Center for Nonprofit Management - FAQ about Nonprofit Boards

Frequently Asked Questions about Nonprofit Boards

An Excerpt from the Center's Nonprofit Answer Book: An Executive Director's Guide to Frequently Asked Questions printed in 1998. Our goal is to provide nonprofit managers and directors with a useful reference for spotting potential problems and enable further research.

FAQ #1. How should we respond to a board member not fulfilling his/her obligations?

By and large, board members want to fulfill their responsibilities and contribute positively to the work of the nonprofit organization on whose board they are serving. It is rare that a board member is only on the board for the name-recognition or other self-interest. When a board member is not actively -participating, it is usually caused by one of the following factors:

* The board member is not clear on what is expected in terms of time and role fulfillment.
* The board member has significant time constraints due to other commitments.
* The board member is not comfortable with the assignment (such as fundraising) given.
* The board member has served an extended period of time on the board and is no longer as committed as in previous times.
* The board member really wants to be a direct service volunteer.
* The board member is fulfilling too many roles within the organization and is experiencing burn out.

A committee chair or the board president should meet with the board member to discuss what is causing the reduced commitment and seek an appropriate resolution. Possible resolutions include: (1) reaching agreement on the board member’s responsibilities and commitment, with the organization providing training or coaching if appropriate; or (2) allowing a graceful way for the board member to resign.

In the event a board member wishes to resign, it is important to express appreciation for their service and, if appropriate, to indicate that there may to be ways to remain involved with the organization, such as serving on a committee, assisting with fundraising and social activities, or serving as a volunteer to the organization.

The likelihood of board member disengagement can be reduced through written expectations of board service (conveyed during the screening process), defined board terms (which present an occasion for both the board and the individual to decide if the relationship should be continued), and annual board evaluation.

FAQ #2. How should boards make decisions?

By law, boards of directors must act as a group. Decisions must be made not by individual directors, but by the whole board or a committee of the board authorized to act on behalf of the board on the matter in question.
Boards generally make decisions using either a majority vote (51% of the board members present at a meeting assuming quorum has been established) or consensus. How boards make decisions is in many ways determined by the -profile of the group and the organization’s culture and values. In making decisions, it is helpful to follow these steps so that all board members can make an informed decision:

* Define the problem and its significance.
* Establish the objective or goal.
* Present alternatives.
* Establish criteria for evaluating the alternatives.
* Compare alternatives against the criteria.
* Present recommendations.

The process for reaching agreement will be more successful if the items listed above are presented in writing in advance of the meeting. If an organization has an active committee structure, most recommendations will be presented by a committee.

If an organization uses a majority vote, board members who were not in favor of an approved motion must then fully support the organization as it carries out the majority’s decision.

For organizations that use consensus, it is important to note that at times there may appear to be unanimous consent, but in actuality there simply may not be strong opposition. This difference can be significant when making important decisions. Trying to ensure that everyone fully supports a decision, on the other hand, can cost valuable time. In these situations, it can be helpful to take a straw vote to see where the group is on a particular topic before proceeding with discussion.

FAQ #3. What decisions are the responsibilities of the board of directors?

Most books written on nonprofit management will contain this sentence: “Boards make policy. Management implements policy.” This sounds simple and clear. Unfortunately, such statements confuse more than they explain. They do not illustrate the difference between a policy decision appropriate for the board of directors and a choice of implementation options that is appropriate for the Executive Director and management.

Policies are statements that set the boundaries of what the organization, through its board and staff, may do. The issue is one of scope. Major and secondary policies, as defined below, are the responsibility of the board of directors using input from management. Boards may choose to take a larger role in setting the functional policies or leave them for the executive director or management to decide. Management should decide on minor policies, standard operating procedures and rules.

While distinctions between kinds of policy decisions and board and staff roles may seem imprecise or subject to interpretation, it is nevertheless helpful to try to create a framework for allocating responsibility for different kinds of decisions. The following is adapted from “Charting the Territory of Nonprofit Boards,” by -Richard P. Chait and Barbara E. Taylor, which appeared in the January-February 1989 issue of the Harvard Business Review.

