Corporate Law & Governance Update - January 2018

by McDermott Will & Emery
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Technology-Driven Disruption

Recent news stories and governance publications serve to underscore the challenge to health systems posed by innovation-based business model disruption. Health care boards will be expected to team with management in order to respond to this challenge.

For example, the 2017-2018 NACD Public Company Governance Survey cites “business model disruption” as the leading trend that board members project to have the greatest effect on their companies in 2018. A recent article in The Wall Street Journal, “Hackers and a Shrinking Talent Pool Top CEO Concerns for 2018,” notes that many corporate executives anticipate that emerging technologies will open new markets, present challenges for executive talent development, or otherwise upend their industries. In addition, a recent feature in The New York Times, “How Big Tech Is Going After Your Health Care,” provides a broad overview of how the “Silicon Valley disruptors” and other similar firms are using new technologies to address provider and patient needs.

The impact of business disruption on fiduciary duties is exceptionally diverse, affecting elements of governance ranging from information flow to the board, to director engagement, to refreshment, to board composition, to the decision-making process and, ultimately, to the nature of the board/management dynamic. Yet, the expectation is that a prudently composed and positioned board of directors can be a highly effective partner to management’s efforts to confront disruptive threats. 

Director Oversight Developments

The “good news” is that Delaware courts continue to uphold high barriers to breach of duty of oversight-related challenges. The “bad news” is that courts in other jurisdictions may have different perspectives.

A recent decision of the Court of Chancery affirmed the basic provisions of the Caremark ruling to dismiss a derivative suit that sought to hold the directors of a large financial services firm personally liable for large financial losses suffered by the firm. The court noted that the facts as pled in the complaint indicated that the warning signs of internal financial control failure may have been evident to the board for a number of years. Nevertheless, the court refused to infer the requisite bad faith from those facts, noting that nothing indicated bad faith (e.g., “conscious disregard”) on the part of the directors, individually or collectively.

That notwithstanding, the recent decision of a Federal District Court in California, in a similarly styled derivative suit against the directors of a different financial services firm, denied the motion to dismiss filed by the defendant officers and directors. In that decision, the Court was sufficiently persuaded by the totality of “red flags” of which the board was allegedly aware, and the fact that many of them were presented in the form of direct communications and reports to the board. The Court also appeared persuaded by the fact that many of the defendant officers and directors also served on committees with direct oversight over the alleged conduct that was the source of the losses cited in the complaint.

The latter decision provides a useful summary of the kinds of facts that—if true and presented in the context of egregious damage or loss to the company—could be interpreted as evidence of bad faith on the part of officers and directors. This may prompt the general counsel to be more proactive in supporting the ability of the board to identify and respond to possible “red flags.”

Supporting Tax-Exempt Status

An unmistakable theme arising from the Tax Cuts and Jobs Act is increasing Congressional skepticism that nonprofit hospitals and health system deserve the benefits associated with tax-exempt status under Section 501(c)(3).

This skepticism is reflected not only in the final exempt organization provisions of the Act, but also in several significant proposals that surfaced in, but did not ultimately withstand, the full legislative process. Both projected a bias against the nonprofit health care sector; i.e., that the nonprofit health care sector is inexorably drifting towards the purely commercial sector (and thus should be taxed accordingly). This theme, and the long term sustainability of tax exemption benefits, present significant planning concerns for corporate leadership, as well as advisors and counsel in the municipal bond sector, as they relate to debt issued by tax-exempt hospitals and health systems.

All this notwithstanding the fact that the final version of the Act preserved tax exemption for private activity bonds. Greater organizational effort will need to be expended in the future to support continued claims to tax-exempt status. This includes a governing board that will be more engaged in assuring operation for charitable purposes, and assuring that IRC 501(r) satisfaction is monitored by the corporate compliance program.

Director Performance and the "Age Factor"

The board nominating committee may wish to be briefed on a new study that examines the relationship between age and director performance—always a sensitive governance issue.

