One of the most misunderstood legal principles in nonprofit governance is the origin and meaning of “fiduciary duties” and their application to the officers and directors of churches and other nonprofit organizations.
Officers and directors of churches—most commonly understood to be church board members or members of church finance committees with decision-making power—must bring intentional care and oversight to the financial affairs of their churches. Whether in the for-profit or nonprofit world, there are examples of corporations or organizations that ran aground because their officers and directors either neglected to learn the financial workings of their organizations or looked the other way—or even worse, led or aided malfeasant activities. The costs of these transgressions are substantial to the organizations, but also can prove legally and financially damaging to the individual officers and directors.
That’s why it’s critical for churches to educate and update new and veteran board and finance committee members regularly on the fiduciary duties they must fulfill in their roles. Any deficiencies in their work can lead to significant legal and financial troubles.
This article will provide much-needed clarification by defining fiduciary duties and explaining their application and relevance to church leaders. Particular emphasis is placed on the origin and nature of fiduciary duties, the fiduciary duties of “due care,” the “prudent investor” rule, loyalty, and obedience, best practices recommended for the nonprofit sector, and the implications of federal tax laws addressing any mishandling of fiduciary duties.
Origin and nature of fiduciary duties
The word “fiduciary” derives from the Latin word fiduciarius, relating to something held in trust. As one court explained:
The term “fiduciary” … is derived from Roman law, and means “a person holding the character of a trustee, or a character analogous to that of a trustee, in respect to the trust and confidence involved in it and the scrupulous good faith and candor which it requires.” Moreover, one is acting in a “fiduciary capacity” when the business which he transacts, or the money or property which he handles, is not his own or for his benefit, but for the benefit of another person, as to whom he stands in a relation implying or necessitating great confidence and trust on the one part and a high degree of good faith on the other part. In re Benites, 2012 WL 4793469 (N.D. Tex. 2012).
Many courts have concluded that the officers and members of the board of directors of a nonprofit corporation are fiduciaries of the corporation they have been chosen to manage. One court noted:
Adherence to the fundamental character of a nonprofit corporation is intended to be insured, in part, by the fiduciary duties imposed on officers and directors of such corporations. It is well established that officers and directors of a for-profit corporation owe a fiduciary duty to the corporation and its members. Directors and officers of corporations are bound to the exercise of the utmost good faith, loyalty, and honesty toward the corporation. The directors of a corporation have to see to it that the corporation had the benefit of their best judgment and act solely and always with reasonable care in good faith to promote its welfare. Summers v. Cherokee Children & Family Services, Inc. 112 S.W.3d 486 (Tenn. App. 2002).
The United States Supreme Court has noted that “to say that a man is a fiduciary only begins analysis; it gives direction to further inquiry. To whom is he a fiduciary? What obligations does he owe as a fiduciary? In what respect has he failed to discharge these obligations?” SEC v. Chenery Corp., 318 U.S. 80, 85-86 (1942).
Many courts and legislatures have attempted to define the fiduciary duties of the officers and directors of nonprofit corporations. These efforts have been labeled “sparse and fragmented,” and “largely undeveloped.” However, the few courts that have addressed fiduciary duties in the context of nonprofit corporations have generally defined fiduciary duties of officers and directors to include the following three duties:
due care prudent investing loyalty, and obedience.
These four duties are summarized below.
(1) The fiduciary duty of “due care”—in general
The officers and directors of nonprofit corporations, like their counterparts in for-profit corporations, have a fiduciary duty to exercise “due care” in the performance of their duties. In one of the most detailed descriptions of this duty, a federal district court for the District of Columbia ruled that the directors of a nonprofit corporation breached their fiduciary duty of care in managing the corporation’s funds. Stern v. Lucy Webb Hayes National Training School for Deaconesses & Missionaries, 381 F. Supp. 1003 (D.D.C. 1974). For nearly 20 years, management of the corporation had been dominated almost exclusively by two officers, whose decisions and recommendations were routinely adopted by the board. The corporation’s finance committee had not convened in more than 11 years. Under these facts, the court concluded:
Total abdication of [a director’s] supervisory role, however, is improper … . A director who fails to acquire the information necessary to supervise … or consistently fails even to attend the meetings … has violated his fiduciary duty to the corporation … . A director whose failure to supervise permits negligent mismanagement by others to go unchecked has committed an independent wrong against the corporation.
The court noted that a director or officer of a nonprofit corporation “has a continuing fiduciary duty of loyalty and care in the management of the [corporation’s] fiscal and investment affairs,” and acts in violation of that duty if:
- he fails, while assigned to a particular committee of the board having stated financial or investment responsibilities under the by-laws of the corporation, to use diligence in supervising and periodically inquiring into the actions of those officers, employees and outside experts to whom any duty to make day-to-day financial or investment decisions within such committee’s responsibility has been assigned or delegated; or,
- he knowingly permits the [corporation] to enter into a business transaction with himself or with any corporation, partnership or association in which he holds a position as trustee, director, partner, general manager, principal officer or substantial shareholder without previously having informed all persons charged with approving that transaction of his interest or position and of any significant facts known to him indicating that the transaction might not be in the best interests of the corporation; or,
- he actively participates in, except as required by the preceding paragraph, or votes in favor of a decision by the board or any committee or subcommittee thereof to transact business with himself or with any corporation, partnership or association in which he holds a position as trustee, director, partner, general manager, principal officer, or substantial shareholder; or,
- he fails to perform his duties honestly, in good faith, and with reasonable diligence and care.
- A ruling of the bankruptcy court in the “PTL ministry” bankruptcy case addressed the fiduciary duties of directors and officers of nonprofit corporations. Heritage Village Church and Missionary Fellowship, Inc., 92 B.R. 1000 (D.S.C. 1988). The court agreed with the bankruptcy trustee that televangelist Jim Bakker (as both an officer and director) had breached his fiduciary “duty of care” to PTL. It quoted a South Carolina statute (PTL was located in South Carolina) that describes the duty of care that a director or officer owes to his or her corporation:
A director or officer shall perform his duties as a director or officer, including his duties as a member of any committee of the board of directors upon which he may serve, in good faith, in the manner he reasonably believes to be in the best interest of the corporation and of its shareholders, and with such care as an ordinary prudent person in a like position would use under similar circumstances.
- The court, in commenting upon this provision, observed:
Good faith requires the undivided loyalty of a corporate director or officer to the corporation and such a duty of loyalty prohibits the director or an officer, as a fiduciary, from using this position of trust for his own personal gain to the detriment of the corporation. In this instance, there are no shareholders of the corporation; however, even though there are no shareholders, the officers and directors still hold a fiduciary obligation to manage the corporation in its best interest and not to the detriment of the corporation itself.
- The court concluded that “the duty of care and loyalty required by [Bakker] was breached inasmuch as he (1) failed to inform the members of the board of the true financial position of the corporation and to act accordingly; (2) failed to supervise other officers and directors; (3) failed to prevent the depletion of corporate assets; and (4) violated the prohibition against self-dealing.”
- With respect to Bakker’s defense that his actions had been “approved” by the board, the court observed that Bakker “exercised a great deal of control over his board” and that “a director who exercises a controlling influence over co-directors cannot defend acts committed by him on the grounds that his actions were approved by the board.” The court acknowledged that officers and directors cannot be “held accountable for mere mistakes in judgment.” However, it found that “the acts of [Bakker] did not constitute mere mistakes in judgment, but constituted gross mismanagement and a neglect of the affairs of the corporation. Clearly the salaries, the awards of bonuses and the carte blanche exercised over PTL checking accounts and credit cards were excessive and without justification and there was lack of proper care, attention and circumspection to the affairs of the corporation. [Bakker] breached [his] duty to manage and supervise … .”
- In support of its conclusions, the court cited numerous findings, including the following: (a) Bakker failed to require firm bids on construction projects, though this caused PTL substantial losses; (b) capital expenditures often greatly exceeded estimates, though Bakker was warned of the problem; (c) Bakker rejected warnings from financial officers about the dangers of debt financing; (d) many of the bonuses granted to Bakker were granted “during periods of extreme financial hardship for PTL”; (e) Bakker “let it be known that he did not want to hear any bad news, so people were reluctant to give him bad financial information”; (f) “it was a common practice for PTL to write checks for more money than it showed in its checkbook; the books would often show a negative balance, but the money would eventually be transferred or raised to cover the checks written—this ‘float’ often would be three to four million dollars”; (g) most of the events and programs at PTL that were made available to the public were operated at a loss; since 1984, “energy was placed into raising lifetime partner funds rather than raising general contributions”; (h) Bakker “during the entire period in question, failed to give attention to financial matters and the problems of raising money and cutting expenses.”
- Though at the time of Bakker’s resignation in 1987 PTL had outstanding liens of $35 million, and general contributions were in a state of decline, “millions of dollars were being siphoned off by excessive spending.” Such spending, noted the court, “is shocking to the conscience to the extent that it is unbelievable that a religious ministry would be operated in such a manner.” The court concluded that “Mr. Bakker, as an officer and director of PTL … approached the management of the corporation with reckless indifference to the financial consequences of [his] acts. While on the one hand [he was] experiencing inordinate personal gain from the revenues of PTL, on the other hand [he was] intentionally ignoring the extreme financial difficulties of PTL and, ironically, [was], in fact, adding to them.” To illustrate, Bakker accepted huge bonuses at times of serious financial crisis at PTL. “Such conduct,” noted the court, “demonstrates a total lack of fiduciary responsibility to PTL.” The court emphasized that “trustees and corporate directors for not-for-profit organizations are liable for losses occasioned by their negligent mismanagement.”
- The key element of the fiduciary duty of care is the performance of one’s duties as a director or officer “honestly, in good faith, and with reasonable diligence and care.”
- There are a number of ways that church board members can reduce the risk of liability for breaching the fiduciary duty of due care, including the following:
- Attend all of the meetings of the board and of any committees on which they serve.
- In advance of each meeting, receive an agenda of matters to be addressed during the meeting, with supporting documentation.
- In advance of each meeting, receive and thoroughly review interim financial statements and other materials that will be presented to enable them to seek clarification of any questions, irregularities, or inconsistencies at the meeting of the board.
- Affirmatively investigate and rectify any other problems or improprieties.
- Thoroughly review the corporate charter, constitution, and bylaws, and be sure copies of these documents are accessible during the meeting.
- Dissent from any board action with which they have any misgivings, and insist that their objection be recorded in the minutes of the meeting.
- Only approve financial reports of the treasurer when those reports are of sufficient importance (such as an annual report) to be referred to auditors, according to Robert’s Rules of Order Newly Revised.
