Fiduciaries, Constituencies, and the Duty of Loyalty in Modern Nonprofits

1 Introduction

Fiduciaries of a charitable nonprofit organization, including members of its board and other officers, are legally bound by fiduciary duties, including the duty of loyalty. According to this duty, a fiduciary of a charity must “act in good faith and in a manner the fiduciary reasonably believes to be in the best interests of the charity in light of its purposes” (American Law Institute 2021, § 2.02(a)).^[1] In fact, these duties are inviolate; although the organizational documents of a charity may be drafted to modify fiduciary duties, they may not be drafted so as to nullify a fiduciary duty. (American Law Institute 2021, s. 208(c)).

In theory, the duty of loyalty seems uncomplicated; in simple cases, it often is. In practice, discerning the duty’s requirements, and sometimes even identifying the charity and the legal purposes to which the duty is owed, is not so simple. Violations of the duty of loyalty tend to take two forms. One type of violation occurs when a fiduciary improperly obtains a personal benefit from or that otherwise should belong to a charity, often in the context of self-dealing.^[2] Our focus is on a second type of violation, “disloyal conduct rooted in inconsistent allegiances of the fiduciary” (Miller 2013, 977). Addressing this second type of violation is particularly vexing since the board members who appoint constituency members and those constituency members themselves have the primary responsibility of compliance with such duties.

Challenges to identifying and complying with duties that are meant to avoid this second, broader type of violation can arise when board members serve because they reflect the experiences of certain constituencies or identities or when they serve on multiple boards. Examples abound. For instance, University boards have long included members who are students, union members, or other stakeholder representatives. More recently, universities and other charities have tried to diversify boards not only in terms of the stakeholders they represent but also in terms of the racial, gender, or other types of identity they bring to the board (see, e.g. (Adediran 2022; Brody 2008).) Both constituency and identity membership can create confusion about to whom duties are owed and how they should be fulfilled. For example, should a board member who was appointed, in part, because of their gender or their identity as a student ultimately vote in the interest of that gender or the student body? How must a fiduciary act when the interests of the entity or its purposes conflict with those of the gender or of the student body?

Identifying and understanding a fiduciary’s duties can be particularly difficult when a charity is part of complex corporate organization, such as when the organization includes multiple, intersecting entities.^[3] Examples include for-profit corporations that appoint the members of their private foundations’ governing board. The same is true in the case of Section 501(c)(3) charitable organizations, when the charity appoints members to the board of an affiliated Section 501(c)(4) social welfare organizations. Lack of clarity about the duty of loyalty also can arise when one nonprofit is a member of another, as is common in large health care systems. In yet another example of arrangements that can muddy fiduciary duties, federal tax law requires representatives of a supported organization to have a place on the boards of certain categories of supporting organizations. Sometimes state laws provide guardrails to ensure that board members protect the interests of the charity in light of its purposes, such as state laws that limit the number of interested directors on a nonprofit board. But not always, and not, at least explicitly, with respect to several of the types of constituencies we discuss here.

In this Article we offer a brief examination of the complications to the duty of loyalty raised by these and other various forms of constituency memberships, the ways in which fiduciary law attempts to clarify duties, and some tentative suggestions to ameliorate confusion regarding the duty of loyalty in complicated contexts. After this introduction, in Part 2, we provide some background on the duty of loyalty and some recent critiques of it. We then discuss two broad categories of constituency members. First, in Part 3, we examine board members who may represent various stakeholders or identity groups such as beneficiaries, grantors, community members, public officials, and members of racial, national-origin, gender, or religious groups. In Part 4, we next discuss board members who represent other entities. These include structures with interrelated entities, such as a nonprofit with for-profit subsidiary or a nonprofit that is the sole member of another nonprofit, structures reflecting federal tax law requirements regarding supporting organizations, and hybrid organizations such as federally charted nonprofits. We then consider various types of laws that specify fiduciary duties and how they address representation more generally in Part 5, including discussion of provisions of the Revised Model Nonprofit Corporation Act, the Model Nonprofit Corporation Act Third, and the American Law Institute, Restatement of the Law, Charitable Nonprofit Organizations. Part 6 concludes by emphasizing the inadequacy of current law and other guidance for managing these situations. It briefly suggests potential tools to address the gaps.

2 Modern Understanding of the Duty of Loyalty

Recent studies of nonprofit boards have criticized them for focusing on management and oversight rather than on charitable purposes (Wallestad 2021). For example, Professor Adediran critiques legal research regarding monitoring and fiduciary duties for “too narrowly defin[ing]…the duties of boards” (Adediran 2022, 371). We have a different view of the law. We believe the law correctly focuses attention, via adherence to fiduciary duties, on the right goals – advancing the interests of the charity in light of its purposes, even at the expense of other goals or other entities.

