Corporate Law & Governance Update - September 2018

by McDermott Will & Emery
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College Football and Corporate Governance

The recently released internal investigation report on the Ohio State football program provides an interesting window into the oversight of workforce culture issues involving senior executive officers of a large organization (in this case, a very successful college football coach).

The focus of the investigation was whether (in connection with the hiring, retaining, supervising and firing of an assistant coach) the head coach violated any law, rule or ethics regulation. The investigation was prompted by concerns that the head coach had been inattentive over a period of time to the allegations of domestic violence raised against the assistant. The circumstances were exacerbated by the personal relationship between the head coach and the assistant coach’s grandfather, and by the head coach’s widely criticized press conference responses. Ultimately, although the head coach was essentially exonerated, the board chose to suspend him for several games.

There are several notable lessons for health systems in the investigative report. For example, the concept of executive “independence” when it comes to discipline of close subordinates should be viewed broadly (e.g., should the head coach have been responsible for the conduct of an assistant with whom he had strong personal ties?) Senior executives should be cautioned about the need for absolute clarity and honesty in public remarks regarding controversial topics (e.g., misstatements by the head coach in a press conference contributed significantly to the controversy). Management should be directed to interpret corporate policies more in the content of their spirit, not simply “black letter” (e.g., there was concern that the head coach interpreted a particularly important university policy too narrowly). The CEO should make certain that she/he is promptly informed of material legal allegations against key subordinates (e.g., there were concerns that important information about the assistant coach’s conduct did not reach the head coach). In addition, policies prohibiting obstruction and document destruction should be expanded to include deletion of emails during the pendency of investigations (e.g., changing the message history setting on the head coach’s phone apparently had been considered).

The Accountable Capitalism Act

A series of recent developments suggest that corporate governance could become a political issue in the 2018 election, for the first time since 2002 and the Enron/Sarbanes environment.

The most significant of these developments is Senator Elizabeth Warren’s introduction of The Accountable Capitalism Act. This controversial new legislative proposal is intended to address concerns that corporations have become overly focused on maximizing return to shareholders. A key element of the proposal is the requirement that corporations with more than $1 billion in annual revenue obtain a federal charter. In the Act’s current proposed form, there is no exemption for nonprofit corporations with more than $1 billion in revenue, even though the proposal seems styled for publicly traded companies.

The terms of this charter would require directors of chartered companies to consider not just the interests of shareholders, but those of employees, customers and the communities in which those corporations operate. Specifically, a US corporation must have the purpose of creating a “general public benefit,” meaning a material positive impact on society resulting from the company’s business and operations, taken as a whole. The proposal also provides that at least 40 percent of the corporation’s directors must be selected by employees, under rules to be established by the US Securities and Exchange Commission (SEC). Notably, state attorneys general would be authorized to submit petitions to the new Office of United States Corporations to revoke a charter based on a history of egregious and repeated illegal conduct and a failure to take meaningful corrective action. Senator Warren comments that this proposal is based in part on concepts reflected in the benefit corporation model that 33 states have adopted.

The Warren proposal should be viewed together with the corporate social responsibility initiatives in the for-profit sector, statutory diversity quota proposals, and the possible influence of provisions of the new UK governance code. All appear to be possible topics for public discourse in the upcoming 2020  presidential campaign. Health system boards should also anticipate increased public discourse on themes relating to “general public benefit” and a broader corporate constituency, and how those issues affect governance.

More University of Louisville Foundation

The evolving circumstances involving the University of Louisville Foundation continue to provide valuable legal compliance lessons to nonprofit, tax-exempt organizations.

The most recent development is news reports that the Internal Revenue Service (IRS) notified the foundation on August 24, 2018, that it has been selected for an audit. According to the reports, the audit will focus on allegations relating to mismanagement and excessive executive compensation. The foundation had previously notified the IRS of the findings of its internal investigation into executive compensation, and promised to submit forms that reflect previously unreported excess benefit transactions involving its former CEO and other officials, according to prior media reports.This is occurring against the backdrop of civil litigation filed by the foundation against certain former officers seeking repayment for what the foundation alleges to be excessive compensation paid to them while under the foundation’s employment. The ongoing saga involving the foundation is generally considered to be one of the most prominent national controversies in recent years involving the business and operations of nonprofit corporations.

The scope of the audit is unlikely to be made part of the public record. However, it is fair to assume that the scope will include the possible application of penalty excise taxes under the Intermediate Sanctions rules of the Internal Revenue Code. Revocation of exempt status—while theoretically an available remedy—would be surprising given the foundation’s extensive, publicly reported efforts over the last year to restructure its governance, executive leadership and financial/compensation practices to address past perceived abuses. However, nonprofit health systems should note the existence of the audit as evidence that the IRS remains attentive to compliance issues arising within tax-exempt not-for-profit corporations.

The Enforcement Authority of State AGs

A complaint recently filed in state court by the Florida attorney general (AG) provides a useful example of the enforcement powers available to the AG to address allegations concerning the governance and financial accounting of not-for-profit corporations.

