Protecting Board Members & Officers

Useful Changes to Tennessee Nonprofit Corporation Act for 2015

Presented by:

William E. Mason, Brittany Brent Smith, Zack R. Gardner

Kennerly, Montgomery & Finley, P.C.

wemason@kmfpc.com

bsmith@kmfpc.com

zgardner@kmfpc.com

Copyright © 2014 Kennerly, Montgomery & Finley, P.C.

Role of Board Members

and Officers in a Nonprofit

Directors make up a nonprofit corporation’s Board of Directors.

Directors work together to oversee the activities of the nonprofit corporation.

Board of Directors appoints the nonprofit corporation’s Officers.

Officers usually consist of, at least, an Executive Director or President, a Secretary, and a Treasurer.

Officers are responsible for the management and day-to-day operations of the nonprofit.

Executive Director or President operates under and reports to the Board.

Other Officers generally report to the Executive Director or President.

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Constituents of a Nonprofit Board

Board

Secretary of State and Attorney General

Members

(if applicable)

IRS

Donors

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Are Directors & Officers Liable

to Nonprofit Corporations?

Generally, a nonprofit's directors and officers are not liable for

the corporation's debts and obligations, including for the

wrongful acts of others involved in the corporation.

However, personal liability may stem from the director's or

officer's breach of its duties to the corporation or other wrongful

acts.

Fortunately, Tennessee law provides for a number of protections

of directors and officers against liability.

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Extension of Protections

to Officers, Employees, and Agents

Tennessee Nonprofit Corporation Act permits

corporation to indemnify and advance expenses to

officers, employees, and agents to the same extent as

directors

Revisions to the Act clarify that Board committee

members who are not directors are entitled to same

protections as directors

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Potential Sources of Liability

Breach of fiduciary duties to nonprofit corporation

Governance

Executive compensation

Wrongful handling of conflicting interest transactions

Failure to protect the nonprofit corporation's charitable assets

Executive compensation

Unlawful distributions

Improper merger, dissolution, sale of assets, etc.

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Breach of Fiduciary Duties - Governance

Directors and officers owe certain fiduciary duties to the nonprofit corporation

Duty to act in good faith, duty of care, duty to act in the best interests of the corporation

Scenario: Director John fails to attend Pleasantville Museum of Art Board meetings regularly, does not review Board materials provided in advance of meetings, and fails to meaningfully participate as a director. John may be in breach of his fiduciary duties to Pleasantville Museum of Art.

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Director Checklist for Proper Governance

Attend Board and committee meetings

Review Board material prior to meetings

Participate in discussions, ask questions

Ensure complete and accurate minutes are taken

Follow the Charter, Bylaws, and other applicable laws

Rely on advice of qualified professionals

Avoid conflicts of interest

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Breach of Fiduciary Duties -

Executive Compensation Issues

Ensuring that the Board has approved reasonable and not excessive

compensation for the nonprofit’s executive director or president is one of the

fiduciary responsibilities of nonprofit boards.

Scenario: Pleasantville Museum of Art needs to hire a new Executive

Director. Directors Ann, John, and Sara did not follow an established process

in choosing a qualified Executive Director and determining the Executive

Director’s reasonable compensation. The Directors hired Executive Director

Mark, John’s Cousin, without consideration of other candidates, agreed to

pay him a high salary without the use of comparability data, and failed to

document their decision-making process. Directors Ann, John, and Sara may

have breached their fiduciary duties to the corporation and put the Museum’s

tax-exempt status in jeopardy.

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Conflicting Interest Transactions

Directors and officers have a duty to disclose potential conflicts of

interest with the nonprofit corporation

Board is required to take specific steps in considering and approving

conflicting interest transactions

Scenario: Pleasantville Museum of Art is considering entering into a

contract with a Acme Consulting Firm, for which Executive Director

Mark’s wife works. If Mark fails to disclose the potential conflict or

the Board fails to properly consider the conflict before approving the

contract, Mark and the Board could be subject to personal liability and

the contract could be rescinded.

Area extensively changed by revisions to the Tennessee Nonprofit

Corporation Act effective January 1, 2015

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Protection of Charitable Assets –

Unlawful Distributions Assets of nonprofits and tax-exempt entities must be used exclusively for

charitable purposes

Improper handling of executive compensation issues constitutes a failure to protect assets and is a basis for liability

Directors’ approval of unlawful distributions of charitable assets is a basis for personal liability

Distribution: a transfer of assets, income, or profit from a nonprofit corporation to its members, directors, or officers

“Unlawful” distribution: a distribution made in violation of the corporate charter or otherwise prohibited by law

Check your charter – Provision imposing liability for unlawful distributions renumbered by revisions to Tennessee Nonprofit Corporation Act.

