A question that frequently recurs when I am speaking to directors and officers of non-profit organizations is why – given that their firms have no shareholders – they need to bother with D&O insurance. The reality is that even though officials at non-profit firms don’t have to worry about the possibility of shareholder claims, non-profit officials still face other potential claims from other potential claimants.
These potential liability issues were underscored in a recent decision by the United States Circuit Court of Appeals for the Third Circuit. In a January 26, 2015 opinion in In re Lemington Home for the Aged (here), the appellate court, applying Pennsylvania law, affirmed the jury’s entry of a liability verdict for the benefit of a bankrupt non-profit nursing home’s creditors against the home’s directors and officers, including the entry of punitive damages against the officers. The appellate court reversed the award of punitive damages against the home’s directors.
As discussed in a March 3, 2015 memo from the Cadwalader law firm about the appellate court’s ruling (here), the court’s opinion “provides a cautionary tale for the corporate officers as well as board members of not-for-profit heath care organizations – for the most part, volunteers – that they may be held to the same standards of accountability as those of for-profit, public corporations.”
The Lemington Home had a long history operating a nursing home under a number of prior names going back to 1883. From September 1997 until the Home closed, Defendant Mel Lee Causey acted as the Home’s Administrator and Chief Executive Officers. From December 2002, Defendant James Shealey acted as the Home’s Chief Financial Officer.
Though the Home had a long history, its more recent history involved a significant number of deficiency citations from the Pennsylvania Department of Health. A number of outside consultants recommended that the Home hire qualified staff and outside specialists. A 2001 study funded by a community foundation recommended that that the Home’s board replace its existing administrator with a “qualified, seasoned nursing home administrator.” The community fund provided a grant of over $175,000 to hire a new administrator; however, the board did not act to replace its administrator, and the grant funds were used for other purposes.
In 2004, the Pennsylvania Department of Health, citing the Home’s failure to properly maintain resident’s clinical records as well as lapses of care (which included the Department’s investigations of two patient deaths that occurred in 2004), concluded that the Home’s administrator “lacks the qualifications, the knowledge of the regulations, and the ability to direct staff.” Even though the administrator had by that time transitioned to a part-time status – in violation of Pennsylvania law – the board still did not replace the administrator.
In addition, the Home’s financial administration lacked appropriate processes and controls. Among other things, beginning in November 2003, the Home’s CFO had ceased to maintain a general ledger of accounting records. In addition, by omitting to bill Medicare, the CFO failed to obtain up to $500,000 in payments that were due for patient services.
In January 2005, the Home’s board voted to close the Home. However, the Home’s Chapter 11 petition was not filed until April 13, 2005. During the interim the patient census dropped significantly. In June 2005, the bankruptcy court approved the Home’s closure. It was later revealed that because the Home delayed until September 2005 filing its Monthly Operating Reports for May and June 2005, the Home did not receive nearly $1.4 million in Nursing Home Tax Assessment Payments (an amount, which if it had been paid might have increased the Home’s chances of finding a buyer).
In November 2005, the bankruptcy court authorized the Committee of Unsecured Creditors to file an adversary proceeding against Causey, Shealey and the individual members of the Home’s board. The committee asserted claims for breach of fiduciary duty, breach of the duty of loyalty, and deepening insolvency. The adversary proceeding had a long procedural history that included two prior trips to the Third Circuit.
In February 2013, following a six-day trial, a jury returned a compensatory damages verdict against fifteen of the seventeen defendants, holding the defendants jointly and severally liable for $2.250 million. The jury awarded punitive damages of $1 million against Shealey and $750,000 against Causey, as well as punitive damages of $350,000 against five of the director defendants.
The January 26 Opinion
In a January 26, 2015 opinion written by Judge Thomas I. Vanaskie for a unanimous three-judge panel, the Third Circuit affirmed the jury’s compensatory damages verdict and the award of punitive damages against Shealey and Causey, but vacated the award of punitive damages against the five director defendants.
Pennsylvania statutory law provides that “An officer shall perform his duties as an officer in good faith, in a manner he reasonable believes to be in the best interests of the corporation and with such care, including reasonable inquiry, skill and diligence, as a person of ordinary prudence would use under similar circumstances.”
