NonProfits: Carson – Fall 2012
1. Intro to Nonprofits
a. Nonprofit: No receipts may be distributed to those associated with the organization.
i. No distributions (ie dividends).
ii. Creditors may not file involuntary bankruptcy against a nonprofit.
iii. No shareholders but a board governs.
iv. IRS restricts salaries of nonprofits to “reasonable compensation.”
b. Charitable Corp: Subset of non-profits. §501(c)(3).
i. Donations to charitable corp are tax deductible.
ii. Upon dissolution, assets of charitable corp must be given to like organization.
c. Reasons for Non-profit Existence
i. Market failures: Certain goods (ie public goods) can’ be handled efficiently by traditional market approaches.
1. Benefits can’t be adequately confined to the purchasers.
2. Reduces incentive for self-interest in service provider.
ii. Why not use Government? Govt requires a consensus.
1. Majoritarian necessity may compromise mission or create barriers.
d. Role of the NP Enterprise: Salamon’s 5 major considerations:
i. Historical: NP sector existence can be explained by historical factors such as the growth of voluntary orgs in American colonies that predated gov.
ii. Market Failure: NP orgs exist in response to certain inherent limitations of the American market economy. Collective goods don’t have the market mechanism
iii. Response: gov. Problem if gov fails too—then need NP b/c both market and gov fail
iv. Government Failure: Failure of gov to provide collective goods b/c much of gov action req majority support.(Lack of resources and/or of consensus and/or bureaucracy) NPs are formed by smaller groups of people to address needs that gov is unwilling or unable to support
v. Pluralism/Freedom: NPs play a valuable role in promoting values of pluralism and freedom
vi. Solidarity: Way an individualistic democratic society can express solidarity through joint action.
2. Choice of Legal Form
a. Section 501(c)(3) requires a charter.
i. Must abstain from all politics.
ii. Must have a stated purpose.
b. Charitable trust requires only a charitable purpose and few formalities.
c. Model Act
i. Ch.2 Formation of a non-profit: §2.02(a)(2) Three Types
1. Public Benefit: Tax deductible donations.
2. Mutual Benefit
3. Religious Corp.
ii. Members: Analogous to shareholders.
1. Rights can be limited via charter.
iii. Ch. 8 D’s and O’s
1. Board functions just like a for-profit.
a. Fundamental structural changes may require member consent.
b. Board must have at least 3 members.
c. Board manages all affairs unless charter indicates otherwise.
iv. Section 3.02: Sets out general powers of a non-profit corp.
v. Section 2.02(b)(5): Indemnifies directors from personal liability.
1. No indemnity against breach of loyalty or intentional wrongdoing.
vi. Section 2.04: J&S liability for pre-incorporation transactions.
vii. Section 8.52 describes mandatory indemnification:
1. Applies when a director defends himself successfully in a suit based on his role as director of the nonprofit.
a. Success must be achieved on every single issue involved.
i. Differs from Del. Pro rata approach.
b. Settlements counted as success.
viii. Section 8.51 describes permissive indemnification.
1. No indemnification for breach of loyalty or suit brought by the nonprofit itself (including member derivative suits).
a. Applies to both judgment and legal expenses.
2. Decision on whether to allow optional indemnification is made pursuant to §8.55—must be made by either:
a. Disinterested directors; or
b. If no quorum of disinterested directors than by a committee appointed by the Board; or
c. Special legal counsel hired to make the decision.
ix. Section 8.53 Advancement of expenses: Nonprofit may advance legal expenses to a director but director must:
1. Sign an affirmation of good faith compliance with §8.51
2. Promise to repay expenses if found guilty
3. Indemnification must not be otherwise prohibited.
x. Section 8.56: Indemnification for officers and employees
1. Mandatory indemnification applies to officers
2. Permissive indemnification applies to employees.
3. Operation and Governance
a. Unincorporated Association: Governance structure determined based on charter and bylaws.
b. Charitable Trust: Governed by trustee according to terms of trust instrument.
i. Trustee held to a strict fiduciary standard.
ii. Trustees are self-perpetuating and may contract with 3rd parties.
c. Nonprofit Corporation: Governed by a board of directors. Model Act §8.01.
i. Board selects management and governs broad goals.
