Conflicts of Interest: Avoiding Common Mistakes
by Napa Legal Staff
Conflicts of Interest and Discounts: Common Misconceptions
A director who is also a technology executive offers to sell technology from his company to a nonprofit school at cost. A director who runs an interior design firm offers to consult for a nonprofit women’s center at a steep discount. The organizations will be getting the best deal on the market.
Must the board review and approve these transactions before the organization can take advantage of the great opportunities?
Yes. The directors of faith-based nonprofits have a duty of loyalty that requires them to put the organizations’ faith and mission ahead of personal interests, both in fact and in appearance. If the organization plans to enter a conflicted transaction, in which the organization will directly or indirectly compensate a person (such as a director or officer or a company owned by a director) who exercises authority or influence over the organization, special due diligence and approval is necessary. If the board does not conduct the required diligence, state and federal penalties may apply. These penalties include financial penalties, legal actions, and even the voidance of the transaction itself. Not all conflicted transactions are prohibited or improper, but all conflicted transactions must be carefully reviewed.
A common misconception is that a conflicted transaction does not require any extra diligence, (such as comparability research or board pre-approval) if the transaction is a “great deal.”
The truth, however, is that a faith-based organization must follow a careful step-by-step approval process even for “great deals” if the transaction will require the exempt organization to make a direct or indirect payment to a director, officer, his or her family member or certain affiliates, or other interested person.
Conflicts of Interest: Understanding the Issues and Protecting Your Organization
As the leader of a faith-based organization, you may wonder what practical steps you should take to properly address conflicted transactions while also accepting opportunities that are in the organization’s best interest.
The three steps below will help you strike the proper balance:
- Understand the Concepts. You should know the basic issues and concepts involved in conflicted transactions, as well as the authorities that regulate them.
- Understand the Process. Both the IRS and most state nonprofit corporation laws lay out specific, step-by-step processes that an organization can follow to reduce the risk the organization will engage in an impermissible transaction and face the related federal and state penalties. This area becomes technical quickly, but you can learn about the details of the federal tax process in our whitepaper series on excess benefit transactions. You can learn about the details of your state’s protections by reading your state’s nonprofit corporation act.
Note: State charities laws typically do not describe specific instructions to protect your organization from improper conflicts and the related penalties, but following the steps to establish the federal and state corporate protections will likely keep your organization in compliance with state charities laws as well.i
- Implement. Your organization should put policies and processes in place to identify conflicted transactions, guard against improper conflicts of interest, and properly approve conflicted transactions when appropriate. Your organization should also have a process in place to educate your staff and leadership about these issues.
Understand the Concepts
Federal tax law (enforced by the Internal Revenue Services or “the IRS”), state nonprofit corporate law (such as the Illinois Nonprofit Corporation Act or the California Nonprofit Religious Corporation Act), and state charitable fundraising laws (such as the Illinois Charitable Trust Act) all establish penalties to deter and punish the use of a nonprofit, tax-exempt, charitable organization’s money and other assets for the benefit of a private person, especially if that individual is an “insider.”
The basic ingredients of a conflicted transaction are: an interested person (such as a director or officer), a tax-exempt nonprofit, and an exchange of economic benefits between the two parties (often, money exchanged for goods or services).
Note that an unequal or unfair exchange of goods or services is not necessary for the conflicted transaction. A conflicted transaction can be, and often is, for the benefit of the organization.
Understand the Process
The basic concepts of the process to “sanitize” a conflicted transaction are set forth below. To understand the technical details that your organization must address when formally approving a specific transaction, read our whitepapers on excess benefit transactions and work with an attorney to understand the applicable state law issues.
- Review the terms of the proposed transaction;
- Obtain comparability data by soliciting bids from similar companies in the area;
- Meet and consider all options, with the conflicted director or officer recusing himself or herself from the meeting, in writing;
- Determine whether the conflicted transactions would be in the organization’s best interest;
- Document the bidding process, the conflicted party’s recusal, and the rationale for the board’s selection in a board resolution; and
- Save the resolution and supporting documents in the corporate records.ii
In addition to understanding the basics of conflicted transactions and the process needed to approve them, you must make sure your organization takes action. Adopt a conflict-of-interest policy that explains how your board will ensure that conflicted transactions go through the proper approval process. Educate your leaders on the steps in the policy and require directors and officers to review and certify to the policy annually.
Set up a process to screen for and pre-approve conflicted transactions. One best practice is to create an annual list of disqualified persons and distribute the list to people on the organization’s team who will be involved in the approval of service contracts and property purchases.
If your organization has faced or is facing an opportunity to do business with a director, officer, or other person with influence over the organization, make sure you understand the concepts at issue and the technical steps needed to avoid an improper conflicted transaction. Remember that the conflicted transaction approval process must be followed even if the transaction prices and rates are below-market.
Once you understand the law and the best practices for protecting your organization, follow the steps and document your organization’s compliance in writing.