- Provide members with the preliminary minutes of each board meeting soon after the meeting is held, and invite additions and corrections.
- Make sure that all actions are properly authorized, and recorded in the minutes.
- Make sure that all actions are consistent with the church’s charter, bylaws, or other governing instruments.
- Implement a training program for new and veteran board members.
- Resign from the board if and when you are unable to fulfill these duties.
- Verify whether several recommendations made by the Freeh Commission in response to the Jerry Sandusky scandal at Penn State University are followed by your church: (1) the church’s governing documents should provide for board rotation and staggered voting; (2) board members’ terms should be limited; (3) the board should be continually informed by church leadership of existing and potential legal and financial risks.
- Encourage diversity in board membership
- Periodically review the performance of senior level church staff.
- Lessons from the for-profit world
- Few courts have addressed the fiduciary duty of care in the context of churches or other nonprofit corporations. But, many courts have addressed fiduciary duties in the context of business corporations, and these cases provide useful clarification in the nonprofit context. Listed below are illustrative cases that demonstrate the types of care and oversight commonly expected of board members:
- Jurista v. Amerinox Processing, Inc. 492 B.R. 707 (D.N.J. 2013). “The duty of care is the wellspring from which more specific duties flow. Corporate directors are required to exercise their duties with due care because the institutional integrity of a corporation depends upon the proper discharge of those duties. In assessing whether corporate directors acted with due care, the court’s inquiry is not into the substantive decision of the director, but rather is into the procedures employed by the board in making its determination … . A director is held to the standard of care that an ordinarily prudent director would use under the circumstances. Directors may not shut their eyes to corporate misconduct and then claim that because they did not see the misconduct because they did not have a duty to look. The sentinel asleep at his post contributes nothing to the enterprise he is charged to protect.”
- Francis v. United Jersey Bank, 432 A.2d 814 (N.J. 1981). “A director is not an ornament, but an essential component of corporate governance. Consequently, a director cannot protect himself behind a paper shield bearing the motto, ‘dummy director.'”
- Williams v. McKay, 18 A. 824 (N.J. 1889). A person voluntarily assuming the position of director also assumes the duties of ordinary care, skill, and judgment. “Directors are not intended to be mere figure-heads without duty or responsibility.”
- Barr v. Wackman, 329 N.E.2d 180 (N.Y. 1975). A director “does not exempt himself from liability by failing to do more than passively rubber-stamp the decisions of the active managers … . Directors undertake affirmative duties of due care and diligence to a corporation in addition to their obligation merely to avoid self-dealing. That unaffiliated directors may not have personally profited from challenged actions does not necessarily end the question of their potential liability to the corporation and the consequent unlikelihood that they would prosecute the action. No custom or practice can make a directorship a mere position of honor void of responsibility, or cause a name to become a substitute for care and attention. The personnel of a directorate may give confidence and attract custom; it must also afford protection.”
- Matter of Kauffman Mutual Fund Actions, 479 F.2d 257 (1st Cir. 1973). “The importance of directorate oversight of the management technocracy is greater than ever. A higher degree of professionalism, sensitivity, and scrutiny may fairly be expected on the part of directors today than in a simpler era.”
- Kavanaugh v. Gould, 119 N.E. 237 (N.Y. 1918). The fact that a bank director never attended board meetings or acquainted himself with the bank’s business or methods was deemed to be no defense to responsibility for speculative loans made by the president and acquiesced in by other directors. The court concluded: “As all these matters, therefore, were known or should have been known to the directors present at the monthly meetings … would they not also have been known to [the director] if he had attended the meetings or had been reasonably attentive to his duties as a director? This, we think, presents a question of fact. And if, as a director, he knew of these facts and circumstances, would he have been justified in permitting the president to continue in his course unchecked or further loans on the underwritings without supervision and control … ?
- “What a director must do in exercising reasonable care in the performance of his duties is always dependent upon the facts. Care is a relative term. This [corporation] was of recent origin; its business had not become established or its methods fixed. Its president was a merchant with apparently no banking experience. Whether a director in exercising reasonable care would have left such an institution without some scrutiny of its initial investments or supervision of its loans, or without directing the nature of its business policy, is a question of fact for the trial court. The directors could, at least, have required the approval of the executive committee before money was advanced … . Yet the directors did nothing, and [the president] went his own way.”
- Feeley v. NHAOCG, LLC, 62 A.3d 649 (Del. 2012). “The members of a board of directors … owe fiduciary duties of loyalty and care to the corporation. Those duties require that the directors exercise their managerial authority on an informed basis in good faith … .”
- Stone v. Ritter, 911 A.2d 362 (Del. 2006). Necessary conditions predicate for director oversight liability are: (a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention.
- In re Caremark International, 698 A.2d 959 (Del. Ch. 1996). The board of directors may not satisfy an obligation to monitor corporation’s activities, which was part of its duty to be reasonably informed regarding corporation’s affairs, without members “assuring themselves that information and reporting systems exist in the organization that are reasonably designed to provide to senior management and to the board itself timely, accurate information sufficient to allow management and board, each within its scope, to reach informed judgments concerning both corporation’s compliance with law and its business performance.”
- Guttman v. Huang, 823 A.2d 492 (Del. Ch. 2003). Where a claim of directorial liability for corporate loss is predicated upon ignorance of liability creating activities within the corporation, only a sustained or systematic failure of the board to exercise oversight, such as an utter failure to attempt to assure a reasonable information and reporting system exists, will establish the lack of good faith that is a necessary condition to liability.
- Senn v. Northwest Underwriters, 875 P.2d 637 (Wash. App. 1994). Director and officer of an insurance company was personally liable for misappropriating more than $12 million from that insurance company, where she breached her statutory fiduciary duty to discover another director’s conversion of funds and that breach proximately caused company’s losses.
- Desimone v. Barrows, 924 A.2d 908 (Del. Ch. 2007).To hold corporate directors liable for a failure in monitoring, the directors have to have acted with a state of mind consistent with a conscious decision to breach their duty of care.In re Citigroup, 964 A.2d 106 (Del. Ch. 2009). The necessary conditions predicate for director oversight liability are: (1) the directors utterly failed to implement any reporting or information system or controls; or (2) having implemented such a system or controls, consciously failed to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention.
- In re Citigroup, 964 A.2d 106 (Del. Ch. 2009). Imposition of director oversight liability requires a showing that the directors knew that they were not discharging their fiduciary obligations.
- Francis v. United Jersey Bank, 432 A.2d 814 (N.J. 1981). Corporate directors may not shut their eyes to corporate misconduct and then claim that because they did not see the misconduct, they did not have a duty to look.
- Rich v. Yu Kwai Chong, 66 A.3d 963 (Del. Ch. 2013). Shareholder’s derivative action sufficiently stated a claim against directors for breach of the duty of loyalty arising from directors’ bad-faith failure to exercise oversight over the company; allegations in complaint indicated that company had no meaningful controls in place, and that the directors knew that its internal controls were deficient but failed to correct the deficiencies, including neglecting such red flags as a warning from NASDAQ that the company would face delisting if it did not bring its reporting requirements up to date with the United States Securities and Exchange Commission.
- In re American International Group, 965 A.2d 763 (Del Ch. 2009). Stockholders stated breach of duty of loyalty and failure to monitor claims against corporation’s former senior vice chairman of general insurance and former vice chairman of investments and financial services, asserting that such executives knew of and helped former chief executive officer’s (CEO) efforts to implement fraudulent transactions to hide corporation’s financial status, to avoid taxes, to sell illegal financial products and to rig markets, and that such executives knew the internal controls were inadequate, in derivative breach of fiduciary duty action. Both executives were long-serving subordinates to CEO and served on corporation’s executive committee, and stockholders alleged diverse, pervasive, and novel wrongdoing totaling billions of dollars which, when taken with executives’ roles at corporation, supported inference that they knew of, and approved, the wrongdoing, and did not bring it to the attention of corporation’s independent directors.
- In re Capital One Litigation, 2013 WL 3242685 (E.D. Va. 2013). To plead a claim that corporate fiduciaries consciously ignored red flags and are therefore liable for failing to prevent the corporation from breaking the law, a plaintiff must demonstrate: (1) that the alleged red flags actually constitute red flags; (2) that defendants were aware of the red flags; and (3) that defendants acted in bad faith in failing to take appropriate action in light of those red flags.
- Francis v. United Jersey Bank, 432 A.2d 814 (N.J. 1981). Directorial management of corporation does not require a detailed inspection of day-to-day activities but, rather, a general monitoring of corporate affairs and policies and accordingly, a director is well-advised to attend board meetings regularly.
- In re BHS&B, 420 B.R. 112 (S.D.N.Y. 2009). A plaintiff alleging breach of the duty of care may overcome the presumption that directors and officers acted on an informed basis by establishing that a decision was the product of an irrational process or that directors failed to establish an information and reporting system reasonably designed to provide the senior management and the board with information regarding the corporation’s legal compliance and business performance, resulting in liability.
- Playford v. Lowder, 635 F.Supp.2d 1303 (M.D. Ala. 2009). The necessary conditions predicate for director oversight liability in a shareholder derivative action are that the directors either (1) utterly failed to implement any reporting or information system or controls, or (2) having implemented such a system or controls, consciously failed to monitor or oversee its operations, thus disabling themselves from being informed of risks or problems requiring their attention; in either case, imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations.
- Clearly, satisfying the fiduciary duty of due care involves a lot of work. Remember that board members have been set apart by their congregation as its representatives in the management and governance of the church. This is a privileged position that demands a director’s utmost diligence and loyalty.
- As one court has observed, “the law has no place for dummy directors.”
- “Directors should know of and give direction to the general affairs of the institution and its business policy, and have a general knowledge of the manner in which the business is conducted, the character of the investments and the employment of the resources. No custom or practice can make a directorship a mere position of honor void of responsibility, or cause a name to become a substitute for care and attention. The personnel of a directorate may give confidence and attract custom; it must also afford protection … . No one is compelled to be a director, but once the office is assumed, it carries with it the light burden of active, diligent, and single-eyed service.” People v. Marcus, 261 N.Y. 268 (N.Y. 1933).
- The fiduciary duty of due care was initially formulated by the courts, and was often construed as imposing on nonprofit corporate directors a duty to act with the same degree of care in the performance of their duties as a “reasonably prudent director” under similar circumstances. The “reasonable person” standard is still followed by many courts and legislatures, but in recent years has been increasingly replaced by a slightly different standard. Most notably, section 8.30 of the revised Model Nonprofit Corporation Act, which has been adopted by several states, provides:
(a) Each member of the board of directors, when discharging the duties of a director, shall act:
(1) in good faith, and
(2) in a manner the director reasonably believes to be in the best interests of the nonprofit corporation.
