Discriminating directors' domain features fiduciary responsibilities.

A fundamental rule in the law of corporations is that ultimate authority for managing the affairs of the corporation is vested in the board of directors. Because the law grants directors such authority, it imposes on them the obligation to act in the best

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This, in essence, is what is meant by the fiduciary obligations of members of boards of directors. With some adaptations, the rules are the same for non-profit and for-profit corporations.

Management Is Vested in Directors

Every state has a corporations' law and many states have separate statutory schemes for for-profit and not-for-profit corporations, although many provisions are similar or identical to each other. In every state, the corporations' statute will provide that "the management of the affairs of the corporation shall be vested in a board of directors."

A director must act in the best interests of the corporation, or at least in a manner not opposed to its best interests. A director owes a "duty of care" to the corporation he or she serves, which the law states as acting with that same prudence and diligence as a reasonable person would use in his or her own affairs.

Ultimate Authority Rests with Directors

Directors may delegate authority and rely on the advice of others, but the ultimate responsibility remains theirs. Although in most situations, directors will not be held personally liable if the corporation is found to be at fault, there are situations in which directors may be held personally liable for the actions of the board or of the corporation.

The power of the directors to delegate their legal obligation to manage the affairs of the corporation is not absolute. Every state statute will expressly say that some powers of the board cannot be delegated.

Directors may rely on the information and advice of others, such as executives and employees or its outside experts, such as attorneys, accountants, bankers, and pension plan administrators. Here, too, however, there are limits on the extent to which the directors can "pass off" responsibility to others.

A good illustration of this is in the selection of plan administrators who are covered by the Employee Retirement Income Security Act of 1974 (ERISA). Rulings have held that where the board of directors selected a plan administrator without sufficient investigation into the competency and expertise of the administrator, but on the basis of personal friendship or favor, the directors could be held liable for any harm suffered by the plan participants due to the mismanagement of the plan administrators. The basis of liability is not that the directors chose a friend, but that the firm chosen wasn't competent.

Another excellent example, because it seems to occur with some regularity, is the obligation to file tax returns. Under federal law, if an association has at least $25,000 in annual income, it must file tax returns. The directors must see to it that these returns are filed; they cannot simply rely on the representations of staff employees or tax accountants or preparers. Otherwise, the association can be subject to daily fines for failing to file, which can result in having to pay thousands of dollars to the IRS. The same applies to almost any other type of tax that must be paid, whether federal or state. This holds especially true for employment taxes and workers' compensation and unemployment compensation taxes.

Nor can directors remain willfully ignorant of the affairs of the association. A director chosen as treasurer, for example, with no knowledge of finance, could not simply rely on the representations and reports of the staff or the auditors that "all is well." The directors do not have to verify the work themselves but they cannot abdicate their responsibility to manage the association by totally delegating this task to others. Again, the standard is how a person would act in his or her own affairs.

The ordinarily prudent, diligent, reasonable businessperson may rely on bankers and stockbrokers to manage investments, but he or she will at least review the statements, talk regularly with advisers, perhaps make suggestions, and ultimately make decisions. Directors of associations must act in the same way vis-a-vis the association.

Directors Must Not Oppose Association's Best Interests

The duty to act prudently, diligently, and reasonably is but one aspect of a director's fiduciary responsibility. Another equally important, and often misunderstood, aspect of this duty is to avoid conflicts of interest. What is frequently misunderstood about avoiding conflicts of interest is that directors think this means they may not have any dealings with the association. This is not correct.

What it does mean is: Acting only with and after full disclosure and approval of the board and not appropriating advantages and opportunities to oneself that belong to the association. This standard is usually interpreted more leniently to require directors to act in a way not opposed to the best interests of the association.

A simple example illustrates these rules. First, suppose the association is looking for land on which to build. A director owns one of the properties the association is looking at. If the director discloses this fact, and the property is selected as the result of an open, competitive process, and if the price paid is one that strangers "dealing at arms' length" would agree to, then there is nothing wrong with the director selling the property to the association at its fair market value.

Now assume that the director knows the association is about to put a bid in on a piece of property, secretly buys the property at a lower price, and then sells it to the association. The director could be held liable for breach of fiduciary duty.

In some states, directors may not vote in a matter involving themselves; in other states, directors may vote.

Proxy Voting Is Generally Prohibited

Generally speaking, directors may not vote by proxy. But most state laws do permit directors to act via telephone, teleconferencing, or by mail, provided there is unanimous consent, at least with respect to votes taken by mail.

Proxy voting is often frowned on because a director's obligation to the association is to give it the benefit of his or her wisdom, expertise, and advice, and to reach decisions after a full exchange of views. None of this can be done if directors vote by proxy.

