NONPROFIT ORGANIZATION DIRECTORS –
LEGAL RESPONSIBILITIES AND RISKS
A Guide for Volunteer Directors of Charities, Cause Organizations, Trade Nonprofit Organizations, Professional Societies and Other Nonprofit Organizations
Association of Corporate Counsel Nonprofit Organizations Committee
Jerald A. Jacobs
Pillsbury Winthrop Shaw Pittman LLP
Washington, D.C.
In his published notes from traveling throughout the nascent United States of American in the early 1800’s, the French commentator Alexis de Toqueville repeatedly observed that there were already thousands of volunteer organizations throughout the land. He said when a new endeavor would be undertaken by the government in France, or by a man of rank in England, you can be sure that it would be undertaken by an association or society in the United States. Internal Revenue Service statistics indicate that there are nearly two million nonprofit tax-exempt organizations in this country (although that number includes churches and schools). This guide attempts to summarize for volunteer directors of nonprofit organizations – charities, cause organizations, trade nonprofit organizations, professional societies, etc. -- the major areas of legal concern for those directors. It is no more than a summary; many texts have been published on the legal aspects of nonprofits and a list of other writings on the subject by this author is included in the “References” section. The serious student of organization law is referred there.
Legal Characteristics of Nonprofit Organizations
Nonprofit organizations are virtually all (1) nonprofit corporations, and (2) tax exempt entities, that are (3) governed by volunteers. Each feature has important legal ramifications.
A nonprofit corporation obtains that status by being chartered under the laws of a state government. Ordinarily the criteria include a prohibition against the nonprofit corporation issuing equity stock (there is no true “ownership” of a nonprofit corporation; it may be considered quasi-public) and a requirement that it be governed according to the chartering state’s laws applicable to nonprofit corporations. The “nonprofit” characterization is a bit misleading; there is no prohibition against the corporation in one or more years having an excess of revenue over expenditures (typically called “surplus,” not “profit,” in the nonprofit corporation context). In some states the “charter” may be called “articles of incorporation.” And nonprofit corporations may be called by other terms (i.e., not-for-profit, non-stock, non-equity, public benefit/mutual benefit, etc.); those distinctions in denomination usually have no practical differences.
A tax exempt organization is a nonprofit corporation that has been determined by the Internal Revenue Service to be exempt from paying federal income taxes on any net of revenues over expenditures (i.e., surplus) each year. There are numerous categories of tax exemption. They include, for example, charitable, scientific or educational organizations with Internal Revenue Code Section 501(c)(3) exemption. There are also “cause” and social welfare organizations with Section 501(c)(4) exemption. And there are trade nonprofit organizations, professional societies, and other business-related organizations with Section 501(c)(6) exemption. Some organizations that enjoy federal income tax exemption in other categories may resemble those listed here. All exempt organizations in any of these categories must be organized other than as for-profit business entities; and they must avoid allowing dividend-like sharing of net earnings with individuals (called “inurement”); exempt organizations in the (c)(3) and (c)(4) categories have more specific inurement-type prohibitions, called the “excess benefit” rules. Income received by a tax exempt nonprofit organization from programs, initiatives and activities related to the purposes for which the organizations received exemption are not subject to federal income tax. But net income from an “unrelated” activity may be taxable if it is: (1) a business, that is (2) regularly carried on, and that is (3) unrelated to the purposes for which the organization originally received exemption (called “unrelated business income tax” or “UBIT”). There is an exception to the rule on taxation of unrelated business income, and thus no taxation, for “passive” income received by an exempt nonprofit organization – rents, royalties, dividends, or interest. An exempt nonprofit organization can have modest amounts of UBIT year after year with no untoward consequences for exemption (although it must pay tax on the net from unrelated activities). But if unrelated income becomes “substantial” compared with related income, the nonprofit organization’s exemption is threatened. The usual protective measure is to transfer UBIT-generating programs to an owned taxable subsidiary before the “substantial” threshold is reached.
