by Lisa A. Runquist
Business Law News, Vol. 15. No. 2, Spring 1994
On a cold, dark, windy night, an action took place that dramatically increased the liability of directors of nonprofit corporations located in California. As described by the California Supreme Court in Frances T. v. Village Green Owners Assn.:
On the night of October 8, 1980, an unidentified person entered plaintiff’s condominium unit under cover of darkness and molested, raped and robbed her. At the time of the incident, plaintiff’s unit had no exterior lighting. The manner in which her unit came to be without exterior lighting on this particular evening forms the basis of her lawsuit against the defendants.
Throughout 1980, the Project was subject to what plaintiff terms an `exceptional crimewave’ … All of the Project’s residents, including the board, were aware of and concerned about this `crimewave’. … In early 1980 the board began to investigate what could be done to improve the lighting … Plaintiff’s unit was first burglarized in April 1980. … In May 1980 plaintiff and other residents of her court had a meeting … [and] transmitted a formal request to the Project’s manager with a copy to the board that more lighting be installed in their court as soon as possible. Plaintiff submitted another memorandum in August 1980 because the board had taken no action on the previous requests. … By late August, the board had still taken no action. Plaintiff then installed additional exterior lighting at her unit, believing that this would protect her from crime.
Unfortunately, the additional lighting was found to violate the CC&R’s, and plaintiff was directed to remove the additional exterior lighting and was told that:
…pending their removal, she could not use the additional exterior lighting. … In order not to use her additional lighting, plaintiff was required to forego the use of all of her exterior lights. … plaintiff complied with the board’s order and cut off the electric power on the circuitry controlling the exterior lighting during the daylight hours of October 8, 1980. As a result, her unit was in total darkness on October 8, 1980, the night she was raped and robbed.
In the past, as long as a director performed his or her duties in accordance with the standard of care specified in Corporations Code Section 5231, the director would “have no liability based upon any alleged failure to discharge the person’s duties as a director.” This exemption, which is commonly referred to as the “business judgment rule,” applies even when the director’s actions or omissions exceed or defeat the corporation’s charitable purpose.
The business judgment rule is rooted in the idea that directors should be entitled to (and in order to properly manage an enterprise must) exercise a broad range of discretion in issues of corporate management and should not be subjected to hindsight assessments of their decisions by the courts. The rule originated in the context of business corporations where shareholders often expect management to take risks in order to maximize profits. Although profit seeking is generally absent from the nonprofit, justification for the rule is no less compelling for directors of nonprofit corporations where risk taking and “business-like” operations are necessary for the nonprofit to survive. Therefore, the concept that directors’ decisions should not be second-guessed without a substantial basis for doing so remains relevant to nonprofits. Frequently, it will not be obvious which of several alternative decisions will turn out to best carry out the corporation’s mission.
The California Supreme Court held in Frances T. that the business judgment rule of Corporations Code Section 7231 is not a bar to individual director liability if a director participates in tortious conduct, even if the director is acting in his or her official capacity. In the Frances T. case, the plaintiff alleged that: (i) the association directors owed a duty to her; (ii) they had specific knowledge that a hazardous condition existed which threatened her personal safety; and (iii) they failed to take action to avoid the harm. In ruling that the plaintiff had stated a cause of action against the directors as individuals, the Supreme Court explained why the directors could not seek protection behind the veil of the business judgment rule:
Directors are liable to persons injured by their own tortious conduct regardless of whether they acted on behalf of the corporation and regardless of whether the corporation is also liable…. Directors owe a duty of care, independent of the corporation’s own duty, to refrain from acting in a manner which creates an unreasonable risk of personal injury to third parties…. A distinction must [also] be made between the director’s fiduciary duty to the corporation (and its beneficiaries) and the director’s ordinary duty of care not to injure third parties. The former duty is defined by statute [i.e., Corporations Code Section 7231], the latter by common law tort principles.
To maintain a tort claim against a director, individually, the Frances T. court held that the plaintiff must show that: (i) the director specifically authorized, directed or participated in the tortious conduct; or (ii) the director knew or should have known that a condition under the board’s control was hazardous and could cause injury and yet the director negligently failed to take action to avoid the harm; and (iii) an ordinarily prudent person, possessing the same knowledge as the director, would have acted differently.
The California Supreme Court specifically noted that individual directors named in a personal injury suit have a defense against personal liability if their conduct was not clearly unreasonable under the circumstances or if they reasonably relied on expert advice or the decision of a subordinate who was in a better position to act. In light of the court’s specific rejection of the business judgment rule as a shield from personal liability, this confirmation that directors have a defense to personal liability if they can prove that they reasonably followed expert advice or reasonably delegated decisions to a subordinate or committee seems inconsistent, yet beneficial. The Francis T. court also held that any director who did not vote in favor of the action which caused the injury would have a defense to personal liability.
Legislative Response to Frances T.
The Frances T. case understandably caused great consternation throughout the nonprofit community. The court expressly acknowledged that the defendants had fulfilled their fiduciary duties to the plaintiff in her capacity as a member of the corporation. Yet the Court ruled that those same directors could be held liable to the same plaintiff for the personal injuries she had suffered.
