Nonprofit organizations (sometimes hereinafter referred to as “NPO”) play an integral role in our society. They provide needed funds for a wide range of charitable causes including education, the environment, the arts, the sick, infirm, and homeless, victims of natural disaster, and research for the prevention of disease. The responsibility for establishing the nonprofit’s mission and ensuring that donations are used for the public good lies with the nonprofit’s board of directors and its officers, (sometimes hereinafter referred to as “D & Os”). More often than not, these positions are filled by unpaid volunteers.
Scrutiny or the financial and management practices of “for profit” organizations is at an all time high in the wake of the scandals rocking Enron and MCI/World.com. Nonprofits have not escaped this scrutiny and are likewise subject to what has been called “increased transparency”. Public records, such as NPO incorporation papers, including the application for tax exempt status or Form 1023, 990 Forms, and IRS tax determination letters, are now available online and can be accessed at any time.
Between 1995 and 2002, newspapers reported 152 incidents of civil and criminal wrongdoing by directors and officers of charitable organizations. Of the 152 incidents, 104 involved criminal activity, 54 involved breaches of fiduciary duty, and 6 that fell in both categories.
Of the 54 breach of fiduciary duty cases, 20 involved misuse of assets for personal gain, 18 involved self dealing, 14 involved payment of excessive compensation, and 8 involved excessive expenditures. Of these cases, 26 resulted in the removal or resignation of the officer or director,13 resulted in the payment of restitution and fines, 8 resulted in the imposition of financial controls, 6 resulted in the dissolution of the charity, and in only 1, was the officer/director exonerated.
With this increase in “transparency,” nonprofit officers and directors must learn to recognize and protect themselves from situations involving conflicts of interest. The purpose of this paper is to provide officers and directors with practical tips for identifying and eliminating common conflicts of interest.
FIDUCIARY DUTIES OF NONPROFIT OFFICERS AND DIRECTORS
Officers and directors owe a fiduciary duty to the nonprofit. Simply stated, this means that D & Os must act in the best interests of the nonprofit at all times. A fiduciary relationship has been described as “one of most abundant good faith requiring absolute perfect candor, openness, and honesty, the absence of any concealment, deception” or self dealing.
Officers and directors have three primary fiduciary responsibilities: 1) the duty of care; 2) the duty of obedience, and 3) the duty of loyalty. The duty of loyalty requires an officer or director to refrain from engaging in conflicts of interest. A conflict of interests arises whenever an officer or director places a competing interest over the best interests of the nonprofit. Competing interests are usually business, personal, financial, or family related.
Texas law states that a nonprofit corporation “is a corporation no part of the income of which is distributable to members, directors, or officers.” This does not mean that an officer or director cannot be paid reasonable compensation for his or her services. However, board members rarely receive compensation for their services. No part of the net earnings of the NPO may be used to benefit a private individual; otherwise, the nonprofit is likely to lose its tax-exempt status. 9 Nonprofits are often more vulnerable to conflicts of interest than for profit corporations because they rely on unpaid volunteers to do most of the work.
COMMON CONFLICTS OF INTEREST
Hypothetical: Local NPO is expanding. It needs a new building for its educational and training programs. It solicits bids from general contractors. Unbeknownst to the officers and the board, board member Joe Cool’s company, “Yellow Rose General Contractors, Inc.” submits a bid to construct the new building. Joe Cool does not tell NPO that his company has submitted a bid, yet he advocates for Yellow Rose’s bid even though it is more expensive and requires more time than the other bids. Cool votes for Yellow Rose to win the bid. The other board members do, too, and Yellow Rose is awarded the contract. Cool’s company makes a hefty profit on the deal.
Did Cool engage in a conflict of interest? Yes. Why? Cool did not act in the best interests of the NPO. Rather, he advocated and voted for a competing interest, that of his company, Yellow Rose, over other bids which would have cost the NPO less money and less time. The best interests of the NPO would have been better served by picking another contractor so that more funds could be spent on other charitable activities. Cool used his board membership to obtain business related benefit.
What could have been done to avoid or minimize Cool’s conflict of interest?
- Require directors and officers to sign a conflict of interest policy each year requiring them to disclose conflicts of interest; and
- Exclude the officers or director with the conflict from all decision making processes involving the conflict.