While age-based mandatory retirement is a recognized director refreshment tool, it is not generally considered a “best practice.” This is, in part, because of an acknowledgment that age itself is not a predictor of director capabilities. On the one hand, experience associated with age is often considered a valuable director attribute. Yet there is corresponding concern with the value associated with the benefits of director “diversity of age” (i.e., board composition that reflects a broad cross section of ages). Indeed, some companies are targeting younger directors, including “millennials,” as a means of enhancing board awareness of product, innovation and consumer trends, particularly with respect to technology matters.

Yet a newly published survey from Equilar suggests that including younger directors on the board may not consistently result in improved board or company performance. The data generated by the study indicates that the age of board members does not have any significant positive effect on performance at this point, but that the long term effects of refreshing boards with younger directors remains to be determined. That notwithstanding, the survey spoke favorably of the practice of refreshment through new, younger directors as a means of providing the board with different perspectives in a changing competitive environment.

This study, and others like it, may prompt a useful discussion at the nominating committee level on the value of mandatory director retirement rules, and on more concentrated efforts to refresh the board with younger members.

New Factors in Board, Executive Search

Several new developments in the commercial sector and tax law, and in media coverage of the workforce culture controversy, combine to potentially influence the manner in which the board pursues executive and board member searches.

For example, the sudden death of a prominent transportation industry CEO underscores the importance of health considerations in the executive search process. This veteran executive had been hired despite broad concerns about his health, which continued after he assumed his responsibilities and began implementing a turnaround plan. According to media reports, the executive refused to allow the board to conduct an independent review of his medical records as a precondition to employment; instead, the board accepted a letter from the executive’s personal physician. The executive’s death, soon into his tenure, reportedly left a substantial leadership void in the company.

Several other published reports suggest that executive and director searches are likely to be affected by the aftermath of the Weinstein and other personal conduct-related controversies. For example, The Wall Street Journal notes that boards have become more sensitive to such concerns and are increasing the level of due diligence applied to CEO candidates in an effort to identify problematic personal conduct. Recently published allegations of board indifference to significant workforce culture problems at a major fine arts charity suggests that the scope of diligence would logically extend to director recruitment efforts as well. The recent departures of highly successful executives from prominent sports entertainment and film industry firms for abusive inter-personal conduct expands the scope of the personal conduct diligence, beyond matters of sex harassment.

These are matters on which the general counsel, the senior vice president, and human resources can team in support of the nominating and executive search committees.

Governance and the "High Five Tax"

The new excise tax on compensation and benefits payable to a certain class of hospital and health system executives, arising from the Tax Cuts and Jobs Act, has significant governance implications that may prompt a recalibration of the historical relationship between the board and its executive compensation committee.

The well-informed board will immediately recognize the new excise tax structure as a direct Congressional challenge to the manner in which tax-exempt hospitals and health systems compensate their senior executives. Such a board will note that the excise taxes emerge from a legislative context that was especially punitive to charities in general and tax-exempt health care systems in particular. Finally, the board will be aware that incurring the excise taxes may raise concerns with the state attorney general as to the extent to which such payment can be characterized as consistent with charitable, nonprofit purposes; and with the media and health care consumers in the context of rising health care costs and limited health insurance options.

For these reasons, it is likely that the health system board will seek greater direct involvement in, or awareness of, a series of decisions that might otherwise fall within the existing authority of the executive compensation committee. This would reflect an interest in assuring compliance with these new statutory provisions, maintaining a competitive executive recruitment and retention process, and addressing the broader tax-exempt status policy issues presented by the Act’s provisions affecting tax-exempt organizations. Yet the board should exercise caution with efforts that may serve to significantly limit the extent of approval authority delegated to the executive compensation committee. Such actions could imperil the availability of the rebuttable presumption of reasonableness for committee decisions, among other important benefits.

Spare Jets and Board Oversight

A recent development underscores the importance of a full awareness by (and communication between) the board, its executive, human resources and compliance leadership, with the breadth of the perquisites associated with the CEO position and discretionary expenditure authority.

