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In early 2003, Barron “Buzz” Tenny, the executive vice president and general counsel of the New York-based Ford Foundation, sat down with the text of the Sarbanes-Oxley Act, the 2002 corporate governance reform law passed in the wake of the Enron Corp. and WorldCom Inc. meltdowns. The law primarily applies to public companies, but two provisions in it were also incorporated into the criminal section of the United States code: the expanded protections for internal whistleblowers and new standards on document retention. Tenny thought that other sections of the law might make sense for his organization too, such as the requirement that audit committee members are completely “independent” � governance-speak for having no business ties with the foundation. He spoke with other Ford Foundation executives and board members about implementing some provisions of Sarbanes-Oxley. “[The topic] was in the air,” recalls Tenny. “[New York Attorney General Eliot] Spitzer had been making noises about cracking down on nonprofits, and everywhere there was talk of increased scrutiny. It became obvious to me that it would be good for us to do something.” Shortly thereafter, Tenny initiated a governance overhaul at the $10 billion charity. A team of lawyers from Morgan, Lewis & Bockius helped him figure out what needed to be done. Then Tenny set to work. He established an audit committee, mandating that each of its five members be completely independent. He also created a code of ethics for the entire board’s 14 members, set up an annual review process to evaluate the directors’ performance, and wrote a new code of conduct for the whole foundation staff. The process took close to 16 months. Tenny won’t reveal the overhaul cost, saying only that, because he used outside counsel mostly in an “advisory” role, the price was “quite modest.” Tenny’s experience isn’t unique. Last November the accounting firm Grant Thornton LLP reported that nearly half � 48 percent � of the nation’s nonprofits have made voluntary changes to their governance practices since the passage of Sarbanes-Oxley. The statistic represents nearly a 60 percent increase from the year before. The reforms are a “validation that people think Sarbanes-Oxley’s principles make good sense,” says Michael Peregrine, a partner at Chicago’s McDermott Will & Emery and a leading practitioner on governance at nonprofits. “But it’s also a sign that [GCs] want to keep their organizations out of trouble.” The nonprofit sector is made up of some 1.8 million institutions. Each of them has made a deal with the U.S. government: In exchange for federal tax exemption, executives at nonprofits pledge to forgo profits and to serve the public good by, for example, managing cultural institutions, educating students, or funding projects for the underprivileged. Nonprofits don’t sell stock, so they don’t have shareholders or Securities and Exchange Commission reporting duties. The most significant financial regulatory burden for most is submitting an annual federal tax return to the Internal Revenue Service. But recently, federal and state regulators have taken a harder line. Last November, California passed the nation’s first governance law for nonprofits, which, among other things, requires charities that do business in the state and have revenues greater than $2 million to form audit and compensation committees. And last summer, in an ironic turn of events for an agency that has cut its oversight of charities in recent years, the IRS announced that it was launching an investigation into nearly 2,000 nonprofits. (Although Congress hasn’t yet approved the $300 million the IRS has requested for the audits.) The largest shock waves hit the sector in early 2003, when Charles Grassley (R-Iowa), chairman of the Senate Finance Committee, announced that he was considering legislation to regulate tax-exempt organizations. Currently his committee is working on a bill that would impose several governance reforms on nonprofits; the legislation is expected to come up for a full committee vote early this year. “That’s a near certainty,” says Jill Gerber, press secretary of the Finance Committee. In the meantime, nonprofits aren’t sitting still. They’re lobbying Congress, chiefly through a Washington, D.C.-based trade association called Independent Sector. They’re also hoping that by showing that they can address their own problems, Congress will apply a soft touch if it does pass a law. At the same time, the charities want to prepare for the worst: a law full of reporting requirements. So, with general counsel taking the lead in many cases, they’re getting their houses in order. BUZZARDS SWIRLING Top in-house lawyers at universities, foundations, health care organizations, and other charitable organizations are acting like Fortune 500 GCs of, well, two years ago. They’re rewriting corporate charters, redrafting conflict-of-interest policies, and, in some instances, performing costly examinations of their internal controls. “The buzzards are swirling around the industry. You’ve got the IRS talking about beefing up their audits, states passing laws, and Congress about to get involved,” says Thomas Hyatt, a D.C.