Liability for Directors of Nonprofit Corporations

by Womble Bond Dickinson
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This article originally was published in the March 2017 issue of South Carolina Lawyer magazine. - See more at: http://www.wcsr.com/Insights/Articles/2017/March/Liability-for-Directors-of-Nonprofit-Corporations#sthash.aPR9Bdfe.dpuf

This article originally was published in the March 2017 issue of South Carolina Lawyer magazine.

This article originally was published in the March 2017 issue of South Carolina Lawyer magazine. - See more at: http://www.wcsr.com/Insights/Articles/2017/March/Liability-for-Directors-of-Nonprofit-Corporations#sthash.aPR9Bdfe.dpuf
This article originally was published in the March 2017 issue of South Carolina Lawyer magazine. - See more at: http://www.wcsr.com/Insights/Articles/2017/March/Liability-for-Directors-of-Nonprofit-Corporations#sthash.aPR9Bdfe.dpuf
This article originally was published in the March 2017 issue of South Carolina Lawyer magazine. - See more at: http://www.wcsr.com/Insights/Articles/2017/March/Liability-for-Directors-of-Nonprofit-Corporations#sthash.DXuYndoC.dpuf
Introduction

Lawyers are often asked to serve on Boards of nonprofit corporations and if they do so, they will often be asked by other directors about the potential individual liability of a director for actions of the nonprofit, for actions of the director and for actions of other directors.  It is essential therefore that such lawyers understand the risks involved.  It is the purpose this Article to further that understanding.

The risk/reward analysis resolves itself into the question of whether  (1) the risk of the liability to the director outweighs the benefit of the service to the public, or (2) the benefit of the service to the public outweighs the risk of liability to the director.  

Directors of nonprofit corporations must have a thorough understanding, first,  of the duties of such a director because it is for a breach of those duties that a director may be sued individually, putting the director’s personal assets at risk.  Insurance companies providing coverage for directors of nonprofit corporations emphasize this concept.  The website of one insurance company states that such potential liability “[C]ould threaten an individual’s livelihood and personal fortune” and that directors owe “fiduciary duties to the nonprofit organization and its grantees and donors.” [1]  The website of a second insurance company brings the liability closer to home, perhaps, by stating that such potential liability threatens “your money, your house, your boat.” [2]  

Although a director of a nonprofit corporation has duties and standards of conduct to adhere to, a system of statutory protection does exist in South Carolina for such a director. This system is more protective of a director of a non-profit corporation than the system protecting a director of a business corporation. Liability insurance exists too, enabling the public benefit to be achieved by directors serving nonprofits to outweigh the risk of personal liability.

Duty of Care as Interpreted by State Law

A director of a nonprofit corporation has two duties under South Carolina law: (1) a duty of care and (2) a duty of loyalty,[3]  with a third related duty being to protect the federal tax exempt status of a nonprofit corporation.  This Article primarily addresses the duty of care.

Three primary South Carolina statutory provisions address the duty of care of a director of a nonprofit corporation: S.C. Code Ann. Sections 33-31-830, 33-31-202, and 32-31-834.

A.  S.C. Code Ann. Section 33-31-830

The governing statutory authority affecting directors is codified in Section 33-31-830 and is based on the second edition of the Model Nonprofit Corporation Act approved by the Committee on Nonprofit Corporations of the American Bar Association in 1987.[4]  Section 33-31-830(a), entitled “General Standards for Directors,” provides that a director shall discharge his duties as follows:

(1) in good faith;

(2) with the care an ordinarily prudent person in a like position would exercise under similar circumstances; and

(3) in a manner the director reasonably believes to be in the best interests of the corporation.[5]

Subsections (1) and (2) constitute the duty of care and the standard is a negligence standard involving an analysis of the specific language of the section, including “a prudent person,” “in a like position,” and “under similar circumstances.”  Id.

Section 33-31-830(d) provides that a director meeting the standard of Section 33-31-830(a) is not liable to the corporation, a member, or any other person if complying with this section. 

B.        S.C. Code Ann. Section 33-31-202

Section 33-31-202(b)(2), provides that no director is personally liable for monetary damages for breach of any duty to a nonprofit corporation or its members, excepting, with respect to the duty of care, “acts not in good faith or intentional misconduct or knowing violation of law.” 

