The Fiduciary Duty of Care

In a previous post I described the three basic fiduciary duties owed by officers and directors of nonprofit organizations — the duties of care, loyalty, and obedience. This post will focus on the duty of care.

Designing football play on chalkboard

One of my law partners likes to say the duty of care is the duty to show up, to suit up and to speak up (or to get out). He talks like that because he’s a former athlete (which he’s happy to talk about — he even has old footballs and pictures from his playing days’ in the 60s all over his office). But he’s right. If you’re not willing to be all in participating as a part of the team, you don’t need to be on the team. Let someone else who is willing to be fully engaged serve that part. It’s a good short-hand way to remember what’s required by the duty of care, but I’ll try to flesh it out a bit.

The duty of care most simplified is a duty to stay informed and exercise ordinary care and prudence in management of the organization. With respect to nonprofit corporate directors and officers, the duty of care under Texas law (where I practice) mandates that the decision maker act (1) in good faith, (2) with ordinary care, and (3) in a manner he or she reasonably believes to be in the best interest of the corporation. This standard developed at common law but has actually been codified as a part of the Texas Business Organizations Code.

Good faith

Texas law doesn’t define “good faith” in the context of fiduciaries. Broadly, the term describes “that state of mind denoting honesty of purpose, freedom from intention to defraud, and, generally speaking, means being faithful to one’s duty or obligation.” BLACK’S LAW DICTIONARY 693 (6th ed. 1990). Whether a director acted in good faith is measured objectively based on objective facts. “Good faith” can be contrasted with “bad faith” which usually means being motivated by self-gain.

Ordinary care

“Ordinary care” requires the director to exercise the degree of care that a person of ordinary prudence would exercise in the same or similar circumstances. If a person has a special expertise (e.g., accounting expertise, legal expertise, etc.), ordinary care means that degree of care that a person with the same expertise would exercise in the same or similar circumstances.

Best interest of the corporation

Finally, decision makers must make decisions they reasonably believe to be in the best interest of the organization. Reasonableness is based on the objective facts available to the decision maker. Determining whether a proposed action is in the best interest of the organization requires weighing varied factors including the short-term interests, the long- term interests, the costs, the benefits, etc.

Business Judgment Rule

Under Texas law decision makers of nonprofit corporations are not insurers and thus are not liable so long as those persons exercise their business judgment in making decisions on behalf of the organization. The Texas Business Organizations Code says a decision maker will not be liable for errors or mistakes in judgment if she acted in good faith with reasonable skill and prudence in a manner she reasonably believed to be in the best interest of the corporation. This is obviously a restatement of the duty of care, but the courts have generally refused to impose liability upon a disinterested director absent a challenged action being ultra vires, tainted by fraud or grossly negligent.

Satisfying the duty of care

To satisfy the duty of care, the director should be reasonably informed with respect to the decisions she is required to make. This means the decision maker must understand the purposes of the organization (i.e. she has to read and have familiarity with the organization’s governing documents) and make decisions in line with those purposes. The same is true for management of the organization, policies of the organization, and any financial data relevant to the decisions she is making. Having this type of familiarity and knowledge requires the director to attend board meetings and actively seek the information necessary to make an informed and independent decision regarding which course of action is in the corporation’s best interest. A director should be careful to personally weigh the benefits and detriments of the course of action to the corporation rather than simply voting with the majority. While a director may rely on the counsel of advisers, the director must nevertheless exercise her own independent judgment in making decisions as to what is in the corporation’s best interests.

Duty of Care Checklist

Decision makers of nonprofit corporations that engage in ongoing operations should understand that their duty of care goes beyond financial or business decisions to reach all decisions made in the course and scope of their duties as directors. The following checklist is provided to aid decision makers in satisfying the duty of care.

