SOX and Non-Profits: Governance Standards for your Board of Directors

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1 SOX and Non-Profits: Governance Standards for your Board of Directors Keith J. Halleland, Esq. Halleland, Lewis, Nilan & Johnson PA 2005 Compliance & Ethics Institute September 13, 2005 Surviving in a Hostile Environment Sarbanes-Oxley and corresponding thinking Criminal enforcement risks Regulatory enforcement risks Whistleblowers Civil (tort) claims and punitive damages Federal and state enforcement Media and public scrutiny

2 Having Your Program Used Against You Failing to meet your own standards Audits, investigations, and other assessments May become litigation roadmaps If you find a problem or weakness, fix it! Don t ask questions if you are not prepared for the answers Follow-up, follow-up, and follow-up Prevention Effective Compliance Program Empowered, available Compliance Officer Nexus between HR and Compliance Exit interviews Auditing and Monitoring Based on Risk Areas and other trends Focus on Board Education and Good Governance

3 Basics of Corporate Governance Board of Directors/Trustees: Membership Independent Directors Inside Directors Key Committees Audit Committee Compensation Committee Qualified Legal Compliance Committee Basics: Directors Fiduciary Duties The Fiduciary Good Faith Obligation Question of Director s state of mind Director must put best interests of corporation first Director must not violate known applicable law Director must not consciously or intentionally disregard his/her responsibilities Lack of good faith may be inferred from a Board decision that is irrational, irresponsible, or beyond reason

4 Basics: Directors Fiduciary Duties The Fiduciary Duty of Care Generally requires reasonable diligence in: Becoming informed about the subject matter of Board decisions, and Continued monitoring and oversight of corporate activities Triggers protection of the Business Judgment Rule Caremark compels Directors to assure that an adequate information and reporting compliance system is in place Basics: Directors Fiduciary Duties The Fiduciary Duty of Loyalty Directors may not usurp opportunities that are made available to the corporation Directors may not use corporate assets for personal gain Directors may not participate in transactions in which they have interests other than their interests as Directors

5 Basics: Directors Fiduciary Duties The Fiduciary Duty of Obedience to Purpose Applies only in the not-for-profit context Board actions and decisions must have bases in educational or charitable purpose for which entity was incorporated Recent Considerations Expanding application of the obligation of good faith in case law: Walt Disney Co. (Del. 2003) knowing or deliberate indifference to fiduciary duties of care or loyalty = bad faith Emerald Partners (Del. 2003) we don t care about the risks attitude = bad faith

6 Recent Considerations US Department of Justice Corporate Leniency Policy corporation may not be criminally charged where it Reports illegal/non-compliant activity to government before it finds out from other source Takes prompt and effective action to terminate such activity (including corporate compliance program) Reports such activity with candor and completeness Makes its report a corporate act, rather than a series of individual ones Makes restitution as appropriate Does not coerce nor lead other parties to participate in illegal/non-compliant activity Recent Considerations SEC Enforcement Model corporation may not be charged by the SEC where it Establishes effective compliance and selfpolicing procedures Conducts a thorough internal investigation and promptly and completely discloses the results Undertakes appropriate remedial and disciplinary actions Cooperates with SEC in a timely fashion

7 Recent Considerations Sarbanes-Oxley Act of 2002 Applies directly to public companies, but also affects private and not-for-profit companies by: Establishing new norms and best practices Possibly serving as a model for state laws of broader application Possibly providing content for reasonableness standards embodied in fiduciary duties Possibly providing safe harbors under other rules, regulations, and duties Serving as a model for potential federal legislation governing not-for-profit entities Recent Considerations: Sarbanes-Oxley Requirements Audit Committee Must be made up of only independent directors (those not employed by or under contract with the corporation other than for service on committee) Must include at least one financial expert or must disclose absence of such with explanation Must be given sufficient budget and authority to hire counsel and advisors and to oversee outside auditors Must pre-approve all audit and non-audit services provided by outside audit firms Must consider all reports of material violations of securities laws or fiduciary duties (unless Qualified Legal Compliance Committee fills this role)

