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The Law and Intent of

Sarbanes-Oxley on Board

Accountability

2009 Wisconsin Rural Health

Conference June 18, 2009

David J. Edquist, Esq.

414.287.1372 or dedquist@vonbriesen.com

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Corporate Integrity Under Siege

• Enormous healthcare recoveries by government

• Management scandals – United Way

– NYSE

• Accounting/financial scandals– Enron etc.

– HealthSouth Corp.

– Tenet Healthcare

• Focus on nonprofit corporate governance– IRS

– Senate Finance Committee

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Director’s Role is Increasingly Important

• Law looks to institution of the board of directors to be part of solution

– State law on board accountability

– Sarbanes-Oxley

– IRS – Good Governance Guidelines

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Nonprofit Boards:Basic Elements

• Duty of good faith

• Best interests of the organization

• Care exercised by ordinarily prudent person under similar circumstances

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Director’s Duty of Care

• Corporate directors must exercise the proper amount of care when making decisions. Decisions should be made:

– in “good faith”

– with the level of care that an ordinarily prudent person would exercise in a similar situation

– with the best interest of the Corporation in mind

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Duty of Loyalty

• Conflicts of interest

• Written policies

• Loans

• Charitable trusts

• Corporate opportunity

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Duty of Obedience

• State and federal law

• Filing requirements

• Governing documents

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Beyond the Basics:Emerging Consensus on

Best Practices in Governance

• More formality

• More diligence

• More documentation

• More disclosure

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Where Does Sarbanes-OxleyFit in this Mix?

• Financial focus

• Roles of:

– Auditors

– Management

– Board

• 2002 law

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SOX and Related Reforms

• Corporate governance and related reforms directly enacted by Sarbanes-Oxley

• Reforms mandated by Sarbanes-Oxley and implemented by other regulatory bodies

• Reforms not mandated by Sarbanes-Oxley, but required by stock exchange listing standards

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Reforms Mandated by SOX

• Accounting Oversight Board

• Auditor Independence

• Corporate Responsibility

• Enhanced Financial Disclosures

• Analyst Conflict of Interest

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Reforms Implemented by Other Regulatory Bodies

• Accounting Oversight Board

• Audit Committee “Financial Experts”

• Certifications on Financial Controls

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NYSE, NASDAQ and Amex Reforms

• Director Independence

• Executive Sessions

• Committee Requirements

• Nominating/Governance Committee

• Compensation Committee

• Audit Committee

• Corporate Governance Guidelines

• Code of Ethics

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Application of SOX to Nonprofit Organizations

• Most SOX provisions do not apply to NFPs

• NFPs generally not “issuers” subject to SOX

• Obstruction of justice provisions apply to NFPs:

– Whistleblower

– Destruction of documents

• External pressures

• Voluntary adherence

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NFP Pressure to Adopt SOX

• “Governmental agencies and public companies, including insurers, will be interested in the extent to which hospital boards have adopted the provisions of accounting reform laws like those introduced by the Sarbanes-Oxley Act.”

• International Journal of Environmental Research and Public Health (2/26/09)

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NFP Pressure to Adopt SOX

• Public accounting firms looking for SOX governance model, whether required or not

• Public awareness has created spillover effect into NFP realm

• Moody’s credit ratings may take governance policies into account

• NFP boards are adopting SOX reforms on a “best practices” basis

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NFP Acceptance of SOX

• Nonprofit Governance in the United States (Urban Institute):

– Substantial percentage of nonprofit board members are not actively engaged in basic governance activities such as fundraising, monitoring programs, and community relations

– Policy makers such as Senate Finance Committee believe that one way to prevent future scandals is to strengthen governance

– IRS believes that good governance practices may lead nonprofits to comply more fully with tax laws and better achieve their charitable purposes

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NFP Acceptance of SOX

• Nonprofit Governance in the United States (Urban Institute):

– Many nonprofits are voluntarily adopting Sarbanes-Oxley provisions such as external audits, independent audit committees, and conflict of interest policies

– Compliance is particularly likely with nonprofits that include board members who also serve on corporate boards, and who bring Sarbanes compliance perspectives to nonprofits

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NFP Acceptance of SOX• Expected that hospitals and healthcare

systems would embrace financial accountability and reporting requirements of SOX.

• Current pressures for better performance and accountability.

• Adoption of SOX provisions on financial reporting should strengthen governance.

