United States: Corporate Law & Governance Update - October 2018

The health system's governance committee may benefit from a general-counsel-led briefing on the relevance of the newly released revisions to the "Commonsense Principles" of corporate governance.

Released on October 18, 2018, this document builds upon the initial 2016 series of recommendations and guidelines concerning the governance-related roles and responsibilities of boards, companies and shareholders, and contains revisions and updates to the initial release of the Principles, as proposed by a group of financial sector leaders. In addition to multiple refinements to the original recommendations, this updated version reflects an expanded consensus, with the additional endorsement of a large number of business leaders.

Many health system boards are committed to following best practices in the course of their responsibilities. However, the concept of what constitutes corporate governance "best practices" is more nuanced than many directors and executives may think, and thus they may benefit from the advice of general counsel with respect to the Commonsense Principles' application. Indeed, the board should look to the general counsel for advice on specific conduct that is recognized as rising to the level of best practice, because it is, in many respects, a matter of law.

The revised Commonsense Principles reflect an important step toward a more accepted set of governance guidelines for large corporations. They also contain several revisions to the prior governance principles that are noteworthy for health systems, particularly with respect to matters of fiduciary duties, board composition, internal governance and board responsibilities.

Waiting for "Yates Lite"

The health system board's audit/compliance committee should note the absence of any changes to the so-called Yates Memorandum in the recently released update of the United States Attorneys Manual (USAM).

In public speeches in September and October 2017, Deputy Attorney General Rod J. Rosenstein announced the US Department of Justice's (DOJ's) intention to identify, review and revise certain outstanding "white collar" memoranda previously issued by former Deputy Attorneys General, and to incorporate them in an updated version of the USAM. In his October 6, 2017, speech, Mr. Rosenstein specifically stated that the Yates Memorandum was one of those policies under review. That comment prompted widespread speculation within the bar that this review might provide some relief from the harsh provisions of the Yates Memorandum.

Contrary to expectations, changes once hinted at by the Deputy Attorney General do not appear in the September 25, 2018, release of the updated USAM. Indeed, two subsequent speeches by other senior DOJ officials served to underscore the government's commitment to principles of individual accountability.

Thus, it remains "business as usual" for health care lawyers, compliance officers, audit/compliance committees and the board in terms of the importance of individual accountability and securing cooperation credit. To some extent, these developments strengthen the credibility of the audit/compliance committee when emphasizing to the full board, senior executive leadership and the broader workforce the importance of a vigorous compliance program.

M&A and the MAC Clause

Directors called upon to review the terms of an M&A definitive agreement may note the important new Delaware decision sustaining a buyer's use of a material adverse change (MAC) clause to terminate a merger agreement.

A MAC clause in a transaction agreement is typically included to allow a party to terminate the agreement in the event that one or more (previously agreed-upon) events occur after the execution of the agreement that threaten the contractual bargain of that party. MACs are often heavily negotiated clauses, often suffer from imprecise definitions, and until the current case, have never been upheld in a termination situation by the Delaware courts.

In the instant case, the Chancery Court concluded that the purchaser validly terminated the definitive transaction agreement in part because the seller's representations regarding its compliance with applicable regulatory requirements "were not true and correct, and the magnitude of the inaccuracies would reasonably be expected to result in a Material Adverse Event."

In a detailed summary of the facts, the court noted that the buyer had received communications from anonymous whistleblowers accusing the seller of regulatory violations. During the course of follow-up investigations, the buyer identified what the court described as "serious and pervasive data integrity problems." In this context, the court concluded that the buyer's decision to terminate was based on legitimate concerns with a company-specific collapse in the seller's business.

This prominent new decision should be of interest to directors when considering MAC-type clauses as a protective measure in a definitive transaction agreement.

NACD on Disruptive Risk

A new National Association of Corporate Directors (NACD) report provides useful guidance to the governing board (and perhaps the audit committee) in exercising oversight of what NACD refers to as "disruptive risks."

The rationale for the report is grounded in a recognition that business entities across industry sectors and corporate forms are confronting a "VUCA" operating environment (i.e., an environment characterized by volatility, uncertainty, complexity and ambiguity). It therefore becomes imperative for boards to support their organizations as they seek to assess what the report refers to as "disruptive risks," i.e., risks that, whether internally or externally driven, could have a significant economic, operational and/or reputational impact on the organization.