8 Recent Considerations: Sarbanes-Oxley Requirements Qualified Legal Compliance Committee Creation is optional, but it would replace requirement for noisy withdrawal of attorney reporting material violation Must be comprised of at least one member of the Audit Committee and two or more other independent directors Must be given authority to receive reports of material violations and require corrective action by the corporation If corrective action is not taken, members must report material violation to SEC Recent Considerations: Sarbanes-Oxley Requirements Compensation and Nominating Committees NYSE and NASDAQ rules adopted pursuant to Sarbanes-Oxley require Boards to adopt updated committee charters spelling out purposes and responsibilities Boards must prepare and adopt: Corporate Governance Guidelines Codes of Ethics and Business Conduct

9 Recent Considerations: Sarbanes-Oxley Requirements Senior Officers (CEO and CFO) Must certify that financial statements fairly present in all material aspects the financial condition of the corporation Must certify that disclosure controls and procedures have been put in place and must assess their effectiveness annually Must return bonuses and equity income if the corporation has to amend financial statements due to material noncompliance of company as a result of misconduct Recent Considerations: Sarbanes-Oxley Requirements Corporate Counsel Inside and outside counsel must report known or reasonably suspected material violations of fiduciary duties up the ladder (including noisy withdrawal or report to Qualified Legal Compliance Committee)

10 Recent Considerations: Sarbanes-Oxley Requirements Outside Auditors Cannot cross-sell other services to corporations that they audit Must rotate audit partners every five years May not be fraudulently coerced or influenced by directors, officers, or employees Recent Considerations: Sarbanes-Oxley Requirements Miscellaneous Provisions Corporation cannot make loans to directors or senior officers (except generally available commercial loans) Shareholders must approve material changes in equity compensation plans Corporation must provide protection for internal whistleblowers Criminal penalties for destruction, falsification, alteration, or concealment of documents

11 Recommendations Take steps to make directors more aware of compliance issues arising in the corporation and better equipped to address situations when they arise Tailor director selection process Increase director training Craft director informational materials in easily understandable language and format Regularly assess director effectiveness Recommendations Directors should exercise stricter oversight in the form of constructive skepticism Board should ask questions rather than simply relying on conclusions of management Board should request additional information when inadequate facts have been provided When management oversees response to compliance events, Board should require frequent updates

12 Recommendations Expand the role of independent directors in day-to-day oversight and response to compliance events Independent directors should constitute majority of Board membership Board may create position for principal or chair independent director Independent directors should meet regularly outside presence of management Independent directors should populate Audit Committee, Qualified Legal Compliance Committee, and Compensation Committee Recommendations Create additional effective reporting channels Corporate counsel and compliance officer should meet with the Board, Audit Committee, Qualified Legal Compliance Committee, and/or independent directors outside of presence of other officers Meetings should be held regularly (quarterly?)

13 Recommendations Remember that fiduciary duties are creatures of equity, rather than law This means that they are flexible and contextdependent This means that they rely on reasonableness and common sense rather than formal check the box requirements Compliance with Sarbanes-Oxley requirements will provide evidence of reasonableness Recommendations Report all significant compliance problems to the Board Significant = Material under GAAP Serious Violation of Law Strong government interest Publicity likely

14 Recommendations When does the Board take direct responsibility for significant compliance issue? Materiality is the issue and must be considered carefully Where does management s role end and the Board s begin? Non-Profit Recommendations Insider Transactions and Conflicts of Interest Non-profit organizations should not provide personal loans to directors or executives If loans are provided, all terms should be disclosed and approved by the Board Effective and updated conflicts of interest policy

15 Non-Profit Recommendations Certified Financial Statements The Chief Executive Officer and Chief Financial Officer and Board of Directors of a non-profit should review the Form 990 or 990-PF before it is submitted to the IRS to ensure that it is accurate, complete, and filed on time Non-Profit Recommendations Independent and Competent Audit Committee All non-profit organizations that conduct outside audits should have separate audit and finance committees

16 Non-Profit Recommendations Whistleblower Protection Non-profit organizations should develop, adopt, and disclose a formal process to deal with complaints and prevent retaliation Non-profit leaders must investigate employee complaints and correct any problems or explain why corrections are not necessary Non-Profit Recommendations Document Destruction Non-profit organizations should have a written, mandatory document retention and periodic destruction policy, which includes guidelines for electronic files and voic If an official investigation is underway or even suspected, non-profit management must stop any document purging in order to avoid criminal obstruction