THE INS AND OUTS OF BEING A DIRECTOR FAQ
1. What is a board of directors?
2. What does it mean to be a director?
3. How do you become a director?
4. What do directors need to know?
5. General responsibilities of directors
6. The duty of obedience
7. The duty of loyalty
8. Breaching the duty of loyalty
9. Complying with the duty of loyalty
10. The duty of care
11. Breaching the duty of care
12. Complying with the duty of care
13. 501-C-3 limitations on private benifit, private inurement, and lobbying
and the prohibition on political campaign activities
14. Director's rights
15. Attorney-client privilege
18.Taxes - the 501-C-3 nonprofit - unrelated business activities- donations
WHAT IS A BOARD OF DIRECTORS?
A. A "board of directors" of a stock corporation is the group of persons which collectively has the legal responsibility of exercising control over and managing the business and affairs of a corporation. Va. Code § 13.1-673
B. A "board of directors" of a nonstock corporation is "the group of persons vested with the management of the business of the corporation irrespective of the name by which such group is designated." Va. Code § 13.1-853
WHAT DOES IT MEAN TO BE A DIRECTOR?
A. A corporation’s power is vested in its directors to manage the business and affairs of the corporation. It is vested in the directors as a board, not in any director individually. As a general rule, directors can act so as to bind the corporation only when they act as a board at a legal meeting. Fletcher Cyclopedia Corporations § 392.
B. While an individual sitting on a board of directors or one of its committees can exert enormous power as a part of that body, as an individual director acting alone has almost no power.
C. A director, however, does have a right to participate in board decisions and has certain rights and duties to be informed about corporate transactions.
HOW DO YOU BECOME A DIRECTOR?
A. In stock corporations, directors are typically elected by the shareholders at the annual meeting. Va. Code § 13.1-675D
B. In nonstock corporations, directors are typically either elected by the members or, if there are no members, by their fellow directors. Va. Code § 13.1-855D
C. Either a stock or a nonstock corporation can have ex-officio or honorary directors. Whether these directors are counted towards a quorum or have a right to vote depends upon what is stated in the bylaws. The bylaws should clearly state how these persons will be treated.
WHAT DO DIRECTORS NEED TO KNOW?
A. Whether the corporation is a for profit or a not for profit. And if a not for profit, is it a nontaxable organization and, if so, what kind of a nontaxable entity.
B. What do the Articles of Incorporation and the Bylaws say. Directors must confine their activities to those within the powers conferred upon the corporation by its articles of incorporation and bylaws and by the statutes governing the corporation's existence.
C. What constitutes a quorum for your board. Unless the articles or bylaws provide differently, a quorum is a majority. Va. Code § 13.1-688 (stock); Va. Code § 13.1-869 (nonstock).
D. If a 501-c-3 nonprofit, its purpose and a copy of its 501-c-3 application. The nonprofit corporation’s activities should be consistent with its purpose.
E. The special rules which apply to 501-c-3 corporations which limit and prohibit certain activities.
F. The three key duties owed by a director. These are the duties of obedience, loyalty, and care.
G. If a nonprofit, the rules concerning donations. These rules deal with when the 501-c-3 should give notice of receiving ad donation and should advise of the fair market value of any goods or services provided to the donor.
H. Be knowledgeable of any fact in the corporation’s affairs which it is the director’s duty to know.
GENERAL RESPONSIBILITIES OF DIRECTORS
A. Statutory Authority - The Virginia Stock Corporation Act, Va. Code § 13.1-673 et seq., and the Virginia Non-Stock Corporation Act, Va. Code § 13.1-853 et seq., mandate that the business of a corporation is to be managed under the direction of its board of directors (the "Board"), subject to any limitation set forth in the corporation’s articles of incorporation.
B. Managerial Oversight - A director has the responsibility of overseeing the operation of the corporation. The daily operations of the corporation are typically handled by the corporations officers and staff, but the ultimate responsibility for the management of the corporations lies with the board of directors. Generally, the board exercises oversight in four ways:
1. The appointment and removal of officers.
2. Approval of the corporation’s finances.
3. Approval of all major undertakings of the corporation.
4. General oversight of the management of the corporation.
C. Potential for Liability - If a director’s conduct violates a duty owed by a director to the corporation and does not fall with a safe harbor provision, that director may be held personally liable to the corporation and its shareholders.
