Legal audits may be particularly timely when an organization undergoes significant organizational changes, including leadership changes, a potential merger or acquisition, or preparation to enter a major growth phase.

Key Areas Covered in a Legal Audit

A legal audit reviews an organization’s compliance and organizational health across a variety of key areas, including the following:

1. Corporate Governance

• Review of articles of incorporation and bylaws
• Verification of current board members and officers
• Board meeting minutes and adherence to governance policies
• Conflict of interest policy and disclosures

2. Tax-Exempt Status and IRS Compliance

• IRS determination letter (501(c)(3), etc.)
• Annual filings (Form 990 or equivalent)
• Compliance with public support test (if applicable)
• Unrelated Business Income (UBI) issues

3. Employment and Labor Law

• Employee vs. independent contractor classification
• Employment contracts and offer letters
• Compliance with wage, hour, and anti-discrimination laws
• HR policies, employee handbook, and training procedures
• Volunteer agreements and waivers

4. Fundraising and Charitable Solicitation

• State charitable registration compliance (multi-state if applicable)
• Donor acknowledgment letters and receipts (substantiation)
• Restricted vs. unrestricted funds tracking
• Compliance with fundraising regulations and platforms

5. Contracts and Agreements

• Review of leases, vendor contracts, MOUs, and grant agreements
• Intellectual property ownership (e.g., logos, content, trademarks)
• Confidentiality and data-sharing agreements
• Insurance policies and liability coverage

6. Financial Oversight and Internal Controls

• Financial policies and procedures
• Audit requirements and practices (external or internal)
• Recordkeeping and document retention policies

7. Risk Management and Insurance

• General liability, directors & officers (D&O), and other coverage
• Event liability and waivers
• Crisis management and disaster recovery plans

8. Privacy, Data, and Technology

• Data privacy and cybersecurity practices
• Website terms of use and privacy policy
• Compliance with applicable data protection laws (e.g., GDPR, CCPA)

Deliverables of a Legal Audit

The findings of a legal audit are often summarized in key documents that allow the organization to make decisions on next steps, and may include the following:

• Audit report summarizing findings and recommendations
• Compliance checklist for ongoing monitoring
• Action plan with prioritized legal fixes
• Updated or new policies, procedures, or templates

The Importance of a Proactive Approach to Compliance

In today’s complex regulatory environment, nonprofit organizations must actively manage legal compliance to protect their mission, reputation, and tax-exempt status. A legal audit provides a structured opportunity to evaluate vulnerabilities, adopt best practices, and strengthen organizational governance. By identifying and addressing potential legal risks early, nonprofits can prevent costly issues and build a solid foundation for long-term success. Whether preparing for growth, funding opportunities, or ensuring daily compliance, a legal audit is a valuable tool for any organization dedicated to operating with integrity and impact.

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Why do we need bylaws? 

Bylaws are important for many reasons, legal and practical. Each state has specific corporate laws that regulate the actions taken by nonprofit boards. Bylaws distill those laws into a series of clear procedures for the board to follow, providing an operational framework and helping to ensure that the actions taken are legally compliant. 

Who should draft our bylaws?

Ideally, drafting bylaws is a collaborative process between the board and an attorney with nonprofit expertise. Your organization’s governance practices will be dictated by the laws of the state in which your organization is incorporated, as well as federal tax laws applicable to exempt 501(c)(3) organizations. 

Nonprofit corporate laws vary from state to state, some with more specific requirements than others. There are areas of the law that provide the board with significant flexibility in deciding how it chooses to operate, so certain sections of the bylaws can be customized to reflect the board’s preferences on governance procedures. An experienced attorney will know the corporate laws of the state in which your nonprofit is formed and be able to advise your board on its legal requirements, optional provisions, and best practices. 

Copying another nonprofit’s bylaws or downloading a sample from the internet may seem like a good option, but it can be costly in the long run.  If your bylaws are not compliant with the laws of the state in which your nonprofit is formed or are not tailored to your board’s needs and preferences, you may face trouble down the road.  In a worst-case scenario, the actions of a board can be challenged by regulators or in court if the board has not been following its bylaws or its bylaws are not legally compliant. 

What should our bylaws cover?

Typical provisions in nonprofit bylaws include –

• Size of the board – minimum (and maximum, if any) number of directors 
• Procedures for the election, resignation, and removal of directors.
• Directors’ term lengths and term limits (if any). 
• Notice requirements for regular meetings and special meetings of the board. 
• Quorum requirements (the minimum number of directors that must be present at a meeting in order to take action). 
• Approval requirements for routine board actions and special approval requirements for major transactions. 
• Procedures by which the board can take action without meeting.
• Procedures for forming and authorizing committees. 
• Procedures for the election, resignation, and removal of officers.
• Officer titles and responsibilities. 
• Indemnification of directors and officers. 
• Procedures for amending the bylaws.
   

Can we change our bylaws? 

Yes! Bylaws can, and often should, be amended to better match the organization’s practices and goals. The bylaws that worked for your nonprofit in its start-up phase frequently need to change as your organization grows and develops.  Laws also change from time to time, so we recommend having an experienced attorney review your bylaws with your board every few years. 

There’s a lot more we can say about governance and bylaws, but we’ll save that for future articles.

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State of the Nonprofit Sector 

Tim Delaney, President & CEO, and Donna Murray-Brown, Vice President of Strategy and Development at the National Council of Nonprofits, presented an overview of the charitable community.  Included in their discussion was the current scale and scope of the sector, external threats to its sustainability, and ideas for how state charity regulators and members of the sector can continue to work together to better protect and serve the community.  