Conflict of interest policies are often included in the NPO’s bylaws, but conflict of interest policies are more effective if the NPO requires all officers, directors, and employees to review and execute a new conflict of interest policy each year. The conflict of interest policy should provide a concrete definition of what conduct creates a conflict of interest, thus enabling the D& Os and staff to identify potential conflicted situations. The policy should require the conflicted officer or director to fully disclose all facts regarding the conflict to the board. Finally, the policy should provide a procedure for minimizing or eliminating the conflict of interest. This is usually done by excluding the D or O from the decision making process that involves the conflict.
Full disclosure and the exclusion of the conflicted D or O from the decision making process puts the nonprofit back on an equal playing field. It can then properly evaluate whether entering into the conflicted transaction will further the nonprofit’s purpose and is in its best interests.
What happens if a conflict arises after the NPO has entered into a transaction? The NPO should exclude the D or 0 from the decision making process regarding the resolution of any dispute with the conflicted transaction.
Hypothetical: Treasurer of nonprofit is charged with the responsibility of approving certain day to day expenditures of the nonprofit. Vendor #1 contacts Treasurer and offers Treasurer and his family an all expense paid two-day golf vacation at a resort. Treasurer accepts. Shortly thereafter, Vendor #1 contacts Treasurer and requests that Treasurer enter into a two year contract with Vendor #1 for Vendor’s products and services. Vendor #2 has offered the same products and services for a lesser price. Treasurer remembers the golf vacation fondly and decides to enter into the contract with Vendor #1.
Did Treasurer engage in a conflict of interest? Yes. What could have been done to avoid or minimize the conflict of interest? Require officers, directors, and employees to execute a gift acceptance policy each year. The gift acceptance policy should prohibit the acceptance of gifts, entertainment, or other favors from any person or entity that:
1) Does or is seeking to do business with the nonprofit;
2) Is a competitor of the nonprofit; or
3) Is seeking loans, grants, or other financial distributions from the nonprofit.
Officers, directors, and employees should also refuse any gifts that a reasonable person would believe were intended to improperly influence the nonprofit. Gifts of insignificant value from persons or entities not related to any nonprofit activity or purpose are acceptable.
Officers, directors, and employees should also refuse any gifts that a reasonable person would believe were intended lo improperly influence the nonprofit.10 Gifts of insignificant value from persons or entities not related to any nonprofit activity or purpose are acceptable.
Serving Two Masters
Hypothetical: Board member of nonprofit homeless shelter also sits on the board of environmental nonprofit. Environmental nonprofit seeks to tear down the homeless shelter to provide for a wildlife refuge. It offers homeless shelter a large donation in the hopes of persuading the homeless shelter to rebuild in a new location. Environmental nonprofit asks board member to advocate on its behalf with the homeless shelter. Board member agrees. The environmental nonprofit’s proposal comes before the board of the homeless shelter. Board member is aware that the cost to build a new homeless shelter in the new location will cost the homeless shelter more money than the environmental nonprofit’s donation. Board member votes to accept the environmental nonprofit’s donation.
Did the board member engage in a conflict of interest? Yes. He was serving two masters and picked one over the other. Fully disclosing the facts and refraining from the decision making process here may not be enough. Sometimes, when an officer or director is involved in more than one organization with competing interests, whether for profit or nonprofit, the only way to resolve the conflict is to require the officer or director to resign, or at least abstain from the vote on the issue. Registration should occur when the interests of the two entities will be ongoing and adverse.
Loans/Charitable Distributions to Family Members and Friends
Hypothetical: President of nonprofit that builds houses for poverty stricken families attends local church. President is personal friends with several of the families that belong to the church. A tornado rips through the town destroying homes belonging to many of the church’s members. Several of the church members go to the President requesting that the nonprofit build them a new home. The economic status of the church members seeking the new homes do not meet the nonprofit’s criteria for a new home because they are no quite below the poverty line. President knows that the church members do not fall within nonprofit’s charitable purpose but he advocates new homes for the church members because “they are members of his church and they are in need of shelter for their families.” President is also a member of the board of the nonprofit. President and the board vote to build new homes for the church members.
Did the President engage in a conflict of interest? Yes. He advocated for the best interests of the church members even though they did not fall with the nonprofit’s charitable guidelines. What should the NPO have done to minimize this risk? It should have promulgated ethical/accountability standards particular to its purpose. These standards should delineate, among other things: 1) the purposes for which NPO funds can be used; 2) the contents of the annual report; 3) the number of board meetings to be held; 4) the term limits for board members; 5) acceptable soliciting and fundraising practices; and 6) the requirements for investing NPO funds.
These ethical/accountability standards should also be reviewed and signed each year by officers, directors, and employees. When there is a question about whether donated funds should be used in a certain way, the directors, officers, and employees can refer to the standards to ensure that the use of the funds falls within the nonprofit’s stated guidelines and purposes.
