Liabilities of Charitable Directors and Trustees In the Post-Enron World Robert J. Weinberg Fax

2 Living in a Climate of Scrutiny The Growing Wealth of the Charitable Sector The Shift from Governmental to Private Funding of Charitable Activities Opportunities for Self-Dealing and Private Inurement Investment Volatility Media Attention Famous Cases –United Way –Bishop Estate –Adelphi University

3 Understanding the Charitable Organization Structure State Law Regulation vs. Federal Tax Law Regulation– –Trust Traditional Common Law Rules Board of Trustees –Nonprofit Corporation Modern Formulation Statutory Law Board of Directors Member or Nonmember Structure

4 Trusts: Fiduciary Duties of Trustees to Beneficiaries Duty of Loyalty Duty of Care Duty of Impartiality

5 Enforcement of Trust Private Trusts Enforced by Beneficiaries Lack of Specific Beneficiaries in Charitable Trusts Charitable Trusts Enforced by Attorney General Political Implications

6 Duty of Loyalty The Most Fundamental Duty of the Trustee Self Dealing - Strict Liability –Remedies Undo the Transaction Pay the Profits to the Organization Surcharge the Trustee for Any Loss Conflict of Interest – Not Strict Liability –Reasonableness Test –Trustee Acted in Good Faith –Transaction Was Fair and Reasonable for the Trust

7 Duty of Care Prudence of Administration –Reasonable Care, Skill and Caution –Higher Standards for More Qualified Trustees –Prudent Investor Rule (see below) Control and Protect Trust Property Keep Trust Property Separate

8 Delegation By Trustees Traditional Rule – No Delegation Transition Rule –Ministerial Duties –Discretionary Duties 1964 UTPA –Delegation OK but Must Use Reasonableness in Selection of Agents Prudent Investor Rule –Delegation May be Prudent and Even Required

9 Nonprofit Corporation Law Duties Duty of Loyalty –Put the Corporation Above Personal Interests –Not Use the Corporation for Personal Profit or Gain –Self-Dealing is Permitted in Certain Circumstances Adequate Disclosure by Interested Director Disinterested Directors Ratify Transaction is Fair and Reasonable to the Corporation

10 Duty of Care A director of a nonprofit corporation shall stand in a fiduciary relation to the corporation and shall perform his duties as a director, including his duties as a member of any committee of the board upon which he may serve, in good faith, in a manner he reasonably believes to be in the best interests of the corporation and with such care, including reasonable inquiry, skill and diligence, as a person of ordinary prudence would use under similar circumstances. In performing his duties, a director shall be entitled to rely in good faith on information, opinions, reports or statements, including financial statements and other financial data, in each case prepared or presented by any of the following:

11 Reliance On Others Officers of the corporation the director reasonably believes to be reliable and competent; Counsel, public accountants or other persons as to matter which the director reasonably believes to be within the professional or expert competence of such person; A committee of the board upon which the director does not serve as to matters within its delegated authority, which the director reasonably believes to merit confidence. »15 Pa. C.S.A. §5712

12 Investments Prudent Investor Rule (Both Corporations and Trusts) –A fiduciary shall manage and invest property held in a trust as a prudent investor would, by considering the purposes, terms and other circumstances of the trust and pursuing an overall investment strategy reasonably suited to the trust. 20 Pa. C.S.A. §7203 –May Invest in Every Kind of Property and Type of Investment

13 Investments A Fiduciary Shall Consider (among other things): –Size of the Trust –Nature of the Fiduciary Relationship –Liquidity and Distribution Requirements –Tax Consequences –Overall Investment Strategy –Special Relationship of the Asset to the Trust

14 Investments Diversification Required (in general) Delegation Permitted and Perhaps Required if Prudent –Not Liable if Selection of Investment Advisor is Reasonable –One Trustee/Director May Delegate to Another Who Has Greater Skill

15 Investments Not Judged by Hindsight The rules of this chapter are standards of conduct and not outcome of performance. Compliance with the rules of this chapter shall be determined in light of the facts and circumstances prevailing at the time of the fiduciary’s decision or action and not by hindsight…. A fiduciary’s investment and management decisions respecting individual assets shall be considered in the context of the trust portfolio as a whole and as part of the an overall investment strategy, and not in isolation. No specific investment or course of action, taken alone, shall be considered inherently prudent or imprudent. 20 Pa. C.S.A. §7213

16 Total Return/Spending Rule Elect to Adopt Investment Policy for Total Return Select a Percentage of the Value of the Assets –Determined Annually –Based on Three Year Rolling Average –No Less than 2 Percent –No Greater than 7 Percent

17 Delegation By Directors Oversee Business and Review and Approve Major Plans Delegation to Committees Is OK Actual Management By Senior Executives Duty to Make Further Inquiries if Prudent Obtain Adequate Information to Make Decision

18 Director Liability Protection Business Judgment Rule –Rationally Believes In Best Interest –Wider Range of Discretion than Reasonableness Test Transfer to Corporate Trustee –Board Is Relieved of All Liability for Administration of Assets –Corporate Trustee Pays the Selected Percentage Return to Charity

19 No Director Will Be Personally Liable Unless : –He or She Breached Duties of Office by: Self-Dealing Willful Misconduct; or Recklessness –The Liability is Criminal –The Liability is for Taxes The Exoneration Must Be in the Bylaws

20 Dissent A Director Is Presumed to Have Assented to Action of the Board Unless: –Dissent is Entered in the Minutes –Files Written Dissent with Secretary Before Adjournment –Transmits Written Dissent Immediately After Adjournment –Cannot Dissent if Voted in Favor of Action

21 Considerations in the Exercise of Powers of Board Effect of Action on –Interest Groups Affected (e.g. Patients, Students, etc.) –Members of the Organization (if any) –Employees, Suppliers and Customers –Creditors of the Organization –Communities in which Located

22 Indemnification Corporation May Indemnify Board of Directors –Must Have Acted in Good Faith –Must Reasonably Believe Action to be in the Best Interests –Had No Reasonable Belief Action Was Unlawful Power to Purchase D&O Insurance

23 Federal Tax Law Regulation of Charities and Boards Private Foundation –Relies on a Single or Small Base for Funding –Accountability is Limited –Two-Tier Excise Tax Penalties for Disqualified Persons Absolute Prohibition Against Self-dealing 5 Percent Minimum Distribution Rule Excess Business Holdings Jeopardy Investments Taxable Expenditures

24 Federal Tax Law Regulation of Charities and Boards Public Charity –Relies on Large Donor Base of Support –Accountable to the Donor Base –Less Stringent Requirements –Private Inurement Test –Loss of Exempt Status – Too Draconian –Intermediate Sanctions – Excise Tax on a Person in a Position to Exercise Substantial Influence Over the Charity’s Affairs

25 Securities Law Issues NASDAQ (Proposed) –Audit Committee of a Company on NASDAQ Must Have Three Independent Directors. –A Director Is Not Independent if the Company Contributed to a Charity on which the Director Serves as a Board Member the Greater of (i) $200,000 or (ii) 5 percent of the Gross Revenue of the Charity or the Company

26 Conclusion Pay Attention Recognize Your Responsibility Understand Financial Statements Seek Information/Ask Questions Carefully Select Executives and Advisors Avoid Private Inurement Be Insured Do Good