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Corporate Law & Governance Update: December 2017

Unprecedented 2018 Board Challenges

The health system board should be prepared to address an extraordinary number of significant, enterprise-level challenges that are expected to arise in 2018. These challenges will impact governance elements ranging from the frequency and manner of board meetings, to information flow, to expectations of director engagement and to the board-management dynamic.  

These developments include, in no particular order: (1) the threat of significant business disruption, primarily through the entry of the Silicon Valley “disruptor” firms into various aspects of the health care sector; (2) the extraordinary level of consolidation in the health care provider sector and the increasing need for organizational “scale” in order to effectively compete; (3) the declining value of tax-exempt status and the benefits of considering some form of portfolio diversification; (4) the ability to implement effective executive and board level talent development efforts within a “seller’s market” for such talent (and given the restrictions of tax exempt, nonprofit status); (5) the need to develop a cohesive approach to the emerging fiduciary obligation to monitor workforce culture; (6) continued government enforcement focus on individual accountability for corporate misconduct; (7) addressing the likely inevitability of a cyberbreach; (8) continued credit ratings challenges, and the business model uncertainty associated with the fate of the Affordable Care Act; (9) the competitive and business model implications of the giant vertical combinations in health care; and (10) oversight of health system/physician relationships within the context of changes associated with the MACRA/Quality Payment Program.

In normal years, any one of these developments would be sufficient to occupy much of the board’s agenda and attention for the year. However, the incredible pace of change and looming industry disruption promises to test the capacity and effectiveness of the governing board in 2018. The extraordinary transaction activity of early December is a harbinger of this change. The general counsel, as a key governance advisor, can play an important role in supporting the ability of the board and management to anticipate and address these challenges. 

The Aftermath of the Tax Bill

Regardless of the ultimate resolution of the Tax Cuts and Jobs Act, the history of the legislative process may motivate boards of tax exempt hospitals and health systems to consider—more than ever before—the benefits of transferring more of their asset portfolio to controlled forms of for-profit ownership, thus reducing their portfolio commitment to the tax exempt sector.

It is painfully aware that, individually and jointly, the two Congressional committees responsible for drafting revisions to the tax laws—the House Ways and Means Committee, and the Senate Finance Committee—have proposed a wide variety of punitive legislative provisions that are principally aimed at the tax exempt hospital sector. These proposals include, of course, those related to access to tax exempt financing, use of deferred compensation, an excise tax on compensation in excess of $1 million, the loss of the rebuttable presumption of reasonableness, and increased UBIT provisions, among others. In a sense, by these various proposals, Congress is sending a clear message to the tax exempt health care sector that it is no longer “special”; that there is a disconnect between the benefits available from tax exempt status and the manner in which many tax exempt health care systems are operating. Proposals that do not make the final version of the tax bill could resurface again in the future.

Following enactment of the Tax Act, the relationship between the benefits of tax exempt status and the regulatory challenges associated with maintaining such status may be perceived as increasingly imbalanced. This realization may prompt inquisitive health system boards to consider evaluating the feasibility of various strategies by which the health system can shift assets to a taxable model, e.g., (1) direct conversion; (2) increased use of for-profit subsidiaries to hold existing assets; and (3) use of for profit and joint venture models through which new assets are developed and acquired. All this, notwithstanding the fact that some of the options may have significant legal and financial barriers. For, given Congress’ action, discussing “conversion” may no longer be boardroom heresy; it may actually be a prudent step.

GE's Lessons on Board Composition

The importance of board composition within the context of a transformative business climate has been emphasized by recent, highly publicized changes to the GE board, as well as by the release of a new survey on board composition.

The substantial restructuring of the GE board, as has been reported in The Wall Street Journaland other publications, will serve to reduce the size of the board from 18 to 12, and remove several long-standing directors, replacing them with directors whose expertise is more closely aligned with the strategy of the new GE CEO to streamline the iconic industrial conglomerate. GE’s actions offer several key lessons to health care boards as they grapple with issues of board composition and organizational strategy.

First, it is important for the board to periodically evaluate its composition to assure the necessary level of effectiveness given the competitive environment, business cycles, disruption and consistency with strategic direction.

