- Richard L. Duquette
Corporate Culture and Bicyclists: Part 2 of 3 Nonprofit Law and Ethics©
Here in Southern California, we in the bicycling community are fortunate to have a wide array of nonprofit organizations that represent our interests in a variety of ways. These groups not only organize races, rides, and other events that bring us together around our shared passion, but also provide education, information, advocacy, and support. I am a member and proud sponsor of many of these organizations.
So, in the interest of strengthening these organizations, I wanted to share some insights gleaned from my years of legal practice that will help these organizations to continue effectively serving their members and avoid some pitfalls that can sabotage their organizational goals. Disclaimer: The information in this article is for general information purposes only. Nothing in this article should be taken as legal advice for any individual, organization, case or situation. This information is not intended to create, and receipt or viewing does not constitute, an attorney-client relationship.
l. Overview: Categories of Nonprofits
Although corporations are in some sense governed by their own bylaws, these bylaws exist in the context of and as a supplement to the universally applicable principles set forth in statutory law. This article provides general information concerning the legal principles governing nonprofit corporations, including the powers and duties of directors and officers.
These principles apply to all California nonprofit corporations, regardless of whether corporate bylaws spell out these requirements in detail. The corporation itself is a creature of state law, and corporate bylaws are a legal requirement for corporate status. It follows that the bylaws themselves exist in the shadow of the laws that create them.
Nonprofit corporations are governed by both State and Federal Law. For purposes of corporate organization and governance, they are generally governed by California Corporations Code. For purposes of Federal Income Tax, they are governed by the tax exemption provisions of the Internal Revenue Code, specifically 26 U.S.C. §501.
Under the Corporations Code, there are different types of nonprofit corporations. These include, but are not limited to: Social Purpose Corporations, Public Benefit Corporations, Mutual Benefit Corporations, and Religious Corporations. Each of these types of corporations, and certain others designated as special purpose corporations, falls into one of the various tax-exempt categories of Section 501(c) of the Internal Revenue Code.
This article focuses on the rules governing Public Benefit Corporations, though many of the principles discussed will be relevant to the other categories of nonprofits as well.
ll. Avoiding Conflicts of Interest and Self-Dealing
By law, all corporations are required to have a Board of Directors and Executive Officers. Directors are elected in rotation and serve terms defined in the bylaws. Their role is to meet occasionally and establish long-term policy for the corporation. Executive officers answer to the Board of Directors, and are responsible for the day to day operations of the organization.
Corporate directors and officers have a fiduciary duty to the corporations they serve. A fiduciary duty is a unique responsibility in the law that applies to persons in a position of power and trust. Because of this position of power and trust, the fiduciary is required to not only act competently on behalf of the person to whom the duty is owed, but also to act in the best interests of that person—even to the fiduciary's own detriment (these are known as the twin duties of due care and loyalty). The classic examples of fiduciaries are attorneys, trustees, agents, and executors. However, as explained below, the law also imposes such a duty on corporate directors and officers, whether the corporation is for profit or not for profit.
California law explains the fiduciary duties of nonprofit corporate directors in the following terms: "A director shall perform the duties of a director…in good faith, in a manner that director believes to be in the best interests of the corporation, and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances." Corporations Code §5231(a) (emphasis added).
It is generally assumed that the standard of care owed by officers is similar or close to that of directors. However, courts have recognized that an officer's obligation may be even greater than that of a director to conduct diligent inquiry under certain circumstances, owing to the officer's more active involvement in day-to-day operations. Gaillard v. Natomas Co., (1989) 208 Cal.App.3d 1250.
This standard of care for nonprofit corporate directors is nearly identical to the standard imposed on directors of business corporations (Compare: Corporations Code §309). The difference is that nonprofits have no shareholders, so the director's duty is ultimately to advance the corporation's purposes as stated in its governing documents, rather than to advance the interests of individuals. Directors are obligated to champion the best interests of their organization (and the organization's constituents), rather than personal interests. In practice, this means there are certain things directors and officers cannot do. For example:
With some narrow exceptions, directors and officers are generally not permitted to use their influence in a corporation to direct business to their own private interests. Self-dealing is defined by Corporations Code §5233 as "a transaction to which the corporation is a party and in which one or more of its directors has a material financial interest."
The exceptions to the prohibition against self-dealing are elaborated on in the same section. The primary exception is that directors may participate in decisions relating to their own compensation.
