How to build an effective board of directors: Handling conflicts of interest

The duty of loyalty requires directors to put the organization”™s interests ahead of their own personal interests, and to disclose any actual or potential conflicts of interest prior to joining the board and as they arise. This article, the third in the corporate governance series “How to build an effective board of directors,” discusses best practices and requirements under New York law for handling actual, potential, or perceived conflicts of interest.

Why it matters

Nonprofit organizations are stewards of the public trust and must serve a public purpose to retain their tax-exempt status. As such, nonprofit organizations must not operate for the benefit of private interests or have income that inures to the benefit of private individuals.

Generally, a conflict of interest arises when a person in a position of authority actually, potentially or is perceived to benefit (either financially or otherwise) from a decision or transaction involving the organization. This may manifest as an outside interest that competes or otherwise interferes with the nonprofit”™s operations, or where an insider in a position of authority has a financial interest in an entity with which the organization is a party to a transaction.

Unless handled properly, a conflict of interest may lead to misuse of the organization”™s charitable assets, damage to the organization”™s reputation, investigations from the Attorney General”™s Office and director liability for breach of the duties of loyalty and care. In addition, the IRS may consider a transaction involving a conflict of interest to be an excess benefit transaction, the consequences of which may include revocation of the organization”™s tax-exempt status and financial sanctions against the interested director and any director who knowingly or willfully participated in the excess benefit transaction.

But conflicts of interest are not inherently bad (unless they are, because of fraud or other misconduct). Some conflicts, for example, may be beneficial to an organization in the form of cost savings, access to equipment or supplies or other benefits. After all, directors are encouraged to use all of who they are and what they bring to the table to advance the work of the nonprofit.

It is often the mishandling of conflicts that gives rise to liability or other harm to the organization. Best practices for handling conflicts of interest demand transparency and allows the board to make informed decisions that are in the best interests of the organization after considering all known facts without undue influence.

Handling conflicts of interest

Every nonprofit should develop a system for managing conflicts of interest. An effective conflict management system will help protect the organization”™s charitable assets and protect directors against claims for breach of fiduciary duty.

The following are five steps for effectively handling conflicts of interest.

1. Disclosure, disclosure, disclosure

Effective management of conflicts requires timely disclosure by directors, officers and key persons (i.e., any person having control or influence equivalent to that of an officer or director) of any actual, potential or perceived interest in a transaction involving the organization before the organization enters into the proposed transaction.

Under New York law, all directors must sign annual statements identifying any entities in which they serve as an officer, director, member, trustee or employee and with which the organization has a relationship, and any transaction of the organization in which the director might have a conflict of interest.

If in doubt as to whether a conflict of interest exists, directors should err on the side of conflict and disclose.

2. Board inquiry

After disclosure, the board has a responsibility to inquire further and obtain all material facts regarding the conflict. The board should ask questions and request information from the interested person, carefully review those facts and obtain advice from appropriate professionals regarding the matter. The board should also obtain information about alternative arrangements that would not constitute a conflict of interest. The depth of the board”™s inquiry will depend on the circumstances, consistent with directors”™ duty of care.

3. Majority board vote

After considering all material facts, the board should deliberate and vote on whether to approve or deny the transaction. The existence of the conflict of interest does not require denial of the transaction. To the contrary, the board may approve the transaction if, upon due deliberation, it decides that the transaction is fair, reasonable and in the best interests of the organization.

Only noninterested and unconflicted directors may deliberate and vote, and such deliberation and vote must occur outside of the presence of the interested person. In other words, the interested person must physically leave the room while the board deliberates and votes. If the interested person is a director, the presence of the director is counted for purposes of quorum and approval of the transaction must be by the majority of directors present for the vote, or as otherwise provided for under the organization”™s bylaws.

4. Contemporaneous documentation

The board must retain contemporaneous documentation of its handling of the conflict, preferably in its minutes. The minutes should reflect that the conflict was disclosed, the board discussed and deliberated upon the conflict, the transaction was either approved or denied and the board”™s reasoning for its determination.

If the transaction was approved, the meeting minutes should clearly reflect that the board determined the transaction to be fair, reasonable, and in the best interests of the organization, after due consideration of the material facts, including any comparability data, if that is the case.

5. Ratification (if necessary)

If the organization has proceeded with a transaction only to later discover the existence of an actual, potential or perceived conflict of interest, the board should still take the above steps, except the vote would be to either ratify or rescind (not approve or deny) the transaction. The board may ratify the transaction if it finds, in good faith, that the transaction was fair, reasonable and in the organization”™s best interest at the time it approved the transaction.

Note that the Attorney General is empowered to bring an action to enjoin, void or rescind any actual or proposed related party transaction that violates conflict of interest requirements or was otherwise not reasonable or in the best interests of the organization. The Attorney General may also bring an action seeking restitution from or the removal of any director or officer involved in the related party transaction.

Implement and enforce a conflict of interest policy

New York law requires all nonprofits to have a written conflict of interest policy, and establishes specific minimum standards for the content of those policies. Each policy must define the circumstances constituting a conflict of interest, provide specific procedures for disclosing a conflict of interest, and establish procedures for deliberating and voting on related party transactions.

The conflict of interest policy should include provisions for handling gifts or entertainment that sets clear standards to avoid the use of gifts and entertainment to influence future contracts or other benefits. Such policy may, for example, prohibit gifts from current or potential vendors or contractors, or limit such gifts to specific dollar values.

A conflict of interest policy is not one-size-fits-all, and must be catered to the specific needs and practices of each organization. Nonprofits should regularly review their conflict of interest policy to ensure that it complies with New York law, adequately addresses the organization”™s needs, is followed and enforced and is reasonable under the circumstances.