Super Lawyers Magazine
by Lisa A. Runquist
Updated 7/14/01
1. Introduction
Nonprofit organizations are big business. Because of this, and because of their unparalleled growth, nonprofits are receiving attention like they never have before (between 1974 and 1997, the sector doubled in size), both from Congress, and because of this, from the Internal Revenue Service. Another more disturbing reason is the spate of highly publicized scandals involving individuals profiting at a charity’s expense. Under these circumstances, anyone who participates in the oversight of a nonprofit organization would be well advised to pay close attention to its operations. One standard I would recommend be used to evaluate every activity of the nonprofit is: How will this look on the front page of the LA Times?
2. What Is A Nonprofit Corporation?
The most common form of nonprofit is the corporation. A corporation is a creature of statute formed by persons pursuing a common goal or enterprise. A principal advantage of a corporation over other possible organizational options, such as an unincorporated association, is that the corporate entity is considered to be its own “person” for legal purposes, distinct from its members, directors and officers. Furthermore, a corporation operates under a clearly defined set of rules of governance and law. The status of an unincorporated association and its members is less clear, particularly if the organization has out-of-state activities. Perhaps most importantly, if a corporation is properly formed and operated, it can offer considerable protection from personal liability to its individual directors, officers, shareholders or members.
The protection from personal liability for persons who act on behalf of corporations is not absolute. For that reason it is generally wise to confirm that the corporation either has substantial assets which can serve as a source for the payment of claims or that insurance coverage, applicable to potential claims, is in place. Care must also be taken throughout the corporation’s existence to observe proper formalities required of doing business in the corporate form, including, without limitation, management by or under the direction of the Board of Directors and the maintenance of minutes and other corporate records.
2.1 California’s Nonprofit Corporation Law
2.1.1 California’s Nonprofit Law, Generally.
The California Corporations Code contains a completely separate law for nonprofit corporations (the California Nonprofit Corporation Law; Cal. Corp. Code ‘ 5000, et seq.) which is divided into three parts, namely the Nonprofit Public Benefit Corporation Law (Cal. Corp. Code ” 5110-6815), the Nonprofit Mutual Benefit Corporation Law (Cal. Corp. Code ” 7110-8817), and the Nonprofit Religious Corporation Law (Cal. Corp Code ” 9110-9690). As the name suggests, the Nonprofit Religious Corporation Law applies to corporations formed primarily or exclusively for religious purposes and the Nonprofit Mutual Benefit Corporation Law applies to corporations formed to pursue a nonprofit purpose which is not charitable, religious or public in nature, but which is of common interest to the organizers such as a social club, a trade association or a community association. Finally, the Nonprofit Public Benefit Corporation Law regulates corporations formed for any public or charitable purpose.
2.2 What a Director Does/Does Not Do.
Directors are charged with responsibility for planning and directing the management of the charity’s business and affairs. Directors have no individual power as a director to bind the corporation. Instead directors, in their capacity as such, take action as a body and those decisions are documented by Board resolutions. Directors who are also officers may be authorized by Board resolution to act on the corporation’s behalf in their capacity as officers, but the Board acts as a unit.
Nevertheless, each director is individually accountable to the corporation’s members and, in the case of directors of charitable organizations, to the state and federal regulatory authorities (primarily the IRS, the State Franchise Tax Board and the Attorney General) who seek to protect the public’s interests in the charity.
Because it is essential to the organization’s tax exempt status that it abide by its stated purposes, one of the principal duties of a director is to be aware of the nature and extent of the charity’s exempt purposes and to assure that those purposes are properly pursued. The purpose of every act and decision of the director should be to advance the charity’s purpose. If the personal aims of the individual are not the same as the aims of the organization, then the individual should not serve as a director. In no event should a director initiate or knowingly support or condone actions that will either exceed or defeat the charity’s stated purposes. For this reason, care must be taken to assure that the Articles of Incorporation and Bylaws correctly state the purposes, in sufficient breadth to allow not only actual or planned activities, but also possible future activities.
2.3 Role of Corporate Officers and Agents.
Officers and agents of a nonprofit organization normally implement the decisions and policies established by the Board of Directors. Typically the Chief Executive Officer of a charity (often its “Executive Director”) and sometimes the Chief Financial Officer (typically called the “Treasurer”) answer directly to the Board. Most other employees, agents and contractors answer to the Executive Director or other senior management duly authorized by the Board.
Although a director of a nonprofit corporation, in his or her capacity as such, should not be involved in the day-to-day operations and activities of corporate management any more than a director of a business corporation, this rule is often ignored in practice. For many nonprofit organizations, particularly small entities operating with limited financial resources, the directors may be the only active participants within the organization. It is also typical for the directors and the officers to be one and the same individuals, particularly in smaller charities. Nevertheless, it is important, from a liability standpoint, for the individuals serving in dual director/management positions to carefully document in the corporate record the capacity in which they are acting.
2.4 The Role of Committees In Charitable Corporations.
2.4.1 Classification of Committees.
Because charitable corporations often place great reliance on volunteers, the creation of committees, to focus on particular tasks is common. If a committee is appointed by the Board to accomplish a single specific task with the view that the committee will dissolve upon completion of that task, it is generally termed a “special committee”. If a committee is established to perform an ongoing function on behalf of the corporation, such as the nomination of candidates for election to the board or the preparation of budgets and the review of financial materials, the committee is designated as a “standing committee”.
If a committee is intended to exercise the authority of the Board, non-directors may not serve on such committees. Committees given Board authority must be designated by resolution adopted by a majority of the total number of directors then in office, at a meeting at which a quorum is present, provided, however, that the Articles or Bylaws of the corporation may modify this rule to require that committees be appointed by a majority vote of a specified number of authorized directors. The concept of “exercising the authority of the board” denotes actions which can bind the corporation without prior authorization from, or later ratification by, the Board.
In addition to committees which are given the responsibility of the Board, corporations can create other committees which have no such authority. Actions of these committees must be ratified by the Board if they are to bind the corporation and their membership may include non-directors. If a committee has non-director members, its scope of authority is similar to that of corporate agents delegated specific responsibilities by the Board, subject to the Board’s ultimate direction and control.
2.4.2 Limitations on Authority of Committees.
Even when committees are comprised solely of directors and are given the authority of the Board, there are certain actions which cannot be taken by any committee. Although committees comprised solely of directors can exercise the authority of the Board (subject to statutory limitations), the Board should require each committee to report to the Board at the Board’s next meeting. Decisions of corporate committees may bind the Corporation and it is prudent, from a policy standpoint, for the Board to be aware of all actions taken by its committees. The existence of a ratification requirement could be important in terms of qualifying the transaction for directors’ and officers’ errors and omissions coverage.
