Pastor, Church & Law

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.

One of the most misunderstood legal principles in nonprofit corporate governance is the origin, definition, and application of “fiduciary duties” to the officers and directors of churches and other nonprofit organizations. The word “fiduciary” derives from the Latin word fīdūciārius relating to something held in trust. As one court explained:

The term “fiduciary” … is derived from Roman law, and means “a person holding the character of a trustee, or a character analogous to that of a trustee, in respect to the trust and confidence involved in it and the scrupulous good faith and candor which it requires.” Moreover, one is acting in a “fiduciary capacity” when the business which he transacts, or the money or property which he handles, is not his own or for his benefit, but for the benefit of another person, as to whom he stands in a relation implying or necessitating great confidence and trust on the one part and a high degree of good faith on the other part.²¹² In re Benites, 2012 WL 4793469 (N.D. Tex. 2012).

Many courts have concluded that the officers and members of the board of directors of a nonprofit corporation are fiduciaries of the corporation they have been chosen to manage. One court noted:

Adherence to the fundamental character of a nonprofit corporation is intended to be insured, in part, by the fiduciary duties imposed on officers and directors of such corporations. It is well established that officers and directors of a for profit corporation owe a fiduciary duty to the corporation and its members. Directors and officers of corporations are bound to the exercise of the utmost good faith, loyalty, and honesty toward the corporation. The directors of a corporation have to see to it that the corporation had the benefit of their best judgment and act solely and always with reasonable care in good faith to promote its welfare.²¹³ Summers v. Cherokee Children & Family Services, Inc. 112 S.W.3d 486 (Tenn. App. 2002).

Many courts and legislatures have attempted to define the fiduciary duties of the officers and directors of nonprofit corporations. These efforts have been labeled “sparse and fragmented,” and “largely undeveloped.” However, the few courts that have addressed fiduciary duties in the context of nonprofit corporations have generally defined fiduciary duties of officers and directors to include the following two duties:

1) due care

2) loyalty

The officers and directors of nonprofit corporations, like their counterparts in for-profit corporations, have a fiduciary duty to exercise “due care” in the performance of their duties. In one of the most detailed descriptions of this duty, a federal district court for the District of Columbia ruled that the directors of a nonprofit corporation breached their fiduciary duty of care in managing the corporation’s funds.²¹⁴ Stern v. Lucy Webb Hayes National Training School for Deaconesses & Missionaries, 381 F. Supp. 1003 (D.D.C. 1974).For nearly 20 years, management of the corporation had been dominated almost exclusively by two officers, whose decisions and recommendations were routinely adopted by the board. The corporation’s finance committee had not convened in more than 11 years. Under these facts, the court concluded:

Total abdication of [a director’s] supervisory role, however, is improper. … A director who fails to acquire the information necessary to supervise … or consistently fails even to attend the meetings … has violated his fiduciary duty to the corporation. … A director whose failure to supervise permits negligent mismanagement by others to go unchecked has committed an independent wrong against the corporation.

The court noted that a director or officer of a nonprofit corporation “has a continuing fiduciary duty of loyalty and care in the management of the [corporation’s] fiscal and investment affairs,”and acts in violation of that duty if:

(1) he fails, while assigned to a particular committee of the board having stated financial or investment responsibilities under the bylaws of the corporation, to use diligence in supervising and periodically inquiring into the actions of those officers, employees and outside experts to whom any duty to make day-to-day financial or investment decisions within such committee’s responsibility has been assigned or delegated; or

(2) he knowingly permits the [corporation] to enter into a business transaction with himself or with any corporation, partnership or association in which he holds a position as trustee, director, partner, general manager, principal officer or substantial shareholder without previously having informed all persons charged with approving that transaction of his interest or position and of any significant facts known to him indicating that the transaction might not be in the best interests of the corporation; or

(3) he actively participates in, except as required by the preceding paragraph, or votes in favor of a decision by the board or any committee or subcommittee thereof to transact business with himself or with any corporation, partnership or association in which he holds a position as trustee, director, partner, general manager, principal officer, or substantial shareholder; or

(4) he fails to perform his duties honestly, in good faith, and with reasonable diligence and care.

