United States: Corporate Law & Governance Update - June 2016

Protecting the Corporate Reputation

An important fiduciary obligation of the board is to protect the reputation of the organization, as a significant enterprise asset. In that regard, the new academic study, "Scoundrels in the C-Suite," from the Stanford Graduate School of Business, may be of particular interest to health system executive committees. The Stanford study examines actions that corporate boards take in response to executive behavior that, while 'not illegal', remains questionable or otherwise inconsistent with the interests of the company or its shareholders. Such questionable behavior includes, but is not limited to, conduct such as making controversial public statements, having relations with an employee or contractor, or developing a reputation for overbearing or verbally abusive behavior. The study also summarizes why responding to such conduct "matters."

With respect to such behavior, the appropriate board response is often less clear than it would be in the case of allegations of illegal activity. To that end, the Stanford study examines the range of actions that boards often take in response to CEO "bad behavior." Specific focus is placed on such considerations as: (i) when are allegations of bad behavior credible enough to bring to the board's attention; (ii) what measures can the board apply to evaluate the impact on the organization of the alleged CEO behavior; and (iii) the possible utility in having the board be proactive in applying information-gathering tools to detect early sign of senior leadership misbehavior.

The Stanford study is a highly-useful resource on board oversight of organizational reputational matters. Certainly, there is risk that any formal board consideration of the study, and implementation of related protocols, could be unsettling to the board/senior management relationship. Yet, there may be real value in a board discussion on its obligation to investigate credible allegations that management has engaged in conduct inconsistent with corporate interests. Most of the study's examples and observations are directly relevant to large nonprofit organizations such as health systems.

Board Composition—Lessons from "Activist Environment"

The health system's nominating committee can draw several important lessons on board composition and qualifications from the perspectives of "activist investors" in the public company sector. According to a new article authored by PwC consultants, the activists are seeking greater influence on board composition decisions in order to pursue their perspectives on director tenure, diversity, expertise, experience and accountability for board self-evaluations.

Many of these perspectives apply favorably to sophisticated nonprofit corporations, as well as to for profit companies.

For example, the article recommends that nominating committees utilize a board composition grid as a tool in helping to assure that the nomination process identifies candidates with skillsets the committee has identified as critical to board oversight of corporate affairs. The article also encourages nominating committee consideration of the full range of diversity concerns: gender, race, ethnicity—and also skills, backgrounds, personalities, opinions and experiences. Note, in this regard, recent media scrutiny of the lack of diversity of a leading communications company that, while making business efforts to appeal to a more diverse audience, is facing shareholder pressure given its decidedly non-diverse governing board.

The article also encourages nominating committee discussion on matters of tenure and mandatory retirement, and succession planning, citing the scrutiny several institutional investors apply to these important issues. (As noted in prior editions of this Newsletter, many leading investor groups express concern about lengthy tenure compromising director independence.) In an interesting aside, the article references investor organizations whose voting policies address nominating committee performance.

Much of the important deliberation on board composition and director refreshment is arising from the activist investor environment in the public company sector. Health system board nominating committees may find several useful lessons arising from the perspectives of the activist community in this regard.

"Yates" Pushback

The Audit & Compliance Committee might benefit from a general counsel briefing on an important new "white paper" issued by the US Chamber of Commerce, "DOJ's Threshold for 'Cooperation'." The white paper focuses on what the Chamber believes are challenges corporations are incurring when considering cooperation with the Department of Justice under its "Yates Memorandum" on individual accountability.

According to the white paper, a series of "unintended consequences" serve to complicate what otherwise would be a "straightforward" decision on whether to cooperate with the government. These include: (i) Yates risks alienating employees whose knowledge of the relevant facts makes them critical to an internal investigation; (ii) Yates can serve to complicate compliance by making employees reluctant to report instances of wrongdoing out of concern with being made a target of an investigation; (iii) Yates renews concerns about governmental pressure to waive the attorney-client privilege; and (iv) it can also serve to create tension between the organization's counsel and executives on what should be disclosed to the government.

Yates has been an important consideration for corporate boards, which as a fiduciary obligation should give close consideration to seeking cooperation credit when responding to a governmental investigation. It has also served to spark the current environment that places increasing emphasis on individual accountability for corporate misconduct or harm. However, the "all-or-nothing" approach of Yates (as the Chamber describes it) could significantly complicate the board's decision-making. The Audit & Compliance Committee would be an appropriate venue for a governance-based discussion of Yates' implications and the Chamber's report. This discussion would logically be led by the general counsel and the corporation's outside white collar counsel.

Compliance Plan Effectiveness

The Audit & Compliance Committee may wish to take note of recent comments from DOJ Fraud Section Chief Andrew Weissmann, on key criteria DOJ uses when evaluating the compliance program effectiveness of companies under DOJ investigation. According to media reports, DOJ applies a "standard question" it asks companies about their compliance program challenges, when they are making a presentation to DOJ about mitigating factors that should be considered in any resolution with the government over allegations of corporate misconduct. These media reports quote Mr. Weissmann as observing, "When we hear from compliance officers...one of the standard questions that we ask is, 'What do you still need to work on? What's not working'?" Mr. Weissmann is further quoted as saying that he believes it indicative of "a working compliance function" when there is internal organizational dialogue about compliance program challenges, and where compliance officers believe that "their program isn't perfect" and that "there is room for improvement."