Previous research is informative. In a discussion of constituency board membership, Professor Evelyn Brody (2008, 371) asked a similar question to those we address here, questions about “whether the duty of loyalty of all board members is the same, regardless of how elected.” She answers affirmatively. Like Brody, albeit in a different context, we also conclude that the duties are the same regardless of how and why a member was selected for the board. More specifically, this examination reminds us that the fiduciary duty of loyalty requires fiduciaries to attend to the interests of the charity that they serve. Not only do the duties run to the organization, as Brody (2008) concludes, but they must serve the interests of the charity only in a manner that advances the legal purposes of the charity. These duties are rooted in fealty to charitable purposes. As Anne Wallestad explained:

[T]he duty of loyalty is often interpreted as the responsibility to think only of the organization when making governing decisions…Instead, boards should focus their loyalty to the organization’s reason for being, fidelity to the reasons that the organization exists and – by extension – to the people and communities its works impacts. (Wallestad 2021; emphasis in original)

This capacious understanding of the duty of loyalty clarifies, even if it does not fully resolve, issues raised by various forms of constituency board membership.

Writing about both charitable and non-charitable trusts, Professor Robert Sitkoff (2014) explained that “[t]he duty of loyalty proscribes misappropriation and appropriation and regulates conflicts of interest by requiring a fiduciary to act in the ‘best’ or even ‘sole’ interest of the principal.” In the context of charities, however, the principal is not the charity but the charity in light of its purposes. Thus, the approach of charities law, the approach we discuss here, more closely resembles Professors Gold’s and Miller’s (2015) explanation in their article on charitable trusts in which they discuss the concept of “fiduciary governance.” Under this concept, “the fiduciary is charged with pursuing abstract purposes,” which includes refraining from misappropriation and managing conflicts of interest but requires more of the fiduciary.

3 Constituency Fiduciaries: Members Who Represent Stakeholders or Identities

One category of board members involves a type of stakeholder or identity group relevant to the charity. The former typically includes members such as donors, beneficiaries, employees, and union members. The latter includes members of a racial, gender, or nationality, and groups of people with pertinent experiences such as refugees or victims of gun violence. Members of the latter category mightalso be characterized as stakeholders but they are not stakeholders in the same structural sense. Due to space constraints, we discuss only two categories of members – beneficiaries of a charity and community members such as those representing various identity groups – and those only briefly.

4 Constituency Fiduciaries: Members Who Represent Entities

In addition to members who represent stakeholders or identity groups, some board members represent related organizations. Here we discuss three situations in which board members may face conflicts between their roles as fiduciaries and as representatives of another entity: a) interrelated entities such as joint ventures and charities with subsidiaries; b) charities with supporting organizations or affiliated social welfare organizations; and, c) charity-government hybrid organizations.

5 Possible Solutions in Existing Law and Gaps

Here we highlight two broad approaches to addressing the problems outlined above, including enforcement of existing law and various approaches available to a charity itself. First, common law offers a seemingly straightforward answer to these problems, and, thus, we end where we started: when acting as a member of a board, that member has a fiduciary duty to the charity on whose board the member sits, in light of that charity’s purposes. This obligation is what the duty of loyalty requires in every state,^[18] even though the requirement to be vigilant in adhering to fiduciary duties falls on the very parties who appoint or themselves are constituency members.

At the same time, because federal law on these matters is sparse, it is unclear how the kinds of conflicts we identify can be regulated at the federal level. Moreover, even in the case of entities established under state law, state attorneys general may not have the resources to enforce existing laws^[19] and a particular state’s law may have high hurdles for enforcement. For example, in some states, the applicable statutes fail to define the duty of loyalty clearly or involve complicated interactions with statutory requirements of good faith or application of the business judgment rule. When state attorney generals do enforce, they tend to focus their efforts on self-dealing violations rather than a broader range of violations of the duty of loyalty, perhaps because the former are far easier to identify and prosecute.

