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Corporate Law & Governance Update April 2019

Directors As Vendors

A new controversy at a large health system highlights the legal and reputational challenges that can arise when directors sell services to the organizations they serve as fiduciaries.

According to media reports, approximately one-third of the health system’s 30-member board provided the system with goods or services for which compensation was payable. Many of these were traditional in nature (e.g., consulting, banking, pest control, civil engineering, insurance, physician services), but others were less so (the purchase of 20,000 books written by a local government official who is also a system board member).

The propriety of director-as-vendor relationships has long been debated. They are generally perceived as legally compliant, given state laws that authorize the payment of reasonable compensation to directors for services rendered—particularly where there is an identified need for the service and the director or the director’s firm is uniquely qualified to provide the service. On the other hand, such arrangements can attract significant external scrutiny, and they reduce the number of independent directors on the board.

In the current situation, at least three of the implicated directors have resigned. Others have taken voluntary leaves of absence, and the CEO is on temporary leave. Several proposals have been presented in the state legislature to prohibit or at least further regulate such arrangements in the future.

This new controversy may prompt boards to reconsider current policies on director-as-vendor relationships and ensure proper disclosure of interested party transactions on the Form 990. It also serves as a reminder of the value of maintaining board control in independent directors.


Inurement And Entrepreneurialism

Recent controversy, featured in both social and mainstream media, involving the creative structure of a new charitable fundraising/incentive compensation program is a reminder to carefully conduct tax planning prior to structuring entrepreneurial-styled ventures with tax-exempt organizations.

The charity’s mission is to end the water crisis in our lifetime, and to bringing clean water and healthy sanitation services to people who live in water impoverished and sanitation distressed areas. Its new funding program allows entrepreneurs who own large positions in private companies to make equity donations (usually pre-IPO) to the charity. If the company goes public, is sold or otherwise converts to public ownership, some of the proceeds from the stock gains would be used to pay bonuses to the charity’s employees. The goal is to encourage donations while supporting talent development by providing the charity’s employees with the potential for equity upside.

The new program has attracted not only significant investment, but also some concern from the philanthropic community that the unconventional bonus program could constitute “inurement per se”—i.e., that the structure of the employee compensation, regardless of whether the compensation paid is reasonable, constitutes proscribed inurement of net earnings, the sanction for which is loss of tax-exempt status.

The private inurement proscription generally provides that no part of the net income of a tax-exempt organization may inure to the benefit of any private shareholder or individual. While structural inurement could be raised by the proposed program, The New York Times coverage did not provide enough information to determine whether the charity’s arrangement constitutes inurement per se. Key factors would be the structure of the bonus payment and whether the amounts paid are reasonable compensation.

For example, it would be perfectly permissible to use the gains from the sale of such securities to fund incentive pools that could be used to provide bonuses to the charity’s employees, if the compensation amounts paid were reasonable and not inconsistent with the charity’s tax-exempt status. By contrast, merely distributing the gains to employees could be problematic.

Tax-exempt health systems are actively establishing new ventures to pursue innovation and the commercialization of research. Many of these ventures are designed to apply creative, entrepreneurial business practices to what are essentially charitable ventures. This particular charitable program controversy underscores the value of legal and tax due diligence when creating such ventures, and shows how such arrangements may be described to the general public. This controversy also underscores the dangers of using social media to announce innovative programs that potentially raise tax-exemption issues.


Major Overboarding Development

Board governance and nominating committees may consider adopting standards on outside board service following Vanguard’s new policy on “overboarded” directors.

The focus on overboarding and its relationship to director effectiveness dates back to the Sarbanes era, when concerns first arose about the connection between director attentiveness and distractions from service on other boards. Both the Business Roundtable and the Commonsense Principles have historically been reticent to recommend limits on other activities directors may pursue outside of their board duties. Given the increasingly significant responsibilities associated with board service, however, there are now higher expectations relating to director engagement.

This is the context in which the Vanguard policy has arisen. Vanguard’s April 1, 2019, proxy voting guidelines provide that the firm will vote against any director who (1) is a named CEO and sits on more than one outside board (and will vote against the director at each company where he or she is a non-executive except the one where he or she serves as CEO), or (2) serves on five or more public company boards (and will vote against the director at each of these companies except, generally, one where he or she serves as chair of the board).

This is not to suggest that Vanguard’s “five boards” limit should represent “best practice” (and arguably the policy should apply to service of sophisticated nonprofit organizations as well). But the governance value of the Vanguard policy is its firm commitment to monitoring overboarding situations, of which health care boards should take notice.

Director Independence Trends

The governance improvements recommended by the Nissan Special Board Committee endorse the importance of vesting board leadership in a majority of independent directors.

The Special Committee was formed in response to the Carlos Ghosn controversy and was intended, among other tasks, to provide recommendations for Nissan “to create a healthy state of governance as a foundation for sustainable business as a world-leading company.” The Special Committee concluded in part that the underlying misconduct it identified was due in large part to the concentration of authority in one director (Ghosn) and the partial failure of the functions of the board to supervise, monitor and audit Mr. Ghosn.

