Indemnification Requirements and Liability Risks
for a Connecticut Organization
Exempt under Section 501(c) of the Internal Revenue Code
Lisa Nachmias Davis
Davis O'Sullivan & Priest LLC
129 Church Street, Suite 503
New Haven, CT 06510
Fax 203-774-1060 or 203-776-4411
DISCLAIMER: This article is provided for informational purposes only. It is not intended to convey legal advice about a particular situation, and does not create an attorney-client relationship. Consult your legal advisor before taking action based on this article
This article may not be republished without the consent of the author.
Connecticut nonstock corporations are required to indemnify directors, officers and agents under certain circumstances. "Indemnification" means that the organization must "pay back" the individual for damages and expenses relating to a claim that arises from conduct in the course of his/her duty for the organization. Indemnification may be required whether or not the corporation's bylaws require such indemnification. For organizations incorporated prior to January 1, 1997, indemnification of directors, officers, and agents (including volunteers) is mandatory. For more recent organizations, some indemnification is "permissive" rather than mandatory, without an express court order, and bylaws should include stronger indemnification provisions when an indemnification requirement is desired.
Federal and state law provides considerable protection from liability for unpaid directors and volunteers for organizations exempt under 501(c). However, the result of this immunity may mean an increased likelihood that an organization itself will be targeted for legal action. Accordingly, appropriate insurance is important. Depending upon the activities of the organization, it may be appropriate to procure only "general liability" insurance, but it is also usually appropriate to purchase "directors' and officers' liability insurance" that may protect the organization found to be vicariously liable for the acts of its agents as well as protecting the directors, officers, and agents themselves.
1. Legal Requirements for Indemnification.
Connecticut nonstock corporations incorporated prior to January 1, 1997 are required by the Connecticut General Statutes to indemnify directors, officers, employees and agents to the same extent that a newer organization would be permitted, but not required, to indemnify officers and directors under section 33-1117 -- unless otherwise specified in the certificate of incorporation. Conn. Gen. Stat. sections 33-1122(4) and 33-1117(e). Connecticut nonstock corporations incorporated since then are not required to indemnify unless the director or other party is vindicated by litigation, or unless a court orders indemnification. Conn. Gen. Stat. sections 33-1118, 33-1120. However, corporations may promise indemnification in their bylaws or certificate of incorporation. In addition, older and newer corporations are permitted to advance expenses under specified circumstances.
Indemnification is permitted for directors (and required for directors, officers, employees and agents of organizations incorporated prior to January 1, 1997 unless the certificate provides otherwise) if (1) the director conducted himself or herself in good faith; (2) the director reasonably believed (A) in the case of conduct in an official capacity with the corporation, that the conduct was in the corporation's best interests, and (B) in all other cases, that the conduct was at least not opposed to its best interests; and (3) in the case of a criminal proceeding, the individual had no reasonable cause to believe the conduct was unlawful. Indemnification is prohibited, however (whatever the bylaws may say), if the individual is adjudicated as being liable to the corporation, or in proceedings charging "improper personal benefit" to the individual -- whether or not involving action in an official capacity -- in which the individual is found liable. Conn. Gen. Stat. section 33-1117. In addition, indemnification is permitted to an officer, employee or agent who is not a director (or not being held liable in that capacity), "to such further extent, consistent with public policy, as may be provided by contract, the certificate of incorporation, the bylaws or a resolution of the board of directors." Conn. Gen. Stat. section 33-1122.
Who determines when indemnification is appropriate for a director, and what constitutes "reasonable expense"? These determinations are to be made (1) by majority vote of the "qualified" directors (pre-2006, the terminology was "disinterested" directors), provided there is a quorum; (2) or, if there is no quorum, by majority vote of a committee of at least two"qualified" directors, designated by the board of directors (and directors who are not "qualified" may participate in the designation); or, at the board's option or if neither of (1) or (2) are possible, (3) by special legal counsel selected by the board according to the methods in (1) and (2), or if this is not possible, by majority vote of the full board of directors; or (4) by members entitled to elect directors. Conn. Gen. Stat. section 33-1121. "Expenses" includes counsel fees. Conn. Gen. Stat. section 33-1116(3). "Proceeding" includes threatened actions, even if informal. By contrast, a decision to indemnify or advance expenses to officers, agents and employees may be decided by a designated officer, rather than the full board as is required for indemnification of directors.
