Nonprofit Governance Reform: Rating Agencies Join The Fray
by Andrew J. Demetriou Fulbright & Jaworski L.L.P. Los Angeles, CA
Over the past three years, nonprofit organizations have wrestled with the degree to which they should undertake the types of governance reforms that are mandated for SEC registered companies under the terms of the Sarbanes-Oxley Act. Common reasons for proceeding slowly, or not at all, were that Sarbanes-Oxley Act does not apply to nonprofits, and except in a handful of states, such as California, there have been no state law mandates for change. There are also practical considerations that militate against strict application of Sarbanes-Oxley in the nonprofit context, including significant differences in the development and expectations for board members, focus on mission rather that profitability and the overlay of federal exempt organization rules.
As a consequence, management of some nonprofit institutions has resisted efforts to reform and have continued practices that arguably are inconsistent with trends prevalent in the for-profit world. Recently, pressure to reevaluate and consider changes in corporate governance has come from a source that will directly affect the pocketbook of many large nonprofit organizations—the agencies that rate tax exempt debt. All three of the major rating agencies, Standard & Poor’s, Moody’s and FitchRatings, have issued statements and/or revised their ratings criteria this year with respect to nonprofit corporate governance issues for healthcare institutions with rated debt. In their comments, they have specifically referenced reforms mandated by Sarbanes-Oxley for public companies as models, and indicated varying levels of expectation that issuers adopt these or similar governance measures.
It is difficult to know exactly how the evaluation of corporate governance will play into ratings for issuers of debt, as none of the rating agencies has explicitly assigned a value to governance factors. However, the mere fact that the rating agencies are stating that responses to specific governance inquiries will be considered in assigning a rating creates a strong incentive for nonprofit organizations to examine and implement reforms. This article will review the pronouncements of the rating agencies and assess the potential impact on issuer organizations.
In its August 9, 2005 Health Care Special Report, FitchRatings identified specific sections of Sarbanes-Oxley that it “views as most relevant to not-for-profit hospitals and healthcare systems and their relative importance to the credit rating process.” Fitch also notes its expectation that future state legislation will mandate Sarbanes-Oxley reforms. The Fitch report identifies three principal areas as important—1) relationships with outside auditors, including limitations on non-audit services and rotation of audit teams (Sections 201, 203 and 204 of Sarbanes-Oxley); 2) internal process, including audit committee charters and financial expertise, certification of financial statements, forfeiture of bonuses tied to restated financial results and adoption of codes of ethics (Sections 301, 302, 304, 406 and 407); and 3) assessment of the adequacy of internal controls (Section 404). Fitch concludes by stating that it will pose specific questions to the board of issuer organizations, relating to audit committee procedure and expertise, certification of financial statements and bond covenants concerning quarterly and annual reports to bondholders, policies on ethics and restatement of financial information, whistleblower and compliance procedures, and the degree to which the board intends to audit financial controls.
Fitch’s guidelines are the most closely aligned with Sarbanes-Oxley, and as a consequence, may present the greatest hurdle to nonprofits that have resisted change. The focus of Fitch appears to be on quality of financial statements and accountability for financial presentations. However, compliance with outside auditor standards, particularly rotation of audit teams, is directly contrary to the advice some nonprofits have received to date from their audit firms, which have viewed preservation of the existing audit team as a cost effective expedient.
Certification requirements are another area in which many nonprofits have justifiably resisted change, since, in the absence of reporting requirements in accordance with SEC Rule 15c2-12 for publicly traded debt securities, there is no particular regulatory body or corporate constituent to which the certification should be made. Fitch does not provide much guidance on this point, except to assume that an increasing number of issuers will be required in the future to issue quarterly financial reports to bondholders, rating agencies and “others” in accordance with bond covenants, and it notes that many issuers have begun to post quarterly financials on their websites. Fitch also highlights several specific elements of what it describes as “good quarterly financial disclosure,” including management discussion and analysis, variance from annual budget and notice of material events beyond what is identified in SEC rule 15c2-12. Adding a management certification requirement, while certainly consistent with accountability, may have the undesirable side effect of dramatically expanding the circle of individuals who may claim reliance on the certification, especially if it is attached to financial statements posted on the internet.
Perhaps the most controversial aspect of Fitch’s statement is that the certification of financials is “less meaningful” in the absence of a “[Section] 404-like” assessment of internal financial controls. Efforts by public companies to comply with Section 404, and Public Company Accounting Oversight Board Auditing Standard No. 2, have resulted in substantial expense to reporting companies, with debatable improvement in the quality of financial reporting or disclosure. In addition, the sheer volume of work required to complete the outside assessment of controls required by the law has taxed the capacity even of the Final Four major accounting firms. Recent reports indicate that Section 404 audits focus on as many as 40,000 “key” financial controls and the process has become a largely mechanical “check the box” exercise. As a result, the SEC has pushed back effective dates for compliance with Section 404, and both the SEC and PCAOB have issued statements suggesting that the focus on individual financial controls is misplaced. Against this backdrop, suggesting that nonprofits take on the burden of compliance with Section 404 may not be feasible or financially practical.