Nonetheless, some nonprofit corporation statutes address at least some of the conflicts discussed in this paper. For example, Section 8.31 of the 1987 Revised Model Nonprofit Act (see Appendix for the full text of § 8.31), which has been adopted in over half of the states (American Law Institute 2021, § 1.02 Reporters’ note 12), applies to both direct and indirect conflicts. It defines an indirect conflict to include a transaction with another entity in which a director is “a director, officer, or trustee” (Nonprofit Organization Committee, Business Law Section, ABA 1987, § 8.31(d)). It permits such transactions with disclosure or knowledge of the material facts and the director’s interest along with good faith belief that the transaction is fair (Nonprofit Organization Committee, Business Law Section, ABA 1987, § 8.31(b)(1)). It also permits approval before or after the transaction by the attorney general or court action (Nonprofit Organization Committee, Business Law Section, ABA 1987, § 8.31(b)(2)). Moreover, it specifies that the articles, bylaws, or board resolution can impose additional requirements on conflict-of-interest transactions.^[20]

Section 8.60 of the ABA’s 2008 Model Nonprofit Corporation Act Third (MNCA 3rd)^[21] includes a detailed section limited to the kinds of conflicts on which the article focuses and how they must be managed. Requirements include identifying conflicts related to arrangements such as those involving common directorships and disclosing material facts to the board members without conflicts. This provision applies quite broadly to “[a] contract or transaction between a nonprofit corporation and one or more of its directors, members of a designated body, or officers or between a nonprofit corporation and any other entity in which one or more of its directors, members of a designated body, or officers are directors or officers, hold a similar position, or have a financial interest….”^[22] Like the provision of Revised Model Nonprofit Act, it applies by its terms to shared members, officers, or similar positions and not just individuals with dual board membership.

In contrast, California law has a more limited statute, which applies only to those who sit on the boards of both parties to the transaction.^[23] It lacks a provision explicitly permitting a vote without the possibly conflicted director’s recusal so long as the conflicted director discloses the potential conflict. The California statute approves transactions between a nonprofit corporation and another corporation when one or more of its board members are also a board member of the other corporation if there is disclosure and recusal from voting by the common director or directors.^[24] If these procedures are not followed, the contract or other transaction nonetheless stands if it “is just and reasonable as to the corporation at the time it is authorized, approved or ratified.”^[25]

Importantly, the California provision does not forbid the director with dual loyalties from discussing the transaction at hand or being present during the vote even if the director recuses herself from the vote. Recusal in the case where, for example, the majority of a section 501(c)(4)’s board consists of board members of its affiliated section 501(c)(3)’s board or a majority of a supporting organization’s board consists of board members of its supported organization, seems inappropriate and perhaps impossible. Such a board would have to rely on the justness and reasonableness of the transaction. Although the statute gives no guidance as to when and how the board demonstrates satisfaction of such criteria, prudence suggests that a board approving such a transaction should document its decision-making.^[26]

As discussed above, individual officers and others who are not themselves board members of one nonprofit entity can be appointed by it to the board of another nonprofit entity. The Revised Model Nonprofit Act § 8.31, the Model Nonprofit Act Third § 8.60, and the Restatement of the Law, Charitable Nonprofit Organizations all apply to such persons. Indeed, the Restatement of the Law, Charitable Nonprofit Organizations states as black letter law that “[f]iduciaries include members of the board, officers, and other persons holding similar powers with respect to a charity” (American Law Institute 2021, § 2.01(b)). The California statute, however, fails to reach so broadly. By including individuals in addition to board members and permitting votes with notice but not recusal, these other sources seem to better address the kinds of common situations that are the topic of this article and to which, in some cases, federal tax law imposes requirements as to representation. Clarifying these duties may not prevent harm to charitable purposes in all such cases, but at least doing so provides notice to potential wrongdoers and can help attorneys general and others enforce duties.

If a provision limited to dual board members, like that of California, applies, we recommend that board members appointed to the board of the charity by another charity nonetheless apply the requirements of California Code Section 5234 and either recuse themselves after disclosure or ensure that the transaction is reasonable. Arguably, high level employees who are not officers would be deemed fiduciaries for the particular purpose of representation if they are appointed by one nonprofit organization to represent it on another nonprofit’s board.^[27] Thus, following procedures like those in California Code Section 5234 would promote adherence to the duty of loyalty.

Nonetheless, the Revised Model Nonprofit Act, the Model Nonprofit Corporation Act Third and the California provision all fail to address other commonly encountered situations. These include beneficiaries, such as students or public interest law clients, who sit on a board or persons sympathetic to the appointing board but who are not members, officers, or other employees. Similarly, community members may be chosen to sit on boards or others chosen in the interest of diversity. Such constituency members do not always raise fiduciary duty red flags because, at least in part, their board service is meant to inform interpretation of the charity’s purposes and board decisions from a potentially overlooked perspective. But no law ensures that the perspective is applied to advance the charity’s purpose and not subjugate it to another end.

The charity itself may be able to encourage fiduciaries to adhere to their duties. For example, careful training as to the duties of the board, the kind needed for all new board members, may sometimes suffice (Langford and Anderson 2022). But not always. An undergraduate student on a university board, for example, may feel unable to vote for any matter that would burden undergraduates even if other factors counsel the need for such action. A client on the board of a public interest law firm may feel unable to support expansion of activities to new and different legal issues and a different group of clients.

