Question: Now that I am on the board, I realize I didn’t ask if I could be sued.
Answer: Yes, but…

In the United States today, it is hard to even leave your house without running the risk of being a defendant in a lawsuit. So, it should be no surprise that by taking on the important responsibilities of a director of a nonprofit organization, you too can be subject to lawsuits. The good news is that nonprofit directors rarely risk personal liability or the need to retain their own legal counsel to protect their personal interests. There are several legal protections designed to insulate directors from personal liability.

Just like the multiple pieces of body padding that a quarterback wears to protect himself from hits by defensive players of the other team, nonprofit directors also can enjoy an overlapping series of protective laws, legal principles and corporate policies.

1. The business judgment rule.

Directors of both for-profit and nonprofit corporations enjoy the limitations placed upon lawsuits by a legal principle called the business judgment rule, which acknowledges that directors cannot foresee the future and can make significant mistakes in controlling the corporation. Generally, directors are not responsible for decisions that, in retrospect, were damaging to the corporation, even if the results were reasonably foreseeable. Directors cannot be sued when they make bad decisions as long as they act “in good faith.”

2. State-specific statutory protections for nonprofit directors.

In some states, directors of nonprofit corporations enjoy the benefit of statutes that provide protections broader than the business judgment rule. In New York State, for example, Section 720-a of the Not-for-Profit Corporation Law states:

“… no person serving without compensation as a director, officer or trustee of a corporation, association, organization or trust …shall be liable to any person other than such …organization … based solely on his or her conduct in the execution of such office unless the conduct of such director …with respect to the person asserting liability constituted gross negligence or was intended to cause the resulting harm to the person asserting such liability.” In New York, “gross negligence” and “intentional harm” are high bars for any plaintiff to overcome. On the other hand, the New York State Attorney General’s Charities Bureau does not have that same limitation and frequently pursues nonprofit directors for bad behavior.

3. Legally Mandated Indemnification Rights.

Indemnification occurs when a third party pays for someone’s economic loss. That happens most commonly when insurance reimburses a policyholder against a property loss. State corporate laws will generally give directors a right of indemnification (reimbursement) from their corporation when the director successfully defends a lawsuit brought against them in their capacity as director.

4. Optional Indemnification Rights.

State corporate laws may also give directors a right of indemnification from their corporation when the director unsuccessfully defends a lawsuit
brought against them in their capacity as director. This usually requires some prior action from the corporation, either by passing an authorizing resolution or, more commonly, adding an explicit indemnification provision to the corporate bylaws.

5. Directors and Officers Insurance.

Sometimes, the first question a new director will ask is: “Do we have D&O insurance?” That is a good question, especially when serving on boards of very small nonprofits. For most organizations, D&O comes bundled with EPLI (Employment Practices Liability Insurance), and in any year, there will be far more employment-related claims than claims against directors. D&O policies will cover defense costs and most other related losses; however, they do come with policy exclusions that need to be carefully reviewed to understand the scope of the coverage. These policies often have a high deductible that tends to hold down the premium. In a future blog, we will have a lot more information about the type of comprehensive insurance program nonprofits need to have in place to protect against a wide variety of risks.

Secured by protective laws, corporate policies and comprehensive insurance, directors should be comfortable that service on a nonprofit board will not require them to put their home in their spouse’s name. But there are no guarantees! Directors can do two more things to further insulate themselves from claims and liabilities. The two behaviors directors of nonprofits should adopt to avoid being sued. No one can guarantee a nonprofit director that they will never be sued; however, there are two simple rules of behavior that a director can adopt that will ensure they will likely never suffer a personal loss from their service on a nonprofit board.

Rule Number One: Show Up

Directors acting “in good faith” have little to worry about when a random lawsuit is filed naming the directors as defendants. In many instances, the directors may never know that they have been sued. On the rare occasion that the directors are pursued, the best defense for the director is to respond that the director acted in good faith, using due diligence when taking the action that precipitated the lawsuit. But what happens when the record shows that the director rarely attends board meetings? How does one act in good faith “in absentia”? So, with the protection of statutes like Section 720-a, your best defense is to say you are an active board member with good attendance who asks questions and tries to make the best decisions after reviewing all available information. Making the best decision possible requires not only time and good information but also that the decision is not motivated by self-interest, which gets us to the MOST IMPORTANT RULE TO FOLLOW.

Rule Number Two: Avoid Conflicts of Interest.

The subject of conflicts of interest is important. It deserves several blog posts on its own, but for our purposes here, understand that the number one reason directors get sued, suffer economic losses and receive embarrassing publicity is because they have engaged in actions and transactions where they have a conflict of interest. The best way to manage conflicts of interest is to avoid them. There are procedures that will allow a director to serve notwithstanding a conflict, but serving on a board while trying to manage a conflict of interest can create situations that may ultimately lead to deep regret for the director, the board and the agency.

Let’s Review What We Have Learned

The Five Essential Legal Protections Available to Nonprofit Directors:

  1. The Business Judgment Rule, which protects directors who make decisions that, in retrospect, were bad.
  2. State-specific statutory protections that limit directors’ potential liability.
  3. Legally Mandated Indemnification Rights, requiring loss reimbursement to directors.
  4. Optional Indemnification Rights that can broaden the scope of the reimbursement.
  5. Directors and Officers Insurance, covering both defense costs and liability.

The two rules directors of nonprofits should adopt to avoid being sued:

Rule Number One: Show Up
Rule Number Two: Avoid Conflicts of Interest.