1. Board may also make investment decisions.
2. Board has a fiduciary duty to nonprofit.
3. Board also has a duty of care. Model Act §§8.30, 8.33, 8.41-42.
a. Failure to supervise (breach of duty of attention)
b. Failing to make an informed decision on a matter before the board.
i. BJR protects board member if due care was used in deciding.
ii. Model Act §8.30 describes Duty of Care
1. Good Faith
2. Care of a reasonably prudent person
3. Best interests of the Corp.
iii. Model Act §8.31 describes duty of loyalty.
1. Deals with conflicts of interest.
2. Transaction is not voidable if it was fair to the company at the time it was entered, or
a. Approved ex ante with disclosure
b. Approved ex post by court or atty gen.
iv. Members may not be expelled without fair and reasonable procedures carried out in good faith. Model Act §6.21
4. Duty of Loyalty
i. George Pepperdine Foundation v. Pepperdine (1954)
1. Sets a very low standard of care.
2. Court finds no violation of any duty where directors depleted the assets of a nonprofit through poor investment decisions.
3. Record did not reflect any self-dealing and bad decisions alone are not enough to show a breach of any duty.
4. Established lower standard of care for nonprofit directors than for a corporate standard.
ii. Trust Standard: Lynch v. John M. Redfield Foundation (1970)
1. Standard of care is even higher than corporate standard.
2. Court finds a breach of duty of care where trustees allowed nonprofit assets to sit in a non-interest bearing account for five years.
3. Good faith is not a defense to an action based on negligence.
iii. Stern (Sibley Hospital Case): Sets standard of care at SAME level as corp.
b. Fitzgerald v. NRA (1974)
i. Court finds that NRA directors breached fiduciary duty by refusing to publish advertisement of a member seeking board candidacy in newsletter.
ii. Directors may not use their power to thwart rivals.
iii. As part of their overall fiduciary rel’p with the SH, it is well-established that directors and officer
b/c NP and no compensation/self-interest involved.
NP charges former directors for damages from dissipation of assets through illegal/speculative transactions and mismgmt.
2. “Instant action is a new demonstration of familiar social phenomenon: when a tragic loss occurs, find a victim to throw to the lions”
3. P is an NP corp, created by Pepperdine. He and his friends labored w/o promise of reward. Each director sought only the public good—no corrupt motives here.
ii. BJR: Although a director of an NP corp is held to highest degree of honor and integrity, he is not personally liable for mistake of judgment.
iii. Case overruled but approach reflects widespread attitude that NP directors are volunteers, so inappropriate to be aggressive as it will discourage other volunteers.
6. Duty of Obedience
a. Directors must not deviate from basic goals of nonprofit.
i. Provides assurance to donors that stated goals will be pursued.
b. Duty of Obedience requires directors to refrain from transactions/activities that are ultra vires—beyond corp powers and purposes as expressed in cert of incorp.
7. Duty of Investment Responsibility
a. Legal restrictions on appropriate types of investments for trusts and endowments.
i. Historically held to “prudent person” standard requiring very conservative investments.
1. Even if overall portfolio was conservative, one risky investment could trigger liability for trustee.
b. The Trust Standard (for investment of funds)
1. Lynch v. John M. Redfield Foundation—Prudent Man Investment Rule
a. Trustee shall exercise judgment/care under circumstances that men of prudence, discretion, intelligence exercise in mgmt of own affairs.
c. Modern trend is to look at overall portfolio for prudence rather than individual investments.
i. UMIFA: Adopted in 48 states authorizes board to expend realized and unrealized appreciation of an endowment to the extent it exceeds the fund’s “historic dollar value.”
1. Value of original donation not accounting for costs or appreciation.
2. Fund may use “appreciated value” per §2.
3. Investment authority may also be delegated to some extent. §5
ii. Failure to diversify can expose a trustee to liability.
d. Sibley Hospital Case (1974) DC
i. Corporate Standard. Corp standard adopted Sibley Hospital Case has become the predominant standard for the duty of care
1. Courts distinguish between the simple negligence as violation of the trust standard and gross negligence necessary for a corp standard.
e. Total Return Investing: Institution may use any amount above the “float” necessary to keep pace with inflation.
i. Does not immunize trustee who makes a particularly unsound investment.
