Nonprofit Governance

Attorneys advising nonprofits and their boards of directors must be aware of both the legal norms governing their conduct and the operative public perceptions concerning not-for-profits and their boards. These legal principles are based in both state and federal law, with the requirements of each body of law being generally, but not entirely, consistent. The additional legal pitfalls and operational issues presented in the operation of organizations with voting members corporations are also discussed. This outline will discuss the basic state and federal laws governing the fiduciary responsibilities and potential liability of nonprofit boards and issues related to appropriate governance behavior in each of these contexts.

1. The Legal Duties of Not-for-Profit Officers and Directors: New York State Law

   Officers and directors are considered fiduciaries of the not-for-profit organizations they manage. Scheuer Family Foundation, Inc. v. 61 Associates, 179 A.D.2d 65, 582 N.Y.S.2d 662 (1st Dept. 1992); The Martha Graham School and Dance Foundation, Inc., et al v. Martha Graham Center of Contemporary Dance, et al, 224 F. Supp. 2d 567 (S.D.N.Y. 2002), aff'd in part, rev'd in part on other grounds, 380 F. 3d 624 (2d Cir. 2004). Their fiduciary duties, derived from common law, are articulated in the New York Not-for-Profit Corporation Law (“N-PCL”).

   1. The Duty of Care

      Nonprofit directors and officers owe the organization on whose boards they serve a duty of care, articulated in Section 717 of the N-PCL as follows:

      Directors and officers shall discharge the duties of their respective positions in good faith and with that degree of diligence, care and skill which ordinarily prudent men would exercise under similar circumstances in like positions.

      1. This formulation of the standard of care is an "expansion of the duty of the comparable section of the Business Corporation Law which does not contain the words 'care' and 'skill.'" Manhattan Eye, Ear & Throat Hosp. v. Spitzer, 186 Misc. 2d 126, 715 N.Y.S.2d 575, 593 (Sup. Ct. N.Y. Cty., 1999).

      2. As at least one commentator has observed, this language is too general and nebulous to be a helpful guide to director and officer conduct. See Fishman, “Standards of Conduct for Directors of Nonprofit Corporations,” 7 Pace L. Rev. 389, 393 (1987) (hereinafter “Fishman”).

      3. However, N-PCL § 717 does suggest that the board members must conscientiously decide the matters that come before it, create and enforce “internal information systems” and “serve as a check or veto on management.” Fishman at 393.

      4. The business judgment rule, applicable to New York not-for-profit corporations, creates a bar to judicial inquiry into actions of corporate directors taken in good faith. Consumers Union of U.S. v. New York, 5 N.Y.3d 327 (2005), following Auerbach v. Bennett, 47 N.Y.2d 619, 629, 419 N.Y.S.2d 920, 925 (1979)(business judgment rule applicable to for-profit corporations). See also People v. Grasso, 11 N.Y.3d 64 (2008) (Attorney General cannot circumvent business judgment rule defense by pleading an action disregarding the knowledge element);

      5. On the other hand, where the directors are guilty of “bad faith and self-dealing, or decisions affected by inherent conflicts of interest, judicial inquiry is triggered.” Spitzer ex rel The New Dance Group Studio v. Schussel, et. al., 851 N.Y.S.2d 74 (Sup. Ct. N.Y. Cty 2007) (citations omitted)

      6. In suits by third parties, as opposed to suits by the corporation itself, many states have limited liability to instances involving gross negligence or intentional harm. See, e.g., N-PCL § 720-a.

   2. The Duty of Loyalty

      The duty of loyalty requires a director to pursue the interests and mission of the not-for-profit with undivided allegiance. However, beyond N-PCL § 717(a)'s reference to discharge of directorial duties “in good faith,” there is no statutory formulation of the general duty of loyalty. One must look to case law for an articulation of the standard under New York law.

      1. To satisfy the duty of loyalty, a director must act “'with an eye single to the interests' of the [organization] to whom he owed a fiduciary duty.” The Martha Graham School and Dance Foundation, supra, quoting Donovan v. Bierwirth, 680 F.2d 263, 271 (2d Cir. 1982) Directors must “subordinate their individual and private interests to their duty to the corporation.” Nechis v. Gramatan, 231 N.Y.S.2d 383, 35 Misc.2d 949 (Sup. Ct. Westchester County 1962), quoting Winter v. Anderson, 242 A.D. 430, 275 N.Y.S. 373 (4th Dept. 1934).

