The Third Circuit Court of Appeals recently upheld a trial court’s jury verdict finding the individual board members and officers of a non-profit healthcare facility personally liable to the facility’s creditors. The board members had a false sense of security based upon the incorrect notion that board members of non-profit organizations, most of whom serve in these roles as volunteers, and officers of non-profit organizations are held to a lower standard of accountability than their counterparts at for-profit organizations. In the case,Official Committee of Unsecured Creditors ex rel. Lemington Home for the Aged v. Baldwin et. al, the appellate court disabused them of this notion and upheld the jury’s award of $2.25 million against the officers and directors for breach of fiduciary duty and further awarded $1 million and $750,000 in punitive damages against two of the facility’s officers. No. 13-2707, at *1 (3d Cir. Jan. 26, 2015).

Lemington was a Pittsburgh-area nursing home with a track record of deficiencies and regulatory citations, egregious financial mismanagement, and self-dealing. For example, before the facility’s bankruptcy filing, the chief financial officer (CFO) unilaterally sought to negotiate a sale of the facility that would secure his employment as president and chief executive officer of the purchaser. The CFO also lied to the board of directors about providing the creditors committee with requested financial information and failed to cooperate with the request. During the facility’s operation, various vendors terminated contracts with the facility due to nonpayment of bills. Further, the CFO failed to keep a general accounting ledger and, arguably most flagrantly, failed to bill Medicare, resulting in a failure to collect approximately $500,000. In light of the foregoing, the appellate court found that the CFO breached his duty of care and his duty of loyalty to the facility. The CFO’s self-dealing was used to support the punitive damages award against him.

The facility’s administrator further added to the facility’s incompetent management and dysfunction. The administrator failed to ensure that vendor contracts were in place and managed financially, failed to maintain the facility’s compliance with federal and state regulations, and continued to serve and accept compensation as the full-time administrator after transitioning to part-time status, in violation of Pennsylvania law. Like the CFO, the administrator also engaged in improper self-dealing by collecting a full salary in spite of working only part time and diverting grant money provided to the facility by a community foundation earmarked specifically for her replacement. The appellate court found that the administrator breached her duty of care and her duty of loyalty to the facility. As with the CFO, her self-dealing was used to support the punitive damages award against her.

The facility’s board of directors had sufficient warning of the trouble the facility faced due to mismanagement by the CFO and administrator. The recurrent themes in the reviews and recommendations from the numerous consultants and regulatory authorities evaluating the facility’s operations were clear – among other glaring defects, the administrator was not qualified to adequately manage the facility and the facility’s employees needed to be replaced. Despite numerous admonishments that the administrator lacked the necessary experience, knowledge, and qualifications to function in such a role, and the $175,000 grant provided to hire a new administrator as well as to help with the administrator’s transition to part-time status, the board still did not act to replace her. Furthermore, the board of directors failed to fill the vacant treasurer position and appoint any members to the finance committee, which contributed to the lack of financial oversight of the facility and the facility’s CFO. In light of the evidence against the board of directors, the appellate court upheld the jury’s finding that the directors failed to exercise the requisite standard of reasonable prudence and care over the facility’s operations in breach of their fiduciary duty. However, the appellate court did not find that the board’s actions met the requisite state of mind standard evidenced by self-interested conduct like that of the CFO and the administrator and declined to impose a punitive damages award against the board members.

The appellate court further cited the board of directors’ and the officers’ mishandling of the facility’s bankruptcy process as consistent with the theory of “deepening insolvency” – “an injury to a debtor’s corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life.” Specifically, the board of directors’ and officers’ failure to disclose that the facility received a $1.4 million “nursing home assessment tax” payment, information that could have increased the home’s chances of finding a buyer; failure to disclose the decision to seek bankruptcy protection for three months; careless recordkeeping; inattention to patient billing; and failure to establish the opportunity to bid for assets and review financial records during the bankruptcy further undermined the facility’s value and deepened the insolvency of the facility.

So, what’s the moral of the story? In re Lemington again puts non-profit organization officers and directors, volunteer or not, on notice that they are held to the same standards of duty, care, and loyalty as their peers at for-profit organizations. The boards of directors of healthcare organizations ought to ensure that its members include individuals with knowledge and experience to sufficiently oversee the organization’s staff, business operations, and financial health. Also, if in a state that recognizes the theory of “deepening insolvency” like Pennsylvania, the organization must be mindful of the duties owed to the organization’s creditors during insolvency.