"It is better to give than to deceive."
In our last article together we discussed three the duties of "Care, Loyalty and Obedience" by which (largely volunteer) directors of nonprofits must abide. Today, we will dive a bit deeper in the Duty of Loyalty, and what that really means. But first...
Disclaimer: The following information does NOT constitute legal advice and is only for general educational purposes. Each situation is different and specific legal issues usually require additional research and investigation, so do not rely on this article to address a particular legal issue; use this as a starting point to gain a general understanding.
Under New York Not for Profit Corporation Law (commonly abbreviated as “N-PCL”) and other “common law” principles, those involved in running a nonprofit, owe the nonprofit a “Duty of Loyalty,” to serve in the nonprofit’s interests and not in the their own self-interest. This duty is shared, by a minimum, between board members, officers and “key employees” (someone who can exercise “substantial influence”). This Duty of Loyalty means avoiding and resolving actual or apparent Conflicts of Interest (“COI”) and Related Party Transactions (“RPTs”).
A COI, is not strictly defined by statute, and each and every nonprofit is free to determine the meaning of such for itself, but define possible COIs the nonprofit must. Commonly used definitions of situations that create COIs are when an individual has a pervasive familial, financial, or personal interest that affects that individual’s ability to be impartial or fully perform their job or role; or if that individual uses company resources or information for their own benefit (personal use also can be a form of RPT, see below). COIs also could involve gifts, personal favors, loans, or an interest in property with the affected nonprofit individual. The individual or their family do not necessarily need to benefit financially, but their personal interest might be so affected that their judgment is compromised.
The “independent” members of the nonprofit’s board of directors, or the nonprofit’s audit committee (comprised only of independent directors) must put together this COI Policy, and also resolve COIs and RPTs as they arise. “Independent,” is strictly defined by statute, which you should read in full, but generally means a director who isn’t employed by or has substantial financial dealings with the nonprofit (or its affiliates), and who doesn’t have relatives or firms that are employed or have substantial financial dealings with the nonprofit (ditto affiliates) (all of the above applies to current situations and within the last three years). It’s a bit more complicated than that, but that’s the gist.
Regular and Diet COIs
Another thing about COIs - they come in two flavors, think of them as regular and diet, only we will call them “actual” and “apparent.” What’s the difference? An “actual” COI is a true conflict in the real sense, in real time. An “apparent” COI, also known as a “perceived” COI, occurs when a “reasonable person” might believe the judgment of the individual of the nonprofit could be compromised in a given situation, whether or not the individual is really capable or incapable of making an impartial decision (i.e. it “looks bad.”); apparent COIs also can be potential COIs, i.e. it’s not a conflict this second, in real time, but could later become one and cause a problem after the fact. Either way, the nonprofit will have to deal with them. Wanna see some examples? No? Then skip to the next section. Yes? Read on…
Actually, before I get to the examples, you should know these basically all are judgment calls. Don’t be surprised if another more cautious lawyer says one of these potential COI examples is really an actual COI, or if a more loosey-goosey attorney says one of these actual COI examples isn’t any kind of conflict at all. My personal take on it is that any COI, whatever you want to call it, is a potential problem: we’re talking possible lawsuits, regulatory action or maybe just poor PR or bad feelings among interested parties. So be careful…
Actual COI Examples
#1: The nonprofit’s “ethics officer” (could be an HR director or someone like that) judges the appropriateness of their own actions (how can a person be impartial toward themselves?) or their own manager’s actions. How can you judge yourself? Wouldn’t everyone want to have power over their boss? Not ideal situations, either way.
#2: A board member belongs to an environmental nonprofit that is about to vote to preserve the habitat of a certain animal that the board member’s other nonprofit raises money to protect. Even though both are good causes that produce no financial benefit to that board member, the board member is indirectly securing a benefit for this other cause that is of direct personal interest, in such a way that comprises that board member’s impartial judgment on that particular vote.
Apparent COI Examples
#1: The nonprofit’s procurement officer, responsible for selecting vendors, just happens to have a friend that works for one of the several companies responding to the nonprofit’s recent request for proposals for services. Since it’s not as if their friend will benefit in any substantive way, it is questionable whether this is an “actual” COI. Nevertheless, the situation could seem unfair to a “reasonable” person, and therefore this situation is at least an “apparent” COI.
#2: A board member of a nonprofit involved in the tech industry, is asked to vote on a measure empowering the nonprofit’s CEO to write a letter to a local legislator to change certain tech regulations. The board member owns insignificant amounts of stocks in some companies, including tech firms. Even though the board member barely has any money invested in these companies, and even though it is debatable whether these regulations could increase or decrease the value of these companies, the board member’s stocks could create a perceived COI to a “reasonable” outsider.
Related Property Transaction
Oh, yeah. There’s sort of another flavor of COIs I forgot to mention, because it’s really its own category of headache with similar, but technically, different rules. Under the New York Not for Profit Corporation Law, there is something called a “Related Party Transaction.” These transactions can be thought of us as a form of self-dealing, or dealing for the benefit of your relatives, or for the benefit of companies under your control.
Basically, if any board member, officer, or key employee is involved in a decision setting compensation, disposing of property, or other financial transactions of the nonprofit or the nonprofit’s affiliate(s), where that board member, officer or key employee has a current financial interest, or had a financial interest in the last five years, that is considered an RPT. The same definition applies also to relatives of the board member, officer or key employee in question, where those relatives have a financial interest or within the last five years had a financial interest, with the nonprofit or one of its affiliates (if any).
