Corporate Law & Governance Update - August 2018

by McDermott Will & Emery
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New Decision Affects D&O Liability

A recent federal bankruptcy court decision addresses important principles of fiduciary conduct (and the benefits of a state exculpatory statute) in the context of a financially distressed not-for-profit hospital.

The case involved claims of negligence and breach of fiduciary duty by members of the board and management team of a not-for-profit hospital, filed by the hospital’s liquidating trust. The claims were based on allegations that, essentially, management and the board were inattentive and unresponsive to multiple signs of financial problems (e.g., significant physician practice losses). 

The court granted a motion to dismiss with respect to the claims against essentially all of the voluntary directors, but denied the motion with respect to certain other directors who were perceived to be compensated, and to one voluntary director who was alleged to have a conflict of interest (the director was the CEO of a local bank with which the hospital had entered into a controversial loan arrangement).

The court’s opinion contains useful discussions of fiduciary duties, possible elements of negligence and the limitations of the business judgment rule (especially given well-pleaded allegations of abdication of authority or failure to act). Notably, the court relied on the exculpatory clause in the hospital’s bylaws as the basis to dismiss the allegations against the voluntary directors. 

What is particularly disconcerting from a governance perspective is that more than six years passed between the bankruptcy filing and the court’s ruling; a long period of uncertainty for the officers and directors. As with the 2015 decision of the US Court of Appeals in Lemington Homes, creditors (in whatever form) are often relentless in their pursuit of claims based on breach of fiduciary duties by directors of financially distressed entities.

New Areas of Board M&A Focus

Several new developments are worthy of board notice in connection with its oversight of the M&A process, with respect to due diligence, representations and warranties, and compliance.

One development is the increasing application of a so-called “Weinstein clause” within a definitive transaction agreement. The focus of the clause is to make a representation with respect to the personal conduct of a seller organization’s corporate leadership. In some instances it may require a form of indemnification escrow to protect against demonstrable harm. The roots of the clause are obviously found in the many corporate scandals of late involving #MeToo issues and other behavioral conduct allegations. They form a major part of what is often referred to as “social due diligence,” and not only reach matters of officer and director conduct, but also may extend to a company’s social media presence and its reputation in the online arena.

Another development relates to the situations in which a successor/acquiror company uncovers wrongdoing in connection with M&A due diligence. If the successor subsequently reports that wrongdoing to the US Department of Justice (DOJ), engages in remedial measures (e.g., extending its own compliance program to the seller) and provides cooperation in any subsequent investigation, the DOJ may provide the successor/acquiror with meaningful credit. While a senior DOJ official discussed this scenario in the context of the FCPA, the suggestion is that DOJ might apply a similar approach in other scenarios (e.g., high-risk industries).

Information Rights of Conflicted Director

A recent Delaware Court of Chancery decision offers guidance on how a corporation may best address document requests by a conflicted director whose interests were adverse to those of the company. 

The case arose from a discovery controversy between competing factions of the board of a large entertainment company. Directors associated with the controlling stockholder had requested production of certain privileged materials. This request was opposed by a special board committee formed to evaluate a transaction that was the subject of much of the controversy. The Chancellor ruled that, among other things, a director’s right to information can be limited in certain ways, including circumstances in which “sufficient adversity exists between the director and the corporation such that the director could no longer have a reasonable expectation that he was a client of the board’s counsel.”

This decision arose from litigation involving a public company and directors appointed by a controlling shareholder who had been opposed to the underlying transaction. Nevertheless, the court’s ruling may be of some relevance to boardroom controversy within a nonprofit corporation as well. There are increasing examples within the nonprofit health care sector of directors who are in a conflict of interest situation, or are otherwise adverse to the interests of the company, and who seek certain categories of corporate information to further their individual objectives. While director information rights are ordinarily interpreted as broad, there may be situations in which adversity or conflict can serve as a basis for limiting information rights. Decisions such as this recent ruling may be supportive of any health system response to such an information request.

The Importance of Board Reputation

So much is made of the board’s obligation to preserve the reputation of the corporation. A new consulting firm report suggests that the board should be similarly focused on preserving its own reputation (as a body).

Proprietary research conducted by Edelman Financial Communications & Capital Markets concludes that a corporate board actually does possess its own reputation, which should be “actively considered and managed” for the benefit of the company. According to Edelman, board reputation comes particularly into play in circumstances of corporate controversy or distress, when specific board actions come under public scrutiny and have a direct impact on public trust in the company.