In addition to enforcement of extant law, therefore, we make a few more suggestions. First, in some cases, such as when a voting student or client cannot make a decision that is faithful to the charity’s purpose, recusal may be the appropriate choice. But self-recusal requires self-knowledge that may not be realistic to expect. Second, we also recommend that bylaw provisions regarding conflicts of interest be drafted broadly to include situations such as these and not be limited to financial conflicts. For example, the Annotated Bylaws from Public Counsel of Los Angeles includes the following: “Directors and Officers shall make an appropriate disclosure of all material facts, including the existence of any financial interest, at any time that any actual or potential conflict of interest arises” (Public Counsel 2023, § 10.5).

Third, in some cases where charities are committed to naming constituency members to, for example, advance diversity, equity, and inclusion, they may wish to consider adopting not only a diversity, equity and inclusion policy, but also a carefully crafted provision in its bylaws to advance those ends.^[28] For example, the Los Angeles Public Counsel’s model bylaws offers this suggestion: “The Corporation shall operate consistently with its Diversity, Equity, and Inclusion Policy (“DEI Policy”). In the event that the DEI Policy conflicts with these Bylaws, these Bylaws shall take precedence” (Public Counsel 2023, Note 7). Importantly, this language avoids any conflict with and thus any violation of the duty of loyalty to the charity’s legal purposes. Such a bylaw may well reduce conflicts between an individual board member’s sense of self as contributing to the organization’s diversity and the board member’s fiduciary duty to the organization, but it risks focusing the board’s attention on purposes that may not be consistent with the charity’s legal purpose. Moreover, as noted earlier,^[29] a bylaw provision adopting diversity, equity, and inclusion as necessary to achieve other of the entity’s charitable purposes and thus at least arguably a purpose in itself would avoid such possible conflict. Nonetheless, any such bylaw may pose risks in light of the current legal landscape. Some organizations that have been considering adopting such a bylaw may now hesitate to do so. Other organizations may even decide to remove such an existing bylaw.

However, a nonprofit board committed to promoting diversity, equity, and inclusion in its membership needs to do more than appoint such members. It also needs to work to ensure an environment of inclusion. A study of almost 1,500 nonprofit board chief executive officers found that board diversity improved governance effectiveness but that these boards “must be certain to allow diverse members have a positive impact.” (Buse et al. 2016, 188).

In addition to training all board members regarding their fiduciary duties and working to ensure an environment of inclusion, charities could do more in circumstances when a board member is appointed by another entity but does not owe a fiduciary duty to that appointing entity. If the appointing entity expects the appointee to represent its interest, it could condition the appointment on the appointees agreeing to act as if they were fiduciaries as part of written acceptance of a board membership or other appointment.^[30] Doing so would alert an appointee to the kind of considerations and actions, such as recusal, that may be required as a dual fiduciary. In addition, a requirement for written acceptance of this agreement could be specified in the bylaws.

As these examples illustrate, given the limitations of applicable statutory provisions and the resources of nonprofit regulators, ensuring fulfillment of the duty of loyalty by fiduciaries facing multiple constituencies calls upon all the fiduciaries of the entity to diligently pursue the duty of care.^[31] “The duty of care is fundamentally a statement a fiduciary’s duty to oversee the charity.” (American Law Institute 2021, § 2.03 comment a). Moreover, “[t]he activities required of a fiduciary to satisfy the standard of care may be more substantial in complex charities than in less complex ones….” (American Law Institute 2021, § 2.03 comment b(4)). The presence of dual fiduciaries introduces such complexity. It thus calls for all board members to pay close attention to what this complexity means for their duty of care as well as what it means for the duty of loyalty of board members with dual loyalties.

6 Conclusions

Fiduciaries face many challenges in enacting their duties to a charity, even in the most straightforward of circumstances. When fiduciaries have commitments to more than one entity or constituency, the duties can be confounded. Here we set out two categories of complicated situations, described several specific examples, and made some preliminary recommendations.

In short, often-used governance structures and approaches to governance that may be efficient or desirable for other reasons can risk violation of the duty of loyalty, leading to harmful consequences for both individual fiduciaries and to the charities which they serve. Fiduciaries who are uncertain about how to guide their decision-making may make bad or, even, illegal decisions; they may well choose to avoid service altogether. Misplaced loyalties will eventually lead a charity away from the purposes that it was organized to serve.

Our bottom line is that extant law for managing those situations is, at best, incomplete. As even this brief and preliminary examination demonstrates, both applicable law and best practices need to develop ways to address these kinds of dual commitments that, as we show here, arise frequently in modern nonprofit structures. At minimum, a proper understanding of the duty of loyalty as discussed here should guide any such efforts.