Governance of Nonprofit Organizations - Module 4 of 5

Module 4: Governance of Nonprofit Organizations

Organizational Liability

Incorporated nonprofit organizations are governed by boards of directors exercising corporate powers as described in the organization’s bylaws.[1] Much like for-profit corporations, there is great flexibility in how a nonprofit board may choose to govern.  Beyond certain fundamental requirements, state nonprofit laws do not generally require specific governance practices.[2] What constitutes “good” governance varies, but usually this means that the board:

 - hold regular meetings with defined agendas,

- hold annual elections of directors, 

- keep minutes of its meetings, 

- allow directors’ access to books and records, 

- delegate responsibility to committees of the board, such as finance, audit, executive and others; and 

- appropriately obtain outside experts for advice prior to making decisions.[3] 

Two important legal doctrines establish the foundation for liability of both individual board members and the nonprofit itself. These are the concept of “piercing the corporate veil” and the doctrine of “respondeat superior.”

When a nonprofit is incorporated, the corporate entity stands separate under the law from the individuals that lead and manage its business activities. The independent status of the organization means that it can be sued. But it also gives a certain degree of liability protection to its directors and officers, who are not personally liable for its debts and other legal obligations.

However, if the corporation is merely a cover for individual activity, if it engages in  fraudulent operations, if acts as little more than a shield against legal obligations for individuals, ignores corporate formalities, is not adequately funded or features some combination of these, a court may ignore the corporate entity entirely and “pierce the corporate veil.”[4] By ignoring the corporate form, the court can subject the owner/shareholder to personal liability for corporate debt.   

Respondeat superior means “let the master answer,” and is a type of vicarious liability derived from the law of agency, In the context of an organization, this means that an officer, director or employee is acting on behalf of the organization, thereby binding the principal its acts. Under the doctrine of respondeat superior, an organization is liable for the wrongful acts of its officers, directors, employees and volunteers when they are acting on behalf of the organization. Moreover, directors and officers have the authority to make contracts on behalf of the organization.[5] An organization is therefore liable for torts committed by its representatives and contracts entered into on its behalf by its directors or officers.

Powers and Duties of the Board

he board of directors of a nonprofit is responsible for oversight of the organization. The directors and officers of a nonprofit are “fiduciaries” and thus have a trust relationship that imputes special duties.  Fundamental powers of a nonprofit board generally include the power to ratify or veto important changes such as large financial transactions or mergers, changes to the corporate status, dissolution of the organization and selection of officers.  Day to day management of the organization usually falls to officers of the organization, led by a chief executive officers, who answer to the board.[6]

Unlike for-profit organizations, there are no shareholders for the directors to answer to. Still, nonprofits such as professional associations may have members. While these stakeholders have no right to share in revenues of the organization, they have certain rights. These rights include the right to vote on the election and removal of directors, the authority to amend the organization’s bylaws and the right to approve certain important actions by the board, such as a merger or dissolution. 

The board is obligated to act fairly in its dealings with members; and though a board may curtail or eliminate certain member rights, it must give members adequate notice of such changes, enough information to understand the changes and the opportunity to vote on the changes. The board’s rights to act on behalf of the organization are limited by its duties to the organization as stipulated in the bylaws and in state law.  These duties include a general duty to act reasonably and in good faith and several fiduciary duties, which we’ll cover a bit later.[7]

Directors generally must act as a reasonable person in a similar situation; this is referred to as the “corporate” standard of care. Directors also must act in the best interest of the organization. Directors cannot be self-serving, must uphold the mission of the organization, and when dealing with members of the organization, must demonstrate good faith and fair dealing. 

Fitzgerald v National Rifle Association[8] is an example that illustrates the limitation on the power of the board of directors and the general duties of the board to act reasonably and in good faith. The plaintiff wanted to run for director on the association’s board. Only NRA “life” members held the right to elect members of the board of directors, while “annual” members held only the rights to make recommendations to a nominating committee, which selected candidates for each election. To promote his nomination by annual members, the plaintiff tried to put an ad in association’s publication, the American Rifleman, which was distributed to all members of the organization. The NRA advised the plaintiff that his ad was unsuitable for publication (since it went to all members, not just life members), and refused to publish it.  The plaintiff sued, claiming that the NRA board acted in bad faith and that they had violated a duty to the organization’s members to provide fair and open elections of officers.