(b) The members of the board of directors or a committee of the board, when becoming informed in connection with their decision-making function or devoting attention to their oversight function, must discharge their duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances.
(c) In discharging board or committee duties a director must disclose, or cause to be disclosed, to the other board or committee members information not already known by them but known by the director to be material to the discharge of their decision-making or oversight functions, except that disclosure is not required to the extent that the director reasonably believes that doing so would violate a duty imposed by law, a legally enforceable obligation of confidentiality, or a professional ethics rule.
(d) In discharging board or committee duties a director who does not have knowledge that makes reliance unwarranted may rely on the performance by any of the persons specified in subsection (f)(1), (3), or (4) to whom the board may have delegated, formally or informally by course of conduct, the authority or duty to perform one or more of the board’s functions that are delegable under applicable law.
(e) In discharging board or committee duties, a director who does not have knowledge that makes reliance unwarranted may rely on information, opinions, reports, or statements, including financial statements and other financial data, prepared or presented by any of the persons specified in subsection (f).
(f) A director may rely, in accordance with subsection (d) or (e), on:
(1) one or more officers, employees, or volunteers of the nonprofit corporation whom the director reasonably believes to be reliable and competent in the functions performed or the information, opinions, reports, or statements provided;
(2) legal counsel, public accountants, or other persons retained by the corporation as to matters involving skills or expertise the director reasonably believes are matters:
(i) within the particular person’s professional or expert competence, or
(ii) as to which the particular person merits confidence;
(3) a committee of the board of directors of which the director is not a member if the director reasonably believes the committee merits confidence; or
(4) in the case of a corporation engaged in religious activity, religious authorities and ministers, priests, rabbis, imams, or other persons whose positions or duties the director reasonably believes justify reliance and confidence and whom the director believes to be reliable and competent in the matters presented.
(g) A director is not a trustee with respect to the nonprofit corporation or with respect to any property held or administered by the corporation, including property that may be subject to restrictions imposed by the donor or transferor of the property.
- The Model Nonprofit Corporation Act reflects the trend to replace a corporate director’s fiduciary duty of “due care” with a duty to act in “good faith … in a manner the director reasonably believes to be in the best interests of the nonprofit corporation.” In practical terms, there is little difference between these two standards.
- “A director or officer may be liable for a violation of fiduciary duty even in the absence of bad faith or dishonesty; affirmative malfeasance is not required—mere passive negligence can be enough to breach the duty and result in liability. Similarly, a director or officer who fails to take the steps necessary to acquire a rudimentary understanding of the business and activities of the corporation may be held liable for damage resulting from that ignorance.” Fletcher Cyc. Corp. § 844.10.
- (2) The fiduciary duty of “due care”—the “prudent investor” rule
- The fiduciary duty of care applies to the investment of corporate funds. However, directors are not accountable for every bad investment they make. They are not held to a standard of perfection. Rather, they are accountable only if an investment decision was not based on “the care an ordinarily prudent person in a like position would exercise under similar circumstances.” The courts have been reluctant to impose liability on directors for an exercise of poor judgment. One state supreme court, in language that has been quoted by several other courts, observed:
[There is] a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Absent an abuse of discretion, that judgment will be respected by the courts. The burden is on the party challenging the decision to establish facts rebutting the presumption.
- What steps can church officers and directors take to reduce the risk of violating the fiduciary duty of due care? Consider the following:
Check state law. If your church is incorporated under state law, be sure to check your state nonprofit corporation law for any provisions that address the duties of officers and directors. This information should be made available to all of the church’s officers and directors.
Check the church’s governing documents and minutes. The governing documents (i.e., articles of incorporation or bylaws) of some churches contain restrictions on investments. Such restrictions may also appear in the minutes of congregational or board meetings. It is essential for board members to be familiar with these restrictions and to enforce them.
Use an investment committee. Many nonprofit organizations use an investment committee to make recommendations regarding the investment of funds. This can be an excellent way to reduce the liability of board members for poor investment decisions. Rather than make decisions themselves, the board appoints an investment committee that includes individuals with proven investment or financial expertise. Committee members may include stockbrokers, CPAs, attorneys, bankers, financial planners, and business leaders. Of course, the committee’s recommendations ordinarily must be approved by the governing board, but by relying on the advice of experts the board is greatly reducing the risk of being liable for poor investment decisions. After all, they were relying on the advice of experts.
Key point. The Model Revised Nonprofit Corporation Act (quoted above) specifies that “in discharging his or her duties, a director is entitled to rely on information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by … persons as to matters the director reasonably believes are within the person’s professional or expert competence … .” This language provides directors with considerable protection when relying on the advice of experts on an investment committee.
Investment policy. A church congregation or board can create an investment policy to govern investment decisions. A policy can prohibit investments in specified instruments or programs.
Avoid speculative or risky investments. If a proposal sounds “too good to be true,” it probably is. Any scheme that promises to “double your money” in a short period of time should be viewed with extreme skepticism. It is absolutely essential that such schemes not be pursued without the thorough evaluation and recommendation of persons with financial and investment expertise.
Key point. Do not rely on the “expert opinion” of persons representing the promoter of an investment scheme. Investment schemes must be reviewed by independent and objective persons having financial and investment expertise. Ideally, these persons will be members of your church, or persons within your community who have a reputation of unquestioned integrity.
- The SEC lists four common investment scams that are perpetrated on religious organizations—pyramid schemes, Ponzi schemes, Nigerian investment scams, and prime bank scams. The SEC has provided the following warning signs of fraudulent bank-related investment schemes:
Excessive guaranteed returns. These schemes typically offer or guarantee spectacular returns of 20 percent to 200 percent monthly, absolutely risk free! Promises of unrealistic returns at no risk “are hallmarks of prime bank fraud.”
Fictitious financial instrument. Despite having credible-sounding names, the supposed “financial instruments” at the heart of any prime bank scheme simply do not exist. Exercise caution if you’ve been asked to invest in a debt obligation of the “top 100 world banks,” Medium Term Bank Notes or Debentures, Standby Letters of Credit, Bank Guarantees, an offshore trading program, a roll program, bank-issued debentures, a high-yield investment program, or some variation on these descriptions. Promoters frequently claim that the offered financial instrument is issued, traded, guaranteed, or endorsed by the World Bank or an international central bank.
Extreme secrecy. Promoters claim that transactions must be kept strictly confidential by all parties, making client references unavailable. They may characterize the transactions as the best-kept secret in the banking industry, and assert that, if asked, bank and regulatory officials would deny knowledge of such instruments. Investors may be asked to sign nondisclosure agreements.
Exclusive opportunity. Promoters frequently claim that investment opportunities of this type are by invitation only, available to only a handful of special customers, and historically reserved for the wealthy elite.
Claims of inordinate complexity. Investment pitches frequently are vague about who is involved in the transaction or where the money is going. Promoters may try to explain away this lack of specificity by stating that the financial instruments are too technical or complex for “non-experts” to understand.
- Especially watch for—and avoid—prime-bank related schemes promoted through the Internet.
- It is also best to avoid investing all or a significant portion of available funds in the stock of one company, since the lack of “diversification” creates added risk. Investing in stock generally should be avoided unless investments are sufficiently diversified (for example, through conservative mutual funds) and recommended by a knowledgeable investment committee.
Key point. Remember, you are investing donated funds. This is no time to be taking risks. Not only do officers and directors have a legal duty to exercise due care in the investment of church funds. Just as importantly, they have a moral duty to be prudent in their investment decisions. No officer or director wants to explain to church members at an annual business meeting how some of their contributions were lost due to poor investments.
Avoid investing in companies or programs in which a board member has a personal interest. It’s critical to avoid investing in companies or programs with direct ties to a member of your board. Such investments are not always inappropriate, but they demand a higher degree of scrutiny.
Key point. A church’s investments should be reviewed at every board meeting. This ensures that all investments will be continuously monitored, and that necessary adjustments are made.
Trustees have a higher duty. Sometimes church board members are designated as the trustees of a charitable trust. For example, a member dies, leaving a large sum to the church for a specific purpose, and designates the church board as the trustee of the fund. Trustees are held to an even higher degree of care in the investment of trust funds than officers or directors of a corporation. However, the Revised Model Nonprofit Corporation Act specifies that “a director shall not be deemed to be a trustee with respect to the corporation or with respect to any property held or administered by the corporation, including without limit, property that may be subject to restrictions imposed by the donor or transferor of such property.” In other words, a church officer or director is not automatically deemed to be a “trustee” of church funds. Officers and directors generally are held to the higher legal standard applicable to trustees only if they are designated as trustees in a legal instrument that creates a trust fund.
Conclusion. Church officers and directors must take steps to inform themselves about any investment decision involving church funds. They can rely on a number of safeguards, including their own research, the recommendations of an investment committee, and common sense.
Kelsey v. Ray, 719 A.2d 1248 (D.C. App. 1998)A District of Columbia appeals court ruled that it was prohibited by the First Amendment from resolving a lawsuit brought by members of a church claiming that the board of trustees breached its fiduciary duties by authorizing an interest-free loan to the pastor and by failing to provide the congregation with adequate information regarding the church’s finances. The court concluded: “A church’s financial regime, including any required reports to members, necessarily reflects an array of decisions about a member’s obligation to pledge funds, and about the leaders’ corresponding responsibility to account for those funds, that a civil court cannot arbitrate without entangling itself in doctrinal interpretations … . Accounting is an area riddled with major subjective decisions. When the entity in question is a religious society, those subjective decisions raise questions of internal church governance which are often themselves based on the application of church doctrine.”
Marwil v. Grubbs, 2004 WL 2278751 (S.D. Ind. 2004)A federal court in Indiana ruled that the directors of a church subsidiary could be sued individually for financial losses incurred by investors in a securities scam on the basis of their breach of their fiduciary duty of care.
The Woodward School for Girls v. City of Quincy, 2013 WL 8923423 (Mass. 2014)The Massachusetts Supreme Judicial Court ruled that the trustee of a charitable trust violated its fiduciary duty of care by investing trust funds in fixed income investments for many years rather than diversifying and investing some of the trust funds in equity securities. The court concluded: [The trustee] failed to invest with the long-term needs and best interests of the income beneficiary in mind, creating a portfolio that consistently provided income but that left the principal vulnerable to inflation and, as a result, depreciation. Accordingly, based on these considerations, the judge’s ruling that [the trustee] committed a breach of its fiduciary duty of prudent investment was not clearly erroneous.”