D. Indemnification and Limitation of Liability - Directors may be indemnified by the corporation or have their liability limited under some circumstances if the Articles of Incorporation or the Bylaws so provide. See Va. Code § 13.1-696 et seq. for stock and Va. Code § 13.1-875 et seq. for nonstock corporations.
THE DUTY OF OBEDIENCE
A. This duty requires directors (and officers) to confine their activities to those within the powers conferred upon the corporation by its articles of incorporation and bylaws and by the statutes governing the corporation's existence.
B. Directors and officers cannot assert as a defense their ignorance of provisions in the corporation's articles of incorporation or bylaws. Marshall v. F & M Savings Bank of Alexandria, 85 Va. 676, 8 S.E. 586 (1889).
THE DUTY OF LOYALTY
A. The duty of loyalty has to do with the relationship between the director and the corporation or, if any, its stockholders. In dealings with the corporation or with the stockholders as a group, the director (or officer) has the same duty of fidelity which arises in dealings between a trustee and his beneficiaries. Adelman v. Conotti Corporation, 215 Va. 782, 21 S.E.2d 774 (1975); Giannotti v. Hamway, 239 Va. 14, 387 S.E.2d 725 (1990).
B. At common law, the duty of loyalty prevented directors (and officers and controlling stockholders, if any) from using their positions for their own profit, and all dealings with the corporation had to open, fair, honest, and done in good faith. Upton v. Produce Company, 147 Va. 937, 133 S.E. 576 (1926); Deford v. Ballentine Realty Corp., 164 Va. 436, 180 S.E. 164 (1935).
C. The United States Supreme Court, reviewing a Fourth Circuit case from Virginia, described the duty of loyalty as follows:
He who is in such a fiduciary position cannot serve himself first and his cestuis [beneficiary] second. He cannot manipulate the affairs of his corporation to their detriment and in disregard of the standards of common decency and honesty. He cannot by the intervention of a corporate entity violate the ancient precept against serving two masters. He cannot by the use of the corporate device avail himself of the privileges normally permitted outsiders in a race of creditors. He cannot utilize his inside information and his strategic position for his own preferment. He cannot violate rules of fair play by doing indirectly through the corporation what he could not do directly. He cannot use his power for his personal advantage and to the detriment of the stockholders and creditors no matter how absolute in terms that power may be and no matter how meticulous he is to satisfy technical requirements. For that power is at all times subject to the equitable limitation that it may not be exercised for the aggrandizement, preference, or advantage of a fiduciary to the exclusion or detriment of the cestuis." Pepper v. Litton, 308 U.S. 295 (1939). See also Rowland v. Kable, 174 Va. 343, 6 S.E.2d 633 (1940); Mardel Securities Inc. v. Alexandria Gazette Corp., 320 F.2d 890 (4th Cir. 1963).
D. Others refer to the duty of undivided loyalty as follows:
Many forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties. A [fiduciary] is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the 'disintegrating erosion' of particular exceptions. Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928) (citation omitted)
BREACHING THE DUTY OF LOYALTY
A. Failure to Disclose
Failure to disclose information that might affect one’s decision-making process where a fiduciary relationship exists will frequently constitute a breach of fiduciary duty. Firebaugh v. Hanback, 247 Va. 519, 443 S.E.2d 134 (1994); Burruss v. Green Auction & Realty Co., Inc., 228 Va. 6, 319 S.E.2d 725 (1984).
B. Operating a Competing Enterprise
Acquiring an interest in another business or activity similar to the type engaged in by the principal can constitute a breach of fiduciary duty. Greenspan v. Osheroff, 232 Va. 388 (1986). However, a partner may be able to acquire an interest separate from the partnership and retain profits from that enterprise, if that interest is outside the partnership’s normal affairs. Miller v. Ferguson, 110 Va. 217, 65 S.E. 562 (1909).
