Attorneys General and Nonprofits

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There is no doubt that the regulatory environment for nonprofit organizations is changing fairly quickly. While a variety of measures at the federal level are still being mulled over in the Senate Finance Committee, activity in the states, where our regulation is closer to home, has already increased in many cases. Current direct regulation of nonprofits, of course, falls to the state attorneys general offices. So we have taken this opportunity to talk with five attorneys general to get their perspective about what the trends are in state-level regulation and how nonprofits can best meet their missions as they uphold government requirements.

The Job

Terry Knowles has been the Registrar of Charitable Trusts with the New Hampshire Attorney General’s Office since 1981. In describing the role of her office she says, “The Attorney General has held the common law authority to regulate charities and to protect charitable assets for over four hundred years. Elizabeth the First authored a document known as the ‘Statute of Charitable Uses’ in 1601, and that document formed the basis for nonprofit law in the United States. While the Attorney General’s authority to regulate charities was generally accepted, in 1943 New Hampshire became the first state in the country to codify into law the Attorney General’s common law jurisdiction over the supervision of charitable trusts.” Since that time nearly every state has adopted some form of legislation regulating charitable organizations and professional fundraising activities.

What does the “supervision of charitable trusts” mean exactly? According to Knowles, the New Hampshire Attorney General supervises and regulates charities doing business in the state; licenses professional fundraisers; regulates games of chance including Las Vegas and Monte Carlo fundraisers; oversees the filing of community benefits plans by healthcare charitable trusts; monitors all legislation that has any relationship to the nonprofit sector; and reviews reports from every town and city in the state of New Hampshire that holds charitable trust funds—234 in all. The Unit has also been assigned the responsibility to monitor charitable gift annuities issued by nonprofit organizations. Finally, the New Hampshire Attorney General is a necessary party to any legal action involving a charitable interest.

“Because the Charitable Trusts Unit consists of five people, we have to triage everything that comes through the door each day.” Says Knowles. “Our first priority focuses on the investigation and prosecution of the increasing incidents of fraud, theft, and embezzlement in the nonprofit sector. Of equal importance, however, is the need for strategic board member recruitment and training. As our time allows, we go into the field and present workshops to nonprofit organizations designed to familiarize boardsof directors members with their responsibilities.” Many state charity offices, faced with this kind of workload are understaffed and overwhelmed. One way of meeting these regulatory challenges and dealing with the lack of resources was the creation of a National Organization of State Charity Officials (NASCO) in 1979.

Since NASCO’s inception, its members have met annually with those of the National Association of Attorneys General to talk about cases and trends. NASCO also invites members of the nonprofit sector to attend a portion of the conference and present their points of view on a variety of topics. NASCO has formed strategic partnerships with some private sector entities and is currently partnering with GuideStar on a Commerce Department grant project designed to streamline the annual financial filing and registration processes required by most states.

How the Environment Is Changing: Public Attitudes

Most of those we talked to said that these responsibilities have been fairly constant. But Bill Josephson, who was with New York’s Office of the Attorney General until August 2004, comments that the environment has changed—and one of those changes has been in the realm of public scrutiny. “My hunch is that our relationship with the sector is not any different today than it was before, but that journalists, whistleblowers, complainants, and the regulators themselves are more present and that September 11th was sort of a catalyst. When an icon like the Red Cross is held up to light and found wanting, all of a sudden a lot of people become concerned about whether or not their faith in the sector was well justified.”

Mark Pacella, from the Pennsylvania Attorney General’s office, agrees. “I don’t mean to put this off on simply those organizations engaged in September 11th relief, because it’s certainly much broader than that. However, I do think it really did trigger a lot of awareness in people who started to think, ‘Well, what about our local organizations?’ We’ve certainly experienced an increase in those kinds of inquiries.”

More generally of course, there has been increasing public attention paid to the need for clearer ethical principles in the governance of organizations.

