Nonprofit Corporate Law

Nonprofit Corporate Law, Governance and Management

Outline

Ellen Aprill, Fall 2009

I.  Introductory materials

A. Some important distinctions

  1. Tax-exempt vs. nonprofit
  2. Nonprofit refers to state corporate law
  3. Tax-exempt usu refers to federal tax rules; also applies to state tax law
  1. 501(c)(3) vs. other 501(c) organizations
  2. c3s are “charities”; donations tax-deductible; requirements inc no campaigning

(3) Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual, no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation (except as otherwise provided in subsection (h)), and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.

  1. c4: Sierra Club, ACLU: no restrictions on lobbying and campaigning
  2. There are 27 types of tax-exempt orgs in 501(c), and some outside 501(c)
  3. Mapping CA forms on tax laws

Public benefit corps (3), (4)

Mutual benefit corps (5), (6), (7)

Religious corps (3), but w/o federal oversight

  1. Public charities vs. private foundations
  2. Distinction is based on how widely supported the org is and what it does
  • Public charity typically receives income from many donors and operates charitable programs rather than making grants to other charities
  • Private foundation typically receives income from own endowment and/or a few large donors, and makes grants to public charities
  1. Private foundations have strict add’l rules attached:

– diff deduction rules, a set of excise tax rules that operate as prohibitions

B. Nonprofit sector

  1. Overview of Sector
  • 12% of GDP in 1995
  • 5% of funds from fees, dues, and charges
  • 3% of funds from government
  • 9% of funds from contributions
  • Individuals largest source of charitable giving
  • Most gifts to churches and other religious orgs
  • Religious organizations largest subsector
  • Service-providing organizations next, with social service agencies the largest of this group
  • Greatest expenditures from health subsector
    • 14% of organizations accounts for 62% of expenditures
  • Anything in introductory reading on which they would like to comment?
  1. Rationales for Sector
  • Historical factors, such as the growth of voluntary organizations in the American colonies that predated government.
  • Market failure, inability of the market to handle public goods that can only be consumed collectively because of free rider problem

Definition of public good

A good or service such that

(1) cost of providing it to many is not appreciably more than cost of providing it to one and

(2) once the good has been provided to one, it is difficult to prevent others from enjoying it as well.

Examples of public good

  • Noncommercial broadcasting
  • National defense
  • Public monuments
  • Scientific research
  • Clean air
  • Safe neighborhoods
  • Government failure, in that government can act only if majority supports; moreover, government action can be cumbersome, unresponsive and bureaucratic.

Some things are desired by a large minority

  • Pluralism, freedom & Solidarity, the nonprofit sector allows smaller groups to play an important role in expressing their values and in engaging in joint action.
  1. Hansmann’s Analysis: two axes, financing and control
  • Financing
    • Donative – grants or donations
    • Commercial – fees for services (eg hospital, university)
  • Control
    • Mutual – by patrons
    • Entrepreneurial – self-perpetuating
  • Nondistribution constraint: Crucial concept

“The advantage of a nonprofit producer is that the discipline of the market is supplemented by . . . the organization’s legal commitment to devote its entire earnings to the production of services; as a result of this institutional constraint, it is less imperative for the consumer either to shop around first or to enforce rigorously the contract he makes.”

C.  Nonprofit vs for profit

  1. For profit:

– Stock can be issued to raise capital

– Profits can be distributed ( best choice if revenue will exceed reasonable compensation)

  1. Nonprofit

– Tax deduction

– Halo effect

– Some states give sales tax deduction (not CA), property tax exemption

– Public filing requirements of Form 990

– Nonprofit sector regulation

– Harder to change

II.   Organizational Forms/Legal Structures

A.  Unincorporated Association

  •  California has statute
  • Lots of uncertainties nonetheless
  • Liability issues
  • Many smaller nonprofits fall into this category – social clubs, athletic organizations, condo owners, religious orgs etc.
  • Defined as two or more persons organized for a common nonprofit purpose.
  • Advantages:
    • Ease of organization
    • Informality with which it can act.
    • Relatively few statutory formalities.
    • California does have its own statute limiting members’ liability and allowing the association to hold real property.
  • Disadvantages:
    • Lack of certainty in law re rights, duties and liabilities of member, directors, officers and agents.
    • Lack of standard of care for a director.
    • Lack of express operating authority, must rely on agency principles.

B.  Charitable trust

  •  Oldest type
  • Fiduciary relationship to property – trustee has legal title subject to equitable duties per terms of trust instrument.
  • Governing instrument is trust agreement or instrument
  • Benefits community.
  • In CA, charitable trusts are enforced by AG (and governed by Probate Code 15000 et seq)
  • In California, a trust may be created for any purpose that is not illegal or against public policy. C sec. 15203.
  • A charitable trust is one that is created for religious, charitable, scientific, literary, educational or other purposes listed in IRC sec. 170(c)(2)(B). C sec. 15205.
  • Advantages
    • Fewer required formalities than corporation to establish and operate.
    • Can allow continuing control by grantor by naming trustees and successors and specifying purpose.
    • Can be easily and quickly formed.
  • Disadvantages
    • High standard of care and liability of trustees.
    • May not be appropriate for entity that intends to engage in operating activities or intends to have members or community involvement.
    • May be difficult to change if need be; likely need to go to court.

C.  Nonprofit Corporation

  •  General comments
  • Predominant form
  • There is statutory guidance and caselaw = certainty
  • Governed by statute
  • Governing instrument is articles of incorporation
  1. CA forms
  1. Public benefit corp: CA Corp C. Part 2
    • Formed exclusively for any public or charitable purpose. Corp C. § 5111
    • Distributions prohibited. Corp C. 5410
    • Public benefit: do good works, benefit society or improve human condition
  1. Mutual benefit corp: CA Corp C. Part 3
  • May be formed for any lawful purpose, except exclusively charitable purposes, Corp. C. § 7111
  • Further common goals of members, whether economic or social.
  • Trade associations, social clubs, fraternal associations.
  • Many have members, and members often have more rights; may get distribution upon dissolution.
  1. Religious corp: CA Corp C. Part 4
  • Formed primarily or exclusively for religious purposes. Corp. C. § 9111.
  1. Formation of PBC
    • Decide where (usually home state).
    • Decide what type
    • Prepare articles
      • CA Corp. Code 5130: Requirements for Articles of Incorporation—must set forth
        1. Name of corporation
        2. Statement of purposes (see statute for wording)
        3. Name and address of agent for service of process
      • File articles with Sec of State.
      • Prepare bylaws (don’t use model).
      • Hold organizational meeting to elect officers, directors, authorize next steps.
      • Get EIN, open bank account.
      • Prepare tax exemptions (federal and state).
  1. More Info on PBC
  • To do good works, benefit society, improve human condition.
  • 501(c)(3) or (4).
  • May have members; may have voting rights.
  • Members cannot have economic interest.
  • AG has oversight.
  • Religious corporations are also within 501(c)(3); less AG oversight.
  • Assets to another nonprofit upon dissolution.

III. Purposes

A. General Rule

GR is any “proper” purpose is acceptable as long as org follows nondistribution and there’s no personal pecuniary profit

  1. Lawful purpose requirement: Cannot be for an illegal purpose
  1. Public policy
  2. It’s within state power to find a purpose invalid if against public policy
  3. This is usually handled as an issue of tax exemption (eg Bob Jones U, racially

discriminatory admissions policy incompatible with charitable purpose)

B.  Commercial Purposes

  1. People ex rel. Groman v. Sinai Temple p 81, Cal. App. 1971
  • Nonprofit may engage in commercial, competitive, profit-making business as one of its main intended activities.
  • These activities can benefit its members (here as a discount) without amounting to a distribution.
  • This case was decided under a no longer operational statutory scheme
  1. CA Corp C. § 5140(l): Powers of PBC

Carry on a business at profit and apply any profit that results from the business activity to any activity in which it may lawfully engage.

  1. Commercial Activities and Property Tax Exemption
  • This is where the action is.
  • State property tax exemptions generally construed more narrowly than federal income tax exemptions.
  • Nonprofit hospital and questions of charity care have been a particular battle ground.
  • California has its own different categories and elaborate rules for property tax exemption.

C.  Charitable Purposes

  1. Restatement (Third) of Trusts has six categories, not inclusive:
  • Relief of poverty
  • Advancement of education
  • Advancement of religion
  • Promotion of health
  • Government or religious purpose (this has also been said as lessening

burden on gov’t)

  • Other (beneficial to community)
  1. Preamble to Statute of Charitable Uses
  • First comprehensive definition of charitable purposes.
  • Regarded as starting point of modern law of charity.
  • [partial list] relief of aged, impotent and poor people, maintenance of sick and maimed soldiers and mariners, schools of learning, free schools and scholars in universities, repair of bridges, ports, havens, causeways, churches, seabanks, highways, education and preferment of orphans, relief or maintenance of houses of correction, help of young tradesmen and persons decayed, relief of prisoners and aid for poor inhabitants
  1. 501(c)(3)

…religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition, or for prevention of cruelty to children or animals…

  1. Cases

Commissioners v Pemsel p 91 1891, British case

  • Recognizes trust for relief of poverty, advancement of education, advancement of religion, and “trusts for other purposes beneficial to the community,” which can benefit rich as well as poor.
  • England has recently enacted new law as to charitable public benefit and how organizations must demonstrate it.
  1. De Costa v De Paz p 94, Chancery, 1754
    • Judaism contrary to law of land, but because of religious purpose of trust, funds diverted to support ministers in Anglican Foundling Hospital.
  1. Test for Charitable Purpose
  2. Rebuttable presumption of validity if within a traditional class
  3. If not, would rational persons in general believe public advantages accrue?
  1. UK Charities Act: 13 charitable purposes; no presumption—all must demonstrate

(Forcing demonstration isn’t working very well)

  • Prevention or relief of poverty
  • Advancement of education
  • Advancement of religion
  • Advancement of health or saving of lives
  • Advancement of citizenship or community development
  • Advancement of the arts, culture, heritage or science
  • Advancement of amateur sports
  • Advancement of human rights, conflict resolution or reconciliation, or the promotion of religious or racial harmony or equality and diversity
  • Advancement of environmental protection or improvement
  • Relief of those in need by reason of youth, age, ill-health, disability, financial hardship or other disadvantage
  • Advancement of animal welfare
  • Promotion of the efficiency of the armed forces of the Crown, or the efficiency of the police, fire and rescue services or the ambulance services
  • Any other purposes recognized as charitable under existing law; as analogous or within the spirit or falling with the act or recognized as such after new Act comes into force.

IV.  Dissolution

A.  Dissolution of trust

  •  Private settlor has no rights.
  • Depends on trust’s terms.
  • See sample, p 957 supp; how to draft a term allowing dissolution
  • Likely court would use cy pres upon dissolution if terms of trust not flexible.