-based partner at Baltimore’s Ober, Kaler, Grimes & Shriver and an expert on nonprofit taxation and governance. “Governance is something that all responsible nonprofits should be thinking about.” The nonprofit world greeted the passage of Sarbanes-Oxley two years ago largely with relief. “We were all just happy it didn’t apply to us,” says Christopher Holmes, the assistant general counsel at Baylor University in Waco, Texas. While Capitol Hill lawmakers hadn’t proposed extending Sarbanes-Oxley to charities, the nonprofit scandals of the 1990s � chiefly at the United Way of America, in which two executives embezzled $2.5 million over a 10-year period � were still fresh in many of their minds. (William Aramony, the former head of the organization, was convicted on fraud charges in 1995; Jacquelyn Allen-MacGregor, the former vice president of finance of the organization’s Lansing, Mich., branch, pleaded guilty to embezzlement charges in 2003.) Still, because two modifications of the federal code passed in conjunction with Sarbanes-Oxley do apply to nonprofits, lawyers at charities couldn’t totally ignore the law. And at many nonprofits, board members, many of whom had vast corporate experience, were quick to propose changes. “A lot of us started getting tougher, asking more questions of management if we didn’t see something that looked quite right,” says F. George Davitt, the managing partner of Boston’s Testa, Hurwitz & Thibeault and a board member at the Massachusetts branch of Volunteers of America. “Most of us had firsthand knowledge of what the for-profit world was doing, and we figured there was no reason why some best practices outlined by SOX couldn’t work at nonprofits.” Some early adopters stepped forward, like Drexel University in Philadelphia. In November of 2002, four months after Sarbanes-Oxley became law, Drexel’s general counsel, Carl “Tobey” Oxholm III, got a call from university President Constantine Papadakis, who told Oxholm he’d been giving the new reform law a lot of thought. Recalls Oxholm: “He said, ‘We’re graduating students who are going into this newly regulated private sector, and if that is good enough for our students, it is good enough for us.’ “ So Oxholm set to work. With his boss’s approval, he asked the board to convene a special committee to look into governance and audit issues. Over the next six months, Papadakis, Oxholm, and the committee made several changes, including a revision of the audit committee’s charter, which required that all members be independent, and the establishment of a code of conduct for all university employees. OFF THE COMMITTEE Oxholm did much of the legwork. He decided how much of Sarbanes-Oxley to adopt, and wrote the changes into the school’s bylaws. He put a whistleblower hot line in place and drafted a new conflict-of-interest policy. “It took a lot of thought,” says Oxholm, who concedes that he probably took a few things too far. The GC says that one member of the audit committee was a shareholder of an agency that had sold the school bonds a few years back. “As a shareholder of that organization, did he gain from our financial decisions?” asks Oxholm. “Probably a little bit. But was it totally necessary that we kick him off the committee? Probably not. But we opted to err on the side of caution.” Oxholm and Papadakis also hired PricewaterhouseCoopers LLP to make sure that all of the school’s departments were in strict compliance with the various state and federal regulations. “They must have talked to 130 or so people in all of our schools and all of our departments,” says Oxholm. “They looked at the federal grants we receive and expenses related to our [National Collegiate Athletic Association] membership and expenses related to patient care at our medical school.” When the audit was done, Oxholm hired a local accounting firm to help implement changes in areas PricewaterhouseCoopers had identified as “high risk.” The GC estimates that the entire project, which ended in July of 2003, cost the university around $150,000. For a Fortune 100 company, that might be chump change. “But for us, that’s really a lot of money,” says Oxholm. Other nonprofits soon tightened their governance, too, although in one notable case � that of The Nature Conservancy � the changes were prompted by scandal. Early in 2003, The Washington Post ran a lengthy investigative series on the group, alleging that the Arlington, Va.-based organization had acted unethically in selling discounted tracts of land to trustees, who then wrote the payments off on their income taxes. The conservancy denied any wrongdoing, but stopped its practice of selling to trustees shortly after the series appeared. The stories sparked the attention of Grassley, who, along with Sen. Max Baucus (D-Mont.), opened an investigation into the organization. In response, the conservancy assembled a panel of outsiders to examine its governance practices. The five-member group, which included Weil, Gotshal & Manges senior partner Ira Millstein and former Harvard University President Derek Bok, put together a list of recommendations for the board. They included creating a governance committee, rechartering other board committees, hiring a chief governance officer, and creating an oversight panel to monitor the 36-member board. The job of implementing the recommendations largely fell to the conservancy’s general counsel, Philip Tabas. He helped put together a risk assessment committee to identify potentially unethical activity before it happens. Tabas led a group that evaluated how the organization manages and uses its land, its most valuable asset. And he directed the conservancy’s efforts to cooperate with the Senate committee’s investigation. According to Gerber, the congressional staffer, the controversy prompted the committee to look at whether the sector needs more federal oversight. They found plenty of evidence. Since 1998, the IRS has cut its annual audits of nonprofits 44 percent, mostly because it shifted resources to the scandal-ridden corporate world. (In 2003, the IRS audited only 5,754 nonprofits.) Congress still hasn’t funded the IRS’s 2004 plan to probe some 2,000 additional nonprofits. And state attorney general’s offices, many of which have bureaus devoted to the oversight of charities, are largely understaffed and underfunded. As a result, says Richard Cohen, the executive director of the D.C.