Unlike privately owned Limited Liability Entities, the type of corporation known as a “not for profit entity” or “501C3” or a “foundation” is not owned by the persons operating the entity but by the State of California. See our article The Non Profit Corporation-The Basics for further details. The tax exempt status granted to the entity requires that dedication to the State of any of the assets not used for the authorized nonprofit purposes of the entity. Thus, if the entity ever closes its doors, the assets must go to another nonprofit engaged in the same business or are transferred to the State.
The income and donations to the entity also must be utilized for the nonprofit purpose and since some misguided persons start nonprofits with the goal of using the structure to enhance their own wealth rather than serve the public purpose, the State’s Attorney General office has both jurisdiction and mandate to investigate the activities of non profits to assure that they are acting in conformity with their sanctioned purpose.
This scrutiny necessarily means that salaries and bonuses paid to employees of the nonprofit are subject to review to ensure that they are in line with the usual salary of someone of that skill set and experience. It means that various expenses, such as fringe benefits, means of transport of key executives, reimbursements, etc. are also subject to far stricter scrutiny than that of a for profit entity.
And it means that the Attorney General will want to make sure that any contracts or relationships entered into between the entity and fiduciaries or members of the entity are not unfairly enriching persons connected with the entity. The typical type of inappropriate action is a contract between a board member of the foundation and the foundation by which the board member is paid an exorbitant consulting fee to provide specified services to the Foundation or purchases an asset of the foundation below market value. Such transactions are not only a violation of the law, but may expose both the individual and the foundation to loss of tax status, penalties, and in extreme cases, even criminal sanctions.
The best solution is for the foundation to create a clear written conflict of interest policy that will be rigidly enforced including a method by which a potential conflict of interest is reviewed by objective members of the board or a committee of the board using precise criteria. That is the topic of this article.
The Basic Law:
A “conflict of interest” is any personal interest that an individual or entity might have that conflicts or could potentially conflict with the interest of the foundation. If a transaction or relationship with the entity is good for you but not necessarily good for the entity, you are in a potential conflict of interest. Typical examples are entering into an employment or vendor agreement with the entity; a consulting agreement with the entity; selling products to the entity; beginning a company in competition with the “business” of the entity, etc. etc. It is vital that the person in the potential conflict of interest make such conflict known to the entity and recuse him or herself from influencing the entity in the decision making or review process as to continuing the relationship that could create the conflict.
A policy governing conflicts of interests is a vital policy for a nonprofit board to adopt. To have the most protection, the policy should be in writing and the board (and staff) should review the policy regularly and enforce it religiously.
Often members of the foundation or third parties are unaware that their activities or personal interests are in potential conflict with the best interests of the nonprofit so a goal for many organizations is to simply raise awareness and encourage disclosure and discussion of anything that could conceivably be a conflict. It is important to promote a “culture of candor and openness.” It should be emphasized that the need to adhere to the policy is not an “accusation” or adverse reflection on any member: it is a requirement of the law and applies to all persons associated with the foundation.
Some charitable nonprofits make it a regular practice to take time at a board meeting once a year to discuss the types of hypothetical situations that could result in a conflict of interest, and then discuss how the board would manage that potential conflict. Other entities ensure that each new fiduciary or even member of the foundation is given a written copy of the conflict of interest policy and asked to read it, initial it, and return it to the foundation for its records.
The key is communication ahead of time when the conflict becomes a problem.
The Basic Information a Conflict of Interest Policy Should Include:
A conflict of interest policy should:
(a) require those with a conflict (or who think they may have a conflict or potential conflict) to disclose in writing the conflict/potential conflict, and
(b) prohibit interested board members or staff or members from voting on any matter in which there is a conflict.
Beyond including those two basic directives, each nonprofit needs to determine how the board will manage the conflict. Keep in mind that the Internal Revenue Service Form 990 asks not only about whether the nonprofit has a written conflict of interest policy, but also about the process that the nonprofit uses to manage conflicts as well as how the nonprofit determines whether board members have a conflict of interest.
It is vital to educate foundation members as to what a conflict of interest is and how they may determine if one may exist so they can report it to the foundation and take corrective action. Our experience is that most conflicts arise due to ignorance, not intention, and that training is an important aspect of eliminating this danger.
· Minutes of board meetings should reflect when a board member or officer discloses that s/he has a conflict of interest and how the conflict was managed. Typical minutes would include a summary of the discussion on the matter without the board member in the room, and that a vote was taken but that the “interested” board member abstained (board members with a conflict are “interested” – board members without a conflict are “disinterested”). It may be noted that anyone with family or direct economic ties to the interested member should consider whether they should abstain.
· Many nonprofits circulate a questionnaire each year to find out whether any board member (or staff member) has a conflict of interest. Typically the questionnaire asks board and staff members to disclose existing possible conflicts and reminds them to disclose any that may arise in the future.
· A written policy should be given to each and every board member and officer and, when appropriate, to any person involved in the nonprofit.
· If in doubt, legal advice should be sought as to appropriate methods to avoid conflict of interest and a written opinion obtained from legal counsel.
· Potential conflicts of interest are particularly difficult to address since they often involve merely possible plans being considered by a board member or officer. A good basic rule is that if it could be a conflict, treat it as a conflict now and get the matter heard by the board as soon as possible.
· If there is a split in voting as to whether a conflict of interest exists, the benefit of the doubt should be given to avoiding the conflict and not engaging in the transaction at issue.
Note that conflicts that are not managed correctly can result in significant penalties to the person who benefits and to the organization, called "intermediate sanctions” and even losing the tax exempt status of the entity. Take it seriously.
The Federal and State governments grant exemption from taxes to these entities predicated entirely on the concept that no profit will be generated to the benefit of private persons. The State thus retains the power to review and reject any aspect of the Foundation that does not meet their criteria.
It is easy, in the press of foundation activities and working with numerous vendors and third parties to forget the level of that scrutiny. Our experience is that the average “conflict of interest” that arises is usually not a plot so much as a reaction to necessity to get something done…a vendor is needed right away, a board member provides that service and is hired without going through the appropriate process.
The way to avoid that is to institute careful methods that are always applied. An innocent act may appear questionable five years down the road during an audit from the State Attorney General and proper procedure and recordation of that process is your best defense.