The controversy involves a corporation formed to preserve a landmark theater in Winter Park, Florida, and the actions taken by its board and management to pursue such preservation. The AG’s specific concern relates to allegations regarding mismanagement, violations of bylaws, inadequate financial recordkeeping, inaccurate board-level minutes, unsupported financial arrangements with the CEO, and the board’s unwillingness to consider alternatives that would enhance the theater’s financial stability.

This litigation’s most direct relevance to nonprofit health systems is twofold. First is the broad assertion of jurisdictional authority over nonprofit corporations in the state. It is an assertion (e.g., powers under both common law and under statute) that is likely to be adopted by most other state AGs in similar enforcement actions against a not-for-profit corporation. This includes an assertion of the public as having an equitable beneficial interest in the theater.

Second is the scope of the equitable relief sought by the AG, i.e.:

  • Immediate appointment of a receiver over all of the property, business and affairs of the not-for-profit corporation (which indeed occurred)
  • Pursuant of equitable accounting bookkeeping and other financial records 
  • Injunctive relief to prevent the corporation from specified financial actions 

Implicit in this requested relief is the state’s focus on what appear to be breaches of fiduciary duty by the corporation’s board and management.

Financial Stewardship and the Latest Moody's Report

The special research report on not-for-profit health care published on August 28, 2018, by Moody’s Investors Service is useful reading for all board members, not just for those who serve on the finance committee.

The special report, “Operating Pressures Persist as Growth in Expenses Exceeds Revenue,” concludes that “not-for-profit and public hospitals continue on an unsustainable path as the median annual expense growth rate continues to exceed the median annual revenue growth rate, driving the second year of significant margin contraction.” The rate of revenue growth is expected to remain pressured, notwithstanding indications that increased M&A activity will support “absolute growth.” This is due to expected decline in reimbursement increases, slower demand and growth in reimbursement from governmental payors. Greater dependence will be placed on investment income, revenue cycle management and cost reduction strategies.

Not all directors are expected to be financial experts to any degree, and there is no expectation that the entire board be familiar with the financial detail typically contained in special reports from credit ratings and other investor service firms. But as financial stewards of the organization, the entire board (not just the financial committee) should be briefed on conclusions and projections contained in well-prepared reports from reliable industry experts such as Moody’s. This is particularly the case when the report reflects financially significant trends and developments.

It is certainly acceptable that the CFO summarize such conclusions and projections for the full board, in an understandable manner. Such information is often best provided in the broader strategic and competitive context—i.e., increasing pressures on the inpatient hospital model, and the fact that competing for-profit and nonprofit hospitals are similarly affected by these trends.

Responding to Unusual Executive Behavior

Recent news reports about executive departures and erratic CEO behavior at Tesla underscore the board’s fundamental obligation to exercise oversight of the CEO and senior management in operating the company’s business.

According to multiple news reports, in recent weeks the CEO has:

  • Engaged in accusatory communications with certain segments of the investor sector
  • Made erratic comments in an interview with The New York Times
  • Issued a tweet about possibly taking the company private, which prompted an inquiry from the SEC (concerned that he was misleading investors)
  • Reportedly refused to heed board directions to stop communicating by Twitter
  • Appeared to smoke marijuana in an interview posted on YouTube 

In addition, the company’s newly hired chief accounting officer quit after barely a month on the job (citing discomfort with the public attention on the company and its pace), and the head of human resources declined to return after the end of a leave of absence. Earlier this year two other senior executives departed, and the company has experienced notable turnover at the vice presidential level. Furthermore, various board members have hired outside counsel to advise them in connection with some of this turmoil.

Monitoring and evaluating the CEO’s performance and overseeing talent development are two particularly critical board functions. Their importance is not lessened when the CEO is well known and widely regarded as a visionary, as is Mr. Musk. Indications of erratic and undisciplined CEO behavior, and evidence that such behavior is creating material distractions for the company and possibly affecting its value and reputation, are warning signs that may prompt a board to take action. While the range of possible action is at the board’s discretion, the oversight responsibility in such circumstances can be seen as unequivocal.

Mandated Board Gender Diversity

The board’s nominating committee should note two recent developments regarding board diversity that arise (significantly) from legislative and regulatory sources.

The first development is the progress of California SB 826, which, if enacted, would require public companies headquartered in the state to maintain a prescribed level of gender diversity. The bill was approved by the state legislature and requires the final approval of the state senate before going to the governor for signature. The bill provides for an escalating level of women on the board, with at least one woman member by December 31, 2019, and by December 31, 2021, at least two women (for boards with five or fewer directors) and three women (for boards with six or more directors). Penalties are applicable for non-compliance.

The second development is the New York City Pension funds’ August 2018 release of a compendium of so-called “best practices” in board matrices included within the 2018 proxy statements of US public companies. The disclosures contained in the compendium are intended as guides for explaining how company directors are uniquely qualified for specific board service, and how the board has achieved racial and ethnic diversity. The compendium was developed as part of the New York City Comptroller’s Boardroom Accountability Project 2.0 initiative, which is focused in part on supporting the appointment of women and persons of color as corporate directors.