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Director’s Personal Liability

for Unlawful Distribution

If a director votes for, or assents to, an unlawful distribution, then the director may be held personally liable to the corporation for the amount distributed that exceeds the amount that could be lawfully distributed. A director held liable for an unlawful distribution may

receive contribution from other directors who voted or assented to the distribution and each person who received an unlawful distribution up to the amount received.

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Unlawful Distributions (Cont’d)

Scenario: Pleasantville Museum of Art held a rather successful fundraising

event where they raised $10,000 more than they needed to fund their

regular operations. Directors Ann and Sara decide that they’ve done such a

great job that they’re going to distribute that excess money to the Directors

and Executive Director Mark for their contributions to the fundraising

success. Director John votes against the distribution and refuses to take any

of the money. The others happily take the money and quickly spend the

funds.

This would be an unlawful distribution, and Ann and Sara would be

personally liable for the total amount distributed and would have the

right to seek contribution from Mark. John would not be liable.

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Notice to Attorney General of Conversions, Mergers,

Significant Asset Sales, and Dissolutions

Attorney General must be given notice of conversions, mergers,

significant asset sales, and dissolutions

Scenario: Pleasantville Museum of Art dissolves, but the Board

fails to notify its members of the pending dissolution, fails to

submit appropriate documentation to the Attorney General in

advance, and fails to distribute its assets to an appropriate

charitable recipient. This is an area of potential liability.

This is an area extensively changed by the revisions to the

Tennessee Nonprofit Corporation Act effective January 1, 2015

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Options for Protecting Directors & Officers

Elimination of personal liability for breach of

certain fiduciary duties in Charter and Bylaws

Indemnification

Insurance

Advancement of expenses

Immunity

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Elimination of Personal Liability

in Charter and Bylaws

Charter may eliminate or limit personal liability of director to the

corporation or its members for monetary damages for breach of fiduciary

duty

Charter shall not eliminate/limit liability for:

Breach of duty of loyalty

Acts/omissions not in good faith or involving intentional misconduct

or violation of law

Approval of unlawful distribution

Similar provision in Bylaws can extend protection to Officers,

employees, and agents

Check your Charter and Bylaws for this provision

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Indemnification

Effective January 1, 2015, Charter may permit or make obligatory

indemnification of a director for liability to any person for any action taken

or failure to take any action as a director

Charter shall not provide indemnification for:

Receipt of a financial benefit to which director is not entitled

Intentional infliction of harm

Approving unlawful distributions

Intentional violation of criminal law

Similar provision in Bylaws can extend protection to Officers, employees,

and agents

Check your Charter and Bylaws for this new provision

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Indemnification (Cont’d)

Tennessee Nonprofit Corporation Act also provides for mandatory and

permissive indemnification of directors.

Mandatory Indemnification: Unless limited by its Charter, a

corporation is required to indemnify a director to the extent the

director is successful (or immune from suit) in the defense of any

proceeding in which the director is a party

This is a change effective January 1, 2015 from prior law

requiring the director to be "wholly successful"

Nonprofit is required to extend mandatory indemnification protection

to its Officers to the same extent as Directors.

A corporation may choose to indemnify its employees and agents, as

well.

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Indemnification (Cont’d)

Permissive Indemnification: A corporation may choose to indemnify a

director if the director acted in good faith and believed the director’s actions

were in the best interests of the corporation

However, the corporation may not choose to indemnify:

if the proceeding was brought by the corporation and the director was

adjudged liable;

where the director was adjudged liable for receiving an improper

personal benefit;

for the director’s breach of his or her duty of loyalty to the corporation or

its members;

for acts or omissions not in good faith, or which involve intentional

misconduct or a knowing violation of law; or

for approval of an unlawful distribution

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Insurance and Advancement of Expenses

Corporation may purchase and maintain insurance on behalf of a director, officer, employee, or agent of the corporation, regardless of whether the corporation would have the power to indemnify the individual

Corporation may pay for or reimburse reasonable expenses incurred by a director, officer, employee, or agent who is a party to a proceeding in advance of final disposition of the proceeding if the individual provides the required documentation to the corporation

Check your Charter or Bylaws for these provisions

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Immunity

Under Tennessee law, directors, trustees, and members of governing bodies of nonprofit corporations that are exempt from federal income taxation under Internal Revenue Code section 501(c)(3) are immune from suit arising from the conduct or affairs of the corporation

No immunity where conduct amounts to willful, wanton, or gross negligence

Immunity does not extend to officers, employees, and agents who are not directors, trustees, or governing body members

