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Nonprofit Basics: Director Duties and Best Practices for the Typical Nonprofit Public Benefit Corporation

June 1, 2022 Podcast
EO Radio Show

Welcome to EO Radio Show, Your Nonprofit Legal Resource, brought to you by the Exempt Organizations Group at Farella Braun + Martel. My name is Cynthia Rowland and I'm a partner at Farella. I'm a business and tax lawyer with more than 30 years of experience advising clients on nonprofit and charity law.

Under state law, the business and affairs of a nonprofit corporation must be managed and all corporate powers are to be exercised by and under the direction of the board of directors. Each director has personal duties to the corporation. Principally, these duties are the duty of care and the duty of loyalty. And that's what we'll talk about today.

This nonprofit basics episode addresses director duties and best practices for the typical nonprofit public benefit corporation. In the first section, I'll summarize the duty of care, including a discussion of the manner in which a careful director meets this standard. The second section discusses the duty of loyalty with a particular emphasis on dealing with actual and potential conflicts of interest.

So let's talk about the duty of care. The legal definition requires that a duty act in good faith in a manner he or she believes to be in the best interest of the corporation, which includes making reasonable inquiry, when appropriate, just as an ordinarily prudent person would do in a similar position and under similar circumstances.

Let's talk about what this means in practical terms. This duty means that a director has to make him or herself reasonably informed, has to actively participate in the decisions of the board by asking questions and proceeding with further investigation when appropriate, and acting honestly, carefully, cautiously, and at arm's length.

The key to being a good board member is not that the director never makes a wrong decision or that the director knows every technical detail about a topic that comes before the board. Instead, the key is to engage in a decision-making process that's deliberate, thorough, and thoughtful in its exploration and identification of the issues and alternatives that face the corporation under the particular facts and circumstances.

So let's talk about the practical application of all of this. A careful director attends meetings regularly. Attendance at a board meeting isn't a privilege that can be delegated. This means that a director can't vote by proxy. A director needs to be informed and aware. And the only way to do these things is to attend scheduled meetings either in person or by video, which should occur at regular intervals. Directors should be cautious about ratifying or authorizing major corporate activities or transactions by written consent.

Let's talk a little bit about appropriate preparation. Courts have been particularly critical of directors who don't avail themselves of the material information pertinent to the matter on which they are asked to vote. A director should carefully study the material available in advance of the board meeting. If a director feels that the information supplied by staff is inadequate in any respect, the best approach is to ask for additional information. A director should ask questions. The director's duty isn't to know everything, but it is the duty to probe, test, and judge the reliability and accuracy of the information presented.

Board members should also keep their own notes and make sure that contemporaneous minutes are prepared for the board meeting. Each meeting of the board should be recorded to include the people in attendance. And usually, the formal minutes are prepared by the secretary or counsel to the board. Contemporaneously prepared minutes are an important documentation of the issues that came before the board and the roles of the directors in confronting those issues. And the minutes provide an accurate history for the corporation. So thinking about particular transactions, the director's duty is to review the material terms, but not necessarily the final documents. The director should understand and approve the material terms when making a decision.

So let's talk about relying on others. A director can carry out his or her duty by relying on expert reports in certain circumstances. Experts can include officers or employees of the corporation who are believed to be reliable and competent. It can include counsel to the corporation, independent accountants, or other independent committees or board members that the director believes are appropriate for reliance in the particular circumstances. A director doesn't simply rely on those outside experts or presenters and should make reasonable inquiries when the circumstances suggest that more information is needed. In all these decisions, the director should act in good faith when deciding to rely on a particular expert.

Delegation of management and oversight responsibilities is also a key sticking point for many board members. While the board as a whole can delegate the day-to-day functions to others, the director isn't held responsible for those actions or omissions when delegated reasonably to these officers, employees, or agents as long as the persons are prudently selected, reasonably monitored, and relied on. It's unfortunately all too common for directors of nonprofits to become so involved in the day-to-day affairs that they clash with management and staff. To counteract this tendency, most boards formally delegate the authority to the CEO or executive director and individual board members do not get involved in day-to-day activities.

Here are some concepts that make it easy to discern whether a board member should be involved in a question or whether it's something that is deferred to the day-to-day managers. The questions I ask when confronted with a situation where it may or may not be a governance matter for the board are the following: Is it a big issue? In other words, is the question material to the existence of the organization? Is it about the future? Is it core to the mission? Does the decision revolve around a high-level policy for the organization? Does the CEO or executive director want and need the board's support or direction?

When these questions are faced by the board, it's probably a board-level matter if the answer is yes, and the good fiduciary board addresses them. Otherwise, it may well just be a day-to-day matter that the executive director or CEO should handle on their own.

Sometimes, however, a governance question isn't an internal question but rather is driven by external factors. For example, is there a red flag? Is a watchdog watching? I mean, is this something that's going to end up in a contested Twitter stream or some other social media? When the board of directors faces one of these sorts of high-profile issues that will attract a lot of attention, even if it's not warranted, it is appropriate for the board as a whole to determine how best to address the situation. But keep in mind, it's the board as a whole, not any individual director.

