The Fiduciary Duty of Obedience

Director, red card, obedienceIn fulfilling their roles as directors of nonprofit organizations, directors owe fiduciary duties. Breaches of those duties can lead to a red card — removal and even personal liability. That directors of charitable organizations owe the fiduciary duties of care and loyalty owed is unquestioned. A third duty – the duty of obedience – is not as well recognized though the ideas behind it figure prominently in charity fiduciary law. The duty of obedience is the duty to remain faithful to and pursue the goals of the organization. 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. In short, the duty of obedience requires that directors see that the corporation’s purposes are adhered to and that charitable assets are not diverted to non-charitable uses.

The duty of obedience is somewhat unique to the nonprofit context and particularly tax-exempt organizations. Because tax exemption rests in the first part on being organized for an appropriate tax-exempt purpose (be it charitable or social or any other recognized exempt purpose), these organizations more specifically identify their purposes in their governing documents compared to a for profit business which may be organized to conduct all lawful operations of whatever kind or nature. One court has noted the distinction stating that “[u]nlike business corporations, whose ultimate objective is to make money, nonprofit corporations are defined by their specific objectives: perpetuation of particular activities are central to the raison d’etre of the organization.” Manhattan Eye, Ear & Throat Hosp. v. Spitzer, 715 N.Y.S.2d 575, 595 (Sup. Ct. 1999). With the additional level of specificity as to purpose, the decision maker faces a more defined realm of permissible actions. That realm can be even more narrowly defined when funds are raised for specific purposes.

In the context of a nonprofit corporation, the purpose is stated in the organization’s governing documents (Articles of Incorporation/Certificate of Formation/Bylaws) and may be amplified by other documents such as testamentary documents directing the creation of the organization, the application for exempt status filed with the Internal Revenue Service or solicitations for contributions. Each of these sources should be consulted. Once a director understands the purpose for which the organization is organized, or the more specific purpose for which money or other property has been donated, she must ensure the organization’s property is used to further those purposes as opposed to being diverted to non-charitable purposes or other purposes that while charitable, aren’t the organization’s purposes. Of course in making that decision the director exercises her duty of care and her duty of loyalty as well.






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.


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.


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