fiduciary duty 101: duty calls ima northeast regional council conference september 21, 2015 leah...

FIDUCIARY DUTY 101: DUTY CALLS

IMA NorthEast Regional Council ConferenceSeptember 21, 2015

Leah Cohen ChatinoverStanger & Associates, LLC433 S. Main St.West Hartford, CT 06010(860) [email protected]

Non Profit Boards of Directors

• Fiduciary Duties

• Legal Obligations

• Protections

© 2015 Leah Cohen Chatinover


Three Questions

• How must a director act and how careful must a director be when exercising his/her judgment and making decisions as a member of a board of a nonprofit organization?

• What are the standards by which a director’s decisions will be judged after the fact by a court or a state Attorney General?

• What statutory and contractual protections are available to a director?

What is a Fiduciary? • A fiduciary is someone in

a relationship of trust vis-à-vis a more vulnerable person or entity.

• Director/Organization• Directors – owe a duty to

act in the interests of the organizations they serve.


To Whom are Fiduciaries

Duties Owed?• The organization

• Community at large/general public

• Beneficiaries or clients

• Donors


Basics of Legal Liability

• Two Sets of Rules:–Procedural

–Substantive



Procedural Rules• State Law

• Certificate of Incorporation

• By-Laws

2 Systems – State and Federal Law

• State Law – corporate existence, governance, protection of charitable endowments – Grew out of Case law (common law) eventually codified

• Multiple States

• Federal Law – Tax exempt status and compliance

©2015 Leah Cohen Chatinover

State Law


• The Model Nonprofit Corporation Act (MNCA) is model legislation prepared by the Nonprofit Organizations Committee of the Business Law Section of the American Bar Association. The MNCA is a model set of statutes governing nonprofit corporations proposed for adoption by state legislatures. The newest published revision of the MCNA is the Third Edition, dated 2008 (although the Committee has adopted changes since then.) Many states have adopted this, or an earlier edition of the MCNA. Those in this region are indicated with an * below.

• New York, Massachusetts and New Hampshire each have unique state-specific laws. New York, which is highly regulated, amended its law for the first time in 30 years, last year. The Massachusetts statute is old, confusingly drafted and difficult to use.

• CT Conn. Gen. Stat. § 33-1000 Connecticut Revised Nonstock Corporation Act**

• MA M.G.L. 156B §§ 11-13 (except the corporation does not have capital stock, the articles of organization omit reference to stock and stockholders) and M.G.L. 180

• ME Title 13-B M.R.S.A. MAINE NONPROFIT CORPORATION ACT **

• NH N.H. R.S.A. XXVII, Ch. 292

• NJ N.J.S.A. T. 15A New Jersey Nonprofit Corporation Act**

• NY Not-for-Profit Corporation Law or NPCL

• RI RI ST § 7-6, Rhode Island Nonprofit Corporation Act* (1952 Model Act)

• VT 11B V.S.A. Vermont Nonprofit Corporation Act**

MNCA and Most Other State Nonprofit Corporation Laws

• Outline basic requirements for governing documents; and

• Provide statutory defaults if governing documents are silent


Certificate of Incorporation• Formally creates corporation's existence• Should:

– reflect current mission– most recent changes in the law– provisions required by IRS for tax exempt status

• Under MNCA and many other state nonprofit laws - may contain indemnification provisions to protect officers and directors

• Filed with the Secretary (Department) of State (Commonwealth)

• Public Document


By-Laws – Procedural Rules• “Constitution” of organization

– Internal governance; allocation of control

• Not a public document

• Adhere to the KISS principle By-laws should be simple enough to follow in practice

• Not just legalese: when a dispute arises: meeting notice, quorum and voting requirements matter



A Hypothetical to Illustrate the Procedural/Substantive Difference

Millie Millions dies and unexpectedly

leaves your organization a $2 million bequest


Hypothetical• That night, the numbers 1 14 26 33 51 37 come to

you in a vision.

• The next day you trot on down to the gas station and buy 50 power ball tickets with those number combinations.

