SILK NONPROFIT LAWCounsel to donors, foundations, and other nonprofit organizations

Thomas Silk, Founder and Proprietor Tel 415-868-975311 Calle del Occidente Cell 415-730-0404Stinson Beach CA 94970-1122 Fax 415-868-9938

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NONPROFIT LAW 101: California Responsibility Rules for Directors and Officers of Nonprofit Public Benefit Corporations

Thomas Silk and Cherie Evans

The purpose of this paper is to consider the corporate responsibility rules for directors and officers of nonprofit public benefit corporations, the statutory corporation form for charities in California, the state with the largest number of nonprofits in America.

Duty to Exercise Oversight

The standard textbook on nonprofit law in America states, “Management of nonprofit organizations normally is vested in its senior employees. A basic function of the board is to select these executives and to oversee their performance.”1 California, like many states, gives statutory form to that pattern. For nonprofit corporations, Section 5210 of the Corporations Code provides:

The activities and affairs of a [nonprofit public benefit] corporation shall be conducted and all corporate powers shall be exercised by or under the direction of the board. The board may delegate the management of the activities of the corporation to any person or persons, management company, or committee however composed, provided that the activities and affairs of the corporation shall be managed and all corporate powers shall be exercised under the ultimate direction of the board.

Thus, Section 5210 begins by holding the board ultimately responsible for managing the corporation. But directors of nonprofits often serve far less than full time, and often as volunteers or for nominal compensation, with the actual management functions performed by the nonprofit's executive staff. Section 5210 addresses this circumstance by permitting a board to delegate its responsibilities. The key issue is how much delegation is permissible without diluting the statute's central objective: to locate final responsibility for corporate management unambiguously in the board.

Limits on the Board’s Power to Delegate

1 ? Fishman and Schwartz, Nonprofit Organizations 152 (1995).

The leading case on the limits of delegation, popularly known as the Sibley case after the charitable hospital involved, was decided in the District of Columbia.2 In Sibley, the Board of Directors delegated the investment function to its Treasurer, who proceeded to invest in a grossly negligent manner (no significant amount of stocks and bonds, extensive certificates of deposit and more than one-third of the assets held in non-interest bearing checking accounts), without any board oversight, and to the Investment and Finance Committee, which never met. The court held that each of the directors breached his fiduciary duty to supervise the management of Sibley’s investments. The Court reasoned:

Total abdication of the supervisory role . . . is improper. . . A director who fails to acquire the information necessary to supervise investment policy or consistently fails even to attend the meetings at which such policies are considered has violated his fiduciary duty to the corporation. While a director is, of course, permitted to rely upon the expertise of those to whom he has delegated investment responsibility, such reliance is a tool for interpreting the delegate’s reports, not an excuse for dispensing with or ignoring such reports. A director whose failure to supervise permits negligent mismanagement by others to go unchecked has committed an independent wrong against the corporation.

A California court took a similar position when it invalidated the decision of a board in a for-profit corporation that delegated complete control of corporate property to a manager merely requiring him to file periodic reports. The court stated:

California has recognized the rule that the board cannot delegate its function to govern. As long as the corporation exists, its affairs must be managed by the duly elected board. The board may grant authority to act, but it cannot delegate its func-tion to govern. If it does so, the [management] contract is void.3

The same rule applies to nonprofit corporations in California. The delegation issue was decided in a recent case involving a nonprofit corporation formed by the Communist Party USA. The Party played a key role in the 1974 formation of a nonprofit corporation in San Francisco, 522 Valencia Street (“522”). The corporation was formed for the purpose of holding title to the building where the Northern California District of the Party and a publishing affiliate maintained their offices. A dispute arose between the national Party and the Northern California District, and in 1992 the District voted to disaffiliate. All of the members of the Board of Directors of 522 also left the Party at the same time. The Party sued, asserting its claim to ownership and control of the assets of 522. The Party claimed it had a “secret agreement” with the Board of Directors that all Board decisions would be made by the Party rather than by the Board, and the Board of Directors was to do “exactly what the Party told them.” The court ruled against the Party, holding that “a contract purporting to delegate ultimate authority and control over a corporation from the board of directors to outside parties…is void and unenforceable.”4 2

? Stern v. Lucy Webb Hayes National Training School for Deaconesses, 381 F.Supp. 1003 (U.S. Dist. Ct., D.C., 1974).

3     ? Kennerson v. Burbank Amusement Co., 120 Cal.App.2d 157, 173 (1953).

4 ? Communist Party of the United States of America v. 522 Valencia, Inc., 35 Cal.App.4th 980 (1995).

