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Non-profit Directors Face Personal Liability

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A recent decision by the U.S. Court of Appeals for the Third Circuit, In re Lemington Home for the Aged, is a reminder to nonprofit corporation directors to act carefully and honestly. This case resulted from an action by unsecured creditors (creditors without collateral) in the context of a Chapter 11 reorganization bankruptcy.

The nonprofit corporation faced financial and regulatory problems. The Board position of Treasurer was vacant for over one year and no financial "meaningful oversight or accounting records" existed during this time. Minutes of Board meetings were incomplete or non-existent. Attendance at Board meetings was often below 50%. The directors served two conflicting entities. The directors declined to commission a viability study upon which a loan was conditioned.

Creditors asserted that the Board had relied on an administrator's judgment even though it knew her part-time employment violated state law and there had been "a string of deficiencies on her watch." The court noted that directors owe fiduciary duties to both the corporation and the creditors of the insolvent entity.

The Court reversed a trial court decision that insulated the directors from liability under the business judgment rule. This rule, absent fraud or self-dealing, shields directors from liability if they exercise reasonable diligence and honesty and reasonably believe their decisions are in the corporation's best interests. In determining reasonable diligence, a court considers factors such as a lack of conflicts of interest, independence, adequate investigation prior to the decision, and reliance upon outside experts.

A few states apply a state law tort of "deepening insolvency." This applies to injuries suffered by creditors from the fraudulent expansion of corporate debt and improper prolongation of corporate life. The Board in question had decided to close the entity but delayed the bankruptcy filing for four months while choosing not to seek additional revenue and comingling funds and transferring equipment to related entities.

It is unclear in the reported decision precisely why the nonprofit directors failed to exercise appropriate oversight. Some common reasons for board failures in general, absent fraud, include dominant executives, group think, a desire to avoid conflict, and the demands of other business activities. However, becoming a nonprofit director creates responsibilities that frequently equal that of a for profit director.

A significant amount of nonprofit litigation involves boards of condominium associations. Sometimes personality clashes turn into suits. Sometimes the board fails to follow state statutes governing condominiums or association bylaws. An "unpublished" 2007 New Jersey state appellate court decision, Ebert v. Briar Knoll Condominium Assn., found violations of the state Condominium Act by the board in the failure to give notice of meetings, voting at meetings not open to unit owners, not taking minutes of meetings, and failing to make minutes available to unit owners before the next open meeting. The Court stated that "the business-judgment rule does not apply where the action of the association is in violation of the Condominium Act, the association's master deed, or its by-laws."

Nonprofit directors should investigate liability insurance options. As in any business, the directors must keep adequate records, consult outside experts when appropriate, and exercise appropriate oversight of executives. A director with a conflict of interest should provide full disclosure and refrain from voting on that matter. Failure to exercise reasonable diligence in this period of financial uncertainty almost assures that unpaid creditors will seek to recover their debts from the personal assets of individual directors. If the nonprofit is subject to detailed statues or regulations, as condominiums are, these requirements must be met by the board.