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Conflicts of Interest and Disclosure Requirements

Both Tennessee and Federal law impose a number of

rules and restrictions upon nonprofit and tax-exempt

corporations

These rules and restrictions can vary depending on

whether the corporation in question is only a state-

registered nonprofit or is also a federally-recognized

tax-exempt entity

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Tennessee Nonprofit Corporations

Tennessee law imposes a number of duties on directors,

officers, and members of nonprofit corporations

T.C.A. § 48-58-301 states that directors must discharge

their duties in good faith, with the care of an ordinarily

prudent person, and in furtherance of the best interests

of the corporation

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Director’s Duty to Disclose

New rule

In discharging his or her duties, a director must disclose to the other board members any information that the director knows to be material to the discharge of the board’s decision-making or oversight functions.

However, if the director has some other positive duty not to disclose, then the director is not required to do so.

For example, an attorney has a duty not to disclose confidential client information

It is also important to include this disclosure in the written meeting minutes of the board.

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Director’s Duties to Disclose (Cont’d)

Information “material” to the discharge of a board’s functions

include information which might affect an objective reasonable

director’s decision on a matter

EXAMPLE 1:

Alvin, Bob, and Charlie are directors of a nonprofit corporation,

Community Outreach, Inc. The corporation is deciding whether it

should use the services of ABC Catering Co. for a fundraising

event. Alvin knows from personal experience that ABC Catering

has a history of poor service and unreasonably high prices

compared to other catering companies in the area. This is

information that might affect an objective reasonable director’s

decision. Therefore, Alvin should disclose this information.

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Director’s Duties to Disclose (Cont’d)

EXAMPLE 2:

Same basic facts as Example 1, except instead of deciding whether to hire ABC Catering Co., the Directors are deciding whether to approve a long-term contract for supplies with Acme Paper Co., a publicly-traded entity. Charlie indirectly owns a small number of shares of stock in Acme Paper Co. through his interest in a mutual fund. Charlie would not need to disclose this fact because the fact that he owns a small amount of stock probably would not affect an objective reasonable director’s decision on whether to order paper supplies from Acme Paper Co.

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Directors May Rely Upon Third Parties

In discharging their duties, directors may rely upon

information, opinions, reports, or statements if prepared or

presented by:

employees or officers of the corporation that the director reasonably believes to

be reliable and competent in the matters presented;

legal counsel, accountants, and other experts; and

a committee of the board of directors of which the director is not a member if

the director reasonably believes the committee merits confidence. T.C.A. § 48-

58-301(b)

However, if a director has knowledge concerning a matter in

question that makes reliance on third persons unwarranted, then

the director will be found to have acted in bad faith. Id. at (c).

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Officers’ Duties

Officers, such as presidents, vice presidents, etc., also have

duties imposed upon them by Tennessee law. Officers with

authority to act on behalf of the corporation in any transaction

must discharge all duties under that authority

in good faith,

with the care of an ordinarily prudent person, and

in the manner the officer reasonably believes to be in the best

interests of the corporation.

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Officers May Rely Upon Third Parties

Similar to directors, officers may rely upon third

persons. Specifically, officers may rely upon

information, opinions, reports, or statements if

prepared or presented by:

one or more officers or employees of the corporation whom the

officer reasonably believes to be reliable and competent in the

matters presented; or

counsel, accountants, or other professionals

No provision for reliance on committees

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Officers’ Duty to Inform

A director’s duty is to disclose material information to other directors, officers have a duty to inform certain persons of information known to the officer. This duty refers to two types of information:

Information regarding the affairs of the nonprofit corporation known to the officer that are within the scope of the officer’s functions and are known by the officer to be material to the person the officer is informing; and

Information related to any action or probable (a) material violation of law involving the corporation or (b) material breach of duty to the corporation by an officer, employee, or agent of the corporation

Note: Directors’ duty to disclose refers to information that may be material to the board in carrying out its functions, while officers’ duty to inform encompasses the two categories above.

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Whom Must Officers Inform?

Persons whom officers must inform are:

superior officers to whom the officer reports;

the board of directors or a committee thereof to which the officer reports; or

another appropriate person or group within the nonprofit corporation, including legal counsel, other professionals, and members of the corporation.

EXAMPLE 3:

Daphne is the vice president of Community Outreach, Inc. and has discovered that the head equipment and supplies manager, Ellen, has been overstating the costs of paper and other products and pocketing the difference. Daphne must inform her superior officer, the president, of these facts because Ellen’s actions constitute a material breach of duty to the corporation by an employee of the corporation.