The court found that NRA’s argument against publication did not “satisfy the heavy burden placed on directors and officers to justify their dealings with corporate shareholders.” It held that it was the NRA directors’ duty to “take all necessary steps to ensure an informed electorate and fair corporate elections” and that in refusing to place the ad, it violated the corporate trust related to the voting rights of its members. The court ordered the NRA to accept the plaintiff’s ad.[9]

Fiduciary Duties

The duty of care relates to the conduct of directors in carrying out their corporate responsibilities. Directors are expected to exercise a certain level of diligence, care, skill and attention. There are two primary ways a director may fail to meet this duty. 

The first is by failing to appropriately supervise the corporation, and the other is by failing to make an informed decision about a matter that comes before the board.[10]  Components of the duty of care include the director’s duty of attention, informed decision making, delegation and reliance on appropriate expert advice.[11]

Under the umbrella of the “duty of care,” the duty of attention requires the director to actively participate in the oversight and governance of the organization. Informed decision making requires that a director adequately prepare for meetings and decisions of the board. The duty to delegate refers to the day-to-day management of the organization. Directors must delegate these daily management activities to the staff of the organization, and in doing so, set sound policies that will govern the organization. Directors must also act in reliance on expert advice where it is appropriate and prudent to do so. This means asking for and reviewing the work of experts in certain fields where the board does not have its own expertise, to provide well-informed leadership on issues and transactions.[12]

The duty of loyalty requires that directors not use their positions on the board as means to achieve personal gain and that they do not act in ways that will do harm to the organization. Having a personal interest in a transaction, though, is not necessarily a breach of the duty of loyalty. A personal interest is okay as long as the transaction is fair to the organization at the time the decision is made and the decision is reached impartially by the other board members. Directors are expected to participate in such decisions objectively and are expected to disclose conflicts of interest so that they may be evaluated and approved by the rest of the board before proceeding with a decision.[13] 

Let’s look at examples of the types of activities that may violate the duty of loyalty.

The use of an organization’s property in a manner more favorable to directors than to those outside the organization may violate the duty of loyalty. For example, if a director is offered a substantially reduced price on a lease of office space owned by the organization than would normally be available to the public, this would be inappropriate. Similarly, the use of material nonpublic organizational information or position to the advantage of a director, exploiting an insider advantage or competing directly with the organization would all likely violate the duty of loyalty.

Usurpation of a corporate opportunity occurs where a director learns and takes advantage of a business opportunity for herself with the knowledge that it would ordinarily be interesting to the organization or is in its direct line of business.

Corporate waste also violates the duty of loyalty and occurs where a decision is made that goes against the best interest of the organization as to spending. For example, voting to increase board member salaries in the middle of a period of financial loss for the organization might be considered waste.[14]

In the case Northeast Harbor Golf Club v. Harris, the defendant, Nancy Harris, was the president of a golf club. The club also had a board of directors, who from time to time had discussed the development of the golf club’s property.  An adjoining property that was encumbered by an easement in favor of the golf club was offered for sale to Harris in the court of her role as president of the golf club. Harris purchased the adjoining land in her own name and did not disclose her plans to the board prior to executing the agreement. She later informed the board of the purchase and that she intended to hold it in her own name. Though the board took no action at first, when Harris tried similar maneuvers twice more, the board sued her for breach of fiduciary duty.

