Our 501(c)(3) nonprofit receives funds from the state that we re-grant to about 50 organizations providing social service programs pursuant to our grant agreement. One of our grantees is insolvent and owes us about $75,000 in overpaid funds because we had to disallow some invoices that failed to meet our requirements. We don’t have sufficient unrestricted funds to repay the state if we can’t collect from the agency. Will our directors be personally liable if we can’t repay the state?
It would be very unusual to impose personal liability on directors merely because one of the grantees failed to fulfill its obligations. To impose personal liability on anyone on your board would require self-dealing, bad faith or gross failure to deal with the situation when it became apparent. From your description, it doesn't sound as though that is the case here.
The business judgment rule protects individual directors from personal liability so long as they act in good faith and in what they believe to be the best interests of your organization. The state would lose most of its volunteer boards if it tried to impose personal liability simply for bad outcomes.
In addition, assuming your directors aren’t paid for their service, they would probably be protected by the Volunteer Protection Act, which protects them from personal liability unless the harm is caused by “willful or criminal misconduct, gross negligence, reckless misconduct, or a conscious, flagrant indifference to the rights or safety of the individual harmed.” (See Ready Reference Page: “Nonprofit Law Protects Nonprofit Volunteers”) And your officers and directors insurance ought to protect them even if they are deemed to be negligent in their conduct.
It may not be a comfortable situation, but your directors should not be at serious personal risk merely because one of your grantees failed to live up to its contract.