Wearing the Right “Hat”: the Duty of Loyalty

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When does a nonprofit director or officer owe loyalty to the organization, and just how much loyalty?  The general answer is that by serving a nonprofit, directors and officers put on their “hat” (or role) to serve the nonprofit with faithful allegiance, continually, steadfastly, and without interruption except in the event of occasional conflicts that may arise.  This article continues our series on the three fiduciary duties of directors and officers of a nonprofit corporation, focuses on the duty of loyalty.

The fiduciary duty of loyalty, as recognized under both state nonprofit laws and federal tax law, requires directors and officers to faithfully act in the nonprofit’s best interests. 

Directors and officers must ensure that they do not use their position of trust to confer special benefits on themselves, their families, friends, and others.  This is not to say that all transactions with such parties are prohibited.  However, whenever personal and business relationships co-exist, primary loyalty must be demonstrated toward the corporation by the decision-makers involved.  The most common transactions that risk a breach of this duty involve conflict of interest, misuse of the organization’s information or opportunities, and misappropriation of the organization’s assets.

1. Transactions Involving Conflict of Interest

Generally, a director or officer who may receive a tangible personal benefit as a result of a decision affecting the corporation's business or assets has a conflict of interest.  The board of directors has the responsibility of reviewing potential conflicts of interest.  The board may work through the conflict to achieve a favorable resolution that does not result in any harm to the organization or in a breach of a director’s duty of loyalty.

In general, state and federal laws permit directors to engage in transactions that involve conflicts of interest, under three conditions: (1) all directors are aware of the situation; (2) the interested director does not participate in the decision to engage in the transaction; and (3) the transaction is fair to the corporation.  The purpose of these steps is ensuring the transaction will serve the nonprofit’s best interests.  The consequence of failing to comply may be the invalidation of the transaction as well as significant penalties.

Consider a scenario where a nonprofit corporation is in need of a new roof for its building, and one of its directors owns a roofing business.  The board’s evaluation of the director’s business for a roofing contract will necessarily involve an inherent financial conflict of interest, since the director owes dual loyalty toward both the nonprofit and his own business.  Therefore, the above three conditions must be met in order for the nonprofit to hire him. First, the director must first disclose his interest in the business to the other board members. This disclosure should be reflected in writing, such as in the board minutes.  Second, the conflicted director may not participate in the board’s determination of which roofing business to hire, and her recusal should be reflected in the written minutes too.  Third, the other directors must decide whether the proposed transaction is fair and in the nonprofit’s best interests, such as by obtaining other bids in order to evaluate which bid is best—both in terms of price as well as other objectively relevant factors such as quality of work, timeliness, and reliability. These steps must be followed, even if the director intends to support the organization by providing the roofing service at a substantial discount.

This area is particularly important to the Internal Revenue Service, which is continually on alert for potential conflicts of interest.  Questionnaires in both Form 1023 for Recognition of Tax-Exempt Status and the IRS Form 990 annual information return reflect their concern.  As more fully explained below, if the IRS determines that a director has benefitted from “insider” transactions that involve a breach of loyalty, the Service may discipline the director.  The director may be forced to surrender or pay back the benefits improperly gained.  Other directors who knowingly permitted the improper transactions may also be compelled to compensate the corporation.  Substantial penalties may also be assessed against both the conflicted director and the other complicit directors. 

To protect both the organization and its directors, a conflict of interest policy should be adopted.  The policy should provide specific guidelines to guard the organization from improper conduct, both actual and apparent.  An annual conflict of interest disclosure should also be completed by all directors, officers, and key employees.  The disclosures should be submitted to the board, which will to evaluate them and make decisions in the organization’s best interests.  In the event of later allegations of improper conflicts of interest, it will be paramount to have such contemporaneous documentation.

2. Misuse of Corporation Information or Opportunities

Directors and officers frequently obtain special information about economic opportunities in the course of their governance activities.  The duty of loyalty prohibits them from using this confidential or other special information for personal benefit when such use would disadvantage the corporation.  Directors who serve on multiple boards with overlapping areas of service may be particularly vulnerable.  For example, a director may learn of potential grant or program opportunities that could benefit more than one of the organizations she serves. In that scenario, she should consider recusing herself from the decision-making process on that matter and resigning from one of the boards.

This scenario became reality for a director of Mile-o-Mo Fishing Club in a landmark 1965 Illinois case.  The facts involved a former board president who gained knowledge of a real estate transaction while in office, including the proposed financial terms between the club and the potential seller.  Ultimately, the club did not purchase the property. However, after the president left office, he used this information in negotiating a sale of the targeted property to himself.  The club learned of the transaction and sued him.  The Illinois appellate court ruled that the officer had misused the information he obtained as a board member and therefore had breached his duty of loyalty to the club.  The court ruled in the club’s favor and, as an appropriate equitable remedy, ordered the former director to transfer the property to the club at the same price they had negotiated before his interference.

