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
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