 

B.  Distribution of Remaining Assets

 Public Benefit Corporation

  • Assets remaining after liabilities are satisfied must go to a c-3. (c-4 for c-4)
  1. Mutual Benefit Corporation
  •  Assets (other than any dedicated to charity) that remain after liabilities are satisfied may be distributed to members.
  • See Corp. C. § 8716-19. p. 43 of statute book. Distribution can be in money, property, or securities. If different classes of membership, they can get different amounts of the assets

Los Angeles Cty Pioneer Society case p 102 (question of whether was PBC or MBC)

Cal. 1953, ct found the distribution of assets to members improper diversion of assets. Purposes=cultivate social intercourse among members, collect and preserve data on early LA history, collect and preserve articles and artifacts, perpetuate memory of historic figures, …

B.   Voluntary dissolution

  1. Authority to dissolve— CA Corp. C. § 6610, 8610 (HO); identical provisions
    1. Approval of either of the following allows dissolution
      • Majority of all members (majority of all votes entitled to be cast)
      • Board and members (majority of all votes actually cast)
    2. Approval of board alone allows dissolution for the following corporations
      • Bankrupt corporation
      • Corporation with no assets that has not conducted any activity for 5 preceding years
      • Corporation with no members
      • Corporation required to dissolve under its articles (we don’t need to know this)
    3. Process for dissolution— See HO I Guide; checklist (HO) * Remember AG approval is required
      1. Resolution to dissolve
      2. Certificate of election to wind up and dissolve filed with Sec of State (not always required)
      3. Notice to AG and request of waiver to objections to proposed distribution of assets (See section VII)
      4. Notice to members and creditors
      5. Winding up of operations, payment of liabilities, distribution of assets
      6. Certificate of dissolution filed with Sec of State
      7. If corporation holds assets in charitable trust (only some MBC’s do not), notice to Registrar of Charitable Trusts
      8. Filing of final informational tax return with AG (if corporation was required to file 990)

C.   Involuntary dissolution

  1. Dissolution forced through court action— CA Corp. C. 6510, 8510 (HO)
    1. Parties who may seek dissolution
  • Half or more of directors in office
  • Person(s) representing 33 1/3 of voting power excluding voting power held by those who participated in fraud, mismanagement, etc (see b(5) below)
  • Any member if ground is formation period has terminated
  • Anyone expressly authorized by articles
  • AG [for MBC, AG only if corporation holds assets in charitable trust]
  • Head organization of a subordinate corporation
  1. Grounds for dissolution [8510 has some additional grounds for MBC; see statute]
  • Corporation abandoned activity for > 1 yr
  • Corporation has even number of directors who cannot agree, leading to potential impairment of property or activities, AND members cannot elect a board with an odd number of directors
  • Internal dissention and deadlock among members
  • Members have failed to elect successor directors over 4 years or two consecutive meetings or written ballots
  • Those in control have countenanced fraud, mismanagement, or abuse of authority, or directors/officers are misapplying or wasting property
  • Corporation is failing and has failed to carry out its purposes, making liquidation reasonably necessary
  • Formation period has terminated without extension
  • Corporation is required to dissolve under its articles
  1. AG is an indispensible party
  1. Attorney General dissolution rules—CA Corp. C. 6511, 8511 (HO) (see also AG section below)
    1. AG may sue on own information or on complaint
    2. Grounds
      • Corporation violated law regulating corporations or charitable organizations
      • Corporation fraudulently abused or usurped corporate privileges and powers
      • Corporation violated any law that calls for forfeiture or corporate existence
      • Corporation failed to pay taxes to FTB for 5 years
    3. If the corporation may fix the problem by amending its articles, AG must give notice and opportunity to fix before filing suit for dissolution
    4. Court may order dissolution or partial relief
  1. Conversion from Non-profit to For-profit and other Nonprofit Structuring

 We need only to know that the issues with HMOs, hospitals and health care re structuring among for-profit and nonprofit entities are many and complicated.

  1. Cy Pres and Deviation; Approach for California Corporations
  • Trusts are always under jurisdiction of courts—changes to purposes must be done through court using cy pres principles
  • For a trust, a court is involved for changes or dissolution, ie cy pres can result in a change or in dissolution.
  1. Cy Pres
  1. R2d versus R3d
  • Restatement (2nd) of Trusts (1959) (Most courts use R2d; including CA)
    • Particular charitable purpose becomes “impossible or impracticable or illegal,” court will direct property to some charitable purpose which falls within the general charitable intention of the settlor.
    • This is standard applied in most cases we read.
    • Standard means the organization cannot continue under the circumstances; e.g., expenses exceed revenues.
  • Restatement (Third) of Trusts (2003):
    • If “designated purpose” becomes “unlawful, impossible or impracticable” or to the extent “it is or becomes wasteful,” court will direct property “to a charitable purpose that reasonably approximates the designated purpose.”
    • Waste = inefficiency
    • Might this test lead to different results?
  1. General Principles
  • Settlor must have general charitable intent for doctrine to apply.
    • Evans v. Abney (p 108) – no general charitable intent, no cy pres

Ga. case, pool for white people; the gift failed.

  • Power is strictly construed and narrowly circumscribed.
  • Frustration must be great.
  • Change must be supposedly as small as possible.
  • Examples
    • Trust to end slavery to trust for former slaves.
    • Money in trust for home for cats to society that cares for abandoned animals. Based on impossibility
    • Scholarships for white females to scholarships for females.
    • Trusts for male students or Protestant Boys to trusts for students.
      • Less likely to apply doctrine for gender or religious discrimination unless state action.
    • If legatee refuses because of restriction, court has options:
      • Remove restriction
      • Hold for another institution
      • Give to testator’s next of kin
    • Court likely to try to discern testator’s intent.
  1. Buck Trust p 109

Calif 1980s—shows how strict the CA cy pres standard is

Beryl Buck left estate in 1975 to charitable trust to provide for needy in Marin County and other charitable purpose in the County. At time worth $7-10 million. Administered by SF Foundation. By 1985, worth $380-400 million. Marin small and one of wealthiest counties in California; in 1985 only 20,000-30,000 below poverty line. In 1984, Foundation petitioned to modify trust to expand area under expansive interpretation of cy pres. Argued for equity and charitable efficiency. AG at first support but then switch sides.

  • Settled out of court.
  • No cy pres allowed, because ineffective philanthropy and inefficiency did not meet “impracticability” standard.
  • Foundation removed as trustee.
  • Court ordered creation of Marin County Community Foundation to be trustee.
  • It has 7 trustees – 2 appointed by County Board of Supervisors, one by Pres of UC, one by Interfaith Council of Marin, one by relatives of Mrs. Buck’s husband and one by the Foundation board.
  1. Deviation
  1. Idea: to help accomplish the purpose by changing technical provisions
  • Allows court to alter administrative or distributive provisions of trust (rather than its purpose).
  • Standard: compliance with these provisions is impossible or illegal or due to circumstances unanticipated by settler; compliance would defeat or substantially impair accomplishment of purposes of trust.
  1. Line drawing can be a problem with deviation vs cy pres—ie, many courts will say they’re applying deviation when really it looks more like a change of purpose
  1. Barnes Foundation, p 111

Pennsylvania Court of Common Pleas, 2004

  • Can Barnes Foundation expand the board and relocate collection to Philadelphia under doctrine of deviation?

– Size of board is purely administrative; demands and expertise needed by nonprofit boards was unforeseen circumstance by settlor; maintaining status quo would impair accomplishment of purpose.

– Court determines that 3 campus model with art collection in Philadelphia the least drastic modification to ensure public exposure of collection and preserve primary mission – formal education program.

  • This decision continues to be very controversial in the Philadelphia area, some arguing that it failed to protect the donor’s intent and thus would curtail philanthropy; others arguing that there was a public interest in protecting the collection and that the benefit of tax exemption undermines the principle of absolute donor control.
  1. California Corporations Rules
  1. Charitable Trust Doctrine: CA NPC holds assets in charitable trust for public benefit
  1. Trust purposes are defined by the articles of incorporation. Corporation and directors have a fiduciary duty to use assets only for the specified purposes.
  1. Amendment is possible for changing purpose going forward only.
  2. Assets received before amendment still dedicated to previous purpose
  1. Change to use of assets in charitable trust must meet cy pres standard(impossible/impracticable to continue carrying out the original purposes).

*    But NOT cy pres procedure: AG would have to be involved.

*    EA isn’t sure whether a court would have to be involved to declare the purpose was impossible/impracticable, or the AG could approve alone

Lesson: make purposes in articles as broad as possible

  1. Solicitation of funds can create charitable trust. There is a duty to use charitable funds for the purposes declared to the person from whom solicited
  1. Deviation is allowed per CA Corp Code 5241
  1. CA PBC’s must give notice to AG for: dissolutions, mergers, sale of all or substantially all of assets, change of corporate form from PBC to MBC, if corporation has assets.
  1. Charitable trust doctrine may also affect directors’ fiduciary duty standards

VII.    Distribution of Assets of Public Benefit Corporations

  1. Ownership Rights
  •  Whether a PBC has full ownership rights over assets or they’re held in
  • Charitable trust is related to some extent to the standard of conduct for those responsible for managing the entity (See “Norms of Behavior”
  • CALIFORNIA is sui generis here. AG must approve any sale of all or substantially all of the assets, as well as any merger

2.  Norms of Behavior

  •  For Charitable Trustees
  • Charitable trustees subject to strict fiduciary norms.
  1. For Directors of PBC’s
  • Generally believed to be somewhat lower
  • Issue, however, is uncertain. Restatement of Trusts is “mealymouthed”
  • Especially uncertain in California, with our notion of assets held in charitable trust per purpose stated in articles.
  • But all charitable corporations must honor gifts given for specific purpose or with restrictions or conditions placed on use. * If restricted gifts w/ specific purpose, cy pres or deviation applies
  1. CA Requirements for Distribution on Dissolution (HO I)
  1. Intended recipient must
    1. Have same IRS exemption
    2. Have same charitable purpose
    3. Be current in reporting obligations
  2. Must seek waiver of objections from AG
    1. Letter detailing recipients, assets to be distributed, date of distribution, recipient’s Articles of Incorporation or trust instrument
    2. Copy of certificate of election to wind up and dissolve or certificate of dissolution
    3. Form 990 copies for prior three years (or if d/n file 990, financial statements)
    4. Copy of Articles of Incorporation
  1. Cases
  1. Matter of MS Service Organization of NY, p 121

NY Ct of Appeals, 1986

  • Dissolution of NY public benefit corporation
  • Should funds go to organizations that emphasize long-term treatment, although not for MS, or to national MS society?
  • Court concludes that trust cy pres standard of “as near as possible” does NOT apply.
  • Need only quasi cy pres standard of “substantially similar activities.”
  • Moreover, board of directors in first instance is to determine to whom distribution should be made.
  1. Queen of Angels v Younger, HO

Cal App 1977

  • Important California case; AG continues to rely on it.
  • For many years, nonprofit corporation operated hospital, instructed nurses and medical students, operated a clinic, and performed general charitable work. In 1971, its board proposed to lease out hospital and use monies to operate outpatient clinics only. Undisputed that outpatient clinic not functionally equivalent to a hospital. AG challenges.
  • Under articles of incorporation, Queen held it assets in trust primarily for the purpose of operating a hospital.
  • Cannot abandon that purpose, however worthy the other uses.
  • “[A]ll the assets of a corporation organized solely for charitable purposes must be deemed to be impressed with a charitable trust by virtue of the express declaration of the corporation’s purposes.”
  • The articles determine the purposes and the uses to which trust funds may be put.
  • Note that amendment of articles has only prospective effect.