The protection in this Section has both positive and negative differences from the protection in Section 33-31-830. On the positive side, the protection from liability here is not only against negligence, but also against gross negligence, because intentional misconduct would be a higher standard than gross negligence.[6]  On the negative side, the protection in Section 33-31-202(b) applies only to a breach of any duty to the corporation or its members, arguably excluding third party claims, and applies only to monetary damages, not to equitable remedies. The South Carolina Reporter’s Comments recognize, again, that extending protection to grossly negligent conduct is founded on the concept that directors in these circumstances are unpaid volunteers.  This is a reflection of the legislative determination that unpaid volunteers, giving of their time and often their money to an entity whose purpose is a public benefit, deserve a higher level of protection than directors of for-profit corporations, whose purpose is primarily financial and whose directors are usually paid for their service.

C.    S.C. Code Ann. Section 33-31-834

Section 33-31-834, is not a part of the Model Act but was included in previous South Carolina statutory law.  Section 33-31-834 provides complete immunity from liability to a director of a nonprofit corporation exempted from taxation under Federal Income Tax Code Section 501(3)(c), (c)(6) or (c)(12), except when the conduct amounts to gross negligence or willful or wanton conduct.  Comparing Section 33-31-834 protection to the other two sections giving protection, the negatives are that the protection of this section applies only to federally tax-exempt organizations, not to mutual benefit nonprofits, and does not extend to gross negligence.  The positive factors are that it does provide coverage against negligence, unlike Section 33-31-830 protection, and applies to any suit, including third party claims, as Section 3-31-830 does, but Section 33-31- 202(b) does not.

Statutory Protection

The levels, then, of the intentional statutory protection for directors of nonprofit corporations in South Carolina, before even addressing indemnity or insurance coverage issues, include the following:

A.        A director of a corporation whose primary beneficiary is the public, recognized by a federal tax-exempt status, is protected under Section 33-31-834 against any claim by any person unless the director is grossly negligent.  One of the few reported cases involving nonprofit corporation director liability[7] in South Carolina includes a perceptive analysis by Federal District Judge Norton of gross negligence in this context and states that such the applicable duty of care standard requires a finding of conscious wrongdoing.  The conduct complained of in that case, brought by a terminated employee of the Medical University of South Carolina, was that two directors in a telephone call with the Plaintiff, prior to an extension of his Employment Contract for an additional period, requested that the Plaintiff agree to certain changes in his Employment Agreement.  The evidence was that the Plaintiff was told by the Chairman of the Board of Directors on that telephone call that if he did not agree to extend his contract he would be terminated immediately.  One of the Plaintiff’s arguments was that the Chairman did not have the authority to terminate his employment, only the Board did.  The Court found that the Director’s testimony was that he believed he did have that authority, so there was no “conscious wrongdoing”.  Obviously, someone engaged in conscious wrongdoing, even in a nonprofit context, should not have protection. 

B.        If a suit is brought against the director of a nonprofit by that corporation or its members, the director is protected under Section 33-31-202(b), even against gross negligence and is liable only for intentional wrongdoing, not just conscious wrongdoing.  In the Official Comments to this Section, taken from the Model Nonprofit Corporation Act, intentional is defined to mean the specific intent to perform or fail to perform the act with actual knowledge that the specific action or failure to act will cause harm, rather than a general intent to perform acts which cause harm.  The Official Comments also give an example of the special considerations applicable to nonprofit directors in finding that those directors could reasonably allocate all of the entities’ grants to “untried and innovative programs” with little chance of success, because there could be significant benefits if those programs were in fact successful.

C.        In a fact situation not covered in Section 33-31-834 or Section 33-31-202(b), Section 33-31-830 extends protection to conduct that was both in good faith and not negligent, provided, importantly, that the standard the director is held to, that of an ordinarily prudent person, should include a specific favorable analysis of the language “in a like position” and “under similar circumstances.” The Official Comments give clear support for special consideration based on a nonprofit director being a volunteer and receiving no compensation, even extending the analysis to the director’s personal background, qualifications, and experience.

Again, in balancing the two concepts, these special considerations do not water down the requirement for prudence.  Section 33-31-830 provides parameters for such prudence, such as the statement in subsection (b) that while a director is entitled to rely on information, reports, and financial statements prepared by others, directors can do so only if they reasonably believe those providing the information or reports are competent and reliable.  In regard to such special conditions, the Official Comment to that Section states that “this does not mean that directors can ignore their responsibilities because they are volunteers or have no economic interest in the corporation or its operations.”  An example would be that directors, in considering employment discrimination claims, including sexual harassment which are all the more common now, would not be entitled to rely solely on managements review of the relevant facts but should conduct their own independent investigation.

