How to Effectively Manage Conflicts of Interest for Nonprofit Organizations

Effectively managing conflicts has become even more important for nonprofit organizations. Under state law it has historically been necessary for directors and officers to address conflict issues to fulfill their fiduciary responsibilities. More recently, the IRS has begun to focus upon the governance and conflict management practices of tax exempt organizations as part of its effort to monitor compliance with applicable requirements.

For example, in Form 1023 the IRS asks whether an applicant for tax exempt status maintains a conflict of interest policy. Also, in Form 990, tax exempt organizations are required each year to disclose information about their conflict of interest processes. The concern is that organizations that do not maintain good governance and conflict management processes are more likely to violate limitations or fail to comply with applicable requirements.

It is therefore more important than ever that nonprofit organizations review and as needed bolster their conflict management policies and practices. Following are key points to consider in developing an effective conflict management process.

Distinguishing Between Types of Conflict of Interest

A conflict of interest arises where a nonprofit organization enters a transaction in which one of its officers or directors has an interest. The interest may be direct if the officer/director owns some portion of the company transacting with the non-profit organization or indirect if he/she is also an officer or director of the company transacting with the nonprofit organization.

However, despite such an interest, the nonprofit may enter into such a transaction depending upon its impact upon the organization. If a transaction would involve a director/officer placing his or her interests ahead of those of the organization, the officer or director would benefit at the expense of the organization. Thus, the organization could not manage such a conflict and should refuse the transaction.

Where, however, a transaction would benefit an officer or director but yet be fair to the organization, the organization may enter into such a transaction if proper processes are followed to review and approve it. For example, assume that a director owns an office equipment leasing enterprise which offers to lease to the nonprofit organization copier equipment at below market rental rates. Clearly, the director will benefit in the sense that his enterprise will obtain additional lease or rental income. However, if the nonprofit organization, through proper processes, determines that the opportunity to lease or rent the office equipment at below market rate is fair to the organization, it can approve and continue with the transaction despite the conflict of interest.

It is important therefore to distinguish conflicts which involve a director or officer benefiting themselves at the expense of the organization from those where a director or officer may be benefited but the organization treated fairly.

Implementing Processes to Identify and Review Conflicts

"Management" of a conflict means that the organization has by appropriate process identified the conflict but determined that it is fair to the organization. To do that, the nonprofit organization should:

  1. Adopt thorough and detailed conflict of interest policies requiring officers and directors to identify any business interests they have or own, directly or indirectly, so that where potential transactions involving these business interests arise, they may be identified as ones requiring detailed consideration.
  2. Establish a process by which officers or directors without an interest in the transaction (“disinterested directors”) review and approve transactions that present a potential conflict of interest. Approval of any such transaction should be undertaken only by officers or directors in circumstances where the interested officer or director was excluded from any discussion or deliberation, and ultimately any voting, on whether to approve the transaction.
  3. Ensure that disinterested officers or directors are presented, and review, alternative opportunities that could achieve the goal of the proposed transaction. This process is important to show that the decision makers made a thorough examination of other appropriate transactions before approving the transaction as fair to the organization. The nonprofit organization should establish specific parameters for how alternative transaction information is to be gathered and presented. This will allow directors to ask specific questions and gather information that supports a logical and reasonable determination.
  4. Train officers and directors in how to implement the policy when a potential conflict of interest arises.

To illustrate how the management process might properly work, consider the same hypothetical stated above. Once the director who owned the office equipment leasing operation proposed the transaction to the president of the non-profit organization, the matter would be submitted to the board of directors for review and approval. At the meeting of the board of directors, the interested director would be excluded as soon as the agenda item was called for consideration by the board. Minutes would reflect the exclusion of the interested member. Thereafter, the remaining disinterested directors would review the merits of the transaction (as described by the president) and consider at least two or three other alternative legitimate transactions to accomplish the same goal. After consideration of the proposal, and appropriate alternatives with sufficient detail, the disinterested board members could then legitimately find that the transaction would be beneficial despite the conflict and vote to approve the proposed transaction.

Adopting Effective Conflict of Interest Policies

As a starting point only, the Internal Revenue Service has attached to Form 1023 a sample conflict of interest policy. Organizations should begin the process of reviewing their management processes by examining that sample policy. Organizations should then work with counsel to create an effective policy and tailor their management processes as appropriate. Once a draft is completed, the policy should be delivered to the board for review and approval, with training to follow using hypothetical transactions to illustrate the application of the policy and how transactions should be discussed, deliberated upon and voted upon.

For more information, please contact any of the following members of the Chambliss Nonprofit Practice Team: James L. Catanzaro, Jr., Chair; Nelson Irvine; William Carriger; Leslie Maclellan; Kirby Yost; Chris Hennen.

Topics:  Board of Directors, Compliance, Conflicts of Interest, Fiduciary Duty, IRS

Published In: Business Organization Updates, Nonprofits Updates, Tax Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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