The California Supreme Court sets new precedent that unlike for-profit corporations, a former non-profit director may maintain a derivative lawsuit.  The decision increases the likelihood that decisions of boards of non-profits will be subject to judicial review.

In corporate disputes when a board of directors will not take action in response to a board member’s request, an outvoted director may file what is referred to as a derivative lawsuit.  In a recent California Supreme Court decision, the court was forced to answer what happens in a non-profit corporation when the board member who files a derivative action is no longer on the board.

May the former board member continue to prosecute a derivative lawsuit? The California Supreme Court in Turner v. Victoria recently ruled that unlike a for-profit corporation, a former non-profit director may maintain a derivative action.

            THE BASIS FOR THE DISPUTE

In the underlying dispute the former director, Deborah, was not nominated for reelection pursuant to the bylaws (the rules governing corporate operations).   As result Deborah was no longer on the board.

The reason the remaining board members did not nominate Deborah was because of her derivative lawsuit.  The derivative lawsuit was based on the former board member’s challenge of the board’s recent settlement.  The settlement arose because the founder of the non-profit, Conrad Prebys, had disinherited his son from his Trust.  Conrad Prebys, was a prominent real estate developer and philanthropist

Pursuant to the terms of Conrad Prebys’s Trust’s assets, after preliminary distributions, were to go to the non-profit corporation.  The Son under the Trust was to receive $0.  Yet, the board settled for $15 million.

And so, the former board member filed a derivative action.

            THE ANALYSIS

For the issue at hand, it is important to note that non-profits are obviously unique and have different rules than for-profit corporations.  Non-profits function in a host of areas and fields providing services.  Many are surprised to learn for instance that even a country club or duck hunting club may function as a non-profit.  Some members of non-profits hold ownership interests in the entity.

For a non-profit, a director however does not have to be a member and very well might not be a member.  By contrast, In a for-profit corporation it is highly unlikely that a director would not also be a shareholder and as a shareholder would have a right to file a derivative action.

In any event, Turner v. Victoria is focused solely on whether a former non-profit director can bring a derivative action and the Court answered  – yes.

The primary basis for the ruling is that California Corporation code sections 5142 and 5233 contain language permitting directors to “bring an action” against breaches of charitable trust and self-dealing.

Yet for a for-profit corporation, the statute includes the phrase “may be instituted or maintained.”  This also applied to shareholder derivative lawsuits.

The reasoning for the distinction makes sense, because as stated above, in a non-profit public benefit corporation context there often would be no other basis by a former director to maintain an action.

In the for-profit context directors are often shareholders.  Shareholders in a for-profit have an opportunity to receive dividends.  There is a direct financial incentive to review board decisions.

Non-profit corporations are prohibited from issuing dividends or otherwise making distributions.  Therefore, directors have little or far less of a financial incentive to bring a derivative action.

Because of the statutory language and the public policy issues, the Court did not wish to curtail and write in a statutory limitation to director derivative actions for non-profit corporations.  To do so would be contrary to the statute and wrongdoers could thwart lawsuits by removal of directors.

Naturally, this would discourage directors from pursuing such claims, which they must individually fund.  This would be a disservice to the public and thwart that the very purpose of permitting non-profit corporations.  The California Attorney General cannot oversee all non-profits due to the sheer numbers.

            TAKEAWAY AND FINAL THOUGHTS

The decision settles any attempt to defeat derivative actions based on former board members.  Going forward, boards of non-profits must understand that their decision making will be subject to review through derivative by former board members.  Non-profit corporations and its board of directors cannot attempt to rely on a procedural defense of non-election of a board member to defeat a derivative action.  Boards will have to continue to abide by their fiduciary duties in making key decisions.

Separately, as to complaints or issues as to board decision making, members of the non-profits can take issue with boards where so provided.  Such members may, subject to the bylaws and overall membership support, seek recall of board members or the replacement of board members.

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