The key element of the fiduciary duty of care is the performance of one’s duties as a director or officer “honestly, in good faith, and with reasonable diligence and care.”

There are a number of ways that church board members can reduce the risk of liability for breaching the fiduciary duty of due care, including the following:

• • Attend all of the meetings of the board and of any committees on which they serve.
  • In advance of each meeting, directors and officers should receive an agenda of matters to be addressed during the meeting, with supporting documentation.
  • In advance of each meeting, directors and officers should receive and thoroughly review interim financial statements and other materials that will be presented to enable them to seek clarification of any questions, irregularities, or inconsistencies at the meeting of the board.
  • Affirmatively investigate and rectify any other problems or improprieties
  • Thoroughly review the corporate charter, constitution, and bylaws, and be sure copies of these documents are accessible during the meeting.
  • Dissent from any board action with which they have any misgivings, and insist that their objection be recorded in the minutes of the meeting.
  • According to Robert’s Rules or Order Newly Revised: “No action of acceptance … is required—or proper—on a financial report of the treasurer unless it is of sufficient importance, as an annual report, to be referred to auditors [in which case] it is the auditors’ report which is accepted.”
  • Provide members with the preliminary minutes of each board meeting soon after the meeting is held, and invite additions and corrections.
  • Make sure that all actions are properly authorized, and recorded in the minutes.
  • Make sure that all actions are consistent with the church’s charter, bylaws or other governing instruments.
  • Implement a training program for board members. Several resources are available at Churchlawandtax.com, including the “4 Hour Legal Training Program for Church Boards” and weekly lessons for church board members.
  • Implement an orientation program for new board members using the “4 Hour Legal Training Program for Church Boards,” available from Churchlawandtax.com.
  • Resign from the board if and when you are unable to fulfill these duties.
  • Several recommendations made by the Freeh Commission in response to the Jerry Sandusky scandal at Penn State University are directly relevant to church boards, and include the following: (1) the church’s governing documents should provide for board rotation and staggered voting; (2) board members’ terms should be limited; (3) the board should be continually informed by church leadership of existing and potential legal and financial risks.
  • Encourage diversity in board membership
  • Periodically review the performance of senior level church staff.

Few courts have addressed the fiduciary duty of care in the context of churches or other nonprofit corporations.

“Directors should know of and give direction to the general affairs of the institution and its business policy, and have a general knowledge of the manner in which the business is conducted, the character of the investments and the employment of the resources. No custom or practice can make a directorship a mere position of honor void of responsibility, or cause a name to become a substitute for care and attention. The personnel of a directorate may give confidence and attract custom; it must also afford protection. … No one is compelled to be a director, but once the office is assumed, it carries with it the light burden of active, diligent, and single-eyed service.” People v. Marcus, 261 N.Y. 268 (N.Y. 1933).

The fiduciary duty of due care was initially formulated by the courts, and was often construed as imposing on nonprofit corporate directors a duty to act with the same degree of care in the performance of their duties as a “reasonably prudent director” under similar circumstances. The “reasonable person” standard is still followed by many courts and legislatures, but in recent years has been increasingly replaced by a slightly different standard. Most notably, section 8.30 of the revised Model Nonprofit Corporation Act, which has been adopted by several states, reflects the trend to replace a corporate director’s fiduciary duty of “due care” with a duty to act in “good faith … in a manner the director reasonably believes to be in the best interests of the nonprofit corporation.” In practical terms, there is little difference between these two standards.

“A director or officer may be liable for a violation of fiduciary duty even in the absence of bad faith or dishonesty; affirmative malfeasance is not required—mere passive negligence can be enough to breach the duty and result in liability. Similarly, a director or officer who fails to take the steps necessary to acquire a rudimentary understanding of the business and activities of the corporation may be held liable for damage resulting from that ignorance.” Fletcher Cyc. Corp. § 844.10.

