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Recent Decision Highlights Potential Personal Liability of Hospital Directors Based on Breach of Fiduciary Duty

10.26.2018

In a recent case, a federal bankruptcy court in Michigan reviewed important questions involving breach of fiduciary duty and the application of the business judgment rule to both management and volunteer board members of a nonprofit hospital. In that case, the liquidating trust for bankrupt Cheboygan Memorial Hospital filed a lawsuit alleging negligence and/or breach of fiduciary duty by the former officers and directors of the hospital. The trust claimed that defendants had failed to address losses from its employed physician practices; failed to address billing and coding issues; failed to ensure adequate control over financial issues allowing the financial statements to overstate the hospital’s revenues; improperly approved the quick sale of a joint venture home health agency for less than fair market value in order to meet payroll; allowed excessive senior management turnover to continue; permitted excessive compensation to physician board members; and allowed a conflict of interest when the hospital refinanced $4.3 million in long-term debt with a bank whose president was a hospital director. CMH Liquidating Trust v. Anderson, Case No. 12-20666, Chapter 11, Adversary Proceeding No. 14-02020 (August 2, 2018).

Michigan Bankruptcy Court Decision. In ruling on the defendants’ motion to dismiss, the court dismissed certain claims but also found that the plaintiff had stated sufficient facts to proceed against the hospital’s interim CEO and five directors. The court found that one director had a conflict between her role as a director and service as president of the bank which loaned the hospital money, and that a physician director was not disinterested because he received excessive compensation for his board service. In addition, the court permitted the case to proceed against three other directors whom the plaintiff alleged were not volunteer directors. These directors all allegedly served on the board at the time of the sale of the joint venture and allowed the payments to be made to the bank. The court dismissed all claims against the other volunteer directors, holding they were immune from liability based on certain exculpatory language in the hospital’s articles of incorporation, as permitted by Michigan statute.

The court reviewed the business judgment rule, which creates a presumption that in making a business decision, directors of a corporation are protected if they acted on an informed basis, in good faith, and with the belief that the action was in the best interests of the company. However, this rule only protects disinterested directors. Moreover, if the plaintiff can show that defendants were given actual notice of the need to take action, this rule provides no protection where directors have abdicated their authority or simply failed to act.

North Carolina Law. Although the North Carolina Nonprofit Corporation Act (the Act), at N.C. Gen. Stat. § 55A, does not use the word “fiduciary” – which was removed to avoid potential confusion between the fiduciary standards applicable under trust law and those in corporate law – the Act imposes the duties of good faith, loyalty, and due care on directors. Like the relevant Michigan statute in CMH Liquidating Trust, the Act requires the directors of a nonprofit corporation to discharge their duties as a director and a committee member:

  • in good faith;
  • with the care an ordinarily prudent person in a like position would exercise under similar circumstances; and
  • in a manner the director reasonably believes to be in the best interests of the corporation.

A director is generally entitled to rely upon information and reports prepared or presented by officers and employees of the corporation, legal counsel or accountants, and board committees if the director reasonably believes they are reliable and competent in the matters presented, unless the director has actual knowledge that makes such reliance unwarranted. Consequently, directors of a nonprofit hospital may not serve as a mere figurehead; instead, they must affirmatively exercise due care in fulfilling their duties as director.

The Act contains a number of provisions which address potential liability of directors. A director shall have no personal liability for any action taken as a director if he performed his duties in compliance with the statute cited above. On the other hand, the corporation may not hold harmless or indemnify a director unless the board of directors determines that the director (1) conducted himself in good faith; (2) reasonably believed that his conduct in his official capacity was in the best interests of the corporation; and (3) in a criminal proceeding, had no reasonable cause to believe his conduct was unlawful.

Personal Director Liability Under N.C. Law. Although the North Carolina courts have recognized the “business judgment rule,” Hammonds v. Lumbee River Elec. Mbrshp. Corp., 178 N.C. App. 1, 631 S.E.2d 1 (2006), review denied, 360 N.C. 576, 635 S.E.2d 598 (2006), this rule has its limits. While a nonprofit corporation’s articles, per the Act, may ostensibly protect a director from personal liability for monetary damages, the director may still be personally liable:

  • if the director knew at the time that the act or omission was clearly in conflict with the best interests of the corporation;
  • the director derived an improper personal financial benefit from the transaction; or
  • if the director consented to an improper loan, guaranty or other security, or consented to a distribution made in violation of the Act or the corporation’s articles of incorporation.

While Michigan had an unusually strong exculpatory statute for volunteer directors, the N.C. provision is narrower than the Michigan statute. Unlike in Michigan, N.C. law permits liability against a director who is aware that an action is not in the best interests of the corporation, even if the director has neither received direct financial benefit nor intentionally inflicted harm on the corporation.

The lessons from the CMH Liquidating Trust case are not limited to situations involving bankruptcy. The court’s decision shows that hospital directors must recognize their duties, act in good faith and in the hospital’s best interests, and avoid any potential conflict of interest. Volunteer directors in North Carolina with actual knowledge of a problem who fail to take action to address such issues are well advised not to rely on the business judgment rule or limited statutory immunity.

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