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Fraud has organizational consequences.

Fraud can scuttle nonprofits but the bigger and older ones fare better

After a director of the Fairmont-Marion County Food Pantry embezzled more than US$50,000, it had to close for two months in 2009 – leaving 1,200 West Virginians who depended on it in a temporary lurch.

The effects of this kind of malfeasance may appear straightforward. Charities caught committing fraud become untrustworthy in their donors’ eyes. Without money, they no longer can serve the public.

That food pantry overcame that crisis and reopened. But as scholars who research nonprofit fraud, we wanted to discover what long-term consequences befall organizations that are supposed to do good things when some of their staff are caught doing bad things.

The frequency of fraud

First, we identified charities that had committed a publicized act of fraud. Then we scoured public filings, news stories and social media for evidence of life after the fraud.

We found that 1 in 4 of these nonprofits closed down for good within three years. That is significantly higher than the overall 4 to 16 percent rate at which nonprofits became defunct during the same time period – the years 2000 to 2012.

Once we saw the big picture, we investigated the factors driving this outcome. We wanted to know if it had to do with the structure of the organizations, the people who commit fraud or the type of fraud committed.

As it turns out, it was a little bit of each.

Other researchers had already documented that newer organizations are more likely to shut down than older ones. Similarly, smaller organizations are more likely to fold than larger ones.

Some downsides to being a newbie

As we explained in the journal Nonprofit Management & Leadership, we found that these concepts hold true with nonprofits after fraud is publicized. Older organizations and ones with bigger budgets and more assets were more likely to survive fraud that had come to the public’s attention than their newer, smaller counterparts.

Consider the fate of the United Way in D.C. The former head of that large nonprofit, which was raising more than $90 million annually, stole almost $500,000 from it. After this wrongdoing came to light in 2002, the organization scaled back some services but continued to exist.

Why? Organizational theory experts Michael Hannan and John Freeman have identified several reasons.

Notably, the leaders and staff of newer organizations tend to lack skills and experience, which leads to problems with reliability and accountability. Newer nonprofits may also lack the structure, systems and routines that older organizations typically possess.

Smaller organizations have the disadvantage of being less able to withstand financial shocks than their larger counterparts because they operate on smaller budgets and lack deep pockets. They may also have trouble fundraising, and often find it difficult to compete for good employees. These struggles can make it harder to recover from a crisis.

Who done it to whom

It also matters what type of fraud took place.

When the nonprofit committed a fraud against the public, the organization was less likely to survive than in cases when an employee or a volunteer preyed on the nonprofit.

When an executive-level employee at the nonprofit committed the fraud, the nonprofit was less likely to survive than if a lower-level employee did it.

For example, the Virginia-based nonprofit Domestic Values Education and Support Inc., a domestic violence counseling group, was forced to shut down following the theft of funds by the organization’s chief financial officer.

Senior managers have easier access to the organization’s funds, financing and official paperwork, potentially making the fraud they commit consequential enough to lead to the organization’s ruin.

What is a nonprofit to do?

Of course, charities can’t instantly become older and larger to avoid risk. However, newer and smaller nonprofits can model the behavior of their older and larger counterparts by adopting fraud prevention and governance measures.

For example, a recent study by Young-Joo Lee, an expert in public and nonprofit management, finds that older and larger nonprofits are more likely to adopt good governance policies.

For example, adopting strict rules regarding the approval of expenditures, and limiting who gets access to cash, can sign checks or use an organizational credit card reduce opportunities to commit fraud.

Other best practices include improving the oversight of personnel screening during the hiring process and supervising staff members well.

We also recommend that nonprofits adopt whistleblower policies, establish tip hotlines and give all employees the chance to be in-house watchdogs if they spot wrongdoing. It also helps to have actively involved boards of directors that include trustees with enough financial expertise to keep an eye on the nonprofit’s managers.

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