United States: Corporate Law & Governance Update - July 2018

Mission Drift

The nonprofit corporate law implications of a business model that evolves from its primary charitable purposes are demonstrated in a recent, highly publicized state attorney general enforcement action involving a prominent local charity.

The term "mission drift" describes the circumstances when the business affairs of a nonprofit corporation begin to shift from its stated purpose, to some alteration or derivative thereof, without proper state/judicial approval. The recent controversy involved a local chapter of a prominent job training charity, which was the subject of a 19-month investigation by the state attorney general. The concern—initially prompted by a series of investigative reports in the local media—was that the charity was focusing far more on revenue-generating sales activity than on the job-training and placement functions it was originally formed to pursue.

The attorney general's investigative report was highly critical of what it found to be a lack of board oversight for management practices that emphasized the revenue-generating activity, and the payment of "excessive" compensation. Yet, ultimately no claims were pursued against the board, but the final settlement with the state included a number of governance-related conditions, and three-fourths of the board rotated out of service.

The relevance to health care organizations arises from increasing recognition that the inpatient health care facility business model is becoming obsolete. As a result, health care companies are shifting their focus to ambulatory and other care delivery platforms. To the extent such shift in focus carries the organization away from its original (e.g., inpatient) mission focus, the need for appropriate state and judicial approvals should be considered.

Board Engagement with CSR

Health care boards may benefit from an ongoing dialogue with senior leadership on the relevance, and possible adoption, of corporate social responsibility (CSR) initiatives. 

CSR has been defined as "voluntary corporate programs and practices that promote fairness, transparency, accountability and ethical behavior across global business, legal and social institutions." It is becoming a matter of significant governance focus as it relates to the long-term sustainability of the enterprise, particularly given the emphasis by investors and in light of the linkage between making a positive contribution to society and positive financial performance.

Leading CSR issues include climate change, energy sources, human capital, labor standards, and consumer and product safety. The board plays a substantial role in CSR matters by partnering with management to achieve the appropriate balance of the financial, operational, societal and reputational considerations with investor interests and directions. In that regard, the board should be informed about how management identifies and addresses CSR-related risks and determines how those risks affect long-term corporate sustainability. The board should also monitor how the company responds to third-party requests concerning CSR, and the manner in which the company discloses its CSR activities and allocates corporate resources to CSR functions.

The pursuit of CSR principles is at this time primarily concentrated in the for-profit sector, but its potential extension to the nonprofit sector should be explored at the board level, given the seeming relevance of core CSR issues to the reputational, value and long-term sustainability interests of nonprofit health systems. 

Enforcement of Corporate Codes of Ethics

The continuing series of high-profile executive departures due to corporate ethics code violations—and the impact of those departures—serves to raise the profile of corporate boards in connection with their interpretation of ethics codes and the possible application of discipline thereunder.

Codes of ethics and conduct are important means by which a company maintains a supportive workforce culture and retains valuable employees. Violations of such codes should be treated with penalties that are appropriate under the circumstances (e.g., the nature of the violation and the seniority of the violator). However, these codes are not always written with controversy in mind, and the board should seek the advice of the general counsel when attempting to apply the code to particular allegations and when considering the appropriate discipline for deemed violations.

In this regard, the board may wish to take steps to ensure the application of "due process" when evaluating specific allegations. Doing so may support the credibility of the evaluation and disciplinary process. It may also help reduce exposure to future legal claims by the subject executive grounded in breach of contract, defamation or civil rights violations (e.g., claims regarding race, gender or age discrimination).

While controversial, it may also be important for the board to consider the impact of employment termination as the primary disciplinary remedy. When dealing with critical executives who have performed at a consistently high level, and for whom there is no obvious replacement, "strict liability" could lead to significant damage to the company's financial and operational condition. On the other hand, perceived leniency could create workforce culture and reputational harm concerns.

Board Committee Structures

A recent survey suggests that board agenda goals will benefit from a re-evaluation of the company's current committee structure and the extent to which it supports effective oversight and decision-making.

The study, conducted by a major consulting firm, tracked board structures of S&P companies over the last five years, with a specific focus on how the committee structure was applied to support the board's oversight duties. One of the major conclusions was that, despite seismic business model change, board committee structures have remained relatively the same over the studied time period.

