Parens Patriae, The Business Judgment Rule and Not-for-profit Corporations
The independence or lack thereof of corporate governance decisions of not-for-profit corporations' decision-makers has been the focus of a number of legal challenges during the last few years. In Florida, for example, the Attorney General intervened to attempt to prevent affiliated not-for-profit hospitals from consolidating some of their operations. Also, in New Hampshire, the attorney general has questioned the reconfiguration of two not-for-profit hospitals and suggested resorting to legal action to block it. Most recently, a leading not-for-profit hospital system filed suit in the Federal District Court of South Dakota in an effort to prevent the attorney general from taking steps to block board action with respect to the sale of community hospitals.
In the Florida action, a not-for-profit corporation board, with governance responsibilities for two hospitals, had decided that it could no longer continue to provide the spectrum of hospital services at one of its facilities without causing financial risk to the entire organization. The board's business decision to consolidate and curtail certain operations at one of the hospitals was challenged by the attorney general, who claimed standing, inter alia, on the basis that the hospital was a public charitable trust or community asset. Following months of litigation, the case ultimately settled.
From this Florida action, as well as other attorney general-initiated actions across the country, the stage may be set for more attorney general/state government scrutiny of not-for-profit corporations and greater scrutiny of board decisions. The purpose of this article is to identify the issues and problems associated with such heightened public scrutiny of the corporate governance of not-for-profit corporations. In so doing, this article first briefly discusses distinctions between not-for-profit corporations and charitable trusts, then reviews a series of challenges by attorneys general to the corporate governance of health care entities.
Not-For-Profit Corporations v. Charitable Trusts
Among the basic forms that charitable entities may take are: (1) the not-for-profit corporation and (2) the charitable trust. While two charitable entities may share the same function, for example, the support of a charitable hospital, the choice of form can lead to very different legal consequences, and at a minimum, different fiduciary obligations in the governance of the charitable entities. Stated simply, trustees of a charitable trust are held to the more rigid trust standard, compared to the officers and directors of a not-for-profit corporation, who are governed by more of what would be considered normal corporate law principles despite the charitable or public purpose of their corporation.
Despite the best of intentions, an attorney general's standing to challenge the business decisions made by the officers and directors of a not-for-profit corporation is confined to certain areas in which authority is provided to attorneys general by statute or case law. A trend can be seen in recent attorney general actions, wherein the restrictions on this authority appear to be ignored, and public oversight of the internal governance of private not-for-profit corporations, particularly health care not-for-profits, expanded, through various theories and devices including the linking of a not-for-profit corporation to a charitable trust.1
Most important to the instant discussion are the differences in fiduciary duties owed by these parties and to whom they are owed. A trustee of a charitable trust owes the strictest duty to the beneficiaries of the trust (usually a charitable class of beneficiaries located in the surrounding community) and must strictly obey the provisions of the trust instrument.2 Accordingly, if the trustee acts in a manner inconsistent with the express terms of the trust, then a state attorney general (or some other public officer with similar type parens patriae3 duties), as the guardian of the public (the beneficiary), may intervene to enforce the trust.
By contrast, the officers and directors of a not-for-profit corporation answer to the corporation in terms of carrying out their fiduciary duties of care, loyalty and obedience, as expressed in the incorporation statutes and the not-for-profit corporation's articles or bylaws. Unlike trustees of a charitable trust, officers and directors of a not-for-profit corporation are permitted, and indeed required, to use their business judgment in acting in the best interest of the corporation. The propriety of actions of the board of a not-for-profit corporation are measured in large part by the "business judgment rule," whereby the board is given wide discretion to render corporate decisions and a court generally will not substitute its judgment for that of the directors.4 Thus, the board of a not-for-profit corporation is generally protected from liability, so long as the decisions or actions were made in good faith, with appropriate inquiry, and with the rational belief that the decisions or actions taken were in the best interests of the corporation.5
Further, although a not-for-profit corporation may perform activities that ultimately benefit the public, its officers and directors owe no special duties to the public, as there are no legal beneficiaries to answer to, and the officers and directors are bound to follow the purposes set forth in the corporation's articles of incorporation. As there are no legal beneficiaries per se, the parties with standing to challenge corporate governance action that contravene the articles of incorporation, bylaws, or statutory proscriptions are those parties that possess a governance-type relation-ship with the corporation and not private donors.6
Most states have ultra vires statutory provisions which identify and limit standing to challenge the actions of not-for-profit corporations to the specific categories of individuals. In Florida, for example, the actions and decisions of a not-for-profit corporation's board may only be challenged in a proceeding:
- by a member against the corporation to enjoin the act;
- by the corporation, directly, derivatively, or through a receiver, trustee, or other legal representative, or through members in a representative suit, against an incumbent or former officer, employee, or agent of the corporation; or
- by the state attorney general to dissolve the corporation or to enjoin the corporation from the transaction of unauthorized business.7 Thus, much to the dismay of attorneys general and generous yet demanding donors, the parties with standing to challenge not-for-profit corporations actions and the areas subject to challenge are substantially limited.
