanes-Oxley Requirements 3. Proposed Requirements Reflect Sarbanes-Oxley's Emphasis on the Importance of Auditing II. THE REFORMS ARE NOT EXCESSIVELY COSTLY A. In General, the Benefits of Sarbanes-Oxley-Inspired Reforms Outweigh the Costs in the Nonprofit Sector B. The Benefits of the Specific Nonprofit-Reform Proposals Similarly Outweigh the Costs III. THE REFORMS CREATE SIGNIFICANT BENEFITS FOR THE NONPROFIT SECTOR A. The Reforms Will Enhance Financial Management 1. The Reforms are Tailored to Improve Data Disclosure 2. Donors Will Use the Improved Data to Force Improved Financial Management 3. Nonprofit Financial Management Would Improve Even if Donors Do Not Use Enhanced Disclosures B. The Reforms Will Alleviate the Concerns of Donors C. Legislation Is the Most Effective Way to Accomplish These Goals CONCLUSION If Americans cannot trust their charities, they will stop giving and those in need will suffer. (1)

INTRODUCTION

There are over one million nonprofits in the United States, (2) and these organizations play a tremendous role in American society. Charities improve the lives of disadvantaged individuals. Religious organizations give people a sense of meaning. Voluntary associations provide opportunities for camaraderie.

Commensurate with the importance of nonprofit organizations, American participation in philanthropy is overwhelming. In recent years, nonprofit organizations reported over $1.5 trillion in revenue to the Infernal Revenue Service ("IRS"). (3) Nearly ninety percent of American households donate money to charity, contributing an average of $1,620 per year. (4) And in 2000, over eighty-million adults volunteered their rime, donating over an estimated $200 billion in free services. (5)

Recently, however, the public has begun to perceive nonprofit organizations as being ineptly or corruptly managed. (6) Following the lead of federal legislation addressing corporate-mismanagement scandals, (7) many proposed similar state and federal legislation and voluntary standards for the nonprofit sector. Legal commentators are universally critical of these reforms. (8) This Note answers many of these criticisms by providing new empirical arguments in support of the legislation. (9) It reviews and analyzes the reform proposals and concludes that these proposals will improve the nonprofit sector. Part I explains the scandals that undermined public perception of nonprofits and the reforms proposed to restore public confidence. Part II argues that the reforms would impose only modest costs on nonprofits. Finally, Part III contends that the reforms would ultimately improve donor confidence.

1. THE "CRISIS IN CONFIDENCE" (10) AND THE RESULTING REFORMS

   Widely publicized scandals over the past several years have led to diminished public confidence in nonprofit organizations. Section I.A describes how scandals involving national organizations such as the Red Cross, the United Way, and the Nature Conservancy shook public perception of nonprofits. Section I.B. discusses how various legislatures and nonprofit leaders proposed reforming financial practices to reassure donors and restore faith in the nonprofit sector. Borrowing heavily from Sarbanes-Oxley, these reforms included mandatory management-officer certification of financial statements, the creation of audit committees, and general auditing requirements by independent auditors.

   1. The Scandals

      In the years leading up to the proposed reforms, scandals affecting highly visible nonprofits captured the public's interest. One of the most publicized scandals involved the handling of donations by the Red Cross following the terrorist attacks of September 11, 2001. Although many donors intended to help the victims of the terrorist attacks, the Red Cross funneled their donations to other operations. (11) After media-fueled outrage over the scandal, the Red Cross apologized and changed the way it used those funds. (12) According to one survey, a higher percentage of Americans paid attention to this scandal than the Enron bankruptcy. (13)

