Directors of Nonprofit Held Financially Liable for Relying on Incompetent Officers and Lack of Oversight
In a striking decision earlier this year, the 3rd Circuit Court of Appeals affirmed a jury’s findings of liability for breach of fiduciary duties and ‘deepening insolvency,’ and the award of $2.25 million in compensatory damages, jointly and severally, against former directors and officers of The Lemington Home for the Aged, a Pennsylvania not-for-profit that is in Chapter 11 bankruptcy.
The court’s decision in In re Lemington Home for the Aged, No.13-2707, 2015 WL 305505 (3d Cir. Jan. 26, 2015) (“Lemington III”) demonstrates the need for proper corporate governance for financially troubled organizations, but more importantly, that governing boards of not-for-profits who have actual knowledge of mismanagement by the officers of the corporation and choose to ignore it and/or not take appropriate action, can be held financially liable for breach of their fiduciary duty of care. The decision carries special weight because it turns on its head the long-held assumption that nonprofit directors are insulated from financial exposure, barring personal involvement in corruption, venality or fraud. This should be a wake-up call to nonprofits about the very real perils of inattention or inaction.
The Lemington Home for the Aged, a not-for-profit Pennsylvania corporation (“the Home”) was established in 1883 and provided residential elder care services in Pittsburgh, Pennsylvania. In 1997 the Home hired an administrator and in 2000, the Home hired a chief financial officer (collectively the “officers”). The Home had been beset with financial troubles for years and by 1999 was insolvent, but by the early 2000s its financial problems became particularly acute and it received going concern warnings. The Home’s financial and billing records were in deplorable condition. Employee insurance premiums were not paid even though payroll deductions had been made for that purpose, over $400,000 of Medicare receivables went unbilled for a year, and the CFO failed to maintain a general ledger.
The Home was also cited for three times the deficiencies of the average nursing home operating in the state in 2001, and an independent review of the Home recommended that due to the Home’s continued citations for health violations, the administrator should be replaced with a seasoned nursing home administrator. Although the Board sought and obtained a grant to fund the search for a new administrator, the funds were never used find a replacement for the administrator, who remained at the Home despite increasing evidence that her performance was poor, and who worked part-time in violation of state law requirements, while collecting her full salary. In 2004, the Home’s problems came to a head when two residents died due to neglect.
During this period, the Board itself was in disarray. The Board did not maintain proper minutes of meetings, attendance at Board meetings was often less than 50 percent and it did not provide meaningful oversight of the Home’s financial operations. The position of treasurer remained unfilled and a finance committee was not set up—even though the by-laws required it—and the Board continued to rely on the CFO, even after learning that he did not maintain customary financial records. The Board also continued to employ and rely on the administrator, despite being aware of the numerous citations, her poor performance and part-time status.
In January 2005, the Board voted to close the Home and not admit any more residents, and sent letters to residents and state agencies informing them of its decision. However, the Board did not approve the filing of a Chapter 11 bankruptcy for another three months. During this interim period, the Board declined to pursue a viability study upon which a loan option was conditioned, and discussed plans to transfer the Home’s principal asset to an affiliated entity whose directors were also the Home’s board members. Meanwhile, the officers continued to contract with vendors, the CFO failed to collect over $400,000 in Medicare receipts, and sent a proposal for the Home’s sale to an organization where he would then be its president and CEO.
The Board also failed to disclose its pre-bankruptcy decision to close and wind down affairs to creditors or the bankruptcy court, and failed to disclose in its monthly debtor-in-possession bankruptcy filings that the Home had received a $1.4 Nursing Home Assessment Tax in May 2005. At a bankruptcy status conference in June 2005, no one expressed any interest in funding or acquiring the Home and consequently, the Bankruptcy Court approved the Home’s closure.
Subsequently, the Official Committee of Unsecured Creditors (the “Committee”) commenced an adversary proceeding on behalf of the Home, against the officers and all 15 former directors of the Home, alleging breach of fiduciary duty of care and loyalty and ‘deepening insolvency’. The officers and directors moved for summary judgment and the district court granted the motion, finding that the business judgment rule and the doctrine of in pari delicto applied to preclude the committee’s breach of fiduciary duty claims, and that the committee would be unable to show there was fraud necessary to support a deepening insolvency claim. The committee appealed and the 3rd Circuit Court of Appeals vacated the district court’s grant of summary judgment in favor of the officers and directors, finding that there were genuine issues of material facts in dispute on all claims and remanded for trial. See In re Lemington Home for the Aged, 659 F.3d 282 (3d Cir. 2011) (“Lemington I”).
