In my last post, I shared a story of a school — they tried to figure out how to hire and then supervise the son of the head of school who was best qualified for a position. They had great intentions but there were too many conflicts and they ended up with a well-intended mess.

Understanding conflict of interest and managing it appropriately is extremely important for boards. Not doing so can lead to legal risks.

Conflict May Not Be Illegal — Transparency Is Key

Can you tell me a bit about yourself?

I joined Perkins Coie out of law school in 1987 from the University of Nebraska at Lincoln. I first joined the business group, but I found that I enjoyed working more with individuals than with big businesses. I now work mostly with tax exempt organizations and I co-chair then National Exempt Organization Industry Group. I work with a variety of nonprofits, public charities, private foundations, trade associations, social clubs, social welfare organizations, and even some taxable nonprofits. I work with business clients who want to do charitable or social purpose activities. I advise them on how to do it and what regulations might apply. I also do a lot of pro bono work.

Can you describe what you mean by conflict of interest for a nonprofit board? Why does it matter?

A conflict of interest exists when a director has a material personal interest in some sort of transaction in which the nonprofit may be a party. A conflict of interest is not inherently illegal or unethical. It does not automatically mean that it is detrimental to the nonprofit. It means that you need to spot a conflict of interest and figure out how to handle it appropriately.

It matters for a number of reasons. State law specifies the fiduciary duties for directors and officers. The two primary duties are the duty of care and the duty of loyalty. The duty of loyalty is where conflict of interest fits into the equation. A duty of loyalty requires a director to serve in good faith and act in the best interest of the nonprofit. That means putting the nonprofit’s interest ahead of the director’s. That is why you have to be able to identify those conflicts. In addition, the IRS has also focused on good governance because most adjustments with nonprofits are the result of bad governance; when the organization does not pay attention to the rules. The IRS wants to make sure nonprofits are operating appropriately. The other reason that conflict of interest matters is PR. No one wants to end up on the front page of the newspaper in an unfavorable light and knowing how to handle conflict helps avoid that.

So, two risks are problems with the IRS and bad press. Are there other risks associated with a conflict of interest?

There are investigations by the attorney general’s office. They have become more active in Washington State and generally across the country

Another important reason is liability and its financial impact. Under Washington State law, there are very good liability limitations in place for directors. But these do not apply if a director personally receives an unfair benefit in money, property, or services. In those cases, directors lose their liability protection.

If there is a conflict of interest, I think it can also derail the way the board works together. For example, if one person thinks another had a conflict but that person does not think they do. So, understanding and having the set of procedures helps the board function on a more streamlined basis.

How does a conflict of interest impact the functioning of a board?

First of all, it is important from a governance perspective, that the nonprofit has a conflict of interest policy. And it is not just enough to adopt the policy, they actually have to review and understand it. A lot of times, the board adopts the conflict of interest policy and then they put it away. And what we really want to do is to adopt the policy, do some training with the board so they understand what it means, and give examples on how to spot conflict. The board should review that policy annually. Annual certifications are a good habit to get into because it makes people think about conflict. And that policy needs to be very clear about who’s covered by the policy and what you do when you actually spot the conflict. Board members should be reminded to bring up a conflict if something new happens during the year. They should not wait until the annual process.

What should happen when you spot a conflict?

As a director, I need to disclose all the actual or possible conflicts and the relevant facts surrounding it. I need to tell the board and I should answer questions from the board if they think they need more information. The board should then excuse me from the room and talk about the conflict, decide if they need any more questions answered, decide if they need to do any additional investigation. The remaining directors have an obligation to fully discuss the conflict and complete a reasonable investigation. Everything needs to be carefully documented in the minutes of the board meeting. So, you need a reasonably detailed description of the conflict that is at issue and the facts that the board considered when thinking about the conflict, documentation that the conflicted person wasn’t in the meeting for the discussion and how the vote went, listing the directors who voted for the transaction and who voted against the transaction. Usually when doing minutes, the secretary will just say that some passed by a majority vote or a unanimous vote. But when it comes to a conflict of interest, it is a good idea to be very clear who voted yes and who voted no. If I am on the board and I ever vote no, on any issue, I like to make sure it is clear in the minutes.

If someone has a conflict of interest should they resign? Recuse themselves from specific votes?

It depends on the conflict. Generally, you don’t need to resign from the board. Some people do. A lot of times you can serve on the board, you can fulfill your contribution, you can be a valuable member. But you recuse yourself from the items where there is a conflict.

Can only board members have a conflict of interest? Can it be a volunteer or staff people?

It depends on the organization and how their conflict of interest policy is drafted. A lot of conflict of interest policies focus on officers and directors. Some have dual layers of conflict of interest policies – one is for management and one for staff and volunteers. So, it is a matter of preference for the nonprofit. The board would be considered management.

Is nepotism considered a conflict of interest?

I think nepotism is a conflict of interest. Does it mean it’s bad? Does it mean you cannot hire someone related to someone else? It just means you need to disclose it and follow your policy. And if it makes sense at the end of the day to hire that person, it is fine to hire that person.

Is there anything else about conflict of interest?

Adopt the policy and then follow the policy. It sounds simple, but it is sometimes hard to do. The other thing is make sure you ask questions. There is a case in New York where the directors really got hammered with penalties and had to sign something that they would never serve as a director of a nonprofit again. They just did not ask questions. They were “yes” men for the executive director. There was a lot of interaction between the executive director and the nonprofit and the executive director’s wife – nepotism – and also businesses owned by the wife. If the board had just asked a few questions, this all could have been averted.

Does this means you should also have the ED sign a conflict of interest?

Definitely. I do them with all management. It does depend on the nonprofit whether management signs a conflict of interest. And remember just because there is a conflict, it does not mean it is bad. A lot of people get so nervous. It just means you have to work through it. Transparency is really key.

I worked with a nonprofit in a pretty small community – where everyone is related to everyone through business or school. How do you handle these conflicts in a practical manner? We had to narrow down what we considered conflict. So, their policy was uniquely drafted with an emphasis on why they viewed something as a conflict so they could function.

How do you narrow it down? What are the criteria?

In this case, they focused on immediate family defined as spouse, children, parents, and someone living in your house. Anybody outside of that, they would not consider a conflict. In connection with another nonprofit, if you were a direct supervisor of someone or you were directly supervised by someone who is related, then there is a conflict. If you were a grant partner where you would also receive funds if the grant was awarded, it was a conflict.

I always like to tell my clients, if you think you might have a conflict, err on the side of disclosure.

In a small organization, do you recommend steering away from nepotism? Hiring someone related?

Practically speaking, people serve on boards because they are interested in the cause. There are a lot of tiny nonprofits around. That means a lot of family interested in the cause. But you constantly run into problems that way. For example, if there is a salary being paid, how do you really have independent directors who are looking at it? That’s another interesting thing – how do you determine compensation when everyone is being compensated? Some nonprofits have a policy that if you are compensated by the nonprofit, you will not be on the board. But a lot of nonprofits want their ED or their salaried president to be on the board. And that is just going to cause a constant conflict. You have to be careful how you handle it.