Board of Directors—
Generally Recommended Level of Decision-Making

* Major Policies: Fundamental issues of service definition, typically involving questions of organizational directions, values, priorities, and principles that guide the other decisions. Examples: organization’s mission statement, vision and guidelines on such issues as inclusiveness and service priorities.
* Secondary Policies: Questions of significance to the organization’s programs, such as the primary clientele, types of service, and delivery systems. Often these policies clarify the priorities of service and perhaps the methods of distributing the organization’s resources (i.e. who is eligible for service and which programs are slated for maintenance and which for growth).

Board of Directors / Executive Director—
Discretionary Level of Decision-Making

* Functional Policies: Concerns of major functional operations, such as planning, budgeting, finance, marketing and personnel. These policies may be either broad in scope and developed at the board level or much more -operational in nature (staff developed). The organization’s personnel policies and the role of the board and executive director in developing a strategic plan would fall under this category of policies.

Executive Director—
Recommended Level of Decision-Making

* Minor Policies: Decisions that govern ongoing operations. Examples of these policies, which help guide the board or executive director in making particular decisions, would be those governing a manager’s request for a leave of absence or application for special grant funds.
* Standard Operating Procedures: Mechanisms and procedures to handle routine transactions and normal operations. An example of these step-by-step actions is a financial internal control system.
* Rules: Regulations that guide or prescribe everyday conduct. An example would be the rule that smoking is not allowed in the building.

FAQ #4. What are the respective roles of the board of directors and management?

While individual organizations may define these roles differently, the most common separation of roles between board members and the management of an organization is as follows:

Board Member Responsibilities
The board of directors is responsible for governance and policy setting. This is a level of board oversight that focuses on mission, direction, priorities, and evaluation of the organization’s programs. Other specific duties generally include financial oversight (through the review of financial statements and setting of budgets), fundraising, and its own operations (nominations and election processes and board evaluation). A critical role of the board is to hire, set the compensation for, evaluate and fire, if necessary, the executive director.
Board members should not be involved in daily management. In most cases, they will not be close enough to the situation to have an appropriate approach and this involvement can undermine the ability of the executive director to run the organization.

The Center has generally found that when board members intervene in ongoing management, there is not sufficient attention being paid to those duties which are the responsibility of the board of directors.

Executive Director Responsibilities
The executive director is responsible for the day-to-day management of the organization and the implementation of the policies of the board of directors. These responsibilities include making policies operational through the development of procedures and rules, hiring and firing of staff, and specific allocation of resources (within broad guidelines set by the board). While the Executive Director should have input into broad level policy, this is the domain of the board of directors.

FAQ #5. Can board members be paid for their board service?

Yes, board members can receive “reasonable” compensation for their duties as board members. This is legally permissible, but not common practice. In many cases the opposite is true. The growing trend is for board members to make personal financial contributions to the organization on whose board they are serving. Board members can be reimbursed for expenses.

Two other issues are sometimes confused with financial compensation to board members in their role as board members: (1) employees serving on the board of directors and (2) contracts or other financial arrangements with a board member. Different legal rules apply in these two situations.

Board Members as Employees
Under California law, no more than 49% (in plain language, less than half) of the board of directors of a nonprofit public benefit corporation can be employees. Again, while this is legally permissible, it is a rare practice to have employees serve on the board of directors, with the possible exception of the Executive Director. The Center advises that organizations not have any employees serve on the board so as to not confuse the issues of authority and supervision.

Contracts with Board Members
Entering into a contract with a board member is considered a self-dealing transaction. This contract could be for services such as printing, rent or legal advice. While permissible, this is an area that should be pursued only with advice from legal counsel familiar with nonprofit law. The arrangement can be approved only by board members who do not have a financial interest in the decision and who recognize the potential conflict of interest. The transaction should then be approved only if it is in the best interest of the nonprofit organization and is the best deal the organization could get with reasonable effort. If a nonprofit organization enters into a harmful self-dealing transaction, there can be personal penalties to board members. For further information, see Board FAQ #8.