There appears to have been a continued commitment to the "big three": the audit, compensation and nominating/governance committees. Many companies also continue to use executive and finance committees. Companies in heavily regulated sectors typically have a risk committee, and companies in specific industries, health care average one or two additional committees. Interestingly, the use of compliance, risk and technology committees grew only marginally. Other popular committees were those addressing public policy and regulatory affairs, and corporate responsibility and sustainability.

The release of this survey is a useful prompt for board-level reconsideration of the effectiveness of its current committee structure, and whether change (in the context of committee focus, composition, responsibilities and/or size) is helpful in terms of enhancing board effectiveness. The general counsel is the logical corporate officer to lead this effort.

Increasing CEO Profile on Social Issues

Recent comments by former Xerox CEO Ursula Burns underscore the increasing expectations that CEOs will take public positions on matters of social policy.

CEOs across industry sectors are under mounting pressure from customers, employees, shareholders and board members to take positions on social or political matters that may implicate their own corporate values. This movement has been described by The New York Times as "part of a broad recasting of the voice of business in the nation's political and social dialogue, a transformation that has gained momentum in recent years as the country has engaged in fraught debates over everything from climate change to health care."

Yet such public positioning is not without significant reputational, performance and perhaps legal risk to the CEO and to the company. Such comments can disturb relationships with the board, confuse other members of the management team, undermine corporate relationships with legislators, and affect consumer preferences.

For advice on how best to balance the risks and rewards of public commentary (as Ms. Burns advocates), CEOs are turning to their general counsel as a wise counselor and guardian of the corporate reputation. In this role, the general counsel is by training capable of advising the CEO in the broadest possible context.

The general counsel will supplement her technical legal analysis with consideration of applicable moral, ethical, political, economic and environmental factors. She will advise not only whether the proposed commentary is legal, but also whether it is the right thing to do from the perspective of the corporation, its stakeholders, the public and sound policy.

Duty of Loyalty Restatement

A recent Delaware Chancery Court decision provides a useful restatement of the duty of loyalty that can serve as a template for board policy formation and director fiduciary education.

The underlying case involved a complex set of facts and allegations, the core of which was that a director breached his duty of loyalty to the company by refusing to assent to certain corrections to corporate records, thus threatening the company's existence and operations. The court concluded that the refusal was solely for the purpose of obtaining leverage to pursue the director's self-interest.

Particularly relevant to health systems are (i) the court's articulation of the "bedrock" duty of loyalty (". . . to protect the interests of the corporation committed to his charge [and] also to refrain from doing anything that would work injury to the corporation"), and (ii) the court's equitable power to relax the traditional requirement of a connection between causation and damages when a breach of the duty of loyalty is proven.

The Chancery Court opinion is a powerful reminder of how seriously corporate law treats duty of loyalty violations. This is especially the case with nonprofit corporations, for which breach of the duty of loyalty involves a potential subversion of the charitable nature of the corporation. Corporate board members should be aware that regulators and courts will closely scrutinize director conduct that raises loyalty-based concerns. This is particularly relevant as many health systems are pursuing transformative relationships, which pursuit (and consummation) implicates various elements of the duty of loyalty (e.g., conflict, confidentiality and appropriation).

Personal Relationships and Conflicts

The question of whether there are circumstances under which personal relationships can implicate board-level conflicts of interest concerns is raised by several recent New York State court decisions.

These cases do not conclude that certain types of personal relationships per se establish a fiduciary relationship. Rather, they suggest that such a conclusion is possible, depending upon the facts and circumstances. In the most recent decision, the court acknowledged that a fiduciary arrangement "might be found to exist, in appropriate circumstances, between close friends or even where confidence is based upon prior business dealings."

The issue affects the scope of disclosure under a board conflicts of interest policy. Most such policies do not require the disclosure of relevant "personal"/non-financial relationships. However, following the lead of these recent decisions, officers and directors should be alert to the benefit of disclosing particularly close personal relationships with individuals who may, or may seek to, (directly or indirectly) conduct business with the company, or who serve in a senior fiduciary capacity with a competitor or a company that seeks to contract with the company the director serves. These conceivably would be relationships that invoke the requisite "trust and vulnerability" that are key elements of a fiduciary relationship.

It should be noted that the existence of "personal relationships" can also possibly affect board and committee-level independence determinations.

Compliance Oversight Effectiveness

The general counsel and chief compliance officer might jointly review the results of a recent consulting firm survey on the level of board engagement on matters of compliance and ethics, i.e., the so-called "tone at the top" function.