• AND YOU HIT!!! And win $15 Million

• So, your $2 million bequest is now $16,999,950


Hypothetical• You form a Board Committee to

interview three well respected investment managers. Based on interviews and recommendations you hire one of these managers to manage your portfolio.

• You rely on research provided by the investment manager, and invest the $2 million in a balanced portfolio targeted for both income and growth.

• Your organization’s $2 million is now worth about $1,400,000.

• And the stock market tanks!


Hypothetical• Exercise of duty of

care is not a guarantee of results.

• Only that the correct procedure and substantive standards were followed.

Traditional Duties Owed by Fiduciaries

• The duty of care.

• The duty of loyalty.

• The duty of obedience.



The Duty of Care• Pay Attention!

• Stay Awake!

• Ask Questions!


The Duty of Care• Connecticut General Statutes §33-1104

Sec. 33-1104. General standards for directors. (a) A director shall discharge his duties as a director, including his duties as a member of a committee: (1) In good faith; (2) with the care an ordinarily prudent person in a like position would exercise under similar circumstances; and (3) in a manner he reasonably believes to be in the best interests of the corporation.

(b) In discharging his 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: (1) One or more officers or employees of the corporation whom the director reasonably believes to be reliable and competent in the matters presented; (2) legal counsel, public accountants or other persons as to matters the director reasonably believes are within the person’s professional or expert competence; or (3) a committee of the board of directors of which he is not a member if the director reasonably believes the committee merits confidence.

(c) A director is not acting in good faith if he has knowledge concerning the matter in question that makes reliance otherwise permitted by subsection (b) of this section unwarranted.

(d) A director is not liable for any action taken as a director, or any failure to take any action, if he performed the duties of his office in compliance with this section.

• MA M.G.L. 180 § 6C• ME Title 13-B M.R.S.A. § 717• NH Attorney General Policy and Common Law• NJ N.J.S.A. 15A: 6-14• NY NPCL § 717 • RI RI ST § 7-6-22• VT 11B V.S.A. § 8.30


The Duty of Care

• A director must use the same care as a director of a non-profit organization as s/he would in his/her own business.

• A director is not liable for actions taken or not taken if s/he complied with this statute.

• S/he can rely on experts.


The Duty of Care

TIPTo Exercise the Duty of Care Avoid This:

The Duty of Loyalty• Don’t abuse the

position of power in the organization!

• Don’t steal from the organization!



The Duty of Loyalty• Codified in MNCA and many other state laws

through conflict of interest statute and indirectly by IRS through requirements on Forms 990 and 1023, and excess benefit transaction regulations.

• Avoid: conflicts of interest; potential for conflicts; appearance of a conflict; insider transactions.

• Disclose: actual or potential conflicts.


The Duty of Loyalty• Connecticut General Statutes §33-1127 - 1130 Concerning “Directors’ Conflicting Interest Transactions”

Sec. 33-1128. Judicial action. (a) A transaction effected or proposed to be effected by the corporation, or by an entity controlled by the corporation, may not be the subject of equitable relief, or give rise to an award of damages or other sanctions against a director of the corporation, in a proceeding by a member or director or by or in the right of the corporation, on the ground that the director has an interest respecting the transaction, if it is not a director's conflicting interest transaction.

(b) A director's conflicting interest transaction may not be the subject of equitable relief, or give rise to an award of damages or other sanctions against a director of the corporation, in a proceeding by a member or director or by or in the right of the corporation, on the ground that the director has an interest respecting the transaction, if: (1) Directors' action respecting the transaction was taken in compliance with section 33-1129 at any time; (2) members' action respecting the transaction was taken in compliance with section 33-1130 at any time; or (3) the transaction, judged according to the circumstances at the relevant time, is established to have been fair to the corporation.

Sec. 33-1129. Directors’ action. (a) Directors' action respecting a director's conflicting interest transaction is effective for purposes of subdivision (1) of subsection (b) of section 33-1128 if the transaction has been authorized by the affirmative vote of a majority, but no fewer than two, of the qualified directors who voted on the transaction, after required disclosure by the conflicted director of information not already known by such qualified directors, or after modified disclosure in compliance with subsection (b) of this section, provided that where the action has been taken by a committee, all members of the committee were qualified directors, and either (1) the committee was composed of all the qualified directors on the board of directors, or (2) the members of the committee were appointed by the affirmative vote of a majority of the qualified directors on the board.