The appellate court found with respect to Causey that the evidence presented at trial demonstrated that Causey “fell far short of fulfilling these responsibilities.” Throughout her tenure, the Home was out of compliance with state and federal regulations. The Home was repeatedly cited for failing to keep proper documentation. It also appeared that at the time of a patient’s death at the Home, Causey was not working full-time, despite holding the title of Administrator and drawing a full-time salary, and even though Pennsylvania law required the Home to employ a full-time administrator. At trial Causey tried to claim she was in fact working full-time, but when confronted with long-term disability benefits application she had submitted, in which she said she was working only “20 to 24 hours a week” at the Home, she admitted that she was working part-time.
The court also concluded that the jury was presented with sufficient evidence that Shealey breached his duty of care. The jury heard evidence from a consultant that a creditor had hired that Shealey had tried to evade inspection of the Home’s financial records until finally being forced to admit that the records simply didn’t exist, and that the Home had operated without a general ledger since at least June 2004. The testimony also showed that Shealey failed to bill Medicare after August 2004, as a result of which the Home failed to collect at least $500,000.
The appellate court concluded that the evidence supports a finding that the director defendants breached their duty of care by failing to take action to remove Causey and Shealey once the results of their mismanagement became apparent.
The appellate court also found that the Creditors Committee had introduced sufficient evidence to support the jury’s finding that the defendants had “deepened the Home’s insolvency.” (The appellate court had previously predicted that Pennsylvania’s courts would recognize the tort of deepening insolvency.) The Court found, among other things, that the delay in filing the bankruptcy petition after the decision to close the facility resulted in a depletion of the patient census resulted in a “slow death” of the facility’s ability to generate revenue. The board contributed to the facility’s inability to find a buyer by failing to preserve and record the Home’s entitlement to a $1.4 million Nursing Home Assessment Payment. The appellate court also said there was sufficient evidence to support the deepening insolvency verdict against Causey and Shealey, due to the failure to maintain financial records and to recoup Medicare payments that were due.
Finally, while the appellate court concluded that there was insufficient evidence to support the award of punitive damages against the director defendants, “we have no such concerns about the punitive damages assessed against the Officer Defendants.”
It is very difficult to read the appellate court’s opinion without concluding that the Home was badly run for many years and that despite numerous concerns raised over the years, neither the officers nor board did anything to remedy the identified concerns – with tragic consequences for some of the Home’s residents. So to some extent the outcome of this case my simply be a reflection of the truly lamentable factual circumstances.
Just the same, there are a number of important lessons from this case. First and foremost, the case highlights the fact that even though non-profit organizations do not have shareholders, the organizations directors and officers can still face D&O claims – as illustrated here, where the claims against the Home’s former directors and officers were asserted by the Creditor’s Committee for the Home’s bankruptcy estate.
Second, even though an organization is a not-for-profit entity, its directors and officers are still expected to perform their duties in compliance with the applicable standard of care, and can be held accountable if their conduct falls below those standards. As the Cadwalader law firm put it in its memo about this decision, this case shows that “the risk that officers and directors of not-for-profit corporations may be personally liable for breach of fiduciary duty is real.” Moreover, the standard of care against which the non-for-profit entity’s directors and officers’ performance of their duty will be judged is the same standard as that applicable to the directors and officers of for-profit organizations.
Third, the most important job for the board of any organization is to make sure that the organization’s professional day-to-day management personnel are qualified to perform their duties and are indeed actually performing those duties. The board of this organization was informed repeatedly that the Home needed an Administrator that had the qualifications and experience required for the position, yet – even though the incumbent Administrator was working only part-time – the board did not replace the Administrator. Indeed, the organization even received a grant from a community foundation to replace the Administrator, yet the organization made no change and the funds from the grant were spent for other purposes.
Fourth, while many jurisdictions do not recognize or at least have not recognized the tort of deepening insolvency, the Third Circuit’s decision does highlight the fact that directors and officers of non-profit organizations may be held accountable for their actions after their organization has become insolvent. The board may owe duties to the organization’s creditors in addition to their fiduciary duties to the corporation. As the Cadwalader memo put it, “it is critical that entities facing financial challenges be mindful of the interests of all of their constituents in making decisions that impact creditor recoveries.”
One of the lessons of this case is that in general directors and officers of not-for-profit organizations will be held to the same standard of care as directors and officers of for-profit entities. However, at the same time, it is important to keep in mind that many states have adopted statutes providing individuals who serve as directors on nonprofit boards with limited immunity from liability, as discussed here. Whether or not this type of limited director immunity was available under Pennsylvania law for the Home’s directors was not discussed in the Third Circuit’s opinion. It is worth noting that the limited immunity available under these types of state statutes is typically limited to non-profit officials who are not compensated for their duties.