2.5 Compensation of Directors
2.5.1 Private Inurement Issues.
Although tax-exempt charitable organizations are prohibited from being organized to benefit any particular person or narrow group of persons, charities are not prohibited from compensating their directors, officers and employees, although 51% of the directors of a public benefit corporation cannot be paid for services other than as a director. However, as discussed below, this is the area in which most nonprofits get into trouble, sometimes losing their exempt status. If even a single dollar of excessive compensation (i.e., “inurement”) is found, the charity’s tax exempt status may be lost.
2.5.2 Effect on Liability Protections.
It is also important to note that many statutes have been passed which seek to limit the liability of directors of nonprofit corporations so long as the director is serving as an uncompensated volunteer. Accordingly, the payment of compensation beyond a per diem or the reimbursement of a director’s out-of-pocket expenses could preclude the director from enjoying these statutory liability protections.
2.5.3 Effect on Funding Opportunities.
Finally, it is important to note that when excessive expenditures are made with respect to the Board and its activities, certain types of funding may be jeopardized. The purpose of the organization and the service of its directors should not be to benefit themselves as individuals or to provide “perks” to the Board and senior management. Rather, the principal objective should always be to advance the purposes of the charity, itself. Funds that are spent on Board activities are not available to be used to advance the nonprofit purposes of the organization. This does not mean that money should never be spent on Board activities, but that each expenditure should be justified in light of the corporation’s specified purposes.
3. Observance of Corporate Formalities
3.1 Why Observe Corporate Formalities
As noted above, a corporation is considered a separate entity under the law, separate and distinct from its members, directors and officers. Furthermore, if the corporation’s directors serve their corporation in accordance with the standard of care described below, they are protected from liability for simple errors in business judgment (except for certain tortious conduct), while the corporation will reap the consequences and/or benefits of their actions. Finally, the members, if any, of a corporation are protected from personal liability for the corporation’s debts, liabilities and obligations (see Cal. Corp. Code Section 5350(a)).
To receive all of the benefits associated with doing business in the corporate form, however, it is important for the corporation’s directors, officers and members to demonstrate that the actions in which they participated were performed by and on behalf of the corporate entity. That corporate actions were intended is most commonly demonstrated by a complete set of corporate minutes, board resolutions and contracts executed in the name of the corporation by duly authorized agents. If verification of corporate action cannot be made because records have been poorly maintained or are non-existent, it may be possible for persons dealing with directors, officers or members to hold them personally liable. This is commonly referred to as “piercing the corporate veil.” Poor record keeping can also jeopardize a nonprofit corporation’s tax exempt status, since the IRS and the State FTB can demand proof that the corporation is operating in a manner consistent with its exempt classification.
3.2 Matters Which Should Be of Concern To The Board
The following is a summary list of the types of matters and issues which should be of concern to directors of a nonprofit charitable organization:
A. Periodic review and evaluation of the Executive Director and other officers;
B. Review of financial reports on at least a quarterly basis and audits following the close of the fiscal year;
C. Careful review of other materials submitted to the Board;
D. Development of both long and short range plans for achieving the corporation’s purposes;
E. Budgeting, fund raising and funding of operations;
F. Complete and thoughtful review and consideration of reports and advice upon which the Board is permitted to rely under the general standard of care;
G. Risk exposures and insurance for the corporation, the Board, and the individual directors;
H. Quality control;
I. Regular attendance by directors at meetings and other indicia of diligence;
J. Development and periodic review of corporate policies;
K. Employee appeals, disputes and complaints (particularly complaints of harassment or discrimination involving management personnel);
L. Nominations for election to the Board.
M. Proposals to amend the Articles or Bylaws.
3.3. Directors’ Rights to Access Information.
Because directors have a duty to make responsible and informed decisions, every effort should be made to furnish information to directors, in advance of the meeting, which is relevant to the actions they will be considering. As a companion to this rule, it should be noted that Section 6334 of the Corporations Code gives every director the absolute right at any reasonable time to inspect and copy all books, records and documents of every kind and to inspect the physical properties of the corporation. These inspection rights cannot be limited by the Articles or Bylaws. See Corp. Code Section 6313.
Just because directors enjoy an absolute right to inspect all corporate books and records does not mean that they are also free of constraints regarding the use of information in their possession. A director’s fiduciary obligation to act at all times in a manner which furthers the corporation’s best interests and purposes may preclude disclosure of certain information (such as attorney-client correspondence), the use of information for personal gain or any other use which does not further the corporation’s purposes.
3.4. Documenting Corporate Actions.
When action is taken at a meeting, the proper procedure is to document that action in corporate minutes. In fact, Section 6320 of the Corporations Code requires nonprofit public benefit corporations to keep minutes of the proceedings of its members (if any), its Board and any committees of the Board. Having maintained contemporaneous documentation will often be found to be critical, especially if the organization finds itself under audit by the IRS, or accused of violating the intermediate sanctions (discussed below).
If a director disagrees with the actions approved by the Board majority, the director has a right to demand that his or her dissent be noted in the minutes. Affirmative disapproval of actions could protect the dissenting director from personal liability in the event that the majority’s actions result in personal injury to a third party (see Frances T. v. Village Green Owners Assn. (1986) 42 Cal.3d 490, 511).
4. Conflicts of Interest
One area of corporate law that has become increasingly important in the nonprofit arena, is that of conflicts of interest. Directors of a nonprofit corporation are expected to adhere to a fiduciary standard, when exercising their responsibilities.
4.1 What Is Meant By “Fiduciary Duty”?
4.1.1 General Definition.
Modern usage of the concept of a fiduciary includes any person who has a duty to act primarily for the benefit of others in matters connected with the undertaking. The cases speak of a “special confidence reposed in one who, in equity and good conscience, is bound to act in good faith and with due regard to the interests of the person who has reposed that confidence.” The type of persons who are commonly referred to as fiduciaries include trustees, attorneys and corporate directors.
4.1.2 The Strict Trustee Standard of Duty.
Cases involving strict fiduciary relationships, such as cases involving claims against trustees, also impose the rule that the fiduciary cannot exert pressure or influence on the party the fiduciary is serving or take any selfish advantage of his or her trust. Trustee-fiduciaries are also prohibited from dealing with the subject matter of the trust in a way which benefits the interests of the trustee or prejudices the beneficiary, unless the fiduciary is acting in the utmost good faith and with the full knowledge and consent of the beneficiary.
4.1.3 The Standard Applied to Directors of Nonprofit Corporations.
The directors of both business and nonprofit corporations have been described in numerous cases as owing a fiduciary duty to their shareholders or members, as well as to the corporation. However, it is well established that a strict trustee standard of duty, which would prohibit any self-dealing with the corporation, regardless of the benefit conferred, is generally not what is intended or required (at least not in California).
