United States: Corporate Law & Governance Update - June 2018

Executive Compensation Recoupment

The most recent development in the prominent University of Louisville Foundation controversy is the release of an independent analysis suggesting that its senior executive leadership was "excessively compensated" between 2010 and 2016.

The executives were the former Foundation president, his former Chief of Staff, a former University provost, and two former chief financial officers. The analysis, performed by the Korn Ferry Hay Group, was made public at a May 29 Foundation board meeting in which the board voted to amend prior Internal Revenue Service (IRS) tax filings to correct statements that reported the executives' compensation as "reasonable." The total amount of compensation determined to be excessive (i.e., the excess benefit) was $3.9 million in the aggregate.

Each of the executives, with the exception of the former provost, were named defendants in civil litigation filed by the University of Louisville and by the Foundation on April 25, seeking damages for what they alleged was a series of unauthorized and illegal actions by the Foundation and its leadership with respect to certain spending and investment practices. The "excessive compensation" analysis was prepared in connection with amended IRS reporting but also is consistent with the allegations, and the relief sought, as identified in the civil complaint.

Three aspects of the analysis are particularly noteworthy: (i) the consultant's recommendation that the board should consider any compensation over the 50th percentile as excessive compensation; (ii) the alleged absence of any Foundation board-level compensation policies; and (iii) the suggestion that other Foundation non-officer executives (particularly those who received deferred compensation and tax gross-ups) be subject to similar review.

Moody's Keys to the Health Care System of the Future

The special report on not-for-profit health care, "Flexibility, integrated planning key to the health care system of the future," published by Moody's Investors Service, is useful reading for all board members—not just for those who serve on the Strategic Planning and Finance Committees.

The special report provides perspectives on steps that not-for-profit hospitals will need to take in order to remain financially viable and competitive in the future. These steps focus on expanding patient care access, capitalizing on digital efficiencies and effective clinical talent development, while maintaining financial flexibility.

Specific recommendations include: (i) balancing investments in outpatient services with maintaining high-margin inpatient services; (ii) pursuing digitalization in order to improve efficiencies and clinical outcomes, and spur innovation, while protecting data through cybersecurity; (iii) investing in "top talent" in recognition of the limited supply and rising cost of nurses and physicians; and (iv) retaining flexibility in the deployment of capital and adapting strategies as the landscape changes. Healthy liquidity will position the organization for success.

It is important for the full board to have a basic understanding of how the credit rating agencies view different strategic capital deployment strategies and their impact on credit considerations.

Guidance on Disposition of Directors' Notes

It is well established that minutes should constitute the single and official record of each board or committee meeting, whether in person or held by telecommunication means. Yet, note-taking is often an important way in which individual directors prepare for and participate in board meetings. A recently published article provides useful guidance on the preparation and ultimate disposition of written notes taken by directors during board and/or committee meetings.

The authors discourage note-taking in general, to the extent that notes in whatever form could be perceived as an unofficial record of the meeting, and potentially troublesome in the event of subsequent litigation or controversy. Note-taking can also result in unintentional waivers of the attorney-client privilege or confidentiality obligations.

The article is particularly useful to the extent that it discusses the practice of taking meeting notes through electronic portals or similar means, a practice which the authors note creates its own unique concerns—particularly if the board portal can be accessed in the event of controversy. Additional security issues arise if board portal materials can be downloaded onto a director's personal electronic devices.

The article recommends the preparation of a specific board policy that addresses the preparation and use of draft minutes, directors' notes and other documents provided to the board. Such a policy should also address how directors may access board minutes and other materials should they be subject to fiduciary controversy or litigation following the completion of their service. The general counsel should play an active role in the development of such a policy, for a multitude of legal, risk prevention and privacy reasons.

Perspectives on the "Reliance" Defense

An interesting new academic paper provides a useful reminder of the public policy basis for, and the general rules relating to, statutes and common law that codify the defense of reliance.

The ability of board members to rely upon the advice of outside experts is a long recognized defense to allegations grounded in breach of fiduciary duty. The elements of that defense reflect a good faith belief by the director that the proffered advice was within the expertise of the expert; that he was selected with reasonable care and was disinterested as to the subject matter of his advice; and that such reliance was reasonable (i.e., that there were no other factors present which would serve to question the reasonableness of such reliance).