C. Unfair Advantage in Dealing with the Principal
Entering into transactions with the principal may result in a breach of fiduciary duty if the position is used to take unfair advantage. Oden v. Salch, 237 Va. 525, 379 S.E.2d 346 (1989). A partner, officer or director may enter into transactions with the partnership or corporation, as long as no unfair benefit is obtained because of the relationship. Rowland v. Kable, 174 Va. 343, 6 S.E.2d 633 (1940). Dealings between an attorney and a client, when they benefit the attorney, are presumptively invalid. Nicholson v. Shockey, 192 Va. 270, 64 S.E.2d 813 (1951).
D. Usurping Opportunities
Usurping an opportunity belonging to the principal, employer, partnership, or corporation can constitute fiduciary duty breach. For example, a joint venturer could not negotiate a lease renewal for himself, at a time when the joint venture was apparently coming to an end. Meinhard v. Salmon, 169 N.E. 545 (N.Y. 1928). Also, a director breached his fiduciary duty when, knowing that his corporation wanted to buy a certain piece of property, he bought it himself. Trayer v. Bristol Parking, Inc., 198 Va. 595, 95 S.E.2d 224 (1956).
E. Misuse of Confidential Information
Using confidential information belonging to another, gained while owing a fiduciary duty, will result in a breach of that duty. Feddeman & Co., C.P.A., P.C. v. Langan Associates, P.C., 260 Va. 35, 42, 530 S.E.2d 668, 672 (2000).
F. Secret Profits
Using one’s position to misappropriate money earned, rightfully belonging to the whole enterprise, or entirely to the principal, is a breach of fiduciary duty. See H-B Ltd. Partnership v. Wimmer, 220 Va. 176, 257 S.E.2d 770 (1979).
G. Using Position for Personal Benefit
A fiduciary can breach his duty by using his position for his own personal benefit when dealing with others, even though the actions do not amount to direct misappropriation of funds. See, e.g., Strickland v. Arnold Thomas Seed Service, 560 P.2d 597 (Or. 1977) (holding that agent breached his fiduciary duty by independently selling his own seed supplies at the same time as his employer’s); Elco Shoe Manufacturers v. Sisk, 183 N.E. 191 (N.Y. 1932) (finding that a salesman breached the duty of loyalty to his employer by selling competing styles of shoes along with his employer’s).
H. Improper Solicitation of Clients and Other Employees
Liability for breach of fiduciary duty can arise by soliciting the principal’s clients or other employees to leave, prior to ending the fiduciary relationship. Feddeman & Co., C.P.A., P.C. v. Langan Associates, P.C., 260 Va. 35, 530 S.E.2d 668 (2000).
COMPLYING WITH THE DUTY OF LOYALTY
A. Conflict of Interest: General Principles
1. A conflict of interests transaction is a transaction with the corporation in which a director of the corporation has a direct or indirect personal interest. Va. Code § 13.1-691 (stock); Va. Code § 13.1-871 (nonstock).
2. A director of the corporation has an indirect personal interest in a transaction if:
a. Another entity in which he has a material financial interest or in which he is a general partner is a party to the transaction; or
b. Another entity of which he is a director, officer or trustee is a party to the transaction and the transaction is or should be considered by the board of directors of the corporation.
3. A conflict of interests transaction is not voidable by the corporation solely because of the director's interest in the transaction if any one of the following is true:
a. The material facts of the transaction and the director's interest were disclosed or known to the board of directors or a committee of the board of directors and the board of directors or committee authorized, approved, or ratified the transaction;
b. The material facts of the transaction and the director's interest were disclosed to the shareholders [members] entitled to vote and they authorized, approved, or ratified the transaction; or
c. The transaction was fair to the corporation.
B. Authorizing, Approving, or Ratifying Transactions
1. By the transaction receiving the affirmative vote of a majority of the directors on the board of directors, or on the committee, who have no direct or indirect personal interest in the transaction.
a. Can’t be done by a single director.
b. If a majority of the directors who have no direct or indirect personal interest in the transaction vote to authorize, approve or ratify the transaction, a quorum is present for the purpose of taking action under this section.