The survey included more than 25 chief ethics and compliance officers across a variety of public, nonprofit and privately held companies operating in a broad cross-section of industries (including health care). While the survey results reflect some positive references to effective practices, by and large the survey reflects negatively on the extent to which boards have been effectively engaged on ethics and compliance matters.

The primary survey observations revolve around that central theme of "disconnect" between the board and its ethics and compliance function. Common symptoms include the following:

  • Boards neither understand the programs nor devote significant time and priority to compliance and ethics.
  • Boards don't focus on the root causes of noncompliant behavior and don't understand the benefits of a pro-compliance culture.
  • Boards don't ask enough of executive management in terms of ensuring effective ethics and compliance.

These are potentially damaging conclusions in context of the board's Caremark obligations. While it is fair to question if the results would have been different had the survey been limited to the health care sector, that consideration does not change the provocative nature of the survey's conclusions. For that reason, there may be value in sharing the survey results with the audit committee and initiating a discussion as to whether the board's commitment to ethics and compliance (in all of its manifestations) is sufficient. The general counsel and the chief compliance officer could "team" in the development of possible corrective action.

Access our Health System Compliance Program Oversight: Elements of Governance Effectiveness, prepared by McDermott partners Michael W. Peregrine and Tony Maida.

Duties of LLC Directors and Managers

The increasing use of the Delaware LLC as the entity of choice for many new health system ventures suggests a need for system board familiarity with its key concepts and themes.

As noted in a recent academic journal article, a key principle of the LLC form is the ability to limit or remove application of the traditional fiduciary duties of care and loyalty. This makes it easier for the LLC to participate in "conflicted" transactions, among other things.

Delaware LLCs are typically subject to the implied covenant of good faith and fair dealing only in limited circumstances. Notably, the judicial application of "good faith" is more limited in the LLC context than in the corporate context. For example, it merely requires "faithfulness to the scope, purpose and terms of the parties' contract" (i.e., actions consistent with the terms of the parties' agreement), and does not project an expectation of "equitable behavior." Rather, the expectation is that a party not take action to defeat the expectations clearly implied by the terms and conditions of the arrangement.

Health system leaders making decisions to invest in LLC operations, and/or filling director and manager positions in LLC investments of the system, would benefit from a briefing by the system general counsel on the advantages of the LLC form of entity, how it differs from the corporate form, the implications of waiving fiduciary duties, and the broad discretion typically afforded the LLC governing board. Presumably, such a briefing would also improve the potential for a meeting of the minds—internally and externally—on the structure of LLC governance and management.

Identifying Officers for D&O Coverage

A recent federal district court decision provides a useful reminder of the value of confirming the proper identification of corporate officers for purposes of directors and officers (D&O) liability insurance policies, and for corporate indemnification and advancement policies.

The case (involving complex procedural history and facts) addressed the question of whether an individual identified as a "vice president" of a leading global investment banking, securities and investment management company was an "officer" of that company within the meaning of its bylaws. The district court ruled that it was bound by a prior Delaware Chancery Court decision with respect to the question. In that case, the Chancery Court concluded that the vice president had failed to prove that a person at the vice presidential level of the company qualified as an officer for indemnification purposes.

The essence of the Chancery Court's decision was that courts will look beyond the title designation and examine instead the specific nature of the individual's job responsibilities in order to determine whether the individual is an officer for purposes of the firm's advancement policies. This examination may include, among other factors, whether the individual held any particular managerial or supervisory duties, the company's historical approach to designating "officers," and relevant industry practice. Noting that the burden of proof rests with the person claiming officer status, the court concluded that the plaintiff "failed to prove that someone who held the bare title of Vice President, but who otherwise held a position with the responsibilities of an employee, qualified as an officer for purposes of advancement under the Bylaws."

There are obvious officer and director retention-related concerns that reflect the importance of this issue. They are underscored by many companies' practice of engaging in "title inflation" and use of non-traditional titles that suggest officer status (e.g., chief innovation officer, chief experience officer). The general counsel is well suited to lead a review of applicable law on officer status in the company's state of incorporation, and an evaluation of who among the management level is indeed an officer for D&O and indemnification/advancement purposes. Greater clarification of relevant portions of the bylaws may be a byproduct of this review.

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Corporate Law & Governance Update - July 2018

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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