Oversight: let the donors decide.

As the Senate Finance Committee examines abuses in the nonprofit sector, a variety of proposals are circulating as to how to reform the sector to prevent fraud, mismanagement and waste of donor funds. The tenor of many of these proposals is to offer solutions that place a greater emphasis on increasing substantive regulation of nonprofit activities by the government.

Many of the reforms are past due. But some of the suggested proposals, such as regulation of nonprofit salaries, travel expenses and the size of nonprofit boards, begin to take the nonprofit sector, whose strength is its independence and flexibility, down a path of government control and one-size-fits-all regulation.

The vast majority of the identified charitable abuses that have caused scandals in recent years are already illegal under existing laws. Many nonprofits argue that the solution is to allocate more resources to enforcement. But the reality we face is that the nonprofit sector consists of more than 1.3 million entities with an additional tens of thousands formed each year. The amount of enforcement one can reasonably expect the government to perform even with vastly increased resources will necessarily be limited.

The best approach to resolving these abuses is to increase accountability through a balanced combination of government regulation and enforcement, industry self regulation, and most importantly, increased monitoring by donors, the news media and watchdog groups. The key to success in each of these areas is to increase the mandated disclosure of a nonprofit's mission, operations and effectiveness. With adequate information, the government can set its enforcement priorities in a targeted manner, the public can decide who receives its donations and the news media can expose and shame outlying nonprofits into adopting best practices. This disclosure can be mandated in a way that is not burdensome to the sector.

The increased transparency of nonprofit operations has advantages to both the general public and the nonprofit sector by allowing nonprofits, particularly those that depend upon public support, to make the case for their mission and business models. Donors can choose which nonprofits are worthy of their investment.

In a sense, nonprofits that rely on contributed funds are already more "public" than companies traded on the New York Stock Exchange, and they should be treating their disclosure to donors and the general public as though they were a public company. What company is more "public" than one that depends on annual individual investments to carry out its mission (nonprofits are always in the midst of a public offering of their "shares") and whose "capital" consists entirely of goodwill? In addition, the tax-exempt status of the sector implies a broader public interest.

The Internal Revenue Service (IRS) Form 990 will need major revisions to become an adequate vehicle for increased accountability. As currently constituted the form is extremely difficult to read and understand. It is a tax return, not a document designed for disclosure of information to a person of average business knowledge.

In addition, the Form 990 does not provide clear information in areas that are today of most concern to regulators (including the IRS), watchdog groups, donors and the public at large: demonstration of a clear nonprofit purpose, good governance practices, and disclosure of meaningful financial information, compensation, and conflicts of interest. The current effort by the Panel on the Nonprofit Sector and two workgroups focused on examining major potential revisions to the Form 990 and Form 990 PF holds great promise for realizing practical and meaningful change.

The most expedient solution might be to replace the non-GAAP financial statements in Parts I-IV of the Form 990 with financial statements filed in accordance with GAAP (including explanatory footnotes) for all filets with over $500,000 of annual revenue (reviewed by an independent public accountant for all over $500,000, audited for all over $2 million).

In addition, the disclosure now in Parts V and Schedule A would be replaced with the more meaningful disclosure discussed below. This additional disclosure could be provided in new sections or on an attachment that would contain "plain English" answers (like is now required in public company filings) to the following questions. At the nonprofit's discretion any additional information the nonprofit believes is relevant for a full understanding of its mission and operations may also be included.

The disclosure would include the following:

1. What are the mission activities of the nonprofit?

2. How does the nonprofit evaluate its effectiveness?

3. What were the nonprofit's accomplishments for the past year and what are its goals for the upcoming year (including information on how the nonprofit plans to achieve its goals and improve its mission delivery)?

4. What was the total compensation, including all fringe and retirement benefits, for the five most highly compensated employees of the nonprofit for the past three years? Are non-employee directors/ trustees compensated? If so, how? (The basic disclosure required in the SEC proxy rules provides a good format for this disclosure.)

5. What was the basis for the determination of the total compensation of the executive officers? This type of enhanced disclosure benefits nonprofits that can show a methodical and reasoned process for their compensation decisions. The raw compensation data is currently available but it is provided without any explanation, and the public, armed with the compensation committee's or board's rationale, could make its own determination of whether the compensation is reasonable. The reports of compensation committees found in public company proxy statements provide a useful model.

6. What are the nonprofit's governance practices (e.g., size of board, frequency of board and committee meetings, description of committees)?

7. Does the nonprofit have a code of ethics and conflict of interest policy? Were there any executive officer or director related party transactions in the past three years? If so, please describe.

8. What is the travel reimbursement policy for the nonprofit?

9. For nonprofits with revenue in excess of $5 million, their disclosure should include an understandable discussion and analysis by management of the financial statements describing (i) revenue related activities and the associated costs, (ii) mission delivery and associated costs, and (iii) the cost of administration. The report and the discussion should contain two years of comparative financial information and a report of the Audit Committee (see public company proxy statement disclosure).

Areas that the IRS and the watchdog groups believe are particularly relevant to judging nonprofits (fundraising or other overhead expenses, for example) could be required to be discussed in detail. The nonprofit would be required not only to provide the raw data of overhead expenses versus mission expenses, which are currently available and one of the primary measures for cross nonprofit comparisons, but also to comment on how it accomplishes its mission and measures its impact--the true return on investment discussion that is currently missing from both nonprofit disclosure and the analysis of third party watchdog groups.

10. Provide electronic copies of documents typically filed by publicly traded companies: articles of incorporation, bylaws, material contracts, code of ethics etc. (These documents would be filed only once, and then could be referenced in future filings until modified.)

While increased disclosure would require additional work by nonprofits, I do not believe that requiring this type of disclosure would be unduly burdensome. It is clearly less onerous than substantive regulation, and the level of disclosure could be tiered based upon the size of the entity with certain very small organizations being exempted entirely. The process of requiring an annual public articulation of purpose and reflection on the prior year's activities should help nonprofits focus on accomplishing their mission in accordance with best practices, and such disclosure could be a powerful development tool.

These "annual reports" could be easily accessible for free and available to the widest audience possible through the Internet. Prospective donors could be directed to these reports on all solicitation materials. The increased openness of nonprofits will no doubt discourage indefensible practices and encourage the adoption of more efficient and effective ones.

With this approach we would provide the best environment for an efficient and responsive nonprofit sector in a much more immediate and constructive manner than the government could hope to achieve through regulation. The Panel's recommendations, especially those with respect to increased transparency and accountability, promise to be major steps forward in best practices for the nonprofit sector which will lead to increased public trust in the nonprofit sector.

Sheffield Hale is the chief counsel of the American Cancer Society in Atlanta. Prior to joining the American Cancer Society in 2002, he was a Partner practicing corporate and securities law with the firm of Kilpatrick Stockton, LLP.