Legal Alert: Revisiting Director and Officer Indemnification - Provisions in the New DC Nonprofit Act

The District of Columbia’s Nonprofit Corporation Code (the “Nonprofit Code”) contains indemnification provisions that are designed to protect officers and directors in case they are sued as a result of their service with a nonprofit organization. This Legal Alert summarizes these provisions and discusses, more generally, the liability protections that your nonprofit may want to consider for its directors and officers.

A. Potential Liability and the Role of Indemnification

Although nonprofits are less likely than forprofit companies to become involved in litigation, nonprofits still face the risk of being sued or becoming the target of an investigation.

Most suits against nonprofits involve employment matters, such as claims for wrongful termination, discrimination, or sexual harassment. However, nonprofits may also become involved in litigation relating to financial mismanagement, and it is possible that a nonprofit’s directors and officers may face liability in connection with these matters.

One way to protect directors and officers from liability is through indemnification. Indemnification is an agreement by one person to pay the obligations of another. In this way, when a nonprofit indemnifies its directors and officers, it is agreeing to pay their legal fees, expenses, judgments, and settlement costs if the officer or director is sued as a result of his or her service with the nonprofit.

Indemnification can play a key role in attracting qualified individuals to serve as directors and officers, as it provides assurances that they will not be personally liable for costs incurred in the carrying out of their official duties.

There are important limits, however, on the extent that indemnification can protect directors and officers. For example, a nonprofit may not have sufficient funds available to make good on its promise to indemnify. This is a particular concern for smaller nonprofits that may not be in the financial position to handle the high costs of litigation, investigations, or settlements. In addition, as will be discussed more below, the law limits the extent to which nonprofits can indemnify their directors and officers.

In order to address many of these limitations the nonprofit may purchase directors and officers insurance (“D&O insurance”). D&O insurance helps alleviate concerns about a nonprofit’s financial condition and can provide protection in cases where indemnification is not legally permitted.

2. Summary of Nonprofit Code

The Nonprofit Code provides for three types of indemnification:

• Mandatory Indemnification
• Permissive Indemnification
• Court-ordered Indemnification

Mandatory Indemnification: Under the Nonprofit Code, a nonprofit is required to indemnify directors and officers to the extent they are successful in the defense of any lawsuit arising from their positions with the nonprofit. This mandatory indemnification includes the payment of reasonable expenses and attorneys’ fees incurred in connection with the lawsuit. Directors and officers are entitled to enforce their right to mandatory indemnification in court.

Permissive Indemnification: In addition, the Nonprofit Code permits, but does not require, a nonprofit to indemnify officers and directors in certain other circumstances. In particular, a nonprofit may indemnify a director or officer for amounts paid as a judgment, settlement, or fine if the director or officer meets the required standard of conduct. To satisfy the required standard of conduct, the director or officer generally must:

• have acted in good faith, and 
• reasonably believed that his or her conduct was in the best interests of the nonprofit, or not opposed to them.

In the case of a criminal matter, the director or officer must also have had no reasonable cause to believe that his or her conduct was unlawful.

In each instance, the Board of Directors then is required to authorize the indemnification once it determines that the director or officer has met the required standard of conduct.

This determination to indemnify should be made by a majority vote of all disinterested directors (that is, directors who were not involved in the legal proceeding)¹. If there are less than two disinterested directors, then the determination must be made by legal counsel who is chosen for this purpose by the directors.

Generally, a nonprofit’s articles of incorporation or bylaws will include provisions specifying that that the nonprofit will indemnify its directors and officers. This type of provision will obligate the nonprofit to indemnify its directors and officers in cases where they have satisfied the required standard of conduct described above.

Advancement of Expenses: Litigation can be expensive. The legal costs can mount quickly and may be due long before a proceeding has concluded. An officer or director may not be able to afford the cost of defending themselves in a legal proceeding. Therefore, the Nonprofit Code permits a nonprofit to advance funds to a director or officer to pay for legal and other expenses before a legal proceeding has concluded. 

In order to be eligible for advancement of expenses, the director or officer must submit to the nonprofit:

a. an affirmation generally stating that he or she has met the required standard of conduct, and
b. an undertaking to repay any amounts advanced if it turns out that he or she ultimately is not entitled to indemnification.

As with permissive indemnification, nonprofits generally will include a provision in their articles of incorporation or bylaws obligating the nonprofit to provide for advancement of expenses, and not just indemnification, consistent with the statute².

Limitations on Indemnification: The Nonprofit Code places a number of specific limitations on a nonprofit’s ability to indemnify its directors and officers. In particular, a nonprofit:

• can only indemnify for reasonable expenses, and not for amounts of any judgment, settlement, or fine, in the event that a director or officer is being sued by or on behalf of the nonprofit itself;
• cannot indemnify a director or officer found liable for receiving an improper financial benefit; and
• cannot indemnify an officer for liability arising out of intentional infliction of harm on the nonprofit or intentional violation of a criminal law.

Court-Ordered Indemnification and Advancement: The Nonprofit Code provides that directors and officers may apply to the District of Columbia Superior Court for indemnification or advancement of expenses in certain circumstances. For example, a director or officer may appeal to the court to enforce his or her rights to mandatory indemnification or rights to indemnification or advancement that are set forth in the nonprofit’s articles of incorporation or bylaws. In addition, a court may also require indemnification or advancement if it determines that, in view of the circumstances, it would be “fair and reasonable.”