The case proceeded to a six-day jury trial in February 2013. At the close of plaintiffs’ case-in-chief, the district court granted the director defendants’ motion for judgment as a matter of law on the breach of fiduciary duty of loyalty claim, but denied it as to the breach of fiduciary duty of care and deepening insolvency. Following the close of defendants’ case-in-chief, the court granted plaintiff’s unopposed motion for judgment as a matter of law as to the defense of in pari delicto. After three days of deliberation, the jury returned a compensatory damages verdict against the CFO, administrator and 13 of the directors (the “directors”), jointly and severally for $2.25 million. The jury also awarded punitive damages in the amount of $350,000 individually against five of the directors, and punitive damages in the amount of $1 million against the CFO and $750,000 against the administrator. Following the verdict, the officers and directors (the “defendants”) filed a motion for judgment as a matter of law, a new trial, or remitturer. The district court denied the motion in entirety, and an appeal followed. See Official Committee of Unsecured Creditors on behalf of the Estate of Lemington Home for the Aged, No. 10cv800, 2013 WL 2158543 (W.D. Pa.. May 17, 2013) (“Lemington II”).
The 3rd Circuit decision – Lemington III
On appeal, the 3rd Circuit Court of Appeals affirmed the jury’s liability findings of breach of the fiduciary duties of care and loyalty and ‘deepening insolvency’ against the officers as well as the award of punitive damages against them. The court also affirmed the breach of the fiduciary duty of care and ‘deepening insolvency’ against the directors, but vacated the punitive damages award against the five director defendants1 as there was insufficient evidence that their actions were of such an “outrageous” nature to demonstrate intentional, willful, wanton or reckless conduct.
Breach of fiduciary duty of care by directors
Fiduciary duties of care and good faith owed by directors and officers of a Pennsylvania not-for-profit are defined by statute. See 15 Pa. Cons. Stat. Ann. §5712(a)-(c). A director must perform his/her duties “in good faith in a manner he[/she] reasonably believes to be in the best interest of the corporation and with such care, including reasonable inquiry, skill and diligence, as a person of ordinary prudence would use under similar circumstances” and he/she is “entitled to rely in good faith on information, opinions, reports or statements, including financial statements and other financial data” prepared by employees or experts. However, “[a] Director shall not be considered to be acting in good faith if he[/she] has knowledge concerning the matter in question that would cause his[/her] reliance to be unwarranted.” Id.
Pennsylvania recognizes directors’ and officers’ liability for negligent breach of fiduciary duty. See Lemington I, 659 F.3d at 292, n.5. However, “a non-profit may restrict the circumstances under which a director may have personal liability for negligent acts by adoption of an appropriate by-law, see 15 Pa.C.S. § 5713(a), in which event a director may be liable for a breach of fiduciary duties or failure to perform the duties of the office only if ‘the breach or failure to perform constitutes self-dealing, willful misconduct or recklessness.’ 15 Pa.C.S. § 5713(a)(2).” Id (emphasis added). The Home, in fact, had such a by-law provision.
The 3rd Circuit held that the evidence supported the jury’s findings that the directors did not exercise reasonable prudence and care in continuing to employ the administrator and CFO and breached their fiduciary duty of care by failing to take action to remove them once the results of their mismanagement became apparent. The Board knew that the CFO had not been maintaining proper financial records but continued to rely on him. It also kept the administrator in her role for six years in the face of abnormally high deficiency findings and allowed her to continue even after she ceased working full time in violation of state law and even after receiving several independent reports documenting her shortcomings and urging that she be replaced. As the court noted, “[t]his [was] not a case where directors, acting in good-faith reliance on ‘information, opinion, reports or statements’ prepared by employees or experts, made a business decision to continue to employ an Administrator whose performance was arguably less than ideal. 15 Pa.C.S. §5712(a).” The directors in this case had “actual knowledge of  mismanagement, yet stuck their heads in the sand in the face of repeated signs that residents were receiving care that was severely deficient.”
