Duties and Dangers: When Can Directors be Personally Liable?

Duties and Dangers: When Can Directors be Personally Liable?

Your friend Arthur founded a non–profit called "The Knights Who Say 'Ni,'" an organization that plants shrubberies to restore the habitat of Mexican whooping llamas. There's been a recent fiasco among the organization's Directors and those responsible have been sacked. Arthur asks you to fill one of vacancies left by the outgoing Directors. 

Meanwhile, your Sicilian relatives are restructuring their family landscaping business, "The Sodfather, Inc.," and your Uncle Vito makes you an offer you can't refuse: Luca Brasi left to start his own koi–pond and aquascape enterprise. Now that he sleeps with the fishes, the family needs need to you fill his spot on the Board. 

Now you must decide which of these two corporations you want to join as a Board member. Being a Director for a corporation can be very rewarding. But did you know that there are situations where a corporation's Board members can be held personally liable for actions taken in their capacity as Directors? This article discusses those situations and the steps you and your organization can take to avoid them.

Understanding Liability Protections for Directors

For Directors, the good news is that incorporation offers a significant shield against personal liability. Once your business or nonprofit is incorporated (which you do in your state), Directors, Officers, trustees, employees, and volunteers are typically not personally responsible for the corporation's debts or liabilities. (This is generally spelled out in the state's code of statutes. Nonprofits and for–profit corporations are usually covered separately.) This includes any unpaid organizational debts and unsatisfied court judgments against the corporation.

Suppose that a corporation gets sued by someone who gets injured on the premises. If the plaintiff wins a judgment, that judgment is a debt of the corporation. But usually, Directors and Officers will not be required to settle these debts personally.

Possible Exceptions to Director Protection

There are always exceptions. Directors could face personal liability in some situations; for instance, if they engage in gross negligence or willful misconduct. 

In addition, liability is quite different for unincorporated groups. For those groups—because legally, they do not exist—the individuals involved may find themselves personally responsible for debts, putting their assets at risk. Obviously, this is a great reason for making that all nonprofits and businesses are properly incorporated. (We are discussing corporations here, as those are entities with Directors, but most small businesses are a different corporate form, such as an LLC—which also provides a shield to liability for the owners/members.)

Incorporating properly, combined with enduring adequate insurance coverage and complying with legal obligations, can provide safeguards.

Getting Personal: Corporations and their Directors

To understand how Directors can be personally liable, it's important to first understand what corporations are and how they work. A corporation, whether it is big or small, for–profit or nonprofit, is a fictitious person. It's not a natural person like you the reader, but it's still a legal person. Sure, you can't shake a corporation's hand or beat it at a round of golf. But under the law, it's recognized as a person that is distinct from the natural persons who form, direct, and operate it. A corporation can own property, enter into contracts, sue or be sued, and even commit crimes, all because the law recognizes it as a person. Since corporations are distinct legal persons, their legal and financial liabilities are distinct from those of their shareholders, Officers, and Directors. 

Corporations are governed by a Board of Directors. In the case of very small business corporations, this Board may be very small and just consist of the owners. Large corporations will have larger Boards, and nonprofits are directed by Boards. 

Directors, or Board members, are the natural persons who control the corporation. While corporations have CEOs or presidents who might often call the shots, those executives only do so at the discretion of the Board of Directors, who are generally a corporation's final authority. But as we know from Spider–Man, with great power comes great responsibility. And in some very limited situations, an individual Director or even the entire Board can be held responsible for acts they took as Directors. 

Although the entire function of a corporation is to take an enterprise's liability away from its individual owners and put it upon a separate entity, there are instances where the Directors of a corporation can be personally liable for corporate actions. Instances where Directors are personally on the hook can be understood under two general categories: (1) breach of fiduciary duties and (2) veil–piercing.

