The Restructuring Report

“The most useful and influential people in America are those who take the deepest interest in institutions that exist for the purpose of making the world better.” What Booker T. Washington recognized in 1901 holds true today. Approximately 25% of adults volunteer with a nonprofit organization, contributing an estimated 4 billion hours valued at $120 billion. Many people act on the desire to make the world a better place by serving on a board of directors or as officers of a nonprofit. Like a for-profit institution, that service comes with responsibilities—fiduciary duties. When a nonprofit becomes insolvent, its mission may conflict with the interests of creditors, posing a unique challenge for directors and officers. Given the number and size of nonprofits as well as increasing challenges nonprofit organizations face, the fiduciary duties that directors and officers owe when a nonprofit finances falter will be a growing issue.

Growth in Number and Size

Nearly 2 million nonprofits are registered with the Internal Revenue Service, with missions that vary from human services to educational or religious in nature. In total, nonprofits spend almost $2 trillion annually, and of that amount, more than $800 million is spent on employing more than 12 million people. Nonprofits contribute over 5% of the U.S. gross domestic product.

Fiduciary Duties Generally

Like for-profit companies, directors and officers of nonprofits have fiduciary duties—duties of care, loyalty and obedience. In the context of a nonprofit, those duties are viewed through the prism of the nonprofit’s purpose or mission. First, the duty of care generally requires the director or officer to actively participate and discharge the duties associated with their role and responsibilities while acting in the best interests of the organization. Second, the duty of loyalty requires the director or officer to act with undivided loyalty so as not to avoid using their role or interest to seek or obtain monetary gain for the director or officer or any related person. Simply put, the duty of loyalty requires the director or officer to put the good of the nonprofit organization first and avoid engaging in transactions with the nonprofit corporation from which the director or officer or related party would benefit. Third and finally, the duty of obedience requires the director or officer to follow the nonprofit corporation’s governing documents, which may include the articles of organization, bylaws and policies. That is most importantly, to carry out the nonprofit corporation’s mission and, in doing so, use the nonprofit’s resources for lawful purposes and comply with laws that relate to the nonprofit corporation and the way in which it conducts its activities.

In a for-profit institution, the duty of care is generally satisfied by the goal of maximizing shareholder value. In a nonprofit institution, however, the best interests of the organization are mission-driven. When establishing a nonprofit, incorporators are required to specify the charitable purpose. These mission statements are the guiding principles for how the nonprofit functions operationally, financially and socially. By their very nature, absent from the mission statement of a nonprofit is the goal of maximizing revenues or profits. Pursuit of a nonprofit’s mission and financial stability are not necessarily mutually exclusive goals. Under the best-case scenarios, they align enabling the nonprofit to successfully pursue and implement the mission.

Nonprofits and Financial Challenges

There is a common perception that nonprofits are immune to the challenges of for-profit enterprises. Unfortunately, that is not the case. Indeed, market forces impact nonprofits in many of the same ways as for-profit companies, and at times even more acutely. The National Center on Charitable Statistics reports that about 30% of all nonprofits close within 10 years of operations. PBS News Hour has estimated that the residual effects of the pandemic have placed more than one-third of nonprofits in financial jeopardy. These challenges take the form of rising operating expenses, limited staff capacity, difficulty in retaining quality staff, and other market and industries forces. The inherent obstacles and growing challenges of nonprofits places greater demands on directors and officers of nonprofits, which they must be prepared to navigate.

Fiduciary Duties and Insolvency         

When an entity experiences challenges and becomes insolvent, do directors and officers’ duties change? In the case of a for-profit entity, the answer to this question is, basically, no. The mission of a for-profit entity, albeit not the exclusive mission, is maximizing profits, which then inure to the shareholders. When a for-profit entity is insolvent, the mission generally continues to be to maximize value, with the beneficiaries of these duties potentially expanding to include creditors.

When a nonprofit becomes insolvent, however, the directors and officers face potentially conflicting duties. Nonprofit directors and officers never owed a duty to shareholders to maximize value so that duty does not readily translate into a duty that potentially encompasses creditors as with for-profit entities. It would be a drastic change to state unequivocally that a nonprofit directors and officers’ duty, when the nonprofit becomes insolvent, is to maximize value without regard to the nonprofit’s mission. In fact, courts have held that nonprofit directors and officers are not required to abandon the nonprofit’s mission and focus exclusively on maximizing value, but the directors and officers of an insolvent nonprofit may begin to owe an obligation that runs to the organization’s creditors.

Existing law does not provide bright-line rules as to how directors and officers of an insolvent nonprofit should best address the tension between the mission and maximizing value. General guidance, however, can be drawn from existing law to assist directors and officers in managing situations or transactions that they may face.