So while board members are not involved in all the day-to-day decision-making at the organization and limit themselves to the agenda items that are properly presented at a meeting, the bigger part of their performance is in setting up fundamental controls and oversight mechanisms so that when these key questions that we just discussed come up, they actually do come to the board or are otherwise drawn to their attention. Some of these key governance tools include board policies, audit reports, tax returns, comparisons of prior year performance to current year performance, and to the budget.

In a large organization with a large board, an individual director may have a lot of trouble trying to attend to all of these various features and policies for the organization. So in these situations, board committees are often established with a duty to cover policies and performance on their delegated area of authority. The typical committees are the executive committee, comp committee, audit committee, investment or finance, and nominations and governance committees. Some states actually mandate the use of a comp committee with the duty to ensure compliance with the tax rules that govern compensation of high-level staff and certain other insiders. A number of states also require that there be an audit committee to supervise the independent audit of the organization. While an executive committee isn't mandatory, as a practical matter executive committees are quite useful for organizations with a large board and active programs. The executive committee acts with the full authority of the board between regularly scheduled meetings.

So let's talk a little bit about the duty of loyalty. A loyal director acts exclusively to promote the best interest of the corporation and not for his or her own interest or the interest of any other person or entity. The issues that arise out of a director's duty of loyalty involve conflicts of interest, corporate opportunities, and confidentiality duties.

A conflict of interest arises when a director has a material personal interest, whether or not financial, in a proposed contract transaction or activity that the corporation's involved in. The conflict may be direct, such as the director proposes to provide professional services to the organization for compensation and not pro bono, or indirect, such as a director that has an employment or investment relationship with another party to a transaction with a nonprofit.

Undisclosed conflicts, while not always fatal to a transaction or to the interested director, do expose the interested director and the entire board to substantial risk of personal liability and tax penalties. A wise director always discloses potential conflicts of interest. Disclosure of the conflict accomplishes a couple of things. First, it enables the other directors to evaluate the transaction for fairness. Second, it also allows the other directors to determine whether the public image of the corporation could be adversely affected by moving forward with a transaction that has even the appearance of impropriety.

So in order to limit inadvertent conflict of interest transactions, the board should adopt a formal written conflict of interest policy. The policy should be drafted to require that each person who's in a position to exercise influence over the organization must disclose all entities controlled by him or her, and must recuse himself from discussions of the transactions in which he or the controlled entities are parties. A board should always consult with counsel before entering into a transaction with an insider or an entity in which an insider has a financial interest including the execution, for example, of employment contracts, leases, sales or exchanges of property, and similar financial transactions.

An issue that doesn't come up terribly often in the nonprofit context, but it's still a rule that applies is the doctrine of usurping corporate opportunities. It does occasionally happen that a nonprofit director has an opportunity to enter into a transaction with a third party that the director knows may now or in the future be of interest to the corporation. So a director needs to be careful about presenting an opportunity like this to the nonprofit board before participating in the transaction for his or her own benefit.

Confidentiality. This is also a really important issue for nonprofit directors. As a matter of good business sense, a director should not make public statements about the corporation's private business activities. Private activities that are already known by the public or part of the public record by definition wouldn't be private. But it's those things that an individual director knows about that are not public that are a concern here.

An individual director isn't authorized to be a spokesperson for the board of the corporation and should avoid responding to inquiries particularly about financial information unless specifically delegated that duty. Instead, a director should refer any inquiries to the chief executive, executive director, or some other designated spokesperson. In this way, a director can avoid inadvertently making remarks that could damage the corporation's public image or get in the way of an important transaction, or otherwise adversely affect the nonprofit.

Some public benefit corporations face the unique situation of confronting an individual or group that demands that meetings of the board be open to the public. Mixed public and private activities of the corporation may subject the corporation to a requirement like this for public meetings. Directors should contact counsel if open meetings are desirable or if mixed public-private activities will also arise. In these circumstances, specific confidentiality rules have to be developed in consultation with counsel.

Additional information on these topics and links to other resources will be in the show notes.

And that's it for today. I'm Cynthia Rowland, and you've been listening to the EO Radio Show, Your Nonprofit Legal Resource, brought to you by the Exempt Organizations Group at Farella Braun + Martel. If you have suggestions for topics you would like us to discuss, please email us at [email protected]. Thank you for joining us. Until next time, make a difference.

Show Notes:

Attorney General’s Guide for Charities; Best Practices for nonprofits that operate or fundraise in California; see Chapter 7, Directors & Officers of Public Benefit Corporations

What Every Prospective Nonprofit Board Member Needs to Know by Lauren A. Galbraith, family wealth partner, Farella Braun + Martel

Additional episodes can be found at EORadioShowByFarella.com.

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