All decision makers should know the following:

  • Legal form of the organization
  • Mission of the organization
  • Provisions of Articles of Incorporation/Certificate of Formation
  • Provisions of Bylaws
  • Any policies affecting decision makers (e.g. Conflict of Interest Policy)
  • Financial Picture (budget and financials)
  • Most recent 990
  • Existence/operations of related entities
  • Where the organization is conducting activities
  • Tax status and applicable legal requirements of the organization
  • Activities being conducted by the organization
  • Management structure
  • Key employees
  • Committee Structure
  • How directors and officers are selected

A director should seek to do the following:

  • Faithfully attend meetings
  • Read materials and prepare for meetings
  • Ask questions before, during and after meetings
  • Exercise independent judgment
  • Rely on appropriate sources of information
  • Review minutes of the board
  • Seek to stay informed as to legal obligations and good governance
  • With other members of the Board, develop schedules for review and approval of the strategic direction of the organization, executive compensation, legal compliance, and budget

Fiduciary Duties: An Overview

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This post is the first in a series about fiduciary duties of directors and officers of nonprofit corporations. Future posts will continue from this overview with a more in depth look at various aspects of fiduciary law in this context.

Federal tax law often grabs the focus of directors of nonprofit organizations. Complying with the requirements of the Internal Revenue Code and understanding the regulatory role of the IRS is (or should be) an ever-present consideration for the board. However, that is only one consideration in complying with legal requirements imposed on directors. The other consideration comes under state law. State law, with the state attorney general as the regulatory authority, governs many aspects of the life of a nonprofit and its board. From governance to charitable solicitation to reporting requirements, directors must be familiar with the laws imposed on nonprofit organizations in their state.

Perhaps the most critical area in which state law dictates requirements for directors is in the area of governance where state law imposes certain fiduciary duties on the directors (and officers) of nonprofit organizations. All decision makers owe certain fiduciary duties to the organizations they serve. A fiduciary duty is simply a duty to act for someone else’s benefit — putting the other’s benefit before your own. Fiduciary law developed at common law, though many states, including Texas, have codified various fiduciary requirements in their business organizations codes.

Corporate fiduciaries stand in the unique position of being the keeper of the organization’s assets and the guardian of the organization’s mission. This unique role plays itself out in the duties of care, loyalty and obedience. Whereas directors are charged largely with making strategic decisions, evaluating, reviewing, overseeing and approving, officers are charged with implementing the decisions and policies established by the board. Nevertheless, the three primary duties remain the duty of care, duty of loyalty, and duty of obedience.

The duty of care most simplified is a duty to stay informed and exercise ordinary care and prudence in management of the organization. With respect to nonprofit corporate directors and officers, the duty of care under Texas law mandates that the decision maker act (1) in good faith, (2) with ordinary care, and (3) in a manner he or she reasonably believes to be in the best interest of the corporation.

The second significant fiduciary duty owed by decision makers of nonprofit organizations under Texas law is the duty of loyalty. The duty of loyalty requires that the decision maker act for the benefit of the organization and not for her personal benefit, i.e. the duty of loyalty requires undivided loyalty to the organization.

To satisfy her duty of loyalty, a corporate decision maker must look to the best interest of the organization rather than private gain. Courts have noted that the duty of loyalty requires an extreme measure of candor, unselfishness, and good faith. The director must not usurp corporate opportunities for personal gain, must avoid engaging in interested transactions without board approval, and must maintain the organization’s confidential information.

Along with the duties of care and loyalty, decision makers of nonprofit organizations owe the additional duty of obedience, the duty to remain faithful to and pursue the goals of the organization and avoid ultra vires acts. In practice, the duty of obedience requires the decision maker to follow the governing documents of the organization, laws applicable to the organization, and restrictions imposed by donors and ensure that the organization seeks to satisfy all reporting and regulatory requirements. The duty of obedience thus requires that directors see that the corporation’s purposes are adhered to and that charitable assets are not diverted to non-charitable uses.

Understanding these three duties, and how to satisfy these duties in the context of governing a nonprofit organization, is the foundation of good governance. The duties inform what decisions should be made (or must be made), how those decision are to be made, and when the issues are ripe for decision. Breach of these duties can do harm to the organization and create personal liability to the breaching director or officer (note, while the board governs, the duties are owed individually). The next posts in this series will take a more in-depth look at each of these three duties in turn. The series will conclude with an examination of standing to complain about breach of these duties.