Advising Nonprofits
A Changing Environment
By Gary W. Derrick

Many Oklahoma lawyers contribute their expertise to nonprofits.1 But what once was somewhat of a backwater in corporate law — how nonprofits operate — has come to the fore. Nonprofits play an increasingly visible role in our society. Universities and hospitals, with their complex operations and extensive assets, are apparent. Perhaps less apparent, but just as critical, are the many smaller nonprofits engaged in work as varied as funding medical and scientific research, providing relief to the needy or encouraging the arts and culture. The vast reach of nonprofits has hastened the competition for contributions, which in turn, has increased demands for better governance, transparency and accountability.2

Nonprofits can be successful only if they have our trust. When the business world was rocked by the corporate scandals at Enron, WorldCom and others, Congress responded with stricter standards for public companies, their directors and their auditors.3 While these standards did not apply directly to nonprofits, the standards suggested a “best practices” model that nonprofits are adopting. The model affords stronger governance, greater transparency and more accountability. Lawyers can assist nonprofits adopting appropriate “best practices” and so enhance the trust that the nonprofits need.

Stronger Governance

Directors owe fiduciary duties of care and loyalty. To discharge their duty of care, directors must inform themselves about the financial condition and operations of the nonprofit. Directors are expected to read and understand financial statements. They are expected to understand the nonprofit’s mission and how its programs fulfill that mission. A willingness to ask questions and seek information from differing sources is helpful.

To discharge their duties of loyalty, directors must elevate the interests of the nonprofit above their own interests. Often directors are asked to donate goods or services to aid the nonprofit. Donated goods or services pose little, if any, conflict. The conflicts grow when directors seek payment for their services or goods. Generally, conflicts of interest should be avoided. When a conflict is unavoidable or the transaction posing the conflict appears beneficial, directors must ensure that all material facts are known and that the transaction is fair to the nonprofit and approved by the disinterested directors.4

In the governance area, best practices have focused on director independence. The key is not just financial independence, but independence from the structural biases afflicting boards that are too inbred. Greater diversity among the directors is often beneficial. Lawyers can help nonprofits develop procedures, especially nomination procedures, that increase the diversity among a nonprofit’s directors.

Greater Transparency

Another step in building trust for a nonprofit is to open its operations. The degree of openness will depend on each nonprofit’s situation. A neighborhood association may increase the information available to its homeowners. A large public charity may increase the information available to the general public.5 Financial information is a critical area. Audited or reviewed financial statements are rapidly becoming the standard for all but the smallest nonprofits.6 The rigor of having an independent audit or review bespeaks sound financial stewardship and can aid in soliciting contributions. Nonprofits are also disclosing more about the costs of administration versus programming. Nonprofits can also provide more detailed information about the nature and scope of their operations.

Accountability

The key to accountability is the recognition that a nonprofit’s resources flow from two sources: its contributors and the public. The donations of contributors are apparent. But nonprofits benefit too from the substantial tax relief granted by our federal, state and local governments. Having received these benefits, nonprofits are obligated both to their contributors and to the public.

In a general sense, the obligation is to use their resources wisely in furtherance of the charitable purpose. Diverting resources to non-charitable purposes must be avoided. Nonprofits must avoid excessive administrative costs. High salaries, large fund-raising costs, private benefits and poor recordkeeping, especially undocumented expenses, are common areas of concern. Nonprofits are also accountable for the efficacy of their programs. Are these programs addressing the nonprofit’s mission effectively? While this area can be somewhat subjective, boards can means to measure the outcomes of its programs.

Conclusion

Nonprofits serve society in innumerable ways, and lawyers are often involved in their service. To the extent lawyers can guide these nonprofits to better practice standards, the nonprofits and the public benefit. We lawyers have the satisfaction of knowing that we have contributed to that end.

If you know of an individual or organization that should be recognized for its pro bono efforts, please let us know. Submissions should be forwarded to probono@okbar.org or Pro Bono Services Subcommittee, c/o Judith Maute, University of Oklahoma College of Law, 300 W. Timberdell Road, Norman, OK 73019-0701.

1. While some observations may have broader applicability, as used in this paper, “nonprofits” refers to not-for-profit corporations formed under the Oklahoma General Corporation Act and qualified as exempt organizations under Section 501(c)(3) of the Internal Revenue Code of 1986, as amended. The paper does not deal with non-corporate entities such as limited liability companies and general and limited partnerships, which are not eligible as exempt organizations. It also does not deal with special purpose nonprofits, such as cooperatives, religious organizations or governmental corporations.

2. The reach of nonprofits in the United States is remarkable. Almost half of all adults volunteer each year. Nine of 10 households make charitable contributions. In 2005, Americans gave over $260 billion, which represents 2.1% of our gross domestic product. Giving USA Foundation 2005 Report.

3. Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (2002).

4. The application for nonprofits under Section 503(c)(3) of the Internal Revenue Code requires a written conflict of interest policy. A sample policy is posted on the IRS website. See www.irs.gov/instructions/i1023/ar03. html.

5. All nonprofits file annual reports on Forms 990 or 990-EZ, which are available to the public. The forms disclose sources and uses of funds, account balances, directors and officers, executive compensation, large contributors and some programming activities.

6. While there is no generally accepted threshold for obtaining audits, a congressionally-appointed group – the Panel on the Nonprofit Sector – recently encouraged Congress to require all nonprofits with over $1 million in annual revenues to obtain annual audits and nonprofits with over $250,000 but less than $1 million to obtain a compilation and review of their financial statements in lieu of an audit. See Panel on the Nonprofit Sector, Final Report (June 2005) (available at www.nonprofitpanel.org/final/Panel_Final_Report.pdf).