VIII.   Fiduciary duties

A.   General

  1. Comparison between duty and operation for trusts and NPC boards
  1. Trustees
  • Operational duties are per terms of instrument
  • Unless instrument states otherwise, meetings, elections, quorums, etc. not required.
  • Title to property in trustees.
  1. NPC board
  • CA Corp C 5210: Activities conducted and powers exercised by or under direction of board. Board may delegate but must provide ultimate direction
  • Board is legally accountable. But it’s hard to get s/o to sue
  • Has rights and obligations.
  • CA Corp Code 5227: Not more than 49% of CA NP Corp may be interested (compensated except as director, or certain relative of one being compensated)
  1. Comparison of fiduciary duty standards for trustees and NPC directors
  • Trustees are governed by Trust Law (Probate Code § 15000 et seq)
  • Trustees’ duties are stricter than duties of corporate directors
  • In CA, esp given doctrine of charitable trust, the difference is very small
  • Bigger difference is that trustees have more limits on what they can do with assets
  • Also, for trustees, self-dealing transactions are presumed to be a violation of the trustee’s fiduciary duties (Prob. Code § 16004(c))
  1. Comparing NPC board and for-profit board
  2. Fundraising is NPC board duty, including board members making donations
  3. Measuring performance: success at mission vs financial bottom line
  1. Suits for Breach of Fiduciary Duty
  2. General provisions for breach of fiduciary duty in CA: § 5142, Breach of Charitable Trust
  3. Suits for breach of fiduciary duty sound in equity
  1. Who Is Subject to Fiduciary Duties
  2. Directors: Per statutes
  3. Trustees: Per trust law
  4. Officers: Sometimes per statutes and other times per case law (also maybe as below)
  5. High-level managers: per case law, employment agreements, and the inherent duties of the position
  1. Membership rights
  1. Fitzgerald v NRA (US DNJ) p 143
  • NRA magazine refuses to carry ad of dissident candidate for Board.
  • Management of magazine has duty of decency & fair dealing as corporate publication of NRA integral to election process.
  • Must alert membership of dissident’s candidacy.
  • But not required to allow candidate to solicit campaign contributions in ad.
  1. CA Corp Code 5056: Definition of “Member”
  2. Person who has right to vote for
    • election of director
    • disposition of all or substantially all of the assets
    • merger
    • dissolution
  3. Person designated as member in articles or bylaws and has right to vote on changes to articles or bylaws
  1. More on fair dealing with membership
  • San Diego Museum note case p 148 (Cal App 1986)– technical compliance with bylaw procedure not enough when reducing membership rights.
  • The Sierra Club example p 148
    • 360 enough to run for board.
    • If low electoral turnout, dissidents could win.
  • How to balance not entrenching the board with not encouraging instability.
  • CA Corp C § 5521: example of statute trying to strike a balance
    • Under 5000 members –nomination by 2%
    • 5000 or more: 1/20 of 1% but not less than 100 or more than 500.
  1. Duty of Care
  1. General rule (but see CA specific formulation below)
  • Directors must act
    • In good faith
    • With diligence
    • Attention, care, skill
    • On an informed basis.
  • “Best” judgment rule applies
  • * When circumstances indicate cause for suspicion, the duty of care imposes a heightened duty to reasonably inquire and not rely on other directors’ or outsiders’ opinions
  • Courts look at process of decision making, not correctness of results.
  • Investment Responsibility is part of duty of care, but has more specific rules (see section G)
  1. Components
  1. Duty of Attention

Duty to properly manage or supervise the corporate entity

  • Regular attendance at board meetings
  • Review of minutes and written materials
  • Periodic meeting with senior management
  • Review of books and records
  • Review of financial statements
  • Questioning outside experts such as accountants and attorneys
  • Staying informed through inquiry of staff, etc.
  1. Duty of Informed Decision Making

Duty to make informed decisions about important transactions and fundamental changes in the way the corporate entity operates

  • Listening to presentations by staff regarding the decision
  • Reviewing written materials explaining the decision
  • Hearing advice and recommendations of outside experts
  • Debating and deliberating regarding a proposal
  • Gathering information from comparable institutions
  • Requesting additional relevant information if needed
  • The more fundamental the change or important the transaction, the greater the need for deliberation—i.e., need to consider the decision over more than one meeting
  1. Cases
  1. Pepperdine Foundation p 152

Cal.App. 1954

  • CA case.
  • Allegation that directors dissipated funds through illegal and speculative transactions.
  • Court rejects liability for nonfeasance, neglect, mistake of judgment, because of voluntary service for public good.
  • No longer law, but attitude lingers. Overruled by Holt (Cal.; discussed in Q of A; Q of A is more important case)
  1. Lynch v Redfield Fdn p 158: trust standard

Cal.App. 1970; BUT superseded by statute (see below)

  • California case
  • Directors have dispute and cannot agree on management
  • Money sits in non-interest bearing account for 5 years.
  • Court says assets of charitable corporation impressed with trust.
  • Thus, trust standard of “prudent man investment rule” applies.
  • That standard not met here.
  • Good faith will not protect – joint and several liability for trustees for negligence.

More on Trust Standard

  • Trustees are liable for mere or simple negligence. Easy to violate
  • Trust standard includes potential for substantial personal liability.
    • Example in text (p 160) of trustees being ordered to pay actual investment losses when retained interest sensitive securities during a period of adverse market conditions.
  • Nonprofit directors no longer subject to trustee standard – sec. 5230(b).
  1. Stern v. Lucy Webb Hayes Nat’l Training School for Deaconesses p 160

AKA Sibley Hospital (US DDC 1974)

  • Famous case.
  • Known for adoption of corporate standard.
  • Under bylaws, board, Executive Committee, Finance Committee, and Investment Committee to meet.
  • In fact, two trustees dominate from 50’s through 1968.
  • Some changes in 1968 when one such trustee die; Finance and Investment Committee first meet in 1971; trustees begin identifiable supervisory role over investment policy and fiscal management in 1972 when other such trustee die.
  • Director must often have committed “gross negligence.”
  • Directors must exercise “ordinary and reasonable care,” exhibiting “honesty and good faith.”
  • Directors may delegate responsibility, even for investment decisions, but must exercise supervision over delegatees.
    • Total abdication is impermissible.
    • Must obtain enough information to supervise.
    • Must attend meetings at which policies are considered.
    • Must review delegatee’s reports.
    • If director’s failure to supervise permits negligent mismanagement by others to go unchecked, the director has committed an independent wrong.
  • Court’s findings
    • Breach of fiduciary duty in failing to exercise due diligence in supervising those to whom responsibility for financial and investment decisions had been delegated.
    • Failure to disclose self-dealing transaction. .
    • Failure to disclose why transaction might not be in best interest of organization.
    • Voting to approve self-dealing transaction. (should have recused themselves)
  1. Distinction btw simple and gross negligence is mushy; consensus is the line is too unclear. Hard to know b/c cases tend to stay out of court unless egregious—ie both standards would be violated.
  1. NP Corporate standard is considered lower than for for-profit corp
  1. California Statutes:
  1. CA Corp C § 5230 says the trustee standard does not apply for NPC in CA

CA follows corporate standard (gross negligence)

  1. CA Corp C. § 5231:

(a) A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.

* “reasonable inquiry” means directors cannot be passive

(b)  Dir’s can rely on others: § 5231(b)

  • Officers/employees; outside experts; board committees
  • BUT, if there are any red flags, director MUST inquire (duty of attention issue)

(c)  If you act in good faith, best interests, w/ care, inc reasonable inquiry, relying appropriately on others, you’ll have no liability no matter how disastrous the results

  1. CA Corp C. § 5210: Delegation of management duties is allowed, subject to ultimate supervision by BoD, w/ duty of care to supervise adequately. (duty of attention issue)
  1. CA Corp C. § 5236 and 5237: liability for distributions and loans/guarantees
  • 5236 prohibits corporations from making loans or guarantees to directors or officers
    • Exceptions: AG approval; paying life insurance premiums; advances for expenses for which reimbursement would apply; loan necessary for purchase of principle residence to secure officer’s services (applies for officers only)
  • 5237 creates joint & several liability for approval of distributions, distributions of assets after dissolution without paying liabilities, making loans or guarantees contrary to § 5236
  • Approval of such transactions may be breach of duty of care
  • Director who receives such benefits may violate duty of loyalty
  1. CA Corp C. § 7236 for MPC
  • Liable for distributions contrary to statute; distribution of assets after dissolution without paying liabilities, making loans or guarantees contrary to § 7235.
  1. Duty of Care for Investments: See section G for specific provisions
  1. Best Judgment Rule

Courts will not second guess action of directors IF

  • Informed decision
  • In good faith
  • Without conflict of interest.
  1. Liability
  1. Causation requirement (how much loss is directly caused by the breach)
  1. CB note (p 169): “duty of care is quite low, and statutory developments have made liability improbable except in the most egregious cases such as improper loans or distribution of corporate assets”
  1. Limitations of Liability
  1. CA Statutory Limits on Liability
  1. CA Corp C. § 5231: Standard of Care (fiduciary duty provision)—for directors only
  • Subsection (c) provides for no liability for directors who act in accordance with 5231
  1.    CA Corp C.§ 5047.5: Action for Damages Against Directors and Officers
  • No action for monetary damages can be brought for negligent act or omission of uncompensated officer or director:
    • Within scope of duties,
    • in good faith,
    • believed in best interest of corp,
    • in exercise of policymaking judgment
  • Nonprofit must maintain general liability insurance
  • EXC: (c) Limit doesn’t apply to self-dealing, conflict of interest, distribution, loan or guarantee, action by beneficiary against trustee, action by AG; intentional, wanton or reckless, grossly negligent, or based on fraud, oppression or malice.
  • Applies to c-3’s and c-6’s (business leagues). (not c-4 or c-5)
  • Nonprofit cannot discriminate on various bases (eg race, sex, disability, age).
  • Officer or director cannot be employee.
  • EA note: this standard is lower than § 5231 standard for duty of care. Director can have liability limitation even if hasn’t met corporate standard
  1.    CA Corp C. § 5239 limits liability to third parties for negligence
  • No personal liability of volunteer executive officer or director to third party for monetary damages for negligent act or omission if all the following are met
    1. Within scope of duties
    2. in good faith.
    3. Act was not reckless, wanton, or grossly negligent
    4. Damages are covered by liability insurance policy or corporation and director/officer made reasonable efforts in good faith to obtain insurance (unsuccessful)
  • Provision for reasonable efforts to obtain insurance is main difference from § 5047.5
  • (h) provides safe harbor for reasonable efforts by PBC w/ budget <$25,000
  • EXC: d/n apply for self-dealing or for distributions, loans or guarantees.
  • EXC: d/n apply to suits brought by AG (5239(e)(2))
  • EA note: ambiguous wording, and no case law to help understand meaning
  1. CA Corp C. § 7231.5 limits liability for directors of MBC
  • No personal liability and no action for money damages can be brought against volunteer executive officer or director if all the following are met
  1. Duties performed in good faith
  2. Duties performed in manner person believes is in best interests of corp
  3. Duties performed w/ such care, including reasonable inquiry, as an ordinarily prudent person in like position would use under similar circumstances
  1. Federal Volunteer Protection Act p 214 of statutory supplement. We d/n need to know
  • Attempt to limit volunteer liability.
  • Seen as problematic.
  • Note State law can limit volunteer liability protection subject to provision of insurance.
  1. CA Corp C. § 5238 and 7237 (HO II) (nearly identical): Indemnification

* In practice, more important than statutes limiting liability

  • Statute gives corporation power to indemnify.
  • Must be determined in each case whether the standard of conduct was met
  • With specific approval, usually by board.
  • Must determine that the person acted in good faith and in manner believed to be in best interests of corporation, and in criminal case had no reasonable cause to believe conduct unlawful.
  • EA note: this isn’t the basic corporate standard (omits “with such care…”)
  • See sample bylaw provision on indemnification and insurance. (HO II p 5-6)
  1. Duty of Loyalty
  1. General rule and overview
  • Director must act in way that does not harm the corporation. CA Corp Code§ 5231: Duty of Good Faith

(a) A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interests of the corporation and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.