These comments might prompt the Audit & Compliance Committee to engage in a more periodic and deliberate dialogue with the general counsel, chief compliance auditor and the internal auditor on compliance program effectiveness matters, specific challenges facing the compliance program, and suggestions on possible ways to overcome these challenges. This dialogue would be consistent with an increasing Committee focus on the elements of compliance program effectiveness, in advance of the release of (long awaited) program benchmarking metrics the DOJ previously indicated it would be preparing for public dissemination. Earlier this year, the DOJ released a seven-metric outline of what its internal compliance officer would apply when evaluating specific compliance programs, but the details beyond the outline remain outstanding.

Separately, the general counsel may wish to read the provocative new law review article, Corporate Governance in an Era of Compliance. The article offers provocative new observations on compliance program utility, and expresses concern with the difficulty in demonstrating the effectiveness of the compliance program. The article's fundamental goal is to prompt further conversation amongst scholars, practitioners, prosecutors, and policymakers on the proper calibration of corporate governance and corporate compliance.

Acute Challenges for Boards

The current edition of Corporate Board Member includes the results of a survey of 345 board members and general counsel on acute challenges confronting boards; i.e., issues that "keep them awake at night." While a majority of those surveyed most likely came from the for-profit sector, their responses are of notable significance to large, operationally complex nonprofit organizations such as health systems.

The survey listed the following leading concerns for directors, in descending order of acuity: IT/cyber security; business innovation/disruption; enterprise risk management; shareholder activism/engagement and government investigations. Leading concerns of surveyed general counsel were similar, with government investigation and shareholder activism considered more acute than ERM. Of particular interest is that almost half of the surveyed directors said that their general counsel formally presents to the board at each board meeting. A third of the surveyed directors said that their general counsel reports to them not only at each full board meeting, but also in private sessions. Even still, that suggests that approximately 20 percent of the surveyed directors do not receive a scheduled briefing from the general counsel. Survey comments also expressed concern that the frequency of general counsel presentations is set by management, "so you never know what you are not aware of."

Particular value of the Corporate Board Member survey comes from the extent to which it promotes boardroom discussion on those issues that "keep them awake at night"; emphasizes the timeliness and context of risk reporting to the board, and underscores the benefit of frequent, scheduled and related interaction between the general counsel and the board.

M&A Planning

The board's Strategic Planning Committee will want to closely track both the resolution of the several current hospital merger enforcement cases, and also in particular recent merger-related warnings to the health care industry from FTC and DOJ antitrust regulators. These comments, made at a May 12 American Bar Association conference, offer useful guidance on the regulators' perspective on using projected efficiencies to justify proposed mergers, as well as other regulatory observations on health care merger enforcement.

Several major themes are projected by the regulators' comments. One, not surprisingly, is to give greater consideration in the strategic process to less-than-merger relationships with competitors; e.g., legitimate joint venture arrangements. Another is the difficulty in demonstrating a range of post-closing efficiencies sufficient to offset regulator concerns about a merger's likely effect on competition.

Particularly relevant were comments by FTC Chairwoman Edith Ramirez, who expressed substantial concern with the rapid rate of consolidation among health care providers. She referenced an 18 percent increase in hospital mergers from 2014 to 2015 and a 70 percent increase since 2010. "While most provider mergers are not anticompetitive," Ramirez is quoted as saying, empirical research by economist Marty Gaynor "found that the disparity in hospital prices within regions is the primary driver of variation in health care spending for the privately insured." Gaynor's study "shows that hospitals that face fewer competitors have substantially higher prices, controlling for quality differences." These regulatory perspectives can be helpful in positioning the Strategic Planning Committee to make more informed decisions with respect to merger/acquisition opportunities with possible competitors.

Conflicts of Interest

The board's Conflicts of Interest Committee might benefit from reviewing the now-public letter from the Pennsylvania Attorney General to the leadership of several Hershey School entities, concerning the latter's compliance with the provisions of a 2013 governance-based settlement negotiated between the parties. That settlement concluded a lengthy investigation of controversial real estate transactions entered into by the charity, that had raised issues involving possible director self-interest. The attorney general's investigation had concluded that the trustees had not breached their fiduciary duties. However, the organization agreed to a series of governance changes at that the attorney general hoped would better support the school's charitable mission.

The Attorney General's new letter, dated February 28, 2016, speaks to the state's "serious concerns regarding apparent violations" of the 2013 settlement. Among the apparent violations included the summer employment of a trustee's son by one of the trust's investment management firms; board compensation in excess of settlement-based parameters; and the board's failure to apply timely, best efforts to recruit new board members with needed competencies. The Attorney General also references a number of other actions which were of concern. As a result, the Attorney General seeks to: (a) remove three long-serving (e.g., ten years or more) board members; (b) implement term limits (10 years); (c) reduce board compensation to levels consistent with the 2013 settlement; and (d) have the board members personally assume the costs associated with an internal conflict of interest investigation, including the costs arising from outside counsel retention.