4.2 Definition of the Directors’ Standard of Conduct (The “Duty of Care”).
The standard of conduct prescribed for directors of nonprofit public benefit corporations is essentially the same standard that the Legislature has imposed on business corporations under Corporations Code Section 309. That standard, as applied to public benefit, mutual benefit and religious corporations, is found in Corporations Code Sections 5231, 7231, and 9241 and is generally referred to as the directors’ “duty of care.” The basic rule reads as follows:
“A director shall perform the duties of a director, including duties as the member of any committee of the board, . . . in good faith, in a manner the director believes to be in the best interests of the corporation, and with such care, including reasonable inquiry, as is appropriate under the circumstances.”
Directors are authorized to rely on information, opinions, reports or statements, including financial statements, prepared or presented by:
(a) One or more officers or employees of the corporation whom the director believes to be reliable and competent in the matters presented;
(b) Counsel, independent accountants and other persons as to matters which the director believes to be within such person’s professional or expert competence; or
(c) A committee of the Board upon which the director does not serve as to matters within the committee’s designated authority.
and for religious corporations,
(d) Religious authorities and ministers, priests, rabbis or other persons whose position in the religious organization the director believes justify reliance.
In relying on the opinions or reports of others, the director must, of course, act in good faith and conduct reasonable inquiry when the need for such inquiry is indicated by the circumstances. The director must also be free of any knowledge which would cause reliance on data received from others to be unwarranted.
4.3 The Directors’ Duty of Loyalty
4.3.1 Generally.
The admonition found in Sections 5231, 7231 and 9241 that a director must act in a manner that the director believes to be in the best interests of the corporation has often been termed the “duty of loyalty.” The duty of loyalty has generally been construed as an obligation of the corporate directors to act in the best interests of the corporation and all of its members, including the members of minority factions, and to administer their corporate powers for the common benefit. See Remillard Brick Co. v Remillard-Dandini Co. (1952) 109 Cal.App.2d 405. This is in keeping with the fundamental nature of a nonprofit, to advance and achieve the corporate purpose, rather than to benefit the interests of any private individuals. Directors are to champion the best interests of their organization (which may include their constituents), rather than personal or selfish interests.
To help ensure that persons with selfish interests are not making corporate decisions, CCC ‘ 5227 requires that at least half of a California nonprofit public benefit corporation’s directors must not be compensated by the nonprofit for services (other than nominal payments to directors for serving as such). Amendments to this section in 1996 give it teeth, by giving certain persons standing to sue to enforce it.
4.3.2 Statutory Regulation of Self-Dealing Transactions.
In speaking of a director’s duty of loyalty, the common thought is that a director should avoid participating in, or seeking to influence, any transaction involving the corporation where the director has a conflict of interest. The California Nonprofit Corporation Law contains no such bright line rule, although the Attorney General’s representatives argued in favor of a complete ban on any self-dealing by nonprofit directors. Instead, Corporations Code Sections 5233 and 9243, and to a lesser degree, 7233 present a complicated statutory scheme for approval of “self dealing transactions”, defined as any transaction to which the corporation is a party, and in which one or more of its directors has a material financial interest. Failure to follow proper procedures can result in strict sanctions on directors of public benefit and religious corporations, and to some degree mutual benefit corporations who engage in self-dealing transactions.
The complexity of the statutory prohibition on “self-dealing transactions”, especially with regard to public benefit and religious corporations, reflects an attempt by the Code’s drafters to accommodate most of the concerns expressed by the Attorney General, while permitting some types of transactions between a corporation and one or more of its directors which might be of substantial benefit to the corporation. Most of the sections’ complexity revolves around the attempt to define what transactions are included and excluded from the term “self-dealing”. In addition, there is no attempt in the statute to define the term “financial interest” or the word “material”. It is also unlikely that the prohibitions of these sections extend to most transactions involving relatives of a director (other than the director’s spouse) or to transactions between the corporation and another corporation in which the director is merely an officer. The following specific situations are excluded (Corp. Code ” 5233(b), 9243(b)):
(a) Actions of the Board fixing director or officer compensation;
(b) Transactions which are part of the corporation’s public, charitable or religious program which are approved by the corporation in good faith and without unjustified favoritism, even if one or more directors or their families are benefited as part of a class of persons intended to be benefited by the program; and
(c) Any transaction of which the interested director or directors have no actual knowledge, and which does not exceed the lesser of one percent of the gross receipts of the corporation for the preceding fiscal year or $100,000.
Finally, there are several ways which the Code permits a transaction which otherwise would be prohibited as falling within the definition of a self-dealing transaction. Such participation is permitted if it is approved or validated in any one of the following ways (Corp. Code ” 5233(d), 9243(d)):
(a) The Attorney General can approve the transaction, either before or after it is consummated;
(b) If a religious corporation, the transaction may be approved by the members of the corporation who are not directors, after disclosure of the material facts and the director’s interest;
(c) The transaction can be validated by proving that: (i) the corporation entered into the transaction for its own benefit; (ii) the transaction was fair and reasonable as to the corporation; (iii) the Board approved the transaction in advance with knowledge of the director’s interest and by a majority vote (without counting the vote of the interested director(s)); and (iv) that prior to approving the transaction the Board considered and in good faith determined, after reasonable investigation under the circumstances, that the corporation could not obtain a more advantageous arrangement with reasonable effort; or
(d) The transaction can be validated by approval of the transaction by a committee or person authorized by the board so long as it is established that: (i) the approving committee or person utilized the standards that the Board must follow under (b), above; (ii) it was not reasonably practicable to obtain prior Board approval; and (iii) the Board, after determining that the requirements for committee approval had been satisfied, ratifies the transaction at its next meeting by a vote of a majority of the directors (excluding the vote of any interested director).
Sections 5233(e) and 9243(e) establish a two-year statute of limitations for initiating an action on account of an alleged self-dealing transaction if written notice setting forth the material facts of the transaction and the director’s interest is filed with the Attorney General by the Board. If no such notice is filed, the limitations period for a religious corporation is five years after the cause of action has accrued, and for a public benefit corporation, is three years, except for the Attorney General, who has 10 years to file.
If an action is timely filed and a self-dealing transaction is found to have occurred, the remedy specified in Sections 5233(h) and 9243(h) is that the defendant director “shall do such things and pay such damages as in the discretion of the court will provide an equitable and fair remedy to the corporation, taking into account any benefit received by the corporation and whether the interested director or director(s) acted in good faith and with intent to further the best interest of the corporation.”
