Reducing Legal Liability for Nonprofit Board Members

Risk is relative.  For some people, jumping out of an airplane is a typical weekend adventure.  For others, driving 5 miles per hour over the speed limit makes your pulse quicken and beads of sweat break out on your forehead.  No matter your tolerance level for it, some risks are unavoidable.  The same is true for serving on a nonprofit board of directors.  The risk certainly doesn’t rise to the level of skydiving, but it’s there.

In this article, we’re going to focus on several areas where this liability can be significantly reduced.

This is always the first line of defense.  As it is, the IRS limits the possibilities to only 4 entity types:  1) corporations, 2) trusts, 3) unincorporated associations, and 4) LLCs.  We can eliminate 2 of those pretty quickly in this conversation.  Trusts are complex legal entities that are only appropriately used for 501(c)(3)s in a tiny percentage of use cases, primarily private foundations.  LLCs really cannot qualify for 501(c)(3) status unless all members of the LLC are themselves already established and recognized 501(c)(3) organizations, not individuals (making this a joint venture, of sorts).  That leaves corporations and unincorporated associations.  These 2 make up the vast majority of 501(c)(3) organizations.

Incorporating creates a legal entity that exists apart from the individuals who created it.  As such, corporations provide a critical layer of liability protection to their board members.  Unincorporated associations, on the other hand, provide no such protection.  While these organizations can qualify for 501(c)(3) status, there is no legal distinction between the nonprofit and those who govern it.  That leaves an unacceptable level of exposure to board members.

Bylaws and Indemnity

I didn’t include this as an entirely separate topic from incorporation, though I easily could have.  Nonprofit corporations must have bylaws, which are the rules by which the nonprofit is governed by its board of directors.  One of the common clauses in most nonprofit bylaws is the indemnity clause.  This is usually relegated to one of the last few citations and is sometimes glossed over by board members who don’t understand what it means.  Generally speaking, a good indemnity clause is a statement that the corporation itself will protect board members from individual loss or liability that may arise due to their board service.  Such indemnity stops at gross negligence and criminal behavior, however (see D&O insurance segment below.

The overall risk to board members is generally low, but this type of insurance can buy peace of mind for your directors.  Commonly referred to as D&O insurance, directors’ and officers’ coverage provides another layer of protection to your board.  It doesn’t cover such things are fraud or criminal activity by a board member.  It will, however, protect board members from personal loss associated with legal suits brought against the nonprofit for other reasons.

There are multiple types of coverage available, depending upon the degree to which the nonprofit already indemnifies the board members from exposure.  The cost of coverage is usually quite reasonable, but check around with multiple insurance providers for the best rates and coverage.

Foundation Group does not endorse or recommend any particular provider of D&O insurance.

Your nonprofit’s policies and procedures can go a long way toward reducing risk.  But it’s not enough just to have the policies.  Your board must understand those policies and work to ensure they are understood and consistently followed by officers, directors, employees, and even volunteers.

We encourage 6 key policies, though there are others that can be brought into the equation, as well.  Those are:

1. Conflict of interest policy
2. Whistleblower policy
3. Records retention and destruction policy
4. Employee compensation policy
5. Gift acceptance policy
6. Fiscal management policy

Each of these essential policies adds certainty and consistency to your operations and helps to limit risk.

Gross negligence that results in legal exposure is one of those things that rarely happens to a nonprofit.  It can also be somewhat difficult to anticipate and prevent, primarily because it involves the actions of people.  People are fallible and even smart, well-meaning people can make mistakes.

Examples of gross negligence can include:

• Failure to de-ice a sidewalk
• Leaving young children unattended
• Exceeding a fire marshall’s occupancy limits
• Not conducting background checks on childcare workers

The list can go on and on.  The problem posed by gross negligence is that it is notoriously difficult to insure against.  Literally, insurance often won’t cover issues of gross negligence, at least not fully.  It can even expose those in governance to legal liability if they allow a preventable situation to exist that could be reasonably foreseen.  All the more reason why great policies are important (see above).

There’s some crossover with policies and procedures with this one.  In fact, many of your best strategies for this should be spelled out in your policies.  Things like:

• Multiple signature requirement for checks
• Two or more people handling cash at all times
• Using an outside bookkeeper or accounting firm

Check-and-balance concerns are not limited to the financial part of your nonprofit, but it’s probably where it is most important.