The fiduciary duty of “due care”—the “prudent investor” rule

The fiduciary duty of care applies to the investment of corporate funds. However, directors are not accountable for every bad investment they make. They are not held to a standard of perfection. Rather, they are accountable only if an investment decision was not based on “the care an ordinarily prudent person in a like position would exercise under similar circumstances.” The courts have been reluctant to impose liability on directors for an exercise of poor judgment. One state supreme court, in language that has been quoted by several other courts, observed:

[There is] a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. Absent an abuse of discretion, that judgment will be respected by the courts. The burden is on the party challenging the decision to establish facts rebutting the presumption.

What steps can church officers and directors take to reduce the risk of violating the fiduciary duty of due care? Consider the following:

• • • Check state law. If your church is incorporated under state law, be sure to check your state nonprofit corporation law for any provisions that address the duties of officers and directors. This information should be made available to all of the church’s officers and directors.
    • Check the church’s governing documents and minutes. The governing documents (i.e., articles of incorporation or bylaws) of some churches contain restrictions on investments. Such restrictions may also appear in the minutes of congregational or board meetings. It is essential for board members to be familiar with these restrictions and to enforce them.
    • Use an investment committee. Many nonprofit organizations use an investment committee to make recommendations regarding the investment of funds. This can be an excellent way to reduce the liability of board members for poor investment decisions. Rather than make decisions themselves, the board appoints an investment committee that includes individuals with proven investment or financial expertise. Committee members may include stock brokers, CPAs, attorneys, bankers, financial planners, and business leaders. Of course, the committee’s recommendations ordinarily must be approved by the governing board, but by relying on the advice of experts the board is greatly reducing the risk of being liable for poor investment decisions. After all, they were relying on the advice of experts.

Key point. The Model Revised Nonprofit Corporation Act (quoted above) specifies that “in discharging his or her duties, a director is entitled to rely on information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by … persons as to matters the director reasonably believes are within the person’s professional or expert competence. …“ This language provides directors with considerable protection when relying on the advice of experts on an investment committee.

• • • • Investment policy. A church congregation or board can create an investment policy to govern investment decisions. A policy can prohibit investments in specified instruments or programs.
      • Avoid speculative or risky investments. If a proposal sounds “too good to be true,” it probably is. Any scheme that promises to “double your money” in a short period of time should be viewed with extreme skepticism. It is absolutely essential that such schemes not be pursued without the thorough evaluation and recommendation of persons with financial and investment expertise.

Key point. Do not rely on the “expert opinion“ of persons representing the promoter of an investment scheme. Investment schemes must be reviewed by independent and objective persons having financial and investment expertise. Ideally, these persons will be members of your church, or persons within your community who have a reputation of unquestioned integrity.

Key point. Remember, you are investing donated funds. This is no time to be taking risks. Not only do officers and directors have a legal duty to exercise due care in the investment of church funds. Just as importantly, they have a moral duty to be prudent in their investment decisions. No officer or director wants to explain to church members at an annual business meeting how some of their contributions were lost due to poor investments.

Church officers and directors must take steps to inform themselves about any investment decision involving church funds. They can rely on a number of safeguards, including their own research, the recommendations of an investment committee, and common sense.

The Uniform Prudent Management of Institutional Funds Act of 2006 (UPMIFA)

The Uniform Prudent Management of Institutional Funds Act (UPMIFA) has been adopted, with minor variations, in most states. It replaces the Uniform Management of Institutional Funds Act (UMIFA), which was adopted by most states since its inception in 1972. UMPMIFA helps in clarifying the fiduciary duty of care, and in particular the “prudent investor” rule.

UPMIFA applies to virtually all funds held by a church or other charity, and is not limited to trust or endowment funds. It is therefore essential for church leaders to be familiar with its directives, which may be viewed as a clarification of the meaning of the “prudent investor.”

“Section 3 applies to all funds held by an institution, regardless of whether the institution obtained the funds by gift or otherwise and regardless of whether the funds are restricted.”

An official comment by UPMIFA’s drafters states:

This section adopts the prudence standard for investment decision making. The section directs directors or others responsible for managing and investing the funds of an institution to act as a prudent investor would, using a portfolio approach in making investments and considering the risk and return objectives of the fund. The section lists the factors that commonly bear on decisions in fiduciary investing and incorporates the duty to diversify investments absent a conclusion that special circumstances make a decision not to diversify reasonable. Thus, the section follows modern portfolio theory for investment decision making. Section 3 applies to all funds held by an institution, regardless of whether the institution obtained the funds by gift or otherwise and regardless of whether the funds are restricted.