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A leading treatise on California corporation law describes the managerial responsibilities of a corporate board as follows:

A balance is to be struck between delegation accompanied by abdication, which will remain improper, and delegation accompanied by monitoring and appropriate review or supervision, which is permitted. Therefore, although active involvement of the board in day-to-day managerial activities is not mandatory, the typical board will under normal circumstances function as a formulator of major corporate policies rather than as a direct participant in day-to-day operations.5

To return to the concepts used by the key California statutory provision, Section 5210 permits a board to delegate management functions to a manager. At the same time, in requiring the board to retain "ultimate direction," Section 5210 prohibits delegation of policy decision-making, and requires the board to monitor and supervise the performance of its managers.

Duty of Care

The California Attorney General has the authority to remove and to surcharge directors and officers of a public benefit corporation for causing that corporation to misuse charitable assets and to breach its charitable trust. In order to prevail, however, the Attorney General (or, for that matter, outsiders claiming a breach of either contract or tort) must demonstrate that the directors have violated one or both of their fiduciary duties: the duty of loyalty and the duty of care. Directors are not absolutely liable for every mistake of judgment, error, or omission they may make; they are liable only if they violate their fiduciary duties and the corporation or its charitable beneficiaries are harmed thereby.

Section 5231 of the Corporations Code sets forth this basic standard. It imposes on all directors a two-fold duty: to act with the best interests of the corporation in mind (the duty of loyalty) and to act with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances (the duty of care). Each director is charged with the duty of loyalty and the duty of care and may be liable to the corporation, to the members (if any), or to outside parties for breaching either duty.

In addition to acting with the best interests of the corporation in mind, a director is also expected to make decisions only after giving the same care to those decisions that an ordinarily prudent person would be expected to give in the circumstances, and making reasonable inquiries where necessary. A director is entitled to rely on certain information, opinions, reports or statements, including financial statements and other financial data, prepared by reliable experts, officers, directors, or board committees. Directors are not expected to be experts in all areas, but they must make sure that they ask questions, make inquiries, and are satisfied with the thoroughness of the reports and statements upon which they rely.

The legal standard set forth in Section 5231 gives substance to Section 5210's requirement that any delegation be subject to the "ultimate direction" of the board. Under Section 5231, directors are only relieved of liability for corporate losses and damages if they have acted with the requisite level of

5    ? Ballantine and Sterling, California Corporation Laws, Fourth Edition, Section 85.02[1], p. 5-26.

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care and loyalty. The statute is explicit in permitting directors to rely upon expert advisors. It is equally explicit, however, in imposing a duty of reasonable inquiry when the circumstances demand it. Directors who delegate the management of the corporation to others will be protected by Section 5231 only if they monitor their delegate's performance and exercise a level of oversight that is reasonable under the circumstances.

As part of its supervisory function, a board must satisfy itself that its manager is acting in the best interests of the corporation. If a manager has interests that compete with those of the corporation, the directors must exercise careful scrutiny to assure that the manager is serving the interests of the corporation rather than his or her own interests.

Duty of Loyalty

The duty of loyalty means that if a director acts other than with undivided loyalty to the corporation, the director may be liable to the corporation for damages caused by such actions. Issues involving the duty of loyalty typically arise in connection with transactions in which a director, a relative of a director, or an entity in which a director has an interest either attempts to engage in activities that are in competition with the corporation (the corporate opportunity doctrine) or seeks to enter into transactions with the corporation where there is a material personal financial benefit (self-dealing).

Corporate Opportunity Doctrine

No specific statutory provision addresses the corporate opportunity doctrine. Rather, it arises logically from the duty of loyalty discussed above. Directors owe a duty of loyalty to the corporation first and are not permitted to usurp any business opportunities of which the corporation might otherwise have taken advantage. If a director violates his or her fiduciary duty by seizing a corporate opportunity that rightly belongs to the corporation, the corporation may claim all benefit wrongfully obtained by the director. This doctrine applies to charitable corporations as well as business corporations.6

An officer or director of a corporation who is presented with a business opportunity that is in the same or a related business as the one in which the corporation is involved, faces a potential conflict situation. The ultimate issue is whether the officer or director is under a duty to first offer the opportunity to the corporation before considering it personally. However, a further issue develops in some cases, depending upon the nature of the conflict, of whether the officer or director may become involved in the competing business opportunity at all while remaining an officer or director of the corporation.

Each case, of course, turns on the specific facts, and there are no general rules as to when this doctrine will apply. Courts consider a variety of factors including7:

6    ? Ballantine and Sterling, California Corporation Laws, § 104.01

7 For a careful and thorough statement of the corporate opportunity doctrine see Principles of Corporate Governance § 505 (American Law Institute, 1992) and the discussion contained in Northeast Harbor Golf Club, Inc. v. Harris, 661 A.2d 1146, 1150-1151 (1995).

