NOT READY FOR PRIME TIME: MODEL NONPROFIT CORPORATION ACT (THIRD EDITION)
DATELINE: April 1, 2008, Chicago
A 13-member task force of the Committee on Nonprofit Corporations of the Section of Business Law of the American Bar Association has been toiling over a revision of the Model Nonprofit Corporation Act for the last several years. All evidence points to a highly-secretive process that so far has allowed expediency rather than a thorough vetting of the issues confronting the task force carry the day. The result is a 450-page model act. It was initially posted to an ABA Business Law Section Website as a document adopted in January 2008. Interestingly, today it was reposted as an exposure draft (Part 1 and Part 2), with a disclaimer that it does not necessarily represent the views of the American Bar Association, the Section on Business Law, or the Committee on Nonprofit Corporations. It now solicits comments, but no comment period or process is outlined.
At this point we can only speculate. If the task force now opens up the process and takes an additional two or three years to develop a product that reflects a widely-shared consensus, we will know that what we are looking at on the Web truly is an exposure draft. On the other hand, if the exposure draft is adopted within six months, we will know that what we saw today was the start of a whitewash. That would be the wrong result. We don't care how much time the task force has put into the proposal and how close they thought they were to finalizing it. The proposal is poorly conceived and executed. It warrants a complete rewrite.
Is this just stupid...
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lawyer technicalities? If only we were so lucky. This revision to the model act potentially affects every nonprofit corporation in the United States. For starters, it establishes the rules as to whether and when directors and officers will be held personally liable and when they will be entitled to indemnification. That should get everyone's attention.
There are at least a couple million nonprofit corporations around the country. To date, the task force appears not to have reached out to these corporations and their members and directors to ask them what they think. We suspect that trade associations like Independent Sector, National Council of Nonprofit Associations, the Philanthropy Roundtable, the American Hospital Association, Association of American Museums, American Society of Association Executives, and countless other organizations will be surprised when they learn that the task force has been working for years on a major revision to the model act. Nor does there appear to have been much communication between the task force and other ABA sections, let alone associations of health care, foundation, and other sector-specific lawyers. We can only wonder whether the IRS has seen any version of the proposal or is even aware of the effort. IRS involvement strikes us as advisable because every organization that seeks charitable tax-exempt status must pass the organizational test. While the task force has focused on secretaries of state in its exposure draft, there is little evidence of any input from state attorneys general. We suspect that theNational Association of Attorneys General—National Association of State Charity Officials (NAAG-NASCO) knows little about the third edition of the model act.
The last revision to the model act was 1987, a time when charities and nonprofits were somewhat of a legal and public backwater. Not anymore. Charities are front and center. Newspapers now have reporters assigned to the charities beat. Both federal and state legislative bodies are looking at a variety of proposals to regulate charities. Various segments of the legal community have been hard at work on law reform projects designed to address issues facing charities. These projects include the Uniform Prudent Management of Institutional Funds Act, the Uniform Trust Code, the ALI's Principles of The Law of Nonprofit Organizations, and the Restatement (Third) Trusts. NAAG-NASCO has been working toward a uniform charity registration law for several years.
Twenty years ago, there was little evidence of litigation involving charities and issues unique to charitable corporations. Not anymore. There is an ever-growing body of case law addressing legal issues unique to charities, including corporate law issues. Like shareholders of publicly-held companies, the public and grant makers are demanding better oversight from those managing charitable organizations. The public and grant makers aren't looking for dividends and capital gains when they invest in a charitable corporation, but that doesn't mean they aren't demanding a higher return on their invested dollars. Those demands are reflected in the shift-in-focus by state attorneys general. They still are concerned that charities register with the state's charities office, but state attorneys general are increasingly focused on governance and whether nonprofit boards are providing enough of it. At the end of the day, none of this is reflected in an exposure draft that appears to have been close to hitting the streets. Shame on the task force.