Second, there is no “best practice” when it comes to board size. The standard should be whether the board size is sufficient to assure that it is capable of satisfying “the business of the board” with the necessary level of engagement, that the health system maintains a culture of legal compliance, effectively safeguards its assets, and furthers its organizational goals and objectives. As the IRS itself has noted, very small or very large governing boards may not adequately serve the needs of the organization. If a corporate behemoth such as GE believes it can be effectively governed by a 12 person board, it may be more difficult to argue that large health systems require large boards to assure effective governance.

Third is the need to address needed skills, competencies and backgrounds in the director nomination process; i.e. selecting directors whose individual expertise is complementary with the strategic direction of the company. (This is particularly important in health care, as many providers and other organizations are revisiting their strategic direction in response to dramatic industry change).

Fourth is the need to maintain robust board refreshment policies and procedures that allow the board to re-tool itself as may be necessary, especially when confronted with concerns about lack of performance by the board as a whole, or by particular constituencies of the board.

Also notable is a new consulting firm survey on board composition, which recommends continued emphasis on such important issues as director diversity, tenure and qualifications.

Anticipating Business Disruption

Multiple recent developments suggest the need for health care system boards to recognize the potential for, and anticipate the implications of, impending business disruption from sources that include, but are not limited to, the Silicon Valley “disrupter” firms; the giant vertical mergers combining heretofore disparate participants in the health care sector; the entry of major new sector participants; and evolving business models.

Indeed, the National Association of Corporate Directors’ annual governance survey identifies industry disruption and business model disruption as the top two trends surveyed directors identified as primary areas of governance concern. Ken Kaufman identifies the high costs of health care delivery, and the lack of convenience associated with its delivery, as increasing traditional health care’s vulnerability to disruption. Even though factors such as industry size and the complexity associated with health care delivery have slowed the progress of disruption, there are increasing indications of how new market entrants are using technology, scale, and consumer insights to compete with existing health care companies on levels of price, convenience and compatibility with the larger digital experience.

The potential disruption of traditional health care is a central challenge for health system governance and the board’s responsibility to sustain the mission of the organization. From a governance perspective, “business disruption” is similar to strategic planning, in which there is a prominent role for both the board (to encourage the development of a plan, and to make sure that management implements it) and management (to develop the actual plan).

The business disruption-related issues the board will want to consider include, but will not be limited to (1) management’s obligation to keep the board informed as to the potential for disruption; (2) whether the board should be proactive or reactive to management advice in identifying potential disruption concerns; (3) the extent to which the board endorses management’s perception of who the disruptors are, the nature of the disruption risk, and the timing of the disruption; (4) whether the board should increase its level of engagement and attentiveness when addressing disruption issues; (5) whether the board feels the imperative to reconstitute its membership to include directors more attuned to identify likely disruptive events; and (6) the need to expedite the board’s traditional decision-making process to address disruption threats and eliminate vulnerabilities.

The WonderWorks Investigation

A recent report from a court-appointed bankruptcy examiner provides an fascinating case study of how a “dominant” chief executive, “left unchecked by a passive and overly deferential Board of Directors, can damage a charity beyond repair.”

The examination was of WonderWork Inc., a New York-based charity that provides surgeries across borders to patients suffering from such ailments as blindness, burns or clubfoot. The charity provides free training, equipment and other aid to doctors in foreign countries so they can perform the necessary surgeries (as opposed to sending American doctors).

The circumstances were prompted in large part by WonderWork’s Chapter 11 bankruptcy filing, which was prompted by the financial challenges associated with an adverse arbitration award arising from litigation with a competing charity. The court appointed examiner conducted a five month examination that uncovered evidence of both financial mismanagement, and improper fundraising and reporting practices, including allegations that the CEO misapplied charitable donations for his own purposes, promoted the use of incorrect and misleading charitable solicitation materials, failed to comply with matching donation commitments, and submitted misleading statements in public filings. The examiner also considered the conduct of the WonderWork board and concluded that a cause of action existed for WonderWork, as debtor in bankruptcy, to pursue certain of the Debtor’s directors based on inattentive oversight (while noting that the likelihood of prevailing on such claims was uncertain; i.e., whether the examples of inattentiveness constituted gross negligence).

