Sunday, June 24, 2007

Sox for Nonprofit Entities

Photo Sharing and Video Hosting at Photobucket When it passed the Sarbanes Oxley Act in 2002, Congress' primary focus was on the transparency and governance of publicly traded companies. But the Act has turned out to have a more pervasive influence, affecting not just public companies but also private companies and nonprofit entities as well. A June 18, 2007 report (here) by a special committee of the Board of Regents of the Smithsonian Institution illustrates how extensive the influence of Sarbanes-Oxley has become, and underscores the heightened expectations for corporate governance in the post-SOX era, even at nonprofit entities.

The Smithsonian itself is an unusual creation. It was founded in 1846 as a hybrid public/private institution to receive a bequest from James Smithson. It is organized as a trust, but functions as a body of the federal government, and it in fact receives the majority of its funding from the federal government. The institution is governed by the Board of Regents, whose members include the Vice President and the Chief Justice of the Supreme Court.

Even though the Smithsonian is a unique institution, earlier this year it found itself facing the kind of crisis that has become all too familiar for institutions and entities across the economy. A February 2007 series of articles in the Washington Post questioned the lavish compensation and spending habits of the Institution’s then-Secretary, Lawrence Small. (As a result of the controversy following this publicity, Small resigned as the Institution’s Secretary on March 26, 2007.) The Institution’s Board commissioned a special investigative committee to look into the concerns. The committee consisted of Charles Bowsher (former Comptroller General and head of the GAO), Stephen D. Potts (fomer director of the U.S. Government Office of Government Ethics) and A.W. "Pete" Smith (former head of the Private Sector Council and also former head of Watson Wyatt Worldwide). The Committee issued its Report on June 18.

The Committee’s Report provides interesting detail surrounding Small’s compensation and corporate spending habits, as well as his insular and imperious management style. News coverage discussing the Report’s findings regarding Small’s compensation, spending and management style can be found here and here. But perhaps even more interesting aspect of the Report is the Committee’s comments and observations on nonprofit corporate governance in the post-SOX era.

The Committee’s governance commentary derives from its observation that “the root cause of the Smithsonian’s current problems can be found in failures of governance and management.” The Committee specifically observed that “as a result of the corporate scandals of the early part of this decade and the adoption of the Sarbanes-Oxley Act of 2002, boards of directors have become increasingly active,” and “many nonprofit institutions have also updated their governance practices following the adoption of Sarbanes-Oxley.” The governance structure of the Smithsonian, the committee found, needs “comprehensive reform,” a process to which the Institution’s Regents “must devote substantial time and resources over the next several months.”

Many of the Committee’s suggested reforms are narrowly targeted to the issues of setting and monitoring the Smithsonian’s Secretary’s salary and spending. The Report also contains numerous recommendations to revise the Board of Regents' composition and process to better position the Board to function more consistently with current governance best practices. The Committee recommended modifying the Institution’s board governance structure, so that the Smithsonian is “run by a governing board whose members act as true fiduciaries and who have both the time and the experience to assume the responsibilities of setting strategy and providing oversight.” The Committee also stated that the Institution’s “system of internal controls and audit needs to be strengthened through additional resources, adoption of best practices, and retention of personnel with substantial experience in the financial and audit area.”
The Smithsonian is far from the typical nonprofit entity, but the problems it faces and the governance reforms it must implement represent increasingly common challenges for nonprofit entities generally. Indeed, the Committee expressly recognized that the Smithsonian’s challenges present issues with implications for all nonprofit entities. The Committee further noted that the increased scrutiny and expectations for transparency raise “the issue of effective management of nonprofits and how governance at these entities should be structured, the responsibilities of their boards of directors and trustees and how oversight of these organizations should be provided.”

The Committee commented that “boards of nonprofits – especially large nonprofits – should move to reform their governance structures to bring them in line with best practices.” While some nonprofits have made progress, others have not, about which the Committee commented that “failure to take voluntary action will likely lead, ultimately, to action by Congress, state legislatures, and the courts to impose reforms from without, just as was done in the case of the corporate world.”

Even without the Committee’s warning about possible legislative or judicial mandates, nonprofit entities have sufficient motivation to address heightened governance and transparency expectations. Well-advised entities are already taking steps to implement reforms addressed to governance, financial controls and reporting, and oversight.

There are a number of good resources on the meaning of SOX for nonprofit entities, a few of which may be found here and here. My recent article on the implications of Sarbanes-Oxley for private companies can be found here.

One final observation is that it is not at all surprising that the Smithsonian’s present challenge, like so many that have arisen in the for-profit world, derives from issues surrounding executive compensation. For whatever reason, executive compensation seems to be the bane of all organizations, regardless of their profit orientation. For that reason, the effective and well-documented regulation of executive compensation should be an indispensable part of any organization’s institutional reform.

Photo Sharing and Video Hosting at Photobucket The Smithsonian Still Has Hope: For all of its present ills, the Smithsonian remains the repository of many of the world’s irreplaceable treasures. A favored childhood memory of a visit to the Smithsonian includes a visit to the Museum of Natural History’s Gem Collection, which houses the astonishing Hope Diamond. According to popular legend, the Hope Diamond carries a curse that brings misfortune on its owner. Among the unfortunate who supposedly have suffered as a result of the curse is Louis XVI, who gave the diamond to Marie Antoinette. Their enjoyment of the diamond's ownership was, shall we say, cut short.

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