Moody’s took a different tack in its Special Comment (June 2005), which stated that governance is a critical issue in the healthcare sector. The Comment notes that “[g]overnance can be an important contributor to the rating outcome, particularly if the hospital’s rating is on the borderline of two rating levels.” Moody’s did not endorse compliance with specific provisions of Sarbanes-Oxley, but rather identified seven factors that it regards as relevant to an assessment of governance: (1) development of the organization’s mission; (2) selection and evaluation of senior management; (3) board composition and performance; (4) understanding and interpretation of financial reporting; (5) use of performance metrics based on external benchmarks to review institutional performance; (6) maintaining and building the organization’s financial resources and (7) avoidance of conflicts of interest.
The choice of these factors reflects an emphasis on practices that will demonstrate value only in the longer term, or in times of institutional crisis, rather than exalting the formality of specific application of Sarbanes-Oxley criteria to a nonprofit organization. While quality of financial presentations is important, Moody’s is more concerned with issues such as review of the quality of management and assurance that the board will be active in preventing poor strategic decisions by management. However, in its report, Moody’s points to the emerging federal and state standards for governance and suggests that its evaluation factors reflect certain core dimensions of governance that are consistent with these developments. Moody’s also sets out particular questions it will pose to directors of nonprofit organizations, to elicit details about compliance with governance factors, and indicates that it may request a meeting or telephone conference with leading board members in cases where the organization is involved in significant strategic change, a major transaction or is subject to unfavorable publicity surrounding litigation or conflicts of interest. The purpose for such inquiries to understand how governance principles adopted by the institution are employed in practice.
Standard & Poor’s (S&P) has been the least specific in its guidance to issuers on governance matters, but its 2005 Public Finance Criteria for Not-For-Profit Healthcare comments on the trend toward adoption of governance reforms and the fact that “many not-for-profit boards have adopted some or all of the rules articulated in the federal Sarbanes-Oxley legislation.” This statement does not reveal which of the Sarbanes-Oxley rules are viewed by S&P as particularly important or helpful. Rather S&P merely states that it wants to understand a board’s view of these rules and what, if any, have been adopted by the board of directors of an issuer. In this respect S&P appears to focus on an evaluation of a board’s choices to adopt particular governance reforms as opposed to mandating specific practices. Thus, S&P has arguably left itself open to follow, or not follow, Fitch and Moody’s on particular issues.
Each of the rating agencies notes that it is difficult to assign quantitative measures to governance issues, and none comments on the degree to which the identified governance issues will actually affect a rating. Fitch did not imply that it will mechanically grade an issuer based on the degree to which it has complied with some or all of the identified provisions of Sarbanes-Oxley and adjust a rating accordingly. In fact the comment was cautionary on a critical issue, namely whether nonprofits should undertake the expensive effort to have an external audit of internal financial controls. Similarly, Moody’s and S&P have sought to identify more general attributes of management that will contribute to long term financial health of issuers—which must be understood in this context as the ability to meet bond covenants and service long term debt.
There is the prospect of great uncertainty for bond issuers, given the differences in focus of the rating agencies. Inconsistent standards for assessment of the governance measures adopted by healthcare institutions may cause the boards of issuers to reconsider governance reforms that were tailored to particular needs of the institution, and may impact settled relationships with outside auditors. It is important that an element of certainty on the necessity of particularly expensive and complex features, such as required certification of financials or assessment of internal financial controls, emerge in the near future.
The pronouncements of the rating agencies will certainly add momentum to governance reform efforts and spotlight particular areas, such as certification of financial statements and assessment of internal management controls, that have not received as much attention as board composition, audit committee practices and ethics policies. Other than broad enactment of Sarbanes-Oxley reforms by the states, this development will probably have the greatest impact on the adoption of emerging governance practices, given the degree of reliance of significant nonprofit organizations on the capital markets and the financial impact of even a fairly minor change in the rating of debt. These developments deserve ongoing attention from boards of directors, management and advisors to nonprofits issuers of debt securities.
NONPROFIT GOVERNANCE REFORM: RATING AGENCIES JOIN THE FRAY
Andrew J. Demetriou, Fulbright & Jaworski L.L.P., Los Angeles, California
The Corporate Compliance & Regulatory Newsletter - www.ljnonline/alm?compliance, Volume 3, Number 5, January 2006
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