-based National Committee for Responsive Philanthropy, “you just don’t see nearly enough oversight at the state level.” After last summer’s hearings, Grassley issued a draft white paper setting out a legislative blueprint. The document proposed that every five years the IRS review each nonprofit’s tax-exempt status; establish federal liability of nonprofit board members who neglect their duties; and require chief executives to certify the accuracy of their annual tax filings. The Grassley proposal was a wake-up moment for charities, cultural institutions, colleges, and hospitals. “It scared the bejesus out of the nonprofit world,” says Pablo Eisenberg, a philanthropy expert and senior fellow at the D.C.-based Georgetown University Public Policy Institute. “It shocked many of them into taking some action.” Skeptics in the nonprofit world think the voluntary reforms are an attempt to head off Grassley’s bill. The changes are “a [collective] attempt to keep the legislation from happening,” says Jeff Krehely, the National Committee for Responsive Philanthropy’s deputy director. But this notion � that the sector is acting only to forestall or to water down congressional action � offends some lawyers in the nonprofit world. “That’s just nonsense,” says Daniel Hale, the general counsel of Novi, Mich.-based Trinity Health, which owns and manages several nonprofit hospitals throughout the Midwest. “The nonprofit sector has always had a compelling interest in doing things the right way.” But what, exactly, is the “right way”? Absent clear direction from Congress, it’s anyone’s guess. Right now, most larger nonprofits � those that have annual budgets of more than $1 million � are picking and choosing from Sarbanes-Oxley’s myriad provisions, trying to follow “best practices” without breaking their budgets or scaring away board members. Some, like Joy “Jamie” Horwitz, GC and director of legal affairs at the Philadelphia-based Pew Charitable Trusts, are redrafting their organizations’ codes of ethics and conduct. Others are tweaking their conflict-of-interest policies. Like Trinity Health’s Hale, who explains that it’s common practice for hospitals in smaller towns to populate their boards with local bankers, auditors, lawyers, and journalists, who may have dealings with the institution. “Obviously, you’ve got to make sure none of these folks have business ties with the hospital,” he says. But only a few are tackling Sarbanes-Oxley’s notorious Section 404, which compels for-profit companies to complete time-consuming and pricey audits of their internal controls, the vast network of reporting channels that make up an organization’s financial and accounting systems. Todd Klipp, Boston University’s general counsel, says the school considered undertaking a review of its internal controls, but opted against it. “You want to be ahead of the curve [in regard to governance], but you don’t want to overreact,” he says. “We didn’t think it was cost-justified at this point.” Cost didn’t stop the 93,000-student Indiana University, with its $2 billion budget, from re-examining the internal controls on its accounting systems. “We’re huge and decentralized and wanted to know where we were on internal controls,” says Kathleen McNeely, the university’s director of financial services. So the university hired PricewaterhouseCoopers, which, over the course of several months in 2003, examined the school’s 17 financial departments, mostly by conducting detailed interviews with close to 120 people. At the end, PWC produced a 130-page assessment of the school’s auditing process, which served as the university’s guiding document. According to McNeely, PWC recommended that the Bloomington, Ind.-based university make “some significant changes” in two of the 17 areas, including the school’s payroll department. “They thought our controls on payroll weren’t as tight as they should have been,” says McNeely. “So we changed some job descriptions and duties to make it harder for employees to ‘steal and conceal’ [from payroll]. Then we wrote those changes into policy.” And the price tag? McNeely wouldn’t divulge the numbers. But she insists that the university wasn’t knocking down walls just to satisfy its curiosity. “It wasn’t so much of an audit as it was an assessment of our internal controls,” she says. “We could have spent three or four times as much had we chosen to do a full audit.” Which is something Congress might be asking every nonprofit to do before too long. Ashby Jones is a reporter for Corporate Counsel , the ALM publication where this article first appeared.

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