Memo on Nonprofit Director Liability

INTRODUCTION:

It is not uncommon for one to be asked to serve on a Non Profit Board of Directors, usually for a public benefit corporation, such as a Foundation, a Church or Temple Board, a School Volunteers Board, etc, etc. Such volunteer efforts are both satisfying and vitally necessary for many of the aspects of our lives that make living in this country worth while.

The reader is advised to read the web article on The Fiduciary Dutylocated elsewhere on this web site for a full discussion of the obligations serving as a Director or Officer imposes upon the individual.

The thrust of this Memo is the question as to what liability attaches for alleged violation of that duty in a Foundation. All too often qualified people decline to serve on Boards, fearful of being sued and hearing rumors of massive judgment being assessed against Board Members who were only trying to, “do good.” As with most “urban myths,” no one is quite sure of the details of these rumored judgments, but one “knows a friend who knows someone” who was injured. Equally often, one finds Boards insisting upon massive insurance policies being in place to protect the Boards and Foundations already strapped for cash find themselves unable to afford decent Board Members.

The reality of the situation is that California has enacted various statutory safeguards making it quite difficult to assign liability to individual board members of a Foundation. Unlike the typical for profit corporations, Foundation Board members are held to a more lenient standard of care and duty and this is done to encourage people to volunteer their services.

While insurance for Board Members is always a good idea, and while suit can be brought against Foundation Board Members as more fully described below, the reality of the situation is that the exposure is much less than one confronts in the typical corporate structure and probably far less risk than one encounters in the average commute to work each day.

 

THE QUESTION: WHAT LIABILITY EXPOSURE EXISTS FOR BOARD MEMBERS OF A NON PROFIT AND DOES RECEIVING COMPENSATION IMPACT EXPOSURE?

SHORT ANSWER:

A corporation created to serve designated non profit purposes is variously called a “Not for Profit” corporation, a “Foundation,” and, depending on its activities, perhaps an “Institute,” or “Volunteer Organization,” etc. etc. The reader is advised to read the web article onThe Basics of Setting Up Your Own Foundation for a more complete discussion of these entities.

California Corporation Code '5231 provides that except for self dealing transactions by an interested director, a director of a nonprofit public benefit corporation who performs the statutory duties of a director in good faith, in a manner such director believes to be in the best interests of the corporation shall have no liability based upon any alleged failure to discharge the person’s obligations as a director, including without limiting the generality of the forgoing, any actions or omissions which exceed or defeat a public or charitable purpose to which a corporation, or assets held by it are dedicated. This liability protection extends to both compensated and volunteer directors.

In addition to the protection afforded by Corp C '5231, Corp C ''5047.5, 5239 and the Volunteer Protection Act of 1977 (42USC ''14501-14505) provide further liability protectionbut this protection is limited to volunteer, noncompensated directors, and is not available to compensated directors and requires the purchase of liability insurance.

 

DISCUSSION:

Fiduciary Duty:

A director of a nonprofit corporation is fiduciary. The term fiduciary is defined as anyone who holds a position requiring trust, confidence, and scrupulous exercise of good faith and candor. It includes anyone who has a duty, created by a particular undertaking, to act primarily for the benefit of others in matters connected with an undertaking. Examples of a fiduciary are trustees, attorneys and directors. Thus, a director of a nonprofit public benefit corporation is a fiduciary.

As a fiduciary, directors of a nonprofit public benefit corporation have a fiduciary relationship to the nonprofit corporation, and owe a fiduciary duty to the corporation they serve as well as to the general public. The assets of a nonprofit charitable organization such as a nonprofit public benefit corporation are deemed held in a charitable trust and the directors must operate the organization in a manner consistent with the purposes for which it was formed.

The fiduciary duties of a director for which a director is liable are discussed below and include the following: 1) the duty of care, 2) the duty of inquiry, 3) the duty of loyalty, and 4) the duty to comply with investment standards.

1. Duty of Care

Corp C 5231(a) sets forth the duty of care for directors as follows:

A director shall perform the duties of a director, including duties as a member of any committee of the board upon which the director may serve, in good faith, in a manner such director believes to be in the best interest of the corporation, and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.

While nonprofit directors may delegate corporate management, the activities and affairs of the corporation must continue to be managed under the ultimate direction of the board.