Given the provision in the Home’s bylaws, implicit in the 3rd Circuit’s decision, therefore, is the finding that there was sufficient evidence for a jury to find that the directors acted recklessly. As the district court in Lemington II opined, the Board’s actions were reckless as it relied on incompetent officers and evidence of the Board’s recklessness also was supported by their lack of oversight of the Officers. 2013 WL 2158543 at *7. “The Board had sufficient reason to know that they should have questioned the reports the officers made at the Board meeting.” Moreover, “the extent of the Officers’  deficiencies may not have been known because appropriate actions were not taken, i.e., setting up a finance committee as required by the bylaws. Violating the Home’s bylaws [went] even beyond basic negligence and me[t] the recklessness standard.” Id.
The 3rd Circuit re-affirmed its earlier position in Lemington I, that it continues to be bound by its own precedents to recognize a ‘deepening insolvency’ cause of action under Pennsylvania law even though the Pennsylvania’s highest court has not yet spoken on the issue. The court predicted that Pennsylvania courts would recognize the tort of deepening insolvency and define it as “‘an injury to the Debtors’ corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life’”. Lemington III, 2015 WL 305505 at * 6 (citing Official Comm. Of Unsecured Creditors v. R. F. Lafferty & Co., 267 F.3d 340, 347 (3d Cir. 2001)). And, “‘[e]ven when a corporation is insolvent, its corporate property may have value’ which can be damaged by ‘[t]he fraudulent and concealed incurrence of debt.’” Id. (citing Lafferty, 267 F.3d at 349).2
The 3rd Circuit found that there was sufficient evidence to support the jury’s verdict that the defendants deepened the Home’s insolvency. The evidence against the directors included the concealment for over three months of the Board’s January 2005 decision to close the Home and deplete the patient census before filing for bankruptcy3, which resulted in a “slow death” of the Home’s ability to generate revenue, and the Board’s failure to disclose in its monthly operating reports the receipt of a $1.4 million nursing home assessment tax which would which would have increased the Home’s chances of finding a buyer. Not “‘establish[ing] a sale process that is customarily done in Chapter 11 cases’” with ‘“[n]obody having an opportunity to bid’” and ‘“no meaningful financial records”, summed up the “mismanagement of the bankruptcy process”. See Lemington III, 2015 WL 305505 at * 6 (citing an email from the Home’s bankruptcy attorney). As to the officers, the evidence included the mismanagement of finances, inattention to record keeping and patient billing and the failure to collect close to $500,000 in Medicare reimbursements, as well as the CFO’s failure to maintain a general ledger and refusal to meet with a consultant hired by the Home’s major creditors and make available information about the Home’s financial condition to potential buyers. “All of this conduct damage the Home’s financial viability after it had already become insolvent.” Id. at 7.
The 3rd Circuit’s decision is a warning to Boards of not-for-profits that placing undue reliance on officers of the corporation and a lack of appropriate oversight may have financial consequences, not just for the corporation, but for directors themselves.
1 Documentary evidence showed they were aware of the CEO’s poor performance, received more correspondence relating to the closure of the Home deficiencies than the other directors against whom liability was imposed, and may have had actual notice of the deficiencies.
2 In Lemington I, the 3rd Circuit confirmed that fraud is a necessary to support a claim for deepening insolvency and that under Pennsylvania law fraud included affirmative statements intended to deceive as well as less direct intentional conduct. See 659 F.3d at 294 (“‘fraud consists in anything calculated to deceive, whether by single act or combination ,or by suppression of truth, or a suggestion of what is false, whether it be by direct falsehood or by innuendo, by speech or silence, word of mouth, or look or gesture.’”) (citations omitted).
3 In Lemington I, the 3rd Circuit held that this evidence would suggest to a jury that “although the Board knew that its actions would cause further deterioration of the Home’s finances to the detriment of its creditors, by its silence, the Home consciously defrauded the Home’s creditors by implementing these policies and delaying the filing of bankruptcy . . .” 659 F.3d at 295.