A board member of a charitable nonprofit organization may find themselves in an awkward position where the board is voting on a matter in which the board member has a conflict of interest. Perhaps the matter has to do with contracting the board member or their company, paying the board member for some service they provide to the organization, or transacting with the board member’s relative or employer.
At the outset, it should be clear to the board that not all matters involving a board member’s conflict of interest are bad or forbidden. In some cases, such matter may be favorable to the organization, such as when a board member is providing a needed service to the organization at below market rates or with greater experience and skills than would otherwise be available to the organization.
Of course, there are other cases where a conflict of interest or even the perception of a conflict of interest can jeopardize the organization’s reputation and diminish public trust in the organization. This can occur where it appears that the organization is acting to provide preferential treatment to one or more of its board members ahead of its mission-related work.
To better understand how organizations and their boards should decide how to accept or manage a transaction involving a board member’s conflict of interest, you should start by understanding the applicable laws.
State Law
Fiduciary duties. Board members owe a fiduciary duty of care and loyalty to their organizations. This means they must act in good faith with due care and in the best interests of the organization when carrying out their responsibilities as board members. In such capacity, board members must place the organization’s interests ahead of their own personal interests. See, e.g., Nonprofit Boards: Duties And Responsibilities.
No private gain. The articles of incorporation of a charitable nonprofit corporation may provide that the corporation is not organized for the private gain of any person. See, e.g., Cal. Corp. Code Sec. 5130(b)(1).
Self-dealing. State laws may also prohibit self-dealing, which may include any transaction to which the corporation is a party and in which one or more of its directors has a material financial interest and which does not meet the requirements of any stated exception. Typically, an exception will include (1) a transaction that the corporation entered into for its own benefit, (2) that is fair and reasonable as to the corporation at the time corporation entered into the transaction, (3) approved in advance in good faith by a majority of disinterested directors with knowledge of the material facts including regarding any director’s interest, and (4) (i) prior to authorizing or approving the transaction the board considered and in good faith determined after reasonable investigation under the circumstances that the corporation could not have obtained a more advantageous arrangement with reasonable effort under the circumstances or (ii) the corporation in fact could not have obtained a more advantageous arrangement with reasonable effort under the circumstances. See, e.g., Cal. Corp. Code Sec. 5233; California Nonprofit Law: The Self-Dealing Prohibition.
Federal Law
Private inurement and private benefit. No part of a 501(c)(3) organization’s net earnings may inure to the benefit of any private shareholder or individual, which generally refer to insiders who are in a position to influence or control use of the organization’s assets for personal gain such as founders, directors, or officers. See Private Benefit Rules – Part II: Private Inurement Doctrine. In addition, an organization will fail to meet the requirements of 501(c)(3) if it confers private benefits upon any individual that are more than incidental, quantitatively and qualitatively, to the furthering of its exempt purposes. See Private Benefit Rules – Part I: Private Benefit Doctrine.
Excess benefit transactions (public charities, social welfare organizations). An excess benefit transaction is a transaction in which an economic benefit is provided by a public charity or social welfare organization, directly or indirectly, to or for the use of a disqualified person (insiders like board members and officers in a position to exercise substantial influence over the affairs of the organization within the past five years), and the value of the economic benefit provided by the organization exceeds the value of the consideration received by the organization. A typical excess benefit transaction results from excessive compensation to a director or officer. See Intermediate sanctions – excess benefit transactions (IRS); Private Benefit Rules – Part III: Excess Benefit Transactions.
Self-dealing (private foundations). Self-dealing, in the context of federal private foundation law, is a prohibited act which generally involves any of the following (note that there are exceptions):
- sale or exchange, or leasing, of property between a private foundation and a disqualified person (which is defined slightly differently from a disqualified person in the excess benefit transaction context, but still includes board members and officers);
- lending of money or other extension of credit between a private foundation and a disqualified person;
- furnishing of goods, services, or facilities between a private foundation and a disqualified person;
- payment of compensation (or payment or reimbursement of expenses) by a private foundation to a disqualified person;
- transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a private foundation; and
- agreement by a private foundation to make any payment of money or other property to a government official (as defined in section 4946(c)), other than an agreement to employ such individual for any period after the termination of his government service if such individual is terminating his government service within a 90-day period.
See Acts of self-dealing by private foundation (IRS); Private Foundations & Self-Dealing; Exempt Organizations Technical Guide” TG 58 Excise Taxes on Self-Dealing under IRC 4941.
