Risk Managers' Forum—D&O for nonprofits 11/07

Since, by definition, a nonprofit organization (NPO) does not have “owners” or “shareholders” as ordinary corporations do, all traditional rights and responsibilities of ownership are vested in the Board of Directors (“the Board”). The Board also bears liability for the organization, hence the creation of directors & officers liability policies. A 501(c)(3) exemption1 granted by the Internal Revenue Services does not increase or diminish these rights, responsibilities and liabilities.

The most obvious and apparent evidence of this nonprofit “ownership” is the tax lien filed by the IRS for failure to pay taxes, remit taxes withheld and the quarterly 941 forms (federal tax returns), etc. In the event an organization’s CFO does not pay the quarterly tax along with employees’ withholding taxes, the IRS properly liens the Board of Directors, not the staff, which defends itself by asserting it is merely following the mission and policies of the Board.

Classic literature and case law assign four well-established duties to the NPO Board of Directors:

1. Establish the mission and policies for the organization. Note, the Board does not establish procedures, just policies. Even though most NPOs throughout history have a “founder”—a visionary who usually occupies the role of executive director or president—this visionary is merely an employee of the organization and the mission is authored by and is a product of the Board of Directors.

2. Establish and adopt a budget. This fiscal responsibility is the sole domain of the Board notwithstanding preparation by staff. At the end of the day, the Board of Education of a school district, the Board of Directors of an NPO, the City Council of a municipality, etc., are responsible for the budget and its components.

3. Hire an executive director/CEO/president and charge him or her with using the adopted budget to carry out the mission of the organization. It is the responsibility of the executive director to hire the people necessary, including all layers of management and line staff. These are the people who toil daily to fulfill and further the work of the organization.

4. Commit to development and fundraising. In a nonprofit taxing authority such as a museum, zoo or transportation district, it is the Board of Directors that approaches the voters for approval, commits resources to the budget, develops fundraising events, and executes grant requests, all in the pursuit of funding necessary to accomplish the first two items.

Most NPOs begin with a visionary who identifies a need and decides that a nonprofit corporation is best suited to fill that need. The “visionary” assembles the Board to meet statutory nonprofit corporation requirements. For these start-up NPOs without a plethora of funds and funding sources, the Board usually does everything from stuffing envelopes to typesetting and printing the monthly newsletters, organizing meetings, classes, etc., up to and including the traditional decision-making, execution and financing roles.

Then, as the NPO grows, the executive director hires the staff, allowing the board members to shed some of their clerical and “hands-on” responsibilities. As the organization grows larger still, there is a natural development towards the four classic duties outlined above. Eventually, the organization becomes so large and corporately organized (e.g., the local symphony, local colleges and universities, local United Way affiliate) that the Board occupies almost all of its time and efforts with fundraising while professionals offer significant advice and assistance in the mission and staff development roles.

“It’s only a nonprofit board. What can happen?” Traditional NPO risk management identifies two major areas of exposure—one is personal and one is corporate—to the entity itself. Just because an organization is chartered under the state Uniform Nonprofit Statutes and complies with all requirements—three board members minimum, conflict of interest disclosures, board duties, membership requirements, etc.—this does not make it immune to tort and immune from pursuit of remedies from damaged parties. Neither does a 501(c)(3) exemption give NPOs immunity from potential claims against alleged tortfeasors.

ERISA establishes individual liability where employee benefit programs (workers compensation, group medical health insurance, 403(b) self-directed retirement plans, etc.) are concerned. This individual liability is imposed on anyone who makes any decisions regarding these benefit programs. This is most important in the early stages of life for an NPO when board members—with growing staff— make these types of decisions.

Even with large well-established and well-funded nonprofit organiza-tions, there can be allegations of personal liability. Consider the local charity horse show where a board member’s horse accidentally kicks a paid attendee at the annual fundraising event. Was it accidental? Where is recourse for medical payments? Can an unscrupulous attorney file a personal injury suit against an unpaid, volunteer board member? Absolutely.

In addition, the entity itself is potentially a defendant in a civil case where someone believes a wrong has occurred. An angry outgoing board chairman believes the successor board members are squandering funds in complete disregard to the original intent and mission of the founders. A recipient of nonprofit funding has his or her services terminated and believes that he or she has been discriminated against. The taxpayers see lavish spending by the board of education with large expense accounts and trips all over the Western Hemisphere and charge them, individually or together, with financial malfeasance. Finally, it’s also possible for a local chapter to incur liability and cause its national organization to be sued as well. This is termed “ascending liability.”

So how do NPO board members avoid personal liability? According to Bruce R. Hopkins in Starting and Managing a Nonprofit Organization:

4. Ask questions. Don’t just show up for board meetings and mindlessly rubberstamp action items on the agenda.

Hopkins summarizes that when directors or officers maximize use of the “four I’s”—Incorporation, Indemnification, Insurance and Immunity, they have done everything possible to avoid liability.

Glen Groegemueller and Garth Allen, both professors at the University of Northern Colorado, have written numerous articles on the consequences of NPO decision-making and potential liabilities. They emphasize four additional duties that have evolved through NPO case law: honesty, loyalty, obedience and diligence.