(c) A majority, but no fewer than two, of all the qualified directors on the board of directors, or on the committee, constitutes a quorum for purposes of action that complies with this section. Directors' action that otherwise complies with this section is not affected by the presence or vote of a director who is not a qualified director.

• MA Attorney General Policy and Common Law • ME Title 13-B M.R.S.A. § 718• NH RSA 7:19-a and RSA 292:6-a (not comprehensive), Attorney General Policy and Common Law• NJ N.J.S.A. 15A: 6-8• NY NPCL § 715-a• RI RI ST § 7-6-26.1• VT 11B V.S.A. § 8.31

The Duty of Loyalty• An insider transaction may not

be a conflict of interest if:

– Proper procedural safeguards were followed – transaction approved by disinterested directors.

– Proper substantive safeguards were followed – transaction was fair to the corporation.



The Duty of Loyalty

• Conflict of Interest Annual Disclosure Form

• Conflict of Interest Policy• Don’t just adopt it, follow it. Don’t

confuse written policy with governance.

Excess benefit transaction - 26 U.S.C.A. § 4958

• transaction in which an economic benefit provided by a tax-exempt organization

• to or for the use of a disqualified person (such as an officer, director or key employee)

• value of the economic benefit provided by the organization exceeds the value of the consideration received by the organization.

• Excess benefit can occur in exchange of compensation for services or property


Executive Compensation


CompensationFair market value of compensation for services = value that would ordinarily be paid for like services by a similar organization in similar circumstances.

Correcting the Excess Benefit

• Disqualified person must undo the excess benefit to the extent possible, and take 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 (and the transaction had not occurred at the problematic level of compensation.)

• Payment in cash or cash equivalents equal to the excess benefit plus the interest on the excess benefit at a rate no lower than the lower than the applicable Federal rate.


Initial Contract Exception

• binding written contract between with a person who was not a disqualified person immediately before entering into the contract.

• fixed payment • contract in which there is a material change,

extension or renewal of the contract, more than incidental change to the amount payable under the contract is treated as a new contract and not within the exception.


Rebuttable Presumption – Procedural Rules - Found in Many Conflicts of

Interest Policies• If an organization meets the following three requirements, payments it makes to a

disqualified person under a compensation arrangement are presumed to be reasonable, and a transfer of property or the right to use property is presumed to be at fair market value.

• The compensation arrangement must be approved in advance by an authorized body (such as Board of Directors) but only those individuals who do not have a conflict of interest concerning the transaction,

• Prior to making its determination, the authorized body must obtain comparability data• The authorized body must timely document the basis for its determination concurrently with

making that determination (in minutes within 60 days or before next meeting).– terms of the transaction – date of its approval– the members who were present and who voted– comparability data relied upon

– actions of any members of the authorized body having a conflict of interest, and documentation of the basis for the determination.


Substantive Alternative

• If Rebuttable Presumption is:• Met, IRS must show that the

compensation is NOT reasonable by attacking the comparability data.

• Not Met, a facts and circumstances approach will be followed – that is, the organization must show that the compensation IS reasonable.


The Duty of Obedience

• Advance the mission of the organization.

• Remain faithful to and pursue the goals of the organization, as expressed in governing documents.

• Ensure that the corporation’s purposes are adhered to and that charitable assets are not diverted to non-charitable uses.

• Subsumed within the other two duties. © 2015 Leah Cohen Chatinover

Management of Endowments

• Subset ofFiduciary Duty of Care

• Steward the financial resources of the organization.


General Concepts

• Restrictions as to Use

• Restrictions as to Maintenance of Corpus (a true endowment)

• Board Designated Funds


Wishes of the Donor Must be Respected

• Expressed in a Gift Instrument

• Letter• Agreement• Will • Trust• Solicitation and

Acknowledgment


UPMIFA• Uniform Prudent

Management of Institutional Funds Act

• Governs Endowments• CT Conn. Gen. Stat § 45a-535• MA M.G.L. 180A • ME Title 13 M.R.S.A. §5101• NH RSA 292:B• NJ N.J.S.A. 15A-25• NY NPCL Article 5-a, §550 eq. seq.

