A recent decision by the 3rd Circuit Court of Appeals is raising some eyebrows and hopefully causing some directors and officers of nonprofit corporations to think twice before taking a casual approach to their duties. The Court in In re: Lemington Home for the Aged upheld a jury verdict that found fifteen former directors jointly and severally liable for $2.25 million dollars for breach of fiduciary duties, and imposed punitive damages of $1 million and $750k against the two former officers.
Summary of the Case
The Lemington Home for the Aged was established in 1883 and “was the oldest, nonprofit, unaffiliated nursing home in the United States dedicated to the care of African-American seniors.” The case was brought by the creditors of the Home, against the defendants, which were the Home’s Administrator and CEO (hired in 1997), the CFO (hired in 2002) and the Home’s fifteen members of the board of directors.
It was well-known that the Home had financial problems, but these problems became particularly bad under the management of the two officers. In January of 2005, the Board voted to close the Home. By the time the Home filed for bankruptcy, the patient totals had been allowed to drop significantly, financial reports were in disarray, and the officers had failed to make any reasonable effort to find a buyer for the Home.
The Court found that there was ample evidence that both the CEO and CFO improperly managed the Home and lacked to qualifications to do so, and as a result of their actions they breached their duties of care and loyalty to the Home. Evidence included:
- An investigation by the Department of Health in 2004 concluded that the CEO was wholly unqualified.
- CEO’s own admission that she was only working part time for a position that state law required to be filled by a full time staff member.
- CFO admitted that the Home had been operating without a general ledger.
- CFO failed to bill to Medicare for at least $500k.
- CFO refused to meeting with a consultant representing one of the Home’s major creditors.
The court found that there was ample evidence that the members of the board of directors breached their duty of care when they failed to remove the two officers once the directors became aware of the officers’ mismanagement. Evidence included:
- The Directors were aware that the Home had three times the number of deficiencies as the average nursing home in Pennsylvania.
- An independent review in 2001 recommended that the Home should have a qualified CEO, due to a continued pattern of health violations.
- The Home obtained a grant to conduct a search for a new CEO, but failed to spend the money for those purposes.
- The Board knew that the CEO was only working part time, in violation of state law.
The facts in this case are obviously pretty egregious. However, it is still important for board members and officers to take heed from this warning. It is not uncommon to see examples of board members that have obviously stuck their heads in the sand [[cough, cough, Community Action of Minneapolis, cough]]. Board members serving for an organization in financial trouble should also take heed of the fact that the plaintiff in this case is a group of creditors. Due to the finding that these individuals breached their duties, these individuals likely will not be eligible for indemnification under state law, or eligible for coverage under an organization’s D&O insurance policy.
The aspect of this case that I find worrisome, however, is that court upheld punitive damages against the two officers for breaching their duty of loyalty to the organization. The basis for this determination was that both of these individuals acted in an incompetent manner, that the CEO went down to part time but still took a full-time salary, and that the CFO approached a church to possibly serve as a buyer. With the exception of the CFO’s actions with regard to a potential buyer, I am not sure that I buy that continuing to work for an organization in an incompetent manner is a breach of the duty of loyalty. While that is obviously an example of someone putting their own financial interests above the interests of the organization – you could perhaps make that same argument for some individuals at large hospitals and universities that make extremely high salaries while programs or benefits to those less well-off are getting cut. Even further – what if you don’t know you are incompetent? Isn’t this more on the board for failure to supervise?