The more than 280-page report included a recommendation that a trustee be appointed to run WonderWork, given the evidence of both financial mismanagement, and improper fundraising and reporting practices.

Both the depth of the examiner’s analysis, and the scope of its concerns with the role of corporate governance in connection with oversight of executive management, offer many lessons on how deficiencies in the board/management relationship can lead to fraud and mismanagement. Along with the University of Louisville Foundation, Wounded Warrior Project and amfAR, the WonderWork situation is one of the most consequential nonprofit controversies over the past year. 

Breaking the Bad Faith Barrier

The standard of proof required to sustain breach of duty of care allegations against corporate directors is increasingly being challenged in shareholder derivative and similar litigation, with particular implications for the level of attentiveness required of such directors in connection with their oversight and decision-making obligations.

Delaware law has historically maintained a high pleading standard in order to demonstrate a breach of fiduciary duty for failure to exercise oversight over compliance matters and corporate business risks; that a “sustained or systemic failure” to exercise oversight is needed to establish the lack of good faith necessary to establish liability (i.e., a demonstration of bad faith). Nevertheless, there is increasing concern that litigation involving extraordinary fact patterns, perhaps coupled with significant consumer and/or shareholder harm, may apply less demanding standards and thus prompt more unexpected results, based upon a disconcertingly strict application of the business judgment rule (as it is applied to a particular board decision) or other standards. As governance thought leaders have noted, this risk is likely to be higher in jurisdictions outside of Delaware.

An example is a recent decision of a federal District Court in California in a derivative suit against the directors of a financial services company that had suffered significant financial harm due to a flawed sales model within one of its operating divisions. The specific allegation was that the directors were inattentive in their oversight of the business activities of the operating divisions; inattentiveness which was a proximate cause of the damage. The defendants had challenged the litigation on the grounds that it failed to state a cause of action against the directors. Notably, the District Court ruled that the plaintiffs’ pleadings made an adequate demonstration that the directors “consciously disregarded” their fiduciary obligations relating to the duty to monitor business operations and risks.

While this particular derivative action is far from a final ruling, it offers a useful reminder for the board to maintain vigorous information reporting, oversight and decision-making processes based upon reasonable practices, and not the “bare minimum” necessary to come within business judgment rule and other forms of liability protection. It should also prompt individual directors to be more assiduous in their preparation and more engaged in board discussions and in the exercise of constructive skepticism. In other words, while it may remain fairly challenging to maintain a breach of duty allegation based on inattentive oversight, there is an increasing likelihood of risk associated with excessively deferential, passive or uninvolved director conduct.

Nonprofit Transaction Subject of Criminal Investigation

The Department of Justice’s criminal investigation of the AIDS charity amfAR’s business transactions with Harvey Weinstein serves as a reminder that the state attorney general is not the only law enforcement agency that has the jurisdictional base from which to investigate certain types of business transactions involving nonprofit organizations.

The core of the controversy reportedly arose from a fundraiser for amfAR, for which Mr. Weinstein provided two items for auction. Allegedly, the contribution was conditioned on an agreement that amfAR would to transfer $600,000 of auction proceeds to the American Repertory Theater, a nonprofit theater that had done a trial run of a musical produced by Mr. Weinstein. According to news reports, the theater had agreed to reimburse Mr. Weinstein for previous production costs and a charitable contribution if he could offset them with payments from third parties. (Theoretically at least, that could prompt private benefit concerns, among other issues.)

Since then, multiple media outlets have reported that the US Attorney’s Office for the Southern District of New York is conducting a criminal investigation into transactions (which, according to media reports, have also been the subject of two separate internal legal investigations requested by the amfAR board). A federal criminal investigation of a nonprofit business transaction is highly unusual (apart from anti-kickback and similar matters), as the state attorney general is often viewed as the regulatory agency with primary enforcement responsibility over the business operations of charitable organizations (the New York State Attorney General has been involved in the amfAR matter).