And finally, the above applies to entities “controlled” by the board member, officer, or key employee and/or their relatives, if that controlled entity has a financial interest or within the last five years had a financial interest, with the nonprofit or its affiliates (if any). Terms like “Affiliate, Controlled Entities, Financial Interest, Key Employees, Officers and Relatives” mostly are defined in the statute for nonprofits, and in some other places by interpretation of various interplaying laws.
An example of an RPT is a board member who is president of a company that provides vital supplies that the nonprofit needs. The board member is willing to ensure that the company sells these supplies at a highly discounted value so that the nonprofit can acquire them cheaply. This is still an RPT and also a potential COI, even if the nonprofit gains a benefit from it and the board member’s company breaks even or even loses money on the transaction. It might still be possible to conduct this beneficial transaction for the nonprofit, but proper steps have to be taken to legitimize this.
Houston We Have A Problem
Okaley Dokaely. So, you identified individuals, like board members, officers, or maybe “key employees” with an actual or apparent COI or an RPT. What to do?
First, it is important that you realize a COI, by itself, does not necessarily mean that a decision maker is disqualified from participating in a particular decision or transaction, or that a specific decision or transaction is void or voidable or should be avoided. However, certainly, these are possible outcomes. It is also possible that certain decision makers should recuse themselves, or for the nonprofit to disqualify them, from participating in that particular decision or transaction.
What it does mean that is that you should Review, Resolve and Report. This will be part of your COI Policy, which remember, above? - your independent directors should have (and hopefully) approved for use in your nonprofit. A COI or RPT should not go forward unless at least a majority of independent board members believes the situation is reasonable, fair and in the best interests of the nonprofit (technically, you could set the bar lower for a COI than for an RPT but I do not recommend it, i.e. the nonprofit is free to figure out what to do about COIs, if anything, but has stricter statutory duties for RPTs).
There are all kinds of reasonable factors you could consider in determining whether a COI or an RPT is acceptable, and they are up to your nonprofit, including industry standards, situational factors, standard operating procedures of your particular nonprofit, exigencies, and so on. If your nonprofit board approves the transaction but someone dissents, ensure their dissent is recorded - if there is a later problem, their recorded dissent could add a further layer of protection against potential liability for that dissenting board member. The same applies to absent board members - if an absent board member disagreed with the decision to approve the COI or RPT, they should make sure the board secretary records their dissent in the minutes, or potentially they could be on the hook (if there is a hook) if something goes wrong with that decision.
Why This All Matters
If a COI, especially an RPT, is wrongfully approved, the attorney general can demand that the board members (1) account for any profits made from such transaction, and pay them back to the nonprofit (2) pay the nonprofit the value of the use of any of its property or other assets used in such transaction (3) return or replace any property or other assets lost to the nonprofit as a result of such transaction, together with any income or appreciation lost to the nonprofit by reason of such transaction, or account for any proceeds of sale of such property, and pay the proceeds to the nonprofit together with interest at the legal rate; and (4) pay, in the case of willful and intentional conduct, an amount up to double the amount of any benefit improperly obtained.
This is not a comprehensive “how-to” construct a Conflict of Interest Policy or how to stay out of trouble. However, this article should give you some ideas of what you need to look into, and where. The New York State Attorney General has many resources and pdf booklets online, easily found with a web search. You should take these duties very seriously, as they can have real consequences.
That said, as always, common sense will take you a long way: don’t do anything obviously fishy or “too easy.” Probably, pass on the baseball tickets by your nonprofit’s vendor. Don’t assume just because your company sells widgets that the nonprofit needs, that’s a slam dunk pairing. Don’t forget that essentially your family is counted like you - if your family member is going to benefit, it’s likely a conflict or an RPT. Same dealio with any other entities you and your family control or over which you exert substantial control. Avoid that stuff or ensure your nonprofit has clear policies and that you abide by them.
Remember, the assets of the nonprofit do not belong to you, or even the nonprofit; they are held in trust for the benefit of the nonprofit’s members and beneficiaries. Squeaky clean practices will insulate you personally, and your nonprofit, from trouble. And, others (regulatory authorities, the public) very well may give you the benefit of the doubt if something unfortunate does happen.
I know this blog issue might be a bit scary, but keep clam and carry on. You are doing a valuable great deed for others that really need your help. If your intentions are good, and you act in good faith, and you proceed diligently and reasonably, you very likely will be OK!
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 N-PCL, §101.
 N-PCL, §102.
 N-PCL, §715a.
 N-PCL, §712a(c) and (e).
 N-PCL, §102.
 N-PCL, §715; also see 26 USC §4958(f)(1)(A) and further specified in 26 CFR §53.4958-3(c), (d) and (e).
 N-PCL, §102.
 N-PCL, §102.
 N-PCL, §713; NYS Attorney General, Conflict of Interest Policy, Guidance Document 2015 - 4, V. 1.0, Issue date: April 13, 2015, Page 2. https://www.charitiesnys.com/pdfs/Charities_Conflict_of_Interest.pdf
 N-PCL, §715 and §715(a).
 N-PCL, §715 and §715(a).
 N-PCL, §719(b).