2. By the transaction receiving the vote of a majority of the shares entitled to be counted (or votes entitled to be cast by members) under this subsection.
a. A director who has a direct or indirect personal interest in the transaction cannot vote to authorize, approve or ratify.
b. For stock corporations, shares owned by or voted under the control of an entity described in subdivision A-2 can’t be voted to authorize, approve or ratify.
c. A majority of the shares (members), whether or not present, which are entitled to be counted in a vote on the transaction under this subsection constitutes a quorum for the purpose of taking action.
C. Consider having a conflict of interest policy.
THE DUTY OF CARE
A. Although the duty of care is sometimes expressed in terms of a fiduciary duty, it does not rise to the standard of care required of a trustee. Williams v. Fidelity Loan & Savings Co., 142 Va. 43, 128 S.E. 615 (1925). Neither the Virginia Code nor the Model Business Corporation Act speaks of directors' duties in terms of a fiduciary relationship. It is clear, however, that directors and officers must exercise some degree of care and prudence in the protection and management of corporate assets. Mismanagement, waste of assets, and dereliction of duty are all actionable by the corporation or derivatively by the stockholders.
B. The standard of care for directors has varied over time and from jurisdiction to jurisdiction. Several states have required directors to act in good faith and with the care that an ordinarily prudent person would exercise under similar circumstances. Others define the duty as that care which an ordinarily prudent director would exercise in a similar position and similar circumstances. 2 Model Business Corporation Act Annot. 936 (3d Edition, 1985). Virginia had no statutorily defined standard before the adoption of §13.1-690A.
C. The general standard of conduct for directors of stock and nonstock corporations are set forth respectively in § 13.1-690A and § 13.1-870A.
D. These Code sections state "A director shall discharge his duties as a director, including his duties as a member of a committee, in accordance with his good faith business judgment of the best interests of the corporation."
1. According to the Joint Bar Committee Commentary, this standard of care eliminates the need to compare a director's conduct with that of a fictional prudent or reasonable man. The standard was designed to be not so high as to discourage persons from serving as directors. Note that the standard applies to directors' actions as well as to passive non-conduct. § 13.1-690C and § 13.1-870C
2. Also note that § 13.1-690 and § 13.1-870C set forth standards of conduct for directors of stock and nonstock corporations, but not for officers.
BREACHING THE DUTY OF CARE
A. To comply with the requirements of the duty of care, the director or officer must be attentive and inquiring.
1. Ignorance of any fact in the corporation's affairs which it is the director's duty to know is not a defense.
2. Inexperience and honest intentions have historically been ineffective excuses for directors who have not exercised the requisite attentiveness or inquisitiveness. Marshall v. F & M Savings Bank of Alexandria, 85 Va. 676, 8 S.E. 586 (1889).
3. Directors must remain aware of significant corporate developments and must consider adverse developments which come to their attention. Lanza v. Drexel & Co., 479 F.2d 1277 (2d Cir. 1973). See also Francis v. United Jersey Bank, 432 A.-2d 814 (N.J.Supr. 1981), a case in which the bankruptcy trustee of the corporation successfully reached an uninquisitive director.
B. Inadequate Care
Actions against directors alleging a breach of the duty of care are frequently defended by calling on the "business judgment rule," which presumes that actions taken by directors (1) on behalf of the corporation (2) are in the best interests of the corporation. Willard v. Moneta Bldg. Supply, Inc., 258 Va. 140, 515 S.E.2d 277 (1999).
1. Not using an adequate amount of care can result in a breach of fiduciary duty, regardless of whether there was any wrongdoing or personal benefit otherwise received. Kessler v. Commonwealth Doctor’s Hospital, 212 Va. 497, 185 S.E.2d 43 (1971).
2. Depending on the type of relationship, the standard of care required can vary. A trustee is likely held to the highest degree of care. Kitchen v. Throckmorton, 223 Va. 164, 172, 286 S.E.2d 673, 676 (1982); See Va. Code Ann. § 26-45.3. Absent other specific instructions, following the guidelines of a statute can raise a presumption that the fiduciary is using the proper duty of care.