The research surveyed a very targeted group: institutional investors with assets under management of more than $1 trillion. To the surveyed group, trust in the corporate board was important when making or recommending an investment. Logic suggests that the emphasis on reputation should similarly apply with respect to boards of large health systems, whether non-profit, private or publicly traded. Issues such as the qualifications of individual board members and, their relative independence, integrity and motivations, are all relevant and could affect the mission and value of the corporation. In addition, public examples of past reasonable and prudent practices of the health system board (especially in times of corporate crisis or stress) may provide comfort to health system constituents and regulators.

As the report suggests, the health system board may wish to give closer consideration of the steps it can take to substantiate its own reputation within the context of the overall focus of the corporation and the activities of the senior leadership team. Nonprofit status should not be a limitation on such efforts.

(More) New Developments on Board Diversity

The board’s nominating committee should take note of several important new developments regarding board diversity, and how they may be applicable to its composition and refreshment policies. 

This continued focus on diversity is driven in large part by a broad cross-section of interested parties, e.g., institutional investors, pension funds, employees/labor unions, state governments and other stakeholders (including, for example, sources of new business opportunities for the health system). This focus applies to nonprofit, publicly held and privately controlled health systems alike.

Noteworthy developments for the nominating committee include willingness of some major companies (including those in the technology and transportation sectors) to adopt a version of the NFL’s “Rooney Rule”; the New York City Comptroller’s “Boardroom Accountability Project 2.0” (with its model board skills matrix); the Midwest Investor Diversity Initiative (with its “toolkit”); various proxy voting guidelines; and the controversial proposed California legislation that would, if enacted, institute gender quotas for corporate boards of public companies headquartered in the state.

Of course, some of these initiatives have met with criticism. For example, a bill intended to require public companies to disclose the gender of its board of directors, has yet to be presented for vote by the US House of Representatives. In addition, the proposed California quota legislation is encountering substantial opposition from the California Chamber of Commerce. Such challenges should not, however, be interpreted as a retreat from broader policy and societal commitments to decreasing unconscious bias, and increasing the number of women and minorities for board positions.

As with issues of cybersecurity, the unrelenting frequency of diversity-related information threatens to dull the board member senses to what is otherwise remains a vitally important governance principle (i.e., that diversity along multiple dimensions is critical to a high-functioning board). The general counsel can be very helpful in maintaining nominating committee focus on this issue.

Overcommitted Board Members

The board’s governance committee should take note of an interesting new consulting firm research paper that provides observations on the important concern of “overcommitted” board members.

The paper, prepared by Equilar, examines the key question of whether experience and industry knowledge gained from serving on multiple boards is overshadowed by excessive time commitments of a director. Data suggests that the experience gained from multiple board seats can be particularly helpful in industries that have “steep learning curves” for new directors. On the other hand, industries in transition (such as health care) are seeking increased time commitment from their board members, who are facing increased expectations of their oversight obligations. In those situations, there is greater internal intolerance for directors who serve on multiple boards.

Concerns with “overboarding” and “overcommitment” have their roots in Sarbanes-era governance guidelines. Yet there is no “best practice” or “magic number” when it comes to determining the proper number of outside boards on which a director should serve. Assuring the focus, engagement and commitment of individual board members should be a key goal of the board’s governance committee. This, given the transformation of the health care sector and the dramatically expanded agenda of the health care company board. The Equilar analysis, and similar reports, are useful resources for governance committee conversations on this increasingly important issue.

When Boards Should Seek Independent Counsel

Recent headlines regarding the staffing of internal corporate investigations serve to raise again the question of when it is appropriate for the board to engage outside independent counsel, as opposed to working on the matter with their general counsel or regular outside counsel.

Law and sound governance practice have long recognized that situations may arise from time to time to prompt the prudent governing board to consider the engagement of “independent counsel”; i.e., counsel other than the company’s general counsel or regular outside counsel.

An obvious example is where the board seeks expertise in a particular area of law that neither the general counsel nor regular outside counsel possess. Other examples include the presence of credible allegations of wrongdoing by senior management, and transactions that present material actual or potential conflicts of interest by management (e.g., management buyouts or tender offers involving management).

Certainly, internal investigations involving suspected or alleged wrongdoing by employees (especially those with pre-existing relationships with the general counsel and/or primary outside counsel) are typically conducted by independent counsel to the board. In addition, board-driven self evaluations are often conducted by independent counsel, particularly when the protection of the attorney-client privilege is sought.