The article's perspective is that evidence of "bad faith" (e.g., conscious disregard of one's duties; systemic failure to monitor red flags) can serve to vitiate the reliance defense. Examples of bad faith might include acceptance of only favorable opinions, or an advisor conflict of interest, or awareness that the advisor's opinion may be incorrect. Ultimately, when evaluating a claim of reliance, a court may evaluate such matters as the expertise of the director, the scope and context of the alleged conduct, the process by which the expert was selected and steps taken by board members to understand the proffered opinion. (In many respects, this last factor may be particularly important.)

The reliance defense is critical to the effective and efficient operation of the health system board. The system's general counsel can provide valued assistance by periodically briefing the board on the scope of the reliance defense as applicable under relevant governing law for the system.

Rod Rosenstein on Lawyers' Fiduciary Duties

In a recent speech, Deputy U.S. Attorney Rod J. Rosenstein offered an interesting and supportive overview of the fiduciary obligations of lawyers in the context of corporate compliance.

Addressing a compliance industry forum, he emphasized the need for companies, as well as the professionals representing them, to work to inculcate a culture of compliance within the organization. In speaking to the particular fiduciary duties of lawyers, he quoted former Supreme Court Justice Robert Jackson's famous comment, "[m]ost of the mistakes and major faults of our time are to be ascribed to a failure to observe the fiduciary principle, old in equity and recognized by law – the principle of trusteeship, without which our kind of society cannot permanently endure."

Mr. Rosenstein was particularly supportive of compliance professionals in his comments, including in that group lawyers and internal auditors, as well as compliance officers. Interestingly, he acknowledged that lawyers sometimes meet internal pushback on some of their efforts, noting that: "Some of you deal with managers who are skeptical of the lawyer's role in helping them succeed...[T]o non-lawyers, it sometimes appears as if our job is to find loopholes, argue about technicalities, and elevate form over substance...[B]ut we know that the future of a business may turn on a seemingly minor detail. Obsessing over details is part of our job."

Primary takeaways from Mr. Rosenstein's comments include that (i) lawyers are expected to exercise their fiduciary duties in counseling clients; (ii) the cultural implications of compliance are a major DOJ consideration; and (iii) the "business case" for compliance continues to be strong;  e.g., avoiding investigation and controversy, and securing the benefits of program effectiveness and cooperation credit.

AG Complaint Against Charity Accounting Advisor

On May 10, the New York Attorney General filed a civil complaint against an accounting firm and its founding partner, for allegedly preparing fraudulent unqualified financial statements for a charity that the state had previously closed.

The complaint appears to be styled somewhat in terms of an "aiding and abetting" claim; i.e., that by its professional services, the accounting firm helped to perpetuate the multi-year existence of "a sham charity," the Breast Cancer Survivors Foundation. This particular charity has ceased operations on a national basis following a settlement with (including a $350,000 payment to) the Attorney General.

The complaint includes allegations that the accounting firm inflated by over 300 percent the value of the charitable activities performed; did not report major internal control deficiencies, and issued audit reports that falsely gave the charity an unqualified audit opinion (in knowing violation of GAAS).

The Attorney General asserts its jurisidiction under authority granted by both state charitable solicitation rules, as well as its fundamental parens patriae power to protect charitable property, protect the public from fraudlent solicitation and to protect the integrity of the nonprofit sector. The Attorney General sought restitution and damages, attorneys fees and civil penalties, among other elements of relief.

This complaint demonstrates the willingness of state charity officials to broadly pursue allegations of fraudulent charitable solicitation, and to use both state statutes and common law authority to litigate their concerns.

SEC on Audit Committee Governance and Culture

Recent comments by the SEC's Chief Accountant on the relationship of governance and corporate culture should be of interest to the Audit Committee, and other board committees responsible for oversight of corporate culture.

The official's comments were premised on the importance of independent, diverse perspectives on corporate boards—particularly audit committees—as an element of strong corporate governance. "The strengthening of corporate audit committees with independent members is one of the most prominent, recent enhancements to the corporate governance scheme."

Notably, the Chief Accountant confirms the connection between audit quality and value and an organizational understanding of corporate ethical values, risks and desired behaviors. From his experience, poorly designed culture initiatives are not long-lasting in terms of addressing behavioral norms.

To that point, he offers an interesting perspective on what he described as the four phases of corporate culture maturity: "(i) Indifferent culture—Requirements do not matter or apply to us; (ii) Reactive culture—We respond and address requirements when others tell us to; (iii) Guiding culture—We need employees to follow the requirements we set for them; and (iv) Pervasive culture—All of our people are involved in our requirements and aware of their connection to our and others' expectations."