The development, as reported by The Wall Street Journal and other business media outlets, concerned the practice of a diversified international corporation to fly a spare business jet to accompany its CEO, when he was travelling in a separate business jet on corporate travel. The initial media stories that reported this practice generated substantial, negative public comment as an excessive corporate benefit, especially since the company in question was experiencing a financial downturn and was pursuing a series of “rightsizing” initiatives. The optical concerns were exacerbated by the fact the board was essentially unaware of this practice until the executive committee received an internal complaint. An internal review was conducted by the executive committee and changes were recommended to the practice. News reports infer that the full board was not informed of the practice or the internal review.

As it turns out, the use of the backup jet—which was apparently established by the company’s corporate air department and was terminated in 2014—was limited to overseas trips that presented either security risks or exceptionally complex itineraries in which mechanical problems with the main jet would be exacerbated. While the CEO was aware of the practice, he stated that he neither requested nor approved of it. This controversy demonstrates the reputational damage a company can suffer when there is lack of effective board oversight of corporate practices that, while reasonable and legitimate for some internal and external audiences, have the potential for disproportionately negative interpretation for many other audiences. Certainly, the practice does not need to rise to the level of a spare corporate jet to invite unwanted scrutiny. It is less a question of whether to provide the executive team with perquisites that have the potential for appearing extravagant, and more of whether there is appropriate board-level awareness and oversight of the practice.

"Disabling" Conflicts of Interest

Recent Congressional scrutiny of a major Trump Administration official’s inability to divest certain holdings provides a useful example of how material, continuing financial conflicts of interest can undermine the ability of an individual to serve in a board or similar fiduciary position.

The circumstances involve the new director of the Centers for Disease Control. According to media reports, the director has divested herself of many investment interests, with certain prominent exceptions. Those relate to investments in health information technology and cancer detection, which she is legally obligated to maintain pursuant to the underlying investment agreements.

As a result, she has largely recused herself from CDC matters relating to cancer and opioids.  This has prompted Senate concerns that she is unable to address issues critical to the performance of her job responsibilities.

Conflicts of interest that preclude a board member from fulfilling significant portions of their directorial duties essentially disables that director from effective fiduciary service. In such circumstances, resignation or declination to serve may be an appropriate remedy.

New Areas of Compliance Program Scope

The Audit & Compliance Committee faces a number of new and emerging challenges in 2018 as they relate to the oversight of the corporate compliance program.

First among the notable challenges is the need to confront the perception of relaxed federal enforcement efforts arising from Trump Administration deregulation initiatives. This perception may be strengthened (without justification) by the anticipated “soft repeal” of the Yates Memorandum.

Other perceived barriers are potential funding cutbacks prompted by executives eager to shift financial resources to other initiatives, such as the need to resolve fundamental job description conflicts between the chief compliance officer and the general counsel. In addition, compliance program scope must be expanded to cover emerging enforcement issues with respect to criminal antitrust enforcement and IRC Sec. 501(r) satisfaction. Compliance officers must also adjust to the empowerment of other corporate officers with overlapping duties (e.g., CISO, Chief Diversity Officer).

Governance Guidance from Institutional Investors

Health system governance committees may benefit from a review of a series of board best practices recommendations* from leading shareholder services firms and other commercial observers.

For example, new Glass Lewis guidelines place emphasis on such emerging topics as director overcommitment, pay-for-performance, CEO pay ratio and board gender diversity. The Investor Stewardship Group’s set of six Governance Principles became effective on January 1, 2018, and it is encouraging companies to publicly state whether they will follow those principles.

In addition, the consulting firm Spencer Stuart recently cited the following key governance practices of “S&P 500” boards: many companies are supplementing boards with first-time directors; board diversity is slowly progressing; director age (and retirement age) is going up; term limits are not common; board size (averaging 10.8 members) and number of meetings (averaging 8.2 yearly) remain fairly constant but with some indications of increase; boards have an average of four committees; numerical limits on other board seats proliferate and most boards disclose performing evaluations.

* Reproduced with permission from Corporate Law & Accountability Report, 233 CARE (Dec. 6, 2017). Copyright 2017 by The Bureau of National Affairs, Inc. (800-372-1033)

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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