April 6, 2021
April 6, 2021
Directors who sit on the boards of public companies or large private corporations often ask the organizations questions about directors and officers (D&O) liability insurance coverage, indemnification, and internal controls prior to agreeing to serve on these boards. But even sophisticated individuals sometimes bypass such questions when invited to join the board of a nonprofit organization. This can be a costly mistake.
Nonprofits do much good, from raising awareness of social and environmental issues to supporting charitable endeavors that improve lives and communities. And many successful businesspeople and donors generously support these organizations by giving their time and talent to nonprofit boards. However, the reality is that nonprofits of all sizes, and in all sectors, can be litigation targets. It is not uncommon for directors and officers at nonprofits to face allegations of fraud, wrongdoing, or liability for employment practice issues—all of which have become more common during the pandemic. For example, according to Insurance Business America, a major liability exposure for nonprofits is the mismanagement of funds. As a result of COVID-19, numerous nonprofit organizations have had to close, suspend fundraising, lay off or furlough staff, or reduce services. Managing these challenges improperly can result in lawsuits.
I recently received a call from a nonprofit board appointee who asked how they could extricate themselves from a difficult situation. The caller shared that after publicly accepting a seat on a nonprofit board, they learned that there were potential allegations of fraud against the treasurer and allegations of mismanagement against other board members. Ironically, one of the people who recruited this board appointee was under investigation. The board member was very upset and concerned about potential impacts to their reputation and personal financials. Clearly, this was the wrong time to be learning about and discussing this situation. Conducting due diligence before joining a board is imperative.
Managing liability risk is a two-way street for organizations and those they invite to serve on their boards of directors. Individuals can feel more comfortable participating as directors when they are less worried about exposure to lawsuits and nonprofits benefit from the experience and insights that directors can bring when the directors are confident in their decision-making.
Nonprofit organizations tend to have less rigor and structure around risk management than private businesses and they do not have the reporting requirements of public companies. Therefore, every individual asked to participate on a nonprofit board should raise certain questions:
Does this nonprofit organization have a D&O policy? Nonprofits commonly purchase D&O liability insurance, but it is critical to understand the quality of the coverage. The D&O policy can be written very broadly to better protect board members, or it can be written with coverage restrictions. It is important to have an experienced insurance professional review the coverage in an effort to best protect the individual director as well as the organization. That said, there are differing types of D&O insurance policies. For example, a Side A policy, which offers coverage solely for the directors and officers, typically sits above a traditional D&O policy and would not provide coverage for suits against an organization itself. It is imperative to understand the policy structure, total amount of coverage, and how the insurance will respond to lawsuits.
What are the policy limits? Smaller organizations might opt for a minimal level of coverage limits, such as $1 million. At face value, that might seem high relative to a nonprofit’s assets. In reality, $1 million today is not a lot of protection for high-net-worth directors. Even in a seemingly frivolous allegation, defense costs can add up quickly to hundreds of thousands of dollars. It is also important to understand that the limit is typically shared between the entity and the individual directors and officers. All of these factors can serve to erode policy limits quickly.
What other risks does the nonprofit have that might share those limits? An advantage of D&O insurance for nonprofit and private organizations is that the coverage is typically very broad. It can respond to a variety of claims, from financial losses to employment practice allegations to third-party liability arising from alleged wrongful acts by management. While the broadness is often beneficial, it can be a negative as well, as the policy proceeds defend even fraudulent actors until final adjudication, making it important to understand who may be eligible for coverage under the policy and when that coverage may cease.
What is the risk profile of the nonprofit organization? For directors, a clear picture of the nonprofit’s operations and risk profile is important. Boards are generally viewed as the ultimate risk owners for the organization and individual directors can make more informed decisions about D&O insurance and indemnification agreements if they better understand potential risks. They must also work to understand the risk-management safeguards in place to protect them as directors and officers outside of the insurance policy. The insurance policy should be a backstop while sound board practices should be the foundation of director and organizational protections.
What does the nonprofit’s balance sheet look like? An organization’s bylaws may grant a director or officer defense and indemnity for alleged wrongful acts committed in their role as a board member. In the absence of a D&O policy, this protection comes from the organization’s balance sheet. The D&O policy provides financial backing to the balance sheet for this obligation, and it also protects directors and officers in many cases where the organization is legally barred from doing so. Where a nonprofit’s balance sheet is weak, adequate D&O coverage becomes more important.
Before committing to join a nonprofit board, potential directors should follow the below tips to better understand and manage the risk that becoming a board member entails.
Seek transparency. The more information a director has about a nonprofit organization—its balance sheet, operations, risk-management program, and more—the better that director can perform their role and the more effective that director can be in mitigating risk, both for the organization and themselves.
Gather insurance details. If a nonprofit has insurance in place for its directors and officers, obtain a copy of the policy along with any related documents, such as indemnification agreements.
Obtain expert advice. If there are any questions about the D&O coverage, its adequacy, or how it might respond to different claim scenarios, directors should discuss those issues with their legal and risk advisors.
Explore alternative risk-transfer options. Directors who worry about personal liability arising from their nonprofit board membership have options further to any D&O coverage the nonprofit may have. Personal insurance policies, such as homeowner and umbrella policies, typically exclude commercial ventures and for-profit board activities. However, there are personal director liability policies that can provide additional coverage specific to an individual nonprofit board member and are designed to sit above the corporate D&O policy.
Given the rising frequency of lawsuits and settlement amounts, it is important to take time to consider your risks as a nonprofit director and review your options with an experienced risk advisor.
Daniel Hanson is senior vice president of management liability and client experience at Marsh & McLennan Agency.
NACD: Tools and resources to help guide you in unpredictable times.