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The extent to which the opportunity is within the corporation's existing line of business.

The extent to which the corporation is financially or otherwise unable to take advantage of the opportunity.

The extent to which the opportunity came to the attention of the director or officer because of his or her role in the corporation.

The extent to which taking advantage of the opportunity would create a conflict for the director or officer vis-a-vis the corporation.

Investments

The investment standards applicable to a California nonprofit corporation are set forth in Section 5240 of the Corporations Code and in the Uniform Prudent Management of Institutional Funds Act at Sections 18501-18510 of the Probate Code. Read together, those provisions adopt the modern prudent investor standard, which focuses on the overall investment strategy rather than on individual investments. Donors may expand the scope of permissible investments that the corporation may make if they do so by an instrument in writing “pursuant to which the assets were contributed to the corporation.”

Putting the Law into Practice

As the preceding discussion indicates, it is the board of directors, rather than management, which must give a nonprofit public benefit corporation its ultimate direction. In the absence of specific judicial or administrative guidance, the meaning of the term ultimate direction is to be found in the custom and practice within the charitable sector. An understanding of how the board is expected to give that ultimate direction may be furthered by exploring the role of the board in the four functional areas of a typical charitable corporation: program, finances and investments, personnel, and compliance.

With regard to an organization's charitable program, the board provides ultimate direction by determining policy. The board, together with management, determines the content of the program and decides whether to continue, expand, modify or contract the organization's program activities. In determining policy, the board may, of course, consider recommendations made by management. Further, the day-to-day operation of the program may be, and usually is, delegated to management -- subject, however, to adequate reporting to the board and the exercise of oversight by the board.

With regard to finances, the board also gives ultimate direction by determining policy. This usually takes the form of approving a revenues and expenditures budget. The budget is ordinarily proposed by management, to whom the responsibility falls for the day-to-day administration of the finances of the organization. The board oversees the financial performance of management through the periodic review of financial reports provided by management and by annual audits or review by outside accountants. The board also determines investment policy, which is often influenced and implemented in reliance on advice from one or more qualified investment managers.

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Board direction with regard to personnel follows a similar pattern. The board, of course, is responsible for hiring, reviewing, and, if necessary, firing, the chief executive staff member. Below that level, hiring and firing decisions are often delegated to the chief executive. Additionally, management generally proposes personnel policies and procedures, but the board must ultimately approve them.

The demands of compliance are pervasive. Each individual in the corporation must, of course, comply with the law, including directors. The board is charged with particular compliance responsibilities. It must, as we have seen, exercise oversight in each of the above five areas. This required oversight is designed to assure compliance not only with external laws but also with internal laws: the rules and procedures of the organization itself. Finally, corporate law vests responsibility for compliance with the board alone. Moreover, both the duties of care and loyalty are requirements expressly imposed by the law on directors and not on officers, managers, or employees. If fines are imposed on the corporation for failing to comply with corporate, tax, or other laws, and non-compliance is due to a failure of the directors to satisfy their duty of care, the Attorney General may hold the directors personally liable to restore the charitable assets diminished by those fines.

Indemnification

Directors, officers, employees and others who act on behalf of nonprofit corporations may be the targets of lawsuits or governmental investigations or proceedings in connection with their service to the corporation. California nonprofit corporations may indemnify their agents in some circumstances as well as advance reasonable defense costs, as provided in Corporations Code Section 5238.

Comparison with Indemnification by Business Corporations

Indemnification provisions are a key part of the laws governing business corporations in California and other states. California’s Nonprofit Corporation Law contains indemnification provisions as well, which are applicable to both public and mutual benefit as well as religious nonprofit corporations. But the nonprofit corporate indemnification statutes can be a trap for the unwary, for they differ in three important regards from their business corporation counterpart.

A business corporation may indemnify an agent beyond the scope permitted by the indemnification statute, but a California nonprofit corporation may not do so. Nevertheless, a nonprofit corporation may purchase insurance against liability even if the indemnification statute prohibits the corporation from indemnifying the agent directly against that particular liability. For this reason, director and officer liability insurance may be even more valuable for a nonprofit corporation than for a business.

Another important difference arises where so many of the directors are parties to the lawsuit or proceeding that a neutral quorum cannot be ob-

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tained. In such a case, a business corporation may act upon the written advice of independent legal counsel. This helpful solution is not available, however, to nonprofit corporations.

Strict limits on indemnification apply in connection with enforcement actions brought by the Attorney General. Since those limits apply only to nonprofit corporations subject to supervision by the Attorney General, business corporations are unaffected by them.

