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Fiduciary Duties of Directors of Insolvent Nonprofit Corporations Fiduciary Duties of Directors of Insolvent Nonprofit Corporations

Fiduciary Duties of Directors of Insolvent Nonprofit Corporations

As the economic turmoil triggered by the COVID-19 outbreak continues, directors and officers of nonprofit corporations should pay heightened attention to their fiduciary duties and responsibilities and specifically how those duties shift when the nonprofit corporation is approaching insolvency or becomes insolvent.[1]
 
Fiduciary Duties of Boards of Directors of Solvent Nonprofit Corporations

As with for-profit boards of directors, the fiduciary duties of boards of directors of solvent nonprofit corporations are governed under applicable state law. Typically, members of a nonprofit board of directors owe fiduciary duties of care and loyalty to the corporation.[2] Under New York law, the fiduciary duties imputed to a nonprofit corporation’s board of directors are codified in the New York Not-For-Profit Corporation Law (“NPCL”), which imposes duties of care and loyalty on members of the board. “Directors and officers shall discharge the duties of their respective positions in good faith and with that degree of diligence, care and skill which ordinarily prudent men would exercise under similar circumstances in like positions.”[3] The board and officers of nonprofit corporations also have an additional fiduciary duty unique to nonprofit corporations: the duty of obedience. The duty of obedience requires the board to ensure that the nonprofit corporation abides by its stated purposes and goals since, “[u]nlike business corporations, whose ultimate job is to make money, nonprofit corporations are defined by their specific objectives” central to the mission of the nonprofit.[4] This duty, for instance, prevents directors of a nonprofit chartered for the purpose of rescuing animals in New York from expending funds to support rescuing animals in Detroit.

Because nonprofit corporations lack shareholders, their officers and directors have more complex fiduciary duties then those of a for-profit corporation.[5] In addition to considering the financial health of their organization, officers and directors must consider the charitable and tax-exempt purposes of the organization and the public benefit for which the organization operates.[6] These duties are further complicated by the fact that non-profit organizations often receive restricted gifts that limit the uses to which such gifts can be put.
 
Fiduciary Duties of Boards of Directors of Insolvent Nonprofit Corporations

The fiduciary duties of boards of directors of insolvent nonprofit corporations are determined under applicable state law and essentially mirror the fiduciary duties of insolvent for-profit corporations. But there are exceptions. Under well-established New York law, for example, the board of an insolvent corporation owes a fiduciary duty to preserve corporate assets for the benefit of its creditors.[7] However, unlike for-profit corporations, even when insolvent, officers and directors of a nonprofit must balance the interests of the corporation’s creditors against the interest of preserving and observing the organization’s charitable purpose.[8]

For example, if an insolvent nonprofit corporation seeks to sell all of its assets, it must consider all of its constituencies, including the beneficiaries of the charitable mission and creditors. Rather than simply aiming to maximize the value of the nonprofit’s assets, the directors must balance the objectives of “paying creditors as much as possible and serving the mission of the corporation…with no other requirement or particular weight to be applied” when determining who to sell the assets to if bidders have opposing objectives.[9]
 
Enforcement of Fiduciary Duties and Business Judgment Rule

Breaches of fiduciary duties related to nonprofit corporations are generally enforced by the state’s Attorney General. In New York, for example, the Attorney General has authority to order fundamental changes and require its approval of major developments and transactions, such as the sale, lease, or exchange of the corporation’s material assets;[10] mergers and consolidations;[11] and dissolution.[12]

Just as with for-profit corporations, in managing the affairs of the nonprofit corporation, directors’ decisions are largely protected from scrutiny by the business judgment rule if they can show that they discharged their duties in good faith, in an informed manner, and did not personally benefit from their actions.[13] Generally, the business judgment rule may protect a board of directors of a nonprofit corporation that, when acting in good faith, decides to pursue potentially risky strategies to generate profits or maximize the value of the corporation—even if the decision does not yield such a result.[14] Even when a company approaches insolvency, the business judgment rule may insulate a board in its decision-making processes.[15] To enjoy the benefits of this rule, however, directors are required, among other things, to inform themselves fully and in a deliberate manner with respect to a transaction or other business decision that the directors will make on behalf of the corporation.[16]

