Nonprofit Governance: Directors Held Personally Liable for Mismanagement

April 27, 2015

By Ofer Lion, Douglas M. Mancino and Christian G. Canas

A recent court ruling highlights the need for robust governance practices for nonprofits. The Third Circuit Court of Appeals affirmed an award of $2.25 million in compensatory damages against former directors and officers of a bankrupt nonprofit corporation – personal liability for breach of fiduciary duties and “deepening insolvency.”[1] The case indicates that nonprofit directors may not be able to rely on the “business judgment rule” if they fail to comply with the corporation’s bylaws and exercise reasonable diligence (including by showing up for board meetings) or to act once they are aware of mismanagement by the nonprofit’s officers or employees.

The Case: Lemington Home for the Aged

The Lemington Home for the Aged was a Pennsylvania nonprofit that operated a nursing home dedicated to the care of African-American seniors. Its decades-long financial difficulties became particularly acute during the early 2000s, under the management of its directors and two officers: the chief executive officer and “Administrator” and the chief financial officer.

The directors allowed the Administrator to run Lemington for six years in the face of abnormally high deficiency findings and independent reports documenting her shortcomings and recommending that she be replaced. Even after she ceased working at Lemington full-time, the directors allowed her to continue in her role (in violation of state law) and collect her full salary. In addition, they relied on the advice of the CFO, even after discovering that he was not maintaining Lemington’s financial records and had failed to bill Medicare for at least $500,000.

The board was also in disarray. Minutes of board meetings, including those involving compensation decisions, were incomplete or non-existent. Board attendance was often below fifty percent, and at least one director failed to participate in a single meeting over several years. Although Lemington’s bylaws required a finance committee with a treasurer as chairperson, this committee was not established, and the position of treasurer remained unfilled.

Duty of Care and the Business Judgment Rule

The standard of conduct for directors of nonprofits generally requires that a director perform the duties of a director in good faith, in the best interests of the corporation and with such care as an ordinarily prudent person would use under similar circumstances.

The “business judgment rule” insulates directors from judicial intervention and liability, in the absence of fraud or self-dealing, if the directors exercise reasonable diligence in reaching decisions and honestly and rationally believe that their decisions are in the best interests of the corporation. Thus, its successful use depends on whether the directors’ reliance upon the information provided by one or more officers (or others) is in good faith and on whether there is a reasonable basis for relying upon such officers.

The court in Lemington Home for the Aged held that the evidence supported a finding that the directors breached their duty of care by failing to take action to remove the officers once the results of their mismanagement became apparent. In other words, the directors did not exercise reasonable prudence and care in continuing to employ the two officers. Furthermore, the board’s failure to follow its own bylaws and continued reliance on the information provided by the two officers, in the face of numerous red flags, supported a conclusion that the directors did not exercise reasonable diligence. As a result, the court found that the business judgment rule should not shield the directors from liability.

Responsible Governance

The board of directors is ultimately responsible for management of a nonprofit. The following recommendations are examples of strong governance practices that seek to ensure that the board’s duty of care is fulfilled.

Bylaws. To ensure that directors can fulfill their duty of care and thereby reduce their risk of personal liability, a board’s practices should remain consistent with the nonprofit’s bylaws (e.g., establish all required committees, ensure that the number of directors in office accords with the number or range called for in the bylaws, etc.), which should be reviewed regularly and amended when necessary.
Term Limits and Turnover. Short term lengths and limits on the number of consecutive terms a director may serve (as opposed to total number of terms) can help prevent board stagnation while reducing the artificial loss of qualified and experienced board members. In addition, staggered terms may ensure that experienced directors’ terms do not expire at the same time. Vacancies in either director or officer positions should be filled as soon as possible, and directors who consistently fail to attend meetings should be reevaluated and replaced if necessary.
Meetings and Minutes. Board and committee meetings should be carefully planned and facilitated to foster full attendance, participation and thoughtful decision-making in the best interests of the nonprofit. Minutes of all meetings should be taken and retained with the corporation’s records. Aside from being required by law, they may also provide evidence that directors faithfully discharged their various fiduciary duties. Minutes should include the names of all attendees, what votes were taken and how each director voted, including any objections or abstentions. When the board or a committee acts on any matters for which there are specialized voting rules, such as where there is or may be a conflict of interest or in setting executive compensation, the minutes should note how those rules were met. In many cases, information or documents the directors relied on when making their decision should also be appended to the minutes.
Officer Evaluations. Officers serve at the pleasure and under the supervision of the board, and their evaluations should be a significant component of a board’s responsibilities. Evaluations are critical to ensuring officers are meeting the board’s expectations and fulfilling the duties delegated to them by the board in managing the nonprofit’s operations and finances. If the board becomes aware that an officer is not fulfilling his or her duties, immediate corrective action may be in the best interests of the nonprofit.
Director Compensation. Board and committee members are expected to keep informed with respect to organizational, industry and regulatory developments, be prepared in advance of meetings and contribute their expertise and judgment in advising management. Because personal liability is a real concern, even when reduced by statutory protections and insurance, an increasing number of nonprofits, particularly those primarily funded with program services revenue (e.g., healthcare, higher education, etc.), are paying directors’ fees in order to attract and retain qualified and experienced directors. Director fees may also serve as a sort of moral deterrent to complacency. Once they are being paid, even if the amount is relatively insignificant, directors may feel bad if they don’t diligently prepare for and attend meetings. You get what you pay for, and paid directors may feel like they have to give nonprofits their money’s worth.

Conclusion

The award of $2.25 million in compensatory damages against former directors and officers of a nonprofit corporation is a stern reminder that both directors and officers of nonprofit corporations may be held personally liable for breaches of their fiduciary duties.

Nonprofit boards should regularly review and update their governance practices to ensure directors are meeting their fiduciary duties and reduce the risk of personal liability.

[1] In re Lemington Home for the Aged, No. 13-2707 (3d Cir. Jan. 26, 2015).

Ofer Lion, Douglas M. Mancino, and Christian G. Canas, attorneys at Seyfarth Shaw LLP, represent tax-exempt organizations and nonprofits on a wide spectrum of tax, corporate, governance, and fiduciary issues. For more information, please visit http://www.seyfarth.com/Tax-Exempt-Organizations. The contents of this blog are for general information purposes only, and should not be construed as legal advice. You are urged to consult an attorney for legal advice concerning your or your organization’s specific situation.

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