California Nonprofit Law: The Self-Dealing Prohibition

Section 5233 of the California Nonprofit Public Benefit Corporation Law defines and prohibits self-dealing transactions. A self-dealing transaction is defined as “a transaction to which the corporation is a party and in which one or more of its directors has a material financial interest and which does not meet the requirements of paragraph (1), (2), or (3) of subdivision (d)” (discussed in the following paragraphs).  Where a self-dealing transaction has taken place, a court may order the interested directors to take certain actions and pay damages as in the discretion of the court will provide an equitable and fair remedy to the corporation.

The Section 5233(d)(1) exception requires the Attorney General or a court to approve the transaction before or after it was consummated.

The Section 5233(d)(2) exception requires that all of the following facts be established:

  • The corporation entered into the transaction for its own benefit.
  • The transaction was fair and reasonable as to the corporation at the time it entered into the transaction.
  • Prior to consummating the transaction or any part thereof the board authorized or approved the transaction in good faith by a majority of the directors then in office without counting the vote of the interested director or directors, and with knowledge of the material facts concerning the transaction and the director’s interest in the transaction.
  • Prior to authorizing or approving the transaction the board considered and in good faith determined after reasonable investigation under the circumstances that the corporation could not have obtained a more advantageous arrangement with reasonable effort under the circumstances or the corporation in fact could not have obtained a more advantageous arrangement with reasonable effort under the circumstances.

The Section 5233(d)(3) exception requires that all of the following facts be established:

  • A committee or person authorized by the board approved the transaction in a manner consistent with the standards set forth in Section 5233(d)(2).
  • It was not reasonably practicable to obtain approval of the board prior to entering into the transaction.
  • The board, after determining in goof faith that the two conditions set forth above were satisfied, ratified the transaction at its next meeting by a vote of the majority of the directors then in office without counting the vote of the interested director or directors.

Section 9243 of the California Nonprofit Religious Corporation Law similarly defines and prohibits self-dealing transactions, but includes Section an additional exception:

The Section 9243(d)(2) exception requires that:

  • The transaction be approved or ratified in good faith by the members other than the directors, after notice and disclosure to the members of the material facts concerning the transaction and the director’s interest in the transaction.

Practical Tips for Compliance

If a nonprofit public benefit corporation is contemplating entering into a transaction in which one or more of its directors has a material financial interest, it likely will first seek to meet the requirements for the Section 5233(d)(2) exception. In such case, the board should take the following steps:

  1. Share with all the directors all the material facts of the potential self-dealing transaction under consideration and the names of the interested directors; make sure the directors are continually updated of any changes before any board action to approve the transaction.
  2. Ensure that all directors understand the laws that may affect the legality of the transaction (which may also include federal tax laws that prohibit private inurement, private benefit, a different type of self-dealing, and excess benefit transactions).
  3. Investigate whether there are reasonable alternatives to the transaction under consideration in which there are no interested directors. This might involve soliciting pricing information and/or bids from other vendors or implementing a RFP (request-for-proposal) process. If a transaction involving an interested director will cost the nonprofit more than a comparable transaction not involving a director, it will be difficult, but not necessarily impossible, to justify the former transaction. In such case, a board might rationalize that the interested director transaction would be in the best interests of the nonprofit despite the increased cost because of the quality of services, experience of the service provider, more favorable non-pricing terms, or familiarity with the vendor. But if the pricing difference is significant, the board should feel very confident that all other aspects of the transaction make up for the increased cost of the interested director transaction as a reasonable initial perception of an outsider may be that the board inappropriately favored the transaction precisely because of a director’s financial interest. Note that Section 5233(d)(2)(D) provides that even if the board did not consider and in good faith determine that no more advantageous alternative was possible with reasonable effort under the circumstances, the 5233(d)(2) exception would still apply if the corporation in fact could not have obtained a more advantageous arrangement with reasonable effort under the circumstances.
  4. Take a proper board action to approve the transaction, which will require an affirmative vote by a majority of the directors then in office without counting the vote of the interested director or directors, either at a duly held board meeting or by unanimous written consent.
  5. Document, in the board action, that the board established all of the facts required to meet the Section 5233(d)(2) exception.

Foreign Corporations Operating in California

The California Attorney General takes the position that foreign nonprofit corporations transacting business in California are subject to provisions of the California Nonprofit Corporation Law, including laws related to self-dealing. See Foreign Corporations and the Application of California Nonprofit Laws.