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How should we write indemnification clause in bylaws?

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How should we write indemnification clause in bylaws?

Most nonprofit corporation bylaws contain a provision directing the corporation to indemnify its board members, including the advancement of expenses defending a claim. Recently, we ran across a provision that included language stating that the corporation would also hold the board member harmless and defend board members against claims. Is this broad language allowable? If so, do you recommend it?

Indemnification is an issue of state law and the states are not all the same.  Most provide wide latitude to indemnify persons who are sued or involved in administrative proceedings while serving on behalf of the organization.  I am concerned, however, about bylaw provisions like the one you recently ran across that appears to hold the director harmless and provide a defense in any and all situations, even where the organization is suing the director for stealing from it.

Our standard form of bylaws (See Ready Reference Page: “Bylaws Function as ‘Constitution’ of Nonprofit Corporation”) commits in Article IX to indemnify a director “if such person acted in good faith and in a manner he or she reasonably believed to be in, or not opposed to, the best interests of the corporation.”  This is the basic language of the Pennsylvania statute, and provides an important qualifier of good faith to obtain indemnification.  Our provision goes on to prevent indemnification where the actions have been found to be based on willful misconduct or recklessness, or where the person is found to be liable to the corporation itself, as provided by the statute. 

We also provide that the corporation may withhold the advancement of expenses where the corporation itself is suing the director.  There is a case in Pennsylvania preventing a nonprofit from suing a treasurer alleged to have stolen from the corporation without first advancing the funds for the treasurer to defend himself as required by an absolute provision in the bylaws.  The likelihood of recovering those costs if the corporation won the basic litigation was not very high.

We recently ran across a bylaw that purported to indemnify a director in the situations in which it is prohibited by our form and by the state law.  Even if the state law ultimately controls, however, providing absolute rights in the bylaws could easily lead to more litigation.

To some extent, this may all be academic because the director may have direct personal rights under the corporation’s insurance policies (assuming you have them).  Some policies may still be written to provide funds to the corporation to fulfill its indemnification obligations and not give direct rights to the officers and directors.  But even where the policy gives direct rights to “named insureds,” including officers and directors, insurance companies have an interest in not paying when they can avoid it and probably have some exculpatory language of their own in the policy to prevent payment in egregious situations. 

You want to protect your directors where they have acted in good faith, even if they have made a mistake.  You don’t want to protect them or defend them where they have acted willfully against the interests of the corporation.

Tuesday, July 27, 2021

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