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Conflicting Interest Transactions

New rule

A “director’s or officer’s conflicting interest transaction” is a transaction effected or proposed to be effected by the corporation (or by an entity controlled by the corporation):

to which the director or officer is a party;

respecting which the officer or director had knowledge and a “material financial interest” known to the director; or

respecting which the director or officer knew that a “related person” was a party or had a material financial interest

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Conflicting Interest Transactions (Cont’d)

A “material financial interest” is a financial interest that would reasonably be

expected to impair the objectivity of a director or officer when deciding

whether to authorize a transaction. TCA § 48-58-701(4)

A “related person” includes:

directors’ and officers’ spouses, children, step-children, grandchildren,

parents, stepparents, grandparents, siblings, step-siblings, half-siblings,

nieces, nephews, and aunts and uncles;

individuals living in the same home as a director or officer;

and an entity controlled by the director or officer

an entity “controlled by” a director or officer is an entity in which the

officer or director has the ability to elect or remove a majority of the

members of the board.

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Conflicting Interest Transactions (Cont’d)

Conflicting interest transactions may subject the corporation, its directors, and its officers to equitable relief and give rise to money damages. TCA § 48-58-702(a)-(b).

Equitable relief includes rescission of contracts, injunctions, removal of directors, and other corrective actions.

However, if proper steps are taken, a transaction which might normally be considered a conflicting interest transaction may be authorized.

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Avoiding Conflicting Interest Transactions

A conflicting interest transaction may still be authorized

without giving rise to corporate or personal liability if:

The majority of qualified directors approve the transaction; or

The majority of qualified members of the corporation approve the

transaction; or

The transaction is found by a court to be to be “fair” under the

circumstances; or

Either the attorney general or court of record approves the transaction

A “qualified” director or member is a director or member whom does not (1)

have material financial interests in the transaction or (2) have familial,

financial, professional, employment, or other interests which might impair

the directors’ objectivity.

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Conflicting Interest Transactions

EXAMPLE 4:

Same basic facts as Example 1, however at the monthly meeting

of the board of directors, Alvin suggests that they use his wife’s

catering company, Pam’s Catering Co., for their upcoming event.

Alvin makes sure to tell them that his wife is the president and

majority shareholder of the company. Alvin takes part in the

discussion and votes on the resolution authorizing the hiring of

Pam’s Catering. The board then takes up unrelated business and

adjourns the meeting.

This is presumed to be an invalid transaction because Alvin is not

a qualified director; he participated in the discussion of whether to

hire his wife’s company, and voted on the resolution.

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Example 4 (Cont’d)

This decision may, however, be ratified by a vote of the two

qualified directors, Bob, and Charlie. To do this, Bob, and

Charlie will need to meet again, discuss the issue, and vote

without any input from Alvin.

Additionally, if a lawsuit is brought and a court finds that the

transaction is “fair” under the circumstances, no director will

have liability due to the conflict of interest.

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Federal Tax-exempt Entities: Conflicts of Interest

Conflict of interest transactions are handled somewhat more

stringently at the federal level for tax-exempt corporations.

§ 501(c)(3) Tax-exempt corporations (i.e., public charities and

private foundations organized and operated to further exempt

purposes including charitable, educational, scientific, and

literary purposes, among others) are prohibited from allowing

more than an “insubstantial” benefit to private individuals or

organizations.

This restriction is in place to ensure that public interests, not

private, are served by the § 501(c)(3) tax-exempt entity.

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Federal Tax-exempt “Conflict Of Interest Policy”

The IRS strongly suggests that each § 501(c)(3) have a “conflict

of interest policy” in place. While not mandatory, the conflict of

interest policy aids tax-exempt organizations in following

procedures which assure that excess benefit transactions and

other private inurement issues do not jeopardize tax-exempt

status.

The IRS provides a Sample Conflict of Interest Policy that

entities may base their policies on. In the sample policy, the

IRS creates requirements similar to those found in Tennessee

law regarding disclosure of financial interests.

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Conflict of Interest Policy (Cont’d)

Like Tennessee’s disclosure requirements, directors, officers,

and members are required to disclose whether the person has a

financial interest in a transaction, directly or indirectly, through

business, investment, or family.

Unlike under Tennessee law, the policy suggested by the IRS

does not set general rules for determining whether a conflict of

interest exists.

Just because there is a financial interest involved, does not mean

there is a conflict of interest. Instead, the IRS Sample Conflict of

Interest Policy allows the directors without a financial interest to

meet and decide whether a conflict of interest exists.