The Special Committee’s overarching recommendation was to adopt a governance system grounded in a board of directors consisting of a majority of independent directors, in order to overcome the misconduct identified in the report and to regain the international committee’s trust in Nissan governance. The composition of the nominating and compensation committees would consist entirely of independent outside directors, and the board chair would also be an independent outside director.

These recommendations underscore the importance that US corporate law and governance discourse attributes to ensuring that a significant majority of the board, and all of the members of key committees (e.g., audit, compensation, and nominating and governance committees) be independent, consistent with applicable standards (e.g., the New York Stock Exchange rules, state law or acknowledged governance best practices). The fundamental goal is to prevent circumstances in which the board is beholden, by the nature of relationships or positions, to the CEO or management.


Age Diversity On The Board

The governance and nominating committee may wish to give additional attention to the matter of age diversity on the board—and how that may be accomplished—according to a new PwC survey.

Clearly, matters of diversity across multiple dimensions (e.g., gender, ethnicity, race, education, thought, background and skills)—continue to attract fiduciary attention. Boards seek cultural and board composition avenues to support efforts to satisfy the corporate mission and purposes, improve talent development, achieve greater financial performance and meet leadership responsibilities in the marketplace. Of the recognized elements of diversity, the matter of director age has yet to receive substantial attention in mainstream governance dialogue.

PwC’s 2018 Annual Corporate Directors Survey contains useful information on the age diversity issue—notably that only 21% of surveyed directors regard age diversity to be a very important board composition issue (compared to 49% who believe gender diversity to be very important). Other interesting survey results include the following:

  • Younger directors (age 50 and younger) fill only 6% of board seats on S&P 500 companies—but 46% of those companies have at least one younger director.

  • 37% of younger directors are women.

  • 95% of younger directors have “active careers.”

  • Almost half of younger directors serve on the audit committee.

PwC’s survey identifies three specific benefits of adding younger members to the board:

  • They typically offer different expertise and skill sets than more established directors—skill sets that can help the board exercise enhanced oversight of new opportunities and challenges.

  • Because they are typically more active in the workforce, they have unique first-hand experience in the current business environment (and are also more familiar with younger consumer preferences and consumer demographics).

  • Together with more experienced directors, they can create a “unique and valuable mix of perspectives.”

The PwC survey and other similar analyses provide important reasons why younger directors should be a specific consideration for the nominating committee in its development and implementation of a framework for identifying appropriately diverse candidates.


Nonprofit Derivative Action

recent federal district court decision addresses the ability of a member of a nonprofit corporation to pursue a derivative claim against the corporation’s directors.

The particular case arose amidst a long-running controversy involving the decision of an Illinois nonprofit corporation to remove an individual member of the corporation. That (removed) member filed an action in federal court (diversity of citizenship) alleging that the corporation’s directors had breached their fiduciary duties by (1) holding a special meeting to amend the corporate bylaws without notifying the members and eliminating the application of Robert’s Rules of Order as procedural requirements, and (2) changing the bylaws and implementing a separate side agreement amongst themselves to disenfranchise the members by distorting their votes.

The court drew a distinction between claims seeking relief of an injury to the corporation (which are to be made in a derivative action on behalf of the corporation) and claims seeking relief for direct harm (which require demonstration of specific harm to the plaintiff individually). In this regard, the court noted that standing would exist only for the claim seeking equitable relief (disclosure and rescission of the side agreement among the individual directors and replacement of one director by a successor properly elected by membership). The count alleging direct harm to the individual member failed because the corporation did not owe a duty to the members/shareholders of the type alleged by the plaintiffs.

Remedies available under nonprofit law to enforce director and officer duties, such as derivative actions by members of the corporation, vary according to jurisdiction. This district court decision is noteworthy to the extent it recognizes standing for a derivative action in the context of a bylaw dispute (especially with Robert’s Rules implications). As incidents of controversy between nonprofit membership and boards of nonprofit organizations begin to increase nationally, the health system general counsel may wish to focus on the range of available remedies against officers and directors, especially in the derivative context.


Proper Board Size

Tesla’s decision to reduce the size of its board prompts renewed focus on the proper size for the governing board of a health system parent or controlling company.

According to The Wall Street Journal, Tesla is planning on reducing the size of its board from 11 to seven directors over the next several years as part of a gradual effort to increase the number of independent directors on its board and more broadly to increase the effectiveness of board oversight. It is also proposing to remove a supermajority voting requirement and reduce director terms from three to two years.

There is no “hard and fast” corporate law rule on proper board size. The general guideline is that boards need to be large enough to accommodate diversity of perspectives and to manage required board processes, but small enough to promote an open dialogue among directors.

Boards that fall at either extreme in terms of size may fail to serve the needs of the organization. Small boards risk lacking the skills and other resources required to effectively govern the organization. Very large boards may be challenged to function efficiently and to make decisions in a timely manner.

