Nonprofit Liability
Written 9/14/11
By Curt Harrington & Patty Juneau


 Many nonprofit "experts" write extensively in a vague and "superfluously lofty" ways about nonprofits and will go to great lengths to avoid any useful information that nonprofit managers may be able to actually use. This is despite the charitable ends which can be served by getting useful information out to the nonprofit community.

Director & Officers liability is an important consideration for anyone charged with operating a nonprofit or serving on the board of a nonprofit. The ability to blunt charges of self dealing and negligence is helped by the mere existence of even a marginally competent board of directors but a really knowledgeable board of directors may go a long way to completely prevent a number of problems. Really knowledgeable potential directors  (the term "directors" includes "officers")  are likely not to serve (and should not serve) unless they are assured that they will be insulated from liability.

The California Corporations Code contains a number of provisions to encourage responsible nonprofits to protect their volunteer directors. In some cases these statutes have been criticized as a patchwork response to the failure of the general "good faith" corporate insulation found in California Corporations Code 7231(c) in the Frances T. case (Frances T. v. Village Green Owners Association 42 Cal. 3d. 490, California Supreme Court 1986). There is a general encouragement to buy corporate insurance, followed by two different specific provisions which grant some degree of limited level liability insulation.

First, and generally, 5005.1 of the California Corporations Code explicitly encourages 501(c) corporations to: (1) Insure itself against all or any part of any tort liability; (2) Insure any employee of the corporation against all or any part of his or her liability for injury resulting from an act or omission in the scope of employment; (3) Insure any board member, officer, or volunteer of the corporation against any liability that may arise from any act or omission in the scope of participation with the corporation; and (4) Insure itself against any loss arising from physical damage to motor vehicles owned or operated by the corporation.

But how much insurance should you have to achieve some level of liability insulation for the directors under two schemes provided in the Corporations code? The California Corporations code 5047.5 goes so far as to set up guidelines to answer that question. If the guidelines are followed, no separate cause of action "for monetary damages shall arise against any person serving without compensation as a director or officer of a nonprofit corporation" for acts which are within the scope of their duty as a board member, which are done in good faith, done in the best interest of the corporation, and which is in the exercise of his or her policy making judgment. In essence, this means that when a suit naming the corporation and naming a director in their personal capacity, adherence to the scheme of Corporations Code 5047.5 will cause the directors to be eliminated as defendants, if three conditions are met. The conditions are (1) none of the causes of action are related to "bad acts" from a given list, (2) the corporation is a 501(c)(3)
or 501(c)(6) nonprofit, and (3) insurance is purchased in accord with stated guidelines.

The list of "bad acts" (which prevent shielding of directors under this section, regardless) includes (1) self-dealing transactions, (2) conflicts of interest, (3) approving corporate distributions and loans, (4) In the case of a charitable trust, an action or proceeding against a trustee brought by a beneficiary of that trust, (5) any action or proceeding brought by the Attorney General, (6) Intentional, wanton, or reckless acts, gross negligence, or an action based on fraud, oppression, or malice, or (7) combinations in restraint of trade under Section 16700 of the Business and Professions Code.

The insurance guidelines for Corporations Code 5047.5 require minimum amounts of insurance as follows: 5047.5(e)(1): If the corporation's annual budget is less than fifty thousand dollars ($50,000), the minimum required amount is five hundred thousand dollars ($500,000).

5047.5 (2) If the corporation's annual budget equals or exceeds fifty thousand dollars ($50,000), the minimum required amount is one million dollars ($1,000,000).

But what if my nonprofit is very small and has a budget of only a few hundred dollars? Well, the legislature didn't forget you, and there is a small nonprofit guideline in Corporations Code 5239. This provision has a requirement that the act was performed within the scope of duties and in good faith. The list of "bad acts" is reduced to a requirement that the act or omission was not reckless, wanton, intentional, or grossly negligent ( 5239(a)(3)), approving corporate distributions and loans, ( 5239(e)(1)), or any action or proceeding brought by the Attorney General ( 5239(e)(2)).

The "low end" insurance requirement is as follows:

5239(a)(4) Damages caused by the act or omission are covered pursuant to a liability insurance policy issued to the corporation, either in the form of a general liability policy or a director's and officer's liability policy, or personally to the director or executive officer. In the event that the damages are not covered by a liability insurance policy, the volunteer director or volunteer executive officer shall not be personally liable for the damages if the board of directors of the corporation and the person had made all reasonable efforts in good faith to obtain available liability insurance.

