At its most basic level, a related party is one that is either directly or indirectly able to significantly influence or control another party. Thus, a related party transaction is a transaction that occurs between two or more parties with inter-linking relationships.
Specifically, in the nonprofit sector, a related party is generally a person who serves as a director, officer, or key employee of the nonprofit organization or any affiliate thereof; any other person who exercises the powers of directors, officers, or key employees over the affairs of the nonprofit corporation or any affiliate; or any relative of any of the preceding individuals. “Relative of an individual” refers to his or her spouse or domestic partner, ancestors, brothers and sisters (whether whole or half-blood), children (whether natural or adopted), grandchildren, great-grandchildren, or the spouse or domestic partner of brothers, sisters, children, grandchildren, and great-grandchildren. In addition, any entity in which any of the foregoing individuals have a 35% or greater ownership or beneficial interest, or, in the case of a partnership or professional corporation, a direct or indirect ownership interest in excess of 5%, constitutes a related party. It’s a long and convoluted list, for sure.
It is important to consider the potential ramifications of a related party transaction involving a nonprofit organization in which a related party has a substantial influence over the affairs of the corporation and the five-year look-back period of the federal statute that accompanies such an instance. Consider this admittedly-muddy example: The wife of the great-grandson of an individual who three years ago was a very significant donor to a nonprofit organization provides services for a fee to the organization. As a result of her affinity for the organization, these services are being provided at well-below market rate and the donor has had no other relationship with the organization. In this example, the donor (great grandparent) could be a “key employee” even though never serving as an employee because, as a very significant donor, the great-grandparent may have been in a position to exercise substantial influence over the affairs of the organization within the five-year look-back period. Therefore, a transaction of this nature is subject to the heightened requirements and procedures for related party transactions. The moral of the story here is to be mindful of these issues as they arise, and become educated enough to spot potential areas of risk and exposure.
Under the New York State Nonprofit Revitalization Act (“NPRA”), the belief is that a related party transaction is invalid and, therefore, unenforceable, unless the organization’s governing body determines that the transaction is fair, reasonable, and in the best interests of the organization. Under previous law, related party transactions gave rise to questions as to whether any director or officer involved was fulfilling his/ her duty of loyalty to the organization; however, such transactions, if approved and entered into, were valid, binding, and enforceable against the organization.
Oftentimes related party transactions can be benign. For instance, an organization purchases a laptop from a company that employs the wife of a staff member who has no decision-making ability regarding the purchase. However, that benign transaction can rapidly turn problematic if the appropriate steps are not followed — for example, if the laptop was not purchased at the best possible price and the transaction was not appropriately reviewed and approved.
Assuming that a related party has an interest in a proposed transaction involving the nonprofit organization, for the transaction to be valid, the related party must:
- Disclose in good faith the material facts concerning his or her interest in the proposed transaction; and
- refrain from participating in deliberations and votes on the proposed transaction.
Of course, a related party is allowed to provide information to the Board (or a Board committee) regarding the proposed transaction and to respond to questions. In addition, when evaluating a related party transaction, the organization’s governing Board must:
- Consider alternative transactions not involving a related party;
- approve the transaction by no less than a majority vote of the directors present at the meeting; and
- contemporaneously document the basis for approval.
The NPRA provides the New York Attorney General with a distinct authority to bring an action to enjoin, void, or rescind any related party transaction or proposed related party transaction that violates any provision of the law or that was otherwise unreasonable or not in the best interests of the organization at the time that the transaction was approved. Alternatively, the Attorney General has authority to seek other relief, including restitution, removal of directors or officers, or in the case of wilful and intentional conduct, payment of an amount up to double the amount of any benefit improperly obtained.
To help combat any potential conflicts within an organization, it is critical that a conflict of interest policy be developed, written, and implemented. While it has been an age-old element of good governance practices for the governing Board of an organization to formally adopt and require compliance with a written conflict of interest policy, the NPRA has codified this practice by requiring that all nonprofit organizations adopt a written conflict of interest policy that meets certain statutory requirements, including a requirement that the presence and resolution of conflicts of interest be documented in the organization’s minutes. Elements of a sound conflict of interest policy are discussed in greater detail within the Board Policies and Procedure section of this guide and a sample template can be found on our website at http://bit.ly/2d024a4.