The report provides a series of recommendations on how large organizations can best identify, assess and respond to these risks. The report classifies disruptive risks within the following categories: government agenda, societal volatility, technology advances, and hazards and accidents. While not all of the disruptive risks will be relevant to the US-centered health system, others most likely will be (e.g., radical regulatory change, corruption and legal discrimination, new technology-driven business models, technology implementation problems, cyberattacks, disaster).

This new NACD report should be a useful prompt to health system board efforts to provide effective oversight of risk. Systems with existing board/management-level risk management functions might compare those to the principles recommended in the report. The general counsel and chief compliance officer are well situated to support any such review and comparison.

"Radical" Decision Making

Boards should anticipate the need to accommodate the pressure for more aggressive decision making with traditional concepts of business judgment.

Netflix co-founder Marc Randolph recently emphasized in a speech to a health industry audience how important it is for innovators in all industries, including health care, to develop a "tolerance for risk" and to have confidence and optimism. "It was not about having good ideas," Mr. Randolph told attendees. "It was about a system and a culture of trying lots of bad ones. What we realized is that the key to this is not the good idea. It was how quickly and easily and cheaply you could try as many ideas as you could think of."

The related governance challenge arises when the health system board is caught in the "vise" of needing to make "radical decisions" to respond to business disruption and industry transformation, on the one hand, yet feels confined by traditional corporate law limitations as they relate to prudent decision making and the business judgment rule, on the other hand. "Radical" decisions could refer not only to the scope and potential impact of certain decisions, and the risk and change they may involve, but also to the process by which the board evaluates those decisions.

The board (and perhaps the strategic planning committee) may benefit from consulting with the general counsel on steps it may wish to implement now to facilitate (and sustain) more radical decision making as the board is called upon in the future to confront transformative challenges.

CEO Tenure Issues

Two recent and prominent developments in the corporate world provide fodder for discussion by the board, and its nominating and executive succession committees, as they relate to matters of CEO tenure.

One such development is GE's recent termination of its CEO, John Flannery, after he served only 14 months in that position. According to news reports, the termination was tied to concerns regarding missed financial targets and the perceived slow rate of organizational change. Those reports also attributed the move to increased board impatience resulting from what was perceived as a long period of declining company financial performance.

The broader governance issue presented by GE's action is whether boards may be more willing in the future to move more quickly on decisions with respect to CEO effectiveness, particularly given volatile markets and competitive environments. The various news reports noted the inherent risks associated with the so-called "quick trigger" strategy.

A related development is the release of a new survey indicating that CEOs are, on average, of the highest age in the last 17 years, with at least 10 percent of CEOs being 65 years of age or older. The survey attributed this trend to a combination of factors: the lack of interest of many CEOs in retiring; the increasing comfort level of the board in retaining existing, well-performing CEOs; and broader interests of organizational stability. The retail and wholesale industries were exceptions to this trend. In addition, the survey noted that this trend may be a direct result of current economic conditions.

Board Liability for Sexual Misconduct

The health system board's audit committee may want to discuss with its legal and insurance advisors the increase in D&O claims arising from allegations of sexual misconduct within the organization.

While it should not be unexpected, the #MeToo movement and related workforce culture considerations are prompting greater focus on the accountability of officers and directors for failing to provide adequate oversight of workforce culture. In 2018 to date, this has been particularly manifested in shareholder derivative suits against officers and directors seeking damages for their actions relating to sexual misconduct alleged to have occurred at their respective corporations.

Many of the derivative actions seek to assess liability for alleged materially false and misleading statements regarding the company's business, operational and compliance policies. In particular, the allegations often focus on failure to disclosure sexual harassment at the executive level; the inadequacy of the code of conduct to prevent inappropriate workforce conduct; and the inevitability that such conduct would negatively affect the company's business and operations, and expose it to reputational harm, heightened regulatory scrutiny and legal liability.