Challenges from Attorneys General
All too common in today's volatile health care market is the sudden merger, restructure, relocation, or outright closure of health care facilities. Often, these facilities are owned and operated by not-for-profit corporations, and these corporate changes are the result of tough decisions made by the board, again, who owe fiduciary duties to the corporation and not to the community per se, which the corporation may ultimately serve.
Obviously, these major corporate changes can be very unpopular and can give rise to drastic problems (e.g. shortage or reduction of health care services and providers) in the surrounding community. Private charitable donors to the corporation usually do not have standing to challenge these actions. Thus, if the public outcry is loud enough, the state attorney general may seek to stop the merger or closing, or redirect or refocus the decision or attempt to dissect and second-guess the same despite the best intentions of those sitting on the board of the not-for-profit corporation. Two examples, one arising from Florida and one arising from New Hampshire, illustrate this trend.8
Florida
In 2001, the Florida Attorney General brought a declaratory judgment action against not-for-profit corporations and a number of their board members seeking, inter alia, a declaration of a constructive charitable trust arising from the reconfiguration of health services provided by two hospitals in Palm Beach County. Although this case ultimately settled, it provides a good illustration of how an attorney general might attempt to attack not-for-profit corporations using charitable trust principles.
In 1994, Good Samaritan Hospital, Inc. ("GSH") and St. Mary's Hospital, Inc. ("SMH") — both not-for-profit corporations — entered into an agreement to create another not-for-profit corporation, Intracoastal Health Systems, Inc. ("IHS") to exercise common governance authority over both GSH and SMH. In 2000, the IHS board of directors proposed a plan to reconfigure the services provided by GSH and SMH such that all acute care services would be offered at the Good Samaritan campus. The attorney general raised substantial questions about the proposal, and subsequently filed the declaratory action.
Citing GSH and SMH as "Palm Beach County's oldest community hospitals," the Attorney General proceeded to argue, inter alia, for the imposition of a charitable trust on the affected hospitals. In support of his request to designate the defendants as charitable trusts, the attorney general stated:
Owing their existence to the generosity of generations of local residents who have donated countless millions to build, equip and expand the two institutions, they are charitable organizations as defined under Chapter 737, Florida Statutes and Section 501(c)(3) of the Federal Internal Revenue Tax Code. These not-for-profit corporations were organized and operated exclusively for charitable purposes.9
The attorney general described the contributions of the local community to support his request for a declaration of a charitable trust:
The existence and historical viability of St. Mary's reflects not only the financial commitment of the citizens of Palm Beach County to their community health care facility, but the time, sweat and effort of countless community volunteers without whom the vision of St. Mary's would never have been a reality. Thousands upon thousands of volunteer hours were the foundation upon which the hospital was built, and that which makes this facility a community asset in the truest sense.10
Such a "blood, sweat, and tears" argument would appear to be inconsistent with or, at a minimum, not fully in sync with well-established corporate and charitable trust law precepts regarding not-for-profit corporations or charitable trusts.
In Florida, the attorney general took the position that his role as parens patriae, combined with statutory authority, permitted him to intervene and challenge the board's decisions. Specifically, the attorney general cited the ultra vires section of Florida's not-for-profit corporation statute, suggesting that the defendants' actions constituted "unauthorized business" because the decision to reconfigure the acute services previously offered at SMH was allegedly inconsistent with their articles of incorporation or by-laws.11
In an apparent effort to argue around the business judgment rule and to exercise his powers in this situation against the backdrop of the statutory restrictions, the attorney general argued for the imposition of a trust:
Such charities [as defendants'] have been likened to public utilities of high order . . . and gifts to charitable entities existing solely for the public benefit, whether incorporated or unincorporated, are usually [considered] to be held in trust for that purpose.
As with gifts to charitable entities, all other assets of a not-for-profit charitable corporation exists for the public benefit. Those assets, while under the control of the corporate entity, are not owned by it. They are deemed to be impressed with a public trust.