Note that under California law, a self-dealing transaction, itself, is not void, voidable or invalid. Instead, the focus is on making the interested director disgorge his or her profits in the matter and making the organization whole. The Court can order the director to make an accounting and pay the profits to the corporation, require the interested director to reimburse the corporation for the value of any corporate property used in the transaction, or require the interested director to return or replace corporate property lost in the transaction or to account to the corporation for the proceeds of any property sold and to pay those proceeds, plus interest, to the corporation.
4.4 Absence of Personal Liability (The “Business Judgment Rule”).
With the exception of liability for “self-dealing transactions”, if a director performs his or her duties in accordance with the standard of care specified in Corporations Code Sections 5231, 7231 and 9241, the director “shall have no liability based upon any alleged failure to discharge the his or her duties as a director.” This exemption, which is commonly referred to as the “business judgment rule,” applies even when the director’s actions or omissions exceed or defeat the corporation’s purpose.
The business judgment rule is rooted in the idea that directors should be entitled to (and in order to properly manage an enterprise must) exercise a broad range of discretion in issues of corporate management and should not be subjected to hindsight assessments of their decisions by the courts. The rule originated in the context of business corporations where shareholders often expect management to take risks in order to maximize profits. Although profit seeking is generally absent from the nonprofit, the justifications for the rule is no less compelling for directors of nonprofit corporations since the element of risk taking and the need for the organization to operate in a “business-like fashion” in order to continue in operation continue to be present; therefore, the concept that directors’ decisions should not be second guessed without a substantial basis for doing so remains relevant to nonprofits. Frequently, it will not be obvious which of several alternative decisions will turn out to best carry out the corporation’s mission.
4.5. Exception for Tortious Conduct.
Even if all of this is done correctly, liability of directors and officers may be found to exist. The leading case in this area is Frances T. v. Village Green Owners Assn. The facts of this case, as summarized by the California Supreme Court are:
On the night of October 8, 1980, an unidentified person entered plaintiff’s condominium unit under cover of darkness and molested, raped and robbed her. At the time of the incident, plaintiff’s unit had no exterior lighting. The manner in which her unit came to be without exterior lighting on this particular evening forms the basis of her lawsuit against the defendants.
Throughout 1980, the Project was subject to what plaintiff terms an `exceptional crimewave’ … All of the Project’s residents, including the board, were aware of and concerned about this `crimewave’. … In early 1980 the board began to investigate what could be done to improve the lighting … Plaintiff’s unit was first burglarized in April 1980. … In May 1980 plaintiff and other residents of her court had a meeting … [and] transmitted a formal request to the Project’s manager with a copy to the board that more lighting be installed in their court as soon as possible. Plaintiff submitted another memorandum in August 1980 because the board had taken no action on the previous requests. … By late August, the board had still taken no action. Plaintiff then installed additional exterior lighting at her unit, believing that this would protect her from crime.
Unfortunately, the additional lighting was found to violate the CC&R’s, and plaintiff was directed to remove the additional exterior lighting and was told that:
…pending their removal, she could not use the additional exterior lighting. … In order not to use her additional lighting, plaintiff was required to forego the use of all of her exterior lights. … plaintiff complied with the board’s order and cut off the electric power on the circuitry controlling the exterior lighting during the daylight hours of October 8, 1980. As a result, her unit was in total darkness on October 8, 1980, the night she was raped and robbed.
4.5.1 Background.
Formerly, as long as a director performed his or her duties in accordance with the requisite standard of care as specified in Corporations Code Section 5231, the director would “have no liability based upon any alleged failure to discharge the person’s duties as a director.” This exemption, which is commonly referred to as the “business judgment rule,” applies even when the director’s actions or omissions exceed or defeat the corporation’s charitable purpose.
The California Supreme Court held in Frances T. that the business judgment rule of Corporations Code Section 7231 is not a bar to individual director liability if a director participates in tortious conduct, even if the director is acting in his or her official capacity. In the Frances T. case, the plaintiff alleged that: (i) the association directors owed a duty to her; (ii) they had specific knowledge that a hazardous condition existed which threatened her personal safety; and (iii) they failed to take action to avoid the harm. In ruling that the plaintiff had stated a cause of action against the directors as individuals, the Supreme Court stated that:
Directors are liable to persons injured by their own tortious conduct regardless of whether they acted on behalf of the corporation and regardless of whether the corporation is also liable…. Directors owe a duty of care, independent of the corporation’s own duty, to refrain from acting in a manner which creates an unreasonable risk of personal injury to third parties…. A distinction must [also] be made between the director’s fiduciary duty to the corporation (and its beneficiaries) and the director’s ordinary duty of care not to injure third parties. The former duty is defined by statute [i.e., Corporations Code Section 7231], the latter by common law tort principles.
To maintain a tort claim against a director, individually, the Frances T. court held that the plaintiff must show that: (i) the director specifically authorized, directed or participated in the tortious conduct; or (ii) the director knew or should have known that a condition under the board’s control was hazardous and could cause injury and yet the director negligently failed to take action to avoid the harm; and (iii) an ordinarily prudent person, possessing the same knowledge as the director, would have acted differently.
The California Supreme Court specifically noted that individual directors named in a personal injury suit have a defense against personal liability if their conduct was not clearly unreasonable under the circumstances or if they reasonably relied on expert advice or the decision of a subordinate who was in a better position to act. In light of the court’s specific rejection of the business judgment rule as a shield from personal liability, this confirmation that directors have a defense to personal liability if they can prove that they reasonably followed expert advice or reasonably delegated decisions to a subordinate or committee seems inconsistent, yet beneficial. The Francis T. court also held that any director who did not vote in favor of the action which caused the injury would have a defense to personal liability.
4.5.2 Legislative Response to Frances T.
The Frances T. case understandably caused consternation throughout the nonprofit community. The court expressly acknowledged that the defendants had fulfilled their fiduciary duties to the plaintiff in her capacity as a member of the corporation. Yet the Court ruled that those same directors could be held liable to the same plaintiff for the personal injuries she had suffered.
Following publication of the Frances T. case, the California Legislature enacted and amended various code sections, such as Code of Civil Procedure Section 425.14 and Corporations Code Sections 5047.5 and 5239 and other similar provisions extending some measure of protection to directors of public benefit, mutual benefit and religious corporations.
These inconsistently worded liability protection statutes, with curious categories of included and excluded organizations, is indicative of hastily negotiated compromises reached by lobbyists for various segments of the nonprofit community. The subparagraphs that follow describe the principal liability “protections” presently available to directors of California charitable corporations.