Director's Act is an Act of the Corporation

Because the law vests the right to manage the affairs of the association in its board and because a legal entity such as a nonprofit corporation can act only through its human agents, the law generally treats the acts of directors as the acts of the corporation.

The directors can bind the association by what they do. This can be one of the most dangerous legal rights and responsibilities both for the association and for the directors personally.

The law recognizes three types of authority: actual, implicit, and apparent. It is apparent authority that causes the trouble. Suppose the board authorizes three directors to hire a chief executive. They have actual authority to do so. (The directors' negotiations with candidates are an example of implicit authority. The board resolution may have said nothing about negotiating an employment contract, but this is implicit in the charge to hire someone.)

Now suppose the board authorized a top salary of $100,000, but the directors offered $150,000. This would be an exercise of apparent authority. The committee has no actual authority to offer $150,000; in fact, it has been told not to go above $100,000. But the candidates for the job don't know this. As far as they know, the committee is authorized to offer whatever salary is necessary. If the committee offers a candidate a job at $150,000 and he or she accepts, the association will be bound by the theory of apparent authority, regardless of the fact that the committee had no actual authority to offer so much.

In 1982, there was a real-life example of how apparent authority can work to the detriment of an association. Several committee members of a standards-setting organization wrote a letter on the association's letterhead which so harshly criticized a company's product that it put the company out of business. The Supreme Court found the association liable for $7 million in damages, on the theory of apparent authority, even though it was uncontested that the committee members acted without the knowledge of the full association.

Because of the theory of apparent authority, directors must be extremely careful about what they say and promise; their words and deeds can create legal liability for the association, even where and when they have no actual or implied authority to do so.

Incorporation Can Act As a Shield

Incorporation itself will shield directors from personal liability, although not in all cases. A basic premise of incorporating is that the corporation becomes a separate, legally recognized "person" responsible for its own acts. Thus, even if individual directors enter into a contract they were not authorized to sign, the other party to the contract will only be able to sue the corporation and not the directors individually.

Two major exceptions exist to this rule, however. First, if the directors are not careful to observe all the formalities and rules of separate incorporation, they can be held individually liable on what are colorfully called the "alter ego" theory (the actions of the individuals and the corporation are so closely combined that one is the alter ego of the other) or the "pierce the corporate veil" theory (the court will look through or beyond the corporation to hold the directors liable). Second, if the directors act criminally or fraudulently, they can be held personally liable.

Of course, even where a third party cannot hold the directors individually liable, the association itself may sue its own directors to recover damages caused by them.

Associations Can Select Indemnification

The second protection that the law affords directors personally is that it allows the corporation to indemnify its directors from liability for acts committed in the exercise of their official duties on behalf of the corporation. The law itself permits very broad indemnification of directors, although it is up to the association itself to decide to what extent it wants to indemnify its directors.

Typically, associations take full advantage of this right by providing in their bylaws that officers and directors shall be indemnified "to the fullest extent permitted by law." Here, too, however, there are limits. Under certain extreme circumstances, which very seldom arise, an association may not have any duty to indemnify directors. It is common for associations to pay for such indemnification by purchasing liability insurance policies for their officers and directors.

More States Are Adopting Volunteer Protection Acts

More states are enacting amendments to their "not-for-profit corporation acts" which grant statutory immunity to directors for their actions as directors on behalf of the nonprofit corporation. Under these amendments, a director may not be sued by a third party for actions taken on behalf of the corporation.

Some of these statutes are rather limited; for example, they may not apply to all nonprofit organizations (such as trade associations or chambers of commerce) but only to charitable nonprofits (schools, universities, and hospitals). They may also apply only where the director can show that he or she was acting in good faith, and not where willful, intentional, reckless, or malicious conduct was proved.

Serve without Fear, But Responsibly

Because the directors' authority is very broad, the ultimate power in an association rests with the board of directors. For this reason, the law imposes a duty on directors to act reasonably in managing the affairs of the corporation. This is often referred to as their fiduciary duty.

The law also tends to be very protective of directors, allowing them, for example, to rely on the information and advice of others, allowing them to engage in business dealings with their own organizations, and declining to hold them liable when they are guilty of nothing more than bad judgment or making a mistake. Nevertheless, protections are not absolute. There are a number of theories and a number of situations in which directors may be held personally liable.

While no one should hesitate or fear to serve on a board of directors because of concern about personal liability, neither should anyone assume that they can act with impunity or reckless abandon simply because they are a director of a nonprofit, tax-exempt association.

Gerard P. Panarro is an attorney with Webster, Chamberlain & Bean, Washington, D.C.