  • Director must avoid acting on issues in which personal financial interests conflict with the corporation’s interests
  • Cannot obtain an advantage that belongs to the corporation.
  • If a director has an interest in a transaction, fact must be disclosed.
  • Many more cases here; easier to identify and measure.
  1. Nixon v. Lichtenstein p 179

Missouri Appeals, 1997

  • Foundation begins as trust; becomes corporation, as permitted in trust indenture.
  • Pays legal fees in estate litigation.
  • Pays directors salary above 5% cap in trust indenture; pays personal expenses.
  • Pays family members as administrative assistant and another as 1st VP and then as President and CEO.
  • In settlement, 7 of 9 board members resign and reimburse for fees in excess of 5% cap.
  • Two sue; trial court find they engaged in self-dealing, wasted assets, misused assets, and acting in manner inconsistent with best interests of corporation.
  • Remove them and appoint others.
  • Issue of trust v. corporate standard
    • Did it matter here?
    • Would it under California law?
    • Could problem be avoided by better drafting?
  • Would we see these same problems in a California family foundation
  1. See CA Corp C § 5227: no more than 49% of corporation’s board can be interested
  • Interested=
    • compensated for services (as EE or contractor; not as director), OR
    • certain relatives of those compensated for services
  • Policy rationale: PBC should not be controlled by insiders who cannot be expected to effectively supervise their own activities
  • Many family foundations use trusts or form in other states (NV, DE) because of this provision
  1. Self-Dealing Transactions

NB: for trustees, self-dealing transactions are presumed to be a violation of the trustee’s fiduciary duties (Prob. Code § 16004(c))

  1. CA Corp C. § 5233 p 12 of statutory supplement

* This does not require the interested director not to participate in the decision (But not participating is a best practices tip, advised by IRS)

  1. Self-dealing transaction=btw corporation and party in which a director has material financial interest
  • Doesn’t apply to officers/employees
  • Material financial interest” isn’t defined, and case law has not developed; thus, meaning is unclear.
    • EA thinks the interest must be relatively direct for the statute to apply (e.g., director who owns adjacent property whose value will increase if corporation buys property next door probably has too indirect an interest)
    • Materiality must be measured with respect to the particular director.
  1. Exemptions: compensation of directors; transactions in which directors get same benefit as anyone else as part of the charitable program; de minimis, i.e., small transactions director d/n know about
  1. Who can sue: AG; corporation or member; director; officer; relator [same as for 5142 except omits “person with reversionary interest]
  1. Processes for cleansing transaction—if cleansed, director is shielded from liability
  • AG, or court if AG is indispensible party, approves before or after transaction

What the AG wants in order to consider whether to approve a transaction:

11 Cal Code Regs 999.1(a) et seq; See HO III p 2

  • letter w/ material facts of transx and material interests
  • description of goods and services
  • price and FMV
  • benefit to corp
  • whether board has approved
  • if so, the factual basis for the approval and the disclosure made
  • alternatives considered and why they weren’t adopted
  • copies of articles, bylaws, financial statements
  • minutes of board meetings at which transaction was discussed
  • letter from interested director disclosing interest, unless redundant

AG will decide w/in 60 days; Request and response become part of corp’s public file at registrar of charitable trusts

  • Board approval before Summary of req’s (burden on director):
    1. Corporation entered into transaction for its own benefit (not director’s)
    2. Transaction is fair and reasonable to the corporation
  • Transaction is approved in advance by disinterested majority of all board members (not just majority of quorum) after disclosure of material facts
  1. Corporation could not have obtained a better deal elsewhere w/ reasonable effort (NB: actual statute is more complex on this point)
  • Committee approval before transaction
    1. All the requirements of (2) apply
    2. It wasn’t reasonably practical to get prior board approval
  • Board ratified the transaction at next meeting
  • If a director offers to provide services for free, board must make reasonable inquiry into whether it’s really free. If corporation must pay costs, it may be able to accept the offer (because no other service provider would do the work for free), or it might need to seek quotes from others—though that’s unrealistic.
  • If a board follows the required procedure, members will be protected from liability.

(e) SOL provisions: 2 years after notice filed w/ AG; 3 years after transaction; AG 10 years

(h)  Remedies under equity, including: account for and pay profits; pay value of use of property; return or replace property used

  1. Stern v. Lucy Webb Hayes Nat’l Training School for Deaconesses p 160

AKA Sibley Hospital (US DDC 1974) Also see above under Duty of Car

  • Again, uses corporate standard: “entire fairness” and “full disclosure” are required.
  • “Modified Corporate Rule” applies in this case. Adds third requirement that interested director must refrain from voting on or influencing a decision to transact business with a company the director has significant interest in or control of. This requirements is added “occasionally” by courts and was added by AHA [American Hospital Assn] in its guidelines and was added to Hospital’s by-laws.
  • Court declares standards (p 193)
  • Purpose not to punish but to prevent recurrence.
  • Notes that here the practices have been corrected, and “removal of defendant trustees would be unduly harsh.”
  • Relief ordered:
    • Requires written policies and other regular reports regarding business w/ companies w/ director interests
    • Directors must disclose affiliations with banks and firms doing bz w/ Hospital
    • Requires trustees to read Court’s order.
  1. Committee to Save Adelphi v Diamandopoulos, p 194

Board of Regents of Univ of State of New York, 1997

  • Some background.
    • Never any compensation committee; chair of board and two other board members set President’s compensation; other board members did not learn of it until it was in the press.
    • No attempt to settle with Board of Regents or AG.
  • Adelphi’s Insurance Coverage
    • Trustee with insurance expertise appointed to committee to explore options.
    • Committee appoints a firm wholly owned by her.
    • Firm says it needs other information from a bid from another firm, but never gets this information. they d/n attempt to get the info
    • Board believes and is told the firm is provided its services for free rather than for a fee. Info provided free for only first year
  • Lois Advertising campaign
    • Trustee Lois presents a proposal for new campaign to board without recusal (which NY law does not in fact require) and without considering other proposals or agencies.
    • Board thinks he is doing it for free.
    • Creative work is free, but Lois is compensated for production of ads and placement of ads.
  • Board members failed to act against trustees once it learned of conflict.
  • Recommend removal of all trustees.
  1. Bishop Estate p 204

Hawaii trust for school for native Hawaiians; IRS audit 1996 led to settlement

  • Fascinating story.
  • A lot of political activity and use of political influence.
  • Compensation based on statutory schedule for trustees.
  • Lead trustee system undermines very nature of board governance.
  1. Conflict of Interest Policies
  • NPC’s may choose to go beyond statutory requirements by creating policies.
  • IRS sample policy on supplement page 1065.
    • Requires interested director to leave room for discussion/voting
  • EA gave us links to Getty Trust and Ford Foundation policies (in Assignment 6 listing)
  • Policies are important, so this is a key piece of advice for counsel to provide NPC board
  • Policies can address things not addressed in statute, such as conflicts with employees (eg Getty policy, d/n allow employees to collect things the organization collects)
  1. Transactions between corps with common directors are governed by CA Corp C. § 5234:
  • A transaction between two corporations isn’t self-dealing just because same person is a director of both.
  • Transaction is ok if fair and reasonable to corporation OR board approves in good faith by vote of disinterested directors (even if common director is present)
  1. Statutes for MBC
  1. CA Corp Code 7233: Conflicts of interest; disclosure; common directorships; just and reasonable contracts
  2. Self-dealing provision
  • Somewhat similar to 5233 for PBC
  • Provides that self-dealing transactions are not void if
    1. Members approve transaction in good faith after disclosure of material facts of transaction and director’s interest
    2. Board or committee approves (by vote of noninterested directors) transaction in good faith after disclosure as above, AND transaction is just and reasonable as to the corporation, OR
    3. If not approved as above, it’s proved the transaction was just and reasonable as to the corporation when it was authorized, approved, or ratified
  1. Common directorship provisions
  • Almost identical to 5233 for PBC
  • Only difference is members may also approve a transaction
  1. CA Corp Code 7236: liability for illegal loans and distributions
  • Liable for distributions contrary to statute; distribution of assets after dissolution without paying liabilities, making loans or guarantees contrary to § 7235.
  • This can be a duty of loyalty breach for the director who receives the loan or distribution
  1. Corporate Opportunity Doctrine
  • For CA, apply ALI and case law
  • COD applies to both directors and employees (senior executives)
  1. ALI approach (applies to NPC and for-profit corps) SEE p 211 for full ALI
  • Chance to engage in an activity of which a director, officer or employee becomes aware
    • In connection with performing functions when person offering this opportunity expects it to be offered to nonprofit org
    • Through use of org’s information or property and individual should reasonably expect activity would be of interest to the org
    • Opportunity to engage in activity closely related to an activity in which org is engaged or expects to be engaged.
  • If a project is a corporate opportunity,
    • Fiduciary must first offer to nonprofit
    • And disclose any conflict.
    • To pursue without disclosure or rejection from nonprofit is breach of fiduciary duty.
  1. Northeast Harbor Golf Club v Harris p 206

Maine 1995

  • President of golf club purchases various property contiguous to club over time.
  • One offered in her capacity as president.
  • She discloses to club’s board each time the purchase and that did not intend to develop, at least at that time.
  • She does eventually develop, with her children.
  • Board sues her.
  • Court endorses ALI test for corporate opportunity.
    • Importance of disclosure to organization and its rejection.
    • Broad definition. Including becoming aware through role with organization or activity closely related to a business in which organization is engaged.
  • Remand to apply ALI test
  1. Duty of Obedience
  1. Definition: Duty to carry out the purposes of the organization as expressed in the articles of association or incorporation. Directors must be faithful to purposes and goals of nonprofit organization.
  1. Often considered part of the duty of loyalty; may not help to think of it as separate
  1. Issues with Duty of Obedience
  • Concern that duty of obedience to purpose of org or to donor’s intent can interfere with meeting contemporary needs
  • EA analogizes this to CA trust standard for assets, which similarly interferes with responding to current situations and meeting current needs
  1. Cases
  • Manhattan Eye , Ear and Throat Hospital v Spitzer, NY Supreme Ct 1989, p 220: In this case, court refused to approve the sale because it did not promote purposes of the corporation. They were going to close the hospital, which means they wouldn’t be carrying out the purposes of the hospital

They almost imported a charitable trust doctrine, but in CA this would not be possible

  • AG v Hahnemann Hospital, Mass 1986, p 220 note case: Hospital wanted to sell its assets and become a grant-making institution instead. AG protested, until trustees amended the articles to allow the sale of hospital assets Okay to sell assets AFTER amendment of articles.

* In CA, this would NOT be possible, because assets are dedicated to original purpose

  • Queen of Angels, Cal App. 1977: p 221, CB calls it a duty of obedience case: “directors violated their duty of obedience to an organization’s purposes when they voted to close a hospital in favor of neighborhood clinics….The essential framework of the purposes clauses was the operation of a hospital.”
  1. Investment Responsibility
  1. CA Corp Code 5240 gives Prudent Investor Rule
    1. Avoid speculation, and focus on permanent disposition of funds
    2. Comply with additional standards imposed by articles, bylaws, gift instruments
    3. Safe harbors if investment follows instructions in a gift instrument
    4. Directors must follow duties of loyalty and of care in 5231(a)
    5. Directors may rely on others as provided in 5231(b)
    6. Directors may delegate investment powers as provided in 5210
    7. UMIFA applies (assume now UPMIFA, CB supp p 82; also see below)
  1. CA Corp Code 5341

Courts may allow deviation from trusts and gift instruments regarding investment decisions, with notice to AG (5341)

  1. UPMIFA also governs in CA
    1. Only for endowments
    2. Gives much more flexibility in managing endowments than previously
  1. Director responsibilities with respect to investment policy
    1. Adopt the investment policy
    2. Provide oversight (per EA)
      • Have a separate investment committee
      • Have a written investment policy
      • Get regular reports comparing performance against benchmarks
    3. May rely on experts, but need some basis for the reliance (i.e., evidence of expertise)
    4. See UPMIFA for other specific standards and rules
  1. Origin of Prudent Person Investment Standard
  • Harvard College v Amory, Mass 1830, p 224, as origin of prudent person rule

– act faithfully and exercise discretion, as men of prudence, discretion and intelligence manage their own affairs as to permanent disposition of funds.