Heavy Duties: Directors as Fiduciaries

The first category of personal liability for Board members is that of breach of fiduciary duties. Directors of corporations are fiduciaries. A fiduciary is a person who is entrusted to act and make decisions for the interests of others and thus owes certain legal duties to the persons on whose behalf they act. Since Directors are fiduciaries, they owe certain fiduciary duties to shareholders of the corporation. 

There are only two fiduciary duties that Directors have: the duty of loyalty and the duty of care. But each of these duties encompasses a broad set of obligations. Let's start with the duty of loyalty. This duty requires Directors to act in good faith for the best interests of the corporation. A Director breaches this duty when he or she acts in bad faith or makes decisions that he or she knows are not in the best interests of the corporation or its shareholders. An example might be where a Director enters into a contract that is not substantively unfair to the corporation, but from which he or a family member personally profits.

The other fiduciary duty Directors have is the duty of care. This duty requires Directors to make informed, deliberative decisions based on all material information reasonably available. Directors breach this duty when they make grossly negligent decisions that result in harm to the corporation or its shareholders. However, the law provides Directors significant protection from lawsuits for breaching the duty of care. This is because of what is known as the "Business Judgment Rule," a principal of corporate law that gives Directors a rebuttable presumption of propriety, so long as they acted in good faith, with reasonable care, and with a reasonable belief that they were acting in the best interests of the corporation.

When one or more Directors is alleged to have breached their fiduciary duties in the for–profit world, they might be sued by one or more shareholders of the corporation. Shareholder plaintiffs can either sue in their individual capacity, or they might institute a shareholder derivative lawsuit, meaning that they step into the shoes of the corporation itself and assert claims against Directors on behalf of the corporation. In the nonprofit world, a lawsuit like this might be brought by the Attorney General, or the IRS could take action to revoke the tax–exempt status.

Unveiled Risks: Piercing the Corporate Veil

The second category of situations in which individual Directors can end up personally on the hook is called "veil–piercing." "Piercing the corporate veil" is a legal term describing a scenario when a party sues a corporation and a court sets aside a corporation's fictitious legal personhood, thus allowing the plaintiff to recover against the natural persons who own or operate the corporation, namely the shareholders, Officers, and Directors.

In a normal scenario, if ACME Corporation were sued and got hit with a multi–million–dollar judgment, the plaintiff's ability to recover that judgment would be limited to ACME's assets as a corporation. If after liquidating all its assets to pay the judgment, ACME was only able to pay 50% of the judgment amount, ACME's owners, Officers, and Directors would not have to worry about the plaintiff attaching any liens on their personal property to satisfy the rest of the judgment. The judgment was against ACME, not against its principals, and the plaintiff's recovery is limited to the corporation's assets.

But in a scenario where ACME's corporate veil is pierced, the barrier between the corporation and the principals of the corporation is dissolved and the plaintiff can recover their judgment against the principals' personal assets. 

Fortunately, veil–piercing is rare. Courts will only lift a corporation's veil and hold its principals personally liable in limited situations such as when the corporation is an alter ego for an individual or where corporate and personal assets and funds are co–mingled. Nevertheless, veil–piercing is still a risk, especially for smaller corporations.

Personal Liability: Exceptions for Nonprofits

In some ways, individuals serving as Directors for a nonprofit have more protection. There is often special statutory protection that rewards people willing to engage in this public service. But there are cases where there could be personal liability. Many of these scenarios could also happen in a for–profit, but are more likely to happen in a nonprofit, where the Directors may not be as sophisticated about the business issues.

• Personal injury—Directors may be liable if they personally and directly injure someone. This makes sense, because injuring people is not part of their Director duties.
• Guaranteeing debts—If someone is reckless enough to personally guarantee a bank loan or business debt, he or she is exposed if the nonprofit defaults on the debt.
• Tax obligation—If Directors do not ensure that payroll and property taxes are filed, or keep up with necessary tax returns, the gentle government will work to ensure their personal liability.
• Fraud—It should be obvious—but if Director engage in intentional fraud or illegal actions;,they can be held liable.
• Commingling funds—Mixing the funds of the corporation and personal funds blurs the legal boundaries between personal assets and corporate assets and can erase the liability protection.