In addition, the organization should develop policies governing awarding of contracts to avoid conflicts of interest with board members, employees and their relatives and friends. Organizations need to consider both real and perceived conflicts of interest.

FAQ #6. What legal duties do directors have? Do they risk personal liability?

Under California law, directors bear all legal authority and responsibility for governing a nonprofit organization (“The buck stops here,” in President Truman’s words). While it is rare, board members of California nonprofit public benefit corporations can be held personally liable for breach of their duties to the corporation and to third parties, as described below. Careful attention to the legal standard of care will help board members avoid liability.

To meet the legal standard of care, directors must:

* Act in good faith in what they believe to be the best interests of the organization,
* With such care, including reasonable inquiry, as an ordinarily prudent person would use in similar circumstances.

Directors owe duties to both to the organization and to third parties. To the organization, the directors owe a duty of loyalty, described in the first part of the above statement of the standard of care, and a duty of care, described in the second part, which requires well considered decisions. Directors also owe a duty of care to third parties to avoid injuring people or property through their decisions; similar to the same duty we all owe others.
Common circumstances in which board members may incur personal liability are when one of the following occurs:

* The organization does not pay payroll taxes.
* The board enters into an inappropriate contract with a board member (further discussed in Board FAQ #8).
* The board violates employment laws in terminating an employee (most commonly, the executive director) or failing to prevent or redress a harmful work situation (e.g., sexual harassment).
* The board fails to take reasonable steps to prevent harm to someone in a situation the board should know may lead to such harm (e.g., allowing child care services to continue under a roof the board knows is failing, or not investigating claims of sexual harassment or misconduct).

General Board Responsibilities
Under their duty to take care in governing the organization, the board has general supervisory responsibility to:

* Establish rules for governing board operations through bylaws and resolutions.
* Establish policies: goals, objectives, priorities, timetables, and procedures.
* Authorize material transactions: investments, acquisitions, major expenditures, etc.
* Select and hire executive director, monitor performance, and remove if necessary.
* Select and remove other corporate officers.
* Establish personnel policies.
* Monitor corporate finances, both income and expenditures, often through a finance committee.
* Monitor and evaluate implementation of board policies and decisions.

Adapted from: “Responsibilities, Duties, Rights and Liabilities of Nonprofit Directors,” by Brad Caftel, and “Obligations and Possible Liabilities of Directors of Nonprofit Corporations,” by Peter B. Manzo

FAQ #7. Can employees be board members?

Answer currently undergoing revision.

FAQ #8. Can we enter into a contract with a board member?

While such transactions are legally permissible under certain circumstances, this is an area where it is always advisable to seek legal counsel familiar with California nonprofit law. “Self-dealing” transactions (the legal term for transactions with a board member or other interested party, including a relative of a board member) present a significant risk of personal liability for board members that generally is not covered by board liability insurance. In addition to potential liability, if transactions are perceived by donors and the general public to serve the personal interests of the board member to the detriment of the organization, such transactions can also damage the organization’s credibility and hinder future fundraising.

Any time a nonprofit organization enters into a contract with a board member it is considered a self-dealing transaction, even if it is more than fair to the organization. For a self-dealing transaction to be acceptable, it needs to be in the best interest of the nonprofit organization, not the singular benefit of the board member. For example, if the nonprofit organization needs to rent space and a board member owns a building and is willing to rent to the nonprofit -organization at a fair market rate, then this may be acceptable self-dealing.
To avoid penalties for improper self-dealing, the proposed transaction must be approved by the board, the Attorney General or a court, in one of the following ways:

* Approval, before consummation, by the disinterested members of the board (or in the interim, by a committee having the authority of the board (e.g., an “executive committee”), with subsequent ratification by the full board), who must find that: (1) the transaction is in the best interests of the organization; (2) the exchange is fair to the organization; and (3) the corporation could not have found a better deal with reasonable effort.
* Approval by the Attorney General, or by a court in a legal action in which the Attorney General participated, either before or after consummation of the transaction.

