Volunteers who serve as directors of a nonprofit hospital may be lulled into a false sense of comfort, especially if they rely exclusively on information provided by hospital management and are only passively involved in the business of the hospital. Directors often assume they are insulated from potential liability by their volunteer status and the hospital’s directors and officers insurance coverage.
In a decision last year, however, a federal bankruptcy court in Michigan allowed a case for damages to proceed against a hospital’s interim CEO and five directors of the bankrupt Cheboygan Memorial Hospital (CMH). The court reviewed important questions involving breach of fiduciary duty and the application of the business judgment rule to both management and volunteer board members of the nonprofit hospital.
In that case, the hospital had filed for Chapter 11 bankruptcy on March 1, 2012. The court confirmed a plan for liquidation in 2013, which provided that the CMH Liquidating Trust (the Trust) was vested with all causes of action that the hospital held against former directors and officers of the hospital. In 2014, the Trust filed a lawsuit alleging negligence and/or breach of fiduciary duty by the former officers and directors of the hospital. The Trust claimed that the defendants had:
- Failed to address losses from its employed physician practices;
- Failed to address billing and coding issues;
- Failed to ensure adequate control over financial issues, allowing the financial statements to overstate the hospital’s revenues;
- Improperly approved the quick sale of a joint venture home health agency for less than fair market value in order to meet payroll;
- Allowed excessive senior management turnover to continue;
- Permitted excessive compensation to physician board members; and
- Allowed a conflict-of-interest transaction when the hospital refinanced $4.3 million in long-term debt with a bank whose president was a hospital director.
Bankruptcy court decision
In ruling on the defendants’ motion to dismiss, the court dismissed certain claims while finding that the plaintiff had stated sufficient facts to proceed against the hospital’s interim CEO and five directors.
Michigan law permits corporations by their articles of incorporation to provide broad protection from liability for a “volunteer director,” which is defined as a director who receives nothing more than nominal value from the corporation for serving as a director other than reasonable per diem compensation and reimbursement for actual, reasonable, and necessary expenses. The court found that one director had a conflict of interest between her roles as a director and as president of the bank that loaned the hospital money, and that another physician director was not a disinterested “volunteer,” because he received excessive compensation for his board service.
In addition, the court permitted the case to proceed against three other directors whom the plaintiff alleged were not volunteer directors. These directors all allegedly served on the board at the time of the sale of the joint venture and allowed the payments to be made to the above-mentioned bank. The court dismissed all claims against the other volunteer directors, holding they were immune from liability under Michigan law based on certain exculpatory language in the hospital’s articles.
The court also reviewed the business judgment rule, which creates a presumption that in making a business decision, directors of a corporation are protected if they act on an informed basis, in good faith, and with the belief that the action is in the best interests of the company. However, under Michigan law, this rule only protected disinterested directors. Moreover, if the plaintiff could show that the defendant directors were given actual notice of the need to take action, this rule would not protect directors who had abdicated their authority or simply failed to act.
Model Nonprofit Corporation Act
The Model Nonprofit Corporation Act (MNCA) has been adopted in whole or in part, or is generally followed, by many states. Although statutes of the individual state must always be examined, the MNCA gives us a good idea how many states address issues surrounding nonprofit governance. Although the MNCA does not use the term “fiduciary”— perhaps removed to avoid potential confusion between the fiduciary standards applicable under trust law and those in corporate law—it imposes a duty of good faith, loyalty, and due care on directors. Like the relevant Michigan statute in CMH Liquidating Trust, the MNCA requires the directors of a nonprofit corporation to discharge their duties as a director and a committee member:
- In good faith,
- In a manner the director reasonably believes to be in the best interests of the corporation, and
- With the care an ordinarily prudent person in a like position would exercise under similar circumstances.
A director is generally entitled to rely upon information and reports prepared or presented by officers and employees of the corporation, legal counsel or public accountants, and board committees if the director reasonably believes they are reliable and competent in the matters presented. Under Michigan law, however, this presumption does not apply if the director has actual knowledge that makes such reliance unwarranted.
Potential liability of directors under MNCA
The MNCA contains detailed provisions that address the potential liability of directors, who generally have no personal liability for any action taken or failure to act as a director if they performed their duties in compliance with the MNCA. On the other hand, a director may be liable for:
- A sustained failure to devote attention to the oversight of the affairs of the corporation; or
- A failure to devote timely attention to make appropriate inquiry, if the conduct proximately caused harm to the corporation; or
- The amount of any financial benefit they received but were not entitled to receive; or
- Any action resulting from lack of objectivity due to the director (or their family’s) financial or business relationship, or
- The director’s domination by another person interested in the challenged conduct, and the director did not reasonably believe that such conduct was in the best interests of the corporation; or
- The director’s assent to a distribution made in violation of the MNCA which was not done in good faith, or which they did not believe was in the best interests of the corporation; or
- Any other breach of the director’s duties to deal fairly with the corporation.