2. Duty of Inquiry

The director’s duty of inquiry arises only when circumstances arise that would cause an ordinarily prudent person in his or her position to make further inquiry. According to Corp C '' 5231(b) in performing the duties of a director, a director shall be entitled to rely on information, opinions, reports or statements, including financial statements and other financial data prepared by officers or employees of the corporation the director believes to be reliable and competent in the matters presented; counsel, accountant and other persons on matters that the director believes to be within the person’s professional or expert competence; or a committee of the board on which the director does not serve, as to matters within the committee’s designated authority.

3. Duty of Loyalty

The directors’ duty of loyalty as set forth in the Corp C 5231 requires that the director act in a manner that the director believes to be in the best interest of the corporation and for all of its members and to administer their corporate powers for the common benefit. In a public benefit corporation without members the directors are obligated to advance and achieve the corporation’s purposes as stated in its governing documents, rather than to advance the interests of individuals and that the constituency of a charitable organization is the segment of the public that the charity is intended to serve according to its stated purposes.

4. Duty to Comply With Investment Standards

Corp C 5240 sets forth the investment criteria for assets of a public benefit corporation that are not directly related to the corporation’s charitable or public programs. These assets are considered assets held for investment and in dealing with these investment directors have a duty to comply with the following special rules of this section: they must avoid speculation and look instead to permanent disposition of the funds; they must comply with any additional standards imposed by the corporation’s articles or bylaws or the express terms of any agreement under which assets were contributed; and they must meet the general standard of care requirements applicable to directors of public benefit corporations.

Many California legal treatises suggest that the standard of fiduciary duty for the director of a public benefit nonprofit corporation is generally not the strict trustee standard of duty which prohibits any self dealing with the corporation regardless of the benefit conferred and cite the following statement by the court in Stern v Lucy Webb Hayes Natl Training Sch For Deaconesses & Missionaries (DC 1974) 381 F Supp 1003, 1013 that a trustee is uniformly held to a high standard of care and will be liable for simple negligence, while a director must often have committed gross negligence or otherwise be guilty of more than mere mistakes of judgment.

The courts apply the business judgment rule as the standard in deciding whether a director satisfied the requirements of careful conduct imposed by the Corporations Code, but court definitions of the business judgment vary from a standard of reasonable conduct and actions taken in good faith to rationally believing that the business judgment is in the best interests of the corporation.

Advising California Nonprofit Corporations, a leading text in the field, at 8.101 advises that the prevailing view of legal commentators in California is that the business judgment rule protects directors from personal liability for the results of their official actions as long as (a) the decision made, or action take was in compliance with the standards of care articulated in Corp C 5231(a), 7231(a), 9241(a), and (b) the decision was not irrational (cite omitted). The above referenced code sections set forth the respective duties of nonprofit public benefit directors, nonprofit mutual benefit directors and nonprofit religious directors. Corporations Code 5231(a) which is relevant to the instant matter is quoted under the prior Duty of Care discussion.

The business judgment rule applies only if the director has no interest in the subject matter on which business judgment is being exercised. If the director is an interested director, there is no presumption in favor of the director’s compliance with the statutory standards for careful conduct and the court could apply the strict trustee standard of conduct.

A director who performs his or her statutory duties in accordance with the statutory standard of care discussed above according to Corp C '5231(c) shall have no liability based upon any alleged failure to discharge the person’s duties as a director. This exemption applies even when the director’s actions or omissions exceed or defeat the corporation’s charitable purpose.

The limitation on personal liability does not apply in self dealing transactions which are defined as any transaction to which the corporation is a party and in which one or more of its directors has a material financial interest, unless the transaction is specifically excluded from coverage by statute (for example action by the board fixing directors or officers compensation)or although otherwise covered by the prohibition is approved or validated in one of the ways set forth in Corp C 5233(d)(attorney general’s approval, court approval, board validation before the transaction or approval by other authorized persons). The prohibition on self-dealing transactions applies regardless of whether the director is compensated for services as a director or is a volunteer director.