Federal Level – Volunteer Protection Act of 1997

At the Federal level, directors have protection under the Volunteer Protection Act of 1997,[8] which is applicable to directors of nonprofits exempt from federal income tax and which preempts inconsistent state law.  In enacting the Volunteer Protection Act, Congress recognized “the willingness of volunteers to offer their services is determined by the protection from liability in actions against them.” [9]  The protection of the Act extends to all volunteers, which would include an unpaid director, and the standard under Section 14503 of that Act is that the action of the director is protected unless caused by “willful or criminal misconduct, gross negligence, reckless conduct . . . .“[10]  The protection of the Act does not, under that same Section, extend to an action by the nonprofit corporation itself against a director, including perhaps derivative actions, or against the corporation for harm caused by the director. 

A related duty of a director of a nonprofit corporation of a federally tax exempt organization to protect that tax exemption is made clear because both Section 33-31-834 and the Volunteer Protection Act require it.  A director also must ensure compliance with the IRS Guidelines applicable to tax exempt nonprofit corporations, including particularly excess benefit transactions, private inurement questions, and executive compensation issues.  Failure to comply can result in loss of the tax exemption, thus eliminating the tax deductibility of contributions.

Lawyers, as well as other professionals serving as directors of nonprofit corporations may be held to a higher standard of care than other directors.  The Official Comments in Section 33-31-830 state that no particular skill or expertise should be expected from directors “unless their background or knowledge evidences some special ability.”[11]  This would mean that a lawyer sitting on a non-profit board and reviewing contracts, not as a lawyer but just as a board member, may still be held to a higher standard of care, as would an accountant reviewing financial information, even if prepared by an outside accounting firm.

Ancillary Legal Concepts

Two ancillary legal concepts integral to any analysis in this area are (1) to whom the duty of care is owed and (2) the availability of a Business Judgment Rule.

The South Carolina Reporter’s Comments to Section 33-31-830 state “to whom duties are owed by directors is a matter of common law.”  The Section does not create a statutory duty to the members of a nonprofit corporation, but it is generally thought that a duty of care does extend to members of a mutual benefit corporation.  The duty does not extend to beneficiaries of the charitable purpose, such as grant donees,  or to donors. For the latter reason, State Attorneys General are generally given some right of oversight of the use of funds by public benefit nonprofit corporations.[12]  Suits against directors have been brought successfully by Creditors Committees in bankruptcy proceedings of non-profit corporations, including tort claims for “deepening” the insolvency.

In dealing with challenges to actions by the Boards of both for profit and nonprofit corporations, Courts often implement a business judgment rule, which means, generally, that a Court will not review a judgment of a Board of Directors in furtherance of its business unless that Board acts outside of its authority with corrupt motives or in bad faith.[13]  Although the Official Comments to Section 33-31-830 state there is no need for the Business Judgment Rule because the standards of Section 33-31-830 replace the Rule, the South Carolina Comments to Section 33-31-830 state that the Business Judgment Rule would be available as a defense in South Carolina even if that Section’s standards are not met.[14]

Indemnity and Insurance

Even if a director of a nonprofit corporation were to be found liable for an act or failure to act, that director may still have an indemnity claim against the nonprofit corporation.  Section 33-31-851 of the South Carolina Nonprofit Act provides that the Corporation may indemnify a director acting in good faith and who reasonably believed that the action was in the best interest of the corporation if acting officially and, in other cases, if the conduct is not opposed to the best interests of the corporation.  Nonprofit corporations should include in their bylaws an indemnity provision covering directors as an inducement to service by those directors.   A director may recover reasonable litigation expenses under Section 33-31-852 of the Act, which provides for a mandatory indemnification of directors if a director is successful on the merits in defending an action against that director personally but the section applies only to reasonable expenses.