4.5.3 Corporations Code Section 5047.5.
Section 5047.5 is found in Part 1 of the Nonprofit Corporations Law which presents defined terms and other provisions which typically apply to corporations in all three nonprofit categories (i.e., public benefit, mutual benefit, and religious). Because of its location, Section 5047.5 should apply to all categories of nonprofit corporations, yet by its terms the Section is restricted to Internal Revenue Code Sections 501(c)(3) and 501(c)(6) organizations, and then only to those that are organized for religious, charitable, literary, educational, scientific, social and other forms of public service purposes. The section purports to protect “uncompensated” directors of covered entities from personal liability for monetary damages on account of negligent acts or omissions occurring within the scope of the person’s duties as an uncompensated director or officer and in the exercise of his or her policy-making judgment so long as the act or omission was in good faith and in a manner the director or officer believes to be in the best interests of the corporation.
Specifically excluded from the liability protection benefits of section 5047.5 are:
* Actions alleging that the director or officer is guilty of self-dealing as defined in Corporations Code Section 5233.
* Actions maintained by the Attorney General against the director or officer.
* Liabilities arising from intentional, wanton or reckless acts, gross negligence, fraud, oppression or malice on the part of the director or officer.
Before an uncompensated director or officer who clears all the hurdles described above can claim protection under Section 5047.5, the corporation he or she serves must maintain general liability insurance applicable to the claim with minimum coverage of at least $500,000 if the corporation has an annual budget under $50,000; or $1 million if the corporation’s annual budget equals or exceeds $50,000. Because a general liability insurance policy will almost never be applicable to a claim against a director or officer, this provision makes any protection afforded by this statutory provision totally illusory.
Further, there is nothing in the statute to limit the suits that are brought against the directors. Even uncompensated directors and officers who arguably fall under the statute’s umbrella of liability protection are likely to face ongoing litigation exposure as they challenge pleadings alleging bad faith, or reckless, willful, wanton, or intentional conduct. Thus, it is likely that nonprofit corporations included within the scope of Section 5047.5 and their directors and officers will continue to be faced with providing a defense of directors and officers named in liability suits.
To make matters worse, it is not clear that any protection afforded by the statute would do away with the Frances T. type of liability that continues to be of concern.
With regard to the issue of compensation, many directors serve as volunteer directors, but may receive compensation for other services rendered. A director who receives no compensation for service as a director, but who receives compensation for other services rendered, does not fall within the statute’s protection.
The standard of care as set forth in Section 5047.5 is essentially the same standard required under Section 5231, but without the ability to rely upon third parties. As a result, section 5047.5, which is supposed to afford more protection, may actually result in less protection to the directors to whom it applies.
In conclusion, Section 5047.5 contains so many exceptions, exclusions and qualifications that the protection it appears to provide is largely illusory.
4.5.4 Corporations Code Section 5239.
Section 5239, applicable to nonprofit public benefit corporations, relieves volunteer directors and volunteer executive officers of such corporations from personal liability for damages caused by the director’s or officer’s negligent act or omissions in the performance of duties as a director or officer. The officers included in the definition of “executive officer” are the president, vice-president, secretary or treasurer. Cal. Corp. Code Section 5239(c).
To be eligible for this statutory protection, damages caused by the act or omission must be covered by a policy of insurance issued to the corporation or directly to the director or executive officer. Section 5239 does not specify any minimum level of insurance coverage nor does it address the issue of insurance deductibles, and therefore an ambiguity is created with respect to the requirement that damages be “covered” by insurance. Does the phrase mean complete coverage or reasonable coverage, given the nature of the corporation and its activities? If no insurance is applicable to the claim, the director or executive officer may still gain protection from liability by establishing that both the board and the director or officer made “all reasonable efforts in good faith to obtain available liability insurance.”
The protections of Corporations Code Section 5239 are not available if a director or officer receives any salary, fee or other consideration of any kind (other than a per diem or expense reimbursement). Second, directors or executive officers seeking liability protection under the Section must prove that: (a) the act or omission was within the scope of the officer’s or director’s duties; (b) the director or officer acted in good faith; (c) the act or omission did not involve self-dealing (as defined in Corp. Code ‘ 5233); and (d) that the act or omission was not reckless, wanton, intentional or grossly negligent. A director or executive officer is likely to remain mired in the litigation for many months, while his or her lawyers seek to establish that all of the requirements for statutory liability protection have been met and that none of the exceptions apply.
As with Section 5047.5, it is not clear that any protection afforded by the statute would do away with the Frances T. type of liability that continues to be of concern.
Again, as with Section 5047.5 the standard of care as set forth in Section 5239 is essentially the same standard required under Section 5231, but without the ability to rely upon third parties. As a result, Section 5239 affords less protection to directors than does Section 5231.
Finally, it should be noted that the personal liability protections afforded by 5239 have no application in the context of any action or proceeding brought by the Attorney General or any action claiming that the director engaged in a prohibited self-dealing transaction.
4.5.5 Code of Civil Procedure Section 425.14.
The last liability protection provision which appears to apply to uncompensated directors and officers of nonprofit corporations organized for “charitable, educational, social, scientific or public service” purposes is California Code of Civil Procedure Section 425.14. What Section 425.14 purports to do is create what is commonly described as a “pleading hurdle” to shield qualified nonprofit directors and officers from suits based on claims arising out of negligent acts or omissions by the director or officer within the scope of the person’s duties as such. Such a claim can only be included in a complaint following a judicial determination (based on a verified petition and supporting affidavits) that evidence exists which substantiates the claim.
Unfortunately, Section 425.14 has as many exceptions, exclusions and qualifications regarding coverage as the two Corporations Code provisions described above. For example:
* Despite the broad reference to “charitable, educational…and scientific” organizations, the pleading hurdle of Section 425.15 is not available to Internal Revenue Code Section 501(c)(3) charitable or educational organizations. Instead, the Section’s coverage is limited to organizations which qualify for exemption under Internal Revenue Code Sections 501(c)(1) (exempt credit unions), 501(c)(5), 501(c)(7) or 501(c)(19).
* The director or officer of a listed exempt organization can receive no compensation.
* The filing of a petition pursuant to Section 425.15 (seeking approval to sue the director or officer) tolls the running of any applicable statute of limitations and requires a vigorous defense of the petition’s allegations.
As can be seen, the “volunteer protection” given to nonprofit directors and officers in California is largely illusory. The potential liability of directors of nonprofits is greater than the potential liability of directors of business corporations. To date, the legislature has resisted adopting any legislation that would adequately protect directors of nonprofits from third party lawsuits.
4.6 Statutory Indemnification Rights of Directors and Officers.
4.6.1. Statutory Scheme of Indemnification, Generally.
In addition to the limited statutory protections against personal liability afforded by the general standard of care, Corporations Code Sections 5047.5 and 5239, and Corporations Code Section 425.15, Code of Civil Procedure Section 424.15, and the protections afforded by a good insurance program, the law permits corporations to indemnify directors and officers under a very strict and technical provisions. Of course, even when such rights of indemnity are available, they are only as good as the financial strength of the corporation.