      2. They also are prohibited from utilizing their fiduciary position to usurp a business opportunity or advantage available to the corporation. This “corporate opportunity doctrine” has been described as follows:

         If there is presented to a corporate officer or director a business opportunity ... in which the corporation has an interest or a reasonable expectancy, and, by embracing the opportunity, the self-interest of the officer or director will be brought into conflict with that of [the] corporation, the law will not permit [the officer or director personally] to seize the opportunity....

         Robinson v. R & R Publ'g, Inc., 943 F.Supp. 18 (D.D.C. 1996), quoting Guth v. Loft, 23 Del. Ch. 255, 5 A.2d 503, 511 (Del. 1939). See also American Baptist Churches of Metro. N.Y. v. Galloway, 271 A.D.2d 92, 710 N.Y.S.2d 12 (1st Dept. 2000); Bolton v. Stillwagon, 410 Pa. 618, 190 A.2d 105 (1963), Fishman at 431-432.

      3. One particular type of self-dealing conduct - loans from the not-for-profit to an officer or director - is explicitly prohibited by N-PCL § 716.

      4. The duty of loyalty does not bar all transactions between a director and the not-for-profit. Section 715 of the N-PCL allows these “interested party transactions” under certain specified circumstances.

         1. The directors' or officers' interest in the transaction must be fully disclosed to the board or be known by them and the transaction must be authorized by a vote of “disinterested” board members, i.e., a majority of the board that does not include the vote of the interested director. N-PCL § 715(a)(1).

         2. In a membership organization, the transaction may be authorized by a vote of the members, if the material facts of the interest are disclosed to the members or known to them. N-PCL § 715(a)(2).

         3. Interested officers and directors can be present at a meeting at which approval of the transaction in which they have an interest is considered, and they can be counted in determining the presence of a quorum at such meeting. N-PCL § 715(c).

         4. The interested party transaction may still be binding on the corporation even in the absence of the required disclosure and in the absence of a vote of disinterested board members, as where the interested director's vote was necessary for the authorization of the transaction. Under those circumstances, the parties to the transaction must “establish affirmatively that the contract or transaction was fair and reasonable as to the corporation.…” N-PCL § 715(b).

   3. Duty of Obedience

      1. The board has the responsibility to assure that the corporation uses its resources only for the stated purpose and mission of the organization. See Manhattan Eye, Ear & Throat Hospital v. Spitzer, 186 Misc. 2d. 126, 152 (NY Sup. Ct. 1999)(“It is axiomatic that the Board of Directors is charged with the duty to ensure that the mission of the charitable corporation is carried out. This duty has been referred to as the 'duty of obedience.'”)

      2. Not all authorities recognize the duty of obedience as a separate legal duty, however. Comment g(3) to § 300 of Tentative Draft No. 1 of the ALI Principles of the Law of Nonprofit Organizations notes that the Principles “do not employ the terminology of a duty of obedience.” The Comment acknowledges, however, that directors have the duty to assure that the organization's assets are used for its stated purposes and that the organization complies with the applicable law.

2. Internal Revenue Code Rules Relating to Conduct of Fiduciaries

   The Internal Revenue Code (“IRC”) also prohibits acts of self-inurement and self-dealing for tax-exempt organizations. IRC § 501(c)(3) requires that every 501(c)(3) organization be operated exclusively for tax-exempt purposes and that “no part of [its] net earnings ... inures to the benefit of any private shareholder or individual ...” While this prohibition affects individuals other than directors and officers, in practice, these rules have the most direct bearing on those charged with the governance of not-for-profit organizations.

   1. Rules for Public Charities

      IRC § 4958 proscribes “excess benefit transactions” between certain charitable organizations and “disqualified persons” (generally, those in a position to exercise “substantial influence” over the organization). This section gives the Internal Revenue Service the authority to impose penalty taxes (known as “intermediate sanctions,” in contrast to the ultimate sanction, revocation of exempt status) when a transaction is found to bestow an excess benefit on a disqualified person.

      1. Definition of Excess Benefit. An excess benefit transaction is one in which the economic benefit provided to the disqualified person is greater than the return benefit to the applicable tax-exempt organization. IRC § 4958(c)(1)(A). In short, the deal is lopsided in favor of the disqualified person. Such transactions include unreasonable compensation paid to a disqualified person, including reimbursement for expenses, and sales of property to disqualified persons for less than the fair market value of such property. See P.L.R. 200829049 (Apr. 10, 2008) (payment of personal expenses for meals, car payments, clothing and services in the home of a disqualified person constituted excess benefit transactions and contributed to revocation of exemption); P.L.R. 200247055 (Nov. 22, 2002) (no excess benefit found where benefit to physicians who were disqualified persons from hospital's free bus...