How to Avoid Director Liability

Even if Directors are not highly experienced, they can avoid Director liability fairly easily by taking some care, as many resources exist to help out.

• Legal Experts—Whether for a nonprofit or a business, legal experts can help you with corporate governance, ensuring that you don't walk into areas of risk.
• Educational Resources—Many educational resources exist to help run the corporation well. On the business side, corporate and HR resources are helpful. On the nonprofit side, there are books as well as organizations whose sole existence is to help other nonprofits.
• Workshops and Webinars--These exist both for businesses and for nonprofits. Nonprofit networks or associations (often in the particular sphere of your own nonprofit) can be interesting and helpful.

A Special Yet Common Risk

A very common area of liability that is worth discussing in more depth is failing to properly keep up with payroll taxes. This is a particular danger for small businesses and nonprofits. When cash flow is tight and payroll taxes are not being paid immediately, the corporation may literally live "paycheck to paycheck" without setting taxes aside to be paid. Sometimes, payroll taxes are forgotten. Other times, they hope to pay later, but there is just "not enough" money for the government's share.

Under the law, any "responsible person" can be held personally liable. This includes accountants, bookkeepers, and key leaders like the CEO. And it also includes Board members. Even if Board members have directed that the taxes be paid, if they don't follow through, they can still be liable.

The good news is that a volunteer Board member may still not be liable. If someone serves in an honorary capacity, is not involved in day–to–day or financial operations, and lacks actual knowledge of the tax issues, he or she should not be liable. This analysis might be complicated, though. A typical nonprofit Board member is a volunteer, might not be involved day–to–day and might not know about the tax issues. But on the other hand, if the volunteer Board member is still supposed to be supervising the nonprofit, the Board member may not be serving in an honorary capacity. And part of the reason for monitoring financial statements is to ensure that these tax issues don't arise.

So keeping on top of financial oversight is really crucial. 

The Gentle Art of Not Being Personally Liable

There are steps that you and your fellow Directors can take to avoid personal exposure. One step is to get a Directors and Officer's (D&O) insurance policy. A D&O policy is liability insurance that a corporation purchases to provide coverage for its Officers and Directors. If someone sues one or more Directors personally on a claim that is covered by the policy, D&O coverage will defend and indemnify the Directors (and their spouses and estates) so that they are not forced to pay for legal defense out of their own pockets or satisfy judgments with their own personal assets.

Another step to take is to make sure that your organization's articles of incorporation expressly include all the possible limitations of liability permitted by the law of the jurisdiction in which it is incorporated. The laws of most states permit corporations to include provisions in their chartering documents that limit the liabilities of Directors and indemnify Directors when they are sued. Take full advantage of your jurisdiction's laws to maximize protections for Directors.

What Should the D&O Policy and Other Insurance Cover?

The D&O Policy should work well together with other insurance. Here's what it should cover:

• Errors and Omissions—The cornerstone of a D&O policy is to protect against mistakes or oversights by the Directors and Officers. If leaders inadvertently make the wrong decision, they are shielded from liability.
• Employment Practices Liability Insurance (EPLI)—Most D&O claims tend to be employment-related, like allegations of discrimination of wrongful termination. The EPLI should cover both the organization and the Directors.
• General Liability Insurance—This should cover personal injury, property damage, or various kinds of abuse.

Conclusions

Avoiding personal liability under the categories of fiduciary duties and veil–piercing is partly a function of structuring the corporation and its decision–making processes in a proper way. In addition, the Directors should be careful to monitor the organization properly, gather information, and make sound business decisions in the best interests of the organization. To ensure that all possible protections are in place, the Board may want to consult with an experienced attorney who can advise on how to best mitigate risks for Director liability.
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Featured Image by Rebecca Sidebotham.