The duty of care requires the members of the board to make prudent and informed decisions. Directors must take reasonable steps to protect the assets of the organization and ensure that they are used to further the legitimate purposes of the organization.  The duty of loyalty requires directors to exercise their powers with undivided allegiance to the organization. This means, among other things, carefully evaluating any transactions that may financially benefit, directly or indirectly, any “insider.”  The duty of obedience requires directors to ensure that the organization’s activities are in furtherance of its mission, and that the organization is in compliance with applicable laws and regulations as well as its own internal governance rules and policies. In this post, I will focus on the duty of care.

In exercising the duty of care, directors are generally entitled to rely on information presented to them by third parties, as long as their reliance is reasonable and in good faith. For example, directors may rely on the reports of outside auditors or consultants concerning the financial condition of the organization if they have no reason to doubt or disbelieve those reports.

For the many directors that serve voluntarily and have otherwise very busy lives, being able to rely on third party advice enables them to effectively carry out their duties.  There are limits, however, to the right of reliance, as highlighted by a recent $5.5 million settlement obtained by the New York Attorney General’s Office.  According to the AG’s office, Educational Housing Services, Inc. (EHS), a nonprofit organization that is a major provider of student housing in New York City, paid millions of dollars to Student Services, Inc. (“SSI”), a company owned by EHS’s President and his wife.  The Attorney General stated that SSI provided unnecessary “middleman” services with respect to third party telecom providers, bundling and reselling the services to EHS at a substantial mark-up that was above market rates.

Because EHS’s President and his wife owned SSI, he had a clear conflict of interest with respect to the transaction between EHS and SSI. The Attorney General emphasized in its findings that the board breached its fiduciary duty of care when it delegated to the President the task of obtaining competitive bids and a legal fairness opinion upon which the board was supposed to rely in reviewing the transaction. Further, the board allowed the President to control the information provided to the third party advisors, failed to independently verify the information that was being provided, and failed to determine what benefits the President would obtain from the transaction.  Given these findings, the AG stated that any purported reliance on third party advice “was neither warranted nor in good faith.” Notably, of the $5.5 million settlement, the board is responsible for paying $1 million ($850,000 in damages for breaches of their fiduciary, and $25,000 per director “to disgorge unreasonable payments received from EHS”).

The EHS settlement makes clear that board members must exercise their own independent judgment. The “business judgment rule” protects board members who make informed, good faith decisions that may in hindsight end up being bad decisions, but it will not protect the board if the evaluation process is so flawed that it precludes the board from making a truly informed decision.

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