External threats include an increased demand for nonprofit services in an environment of increased costs and reduced contributions.  At the same time, nonprofits are faced with the antiquated and broken systems of government contracts and grants while the sector is experiencing a workforce shortage.  This has weakened the delivery of services to the public.  

Charity regulators and nonprofits are encouraged to work together to protect and serve the public by focusing their efforts on preventing bad actors from misuse of the charitable nonprofit system and on stopping scam artists from masquerading as charitable nonprofits. 

Lessons in Nonprofit Governance from the Big and Small Screen

Gene Takagi, principal of Neo Law Group, entertained participants with key points about “good and not-so-good governance” by quoting characters from popular television shows and movies. My favorites included Ted Lasso (“Believe”), Captain America (“How do we do this? As a team!”), Spiderman (“With great power comes great responsibility”) and Dumbledore (“it takes a great deal of bravery to stand up to your enemies, but a great deal more to stand up to your friends”).   Gene used the quotes to walk participants through key issues of the duties of care and loyalty, delegation, trust and reliance, board composition and vacancies, succession planning, prohibition of private benefits, as well as governance and charitable solicitations.  For more detail, read Gene’s Lessons in Nonprofit Governance from the Screen.

Purpose Driven Board Leadership

Dani Robbins, Director of Governance Strategy at Board Source, delved into a new way of framing nonprofit board members’ roles through a discussion about purpose-driven board leadership which prioritizes purpose and mission over the organization’s needs.  In summary, this framework is premised upon four principles. 

Purpose Before Organization 

Prioritizing the organization’s purpose and the problems it addresses versus the organization as an entity by reframing the “duty of loyalty as the center of its own gravity” to how the organization can best steward its resources to serve its purpose.

Respect for Ecosystem 

Acknowledgment that because an organization’s actions have an impact on the ecosystem it requires an obligation to consider the organization’s actions as part of its decision-making processes. 

Equity Mindset 

Commitment to advancing equitable outcomes, avoiding ways in which the organization’s work may reinforce systemic inequities and being willing to break down barriers that may have been created by the organization in the past. This must be applied across a number of areas including allocation of the organization’s resources, programmatic oversight, and creating a diverse and inclusive board. 

Authorized Voice and Power 

Recognition that the organization’s power and voice must be informed and authorized by those who are impacted by the organization’s work, which requires decisions to be made in the context of real understanding of community assets, needs, preferences, and aspirations, listening to community needs and experiences, and sharing power by inviting individuals to the board who have relevant lived experiences.  

Reframing for purpose requires a shift in focus from the board’s traditional position of operating in service to the organization to a primary responsibility for sustaining the organization and its ability to exist in service to its mission and to its service for the public good with a primary responsibility to steward organizational capacity such that it maximizes positive effect to that core purpose. 

The Uses of Different Business Structures by Charities

While the agenda promised a discussion of “some of the latest developments in what can be complex arrangements and structures in the section,” this session focused on just one – the Versatile LLC. Sharon Lincoln, Partner with Casner & Edwards, LLC, shared her insights about the Versatile LLC in the session “What Board Members and State Regulators Need to Know”.  

She explained that a limited liability company (LLC) is the U.S. version of a private limited company, one that provides flexible tax treatment and limited liability for its members.  It offers three options for the tax classification -corporation, partnership, or disregarded entity.  Ms. Casner then focused her discussion on answering the following three questions. 

Can an LLC operate for philanthropic purposes? 

The short answer is yes, but it requires a review and understanding of statutory considerations, the LLC’s certificate of formation and operating agreement, as well as who or what are the members of the LLC and how the activities of the LLC will be funded.

Can an LLC operate as or be a 501(c)(3) organization? 

A single-member LLC may be a subsidiary of a 501(c)(3) organization (see also IRS Notice 2021-56 which permits an LLC to apply on its own for recognition as a 501(c)(3) under certain circumstances). 

When can an LLC be useful to a charity?

This answer depended upon the various forms of corporation, partnership, or disregarded entity.

The discussion concluded with some state-specific considerations, such as what purposes the LLC statute permits and charity bureau oversight in related-party transactions, mergers, asset transfers and dissolution. 

State Update

Unfortunately, noticeably lacking in this year’s conference was a robust discussion about the state regulators’ enforcement efforts.  Only twenty minutes of the five hours allocated were devoted to sharing enforcement updates.  The Annual Report on State Enforcement and Regulation, which highlights enforcement actions in the areas of deceptive solicitations, governance and trusts and estates, as well as summarizes outreach efforts and published guidance, transaction reviews and updates regarding regulations and legislation was provided with the conference materials.  It was not, however, a substitute for the usual color and insight that have been shared with conference attendees in the past, a key incentive for attendance by members of the sector. 

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So how is advocacy different from lobbying, and exactly where is the line between the two? As I wrote in my previous article, advocacy is a broad term which  describes various facets of the work nonprofit organizations undertake.  Although it isn’t a statutorily defined term, advocacy refers to many types of activities, which include educating about and raising awareness of an issue; advancing the organization’s charitable mission; raising funds; communicating with members and the public; and influencing behaviors, attitudes, and policies related to the organization’s mission.