The courts recognize that even with adequate information, thoughtful evaluation, and careful deliberation, some policy decisions of the board will not lead to successful outcomes. However, the “business judgment defense” is available to board members who show that the board acted on an informed basis, in good faith, and with the honest belief that the action taken was in the best interest of the corporation. The “business judgment” rule emphasized the decision process over the decision. Directors will not be liable if they act prudently.

Statutory Immunity. All 50 states, in one form or another, codify immunity for nonprofit board members upon several conditions. Most often these statutes contain three common conditions:

1. Noncompensated—Board members may be reimbursed for reasonable travel and meal expenses but cannot be compensated just because they attend a meeting or sit on the board (as publicly held corporations typically do).

2. Absence of “gross & willful” negligence—Most legislatures accept the fact that accidents happen, people get hurt, property gets damaged, financial conditions go askew. As long as the alleged negligence is “ordinary” and does not rise to the level of “gross and willful,” the board member will still enjoy the immunity.

3. Within the definition of “duties” as outlined in the bylaws of the organization—The board members of the local organization enjoy immunity as long as their activities are related to that core mission (such as dedicated to the advancement of children diagnosed with autism). We typically will suggest that organizations revise their bylaws so the duties clause reads “any legal purpose” or some other similar broad language so they don’t get tripped up in a lawsuit by this provision.

This statutory immunity usually extends to the board members only in their personal capacity and does not extend to the entity itself. A civil case where the NPO and all board members are individually listed as defendants may take advantage of the statutory immunity provisions to get the individual members summarily dismissed from the petition, thereby allowing the case to go forward against the organization itself.

Corporate reimbursement or indemnity. Most states, in the recent versions of their Model Nonprofit Act, usually provide for the organization to indemnify board members and officers in the event they are claimed against. If you research the relevant statute in your state, make note whether or not the legislature used the word “shall” or “may” in this particular section of the Act.

Volunteer immunity statutes—federal and state. On June 18, 1997, President Clinton signed into law S.543, the “Volunteer Protection Act of 1997.” The legislation was the culmination of more than 10 years’ effort to enact a federal law to provide some protection from liability for volunteers. The act provides civil liability protection for nonprofit or government volunteers if:

• The volunteer was properly licensed, certified or authorized to engage in the activity or practice (if required by the state in which the damage occurred) and those activities were within the scope of the volunteer’s responsibility.

• The harm was not caused by willful or criminal misconduct, gross negligence, reckless misconduct or a “conscious, flagrant indifference” to the rights or safety of the individual harmed by the volunteer.

• The harm was not caused by the operation of a motor vehicle, aircraft, or other vehicle for which an operator’s license or insurance is required by the state.

Pre-emption and state election of nonapplicability: The federal Volunteer Protection Act pre-empts existing state laws except those (like New Jersey’s) that provide broader volunteer protection than the federal law. However, the new law does allow states to enact their own legislation to make the federal law inapplicable in a particular state.

Directors & officers liability insurance. This type of policy provides two major categories of coverage:

1. For board members and officers individually, it provides legal defense costs to establish the immunities outlined above resulting in summary dismissal from the cause of action.

Remember that D&O liability insurance does not provide coverage for bodily injury or property damage liability; that is covered by the comprehensive general liability (CGL) form. Instead, as in the case of most professional liability policies, the D&O provides coverage for allegations of financial malfeasance.

In addition, because of the traditional roles courts have interpreted boards to have, these policies are usually endorsed with both employment practices liability (EPL) coverage and fiduciary coverage. Current insurance industry statistics show that the majority of claims against nonprofit boards in 2005 fall under the EPL category.

Personal umbrella policies. For some time now, the personal umbrella policy has provided legal defense coverage for claims against the insured arising out of noncompensated nonprofit board activities. The personal umbrella policy is an often-overlooked avenue for remedies. This policy will typically provide legal defense and protection against liability claims of many sorts including automobile, premises liability, libel, slander, defamation and sexual harassment. It was widely reported that former President Bill Clinton’s personal umbrella policy picked up much of the legal defense cost in the Paula Jones case.

Do you sit on the board of a local nonprofit organization? Does any of your clients? Think you or they are immune from civil claims for damages? In most local jurisdictions, the cost of filing a lawsuit is under $200 and anyone who can rustle up an attorney who’s not too busy can sue you, even if you’re on the board of an NPO. And most uniform rules of procedure require that you have representation by an attorney admitted to the bar in your state. While good practices and good documents will go a long way in helping you to establish your defense or even get you dismissed from the case, it always helps to have an underwriter picking up the defense costs. Better yet, avoid liability to begin with by adopting good NPO risk management practices. *

1 A 501(c)(3) exemption applies to organizations that are organized and operated exclusively for one or more of the following purposes: charitable, religious, educational, scientific, literary, testing for public safety, fostering amateur sports competition, and the prevention of cruelty to children or animals.

The author
George J. Gladis, CIC, CRM, ARM, has been an insurance agent and broker for more than 15 years and is currently a producer with Huntleigh McGehee in St. Louis, Missouri. George specializes in risk management and insurance for health care (long term care and acute care), large fleet transportation, not-for-profit organizations and construction. He is a member of the national faculty for The National Alliance’s CRM program. For information on the Certified Risk Managers (CRM) program, call (800) 633-2165 or go to www.TheNationalAlliance.com.