Conflict of Interest Policy
Nonprofits may focus on a number of priorities to be addressed by their conflict of interest policies:
- Compliance with state self-dealing laws;
- Protection of following the rebuttable presumption of reasonableness procedures, which for public charities and social welfare organizations, would shift the burden of proof to the IRS to prove that a benefit given to a disqualified person (like a board member) is excessive;
- Compliance with federal tax self-dealing laws applicable to private foundations;
- Avoidance of transactions that are contrary to the organization’s core values;
- Mitigating the risks of transactions that are likely to be perceived as contrary to the organization’s core values or that might otherwise harm the organization’s reputation.
Generally, a conflict of interest policy will require (1) disclosure of the conflict or potential conflict, (2) abstention of an interested person from voting on a matter involving a conflict or potential conflict, and (3) the required approval of a majority or supermajority of disinterested decision-makers (typically the board or a board committee). In addition, board members, officers, and key employees may be required by the policy to complete an annual affirmation and disclosure statement.
While the law may focus on conflicts of interest in which an insider or related person or entity has a material financial interest in the transaction or arrangement, an organization’s values and ethics may also demand a focus on non-financial conflicts of interest. For example, a board member may have a personal, non-financial interest in a policy decision being made by the organization, in which case the board member may want to abstain from voting on such decision or remind themselves that their fiduciary duty of loyalty requires them to make that decision in the best interests of the organization. See, e.g., Nonprofit Conflict of Interest: A 3-Dimensional View (Jan Masaoka, Blue Avocado).
See Conflict of Interests for Nonprofits | BoardSource; Conflicts of Interest (National Council of Nonprofits)
Managing a Board Member Conflict of Interest
The conflict of interest policy should be drafted to guide the organization and its board to manage board member conflicts of interest. First, the board should define conflict of interest and set forth how a particular transaction or arrangement is determined to be a conflict of interest. While some cases may make for easy determinations, others may be more difficult and require interviews, investigations, and other due diligence. The organization may also need to adopt a policy regarding transactions or arrangements that the organization’s decision-makers determine do not create a conflict of interest for the board member at issue but do create a reasonable perception of a conflict of interest that could harm the organization’s reputation.
Next, the board should define what related parties (e.g., relatives, businesses) should be considered in determining whether a board member has a conflict of interest. Applicable laws will provide some guidance, but the organization may decide to reach out further. No organization should treat a business as related to a board member based on a tiny percentage of ownership (e.g., they have a $10,000 investment in a mutual fund that includes holdings in Apple stock), but what percentage of ownership is appropriate to create a relationship for purposes of determining whether the board member has a conflict of interest? For purposes of guarding against an excess benefit transaction, a 35 percent ownership would match the applicable law’s definition. But state laws might factor in all the facts and circumstances to determine that a board member has a conflict of interest in a transaction between the organization and a business in which the board member has a much smaller ownership interest.
Management of conflicts of interest will require timely disclosure when the board member is aware of the conflict and deliberation of a governing body (e.g., the board or a board committee) in assessing the transaction or arrangement, determining whether it is a conflict of interest, reviewing whether there are more advantageous transactions or arrangements, and deciding on approval or disapproval. In many cases, there may be a decision to continue negotiating with the other party or parties to obtain the best deal reasonably possible and to help evidence an appropriate decision made by the organization in its best interests.
Enforcement of the conflict of interest policy is also a critical part of management. In certain circumstances, board members who failed to timely disclose their interest in a particular transaction or arrangement or misrepresented their interest should face appropriate disciplinary and corrective action.
Finally, organizations should ensure they maintain proper documentation of the management of board member conflicts of interest.
Some Examples That May Require Additional Counsel
- Compensating a board member for their service as an executive (e.g., president, executive director)
- Compensating all board members for their service as board members
- Purchasing services from a company in which one or more board members have a financial interest
- Renting an office from a board member’s company
- Making a grant to a charity with which a board member is also affiliated
- Sharing resources with a noncharitable nonprofit (e.g., a 501(c)(4) or 501(c)(6) organization) with which a board member is also affiliated
- Contracting with a board member’s extended family member or close friend
Additional Resources:
Conflict of Interests for Nonprofits (BoardSource)
Conflicts of Interest (National Council of Nonprofits)
Charity Conflicts of Interest: A Guide (Nonprofit Quarterly)
Conflict of Interest: Recusal Is Not Enough (Nonprofit Quarterly)
COI: Candor Or Inhibition? Managing Conflicts Of Interest (Nonprofit Risk Management Center)
Nonprofit Conflict of Interest: A 3-Dimensional View (Jan Masaoka, Blue Avocado)