Current public controversies in the entertainment, broadcasting and technology sectors provide a useful opportunity for the general counsel to revisit the circumstances in which it is appropriate for the board to seek independent legal advice, rather than use its general counsel or regular outside counsel.

CEO Succession Planning

A substantial increase in CEO turnover in 2018 has heightened focus on the governing board’s important obligation to maintain and periodically update both regular and emergency succession protocols. 

As The Wall Street Journal has noted, such turnover is arising not only in the ordinary course, but also in the context of compliance and litigation-related challenges; allegations regarding personal conduct/violations of company policy; and personal circumstances of which the board may not have previously been aware (at least to the appropriate degree). The frequency of such turnover places increasing pressure on the preparedness of the board. Indeed, as the Business Roundtable concludes, “[P]lanning for CEO and senior management development and succession in both ordinary and emergency scenarios is one of the board’s most important functions.”

The general counsel can be a valuable resource to the board in evaluating how best it may approach its succession management responsibilities. According to the Business Roundtable, this may prompt a decision to address succession planning at the full board level, or to rely on a committee composed of independent directors. In addition, the board, or the responsible committee, should (i) maintain a list of the qualities and characteristics desired in an effective CEO; (ii) monitor the development of potential internal candidates; (iii) seek the current CEO’s personal evaluation of candidates for the CEO and other senior management positions; (iv) periodically discuss CEO succession planning outside the CEO’s presence; and (v) review, at least annually at the full board level, both the company’s succession plan and the effectiveness of the succession planning process.

“Best practice” also suggests that this succession planning process extend beyond the senior management level to more junior levels in order to ensure effective talent development.

Outside Business Arrangements of Management

There continues to be compliance and reputational value associated with a policy requiring members of the management team to obtain senior corporate approval before accepting outside business arrangements and board service.

This value is underscored by recent developments involving a major private university and a long-serving senior executive with responsibility for administration and finance. According to media reports, the former executive received an annual fee of approximately $14,000 for serving on the board of a construction-technology company. These reports determined that the former executive was pressuring colleagues to use the company’s services, and promoting the company’s work within the university.

While the former executive reportedly had obtained the approval of the university chancellor for this board service, he allegedly failed to disclose that there was a pre-existing business relationship between the company and the university, and that university divisions under the former executive’s direction were conducting business with the company. As is often the case, the full circumstances were brought to the university’s attention through a whistleblower complaint and were the subject of substantial public notoriety. (In essence, the former executive appears to have jeopardized a long career for a de minimis annual stipend.)

A well-structured “Outside Business Arrangements” policy will help balance the legitimate benefits obtained by an executive from outside business arrangements/board service, with the distraction to the executive’s daily duties, and potential conflicts, arising from that service. Approvals are typically made by the CEO and ratified by the board (or a committee thereof). Criteria for approval include a description of the nature of the service; demonstration of how the service will benefit the employer organization; the absence of actual or potential conflict; an understanding of how related compensation will be allocated; confirmation that the outside service will not distract from the performance of the executive’s duties; and a full, good faith disclosure of all relevant facts.

AG/FTC Charities Cooperation

A recent joint initiative between the Federal Trade Commission (FTC) and charity officials in every state demonstrates the extent of inter-governmental agency cooperation with respect to charity regulation. 

The recently announced “Operation Donate with Honor” is an inter-agency enforcement action involving the FTC, NASCO, and law enforcement officials and charity regulators from every state, focused on fraudulent charities that induce donors by falsely promising that their donations will support veterans and active duty servicemembers. As a result of the action, the FTC and various states have entered into settlements with several purported charities and their leadership that, among other requirements, ban the individual defendants from soliciting charitable contributions and prohibit them from participating in charity management and oversight of charitable assets. The FTC and NASCO collaborated on a similar national charity fraud action in 2015.

Several lessons to nonprofit health care systems arise from this initiative. First is that state and federal agencies will cooperate to address what they identify as widespread violations of law involving actual or purported charities. Second is that this cooperation extends to activities conducted across state lines (e.g., the activities of a multi-state health care system). Third is that such cooperation at the federal level is not limited to the FTC; Internal Revenue Code Section 6104(c) permits the Internal Revenue Service  to notify state officials when an organization fails to qualify for exemption or its exemption is revoked (see, e.g., the “Bishop Estate” controversy). While the circumstances prompting such inter-agency cooperation are usually egregious in nature, avenues for such cooperation do exist.

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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