1. Cash flow plan

Courts have generally found that, as long as a struggling nonprofit is able to meet its current obligations to creditors, directors and officers can continue to prioritize the mission over long-term financial stability. When obligations to creditors cannot be satisfied, however, courts have looked to the interests of all parties involved, particularly the interests of creditors. In order to satisfy its fiduciary duties to the nonprofit itself and potentially to the creditors, a nonprofit’s board of directors and its officers need to have a plan to address the nonprofit’s financial distress. Maintaining the status quo, and thereby increasing the number of creditors and the size of their claims, may render directors and officers vulnerable to claims of inappropriate oversight. A prudent plan should include a process for immediate management of cash receipts and expenses and a strategy for returning the nonprofit to solvency or minimizing the negative impact on creditors. Where such a plan is not feasible, directors and officers should consider what strategic decisions may need to be explored and enacted, and what level of disclosure of the financials to creditors may be appropriate.

2. Sale of assets

 Directors and officers may face a direct conflict between mission and value when the nonprofit becomes insolvent and is forced to sell assets. The nonprofit may receive competing bids for the assets. A for-profit entity may submit a higher monetary bid for the assets because it will not continue the nonprofit’s mission, and a nonprofit entity may submit a lower bid on the assets with the intention of continuing the nonprofit’s mission or a similar mission. Directors and officers who find themselves in the situation of evaluating competing bids for a nonprofit’s assets when the nonprofit can no longer meet current obligations should document a comprehensive evaluation of all bids and the impact on all relevant stakeholders, including employees and those individuals who the nonprofit serves. Approving a sale based on the outcome of totality of the circumstances analysis best satisfies a director and officer’s fiduciary duties.

3. Financial distress of a division

Directors and officers may also face competing duties when a division or one-arm of the nonprofit organization is financially distressed and causing the organization as a whole to suffer. When assessing the alternatives for addressing a failing division, directors and officers should be guided by process and assess the totality of the circumstances. When directors and officers base their decisions on solid information and maintain a record of those decisions and the information underlying them, courts have been willing, if not eager, to find that decisions were informed and satisfied the fiduciary duties to the nonprofit.

4. The insider transaction

As noted above, one of the duties that a director or officer owes to a nonprofit is the duty of loyalty—a director or officer cannot put his or her own interests above the interests of the nonprofit. This duty comes into play when a director or officer enters into a transaction with the nonprofit, particularly when that nonprofit is distressed. For example, the director or officer may lease space to or from the nonprofit or enter into a sale transaction with the nonprofit. If the nonprofit is insolvent, these transactions will be subject to great scrutiny. Moreover, the decision of another director or officer to approve (or failure to identify) a transaction that involves the insider director may also be subject to scrutiny. Most importantly, the transaction itself must be at fair market value. To ensure fair market value, directors and officers should obtain appropriate information concerning the value of the transaction, such as comparability data. Directors and officers should review this data and document the basis for their approval in advance of the transaction. Also, the directors and officers should consider instituting procedures laying out criteria and process to be used to review any potential transactions between an insider and the nonprofit.

5. Good process

One of the most common charges levied against directors or officers when an organization experiences financial distress is a failure of oversight. Officers are charged with overseeing the operations of the nonprofit, including its employees. The duty to oversee a nonprofit’s management is part of a director’s duty of care. Ordinarily prudent people overseeing an entity must monitor the financial health of the organization. The best approach for directors and officers is to ensure that they are receiving regular reports about the financial health and general operations of the nonprofit. The board meetings should include an opportunity to review and discuss the financial reports, with these processes documented in the board minutes.

6. Managing risk

Best efforts to meet the directors and officers’ fiduciary duties cannot eliminate all risks. With that in mind, directors and officers should ensure that the nonprofit has an appropriate D&O policy in place. In addition, directors and officers should familiarize themselves with the applicable state statute that may provide indemnification or potentially even immunity to the director or officer of a nonprofit in certain circumstances such as when the director or officer (a) serves without compensation, (b) has acted in good faith, (c) has acted within the scope of his or her responsibilities, and (d) has not engaged in willful or reckless misconduct.

Conclusion

Nonprofits face revenue and expense challenges that for-profit organizations do, and some additional challenges that for-profit entities may not. Directors and officers need to be aware of their duties to the organization and how those duties may change if the nonprofit becomes insolvent. To satisfy these duties, directors and officers should be familiar with and understand the mission of the nonprofit; ensure that they are regularly reviewing financial data and documenting that review; be alert to how changes in economic conditions may affect the nonprofit; and be aware of how the prioritization of the mission may change if the nonprofit becomes financially distressed.