A second exception is when the transaction is (1) a part of a public charitable program of the corporation enacted in good faith and without unjustified favoritism, and (2) the benefits accruing to directors or their family are incidental as members of the class that the program is intended to benefit.
The third major exception is when the interested director or directors had no actual knowledge of the transaction, and it does not exceed the lesser of 1% of the corporation's gross annual receipts, or $100,000.
Apart from these exceptions (which are really more like exclusions), self-dealing transactions may be legally entered into only if approved or validated by (1) the Attorney General, (2) a court, (3) the board of directors, or (4) a committee authorized by the board of directors. The board should seriously consider placing any above issues, like compensation (or a change in the bylaws), up for a vote of the general membership. Counsel should be consulted.
In any of these cases, the corporation must show that they genuinely considered alternatives in good faith, with full knowledge of the interested director, and determined that they could not obtain a more advantageous arrangement with reasonable effort under the circumstances. In other words, before approving a self-dealing transaction, corporate boards must go out of their way to consider other options. Again, counsel should be consulted.
b. Corporate Opportunity Doctrine
One form of self-dealing is taking advantage of a corporate opportunity. The corporate opportunity doctrine is the principle that a director or officer may not use their position of power or inside knowledge to take advantage of a particular business or investment opportunity that should rightfully accrue to the corporation. Industrial Indem. Co. v. Golden State Co., (1953) 117 Cal.App.2d. 519. This principle is grounded in the director's duty of loyalty.
Though the corporate opportunity doctrine originates with for-profit enterprises, its logic applies to nonprofits as well. A director's pursuit of certain opportunities for financial gain could violate obligations imposed by the governing documents to avoid even the appearance of conflicts of interest and self-dealing, or it could threaten the charity's tax-exempt status if impermissible private inurement is found.
c. The Business Judgment Rule
The business judgment rule is the standard the courts apply in deciding whether a director, acting without a financial interest in the decision, satisfied the requirements of careful conduct imposed by the corporations code. See generally Burt v. Irvine Co., (1965) 237 Cal.App. 2d 828; Marble v. Latchford Glass Co., (1962) 205 Cal.App.2d 171; Lee v. Interinsurance Exch., (1996) 50 Cal.App.4th 694; Gaillard v. Natomas Co., (1989) 208 Cal.App.3d. 1250.
The rule generally protects directors from liability to the corporation's members or shareholders if they make a decision that doesn't go as planned and possibly hurts the corporation, as long as the decision was made in good faith and was reasonable at the time.
However, as explained below, the business judgment rule does not apply when a director has a personal interest in the subject matter on which the business judgment is being exercised. See Heckmann v. Ahmanson, (1985) 168 Cal.App.3d. 119; Raven's Cove Townhomes, Inc. v. Kuppe Dev. Co., (1981) 114 Cal.App.3d. 783.
d. Interested Directors
A second form of self-dealing is the problem of an interested director. Courts will impose a higher standard of care on the decisions made by a director with a personal interest in their decisions. Cohen v. Kite Hill Community Assn., (1983) 142 Cal.App.3d. 642.
Although the cases above involve profit-making enterprises, the same legal principles apply to nonprofit corporations if a director is claimed to have breached their duty to the corporation and evidence shows that they were seeking to defend their position of power against hostile factions or protect a material financial interest.
In other words, if a director or officer of a nonprofit corporation acts contrary to the corporation's best interests (defined either as the class of people served by the corporation or as the corporation's goals and purposes), and if this act benefits them in any way, they are liable for breach of fiduciary duty. Again, to be an interested director, the benefit accruing to the director does not have to be strictly pecuniary in a nonprofit context. It could be an act of consolidating power or of promoting their own ideas and agenda over that of the corporation's goals outlined in its charter documents.
In the case of a nonprofit, this means the organizational purpose is critical. Unlike a for profit corporation, in which the director's primary duty is to protect the company's bottom line, a director or officer of a nonprofit organization has a duty to act in such a way that advances the cause of the organization. So, using one's position of power or publicity in a nonprofit corporation to advance an agenda that does not support the organization's cause is analogous to using one's position of power in a for profit corporation to financially benefit at the expense of the corporation. For instance, if a director or officer in a nonprofit whose purpose is to promote the Democratic party diverts organizational resources or publicity to advance their own "pet cause", or to benefit a political candidate or issue that is otherwise inconsistent with the Democratic party platform, they are in breach of their fiduciary duty to the organization. This is grounds for removal as a director or officer for cause.
© 2017 Richard L. Duquette and Justin M. Nelson. All rights reserved. May 17, 2017