When Indemnification May Be Available

Indemnification refers to the payment, or at least an agreement to pay, by a corporation of the legal expenses, judgments, fines, or settlement amounts that would otherwise have to be paid personally by an agent of the corporation. “Agent” is defined broadly under Section 5238. It includes “any person who is or was a director, employee, or other agent of the corporation.”

An agent may seek advances or indemnification with regard to “any threatened, pending or completed action or proceeding, whether civil, criminal, administrative or investigative.” Thus, the actual filing of a lawsuit is not a prerequisite. An agent whose conduct is being investigated by the Attorney General, for example, may seek advances or indemnification from the corpora-tion even if the matter never reaches litigation.

Advances

The right of an agent to indemnification can be determined only after a proceeding is concluded. While the proceeding is pending, the corporation may advance funds to its agent for the agent's legal defense costs. An advance is only permitted if the charity first receives "an undertaking by or on behalf of the agent to repay such amount unless it shall be determined ultimately that the agent is entitled to be indemnified." Advances are discretionary, not mandatory. If the agent serves on the charity's governing body, the advance is a self-dealing transaction under Corpora-tions Code Section 5233, and the board must comply with the disclosure and approval procedure described in that statute.

Indemnification: General Rule

The statute contains two indemnification patterns, one applicable to enforcement actions brought by the Attorney General and the other applicable to all other proceedings.

In proceedings not brought by the Attorney General, indemnification is mandatory when a judgment on the merits has been rendered in favor of the agent. Where the agent has not prevailed on the merits, such as where the case is settled or where a judgment is entered against the agent, indemnification of the agent for the costs of judgment, settlement, or legal defense costs is discretionary. The charity may indemnify the agent if the court, the board (by a majority vote of a quorum of the directors who were not parties to the proceeding) or the members (excluding those to be indemnified) determines that “such person acted in good faith and in a manner such person reasonably believed to be in the best interests of the corporation and, in the

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case of a criminal proceeding, had no reasonable cause to believe the conduct of such person was unlawful.”

If a proceeding is settled and the Attorney General is not involved in the proceeding, a charity may indemnify its agent for the agent’s defense costs and any amounts paid in settlement. This result is similar to the rule discussed above for indemnification of the agent who loses a judgment. Thus, a court, the board (by a majority vote of a quorum of the directors who were not parties to the proceeding) or the members (excluding those to be indemnified) must determine that “such person acted in good faith and in a manner such person reasonably believed to be in the best interests of the corporation and, in the case of a criminal proceeding, had no reasonable cause to believe the conduct of such person was unlawful.”

Indemnification: Enforcement Action by the Attorney General

In an enforcement proceeding involving the Attorney General, mandatory indemnification is also called for if the agent prevails on the merits. Otherwise, the indemnification rules differ. If the court holds the agent liable, indemnification is prohibited unless the court determines that the agent is fairly and reasonably entitled to indemnification for expenses that the court shall determine. As to amounts paid in settlement and legal defense costs, two levels of approval are required before indemnification is allowed. First, as provided above, a court, the board (by a majority vote of a quorum of the directors who were not parties to the proceeding) or the members (excluding those to be indemnified) must determine that “such person acted in good faith and in a manner such person reasonably believed to be in the best interests of the corporation and, in the case of a criminal proceeding, had no reasonable cause to believe the conduct of such person was unlawful.” Second, indemnification requires approval by the Attorney General.

Conflicts of Interest

Both California and federal law contain conflict of interest provisions applicable to a nonprofit corporation.

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Independent Board

California nonprofit law contains a distinctive provision designed to assure independent control of the board of directors. Section 5227 of the Corporations Code provides that no more than 49% of a public benefit corporation’s governing body may be composed of “interested directors.” These directors are defined as any person who has been compensated by the corporation for services within the last 12 months, and any member of such person’s family. The attribution rules can catch a board unaware. For example, the board of directors of a family foundation may properly consist of husband and wife and their lawyer. While the lawyer is presumably paid, the other two directors are not. The board is in compliance with Section 5227. But suppose the foundation hires an adult child or other relative of the husband and wife and pays that person reasonable compensation, the foundation is now out of compliance because the compensation paid to the relative is attributed to the husband and wife and, subsequently, all directors are now regarded as compensated.

Self-dealing Prohibition

Section 5233 of the Corporations Code specifies what a board must do when a director has a personal financial interest in a transaction that may affect the director’s judgment. Section 5233 focuses on transactions of a nonprofit corporation in which one of the directors has a material financial interest.8 Such a transaction is defined as a “self-dealing” transaction.9 A nonprofit corporation may only engage in a self-dealing transaction if it obtains prior approval from the Attorney General or follows the disclosure and approval procedure specified in Section 5233. Failure to comply with these requirements means that the interested director may be sued by the Attorney General, the corporation itself, or any other director or officer and required to pay back any profits from the transaction.

