The Importance of Indemnifying Directors and Officers

Everybody has his or her gripes. As an in-house lawyer, mine are document retention policies and indemnification of directors and officers. They make my head hurt--literally. I get headaches when dealing with either. So, I bravely risk pain to advise my in-house colleagues on why today's terrible economy is reason to study up on the intricacies of indemnifying your board of directors.

Times are tough for the non-profit sector, as a GuideStar survey recently confirmed. Forty percent of charities reported that contributions were way down this year, and 8 percent said they were in imminent danger of shutting their doors. The survey's best news seemed to be that most charities at least were able to maintain operations despite the economic downturn. This is the time non-profits need experienced, capable, diverse and wise leadership on their boards and in their management, but the disincentives to such people are piling up.

In recent years Congress has been paying close attention to non-profits in general, particularly in the area of corporate governance. The IRS, not unexpectedly, has followed that lead by stressing governance issues in audits and otherwise. Cash-starved state and local governments continue to be skeptical about all that tax-exempt property in their midst. And the citizen watchdog groups, not to mention the investigating journalists and attorneys general, are ever present and ready to jump on the misuse of government funds or charitable contributions.

In this environment, what experienced, substantial person would willingly take on the work, much less the serious legal duties, of charity board service? The charity's recruitment of talent will be easier if it can allay a prospective director's anxiety about personal liability with a clear statement about indemnification. Basically, that means the organization will defend or cover the costs (or both) of a director or officer who faces litigation as a direct result of service on behalf of the organization.

As a legal matter, indemnification is a many-layered thing and requires close attention by the in-house lawyer and the lawyers of the potential directors. State law determines whether your non-profit even has the right to offer indemnification (it probably does) and to whom, and your certificate of incorporation says whether your non-profit affirmatively took on the right. If the obligation to indemnify is found in the bylaws, you might want to strengthen the non-profit's commitment by amending the incorporation papers, which can't be changed nearly as easily as bylaws. A prospective director may be leery of a promise that can rescind a simple majority vote. Wherever the indemnification policy is lodged, it should cover administrative actions, including mediation and arbitrations, in addition to lawsuits. You're in luck if a prospective director is covered by her employer's liability insurance policy and if service on your non-profit board is at the request of her employer. It is even possible that the candidate's personal umbrella policy covers service on non-profit boards, and it probably does so at a low premium.

Many of the indemnification headaches (but not all) for the in-house lawyer can be dealt with in a good D&O (directors and officers) liability insurance policy. As with most insurance, the exclusions are critical, and D&O policies tend to exclude many very specific types of actions from coverage, such as Superfund issues, bodily injury claims and willful violation of a statute. Such a policy is more attractive if it is a "duty to defend" policy than if it is a mere "indemnity" policy. The former will make defense cost payments as they are incurred; the latter reimburses costs of defense after a decision is made. The former is more expensive, but the cost could be worthwhile as an incentive to board candidates and as a comfort to board incumbents.

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