Conflict-of-Interest: What Non-Profit Organizations Need to Know

The laws of most states require officers and directors of non-profit organization to discharge their duties in accordance with his good faith belief that they are acting in the best interests of the organization.   Doing so protects them from liability acts or omissions in connection with their responsibilities.  But, as a general rule, officers and directors that consent to distributions in involving conflicts of interest are personally liable to the organization for the amount of the distribution.  To mitigate this significant risk, officers and directors should be well-versed in the procedures for handling conflict-of-interest transactions.

An officer or director could have a conflict-of-interest in any transaction with its non-profit organization in which the director personally profits or has a personal interest.  The transaction is then “tainted” and may usually be set aside unless (a) full disclosure is made and authorization, approval, or ratification is obtained or (b) the transaction is otherwise fair to the organization.  Full disclosure and approval may be obtained by either the board of directors or members of the board of directors, or, in the case of a membership non-profit, by the members entitled to vote.  A conflict-of-interest transaction is considered authorized, ratified, or approved if it receives the affirmative vote of a majority of disinterested directors or members.

Some individuals serve as directors of more than one non-profit organization.  If two organizations with the same director engage in transactions, the interlocking directorate may taint the transaction with conflict-of-interest and create a presumption that the transaction is unfair.  A director is considered to have an indirect interest in a transaction if (a) another entity in which he or she has a material financial interest or in which he or she is a general partner is a party to the transaction or (b) another entity of which he or she is an officer, director, or trustee is a party to the transaction and the transaction is or should be considered by the board of directors of the organization.  In this situation, the director should make the disclosure to each organization and obtain the authorization, approval, or ratification described above.

A strong conflict-of-interest policy is quickly becoming an essential document for non-profit organizations.  Although the IRS does not formally require a conflict-of-interest policy (yet), it has taken steps to “encourage” organizations to adopt them.  These policies can protect the interest of the exempt organization when it enters into transactions that could potentially benefit an officer or director.  And as importantly, a good conflict-of-interest policy (if followed) can protect officers and directors from personal liability for decisions in transactions in which they have an interest.

Most conflict-of-interest policies define who is considered to have a conflict and then provide procedures for making decisions in transactions involving that person or persons.  The policies typically require the tainted person or persons to make full disclosure of the conflict-of-interest to the board of directors of any actual or potential conflict.  The board then follows a procedure for determining if a conflict actually exists and, if so, how or whether to proceed with the transaction.  Directors, officers, and others who exercise control over a non-profit organization should sign a statement every year to acknowledge their awareness of the organization’s conflict of interest policy.  The IRS has promulgated a Sample Conflict-of-Interest Policy that should be adopted by organizations that do not have a substantially equivalent policy of their own.

Next: The Prohibition of Private Inurement