C. The Business Judgment Rule - The business judgment rule will protect a director from liability for action taken on behalf of the corporation or failure to take action provided the director:
1. acted in good faith;
2. was reasonably informed; and
3. rationally believed the action taken was in the best interests of the corporation.
D. Reliance - Unless a director has knowledge or information making reliance unwarranted, a director is entitled to rely on information, opinions, reports or statements, including financial statements and other financial data, if prepared or presented by:
1. One or more officers or employees of the corporation whom the director believes, in good faith, to be reliable and competent in the matters presented;
2. Legal counsel, public accountants, or other persons as to matters the director believes, in good faith, are within the person's professional or expert competence; or
3. A committee of the board of directors of which he is not a member if the director believes, in good faith, that the committee merits confidence. Va. Code § 13.1-690B (stock); Va. Code §13.1-871B (nonstock).
1. A board of directors is not expected to engage in the day-to-day operations of a stock or nonstock corporation. The operation of the corporation is the job of the officers and agents of the corporation.
2. A board may want to adopt bylaws or board resolutions setting forth the scope of management authority given to the officers or executive director so that the lines between oversight and carrying on the business of the corporation are more clear.
3. Board should be aware of the kinds of legal claims typically made against corporation such as theirs and establish appropriate policies and procedures to ensure that the corporation complies with applicable law.
COMPLYING WITH THE DUTY OF CARE
A. To comply with the duty of care, a board should consider the following:
1. Have regularly schedule meetings
2. Receive the minutes of the last meeting and the agenda for this upcoming meeting sufficiently prior to the meeting so that there will be time to review them. Both stock and nonstock corporations are required to keep minutes. Va. Code § 13.1-770A; Va. Code § 13.1-932A.
3. Receive committee reports sufficiently prior to the meeting so that there is time to review them.
4. Limit the use of written consents in lieu of meetings to routine business or business that has already been fully discussed.
B. Be familiar with the Business Judgment Rule.
C. Be familiar with legal requirements that apply to the corporation and, if relevant, its tax exempt entity status.
501-C-3 LIMITATIONS ON PRIVATE BENEFIT, PRIVATE INUREMENT, AND LOBBYING AND THE PROHIBITION ON POLITICAL CAMPAIGN ACTIVITIES
A. A 501-c-3 corporation is not operated for charitable purposes if it serves a private interest.
1. No part of the net earnings of a corporation may enure to the benefit any private shareholder or individual.
2. Such occurs, for example, when:
a. the corporation pays for good or services in excess of their fair market value
b. corporate assets are given to or used by an individual who gave less that fair consideration; or
c. an individual or other entity is paid on a percentage basis.
B. A 501-c-3 corporation cannot devote a substantial part of its activities to lobbying, propaganda, or attempting to influence legislation
a. 26 U.S.C. § 501(h) provides a safe harbor for certain corporations which wish to engage in some lobbying. However, it imposes strict penalties if these limits are exceeded.
b. Generally, if less that 5 % of a corporation’s activities are devoted to lobbying, etc., it will not be found to be devoting a substantial part of its activities to such.
C. A 501-c-3 corporation cannot support, participate, or intervene in any election for public office.
A. Directors should have access at a reasonable time in a reasonable manner to the key officers and/or the executive director, if any, of a corporation.
1. Directors who also receive services from or volunteer for the corporation should be extremely careful not to make requests of staff that would be inappropriate for other clients or volunteers to make.
2. Requests for access to information are most effective if requested at a board meeting or pursuant to committee work.
B. Directors should be permitted at reasonable times for reasonable purposes to inspect the books and records of the corporation.
1. Limitation - HIPPA and medical information on employees
2. Limitation - Personnel records and the need to know.
C. Directors are entitled to receive reasonable notice of special meetings. Va. Code §§ 13.1-686 (stock); Va. Code §§ 13.1-866 (nonstock). Notice of regular meeting is not necessary unless required by the articles or bylaws.
D. Directors have a right to dissent and have their dissent recorded in the minutes.
E. Directors should receive the minutes of the last meeting in a timely fashion.
A. The Privilege is owned by the corporation and can only be waived by a vote of the directors at a meeting at which a quorum is present.