An organization governed by volunteers means that the principal decision-making mechanism of an organization is the governing board; it consists of individual directors (who might also be called “trustees”) who are drawn from the field served by the nonprofit organization and who usually serve as volunteers without compensation (although expenses are sometimes reimbursed). Typically the board elects officers who often form an executive committee to govern during the periods between board meetings. Depending upon its size and budget, the nonprofit organization may also maintain employed executive staff who report to the board and its officers. The volunteer governance of a nonprofit organization means that decision-making sometimes occurs more slowly than in a business corporation and that transactions can be more cumbersome. It can also raise singular challenges when attempting to maintain consistent long-term policies and programs.
Legal Responsibilities of Directors
Directors of nonprofit organizations, even though they usually serve voluntarily and without compensation, have “fiduciary duties” – including duties of both “care” and “loyalty” – to their organizations. They are required to act reasonably and in the best interests of the nonprofit organization, to avoid negligence or fraud, to avoid conflicts of interest, etc. In the event that one of these duties is breached, the person breaching the duty is liable to the nonprofit organization for any damages caused. There are three main legal principles encompassed in the fiduciary duties.
1. The Duty to Act in the Best Interests of the Nonprofit Organization
This duty is very broad, requiring directors to exercise ordinary and reasonable care in the performance of their duties, exhibiting honesty and good faith. Thus, anonprofit organization volunteer has the duty to exercise due care when acting on behalf of the organization, to attempt to avoid generating legal liability for the organization, and to attempt to further the organization’s collective interests rather than the individual’s own interests or the interests of any other party. The duty also imposes an obligation to protect any confidential information obtained while serving in the fiduciary role with the nonprofit organization.
2. The Duty to Avoid Conflicts of Interest
The duty of loyalty encompasses a duty to avoid conflicts of interest and to provide undivided allegiance to the nonprofit organization’s mission. A conflict may exist when a volunteer director participates in the deliberation and resolution of an issue important to the organization while the individual, at the same time, has other professional, business, or volunteer responsibilities outside of the organization that could predispose or bias the individual one way or another regarding the issue. The organization and its constituency have a right to unbiased governance; and it is the governing board of the organization that has the ultimate say in determining in whether a directorhas a conflict, as well as what needs to be done to avoid that conflict impinging upon the organization’s governance.
In these situations, it is typically not enough for the individual to be aware of the conflict and to attempt to act in the nonprofit organization’s best interest despite the conflict. On the contrary, for many conflicts, full disclosure to the organization and refraining from participation in the organization’s deliberation and resolution of the issue (i.e.,”recusal”) may be required to neutralize the conflict. For serious, visible, continuing, or pervasive conflicts, withdrawal from the position, or from the outside conflicting responsibility, may be the only alternative to assure unbiased decision making for the organization. It is important that one be sensitive to, and avoid, apparent conflicts of interest as well as actual conflicts.
3. The Duty to Respect Corporate Opportunities
The duty of loyalty specifically prohibits competition by anonprofit organization director with the nonprofit organization itself. Those individuals may generally engage in the same “line of business” or areas of endeavor as the organization, provided it is done in good faith, after full disclosure, and without injury to the organization. One form of competition that is not permitted, however, is appropriating “corporate opportunities.” A corporate opportunity is a business prospect, idea, or investment that is related to the activities or programs of the nonprofit organization and that the director knows, or should know, would be in the best interests of the organizationitself to accept or pursue. Anonprofit organization’s volunteer representatives may take advantage of a corporate opportunity independently of the organization only after it has been offered to, and rejected by, the organization.
Another aspect of directors’ duties to the nonprofit organization is that of “apparent authority.” The U.S. Supreme Court has held that illegal activities of an nonprofit organization volunteer are the responsibility of the organizationitself if the volunteer only “appeared” to be acting with the authority of the organization – even when the organization’s governing board did not approve the activities, did not benefit from them, and did not even know about them. This means that nonprofit organizations, lest they become legally liable for anything volunteers do or say that even appears to be done or said with the organizations’ authority, must be careful to limit who is authorized to act or speak for the organization. Directors should never assume they have the power to represent their organization unless they are given specific authorization to do so.