* * *
Fundamental changes in the corporate purpose or character which adversely affect the charitable purpose would constitute a breach of the trustee's fiduciary duty not only to the charitable corporation itself but, more importantly, to the community it serves.12
Citing Florida trust law, the attorney general suggested that court approval would be required for such a deviation of a trust (the carrying out of the business decision at issue) as the one proposed by the defendants.13
The defendants' response — in addition to demonstrating the bona fides and necessity of the business decisions — was simply (1) that a not-for-profit corporation, by Florida statute, is not a trust, thus trust law has no application; (2) the attorney general's standing is extremely limited by statute; and (3) the business judgment rule controls the fiduciary duties of the officers and directors with respect to decisions such as the ones made by defendants. Accordingly, the decision to consolidate the services at GSH and SMH was well-within the sound business discretion of the board.
Because the case ultimately settled, there is no "right" answer to glean from this analysis. Instead, it brings to light an issue that has appeal and strong support on both sides. On the one hand, the attorneys general are invested with certain powers under state law typically designed to assure that a corporation does not act ultra vires or that its assets are not misappropriated. On the other hand, however, not-for-profit corporations are private entities engaged in charitable activities.
The governing boards of these corporations are typically populated with experienced business professionals who must be permitted to govern charitable activities without fear of being second-guessed. The law of trusts and the law of corporations must not be blurred completely. Even if a charitable entity is required to obtain approval before "major" deviations in corporate purpose, that does not necessarily mandate the attorney general's approval for every business decision that the board of a not-for-profit corporation seeks to make."14 The business judgment rule governs the decisions of the board of a not-for-profit corporation such as the decisions discussed above. Those decisions may not be popular to the community, but the laws of the State of Florida and many other states are clear on this issue.
New Hampshire
In 1998, in response to the creation of a new corporation to oversee the operations of two separate hospitals — one created by the legislature as a "public charity" and one established as a not-for-profit corporation — the Attorney General of New Hampshire issued a report questioning the validity of such a transaction and suggesting a cy pres action in probate court to examine the matter further.15 Although this situation admittedly differs slightly from the Florida case because one of the New Hampshire hospitals was indeed a statutory "public charity," the attorney general's findings and legal analysis with respect to the not-for-profit corporation are telling.
Prior to 1994, the city of Manchester was served by two community hospitals — Elliot Hospital ("Elliot"), a "public charity" created by the legislature, and Catholic Medical Center ("CMC"), a not-for-profit corporation.16 These hospitals were managed and supported by two separate organizations, Elliot Health Systems and Fidelity Health Alliance, which merged into the newly-created not-for-profit corporation, Optima Health, Inc. ("Optima") in 1994.17 Subsequently, Optima decided to "consolidate all acute care services delivered by both hospitals at the Elliot campus, reducing CMC [to] a rehabilitative and psychiatric unit within a larger hospital organization."18 It was this decision, to effectively shut down the acute care provided at CMC, that was at the heart of the Attorney General's concerns.19
In his report, the Attorney General stated:
Both CMC and Elliot are nonprofit charitable institutions and are bound by a social contract to the local community. Through their trustees and management, Elliot and CMC have fiduciary duty to protect their charitable assets and to ensure that those. assets are used for purposes consistent with the fundamental charitable missions of the respective institutions . ... As a public servant, Optima's actions must be judged by how they benefit the community that founded and continues to support it.20
These arguments — that the receipt of charitable donations and the provision of health care services import a fiduciary duty on the not-for-profit corporations to the public — are the same kinds of arguments made in Florida and elsewhere. Here, however, the New Hampshire Attorney General went even further, announcing an outright refusal to apply the business judgment rule:
Economic efficacy is not dispositive of the question of legality. Proof of convenience, or even a good faith belief in economic "efficiencies," does not resolve the question of Optima's authority to merge two charities. That Optima management may have had a good faith belief in the economic wisdom of its decisions is not dispositive of the question of whether the merger of Fidelity and Elliot Health in 1994 authorized Optima to assume owner-ship and control of CMC and Elliot Hospital, and whether the changes in the mission and governance of CMC and Elliot were so significant as to require notice to the Director of Charitable Trusts and approval by the Probate Court.21
Whether this type of reasoning is an excessive intrusion into the governance of not-for-profit entities is an issue that needs to be wrestled with by competing interests. Working with attorneys general and getting them involved early is often helpful to facilitate a transaction. However, cooperation should not mean the second-guessing of decisions or opening the process to public debate. Clearly, where the statutory requirements mandate attorney general or court approval, appropriate action should be taken. But there exists a fractional gray area that will continue to impose hurdles for the competing interests.