  • Prudent Person Rule sounds very flexible at its origin
  1. Revisions to Traditional Rule
  • Interpretations and application of the prudent man rule did not keep up with financial innovation and modern portfolio theory.
    • As applied, called for very conservative investment.
    • The rule as applied looked too much to performance and to individual investments rather than to process and total portfolio.
  • Bevis Longstreth’s Suggestions for Appropriate factors (p 227)
    • Role of investment in total portfolio
    • Whether that role serves purpose of portfolio when risk of loss and possibility of gain, diversification, risk, cash flow from income and capital gain in long and short term and need for cash are considered.
    • Competence of fiduciary or delegates
    • Terms and conditions of any delegation

UPMIFA (Uniform Prudent Management of Institutional Funds Act)—For endowmentfunds

CB supp p 82; see CB supp pp 9-12 for summary

  • Has been adopted in California. (Probate Code § 18500 et seq.)
  • Applies to investment of “endowment funds
  • Applies to “charitable institutions”: incorporated or unincorporated organizations (including trusts) operated exclusively for educational, religious, charitable, or other eleemosynary purposes § 1(a)
  • Also applies to trusts, but only if charity is the trustee (not if trustee is outside entity like a bank)
  • Of great importance in this economic climate regarding spending from endowments.
  • Creates a flexible prudence standard for managing and investing a fund when charity manages or is trustee.
  • Standard of Conduct in Managing and Investing Institutional Funds (§ 3)
  1. UPMIFA lays out fiduciary standards
  2. Duty of Loyalty applies
  3. Duty of Care articulation: “manage and invest in good faith and with the care an ordinarily prudent person in a like position would exercise under similar circumstances–§3(b)
  4. Sets out rules to apply unless a gift instrument supersedes –§3(e)
  • Allows an institution to spend or accumulate as much of an endowment fund as it determines is prudent under the circumstances (§ 18504) unless limited in gift instrument
  • Lays out factors to consider in managing and investment decisions–§3(e)(1)
  • Decisions must be made in context of portfolio and overall investment strategy
  • May invest in any kind of property or investment (no restrictions on type of investment)
  • Diversification encouraged but not required (see below for more)
  • When property is received, institution must do something with it in a reasonable time
  • Those with special skills and expertise has a duty to use them in managing and investment
  • No longer restricts spending to amounts above historic dollar value (fair market value of gifts at the time made).
    • Very important for underwater funds because allows use of principal.
    • Instead, charity is to preserve principal by using reasonable spending rate.
    • Subject to clear intent of donor as expressed in gift instrument, but boilerplate is considered insufficient to overcome the reasonable spending rate provisions. (§ 4)
    • California has adopted optional provision creating presumptive imprudence for spending more than 7% over last 3 years (§ 4(d))
  • Rules for releasing restrictions (§ 6)
    • Allows donors to release restriction.
    • Allows court to release restriction under cy pres standards.
      • In CA, must give notice to AG
    • Allows charity itself to release restriction for small funds over 20 years old.
      • Amount is $100,000 in California.
      • Must give notice to AG

Restatement (3d) of Trusts § 227

  • Provides new articulation of prudent investor rule
  • Requirements:
    • Consideration of purposes, terms, distribution requirements
    • Overall investment strategy, not in isolation (allowing riskier investments)
    • Diversification

Uniform Prudent Investor Act

  • Regulates the investment responsibilities of trustees of charitable trusts, among others.
  • Codified in California as part of Probate Code regarding investment of trust assets.
  • Served as a model for UPMIFA
  • Prudence applies to investment as part of total portfolio, rather than individual investment.
  • Fiduciary must consider trade-off between risk and return.
  • No prohibition on any particular investment; any investment that plays an appropriate role in achieving risk/return objective of prudent investing permitted.
  • Diversification is essential to prudent investing.
  • Delegation of investment and management specifically permitted.
  1. Movement to More Sophisticated Investment Strategies
  1. Endowments
    • Uses of endowments
      • Intergenerational equity— Spending for the future
      • Way to deal with inflation
      • Source of funds for bad times?
    • Draw on concept of investing for total return: income and appreciation
    • Recent losses in endowment funds and lack of liquidity, eg Harvard’s endowment dropped 22%
  1. Investment fraud and Ponzi schemes
  • Madoff scheme especially hit small family foundations without sophisticated investment committees.
  • Director’s duties in avoiding fraud: must monitor and follow up if there is evidence that an investment professional is faking reports, etc.
  1. Duty to diversify
  • UPMIFA creates no per se rule regarding a duty to diversify
  • 3(4): institution shall diversify…unless it reasonably determines that…purposes are better served without diversification
  • Best Judgment Rule would probably apply
  1. Socially Responsible Investing
  • Issue: whether socially responsible investing violates the prudent person standard, versus, if charities are created for public good, do fiduciaries have duty to do SRI or does it violate prudent person rule?
  • UPMIFA provides wiggle room: one factor is an asset’s special relationship or special value to the charitable purposes–§ 3(e)(1)(H)
  • Examples:
    • No investment in alcohol, tobacco, gambling, weapons, defense, nuclear power.
    • No investment in companies that violate human rights or labor statutes.
    • Invest in companies that have particularly good record on human rights or other issues.
  • Largest SRI Fund, Domini Social Equity Fund, with over $1 billion in assets, earned an average annual return of .86% for 5 years through March 06 as compared to 2.91% for S&P 500-stock index.
  1. Executive Compensation
  1. CA Corp Code 5235 [applies to compensation of directors, or officer who’s also director]

(a)  Board may fix compensation of directors as directors or officers (ie as board members or as employees)

(a)  OK for persons receiving compensation to participate in decision, unless not just and reasonable as to the corporation at the time of the decision

(b)  Liability is limited to the amount over a just and reasonable amount (plus interest), unless fraud was involved

  1. California Nonprofit Integrity Act (Gov Code § 12586(g)), supp p 48

[Applies to organizations that must register with the AG]

  1. Board or committee must review and approve compensation for CEO/president and CFO/treasurer
  2. Payment must be just and reasonable
  3. Review and approval must occur
    • At initial hiring
    • When a term is renewed or extended, AND
    • When compensation is modified
  1. Intermediate Sanctions Rules (Tax Code approach)
  • IRS has new rules about reasonable compensation for key employees (“insiders”) of 501(c)(3)’s and (4)’s.
  • Sanctions through excise tax penalties
  • Reasonable compensation must be supported by comparables.
  • May compare with for-profit sector.
  1. Forms of Regulation
  1. Self-regulation
  1. Methods
  • Norms: informal social regularities that individuals feel obligated to follow b/c of sense of duty or fear of nonlegal sanctions.
  • Best practices and principles: Guidelines to wh/ NP members adhere. Charity watchdog groups compile these.
  1. Issues
  • Low level of enforcement and oversight leads to need for self-regulation
  • Self-regulation isn’t that effective, per EA—there’s still a need for checks and balances
  1. Recordkeeping
  1. Summary of requirements for CA PBC’s
    • Keep books and records of accounts [6320]
    • Keep minutes of meetings of members, board, and committees of board [6320]
    • Membership lists [if there are members] [6320]
    • Prepare annual report for members and statement of transactions with interested persons [6321 and 6322]
  1. Specific CA governing statutes [See paper inside statute supp for more detailed summaries]
  • CA Corp Code 6215: Liability for required filings

Officers, directors, employees, or agents liable jointly and severally for damages from involvement in falsifying documents

  • CA Corp Code 6216: Enforcement for required filings

AG may enforce in response to complaint or on her own

  • CA Corp Code 6320: Books and Records (8320 for MBC)

Corporation must keep

  1. Books and records of accounts
  2. Minutes of meetings of members, board, and board committees
  • Membership lists
  • CA Corp Code 6321: Annual report
  • CA Corp Code 6322: Annual Statement of Transactions with Interested Persons and of Indemnifications
  • CA Corp Code 6323: Judicial enforcement; award of expenses and attorney fees
  • CA Corp Code 6811-14: Listing of crimes and criminal penalties related to directors’ actions with respect to recordkeeping requirements
  1. Member and Director Rights
  1. Summary
  • Members may inspect and copy members’ names, addresses, and voting rights for stated proper purpose. [6330]
  • Members can inspect records for proper purpose at reasonable time. [6330]
  • Directors have absolute right at any reasonable time to inspect and copy books and records. [6333]
  1. Specific CA governing statutes
  • CA Corp Code 6330: Demand for inspection
  • CA Corp Code 6333: Accounting books, records, and minutes are open to inspection
  • CA Corp Code 6334: Directors’ rights: absolute right to inspect at reasonable time
  1. Government Filings
  1. CA filing requirements—All charitable organizations must register 30 days after they acquire property (some exemptions apply, as below for CNIA). All that must register are subject to these filing requirements.
    • CT-1, Initial Registration Form, filed with AG—see HO III
    • RRF-1, Registration Renewal Fee Report; filed annually with AG—see HO III
    • SI-100 (Statement of Information) filed with Secretary of State biennially—see HO III
    • Form 199 with Franchise Tax Board, annually
      • May do only page 1 and attach Form 990 if you prefer
    • Form 990 filed with AG (IRS Return of Organization Exempt from Income Tax), annual
      • Organizations with <$25k revenues and <$25k assets may file every 10 years instead of annually
  1. Federal filing requirements
    • Form 990 with IRS, annual
      • Form 990-N e-Postcard required for “tiny” nonprofits
  1. California Nonprofit Integrity Act, summary on Supp pp 47-54
  1. EA summary
  • Sarbanes-Oxley-type requirements
  • Applies to organizations that have to register with the AG
  • Does not apply to government entities, schools, religious organizations, hospitals, licensed health care service plans, cemetery corporations, PAC’s, trusts where bank is sole trustee (b/c they don’t need to file reports w/ AG)
  • Charities with revenues over $2 million must have audit and make it public.
  • Charities that must have an audit must appoint audit committee excluding paid staff, CEO/president, or CFO/treasurer—for CEO and CFO, this does not apply if they are acting only as directors, not as staff
  • Must review compensation of CEO and CFO as just and reasonable.
  • Many requirements re fundraisers. [see Section X on regulation of solicitations]
  • Expansion of SOX into nonprofit sector in other states has not materialized.
  1. Other requirements and notes per supplement summary
    • Charitable organizations have 30 days to register and file AoI with AG
    • Charities w/ gross revenues over $2 million: excludes government grants for which accounting is required
  1. Enforcement of Fiduciary Obligations
  1. Standing for Breach of Charitable Trust (NB: only applies to NP corps, not trusts)
  • CA Corp Code 5142 provides for power to bring an action for breach
  • Who can sue under this section:
    • Corporation
    • Member in corp’s name (derivative; CA 5710, not assigned)
      • Must show member tried to get board to act and they refused, OR
      • Must show futility
    • officer or director (EA note: not honorary directors, only those w/ fiduciary duties);
    • s/o with reversionary, contractual, or property interest in assets subject to charitable trust (EA note: you’d need to prove breach, and info to do so is not easy to get);
    • AG
    • Relator
      • AG controls suit
      • Relator bears costs;
      • Done in quo warranto proceeding;
      • Status rarely granted
  1. Role of Attorney General
  1. AG has responsibility for supervision and oversight of charitable trusts and corporations.
  1. AG role specifics:
  • enforcement/supervisory interest in property/income
  • maintain registries
  • interested party in proceedings affecting charitable trusts, uses, and estates
  • can institute proceedings and recover damages
  • can protect charities when an attack is made
  1. Specific powers: annul, dissolve, remove directors and trustees, bring proceedings and accounts, investigate, supervise indemnification, bring quo warranto proceeding, receive notice of suit by others, necessary party to settlements
  1. CA Corp Code 5250: Examination by AG
    • AG has power to inspect/examine a corporation’s affairs to determine compliance with trusts it has assumed and with the corporate purposes
    • AG may institute proceedings to correct noncompliance
  1. CA Corp Code 6511: AG actions related to involuntary dissolution

AG may bring action to dissolve a corporation on various grounds. That power is restricted if amendment of the Articles could provide a remedy, unless the AG provided notice and the corporation failed to take the needed action

  1. CA Corp Code 9230: AG rights as to religious corporations

Provides a blanket statement that AG has no powers wrt religious corporations except for crimes and the following:

  • to determine whether it’s not really a religious corporation
  • to enforce specific charitable purposes for which funds were solicited
  • see statute for more detail on AG rights
  1. Standing for Others

Move to give standing to others is based largely on AG not always being able to truly represent the interests of the charity or beneficiaries

  • lack of interest
  • lack of funds
  • political considerations
  1. Standing for Others—beyond CA Corp Code 5142 (see above for 5142)
  1. Donors
  • CA has not granted donor standing
  • Herzog Foundation v University of Bridgeport, Conn 1997, p 253

Foundation gave grants for scholarships for “medical related education.” Originally fdn gave annual grants but university persuaded it to create an endowment. When Foundation asked several years later for update, was told school closed and endowment commingled with general funds. Sought accounting and reestablishment of fund or send funds to other charity. Court found, through statutory interpretation,  no donor standing under UMIFA.

