May a nonprofit indemnify an officer who violates the organization’s bylaws by taking private inurement? I think that the statement in the bylaws that the board of directors will decide whether or not to indemnify an officer seems to be a good one. However, the board could decide to do so even though the action being addressed is inconsistent with the bylaws. Is that possible?
Matters of indemnification are matters of state law and not all states deal with the issue in the same way. Generally, they require a nonprofit corporation to indemnify an officer or director who is made a defendant in some sort of action by a third party and is not found liable for any wrongdoing. The statutes also usually permit, and bylaws frequently require, the nonprofit to indemnify an officer or director who has 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. (See Ready Reference Page: “Bylaws Function as ‘Constitution’ of Nonprofit Corporations)
In applying that definition, officers could be indemnified even if they violated the bylaws if they acted in good faith and in what they believed to be the best interests of the corporation. It is easy to imagine that an officer could think the value of their services to the corporation is significantly more valuable than others do. They may be entitled to protection if they made an honest mistake.
In addition, most statutes and many bylaws provide that the basis stated for indemnification set out in the statute or the bylaws is not necessarily the exclusive standard for indemnification. That could allow indemnification even if the officer did not act in good faith. It might raise an issue of fiduciary duty (or excess benefits for federal income tax purposes) if the board were to approve indemnification for a person who stole from the organization. But the issue is murky and the stated standard may not be the only one possible.
Comments
Just because a director may do something doesn’t mean that the director will do it. We generally want to protect those who serve on the boards, especially volunteers giving their time, effort and often finances for the public good. In my view the good faith standard is a good one that the vast majority of directors will follow it. I don’t think your suggestion of a bylaw prohibiting indemnification in the case of a violation of the bylaws would be a good one.
To include such a limitation in the bylaws would introduce an arbitrary provision that would create more problems than it would solve. Consider the board members who are sued personally because they decided not to hold the annual meeting of members for the election of new directors in June 2020 because the state prohibited assemblies of groups of that size during the Covid pandemic. After some litigation, the case was settled with a different date and method for an annual meeting. But it was clear that they didn’t follow the bylaws. Should they not be indemnified for their costs?
What about the situation in which a director was prohibited from running for a new term because of the term limit in the bylaws? The board, relying on the opinion of the organization’s counsel, said service of a partial term was a term and prohibited the director from running again. The director said the partial term should be disregarded and sued the corporation and the directors individually. The bylaws didn’t say anything about partial terms. After a year or so of litigation, including numerous motions and depositions, the director decided it wasn’t worth it, dropped the suit and joined the board of a competitive nonprofit across town. Are the directors indemnified because there was no determination that they violated the bylaws?
What if, instead, after years of litigation and a full trial, a court said the director who wanted to run was right, the bylaws had been violated, and the director was able to run for another term? Do the directors all have to repay their portion of the legal fees advanced during the litigation?
That doesn’t seem to be a good result. The good faith standard seems a lot better to me. —Don Kramer
I appreciate my question being addressed. I must say the answer leaves a lot to be desired. It seems that most any thing goes depending on the claim of the person being challenged and how weak kneed the board members are. In other words, anything is possible.
The comment that the issue is merky seems to be a common answer to many questions although this specific term isn’t always used.
Is the best option to be very specific in an organization’s bylaws in defining what a board may indemnify? For example the board may only indemnify board member(s) who do not violate bylaw provisions and maintain the spirit of the nonprofit regardless of their level of understanding as each board member is responsible to know and understand the issues including the issue of inurement. —K.B.