Everyone knows the fiduciary duties of for-profit directors (duty of care, loyalty, and faith), but what about non-profit directors? Does anything change? In Washington, the answer is surprisingly vague. To help clarify, I have written three blog posts–one for each duty.
The following is a discussion of the duty of obedience.
Duty of Obedience
The last major fiduciary duty is the director’s duty of obedience. This duty is not codified in statute, but is a product of common law. The duty of obedience requires that a director: (1) comply with applicable law; and (2) be faithful to the purposes and goals of the organization the director serves. Kurtz, supra at 14.
The first aspect of the duty of obedience—compliance with applicable law—is important, but it is also straightforward. Directors breach their duty of obedience if they direct the nonprofit organization in a manner that is illegal. Id. Because this is not a complicated analysis, it will not be discussed again until the “Procedures” section below.
The second aspect is more nuanced, and directs courts to determine whether the directors managed the nonprofit in a manner consistent with the organization’s purposes and goals. The purposes and goals of the organization can be found in “the legal documents creating the organization, such as its certificate of incorporation, and any amendments thereto, its bylaws and in other documents defining its mission, such as its application for tax-exemption or grant proposals and public solicitations in which the organization makes representations about its purposes and activities.” Id. If any of these documents establish a limitation on director power, and the director acts in a manner inconsistent with the limitation, the director has breached his or her duty of obedience.
Exception
There is little law describing how a director discharges his or her duty of obedience. Legal authorities only offer broad statements that directors must ensure that the corporation acts within its “mission and purpose.” See, e.g., Hazen, supra at 386-87; Kurtz, supra at 14. Therefore, there are likely many routes to compliance, unlike the duties of care and loyalty, which promote certain generally accepted practices.
Cautionary tale
The following scenario describes a situation where directors disregarded the purpose of the nonprofit—as established in the nonprofit’s governing documents—and breached their duty of obedience:
Nonprofit hospital’s articles of incorporation state that the hospital’s corporate purposes are to provide general treatment to persons suffering from certain illnesses, and to maintain a school for post-graduate instruction. For the majority of the hospital’s existence, the hospital was excellent at providing these services.
However, due to the changing nature of medicine, the services provided by the hospital became increasingly unprofitable. While the hospital took certain measures to cope with the changing landscape of healthcare, the directors concluded that the business had no value. Therefore, the directors decided to sell the hospital and substantially all of its assets.
The court rejected the directors’ attempts to sell the hospital. Because directors of nonprofit corporations are “charged with the duty to ensure that the mission of the charitable corporation is carried out,” the directors had to “be faithful to the purposes and goals of the organization.” However, because the directors did not consider other methods to preserve the nonprofit’s mission and the sale did not promote the charitable purposes of the hospital, the court found that the sale violated the directors’ duty of obedience. A decision to turn the organization away from the charitable purpose should be a “last resort.”
Manhattan Eye, Ear & Throat Hosp. v. Spitzer, 186 Misc. 2d 126 (Sup. Ct. 1999).
Take note that the court used language and concepts found in duty of care and loyalty cases. For example, the court discussed the failure of the board to consider comparable methods for preserving the organization. This is failure is often present when directors breach a duty of loyalty or care, i.e., the director stood to gain from the transaction, so did not ascertain whether a better deal existed or the director failed to ascertain the information needed for the director to properly exercise his or her business judgment.
However, despite the similar language, the above case clearly involved a breach of a duty of obedience. This is because a there was not enough evidence of breach of duty of loyalty: there was no showing that the directors derived a personal or improper benefit from the transaction. Similarly, there was not enough evidence of breach of duty of care: there was not enough evidence that the directors were grossly negligent when ascertaining alternative methods of preserving the organization. Therefore, the court was prudent to rest its decision on a breach of duty of obedience.
To reiterate the distinction between the duty of obedience and the duties of care and loyalty: The duty of care is the directors’ duty to reasonably manage the nonprofit’s assets, while the duty of loyalty is the directors’ duty to use the nonprofit’s assets for the nonprofit, rather than for personal benefit. The duty of obedience, on the other hand, is the duty to act in accordance with the nonprofit’s purposes and goals. See Kurtz, supra at 14. Directors may observe their duties of care and loyalty, and still act in a manner inconsistent with the nonprofit’s purposes and goals.
Procedures
As noted above, authorities are vague on how directors should discharge their duty of obedience. The Washington Secretary of State has provided a few pointers, concerned mostly with compliance with applicable law. These pointers include knowing applicable local, state, and federal law and being familiar with all of the nonprofit’s organizational documents (e.g., articles of incorporation and bylaws). Quick Guide Handbook, 5. The Secretary of State’s Nonprofit Handbook does not even mention the duty of obedience by name, but rather states that directors should “act lawfully when conducting business on behalf of the corporation…act within the scope of authority and purpose of the corporation as specified in the corporation’s governing documents…[and] ensure that the corporation is in compliance with laws and other regulations.” Nonprofit Handbook, 34. However, because the duties of care and loyalty are strongly related to the duty of obedience, nonprofit directors complying with their duties of care and loyalty should also comply with their duty of obedience.
Conclusion
While unclear, it is likely a court may punish a director’s breach of the duty of obedience in a manner similar to a breach of a duty of care or loyalty. However, it is relatively rare (such that I could not find any published case) where only the duty of obedience was breached.
Because of these legal threats, directors of nonprofit corporations must observe their fiduciary duties. To ensure this happens, the nonprofit corporation should have a binding code of conduct, and implement a conflict-of-interest policy. The nonprofit corporation should also audit its decision-making practices to ensure compliance with the code of conduct and conflict-of-interest policy. Lastly, the directors should personally commit to their fiduciary duties, in the interest of ethical and effective corporate governance.
See Part I (duty of care) and Part II (duty of loyalty) for further discussion of the duties of nonprofit directors!
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