  • Issue should be addressed in drafting gift instrument,
    1. Cannot draft reverter b/c that endangers donor’s charitable deduction
    2. Eg, provide that in case of breach, gift goes to another charity
    3. Eg, provide that donor may monitor, and charity will not challenge donor’s standing—this is a standard provision per EA
    4. Recognize that cy pres may override donor’s demands, with court releasing restriction
  • Organizations often come to agreement with living donor, for PR reasons
  • Some courts have allowed standing under contract or trust theory, but EA calls this “unlikely though good observation.”
  1. Members: may sue in derivative capacity; see 5142 above
  1. Beneficiaries and Those with Special Interests
  • CA case law recognizes the right of beneficiaries and those w/ interests beyond the general public—i.e., those with special relationships to the organization
  • A court may interpret the benefited class broadly to allow standing, and may envision stakeholders in the community having a special relationship for purposes of standing (eg Hershey PA case, where trust was found to have responsibility to the community)—rationale would be that the people stand in for the public, and the corporation is formed for public benefit
  • Courts find the following factors important in determining standing:
  • The AG’s availability or effectiveness—i.e., the reason the AG turned down the suit
  • The extraordinary nature of the acts complained of and the remedy sought.
  • The presence of fraud or misconduct on the part of the charity or directors
  • The nature of the benefited class and its relationship to the charity
  • The subjective and case-specific factual circumstances
  1. Member of public: no standing absent specific statutory grant
  1. Standing for Nonstatutory Causes of Action (for all kinds of NP organizations)
  1. AG will always have standing
  2. Others will be granted standing if the court in equity chooses to grant it.
    • Very unlikely, and will depend mostly on AG’s reasons for not bringing suit itself
    • Factors as above for beneficiaries will be considered

Board Committees

  1. Authority and Need for Committees
  1. CA Corp Code 5210: Board of Directors Powers and Delegation
  • Board may delegate to any committee however composed or to other persons.
  • Activities and all corporate powers are under ultimate direction of the board.
  1. Board Committees CA Corp Code 5212 [in HO IV]: Creation of Committees
    1. This section authorizes committees consisting solely of board members.
    2. They may have staff or nonboard members who advise. But only bod members can vote. Others are not official members of the committee.
    3. There must be at least two members.
    4. These committees have the board’s authority, to the extent provided in the resolution or bylaw establishing them, subject to exceptions.
    5. Among the exceptions: Board committees cannot fill board vacancies, set board compensation, take action for which membership approval is required, amend bylaws, appoint members to board committees. (see 5212(a)(1)–(8) for exceptions)
  1. Other Committees
  1. These committees can include non-board voting members.
  2. They do not have the authority of the board.
  3. They are often known as advisory committees.
  4. However, they can have considerable authority.
  5. They are nonetheless always subject to direction of board.
  6. See Ca Corp C sec. 5151(c)(4) [not on list of assigned provisions].
  1. Need is based on size of nonprofit boards
    1. Boards can be 30 to 70 people for fundraising and prestige reasons
    2. Committees allow the board to function despite its size

Common Board Committees

  1. Executive
  • Empowered to act between board meetings if necessary
  • Sometimes has specifically delegated authority to act in particular areas on behalf of board
  • Often made up of board officers and committee chairs
  1. Audit (required under CA Nonprofit Integrity Act, if revenues over $2 million)
  • Oversight of independent(outside) audit process
  • Oversight of financial integrity and finance/accounting controls of organization
  • Trend is for audit committee to be made up of “independent” board members who have substantial financial expertise
  • Independence required by CNIA (no paid staff may be on the audit committee)
  1. Finance
  • Provides detailed review of financial statements and issues, including budget, accounting, tax, and investment issues
  • If there is a separate investment committee, finance committee usually focuses on outflows
  • If there is no separate audit committee, deals with audit issues
  1. Investment
  • Oversight of investment of funds, especially endowments and pension funds
  • Creates or recommends investment policies
  1. Compensation/Personnel
  • Develops compensation and benefit policies and guidelines for paid staff
  • Sometimes approves salaries or employment offers for top executives
  • May review CEO performance
  • May approve severance agreements
  1. Governance
  • Review and make recommendations on governance issues, such as bylaw amendments, board member service, trust governance, conflict of interest policies
  • Sometimes evaluates performance of board, committees, and individual board members
  • Often combined with nominating committee
  1. Fundraising/Development
  • Oversight of organization’s fundraising process
  1. Nominating (often nonboard, with subsequent board approval—aim is to get new blood on board)
  • Finds and recommends new directors
  • Sometimes also recommends officer and committee appointments

Additional Notes

  1. Smaller nonprofits
  • One guru recommends only 3 committees:
    • Internal Affairs (finance and HR)
    • External Affairs (fundraising and PR)
    • Governance (new board members and efficient board)
  1. Ad hoc committees
  • For both large and small organizations, there are often ad hoc committees (as opposed to standing committees)
  • May be board and non-board.
  • Common examples of ad hoc committees:
    • Strategic planning
    • Special event
    • Relocation
    • CEO transition
    • Mergers
    • Special problem
  1. Other comments
  • It is important to set out charge for committees.
  • Many organizations do so in their bylaws.
  • Advising California Nonprofit Corporations has bylaws language models.
  1. Regulation of Charitable Solicitation
  1. Abuse Examples
  1. Specific Examples
  • Direct mail solicitation raises tens of millions of dollars; all of the contributions go to fundraiser’s firm for fees and to generate more mailings; the exempt organization’s directors and officers consist of direct mail experts and former officers of fundraisers.
  • Sponsored child from Save the Children Federation had been dead for 4 years; letters to donors, supposedly from the children had been written by the organization.
  1. Examples show solicitation of funds involves questionable use of funds up to outright fraud
  2. Paid solicitors pass on between 30% and 50% (or even less) of the funds raised
  1. State Approaches in General
  1. States are allowed to regulate charitable solicitation under police powers, based on idea that misuse of charitable funds diverts tax dollars from state and federal treasuries.
  1. Regulatory schemes’ common elements
    1. Mandatory disclosure through registration and licensing requirements
    2. Prosecute fraudulent solicitation
    3. States have tried to control costs of solicitation as percentage of amount raised, but Constitutional challenges have prevailed
  1. State motives may include:
  • Protecting charities from those who provide high cost solicitation services.
  • Protecting against charities’ own “corruptive self-interest” since charities often bear no financial risk with professional solicitors.
  • Economic regulation of the big business of charitable solicitation, since many charities are run by inexpert volunteers.
  • Promoting public’s perception of the integrity and efficiency of charities and a pro-charitable environment.
  • Acting as a protector of the public interest (both donors and beneficiaries), the third party in interest when fundraisers and charities enter contracts.
  • Using police power to protect against nuisance and criminal activity that may accompany door-to-door solicitation.
  1. Charities’ Objections to State Regulation
  • Unduly burden ability to freely communicate ideas.
  • Infringe upon their autonomy and ability to operate.
  1. US Cancer Council v Commissioner, 7th Cir, p 276

Charity encourages preventive and ameliorative approaches, through affiliated local cancer societies. In desperate straits, it hires fundraiser. Fundraiser fronts all expenses and has 5 year exclusive deal with co-ownership of donor list. Each letter included advice on cancer. 70% of letters included chance to win sweepstakes. Raises $28.8 million, but charity gets only $2.3 million net ($12.2 million deemed educational expenses; $12.5 printing and postage). Did not renew contract, but experience with another fundraiser was a disaster and organization filed for bankruptcy.

IRS revokes tax exempt status, claiming charity was run for fundraiser’s benefit as insider, which is forbidden, and that part of net earnings inured to the benefit of the fundraiser as a private shareholder or individual. IRS argued fundraiser was an insider because like a founder (bore expenses) and had control (charity as its mercy). Judge Posner rejects based on an arms’ length contract.