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NFP Acceptance of SOX

• Adoption of SOX may soon be seen as the standard for hospital governance effectiveness.

– “Building an Exceptional Board: Effective Practices for Health Care Governance.” Report of the Blue Ribbon Panel on Health Care Governance (2007)

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Key SOX areas for Hospitals

• Independent Audit Committee

• Issuance of financial statements and mechanisms for internal controls

• Ethics code for management and executive compensation

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SOX and Audit Committees

• Centralizes audit function

• Responsible for hiring outside auditors, which report directly to audit committee

• Minimize overlap among audit, financial and investment committees

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SOX and Audit Committees

• Assures that boards have access to findings

• Allows boards to focus on oversight responsibilities

• Holds management accountable for results

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Audit Committee Membership

• Audit Committee must be comprised of “independent” board members

• One member should be a “financial expert”

– A person who through education or experience has expertise in GAAP, and

– preparation of financial statements, accounting principles, internal controls, and audit committee functions

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Financial Expert

• Enhances understanding of audit process

• Increases board accountability

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Audit Committee Role

• Appointment, compensation and oversight of auditor

• Auditor reports directly to audit committee

• Approval of all audit and permitted non-audit services

• Handles complaints about auditing and internal controls

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Auditor Responsibilities

• Rotate audit partner every five years

• Auditor must attest to and report on management’s assessment of internal control structures and procedures

• “Cooling off” period of one year between hiring of audit staff as senior executive and next audit by same firm

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Restrictions on Auditor Activities

• Bookkeeping or similar services

• Financial information system design and implementation

• Appraisal or valuation services, fairness opinions

• Actuarial services

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Restrictions on Auditor Activities

• Internal audit outsourcing services

• Management functions or HR

• Broker-dealer, investment advisor, or investment banking services

• Legal services and expert services unrelated to the audit

• Any other services that the board deems impermissible

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SOX: Disclosure and Integrityof Institutional Information

• Disclosures by nonprofit organizations

• Executive certifications

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Financial Statements andInternal Controls

• CEO and CFO must

– certify quarterly and annual financial reports

– establish and maintain appropriate internal controls

– disclose to the auditor and audit committee any fraud or deficiencies in internal controls

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Financial Statements

• Must be prepared in accordance with GAAP

• Each periodic report must disclose all material off-balance sheet transactions and other relationships with unconsolidated entities

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Other Disclosures

• Material changes in financial condition or operations must be disclosed on a rapid and current basis

• Entity must disclose whether

– there is a code of ethics

– audit committee has at least one “financial expert”

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Codes of Conduct:Ethics and Business

• Conflict of interest policies

• Ethics and business conduct policies

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Whistleblower protections

• Required protections for employees of public companies or audit firms

• No express guidelines

– Policies

– Anonymity

– Reporting

– Retention

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Document Retentionand Destruction

• Prohibits the destruction of documents to impede any investigation whether already begun or only being contemplated

• Prohibits altering or concealing of any document subject to an official proceeding

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A Second Look at SOX• Defining Board priorities

– Clinical Care

– Patient Safety

– Regulatory Compliance

• vs.

– External financial reporting

– External auditing

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A Second Look at SOX• SOX: audit and reporting focus

• Stock exchange rules: governance

– “the new listing requirements of the stock exchanges are broader, clearer and better prescriptions for governance reform”

– “Looking at Sarbanes-Oxley isn’t enough”

• “Strengthening Governance in Hospitals and Health Systems” American Governance Group (American Hospital Association 2004)

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A Second Look at SOX• Stock exchange rules potentially appropriate for

healthcare entities:– Adoption/disclosure of governance guidelines

– Codes of business conduct

– Separate audit, compensation and governance/nominating committees composed of independent directors

– Committee charters

– Executive sessions of independent directors

– Executive compensation

– CEO certifications of compliance with governance standards

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A Second Look at SOX• Even as to financial issues, Boards

must balance their oversight role for financial performance with the pressures of financial accountability

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The Role of Hospital Boards: Financial Oversight

• How do boards interpret their role in financial oversight and the way they use financial information to make decisions that impact hospital financial performance?