The standards of appropriate conduct for directors of nonprofit organizations are evolving rapidly, owing in part to the legislative governance reforms for business corporations under the Sarbanes-Oxley law of 2002 and related influences. Two features of that law apply to all entities, including nonprofit organizations, and carry criminal penalties for violations: (1) the provisions prohibiting destruction of documents in connection with federal investigations, and (2) the provisions prohibiting retaliation against “whistle-blowers.” But other features as well, while not strictly applicable to nonprofit organizations, are being adapted in the nonprofit community, including: (a) frequent and detailed financial reports to constituents, (b) certification of the accuracy and completeness of financial reports by organization’s CEO and/or CFO; (c) vesting in independent audit committees (those with no voting role for management) all authority over auditors and audits; and (d) implementation of confidential paths for receipt of complaints from employees, members or others.
Areas of Potential Legal Liability
There are numerous kinds of policies and programs of nonprofit organizations that can lead to serious legal liability. The most important of those are summarized here. Directors should become familiar with the legal risks facing nonprofit organizations so they can effectively manage and control those risks.
1. Liability from Antitrust Generally
The federal antitrust laws (principally the Sherman and Clayton Acts) and the trade regulation statutes (principally the Federal Trade Commission Act) are intended to promote open and fair competition in all commercial endeavors. State antitrust laws generally follow the federal pattern and have the same objectives. Since the 1970’s, it has been clear that the federal antitrust laws apply with full force not only to businesses and business organizations but also to professions and to their societies, including in architecture, law, engineering, medicine, dentistry, and other professions.
Nonprofit organizations members often compete with one another. Therefore, virtually any action that anonprofit takes, and particularly actions that involve the attempted private regulation of an industry, profession, or business, may raise antitrust issues. Many of these actions are perfectly lawful. There is a broad range of lawful activities for nonprofit organizations to undertake relating to standard setting, certification of products or professionals, dispute resolution, and other forms of business or professional self-regulation. Great care must be taken, however, to ensure that anonprofit organization’s activities do not fall within the special unlawful categories established by the courts as “anticompetitive.” The courts consider an action to be anticompetitive when, on balance, it raises prices or fees or lowers the quantity or quality of available goods or services. Prices and fees, in fact, are a particularly sensitive area. Any action of an organization that directly raises, lowers, or stabilizes prices or fees has the highest risk of antitrust scrutiny and the greatest potential penalties. Even action that may only indirectly affect prices and fees, such as nonprofit organization-promulgated arrangements on terms and condition of sale, warranties, limitations on the extent or type of advertising, and hours of operation, can also be expected to attract antitrust scrutiny of the organization.
Violations of the antitrust laws may be prosecuted by the federal government, either civilly or criminally, and by injured private persons or entities. Courts may award injunctive relief against violators and may require violators to pay victims three times the financial injury actually suffered (called “treble damages”), plus their attorneys’ fees.
Violations of the antitrust laws fall into two basic categories: (1) actions that are unlawful without regard to their actual impact on competition (called per se violations) and (2) actions that are not necessarily unlawful, but may be so, depending on their actual impact on competitive conditions (called Rule of Reason violations). Actions that are likely per se unlawful include the following: (a) agreements fixing prices or fees or setting floors or ceilings on prices or fees; (b) agreements to boycott competitors, suppliers, third-party payers, or customers/patients/clients; (c) agreements among competitors dividing or allocating markets; and (d) agreements coerced by a provider with a dominant market position tying the purchase or provision of one product or service to the purchase or provision of another product or service. Any other agreement, including resolutions of an organization of competitors—may violate the antitrust laws under a Rule of Reason analysis if its effect is generally to raise prices or fees or to reduce the quality or quantity of available goods or services.