  1. California Rules
  1. Summary from various sections of B&P Code and elsewhere
  • With limited exceptions, any person who solicits a gift or sale must disclose to prospective donor in writing:
    • Name and address or organization
    • Percentage of gift or purchase that can be deducted
  • If the solicitation is not for a sale and is made by a volunteer, reduced disclosure requirements: only organization name, address, charitable purpose and statement that financial information is available at address are required.
  • No disclosure is required for solicitation to members or for solicitation on organization’s premises.
  • Provision no longer requires disclosure of percentage of solicitation to be used for charitable purposes, although other provisions still do, despite questionable constitutionality. (Also, commercial fundraisers must disclose the percentage used for charitable purposes on request by solicited person.)
  • City and counties may have their own ordinances; satisfying them will satisfy state requirement. Many fail to take account of Supreme Court decisions.
  1. CA Nonprofit Integrity Act, sections 5-13 (supp pp 49–54)
    1. Commercial fundraisers must register with AG
    2. Commercial fundraiser must notify AG before starting a solicitation campaign
    3. Commercial fundraiser must have written contracts with charities for whom they solicit
    4. Same requirements for fundraising counsel (those who give fundraising advice but do not solicit or receive donations)
    5. Charitable organizations can void contracts with unregistered commercial fundraisers
    6. Charitable organizations can cancel contracts with commercial fundraisers
    7. Specific obligations in fundraising
      • Cannot misrepresent purpose of the charitable organization
      • Organization must exercise control over fundraising activities
      • Can only contract with registered commercial fundraisers
      • Organization must be registered with AG if required to be
    8. Prohibition against engaging in misrepresentation and other acts in solicitation
      • No unfair or deceptive acts
      • No engaging in fraud
      • No use of names, symbols, etc., that falsely suggest a contribution is for a particular organization
      • No falsely telling donors a contribution is for a particular organization or will be used for a particular purpose
      • No telling donors a particular person sponsors or endorses a solicitation
      • etc
    9. Commercial fundraisers must keep records of solicitation campaigns for 10 years
  1. Constitutional Restrictions: Supreme Court Cases
  1. Schaumburg v Citizens for a Better Environment, SCOTUS 1980, p 285
  • Ordinance prohibited door-to-door or on-street charitable solicitations by organizations that did not use at least 75% of receipts for charitable purposes.
  • Court struck it down: “Prior authorities . . . clearly establish that charitable appeals for funds, on the street or door to door, involve a variety of speech interests –communication of information, the dissemination and propagation of views and ideas, and the advocacy of causes – that are within the protection of the First Amendment.
  • Soliciting financial support is subject to “reasonable regulation.”
  1. Watchtower Bible and Tract Society v Village of Stratton,  SCOTUS 2002, p 288
  • Supreme Court struck down local ordinance that required permit from mayor’s office for canvassers for any cause, finding it overbroad as applied to religious proselytizing, anonymous speech, and distribution of handbills.
  • In dictum, said arguably would have been okay if limited to commercial activities and solicitation of funds.
  • Shows difficulty of separating solicitation from speech
  1. Riley v National Federation of the Blind, SCOTUS 1988, p 289
  • North Carolina prohibited professional fundraisers from retaining “unreasonable” or “excessive” fee, defined by a 3-tiered schedule, based on percentages.
  • Disclosure and licensing requirements.
  • Court said solicitation of charitable contributions is protected speech; using percentages to decide legality of fee is not narrowly tailored to State’s interest in preventing fraud.
  • Charities can decide for themselves what they want to say and how to say it.
  • North Carolina was still free to enforce its antifraud law and require disclosure of financial information by fundraisers to the state.
  • Compelled disclosure of percentage of funds over past 12 months turned over to charity was also unconstitutional.
  • There can be value from act of solicitation itself.
  • Donors are told the solicitation is by a professional and can make inquiries.
  • This rule hurts smaller and unpopular charities.
  • State itself may publish detailed financial disclosure forms of professional fundraisers.
  • Delay in licensing also not permissible.
  1. Reasons fundraising costs might be high for particular charities
  • New organization with unfamiliar mission
  • Seeking new donors
  • Primary purpose educational
  • Small average contribution
  • “Hiding” fundraising costs in other categories – see 990 data
  1. IL ex rel Madigan v Telemarketing Associates (SCOTUS 2003), p 304 note case
  • Supreme Court held that fraud by fundraisers is unprotected speech.
  • Fundraiser allegedly knowingly misrepresented to donors that a significant amount of each dollar donated would be paid over to the charity; when 85% of the gross amount was to be retained.
  1. Summary of what is and isn’t allowed based on Supreme Court cases
  1. Cannot create percentage requirements (how much of funds raised must go to charity)
  2. Cannot require disclosure to potential donors
  3. Cannot prohibit certain organizations from using commercial solicitors (equal protection)
  4. Can require fundraisers to register with state
  5. Can require fundraiser to disclose profit percentage to state after the fact
  6. Can create regulations based on reasonable safety and other police power reasons (eg prohibiting solicitation on highways)
  1. City Cases
  1. Gospel Missions of America v Bennett (CD Cal 1997) p 304 note case
  • LA City and County ordinances regulating charitable solicitation were held unconstitutionally vague and overbroad
  • Required detailed financial information disclosures and disclosure of personal nformation about board members
  • Too much discretion to officials, constituting prior restraints
  1. Young v NYC Transit Authority, 2nd Cir 1990, p 305

Prohibition of begging and panhandling in NYC subway system. Suit based on possible 1st Am violation. Court found begging was more conduct than speech, and distinguished between begging and charitable solicitation

  1. Internet Solicitation
  • Mounting solicitation campaigns in many states poses challenges to nonprofits.
  • There are firms that specialize in this.
  • Internet complicates.
  • Charleston principles try to give guidelines:
    • Look to existing law to determine whether personal jurisdiction exists—whether charity targets the state, receives contributions from the state on an ongoing or substantial basis, or sends email messages or contacts person in state in other ways to promote web site.
    • If so, under Charleston principles the charity would have to regiester
  • It asserts that state can enforce law against any entity whose Internet solicitations mislead or defraud.
  1. Federal Regulation of Charitable Solicitation

Possible sources/methods of regulation:

  • IRS Code, through excise taxes
  • FTC, through fraud provisions (deceptive trade practices)
  • Legislation, though so far it hasn’t been successful
  1. Examples of Tax-Exempt Organizations
  1. Overview of Achieving and Maintaining Tax Exemption
  1. Requirements to Qualify Under 501(c)(3)
    1. Organized as NPC or “community chest, fund, or foundation”; this includes unincorporated assns and trusts
    2. Purpose: exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, to foster amateur sports competition, or to prevent cruelty to children or animals
    3. No private inurement (of “net earnings”)
    4. No “substantial part” of activities can be lobbying
    5. No campaigning
  1. Organizational and Operational Tests for Charitable Purpose
    1. Organization must meet both tests to qualify for tax exemption
  1. Organizational Test – Reg. sec. 1.501(c)(3)-1(b)(1)
  • What the documents say
  • Purpose must be stated properly.
  • Cannot be authorized for purposes broader than those stated in c-3.
  • Limit purposes to one or more purposes described in statute (can be narrow or broad)
  • Must not expressly empower organization to engage, except to an insubstantial degree, in activities that do not further exempt purpose
    • Expressly prohibit campaign intervention
  • Under charter or applicable law, dedicate assets to exempt purposes upon dissolution
    • California does so by applicable law, but generally you want to put in documents
  1. Operational Test
  • What organization actually does.
  • Must engage primarily in activities that accomplish exempt purpose.
  • Reg sec. 1.501(c)(3)-1(c)(1) explains that exclusively means primarily.
  • Test is not met if “more than an insubstantial part of the organization’s activities are not in furtherance of an exempt purpose.
  • Cannot be a c-3 if purpose is to be an “action organization” – to influence legislation as substantial part of activities or to participate in campaigns for public office.
  1. Notice requirement
  • Most c-3’s must notify IRS that they are applying for exemption and must obtain favorable determination.
  • To avoid private foundation status, must notify IRS it’s not a private foundation
  • Exceptions: churches, organizations other than private foundations with gross receipts less than $5k, affiliates covered by group exemption.
  • Many file anyway,
    • to assure donors that their donations are tax deductible
    • because grant-making foundations may insist on a determination letter
    • to make it easy to prove tax exemption when seeking services provided to tax-exempt organizations
  1. Application for Exemption: Form 1023, “Application for Recognition of Exemption”\
  • Can do within 27 months of organization
  • Can be daunting; must be taken seriously
  • Fee of $300 if gross receipts under $10K; otherwise $750.
    • In January will increase to $400/$850.
    • IRS is working on a cyber-assistant, which will reduce fee to $200
  • If filed in time, exemption is retroactive and gifts from time of creation are deductible.
  1. Annual Information Return—Form 990
  • Most EO s must also file the Form 990 (except tiny orgs and churches).
  • There is a new and elaborate Form 990, which raises many difficult issues.
  • Helping organizations fill these out for larger organizations often requires help of lawyers and accountants.
  • The governance section has been especially controversial.
  • Issues for smaller organizations have also been difficult.
  • Even the tiniest organizations must now file an E postcard.
  1. Public Interest Law Firms
  1. Distinguished from legal aid, which is charitable because it helps the poor, and from defense of human or civil rights, which is also charitable independent of the following guidelines.
  1. What Constitutes a Public Interest Law Firm ( Rul. 75-74; p 377)
    1. Cases are chosen because they address a matter of broad public interest and importance
    2. Representation for this type of case is not ordinarily provided by traditional private law firms (AKA representation is economically infeasible; private parties could not maintain an action)
  1. Rul. 75-74 found public interest law firm is a valid tax-exempt organization
  1. Guidance provided in Proc. 92-59
  2. Typical public interest cases: class action in public interest, injunctions against government or private interest affecting public; representation before administrative agencies; test suits where private interest small.
  3. Does not extend to direct representation of litigants in actions where financial interests permit private legal sources. In such cases, if issue would affect broad public interest, organization can file amicus brief
  4. Organization cannot achieve objectives through disruption, violation of ethics.
  5. Must list cases and rationale for them on 990.
  6. Policies and programs must be developed by board or committee representative of public interest
  7. Not operated in way to create identity or confusion with a particular private law firm.
  8. May accept court-awarded or client fee, but cannot be reason for taking case.
  9. Such fees cannot exceed 50% of total cost of legal functions over 5 years.
  10. Fees must be paid to organization, not individuals.
  11. Must report all fees on 990.
  12. Client-paid fees must not exceed actual cost incurred in each case; must not withdraw from case if client unable to pay.

Community Development

  1. Community Development as a separate category
    1. Organizations that purely serve poor people qualify under traditional charitable categories
    2. As separate area, community development involves organizations that partner with private sector and involve private benefit beyond the charitable class
  2. Rul. 74-587 set out facts in which an organization qualified as tax exempt
  • Organization operated in high-density, mostly low-income, minority, urban areas
  • Declared objectives—These are critical to the tax-exempt determination
    • relief of poverty
    • elimination of prejudice
    • lessening of neighborhood tensions
    • combating community deterioration through financial assistance and other aid to improve economic conditions and opportunities in the areas
  • Gave loans or bought equity interests in businesses that filled community needs.
  • Consulted with other nonprofit and governmental agencies to choose recipients of aid.
  • Gave preference to businesses that provided training or employment for unemployed or underemployed people
  • Qualifies as exempt because individuals who received aid were instrument for achieving charitable purposes.
  1. Housing

 Rev. Rul. 70-585

  1. RULE: An organization providing housing for low-income and, in certain circumstances, moderate-income families, is qualified for tax-exemption under (c)(3)
  2. Examples:
  • Organization formed to construct and renovate homes for low-income families is eligible.

– Because relieving the poor and distressed is charitable

  • Organization that builds and sells homes at or below cost to minority persons of low and moderate income to eliminate discrimination is eligible.

– Because eliminating discrimination and lessening neighborhood tensions are charitable

  • Organization of residents, businesses and community groups to rehabilitate and fight deterioration is eligible.

– Because combating community deterioration is charitable

  • Organization to help moderate-income families deal with housing shortage is not

– Because serving the middle class is not a charitable purpose, and no other charitable purpose is met here.