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Core Financial Responsibilities

• Set financial objectives

• Review and align management’s financial plans with stated objectives

• Enhance creditworthiness

• Effective allocation of capital

• Monitor financial performance

• Verify financial statements

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Financial Literacy• Hospital boards typically have a diverse

membership

• Reliance on finance committees to monitor financial performance, oversee budgeting and capital expenditures, and endowment performance

• Some members of finance committee should have a business background

• Recent study found no correlation between financial knowledge and higher financial performance

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Financial Transparency

• Publish financial reports for stakeholders

• Internal distribution of financial reports

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SOX: Open Questions

• SOX may tend to refocus boards on overall performance

• Will adoption of SOX actually improve overall financial performance?

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SOX: Open Questions

• Does making boards more accountable for financial transactions relative to financial risks push boards more toward financial performance and management rather than financial oversight?

• Will the adoption of SOX principles ultimately interfere with a board’s financial oversight role?

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SOX: Open Questions

• Given increasing concerns over allocation of limited resources, will a focus on SOX principles interfere with a board’s oversight role relative to clinical and compliance functions?

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IRS and Good Governance: Picking Up Where SOX Leaves Off?

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IRS: Why Practice Good Governance?

• Increases the likelihood that the organization will:

– Comply with tax law;

– Protect its charitable assets; and

– Best serve its charitable beneficiaries.

• Sound management practices result in more efficient operations.

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IRS and Good Governance

• IRS Code does not mandate particular management structures or governance policies.

• IRS posted a draft of good governance practices on its website on Feb. 7, 2007.

• After the redesign of the Form 990, the IRS removed the governance document.

• Current IRS position on nonprofit governance is best reflected in the reporting required by the new Form 990.

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Governance and Related Topics• IRS website still maintains a section devoted to suggested policies

and practices regarding:

– Mission

– Organizational Documents

– Governing Body

– Governance and Management Policies

– Financial Statements and Form 990 Reporting

– Transparency and Accountability

• Recommends that organizations consult “Principles for Good Governance and Ethical Practice: A Guide for Charities and Foundations” by the Panel on the Nonprofit Sector.

• The following slides detail suggestions by the IRS and the Principles guide.

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Mission

• Regularly review the organization’s mission.

• A clearly articulated mission:

– Explains the organization’s purpose; and

– Guides the organization’s work in addressing what it hopes to accomplish the activities it will undertake, and the population it serves.

• Review is recommended every five years.

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Organizational Documents

• Provide the framework for governance and management.

• Regular review helps ensure that the organization is abiding by the rules it has set for itself, and identifies whether changes are needed.

• Review could be delegated to a committee, but full board should review and act upon the committee’s recommendation.

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Governing Body

• An active and engaged board is vital to a tax-exempt organization’s success.

• Organizations with affiliates, chapters, or other branches should have procedures in place to ensure that activities and operations are consistent with the parent organization.

• Board should meet regularly enough to conduct its business and fulfill its duties.

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Governing Body Size

• Board size is an important factor.

• Board size should be appropriate to the organization’s size.

• Small boards may not represent broad public interest and lack the required skills.

• Boards that are too large may find decision-making difficult; consider delegating responsibilities to committees.

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Governing Body Members• Members of the governing body should be:

– Independent (majority should not be employees of connected to the organization through family or business relationships)

– Informed about the mission of the organization

– Selected with the organization’s needs in mind (e.g. accounting, legal, marketing, fundraising, etc.)

– Reflective of the culture and community served by the organization

• Consider the requirements of current and prospective funding sources; certain grants require specific representation on a board.

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Educate Governing Board

• Orientation should detail the broad oversight responsibilities and specific legal and ethics duties.

• Ongoing process includes ensuring that members receive pertinent information, within a reasonable time, on issues to be addressed at board meetings.

• Board should evaluate its performance as a group and as individual members periodically in order to effectively remove board members who are not fulfilling their responsibilities.

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Governance and Management Policies

• As previously noted, the IRS does not require specific management policies.

• The word “governance” never appears in IRS Code § 501.

• Some public comments on the final Form 990 question whether the IRS has the authority to regulate in this area.

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Governance and Management Policies

• Governance is a focus of IRS tax-exempt organizations section.

• IRS reviews applications for tax exemption and Form 990 to determine if an organization has implemented policies regarding:– Executive compensation - Fundraising

– Conflicts of interest - Investments

– Whistleblower Claims - Document retention

– Documenting governance decisions

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Executive Compensation Policy• Executive compensation is a focus point in IRS

examinations.

• A tax-exempt charity may not pay more than reasonable compensation for services rendered.

