Compensation paid by nonprofits is governed by both the corporation laws of the state of organization and Federal tax laws. Most states’ corporation laws require a nonprofit corporation to be organized and operated other than for the pecuniary gain or profit of its members, directors, officers or other private persons, except for payment of reasonable compensation for services rendered. Federal tax laws require a charitable or 501(c)(3) tax-exempt organization to be organized and operated “exclusively for religious, charitable, scientific, testing for public safety, literary or educational purposes … part of the net earnings of which insures to the benefit of any private shareholder or individual.”

This is the first of a three-article series discussing some important requirements of corporation laws and federal tax laws that directors of nonprofits should known in considering executive compensation. This article discusses your duties, roles and rights as a director or member of the compensation committee under state corporation laws. The second article will discuss the safe harbor from Intermediate Sanctions under federal tax laws, and the third article will discuss issues for consideration in Form 990 reporting.

Directors’ Duties, Roles and Rights under State Corporation Laws

Duties. Under most states’ corporation laws, each governing board member and officer has a duty of care to act “with the care that an ordinarily prudent person in a like position would use under similar circumstances” to comply with the nonprofit requirements of the state’s corporation law and the tax-exempt requirements of federal tax laws. Also under state corporation laws, the governing board has a duty of loyalty to act “in good faith, in a manner the director reasonably believes to be in or not opposed to the best interests of the corporation.”

Roles. Members of a governing board have three commonly recognized roles under state corporation laws:

  • Decision making as to matters of policy, direction, strategy and governance. The decision-making role generally involves both the formulation with management of corporate policy and strategic goals, as well as the authorization of major transactions or other actions, including approval of at least the philosophy for compensating the corporation’s executives and other employees. Courts have held that directors making compensation decisions regarding a person should know the total compensation of that person, including cash and non-cash, current and deferred, and vested and unvested.
  • Oversight as to matters critical to the health of the organization. The oversight role is often performed largely by board committees such as audit, compensation, nominating/governance and legal compliance committees. Oversight does not, in general, mean specifically required decisions or approvals, but instead involves periodic attention to internal systems and controls, such as for preparation, review or examination of financial statements to provide assurance that the statements present fairly financial conditions and results of operation; and a philosophy setting forth standards for compensation to provide assurance that compensation is reasonable and does not result in a waste or misuse of assets.
  • Mentorship of the CEO and senior management. The mentorship role generally involves serving as a resource for management. The board and its members can aid the CEO and other senior executives through advice, mentoring and introductions. State corporation laws allow a member of a governing board to make available to the corporation any expertise or experience the board member may have without incurring any greater risk of liability under most states’ corporation laws because the duty of care of a director, regardless of his or her level of expertise or experience, remains to act “as an ordinarily prudent person in a like position would [act] under similar circumstances.” Your experience with compensation will be valuable to other members of the board or any committee in considering executive compensation.

Right of Reliance. In performing his or her duties and roles, each director is entitled under state corporation laws to rely upon (and is protected from liability under state corporation laws to the extent relying upon) information, opinions, reports or statements that are prepared or presented by:

  • Officers or employees (as well as other directors) of the corporation who the director reasonably believes are reliable and competent in the matters prepared or presented. Accordingly, in making decisions and overseeing compensation, you are entitled to rely upon information provided by the corporation’s officers and employees who you reasonably believe are reliable and competent to do so. Accordingly, it is important for you to be familiar with officers and employees having information important to your decision-making and oversight roles regarding compensation, and for these officers and employees to be familiar with you and your expectations of them.
  • Professionals, such as legal counsel, accountants and compensation experts as to matters that the director reasonably believes are within the person’s professional or expert competence. Accordingly, in making decisions and overseeing compensation, you are entitled to rely upon processes recommended by legal counsel, data provided by compensation experts, and their opinions on the reasonableness of such processes and data.
  • A committee of directors upon which the director does not serve, duly established in accordance with a provision of the articles or the regulations, as to matters within its designated authority, which committee the director reasonably believes to merit confidence. Accordingly, the remaining members of the board may rely upon any information, recommendations or decisions of the compensation committee; and it is important for you to know your compensation committee’s designated authority under the committee charter approved by the board.

Importance of Approval by Disinterested Directors. To the extent possible, matters in which an officer or director has a financial or personal interest, such as his or her compensation, should be approved by vote of a majority of the board’s or a designated committee’s directors who do not have such financial or personal interest even though the disinterested directors constitute less than a quorum. In absence of such approval by disinterested directors, the board or committee will be required by state corporation laws to prove, if questioned, that the matter is “fair” to the corporation at the time it was approved.

In conclusion, directors of nonprofits have a duty of care under state corporation laws to comply with the requirements of state corporation laws and federal tax laws that compensation paid is reasonable. In making decisions and overseeing compensation, you are entitled under state corporation laws to rely (and are protected when reasonably relying) upon professionals for matters within their professional competence. This may include relying upon lawyers for matters of process or procedure and upon compensation consultants for peer data, and their opinions on the reasonableness of such processes and data.

You may find additional information regarding the board’s role in considering compensation in Acredula, a periodic newsletter on issues of interest to boards and executives, and at its Web page, www.acredula.com.