The Maine appellate court found that Harris had violated the duty of loyalty by usurpation of corporate interest. She failed to disclose the conflicts of interest prior to pursuing the land which had a proximity to golf club and failed to disclose the various business opportunities, which the golf club would have interests in based on its “line of business.” It was a corporate opportunity because the acquisition of the property would have allowed the club to expand its property for the recreation services it offered.  Harris’ actions foreclosed the possibility that the club might someday expand its property.[15]

The duty of obedience requires directors to carry out the business of the nonprofit organization within the purposes and rules of the organization. Actions taken outside the scope of the corporation’s purpose are called “ultra vires” actions, which include activities or transactions that are beyond the corporation’s powers and purposes as expressed in the articles of incorporation. Nonprofit directors may not deviate in any substantial way from the purposes under which the organization was formed.[16]

For example, in Matter of the Manhatten Eye, Ear & Throat Hospital v. Spitzer[17], a proposed sale of substantially all of the nonprofit hospital’s real estate assets to a land developer and closure of the hospital and sale to another hospital was proposed by its board of directors. The court held that the duty of obedience compelled the board to ensure that the mission of the organization is carried out. The proposed sale of substantially all its assets did not promote the purposes of the organization and so was beyond the scope of the director’s authorities.

The Best Judgment Rule

Where directors have complied with fiduciary duties, the business judgment rule, known also in the nonprofit context as the best judgment rule” can relieve directors of liability for losses suffered as a result their actions. The rule only applies in the absence of fraud, illegality or serious conflicts of interest.[18]

For mutual-benefit nonprofits, such as business leagues and membership associations, the standard of care is that a director must perform her duties in good faith and with a degree of diligence, care and skill which an ordinarily prudent person would exercise under similar circumstances. This is known as the “corporate” standard. The “trust” standard is a more stringent standard applied to trustees of charitable trusts and other charitable nonprofits who have heavily prescribed duties under state law.

Responsibilities of a nonprofit board often include investing on behalf of the organization. In carrying out financial activities and decision-making, directors must act with the care of a prudent investor. However, what constitutes reasonably prudent actions on the part of the board depends on the circumstances, whether the organization is a mutual benefit organization or a trust and other factors. 

A District of Columbia federal case, Stern v. Lucy Webb Hayes National Training School for Deaconesses,[19] interpreted the predominant “corporate” standard for the duty of care, as it appears in many nonprofit corporation statutes.

A class action suit was brought on behalf of patients of Sibley Memorial Hospital, alleging mismanagement of the hospital’s finances was brought against members of the hospital’s Board, several financial institutions and the hospital itself.  The plaintiffs claimed that certain board members conspired to enrich themselves and several financial institutions with which they were affiliated by favoring those institutions in financial transactions, and that in doing so, they breached their fiduciary duties of care and loyalty in the management of hospital funds.

The court found that the defendants failed to exercise ordinary and reasonable care in the performance of their duties by ignoring their corporate responsibilities in several ways. First, the directors assigned to the board finance and audit committee failed to inquire or object when no meetings were called for over ten years. Second, they had failed to report the existence of investment funds. Third, the defendant members of the board’s executive committee ignored their charge to seek out important information and reports relevant to board votes, such as the opening of new bank accounts. Fourth, they routinely ignored annual audits.  Finally, the court found that the defendant directors knowingly and repeatedly allowed the hospital to enter into business transactions that benefited the directors’ own interests and favored certain financial lenders. 

Applying the corporate standard of ordinary and reasonable care, honesty and good faith, the court found that the defendant directors breached their fiduciary duties to manage the finances of the hospital. The court ordered the defendants to create and present to the full hospital board a fiscal policy that would establish procedures for oversight and periodic reexamination of existing investments. It also ordered that no existing financial relationships could continue unless consistent with the established policy and found by disinterested members of the board to be in the hospital’s best interests, requiring full disclosure of any board member’s affiliation with lending institutions. Finally, newly elected directors would be required as a condition of their appointment to read the court’s opinion on the matter.

Taken together, the duties of nonprofit directors and officers protect the nonprofit from actions by its governing body that may otherwise undermine the organization. The laws and norms that relate to governance of nonprofits ensure that nonprofits are able to continue to serve the public good, for which they are uniquely situated.  In our last module, we will take a closer look at the powers and privileges of non-profit directors and officers.