These two developments are notable in the broader national movement towards board diversity. The enactment of SB 826 could trigger similar legislative initiatives in other states. The compendium could be a useful reference to nominating committees in their application of diversity factors in the nominating process.

Compliance Lessons from Monitor's Report

The interim report of the Independent Compliance Monitor appointed for a major manufacturing company reflects the challenges associated with resurrecting a previously discredited compliance program and changing corporate culture—and includes a harsh demonstration of individual accountability principles.

The US Department of Justice appointed the Monitor in connection with a 2017 plea agreement relating to, among other matters, claims that the company engaged in a conspiracy to violate the Clean Air Act. The interim report’s purpose was to evaluate the extent of the company’s compliance with the terms of a civil settlement with the United States, and its progress toward becoming a more ethical company.

The Monitor had not yet reached any conclusion as to whether the company had complied with the terms of the settlement. It did, however, note that some long-time members of senior management remained “in denial” of the enormity of the scandal, that the process of implementing internal controls had been delayed, that the whistleblower program had yet to become effective, and that the company had been insufficiently transparent with the Monitor (in part because the company had long enjoyed a prominent corporate status in its home country).

The Monitor was indirectly critical of the company’s decision to support an imprisoned executive, commenting that in its experience, “one of the cornerstones of any effective ethics and compliance effort is the organization’s willingness to hold itself and its executives, especially top executives, accountable for wrongdoing.”

The scrutiny applied by the Monitor may serve as a prompt for companies whose current compliance programs fall short of major indicia of effectiveness.

NFL, Nike and the Business Judgement Rule

Nike’s recent decision to feature Colin Kaepernick in its advertising campaign has yielded interesting academic commentary on the application of the business judgment rule, which is relevant to health care system boards.

The Kaepernick-based ad campaign decision was subjected to substantial public controversy following its release, and the company’s stock price suffered some initial decline as a result. This prompted questions regarding the board’s role in the decision and the extent to which any such involvement merited business judgment rule protection. According to a leading business law professor, any such board involvement should be viewed as entirely consistent with the rule.

The professor based his observation on the assumption that the board was probably made aware of the Kaepernick decision in advance, even though the board likely delegates major advertising decisions to senior executives. In such a situation, the delegation itself is likely justifiable under the business judgment rule, given the historical success and sophistication of Nike’s advertising program. Corporate law makes it very clear that directors are entitled to rely on the honesty and integrity of their executives and other managers, unless they have information to the contrary. Here, the directors were clearly comfortable with management’s role.

Many significant corporate decisions (e.g., marketing or advertising campaigns) are inherently subject to risk—especially decisions that may be progressive or likely to invite controversy that could harm corporate reputation. Nevertheless, the board’s decision to delegate that decision-making authority to senior management can be structured to satisfy the business judgment rule.

The discussion regarding the Nike campaign is a topical example that can remind the health system board not only about the valuable scope of the business judgment rule, but also of the need to ensure that appropriate processes are in place when major decisions are being made (including a decision to delegate), to help support a claim to such protection.

The GC and the Code of Culture

The importance of general counsel oversight of the health system’s code of conduct is becoming increasingly critical, given the extent to which the code is used to evaluate the appropriateness of executive conduct and certain emerging controversies surrounding such use.

The corporate code of conduct has been thrust into the spotlight as the platform from which many prominent corporate leaders have been terminated because of allegations of egregious personal behavior. According to one news report, more than 670 senior executives and employees have been accused of engaging in harassment or other misconduct-based code of conduct violations over the last two years, with many of them leaving their company as a result. A separate report from The Wall Street Journal suggests that some of these executives are challenging the allegations through litigation or other high-profile public means.

It is of course critical that corporations have the ability to punish aberrant employee and leadership behavior. Codes of ethics and conduct are key tools by which the board can exercise its oversight responsibility for workforce culture and, by extension, promote talent development and protect the corporate reputation. Yet the recent public discourse has raised some concern that the code may be a flawed means of evaluating conduct—that it is fundamentally a general statement of expectations and was never intended to be used for such consequential purposes. If left unaddressed, these and other issues can limit the effectiveness of the code of conduct and frustrate the board’s ability to exercise workforce culture oversight. Flawed procedures also can cause constituents to lose confidence in the equity applied in the interpretation of the code. Addressing possible code weaknesses is consistent with the board’s oversight duty.

The general counsel is the logical corporate officer to guide the board in its evaluation of code of conduct effectiveness. She knows the legal risks to the organization posed by flawed code enforcement. She appreciates the value of precise document language and intent. She is experienced in coordinating issues with other corporate officers (e.g., chief human resource officer, chief compliance officer). Most importantly, she understands the long-term organizational value created by a positive and protective workforce culture.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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