B. The rules of evidence make it possible that any statement by a director to a third party about what is discussed in a board meeting could be binding on the corporation.
C. An express condition of confidentiality should be required from each director before confidential communications are discussed.
D. Honorary and ex-officio members should be asked to leave the meeting when confidential communications are being discussed so as to preserve the privilege.
A. Directors should refrain from disclosing to the public or the press information about the corporation’s legitimate activities unless they are already know to the public or in the public record.
B. A mere director is not a spokesperson for the corporation.
A. A committee’s purpose, powers, duties, and limitations, and its membership, their term of office, and their method of appointment should be stated in the corporation’s bylaws or in a board resolution stated in the minutes. Va. Code § 13.1-689 (stock); Va. Code §13.1-869 (nonstock).
B. Committees may be special or standing committees
C. Common committees include: audit committee, compensation committee, nominating (and removal) committee, and personnel committee.
TAXES - THE 501-c-3 NONPROFIT - UNRELATED BUSINESS ACTIVITIES - DONATIONS
A. A 501-c-3 must be organized and operated "exclusively" for exempt purposes.
1. Exclusively = primarily
2. The presence of a single non-exempt purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of the truly exempt purposes.
3. Exempt purposes are: "[C]orporations, and any community chest, fund or foundation, organized or operated exclusively for religious, charitable, scientific, testing for public safety, literary or educational purposes, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), or the prevention of cruelty to children or animals...."
B. In general, a Form 990 information return must be filed if on the average a nonprofit’s gross receipts for a year exceed $25,000.00.
C. Conducting unrelated business activities may not disqualify an 501-c-3 if the unrelated activities do not constitute the corporation’s primary purpose; however, it may be taxed on income from the unrelated activity.
1. A 501-c-3 corporation may be taxed if it regularly carries on a trade or business that is unrelated to its exempt purpose.
2. If the income from such unrelated business activities begins to become substantial, the corporation should create a taxable subsidiary.
D. Generally contributions of $250 or more to a 501-C-3 corporation are only deductible if the 501-c-3 provides the donor contemporaneous substantiation as to the receipt of the donation.
1. U.S. Code 26 U.S.C. § 170 states the substantiation requirement for certain contributions and what is needed in the acknowledgment.
2. An acknowledgment must state:
a. The amount of cash and a description (but not value) of any property other than cash contributed.
b. Whether the donee organization provided any goods or services in consideration, in whole or in part.
c. A description and good faith estimate of the value of any goods or services provided to the donor or, if such goods or services consist solely of intangible religious benefits, a statement to that effect.
3. The acknowledgment is contemporaneous if the taxpayer obtains the acknowledgment on or before the earlier of
a. the date on which the taxpayer files a return for the taxable year in which the contribution was made, or
b. the due date (including extensions) for filing such return.
4. An exception exists if the contribution is reported by the donee organization in its return which includes the information described in 2.
E. 501-c-3 contributions in return for items of value
1. When a donor receives an item of value in return for a contribution to a 501-c-3, the donor’s deduction is limited to the difference between the amount contributed and the fair market value of the goods or services provided to the donor.
2. 26 U.S.C. § 6115 provides that if a 501-c-3 receives a quid pro quo contribution in excess of $75, the organization shall, in connection with the solicitation or receipt of the contribution, provide a written statement which
a. informs the donor that the amount of the contribution that is deductible for Federal income tax purposes is limited to the excess of the amount of any money and the value of any property other than money contributed by the donor over the value of the goods or services provided by the organization, and
b. provides the donor with a good faith estimate of the value of such goods or services.
3. A quid pro quo contribution is defined as a payment made partly as a contribution and partly in consideration for goods or services provided to the payor by the 501-c-3.
This FAQ is not provided for use or reliance by you or any third parties and does not purport to be exhaustive or to render legal advice for your particular situation or any other specific case. It is meant merely to assist you in sharpening the questions you might ask of your legal advisor in your particular case. Please give me a call should you have any questions. (See: Disclaimer)