Obviously, there are two sides to this particular controversy. Yet, the Attorney General's letter provides a graphic example of the interest of the state in addressing conflicts of interest and other governance issues involving nonprofit corporations, and the scope of its authority in pursuing a resolution of nonprofit board actions that the AG determines to be inconsistent with charity laws.

Grassley's Back (Again)

Two unrelated actions confirm the continuing and forceful interest of Senator Charles E. Grassley in the governance and operation of nonprofit organizations in general, and nonprofit health systems in particular. Senator Grassley now serves as Chairman of the Senate Judiciary Committee, and as a member of the Finance Committee. In a letter to the memberships of both the Judiciary and Finance Committees, Sen. Grassley recommends that Congress apply "vigorous oversight" to assure that nonprofit hospitals "appropriately manage their responsibilities to low-income communities...[T]hat is, after all, one of the reasons why we created the tax-exempt status for charitable institutions in the first place." The letter summarizes Sen. Grassley's review of the billing and collection practices of a Midwestern nonprofit, tax-exempt health system that reportedly placed "thousands of accounts in collection." Sen. Grassley's letter reviewed the policy changes implemented by the health system following Senate scrutiny, and commended it for the corrective action taken (which included the forgiveness of $16.9 million in debt for over 5,000 patients).

The other notable Sen. Grassley action in May was his continuing focus on the administrative and other expenses of a prominent nonprofit veterans' charity. By letter to the charity's chairman, he expressed concern with the charity's claim that over 80 percent of its 2013 and 2014 expenditures were used to benefit veterans. Sen. Grassley based his concern on his review of the charity's consolidated financial statements and Form 990 for the time period. Particular scrutiny was applied to the charity's treatment as "program expenses" of money spent on free media and advertising; on certain types of joint educational and fundraising solicitations; to its provision and funding of long-term support programs, and to program expenditures for certain conferences, conventions and meetings. By the letter, Sen. Grassley poses a series of questions relating to program-related expenses—and requests a copy of the independent review of the charity's spending practices, as commissioned by its board of directors.

Senator Grassley's May actions are consistent with his historical close scrutiny of the nonprofit, tax-exempt organization sector. They come at a time of subtle yet noticeable concern about health care system tax-exempt status at both the state and federal level. As such, they are worthy of note by

The Evolving Role of the General Counsel

An article in the current edition of Corporate Board Member magazine describes the evolution of the role of General Counsel's role, from simply a technical legal advisor to becoming a core member of the senior management team and a participant in strategic decisions and actions. Authored by the estimable Ben W. Heineman, Jr. the article traces the history of this evolution, concluding that it has transformed both business and legal practices in two key ways.

First, from an internal perspective, the general counsel has replaced the senior partner of the company's outside law firm as the primary counselor to senior management and the governing board. The general counsel's role now typically extends beyond advising on matters of law, to addressing matters of organizational performance, ethics, governance and corporate citizenship. In that regard, the general counsel is more often perceived by corporate leadership as having a degree of stature and importance comparable to that of the chief financial officer. As a result, the expertise, quality, depth and authority of the general counsel has increased proportionately.

Second, from an external perspective, the general counsel's role has also grown with the shift in power from outside law firms, to the internal corporate legal department. As law departments have become more sophisticated, capable and influential within the organization, they are increasingly the corporate "points of contact" on a wide variety of matters involving law, ethics, enforcement and public scrutiny.

Mr. Heineman's perspective of the general counsel as a "Lawyer/Statesman" is widely respected, and is increasingly the standard which boards and senior management refer when crafting hierarchical responsibilities for the corporate legal department.

Expanding Scope of Antitrust Compliance

The increasing scrutiny by the federal antitrust enforcement agencies of conduct apart from mergers and acquisitions should be closely monitored by health system audit and compliance committees. The Department of Justice in particular appears to be pursuing a more aggressive antitrust profile in health care. This includes application of the Yates Memorandum on individual accountability, and expanding the scope of its enforcement profile to encompass conduct that is perceived to violate the antitrust laws relating to price fixing, market allocation and similar kinds of activity.

Under this new enforcement approach, legitimate antitrust exposure can arise from a broad spectrum of individual and organizational conduct that has traditionally been perceived to be in the realm of corporate operations, and affect employees and others who may not regularly interact with the legal and compliance department. Examples might include managed care contracting employees, who might conceivably engage in conduct interpreted as exclusionary contracting practices that harms competition; strategic/business development employees who might conceivably engage in collaborations perceived to effect service or territorial allocation; and human resources employees who may be perceived through their communications as engaging in wage-fixing or unlawful "no-poach" agreements. There are many other examples.

The ultimate question is whether the health system's existing corporate compliance program addresses these types of antitrust concerns. The general counsel, working in consultation with the chief compliance officer, is well suited to help the Audit & Compliance Committee evaluate whether additional internal controls, standards of conduct and education/training and monitoring mechanisms are needed to reduce organizational risk.

Corporate Law & Governance Update - June 2016

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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