Boards are often well advised to engage outside advisors to provide detailed information regarding certain transactions or decisions that will be made by the board, especially if the board deems there to be risk associated with a potential decision.  Boards may rely in good faith on the information, opinions, reports, or statements prepared or presented by legal professionals, public accountants, investment professionals, among others, in discharging their duties.[17]
 
Conclusion

A nonprofit corporation’s directors and officers should be mindful of their fiduciary duties while navigating financial hardships and potential insolvency. If a nonprofit corporation is approaching insolvency, becomes insolvent, or elects to file for bankruptcy, particular scrutiny will be given to the officers’ and directors’ actions. Involving legal counsel and financial advisors in the decision-making process and relying on their advice can further protect individual board members from personal liability. Nonprofit board members and officers should consider the following while assessing corporate action as the non-profit corporation navigates potential or actual insolvency:
 
  1. Whether the action serves the goal of maximizing the corporation’s stated purpose and mission;
  2. Whether the action is predicated upon a fair assessment the debtor’s financial condition;
  3. Whether the action favors certain creditors or constituencies over others in the absence of business considerations or contractual rights that dictate otherwise;
  4. Whether the action is based on a well-informed decision; and
  5. Whether the action benefits the officers and directors of the nonprofit corporation at the expense of the corporation’s mission or other constituencies.
By engaging in such due diligence, the nonprofit board should be better positioned to demonstrate the requisite good faith exercise of its duties, as a defense to any challenge.

Ice Miller represents both for-profit and not-for-profit companies in financial distress or considering restructuring due to insolvency. Ice Miller regularly counsels individuals and corporations regarding corporate, governance, tax issues for tax-exempt entities, as well as  gift, estate, trust taxation, estate planning, estate and trust administration and charitable giving for nonprofit organizations.

This publication is intended for general informational purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstance.

Chelsea Abramowitz is a law clerk in Ice Miller’s Business and Bankruptcy, Restructuring, and Creditors’ Rights Groups (admission to the New York state bar pending). Chelsea earned her juris doctor from Fordham University School of Law and has a degree in public health from Tulane University.

Louis DeLucia is a partner in and chair of Ice Miller’s Bankruptcy, Restructuring, and Creditors’ Rights Group. His representation encompasses a wide range of issues, including complex Chapter 11 cases, bankruptcy and creditors’ rights related litigation in state and federal courts, liquidation proceedings, cross-border insolvency proceedings, non-judicial loan restructuring, workouts and other alternatives to the bankruptcy process, and state court asset recoveries and foreclosures.

Alyson Fiedler is a partner in Ice Miller’s Bankruptcy, Restructuring, and Creditors’ Rights Group. She has been involved in some of the largest and most complex bankruptcy cases in recent years, having served as counsel to creditors, creditors’ committees, boards of directors and managers, debtors, fiduciaries and other interested parties.

Gina Giacone is a partner at Ice Miller. She focuses on corporate, governance and tax issues for tax-exempt entities and gift, estate and trust taxation, estate planning, estate and trust administration and charitable giving.

Michael Ott is an attorney in Ice Miller’s Bankruptcy, Restructuring, and Creditors’ Rights Group. He counsels banks, financial institutions and other creditors in distressed situations and has extensive experience with commercial litigation, including litigation involving complex financial instruments and transactions.

Daniel Swetnam is a partner in Ice Miller’s Bankruptcy, Restructuring, and Creditors’ Rights Group and a member of the Risk Management Committee. He also represents several charitable organizations and private foundations in a variety of matters and has been actively involved in bankruptcy proceedings of large nonprofit organizations.
 