The Chief Accountant's emphasis on the value of independent directors, and the maturity of corporate culture, is intended to apply to private, as well as public companies. As such, his comments are of particular relevance to health system boards, and the extent to which they maintain and apply both codes of ethics and conduct, as well as policies relating to the inclusion of independent members on the board and key committees.

Board Performance Evaluations

The Governance and Nominating Committee might find of interest a recent article outlining a seven-step process for effective board performance evaluations.

Properly structured performance evaluations are a particularly important element of a comprehensive director refreshment protocol. The article suggests that the most valuable evaluations are those that reflect an awareness of the different types of board review processes, and are the byproduct of proper planning and implementation at the Board/Governance and Nominating Committee levels.

The recommended process incorporates the following steps: first, confirming the board's objectives in pursuing the evaluation process (e.g., conforming to external expectations, and/or improving organizational and board performance); second, determining what will be evaluated (e.g., the full board and all committees; individual directors and officers; and/or senior governance personnel such as CEO, CGO and corporate secretary); third, what is the criteria for the evaluation process (e.g., general or specific performance); fourth, who will participate in the evaluation process—solely the board, or will others within or outside the organization be sought for feedback; fifth, what will be the qualitative and quantitative techniques to be applied in conducting the evaluations; sixth, who will conduct the evaluation (e.g., internal sources such as governance personnel or other directors, or external personnel such as consulting or law firms); and finally, how best to handle the results; i.e., to whom or what will the evaluation results be released.

DOJ Recommends Antitrust Elements in Compliance Plan

The Audit & Compliance Committee should consider incorporating antitrust guidance within the health system's corporate compliance program, given recent comments by DOJ Antitrust Division leadership.

In a recent speech, Principal Deputy Assistant Attorney General Andrew Finch stated that the Antitrust Division is re-examining whether, and to what extent, to recognize pre-existing compliance programs with some form of credit, including potentially at the charging stage or at sentencing. This might take the form of fine discounts of up to 20 percent for companies that have a "credible and effective" compliance program. The Division already grants credit for extraordinary compliance measures taken after the discovery of wrongdoing, and such credits have saved companies millions of dollars in fines.

The DOJ's latest statements and topics of antitrust enforcement apart from mergers (e.g., poaching, market allocation, price fixing) reinforce the benefits of having a strong, up-to-date plan for antitrust compliance. Incorporating specific antitrust-focused elements within the compliance program can mitigate such antitrust risks, and reduce the potential that employees might engage in problematic conduct. It may also support the ability of the company to take advantage of the Antitrust Division's leniency policy, which applies only to the first company to self-report criminal wrongdoing and cooperate with the Division's investigation.

The timeliness of such a discussion with the Audit & Compliance Committee is underscored by recent public comments of a separate Antitrust Division leader on the enforcement of criminal antitrust violations by health industry companies.

Time Warner/AT&T and M&A Strategic Planning

The June 12 decision of a Federal District Court judge to dismiss the government's antitrust challenge to AT&T's proposed acquisition of Time Warner is likely to have strategic planning implications for health systems.

The decision was fact intensive, and the judge did not make broad findings on what the DOJ needs to establish in order to successfully challenge a vertical merger on antitrust grounds. Nevertheless, the opinion does demonstrate some of the difficulties that the government would have in challenging a vertical transaction in any industry, including health care.

First, the judge clearly finds that vertical transactions are generally pro-competitive, so DOJ must show that any anticompetitive effect will outweigh some given amount of cost savings. Second, the judge gives very little weight to competitor complaints in the context of vertical mergers; the government needs more than customers expressing views without any analysis to support the complaint. Third, because vertical transactions often require hypothetical models/theories, it is easier for the defendants to challenge the government's theory if the government does not have historical/natural experiments. Finally, the judge placed significantly greater weight on key executives' views rather than those of lower level employees.

In this case, the judge declined to take an aggressive view on some key legal principles for vertical mergers. Instead he concluded that under the DOJ's model/theories, the facts did not support a finding that the specific transaction would lead to a substantial lessening of competition.

As a result, the sense of possibly lower antitrust barriers to vertical mergers could encourage senior executives to pursue such transactions, including many under consideration in health care. This, even though it is unclear whether the opinion will have a significant impact on the DOJ/FTC decision to challenge vertical transactions in industries beyond media.

The health system's Strategic Planning Committee would likely benefit from a high-level briefing from the General Counsel on the implications of this new decision.

Corporate Law & Governance Update - June 2018

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