Cautionary Tale for Directors and Officers of Not-For-Profit Organizations

April 21, 2015

Official Committee of Unsecured Creditors, on behalf of the Estate of Lemington Home for the Aged v. Baldwin, No, 13-2707, 3d Cir., January 26, 2015

In an Opinion on appeal of a jury verdict in the Western District of Pennsylvania, the Third Circuit has affirmed that verdict ruling that the employed Chief Financial Officer (“CFO”) and Administrator of a failed not-for-profit nursing home facility had personal liability for claims brought by the unsecured creditors of that facility.  The conduct of the CFO and Administrator were particularly egregious, but somewhat more surprising was the Court’s affirmance of liability on the part of board members who served in a voluntary capacity.

The trial jury awarded $2.25M jointly and severally against certain of the officer and director defendants for breach of fiduciary duty to the not-for-profit corporation[1], as well as a further award of $1M in punitive damages against the CFO and $750K in punitive damages against the Administrator.[2]  In particular, the Court held that the CFO had violated duties of care and loyalty and had engaged in self-dealing.  The Administrator, who was an employee, but may not have been an officer, was found liable on the same bases.

In particular, the CFO had overtly refused to cooperate with the board and a financial consultant retained by the creditors committee.  He failed to maintain minimally necessary ledgers and other financial controls, failed to timely bill Medicare and make other collections.  Most notably, he tried to position himself as the eventual CEO of an entity that possibly would acquire the facility in a merger transaction. All of this supported the punitive damages award and finding of self-dealing.

Likewise, the Administrator was woefully incompetent and was working in a part-time capacity while collecting a full-time salary in violation of applicable Pennsylvania law and regulation.  Indeed, she also at least initially deliberately misrepresented her part-time capacity to the creditors committee.

While the Court found the actions of the board members less culpable, all that gained for them was an avoidance of the award of punitive damages against the CFO and Administrator.  It should be noted that in Pennsylvania and certain other jurisdictions, directly assessed punitive damages are not insurable.  While punitive damages may be insured if vicariously assessed, in this case the CFO and Administrator were the actual bad actors and their liability did not flow vicariously from the acts of others.

Without delving into Pennsylvania law that may or may not exculpate volunteers at a not-for-profit from liability, the Court had little trouble in finding the breaches of the duties of care and loyalty, as they would have with any private or public company.  Unlike a number of other states, Pennsylvania still recognizes a cause of action for “deepening insolvency”, which in this case gave rise to director liability to the organization’s creditors.

This decision should be a wake-up call to not-for-profit entities and their boards that there can be very significant financial exposure as a result of lax management.  It also highlights to insurers the significant risk exposures that can occur in the not-for-profit sector. While insurance likely could not have responded to the punitive damages award and, dependent on the findings in the court below, may not have covered the compensatory awards against the CFO and the Administrator, D&O insurance certainly could be of considerable benefit with respect to defense and appellate costs incurred, as well as the compensatory damages awarded against the board members.

For a copy of the Third Circuit’s Opinion see [here].

 


[1] It appears that two of the seventeen individual defendants were found not liable by the  jury, but the Court did not elaborate on that.

[2] Five of the defendant directors were also found liable for $350K in punitive damages, but the Court vacated the award as against them due to lack of requisite state of mind evidence against them.

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