By contrast, lobbying is a statutorily defined term.  The Lobbying Disclosure Act regulates federal lobbying, and each state and many cities have their own  laws that define and regulate lobbying.  For public charities, the IRC defines lobbying as “any attempt to influence any legislation through an attempt to affect the opinions of the general public or any segment thereof, and any attempt to influence any legislation through communication with any member or employee of a legislative body, or with any government official or employee who may participate in the formulation of the legislation.” This federal tax code definition covers both grassroots and direct lobbying. 

The IRC defines certain activities as exceptions, and, therefore, does not count them towards the organization’s lobbying limits.  These include: making available the results of nonpartisan analysis, study, or research; providing technical advice or assistance to a governmental body; appearances before, or communications to, any legislative body about decisions that might affect the existence of the organization, its powers and duties, and tax-exempt status; communications between the organization and its members on legislation or proposed legislation of direct interest to the organization and its members; and any communications with a government official other than communications that would be considered lobbying. 

The term advocacy generally encompasses a broad range of exceptions to lobbying.  If your organization is conducting and publishing research and disseminating it in a nonpartisan manner, it is not considered to be lobbying.  What about activities that don’t easily fall into one of these exceptions?  For example, perhaps your organization has a meeting with legislators and their staff about important policy issues without discussing specific legislation.   What if, during the meeting, your organization identifies legislative priorities and its position on various topics, some of which are addressed in currently pending legislation?  Most often, the answer to the question “is this lobbying” is going to be “it depends.”  It depends on who is present, what is said, and other factors. 

With this clear-as-mud guidance, it can be both confusing and onerous for a public charity to assess and determine whether the multitude of advocacy activities it engages in count as lobbying.   When clarity is called for, there are two recommended steps: 1) confer with legal counsel, and 2) establish written guidelines for organizational lobbying. 

Consulting with legal counsel serves a few purposes.  First and foremost, your legal counsel can analyze how the unique facts apply to the law – something an online search can’t do.  Next, talking to your lawyers about your current and planned lobbying activities gives the organization an opportunity to educate and train staff and Board members on the rules and limitations. Once the organization’s leadership is trained, they should draft guidelines based on the types of activities the organization typically engages in.  By developing guidelines for the organization, leadership can craft a strategy with respect to advocacy and lobbying activities with a better understanding of what is, and what is not, lobbying. This will ensure compliance while fostering the confidence to effectively advocate in furtherance of its charitable objectives. 

Because the rules can be confusing, many organizations shy away from engaging in certain activities for fear they may breach the regulations on lobbying.  It’s good to remember, however, that public charities are allowed to lobby up to a certain limit if they track their expenditures and report them.  Once understood and exercised with confidence, lobbying can be a powerful tool in assisting a charity to fulfill its mission. 

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The bill follows New York’s passage in 2019 of another diversity related law which calls for a study of the number of women serving on certain corporate boards.

The bill’s sponsors say ethnic diversity is critical to a nonprofit board’s ability to understand its community’s needs.  They say when the ethnic makeup of a nonprofit board mirrors that of the community it serves, the board is more able to relate to the shared experiences of its community, and is therefore better equipped to identify problems and feasible solutions.   The bill makes an analogy to ethnically diverse police departments, stating that as data bears out that diverse police forces provide better service to diverse communities, the same may be true for nonprofit boards.

On January 5, 2022, the bill was referred to the Senate’s Corporations, Authorities and Commissions Committee.  It’s unclear whether this bill will gain traction during this legislative session.  Nevertheless, the call for more diversity on boards is trending not only in New York, but in California, Maryland, Illinois and other states where board diversity requirements have either been enacted or proposed.  Given the growing expectation for greater inclusion of underrepresented minorities on boards, nonprofits should consider familiarizing themselves with best practices for board diversity.

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Historically, New York’s NPCL did not allow nonprofit organizations to hold virtual membership meetings. That changed with the COVID-19 pandemic, when New York offered temporary flexibility to the boards of charitable and religious nonprofits.  Under the COVID-19 rules, boards of charitable nonprofit or religious organizations could unilaterally decide to hold member meetings virtually. Under the revised law, boards of nonprofit charitable organizations may unilaterally determine whether or not to hold member meetings electronically, as long as their certificate of incorporation or bylaws do not prohibit such a decision.

Similarly, the newly-created default rule under New York’s Religious Corporations Act (RCL § 28) is that a board of a religious corporation may organize a virtual membership meeting if the board is already authorized to determine the place of a membership meeting, under either the organization’s governing documents or another provision of the RCL. However, leaders of religious organizations should bear in mind that the RCL contains different provisions depending on the denomination of the organization – leaders must be careful to review their organizing documents as well as the applicable sections of the RCL to confirm whether they have the requisite power to call virtual membership meetings or, if not, whether they could amend their governing documents to acquire that power.

Any boards considering adopting a virtual format for their upcoming membership meeting should consult with an advisor to review their organizational documents. Any nonprofit or religious corporations whose certificate of incorporation or by-laws prohibits virtual membership meetings should consider whether and how to revise their documents to provide the board with additional flexibility. We anticipate that many organizations and their members will decide to operate under virtual or hybrid formats in the near future.

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Attorneys for nonprofits are ultimately responsible to their boards.

Since there are no owners or shareholders of a nonprofit organization, they are supervised by their boards in accordance with the directors’ fiduciary duties.  This means that boards must be informed of any problems or possible issues by senior staff and/or by the organization’s attorneys.  It is incumbent upon legal counsel to ensure that the board is notified of such problems in a timely manner and engaged in their resolution.

Depending on the circumstances, attorneys should maintain communication with the Board Chair, and with the entire board when appropriate. 

