Handling Conflicts of Interests And Related Party Transactions While Serving On The Board of a Not-For-Profit Corporation
Many community-minded people serve on the board of directors of not-for-profit entities. Although motivated by a desire to serve their community in a volunteer capacity, such board members may suddenly find themselves confronted with a conflict of interest, or grappling with how to deal with the conflict of a fellow board member. For example, let’s say Dave the Director serves on the board of a little league and also owns a uniform shop. The little league annually purchases its uniforms from Dave’s uniform shop and the transaction is more than de minimus. The transaction is not necessarily prohibited, but New York law has recently changed in a significant way with respect to conflicts of interest and related-party transactions, and people serving on boards of directors of these entities should be aware of their legal obligations when confronted with such a situation.
The Nonprofit Revitalization Act of 2013 (the “NPRA”) requires that all New York not-for-profit entities now have a conflict of interest policy. There are several mandatory elements to a conflict of interest policy. The policy must define what constitutes a conflict of interest. It must also establish procedures for disclosing conflicts of interest, both before a board member is elected or appointed to serve on the board of directors, and then annually thereafter. The policy must prohibit persons with conflicts of interest from deliberating, participating, or voting on transactions or other matters involving the area of their conflict. The policy must also require documentation in the board minutes of the existence of the conflict and how it was resolved, including the abstention of the conflicted director from participation in the deliberations and vote relating to the area of conflict.
The conflict of interest policy should also establish procedures for disclosing and dealing with related party transactions. A related party transaction is any transaction, agreement or other arrangement in which a “related party” has a financial interest and in which the not-for-profit corporation is also a participant (with a few exceptions). A “related party” is (i) any director, officer or key person of the corporation, or an affiliate, (ii) a relative of any of those individuals, or (iii) any entity in which any individual described above has a 35% or greater ownership or beneficial interest or, in the case of a partnership or professional corporation, a direct or indirect ownership interest in excess of 5%.
Related party transactions are not prohibited per se. Instead, there are affirmative steps that must be followed if a not-for-profit entity wishes to engage in a related party transaction. First, the director, officer or key person who has an interest in the related party transaction must disclose in good faith the material facts concerning the interest. That director, officer or key person must also abstain from any discussion, deliberation or voting regarding the transaction, except that she may give general information regarding the transaction itself and answer any questions the board has. However, the interested director, officer or key person may not exert any influence over the board’s deliberations and must recuse herself from any vote.
The fact of the director, officer or key person’s interest in the transaction and recusal and abstention from the deliberations and vote should be noted in the board’s minutes. If the board approves the related party transaction, it must determine that the transaction is fair, reasonable and in the best interest of the organization at the time of the determination, which must also be contemporaneously noted in the board minutes. The transaction should be approved by a majority of disinterested board members. If the not-for-profit is a charitable corporation and the transaction involves a substantial financial interest, the board also has a duty to consider other alternatives and to document in the minutes that it has done so and why the related party transaction is in the best interest of the organization.
Failure to follow the foregoing procedures can result in an action by the Attorney General against the not-for-profit and the interested directors for disgorgement of the benefits received, or worse if the violations were willful. However, if an entity fails to follow the foregoing procedures, the law does provide a means of ratifying a transaction after the fact, as long as the board engages in the above process and documents it in the minutes, along with the reasons why the above procedure was not followed and the steps the entity has put in place to ensure its compliance in the future.
Now back to Dave the Director. To comply with New York law, Dave’s little league must adopt a conflict of interest policy that meets all the statutory elements. Pursuant to that policy, Dave must disclose his interest in the uniform company before coming onto the board, and then annually. When the board meets to discuss the purchase of uniforms, Dave must recuse himself from the vote and may not participate in the board’s deliberations regarding the transaction. Dave may answer general questions about the transaction – e.g., what are the terms of the proposed transaction – but he may not exert influence over the board’s decision in any way. Dave should leave the room while the board deliberates and votes. The minutes of the meeting should reflect that Dave has disclosed his conflict of interest, that he has not participated in the board’s deliberations, and that he has recused himself from the vote. The board of remaining disinterested directors must approve the transaction by a majority vote. The minutes should also reflect that the board has considered other alternatives and that the transaction with Dave’s shop is fair, reasonable and in the best interest of the organization at the time of the determination. It may very well be that Dave is giving the organization the best deal, or for some other reason is the best person for the job, but it is up to the board of directors to document the steps they have taken to act in the organization’s best interests in light of Dave’s conflict.
This is not intended to be legal advice. You should contact an attorney for advice regarding your specific location.