Another common conflict of interest occurs when unsecured loans are made to relatives of the officers or directors. To minimize the risk of improper use of nonprofit funds, independent auditors should review the use of donor funds and nonprofit assets on a quarterly basis to ensure that the funds are being used in compliance with the individual donor’s wishes and the nonprofit’s purpose.
Estate Planning Advice to Donors
Hypothetical: President and board member visit retiree seeking a donation. Retiree invites President and board member in for coffee. Board member who happens to be an estate planning attorney advises retiree about the financial, tax, and legal aspects of making a donation to the NPO. Retiree is on a fixed income but has $2,950,000 in assets. Retiree is so taken with the charity, its cause, and the board member and president that she agrees to donate $800,000. The board member/attorney advises her that this will reduce the inheritance taxes on retiree’s estate. He also offers to draft her will and other estate planning documents for free. President and board member return two weeks later with the estate planning documents. Retiree executes the estate planning documents and gives the President and board member/attorney the $800,000 check.
Did the President and board member/attorney engage in a conflict of interest? Yes. Although President and board member/attorney promoted the NPO’s best interests by obtaining the $800,000 donation, they also agreed to act in !he retiree’s best interests by providing her with financial, legal, and tax advice. Moreover, the attorney formed an attorney client relationship with the retiree requiring the attorney to act in the retiree’s best interests in implementing the estate plan. This could pose significant problems for the nonprofit in the future.
What should the nonprofit have done to minimize this risk? NPOs should be very careful when discussing the financial ramifications of donations. The ethical/accountability standards should state very clearly that officers, directors, and employees are not to discuss the tax or legal aspects of a donation. NPOs should never provide will forms or other estate planning documents to donors. If a donor asks questions about the legal or tax implications of a donation, the NPO should refuse to accept the donation until independent legal counsel is present to advise the potential donor about the consequences of the donation.
Hypothetical: The NPO offers the officers increased compensation for securing donations over $50,000. The compensation increases on a stair step basis as the amount of donations the officer secures increases. Has the officer engaged in a conflict of interest? Maybe. Rather than acting in the NPO’s best interest, the officer has an incentive to act in his or her own best interests. While incentive based compensation is often the norm in a “for profit” organization, it creates a potential conflict of interest in a nonprofit organization. Incentive based compensation is difficult to justify in a nonprofit. Compensation must be reasonable and not excessive for the services performed. The purpose of the NPO is to ensure that the highest percentage of its funds go to benefit the public good, not the officer’s pocket book. A nonprofit can minimize this risk by conducting independent audits.
AVOIDING AND ELIMINATING CONFLICTS OF INTEREST
Conflict of Interest and Gift Acceptance Policies
The first line of defense against a conflict of interest is for the officer or director to be able to identify a situation that presents a conflict of interest. Conflict of interest policies which clearly define what situations involve a likely conflict should signed by officers and directors annually. They should require D & Os to fully disclose the facts surrounding any conflict of interest and they should exclude the D or O from any decision making process involving the conflict.
Gift acceptance policies should also define the circumstances in which gifts can be accepted.
Annual Risk Assessment
Not every conflict of interest can be avoided. The nonprofit should perform an annual risk assessment. It should review its internal and external activities to evaluate what situations pose the highest risk for conflicts of interest. Based on its findings, the nonprofit should hold a meeting of all directors, officers, and employees to educate them on the results. This will further help the nonprofit identify what situations present conflicts. The nonprofit should then draft policies and procedures to protect against these particular conflicts. Evaluating and providing this information on a yearly basis to the officers, directors, and employees will enable them to recognize conflicts as trends and business practices change.
The nonprofit should implement and adopt ethical/accountability standards that are unique to its particular mission and purpose. D & Os and staff should review them each year and sign a written statement acknowledging that they have reviewed the standards and agree to abide by them.
An independent audit of the nonprofit’s financial activities should occur at least on an annual basis.
Conflicts of interest affect every officer and director and this is especially true in the nonprofit sector. Written policies and procedures reviewed annually, such as conflict of interest policies, gift acceptance policies, and ethical/accountability standards, enable D & Os to identify conflicts and guard against them. Independent audits should also take place annually and more frequently if possible so that any potential problems can be caught and rectified.
This article was authored by Shelly L. Skeen, a shareholder at BFS Law Group, PLLC. Copyright 2006, All rights reserved, Shelly L. Skeen.