This is particularly important if there are problems meriting board knowledge and involvement.  Attorneys should ensure that board members are informed and engaged and act in an independent manner.

There are no specific ethical rules governing representation of nonprofit organizations.

The rules and cases construing professional responsibility in the for-profit context offer significant guidance.  Certainly, court decisions that apply the attorney ethics rules to situations involving nonprofit clients can be of particular assistance.

An attorney representing an organization owes a duty to the organization rather than any persons employed by or associated with the organization. (See ABA Model Rule 1.13)

When an attorney who is employed or retained by an organization is dealing with its directors, officers, or employees, if it appears that the organization’s interests may differ from the individual’s interests, the attorney is obligated to explain to the individual that he or she represents the organization and not the individual.  NYRPC 1.13(a).

If the attorney knows that a person involved with the organization is acting in a manner that violates, or is likely to violate, the legal obligations of the organization, and the attorney determines that this violation is likely to result in substantial injury to the organization, the attorney is obligated to proceed as is “reasonably necessary in the best interests of the organization.”  NYRPC 1.13(b).

If an issue arises whereby the attorney may have a conflict of interest as a result of prior representation of the organization, the attorney should consider advising the organization to retain other counsel.  For example, if an attorney has handled a transaction for a client that later winds up in litigation, the client should retain an attorney for the litigation who was not involved in the initial transaction.

Examples of where an attorney should ensure that nonprofit boards act appropriately and independently from senior leadership include:

• Setting compensation for top executives
• Overseeing conduct and performance of executives
• Addressing complaints or problems involving executives, including allegations of discrimination or harassment
• Addressing allegedly inappropriate or illegal conduct within the organization
• Responding properly to whistleblower complaints
• Complying with conflict of interest and related party rules and law

Summary:

In the practice of representing a nonprofit organization, attorneys must consider their ethical obligations to ensure that the organization will be well-served and in compliance with legal requirements.

The information provided in this article does not constitute legal advice, and is not intended to substitute for legal counsel.

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One serious challenge in the age of COVID is how, or whether, to hold in-person meetings. We have received a number of questions from clients about their ability to hold virtual meetings for directors and members. While many states have relaxed rules around virtual meetings, nonprofits must continue to be vigilant. In this post I briefly discuss how nonprofits can make sure they are able to hold virtual meetings while complying with applicable law.

Meetings are important!

Board and member meetings serve important functions. Membership meetings allow the members to elect directors and weigh in on important issues facing the nonprofit. Directors’ fiduciary duties continue, notwithstanding the pandemic – their duties include effective oversight of the nonprofit’s activities and management. While some nonprofit activity has ground to a halt, other organizations are busier than ever, being asked to cope with the intersecting challenges of a pandemic, economic recession, and civil rights movement taking place at the same time. Board members cannot put their fiduciary duties on hold because in-person meetings are more difficult. Directors have to find a way to carry out their normal board activities in these abnormal times. Virtual meetings are one tool.

Check your documents!

Before the Board can arrange a virtual board or member meeting, the Board needs to confirm that virtual meetings aren’t prohibited by the nonprofit’s own rules. Any restriction on virtual meetings would typically be spelled out in the organization’s bylaws. Most nonprofits formed in the past ten years will likely have language that expressly allows for virtual meetings, or will be silent on virtual meetings. If your organization has members, check the sections of the bylaws that apply to member meetings and then check the section that deals with board meetings – sometimes there are different rules!  Also, if your bylaws reference Robert’s Rules of Order as rules applicable to the organization, you should also review those rules with respect to the conduct of virtual meetings.

Unfortunately, some bylaws specifically require in-person meetings. If your bylaws specifically require in-person meetings, the organization cannot move forward without making a revision that allows virtual meetings. Bylaws revisions are important to get right procedurally – I recommend checking with counsel to ensure that any bylaws revisions are properly handled.

Check the law!

Assuming the bylaws do not prohibit virtual meetings, you should check applicable state law to see how state law deals with virtual meetings. The law that applies depends on where the nonprofit is legally incorporated. That can differ from where the nonprofit’s headquarters is located or where it conducts its activities. Be sure to check the appropriate state rules (or get your favorite attorney to check for you)!

State laws vary, but in general they permit virtual board meetings if the nonprofit’s bylaws don’t prohibit such meetings. State laws with regards to member meetings tend to favor in-person meetings, but some states permit virtual meetings. Look for other requirements – some state laws specify that all participants in the virtual meeting must be able to hear and be heard throughout the meeting. Other states have different participation requirements for members and directors.

The “hear and be heard” requirement is tricky when dealing with large meetings (especially in the member context). Logistically, many organizations use the “mute” function of a videoconferencing app for large meetings. The mute function guarantees that there are no unexpected or unintentional disruptions during the meeting. However, in order to comply with state law, your participants need to be able to voice their opinions throughout the meeting. If they’re muted by the organizer, your meeting may technically be in violation of state law unless members are able to un-mute themselves. I recommend asking members to voluntarily mute themselves, or if muted by the organizer, allow users to un-mute themselves if they would like to contribute to the conversation. The organizer could also mute participants for the presentation of each agenda item, then the floor can be opened for discussion for each agenda item so all participants have a chance to weigh in on each piece of business before the organizer mutes the participants again.

Some states require a physical location to be designated in the notices for the meetings, even if they are to be held virtually. I generally recommend designating the organization’s principal office, but clarifying that all aspects of the meeting will be virtual.