The disclosure and approval procedures under Section 5233 require board action. Before the corporation may properly engage in a self-dealing transaction,10 a majority of the disinterested directors, after reviewing the material facts of the transaction, the director's interest in it and after reasonable investigation under the circumstances, must conclude:

The corporation is entering into the transaction for its own benefit, and in its own best interests.

The transaction is fair and reasonable to the corporation at the time it was entered into.

8 In practice, this includes a director who is a shareholder or an employee of an organization that contracts with the corporation.

99 This usage of the term “self-dealing” differs from the way the term is used in Section 4941 of the Internal Revenue Code. That statute applies only to private foundations, whether in trust or in corporate form. Section 5233 applies to all California nonprofit public benefit corporations, regardless of their federal tax classification.

10 Where it is not possible for the full board to meet in order to review the facts and decide whether to approve the transaction in advance, the statute provides for advance approval by a committee of the board, followed by board ratification at the next opportunity.

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The corporation could not have obtained a more advantageous arrangement with reasonable effort under the circumstances.

It is essential that the board adopt these disclosure and approval resolutions before entering into the transaction.

A fuller understanding of Section 5233 may be gained by taking into account the legislative history and legal context at the time. A few years before the enactment of the Nonprofit Corporation Law in 1979 the Attorney General had achieved an important victory by persuading the court in Lynch v. Redfield Foundation that a strict trustee standard of care rather than the more relaxed corporate standard should apply to directors of California nonprofit corporations.11 As the Nonprofit Corporation Law was being considered, the State Bar Committee strongly urged the legislature to overturn Redfield by adopting the corporate standard. The legislature responded with Section 5231, which makes applicable the corporate standard of care to directors of public benefit corporations, and with Section 5230(b), which makes clear that the statutory provisions containing the trustee standard are inapplicable to public benefit corporations.

The Attorney General and the State Bar Committee also disagreed about the preferred conflict of interest standard to adopt for nonprofit corporations. The General Corporation Law permits conflicts of interest (or self-dealing) between a director and a corporation if the material facts and the director’s interest are disclosed and the board or shareholders approve the transaction. But the transaction may be valid even without such approval if the interested director succeeds in proving that the transaction was just and reasonable to the corporation.12 The Attorney General opposed this corporate law approach, taking the position that “no benefit may flow to a director even if the transaction is fair and reasonable [while] a majority of the State Bar Committee felt that transactions should be valid if the director could prove they were fair and reasonable.”13

As enacted, Section 5233 is a compromise between the two positions. Thus, the self-dealing rule applicable to a public benefit corporation follows the corporate conflicts rule in broad outline. However, it departs in three major regards: (1) the director’s financial interest must be “material” to qualify as self-dealing, (2) self-dealing is permitted only if approved by the Attorney General, a court, or, prior to the transaction by the board of directors (without counting the vote of the interested director), and (3) the transaction must satisfy a “most advantageous arrangement” standard.

Prohibition against Loans

California law strictly regulates loans to insiders. Section 5236 sets forth a general rule prohibiting loans to directors or officers of nonprofit corporations unless approved by the Attorney General. Exceptions exist for advances of reimbursable expenses and for payments of 11 9 Cal.App.3d 293, 299-300 (1970).

12 Cal. Corp. Code § 310(b).

13 Report of the Assembly Select Committee on the Revision of the Nonprofit Corporation Code (1979) at B-10 and B-11.

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premiums on life insurance policies of directors, if repayment is secured by the policy proceeds. Exceptions also exist for a secured loan to an officer to finance the purchase of a principal residence, if it is necessary to secure the services of the officer.

Federal Prohibition on Excess Benefits to Insiders

For many years, Section 501(c)(3) of the Internal Revenue Code and its predecessors has prohibited inurement and improper private benefits. In 1996, Congress enacted Section 4958, which penalizes insiders to a public charity in connection with any transaction that results in excessive benefits to anyone who exercises, or has exercised, substantial influence over the organization.14 Penalty taxes are imposed on the insider where there is an “excess benefit transaction” between a Section 501(c)(3) public charity and a “disqualified person”.

Excess benefit transactions. Excess benefit transactions are transactions in which an excessive economic benefit is provided by a public charity to a disqualified person. A benefit is excessive if its value exceeds the value of what the charity received from the disqualified person. Typically, excess benefit transactions involve compensation of insiders, but they can also involve the sale or other transfer of a charity’s property, and they can involve the use by a disqualified person of a charity’s property, including intellectual property.

