Deepening Insolvency in Nonprofits: Will your Board Be Personally Liable?

This is part of our six part series. This series covers when to close a nonprofit, methods of dissolving, methods of reorganizing, insolvency, deepening insolvency, and receivership.

When a nonprofit organization is insolvent, the Board of Directors have a duty to organization’s creditors (individuals/entities to whom they owe money).  The board must take steps to ensure that they “preserve the assets” or otherwise maximize the amounts they could receive from the sale of the property when the organization winds up its affairs and dissolves. If a Board of Directors attempts to divert or lessen the value of the assets of the organization, they could face personal liability for their decisions. Simply put, the individual directors may have to personally pay out of their own pockets.

Simply put, the individual directors may have to personally pay out of their own pockets.

This is especially concerning for volunteer directors, and another reason why they must always remain vigilant and attentive to the financial health of the organization. For a deeper explanation of the duties that directors have to the organization, please refer to our previous post titled Let The Good Deed Go Unpunished: Avoiding Nonprofit Board Liability.

In 2015, a Federal Court emphasized the importance of the Board of Directors’ abiding by its fiduciary duties to the organization and its creditors. The court held that governing boards of nonprofit organizations who have knowledge of mismanagement or insolvency, and then ignore the conditions or fail to take appropriate action can be held financially liable for breach of their fiduciary duty of care. This ruling disturbed the long-standing view that nonprofit directors were insulated from financial liability, and emphasizes that the importance of taking insolvency seriously.

At the core of the analysis is the concept of recklessness, or whether the directors knew or should have known about mismanagement and insolvency. It is impossible to draw a line between simply making mistakes and engaging in reckless behavior. Recklessness depends on a variety of conditions, many of which are unique to the particular situation. A judge or jury determines what recklessness truly means, but they will analyze whether a reasonably prudent and objective person would have acted the same way in a similar situation. If the answer is no, then the directors of your organization could be in trouble.

The final message is the same: nonprofit directors must take great care to address insolvency appropriately.

In some jurisdictions, deepening insolvency is an independent cause of action, and in others it is part of the directors’ fiduciary duties. Either way, the final message is the same: nonprofit directors must take great care to address insolvency appropriately. We strongly suggest that your organization speak with a qualified attorney to advise you and identify common pitfalls when managing an insolvent nonprofit organization.

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