It is very important to understand that the antitrust laws can be violated by mutual understandings or other informal arrangements falling far short of a formal contract or written resolution. Directors of an organization, or just ordinary members, can implicate the organization in antitrust violations by using the organization to facilitate their undertaking anticompetitive arrangements among themselves, even without invoking any of the formal mechanisms of the organization. As noted above under the “apparent authority” doctrine, an organization may be held responsible for anticompetitive conduct by volunteers who appear to be acting in the name of the nonprofit organization.
2. Liability from Codes of Ethics
Many nonprofit organizations formulate and enforce codes of ethics or conduct for their memberships. Ethics codes of nonprofit organizations often set forth both desirable goals and behavioral requirements considered essential for the protection of the public and for the optimal development of the field represented by the organizations. Enforcement ordinarily occurs according to a detailed set of procedures intended to ensure objectivity and fairness. Both the establishment of ethical requirements and their enforcement are legally sensitive areas. For this reason, ethics enforcement should be entrusted solely to a discreet group within anonprofit, either its board or a delegated committee, operating with the close assistance of legal counsel.
The first area of risk from nonprofit organizations’ codes of ethics is that of antitrust law violations. Any action taken by an nonprofit organization that is viewed by a court as “anticompetitive” may violate federal or state antitrust laws. Actions are anticompetitive when they raise prices or fees, restrict the supply of products or services, or lower the quality of products or services. Some kinds of actions are so likely to be anticompetitive that they should be avoided entirely. Examples include; (1) provisions or procedures setting or suggesting maximum or minimum prices or fees to be charged or paid, or otherwise imposing upon the freedom of members to freely and individually establish prices or fees for their own products or services; (2) provisions or procedures limiting or discouraging non-deceptive advertising of members’ products or services; and (3) provisions or procedures requiring or suggesting boycotts of suppliers, competitors, or customers/patients/clients.
Many ethical rules of nonprofit organizations are pro-competitive—they result in better products or services, increased availability or access, or lower prices or fees. All ethical rules, however, must be evaluated to ensure that the motives and effects of the rule are to benefit competition in the ways deemed appropriate by the antitrust laws.
The second area of risk from nonprofit organization codes of ethics is the risk of inadequate procedures. Nonprofits can impose discipline, of course, only upon their members. In doing so, the law requires that the organizations be careful to establish and observe rules and procedures to assure “due process” for members. Minimal due process includes: (1) written notice outlining the alleged violation, possible sanctions, and right to respond; (2) opportunity to respond to the allegations of unethical conduct and to review and respond to all charges and evidence to be considered by the decision maker; and (3) with respect to the most serious sanctions, the right to appeal an adverse decision to an unbiased decision-making body such as the organization’s board of directors or some specially-constituted, unbiased appeals board.
3. Liability from Standards, Testing, and Certification
Product standardization, testing, and certification are among the oldest and most common activities of United States nonprofit organizations. Since colonial times, groups of businesses have issued statements on common terminology, simplification of parts or styles, and, most typical of all, uniform design or performance specifications. Tens of thousands of nonprofit organization-promulgated product standards are now in place. Nonprofits that have developed product standards have often gone the next steps and engaged in testing and certification of products against the established standards. Testing might be performed by the organization itself or by commercial or nonprofit laboratories approved or recognized by the organization. Although it is most often trade or business groups that undertake these programs, it is also not unusual for a professional organization to develop standards, testing, and certification programs for the products used by the profession. These product quality endeavors have manifest benefits for manufacturers and sellers of products. They raise the level of competition, provide common targets and goals, simplify ordering and communication, and help assure interchangeability of parts. The programs also have very substantial benefits for buyers and users of products. They help upgrade and maintain quality, provide benchmarks for consumers, and often limit the numbers and types of items that must be purchased. Programs of privately-issued standards, testing, and certification are always voluntary—there is no compulsion of law for compliance or participation; nevertheless, government agencies have often adopted nonprofit organization product quality programs through mandatory regulations.