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Nonprofit Law and Governance Hazards to Avoid

• Introduction (Golf and Governance)

Hazard #1: Ignoring Basic Fiduciary Duties

Nonprofit governance refers to the work of the organization’s board of directors (or trustees). This work includes establishing the organization’s mission, charting its general direction, providing oversight, ensuring adequate funding, and creating the organization’s culture. Carrying out these responsibilities requires an understanding of the specific legal duties and standards that apply to nonprofit boards.

The legal duties and standards for nonprofit boards are established by state law, and generally may be found in a state’s nonprofit corporations act or similar legislation, as well as in court-established common law principles. Each state’s law may vary as to the precise duties and standards that apply.

Most states require that directors discharge their duties (1) in good faith, (2) with the care that an ordinarily prudent person in a like position would exercise under similar circumstances, and (3) in a manner the director reasonably believes to be in the best interests of the corporation. This list of basic duties may be found in the Revised Model Nonprofit Corporation Act (1987), Chapter 8, Subchapter C (Standards of Conduct), § 8.30 (General Standards for Directors).

In applying these statutes, courts have explained that corporate directors have two basic duties: a duty of care, and a duty of loyalty. The duty of care has been described as a duty to exercise the care that a reasonably prudent person in a similar position would exercise under similar circumstances.

The duty of loyalty relates to the prohibition against self-dealing (acting in one’s own self-interest to the detriment of the organization), and requires that directors be able to show that any particular decision or action is fair and serves the best interests of the organization.

Put another way, directors and officers may not enhance their own personal interests at the expense of the organization’s interests, nor may directors personally profit or benefit at the expense of the organization. Rather, they must promote the interests of the corporation to the exclusion of their own self-interest.

In something of a twist, directors who apply these basic fiduciary duties ARE acting in their own best interest. How so? Because a director who complies with these standards generally may not be held liable for any decision or action (or inaction) of the board, even if that decision or action fails to put the organization in a better position. This legal standard is known as the business judgment rule.

In future posts, I’ll cover specific items, including conflicts of interest. In the meantime, below are examples of what can go wrong when boards ignore their fiduciary duties, and some tips and best practices.

Penalty Strokes

So what happens when boards ignore basic fiduciary duties?

In cases involving a complete abdication of the board’s responsibilities, conflicts of interest, fraud, bad faith, or decisions that are clearly unreasonable based on facts that are known at the time, directors may be held personally liable for resulting damages to the organization or outside third parties. Federal tax law penalties may also apply in certain circumstances (more on these in later posts).

In less severe situations, the business judgment rule ordinarily protects directors of nonprofits from personal liability for a breach of the duty of care. But there are cases when directors of nonprofits have been held personally liable simply for failing to provide appropriate oversight. Two recent examples:

• In 2015, a U.S. Court of Appeals upheld a $2.25 million jury verdict against the directors of a nonprofit nursing home. The directors were held personally liable for breach of their duty of care, based on their failure to remove the nursing home’s administrator and CFO “once the results of their mismanagement became apparent.” See In re Lemington Home for the Aged, 777 F.3d 620 (3d Cir. 2015).
• In 2010, the California Attorney General filed suit against nonprofit and former officers and directors, based on alleged misuse and misappropriation of funds; lack of appropriate controls and oversight. One significant aspect of the complaint is that it did not merely accuse the former directors and officers of affirmative wrongdoing, but suggested they were at fault for failing to provide appropriate oversight. The case was eventually settled. See California v. Monterey County AIDS Project, et al (Monterey County Sup.Ct. No. M105979) (Complaint filed May 21, 2010) (“Complaint”), available at http://oag.ca.gov; see also Attorney General Kamala D. Harris Announces Settlement, Funds Recovered to Benefit HIV/AIDS Patients (Cal. Atty. Gen.), Jan. 20, 2012.

Staying on Par: Tips and Best Practices to Comply with Basic Legal Duties

Below are general tips and best practices for complying with board duties.

• Understand and adhere to requirements and procedures in governing documents (articles of incorporation and bylaws)
• Attend board meetings regularly
• Review meeting minutes, committee reports, and other materials prepared for board meetings in advance; prepare questions and discussion points in advance of the meeting
• Review financial statements, Form 990 (Annual Information Return), audit reports, and reviews and management letters prepared by the organization’s auditors
• Request that experts be retained when the board must make a decision on a matter that exceeds the collective expertise of the directors and chief executive
• Insist on compliance with applicable laws and internal controls, even if compliance may increase the organization’s operational costs or result initially in negative publicity
• Promptly disclose conflicts of interest; adhere to the procedures in the organization’s conflicts of interest policy
• Understand and adhere to policies and procedures of the organization that may involve the board (e.g., confidentiality policy, document retention and destruction policy, etc.)
• Keep sight of the governance role of the board, and avoid crossing the line into the day-to-day management of the organization (micro-managing)
• On the other side of the spectrum, take steps to ensure that the board is fulfilling its governance and oversight functions, and avoid simply turning everything over to the executive director
• Establish committees or working groups to carry out the board’s activities and fulfill its oversight role in particular areas (e.g., audit committee, finance committee, board recruitment committee, etc.)
• Be proactive in creating a sustainable growth mindset and a culture of openness, transparency, accountability, and mission-mindfulness

Next up: Ignoring the distinctions between a privately-owned business and a nonprofit organization