Nonprofits in the zone of insolvency: two cautionary tales

May 07, 2015

Nonprofit Organizations Alert

Author(s): Michael J. Cooney, Christopher M. Desiderio, Victor G. Milione, Robert G. Trott

Earlier this year, the Third Circuit Court of Appeals served notice that the nonprofit corporate structure does not fully insulate trustees and senior management from personal liability for breaches of their fiduciary duties when such nonprofit is on the verge of insolvency. In re Lemington Home for the Aged, 777 F.3d 620 (3d Cir. 2015) (“Lemington III”). In Lemington III, the court not only upheld a jury verdict of $2.25M against former directors of the nonprofit, but also upheld punitive damage awards of $1M and $750,000 against the former CFO and home administrator, respectively. Based on the egregious facts presented at trial, it is easy to understand why the court felt compelled to impose personal liability where directors either participate in a breach of fiduciary duty, or are aware of such breaches and fail to act to correct the breach.

Shortly after Lemington III was decided, on March 3, 2015, Sweet Briar College interim President James Jones gathered faculty and staff in the school chapel to tell everyone that the graduating class of 2015 would be the College’s last. In the two months since the announcement, the College has been through a whirlwind of judicial activity: first, a court has refused to issue an injunction to prevent the school from closing, then a court issued an injunction to prevent the school from selling any of its assets for six months, and finally a court has allowed a suit filed by a 2007 graduate to proceed, which opens the door for more potential lawsuits. A grassroots movement called “Saving Sweet Briar College” has purportedly raised $10M to help keep the College open. College representatives claim shutting the doors is the only option given the current financial struggles and a vastly changed educational landscape, while the opposition claims there is no immediate financial need to close the College, and that viable options exist for improving the College’s financial situation going forward.

The zone of insolvency

Like for-profit businesses, nonprofit institutions run into financial troubles. Their lack of access to equity capital is both a blessing and a curse in such circumstances. While there are no shareholders to shoulder the financial burden of bankruptcy, there are many other constituencies (from attorneys general to donors, employees and local government) who claim a legal interest in the future of the nonprofit, and thus stand ready to challenge board decisions made close to or at the “zone of insolvency.” See Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. Dec. 30, 1991). This dilemma is one that most fiduciaries would like to avoid.  Particularly in nonprofit institutions, directors can be so closely committed to the mission of the nonprofit, financial considerations sometimes take a back seat. Therefore, a decision to wind-up corporate affairs when it is financially viable to do so is constantly counter-balanced by the ever-present optimism that an institution might be saved just one more time.

The “zone of insolvency” exists where a corporation is on the verge of insolvency—or is likely to become insolvent as a result of a transaction that will leave the entity with unreasonably small capital—but is not yet insolvent. The two primary standards of insolvency are: (i) the equitable insolvency test, which considers an entity to be insolvent when it is unable to pay its debts as they become due; and (ii) the balance sheet insolvency test, which considers an entity to be insolvent when its total liabilities exceed its total assets.

As originally conceived, the zone of insolvency was an abstraction that created an expanded window of time during which creditors could assert claims against a corporation’s board and directors for breaches of fiduciary duties before the corporation was technically insolvent. Credit Lyonnais, WL 277613 at 34. More importantly, it expanded the scope of the fiduciary duties owed by a corporation’s managing officers and directors from solely the shareholders to also include the corporation and creditors of the corporation. Lyonnais, WL 277613 at 34 n.55. Prior to the Credit Lyonnais case, courts generally considered the point of actual insolvency as the point where fiduciary duties shifted from equity holders to creditors (in a for-profit venture) and from the entity’s mission to creditors (in a nonprofit venture), since insolvency represented the point where shareholders no longer had a cognizable interest in the assets of the corporation.

The nebulous zone of insolvency demands the exercise of proper corporate governance, but for whose benefit? Lemington III is a warning that the zone of insolvency can span years, during which the directors’ actions will be closely scrutinized. Sweet Briar, on the other hand, is a demonstration of the difficulties directors face when they perceive the rapid approach of financial calamity and act as they see fit.

Lemington Home for the Aged

Lemington III describes a fiduciary situation out of control. The Lemington Home for the Aged was a nonprofit corporation that provided residential care to the elderly, dating back to 1883. In addition to being cited for three times the number of average nursing home deficiencies in some years, Lemington was insolvent by 1999. Conditions continued to worsen, financial and billing records were in chaos, payroll deductions withheld for employee benefits were not being remitted, and several hundred thousand dollars in receivables went unbilled annually.

An independent review resulted in a recommendation that the administrator be replaced and the board successfully obtained a grant to fund the search for a new administrator, but the money was never used. The administrator remained and even took a part-time job while collecting her full salary from Lemington in direct violation of state law. Attendance at board meetings was regularly less than fifty percent of the members, minutes were inadequate, and the board provided little to no oversight of the Home’s management. For example, even in light of the troubles at the Home, a finance committee was never formed and the treasurer position went unfilled. Moreover, the CFO did not maintain customary financial records and such failure was known to the board. Finally, two residents died because of the Lemington’s insufficient care in 2004.

