Five Ways Nonprofit Board Actions Can Be Challenged Under Law
It is well-known that Board members are subject to fiduciary duties in their oversight and decision-making role, among other rules that apply to nonprofit orgnizations. However, the practical reality of how these requirements are scrutinized, applied, and enforced is less understood. This article provides a brief overview of some common ways that Board decisions and actions could be challenged in court.
Standard nonprofit Board orientations and trainings usually include an overview of the three core fiduciary duties (the duty of care, duty of loyalty, and duty of obedience), and there is no shortage of guidance and resources on important topics such as complying with an organization’s governing documents, donor restrictions, and conflict of interest rules and policies.
This education is essential, but understanding these principles in the abstract does not necessarily translate to an awareness of how these rules play out in the real world. Having a basic understanding of who may be in a position to challenge a Board action and how they would do so will deepen your understanding of your legal duties as well as the potential stakes.
This article discusses five common legal mechanisms for challenging Board decisions and actions, with a primary focus on mechanisms that are typical under state or local law (with less focus on federal law):
1. Actions by the Attorney General
2. Actions by Claimants with a Direct Injury
3. Derivative Actions
4. Court Review of the Validity of Corporate Actions
5. Actions by Receivers or Trustees
For the sake of brevity, this article does not address the enforcement of tax rules applicable to nonprofit organizations, such as Internal Revenue Service audits, assessment of excise taxes and penalties, and decisions to revoke an organization’s tax-exempt status. While this is a clearly important and relevant topic for nonprofit organizations and their Boards, the complexity of this area would require a separate article.
1. Actions by the Attorney General
The Office of the Attorney General is one of the primary governmental bodies charged with enforcement of laws that apply to nonprofit organizations. In addition to serving as legal counsel to the government, Attorneys General are also responsible for protecting the interests of the public and upholding the rule of law.
At the state level, this public interest role includes enforcing charitable registration solicitation laws, laws that require compliance with donor-imposed restrictions, and laws that restrict organizations from defrauding the public, among other laws applicable to nonprofit organizations. The federal Attorney General and Department of Justice has similar authority with respect to federal law.
Additionally, state nonprofit corporation statutes typically empower the state Attorney General to oversee the governance of nonprofit organizations and bring court actions related to matters such as the organization’s compliance with its own Articles of Incorporation and Bylaws, fiduciary duties, conflicts of interest, meeting and voting processes, reporting and disclosure requirements, and more.
Enforcement actions in the areas described above can be brought through civil and, in some cases, criminal lawsuits against organizations and/or individual Board members. Attorneys General may seek, and courts can approve, a wide range of remedies such as the imposition of penalties, “restitution” of improperly used funds, or “injunctive relief” such as the reversal of transactions or other Board decisions.
As a practical matter, it is important to keep in mind that Attorneys General tend to focus their enforcement efforts on more extreme cases and are less interested in getting involved in an organization’s internal disputes that do not directly involve the interests of the public in a broader way.
2. Actions by Claimants with a Direct Injury
Some Board decisions and actions may directly affect individuals in a way that gives rise to personal claims that an individual can bring against the organization and potentially its directors, officers, and other representatives (but note that nonprofit directors, officers, and volunteers have some protections against personal liability as we discussed in The Personal Liability Risks of Nonprofit Board Service).
These “direct actions” can include common claims based on “torts” (personal injuries, defamation, damage to property, infringement of intellectual property, etc.), contract rights (contracts for services, sponsorship agreements, and membership agreements, etc.), and/or certain statutorily protected civil rights (employment protections, privacy laws, etc.).
More specific to nonprofit organizations, some individuals may have “standing” (i.e. the eligibility to sue in court) to challenge certain Board decisions or actions that impact their individual rights within the organization. For example, in the context of a membership organization, voting members may be able to challenge an organization’s termination of their membership status or refusal to provide documents to which the member was entitled under the law. Similarly, an individual Board member or officer may be able to sue to challenge a Board decision to remove them from office if the decision was (allegedly) in violation of the organization’s Articles of Incorporation or Bylaws.
