California's Nonprofit Integrity Act of 2004 (SB 1262)

Compliance Issues for Charities

Barbara Berg, Counsel, Downey Brand LLP

The big news this year in nonprofit legislation is the California Nonprofit Integrity Act of 2004 (the Act), which became effective on January 1, 2005. If your organization is tax exempt under Internal Revenue Code Section 501(c)(3), or otherwise holds charitable assets, you must be prepared to comply with the provisions of the Act. The Act imposes new governance requirements for charities covered by the Act, specifically in preparing and disclosing annual audited financial statements, establishing an audit committee, and reviewing executive compensation. The Act also places additional requirements on covered charities engaging in charitable fundraising. Finally, the Act may serve as a guide for those entities not subject to the Act but which seek to be in the forefront in nonprofit transparency and accountability in their governance practices.

APPLICABILITY TO CHARITIES
The Act applies to any nonprofit organization which is: (1) a charitable corporation, association or trustee, or any other legal entity holding assets for charitable purposes (which generally include relief from poverty, advancement of education, benevolent or other purposes beneficial to the community); and (2) required by law to register with the California Attorney General. Exempted from the registration requirement and therefore the requirements of the Act are charitable organizations organized and operating primarily as a hospital, religious organization or educational institution. Most but not all of the organizations subject to the Act (hereafter “charities”) are California nonprofit public benefit corporations exempt from federal income tax under IRC section 501(c)(3).

Whether the Act applies to charities organized or operating primarily outside of California, such as a national charitable organization, depends upon the particular facts. If the out-of-state charity solicits donations, conducts charitable activities, has employees, maintains an office, holds funds or other property, or holds board meetings in California, it is likely subject to the Act. However, an out-of-state organization or other organization not otherwise subject to the Act must comply with the Act’s financial disclosure obligations if it controls a covered charity and prepares consolidated financial statements (see below).

GOVERNANCE
For purposes of the governance provisions, the Act identifies three groupings of charitable organizations: (1) those exempted from coverage, as discussed above; (2) those that are required to register with the Attorney General; and (3) those that are required to register with the Attorney General and have gross revenue of at least $2 million. Charitable organizations exempted from coverage, as well as other nonprofits not subject to the Act, may wish to consider adopting some of the Act’s governance practices for the purpose of improving their transparency. A brief discussion of this issue is included at the end of this article. The remainder of this discussion addresses only the other two groupings which are covered by the Act.

Compliance Required of All Charities Covered by the Act
All charities covered by the Act, regardless of gross revenue, are required to comply with the following:

• Executive compensation of the CEO or president, and the CFO or treasurer, must be reviewed and approved by the board of directors or its authorized committee to assure that it is just and reasonable. In addition, regulations proposed by the Attorney General extend the board’s obligation to review and approve compensation to every person who has powers, duties or responsibilities comparable to the CEO, president, CFO or treasurer, regardless of title. The compensation, including benefits, is to be reviewed and approved upon initial hiring, renewal or extension of the employment contract term, and modification of compensation. If the officer has no employment contract, the review should be done as soon as is “reasonable” after January 1, 2005; the Attorney General’s office recommends that it be completed during the first quarter of 2005. If a modification of compensation (e.g., change in benefits) extends to substantially all employees, no separate review and approval of the executives’ compensation is required. Although the requirements of the Act for executive compensation review overlap considerably with the federal excess benefit transaction rules (also known as “intermediate sanctions”), the charity must be careful to comply with both.

• Audited financial statements prepared by those charities required to file periodic RRF-1s with the Attorney General, but not having gross revenue of at least $2 million, must be made available for inspection by the Attorney General and the general public. The inspection requirements are the same as described below for charities with gross revenue of at least $2 million.

• Registration of new charities with the Attorney General must be completed within 30 days after receipt of property for charitable purposes instead of the six months dictated by the previous law. Any new charity that first received charitable property on or after August 1, 2004 must register by January 31, 2005.

Additional Compliance Required by Charities with Revenues of at Least $2 Million
Charities covered by the Act and having gross revenue of at least $2 million for the particular fiscal year are subject to the additional requirements listed below. Gross revenue excludes grants from and service contracts with governmental entities if the governmental entity requires an accounting from the charity of the funds received. However, one time gifts, grants or donations are included in calculating gross revenue, as are non-cash contributions, according to the Attorney General’s office.

• A charity must prepare annual financial statements that are audited by an independent CPA using generally accepted accounting standards, for fiscal years ending on or after June 30, 2005. If a national organization includes a charity that it controls in its consolidated financial statements, and that controlled charity is subject to the Act, those consolidated financials are subject to the Act’s audit and inspection requirements. Note that an extension of the period in which to file IRS Form 990 does not extend the period for preparing the audited financials.