(NY has several unique provisions)• RI RI ST § 18-12• VT 14B V.S.A. § 3411

• Predecessor statute – UMIFA. For the most part these trends began with UMIFA - UPMIFA clarified and added detail.

• Biggest Departure from UMIFA – Elimination of Historic Dollar Value (HDV)


Definitions• Institutional Fund: a fund held by an institution (entity

organized and operated exclusively for charitable purposes) exclusively for charitable purposes or a fund held by a trustee for a charitable community trust.

• Endowment Fund: institutional fund not wholly expendable by the institution on a current basis under the terms of a gift instrument. The term does not include assets of an institution designated by the institution as an endowment fund for its own use – (Board Designated Funds)


Modern Portfolio Management Theory

• Fund Management – prudency standard for managing and investing funds: in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances.


Modern Portfolio Management Theory

• Institution may pool two or more institutional funds for purposes of management and investment. (Fund accounting no longer required.)

• Management and investment decisions made in the context of the organization’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.

• Diversification

• Rebalancing


Professional Management• Management and investment may be

delegated to an external agent. • Directors subject to prudence standard

– in good faith, with the care that an ordinarily prudent person in a like position would exercise under similar circumstances, in:

• Selecting an agent;• Establishing scope and terms of the

delegation;• Periodically reviewing agent’s actions in

order to monitor performance and compliance.


Release or Modification of Restrictions

• With a (living) donor’s written consent. Not a deceased donor’s family.


• By a court, if a restriction becomes unlawful, impracticable, impossible to achieve or wasteful. Attorney General notice and opportunity to be heard. Modification in accordance with the donor’s probable intention. (Depending on the state, failure of the institution may not qualify.)

Expenditure – Elimination of Historic Dollar Value

• Furthest departure from UMIFA and most controversial.

• UMIFA – Historic Dollar Value must be maintained. That is, the aggregate value of the donor’s original contributions to the fund. Designed to preserve original monetary value of the endowment in perpetuity.

• No adjustment for inflation; no requirement to preserve original purchasing power.

• Example of HDV: Original Gift: $100,000. Interest and Appreciation: $5,000 annually.

• May spend $5,000; must preserve $100,000 in perpetuity.


UPMIFA – Eliminated HDV

• Institution (Board of Directors) may appropriate for expenditure or accumulate so much of an endowment fund as the institution determines is prudent for the uses, benefits, purposes and duration for which the endowment fund is established.

• Subject to intent of the donor expressed in a gift instrument

• Board must act in accordance with the prudence standard (act in good faith, with the care that an ordinarily prudent person in a like position would exercise under similar circumstances.)


Board must consider 7 factors:

• duration and preservation of the endowment fund;• purposes of the institution and the endowment fund;• general economic conditions;• possible effect of inflation or deflation;• expected total return from income and the

appreciation of investments;• other resources of the institution; and• investment policy of the institution.• NY – presumption spending over 7% is imprudent


IN THEORY• Elimination of bright line HDV would provide stricter

guidelines on spending from endowment funds.• Language designed to encourage maintenance of original

purchasing power.• Under UMIFA, once an endowment fund went

“underwater,” appreciation could no longer be spent, creating an incentive for institutions to invest for current income.

• Conversely, where fair market value was far greater than HDV, the old rule did not provide much of a limit on expenditure.

• UPMIFA drafting committee concluded that prudence standard + more detailed guidance was best; elimination of historic dollar value should not lead to overspending of endowment funds.


IN PRACTICE

•Plenty of Questions.

•No Answers.


“Underwater” Funds

When the National Conference of Commissioners on Uniform State Laws (NCCUSL) approved UPMIFA in July 2006, it did not anticipate the collapse of financial markets so soon thereafter. Drafting committee did not address sharp decline in value.


“Underwater Funds” became the focus of the discussion.

“Underwater” Funds• Does UPMIFA permit a Board to spend

below HDV to maintain spending at its historic rate?