Specifically, when directors and/or officers of a public benefit corporation are sued, Corporations Code Section 5238 permits the corporation to indemnify the named defendants to the extent provided in the section. In fact, this indemnification authority extends beyond directors to include all officers (not just “executive officers”) as well as other “agents” of the corporation, such as corporate employees. The scope of the permitted indemnity extends to “any threatened, pending or completed action or proceeding, whether civil, criminal, administrative or investigative.” The intent of this broad language is to cover all legal threats asserted against a director or officer with respect to which he or she may be forced to employ counsel or otherwise incur expense. In the following discussion, references to corporate agents shall include directors and officers. Unlike the General Corporation Law, Section 5238 does not permit the corporation’s articles to confer broader indemnification rights than those it provides.
A corporate agent cannot demand indemnification in all instances. Instead, except as provided below, a public benefit corporation can only authorize indemnification in a specific case, upon determination that indemnification of the agent is proper under the circumstances because the agent’s conduct satisfied the minimum standards of care. Different standards of care are imposed for agents named in suits brought by third parties, on the one hand, and for agents named in derivative suits brought on behalf of the charitable corporation, suits challenging a self-dealing transaction or suits brought by the Attorney General, on the other. Where a director breaches his or her fiduciary duties to the corporation, no indemnification is permitted regardless of who brings the action.
Assuming the applicable standard of care has been met by the corporate agent, authorization for indemnification may be made in any of the following ways:
(i) By a majority vote of a quorum consisting of directors who are not parties to the proceeding;
(ii) By approval of the members, excluding the vote of any person to be indemnified;
(iii) By approval of the court in which the proceeding is or was pending upon application by the corporation, the defendant agent or by the attorney who is providing the agent’s defense.
Unlike the General Corporation Law, there is no authority in Section 5238 to have indemnification approved by independent legal counsel if it is impossible to obtain a majority vote of disinterested directors.
4.6.2. Minimum Standard of Care for Indemnification.
If the suit naming the director or officer has been filed by a third-party plaintiff (i.e., a non-derivative action), in order to authorize indemnification the corporation must determine that the agent acted in good faith and in a manner he or she reasonably believed to be in the best interests of the corporation. If the case is a criminal proceeding, it must also be established that the agent had no reasonable cause to believe that his or her conduct was unlawful. Corp. Code Section 5238(b). Unlike the standard for indemnity in the context of derivative or Attorney General actions (see next paragraph), in third-party suits there is no requirement that the director exercise the care than an “ordinarily prudent person” would use, presumably because the director is being held liable to a third party precisely because the director failed to use such care.
In the case of any action: (i) brought “in the right of the corporation” (i.e., a derivative action); (ii) brought under Section 5233 (self-dealing transactions); or (iii) brought by the Attorney General, indemnification is only proper if the corporation concludes that the agent was acting in good faith, in a manner he or she believed 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. Corp. Code Section 5238(c). Although this standard for derivative, self-dealing and Attorney General actions appears more stringent than the standard applicable to third-party actions, it should be noted that in a third party action, it is required that the agent “must have reasonably believed” that his or her actions were in the best interests of the corporation, whereas in a derivative action it is only necessary that he or she actually believed that this was the case.
The fact that indemnification is conditioned upon a finding that the agent performed his or her duties in accordance with the specified minimum legal standard does not necessarily mean that the agent must win the lawsuit in order to qualify for indemnification. Section 5238(c)(1) states that no indemnification shall be made “in respect of any claim, issue or matter as to which such person shall have been adjudged to be liable to the corporation in the performance of such person’s duty to the corporation, unless and only to the extent that the court in which such proceeding is or was pending shall determine upon application that, in view of all the circumstances of the case, such person is fairly and reasonably entitled to indemnity for the expenses which the court shall determine.” Accordingly, the Code authorizes the court to determine that the agent is entitled to indemnification for his or her expenses, even though the agent has lost the case and did not meet the standard of conduct referred to above. This decision is left almost entirely to the court’s discretion.
Section 5238(c)(3) also permits indemnification of expenses incurred in defending a threatened or pending action which is settled or otherwise disposed of without court approval so long as to the settlement is approved by the Attorney General.
4.6.3. Agents’ Right to Demand Indemnification.
As noted above, indemnification is generally contingent upon obtaining proper corporate approval, in accordance with the procedures noted above. However, directors or officers have the right, pursuant to Section 5238(d), to be indemnified with respect to expenses actually and reasonably incurred in the defense of any proceeding (whether third party or derivative) if they are successful on the merits. Note that this absolute right to indemnification upon demand exists even when the agent wins a suit brought by the Attorney General. Subparagraph (d) of Section 5238 recognizes the right of a director or officer, which probably existed at common law, to compel the corporation to indemnify the director/officer with respect to expenses incurred in litigation arising out of the directors’/officer’s performance of services as an agent on behalf of the corporation.
If a corporate agent is only successful with respect to a portion of a suit, expenses must be apportioned among the various claims. If the charity resists indemnification under circumstances where the agent has been successful in his or her defense, the agent has a right to file an independent lawsuit against the charity to collect the amounts to which he or she is entitled. In the alternative, the agent has the right to apply for indemnification to the court in which the action is pending, regardless or whether the application is opposed by the corporation.
4.6.4. Amount of Indemnification.
In all of the cases where indemnification is properly authorized by the corporation or may be claimed as a right by the director or officer, the indemnification may include all expenses that the agent incurred in defending the case, including attorneys’ fees and expenses incurred to establish the director’s/officer’s right to indemnity. However, when a director or officer seeks indemnification not only with respect to his or her expenses, but also with respect to sums paid in response to an adverse judgment or in settlement, once again, the statute distinguishes between third party actions and derivative actions. If the claim is a third party claim, indemnification is proper not only with respect to expenses, but also with respect to “judgments, fines, settlements and other amounts actually and reasonably incurred.” This permits the corporation to indemnify the agent for any amounts to which the agent is held liable in the action.
In derivative actions, on the other hand, indemnification is limited to “expenses actually and reasonably incurred”. The logic of not permitting indemnification of amounts paid in settlement or on account of an adverse judgment in a derivative action is that the settlement or judgment is likely to require the defendant to pay amounts to the corporation, since the corporation in such an action is the party in whose favor judgment is being sought, and indemnification would reverse that payment, perhaps with additional rebates of legal fees and court costs.
4.6.5. Advancement of Litigation Expenses.
Section 5238(f) provides that “Expenses incurred in defending any proceeding may be advanced by the corporation prior to the final disposition of such proceeding upon receipt of an undertaking by or on behalf of the agent to repay such amount unless it shall be determined ultimately that the agent is entitled to be indemnified as authorized in this section.” This provision permits the charity to pay currently the legal fees and other expenses incurred by a director or officer in defending an action, without having to make a final determination whether indemnification will ultimately be authorized. Advancement of expenses can be approved by Board resolution and the directors need not comply with one of the three listed methods for authorizing indemnification.
