What Booker T. Washington recognized in 1901 holds true today. More than 25 percent of adults volunteer with nonprofit organizations, contributing an estimated 8.7 billion hours valued at $179.2 billion annually.1 Many people act on their desire to make the world a better place by serving on boards of directors of nonprofits. Like their counterparts at for-profit institutions, nonprofit directors’ service comes with responsibilities—fiduciary duties.
When a nonprofit becomes insolvent, its mission may conflict with the interests of creditors, posing a unique challenge for directors. Given the growing number and size of nonprofits, as well as a widely held belief that the U.S. may be in the late stages of an economic expansion cycle, the fiduciary duties that directors owe when nonprofit finances falter is likely to be a growing issue in the years ahead.
Nearly 1.5 million nonprofits with missions that vary from human services to educational or religious in nature are registered with the Internal Revenue Service.2 Over the past 10 years, the number of public charities has grown by approximately 20 percent and now totals nearly 1 million.3 The remaining 500,000 nonprofit organizations comprise primarily private foundations. In total, nonprofits contribute an estimated $905.9 billion to the U.S. economy annually.4
Like those at for-profit companies, directors of nonprofits have fiduciary duties of care, loyalty, and obedience. The duty of care requires a director to act in good faith, in a manner he or she believes to be in the best interests of the nonprofit organization, and with the care an ordinarily prudent person in a like position would exercise under similar circumstances. The duty of loyalty requires directors to avoid engaging in self-dealing or using their position to financially benefit themselves or another person.
In a for-profit company, the duty of care is generally satisfied by the goal of maximizing shareholder value. In a nonprofit institution, however, the best interests of the organization are mission-driven. When establishing a nonprofit, incorporators are required to specify the charitable purpose of the organization. These mission statements are the guiding principles for how nonprofits function operationally, financially, and socially. Examples include:
Noticeably absent from these mission statements is the goal of maximizing revenues or profits. Pursuit of a nonprofit’s mission and financial stability are not necessarily mutually exclusive goals. Under the best-case scenario, they align, enabling a nonprofit to successfully pursue and implement its mission.
Nonprofits are not immune to financial distress. Indeed, market forces impact them in many of the same ways as they do for-profit companies, and at times even more acutely. During the Great Recession, 80 percent of nonprofits in one survey reported some level of financial distress, and nearly 40 percent of those considered the distress to be severe or very severe.8 If those percentages held true for today’s greater number of nonprofits in another recession as severe as the Great Recession, more than 1.1 million nonprofit entities would experience some financial distress, and for more than 560,000 of those, the financial distress would be severe or very severe.
The financial distress that nonprofits may experience in a downturn is often the product of their sources of revenue. Nonprofits generally have three sources of revenue: (1) program service revenues, such as tuition or fees for services; (2) donations, gifts, and grants; and (3) “other” income, including rental and special event income. Cash management is often an ongoing challenge because revenue sources, particularly gifts and grants, can be unsteady and highly elastic during a downturn in the economy.
Even in the midst of a seemingly growing economy, nonprofits may experience financial distress. Numerous universities or other educational charities have experienced dwindling revenues due to changes in accreditation and shifting demand. Many nonprofits own aging buildings that require significant capital upkeep that, in turn, strains operating budgets. Other nonprofits that have as their goal providing free goods and services to individuals in need are unprepared to meet financial challenges as demand grows. Still other institutions face financial challenges related to attracting and maintaining talented managers and employees.
When an entity experiences challenges and becomes insolvent, do directors’ duties change? In the case of a for-profit entity, the answer is, basically, no. The mission of a for-profit entity, albeit not the exclusive mission, is maximizing profits, which then inure to the shareholders. When a for-profit entity is insolvent, the mission generally continues to be to maximize value, but the beneficiaries of these duties expand to include creditors.
When a nonprofit becomes insolvent, however, the directors face conflicting duties. Nonprofit directors never owed a duty to shareholders to maximize value, so that approach does not readily translate to encompass creditors, as it does with for-profit entities. It would be an oversimplification to state unequivocally that a nonprofit director’s duty, when the nonprofit becomes insolvent, is to maximize value without regard to its mission. In fact, courts have held that directors are not required to abandon a nonprofit’s mission and focus exclusively on maximizing value, but the directors of an insolvent nonprofit begin to owe a duty that runs to the organization’s creditors.
The duties and tension were summarized in a recent decision of a U.S. Bankruptcy Court as follows:
The Debtors [nonprofits] are not required, under traditional circumstances, to maximize profits. Rather, they must pursue their philanthropic mission … . Although, it should be noted that once in bankruptcy, the directors and management owe fiduciary obligations to creditors to ensure that the pursuit of their philanthropic mission is not financed on the backs of creditors without their consent….Nonetheless, the Debtors are not required to abandon their philanthropic mission. Thus, as long as the Debtors are able to pay their creditors, they are free to pursue their mission.9
Existing law does not provide bright-line rules as to how directors of an insolvent nonprofit should best address the tension between the mission and maximizing value. Recent court cases, however, have provided guidance to managing a number of situations or transactions that directors may face.
1. Cash Flow Plans
Courts have generally found that as long as a struggling nonprofit can meet its current obligations to creditors, its directors can continue to prioritize the organization’s mission over long-term financial stability. When obligations to creditors cannot be satisfied, however, courts have looked to the interests of all parties involved, particularly those of creditors.