3. Misappropriate of Corporate Assets or Resources: Inurement and Excess Benefit Transactions

Blatant theft of nonprofit assets is uncommon.  However, it is fairly common for directors and officers to use their positions of influence to gain unauthorized personal access to corporate resources like cars, telephones, office and production equipment, etc.  These activities are often rationalized as a form of casual compensation by a person who works hard as a "volunteer" director.  Sometimes these activities are characterized as “perks” given to board members or added to board-approved compensation packages for employees.  

If these benefits are an improper use of charitable resources, then they will constitute prohibited “inurement of private benefit.”  Section 501(c)(3) of the Internal Revenue Code, under which many nonprofits operate, expressly forbids inurement, as it is antithetical to public charity status.  In other words, the penalty for these improper “perks” could be as serious as a revocation of the organization’s tax exempt status.

Additionally, the organization will be subject to federal intermediate sanctions under section 4958 of the Internal Revenue Code.  This law authorizes “intermediate sanctions” against “disqualified persons,” “organization managers,” and others who receive or approve of improper private benefits, known as “excess benefit transactions” (EBT).  An EBT occurs whenever a disqualified person receives a benefit from an exempt organization (as described in section 501(c)(3) and 501(c)(4) of the Code) that exceeds the value of the services or goods provided to that organization.  The term “disqualified person” includes anyone who exercises (or can exercise) substantial influence over the organization within five years prior to the transactions at issue.  This not only includes directors, trustees, officers, key employees, but also their family members, business partners, or entities in which any of these persons own more than a thirty-five percent interest.  An “organization manager” may include a director or officer.

If an EBT occurs, the disqualified person is required to return the nonprofit to the financial position it would have been in if the transaction never occurred.  Generally, this includes paying back the full amount of the “excess” benefit (plus interest).  The individual is then subject to statutory penalties of up to 225% of the EBT. Paying back the EBT promptly will dramatically reduce the likelihood that penalties will be imposed.  Board members who approve payments of funds or other transactions that are EBTs are subject to personal liability for an excise tax of 10% on each EBT, up to a $20,000 maximum penalty.  Joint and several liability may be imposed in the case of multiple decision-makers.  Organizations may not pay any penalties on behalf of disqualified persons or board members; the liability rests solely with the responsible individuals.  These federal penalties are in addition to any liability imposed under state law for breach of the fiduciary duty of loyalty.  

Other examples of EBTs include compensation and reimbursement expenses paid to disqualified persons.  For example, an executive director’s compensation package may amount to an EBT if it exceeds what would be objectively reasonable pay under the circumstances.  However, certain safeguards can be used to create a rebuttable presumption will arise that the payment is reasonable and thus not an EBT.  First, the compensation plan, including all direct and indirect benefits, should be approved by a disinterested and independent board.  Second, the board should consider comparable pay data for similarly situated organizations.  Third, the decision should be contemporaneously documented in board minutes, written resolution, or as otherwise appropriate.

Another example of EBTs are zero or low-interest loans, such as to help a new executive director relocate.  When a director loans money to a nonprofit organization, an unreasonably high interest rate paid in return to the director may similarly be an EBT.  Perks such as payments by a nonprofit organization on behalf of board members, such as spousal travel or club memberships, also may constitute EBTs under certain conditions.

If an organization makes payments, but does not have or does not comply with a written accountable reimbursement plan for legitimate expenses, the IRS will automatically treat these payments as EBTs.  Where no reimbursement plan is in place, repayment of the unaccounted expenses must be made, regardless of whether the expenses are shown to be legitimate. 

The IRS has demonstrated great concern about potential EBTs and other abuses of charitable resources.  For example, Part IV of the IRS Form 990 contains questions requiring disclosure of all EBTs.  Failure to respond fully may trigger additional late filing penalties for the reporting organization.  In addition, the IRS may consider revocation of the organization’s tax-exempt status for repeated EBTS.

In light of the significant penalties and other adverse consequences to which disqualified persons, board members, and organizations may face, EBTs should be avoided through careful board oversight of financial expenditures, proper due diligence and documentation regarding compensation and other payments, and prompt repayment of any resulting EBTs.

4. Best Practices

For optimal legal compliance, responsible nonprofit leaders are well advised to maintain a conflict of interest policy and to require directors and officers to complete annual conflict of interest disclosures.  Further, as situations arise involving potential conflict of interest issues, nonprofit leaders should address them squarely in order to safeguard the organizations’ charitable assets, its public reputation, and directors’ and officers’ own interests in avoiding improper benefits and unwanted controversy.

With respect to EBTs, nonprofit organizations should make sure that a written accountable reimbursement plan is in place, with a specific requirement that documentation be timely submitted for reimbursement.  The organization should also be scrupulous regarding organizational use of credit cards, requiring meticulous record-keeping and substantiation of expenditures.  Board members may be reimbursed or otherwise spend organizational resources only for legitimate board purposes, such as reasonable expenses related to board meetings, committee work, or other activities on behalf of the organization. 

This blog post is part two of a three-part series on the fiduciary responsibilities of care, loyalty, and obedience.