We aren't the only ones who have objected to the process. Gerry W. Jenkins, an assistant professor of law at The Ohio State University Moritz College of Law, has written:
Although general section and committee membership is open, membership on the drafting committee responsible for the Model Nonprofit Corporation Act is closed and does not operate under the supervision of the broader standing committee in any meaningful way. Thus, nonprofits have limited opportunities, because of the make-up of the section and the nonprofit subcommittee, to receive sizeable representation on the drafting committee. The Model Business Corporation Act is produced by the section's Committee on Corporate Laws. This is a closed committee as well, but its membership—determined through a rigorous application and selection process—consists largely of practitioners closely connected to business. With respect to the RMNCA, while the open committee membership of the ABA seems to offer some opportunity for nonprofit organizations and their representatives to provide input in the project, the closed drafting process does not necessarily permit significant direct involvement by nonprofits. In addition, as with older versions, a primary focus of the drafters continues to be maintaining close parallels between the RMNCA and the Model Business Corporation Act. Furthermore, even with an open membership process, the project is run through an ABA section dominated by attorneys specializing in representing for-profit firms, meaning that nonprofit voices may not carry the day or influence the final draft to the same degree that for-profit firms can influence the ultimate text.
Incorporation Choice, Uniformity, and the Reform of Nonprofit State Law, 41 Georgia L. Rev. 1113, at p 1137 (2007).
Even a quick look at the exposure draft and the source references after each section demonstrates that the task force wanted to align the act with the model business corporation code despite the fact that nonprofits face an entirely different set of issues and circumstances than those faced by business corporations. Those notes cite virtual no nonprofit case law. They do not even highlight changes from the existing model act, making it hard for those familiar with current law to quickly identify the alterations and comment on the merits of the proposed changes.
Here is a brief look at the major issues posed by the exposure draft. This description does not address the hundreds of technical issues and problems that are embedded in the draft that its drafters hope will govern nonprofit corporations for decades to come.
Issue 1: Limitation on Director Liability. The liability shield applicable to directors is indecipherable. Those lawyers who advise nonprofit corporations would be insane to place any reliance on this provision, meaning that they are likely to look to states that have not adopted this version of the model act for purposes of incorporating, assuming there is no change to the exposure draft.
Issue 2. Separate Charitable Corporation Statute. The IRS recently reported that for the fiscal year ending September 30, 2007 it received requests from 85,000 organizations for recognition of Section 501(c)(3) status. The exposure draft draws a distinction between charitable and other nonprofit statutes, but almost as an afterthought. Rather than require those running charities to hunt through the statute trying to identify distinctions between charitable corporations and other nonprofits, the drafters should have provided for a separate statutory regime applicable to just charities. The current Model Act does just that.
Issue 3. Deceptive Names. The task force views the secretary of state's role as purely ministerial. For most purposes that should be the case. However, there have been many reports of fraudsters using names deceptively similar to those of well-known charities to raise funds from the public. The revision of the model act is an opportunity to bring state charity officials into the process. Possibly, there could be a provision requiring the secretary of state to notify state charity officials of the names of newly incorporated charitable organizations (and changes in names), with the proviso that if the state's charity official objects to the name within a specified period of time, the organization is not permitted to use the name. The committee should have consulted with NAAG-NASCO.
Also, there is confusion among members of the public (and even lawyers) between the relationship between laws giving protection to trade names and state corporate enabling statutes. At a minimum, the task force should offer a clarifying comment. However, it may be time to prohibit new entities from using names that are registered as trade names. The task force should consult with ABA's Intellectual Property Section.
Issue 4. Whistleblowers. Section 8.42 imposes whistleblower obligations on all officers, providing:
The duty of an officer includes the obligation to inform:
(1) the superior officer to whom, or the board of directors or the committee thereof to which, the officer reports of information about the affairs of the nonprofit corporation known to the officer, within the scope of the officer's functions, and known to the officer to be material to the superior officer, board, or committee; and
(2) his or her superior officer, or another appropriate person within the nonprofit corporation, or the board of directors, or a committee thereof, of any actual or probable material violation of law involving the corporation or material breach of duty to the corporation by an officer, employee, or agent of the corporation, that the officer believes has occurred or is likely to occur.
Ultimately, this sort of provision could significantly improve board oversight and governance. At the same time, it poses serious organizational and legal questions. As just one example, how does it apply to a nonprofit's general counsel? Also, if the board is nonresponsive, does the whistleblower have a duty under this provision to report the problem to the state attorney general, who might be viewed as the equivalent of a shareholder? This issue has come up in the State of Texas.
Issue 5. Designated Bodies. The exposure draft creates a new body, known as the designated body. This is a poorly defined concept. The overarching question: What problem is this new concept aimed at addressing? What is the difference between a designated body and a committee? Is a designated body external to the organization? For example, Nonprofit X can only do X if the board of directors of Nonprofit Y approves the decision.