Advising California Nonprofit Corporations further states that the limitation on personal liability provided by the statutory business judgment rule is not a bar to individual director liability if a director, acting in his or her official capacity, participates in tortuous conduct. [cite omitted] Although directors may be held liable in an action brought by a third party for tortuous acts committed on the corporation’s behalf, they are not responsible to third persons for negligence merely based on nonfeasance or a breach of duty owing to the corporation alone (and not to a third person) according to the court in United States Liab. Ins. Co. v. Haidinger-Hayes, Inc. (1970) 1 C3d 586, 595, 83 CR 418. Directors are also liable to third parties for falsehood or fraud.

In addition to the statutory protection from personal liability provided to nonprofit directors by Corporations Code 5231 discussed above, the following statutes provide additional liability protection to uncompensated, volunteer directors:

 

1. Corp C 5047.5

This statute provides additional liability protection to uncompensated directors of IRC 501(c)(3) organizations from personal liability for monetary damages from negligent acts or omissions occurring within the scope of their duties as an uncompensated director or officer and in the exercise of their policy-making judgment, as long as the act or omission was made in good faith and in a manner the director or officer believed to be in the corporation’s best interests. An uncompensated director or officer is one who receives no compensation of any sort from the organization. Excluded from the liability protection of Corp C 5047.5 are actions alleging that the director is guilty of self-dealing; actions maintained by the Attorney General against the director or officer; or liabilities arising from intentional, wanton, or reckless acts, gross negligence, fraud, oppression, or malice by the director or officer. In order for the claim protection under 5047.5 to apply, the corporation must maintain general liability insurance for the claim with the following minimum coverage requirements: there must be coverage of at least $500,000.00 if the corporation’s annual budget is under $50,000, and $1 million coverage if the corporation’s annual budget is $50,000 or more.

2. Corp C 5239

Volunteer directors and executive officers of public benefit and religious corporations are not personally liable for damages caused by their negligent acts or omissions in performing their duties as directors or officers. Again, to be eligible for the statutory protection the act or omission must be covered by an insurance policy issued to the corporation or to the director or officer individually, but no minimum level of insurance is specified. This protection is available only to volunteer directors and officers and is not available to any director or officer who receives a salary, fee, or other consideration other than per diem or expense reimbursements. The personal liability protection does not apply to any action brought by the Attorney General or any action alleging self-dealing.

3. Volunteer Protection Act of 1997 (42USC 14501-14505)

The Volunteer Protection Act of 1997 limits lawsuits against volunteers who perform services to a nonprofit organization for no compensation (including directors) and who receive no compensation or other things of value (other than reimbursement of expenses) in excess of $500 a year. The Act provides a complete defense to any action not excluded in the Act and covers nonprofit organizations that are either tax exempt under IRC 501(c)(3) or any not-for-profit organization which is organized and conducted for public benefit, and operated primarily for charitable, civic, education, religious, welfare or health purposes. There are conditions to the liability protection such as the volunteer was acting within the scope of the volunteer’s responsibilities; the volunteer possessed any required license or certification; the harm did not result from willful or criminal misconduct, gross negligence, reckless misconduct , or a conscious flagrant indifference to the rights or safety of the individual harmed; or harm was not by the volunteer operating a motor vehicle, vessel, aircraft, or other vehicle which must either be insured or operated with a license under state law. There are also limitations regarding hate crimes, sexual offenses, civil rights violations, harm resulting while under the influence of drugs or alcohol or misconduct stemming from crimes of violence or acts of terrorism.

 

CONCLUSIONS AND RECOMMENDATIONS:

1. Directors should carefully perform their duties as directors as set forth in the statutes discussed above and avoid self-dealing transactions in order to avail themselves of the liability protection offered by Corp C 5231.

2. The nonprofit corporation should investigate the cost of director and officer liability insurance particularly if the directors are to be compensated.

3. If the directors are to be compensated, Advising California Nonprofit Corporations advises that the terms of their compensation should be addressed in the bylaws or a board resolution.

4. If the directors are to be compensated the directors need to research what is reasonable compensation that will meet the IRS tests of reasonableness. Payment of per diem compensation or reimbursement of out-of-pocket expenses is not considered compensation. The IRS tests reasonableness by examining compensation paid by similar organizations with a similar public or charitable purpose. Advising California Nonprofit Corporations warns that excessive compensation may result in a finding of impermissible private inurnment which would jeopardize the charity’s tax exempt status as well as preclude the director from enjoying statutory liability protections.