  1. Low-Income Housing Credit and Safe Harbor
  • Credit involves nonprofit and for-profit developers and is very complicated
  • Proc. 96-32 creates safe harbor for mixed-income developments. See p 389 for how it defines “low income” and “very low income”

 Environment

  1. Environmental organizations may be recognized as charitable under other categories: educational, scientific, or charitable
  2. Rul. 76-204: Environmental protection was recognized as its own charitable category
  • Organization acquires and maintains ecologically significant undeveloped land.
  • Some land is held in natural state, with some educational and scientific research.
  • Other tracts are held undisturbed until transferred to government conservation agency.
  • Rul. cites to charitable trust authorities, revenue rulings and federal legislation for proposition that preserving and protecting natural environment for public is charitable purpose.
  • Organization qualifies as c-3.
  1. Rul. 78-384: Limited scope of environmental tax-exemption
  • Organization restricts use of land to farming or other uses ecologically suitable.
  • Ruling concludes this is not preserving land with any distinctive ecological significance and there is no benefit to public from this restriction. Needs to be sufficiently broad public benefit
  • Not eligible for c-3.
  • This ruling is very criticized
  • EA offers way to distinguish (from problems): if you can base an organization’s programs on promoting a clearly articulated governmental conservation policy, that might suggest public purpose/benefit.
  1. Land Trusts
  • Popular conservation vehicle because of flexibility and ability to act more quickly than government
  • Usually a private nonprofit corporation, though sometimes governmental or quasi-governmental
  • First-hand involvement in land transactions or management
  • Help negotiate conservation transactions
  • May take advantage of available tax savings.
  • May use outright donations and easements.
  1. Disaster Relief
  1. RULE: Disaster relief is a charitable purpose
    1. Immediately after a disaster, any recipient is acceptable
    2. Long-term, the recipients must be appropriate recipients of charity—look to charitable class
  2. Charitable class— must be “large or indefinite enough that providing aid to its members benefits the community as a whole.”
  • Section 501(c)(3) organizations cannot be formed to benefit a few individuals or
  • An open-ended organization can be formed and it can then benefit an individual or family.
  1. Donations earmarked for a particular recipient should be rejected
  2. New rules after 9/11
  • Generally one must be needy for long-term relief from charities but we had special rules for 9/11.
  • We now have section 139 to exclude from income qualified disaster relief payments (president must have declared the disaster).
  • It is now clear that businesses can receive tax-free gifts if there is no quid pro quo.
  1. Credit Counseling Organizations
  • 1990s saw abuses when CCOs proliferated.
  • Congress enacted detailed statutory requirements for a CCO to satisfy to qualify under (c)(3) or (4). These appear in 501(q) (CB supp p 100)
  • There is speculation that some of these rules – independent board, services without charge – will be applied to other c-3’s—possibly for c-3’s generally, or for particular categories such as health care

XII.    Special Problems of Private Membership Associations

  1. General Notes

 Values Served by Private Voluntary Associations

  • self-definition and pursuit of personal happiness
  • fellowship and social interaction
  • democratic values and self-government
  • counterweight to state power
  • societal diversity and pluralism
  1. Judicial Role in Internal Affairs
    1. Chafee article from 1930, p 1032
      • Argued for tort as proper approach in expulsion
      • Example of Colonel Dawkins, expelled from his club after he published a pamphlet criticizes a member of his court martial.
      • Focus on process, not merits: Court in Dawkins asks whether expulsion according to rules & procedures, bona fide, and honest exercise of powers, does not look to merits of the decisions.
    2. Focus on process has continued
  1. Rights of Withdrawn Member in Dissolution:

RULE: former member have no rights to assets on dissolution (p. 1037)

  1. Expulsion of Members
  1. Potential Costs of Expulsion
  • From religious group, excommunication can be very severe sanction.
  • Social group and reputation.
  • Labor union or trade association and livelihood.
  • Consider expulsion from school.
  • Monetary damages may not suffice.
  1. Membership as Property or Contract Right

Lambert v Fishermen’s Dock Cooperative, Inc. New Jersey S Ct 1972 p 1036

Plaintiff joins cooperative by buying two shares of stock. At time he joined, bylaws said stockholder gets fair book value back if terminated. Bylaws permitted amendment. Bylaws were amended to say get back only price paid if terminated. He is terminated; wants the amount promised at time he joined under contract theory. Court agrees: amendment of bylaws cannot impair or destroy a vested or contractual right.

But this looks more like a property right; the member is a stockholder

It’s a little hard to know where this case fits in w/ the other cases for membership rights for MBC

  1. Procedural Requirements: CA Corp Code 7341: Expulsion [Identical to 5341 for PBC (not in supp)]
    1. No member may be expelled or membership terminated except in accordance with this section. Otherwise it’s void.
    2. Must be done in good faith and in a fair and reasonable manner
    3. Will be fair and reasonable if follows this procedure (but a court may find other procedures fair and reasonable too)
      • Procedure is set forth in articles or bylaws, or copies of procedure are sent annually to members
      • 15 days prior notice of action and reasons
      • Opportunity to be heard orally or in writing not less than 5 days before effective date
    4. Notice must be by method reasonably calculated to give notice
    5. SOL: 1 year after date of expulsion
    6. Court may order any equitable relief, including reinstatement; but may set aside a vote only if bad faith existed and it was done to exclude the member from the vote
    7. Compliance w/ this section doesn’t make a substantively unlawful expulsion valid (eg violation of contractual or other rights)
    8. Expelled member is still liable for charges, dues, and fees incurred before expulsion
  1. Substantive Requirements

In addition to the procedural requirements above, expulsion must meet substantive standards. Relevant factors include the following.

  • If members had notice, if sanction seems appropriate or out of proportion, if the association is protecting an essential interest (something central to organization’s purpose)
  • Whether the association violated Constitutional, property, or contractual rights
  1. Rules for Religious Organizations
  1. Old case law (predates current statutory scheme)

Owen v. Rosicrucian Fellowship CalApp 1959, p 1038

Two members sought to inspect membership records and then were suspended and expelled following the church’s procedures. Sued for readmission and right to examine membership list. Court found the church followed its procedure, which the members had contracted to follow and abide by—i.e., court found a contractual relationship, not a property right, and found the contract not breached

  1. Governing Statute: sec 9340 (not on list of covered statutes; not in supp)

RULE: Membership in a religious corporation may be terminated as provided in the articles or bylaws.

* Court won’t question the procedures provided, but it will question whether the procedures were followed.

  1. Professional Organizations

Bernstein v Alameda-Contra Costa Medical Assn, CalApp 1956, p 1041

Doctor was expelled from medical assn as a result of violations of the AMA principles of medical ethics. Expulsion meant he was unable to work in that community.

  • Courts are sensitive to fact that expulsion from professional organization can mean inability to practice one’s profession.
  • Court rejects one charge (regarding testimony as expert witness) as interfering with judicial process and as inconsistent with language of association’s own principles.
  • It rejects a simple property right analysis to ask whether the association has acted “in good faith, in accordance with its laws and the laws of the land.” Found the expulsion ok b/c association followed its rules.
  1. Misc notes on procedure and substance
  • Associations, especially those with quasi-public status, held to reasonable standards of due process: notice and right to defend oneself (lower than in court; can vary depending on nature of organization and nature of charge and on gravity of lost rights or privileges)
  • Groups must follow their own procedures and courts generally defer to group’s interpretation and understanding of its own procedures.
  • Standard for following procedures is substantial compliance
  • Groups can form their own substantive goals.
  • Substantive limits exist, including that groups cannot ask member to violate law or expel for refusing to do so.
  • Cannot mislead member.
  • Courts generally look to member’s reasonable expectations, general purposes of the association.
  1. Expulsion from Social Clubs
  1. In many states, social clubs have great power to expel members; bylaws/articles govern, and courts may overlook procedural errors
  2. In CA, social clubs are MBC’s, so CA Corp. Code 7341 governs
  3. CA depublished case construed the statute: Aluisi v Ft Washington Golf Club, Cal App 1995, p 1048—NB: Do not rely on this case in exam

In response to complaints about member’s demeaning comments about women, board held expulsion hearing, kept it closed and gave evidence from anonymous complainants (they were “scared to death” of him). Board also discussed other matters not disclosed to the member in advance of the hearing (bad behavior of his). Board expelled him based on all these complaints. Court case discusses the Corp Code provisions as codification of case law and safe harbor, and as meant to protect existing DP protections. Because member wasn’t allowed to confront witnesses and there was lack of notice, he won and was readmitted.

  1. Admission of Members
  1. Bases for Challenging Organization’s Refusal of Membership
    1. Contract and property rights do not exist for a nonmember, so these bases don’t work
    2. Tort would work for refusal to admit: key issue is relationship between individual and assn.
    3. Violation of Public Policy: Falcone case

Falcone v Middlesex Cty Medical Society, Super. Ct NJ 1961, p 1049

Doctor first studied osteopathic medicine, at institutions unapproved by the AMA, and passed the state medical board exams (ie was licensed in the state). Then he went to an AMA-approved school in Italy but studied only 7 months there, getting credit for his previous study. He applied for membership in the society without mentioning his D.O. training and was admitted as an associate member. The society found out about the D.O. training and refused to recommend Dr. for active membership. The membership was necessary to have privileges at the two area hospitals.

Court found the refusal to admit violated the state’s licensing regime.

  1. People refused membership may also have issues with standing and financial ability to bring suit
  1. Freedom of Association
  1. Issue: freedom of association versus equality and nondiscrimination

—how to find the right balance between organizations’ rights and individuals’ rights

—one question is whether admitting the excluded people would affect the group’s identity

  1. Some important distinctions
    • public versus private (eg shown in NY State Club Ass’n v NY, p 1064, in which the city law applied to private clubs of > 400 members that provided meal service)
    • commercial versus noncommercial—if association offers business benefits like networking (eg shown in O’Connor’s dissent in Jaycees, p 1062)
    • home versus marketplace—sort of combines both of the above, and captures the “spectrum” analysis of Jaycees case
  1. Two main Supreme Court cases
    • Roberts v US Jaycees, SCOTUS 1984, p 1058

FACTS: US Jaycees allows only men 18-35 yo as full members. Women and older men can be associate members but c/n vote or hold local or national office. Two local chapters in MN admitted women and were sanctioned by the national org. Local chapters sued based on MN Human Rights Act, which forbids discrimination on various grounds, including sex, in “place of public accommodation.” US Jaycees defended on basis of constitutional right of free speech and association.

ANALYSIS: Freedom of association has two senses

(1)  Personal liberty to chose who you associate with

(2)  Right to associate for expressive reasons (Expressive association)

First analysis involves spectrum between intimate (family) and attenuated personal attachments. Factors: size, purpose, policies, selectivity, congeniality, other pertinent characteristics

Second analysis involves whether infringements on the right of expressive association are justified by a compelling state interest that cannot be achieved by significantly less restrictive means

Here, the Jaycees relationships were too attenuated (large, unselective organization). And there was a compelling interest in eradicating discrimination against women, and little infringement on associational freedom given that women were already associate members and the Jaycees didn’t have to change their creed to allow women to join.

  • Boy Scouts of America v Dale, SCOTUS 2000 (Rehnquist), p 1066

Dale became scout in 1978. Applied for adult membership 1989, approved as assistant scoutmaster. Went to Rutgers, came out, and became active in gay community. Was interviewed by newspaper, and then expelled from boy scouts. Court accepts sincerity of position that BSA does not believe homosexuality is morally straight and that having Dale as a leader would significantly burden their expressive activity. Because of this significant infringement, the Court balanced the burden/intrusion against the state interest. Found the burden too great.

  1. CA cases
    • More restricted concept of “place of public accommodation”
    • Unruh Act: entitles all people, regardless of sex, full and equal accommodations, advantages, facilities, etc., in business establishments
    • BOD of Rotary Int’l v Rotary Club of Duarte, SCOTUS 1987

Court held it did not violate the First Amendment right of free association to apply Unruh Act to Rotary Club, which did not allow women to become members. Factors in analysis: size, purpose, selectivity, whether others are excluded from critical aspects of the relationship

    • Clubs were large, had high turnover, inclusive, public purpose, encouraged strangers.
    • Slight impingement on members’ right; state compelling interest in eliminating discrimination against women.
  • Ibister v. Boys’ Club of Santa Cruz, Cal 1985: Court held that Unruh Act’s “business establishment of any kind” included nonprofit w/ gym and swimming pool. Thus, Boys’ Club could not exclude females.
  • Curran v. Mt Diablo Council of the Boy Scouts of America, Cal 1998: Court held Boy Scouts were not subject to Unruh Act b/c not a business establishment; Boys Scouts primary function was inculcation of a specific set of values. Thus, could exclude gay leader.
  • Randall v. Orange County Council, BSA, Cal 1998: Can exclude atheists for same reason.  [this case not in the book]
  • Boy Scouts could exclude women and Mexicans, but not African Americans (b/c unconstitutional)
  1. Exam approach
    • Identify the issues
    • Discuss the approaches of the various cases
    • We don’t know what the future holds given the lack of clarity in the Dale case
    • Draw a conclusion about what the best approach would be in the circumstances under the case law (especially whichever case seems most relevant)

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