Increased Complexity in the Midst of Scarce Resources

The infrastructure for monitoring the nonprofit sector is not robust relative to the size, diversity, and growing complexity of the field. “The fact is that staffing and resources to regulate charities are woefully inadequate,” comments Knowles, of New Hampshire. “There’s no other way to put it. We have laws out there on the books, both at the federal and the state levels, but it’s a real challenge keeping up with the sector’s growth,” she explains. “When I started with this office we had approximately 1,100 charities registered here. We’re now approaching 7,000—and we’re one of the smaller states. You have states like California, which has 89,000 registered charities, and Massachusetts, with over 20,000 nonprofits, so the sector has just exploded in the past 20 years. In addition, the issues relating to the nonprofit sector have become very, very complex. For example, three United States Supreme Court decisions from the 1980s concerning the regulation of professional fundraisers rendered many state laws in this area unconstitutional. State legislatures had to scramble to enact new laws in order to comply with the pronouncements of the Court and many of those laws, in turn, became the subject of legal challenge. . . There are all sorts of nuances now relating to how charities invest their money, how they carry out their board responsibilities, what level of compensation should or should not be paid to chief executive officers, what constitutes a conflict of interest, and, above all, what is the role of the Attorney General in regulating charitable activity. . . It is very different from the way it used to be.”

Pacella again concurs, commenting, “A good example of this would be in our health care sector where you have nonprofit charitable community hospitals or health care systems that undergo mergers, affiliations, divisions, perhaps conversions or sales to for-profit acquirers. State regulators are finding themselves in the throes of those transactions, reviewing to ensure that the public’s interests are being safeguarded, that state laws are being complied with, etc. Given this growing complexity, being able to continue to address the enforcement needs of the sector within the parameters of existing resources has always been a challenge and doesn’t look to be getting any easier.”

Jamie Katz of the Massachusetts Attorney General’s Office takes this one step further: “We clearly deal first and foremost with inappropriate governance and spending, and improper use of charitable assets, as well as the weak financial systems often found in those situations. Another set of issues revolve around fraudulent solicitation, and solicitations that involve either charities or fundraisers making misrepresentations. In some cases, there are campaigns between for-profit fundraisers and charities that are a sham. On top of these more traditional problems, over the last 10 or 15 years charities have behaved differently. They have set up relationships with for-profits that were never there before. They have compensated management and trustees in ways that were not used before, and have modeled their behavior on for-profits or fundraised in ways they had not done before. Some of that is necessary and appropriate and has really helped charities perform their missions better and has strengthened their financial base. But there’s no question that we’re seeing relationships with for-profit entities that are wholly inappropriate. We’re seeing diversions of charitable assets and the emergence of systems and structures that do not protect charitable assets. We are confronting some combination of weak management and abuse in far too many cases. What’s hard is that there are 22,000 public charities in Massachusetts, many with increasingly complicated issues. We strive not only to deal with the governance issues, but also to register them, get them in compliance, and handle all the probate, trust, and fundraising matters.”

Katz says that this has led his office to a kind of leveraging strategy. “We are pursuing enforcement cases that have more general applicability. It’s kind of like the trip you take on the interstate when you pass the state trooper who’s got a couple of cars pulled over to write tickets. You tend to slow down if you know there’s some enforcement in that area. And that’s a good analogy for us. We don’t have to reach every excess compensation case that exists. We’ll never do that. But if we reach enough of them that people are a little concerned and think two or three times before they decide to overreach, we probably will have a pretty positive effect on those kinds of abuses.”

Streamlining for Greater Transparency

The attorneys general are working not only with the challenges of the growing size and complexity of the sector, but also with problems of disconnection between state and federal reporting and monitoring mechanisms.
“We’ve found from time to time when we are investigating a charity that we’re actually running on a parallel track with the IRS in their investigation,” says Knowles, “but under federal law they can’t tell us anything they are doing or indeed whether or not they are looking at a particular charity. And you find the charities under review become frustrated because they are dealing with two government agencies that can’t talk to each other—that’s a big problem. In my opinion we are wasting our very scarce regulatory resources. If that barrier were removed we’d be in a position to be more effective in the investigations that we do carry out.”

Bill Josephson anticipates that these barriers may soon be diminished. “IRS state cooperation provisions that are now in HR1528 as passed by the Senate create a window of opportunity around cooperation. Enactment is really critical because, as you know, until they are enacted we really can’t work jointly with the IRS. The IRS can’t speak to the AG offices. If we get the IRS cooperation provision then obviously the next step is to get resources to the IRS, as the Senate Finance Committee Staff has proposed”

Josephson also thinks the sector will become more transparent if registration and filing systems are made consistent and simpler for nonprofits to manage. “Electronic filing and national and state registry are critically important for ease of filing … to cut down the processing time so that the public and journalists can have access to more timely information, and to enable the states and the IRS to work together more efficiently. As it is now, the 990s, when we finally have them, are almost two years old.”