Shepherd of the Valley Lutheran Church v. Hope Lutheran Church, 626 N.W.2d 436 (Minn. App. 2001)A Minnesota court ruled that a church officer violated his fiduciary duties to his church as a result of his secret efforts to remove the pastor and have the church property transferred to a new church that he had formed. The court noted that “an officer of a nonprofit corporation owes a fiduciary duty to that corporation to act in good faith, with honesty in fact, with loyalty, in the best interests of the corporation, and with the care of an ordinary, prudent person under similar circumstances.” The officer conceded that he owed a fiduciary duty to the church, but he insisted that the evidence did not support a finding that he breached his fiduciary duty because his actions were consistent with the wishes of the church members who supported him. The court disagreed: “As the bearer of a fiduciary duty, the law imposed on him the highest standard of integrity in his dealings with the other officers of [the church] and the entire [church] congregation, not just those who [supported him]. Therefore … as an officer of [the church] his fiduciary duty prevented him from assuming positions, and taking actions, that conflicted with the interests of [the church] and the congregation as a whole … . There is sufficient evidence in the record to establish that the officer breached his fiduciary duty to [the church]. He admitted that while he was vice president of the church he organized a faction for the purpose of forming another church to directly compete with [the original church]. Further, the formation of a new church was intended to be a method of circumventing the national church’s termination provisions governing the pastor’s services. To achieve his goals, he held secret meetings and continuously encouraged secrecy among [his supporters]. He did not inform other church officials and members of … his plans to form [a new church], separate from [the original church], and transfer the church property from [the original church to the new church] without compensation.”
Basich v. Board of Pensions, 540 N.W.2d 82 (Minn. App. 1995)A Minnesota court dismissed a lawsuit brought by Lutheran pastors against a denominational pension board for allegedly breaching their fiduciary duty to participants by not investing in companies that did business in South Africa. The Evangelical Lutheran Church in America (ELCA) established a board of pensions in 1988 to manage and operate a pension fund for Lutheran pastors and lay employees “exclusively for the benefit of and to assist in carrying out the purposes of the ELCA.” The ELCA adopted the position that the system of apartheid in South Africa was so contrary to Lutheran theology that it had to be rejected as a matter of faith. The ELCA passed a resolution to “see that none of our ELCA pension funds will be invested in companies doing business in South Africa.” A dissenting group of Lutherans opposed the ELCA’s decision to use its assets as a political weapon and asked to withdraw their pension funds. When their request was denied, they sued the board of pensions and the ELCA, claiming that both groups had violated their fiduciary duties to participants in the pension program by elevating social concerns over sound investment strategy. A state appeals court dismissed the lawsuit on the ground that a resolution of the lawsuit would require the court to interpret religious doctrine in violation of the First Amendment’s nonestablishment of religion clause. The court concluded that the “ELCA enacted the [apartheid] policy in an effort to further its social and doctrinal goals … . Accordingly, any review of the Board of Pensions’ [investment policy] would entangle the court in reviewing church doctrine and policy.”
Spitzer v. Lev, 2003 WL 21649444 (N.Y. Sup. 2003)A New York court ruled that the officers of a nonprofit organization violated their fiduciary duties and could be removed from office by the attorney general and ordered to pay damages. The state attorney general of New York sued the officers of a charity seeking to hold them personally liable and financially accountable for amounts totaling more than $120,000, which they allegedly received in violation of their fiduciary duties. The attorney general also sought to remove two of the officers and permanently bar them from ever serving as board members of a public charity. One of the officers freely admitted that he charged several personal expenses to the charity, but defended himself by stating, “I erroneously believed that it would be permissible for me to charge certain personal expenses to [the charity] and have them reclassified as personal expenses to be paid back to [the charity].” The court called this allegation “startling,” and further observed, “This court is at a loss as to why anyone would think they could charge something to a not-for-profit corporation as long as they paid it back later. After all, [the charity] is a not-for-profit corporation and not a revolving credit line.”
Scheuer Family Foundation, Inc. v. 61 Associates, 582 N.Y.S.2d 662 (A.D. 1 Dept. 1992)A New York appeals court ruled that directors of a charitable trust could be sued for breaching their fiduciary duties. A child of the founder of the trust filed a lawsuit seeking to remove eight of the trust’s eleven directors. He asserted that the eight directors breached their fiduciary duties, mismanaged the trust’s investments, and negligently selected the trust’s investment advisor. The court ruled that the eight directors could be sued. It noted that “it is well established that, as fiduciaries, board members bear a duty of loyalty to the corporation and may not profit improperly at the expense of their corporation.” In this case, the lawsuit alleged that the eight directors breached their fiduciary duties by investing a substantial portion of the trust’s assets in speculative securities and in the stock of a company with direct ties to the directors. The court concluded that the “business judgment rule” (which protects directors from any liability for their reasonable and good faith decisions) did not apply in this case, since it was not available “when the good faith or oppressive conduct of the officers and directors is in issue.”
Harris v. Matthews, 643 S.E.2d 566 (N.C. 2007)The North Carolina Supreme Court ruled that it was barred by the First Amendment from resolving a complaint by church members that their pastor and two other church officials had breached their fiduciary duties by improperly using church funds. The court noted that the plaintiffs alleged that the pastor and other defendants usurped the governmental authority of the church’s internal governing body, and breached their fiduciary duties by improperly using church funds, which constitutes conversion. The court concluded: “Determining whether actions, including expenditures, by a church’s pastor, secretary, and chairman of the board of trustees were proper requires an examination of the church’s view of the role of the pastor, staff, and church leaders, their authority and compensation, and church management. Because a church’s religious doctrine and practice affect its understanding of each of these concepts, seeking a court’s review of the matters presented here is no different than asking a court to determine whether a particular church’s grounds for membership are spiritually or doctrinally correct or whether a church’s charitable pursuits accord with the congregation’s beliefs. None of these issues can be addressed using neutral principles of law. Here, for example, in order to address plaintiffs’ claims, the trial court would be required to interpose its judgment as to both the proper role of these church officials and whether each expenditure was proper in light of the church’s religious doctrine and practice, to the exclusion of the judgment of the church’s duly constituted leadership. This is precisely the type of ecclesiastical inquiry courts are forbidden to make.” The court rejected the plaintiffs’ claim that, since the church was incorporated, the state nonprofit corporation law could be used to resolve the dispute. It simply noted that “a church that incorporates under the North Carolina Nonprofit Corporation Act does not forfeit its fundamental First Amendment rights. Regardless of a church’s corporate structure, the Constitution requires courts to defer to the church’s internal governing body with regard to ecclesiastical decisions concerning church management and use of funds.”
Tibbs v. Kendrick, 637 N.E.2d 397 (Ohio App. 1994)An Ohio court refused to allow church members to sue board members personally for breaching their fiduciary duties by failing to oust a pastor who allegedly had engaged in financial improprieties. It observed: “Inquiry into the relationship between the trustees and the congregation in matters concerning the pastorship would require the courts to consider each party’s view of who should preach from the pulpit. Review of such matters would further require the court to determine the issue of whether the trustees’ performance of their duties met the standards of the congregation and would therefore involve an inquiry into ecclesiastical concerns. Therefore … civil courts lack … jurisdiction to entertain such matters … . [We] hold that the lower court has no jurisdiction over the claims brought by the individual members of the congregation seeking to … hold the board liable for breach of fiduciary duty to the congregation.”
- The Uniform Prudent Management of Institutional Funds Act of 2006 (UPMIFA)
- The Uniform Prudent Management of Institutional Funds Act (UPMIFA) has been adopted, with minor variations, in 47 states. It replaces the Uniform Management of Institutional Funds Act (UMIFA), which was adopted by most states since its inception in 1972. UPMIFA helps in clarifying the fiduciary duty of care, and in particular the “prudent investor” rule.
- Section 3 of the Act specifies:
(a) Subject to the intent of a donor expressed in a gift instrument, an institution, in managing and investing an institutional fund, shall consider the charitable purposes of the institution and the purposes of the institutional fund.
(b) In addition to complying with the duty of loyalty imposed by law other than this [act], each person responsible for managing and investing an institutional fund shall manage and invest the fund in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances.
(c) In managing and investing an institutional fund, an institution: (1) may incur only costs that are appropriate and reasonable in relation to the assets, the purposes of the institution, and the skills available to the institution; and (2) shall make a reasonable effort to verify facts relevant to the management and investment of the fund.
(d) An institution may pool two or more institutional funds for purposes of management and investment.
(e) Except as otherwise provided by a gift instrument, the following rules apply:
(1) In managing and investing an institutional fund, the following factors, if relevant, must be considered:
(A) general economic conditions;
(B) the possible effect of inflation or deflation;
(C) the expected tax consequences, if any, of investment decisions or strategies;
(D) the role that each investment or course of action plays within the 2 overall investment portfolio of the fund;
(E) the expected total return from income and the appreciation of investments;
(F) other resources of the institution;
(G) the needs of the institution and the fund to make distributions and to preserve capital; and
(H) an asset’s special relationship or special value, if any, to the charitable purposes of the institution.
(2) Management and investment decisions about an individual asset must be made not in isolation but rather in the context of the institutional fund’s portfolio of investments as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the fund and to the institution.
(3) Except as otherwise provided by law other than this [act], an institution may invest in any kind of property or type of investment consistent with the standards of this section.
(4) An institution shall diversify the investments of an institutional fund unless the institution reasonably determines that, because of special circumstances, the purposes of the fund are better served without diversification.
(5) Within a reasonable time after receiving property, an institution shall make and implement decisions concerning the retention or disposition of the property or to rebalance a portfolio, in order to bring the institutional fund into compliance with the purposes, terms, distribution requirements, and other circumstances of the institution and the requirements of this [act].
(6) A person who has special skills or expertise, or is selected in reliance upon the person’s representation that the person has special skills or expertise, has a duty to use those special skills or that expertise in managing and investing institutional funds.
- The Act defines an “institutional fund” as “a fund held by an institution exclusively for charitable purposes.” An “institution” is defined to include as “a person, other than an individual, organized and operated exclusively for charitable purposes.” A “charitable purpose” is defined to include “advancement of education or religion.”
- As a result, UPMIFA applies to virtually all funds held by a church or other charity, and is not limited to trust or endowment funds. It is therefore essential for church leaders to be familiar with its directives, which may be viewed as a clarification of the meaning of the “prudent investor.”
