Conflicts of interest are a normal part of organizational life, but dealing with them is anything but simple. Whenever nonprofit directors, officers or staff members’ personal interests are impacted by their decision-making on behalf of the nonprofit, conflicts of interest can arise. All nonprofits encounter conflicts and all nonprofits need to understand effective conflict management.
First, it is important for all decision-makers to understand that conflicts of interest are not illegal; however, they can lead to violations of the law if they are not properly managed. The question is not whether the nonprofit has conflicts, but rather how the conflicts are managed. With proper management, nonprofits can reduce or even eliminate the potential for biased decisions.
Conflicts of Interest
A conflict of interest can include any situation in which a nonprofit representative’s private interest differs from the nonprofit’s interest. For example, a conflict arises when:
- A nonprofit director serves as a board member of a private foundation that is one of the nonprofit’s funders;
- A nonprofit pays reasonable and necessary compensation to the law firm of a board member to provide legal advice;
- A nonprofit makes a scholarship grant to a director’s grandson;
- A nonprofit leases space from a director’s company.
Note that in all these examples, the nonprofit’s activity is not patently illegal. However, the transactions could result in private inurement or an excess benefit transaction if the amounts paid to insiders or their relatives prove to be excessive. To guard against making excessive payments or biased decisions, the nonprofit should ensure that the directors, officers or staff members affected by the conflicts do not take part in decisions that could benefit their personal interests. To help manage the decision-making process and reduce the potential for bias, most organizations adopt and follow a conflict of interest policy.
Conflict of Interest Policy
Generally, conflict of interest policies are not legally required. However, the IRS requires organizations applying for tax-exempt status to state whether they follow a conflict of interest policy and provide an explanation if they do not. Further, the annual Form 990 asks whether organizations follow a conflict of interest policy. We have yet to encounter an organization that can articulate a good reason for not having one. Also, Arizona law requires nonprofit corporations with assets in excess of $10,000,000 to adopt and follow a conflict of interest policy.
A well drafted policy will require the organization to take certain steps to manage the conflict as follows:
- Disclosure. The conflicted party must disclose their affiliations and potential conflicts. Many organizations circulate a questionnaire annually and require potential conflicts to be disclosed as they arise.
- Evaluation. The Board or a Board committee should determine whether the disclosed affiliations have the potential to influence decisions and thus rise to the level of a conflict of interest.
- Recusal. If an affiliation does have the potential to influence decisions, then the interested individual should refrain from voting on the conflicted matter. The individual with the conflict may provide background information to assist the Board with its decision; however, once background information has been provided, the interested individual should recuse themselves and ideally, leave the meeting room. The remaining board members who do not have a conflict of interest must decide the matter without the influence of the conflicted individual(s).
- Review Alternatives. The disinterested directors should seek alternatives that do not give rise to a conflict of interest where possible. If, after reviewing the alternatives, the disinterested directors determine that the conflicted transaction is in the organization’s best interest, they can approve it with confidence.
- Document. Finally, meetings involving conflicts should be carefully documented. Minutes should reflect who was present at the meeting, a description of the conflict, the fact that the interested individuals left the meeting room prior to the deliberations and vote, the alternatives considered, and the basis for the final decision. If the conflicted transaction is approved, the minutes should list the facts that convinced the decision makers that it was in the organization’s best interests.
Handling conflicts of interest in this manner not only helps the organization and its leaders avoid legal violations, it also ensures its decisions are made with integrity thereby enhancing the organization’s reputation.
Finally, it is important to note that private foundations subject to the self-dealing rules have additional considerations as the self-dealing rules generally prohibit conflicted transactions.
Ellis Carter is a nonprofit attorney licensed to practice in Washington and Arizona. Ellis advises tax-exempt clients on federal tax matters nationwide.