The board’s and management’s malfeasance and nonfeasance continued. For example, the board voted to close the home in January 2005, but did not file for Chapter 11 bankruptcy until three months later. The board refused to commission a viability study. The CFO proposed a sale of Lemington to an organization of which he would be president and CEO.

Even in times of this financial and operation turmoil, Lemington continued to contract with vendors. More than $400,000 in receivables went uncollected. There was no pre-bankruptcy communications with creditors or the bankruptcy court about winding down and other issues.

As a result of these issues, the Official Committee of Unsecured Creditors (the “Committee”) commenced an adversary proceeding on behalf of the Home for breach of fiduciary duty of care and loyalty and “deepening insolvency.” While the officers and directors successfully moved for summary judgment in district court, the court of appeals vacated the district court’s grant of summary judgment and the case moved forward until the decision in Lemington III.

Sweet Briar College

Sweet Briar posted a statement on its website citing unsustainable tuition discount rates and declining interest in rural, liberal arts colleges—and single-sex institutions in particular—as primary causes of the financial difficulties prompting the College to close its doors. Evidence supports this claim, including a precipitous drop in female-only colleges over the past fifty years, falling enrollment numbers at Sweet Briar over the past five years, and a tuition discount rate that has increased from 40% to nearly 60% since 2009. More than 75% of the College’s $85 million endowment is restricted, it has $25 million in debt, and $28 million in maintenance costs, in addition to other expenses. All told, Jones claims Sweet Briar needed more than $200 million to stay afloat.

Some alumnae do not agree and seem particularly upset that the college never gave an indication of trouble or that insolvency loomed. Jones claimed a warning would have expedited insolvency because no one would choose to attend and those who were already enrolled would have fled. Alumnae counter that the College’s graduates could have made a difference had they known and that school administrators chose to let the College’s financial situation worsen rather than make an effort to save their beloved alma mater. Interestingly, the overwhelming majority of the board that voted unanimously to close Sweet Briar were graduates of the College.

Nonprofits in the zone of insolvency

The Sweet Briar situation typifies more nonprofits’ struggles than does Lemington III. But each demonstrates a fiduciary reaction (or lack thereof) to vexing issues that arise at the zone of insolvency. At its core, Lemington III teaches us that doing nothing when confronted with fiduciary breaches in this zone is not an option. The elevation of personal self-interest in such situations is almost a certain trap for fiduciaries.  Sweet Briar teaches us that even when it seems clear to directors that they are in the zone of insolvency and express their desire to act in the best interest of the nonprofit, reasonable minds may differ. Those minds might be angry and have standing granted by a court to file suit.

This raises troubling issues for nonprofits who might be in or near the zone of insolvency. Most fiduciaries have little exposure to insolvency or bankruptcy in their daily lives, so have no particular perspectives to bring to those issues in the charitable context. Government funding, charitable pledges and appropriation of donor restricted assets are each special concerns in the nonprofit context. For nonprofits that have been living with razor-thin margins for years, or even repeated deficit budgets, it becomes difficult to assess the existence of the zone of insolvency without outside assistance. And the government provides little support: the Department of Education tests to measure whether an institution is fiscally stable enough to participate in federal student loan programs gave Sweet Briar a perfect score just at the time that the governing board was seeing compelling reasons to close.

Unexamined proclamations about adherence to the duties of care, loyalty and obedience to corporate purposes are severely tested in this environment, as fiduciary duties shift once in the zone of insolvency. Good counsel requires experience in both the nonprofit corporate and creditors’ rights areas. Some state statutes even extend the legal right to challenge board decisions to creditors, so that fiduciaries of entities incorporated in New York or Pennsylvania are subject to greater personal exposure than those formed in Delaware.

How to avoid being Lemington IV

In light of Lemington III, how can directors best protect themselves? First, the board should be trained and advised of their fiduciary duties—whether or not they are operating in the zone of insolvency—including understanding the institution’s financial position and whether it could be in such zone. Access to legal counsel familiar with these issues is a practical necessity, and helps to demonstrate the satisfaction of fiduciary duties. The governing board should well understand the reach of state statutes on statutory exculpation of charitable fiduciaries as well. Further, transactions between affiliates should be formalized and at arm’s-length to the greatest extent possible. Significant financial expenditures should be given heightened consideration. Donor-restricted gifts, tax trust accounts and other restricted funds should not be re-purposed for general obligations. In situations where a conflict between duties may arise, it may be appropriate to consult with the attorney general’s charities bureau.

When in the zone of insolvency, directors should take all efforts to avoid the following: failing to collect receivables diligently; allocating funds to new, major capital projects; entering into new lines of services on a speculative basis; providing unreasonably lucrative pay or benefits to management; taking actions for the sole benefit of the parent entity in a multi-corporate nonprofit system; entering into transactions that principally benefit individual directors; or approving loans on non-market terms. Each of these actions alone could give rise to personal liability.

Lemington Home and Sweet Briar College represent very different points along a continuum, but we should expect that they will have more company along that narrow tightrope in the not too distant future. Charitable fiduciaries should educate themselves now on these unique issues, before they find themselves in the zone of insolvency.

The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.

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