Conflicts of interest and the risk of self-dealing are important concerns for directors of nonprofits. Any proposed transaction that would involve a director, the director’s business, or a member of the director’s family or their businesses, should be given close scrutiny. Entering into a contract with a director’s business is not necessarily a problem, but needs to be handled with care to avoid serious consequences for the organization and the board.
The risk for a nonprofit that contracts for services or other transactions with a director’s outside firm is that the deal will be characterized as self-dealing. Authorities, including the California Attorney General and the IRS, may point to self-dealing to impose penalties or, in severe cases, strip the organization of its tax-exempt status.
California defines a self-dealing transaction as one in which one or more of a nonprofit’s directors has a material financial interest and which doesn’t fall within an established exception. The director with a financial interest in the transaction is defined as an “interested director.” An important exception, provided under Corporations Code Section 5233(d)(2), is made for transactions that have these features:
- The nonprofit entered into the transaction for its own benefit (e.g., the transaction was not solely to benefit the director or the director’s business).
- The transaction was fair and reasonable to the nonprofit at the time it was entered into.
- The nonprofit’s board approved the transaction in good faith and with knowledge of the material facts concerning the transaction and the interested director’s financial interest in it. The interested director must abstain from this vote.
- Before approving the deal, the board made a good faith determination, based on reasonable investigation, that the nonprofit could not have found a better deal elsewhere with reasonable effort, or the nonprofit could not in fact have obtained a better deal.
These rules effectively break down into two key questions: is the contract a good deal for the nonprofit, and has the board met its fiduciary obligations to study the deal and formally approve it. Note that a contract involving a director’s business can’t simply be signed the way an ordinary contract might be if, for example, the organization permits contracts for day-to-day operations to be executed without board oversight. This is true even if the contract doesn’t involve a significant financial value.
The Church Law Center of California advises churches and other nonprofits on legal matters. If you have questions about how your nonprofit can best manage a proposed transaction with one of your directors, we would be happy to discuss your options with you. Call us today at (949) 689-0437 or reach out to us through our contact page.