Piercing the Nonprofit Corporate Veil—How Vulnerable Are You?

I recently had lunch with a commercial insurance agent who commented that one of the most financially risky steps an individual could take is to join a nonprofit board of directors. Having worked with several boards of directors as a nonprofit executive, served on various boards myself, currently serving as a board member for a local nonprofit organization, he had my attention.

Of course, he was not giving financial investment advice, nor was he suggesting that people should avoid board service. Quite the contrary. But, with years of experience dealing with commercial insurance, he knew first-hand the reality of the incredible lack of awareness, and therefore personal financial exposure, that comes with board membership.

Most, if not all, people join boards to provide their support and leadership to a good cause. However, with more than 20 years of attending board meetings and board recruiting discussions, I cannot recall any conversations addressing the issue of the personal liability of board members. As a former nonprofit CEO, I feel a bit remiss in having not initiated those conversations. To be fair, however, during that part of my career I was largely ignorant of the reality. I expect that might be true of other nonprofit executives and board members as well.

Doing Good Things Does Not Necessarily Protect You From Legal Liability

My hunch is that many nonprofit board members approach their service on the board as somewhat removed from the legal realities connected with corporate law. That might be due to thinking that there is still a doctrine of charitable immunity that protects nonprofit organizations. That’s a huge mistake! In California, the Corporations Code governs everything from the organization of nonprofits, to governance, to dissolution, and everything in between. In addition, if the organization has an IRS 501(c)(3) designation, there are numerous federal regulations with which to comply as well. Consequently, a board member can potentially be personally liable for acts that result in someone else’s harm.

Piercing the Corporate Veil Applies to Nonprofit Corporations Too

Corporate law in general provides for limited liability. In the for-profit world, incorporation protects shareholders (owners) from personal liability for the losses the corporation might incur through a lawsuit. For example, imagine that a corporation enters into a contract with another party, and then somehow breaches that contract resulting in a loss that amounts to more money than the corporation has in cash and other assets. General liability insurance will kick in, but it has limits, of course. For example, if the injured party suffered $10,000,000 in harm, and the insurance policy had a limit of $1,000,000, the corporation is on the hook for the rest. If the corporation is worth less than the remaining $9,000,000 liability, who pays the difference? Typically nobody does. That’s one of the benefits of having a corporate status.

In some cases, however, the court might “pierce the corporate veil” and allow the injured party to go beyond the assets of the corporation to recover financially. If so, shareholders and/or corporate directors and officers can be held personally liable for the organization’s losses. Nonprofit organizations and their directors and officers are NOT exempt. To the contrary, the Corporations Code repeatedly carves out reasons that individual board members could be personally liable.

How Should We Then Behave?

The objective of this article is not to scare you into resigning your board position for fear of losing your house or other assets. It is to highlight the reality that those possibilities do exist—especially if you are unaware of how you should be performing your board service. Nobody expects to be sued for doing good things, but to ignore that possibility is the reason my insurance friend suggested that board membership is risky business.

Both California and federal laws provide a lot of protection for volunteer directors. But that protection is always qualified. In other words, there is no protection from personal liability for failure to act with due care, being grossly negligent, or not maintaining the required level of liability insurance coverage. You might also be held liable for self-dealing transactions, unreasonable compensation decisions, and certain loans made by the organization. Only one of those issues can be clearly measured—that is, how much insurance coverage does the organization have. The others are the fodder for lawsuits every day.

What you might consider to be due care might differ considerably from what the court determines. And what the court might consider to be grossly negligent may be interpreted with less severity than how you might interpret it. Further, knowing the line regarding self-dealing transactions is not always clear cut. For that matter, what dollar figure ensures that compensation is “just as reasonable as to the corporation”?

The bottom line—while there is a lot of protection for the personal liability of nonprofit board members, it is in the best interest of anyone serving on a nonprofit board to know the personal risks and liabilities that accompany board service. Most personal liability can be avoided by being fully informed of the risks and by knowing and exercising your fiduciary duties responsibly.

How does your board handle this? Do you include a discussion about personal liability in your board recruitment or training? Dose this issue ever come up at board meetings? Please comment below.