      Like the Red Cross, the United Way recently endured widely publicized scandals. The United Way of the National Capital Area (which covers the Washington D.C. area) fell victim to financial mismanagement (14) when the CEO of the organization took $1.5 million in "questionable payments," including advances on salary and undocumented reimbursements, from 1987 to 2001. (15) Some board members knew of the suspicious behavior but failed to alert the entire board or otherwise correct the situation. (16) When the scandal broke in 2002, donations to the Focal charity dropped sixty percent, from $45 million to $18 million. (17) Contemporary high-profile scandals at other United Way chapters, such as the 2002 discovery of the embezzlement of $2 million from the chapter based in Lansing, Michigan, (18) led many to question United Way chapters around the country. (19)

      Other nonprofit financial scandals bombarded the public during this time. For example, Congress began investigating the "world's largest environmental organization," the Nature Conservancy, for improper land deals that benefited "insiders." (20) In California, legislators were concerned when Aaron Tonken, a Hollywood fundraiser, pleaded guilty to diverting $7 million of charitable donations to himself and his "associates." (21) News articles from 1995 to 2002 reported a total loss of $1.28 billion due to nonprofit scandals during that period. (22) Simultaneously, financial scandals in the corporate world, such as Enron, exacerbated the public's worries. (23)

      Public trust in nonprofit organizations waned as a result of these scandals. One survey found that confidence in nonprofits dropped from 90% to 60% between 2001 and 2002. (24) Most of this distrust stemmed from how nonprofits handled money. In 2006, 71% of those surveyed said that nonprofits waste a great deal or a fair amount of money. (25) While 30% of the survey participants thought that charities did a very good job helping people, only 11% thought they did a good job spending money wisely. (26) This distrust manifested itself in part in the increasing number of individuals choosing to create private foundations rather than trust preexisting organizations. (27)

      Influenced by media coverage of the "bad apples," (28) many donors concluded that the entire nonprofit sector was corrupt. (29) When nonprofits with a strong national name such as the Red Cross are tainted, the effects of the scandal reverberate. Indeed, the two strongest predictors of an individual's confidence in the nonprofit sector are that individual's confidence in the Red Cross and United Way. (30) Whether justified or not, this perception led to calls for nonprofit-sector reform.

   2. The Reforms

      Over the past four years, state attorneys general and nonprofit-sector leaders have suggested nonprofit reforms. At the federal level, the Senate Committee on Finance produced both a "staff discussion draft" paper to assist the committee in formulating "possible legislation" (31) and a bill that died in committee. (32) Meanwhile, several states considered (33) or adopted (34) their own reforms. The nonprofit community simultaneously suggested voluntary reforms, in part to stave off more stringent, mandatory regulation. (35)

      The nonprofit-reform proposals focused primarily on improving disclosure by incorporating Sarbanes-Oxley-style provisions. (36) Section I.B.I describes efforts to improve the accuracy of annual reports. These proposals would make the nonprofit CEO responsible for the accuracy of such reports. Section I.B.2 discusses new proposed requirements that would increase the thoroughness of annual-report audits. Section I.B.3 details the mandates requiring structural or governance changes to the board of directors.

      1. Proposed Certification Requirements Mirror Sarbanes-Oxley

         Several nonprofit reforms mimic Sarbanes-Oxley's officer-certification requirements. SOX mandates that a corporate CEO and CFO certify that the periodic financial reports "fairly present in all material respects the financial condition" of the company. (37) The officer must also certify that effective internal controls are in place. (38) Similarly, several nonprofit reforms would require ah organization principal to certify reports. The Senate Finance Committee Staff proposal closely mirrors Sarbanes-Oxley's certification provision. It requires that the CEO certify that the nonprofit has "processes and procedures" that ensure accurate reporting and that the CEO "[be] provided reasonable assurance of the accuracy and completeness of all material aspects of the return." (39) Similarly, the Panel on the Nonprofit Sector, a coalition spearheaded by the Independent Sector (40) (at the behest of the Senate Finance Committee, recommended that the IRS require either the CEO or CFO of a nonprofit to sign Form 990 statements (41) under penalty of perjury to attest that they are "true, correct, and complete." (42) The Panel stopped short of suggesting a...