- An official comment by UPMIFA’s drafters states:
This section adopts the prudence standard for investment decision making. The section directs directors or others responsible for managing and investing the funds of an institution to act as a prudent investor would, using a portfolio approach in making investments and considering the risk and return objectives of the fund. The section lists the factors that commonly bear on decisions in fiduciary investing and incorporates the duty to diversify investments absent a conclusion that special circumstances make a decision not to diversify reasonable. Thus, the section follows modern portfolio theory for investment decision making. Section 3 applies to all funds held by an institution, regardless of whether the institution obtained the funds by gift or otherwise and regardless of whether the funds are restricted.
The Drafting Committee discussed extensively the standard that should govern nonprofit managers. UMIFA states the standard as “ordinary business care and prudence under the facts and circumstances prevailing at the time of the action or decision.” Since the decision in Stern v. Lucy Webb Hayes Memorial Training School for Deaconesses [summarized above] the trend has been to hold directors of nonprofit corporations to a standard nominally similar to the corporate standard but with the recognition that the facts and circumstances considered include the fact that the entity is a charity and not a business corporation.
The language of the prudence standard adopted in UPMIFA is derived from the Revised Model Nonprofit Corporation Act (RMNCA) and from the prudent investor rule of the Uniform Prudent Investor Act (UPIA). The standard is consistent with the business judgment standard under corporate law, as applied to charitable institutions. That is, a manager operating a charitable organization under the business judgment rule would look to the same factors as those identified by the prudent investor rule. The standard for prudent investment set forth in Section 3 first states the duty of care as articulated in the RMNCA, but provides more specific guidance for those managing and investing institutional funds by incorporating language from UPIA. The criteria derived from UPIA are consistent with good practice under current law applicable to nonprofit corporations.
Trust law norms already inform managers of nonprofit corporations. The Preamble to UPIA explains: “Although the Uniform Prudent Investor Act by its terms applies to trusts and not to charitable corporations, the standards of the Act can be expected to inform the investment responsibilities of directors and officers of charitable corporations … .”
Because UPMIFA applies to charitable organizations, UPMIFA makes the duty of care, the duty to minimize costs, and the duty to investigate mandatory. The duty of loyalty is mandatory under applicable organization law, corporate or trust. Other than these duties, the provisions of Section 3 are default rules. A gift instrument or the governing instruments of an institution can modify these duties, but the charitable purpose doctrine limits the extent to which an institution or a donor can restrict these duties. In addition, subsection (a) of Section 3 reminds the decision maker that the intent of a donor expressed in a gift instrument will control decision making. Further, the decision maker must consider the charitable purposes of the institution and the purposes of the institutional fund for which decisions are being made … .
The duties imposed by this section apply to those who govern an institution, including directors and trustees, and to those to whom the directors or managers delegate responsibility for investment and management of institutional funds. The standard applies to officers and employees of an institution and to agents who invest and manage institutional funds. Volunteers who work with an institution will be subject to the duties imposed here, but state and federal statutes may provide reduced liability for persons who act without compensation. UPMIFA does not affect the application of those shield statutes … .
Subsection (c)(1) … requires an institution to minimize costs. An institution may prudently incur costs by hiring an investment advisor, but the costs incurred should be appropriate under the circumstances.
Consistent with the portfolio theory of investment, subsection (e)(3) permits a broad range of investments. Subsection (e)(4) assumes that prudence requires diversification but permits an institution to determine that nondiversification is appropriate under exceptional circumstances. A decision not to diversify must be based on the needs of the charity and not solely for the benefit of a donor. A decision to retain property in the hope of obtaining additional contributions from the same donor may be considered made for the benefit of the charity, but the appropriateness of that decision will depend on the circumstances … . Subsection (e)(5) imposes a duty on an institution to review the suitability of retaining property contributed to the institution within a reasonable period of time after the institution receives the property. Subsection (e)(5) requires the institution to make a decision but does not require a particular outcome. The institution may consider a variety of factors in making its decision, and a decision to retain the property either for a period of time or indefinitely may be a prudent decision … .
The intent of subsection (e)(6) is that a person managing or investing institutional funds must use the person’s own judgment and experience, including any particular skills or expertise, in carrying out the management or investment duties. For example, if a charity names a person as a director in part because the person is a lawyer, the lawyer’s background may allow the lawyer to recognize legal issues in connection with funds held by the charity. The lawyer should identify the issues for the board, but the lawyer is not expected to provide legal advice. A lawyer is not expected to be able to recognize every legal issue, particularly issues outside the lawyer’s area of expertise, simply because the board member is a lawyer.
- (3) The fiduciary duty of loyalty
- Directors of nonprofit corporations have a fiduciary duty of loyalty to the corporation. This duty generally requires that any transaction between the board and one of its directors be (a) fully disclosed, (b) approved by the board without the vote of the interested director, and (c) fair and reasonable to the corporation. A board member does not have to offer the church the lowest price for a product or service to discharge the duty of loyalty. All that is required is that the price be fair and reasonable to the corporation.
- There are sound reasons why a church might want to do business with a member of the board at a cost that is higher than what another business may charge. To illustrate, a church board may conclude that the church will receive better quality, and customer support, by doing business with a fellow board member. Of course, this does not mean that cost is irrelevant. At some point, the price for a product or service offered by a board member may be so much higher than what is offered by competitors that it ceases to be fair and reasonable to the church. In such a case, the duty of loyalty may be violated.
- The duty of loyalty also means that a board member will not usurp a corporate opportunity. This means that board members may not enter into personal transactions in which the church would have an interest. To illustrate, assume that a church needs to expand its facilities, and a five-acre tract of undeveloped land lies adjacent to the church’s property. The senior pastor of the church (who is president of the church corporation) purchases the land for himself at a cost of $100,000, and later offers to sell it to the church for $250,000. Under these circumstances, the pastor likely has violated the fiduciary duty of loyalty by usurping a corporate opportunity.
- Few courts have addressed the fiduciary duty of loyalty in the context of churches or other nonprofit corporations. A Minnesota court ruled that a church officer violated his fiduciary duties to his church as a result of his secret efforts to remove the pastor and have the church property transferred to a new church that he had formed. A church (the “original church”) was established in 1985 and a member of the Lutheran Church, Missouri Synod (the “national church”). Congregations which affiliate themselves with the national church agree to accept its doctrinal positions, constitution, bylaws, and resolutions. The church, as a member of the national church, is served by a called pastor, who may be terminated only for specific reasons. In 1997 the church called a new pastor. As a part of his duties, the pastor conducted communion. According to the national church, the pastor was required to allow only those who were members of the national church to participate in communion. The pastor’s refusal to allow non-members to participate in communion became a point of contention that eventually led to a division in the congregation.
- A church officer (“Jack”) sought to remove the pastor, but the board of elders unanimously determined that there was no basis to do so. Jack’s attempts to remove the pastor continued. A severance package was offered to the pastor, which he refused; an unsuccessful motion proposed a reduction of the pastor’s salary to $0; and another unsuccessful motion proposed the amendment of the termination provisions in the church’s constitution relating to called pastors. Following these unsuccessful attempts to remove the pastor, Jack and his supporters discontinued financial support of the church. Jack began organizing meetings that consisted of only those members of the congregation who opposed the pastor.
- The church constitution provided that “If, at any time, a separation should take place within this congregation … [and] a division into factions of the congregation shall occur because of doctrinal issues, the property of the congregation and all benefits therewith connected shall remain with those members who adhere in confession and practice [of the national church]. If division takes place for non-doctrinal reasons, the property shall remain with the majority of the communicant members.”
- Based on this provision, Jack and his supporters established a new church and then prepared a deed conveying the property of the original church to the new church. Throughout this time period, Jack retained his position as an officer of the original church. He did not inform other officers, or the general congregation, of his plans to seek separation and his efforts to form a new church. He also encouraged his supporters to remain quiet about their activities.
- Eventually, Jack informed another officer of the original church that he intended to seek separation of the congregation at the annual meeting. At the annual meeting, a motion to separate was put before the congregation. A majority of those present at the meeting voted to separate based on non-doctrinal reasons and to transfer the church property to the new church without any payment of money. Following the annual meeting, Jack changed the locks on the church sanctuary and informed those who opposed the transfer that they would not be welcome. The ousted members began worshiping in members’ homes or in rented facilities.
- The original church members who opposed the transfer of the church property to the new church filed a lawsuit in which they alleged that Jack had breached his fiduciary duties to the church. They also sought money damages from Jack, and a return of the property to the original church. A jury agreed that Jack had breached his fiduciary duties, and ordered him to pay $8,000 in damages. It also agreed that title to the church property should be returned to the original church. Jack appealed.
- Breach of fiduciary duties
- The court began its opinion by observing that “the underlying issue that gave rise to this lawsuit involves a doctrinal dispute amongst the congregation” and that “a court can apply neutral principles of law in resolving church property disputes so long as it does not determine disputes by examining the basis of the religious doctrine.” It observed, “Because it is not necessary for us to examine the religious doctrine underlying this lawsuit, we may resolve the property dispute … by applying neutral principles of law.”
- The court, referring to Minnesota law, noted that “an officer of a nonprofit corporation owes a fiduciary duty to that corporation to act in good faith, with honesty in fact, with loyalty, in the best interests of the corporation, and with the care of an ordinary, prudent person under similar circumstances.” Jack conceded that as an officer he owed a fiduciary duty to the original church, but he insisted that the evidence did not support a finding that he breached his fiduciary duty because his actions were consistent with the wishes of the church members who supported him. The court disagreed with Jack’s assessment. It observed,
Contrary to Jack’s argument, as the bearer of a fiduciary duty, the law imposed on him the highest standard of integrity in his dealings with the other officers of [the church] and the entire [church] congregation, not just those who [supported him]. Therefore, his actions must be viewed in light of the fact that as an officer of [the original church] his fiduciary duty prevented him from assuming positions, and taking actions, that conflicted with the interests of [the church] and the congregation as a whole.
Reviewing the evidence presented to the jury … there is sufficient evidence in the record to establish that Jack breached his fiduciary duty to [the original church]. He admitted that while he was vice president of the church he organized a faction for the purpose of forming another church to directly compete with [the original church]. Further, the formation of a new church was intended to be a method of circumventing the national church’s termination provisions governing the pastor’s services. To achieve his goals, Jack held secret meetings and continuously encouraged secrecy among [his supporters]. He did not inform other church officials and members of … his plans to form [a new church], separate from [the original church], and transfer the church property from [the original church to the new church] without compensation … .