The matter of donor-imposed restrictions on charitable gifts raises interesting legal issues that vary from state to state. Traditionally, most state courts have not recognized the standing of individual donors to sue an organization for failing to comply with their restrictions, holding instead that this authority resides exclusively with the Attorney General. However, as discussed in this 50-state guide by Philanthropy Roundtable, this has started to change in recent years, with some state legislatures enacting “donor standing” statutes and courts in other states increasingly recognizing donor standing in some circumstances.
3. Derivative Actions
In contrast with the direct actions described in the preceding section, one or more Board members, voting members, or other persons empowered by statute may be able to challenge a Board decision or action on behalf of the organization in a “derivative action” (sometimes also referred to as a “derivative suit” or “derivative proceeding”).
The difference between a derivative action and a direct action is that the purpose of a derivative action is to redress a harm to the organization itself. Thus, a derivative action would normally seek damages to be paid to the organization rather to an individual, or other injunctive relief for the organization’s benefit. This can occur, for example, if the petitioners allege that one or more Board members are receiving improper personal benefits from the organization, or that they took an action that was otherwise in violation of their fiduciary duties and harmful to the organization or its mission.
However, derivative actions are complicated and face numerous hurdles. State law typically requires that the petitioner(s) first make an unsuccessful demand that the Board of Directors itself pursue the claim and wait a specified period of time or, if earlier, until the Board rejects the demand . Second, the right of persons besides Board members to pursue derivative actions is generally quite limited. For example, an organization’s voting members often cannot bring a derivative action unless a sufficient number of voting members have joined the effort.
4. Court Review of the Validity of Corporate Actions
As an alternative to the process of bringing a derivative action, some states have mechanisms for directors, officers, voting members, or other specified persons to petition a court to review the validity of a corporate action. We discussed a real-life example of this type of claim in Seven Key Steps for Managing Nonprofit Corporate Governance Disputes.
Examples of the types of decisions or actions that may fall within the scope of this type of challenge include mergers and acquisitions, the sale, grant, or transfer of the organization’s assets, a purchase of real estate, changes in mission, starting or terminating certain programs or activities, and more.
While a wide range of actions can potentially be challenged in this manner if applicable state law provides the mechanism, these types of claims are generally best suited to situations where the disputed action allegedly violated the organization’s Articles of Incorporation or Bylaws (often called “ultra vires” actions) or actions that otherwise violated the law.
5. Actions by Receivers or Trustees
In certain relatively extreme situations, an organization may be in such disarray or financial distress that a court removes the power of the current Board of Directors and places control of the organization in the hands of a court-appointed receiver or trustee, such as an individual or another nonprofit organization. This can happen, for example, if an organization is grossly mismanaged or in the context of a bankruptcy proceeding.
When an organization is placed in receivership or trusteeship, the court-appointed receiver or trustee can generally pursue any remedy that an organization’s Board of Directors would normally be able to pursue. If mismanagement, embezzlement, fraud, or other misconduct is at issue, it is not uncommon for the receivers or trustees to pursue claims against prior Board members or officers. A recent example of this can be seen in the case involving an organization in Washington D.C. called Casa Ruby, as described in this article in the Washingtonian.
Planning Tip – In the event of any challenge to a Board action or decision, whether brought by a governmental body or an individual claimant, the organization’s Board and committee meeting minutes will be one of the first documents that is closely scrutinized and the most authoritative internal records of what took place. This is one of the many reasons why it is crucial to develop good meeting and minute-taking habits and to assess and reassess these habits periodically. Make sure that all Board and committee meeting minutes are carefully drafted, reviewed and approved in a timely manner by the full Board or, if applicable, committee, and that all final approved minutes are signed by an officer. Adopting these best practices will help to avoid a lot of potential confusion and controversy in the future.
Be aware that the mechanisms for legal action described in this article are not exhaustive, as some may arise that don’t fit into these categories.
Additionally, don’t assume that a dispute or allegation can only be pursued through one of these mechanisms at a time. In especially contentious situations it is not uncommon for two, three, or more of these types of claims to be going on simultaneously. But, as always, the best way to avoid these entanglements is through education, adopting effective governance practices, and thoughtful planning and decision-making.
