Fraud in the Nonprofit Sector

Fraud (or willful withholding of pertinent financial information) in the Nonprofit Sector and what a foundation should examine when considering a grant.

In my time serving the board of trustees of a foundation, I’ve come across a few types of outright fraud. After reading an article in today’s Wall Street Journal involving a leader of a Florida non-profit involved in a theft ring, I thought I’d write about a few cases of fraud I’ve encountered in my experience and provide a few suggestions for how to spot them.

Note: Occupational fraud is a type of fraud committed by employees against employers. Occupational fraud in the nonprofit sector is a serious topic and not one taken lightly. None of the content here is directed toward any specific non-profit nor is it intended to shed light on financial fraud of which I’m aware. Fraud happens, but fortunately it doesn’t happen often. A 2021 study found that nonprofits represented 9% of the fraud cases examined and suffered a median loss of $75,000. Of the nonprofit cases, the average loss was $639,000.

One example below is not fraudulent and is entirely legal, but in the framework of a foundation conducting due diligence in anticipation of awarding a financial award, it can at the very least be labeled ‘willful negligence’ or ‘strategic withholding of pertinent financial information.’ 

Let’s examine a few types of occupational fraud (and one ‘not so fraudulent’ (willful withholding of pertinent and relevant financial information?) case) and identify some common areas to analyze in your due diligence work. Again, each of these involved an actual case.

Staff Members Skimming Funds Off the Top

One of the ‘oldest’ types of fraud but often the most difficult to spot. Often not evident when examining financials and audits. In my experience, the one major case of skimming funds to pay for private expenses was solved due to a rumor. Unfortunately, the board had also heard rumors about financial abuse but were hesitant to ask the hard questions. Ultimately, it took a journalist to start asking questions for the matter to come to light. 

Required Due Diligence for a Program Officer

This type of fraud usually takes two to tango. One person usually works within the finance department and has oversight on spending while the other may work in another department.

If the board is composed mostly or entirely of close associates and/or friends of the CEO along with other members who may be entirely checked-out on oversight matters, it may warrant closer attention. Does the organization change auditors on a regular (3-5 years) basis? If not, why? Organizations should change auditors on a regular basis to insure proper financial oversight from an outside party.

Board Members Self-Dealing

Another common area of fraud involves board members engaging in self-dealing practices. This can include scenarios such as entering a purchasing agreement on a piece of property, procuring the property, subsequently allowing the property to deteriorate and become condemned and then repurchasing it (usually from the tax authorities) at a significantly reduced price. 

Required Due Diligence for a Program Officer

This can be a difficult area of due diligence requiring specific attention on each board member and the nature of their relation to the non-profit. Is there a network of board members involved in joint business matters? Not a red flag per se, but this type of fraud usually requires the involvement of at least a majority of board members. In this case, a cluster of board members were working jointly to carry out this fraud. A number of other board members were minimally involved in conducting oversight of the agency.

Borrowing Against Real Estate

This last type is not a form of fraud but can be a potential area of willful ignorance or  mismanagement. Nonprofits sometimes borrow against the properties (buildings or land) they own to fund initiatives or cover operating costs. While this is a common practice, it becomes risky when an organization enters a purchasing agreement on an asset with a mortgage involving a balloon payment due several years down the road. 

In one instance, an organization owed a balloon payment on a note. The amount was equal to one year’s operating budget and due in two years. The agency had less than 5% of their operating budget on-hand in cash. Minus a willing donor appearing at the last minute, the organization was headed for a financial reckoning. This became an issue when the matter was only brought to light during the due diligence process. Organizations should bring these types of arrangements out up front, along with a plan to make the payment. 

Required Due Diligence for a Program Officer

This obligation might not be apparent in regular financial statements, may not be evident as an expense when reviewing monthly financials but would be buried in auditors\’ notes. Careful scrutiny of audit reports is necessary to identify such hidden financial risks.

Understanding these potential fraud scenarios and being vigilant about financial oversight can help nonprofit leaders protect their assets and maintain the trust of their stakeholders. It can also help foundations avoid instances of loss from poor investment decisions.