When the board considers any self-dealing transaction, any interested board member must abstain from the vote. Their abstention, and the vote of any board member voting against the transaction, should be explicitly outlined in the minutes. (Abstention will not protect a board member from liability arising from an improper decision by a board; if you oppose a resolution and are concerned about its risks, you should expressly vote against it.)

Whenever an outside vendor’s bid for goods or services is close to a board member’s, the Center recommends going with the outside vendor. This avoids the perception of improper board member benefit. Increasingly nonprofit organizations are making it their policy never enter into a self-dealing transaction with board members— principally because of how such matters are viewed.

FAQ #9. What is “indemnification”? How can we further protect our board members?

Indemnification basically means that one party promises to protect and defend another party from loss or harm resulting from specified risks. In our context, indemnification arises when a nonprofit corporation agrees to protect, defend and pay costs for board members and officers if they are sued for actions they take on behalf of the organization in their role as board members or officers.
This is a very complex area. Nonprofit corporations that have questions about their ability or obligation to indemnify officers and directors should seek legal counsel familiar with California law as it applies to nonprofit corporations. The following discussion is intended for general information purposes only; readers are advised not to rely on it, but to seek advice of counsel about any particular issue that they may have.

Nonprofit organizations are required to indemnify directors in some instances and prohibited from indemnifying them in others. (See California Corporations Code Sections 5238, 9246.) A nonprofit is required to indemnify a director who has successfully defended himself or herself against a suit for all costs the director incurred in the defense.

Two situations arise when a director either loses a case or settles it. In a suit brought by a third party (in which no claims are being made on behalf of the nonprofit against the director), or by the Attorney General or some other party against the director for breach of duty to the charitable or religious purposes of the nonprofit, the nonprofit may indemnify the director against expenses and judgments, fines, penalties, settlement payments and other amounts, if a majority of a quorum of the board (not including the involved director), and the members of the nonprofit (if any), or the court (upon a request by the involved director or the nonprofit, even if the nonprofit opposes the request) decides that these conditions existed:

* The director acted in good faith, in a manner the director believed to be in the best interests of the nonprofit.
* There was no reasonable cause to believe that his or her conduct was illegal [in the case of criminal proceedings.

In a suit or trial in which the director is found liable of some breach of duty to the corporation or its charitable or religious purposes, the nonprofit may indemnify the director for his or her defense expenses only, not for the cost of any judgment, fines or other penalties imposed by the court, unless the court decides the director is entitled to indemnification against those costs. Again, the board and any members of the nonprofit would have to make the same findings as above, with an added finding that the director had acted with such care, including reasonable inquiry, as a prudent person would have acted in their situation. If the matter is settled before a final judgment, with or without court approval, the nonprofit is not permitted to indemnify the director for payment of any settlement amount, nor is it permitted to indemnify the director for his or her defense costs unless the Attorney General approves such indemnification (California Corporations Code Sections 5238(c), 9246(c)).

A nonprofit can take steps to protect itself, its directors and officers from costs arising from allegations of wrongful actions by purchasing Director’s and Officer’s insurance and by including in its bylaws important provisions regarding indemnification. For further discussion, see Board FAQ #20.

FAQ #10. Are there resources to assist our organization in recruiting board members?

There are several organizations and professional associations, which will assist nonprofit organizations in identifying potential board members from within their membership or volunteer base. For these services to be most useful, a nonprofit organization should first identify the skills needed on the board and other demographic characteristics that would be helpful to the organization (see Board FAQ #12.) In addition, the “match” will be more effective if you have board recruitment materials outlining what is expected of each board member and a short job description for the particular individual you are seeking. As of this writing, there currently does not exist in Los Angeles County one service to assist the broad cross section of nonprofit organizations to identify candidates from various backgrounds and skill areas.

Board candidate services, which specialize in individuals with particular skills, include:

* Riordan Volunteer Leadership Program, Los Angeles Junior Chamber of Commerce
Trains and places young executives on boards of directors.

In addition, you may be successful in identifying potential board members by contacting professional associations (such as the CPA Society and Los Angeles County Bar Association), alumni associations of particular graduate schools, and social or fraternal groups.