Following publication of the Frances T. case, many nonprofit organizations found it difficult or prohibitively expensive to secure adequate directors’ and officers’ errors and omissions insurance. In response to this insurance crisis, to changes in liability of corporate directors being made in other states, and to continuing concern on the part of nonprofit corporations and their directors regarding their potential liability, the California Legislature enacted and amended various code sections, such as Code of Civil Procedure Section 425.14 and Corporations Code Sections 5047.5 and 5239 and other similar provisions extending some measure of protection to directors of public benefit, mutual benefit and religious corporations.
The array of inconsistently worded liability protection statutes, with curious categories of included and excluded organizations, is indicative of hastily negotiated compromises reached by lobbyists for various segments of the fractionalized nonprofit community. The subparagraphs that follow describe the principal liability “protections” presently available to directors of California charitable corporations.
Corporations Code Section 5047.5. Section 5047.5 is found in Part 1 of the Nonprofit Corporations Law which presents defined terms and other provisions which typically apply to corporations in all three nonprofit categories (i.e., public benefit, mutual benefit, and religious). Because of its location, Section 5047.5 should apply to all categories of nonprofit corporations, yet by its terms the Section is restricted to Internal Revenue Code Sections 501(c)(3) and 501(c)(6) organizations, only those that are organized for religious, charitable, literary, educational, scientific, social and other forms of public service purposes. The section purports to protect “uncompensated” directors of covered entities from personal liability for monetary damages on account of negligent acts or omissions occurring within the scope of the person’s duties as an uncompensated director or officer and in the exercise of his or her policy-making judgment so long as the act or omission was in good faith and in a manner the director or officer believes to be in the best interests of the corporation.
Specifically excluded from the liability protection benefits of section 5047.5 are:
* Actions alleging that the director or officer is guilty of self-dealing as defined in Corporations Code Section 5233.
* Actions maintained by the Attorney General against the director or officer.
* Liabilities arising from intentional, wanton or reckless acts, gross negligence, fraud, oppression or malice on the part of the director or officer.
In addition, before an uncompensated director or officer who clears all the hurdles described above can claim protection under Section 5047.5, the corporation he or she serves must maintain general liability insurance applicable to the claim with minimum coverage of at least $500,000 if the corporation has an annual budget under $50,000; or $1 million if the corporation’s annual budget equals or exceeds $50,000. Because a general liability insurance policy will almost never be applicable to a claim against a director or officer, this provision makes any protection afforded by this statutory provision totally illusory.
Further, there is nothing in the statute to limit the suits that are brought against the directors. Even uncompensated directors and officers who arguably fall under the statute’s “Swiss cheese” umbrella of liability protection are likely to face months or even years of litigation exposure as they challenge pleadings alleging bad faith, or reckless, willful, wanton, or intentional conduct. Thus, it is likely that nonprofit corporations included within the scope of Section 5047.5 and their directors and officers will continue to be faced with providing a defense of directors and officers named in liability suits.
To make matters worse, it is not clear that any protection afforded by the statute would do away with the Frances T. type of liability that continues to be of concern.
With regard to the issue of compensation, many directors serve as volunteer directors, but may receive compensation for other services rendered. A director who receives no compensation for service as a director, but who receives compensation for other services rendered, does not fall within the statute’s protection.
The standard of care as set forth in Section 5047.5 is essentially the same standard required under Section 5231, but without the ability to rely upon third parties. As a result, section 5047.5, which is supposed to afford more protection, may actually result in less protection to the directors to whom it applies.
In conclusion, Section 5047.5 contains so many exceptions, exclusions and qualifications that the protection it appears at first blush to provide is largely illusory.
Corporations Code Section 5239. Section 5239, applicable to nonprofit public benefit corporations, relieves volunteer directors and volunteer executive officers of such corporations from personal liability for damages caused by the director’s or officer’s negligent act or omissions in the performance of duties as a director or officer. The officers included in the definition of “executive officer” are the president, vice-president, secretary or treasurer. Cal. Corp. Code e 5239(c).
To be eligible for this statutory protection from liability, damages caused by the act or omission must be covered by a policy of insurance issued to the corporation or directly to the director or executive officer. Section 5239 does not specify any minimum level of insurance coverage nor does it address the issue of insurance deductibles, and therefore an ambiguity is created with respect to the requirement that damages be “covered” by insurance. Does the phrase mean complete coverage or reasonable coverage, given the nature of the corporation and its activities? If no insurance is applicable to the claim, the director or executive officer may still gain protection from liability by establishing that both the board and the director or officer made “all reasonable efforts in good faith to obtain available liability insurance.”