The more liberalized approval for the advancement of expenses reflects the fact that many actions against corporations and their directors and officers are frivolous and therefore an advancement of expenses should be fairly easy to obtain in order to enable the individual defendants to present an adequate defense which they might not otherwise be able to afford. If it is ultimately determined that the director or officer is not entitled to indemnification, the corporation would be obligated to pursue appropriate legal remedies to enforce the agent’s commitment to reimburse the corporation.
4.6.6. Expansion of Indemnification Rights is Prohibited.
Section 5238(g) does not permit the corporation to expand indemnification rights, beyond those set forth in Section 5238, by including a more liberal provision contained in the Articles or Bylaws. This rule is contrary to the rule applicable to business corporations under Corporations Code Section 317. In contrast, Section 317(g) permits business corporations to offer broader indemnification pursuant to an appropriate article or bylaw provision.
4.6.7. Insurance To Fund Indemnities.
Section 5238(i) permits a corporation to purchase and maintain insurance on behalf of any agent against any liability asserted or incurred by the agent in his or her capacity as such, regardless of whether the corporation has the power to indemnify the agent against the liability under Section 5238. However, this insurance authorization has one exception, namely that charities are prohibited from purchasing insurance to indemnify any agent for a violation of the self-dealing prohibitions of Section 5233.
4.7 Federal Volunteer Protection Act.
On June 18, 1997, the “Volunteer Protection Act of 1997” was enacted into law by the United States Congress (111 Stat. 218). As with similar state laws, the purpose of this Act is to limit lawsuits against volunteers serving nonprofit public and private organizations and governmental agencies. The Act was enacted in response to the withdrawal of volunteers from service to nonprofit organizations because of concerns about possible liability. By limiting lawsuits against such volunteers, it was thought that the number of volunteers would increase, thus promoting the ability of nonprofit organizations and governmental entities to provide services at a reasonable cost. The intention of this law is laudable. However, the language of the Act is flawed, and is unlikely to provide significant protection for volunteers. It will not shield volunteers from the time, expense and aggravation of defending a lawsuit, even if the Act is ultimately found to bar a judgment. At its worst, the Act may create a guide map for pleading within the statutory exceptions and limitations in order to plead technically adequate causes of action or defenses, thus surviving possible legitimate challenges early in an action and embroiling volunteers in expensive and protracted litigation. See VOLUNTEER PROTECTION ACT OF 1997 – AN IMPERFECT SOLUTION for more specific information.
4.8 IRS’ Position on Conflicts of Interest.
As is discussed above, the duty of loyalty requires that when a director is making a decision on behalf of the corporation, he/she must be looking out for the corporation’s best interests, rather than his/her own. When a decision could benefit or harm the director personally, then the director is considered to have a conflict of interest. This has become a particular concern to the IRS, especially with regard to private benefit and private inurement issues.
This concern is addressed in the 1996 (for 1997) Exempt Organizations CPE Technical Instruction Program Textbook, in an article entitled, “Community Board and Conflicts of Interest Policy. The IRS describes the purpose of a conflicts of interest policy:
“The primary benefit of a conflicts of interest policy is that the board can make decisions in an objective manner without undue influence by persons with a private interest. The presence and enforcement of a conflicts of interest policy can also help assure that an exempt health care organization fulfills its charitable, properly oversees the activities of its directors and principal officers, and pays no more than reasonable compensation to physicians and other highly compensated employees.” FY 1997 CPE Textbook Chapter C, p.18-19.
Although this article focuses specifically on the health care industry, everything is equally applicable to non-health care exempt organizations.
According to the 1997 Textbook, “A substantial conflicts of interest policy should include the following provisions:
A. Disclosure by interested persons of financial interests and all material facts relating thereto.
B. Procedures for determining whether the financial interest of the interested person may result in a conflict of interest.
C. Procedures for addressing the conflict of interest after determining that there is a conflict:
1. Requiring that the interested person leave the meeting during the discussion of, and the vote on, the transaction or arrangement that results in the conflict of interest;
2. Appointing, if appropriate, a disinterested person or committee to investigate alternatives to the proposed transaction or arrangement;
3. Determining, by a majority vote of the disinterested trustees present, that the transaction or arrangement is in the organization’s best interests and for its own benefit; is fair and reasonable to the organization; and, after exercising due diligence, determining that the organization cannot obtain a more advantageous transaction or arrangement with reasonable efforts under the circumstances; and
4. Taking appropriate disciplinary and corrective action with respect to an interested person who violates the conflicts of interest policy.
D. Procedures for adequate record keeping. The minutes of the board meeting and all committees with board-delegated powers should include:
1. The names of the persons who disclosed financial interests, the nature of the financial interests, and whether the board determined there was a conflict of interest; and
2. The names of all persons present for discussions or votes relating to the transaction or arrangement; the content of these discussions, including any alternatives to the proposed transaction or arrangement; and a record of the vote.
E. Procedures ensuring that the policy is distributed to all trustees, principal officers and members of committees with board-delegated powers. Each such person should sign an annual statement that he or she:
1. Received a copy of the conflicts of interest policy;
2. Has read and understands the policy;
3. Agrees to comply with the policy;
4. Understands that the policy applies to all committees and subcommittees having board-delegated powers; and
5. Understands that the organization is a charitable organization that must engage primarily in activities that accomplish one or more of its tax-exempt purposes to maintain its tax-exempt status.
F. Procedures for applying the policy to a compensation committee should include:
1. Restrictions barring physicians who receive, directly or indirectly, compensation from the organization, for services as employees or as independent contractors, from membership on its compensation committee; and
2. Restrictions precluding a voting member of a compensation committee who has a conflict of interest in the organization from which the member receives compensation, directly or indirectly, from voting on matters pertaining to that member’s compensation. FY 1997 CPE Textbook Chapter C, p. 21-23
The textbook goes on to suggest that the nonprofit, as part of its system of controls, conduct periodic reviews of the activities to ensure that the organization is operating in a manner consistent with accomplishing its charitable purpose, and does not result in private inurement or impermissible private benefit. It also includes a Sample Conflict of Interest Policy, a copy of which is attached as Appendix A, below.
Adopting and complying with a conflict of interest policy will assist the organization in carrying out its responsibilities to avoid private inurement or private benefit, addressed in the intermediate sanctions rules, below.
See also How to Keep Your Exempt Organization Out of Trouble with IRS for more suggestions on operating your organization in a manner that will avoid problems with the IRS.