• The audited financials must be made available for public inspection and inspection by the Attorney General within nine months after the close of the fiscal year covered by the financial statement. The rules governing public inspection of the charity’s Form 990s also apply to inspection of the charity’s audited financials. This provides a good opportunity for the charity to review its compliance with its disclosure and inspection obligations for its Form 990s and for its exemption application, determination letter and related documents.

• An audit committee must be appointed by the board of directors of any covered charities operating in corporate form.

FUNDRAISING

Heightened Responsibilities of Charities in Fundraising
Charities covered by the Act must now comply with the following general requirements in their fundraising activities:

• Establish and exercise control over the fundraising activities conducted for the charity’s benefit, including approval of all written contracts and agreements, and assure that fundraising activities are conducted without coercion. Although not required by the terms of the Act, consider adopting record-keeping procedures that will document the charity’s compliance with this overarching obligation.

• When raising funds for other charities, ensure that the other charity is registered with the Attorney General (if so required), and if not, that the charity agrees to register (a written agreement is preferable) prior to the commencement of the solicitation.

• Avoid misrepresenting (by words, acts or the omission of a material fact) the purpose of the charity.

• Avoid misrepresenting the purpose, the nature or the beneficiary of a solicitation by the charity.

• Be familiar with and avoid the Act’s twelve prohibited acts and practices in connection with planning, conducting or executing any solicitation or charitable sales promotion. These twelve prohibited acts are listed in Government Code section 12599.6(f), and also on the Attorney General’s website (reference below). The prohibitions cover a number of types of misrepresentations, such as:

The Charity’s Contracting Responsibilities
When entering into a contract with a commercial fundraiser or fundraising counsel, the charity must now comply with the following contract-related requirements to avoid violating the Act:

• Only enter into an agreement with a commercial fundraiser or fundraising counsel who is registered with the Attorney General or, if not registered, agrees (preferably in writing) to register prior to the commencement of the solicitation.

• Enter into a written contract with the commercial fundraiser or fundraising counsel for each solicitation campaign, event or service. The contracts must be made available for the Attorney General’s inspection, and must contain provisions regarding:

The Charity’s Contract Cancellation Rights
The covered charity now has an array of rights to cancel or terminate a contract with a commercial fundraiser or fundraising counsel, specifically:

• The charity has the right to void a contract with a commercial fundraiser or fundraising counsel if either of those parties is not registered with the Attorney General prior to commencement of the solicitation.

• The charity has a “cooling-off” period, i.e., the right to cancel a contract with a commercial fundraiser or fundraising counsel within 10 days of the contract execution, without liability.

• After the 10-day cancellation period, the charity may terminate such contract by giving 30 days’ written notice; however, the charity will be liable for any services provided by the commercial fundraiser or fundraising counsel up to 30 days after the charity serves the termination notice.

• After the 10-day cancellation period, the charity may terminate such contract at any time by written notice, without compensation, if the fundraiser or the fundraising counsel (1) makes any misrepresentations in the solicitations or with respect to the charity; (2) is found by the charity to have been convicted of a crime arising from a charitable solicitation that is punishable as a felony or misdemeanor; or (3) otherwise conducts fundraising activities in a manner that could cause public disparagement of the charity’s good name or good will.

The Act also imposes substantial new requirements directly on commercial fundraisers and fundraising counsel; however, these requirements are beyond the scope of this discussion.

GUIDANCE FOR NONPROFITS NOT COVERED BY THE ACT
The governance practices implemented by the Act specifically for charities can also serve as a model for exempted charitable organizations and other nonprofits not covered by the Act.

First, preparing audited financial statements may benefit nonprofits by potentially uncovering financial irregularities in the early stages. In addition, providing audited financial statements to its members or constituents may serve to strengthen its relationship with those groups. Similarly, an independent audit committee can demonstrate the unbiased nature of the nonprofit’s audited financials.

Periodic review and approval of executive compensation is important for many nonprofit public benefit corporations, as state law requires that executive compensation of directors as officers be “just and reasonable”. For other nonprofits, periodic review of executive performance and compensation is simply a prudent practice.

Finally, any nonprofit engaging the services of a consultant for fundraising (even if it is not for charitable purposes) could consider incorporating into the fundraising contract provisions derived from the Act. Specifically, it may be appropriate to include terms regarding not misrepresenting the nonprofit’s purposes and the use of the solicited funds, the fundraisers handling of the funds received, and that the nonprofit controls the fundraising.

A complete copy of SB 1262 as enacted can be downloaded from the following website: http://www.leginfo.ca.gov/bilinfo.html. Additional information on the Act, including the Attorney General’s Guide to the Nonprofit Integrity Act and related FAQs, is available at: http://caag.state.ca.us/charities/index.htm.