- Jack’s trial testimony, the court also noted, revealed he did not disclose to the president of the church corporation that he was conducting secret meetings and preparing legal documents that would result in the transfer of the church’s property to the new entity. The court concluded, “Holding secret meetings and advance preparation of legal documents is improper conduct by an officer, amounting to a breach of fiduciary duty. Based on Jack’s own testimony, we cannot say that the jury’s verdict or the trial court’s amended order finding that he breached his fiduciary duty to [the original church] was unsupported by the evidence.”
- The court rejected Jack’s argument that a state law providing uncompensated board members of nonprofit corporations with limited immunity from liability prevented him from being found liable in this case. The court observed, “The Minnesota Nonprofit Corporation Act provides immunity from civil liability to unpaid directors of nonprofit organizations if the director (1) acts in good faith; (2) within the scope of his responsibilities as a director; and (3) does not commit reckless or willful misconduct. The party relying upon the immunity bears the burden of proving he or she fits within the scope of the immunity.” The court concluded:
Jack is not entitled to statutory immunity because his actions in bringing about the separation of the congregation and the transfer of the church property constituted willful or reckless misconduct. It is misconduct for an officer to withhold material information from other officers and members of the corporation. Because Jack testified that he intentionally withheld material information from other church officials and certain members of the congregation, his actions constituted willful misconduct.
- This decision is one of the most extended discussions ever provided by a court on the nature of a church officer’s fiduciary duties to the church. There are several points to note.
- First, church officers and directors owe fiduciary duties to their church. These duties are imposed on these persons because they have been selected to represent and promote the best interests of the church.
- Second, these duties may be summarized as follows, “An officer of a nonprofit corporation owes a fiduciary duty to that corporation to act in good faith, with honesty in fact, with loyalty, in the best interests of the corporation, and with the care of an ordinary, prudent person under similar circumstances.”
- Third, a church officer or director owes fiduciary duties to the entire church membership and not simply a particular group of members.
- Fourth, Jack violated his fiduciary duties by (1) creating a separate church to directly compete with the original church; (2) creating a separate church in order to circumvent the national church’s provisions pertaining to the termination of a pastor; (3) conducting secret meetings of members; (4) preparing legal documents to facilitate the transfer of the church’s property to the new church, without compensation; and, (5) not disclosing his actions to other church officers and directors.
- Fifth, the state charitable immunity law protecting uncompensated board members of nonprofit corporations from personal liability did not apply to Jack, because his actions could be characterized as “willful misconduct” and the law provides no protection for such behavior.
- Sixth, the court upheld the $8,000 verdict against Jack based on the breach of his fiduciary duties. This illustrates that money damages may be assessed against church board members who violate their fiduciary duties. Shepherd of the Valley Lutheran Church v. Hope Lutheran Church, 626 N.W.2d 436 (Minn. App. 2001). (Editor’s Note: This case is also referenced under the section covering the fiduciary duty of the “prudent investor” rule, which begins on page 8.)
- While few courts have addressed the fiduciary duty of loyalty in cases involving church board members, many courts have addressed fiduciary duty of loyalty in the context of business corporations, and these cases provide useful clarification in the nonprofit context. Listed below are illustrative cases:
Guth v. Loft, Inc. 5 A.2d 503 (Del. 1939). “Corporate officers and directors are not permitted to use their position of trust and confidence to further their private interests. While technically not trustees, they stand in a fiduciary relation to the corporation. A public policy, existing through the years, and derived from a profound knowledge of human characteristics and motives, has established a rule that demands of a corporate officer or director, peremptorily and inexorably, the most scrupulous observance of his duty, not only affirmatively to protect the interests of the corporation committed to his charge, but also to refrain from doing anything that would work injury to the corporation, or to deprive it of profit or advantage which his skill and ability might properly bring to it, or to enable it to make in the reasonable and lawful exercise of its powers. The rule that requires an undivided and unselfish loyalty to the corporation demands that there shall be no conflict between duty and self-interest. The occasions for the determination of honesty, good faith and loyal conduct are many and varied, and no hard and fast rule can be formulated. The standard of loyalty is measured by no fixed scale.
“If an officer or director of a corporation, in violation of his duty as such, acquires gain or advantage for himself, the law charges the interest so acquired with a trust for the benefit of the corporation, at its election, while it denies to the betrayer all benefit and profit. The rule, inveterate and uncompromising in its rigidity, does not rest upon the narrow ground of injury or damage to the corporation resulting from a betrayal of confidence, but upon a broader foundation of a wise public policy that, for the purpose of removing all temptation, extinguishes all possibility of profit flowing from a breach of the confidence imposed by the fiduciary relation. Given the relation between the parties, a certain result follows; and a constructive trust is the remedial device through which precedence of self is compelled to give way to the stern demands of loyalty.”
In re MF Global Holdings Ltd., 507 B.R. 808 (S.D.N.Y. 2014). “Directors and officers of a corporation owe a duty of loyalty to the corporation. The duty of loyalty requires an officer or director to (1) avoid fiduciary conflicts of interest and (2) act in good faith for the corporation’s best interest. Bad faith encompasses circumstances when the director or officer does not act with an honesty of purpose and in the best interest and welfare of the corporation.”
In re Orchard Enterprises, Inc., 2014 WL 1007589 (Del. Ch. 2014). “A plaintiff can call into question a director’s loyalty by showing that the director was interested in the transaction under consideration or not independent of someone who was. Or a plaintiff can demonstrate that the director failed to pursue the best interests of the corporation and therefore failed to act in good faith. The duty of loyalty mandates that the best interest of the corporation takes precedence over any interest possessed by a director or officer … . Corporate fiduciaries are not permitted to use their position of trust and confidence to further their private interests. A failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation.”
Westmoreland County Employee Retirement System v. Parkinson, 727 F.3d 719 (7th Cir. 2013). “But there are important limits to directors’ insulation from personal liability. If a director breaches the fiduciary duty of loyalty—which requires conduct that is qualitatively different from, and more culpable than, the conduct giving rise to a violation of the fiduciary duty of care (i.e., gross negligence)—the business judgment rule affords no protection. The fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest, but also encompasses cases where the fiduciary fails to act in good faith. Where directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith. Or, put slightly differently, the intentional dereliction of duty or the conscious disregard for one’s responsibilities [constitutes] bad faith conduct, which results in a breach of the duty of loyalty.”
Jurista v. Amerinox Processing, Inc., 492 B.R. 707 (D.N.J. 2013). “Corporate officers likewise owe a fiduciary duty of loyalty to the corporate entity which they represent. The duty of loyalty requires corporate directors to act in the best interests of the corporation, rather than for their own benefit, and requires an undivided and unselfish loyalty to the corporation [and] demands that there shall be no conflict between duty and self-interest. The threshold inquiry in assessing whether a director violated his duty of loyalty is whether the director has a conflicting interest in the transaction. Directors are considered to be interested if they either appear on both sides of a transaction or expect to derive any personal financial benefit from it in the sense of self-dealing, as opposed to a benefit which devolves upon the corporation generally. The director will be found to have breached his duty of loyalty and the business judgment rule will cease to protect him if instances of self-dealing or usurpation of corporate opportunities are found.”
Lippel v. Hirsch, 119 N.Y.S.2d 453 (N.Y. Sup. 1953). The test of undivided loyalty is whether corporate action is the result of the exercise by the directors of their unbiased judgment in determining that such action will promote the corporate interests.”
Urban J. Alexander Company v. Trinkle, 224 S.W.2d 923 (Ky. 1949). “A director or managing officer has a fiduciary relation to the corporation … . It is well settled by a long train of decisions that he has the duty to act in the utmost good faith and to further the corporation’s interest and business. He may not, therefore, acquire an interest in property adverse to that of the corporation or enter into a contract to serve his own interests or to assume a position which will bring his private interests into conflict or competition with that of his company. If he does so, he may be required to account for profits made in the transaction by reason of the breach of the trust relationship. This is a very emphatic rule where an undue advantage is secured at the expense of the corporation.”
- (4) The fiduciary duty of obedience
- Some courts have ruled that the officers and directors of nonprofit corporations have a fiduciary duty of “obedience.” This duty was described by one court as follows:
It is axiomatic that the Board of Directors is charged with the duty to ensure that the mission of the charitable corporation is carried out. This duty has been referred to as the “duty of obedience.” It requires the director of a not-for-profit corporation to “be faithful to the purposes and goals of the organization,” since unlike 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’être of the organization. Manhattan Eye, Ear & Throat Hosp. v. Spitzer, 715 N.Y.S.2d 575 (N.Y.Sup.1999).
- The duty of obedience encompasses the duty of nonprofit board members to ensure that the church:
- Is organized and operated exclusively for religious or other exempt purposes.
- Retains its exemption from state and federal taxes. This means, for example, that the church’s assets do not inure to the private benefit of individuals, that the church does not engage in more than insubstantial efforts to influence legislation, and that the church and its officers and directors do not participate or intervene in any political campaign on behalf of, or in opposition to, a candidate for public office.
- Is in compliance with its constitution, bylaws, or other governing instrument.
- Is in compliance with applicable federal, state, and local laws and regulations.
- One court concluded that “[t]he duty of obedience requires a director to avoid committing … acts beyond the scope of the powers of a corporation as defined by its charter or the laws of the state of incorporation.” Batey v. Droluk, 2014 WL 1408115 (Tex. App. 2014).
- Recommendations of the Panel on the Nonprofit Sector
- In the midst of the financial scandals involving several prominent companies in 2002 and 2003, the media began focusing on allegations of questionable conduct by trustees and executives of public charities. In some cases the alleged abuses were clear violations of the law. In others, the issue was whether certain practices met the high ethical standards expected of the charitable sector.
- These disclosures caught the attention of Congress. In September of 2004 the chairman of the Senate Finance Committee, Senator Charles Grassley (R-IA), and the ranking member, Senator Max Baucus (D-MT), sent a letter to the Independent Sector encouraging it to assemble an independent group of leaders from the charitable community to consider and recommend actions “to strengthen governance, ethical conduct, and accountability within public charities and private foundations.” The Senate Finance Committee leadership requested a final report in 2005.
Key point. The Independent Sector is a nonprofit, nonpartisan coalition of approximately 500 national public charities, foundations, and corporate philanthropy programs, collectively representing tens of thousands of charitable groups in every state across the nation.
- The Independent Sector responded by creating a Panel on the Nonprofit Sector consisting of 24 leaders of public charities. The Panel embarked upon a wide-ranging examination of how to strengthen the governance, accountability, and ethical standards of public charities. It convened several public hearings, obtained valuable input from advisory groups and work groups, and consulted with dozens of professionals. The Panel’s final report was submitted to the Senate Finance committee on June 22, 2005. It consists of nearly 100 recommendations for changes to be adopted by Congress, the IRS, or charities themselves.
