In part one, we discussed several factors to consider when deciding whether to join a nonprofit board, including the organization's size and structure, the board's role in fundraising, and the associated time commitment. Below we explore additional factors for conducting due diligence prior to joining a nonprofit board.
You should always conduct some financial due diligence regarding the organization. A first step is to review the most recent copy of the organization’s audit report, including the financial statements (income statement, balance sheet, and cash flow statement) and “management letter.” Be sure not to overlook the notes to the financial statements, as these are oftentimes a critical component of the financial statements. The notes often address issues that are not obvious from the figures in the main portion of the financial statements.
The management letter identifies those areas of operations or procedures that the auditor believes could be improved. The most common issues raised in a management letter deal with internal controls, which are the processes, systems, and internal procedures that help to ensure that all financial transactions are recorded properly. An important question is whether the nonprofit organization has implemented the suggested improvements contained in the previous management letter.
Although sometimes not legally required, most nonprofit organizations obtain an independent audit of their annual financial statements. A small nonprofit organization may not obtain an independent audit because of the cost and the scarcity of the nonprofit’s resources. If a nonprofit organization does not have an independent audit, a prospective board member should ask why and understand the reasons for such a decision.
Other items you should examine are the recent annual income tax returns of the nonprofit organization. These returns can provide information not found in the financial statements. Nonprofit tax returns and other information can be found at www.guidestar.org.
Legal Obligations of a Nonprofit Board Member
As a prospective board member, you should understand the legal obligations of being a board member of a nonprofit organization. Under Florida law, directors of a nonprofit organization serve in a fiduciary capacity and have two primary fiduciary duties that they owe to the organization.
The first fiduciary duty is the duty of loyalty. This duty requires you to act in the best interests of the organization rather than out of self-interest or self-dealing. You should inquire as to whether a nonprofit organization has a conflict of interest policy regarding transactions between the nonprofit organization and the organization’s directors and officers and other key employees. The conflict of interest policy should require these insiders of the organization to annually certify their compliance with the policy. Effective July 1, 2014, amendments to the Florida Charitable Solicitations Act require most nonprofit organizations to have a conflict of interest policy with an annual certification requirement.
The second fiduciary duty is the duty of care. When voting on issues or otherwise making decisions as stewards of a nonprofit organization, the duty of care requires that you make decisions in good faith with the level of care that an ordinarily prudent person in a like position would exercise under similar circumstances. Therefore, before voting on an issue, you should always obtain adequate information in order to make a reasonably informed decision. In discharging the duty of care, you are entitled to rely upon information prepared or presented by (i) the officers or employees of the organization; (ii) legal counsel, accountants, and other advisors to the organization; and (iii) other board members. As long as you are well-informed, without exhaustingly researching every issue, you will not be liable for an honest and reasonable decision.
You also have a legal obligation to make sure the nonprofit organization complies with applicable law, its mission, and the terms of its Articles of Incorporation and Bylaws. This obligation is sometimes referred to as the “duty of obedience.”
It is important for you to inquire about whether the nonprofit organization has directors and officers (“D&O”) insurance coverage, the type of coverage, and the coverage amount. D&O policies generally cover actual and alleged wrongful acts that constitute a breach of fiduciary duty, including employment-related claims (such as discrimination, harassment, and wrongful termination), mismanagement of assets, and misuse of grant funding (i.e., using grants inconsistently with the grant requirements). D&O insurance generally does not cover bodily injury or property damage. Generally, your personal liability insurance, including umbrella coverage, is not going to cover the types of claims covered by a nonprofit organization’s D&O insurance policy.
There are no standard D&O insurance policies, so you must evaluate each one separately. A few of the many issues to be considered are:
Claims-Made Coverage. D&O insurance policies are typically “claims-made” policies, which means they cover lawsuits filed or claims made during the policy period, regardless of when in the past the alleged wrongful act occurred. This is generally different from other types of insurance policies, such as general liability, automobile, or workers’ compensation insurance, which cover alleged wrongful acts incurred during the policy period, regardless of when the subsequent lawsuit is filed.
Tail Coverage Issues. Because most D&O policies are claims-made policies, if the policy is canceled or not renewed and a lawsuit is subsequently filed, the policy will not cover the lawsuit. Therefore, when considering whether to cancel or non-renew a D&O insurance policy, the analysis should consider whether tail coverage (also known as “extended reporting period”) can be purchased and, if so, for what period of time.
Coverage Amount. You should give careful consideration to the insurance policy coverage amount. Most D&O insurance policies include the cost of defending a claim (which includes attorneys’ fees) within the coverage amount. This means that the defense costs will reduce the amount of coverage available to settle the claim. Also, if more than one director is sued and directors start pointing their fingers at each other, then each director may need his or her own attorney, which can quickly dwindle the coverage amount available to settle the claim.
Again, the purpose of this article is not to scare you away from joining a nonprofit board. Instead, we hope it helps you make a better-informed decision and pick the best nonprofit organization for you. We hope your board service is a rewarding and fulfilling experience for you.
Mike practices tax, corporate, and business law, handling sophisticated tax planning and tax controversy matters and advising clients on their most significant business transactions. He is actively involved in the boards of many civic and legal organizations. Mike earned his JD and MAcc from the University of Florida and he is certified by the Florida Bar as an expert in tax.