• Key point 6-07.03. Church board members have a fiduciary duty to use reasonable care in the discharge of their duties, and they may be personally liable for damages resulting from their failure to do so.
• Key point 6-07.06. Federal and state securities laws make board members personally liable for acts of fraud committed by an organization in connection with the offer or sale of securities. These laws apply to churches, and as a result church board members may be liable for fraudulent practices occurring in connection with the offer or sale of church securities.
Church Officers, Directors, and Trustees
* A federal court in Indiana ruled that the directors of a church subsidiary could be sued individually for financial losses incurred by investors in a securities scam on the basis of their breach of their fiduciary duty of care. A denomination created a subsidiary organization (the Loan Fund) in the 1920s to raise funds for denominational programs and to provide loans to affiliated churches. From 1996 to 2002 the Loan Fund raised millions of dollars by selling investment notes, mostly to church members. The notes were sold in connection with “offering circulars” containing detailed information about the Loan Fund and its finances and operations. The offering circulars informed investors that the funds from these notes would be used primarily to make interest-bearing loans to local churches. In 2002, the Loan Fund owed approximately $85 million to noteholders.
The United States Securities and Exchange Commission (SEC) filed a civil enforcement action against the loan fund on the ground that it was insolvent and had raised millions of dollars unlawfully by making false statements to prospective investors. A federal court appointed a receiver to liquidate the loan fund’s assets and meet as many obligations to creditors as possible, including the noteholders.
The court-appointed receiver sued the individual directors of the Loan Fund, claiming that they breached their “fiduciary duties” as a result of various activities, including certain “bargain sale” transactions. Bargain sales can be a lawful and prudent way to allow a charity to generate income from contributions of property. In a typical bargain sale, a seller sells property to the charity for less than full value. For accounting purposes, the charity records the difference between the sale price and market value as income. The seller (with some conditions) can treat the difference between the market value and sale price as a charitable contribution. The determination of market value is critical to the legitimacy of the transaction.
The receiver alleged that the Loan Fund board engaged in a series of high-risk bargain sale transactions from 1996 through early 2002 using inflated appraisals to exaggerate the value of the properties acquired. He alleged that those transactions resulted in the Loan Fund recognizing more than $24 million in “phantom income” during those years. This phantom income allowed the Loan Fund to claim that it was solvent when it was insolvent, and therefore to deceive prospective investors into buying still more notes. In reality, the Loan Fund was experiencing substantial losses, and most of its reported income was the artificial product of the bargain sale transactions. The receiver claimed that the Loan Fund’s directors breached their fiduciary duties by recklessly undertaking and approving bargain sale transactions, and by continuing to issue notes that the Loan Fund could not reasonably expect to repay. The receiver alleged that the board members knew that the Loan Fund’s reserves were perilously low, that the transactions offered no hope of significant cash flow or profits, and that the transactions would further diminish the Loan Fund’s ability to pay its creditors, ultimately resulting in insolvency and liquidation.
fiduciary duty of care
The court noted that the officers and directors of a nonprofit corporation owe various “fiduciary duties” to the corporation. One of those duties is the “duty of care.” The court concluded, “Plaintiff alleges that the defendant officers knew or should have known that the property appraisals for the bargain sale transactions were unreasonably high, that the Loan Fund could not afford to issue more notes to investors or to pay existing investors, and that continuing to issue notes would hurt the company. These allegations are sufficient to state a claim for breach of the officers’ fiduciary duty of care.”
officers or directors
The Loan Fund directors asked the court to dismiss the lawsuit on the ground that it “obliterated the distinction between the duties of corporate officers and those of directors.” The court rejected this argument, noting that both corporate directors and corporate officers owe fiduciary duties to the corporation, and that any differences that may exist between the duties of officers and directors was immaterial and of no relevance in this case.
business judgment rule
The Loan Fund directors claimed that they were all immune from liability because of the “business judgment rule.” The business judgment rule protects directors against personal liability for many decisions they make as directors. The court explained the rule as follows:
A director has a duty under the law to act in good faith, with ordinary care under the circumstances, and in a manner the director believes to be in the best interests of the corporation. Individual director liability requires proof that a director not only breached a duty of good faith or ordinary care, but that the breach constituted “willful misconduct or recklessness” …. Director liability for damages requires proof of, at a minimum, conscious disregard of or indifference to the consequences of a risky act.”
The court noted that while this protection is extensive, it is not absolute: “The business judgment rule protects directors from liability only if their decisions were informed ones. Directors are also obliged to act in good faith.” The court rejected the board members’ motion to dismiss the case, noting that it “must assume” that the receiver “would be able to prove that the directors, as alleged, willfully or recklessly breached their duties in ratifying the bargain sale transactions at issue in this case.” It concluded,
[The receiver] alleges that the directors breached their fiduciary duty by ratifying transactions that they knew or should have known [the Loan Fund] was financially incapable of sustaining. Although the business judgment rule may make it difficult for [the receiver] to prove these claims, they are certainly sufficient to survive a motion to dismiss. The allegations regarding the directors’ approval of the bargain sale transactions are the sort of allegations that could sustain a breach of fiduciary claim if supported with evidence that the directors deliberately chose that course of action knowing that [the Loan Fund] was not financially strong enough to meet its obligations. Such evidence also could convince a [jury] that the directors did not act in the best interests of the corporation or were indifferent to the interests of the corporation.
The board members also argued that the business judgment rule allowed them to rely on professional recommendations concerning the bargain sale transactions. Specifically, they argued that they properly relied on the recommendations of professional appraisers, accountants, and attorneys before engaging in the transactions. The court responded, “Although the statute protects such reliance, generally speaking that protection is subject to the limitation that a director was reasonably familiar with the recommendations made …. The court must assume at this stage in the proceedings … that the directors could not have reasonably believed that the appraisals were reliable.”
Application. Church board members are subject to certain “fiduciary duties” in the discharge of their duties. Very few courts have addressed the application of these duties to church board members, and so this case is very important. Note the following conclusions in particular:
(1) The officers and directors of a nonprofit corporation owe various “fiduciary duties” to the corporation. One of those duties is the “duty of care.” This duty may have been violated by the Loan Fund directors who “knew or should have known that the property appraisals for the bargain sale transactions were unreasonably high, that the Loan Fund could not afford to issue more notes to investors or to pay existing investors, and that continuing to issue notes would hurt the company.”
(2) According to the so-called “business judgment rule,” a director of a nonprofit corporation “has a duty under the law to act in good faith, with ordinary care under the circumstances, and in a manner the director believes to be in the best interests of the corporation. Individual director liability requires proof that a director not only breached a duty of good faith or ordinary care, but that the breach constituted willful misconduct or recklessness.”
(3) The board members argued that the business judgment rule allowed them to rely on professional recommendations concerning the bargain sale transactions, such as the recommendations of appraisers, accountants, and attorneys. The court noted that while board members may rely on the advice of professionals in the discharge of their duties, this rule “is subject to the limitation that a director was reasonably familiar with the recommendations made” and that they were reliable. This exception, the court concluded, may not have been met by the directors in this case. Marwil v. Grubbs, 2004 WL 2278751 (S.D. Ind. 2004).
© Copyright 2005 by Church Law & Tax Report. All rights reserved. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Church Law & Tax Report, PO Box 1098, Matthews, NC 28106. Reference Code: m56 c0405