Belinda Johns, with the Attorney General’s Office in California, points out some of the benefits of such a system for nonprofits and particularly those that function in multiple states. “Our goal is single point filing; that is, a single site where nonprofits can comply with the filing requirements of all states in which they operate. But in addition to that, as electronic filing becomes more available, it will be easier for nonprofits to comply in multiple states because accounting software packages will include the secondary reporting forms required by each state. What charities have to do differently in the various states is primarily related to solicitation. The nonprofit corporation laws in each state are fairly similar—it’s only when solicitation comes into play that the laws tend to vary more.

Pacella thinks that making all filings electronic and creating links between systems will help in transparency and regulation. “I think this technology can dramatically improve the accuracy and timeliness and the usability of the data in a meaningful way. There’s a tremendous amount of information submitted on paper and it is a great benefit to regulators to have this information. But in large part, because of the volume that comes in and the resources that are in place now, that information is oftentimes simply on file. It is available, but the only way it gets looked at is if other circumstances draw our attention to it. Electronic filing, electronic data, for instance, holds the promise of changing all of that. Moreover, if organizations are going to have their financial realities open to public inspection, which I don’t think anybody says is a bad thing, it really is important that the information that is made publicly available be accurate and timely. And we have certainly not reached that plateau yet based on the experience of regulators and the amount of errors and omissions that we see in filings.”

Self-Regulation

Josephson feels that the increased scrutiny nonprofits are feeling should be seen as an opportunity. “A big challenge is the acceptance of self-regulation and self-accreditation. It’s amazing to me that so much of the sector does not yet perceive that. It ought to perceive that going in that direction is preferable to further regulation from any outside authority.”
Many attorneys general offices already try to help in this regard. Besides taking on the high-profile cases that may educate, “We do a lot of education,” says Katz. “We have materials up on our Web site, we sponsor a conference every year or two, we speak at a lot of meetings, and we have packages of material we send out to new charities. We will continue focusing on education, but we also need the trade associations and groups of charities to understand and advocate themselves for more accountability and better oversight. We will also offer legislation late this year, which we hope will pass and help set some standards. Certainly a lot of our time is spent putting out fires and dealing with problems that arise quickly, but by sponsoring legislation, by doing the education, we are trying to articulate what we think are the appropriate standards. We’re trying to help charities’ leaders prepare better to lead their charities.” Belinda Johns adds, “Education for donors and nonprofits will become more important, and for that reason we are beefing up our Web site to provide more information to both of those constituencies.”

For Knowles it boils down to prevention. “The more board training I do the better off I am, because if these organizations are governed properly I’m not going to be looking over the shoulders of the board members,” she says, “and that is a positive step. On the other hand, my message is not always warmly received—especially when I lecture on liability and risk management. It is often difficult for public-spirited citizens to recognize the culture of board membership has changed from the time-honored ‘pillar of the community’ model to a new era of responsibility, public accountability, and increased liability. At the conclusion of my training sessions invariably someone will say, ‘But we are only volunteers. Do we really have to do all of this?’ And the answer today is, of course, ‘Yes.’”

Box: Comments of the AGs on the Relevance of Sarbanes-Oxley Principles to Nonprofits

Josephson: At least in New York I hear stories of charity after charity that is voluntarily accepting what I would call Sarbanes-Oxley principles. These include board acceptance of responsibility for financial accountability; creation of audit committee; rotation of auditors; much greater interaction between board and independent public accountants with respect to the draft audit, the final audit, and management letter; and much more concern about interested director transactions.
Pacella: Sarbanes-Oxley, I think, fits best in large organizations, large institutions that have not only the resources to implement these procedures, such as internal accounting controls and safeguards against errant record keeping, but also the degree of sophistication to know what records are appropriately required, etc. However, no one is suggesting that small nonprofits should not have accurate books and records or not be accountable. I’m simply saying that there are limits to the practicality of applying Sarbanes-Oxley to every nonprofit.

Katz: Some of the legislation that we propose (in Massachusetts) will have components that are similar to Sarbanes-Oxley, although we are going to have some substantially different provisions as well. I think it’s important that people understand that there are certain standards for accountability that corporations, whether nonprofit or for-profit, need to meet. But we also are trying to put in place standards that really fit the charities world and not the public corporations world, which is, of course, where Sarbanes-Oxley comes from.