In spite of Corporations Code Section 5239, directors and officers of nonprofit charitable organizations are again not free of all concerns regarding personal liability exposure. First, the protections of the Section are not available if a director or officer receives any salary, fee or other consideration of any kind (other than a per diem or expense reimbursement). Second, directors or executive officers seeking liability protection under the Section must prove that: (a) the act or omission was within the scope of the officer’s or director’s duties; (b) the director or officer acted in good faith; (c) the act or omission did not involve self-dealing (as defined in Corp. Code e 5233); and (d) that the act or omission was not reckless, wanton, intentional or grossly negligent. A director or executive officer is likely to remain mired in the litigation, with the associated anxiety and stress of personal liability exposure and burden of litigation expenses (in the absence of insurance coverage), for many months, while his or her lawyers seek to establish that all of the requirements for statutory liability protection have been met and that none of the exceptions apply.
As with Section 5047.5, it is not clear that any protection afforded by the statute would do away with the Frances T. type of liability that continues to be of concern.
Again, as with Section 5047.5 the standard of care as set forth in Section 5239 is essentially the same standard required under Section 5231, but without the ability to rely upon third parties. As a result, Section 5239 affords less protection to directors than does Section 5231.
Finally, it should be noted that the personal liability protections afforded by 5239 have no application in the context of any action or proceeding brought by the Attorney General or any action claiming that the director engaged in a prohibited self-dealing transaction.
Code of Civil Procedure Section 425.14. The last liability protection provision which appears to apply to uncompensated directors and officers of nonprofit corporations organized for “charitable, educational, social, scientific or public service” purposes is California Code of Civil Procedure Section 425.14. What Section 425.14 purports to do is create what is commonly described as a “pleading hurdle” to shield qualified nonprofit directors and officers from suits based on claims arising out of negligent acts or omissions by the director or officer within the scope of the person’s duties as such. Such a claim can only be included in a complaint following a judicial determination (based on a verified petition and supporting affidavits) that evidence exists which substantiates the claim.
Unfortunately, Section 425.14 has as many exceptions, exclusions and qualifications regarding coverage as the two Corporations Code provisions described above. For example:
* Despite the broad reference to “charitable, educational…and scientific” organizations, the pleading hurdle of Section 425.15 is not available to Internal Revenue Code Section 501(c)(3) charitable or educational organizations. Instead, the Section’s coverage is limited to organizations which qualify for exemption under Internal Revenue Code Sections 501(c)(1) (exempt credit unions), 501(c)(5), 501(c)(7) or 501(c)(19).
* The director or officer of a listed exempt organization can receive no compensation.
* The filing of a petition pursuant to Section 425.15 (seeking approval to sue the director or officer) tolls the running of any applicable statute of limitations and requires a vigorous defense of the petition’s allegations.
Advice to Nonprofits:
Get Insurance. Despite the real lack of protection available to directors of nonprofit corporations in California, it appears that the majority of nonprofits are not even attempting to obtain directors and officers insurance. The Nonprofits’ Insurance Alliance of California (NIAC), a liability pool exclusively for 501(c)(3) nonprofits in California, curiously reports that less than 20 percent of its 1000 member-insureds purchase directors and officers insurance. During the mid-1980’s this type of coverage was extremely difficult to obtain, and minimum premiums were generally beyond the reach of most community-based nonprofits. However, prices for this coverage have dramatically declined and policies are available from many sources. For example, NIAC reports that for an annual premium in the range of $1,500 to $1,800, most small to medium-sized 501(c)(3) organizations could obtain a broadly worded directors and officers policy with limits of $1,000,000 covering both the organization and its individual board members. Yet most organizations do not even apply for coverage. Although the insurance market, being cyclical, is likely to increase the cost of this insurance at some point in the future, the organization is doing a disservice to all its board members, if it does not purchase both this and a general liability insurance policy, when reasonably priced.
When asked by NIAC why they do not purchase directors and officers coverage for their organizations and boards, executive directors and board members have almost unanimously replied that they have been advised by either their insurance brokers or their attorneys that such coverage is not necessary because of the immunity provisions in California law. If this is true, then their attorneys and insurance brokers appear to be providing them with information that is, at best, inadequate, and at worst, completely wrong. Frequently, the real truth is learned only when the board finds itself faced with a lawsuit which has been declined by its general liability carrier. Defense of these cases can be prolonged and expensive. Without proper insurance coverages, the claims can drain the resources of both the organization and its board of directors.
Support a Change in the Law. Although all attempts to date to limit the liability of directors have been mostly ineffectual, an attempt is being made once again to obtain a reasonable limitation of liability. It is suggested that if you, any of your clients, friends, relatives, or neighbors serve on the board of a nonprofit organization, you should consider writing (and requesting that your clients, friends, relatives and neighbors consider writing) to California legislators asking them to support such a change. A bill currently pending that you might want to examine is SB 1677 introduced by Senator Quentin Kopp.
Leave the Lights On. Whenever an action taken by the board of directors may have untoward consequences with regard to third parties, the board should be very aware of the potential consequences, evaluate its decisions in light of these consequences, and take steps to minimize potential damages. For example, in the Frances T. case, the board could have allowed the extra lights to remain on, at least until they could be disconnected from the system, or until additional lighting that conformed to the CC&R’s could be installed. Had they done this, the directors might have been able to avoid or limit their personal liability.