The Tesla action is likely to attract broader attention in the corporate world, especially among those who support the smallest possible number of directors on the board. Yet in its periodic consideration of board size, the governance committee should be guided by factors that are intended to enhance director engagement and independent board oversight.


Health Care Disruption Notes

Recent indicators on retail store closings (and the factors motivating such closures) have substantial relevance to business disruption trends in health care and to boards that monitor such trends.

The New York Times recently reported on how internet-prompted changes in consumer shopping habits have affected retail stores. According to Coresight Research, as of mid-April 2019, US retailers had announced plans to shut 5,994 stores this year, exceeding the 5,854 closings announced in all of 2018. Financially stable retailers are paring locations as their leases expire, while other major brands are filing for bankruptcy and closing hundreds of stores shortly thereafter. The suggestion is that retail will not grow again from a brick-and-mortar perspective, and that surviving stores are those that offer consumers more compelling experiences and better complement online shopping options.

Kaufman Hall’s Rob Fromberg suggests that health care boards take note: “Online sales as a percentage of all retail sales has been in single digits for years and just hit 10 percent (estimated) in 2018.” According to Fromberg, “[T]hat has two implications for legacy healthcare organizations that may be tempted to point to single-digit use rates of retail clinics and telehealth as evidence that the threat is weak: 1) a small shift in consumer behavior can have a huge effect economically, and 2) a statistic such as use rates is only one piece of evidence of a much larger socioeconomic shift. In other words, the comparison to retail is quite valid.”

Kaufman Hall Chairman Ken Kaufman adds two economic observations. “The first is that firms succeed or fail on the margin. So even though only 10 percent of all retail has moved on-line that marginal change of revenue has been enough to bring hundreds of brick and mortar stores down. Second, the impact on retail of that 10 percent has likely been disproportionate . . . in other words some chains only lost 2 percent of business but others lost 17 percent . . . and those that lost 17 percent have gone bankrupt.”


Patagonia’s Strike For CSR

controversial marketing decision by the clothing company Patagonia is indicative of the extent to which sophisticated corporations are embracing corporate social responsibility principles.

In late 2018, Patagonia changed its mission statement to “We’re in business to save our home planet.” In connection with that change, Patagonia’s Corporate Sales Program recently decided to revise its co-branding products, to support brands aligned with its mission. Thus, as reported in The New York Times, future co-branding activity will shift away from financial services companies (e.g., its ubiquitous fintech-sector-branded fleece sweaters) and focus more on companies certified for environmental and social standards and performance.

This marketing decision is a notable and highly publicized extension of corporations’ increasing focus on corporate social responsibility (CSR) and social purpose. As defined by the American Bar Association, CSR principles refer to “voluntary corporate programs and practices that promote fairness, transparency, accountability and ethical behavior across global business, legal and social institutions.” The specific focus on corporate purpose has been magnified by the efforts of BlackRock chair Larry Fink to encourage companies to serve a social purpose. He writes, for example, that in order to prosper over time, “companies must not only deliver financial performance, but also show how it makes a positive contribution to society.”

CSR principles have appeared to come slowly to the health care sector, in part because of the prevalence of health care companies formed for charitable purposes, and in part because of the inherent social benefits of providing health-care-oriented services. However, as CSR is adopted more broadly across industry sectors, health care boards will be called upon to give greater consideration to the extent to which they are serving social purposes as the concept is increasingly defined.


Progressive Proposals Affecting Governance

As the 2020 election process moves forward, boards may wish to familiarize themselves with the views of the progressive presidential candidates on matters of corporate responsibility, individual executive accountability and antitrust.

For example, Senator Elizabeth Warren proposes to require corporations with more than $1 billion in annual revenue to obtain a federal charter. Directors of chartered companies would be required to consider not just the interests of shareholders, but also those of employees, customers and the communities in which those corporations operate. In addition, 40% of chartered company directors would need to be elected by the company’s employees.

Senator Warren has also submitted two separate but parallel criminal law proposals. One proposal would create a new permanent federal law enforcement unit for financial crimes; require senior executives of financial institutions to certify annually that they have conducted due diligence and found no criminal conduct or civil fraud within their institution; and provide for judicial oversight of deferred prosecution agreements.

The other proposal would introduce three separate means by which executives could face criminal liability for their inattentiveness to compliance risks, and reflects the senator’s stated annoyance with what she perceives as both a lack of executive accountability for corporate misconduct and the failure of prosecutors to criminally pursue those executives.

Senator Amy Klobuchar has proposed antitrust legislation to more closely scrutinize “mega-mergers” and deals that substantially increase market concentration, by shifting the burden to the merging companies to prove that their consolidation does not harm competition.

These and other bills project more aggressive concepts of corporate regulation, corporate responsibility and individual accountability. In anticipation of the 2020 election, health system boards may wish to evaluate how a progressive administration would affect corporate strategy, the tone of the system’s corporate culture, the effectiveness of its risk and compliance programs, and its relationship with its CEO.

© 2019 McDermott Will & Emery

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