Finally, check to see if the state has issued special guidance related to meetings. Many state regulators and governors have attempted to loosen restrictions on virtual meetings during COVID, to the extent they are permitted by law. Their guidance may affect whether you need to make any changes to your organization’s bylaws. For instance, New York’s Charities Bureau issued special guidance with regards to virtual meetings early in the pandemic. The notice discussed temporary changes to New York law during the pandemic allowing annual members’ meetings to take place virtually. The state also provided helpful information to guide organizations as they prepare to carry out a virtual meeting for the first time.

Be Careful!

To ensure that your organization doesn’t become too relaxed with its compliance around meetings, I offer the following cautionary tale. Just as directors must continue to observe their fiduciary duties, state regulators are keeping an eye on nonprofits during the pandemic. In July, the Pennsylvania Attorney General filed a lawsuit against Lincoln University’s Board of Trustees for failing to follow statutory and internal policies and procedures with regards to their meetings. While there were a number of other issues,** a large portion of the lawsuit relates to two main problems: (i) a portion of the Board was unable to participate in a Zoom when their microphones were muted by the host; and (ii) the Board allegedly failed to comply with the notice provisions in its own bylaws.

** The main dispute relates to the ability for newly designated Trustees to be seated without approval of the Board’s Nominations Committee. But the AG’s hook to bring the suit related to relatively dry issues of governance compliance.

Conclusion

While boards and members should make use of the tool of virtual meetings, it’s important to do so while complying with the nonprofit’s internal governance and applicable state law. If virtual meetings are new to your organization, it’s a good idea to check in with your legal counsel to make sure you’re doing everything right.

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August 9, 2019 – Politico – Liberty University [1]
Disclaimer – This article discusses the nonprofit governance principles at issue in publicly-reported allegations in an attempt to glean a clear lesson for current and future nonprofit leaders. We have no knowledge of the truth of the facts in the article discussed, and merely reference them for purposes of discussing nonprofit governance issues applicable to nonprofit leaders.

On August 9, 2019, Politico Magazine posted an article about alleged discontent by current and former Liberty University officials. The article described governance issues related to a variety of matters ranging from real estate deals, loans, political events, and the evolution of Liberty University since the death of its founder, the Rev. Jerry Falwell Sr. in 2007.

The overarching theme from the article – issues that arise from control over a major nonprofit institution by a family, or perhaps one person – can provide lessons in governance for the sector. In the paragraphs that follow, I’m going to walk through some of the allegations from the Politico article in order to highlight key governance lessons for nonprofit leaders.

Overview of the allegations
One of the undisputed statements in the article is that Jerry Falwell Jr., currently the President of Liberty University, is central to the University’s revenue-generating activities. Also undisputed is that the University’s finances have dramatically improved under Mr. Falwell Jr.’s leadership, ballooning from assets of $259 million in 2007 to $2.5 billion in 2017. Understandably, these two factors may have generated substantial goodwill and a certain level of trust from the University’s trustees, who have faith in their President’s ability to grow the University and reach more students.

What gave rise to concerns of some current and former University officials, and scrutiny from the media, were transactions in which Mr. Falwell Jr. was allegedly steering university business opportunities to his friends and family. As I discuss in the paragraphs that follow, there are steps that other similarly-situated nonprofits can take to help avoid these types of conflicts of interest, or, if they do arise, provide evidence to reporters and concerned staff that the nonprofit’s dealings are fully above-board.

A Powerful President
One detail that is clear throughout much of the recent reporting on Liberty University is that Mr. Falwell Jr. is the main decision-maker at the University[2].  Major strategic decisions, such as where and when to make substantial investments of the University’s time and resources in the near and medium term, seem to have begun and ended on his desk. This raises the question – what is the appropriate role of the President of a nonprofit organization vis-à-vis its Board?

It’s not uncommon for a Board to give its President a substantial amount of authority, especially where the President has a track record of success. While the Board bears ultimate legal oversight responsibility for the nonprofit, Board members aren’t expected to be involved in all day-to-day decisions. Boards can pass resolutions specifying what the President’s (or other senior staff’s) authority is to enter into agreements or to otherwise bind the nonprofit. A nonprofit’s Bylaws also sometimes describe, and thereby limit, the role of the nonprofit’s senior-most staff.

It’s important, however, for the Board to keep abreast of big or risky transactions (such as purchases of real property, investments in unrelated businesses, or c-suite staffing) to ensure the parameters set by the Board are observed. Periodic reviews of the President’s performance should be standard, with a report issued to the full Board and communicated to the President. Among other, broader issues relating to the President’s performance, a periodic review allows the Board to re-evaluate whether the guidelines in the Bylaws and any Board resolutions are appropriate or if they should be clearer about what transactions require Board approval and what authority the President has to act alone.

A lesson for nonprofit leaders is that they should build parameters for their officers into their core policies, officers’ job descriptions, and even occasionally the Bylaws. In addition, the Board should provide ongoing oversight of the senior staff, and the Board must review their performance regularly. This is for the Board’s and the staff’s benefit – whenever roles and authorities are clearly defined, an officer has greater clarity as to whether he or she is effectively carrying out his or her responsibilities effectively, and the Board can more easily and objectively assess an officer’s actions against established performance criteria.

Conflict of Interest can be Managed
Another theme in the recent reporting on Liberty University is conflict of interest (whether actual or apparent). Mr. Falwell Jr. disputed allegations that he or the University acted improperly, while reports and sources in those articles argued that Mr. Falwell Jr. used his position to improperly benefit himself, his family, and his friends. Examples included allegedly directing business to his son, co-investing University assets with a business partner, and issuing University-backed loans to friends.