Consequently, directors of a nonprofit hospital may not serve as mere figureheads; instead, they must discharge their duties as directors with the care that a person in a like position would reasonably believe appropriate under similar circumstances. On the other hand, a director’s liability may be precluded by the provisions of the corporation’s articles of incorporation if consistent with the MNCA.
Although cases holding volunteer hospital directors liable for breach of duty are relatively rare, it is not necessary for a director to actually receive a financial benefit to support a finding of breach of fiduciary duty. Consistent with the provisions of the MNCA, courts have found that a hospital director who fails to supervise the management of a hospital’s investments, leading to negligent mismanagement by others, has committed an independent wrong against the corporation.
Conflict of interest transactions
Unless resolved in accordance with MNCA, a director’s conflict of interest may lead to liability to the nonprofit corporation. A conflict of interest under the MNCA is one in which the contract or transaction is between the nonprofit corporation and one or more of its members, directors, officers, or between the nonprofit and an entity in which one of its directors, members, or officers have a financial interest or hold a position. Such a transaction is not to be void or voidable, even though the interested person was present or participated in the meeting that authorized the transaction, if the material facts of the relationship or interest were disclosed to, or known by, the board of directors, and the board in good faith authorized the transaction by a majority of the disinterested directors, or the transaction was fair to the corporation at the time it was approved or ratified by the board of directors. In addition, any private inurement to “insiders” can lead to excise taxes (i.e., intermediate sanctions) and the loss of the corporation’s tax-exempt status.
Business opportunity rule
A director’s action usurping a business opportunity that should have first been offered to the nonprofit corporation may also result in the director’s liability. On the other hand, a director is not subject to money damages or equitable relief if, prior to taking action to become legally obligated or entitled to the opportunity, the director brings the matter to the attention of the corporation, and the board of directors or members of the nonprofit corporation disclaim the corporation’s interest in the transaction by vote of the disinterested directors or members, in accordance with the MNCA’s provisions for resolving conflict-of-interest transactions as referenced above.
A key component of director liability is the extent to which the hospital will indemnify the person for any liability related to their service as a director. Under the MNCA, a nonprofit corporation may indemnify a director against liability if the director acted in good faith and reasonably believed that their conduct in an official capacity was in the best interests of the corporation. In other cases, indemnification may be available if the director’s conduct was at least not opposed to the best interests of the corporation. In the case of a criminal proceeding, the corporation may indemnify a director if the director had no reasonable cause to believe his/her conduct was unlawful. To the extent they were successful, a director is entitled to indemnification by the corporation for reasonable expenses incurred in the defense of a proceeding in which they were a party because they were a director. On the other hand, a nonprofit corporation may not indemnify a director under the MNCA if the liability relates to conduct for which the director was adjudged to be liable based on their receipt of a financial benefit to which they were not entitled.
Although Michigan had an unusually strong exculpatory statute for volunteer directors, which affected the decision in the CMH Liquidating Trust case, the MNCA and most states have narrower protections. Thus, a director may normally be liable if he/she was aware that an action was not in the best interest of the corporation, even if the director had neither received direct financial benefit nor intentionally inflicted harm on the corporation. The lessons from the CMH Liquidating Trust case are not limited to situations involving bankruptcy.
The court’s decision shows that hospital directors must recognize their duties, act in good faith and in the hospital’s best interests, and avoid any potential conflict of interest. Specifically, volunteer directors generally have an affirmative duty of good faith, loyalty, and due care in discharging their duties as a director and committee member.
A director who fails to supervise the management of a hospital’s affairs or make adequate inquiry, which leads to negligent mismanagement by others, may have violated his/her fiduciary duty. Given the increasing financial pressures in the healthcare industry, an enhanced level of commitment and diligence is appropriate. Volunteer directors who have actual knowledge of a problem and who fail to take reasonable action to address such issues may not rely on the business judgment rule or limited statutory immunity.
Directors should take every action to avoid an appearance of impropriety, which is not limited to personal financial benefit. Directors should fully disclose to the board any potential conflicts of interest and ask to be recused from attending, engaging in discussion, or voting on any matter in which he/she, a family member, or another organization in which they have invested or hold a position, is a party to or may benefit from, either directly or indirectly.
Nonprofit hospitals should adopt conflict of interest policies consistent with IRS requirements, obtain acknowledgement of compliance from directors annually, and have in place and use strict disclosure requirements for potential conflicts of interest to avoid the possibility of self-dealing by directors and management.
- Volunteer hospital directors have an affirmative duty of good faith, loyalty, and due care in their duties as directors and committee members.
- A director who fails to supervise the management of a hospital’s affairs or make adequate inquiry, which leads to negligent mismanagement by others, may have violated their fiduciary duty.
- Volunteer directors who have actual knowledge of a problem and who fail to take reasonable action to address such issues may not rely on the business judgment rule or limited statutory immunity.
- Directors should take every action to avoid an appearance of impropriety, which is not limited to personal financial benefit.
- Nonprofit hospitals should adopt conflict-of-interest policies consistent with IRS requirements, obtain acknowledgement of compliance from directors annually, and have in place and use strict disclosure requirements for potential conflicts of interest.