Additional Resources:
Website to help nonprofit boards locate board members http://boardnetusa.org

FAQ #11. How should we recruit board members?

In recruiting board members, it is helpful for the organization to determine the skills and characteristics sought assess current board members in relationship to that desired profile and then recruit to fill any gaps. The board should designate a nominations or board development committee to identify potential candidates. Using input from the full board and following the desired profile for board recruitment, the recruitment process would then proceed along these lines:

* A board member submits the prospect’s resume and qualifications to the nominations committee. The nominator should be prepared to answer these questions: What will this person contribute to the board? What appears to be the prospective board member’s unique contribution?
* The nominations committee reviews the candidate’s qualifications in light of the current board profile or program plans.
* The board chair, chair of the nominations committee, or sponsoring board member (as determined by the nominations committee) contacts the candidate to arrange an interview and meeting. In this meeting the board member and the executive director provide information on the organization and requirements of serving on the board, answer questions, and interview the candidate about his/her interest in serving on the board.
* If the candidate is willing to serve on the board, the full board votes to either accept or reject their nomination, and the candidate is informed of the decision. Once a candidate has been elected to the board, the organization should send them a confirming letter, including a board orientation package, the date of next meeting and a regular meeting schedule.

Additional Resources:
Website to help nonprofit boards locate board members http://boardnetusa.org

FAQ #12. What should we look for in recruiting board members?

Boards of directors look for different skills and characteristics in identifying potential board members depending upon the age, mission and values of the organization, current board composition, current staffing and sources of funding.

Skills
The Center generally recommends that a board of directors start by deciding which skills they desire in fellow board members. One approach is to seek “Wealth, Wisdom, and Work.” Under this approach approximately one-third of the board would be people with access to financial resources or people who feel comfortable doing special events and soliciting donations (wealth); one-third of the board would be people with technical and management expertise, such as legal, accounting, personnel, planning, marketing and facility management skills (wisdom); and one-third of the board would be people with expertise in the service field of the organization or community members who can provide direct input about their needs and alternative approaches to meeting those needs (work).

Characteristics
After the board has reached agreement on the skills it is seeking, it should discuss other characteristics such as age, gender, ethnic and cultural diversity, personal familiarity with the cause, point of view (e.g. a low income resident for the board of a community affordable housing agency), and geographic representation. Recruiting individuals with such characteristics can be coupled with the skill areas listed above.

Board Requirements
It is important for the board to define the requirements of board service. These requirements might include making a personal financial contribution to the organization, maintaining a minimum level of fundraising, attending board meetings regularly, participating on a committee, and serving as a spokesperson for the organization. It is helpful to have these requirements in writing to give to potential nominated board members.

FAQ #13. Should board members have a set length of term and a set number of terms?

The Center recommends that all boards have defined terms for their board members. Terms generally range from one to four years in length.

Board terms give both the board member and the organization a regular opportunity to determine if continued board service is desirable to both parties. It is not unusual where there are no stated terms for board members to serve 20-30 years; this can sometimes limit the organization’s ability to recruit new board members and to be flexible and responsive to changing needs.

Nonprofit organizations vary in their use of term limits. In some cases, there is no limit to how many terms a board member can serve. The rationale is that if you have solid, active, contributing board members, you want the organization to benefit from this continued involvement.

The case for term limits is that the organization may need to have fresh approaches, be able to recruit board members who are very busy, and rotate board service through the community. Most provisions for term limits allow a board member to come back on to the board after a hiatus of normally one year.

In either case, there are many ways for energetic board members to remain involved with the organization after their board service has been completed, such as through serving as a volunteer, on an advisory committee, or being involved in fundraising.

FAQ #14. What are standard board committees? What powers may committees have?

Boards may choose to operate in committees so as to more effectively use their resources. Several smaller groups may be able to accomplish more than the board could as a whole. Some boards, most frequently those in small organizations or those with a small number of members, operate without any committee structure. Although there are some common board committees, there are no “standard” board committees. The most common committees are: (1) executive; (2) finance/administration; (3) board development or nominations; (4) fundraising or resource development; and (5) program.