Disqualified persons. Disqualified persons are persons who are, or in the previous five years have been, in a position to exercise substantial influence over the charity’s affairs. The following persons are deemed to have substantial influence: each member of the Board of Directors; the president, chief executive officer, chief operating officer, treasurer and chief financial officer; such persons’ spouses, ancestors, children, grandchildren, great-grandchildren, brothers, and sisters; the spouses of the children, grandchildren, great-grandchildren, brothers, and sisters; and any entity in which such persons hold more than 35 percent of the control. For a corporation, this means more than 35 percent of the voting power, for a partnership it means more than 35 percent of the profit interest, and for a trust it means more than 35 percent of the beneficial interest. In addition, the board may determine that other persons exercise substantial influence over the charity’s activities based on facts and circumstances. Such persons could include the founder of the charity, a substantial contributor to the charity, a person with managerial authority over the charity or a person with control over a significant portion of the charity’s budget.

Establishing the presumption of reasonableness. Normally, when a charity engages in a transaction with a disqualified person (such as a major donor or a board member), it must be prepared to demonstrate that it has taken appropriate steps to ensure that it is not providing an excess benefit to the insider.

Regulation Section 4958 (the “Regulations”), released in January 2002, describes the steps an organization may take to create a presumption that no excess benefit transaction occurs and to

14 ? Note that there is a discrepancy between Section 4958, which anticipates that in some cases the IRS could choose to impose penalty taxes on insider transactions without revocation of the organization’s exempt status, and the private inurement rules that mandate that any amount of inurement results in the revocation of exempt status.

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shift the burden of proof onto the IRS. Under Section 53.4958-6 of the Regulations, payments under a compensation arrangement will be presumed to be reasonable, and a transfer of property or services between a charity and a disqualified person is presumed to be at fair market value if the following conditions are satisfied:

The compensation arrangement or terms of transfer are approved in advance by the charity’s governing body, or by a committee of the governing body composed entirely of individuals who do not have a conflict of interest with respect to the arrangement or transaction; and

The governing body or committee obtained and relied upon appropriate data as to comparability before making its decision; and

The governing body or committee adequately documented the basis for its decision concurrently with making that decision.

To ensure that the board of directors is not inappropriately influenced by a director with a conflict of interest, the Regulations provide that a director with a conflict of interest can meet with other members of the board only to answer questions. The director should be recused from the meeting and should not be present during debate and voting on the transaction in question.

The Regulations provide some examples, but not an exhaustive list, of the type of data that is considered appropriate when considering comparability. In the case of compensation, relevant information includes compensation levels paid by similarly situated organizations for functionally comparable positions; the availability of similar services in the geographic area; independent compensation surveys compiled by independent firms; and actual written offers from similar institutions competing for the services of the disqualified person. In the case of property, the Regulations provide that relevant information includes, but is not limited to, current independent appraisals of the value of all property to be transferred; and offers received as part of an open and competitive bidding process.15

To document the decision adequately for purposes of creating the rebuttable presumption, the written records of the governing body or committee must note (1) the terms of the transaction that was approved and the date it was approved; (2) the members of the board or committee who were present during the debate on the transaction or arrangement that was approved and those who voted on it; (3) the comparability data obtained and relied upon by the board or committee and how the data was obtained; and (4) the actions taken in order to appropriately exclude directors with a conflict of interest while the transaction was considered. The records must be prepared by the later of the next meeting of the board or committee or 60 days after the final action regarding the transaction was taken, and must be approved within a reasonable time after that.

Penalty taxes. Section 4958 creates a two-tier excise tax structure on excess benefit transactions. The initial tax is 25% of the excess benefit resulting from each excess benefit transaction. The

15 Treas. Reg. Section 53.4958-6(c)(2).

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25% tax is payable by the disqualified person. If the 25% tax is imposed on an excess benefit transaction and the disqualified person does not correct the excess benefit within a certain amount of time, a second tier tax of 200% of the excess benefit is imposed on the disqualified person. For example, if a Section 501(c)(3) organization was found to have paid $150,000 to a disqualified person in a transaction for which $100,000 was fair market value, the disqualified person would have to pay a tax of 25% of $50,000, or $12,500 to the IRS. In addition, the disqualified person would have to return the excess benefit of $50,000 to the organization, or be subject to the added 200% penalty tax (of $100,000).