Challenges from Donors
As previously noted, the governance and operation of not-for-profit corporations are generally controlled by the not-for-profit corporation statutes of the particular state in which the corporation operates. Problems may arise, however, when a not-for-profit corporation receives charitable donations and the donor(s) of those funds take(s) issue with certain corporate decisions that he or she believes to be inconsistent with the donative intent of the gift maker. The charitable donor may not be pleased with a decision of a not-for-profit corporation and attempt to challenge the decision by suggesting that it is inconsistent with the terms of the gift. Two Florida cases are particularly illustrative."22
In West Coast Hosp. Assoc. v. Hoare, the Florida Supreme Court held that individuals or groups alleging to be donors to a not-for-profit corporation have no standing to challenge the ownership, management and governance of the corporation based upon their donations to the entity. The background of the case involves a physician-donor who brought suit against the not-for-profit corporation that owned and operated the hospital where he practiced. Among the physician-donor's allegations were that he, along with the citizens of the City of Clearwater and the County of Pinellas, had made various contributions for the construction, maintenance, and operation of the hospital serving the community. Specifically, the physician donor argued that his making such contributions "not only makes him a member of the corporation but gives him some kind of a special right, or privilege" with respect to the governance of the hospital.23
The Court, however, saw other-wise, holding that the fact that one "has made contributions to that corporation gives him no special or vested right [in its governance] . . . . [and] [t]he right of a non-profit corporation to manage its affairs by its Board of Directors or other officers specified in its charter is fixed by the statutes."24
Similarly, in Persan, the plaintiffs were donors of property and funds to a not-for-profit corporation for the construction of homes for disadvantaged adults in the community.25 After 15 years of operation, the corporation's board decided to close the homes, and the donors brought suit, challenging the board's decision — under charitable trust law principles — arguing that the corporation could not use their donations for purposes that were allegedly unrelated to their original donative intent without first obtaining the approval of both the donor "beneficiaries" and the court.26
The District Court of Appeals of Florida, Fifth District, did not agree with the donors, instead upholding the basic yet important distinctions between not-for-profit corporations and charitable trusts, and ruling that donations by members of the public to a not-for-profit corporation do not create a charitable trust, do not result in the corporation's assets becoming subject to a charitable trust, and do not change the rules of the game from corporate law to trust law. Specifically, the court stated that "[m]aking a gift to a charity for a specific project or purpose does not create a charitable trust . . . [and] to suggest that it does would create havoc for charitable institutions."27
Further, the court determined that the donors failed to demonstrate that they had made their contributions with the necessary intent to create an express trust (one that is (i) in writing with a declaration that the property is to be held in trust, and (ii) with a manifestation of intent that members of the public are the subjects of its beneficial enjoyment), for which the not-for-profit corporation would be bound to assume fiduciary responsibilities on behalf of these specific donors.28 Instead, the donors had made gifts which could be used by the corporation for purposes that were consistent with its charter, allowing the corporation to exercise its own business judgment.
Other jurisdictions are in accord. In Michigan, for example, a state appellate court denied standing to "donor petitioners" seeking to enjoin the sale of a not-for-profit hospital to a for-profit hospital, where the donors alleged that the sale would be detrimental to the community.29 Similarly, Illinois state courts have refused standing to donors and contributors seeking to challenge the actions of not-for-profits corporations.[30] The Supreme Court of Connecticut recently denied standing to a donor seeking to challenge the enforcement of his charitable gift.31 Finally, the Iowa Supreme Court ruled nearly sixty years ago that a widow and the heirs of a donor to a charitable not-for-profit corporation held no interest in, and could maintain no standing in, a suit involving the charitable corporation.32
It is clear that charitable donors have no standing to challenge the actions of the board of a not-for-profit corporation by virtue of the gift itself — making a charitable gift will not result in a free pass to the boardroom of a not-for-profit corporation.
Conclusion
In most states, not-for-profit corporations and charitable trusts are two separate and distinct forms of charitable entities. The differences are basic but substantial. The trust is bound by the terms of the express trust instrument, and decisions affecting the trust are judged by strict trust principles. The not-for-profit corporation is bound by its articles of incorporation, and actions affecting the corporation are judged by the duties of obedience, loyalty, due care and the business judgment rule, except in those situations where the statutory law has created charitable trust law issues. The provision of health care services does not blur those distinctions, and neither donors nor attorneys general may ignore those distinctions in their efforts to intrude upon the governance of not-for-profit corporations.
The key will be finding the proper balance. Attorneys general act with the public in mind and not-for-profit corporations are managed by those who bring their business judgment to decisions affecting the corporation. The goal is to find the proper balance without providing a system of second-guessing that results in the corporate decision-making process moving from the boardroom of the not-for-profit corporation to the courtroom.