- Application of the Panel’s recommendations to churches
- Many of the Panel’s recommendations pertain to public charities that file a Form 990 with the IRS. Churches and many other religious organizations are exempt from this requirement, and on this basis are not targeted by many of the recommendations. However, the recommendations are relevant to church leaders because they provide one of the most comprehensive evaluations of board governance and responsibilities ever undertaken, and for this reason they are relevant in any consideration of fiduciary duties.
- Several of the Panel’s recommendations call for voluntary action (without intervention by Congress or the IRS) by charities themselves. While churches are exempt from many of these recommendations, some church leaders may want to voluntarily comply with them. Many of the recommendations help clarify the meaning of fiduciary duties. Some of the most pertinent recommendations for church officers and directors include the following:
• The Panel “generally discourages payment of compensation to board members of charitable organizations.” However, “where compensation is deemed necessary due to the complexity of the responsibility, the time commitment involved in board service, and the skills required” charities should base compensation on a review of the practices of comparable organizations. This recommendation is for voluntary action by charities, with no action by Congress or the IRS.
• Charities should make available to “peer organizations on request relevant information that would assist in reviewing the reasonableness of board compensation policies.”
• Charities are urged to add to their bylaws or other governing document a requirement that the full board must approve, annually and in advance, the compensation of the CEO unless there is no change in compensation other than a cost-of-living adjustment.
• Governing boards or compensation committees should review the charity’s staff compensation program periodically, including salary ranges for particular positions.
• “Charitable organizations that pay for or reimburse travel expenses of board members, officers, employees, consultants, volunteers, or others traveling to conduct the business of the organization should establish and implement policies that provide clear guidance on their travel rules, including the types of expenses that can be reimbursed and the documentation required to receive reimbursement. Such policies should require that travel on behalf of the charitable organization is to be undertaken in a cost-effective manner. The travel policy should be provided to and adhered to by anyone traveling on behalf of the organization.”
• “Charitable organizations should not pay for nor reimburse travel expenditures (not including de minimis expenses of those attending an activity such as a meal function of the organization) for spouses, dependents, or others who are accompanying individuals conducting business for the organization unless they, too, are conducting business for the organization.”
• Congress should amend the tax code to require public charities to have at least three members of the board of directors as a requirement for tax-exempt status.
• Congress should amend the tax code to require at least one-third of a charity’s board to be “independent,” meaning individuals “(1) who have not been compensated by the organization within the past twelve months, including full-time and part-time compensation as an employee or as an independent contractor, except for reasonable compensation for board service; (2) whose own compensation, except for board service, is not determined by individuals who are compensated by the organization; (3) who do not receive, directly or indirectly, material financial benefits (i.e., service contracts, grants, or other payments) from the organization except as a member of the charitable class served by the organization; and (4) who are not related to (as a spouse, sibling, parent, or child) any individual described above.”
• Congress should amend the law “to prohibit individuals barred from service on boards of publicly traded companies or convicted of crimes directly related to breaches of fiduciary duty in their service as an employee or board member of a charitable organization from serving on the board of a charitable organization for five years following their conviction or removal.”
• “Every charitable organization, as a matter of recommended practice, should review its board size periodically to determine the most appropriate size to ensure effective governance and to meet the organization’s goals and objectives. All boards should establish strong and effective mechanisms to ensure that the board carries out its oversight functions and that board members are aware of their legal and ethical responsibilities in ensuring that the organization is governed properly.”
• “A board of directors should ensure, as a matter of recommended practice, that the positions of chief executive officer, board chair, and board treasurer are held by separate individuals. If the board deems it is in the best interests of the charitable organization to have the CEO serve as the board chair, the board should appoint a lead director to handle issues that require a separation of responsibilities.”
• “The charitable sector should undertake a vigorous effort to provide information and education to its organizations regarding the roles and responsibilities of board members and the factors that boards should consider in evaluating the appropriate size and structure needed to ensure the most effective and responsible governance.”
• “Charitable organizations should include individuals with some financial literacy on their board of directors in accordance with the laws of their state or as a matter of recommended practice. Every charitable organization that has its financial statements independently audited, whether legally required or not, should consider establishing a separate audit committee of the board. If the board does not have sufficient financial literacy, and if state law permits, it may form an audit committee comprised of non-voting, non-staff advisors rather than board members.”
• “There should be a sector-wide effort to educate charitable organizations about the importance of the auditing function.”
• The IRS should modify Form 990 to require public charities to disclose whether they have a conflict-of-interest policy.
• “Adopt and enforce a conflict-of-interest policy consistent with the laws of its state and tailored to its specific organizational needs and characteristics. This policy should define conflict of interest, identify the classes of individuals within the organization covered by the policy, facilitate disclosure of information that may help identify conflicts of interest, and specify procedures to be followed in managing conflicts of interest. Special attention should be paid to any transactions between board members and the organization.”
• “Establish policies and procedures that encourage individuals to come forward with credible information on illegal practices or violations of adopted policies of the organization. These policies and procedures should specify the individuals within the organization (both board and staff) or outside parties to whom such information can be reported, and should include at least one way to report such information that will protect the anonymity of the individual providing the information. The policy also should specify that the organization will protect the individual who makes such a report from retaliation.”
- Federal Tax Law
- In recent years, federal tax law has helped define the fiduciary of care in some important ways. A federal appeals court has noted, in this regard, that “maybe tax law has a role to play in assuring the prudent management of charities.” United Cancer Council v. Commissioner, 165 F.3d 1173 (7th Cir. 1999).
- (1) Excess benefit transactions
- One of the ways this is done is the potential liability of board members of tax-exempt organizations, including churches, for excess benefits paid to “disqualified persons” (generally, officers or directors, and their relatives). This potential liability clarifies and augments the definition of the fiduciary duty of care in the context of compensation planning.
- Section 501(c)(3) of the tax code exempts churches and most other religious organizations and public charities from federal income taxation. Five conditions must be met to qualify for exemption. One is that none of the organization’s assets inures to the private benefit of an individual other than as reasonable compensation for services rendered. Churches and other tax-exempt organizations that pay unreasonable compensation to an employee are violating one of the requirements for exemption and are placing their exempt status in jeopardy. However, the IRS has been reluctant to revoke the tax-exempt status of charities that pay unreasonable compensation, since this remedy is harsh and punishes the entire organization rather than the individuals who benefited from the transaction. For example, should Notre Dame University lose its tax-exempt status because of the compensation it pays to its head football coach?
- For many years the IRS asked Congress to provide a remedy other than outright revocation of exemption that it could use to combat excessive compensation paid by exempt organizations. In 1996, Congress responded by enacting section 4958 of the tax code. Section 4958 empowers the IRS to assess intermediate sanctions in the form of substantial excise taxes against insiders (called “disqualified persons”) who benefit from an “excess benefit transaction.”
- Section 4958 also allows the IRS to assess excise taxes against a charity’s board members who approved an excess benefit transaction. These excise taxes are called “intermediate sanctions” because they represent a remedy the IRS can apply short of revocation of a charity’s exempt status. While revocation of exempt status remains an option whenever a tax-exempt organization enters into an excess benefit transaction with a disqualified person, it is less likely that the IRS will pursue this remedy now that intermediate sanctions are available.
- Intermediate sanctions consist of the following three excise taxes:
- 1. Tax on disqualified persons
- A disqualified person who benefits from an excess benefit transaction is subject to an excise tax equal to 25 percent of the amount of the excess benefit (the amount by which actual compensation exceeds the fair market value of services rendered). This tax is paid by the disqualified person directly, not by his or her employer.
- 2. Additional tax on disqualified persons
- If the 25 percent excise tax is assessed against a disqualified person and he or she fails to correct the excess benefit within the taxable period (defined below), the IRS can assess an additional tax of 200 percent of the excess benefit. Section 4958 specifies that the disqualified person can correct the excess benefit transaction by “undoing the excess benefit to the extent possible, and taking any additional measures necessary to place the organization in a financial position not worse than that in which it would be if the disqualified person were dealing under the highest fiduciary standards.” The correction must occur by the earlier of the date the IRS mails a notice informing the disqualified person that he or she owes the 25 percent tax, or the date the 25 percent tax is actually assessed.
- 3. Tax on organization managers
- An excise tax equal to 10 percent of the excess benefit may be imposed on the participation of an organization manager in an excess benefit transaction between a tax-exempt organization and a disqualified person (see below).
- Section 4958(c)(1)(A) of the tax code defines an excess benefit transaction as follows:
The term “excess benefit transaction” means any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit. For purposes of the preceding sentence, an economic benefit shall not be treated as consideration for the performance of services unless such organization clearly indicated its intent to so treat such benefit.
- Stated simply, an excess benefit transaction is one in which the value of a benefit provided to an insider exceeds the value of the insider’s services. The excess benefit can be an inflated salary, but it can also be any other kind of transaction that results in an excess benefit. Here are three examples:
sale of an exempt organization’s assets to an insider for less than market value, use of an exempt organization’s property for personal purposes, and payment of an insider’s personal expenses.
- An excess benefit occurs when an exempt organization pays a benefit to an insider in excess of the value of his or her services. In other words, an excess benefit is a benefit that is paid in excess of reasonable compensation for services rendered. The income tax regulations explain the concept of reasonable compensation as follows: “The value of services is the amount that would ordinarily be paid for like services by like enterprises (whether taxable or tax-exempt) under like circumstances (i.e., reasonable compensation).”
- Compensation for purposes of determining reasonableness under section 4958 includes “all economic benefits provided by a tax-exempt organization in exchange for the performance of services.” These include, but are not limited to, (1) all forms of cash and non-cash compensation, including salary, fees, bonuses, severance payments, and deferred and non-cash compensation; and (2) all other compensatory benefits, whether or not included in gross income for income tax purposes, including payments to plans providing medical, dental, or life insurance; severance pay; disability benefits; and both taxable and nontaxable fringe benefits (other than fringe benefits described in section 132), including expense allowances or reimbursements (other than expense reimbursements pursuant to an accountable plan) and the economic benefit of a below-market loan.
- Income tax regulations clarify that compensation is presumed to be reasonable, and a transfer of property or the right to use property is presumed to be at fair market value, if the following three conditions are satisfied:
the compensation arrangement or the terms of the property transfer are approved in advance by an authorized body of the tax-exempt organization composed entirely of individuals who do not have a conflict of interest with respect to the compensation arrangement or property transfer; the authorized body obtained and relied upon appropriate “comparability data” prior to making its determination, as described below; and the authorized body adequately documented the basis for its determination at the time it was made, as described below.