• Compensation should be determined by those knowledgeable in compensation matters who have no financial interest in the decision.

• Establish clear policies regarding payment or reimbursement of expenses by anyone conducting business or traveling on behalf of the organization.

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Executive CompensationRebuttable Presumption: IRC § 4958• Compensation is presumed to be reasonable if:

– Compensation arrangement is approved in advance by an authorized body composed entirely of individuals with no conflict of interest with respect to the arrangement;

– Authorized body obtained and relied upon appropriate data as to comparability prior to making the determination; and

– Authorized body adequately documented the basis for its determination concurrently with making the determination.

• Comparability data includes compensation levels paid by similarly situated organizations for functionally comparable positions.

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Conflict of Interest Policy

• Members of the governing body owe a duty of loyalty to act in the best interest of the organization.

• IRS encourages adoption of a policy to avoid conflicts and act without regard for personal interests.

• Policy should apply to directors, trustees, officers, committee members, and employees and conform with state law.

• Distinguish between a “material” conflict and situations that merely have the appearance of a conflict.

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Conflict of Interest Policy

• IRS has sample policy for healthcare organizations (handout).

• Directors, trustees, officers, employees, committee members and others should periodically be required to disclose known financial interests that the individual or his or her family member has in an entity that transacts business with the organization.

• Governing body members with a material conflict of interest are required to recuse themselves from votes and discussions regarding those matters, other than to respond to information requests.

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Investments Policy

• Governing body or trustees may be required by state law or the organizational documents to oversee or approve major investments, such as joint ventures, for-profit subsidiaries, and other financial investments.

• Organizations making such investments should adopt written policies requiring evaluation of the investment to safeguard the organization’s assets and tax-exempt status.

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Fundraising Policy• Policy should ensure compliance with federal and state law.

• Specify that solicitation materials will be accurate, truthful, and candid.

• Charities are encouraged to keep fundraising costs reasonable and provide information about fundraising practices to the public.

• Provide donors with specific acknowledgements of charitable contributions in accordance with IRS requirements.

• Do not compensate internal or external fundraisers based on a percentage of amounts raised.

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Governing Body Records Policy

• Minutes of meetings and actions taken outside of meetings should be contemporaneously documented.

• Any supporting documentation for a decision, such as reports regarding fair market value, disclosure of conflict of interest, etc. should be kept with the minutes of the meeting.

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Document Retention Policy• Establish standards for document integrity, retention, and

destruction of files, including electronic files.

• IRS Code requires an organization to keep books and records relevant to its tax exemption and IRS filings.

• Include the following:– Retention time

– Backup procedures

– Archiving of documents

– Regular reliability checks on retention and destruction system

– Specify that any document destruction will be immediately halted if an official investigation of the organization is underway or anticipated.

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Code of Ethics• Demonstrates compliance with ethical standards that

promote the public good.

• Develop a code of ethics that describes behavior the organization wants to encourage and behavior it wants to discourage.

• Code should fit the organization’s characteristics and be complemented by policies describing how the code of ethics will be implemented.

• Adopt a policy for handling employee complaints and procedures for employees to report in confidence any suspected misuse of the organization’s resources.

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Whistleblower Policy

• Adopt a policy for handling employee complaints and procedures for employees to report in confidence any suspected misuse of the organization’s resources.

• Stipulate that there will be no retaliation against individuals reporting a suspected violation.

• Some larger organizations have created computerized systems allowing for anonymous reports, and toll-free numbers, or intranet site reporting of misconduct.

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Financial Oversight by Governing Body

• Governing body oversight includes:– Regular of review financial statements, auditor’s

or audit committee’s reports, and Forms 990.

– Review and approve of the organization’s annual budget and monitor actual performance against projections.

– Ensure that a large percentage of the annual budget is spent on programs/activities that further the exempt purposes.

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Transparency and Accountability

• IRS Code requires that an organization make available for public inspection its:

– Application for tax exemption

– Form 990

– Form 990-T

• Consider how these documents will be made available to the public, such as an annual report, through the organization’s website, etc.

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Putting It All Together• Best Practices: an Integrated Approach

– SOX

– Exchange rules

– IRS guidelines

– Other resources (e.g. NACD)

• Compliance only vs. good governance

• Decide what you want to accomplish through good governance practices

• Identify where you are on spectrum of implementation

• Make governance a continuing topic of discussion

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Questions?