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Excess Benefit Transactions

Insiders, such as directors, officers, and organizations which

may have substantial influence over the corporation’s affairs,

must be sure not to engage in “excess benefit transactions.”

Treas. Reg. § 1.501(c)(3)-1(f)(2)

Excess benefit transactions are those in which the tax-exempt

corporation provided an economic benefit to any person, such as

those described above, which exceeds the fair market value of

any goods or services received in exchange for the economic

benefit provided.

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Excess Benefit Transactions (Cont’d)

An example of an excess benefit transaction would include a

situation where an insider, such as a director, owns a business

that is hired to perform services for the tax-exempt organization

but the price paid to the director-owned business is

unreasonable.

Example: Children’s Book Charity, Inc. hires Director Ben’s

company, Ben’s Trucking Co., to ship books to schools around the

country. The usual price charged for comparable services works

out to be around $50-60 for every 100 books shipped depending

on fuel costs. Ben’s company charges a rate of $75-85 for 100

books shipped. This would be unreasonable.

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Excess Benefit Transactions (Cont’d)

Example 5:

Acme Development Corporation is a Tennessee non-profit, federal tax-exempt corporation. Its board of directors, Alice, Bradley, Chuck, and Dianne oversee the corporation’s general operations on a part-time basis. The board decides to pay each director an annual salary of $100,000. The fair market value for similar services is much less—around $20,000.

This would be considered an excess benefit transaction because the board of directors—all insiders—were provided with an economic benefit which far exceeded the fair market value of the services provided. This may subject them to civil liability under Tennessee law, and it may jeopardize the corporation’s federal tax-exempt status.

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Excess Benefit Transactions (Cont’d)

If a tax-exempt organization engages in a substantial amount

of excess benefit transactions, the IRS may revoke the

organization’s tax-exempt status. Treas. Reg. § 501(c)(3)-1(a)-

(f).

If an entity engages in an excess benefit transaction with an

insider, they must report the transaction to the IRS using a

Form 990 or Form 990-EZ.

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Information on the Firm

Kennerly Montgomery is a general practice law firm that has provided legal

advice to clients for almost 100 years. KM attorneys practice in a variety of

areas, representing public, private, and municipal clients, including nonprofit

and tax-exempt entities, public and private employers, local governments,

agencies and public utilities.

Bill Mason, Brittany Brent Smith, and Zack Gardner practice extensively in the

firm’s corporate law practice area, representing numerous nonprofit and tax-

exempt entities. The attorneys practicing in this area routinely guide nonprofit

and tax-exempt entities through various issues concerning formation, operations,

governance, employment, and financing under various applicable federal, state,

and local laws.

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A Little About Your Presenters

Bill Mason received his JD from Harvard Law School in 1974, and has been practicing law for 40 years, most

of that time in employee benefits for governments. He worked for the Tennessee Valley Authority from 1974 –

1986, Wagner Myers & Sanger PC, from 1986 – 1988, and William E. Mason PC from 1988 – 2009. Bill joined

Kennerly Montgomery in 2009. He is the Chair of the Hillcrest Healthcare Board of Directors.

Brittany Brent Smith is an associate with Kennerly Montgomery focusing in the areas of corporate law and tech

transfer and commercialization. Brittany assists business and corporate clients with a range of business

planning and operations services, including establishing, organizing, and maintaining their entities. She

routinely assists non-profit and tax-exempt entities with forming their organizations and obtaining and

maintaining their non-profit and tax-exempt statuses. Brittany counsels public entities and private companies,

senior management, boards of directors, and board committees on a broad range of corporate governance and

compliance matters, including governance structure, governance materials, conflicts of interest, and general

functioning. She serves as a member of the Board of Trust of the Appalachian Ballet Company.

Zack Gardner joined Kennerly Montgomery as an associate in July of 2014. He works primarily in the firm’s

business & corporate law practices. He graduated cum laude from the University of Tennessee with a

Concentration in Business Transactions in 2013 and also earned a Bachelor of Arts in Political Science and

History, summa cum laude, from the University of Tennessee in 2010. He also serves on the Knox Bar

Association’s Minorities Opportunities Committee.

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Bill Mason: wemason@kmfpc.com

Brittany Brent Smith: bsmith@kmfpc.com

Zack Gardner: zgardner@kmfpc.com

KENNERLY, MONTGOMERY & FINLEY, P.C.

550 MAIN STREET, FOURTH FLOOR | KNOXVILLE, TN 37902

P.O. BOX 442 | KNOXVILLE, TN 37901

PH (865) 546-7311 | FX (865) 524-1773 | WWW.KMFPC.COM

Copyright © 2014 Kennerly, Montgomery & Finley, P.C.