Finally, a 10% tax is imposed if the board knowingly and willingly participated in the excess benefit transaction, up to a total of $10,000 for each excess benefit transaction. The board will not be considered to have knowingly participated if, (1) after making full disclosure of the facts to an appropriate professional, the board relies on the professional’s reasoned written opinion regarding the elements of the transaction within the professional’s expertise, or, (2) the board relies on the fact that the requirements for the rebuttable presumption of reasonableness have been satisfied.16

Charitable Trust Doctrine

California law reflects a strong public policy favoring donor intent with regard to gifts to charity. For example, California’s charitable solicitation law provides (Cal. Bus. & Prof. Code Section 17510.8):

Notwithstanding any other provision of this article, there exists a fiduciary relationship between a charity or any person soliciting on behalf of a charity, and the person from whom a charitable contribution is being solicited. The acceptance of charitable contributions by a charity or any person soliciting on behalf of a charity establishes a charitable trust and a duty to on the part of the charity and the person soliciting on behalf of the charity to use those charitable contributions for the declared charitable purposes for which they are sought. This section is declarative of existing trust law principles.

An unusual aspect of California’s donor intent-enforcing policy is that it avoids the evidentiary problems generally associated with the search for the subjective intent of a donor by creating a reciprocal, objective, charitable trust doctrine which looks instead to the representations made by the donee and then infers from those representations what the donors to the charitable donee intended.

In Pacific Home v. County of Los Angeles, 41 Cal.2d 844, 852 (1953), the California Supreme Court announced the charitable trust doctrine:

[A]ll the assets of a corporation organized solely for charitable purposes must be deemed to be impressed with a charitable trust by virtue of the express declaration of the corporation’s purposes, and notwithstanding the absence of any express

16 Treas. Reg. Section 53.4958-1(d)(4)(iii) and (iv).

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declaration by those who contribute such assets as to the purpose for which the contributions are made. In other words, the acceptance of such assets under these circumstances establishes a charitable trust for the declared corporate purposes as effectively as though the assets had been accepted from a donor who had expressly provided in the instrument evidence the gift that it was to be held in trust solely for such charitable purposes. (Emphasis added.)

As initially formulated in Pacific Home, the charitable trust doctrine looked to language in the Articles of Incorporation and other formal manifestations of declared corporate purposes. The Court reasoned that donor intent and donor restrictions need not be express, but could be inferred from donee representations that are written and formal.

Eleven years later, the California Supreme Court took the next step in expanding the charitable trust doctrine when it dropped the requirement that donee representations be written and formal and accepted them as equivalent to express donor restrictions even where they were oral and informal. Thus, a college of osteopathic medicine could not change to become a college of allopathic medicine when it had “held out to the public” that it is a college of osteopathic medicine and “solicited and received donations for use in teaching…osteopathy.” Holt v. College of Osteopathic Physicians and Surgeons, 61 Cal.2d 750, 758 (1964).

Then, in Queen of Angels Hospital v. Younger, 66 Cal.App.3d 359 (1977), the Court broadened the application of the charitable trust doctrine to encompass a wide array of donee acts and representations. The Court considered the language of the Articles of Incorporation, which included the name “Queen of Angels Hospital” and a hospital purpose clause. The Court also noted that Queen had operated a hospital since 1927 and stated:

Queen also represented to the public that it was a hospital. In its statement to the Franchise Tax Board, it stated that it was in the “business of running a hospital.” Similar statements were made to the Internal Revenue Service and Los Angeles county tax authorities. Funds were solicited from the public for the hospital or hospital purposes. Such acts further bind Queen to its primary purpose of operating a hospital. Id. at 368.

The result, in Queen of Angels, was that a charitable organization that operated a hospital and raised funds based on its representations as a hospital, was prevented from abandoning the operation of a hospital and operating a medical clinic instead. See also, In Re Metropolitan Baptist Church of Richmond, Inc., 48 Cal.App.3d 850 (1975) [Representing itself as a fundamentalist Baptist church located in Richmond, California, the church was prohibited from distributing its assets on dissolution to distant Baptist churches and required to distribute them to fundamentalist Baptist churches nearest geographically to Richmond.]

The Queen of Angeles decision also has continuing importance for its treatment of bonuses and settlements. Queen expected to receive a significant positive cash flow from the proposed lease of its hospital, which was to run for 25 years with two options for 10-year extensions. The lease amount was $800,000 during the first two years and $1 million annually thereafter. The Franciscan Sisters submitted a claim for $16 million for the value of the Sisters’ past services.

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The Board of Directors of Queen unanimously accepted the validity of the claim and entered into a settlement agreement whereby Queen would provide for the retirement of each sister by paying her approximately $200 per month for life, with an initial annual cost of approximately $300,000. The trial court upheld the Attorney General’s objections to the proposed payments because: there was no evidence to support the Sisters’ claim; Queen had no legal obligation to pay the Sisters; and the settlement agreement was invalid and would constitute an improper diversion of charitable assets if implemented. The court of appeals affirmed, with the result that the Attorney General’s Office often relies on Queen of Angeles in support of two propositions:

Despite sympathetic circumstances, payment by a charity of bonuses, including unearned retirement amounts, may constitute an improper diversion of charitable assets unless they are made pursuant to a binding legal obligation to pay.