To satisfy its fiduciary duties to the nonprofit and also potentially to creditors, a board of directors needs to have a plan to address the organization’s financial distress. Maintaining the status quo, and thereby increasing the number of creditors and the size of their claims, renders directors vulnerable to claims of inappropriate oversight. A prudent plan should include a process for immediate management of cash receipts and expenses and a strategy for returning the nonprofit to solvency or minimizing the negative impact on creditors. Where such a plan is not feasible, directors should consider what level of disclosure of the financials to creditors may be appropriate.
2. Sales of Assets
Directors may face a direct conflict between mission and value when the nonprofit becomes insolvent and is forced to sell assets. The nonprofit may receive competing bids for the assets, including offers from both for-profit and nonprofit entities. A for-profit entity may submit a higher monetary bid for the assets because it doesn’t plan to continue the nonprofit’s mission, while a nonprofit entity that intends to continue the nonprofit’s mission or a similar objectives may submit a lower bid.
In a case addressing just such a scenario, a court analyzed two competing bids’ impact on a long-term care facility’s current and former residents, employees, and unsecured creditors.10 The court performed a detailed analysis of the pros and cons of the competing bids, including whether a change in zoning was required, the likelihood that the bidders could close the transaction, the marketing projections for both bidders, and the risk of nonpayment to the creditors over the short and long terms.11 Ultimately, the court concluded that the financial impact was a wash and found in favor of the bidder that would continue the nonprofit’s mission.
Directors who find themselves evaluating competing bids for a nonprofit’s assets when the entity can no longer meet current obligations should document a comprehensive evaluation of all bids and the impact on all relevant stakeholders, including employees and those individuals the nonprofit serves. Approving a sale based on the outcome of an analysis of the totality of circumstances best satisfies a director’s fiduciary duties.
3. Financial Distress of a Division
Directors may also face competing duties when a division or one arm of a nonprofit organization is financially distressed, causing the organization as a whole to suffer. In a recent case, creditors claimed that the board was abdicating its responsibility to maximize value for creditors and sought to appoint a bankruptcy trustee to displace directors and manage the nonprofit’s business.12 The creditors noted that the nonprofit had some business lines, including commercial rental property, that were profitable. But the research and development (R&D) line was a drain on the nonprofit’s resources.
The court rejected the request for appointment of a bankruptcy trustee and held that the board “is entitled to exercise its business judgment so long as the judgment is well-informed.”13 The court noted that the R&D arm became unstable when the nonprofit lost government contracts and that the board made an informed decision to self-fund R&D so the organization could compete for future contracts. The court also explained that if a trustee had been appointed, the nonprofit risked losing its nonprofit status and therefore would potentially incur new liabilities. Ultimately, the nonprofit was able to secure contracts, and the cash flow stabilized.
When assessing the alternatives for addressing a failing division, directors should be guided by process and assess the totality of the circumstances. When directors base their decisions on solid information and maintain a record of those evaluations and the information underlying them, courts have been willing, if not eager, to find that decisions were informed and satisfied the fiduciary duties to the nonprofit.
4. Insider Transactions
As noted earlier, one of the duties that a director or advisor owes to a nonprofit is the duty of loyalty—a director cannot put his or her own interests above those of the nonprofit. This duty comes into play when a director enters into a transaction with the nonprofit. For example, the director may be engaged as an advisor to represent the nonprofit, lease space to or from the nonprofit, or enter into a sale transaction with the nonprofit. If the nonprofit is insolvent, these transactions will be subjected to a great deal of scrutiny. Moreover, the decision of another director to approve (or a failure to identify) a transaction that involves an insider director may also be subjected to heightened scrutiny.
Most importantly, the transaction must reflect fair market value. To ensure fair market value, directors should obtain appropriate information concerning the value of the transaction, such as comparability data. Directors should review this data and document the basis for their approval in advance of the transaction. Also, directors should consider instituting policies laying out criteria and the process to be used to review any potential transactions between an insider and the nonprofit.
5. Good Process
One of the most common allegations levied against directors when an organization experiences financial distress is a failure of oversight. The duty to oversee a nonprofit’s management is part of a director’s duty of care. Ordinarily prudent people overseeing an entity must monitor the financial health of the organization. Creditors of insolvent nonprofits have brought suit against directors, alleging that they failed to adequately oversee the nonprofits, thereby leading to their financial demise, to the detriment of the creditors.14
While these claims are difficult to prove, the best approach is to take steps to minimize the prospect of any claims materializing. To avoid these types of claims, directors should ensure that they receive regular reports about the financial health of the nonprofit. Board meetings should include an opportunity to review and discuss the financial reports, with these processes documented in the board minutes.
6. Managing Risk
Best efforts to meet directors’ fiduciary duties cannot eliminate all risks. With that in mind, directors should ensure that a nonprofit has appropriate directors and officers (D&O) liability insurance in place. In addition, directors should familiarize themselves with applicable state statutes that may provide immunity to directors of nonprofits in certain circumstances, such as when a director (a) serves without compensation, (b) has acted in good faith, (c) has acted within the scope of his or her responsibilities, and (d) has not engaged in willful or reckless misconduct.
Nonprofits face all of the revenue and expense challenges that for-profit organizations do and some additional difficulties that for-profit entities may not. Directors need to be aware of their duties to the organization and how those obligations may change if the nonprofit becomes insolvent. To satisfy these duties, directors should be familiar with and understand the mission of the nonprofit, ensure that they regularly review financial data and document those assessments, be alert to how changes in economic conditions may affect the nonprofit, and be aware of how the prioritization of the mission may change if the nonprofit becomes financially distressed.