Knowles: There are some things in Sarbanes-Oxley that just don’t translate well into the nonprofit sector—especially in a state like New Hampshire, where 70 percent of our nonprofits have assets of less than $500,000. Before enacting a complex new piece of legislation which may negatively impact the internal capacity of small nonprofits, I think we need to analyze the benefits versus the cost of implementation for these entities. There are practical considerations for larger nonprofits as well. For example, Sarbanes-Oxley requires a change in the organization’s auditor every so many years, and in a state like New Hampshire, where we have very few CPAs who do nonprofit work, it would be nearly impossible to comply with this requirement. While the goals of Sarbanes-Oxley are meritorious, in my opinion one size does not fit all.

Johns: We want charities to pay attention to Sarbanes-Oxley. While Sarbanes isn’t completely relevant, it is in many respects because it focuses on ethical behavior of the board, internal controls, investment spending policy, and compensation standards. And those are the things that we want charities to focus on. There have been a lot of complaints during the process of our legislative initiative this year about how we are harming small nonprofits. But, frankly, small nonprofits can sometimes be the worst offenders. It’s frustrating because they’re right—they don’t have a lot of money—but they’re also not protecting their resources in a lot of cases.

Box: Attorneys General on Nonprofit Accountability

The state attorneys general are charged with regulating a system where information about the organizations in the sector is not always accessible or easy to interpret. This means that most of the onus for ensuring that nonprofits can be easily monitored is on nonprofits themselves. As Belinda Johns comments, “Transparency is very important for nonprofits because, essentially, the money they work with doesn’t belong to them, it belongs to the people. To be specific, the money belongs to the beneficiaries of the charity—it’s in the trust and under the stewardship of the nonprofit. Such relationships always have to be monitored, and transparency makes this easier.”

Additionally, although the attorneys general we talked with were sympathetic to smaller nonprofits with less sophisticated financial systems, they also saw the need for them to pay more attention to their accountability systems. “I don’t think you’re going to meet a state regulator anywhere that says ‘Hands off the small charities,’” said Jamie Katz. “They’re still fundraising from the public, still not paying taxes, still getting benefits from society, and they have certain obligations. Because they are in a position of trust, all charities need strong systems in place to deal with the range of accountability issues: things like conflicts of interest, issues concerning related parties, and the need for strong checks and balances in the financial operation. If you have these and make sure that there is a way to deal with problems that arise, you’re not going to have problems with regulators.”

Terry Knowles agrees but sees a real problem that stems back to issues of the quality of governance in many organizations. In her opinion, “We see many uninformed and dysfunctional boards of directors, and this is a complex issue involving the culture of nonprofit governance. Years ago if a person was invited to become a member of the board of directors of a nonprofit, it was an honor but not generally regarded as a huge responsibility. Although the legal requirements and accountability of nonprofits have changed over the years, the culture of board membership, by and large, has not. There are many dedicated people on nonprofit boards who take their fiduciary responsibility seriously, but there are also folks who are less attentive to their duties, creating a climate ripe for theft and mismanagement. To protect everyone, boards need to understand their responsibilities and pay more attention to accountability systems.”

Bill Josephson believes that nonprofit tax exemption should not be perpetual. “I believe that the 1023 [the form nonprofits must file to request exemption under section 501(c)(3) of the Internal Revenue Service code] needs to be very drastically revised so that it is a document by which both fiduciary accountability and program accountability can be measured. I would use this as the basis of a five-year or ten-year review to see whether the organization really is living up to what it said it intended to do.” While many disagree with him, this is one of the proposals being forwarded at the federal level.
Those who disagree with such new measures feel that there are enough other laws and provisions already on the books that are not being implemented well. Rather than layering on a new set of regulations, they feel that reorganizing existing ones to work well would go a long way toward improving standards of reporting and public accountability. In particular, several of our interviewees pointed out the shortcomings of the form 990, which is the standard “informational return” nonprofits submit to the federal government each year.

Josephson emphasizes that “the 990 today would also have to be drastically revised. It’s not even a good accounting document. It’s not consistent with certified financial statements prepared in accordance with GAAP [Generally Accepted Accounting Principles]. The 990 needs to be more programmatic, and to the extent that it remains a financial reporting document, it’s got to be one that is consistent with the accompanying financial statement.”

Researchers have found that is almost impossible to compare one return to another because of problems of interpretation and, as of now, the way the information is collected and stored for use is largely reliant on private charitable dollars.