But even the "reasonable efforts in good faith" are spelled out in 5239(h):

As used in this section as applied to nonprofit public benefit corporations which have an annual budget of less than twenty-five thousand dollars ($25,000) and that are exempt from federal income taxation under Section 501(c)(3) of the Internal Revenue Code, the condition of making "all reasonable efforts in good faith to obtain available liability insurance" shall be satisfied by the corporation if it makes at least one inquiry per year to purchase a general liability insurance policy and that insurance was not available at a cost of less than 5 percent of the previous year's annual budget of the corporation. If the corporation is in its first year of operation, this subdivision shall apply for as long as the budget of the corporation does not exceed twenty-five thousand dollars ($25,000) in its first year of operation. An inquiry pursuant to this subdivision shall obtain premium costs for a general liability policy with an amount of coverage of at least five hundred thousand dollars  ($500,000).

So, the step of annually requesting a $250,000 general liability insurance from an insurance professional once per year, for nonprofits having a budget of $25,000 or less and comparing the cost of insurance to 5% of the applicable budget amount, enables nonprofits to take advantage of this "low-end" provision. Smaller nonprofits having a yearly budget of, say, $4000 would only be required to buy insurance to qualify for this provision if the annual insurance cost was below $200 for a $500,000 limit policy.

It is again emphasized that both of the above insurance mechanisms are for non-compensated boards. There is a lot of interest on both sides of this question, and its pretty clear that state governments had rather that board directors not be paid to direct. If it is decided to pay a board of directors, reliance upon either of the statutory schemes previously mentioned is unavailable. Further, even the statutory arrangement above doesn't specify the specific type of insurance except for the word "liability" in the earlier sections and "general liability" mentioned with respect to 5239(h).

Depending on the exposures, a nonprofit organization may be in need of the following types of policies; General Liability which can be bundled with Property insurance to form a "Package policy", Directors and Officers Liability, Errors and Omissions Liability, Commercial Auto, and Employee Dishonesty policies.

General Liability provides coverage when someone alleges bodily injury and property damage occurred on your premises or as an example at a trade show. Typically, personal injury and advertising liability are included as well as premises medical payments coverage. Directors and Officers of an organization should be concerned with having a Directors and Officers Liability policy in place. This type of policy will provide coverage for each
individual director and officer if they should be named in a lawsuit pertaining to the functions, policies, and procedures of the organization.

Depending on how the Bylaws of the non-profit are structured, often times the organization will NOT indemnify the board for the functions of the organization. What this means is that if you DO NOT have a Directors and Officers policy in place each board members personal assets are at risk. In certain cases you can purchase a combination policy which will provide General Liability and Directors and Officers coverage onto one policy.

The cost will depend upon the policy limits, but if the statutory scheme of 5239(h) and 5047.5 are of interest, it makes no sense to obtain a policy with limits of less than the applicable $500,000 and $1,000,000. Nonprofits should be looking for much more in terms of coverage and much more in terms of what is covered.

However, some example coverage limits are as follows. Non profits that do not fall within the definition of a political organization or political advocacy organization with a budget of 50,000 or less will have a minimum premium of from $750.00 to $1100.00 for Directors and Officers Liability Insurance for a $1,000,000 limit of liability. A minimum premium is the lowest amount of premium an insurance co. will charge for a certain type of policy.  Therefore, a $500,000 limit will cost the same as a $1,000,000 limit of liability.

Taking an average of the above range minimum of $750, and dividing by .05 gives a budget threshold of $15,000 for the "low end". Thus, any nonprofit with a budget of less than $15,000 has a good chance of returning a minimum policy limit which is more than 5% of its budget. The upper premium above corresponds to an annual budget of about $22,000. This establishes the budget range of about $15,000 to $22,000 over which a nonprofit "might" be able to fit within he "low end" protection, with a budget of $15,000 to zero creating a high probability of fitting within the protection limits of 5239(h) & 5239(a)(4).

Beyond the "low end" protection of 5239(h) & 5239(a)(4), and given the fact that a $500,000 limit will cost the same as a $1,000,000 limit of liability, it makes no sense for any nonprofit with a budget of over $15,000 to fail to buy insurance.

It is believed that underwriting criteria used to establish the premium would not include an operating budget, although the legislature has tied the need for various levels of insurance, or permissible excuse for lack of insurance (the "low end" protection). Some underwriting factors include the type of organization, number of years in business, whether there been any prior litigation or allegations made against the organization, the size and type of board, to name a few.