It is common practice for both for profit and nonprofit corporations to carry directors’ and officer’s liability insurance, “D&O Coverage”, which generally protects directors of nonprofit corporations from having to personally fund the expenses of litigation against that director as well as covers, to the insurance limits, any judgment against that director.  There are various issues with regard to the types of coverage available and the amounts of coverage which can be obtained. . A nonprofit corporation should offer the most coverage possible to recruit and to protect its directors . Three types of D&O coverage exist.  A-Side Coverage extends to claims for direct payments to a director for defense costs and liability damages if the directors do not have a right to be indemnified or if indemnification is useless due to the financial condition of the nonprofit corporation. B-Side Coverage reimburses the nonprofit corporation for indemnity payments to directors and officers.  C-Side Coverage extends to the entity itself for its wrongful acts.  Subject to costs consideration, A-Side coverage would appear to best serve the directors of nonprofit corporations and, after proper analysis, could include layering primary and excess coverages and reducing policy exclusions.

To maintain coverage, nonprofits must ensure they maintain their 501(c)(3) or other federal tax exemption by adopting conforming policies for conflicts of interest, document retention, whistleblower protection, fundraising, investments, and executive compensation determination.  A nonprofit corporation should also adopt a specific review policy for preparation of Form 990, which is the Form nonprofits use to report its financial activities to the Internal Revenue Service, before its filing. 

As to Best Practices to be followed by directors of nonprofits corporations, Section 33-31-830(b) recognizes the ability of a director to rely on information, reports, and statements presented by others but requires that the director reasonably believes that such person is reliable and competent in the relevant area.  Included would be the ability of a director to rely on outside legal counsel and accountants.  In addition, ABA’s Guidebook for Directors of Nonprofit Corporations provides good practical suggestions for Best Practices,[15] to include attending regularly scheduled meetings of directors, avoiding multiple executive sessions, adopting a standard form of meeting agenda, minimizing action by written consent as opposed to by resolution adopted at a regular or special meeting of the board, limiting voting by email, and adopting a regular schedule of information to be provided to directors.

Conclusion

The Comments in the South Carolina Reporter for the Nonprofit Corporation Act in South Carolina state that charitable immunity, including director liability, of nonprofit corporations still exists in South Carolina, but it “takes some looking for.” [16]  Indeed, subject to limitations, statutory director protection does exist in the nonprofit corporation world, and the public benefits from such service outweigh the potential individual liability. Liability should only result either from gross negligence  - conscious wrongdoing that should have no protection – or breach of a negligence standard subject to a weighing of certain factual matters favorable to a director, such as volunteerism and public benefit.  Directors can be covered by insurance, which all nonprofits should provide.

The statutory requirement that a director of a nonprofit corporation should act prudently should be an acceptable requirement to anyone serving, or considering service, as a director of a nonprofit corporation in South Carolina.



[1] Zurich Insurance Company website.  The reference to liability to grantees and donors appears to be overstated.

[2] See Travelers Insurance Company website.

[3] South Carolina Nonprofit Corporate Practice Manual, 2nd Edition (2015).  Section 4.04, 3.

[4] It should be noted that the Model Nonprofit Corporation Act, 3rd Edition, changes the language of Section 830 by deleting the negligence standard in (2) from subparagraph (a) and substituting such a standard in a different subparagraph (b) which limits the standard specifically to the decision making function and the oversight function of a director.

[5] S.C. Code Ann. § 33-31-830(a)(1)-(3).   

[6] See South Carolina Reporter’s Comments to Section 202(b), 3.

[7] See Osborn v University Med. Associates, 278 F.Supp. 2nd 720 (D.SC. 2003).

[8] 42 U.S.C. §14501 et seq.  For a detail analysis of the Federal Volunteer Protection Act, see Section 604 of the South Carolina Nonprofit Corporate Practice Manual, 2nd Edition, Page 99, et seq.

[9] 42  U.S.C.

[10] 42 U.S.C.

[11] See Section 33-31-30, Official Comment, 2.

[12] In South Carolina, see Section 33-31-1403 and, generally, Guidebook for Directors of Nonprofit Corporations, 3rd Edition (212) of the American Bar Association, page 11.

[13] See The Dockside Association v. Detyens, 352 S.E.2d 714 (SC Court of Appeals 1987)

[14] The Business Judgment Rule was applied to nonprofits in Dockside Associates v. Detyens, 352 S.E.2d 714 (Ct. App. 1987), aff’d, 362 S.E.2d 874 (1987).

[15]Guidebook for Directors of Nonprofit Corporation, 3rd Edition.

[16] Charity Immunity:  Statutory Remnants in South Carolina, 8 S Carolina Lawyer 28, at Page 31 (1996).

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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