- If these three requirements are met, the IRS may rebut the presumption of reasonableness if it “develops sufficient contrary evidence to rebut the … comparability data relied upon by the authorized body.” An authorized body means “the governing body (i.e., the board of directors, board of trustees, or equivalent controlling body) of the organization, a committee of the governing body … or other parties authorized by the governing body of the organization to act on its behalf by following procedures specified by the governing body in approving compensation arrangements or property transfers.”
- An individual is not included in the authorized body when it is reviewing a transaction if that individual meets with other members only to answer questions and otherwise recuses himself or herself from the meeting and is not present during debate and voting on the compensation arrangement or property transfer.
- A member of the authorized body does not have a conflict of interest with respect to a compensation arrangement or property transfer only if the member:
is not a disqualified person participating in, or economically benefiting from, the compensation arrangement or property transfer and is not a member of the family of any such disqualified person;
is not in an employment relationship subject to the direction or control of any disqualified person participating in, or economically benefiting from, the compensation arrangement or property transfer; does not receive compensation or other payments subject to approval by any disqualified person participating in, or economically benefiting from, the compensation arrangement or property transfer; has no material financial interest affected by the compensation arrangement or property transfer; and does not approve a transaction providing economic benefits to any disqualified person participating in the compensation arrangement or property transfer who in turn has approved or will approve a transaction providing economic benefits to the member.
- An authorized body has appropriate data as to comparability if, given the knowledge and expertise of its members, it has sufficient information to determine whether the compensation arrangement is reasonable or the property transfer is at fair market value.
- In the case of compensation, relevant information includes, but is not limited to:
compensation levels paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions; the availability of similar services in the geographic area of the applicable tax-exempt organization; current compensation surveys compiled by independent firms; and, actual written offers from similar institutions competing for the services of the disqualified person.
- For organizations with annual gross receipts (including contributions) of less than $1 million reviewing compensation arrangements, the authorized body will be considered to have appropriate data as to comparability if it has data on compensation paid by three comparable organizations in the same or similar communities for similar services. An organization may calculate its annual gross receipts based on an average of its gross receipts during the three prior taxable years.
- Tax on “managers”
- An excise tax equal to 10 percent of the excess benefit may be imposed on the participation of an organization manager in an excess benefit transaction between a tax-exempt organization and a disqualified person. This tax, which may not exceed $20,000 with respect to any single transaction, is only imposed if the 25 percent tax is imposed on the disqualified person, the organization manager knowingly participated in the transaction, and the manager’s participation was willful and not due to reasonable cause. There is also joint and several liability for this tax. A person may be liable for both the tax paid by the disqualified person and this organization manager tax in appropriate circumstances.
- An organization manager is not considered to have participated in an excess benefit transaction where the manager has opposed the transaction in a manner consistent with the fulfillment of the manager’s responsibilities to the organization.
- Participation by an organization manager is willful if it is voluntary, conscious, and intentional. An organization manager’s participation is due to reasonable cause if the manager has exercised responsibility on behalf of the organization with ordinary business care and prudence.A person participates in a transaction knowingly if the person has actual knowledge of sufficient facts so that, based solely upon such facts, the transaction would be an excess benefit transaction. Knowing does not mean having reason to know. The organization manager will not be considered knowing if, after full disclosure of the factual situation to an appropriate professional, the organization manager relied on a professional’s reasoned written opinion on matters within the professional’s expertise or if the manager relied on the fact that the requirements for the rebuttable presumption have been satisfied.
- Effect on tax-exempt status
- The regulations caution that churches and other charities are still exposed to loss of their tax-exempt statuses if they pay excessive compensation. The fact that such compensation arrangements may trigger intermediate sanctions does not necessarily protect the organization’s tax-exempt status.
- Automatic excess benefit transactions
- The IRS maintains that some transactions will be considered “automatic” excess benefit transactions resulting in intermediate sanctions regardless of the amount involved. Even if the amount involved in a transaction is insignificant, it still may result in intermediate sanctions. This is an important interpretation, since it exposes virtually every pastor and lay church employee to intermediate sanctions that until now had been reserved for a few highly paid CEOs. The term “excess” in effect has been removed from the concept of excess benefits.
- An automatic excess benefit is any benefit paid to a disqualified person that is not reported as taxable compensation by the recipient or the employer.
- (2) Liability for failing to withhold payroll taxes
- Without question, the most significant federal reporting obligation of most churches is the withholding and reporting of employee income taxes and Social Security taxes. These requirements apply, in whole or in part, to almost every church, but many churches do not comply with them because of unfamiliarity. This can trigger a range of penalties.
- For example, section 6672 of the Internal Revenue Code specifies that “any person required to collect, truthfully account for, and pay over any [income tax or FICA tax] who willfully fails to collect such tax, or truthfully account for and pay over such tax, or willfully attempts in any manner to evade or defeat any such tax or the payment thereof, shall, in addition to other penalties provided by law, be liable for a penalty equal to the total amount of the tax evaded, or not collected, or not accounted for and paid over.”
- Stated simply, this section says that if an employer has failed to collect or pay over income and employment taxes, the trust fund recovery penalty may be asserted against those determined to have been responsible and willful in failing to pay over the tax. Responsibility and willfulness must both be established. Many church board members will satisfy this definition, which makes them potentially liable for their church’s failure to withhold payroll taxes or transmit them to the government.
- The potential liability of church board members for a church’s failure to withhold payroll taxes, or transmit them to the government, is an example of the use of federal tax law to compel compliance by church board members with their fiduciary duties.
Resource. The liability of church board members for unpaid payroll taxes is addressed fully in chapter 11 of Richard Hammar’s Church & Clergy Tax Guide available on ChurchLawAndTaxStore.com.
- (3) Private benefit
- The IRS defines private benefit as follows:
An IRC section 501(c)(3) organization’s activities must be directed exclusively toward charitable, educational, religious, or other exempt purposes. Such an organization’s activities may not serve the private interests of any individual or organization. Rather, beneficiaries of an organization’s activities must be recognized objects of charity (such as the poor or the distressed) or the community at large (for example, through the conduct of religious services or the promotion of religion). Private benefit is different from inurement to insiders. Private benefit may occur even if the persons benefited are not insiders. Also, private benefit must be substantial in order to jeopardize tax-exempt status. IRS Publication 1828.
- The prohibition of private benefit is an example of the use of federal tax law to compel compliance by church board members with their fiduciary duties (specifically, the duties of loyalty and obedience).
- Effect of violations of fiduciary duties
- Even if a breach of fiduciary duties occurs, the questions become (1) who could challenge the breach, and (2) what remedies are available? The vast majority of cases alleging breach of fiduciary duties involve shareholder “derivative” lawsuits against a for-profit corporate board for financial losses. Shareholders claim that the board’s breach of fiduciary duties resulted in an undervaluation of shares for which the individual board members may be personally liable. But such cases are of limited relevance to churches and other nonprofit corporations that do not have shareholders who have experienced a direct financial loss (undervaluation of shares).
- There have been very few cases involving breaches of fiduciary duties by nonprofit board members. Churches and other nonprofit corporations typically do not have shareholders, some lack “members,” donors lack standing to challenge violations of fiduciary duties, and state attorneys general who have the legal authority to investigate such breaches rarely do so. Further, uncompensated board members of nonprofit corporations have limited immunity from liability for their ordinary negligence, which may be asserted as a defense by nonprofit board members in any case alleging a violation of their fiduciary duties. These factors generally mean that it is difficult to hold board members of churches and other nonprofit corporations for breaches of their fiduciary duties. One legal scholar has noted:
Extensive problems exist regarding the enforcement of the state law fiduciary duty of care of a charitable nonprofit corporate board to detect and correct management excesses. Moreover, even in the for-profit sector where the robust shareholder derivative suit remains to enforce breaches of the fiduciary duty of care … director monetary liability is rare except in extreme systematic cases of abdication of directorial responsibility. That said, directorial abdication is much more likely in a more passive, captured, and volunteer charitable nonprofit board with a diverse charitable mission. As a reasonable duty of care surrogate for directors without financial conflicts of interest, federal excise taxes on self-dealing and excess benefit transactions are reasonable, government-enforced, cost-effective proxies for charitable board inattention. The taxes, therefore, superimpose limited monetary liability on a careless or absentee board. However, federal excise tax liability is triggered in the first instance by a breach of the state law fiduciary duty of care. As a result, the Model Nonprofit Corporation Act has, and future reform proposals must, maintain the current fiduciary duty scheme, even though it seldom results in state law enforcement or liability. C. Bishop, “The Deontological Significance of Nonprofit Corporate Governance Standards: A Fiduciary Duty of Care Without a Remedy,” Catholic University Law Review, vol. 57 (2008).
- However, the personal liability of board members of churches and other nonprofit organizations may consist of one or more of the following:
A board’s authorization of excess benefits for “disqualified persons” can lead to intermediate sanction penalties against “managers” (i.e., board members) under section 4958 of the Internal Revenue Code. A board’s authorization of unreasonable compensation may result in “inurement” of a church’s assets to the personal benefit of a private individual, thereby jeopardizing a church’s tax-exempt status. A board member’s violation of fiduciary duties may result in removal from office pursuant to a church’s bylaws or other governing document. Several state nonprofit corporation laws specify that board members are personally responsible for authorizing a loan to an officer or director that is not repaid. Several state nonprofit corporation laws specify that board members are personally liable for approving a transaction that violates a board member’s fiduciary duty of loyalty. One court upheld an $8,000 verdict against a church board member based on a breach of his fiduciary duties. This illustrates that money damages may be assessed against church board members who violate their fiduciary duties. Shepherd of the Valley Lutheran Church v. Hope Lutheran Church, 626 N.W.2d 436 (Minn. App. 2001) (discussed above).
- Invest in your leaders
- The officers and directors of churches are tasked with serving countless hours, often over a period of years, to help guide and lead their congregations. It can be a demanding effort, and perhaps at times, a seemingly thankless one. The training and education provided to these leaders, especially with respect to their fiduciary duties, is essential to setting them up for success. It’s also essential to your church’s overall health and well-being. A mishandled duty can lead to financial and legal troubles for these leaders and the church, sapping time, energy, and resources away from other ministry priorities.
- Take time now to educate new and veteran board and committee leaders on these important duties, and schedule ways for this education to periodically reoccur. Doing so can build a solid foundation from which your key decision-makers can build upon for years to come.