We don’t know enough facts for certain to determine whether the transactions described were actual conflicts of interest and, further, whether those transactions were inappropriate. Some conflict of interest transactions can be in the best interests of a nonprofit. For instance, imagine a situation in which a nonprofit needs to build a new gymnasium to support its community programs. If the only contractor in town capable of building a gymnasium also happens to sit on the nonprofit’s Board, that doesn’t mean the nonprofit can’t move forward. It just means that the nonprofit’s Board needs to manage the conflict of interest carefully to make sure the contractor doesn’t abuse his position on the board to overcharge for the construction of the gymnasium.

The process of managing a conflict of interest usually includes a few key features. First, a written conflict of interest policy should be approved by the Board. This policy should (i) require that any conflicts, or potential conflicts, be disclosed, (ii) outline how potential conflicts are to be reviewed, and (iii) state in what circumstances alternatives should be sought, and (iv) spell out how the conflict transaction can be approved. The policy should require any conflicted individual to recuse themselves from the discussion and deliberation of the conflict transaction (other than to answer questions asked by the other board members).

Written evidence of the review and approval should be kept on hand. The process creates a record that can be used to rebut accusations of improper benefits. Just as clearly defined roles and responsibilities (discussed above) protect the organization, the board, and the individuals involved, a good conflict of interest policy protects everyone. The individuals who allegedly have a conflict can insulate themselves from later critique; the board can demonstrate it followed a robust and fair process; and the nonprofit can be sure its assets are not improperly used to benefit an insider. Sample conflict of interest policies abound and many states (such as New York) require nonprofits to include certain elements in their policies.

Policies are Helpful
The article on Liberty’s alleged problems also implies that rules that applied to some employees didn’t seem to apply to all. One example was a Liberty University employee, John Gauger, who also ran an online business that was paid by Liberty and on which Mr. Gauger was alleged to have worked while technically being on-the-clock for Liberty. Other instances included allegations that Mr. Falwell Jr.’s wife Becki took part in employment decisions regarding Liberty staff, and that Trey Falwell, the son of Mr. Falwell Jr., was allowed to work with Mr. Gauger, operate a real estate business, and manage properties owned by Liberty, all while serving as a vice president of the University.

There could be legitimate reasons to permit staff to work on outside business during work hours, to outsource staff decisions to experts in HR or bring in real estate experts to manage a vast portfolio of properties. For instance, when a nonprofit seeks to attract talent in a particular industry, the nonprofit may offer flexibility in terms of working time, location, and outside businesses. When it is not able to compete at industry pay scales, the nonprofit may rely on outside professionals if it lacks in-house human resources capabilities. Problems arise, however, when the organization doesn’t have an adequate decision-making process in place, such that decisions appear to be made arbitrarily, or it appears that assets are being used for a private purpose.

Presumably, Liberty University has an employee handbook that addresses issues such as conflict of interest, engaging in outside employment, and grounds for dismissal. Unclear in the Politico article is whether those policies were followed in the course of dealings with Mrs. Falwell, Trey Falwell, or Mr. Gauger. If they were, the Board and the nonprofit should have kept a paper trail to demonstrate that their policies were properly implemented and any exceptions made were justifiable.

Every nonprofit with employees should take the time to re-examine its employment policies to make sure they (1) comply with local, state, and federal law and (2) meet the organization’s needs. If the leadership wants to cultivate an entrepreneurial environment within the organization, it can remove any restrictions on outside activities as long as staff are meeting their responsibilities to the organization. What matters is whether the Board and senior staff have thought about the policies, communicated them to throughout the organization, and implemented the policies fairly. The Board and President should periodically review the policies to ensure they are up to date and being properly applied.

Political Activity
Lastly, the Liberty University story makes a number of references to “political campaign activity” – the oft-underenforced third rail for 501(c)(3) organizations. Liberty University was alleged to have tweeted support of a candidate for federal office, as a “thank you” for making a speech at the University’s convocation. Furthermore, the University’s Chief Information Officer was hired by a presidential candidate to try to increase the candidate’s poll numbers. The University was also alleged to have rearranged its calendar in order to influence local elections.

The IRS definition of 501(c)(3) organization includes a prohibition on political campaign activity. Under the definition, an organization that wants to be exempt from federal income taxation under section 501(c)(3) of the Internal Revenue code cannot “participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office.”

Colleges and universities are uniquely situated, being treated as public spaces (or quasi-public spaces) for First Amendment purposes but with civically-engaged students who crave civic and political engagement. There are many politics-adjacent activities that all 501(c)(3)s, including colleges and universities, can engage in, such as voter registration drives, hosting candidate fora, and overseeing student groups that are expressly political (College Republicans, for example). These activities should be carefully undertaken with the advice of counsel to ensure that the activities stay within the permissible bounds of the organization’s 501(c)(3) exemption.

Nonprofit leaders, even those like Mr. Falwell Jr. who are closely associated with the organization they lead, are also allowed to hold and express their own political views. They can campaign with or for their chosen candidates. But nonprofit leaders must be careful that their personal activities stay separate from the organization they lead or they jeopardize the organization’s exemption. As always, a trusted legal advisor is indispensable to ensure leaders don’t sacrifice their First Amendment rights while the organization preserves its tax exemption.