In creating committees, the full board of directors delegates some of its powers to the committees on certain matters which should be specified in a resolution. Under California law for nonprofit corporations, there are limits on the powers that the board can delegate to committees. Committees are not permitted to:

* Take any final action on matters which, under California law, require approval of the entire board (such as changing the number of board positions or approving any merger, reorganization, dissolution, or disposition of substantially all corporate assets).
* Fill vacancies on the board of directors or in any committee.
* Fix compensation of the directors for serving on the board or on any committee.
* Amend the bylaws.
* Amend or repeal any resolution of the board of directors.
* Appoint any other committees of the board of directors or the members of these committees.
* Approve any transaction between the organization and a board member.

For specific projects that have a short time frame, a board can form a task force or an ad hoc committee.

Most boards that have a committee structure require each board member to serve on a committee. Some boards limit the number of committees on which a member can serve to even out the work load. Likewise, the board’s work load should be evenly distributed among the standing committees.

FAQ #15. What is the most effective way of running a board committee?

In order for any committee structure to be successful, board members must respect each other’s work and refrain from overhauling or repeating the work of the committee when recommendations are brought to the full board. In addition, to operate effectively, each committee needs:

* A specific directive approved by the full board so that it is aware of its responsibility and the limits of its authority.
* A capable staff member or designated volunteer who can provide supplementary assistance when needed.
* An effective chairperson who: (1) understands the decision-making process; (2) knows how to lead a group through that process; and (3) enables the committee to arrive at appropriate decisions.
* Responsible committee members who: (1) spend the time and effort necessary to be knowledgeable on the issues; (2) understand how to contribute to the committee’s search for conclusions; (3) help the committee members evaluate the adequacy of available data; (4) search for and evaluate alternative courses of action; (5) make reasonable and thoughtful decisions; and (6) know when a matter requires additional input before a decision can be made.

FAQ #16. Do committees of the board need to take minutes of their meetings?

Answer currently undergoing revision.

FAQ #17. What is the board’s responsibility for fundraising?

The board of directors does not have a legal responsibility to raise money for the organization, but in practice, this is a primary function of most nonprofit boards. Board members need to understand that this responsibility flows from their legal responsibility to see that the organization fulfills its mission. It is reasonable to ask the board to make certain that there are sufficient resources to fulfill the mission. As nonprofit organizations are facing additional reductions in government funding, board members involvement in fundraising has become even more important.

Nearly 90% of all philanthropic support comes from individuals. Board members are initially in the best position to maximize this support because of their position as board members and personal contacts in the community. Further, a request for funds made by a board member can be more compelling than a request by a staff member, which some potential donors might view as self-serving (i.e. asking for one’s own salary).

FAQ #18. How can a board that has never raised money be involved in fundraising?

Increasing board members’ involvement with fundraising is usually more successful if the following steps are initiated by a board member, such as the board chair or the chair of the fundraising committee. Some steps that may be used to involve the board member in fundraising include:

* Work with the board members to have them accept that fundraising is a board responsibility. Conduct a session with the board to discuss any reluctance to be involved in fundraising. Such sessions usually reveal lack of familiarity with how to raise money, fears of failing the organization, negatively comparing fundraising to “begging” and personal reluctance to ask friends. Most of these fears and constraints can be removed or mitigated so that the board can begin some type of fundraising. This type of session would generally be most effective if conducted by an outside facilitator. The facilitator brings the credibility of having worked with other organizations, has the ability to “prod” the board and ask some of the difficult questions, and has the needed listening and facilitation skills to move a group to a changed behavior.
* Involve the board members in writing the case statement that describes why potential donors should give to their organization. This process usually inspires the board about the needs the organization serves and provides them with a way of presenting the organization.
* Provide the board with training in fundraising strategy and techniques, and set up a structure for successful fundraising that may include partnering board members with other board members, volunteers or staff members.

Through these steps, the current board may come to accept that fundraising is a board responsibility but determine they are not the right members to do fundraising. In this situation, the board should work to replace themselves by recruiting a board that is willing and capable to do fundraising. The -organization may choose to make this change gradually, with some board members more involved in fundraising than others. For a transitional period, this should not present a problem. In the end, though, boards involved in fundraising tend to be most successful if all board members are involved.