Who is a "qualified" director for these purposes? New definitions were adopted by the legislature in 2006. Under section 17 of Public Act No. 06-68, a "qualified director" is one who "(1)(A) is not a party to the proceeding, (B) is not a director who sought approval for a director's conflicting interest transaction under section 33-1129 . . . . or a disclaimer of the corporation's interest in a business opportunity under section 26 of this act, which approval or disclaimer is challenged in the proceeding, and (C) does not have a material relationship with a director described in either subparagraph (A) or (B) of this subdivision." Subsection (2) goes on to explain that a "material relationship" means "a familial, financial, professional or employment relationship that would reasonably be expected to impair the objectivity of the director's judgment when participating in the action to be taken." This is a broad, subjective test and it would be prudent, accordingly, to err on the side of finding oneself not "qualified."
If a request for indemnification is refused, an individual may apply to court for an order requiring the organization to provide indemnification. A court may award indemnification "if the court determines, in view of all the relevant circumstances, that it is fair and reasonable," even if the relevant standard of conduct has not been met. Conn. Gen. Stat. section 33-1120.
What is the scope of the indemnification, if indemnification is required?
Indemnification in connection with a proceeding brought "by or in the right of" the corporation is limited to "reasonable expenses incurred." Conn. Gen. Stat. section 33-1117(e). In other words, if a director is charged with misappropriation and is exonerated, the director may be repaid "reasonable expenses incurred." Similarly, "reasonable expenses" must be paid whenever a director is wholly vindicated. Conn. Gen. Stat. section 33-1118. If the corporation refuses to indemnify and the individual must go to court for an indemnification order, the corporation must also indemnify the individual for the expenses of obtaining the order. Conn. Gen. Stat. section 33-1120.
May the corporation advance expenses? A corporation is not required to advance expenses prior to the final disposition of a proceeding, but may advance expenses if (1) the individual furnishes the corporation a written affirmation of his good faith belief that he or she has met the required standard of conduct; (2) the individual provides a written undertaking to repay the advances if it is determined that he or she did not meet the standard of conduct (but no security or ability to pay is required), and (3) a determination is made that the facts known do not preclude indemnification for failure to meet the required standard of conduct. Conn. Gen. Stat. section 33-1119 (directors); 33-1122 (non-directors). The determination is made by the same methods used to determine where indemnification is required and what constitute "reasonable expenses" to be indemnified.) If the individual is not a director, or is not being subjected to suit by virtue of being a director, advances may go further: "to such further extent, consistent with public policy, as may be provided by contract, the certificate of incorporation, the bylaws or a resolution of the board of directors." Conn. Gen. Stat. section 33-1122.
2. Recommended Bylaw Provision.
As discussed above, indemnification may be required whether or not the organization's governing documents so provide. However, for organizations formed on or after January 1, 1997, and for all organizations wishing to incorporate an indemnification requirement into their bylaws, the following "catch-all" provision may be appropriate:
The Corporation shall indemnify directors, officers, employees and agents of the Corporation to the maximum extent permitted by law, including, without limitation, sections 33-1116 through 33-1124 of the Connecticut General Statutes. The Corporation may procure insurance providing greater indemnification to such persons as well as to volunteers, and may share the premium cost with any director, officer, employee or agent on such basis as may be agreed upon.
Note that if it is intended that expenses be advanced whenever permitted by statute, the following language should be inserted after "agents of the Corporation": "and shall advance expenses to such persons prior to the final disposition of a proceeding." Without this addition, expenses may be advanced as authorized by statute, but are not required.
3. How Often is Indemnification Necessary? Other Protections from Liability.
Federal Law Protection: The Volunteer Protection Act of 1997, 42 U.S.C. section 14501 et seq., (the "VPA"), provides that an individual who harms another by conduct engaged in as a volunteer for a nonprofit organization is not liable for and cannot be successfully sued for the harm inflicted. The organization or entity can be sued, but not the volunteer personally. Even if successfully sued (because of one of the exemptions to immunity), the volunteer is only liable for non-economic damages in proportion to the volunteer's own individual responsibility. There are also strict requirements for the imposition of punitive damages. "Volunteers" include unpaid officers and directors; "unpaid" means receiving no more than $500 per year in expenses. The Act preempts state laws unless the state specifically adopts legislation designed to avoid application of the Act.
The statute refers only to organizations exempt under 501(c)(3) and those organized and conducted "for public benefit and operated primarily for charitable, civic, educational, religious, welfare, or health purposes," but the legislative history shows that this language was intended to encompass other kinds of "nonprofits" such as business leagues and trade or professional associations. Some of the major backers of the legislation included 501(c)(6) organizations.
The VPA does not provide immunity for:
- conduct engaged in without a license when a license was required,
- willful, criminal or reckless misconduct (including hate crimes, sexual offenses, civil rights violations),
- gross negligence or a conscious, flagrant indifference to the rights or safety of the person harmed,
- negligence in the operation of a motor vehicle, aircraft, vessel or any other vehicle requiring insurance coverage or a license to operate, or
- acts committed under the influence of drugs or alcohol.