In Conclusion
Sometimes my clients hate it when I tell them to adopt a conflict of interest policy. They don’t like reviewing their employee handbook. Executive Directors want the freedom to make quick decisions and boards don’t want the hassle of looking over everyone’s shoulder. But as I tell my clients, and as the article on Liberty University bears out, a lack of process can come back to hurt you. Even if the organization reaches the same decision, a good process provides backup for the Board and the organization’s leaders to defend their decisions against critics within and without. And perhaps most importantly, a good process protects the organization so it can focus on achieving its charitable mission.

[1] This post references the version of the Politico Magazine article, ‘Someone’s Gotta Tell the Freakin’ Truth: Jerry Falwell’s Aides Break Their Silence: More than two dozen current and former Liberty University officials describe a culture of fear and self-dealing at the largest Christian college in the world, By BRANDON AMBROSINO, available at http://politico.com/magazine/story/2019/09/09/jerry-falwell-liberty-university-loans-227914 on September 09, 2019

[2] Such as https://www.washingtonpost.com/outlook/2019/07/24/inside-liberty-universitys-culture-fear-how-jerry-falwell-jr-silences-students-professors-who-reject-his-pro-trump-politics/?noredirect=on (accessed 9.11.19, published 7.24.19); https://world.wng.org/2018/08/papered_over (last accessed 9.11.19, published 8.16.18); https://www.reuters.com/article/us-usa-falwell-trainer-exclusive/exclusive-falwell-steered-liberty-university-land-deal-benefiting-his-personal-trainer-idUSKCN1VH283 (last accessed 9.11.19, published 8.27.19).

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While New York’s new law doesn’t affect nonprofits that are controlled by other nonprofits[i], the reasoning for New York’s change is instructive. It grew out of regulators’ and lawmakers’ concerns that a sole member structure is susceptible to abuse – a nonprofit controlled by one or two people is more likely to engage in self-dealing or private benefit transactions, both of which are prohibited under state and federal law.

New York’s restrictions on sole member structures comes at a time when charities regularly use corporate sole member structures as part of a variety of major transactions and strategies. Typically, the arrangement is used by a large, well-funded nonprofit that is either (i) forming a new entity in which to house a new activity, or (ii) taking control of an existing nonprofit.

A nonprofit sole member structure puts directors of the subsidiary in a challenging position because their fiduciary duties to the nonprofit can sometimes put them at odds with the interests and direction of the sole member. Below I walk through:  (i) what is a sole member structure; (ii) how sole member nonprofits are useful; (iii) when implementing a sole member structure, what are some challenges; and (iv) suggestions to help implement a sole member structure.

What is a sole member nonprofit?

Modern nonprofits are typically run by a board of directors that is self-sustaining – that means the board elects new directors to fill empty board seats. Historically, however, a nonprofit was a membership corporation and the “members” were responsible for electing the board. Who the “members” differed from organization to organization, but the members met at least annually and took an active role in electing the board of the organization. A good modern analogue is a labor union – the membership is active in electing the leadership, so even though the Board is still responsible for overseeing the union’s activities, the members can keep the Board in check. A membership structure parallels the shareholder structure of a for-profit corporations, where shareholders elect directors to the Board but are removed from the corporation’s day-to-day operations.

Many states’ laws still allow one person, or one corporation, to be the “sole member” of a nonprofit, retaining the right to elect and remove directors. There is no federal prohibition against that structure, provided that the controlled nonprofit and its Board observe all of the other rules applicable to 501(c)(3) organizations. The sole member structure, therefore, has been popular as a way to give individuals or large nonprofits the ability to keep control over a subsidiary nonprofit.

How are sole member nonprofits useful?

A sole member structure is really appealing when an individual or corporation creates a new nonprofit and wants to retain long term control over the nonprofit’s mission and activities. By making themselves the sole member, the founder can give themselves the power to appoint or remove board members. This allows the sole member to have a veto power over board decisions that the sole member disagrees with – they can always remove (or threaten to remove) board members who vote against the sole member’s interests.

Most founders use this veto power for good. The founder, who is passionate about the organization and its mission, is especially sensitive to mission creep. If they sense that board members are not pulling their weight or are moving the nonprofit in the wrong direction, the sole member can appoint new board members and remove the bad ones to get the nonprofit back on track.

Another scenario where we often see a sole member structure is a small nonprofit that is approaching an inflection point and is in need of assistance.  Enter a large financially-healthy nonprofit, able to take over back office and administrative functions for the smaller nonprofit. Both organizations recognize that the smaller nonprofit has developed goodwill, so they don’t want to just absorb the smaller nonprofit’s programs into the larger nonprofit – there’s a benefit to keeping the smaller organization as a separate legal entity, with its “brand” and support intact. The larger nonprofit’s board may also want to protect the larger nonprofit from liability by maintaining the separate legal entity.

Transaction costs are also much smaller in a change of control transaction involving a sole member compared to a traditional merger or acquisition – a sole member transition often requires little more than a minor revision to the bylaws to provide for a sole member. A formal merger with, or transfer of assets to, a larger nonprofit often requires regulatory approval and generally entails more legal fees and staff time to implement.

A third situation where we often see a sole member structure used is where a large nonprofit identifies a new market – either a new location where its programs can succeed, or a new type of program the nonprofit would like to implement. If the new market creates new types of legal or financial exposure, the large nonprofit might want to insulate itself by housing the new venture in a separate legal entity.[ii] The large nonprofit, to encourage the small nonprofit to be self-sufficient, could set the new nonprofit up as a separate 501(c)(3) public charit with its own board and staff. While there may be some start-up support, the goal is often to have the large nonprofit’s input be limited to high-level oversight and the appointment of the board members each year. The large nonprofit can ensure there’s no mission creep through its control of the board of the new nonprofit, but it owes no legal duty to the smaller nonprofit.