FAQ #19. What is the relationship between the board chair and the executive director?

The relationship between the board chair and the executive director is very important to the functioning of a nonprofit organization. This key relationship must be built on the basis of mutual trust and confidence. More specifically, these key players need to:

* Have clearly defined roles and responsibilities.
* Have a common understanding of the mission of the organization and a shared vision for its future direction.
* Meet regularly on a face-to-face basis. Meetings can occur every two weeks, monthly, quarterly, or in whatever timeframe makes sense for the organization. Meeting too often could confuse the distinction between board governance and management oversight, while meeting too infrequently runs the risk that the board chair will not be aware of significant opportunities and changes within the organization.
* Be open, candid and straightforward. There should be no organizational secrets between the board chair and the executive director.
* Communicate. Each person should keep the other informed about new developments, return calls promptly, and be available to the other when needed.
* Share and, hopefully, agree on basic beliefs about people. Research indicates that a primary requisite for success in organizational functioning is that the board chair and the executive director share a basic belief and confidence in people.

Adapted from: Managing for Impact in Nonprofit Organizations, by James M. Hardy.

FAQ #20. How can we insure our directors and officers against personal liability?

A nonprofit’s powers to indemnify directors and officers are set by law and cannot be changed by provisions in the organization’s bylaws or articles of incorporation. As discussed above in Board FAQ #10, under California law nonprofits are required to indemnify directors in some instances and are prohibited from indemnifying them in others (California Corporations Code Sections 5238, 9246). One problem directors may face, however, is the issue of whether the nonprofit can and will advance funds to the director to pay for his or her defense and whether the nonprofit will have funds available to reimburse directors for losses as required or permitted by law. If not, directors will have to spend their own money to establish that they are entitled to indemnification from the corporation, and even if they can establish that they should be indemnified, that right may be useless to them if the nonprofit has no money to cover this obligation.
It is prudent and necessary, therefore, for an organization to purchase Directors and Officers Liability Insurance (D&O insurance). D&O insurance can enable the nonprofit to indemnify directors and officers, or, in the case of those few nonprofits that actually have enough assets to indemnify directors and officers out of the nonprofit’s funds, will reimburse the nonprofit for funds it advanced to them. Further, D&O insurance can pay losses incurred by directors and officers against which the nonprofit is not permitted by statute to indemnify them. If a nonprofit is not able to offer this protection, it may have difficulty recruiting directors and runs the risk that it may be wrecked if a situation arises where it is mandated by law to indemnify a director. (Note, however, that individuals who serve on nonprofit boards at the request of or with permission from their employer may already be covered by their employer’s D&O policy.)
D&O insurance does two things: (1) it directly reimburses directors for costs they incur which the nonprofit cannot or will not pay, and (2) it reimburses the corporation for costs it incurs in indemnifying directors. Unless the nonprofit organization is itself named as an “insured party” as that term is defined in the policy, D&O insurance will not insure against liability or defense costs incurred by the corporation itself.

Be sure to read the policy carefully. In many cases, the policy does not require the insurance company to pay the insured until the insured actually suffers “loss” (a defined term in the policy), which generally does not occur until the insured’s legal obligation to pay becomes fixed, usually by a judgment or settlement. Unless specifically required by the policy, the insurer is not obligated to advance funds to pay for the defense; when policies include a duty to advance funds, they often include a clause requiring the insured to repay funds advanced for costs that turn out not to be covered, and perhaps to put up a bond to secure that repayment. It is important to note that defense costs often are included within the term “loss” and within the policy limit. If defense costs are not covered outside of the limit of liability, it is possible that defense costs could eat up the majority of the coverage and leave the director or corporation with a large judgment to pay if the director loses the case. Many policies state that the insurer has the right, but not the duty, to defend the insured. This means that the insurer can appoint the defense counsel, if it chooses. In connection with that right to defend, many policies state that the insurer will not pay any defense costs the insured incurs without the insurer’s prior consent. The bottom line is that unless the policy requires the insurer to advance the costs of defense, or the nonprofit is able to and agrees to advance such funds, a director may be forced to expend his or her own funds to defend the action until it is decided by a court or is settled. (That may exert some pressure on directors to settle cases before trial).