It is likely, of course, that this type of conduct will be such that no indemnification is permitted under Connecticut law, but insurance may be obtained to cover such conduct.
In addition, the VPA does not protect against claims brought directly against the organization. And finally, because of the "exceptions," such as "gross negligence," a volunteer might incur legal expenses (required to be indemnified, under Connecticut law), even if immunity is ultimately available.
State Law Protection: Under Connecticut General Statutes section 52-557m, officers, directors and trustees of nonprofit organizations exempt under section 501(c) of the Internal Revenue Code, acting in such capacity, are immune from suits brought by third parties. However, there would be no immunity under this statute if the individual engages in "reckless, wilful or wanton misconduct," or violates certain Connecticut statutes (such as failing to pay sales tax collected, Connecticut General Statutes section 12-414a, or distributing assets in violation of the certificate of incorporation, Connecticut General Statutes section 33-1105) or federal laws (such as failing to deposit withheld employment taxes). In addition, if an appropriate provision is included in the certificate of incorporation, directors' liability in the event of claims brought by or on behalf of the corporation will be limited to one year's salary (therefore, there will be immunity if the director is a volunteer). Connecticut General Statutes section 33-1026(b)(4). For example, such protection should be made available by including the following provision:
A director of the Corporation shall not be liable to the Corporation for breach of duty as a director for monetary damages in an amount in excess of the compensation received by such director for serving the Corporation during the year of such breach (or such lesser amount as may hereafter be permitted by the Connecticut Revised Nonstock Corporation Act), except to the extent such exemption from liability or limitation thereof is not permitted under the Connecticut Revised Nonstock Corporation Act as currently in effect or as the same may hereafter be amended.
A more specific provision might provide:
A director of the Corporation shall not be liable to the Corporation for breach of duty as a director for monetary damages in an amount in excess of the compensation received by such director for serving the Corporation during the year of such breach (or such lesser amount as may hereafter be permitted by the Connecticut Revised Nonstock Corporation Act), if such breach did not (A) involve a knowing and culpable violation of law by the director, (B) enable the director or an associate to receive an improper personal economic gain; (c) show a lack of good faith and a conscious disregard for the duty of the director to the corporation under circumstances in which the director was aware that his conduct or omission created an unjustifiable risk of serious injury to the corporation, or (D) constitute a sustained and unexcused pattern of inattention that amounted to an abdication of the director's duty to the corporation, and except to the extent such exemption from liability or limitation thereof is otherwise not permitted under any subsequent amendment or revision of the Connecticut Revised Nonstock Corporation Act.
4. Directors' and Officers' Liability Insurance ("D&O" coverage).
Corporations are specifically authorized by statute to procure "directors' and officers' liability insurance" insuring directors, officers, employees or agents against liability asserted against or incurred by the individual in such capacity or arising from such status. Conn. Gen. Stat. section 33-1123. Purchase of such insurance is strongly recommended.
The policy will usually apply only to claims brought against an individual because of his/her relationship (such as by serving on the board), or to claims by the organization when it is required to indemnify the individual. Such policies will usual pay for any "loss," that is, any damages required to be paid by the "covered person" (or required to be indemnified by the organization), and reasonable expenses of defense (which may or may not require the use of the company's attorney). The organization may pay for this kind of insurance even though in a sense it "benefits" private individuals, the directors, officers, or others, without any effect on its tax-exempt status. The value of the insurance will be included as compensation when determining whether the individual's overall compensation is "reasonable," however. (For a discussion of the "excess benefit" rules that applies to 501(c)(3) organizations, see my article, "How to Stay Out of Trouble Under the Excess Benefit Rules," lawyer version (PDF) or user-friendly version.)
However, protection provided by D&O insurance is only as good as the policy. All too often, the policy specifically exempts the very conduct or situations for which protection is needed. Policies often exclude coverage for the following unless it is possible to negotiate a specially written policy or endorsement:
Fines and penalties, punitive or exemplary damages, including multipliers such as the excess part of triple damages claims. Claims involving deliberate dishonesty. Willful violations of law. Violations of environmental laws. Violations of ERISA (claims arising out of pension or other employee benefit plans). Claims of "bodily injury" or other physical damage (sometimes including claims of "intentional infliction of emotional distress"). Claims of knowing libel or slander. Willful violation of penal statutes or ordinances. Sexual harassment claims.
Generally, if the policy does not cover a claim, the insurance company also will not defend against it. The point is that in many cases a good agent can persuade the company to add a "rider" that will solve the problem, but every policy should be read on its own. (Of course, when applying for coverage it is important to disclose all information requested to prevent a later denial of coverage for an incomplete or fraudulent application.)
Copyright 2003, 2006 Lisa Nachmias Davis. All rights reserved.
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