Nonprofit and Business Directors Must Be Vigilant -- Board Liability Costs Could Be $2.2 Million!

04/05/2015 02:55 pm ET | Updated Jun 05, 2015

The personal cost of director inattentiveness is made painfully clear in an important federal appeals court decision. The U.S. Court of Appeals decided the decision, in re Lemington Homes, on January 26, 2015 for the Third Circuit. ... [T]hese difficult facts arose from a small, nonprofit organization. ... Yet the standard of director conduct applied by the appeals court is quite similar to that which might be applied to a traditional (business) corporate board. * (The case results) also addresses the appropriateness of punitive damages against officers and directors....

The court determined that (15 of 17) directors were aware of the mismanagement yet took no action, despite clear evidence of deficient care to the institution's residents. ...[T]his breach of care, (led to) $2,250,000 in joint and several compensatory damages. As such, the decision offers a particularly valuable -- and practical -- board education opportunity.

The lack of nonprofit director and officer care is not unusual, possibly because directors are part-time volunteers, sometimes not understanding their potential liabilities. For one other current example see here.

Following are some examples of board laxity that I have encountered over the years that I have been involved with nonprofits, up to now not subject to personal liabilities.

Failure to assess staff realities - A social work staff became concerned with the authoritarian style of a newly appointed ED. The community style board felt that to avoid negatively publicity about the agency it needed to give the ED a second chance to improve relations. In the meantime a local electrical workers union heard about the problem and, without the board's knowledge, began to take steps to unionize the agency's social work staff. At the end of six difficult months, the staff voted to be unionized, and the ED was fired for failing to develop positive staff relationships. The organization's United Way funding was temporarily placed in jeopardy -- a reputation loss to the directors and management.

Lacks an effective audit committee -- I have encountered many nonprofit boards that don't have an audit committee, even when it is a state requirement. This is especially prevalent when nonprofit boards feel too rigorous an examination indicates that the board does not trust management and staff. The other extreme that has been reported in the press is where the ED is clearly guilty of an offense, but the board refuses to take proper action and state authorities have to replace the board members.

Board members don't protect each other -- I have encountered situations where the board has refused to purchase D&O insurance for its directors and managers. The faulty rationale was that the board is very close to the finances, and "(fraud) can't happen here." In one instance, the board had responsibilities for a $400K annual budget, a $700K reserve fund and $24 million in real estate assets. Note, if a $1 million D&O policy only covered the fines in the Lemington Homes case, the 15 directors together would be personally responsible for the balance, an average of $83,000 each plus a reputation loss.

Boards are not attentive to compliance basics such as: --
1. Making certain that all directors are thoroughly familiar with duties of due care; their responsibilities related to the IRS Form 990, the Intermediate Sanctions Act and the basics of fund accounting for financial reports
2. Requiring all persons involved with finances take two weeks vacation each year.
3. Making certain that the board and top management are serious about punishing those who use organizational resources for themselves.
4. Requiring board members to sign a conflict of interest statement each year.
5. Making certain that all non-routine expenditures over XX have signatures of two board members.
6. Making certain all persons with access to cash are covered by a surety bond policy.
7. Changing auditing firms or the partner in charge of the account every three to five years.

Nonprofit board members, as volunteers, can be hesitant to be rigorous in their evaluations of the organization and the CEO. They fear, for example, that establishing a whistle-blowing hotline, very common the 21st century, will be interpreted by the staff as the board distrusting staff. Such board laxity, in the long run, can lead to board conflict, require additional board meetings and cause personal rifts with colleagues or friends. Based on the outcome of the Lemington Homes case precedent cited above, not being rigorous about their due care evaluation responsibilities can be very costly to nonprofit and possibly for-profit directors.

* Author's bolding