• Factors that might be relevant:– programmatic disruptions caused

by dramatic changes in funding.– inefficiencies created by stop-and-

go funding. – need is greater during down cycle.


• There are no answers.

• Document thorough analysis of the human and programmatic costs of reducing spending; growth investment orientation

Attorney General Interpretations

• Informal position of CT AG’s office is that this portion of the statute is unconstitutional.

• Only Court can modify a donor restriction in this way.


• MA AG formal opinion that institution must maintain original purchasing power

LAWYERS VS ACCOUNTANTS

• FASB 117• Over strenuous objection of the NCCUSL, FASB

issued guidelines requiring that:– endowment funds be classified as

permanently restricted net assets. – Essentially reinstated the HDV floor for

financial statement purposes.– FASB proposal still in comment stage to

eliminate temporarily restricted classification, but this proposal won’t change requirement to classify endowment funds as permanently restricted


Expenditure to Support a Financially Weak Institution

• In principle, the law favors perpetuity of the fund (in the hands of another institution) over perpetuity of the institution.

• But, UPMIFA gives Boards almost total discretion (with a reminder to keep perpetuity in mind).

• How long is perpetuity? What are the needs of the charity? What was the donor’s intent?

• Boards of Directors can easily justify/rationalize spending decisions.

• Example: Does the statute allow a Board to spend down an endowment to bolster a failing school, based on an expectation of increased enrollment (which then doesn’t happen?) Law may be different in different states.

• Is this prudent?


Limitations on Personal Liability – Volunteer Protection

• Federal Volunteer Protection Act - 42 U.S.C.A. § 14501 et seq. – “VPA”• The VPA establishes a minimum level of protection that pre-empts state law except to the

extent that state laws provide greater protection• VPA provides immunity for volunteers serving nonprofit organizations for harm caused by their

acts or omissions• if:

– the volunteer acting within the scope of his or her responsibilities at the time of the alleged act or omission.

– the harm not caused by willful, criminal or reckless misconduct, gross negligence or a conscious, flagrant indifference to the rights or safety of the individual harm.

– the harm was not caused by the volunteer operating a motor vehicle, vessel, or aircraft

• Nevertheless, despite the VPA, many volunteers remain liable for harm they cause, and all volunteers remain liable for some actions.

• Every state in the United States also has a law that pertains specifically to the legal liability of some volunteers. These laws differ to a great extent. NY is very limited. Others are less limited.


Indemnification• Statutory – Some States

more flexible than others• Reflected in Certificate of

Incorporation and/or By-laws.

• Permissive or Mandatory• Corporation may select

from various levels of protection for its Directors and Officers

• What is Indemnification?

• Corporation covers the expenses a director incurs in defending an action and paying settlements or judgments related to service on the board.


Indemnification• Connecticut General Statutes §33-1117

• Middle Ground - a corporation may indemnify an individual who is a party to a proceeding because he is a director against liability incurred in the proceeding if: (1) (A) He conducted himself in good faith; (B) he reasonably believed (i) in the case of conduct in his official capacity, that his conduct was in the best interests of the corporation; and (ii) in all other cases, that his conduct was at least not opposed to the best interests of the corporation; and (C) in the case of any criminal proceeding, he had no reasonable cause to believe his conduct was unlawful.

• MA M.G.L. 180 § 6• ME Title 13-B

M.R.S.A. § 714• NH ??• NJ N.J.S.A. 15A: 3-4• NY NPCL § 722 • RI RI ST § 7-6-6• VT 11B V.S.A. § 8.51


Indemnification• Circumstances when indemnification

is not available:• Insufficient funds.• Board unsympathetic to director

who has been sued and refuses to authorize the indemnification (if permissive).

• Organization decides it is inappropriate to use resources in this way.


Director and Officer Liability Insurance

• Fills the Gap: Defense Costs

• Covers Employees/Paid Officers

• Covers actions other than those in the exercise of policy or decision-making responsibilities

• Critically Important



Conclusion

fiduciary duty 101: duty calls ima northeast regional council conference september 21, 2015 leah...

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