J.R. Hall contributed to this article, which originally appeared in the ABA Health Section's The Health Lawyer.
1 Moreover, there are signs that the federal government has begun to step back from its traditional role of enforcing antitrust laws in the health care industry, leaving room for state attorneys general to become more aggressive and proactive. See Mark Taylor, Who's Minding the Store? With the feels scaling back, state attorneys general are left to fill antitrust gap, Modern Healthcare, Feb. 11, 2002, at 18.
2 See Austin Wakeman Scott & William Franklin Fratcher, The Law of Trusts § 348 (4th ed. 1989).
3 Id.
4 See e.g., Lobato-Bleidt v. Lobato, 688 So. 2d 431, 434 (Fla. App. 5 Dist. 1997).
5 See e.g. International Ins. Co. v. Johns, 874 F.2d 1447, 1458 (11th Cit. 1989); Auerbach v. Bennett, 47 N.Y. 2d 619, 629-30, 393 N.E. 2d 994, 1000 (1979); see also Cal. Corp. Code § 309(a) (West 2001).
6 See Persan v. Life Concepts, Inc., 738 So. 2d 1008, 1010 (Fla. App. 5 Dist. 1999).
7 Fla. Stat. Ann. § 617.0304 (West 2000); see also Cal. Corp. Code § 208 (West 2001); N.Y. Not. Prof. Corp. § 203 (McKinney 2002).
8 More recently, Banner Health System, one of country's largest not-for-profit hospital systems, filed suit in U.S. District Court in South Dakota, seeking an injunction to prevent Attorney General Mark Barnett from interfering with its property rights in the proceeds from the sale of two of its facilities. The Attorney General seeks to keep the "community assets" in the community, while Banner seeks the freedom to make its own business decisions. See Late News: Banner sues attorney general, Modem Healthcare, Mar. 11, 2002, at 4.
9 See Complaint ¶ 11 (emphasis added).
10 See Complaint ¶ 24.
11 See Fla. Stat. Ann. § 617.0304.
12 See Office of the (Florida) Attorney General Report: Intracoastal Health Systems, Inc., Dec. 19, 2000, at 33 (emphasis added).
13 See Fla. Stat. Ann. § 737.4031.
14 See e.g. Fla. Stat. Ann. § 737.4031 (West 2001).
15 See New Hampshire Attorney General's Report on Optima Health, Mar. 10, 1998.
16 Id. at 9.
17 Id. at 10. The merger resulted in one statutory "voluntary corporation," (i.e. a not-for-profit corporation). New Hampshire Voluntary Corporations and Associations Act, RSA Ch. 292. "A voluntary corporation may take action only in accordance with chapter 292, the corporation's articles of agreement, and the corporation's bylaws." Id. at 12.
18 Id. at 11.
19 Id. at 12 ("The Attorney General has intervened in this matter to review and address the legality and practical effect, under New Hampshire charitable law, of Optima's decision to consolidate all acute care services previously performed at Elliot Hospital and CMC at the Elliot campus and to create a single integrated facility, effectively terminating the century-old charitable mission of CMC . . . to serve as an acute care Catholic hospital within the City of Manchester.").
20 Id. at 2 (emphasis added).
21 Id. at 6.
22 See West Coast Hosp. Assoc. v. Hoare, 64 So. 2d 293 (Fla. 1953); Person v. Life Concepts, Inc., 738 So. 2d 1008 (Fla. App. 5 Dist. 1999).
23 West Coast Hosp., 64 So. 2d at 296
24 Id.
25 Person, 738 So.2d at 1009.
26 Id. at 1012.
27 Id. at 1010.
28 Id. at 1012. The donors had failed to demonstrate a "resulting trust" as well.
29 See Olesky v. Sisters of Mercy of Lansing, 253 N.W. 2d 772 (Mich. Ct. App. 1977).
30 See Skokie Valley Prof'l. Bldg., Inc. v. Skokie Valley Comm. Hosp., 393 N.E. 2d 510 (Ill. App. Ct. 1979); Holden Hosp. Corp. . Southern Ill. Hosp. Corp., 174 N.E. 2d 793, 796 (Ill. 1961).
31 See Carl J. Herzog Found., Inc. v. University of Bridgeport, 699 A.2d 995, 997 (Conn. 1997).
32 See Amundson v. Kletzing-McLaughlin Mem'l. Found. College, 73 N.W. 2d 114, 117 (Iowa 1955).