5. Intermediate Sanctions
Intermediate sanctions. which are designed to provide a penalty short of revocation, for private inurement/private benefit, is probably the most significant change to affect nonprofit organizations over the last thirty years. The intermediate sanctions law does not affect the ability of the IRS to revoke the exemption of an organization that engages in private inurement or private benefit. It simply provides another weapon in their arsenal. Although it is anticipated that intermediate sanctions will be used when revocation appears to be an extreme response, there is no limitation on the ability of the IRS to use either or both weapons. See INTERMEDIATE SANCTIONS – New Regulations for more specific information.
6. Raffles
Beginning July 1, 2001, raffles are not permitted unless the organization complies with a number of requirements, including registration with the California Attorney General. See RAFFLES IN CALIFORNIA.
APPENDIX A – IRS SUGGESTED CONFLICT OF INTEREST POLICY
Article I Purpose
The purpose of the conflicts of interest policy is to protect the Corporation’s interest when it is contemplating entering into a transaction or arrangement that might benefit the private interest of an officer or director of the Corporation. This policy is intended to supplement but not replace any applicable state laws governing conflicts of interest applicable to nonprofit and charitable corporations.
Article II Definitions
1. Interested Person
Any director, principal officer, or member of a committee with board delegated powers who has a direct or indirect financial interest, as defined below, is an interested person. If a person is an interested person with respect to any entity in the healthcare system of which the Corporation is a part, he or she is an interested person with respect to all entities in the healthcare system.
2. Financial Interest
A person has financial interest if the person has, directly or indirectly, through business, investment or family
a. an ownership or investment interest in any entity with which the Corporation has a transaction or arrangement, or
b. a compensation arrangement with the Corporation or with any entity or individual with which the Corporation has a transaction or arrangement, or
c. a potential ownership or investment interest in, or compensation arrangement with, any entity or individual with which the Corporation is negotiating a transaction or arrangement.
Compensation includes direct and indirect remuneration as well as gifts or favors that are substantial in nature.
A financial interest is not necessarily a conflict of interest. Under Article III, Section 2, a person who has a financial interest may have a conflict of interest only if the appropriate board or committee decides that a conflict of interest exists.
Article III Procedures
1. Duty to Disclose
In connection with any actual or possible conflicts of interest, an interested person must disclose the existence and nature of his or her financial interest and all material facts to the directors and members of the committees with board delegated powers considering the proposed transaction or arrangement.
2. Determining Whether a Conflict of Interest Exists
After disclosure of the financial interest and all material facts, and after any discussion with the interested person, he or she shall leave the board or committee meeting while the financial determination of a conflict of interest is discussed and voted upon. The remaining board or committee members shall decide if a conflict of interest exists.
3. Procedures for Addressing the Conflict of Interest
a. An interested person may make a presentation at the board or committee meeting, but after such presentation, he/she shall leave the meeting during the discussion of, and the vote on, the transaction or arrangement that results in the conflict of interest.
b. The chairperson of the board or committee shall, if appropriate, appoint a disinterested person or committee to investigate alternatives to the proposed transaction or arrangement.
c. After exercising due diligence, the board or committee shall determine whether the Corporation can obtain a more advantageous transaction or arrangement with reasonable efforts from a person or entity that would not give rise to a conflict of interest.
d. If a more advantageous transaction or arrangement is not reasonably attainable under circumstances that would not give rises to a conflict of interest, the board or committee shall determine by a majority vote of the disinterested directors whether the transaction or arrangement is in the Corporation’s best interest and for its own benefit and whether the transaction is fair and reasonable to the Corporation and shall make its decision as to whether to enter into the transaction or arrangement in conformity with such determination.
4. Violation of the Conflicts of Interest Policy
a. If the board or committee has reasonable cause to believe that a member has failed to disclose actual or possible conflicts of interest, it shall inform the member of the basis for such belief and afford the member an opportunity to explain the alleged failure to disclose.
b. If, after hearing the response of the member and making such further investigation as may be warranted in the circumstances, the board or committee determines that the member has in fact failed to disclose an actual or possible conflict of interest, it shall take appropriate disciplinary and corrective action.
Article IV Records of Proceedings
The Minutes of the board and all committees with board-delegated powers shall contain
1. The names of the persons who disclosed or otherwise were found to have a financial interest in connection with an actual or possible conflict of interest, the nature of the financial interest, any action taken to determine whether a conflict of interest was present, and the board’s or committee’s decision as to whether a conflict of interest in fact existed.
2. The names of persons who were present for discussion and votes relating to the transaction or arrangement, the content of the discussion, including any alternatives to the proposed transaction or arrangement, and a record of any votes taken in connection therewith.
Article V Compensation Committees
1. A voting member of any committee whose jurisdiction includes compensation matters and who receives compensation, directly or indirectly, from the Corporation for services is precluded from voting on matters pertaining to that member’s compensation.
2. Physicians who receive compensation, directly or indirectly, from the Corporation, whether as employment whether as employees or independent contractors, are precluded from membership on any committee whose jurisdiction includes compensation matters. No physician, either individually or collectively, is prohibited from providing information to any committee regarding physical compensation.
Article VI Annual Statements
Each director, principal officer and member of a committee with board delegated powers shall annually sigh a statement which affirms that such person
a. has received a copy of the conflicts of interest policy,
b. has read and understands the policy,
c. has agreed to comply with the policy, and
d. understands that the Corporation is a charitable organization and that in order to maintain its federal tax exemption it must engage primarily in activities which accomplish one or more of its tax-exempt purposes.
Article VII Periodic Reviews
To ensure that the Corporation operates in a manner consistent with its charitable purposes and that it does not engage in activities that could jeopardize its status as an organization exempt from federal income tax, periodic reviews shall be conducted. The periodic reviews shall, at a minimum include the following subjects:
a. Whether compensation arrangements and benefits are reasonable and are the result of arm’s-length bargaining.
b. Whether acquisitions of physician practices and other provider services result in inurement or impermissible private benefit.
c. Whether partnership and joint venture arrangements and arrangement with management service organizations and physician hospital organizations conform to written policies, are properly recorded, reflect reasonable payments for goods and services, further the Corporation’s charitable purposes and do not result in inurement or impermissible private benefit.
d. Whether arrangements to provide healthcare and agreements with other healthcare providers, employees, and third party payors further the Corporation’s charitable purposes and do not result in inurement or impermissible private benefit.
Article VIII Use of Outside Experts
In conducting the periodic reviews provided for in Article VII, the Corporation may, but need not, use outside advisors. If outside experts are used their use shall not relieve the board of its responsibility for ensuring that periodic reviews are conducted.
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Copyright © 2009 Lisa A. Runquist, Attorney at Law
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