What does Section 8.12 mean when it uses the phrase "some, but less than all?" How far can a board go in delegating duties to the designated body? What power must it retain? Can all authority or functions be distributed over multiple designated bodies, or does the board always have to retain some power?
Shouldn't all provisions pertaining to a designated body be spelled out in the articles of incorporation? The Form 990 and many charity regulation statutes require the board of directors to be named. Shouldn't the public be put on notice of a body that has board-delegated powers?
Why can a designated body be populated by one person, but a board must have a minimum of three directors? Shouldn't the exercise of all powers vested in the board, whether delegated or not, be subject to the judgment of at least three persons? Why should delegation eliminate that baseline requirement? Would the corporation's attorney-client privilege extend to information provided to the designated body?
Issue 6. Change of Charitable Purpose. There has been significant and ongoing debate on the effect of a change in a nonprofit's purpose on funds that it has previously raised. This is a difficult issue, one that will require a lot of thought and debate before a workable framework is agreed upon. To this point, it has largely been an issue that people have ignored because of the difficult issues it poses. If statutes are to be meaningful, they must address issues that those subject to them regularly face. The task force should not have taken a pass when it comes to addressing this issue.
Issue 7. Board Officers vs. Corporate Officers. There is considerable confusion when it comes to officers. There are really two categories of officers: (i) the board's officers (president, treasurer, secretary) and (ii) corporate officers. The latter are employees who are involved in the nonprofit's operations. The law has not drawn a clear distinction between the two categories. Nonprofits would find it helpful if there were a legal framework that drew this distinction and defined the consequences. Within the last six months, a Georgia court invalidated an employment contract as violating the state's nonprofit corporation act because it exceeded one year. In the court's view, because an officer's term could not exceed one year, a contract with an officer could not exceed one year. That may have been the right construction, but it was the wrong result.
Issue 8. Fiduciary Duties of Members. The exposure draft does not address whether members have any fiduciary duties. There currently is litigation pending over this issue.
Issue 9. Fiduciary Duties of Nonboard Committee Members. The task force contemplates nonboard members serving on committees. Do these individuals have any fiduciary duties? If they are not board members, can they sit in on discussions with the nonprofit's legal counsel without jeopardizing the organization's attorney-client privilege.
Issue 10. Distributions to Affiliated Charities. Affiliated groups of charities may want to distribute funds up the corporate chain (lower-tier to upper-tier). Under many existing nonprofit corporation statutes such periodic distributions are not possible. The task force needs to focus on these sorts of parent-subsidiary issues.
Issue 11. Common Purpose. Many parent corporation's appoint the directors of subsidiary nonprofits through a single-member construct. Does a director who is appointed by a parent to a subsidiary's board owe his allegiance to the parent or the subsidiary when serving as a director? Can an affiliated group of corporations have one purpose?
Issue 12. Trusts and Corporations. There has been a great deal of controversy and confusion regarding the rules that apply to corporations and those that apply to trusts. Are they the same? Should they be the same? The exposure draft does not reflect any or the ongoing discourse. Nevertheless, courts have had to deal with this issue, as we saw in a recent decision involving Randolph-Macon College.
Issue 13. Substantial Sales of Assets. There have been several court cases where nonprofit colleges have attempted to eliminate control by an outside organization by re-incorporating through a sale of assets to another a newly-formed shell entity. The model act should explicitly address the issues posed by these transactions.
Issue 14. Consequences of Not Adhering to Bylaws. Many nonprofits and their boards are nowhere as sophisticated as officers and directors of business corporations. The exposure draft should address the consequences when a board or officers ignore the organizations own internal rules.
Issue 15. Cumulative Voting. Each organization should have the opportunity to permit cumulative voting. This is particularly important in condominium associations.
If we can find 15 major issues that the task forced failed to address, just imagine how many issues a group of experienced nonprofit legal practitioners could find. In short, the closed process has resulted in a wasted opportunity so far. However, the task force has only itself to blame for this. We, the public, should not be concerned about the tragedy of their wasted time. It is time for the ABA to impose an open process on the task force, staff it with people with diverse viewpoints, and let the process begin anew.
If you are a member of the ABA, voice your opinion. If you are not, voice it anyway.
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