The Drafting Committee discussed extensively the standard that should govern nonprofit managers. UMIFA states the standard as “ordinary business care and prudence under the facts and circumstances prevailing at the time of the action or decision.” Since the decision in Stern v. Lucy WebbHayes Memorial Training School for Deaconesses [summarized above] the trend has been to hold directors of nonprofit corporations to a standard nominally similar to the corporate standard but with the recognition that the facts and circumstances considered include the fact that the entity is a charity and not a business corporation.

The language of the prudence standard adopted in UPMIFA is derived from the Revised Model Nonprofit Corporation Act (RMNCA) and from the prudent investor rule of the Uniform Prudent Investor Act (UPIA). The standard is consistent with the business judgment standard under corporate law, as applied to charitable institutions. That is, a manager operating a charitable organization under the business judgment rule would look to the same factors as those identified by the prudent investor rule. The standard for prudent investment set forth in Section 3 first states the duty of care as articulated in the RMNCA, but provides more specific guidance for those managing and investing institutional funds by incorporating language from UPIA. The criteria derived from UPIA are consistent with good practice under current law applicable to nonprofit corporations.

Trust law norms already inform managers of nonprofit corporations. The Preamble to UPIA explains: “Although the Uniform Prudent Investor Act by its terms applies to trusts and not to charitable corporations, the standards of the Act can be expected to inform the investment responsibilities of directors and officers of charitable corporations. …”

Because UPMIFA applies to charitable organizations, UPMIFA makes the duty of care, the duty to minimize costs, and the duty to investigate mandatory. The duty of loyalty is mandatory under applicable organization law, corporate or trust. Other than these duties, the provisions of Section 3 are default rules. A gift instrument or the governing instruments of an institution can modify these duties, but the charitable purpose doctrine limits the extent to which an institution or a donor can restrict these duties. In addition, subsection (a) of Section 3 reminds the decision maker that the intent of a donor expressed in a gift instrument will control decision making. Further, the decision maker must consider the charitable purposes of the institution and the purposes of the institutional fund for which decisions are being made. …

The duties imposed by this section apply to those who govern an institution, including directors and trustees, and to those to whom the directors or managers delegate responsibility for investment and management of institutional funds. The standard applies to officers and employees of an institution and to agents who invest and manage institutional funds. Volunteers who work with an institution will be subject to the duties imposed here, but state and federal statutes may provide reduced liability for persons who act without compensation. UPMIFA does not affect the application of those shield statutes. …

Subsection (c)(1) … requires an institution to minimize costs. An institution may prudently incur costs by hiring an investment advisor, but the costs incurred should be appropriate under the circumstances.

Consistent with the portfolio theory of investment, subsection (e)(3) permits a broad range of investments. Subsection (e)(4) assumes that prudence requires diversification but permits an institution to determine that nondiversification is appropriate under exceptional circumstances. A decision not to diversify must be based on the needs of the charity and not solely for the benefit of a donor. A decision to retain property in the hope of obtaining additional contributions from the same donor may be considered made for the benefit of the charity, but the appropriateness of that decision will depend on the circumstances. … Subsection (e)(5) imposes a duty on an institution to review the suitability of retaining property contributed to the institution within a reasonable period of time after the institution receives the property. Subsection (e)(5) requires the institution to make a decision but does not require a particular outcome. The institution may consider a variety of factors in making its decision, and a decision to retain the property either for a period of time or indefinitely may be a prudent decision. …

The intent of subsection (e)(6) is that a person managing or investing institutional funds must use the person’s own judgment and experience, including any particular skills or expertise, in carrying out the management or investment duties. For example, if a charity names a person as a director in part because the person is a lawyer, the lawyer’s background may allow the lawyer to recognize legal issues in connection with funds held by the charity. The lawyer should identify the issues for the board, but the lawyer is not expected to provide legal advice. A lawyer is not expected to be able to recognize every legal issue, particularly issues outside the lawyer’s area of expertise, simply because the board member is lawyer.