Other Matters: The Nonprofit Code includes a number of additional provisions that may be of interest to your organization:

• The Code explicitly permits nonprofits to purchase insurance on behalf of its directors and officers for liability they may incur as a result of their official duties. The Code acknowledges that protection from insurance can be broader than that afforded by indemnification, as insurance can shield directors and officers from liability “whether or not the [nonprofit] would have the power to indemnify or advance expenses to the individual against the same liability” under the Code³.
• The Nonprofit Code also allows nonprofits to elect to indemnify their directors and officers for expenses incurred as a witness in cases where they are not themselves parties to the litigation.

Finally, the Nonprofit Code allows nonprofits to indemnify, advance expenses to and provide insurance for, employees, agents and volunteers to the same extent that it does for directors and officers. Nonprofits with limited financial resources should give careful consideration to which, if any, of these individuals they would like to extend indemnification to, so that they do not create obligations that they may have difficulty satisfying.

3. Directors and Officers Insurance

In order for a nonprofit to protect its officers and directors, and to fund its obligation to indemnify officers and directors from liability, a nonprofit should obtain directors and officers liability insurance.

A D&O policy more broadly covers liability arising from an alleged “wrongful act” committed by the officer or director. It insulates your directors and officers from personal liability relating to participation on the board or running the nonprofit.

The wrongful acts covered by a D&O policy include claims that the officer or director breached his or her fiduciary duty when carrying out his or her responsibilities. It also covers claims that the officer or director discriminated against someone applying for benefits from the nonprofit.

For example, if an individual applies for housing from the nonprofit and is denied, the individual may claim that the nonprofit engaged in illegal discrimination when denying the benefits. The D&O policy is designed to cover such claims. In addition, nonprofit D&O policies may also cover employment discrimination claims. A nonprofit should check with its insurance broker to see if its D&O policy covers such potential liability.

A nonprofit D&O policy should insure not only the directors and officers, but also the employees, volunteers, and the nonprofit organization itself. It should also include a “duty to defend” clause, which provides that the insurance company must hire an attorney to defend the officer or director in the course of the litigation. The benefit of this provision is that neither the officer or director nor the nonprofit must pay the litigation costs in advance, and then wait for reimbursement from the insurance company.

4. What Should My Nonprofit Do?

After familiarizing yourself with the terms of the Nonprofit Code, a useful next step is to assess whether revisions to your articles of incorporation and bylaws are appropriate. Often nonprofits will include a relatively brief provision in their articles of incorporation stating that they will indemnify their directors and officers to the fullest extent permitted by law, and then they will include in their bylaws more information regarding indemnification and any rights to the advancement of expenses. As discussed above, many of the indemnification provisions in the Nonprofit Code are permissive rather than mandatory, and as a result nonprofits that wish to provide their directors and officers with the full scope of permitted protections should make sure that such protections are reflected in their governing documents. An example of an indemnification bylaw for a DC nonprofit is attached as an exhibit to this alert.

You may also wish to evaluate whether D&O insurance would be appropriate for your nonprofit, if you have not already obtained it. Even for nonprofits with little history of litigation, D&O insurance can provide a meaningful safeguard, as even frivolous claims need to be defended and even relatively minor lawsuits can result in significant costs. Not only does D&O insurance shift the risk of litigation losses from the nonprofit to the insurer, it can also provide protection that goes beyond what can be indemnified pursuant to the terms of the Nonprofit Code.

5. Additional Resources

You may find the following information helpful:

• Leonard M. Polisar & Anthony V. Raftopol, When Charities Get Into Trouble: Limiting the Liability of Directors and Officers of Nonprofit Organizations, in NONPROFIT GOVERNANCE AND MANAGEMENT (Victor Futter ed., 2002)
• LISA A. RUNQUIST, THE ABCS OF NONPROFITS (2005)
• John A. Edie & Jane C. Nober, Directors and Officers: Liability Insurance and Indemnification (2007)

 

1: In the case of a nonprofit that has voting members (i.e., members who vote to elect directors and approve major corporate transactions) the members may vote on whether to indemnify an officer or director.

2: The Nonprofit Code states that a nonprofit may provide in its articles of incorporation or bylaws that it will indemnify the officer or director “to the fullest extent permitted by law.” In such case, the nonprofit will be legally obligated to indemnify every officer or director to the fullest extent permitted by the Nonprofit Code, regardless of the nonprofit’s financial ability or other circumstances at the time of the indemnification. In addition, the nonprofit will be obligated to advance expenses to the fullest extent permissible, unless the articles of incorporation or bylaws explicitly state otherwise.

3: The Nonprofit Code also provides that a nonprofit volunteer is immune from civil liability for any acts or omissions except:

• The volunteer’s willful misconduct;
• The volunteer’s criminal conduct, unless the volunteer had reasonable cause to believe that the conduct was not illegal;

 

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Additional information for nonprofits and small businesses is available at the D.C. Bar Pro Bono Center’s resource website: www.lawhelp.org/dc/NPSB.

If you have questions, feel free to contact us at npsb@dcbar.org.

 

© D.C. Bar Pro Bono Center 2012, 2017

This communication is provided by the D.C. Bar Pro Bono Center solely for informational purposes, without any representation that it is accurate or complete. It does not constitute legal advice and should not be construed as such. It does not create an attorney-client relationship between the recipient and any other person, or an offer to create such a relationship. This communication contains information that is based, in whole or in part, on the laws of the District of Columbia and is current as of the date it is written. However, laws vary from state to state and may change from time to time. As a result, the information may not be appropriate for anyone operating outside the District of Columbia and may no longer be timely. Consult an attorney if you have questions regarding the contents of this communication.