Three Key Components to the Fiduciary Duty of Loyalty

Golden Retriever holding mail

Loyalty — Putting the Organization First

In my last post, I covered the duty of care – the duty to show up, suit up, speak up, or get out as one of my partners likes to say. This post will focus on the second significant fiduciary duty owed by decision makers of nonprofit organizations, 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. Simply put, the duty of loyalty requires undivided loyalty to the organization. As the Texas Supreme Court has stated, the duty of loyalty requires an “extreme measure of candor, unselfishness, and good faith.” See International Bankers Life Ins. Co. v. Holloway, 368 S.W.2d 567, 577 (Tex. 1963).

The duty of loyalty has three key components: (1) the director must not usurp corporate opportunities for personal gain, (2) must avoid engaging in interested transactions without board approval, and (3) must maintain the organization’s confidential information.

Corporate Opportunity

The corporate opportunity doctrine prohibits a corporate director from usurping corporate opportunities for personal gain. Texas law defines such a breach as misappropriating a business opportunity that properly belongs to the corporation. An opportunity properly belongs to the corporation where the corporation has a “legitimate interest or expectancy in and the financial resources to take advantage of” the particular opportunity. Where the opportunity properly belongs to the corporation, the fiduciary has an obligation to disclose the opportunity and offer the opportunity to the corporation. For example, if a nonprofit museum of history collects artifacts from World War II and the curator, while on a trip to search for search pieces, finds one yet purchases it for his own account, this would be a breach of the duty of loyalty by usurping a corporate opportunity.

The director or officer accused of usurping a corporate opportunity can raise three primary defenses (in addition to simply denying the factual basis of the claim): (1) the corporation lacked the financial resources to pursue the opportunity; (2) the corporation abandoned the opportunity; or (3) the opportunity constituted a different line of business than that pursued by the corporation. Importantly, the fiduciary bears the burden to show abandonment or lack of financial ability.

Interested Transactions

A common type of violation of the duty of loyalty is the interested director transaction, broadly characterized as a contract between the corporation and a director. An officer or director is “interested” if he or she (a) makes a personal profit from the transaction with the corporation; (2) buys or sells assets of the corporation; (3) transacts business in the officer’s or director’s capacity with a second corporation of which the officer or director has a significant financial interest; or (4) transacts corporate business in the officer’s or director’s capacity with a member of his or her family. In Texas, interested transactions between corporate fiduciaries and their corporations are presumed to be unfair on the part of the officer or director, fraudulent on the corporation and are thus generally voidable.

Texas law provides a safe harbor of sorts for interested transactions. Where the material facts are disclosed and a majority of the disinterested directors, in good faith and the exercise of ordinary care, authorize the transaction, the transaction is not void or voidable solely because of the director’s interest or the director’s participation in the meeting at which the transaction is voted on. Further, such a transaction will not be void or voidable if it is fair to the corporation (though the burden to show fairness is on the fiduciary in such event) when it is authorized, approved or ratified by the board.

Because it is imperative that in the event an issue arises in which a decision maker has a personal interest the decision maker disclose the interest related to the decision being made and abstain from any vote, it is prudent for the organization, and beneficial to the decision makers, for the organization to adopt a conflict of interest policy requiring disclosure of material facts related to actions between the decision maker and the organization and abstention from voting by the interested decision makers.

Certain interested transactions between directors and the nonprofit corporations which they serve are strictly prohibited under Texas law. For example, loans to directors are not allowed. Directors who vote for or assent to the making of such loans in violation of the statutory prohibition are jointly and severally liable to the corporation for the amount of such loan until the loan is fully repaid. Additionally, while state law may allow for some types of interested transactions where the transaction is fair to the corporation, federal law may prohibit the very same transaction. This is particularly true where the organization is a private foundation and subject to the prohibition on self-dealing. As such, directors should act with caution ensuring that not only is the conflict of interest policy followed but no federal proscriptions are breached.

Confidentiality

Finally, the duty of loyalty requires a decision maker to maintain confidentiality and therefore prohibits disclosure of information about the corporation’s business to any third party, unless the information is public knowledge, required by law to be disclosed, or the corporation gives permission to disclose it.

Next up, the third and final major fiduciary duty, the duty of obedience.

 

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.

 

 

Four Keys to Creating Lasting Vision for a Nonprofit

Vision

Years before releasing his influential book, Good to Great, Jim Collins teamed with Jerry Porras to author an article in Harvard Business Review titled, Building Your Company’s Vision, examining one aspect of how companies had created lasting success – vision.  Central to their theories of visionary companies is the idea that “companies that enjoy enduring success have core values and a core purpose that remain fixed while their business strategies and practices endlessly adapt to a changing world.”  This same idea applies with equal force to the nonprofit sector (as Collin subsequently noted in Good to Great and the Social Sectors:  A Monograph to Accompany Good to Great).

So what is “vision?”  Collins and Porras define “vision” as consisting of two major components: core ideology and envisioned future, with the core ideology being composed of core values and core purpose and envisioned future being ten to thirty-year goals.  Working together, core ideology and envisioned future combined to form a vision for the organization, functioning in the role of a “North Star” for the foundation and its board.

I suggest there are four keys to to creating lasting vision in the nonprofit context:

1. Conceptualizing Vision: Whether done at the founding stage of the organization or after, the board should take time to distill the core values (the essence of the organization) and core purpose (the reason for being) of the organization.  What values and purpose should stand the test of time, remaining fixed despite the changing world.

2. Stabilizing Vision: Once the core values and core purpose (together, the core ideology according to Collins and Porras) have been conceptualized, the board should embed that core ideology into the foundational aspects of the organization.  This will look different depending on the type of organization but may include choosing a specific form or entity to further the core ideology, drafting a specific purpose statement (as opposed to the standard broad purpose statement) into the governing documents, making choices such as whether a foundation is to be perpetual or a spend-down foundation, and considering other provisions such as requiring super-majority votes or external court approval to amend specific purpose provisions of the governing documents.

3. Institutionalizing Vision:  Because most nonprofits are created with a potential perpetual duration, and because boards change over time, the vision must move from individual to institution, from entrepreneur to enterprise.  This is accomplished through board initiation, ongoing board training (particularly including training on fiduciary duties), and strategic planning (including succession planning).  Where the organization is a family foundation, the use of junior advisory boards can be a great way to pass on vision to successive generations.

4. Contextualizing Vision: While core values and purpose should remain fixed, strategies and practices must adapt to the changing world, making the organization relevant and effective to its particular time and place.  Contextualizing the vision will necessarily look differently depending upon the variables involved—the board members, the investment climate, technological advances, the needs to be met, and those to be benefited by the organization’s work.  This requires the hard work of the board to differentiate between what is part of the core ideology of the organization and what is not.  It also requires ongoing study of what is working in the organization’s field.  Finally it requires the willingness and courage to make changes to strategies and practices.