D&O policies are “claims made” policies. They insure against the risk that a claim will be asserted against the insured within the period of the policy. Insurers, however, generally exclude claims made in the policy period arising from events that occurred prior to some cut-off date (often the beginning of the period). Therefore, in actuality, only claims based on events occurring after the cut-off date and asserted during the period, are covered.

A “claim,” in general, is defined as a demand, suit or proceeding that seeks monetary or other relief. Obviously, the filing of a suit against a director is a “claim.” In contrast, the mere threat of a lawsuit is not itself a “claim” covered under the policy. Many policies, however, require the insured to give the insurer prompt notice of any “wrongful act” (discussed below) that may give rise to a claim. Even if the policy does not require such notice, if there are facts supporting a potential claim, the corporation should consider the likelihood that a claim will indeed be brought and the possibility that it might be brought after the policy period ends. The corporation could inform the insurer of the potential claim which, though it may lead the insurer to cancel the policy, would lock in coverage of that potential claim (assuming, as in many policies, such notice to the insurer is included in the definition of “claim”).

“Loss” is generally defined as (1) amounts (including judgments, settlements, costs, and expenses, but not legal fines or penalties) that the individual, insured directors are required to pay, or for which the corporation is required or permitted to indemnify any director or officer, (2) arising from a claim made against the director or officer based on alleged “wrongful acts.” “Wrongful acts” are generally defined as (a) actual or alleged error, misstatement, misleading statement, act or omission, or breach of duty by directors or officers while acting in their official capacity, or (b) any charge made against directors or officers only by virtue of the fact that they are directors or officers.

In short, D&O policies are complicated things. Directors should be aware that such policies might not protect them from having to spend money up front to defend against merit less claims. When the nonprofit shops for a policy, directors should make sure that an insurance broker or knowledgeable attorney explains clearly what the policy covers and what it does not cover. Key items to consider will be:

* Whether the policy will automatically cover directors and officers who come on after the policy has taken effect.
* Whether it provides for the advancement of funds to pay defense costs as they become due, rather than only after the case is disposed of by settlement or judgment.
* What, if any, coverage it will give for claims arising from events occurring before the beginning of the policy period.
* Whether it imposes a duty on the insurer to defend.
* Whether the policy itself or an endorsement provides coverage for employment practices liability (many policies exclude such claims).
* What are the policy limits and deductibles.

One last note regarding directors and officers insurance. The Nonprofits’ Insurance Alliance of California (http://www.niac.org/) reports that of lawsuits against directors reported by its insurers, fifty five percent (55%) are wrongful termination suits (often involving a claim by a former Executive Director), eleven percent (11%) involve sexual harassment, thirty percent (30%) involve claims of discrimination, three percent (3%) involve claims for breach of contract and one percent (1%) involve claims of breach of fiduciary duty. (Figures current as of December, 2004.)

Adapted from: Am I Covered For...?: A Guide to Insurance for Nonprofits, by Terry S. Chapman and Elmer L. Steinbock; Advising California Nonprofit Corporations (California Continuing Education of the Bar 1984, 1997); Legal Duties and Potential Liabilities of Directors and Officers of Nonprofit Corporations, by Peter B. Manzo; D&O Policy Clinic, by Pamela Davis.

Additional Resources:
Directors and Officers, Key Facts About Insurance and Legal Liability produced by Nonprofits’ Insurance Alliance of California and Alliance of Nonprofits for Insurance, Risk Retention Group available at http://ani-rrg.org/ANI2/ResourceCenter/DownloadableFiles/DandOBook.pdf

DISCLAIMER:

The answers provided can deal with complicated and sensitive legal issues. These answers are only intended to give general guidance and does not contitute legal advice. The law is constantly changing and its application always depends on the particular circumstances involved. We strongly urge readers to seek legal counsel in the event they are confronted with a possible legal problem.