A recent academic paper identified the most likely areas of potential D&O liability: (i) directors and officers actually engaging in sexual misconduct; (ii) a Caremark-type failure to adequately monitor harassment; (iii) breach claims for board-level actions, or inactions, that somehow allow the harassment to continue (i.e., the "blind eye" perspective); and (iv) securities-law-based allegations related to misleading or inaccurate statements regarding workplace sexual misconduct.

Those risk areas notwithstanding, perhaps a particularly disconcerting liability theme is that which relates to inadequate codes of conduct—something that the board may want to affirmatively discuss with its general counsel.

A/C Privilege and Lawyers on Boards

A recent federal district court decision (applying Tennessee law) concluded that the mere inclusion of a lawyer on the board of a nonprofit corporation did not establish the attorney-client privilege to communications with that director.

The case arose from a discovery/document production dispute in the context of a gender-discrimination-based termination action filed against a large nonprofit organization. The plaintiff (the terminated employee) sought to compel production of certain documents, some of which the defendant (a prominent zoo) sought to protect from discovery on the assertion of attorney-client privilege. The documents in question were emails to a member of the defendant's board, who also served as assistant general counsel for a large, unaffiliated corporation.

The zoo's argument was that the lawyer played multiple roles while serving as a board member, and in this particular circumstance (the discussions regarding the termination action), her role was to provide legal advice to other board members. The court rejected this position, holding that merely providing legal advice to other members of the board did not alone make any related communication privileged. Rather, an assertion of privilege required demonstration of an attorney-client relationship, and the zoo failed to establish that necessary fact. Indeed, the court's decision contained a useful analysis of the attorney-client privilege under state law.

Beyond the direct import of its conclusion, this decision is a useful reminder that the mere fact that a lawyer serves as a voting member of a board of directors is unlikely to provide a basis for any special benefits (e.g., reliance on advice) to inure to the board from that service, apart from the unique perspective that lawyer may bring to the board.

Director Refreshment Trends

The governance and nominating committee may wish to consider, and compare against its own policies, current trends with respect to director refreshment, in part as summarized in a recent paper from ISS Analytics.

Director refreshment is a term often used to describe the various ways in which boards seek to address issues associated with director and full board effectiveness, board composition and length of service. It most often is considered to include matters of term limits, age limitations, diversity commitments, competency standards, board and director evaluations, change in board/committee size, "fitness to serve" qualifications, "change in status" conditions, director succession policies and independence standards.

The ISS paper makes two notable conclusions from its survey data: first, that companies with balanced board composition, as it relates to director tenure, project more desirable performance indicators than companies whose board composition is heavily weighted in terms of director tenure (e.g., either short or long term). Specific recommendations include the following:

  • Conduct "robust" annual board and director evaluations that address the needs of the company.
  • Revisit previously targeted director skills and competency levels in the context of long-term corporate needs and the evolving market environment.
  • Establish specific board renewal programs that shape refreshment and tenure balance according to specific goals.

The ISS Analytics report serves as a prompt to health system board governance and nominating committee efforts to avoid director entrenchment and address the need for director independence, new board perspectives and enhanced diversity.

The California Diversity Law

The board nominating committee should consider the broader governance implications of the controversial new California law mandating certain levels of board gender diversity.

As is generally recognized, the law is limited in terms of its mandate, both as to the number of women required to be on the boards, and the fact that it applies only to publicly held corporations whose principal executive offices are located in California. Governor Jerry Brown also has acknowledged the potential flaws in the legislation and how they may ultimately "prove fatal to its implementation." But the law's controversial nature, and its limited application, should not prevent the nominating committee from discussing of the broader policy (and political) issues it presents.

The inclusion of diversity across all elements—gender, race, age, experience—within governance remains an important "best practice" for both the full board and its nominating committee. Regardless of whether the California law is sustained, this emphasis won't be changing any time soon. The nominating committee should be particularly focused on a thorough process for accommodating diversity principles and concepts within its director recruitment, nomination and retention efforts. The new California law notwithstanding, this process should not be limited to gender diversity.

Indeed, the new law demonstrates both the willingness of legislatures to directly intervene in aspects of corporate governance that have traditionally been limited to the courts, and the likelihood that governance will become a political issue in future election campaigns at the state and federal levels.

Corporate Law & Governance Update - October 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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