[1] This alert focuses on New York law, and while many other states follow similar rules, the specific fiduciary duties and obligations of directors of a non-profit can vary greatly from state to state. It is important to seek legal counsel regarding your state’s law.
[2] See In re Wonderwork, Inc., 611 B.R. 169, 194 (Bankr. S.D.N.Y. 2020); People v. Grasso, 831 N.Y.S.2d 349 (Sup. Ct. 2006), aff'd, 54 A.D.3d 180 (1st Dep’t 2008).
[3] See New York Not-For-Profit Corporation Law (“NPCL”) § 717(a).
[4] Id.
[5] Manhattan Eye, Ear & Throat Hosp. v. Spitzer, 715 N.Y.S.2d 575, 593 (Sup. Ct. 1999) (“MEETH”) (holding that the Board’s duty of care is an “‘expansion of the comparable section of the Business Corporation law…”)
[6] See, e.g., N-PCL § 511.
[7] United States Small Bus. Admin. v. Feinsod, 347 F. Supp. 3d 147, 160 (E.D.N.Y. 2018); see N.Y. Credit Men’s Adjustment Bureau, Inc. v. Weiss, 110 N.E.2d 397, 398 (N.Y. 1953) (“If the corporation was insolvent at that time it is clear that defendants, as officers and directors thereof, were to be considered as though trustees of the property for the corporate creditor-beneficiaries.”); see also Clarkson Co. v. Shaheen, 660 F.2d 506, 512 (2d Cir. 1981), cert. denied, 455 U.S. 990 (1982) (citing Weiss in holding that directors of an insolvent New York corporation owe fiduciary duties to creditors, and creditors can sue to enforce those duties); Hughes v. BCI Int’l Holdings, 452 F. Supp. 2d 290 (S.D.N.Y. 2006) (holding that creditors had standing to assert a breach of fiduciary claim against the director of an insolvent New York corporation, because even though “[a]n officer or director does not owe a fiduciary duty to the creditors of a solvent corporation, the fact of insolvency causes such a duty to arise.”).
[8] Abandonment of the nonprofit corporation’s charitable mission “should be a carefully chosen option of last resort.” MEETH, 715 N.Y.S. at 595; See also In re HHH Choices Health Plan, LLC, 554 B.R. at 704.
[9] See In re HHH Choices Health Plan, LLC, 554 B.R. 697, 704 (Bankr. S.D.N.Y. 2016) (reasoning that “it cannot be the case that . . . paying creditors as much as possible and serving the mission of the corporation, cannot be met at the same time” and determined that “all of these considerations are supposed to be taken into account and balanced in a reasonable way, and with no other requirement or particular weight to be applied.”).
[10] NPCL §§ 510, 511.
[11] NPCL § 907.
[12] N-PCL Articles 10 and 11.
[13] See Consumer Union of U.S., Inc. et al. v. The State of New York, Empire HealthChoice, Inc. et al., 840 N.E.2d 68 (2005) (accepting the business judgment rule for nonprofit corporations by barring plaintiff’s claim that the board breached its fiduciary duties by deciding to convert to a for-profit corporation and that the board encouraged politician-legislators to decide how its assets should be used after the conversion); William J. Higgins v. New York Stock Exchange, 806 N.Y.S. 2d 339 (Sup. Ct. N.Y. 2005) (citing Consumer Union as authority for the applicability of the business judgment rule to decisions made by nonprofit boards); Spitzer v. Schussel, 2007 WL 3133222, 8 (N.Y. App. Div. Sept. 11, 2007) (recognizing the business judgment rule, but holding that where there is a “showing that a breach of fiduciary duty occurred, including evidence of bad faith and self-dealing, or decision affected by inherent conflicts of interest, judiciary inquiry is triggered.”).
[14] See Dennis v. Buffalo Fine Arts Acad., 15 Misc. 3d 1106(A), 836 N.Y.S.2d 498 (Sup. Ct. 2007) (stating that the business judgment rule protects “those actions taken by a board of directors in good faith in the exercise of honest judgment and within legitimate corporate purposes cannot be overturned by a court. Without a showing of bad faith in the form of self-dealing, fraud, or unconscionability, a court’s review of the directors’ decision will be limited.”)
[15] New York courts follow the legal precedent of N. Am. Catholic Educ. Programming Found., Inc. v Gheewalla, 930 A.2d 92, 101 (Del. 2007) and reject the notion that directors owe fiduciary duties to creditors while a company is in the zone of insolvency. However, some New York courts continue to use the phrase “zone of insolvency” as a synonym for “insolvency.” See e.g., In re Sabine Oil & Gas Corp., 547 B.R. 503, 556-57 (Bankr. S.D.N.Y. 2016) (appearing to use “zone of insolvency” as synonym for insolvency).
[16] Consumers Union, 840 N.E.2d at 68.
[17] N-PCL § 717(b)(1)-(3).
 
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