Three Key Components to the Fiduciary Duty of Loyalty

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.