California Nonprofit Integrity Act of 2004
By Susan B. Waters, CAE, Sextant Consulting

The California legislature fancies itself the leader of political thought in the country and believes that it is its responsibility to enact legislation and regulation to serve as a standard for the rest of the country. So, it is not surprising that California is the first state to attempt to extend Sarbanes-Oxley-like requirements to nonprofit organizations, and to make the legislation far reaching. The California Nonprofit Integrity Act of 2004, which took effect on January 1, 2005, does just that.

What Organizations are Subject to the Act?

The act applies to charitable corporations, unincorporated associations, trustees, commercial fundraisers and fundraising counsel that are domiciled in California or conduct activities or hold property in California. Specifically, the act applies to organizations exempt under IRS sections 501(c)(3) and 501 (c)(4) that have gross revenues (as shown on line 12 of Form 990) of $2 million or above, although certain governance requirements apply to all covered organizations, regardless of the level of income (see below). The budget base excludes government grants or contracts that are subject to audit by the governmental agencies.

Foreign corporations (to California) that have offices in California or own real property in California are covered by the act. For example, a national organization that solicits contributions from people in California is covered by the act, even if the amounts raised in California are minimal. If a nonprofit charity has a meeting of its governing body or its membership in California, the act applies. If an officer or employee of the charity performs work in California, it is covered. (This could be bad news for Californians who seek elective office in national organizations not otherwise doing business in California.) If the charity does business with a financial institution located in California, it is covered.

Not covered are educational institutions, hospitals, cemeteries, and religious organizations.

Are organizations organized under IRS section 501 (c)(6) that do not engage in fundraising covered by the act? An argument can be made that the specification of 501(c)(3) and 501(c)(4) implies their exclusion, unless they are engaged in fundraising. However, the California Nonprofit Integrity Act of 2004 never clearly defines a charity, and California common law defines the term charitable purpose broadly and includes poverty relief, advancement of education or religion, promotion of health, governmental or municipal purposes, or other purposes that are beneficial to the community (see California Attorney General’s Guide for Public Charities 2, 1988 and “California Enacts Sweeping Governance Reforms for Nonprofits, ASAE’s Association Law and Policy Special Report by Jeffrey S. Tenenbaum, Esq. and Tammy W. Klein, Esq., Venable LLP, November 30, 2004). An argument can also be made that any association organized for the promotion of health is covered. Likewise, virtually all associations advance education for their members, so if they conduct any business in California, including perhaps holding a conference there, they may be covered. Finally, since we argue that association activities that promote professions or trades are beneficial to the public, this could bring all associations under the provisions of this act.

What Does the Act Require?

Governance Provisions that Apply Regardless of Revenues

The Board of Directors, or a designated committee of the Board, must review the compensation of the chief executive officer and chief financial officer to ensure that it is “just and reasonable” whenever one of those officers is hired, their term of employment is renewed, or the compensation is changed, including annual performance salary reviews. The only exemption from this requirement is if there is a salary adjustment, such as a cost of living adjustment, that applies to virtually all employees, and is applied equally to the two officers. If the organization is affiliated with other organizations, then this is satisfied so long as the board of the charitable organization that makes compensation and retention decisions about these officers undertakes this review. Therefore, chapter boards should not be required to review the compensation of the CEO and CFO of a national parent, and federated organizations need not review the compensation of these officers in affiliated organizations.

If the charitable organization has financial statements prepared by the Certified Public Accountant and is required to file reports with the Attorney General, then the financial statements must be made available to the Attorney General and the public.

Provisions that Apply to Organizations
with Gross Revenues Exceeding $2 Million

Annual Audits

Charities with gross revenues in excess of $2 million, as shown on line 12 of the 990 form, must have an annual audit, performed by an independent CPA according to Generally Accepted Accounting Principles (GAAP) and according to the standards established by the Government Auditing Standards Board (GASB), and published in the Yellow Book, which is available from the U.S. Comptroller General. Standards for auditor independence will apply if the auditor or audit firm provides other services to the charity, consistent with the Yellow Book. Yellow Book standards are less onerous than those in Sarbanes-Oxley, a compromise that was hard won in the legislative process.

The audited financial statements must be made available to the Attorney General and the public within 9 months of the close of the fiscal year. The disclosure standards are consistent with the disclosure standards that apply to form 990. This means that the audit reports must be made available for a period of three years at all offices of the charity during normal business hours, and must be mailed to any person requesting a copy in writing, or, alternatively, may be made available on the charity’s public web site.

Audit Committee

Those charities that are required to have an annual audit must also have an audit committee appointed by the Board. No member of the charity’s staff and no person having a material financial interest in any entity doing business with the organization may serve on the audit committee. Non-board members may serve on the audit committee. The chair of the audit committee may not be a member of the finance committee, if the organization has one, but members of the finance committee may serve on the audit committee so long as they make up fewer than half of the members. Compensation to audit committee members may not exceed compensation to board members.

The audit committee is responsible for recommending the hiring or termination of the audit firm, and the compensation to the audit firm. The audit committee must meet with the auditor to satisfy itself that the financial affairs of the charity are in order, must review the audit report, and must approve any non-audit services provided by the audit firm to the charity.

Fundraising

Charities must exercise control over all fundraising activities, including the approval of all contracts with fundraising counsel or commercial fundraisers. There must be a written contract for each campaign, service or event that specifies the legal name of the charity, the charitable purpose of the campaign, the obligations of the parties under the contract, the fee to be paid by the charity for fundraising assistance and a good faith estimate of the percentage of the funds raised that will be paid for fundraising assistance if the fee is fixed, and disclosure of the percentage if compensation is set in that manner.

Commercial companies that provide fundraising services and fundraising counsel must register with the Attorney General. Notice of any fundraising campaign, event or service must be provided to the Attorney General not less than 10 days before the activity commences and must specify the contact information of the charity and any fundraising company or counsel, the methods to be used, and the duration of the campaign. If the fundraising campaign or event is for assistance after a disaster, this notice must be provided by the date of the commencement of the campaign or event.

Fundraising may not be coercive and may not misrepresent the organization’s purpose or the purpose of the beneficiary of the solicitation. Misrepresentation may be established based on word, conduct or failure to disclose a material fact.

Where Can I Get a Copy of the
California Nonprofit Integrity Act of 2004?

A copy of the act is available at www.leginfo.ca.gov/pub/bill/sen/sb_1251-1300/sb_1262_bill_20040930_chaptered.html.

Summary

The California Nonprofit Integrity Act of 2004 is the first state statute that applies Sarbanes-Oxley-type requirements to nonprofits. This act was sponsored by the Attorney General and applies to California charities and out of state or foreign organizations that conduct activities or hold property in California. It makes significant changes in governance requirements for all charitable entities and imposes new requirements on those entities with gross revenues in excess of $2 million, and on firms that provide fundraising assistance or counsel. During the legislative process, the proposal was significantly modified to ease the requirements, establish Yellow Book, rather than Sarbanes-Oxley, standards, and limit application to charities with gross revenues in excess of $2 million. Still, the changes are significant and covered organizations should become familiar with the requirements of the act. Charities based outside of California may well be covered, and the governance, audit and audit committee requirements may extend to associations that do not conduct fundraising activities. Other states, such as New York are considering similar legislation that could require covered entities to register in multiple states.