Indemnification of Corporate Officers

Many bylaws provide some financial protection for board members facing a lawsuit.

Church Law and Tax 1996-11-01

Officers, Directors, and Trustees

Key point. Corporate bylaws sometimes contain a provision agreeing to indemnify officers or directors against legal fees incurred in the defense of a lawsuit arising from their duties. However, such provisions may require officers or directors to repay the corporation if they loose the lawsuit.

A Pennsylvania court ruled that a nonprofit corporation could not sue its officers for mismanagement unless it paid their legal fees, as required by the corporate bylaws. A nonprofit corporation sued its officers for negligence, breach of fiduciary duties, and mismanagement. The officers sought a court order prohibiting the lawsuit from proceeding until the corporation paid their legal fees. The corporation’s bylaws and state nonprofit corporation law specify that officers or directors who are sued as a result of the performance of their official duties “shall be indemnified” by the corporation and that the right of indemnification includes the right to be reimbursed “in advance” for their legal fees in the defense of such a lawsuit. Before being reimbursed for legal fees, an officer or director must present the corporation with a letter acknowledging that all legal fees advanced by the corporation will be repaid if a court determines that the officer or director engaged in willful misconduct or recklessness or did not act in good faith. The trial court rejected the officers’ demand that the corporation prepay their legal fees, noting that officers of nonprofit corporations owe a fiduciary duty to their corporation and that this duty is not consistent the prepayment of the legal fees of officers who are sued for breaching their fiduciary duties. Pennsylvania nonprofit corporation law specifies that “a director of a nonprofit corporation shall stand in a fiduciary relation to the corporation and shall perform his duties as a director … in good faith, in a manner he reasonably believes to be in the best interests of the corporation and with such care, including reasonable inquiry, skill and diligence, as a person of ordinary prudence would use under similar circumstances.” The officers appealed this ruling, and a state appeals court reversed the trial court’s decision and ruled that the corporation had to prepay the legal fees of the officers. It observed, “[f]rankly, we do not see how the bylaws providing for the advancement of defense costs to the officers can reasonably be determined to be in conflict with this section. There has been no judicial determination that the officers did not in good faith or that they engaged in willful misconduct or recklessness, which would … preclude their indemnification.” The court quoted with approval from another decision: “The corporation maintains the right to be repaid all sums advanced, if the individual is ultimately shown not to be entitled to indemnification. Thus the advancement decision is essentially simply a decision to advance credit.”

What is the significance of this case to churches and ministers? Many churches have bylaws providing for the indemnification of corporate officers and directors who are sued as a result of their official duties. In addition, many ministers serve on the boards of educational and charitable corporations having bylaws providing for the indemnification of officers and directors. Prior to accepting a position on such a board, it would be prudent to review the indemnification provision (if any) in the organization’s bylaws. This case illustrates the importance of a bylaw provision calling for the prepayment of legal fees in the event of a lawsuit. The court in this case noted indemnification clauses are designed to “avoid deterring qualified persons from accepting responsible positions with [nonprofit corporations] for fear of incurring liability in excess of their means.” Neal v. Neumann Medical Center, 667 A.2d 479 (Pa. Common. 1995). [ Personal Liability of Church Officers, Directors, and Trustees]

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