Meeting a director’s duty of loyalty generally requires acting in good faith and in the best interests of the corporation.  The key to meeting this duty is to place the interests of the corporation before the director’s own interests or the interests of another person or entity.  This post discusses aspects of the duty of loyalty from the perspective of a director of a California nonprofit public benefit corporation exempt under Section 501(c)(3) of the Internal Revenue Code and described as a public charity.

Conflict of Interest

A conflict of interest exists when a director has a personal material interest in a proposed transaction to which the corporation may be a party.  Conflicts of interest are neither unusual nor generally prohibited.  Indeed, transactions involving a conflict of interest may be in the best interest of the corporation.  For example, it may be perfectly appropriate for a board to approve a transaction with a director in which the director is providing the corporation with some good, service or facility at below market rates.

From a legal perspective, it is the manner in which conflicts of interest (even ones that are favorable to the corporation) are handled by the director and the board that may determine whether the director’s duty of loyalty has been breached and whether the transaction may be rendered void.  It should be noted, however, that transactions involving even a perceived conflict of interest may subject the interested director and the corporation to a serious loss in reputation.  Accordingly, corporations should enter into such transactions cautiously where the directors believe that it could be viewed negatively if brought to light by the media.  For all these reasons, a conflict of interest policy is highly recommended.

A conflict of interest may exist in the following situations:

• Employment or independent contractor agreement between the corporation and a director or a member of the director’s family.
• Provision of a good or service or use of a facility to a director, a member of the director’s family or an entity affiliated with a director.
• Provision to the corporation of a good, service or use of a facility by a director, a member of director’s family or an entity affiliated with a director.
• Decision to engage in a transaction or activity that may otherwise benefit or harm a director’s personal interests.
• “Self-dealing transactions” as defined in state law.
• “Excess benefit transactions” as defined in federal tax law.

Self-dealing Transactions

Section 5233(a) of the California Corporations Code defines a self-dealing transaction as “a transaction to which the corporation is a party and in which one or more of its directors has a material financial interest and which does not meet the requirements of paragraph (1), (2), or (3) of subdivision (d)” (discussed in the following paragraphs).  Where a self-dealing transaction has taken place, a court may order the interested directors to take certain actions and pay damages as in the discretion of the court will provide an equitable and fair remedy to the corporation.

The Section 5233(d)(1) exception requires the Attorney General or a court to approve the transaction before or after it was consummated.

The Section 5233(d)(2) exception requires that all of the following facts be established:

• The corporation entered into the transaction for its own benefit.
• The transaction was fair and reasonable as to the corporation at the time it entered into the transaction.
• Prior to consummating the transaction or any part thereof the board authorized or approved the transaction in good faith by a majority of the directors then in office without counting the vote of the interested director or directors, and with knowledge of the material facts concerning the transaction and the director’s interest in the transaction.
• Prior to authorizing or approving the transaction the board considered and in good faith determined after reasonable investigation under the circumstances that the corporation could not have obtained a more advantageous arrangement with reasonable effort under the circumstances or the corporation in fact could not have obtained a more advantageous arrangement with reasonable effort under the circumstances.

The Section 5233(d)(3) exception requires that all of the following facts be established:

• A committee or person authorized by the board approved the transaction in a manner consistent with the standards set forth in Section 5233(d)(2).
• It was not reasonably practicable to obtain approval of the board prior to entering into the transaction.
• The board, after determining in goof faith that the two conditions set forth above were satisfied, ratified the transaction at its next meeting by a vote of the majority of the directors then in office without counting the vote of the interested director or directors.

2017 UPDATE: For more details, see California Nonprofit Law: The Self-Dealing Prohibition.

Excess Benefit Transaction

Section 4958(c)(1)(A) of the Internal Revenue Code (IRC) defines an excess benefit transaction as “any transaction in which an economic benefit is provided by an applicable tax-exempt organization directly or indirectly to or for the use of any disqualified person if the value of the economic benefit provided exceeds the value of the consideration (including the performance of services) received for providing such benefit.”  An excess benefit transaction involving a director is an example of self-dealing and a conflict of interest.  Moreover, any excess benefit transaction is prohibited and may subject the disqualified person and the directors who knowingly approved such transaction to significant federal excise taxes.  See IRC Section 4958(a) and (b).

IRC Section 4958(f)(1) generally defines a disqualified person with respect to a transaction to include:

• any person who was, at any time during the 5-year period ending on the date of such transaction, in a position to exercise substantial influence over the affairs of the organization,
• a member of the family of an individual described above, and
• a 35-percent controlled entity.

2017 UPDATE: For more details, see Private Benefit Rules – Part III: Excess Benefit Transaction Rules.