When implementing a sole member structure, avoid key pitfalls

Sole member structures can be very useful, especially when trying to quickly take over a nonprofit or when structuring a new organization to ensure it can be controlled going forward. It can also be an intermediary step to a full merger transaction.  But let’s step back for a minute to consider some of the practical and legal issues that can arise with sole member structures.

Donor Confusion

Donors want to know where their money and support is going. They want to feel like they understand the values of the organization they support and who is responsible for making decisions. That’s why nearly every nonprofit website includes an “About Us”, “Board”, or “Team” page that lets donors know who is in charge. By introducing a sole member structure, you risk confusing donors if the relationship isn’t clearly defined. Donors, especially your biggest donors, do not want to call up a board member to discuss a major decision, only to learn there’s another entity the donor has never heard of that controls the board.

Board Member Dilemmas

Nonprofit board members are often more familiar with the for-profit world than they are the nonprofit sector. In a for-profit, board members owe their fiduciary duties to the shareholders and the organization. That’s not the way nonprofit law works for 501(c)(3) organizations. In a 501(c)(3), even one with members, the board members’ fiduciary duties are owed to the organization and, tangentially, the public. But we have heard from board members at nonprofits controlled by a sole member who are confused or frustrated by the ways in which they believe decisions that would be in the best interest of their nonprofit are at odds with the sole member’s interests. For instance, the sole member may believe that entering into a management agreement with the controlled nonprofit would be in everyone’s best interests, but board members at the controlled nonprofit think the management fees the sole member wants to charge are too high.

Placed in that position, the controlled nonprofit’s board members can feel helpless – stand up for what they believe are the best interests of the controlled nonprofit and they risk being removed from the board, but yielding to the sole member could be a breach of their fiduciary duty to their organization. While it’s a difficult choice, legally the board members owe their loyalty first and foremost to the controlled nonprofit on whose board they sit. You need to make sure that board members are fully briefed on their obligations, both to protect the organization and uphold their legal duties as board members.

Staff Confusion & Fear

When staff members see a new organization come in as sole member, it can create anxiety about how operations will change. Nonprofits should clearly message what functions will and will not change. Similarly, governance, HR, and oversight functions should be reviewed to see how to efficiently operate with closely related organizations. In some scenarios, leaving in largely separate systems might make sense, whereas in others the new sole member might displace a number of the controlled nonprofit’s overhead functions.

Related Party Transactions

Governance best practices, along with many state laws, require independent board members to carefully review related party transactions. Wherever the sole member enters into a major transaction with the controlled nonprofit, best practice would require that only independent directors should be involved in reviewing and approving those transactions. The board of the controlled nonprofit is under a legal obligation to make sure that the transaction is fair to, and in the best interests of, that organization. In many cases, however, there is reluctance among board members to treat transactions with the sole member as creating a conflict of interest. Often we hear that the interests of both organizations are aligned, and the controlled nonprofit is wholly dependent on the sole member, so board members think it does not make sense to treat a transaction with the sole member as a conflict of interest. This conflates practical considerations with legal ones – just because a controlled nonprofit needs the sole member doesn’t mean it should accept any transaction with the sole member without proper consideration of alternatives.

Strategies to Implement a Sole Member Structure     

Now that we’ve reviewed some common pitfalls, let’s talk about some relatively simple structural changes that can mitigate the possible downsides of a sole member structure. Remember, there are many reasons why a sole member structure can be beneficial. As with any governance decision, a sole member structure should be well-considered and tailored to the needs of each organization at which its implemented.

Staggered Boards and Limited Removal Rights

Nonprofits should balance the control of the board by the sole member with directors’ fiduciary obligations. One way to do that is to stagger board terms (for instance, three year terms with 1/3 of the board up each year) and place some limitation on the sole member’s right to remove directors. The sole member might still have the ability to remove directors, but that right can be limited to “for cause” removals or require ratification by a majority of the board. By insulating directors slightly from the sole member, directors will have the space to speak critically when they feel the organization is being led down the wrong path.

Independent Directors

Another possible solution is for certain board seats to be reserved for independent board members, individuals who are NOT appointed by the sole member. This will likely be limited to a small minority of the Board, but a small number of directors can play a big role in providing assurance to the whole board that transactions, including ones with the sole member, are in the best interests of the controlled nonprofit. Independent directors can also be useful barometers of the board’s performance and governance.

Clear Messaging

Internally and externally, the sole member and the controlled nonprofit should make sure it is clear how the entities are related and how they work together. Donors deserve to know if money given to one organization will end up supporting another organization (albeit indirectly). Regulators want to know that transactions are properly and fairly approved. Staff need to know to whom they are answering and who is setting policy internally.

In conclusion

Corporate sole membership structures can be useful to all everyone involved. They can help grow and manage complex organizations. Sole member structures can also mitigate legal exposure to their parent nonprofits. As with anything, board members should be prudent when contemplating a sole membership structure. Potential pitfalls can be mitigated by embedding certain structural safeguards to protect the controlled nonprofit’s independence, which should ultimately provide reassurance to the boards of BOTH organizations that a healthy corporate structure is in place.

[i] Where a corporate entity is the sole member and the corporate entity itself is owned or controlled by at least three people.

[ii] There are many other options (such as an LLC) that could accomplish this goal, but we won’t get into those in this article.

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