Nonprofits and the Zone of Insolvency – Part Two

Earlier this fall, I wrote a post about Ron Mattocks' book: Zone of Insolvency: How Nonprofits Avoid Hidden Liabilities and Build Financial Strength.  Here are some questions and answers from the media kit associated with the book:

What are three steps on (sic) organization must take immediately upon realizing they've drifted into the zone of insolvency?

First the board and management team must come together and admit that they have a problem, i.e. that they have have wandered into the Zone of Insolvency.

Second, they must make a decision that they will not continue in the Zone of Insolvency, and every decision and every action moving forward must demonstrate their commitment to move out of the Zone of Insolvency.

Third, they must identify the behaviors that have allowed their organizations to drift into the Zone of Insolvency, and work consciously to change those patterns of behavior.

What does a board member need to know, legally, when it's operating [in the] Zone of Insolvency?

In principle, corporate law reduces individual liabilities for actions made when sitting on a corporate [board].  Various state laws offer some additional protections for those serving on nonprofit boards.  But there are limits to all these protections, and there has never been a time in history when nonprofit board members have such a high risk of being sued for their volunteer work on the board.  When governing in the Zone of Insolvency, a board should have special legal counsel to assure that no action benefits one party of interest while disadvantaging another.  And it is absolutely critical that adequate D&O Insurance be in force when governing a financially distressed organization.

In what ways must the board members of an organization operating in the Zone of Insolvency demonstrate a new level of commitment to the fiscal condition of the nonprofit?

The prudent board will understand that it is too risky to remain in the Zone of Insolvency, and will decide to move out of the zone.  Every action of the board moving forward should be a proof of the commitment to escape from the zone.  There are only three ways out: a financial turn-around, a merger, or filing for dissolution.  The board that chooses the financial turnaround must understand the risks, the resource requirements, and reasonable timelines.  The board that cannot accept the risk associated with a financial workout should opt for a merger or dissolution.

How has the legal arena changed for nonprofits in the past 20 years in terms of the obligations of board members in regards to the Zone of Insolvency?

The issue is increased accountability for boards of all corporations, including nonprofit boards, coming out of scandals such as Enron, United Way, Baptist Foundation of Arizona, WorldCom and others.  Sarbanes Oxley, the California Nonprofit Integrity Act of 2004, and the Zone of Insolvency all run parallel tracks pushing for increased corporate accountability.  As a result, there has never been a time in history when a nonprofit board member has been so likely to be sued in the course of his or her volunteer board work.  In 1992, the courts identified the Zone of Insolvency, making the governance of a financially distressed organization especially risky.  The nonprofit culture that tolerated or encouraged living in financial distress in years past is a very risky proposition in today's litigious environment.

Read Part One of this post here.