The main difference between a General Liability policy versus a Directors and Officers liability policy is that General Liability is designed to provide coverage for negligent acts that result in bodily injury or property damage on the premises; at a fund raiser the non-profit is sponsoring or another example, we have a bake sale and someone gets sick. A Directors and Officers liability policy will provide coverage for alleged allegations against the individual directors and officers for negligent acts or omission, or misstatement or misleading statements when acting within the scope of a director and/or officer of the non-profit organization. Unlike General Liability insurance, bodily injury or property damage is not the trigger for coverage.

In some instances an insurance company will bundle together General Liability and Directors and Officers Liability onto one contract. Often times this can be the most cost effective, however, it may not be the wisest choice for several reasons. Claims filed on one coverage line can affect the entire contract. If the insurance company no longer wishes to write the General Liability portion the entire policy is non-renewed, thereby, demanding the Directors and Officers Liability policy be replaced as well as the General Liability.

The statutory schemes of 5239(h) and 5047.5 thus far outlined deal with liability to third parties for negligence. But what about a suit by the state attorney general which is mentioned in some of the statutory language above? What about liability for taxes from the state taxing authority? What about lawsuits from staff over policy set by the board?

Considering federal liability adds a whole new dimension, as an insulatory state statutory authority for directors has no real ability to shield federal liability. I believe that one of the most dangerous liabilities for boards of directors is the IRS trust fund penalty tax under federal Internal Revenue Code 6672 (also known as the "responsible person" penalty). Many nonprofits who experience money problems will pay the staff employees first and put the IRS last; and let it go on for months. When the IRS looks to get paid, and knowing that the nonprofit is strapped, they will go directly after the directors. Some sort of Fidelity/Employee dishonesty insurance is needed to insure against this eventuality. In addition, even where the nonprofit pays all of its withholding and taxes to its payroll services, a lot of people within those services can abscond with the funds leaving the nonprofit liable for the taxes and the directors liable for the trust fund portion. The payroll services company can be required to have Fidelity/Employee dishonesty insurance, but what use is it if they don't pay their insurance premiums and overlook telling their clients?

The bottom line is that no prudent person should serve on a nonprofit board unless such prudent person is either completely insured against the foregoing and many more risks not dealt with above, or unless such potential board member is willing to risk personal assets in the service to the charity's potential shortcomings.

Curtis L. Harrington is a principal in the law firm of Harrington & Harrington, which specializes in taxation and intellectual property. Curt may be reached by phone at (562) 594-9784, by fax at (562) 594-4414, or by e-mail at curt@patentax.com. In his capacity as a Taxation Specialist of the State Bar of California Board of Legal Specialization, he is currently (2011) chair of the Tax Law Advisory Committee of the Board of Legal Specialization and admitted to practice before the state bars of CA, TX, AZ, and NV; the U.S. District Court; the U.S. Court of Appeals, Fifth and Ninth Circuits; the U.S. Supreme Court; the U.S. Patent and Trademark Office; and the IRS. He holds a B.S. in Chemistry (Auburn Univ., 1974); M.S. in Chemical Engineering (Georgia Tech, 1977); JD (Univ. Houston, 1983); MBA (Univ. Oklahoma, 1985); M.S. in Electrical Engineering (California State Univ. - Long Beach, 1990); and LLM in Taxation (Univ. San Diego Law School, 1997).

With more than three decades of insurance experience, Patty Juneau has developed a sharp eye for how business insurance portfolio's are overpriced and often times lack the coverages necessary to protect the assets of the owners and their investors. As the owner of PMJ Insurance Services she works closely with clients to create a custom insurance program that provides comprehensive coverages at an affordable price with financially sound insurance companies. As an entrepreneur who built her own successful insurance agency, Patty Juneau diligently educates companies about various insurance issues that impact their businesses and can be reached at (877)630-7711 or patty@pmjinsurance.com. Her clients have ranged from entertainment giants like The National Academy of Recording Arts and Sciences, to small manufacturing and non-profit organizations with 10 for fewer employees and gross sales of $2,000,000. Growing up in the insurance business she was voted Wall Street Journal Business Woman of the Year 1996 and designed a custom insurance program for the First & Only Presidential Summit for America's Future on Behalf of the Living Presidents of the United States. She created a Nationwide Insurance Program for the Bungee Jumping & the Amusement Ride Industry and has provided International Insurance for Businesses in Canada, China, Australia, and Mexico. Patty Juneau belongs to the Association of Strategic Marketing and Employment Practices Liability Association in addition to volunteering at various non-profit organizations. A native of California her firm is licensed in 16 states.

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