Although a charity is generally empowered to settle disputes without the consent of the Attorney General, a settlement agreement that “was not a proper exercise of sound business judgment” may be invalid and unenforceable. 17

However, the charitable trust doctrine varies from state to state. In some states, the doctrine means little more than assets of a charitable organization must be used for charitable purposes. In California, however, the courts have adopted a strict construction of the charitable trust doctrine, which contains these rules:

A donor's charitable contributions to a nonprofit corporation are subject to any valid legal restriction imposed by the donor at the time of contribution. These restrictions impose a charitable trust on the assets, binding the charitable recipient.18

Even where a donor imposes no express restriction, assets accepted by a nonprofit corporation are restricted by operation of law and may only be used for the specific charitable purposes set forth in the corporation's Articles of Incorporation.19

These restrictions apply not only to contributions and donations received and accepted by a nonprofit corporation but also to revenues generated by it from the performance of its charitable activities. Revenues, like contributions, are impressed with a charitable trust and may only be used for the charitable purposes set forth in the Articles of Incorporation at the time the revenues are received.20

17 Id. at 371,. Cf. Estate of Horton, 11 Cal.App.3d 680, 685 (1970) [Court rejects objections by the Attorney General to the terms of a settlement agreement between an income beneficiary and a charitable remainder beneficiary, stating that “We are cited no statutory or case law authority placing the Attorney General in the position of a super administrator of charities with the right to control over, or right to participate in, the contractual undertakings of the charities” absent fraud or collusion.]

18 See In Re L. A. County Pioneer Society, 40 Cal.2d 852, 864-865 (1953).

19 In re Metropolitan Baptist Church of Richmond, Inc. 48 Cal.App.3d 850, 857 (1975), citing Lynch v. Spilman 67 Cal.2d 251, 260; See also In re L.A. County Pioneer Society 40 Cal.2d. 852, 860 and Estate of Clippinger 75 Cal.App.2d 426, 433.

20 See Queen of Angels Hospital v. Younger, 66 Cal.App.3d. 359 (1977).

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Unless made pursuant to a binding obligation to pay, the payment of bonuses by a charity to its employees constitutes an improper diversion of charitable assets. 21

Charitable trust restrictions, once imposed, continue to apply to assets impressed with a charitable trust even if a corporation later changes its purpose, dissolves and distributes its assets, or transfers its assets to another charity without receiving full consideration. Charitable restrictions, once imposed, also continue to apply to the proceeds from the sale or lease of any charitable assets.22

A nonprofit corporation is free to change its charitable purpose by amending its Articles of Incorporation, but such a change applies only to later-acquired funds, not to existing assets.23

The charitable use of existing assets can be changed only where there is a general charitable purpose and the specific charitable use has become illegal, impossible or impracticable. In that case, the doctrine of cy pres requires the assets to be used for a charitable purpose that is as near as possible to the original charitable purpose.24 In certain circumstances, the donor may include in the initial gift a variance power, empowering the donee charity to alter the specific purposes of the gift if the governing body of the charity determines that such later alteration is warranted by changed circumstances.

Conclusion

Charitable organizations in the United States are subject to a dual legal regime. Their purposes and activities must fit within the legal and regulatory framework of state charitable law (and state income tax law, where applicable) as well as that of federal income tax law. Although lawyers may be aware of the importance of state charitable law and the role of Attorneys General, the lay public is far less likely to be. Part of the explanation is that considerably more information is available to the general public about Section 501(c)(3) and federal law applicable to tax-exempt organizations than about state charitable law. Consequently, nonprofit corporate responsibility rules, which are mainly grounded in state law, as this paper demonstrates, are largely unknown to the lay public.

Our aim, in writing this paper, is to contribute toward righting that imbalance by drawing attention to core governance rules applicable to California nonprofit public benefit corporations. Knowledge of those laws by directors and officers, and their advisors, may lead to increased compliance, with the result that the public will be benefited and, at the same time, the directors and officers will be less exposed to liability.

21 Id. at 371.

22 See, e.g., Pacific Homes v. County of Los Angeles, 41 Cal.2d 844, 854 (1953).

23 See In Re Veterans' Industries, Inc., 8 Cal.App.3d. 902 (1970).

24 See In re Los Angeles County Pioneer Soc. 40 Cal.2d 852, 865-866 (1953).

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