Indeed, there can be a range of charges—from embezzlement, to mail/wire fraud, honest services fraud and 18 USC sec. 666 (theft/bribery in connection with federal programs)—available to the Department of Justice to investigate nonprofit organizations. Sometimes, these types of laws are used to pursue fraud allegations involving misuse of charity funds by officials associated with those charities, and by the executives of those charities. The general counsel can use the current amfAR controversy as a reminder to corporate leadership that, in addition to the state attorney general, the Department of Justice may well have jurisdiction to investigate charity business practices, particularly in the presence of allegations that corporate insiders are, through various business transactions, taking advantage of the charity.

Rosenstein Affirms Individual Accountability Focus

In his comments introducing a new Foreign Corrupt Practices Act (FCPA) Corporate Enforcement Policy, Deputy Attorney General Rod J. Rosenstein strongly endorsed a continued DOJ emphasis on individual accountability as an enforcement mechanism. This could presage the scope and nature of the anticipated changes to the so-called Yates Memorandum, and thus is worthy of note by the Board’s Compliance Committee.

Of course, the FCPA does not apply to the conduct of most domestic-based health care systems, and is unique in its emphasis on voluntary disclosure, and the expectation that DOJ will resolve a matter through declination (if the self-disclosure reflects full cooperation and timely and appropriate remediation). Nevertheless, Mr. Rosenstein’s comments introducing the new policy were replete with references to the continuing DOJ emphasis on holding individuals accountable for criminal conduct, without unnecessarily penalizing corporate constituents. “Effective deterrence of corporate corruption requires prosecution of culpable individuals. We should not just announce large corporate fines and celebrate penalizing shareholders.” There was also a recognition that “most American companies are serious about engaging in lawful business practices and want to do the right thing.” In his comments, Mr. Rosenstein also spoke to the value of incentivizing companies to engage in ethical behavior (e.g., to fully cooperate, and to remediate misconduct).

In addition, Mr. Rosenstein referenced several corporate compliance program-related changesincorporated within the new Policy as “hallmarks of an effective compliance program”: (the board’s) fostering a culture of compliance; dedicating sufficient resources to compliance activities; and ensuring that experienced compliance personnel have appropriate access to management and to the board.

The unique nature of the FCPA notwithstanding, Mr. Rosenstein’s comments suggest that any forthcoming changes in what has been called the “Yates Memorandum” will focus on strengthening individual accountability measures and emphasizing the elements and benefits of robust compliance programs.

Additional Role for the General Counsel

Because the GC is the primary advisor to the board on its compliance oversight obligations, it is a logical step that she would be the best qualified executive to serve as primary board advisor on workforce oversight obligations; the duties and goals are extremely similar.

One of the principal governance developments of 2017 has been the emergence of board oversight of workforce culture as a new governance “best practice.” Many boards are struggling to understand not only the definition of “culture,” and their basic their responsibilities for organizational culture; but also who among the executive leadership team is best suited to advise them on their culture-related responsibilities. Several internal executives (e.g., the SVP/HR and the CCO) are likely to jockey for the role as board advisor on corporate culture.

However, many signs point to the general counsel to fill that role, given her service as both technical legal advisor and ethical counsellor. But one of the most compelling reasons falls into the “been there, done that” category—that the general counsel’s experience as the board’s chief advisor on compliance program oversight is a compelling qualification for her to serve as its chief advisor on workforce culture oversight. There are notable similarities between the board obligation to oversee workforce conduct, and its historical oversight obligations with respect to legal compliance. At their core, both obligations are based on a need to monitor and favorably motivate employee behavior in a manner reflective of corporate mission and values—and law. They both recognize that appropriate, consistent culture across the entire organization is a unifying force, and an organizational asset. They also recognize that deviations from conduct-related policy can have serious legal and reputational implications. These are all concepts with which the general counsel is most familiar from her role as legal compliance program advisor to the board.

New Hospital Tax Exemption Revocation

The recent IRS decision to revoke the tax exempt status of a general acute care hospital—the second revocation action in 2017—is the latest example of what appears to be an invigorated Exempt Organizations Division.

The most recent revocation action involved a rural hospital that had experienced a prolonged period of financial distress. At some point in its operating history, it entered into a lease with a for-profit entity covering property, plant and equipment as well as control over hospital operations and revenue collection. Subsequent to the transfers and the execution of the lease, the sole remaining activities of the tax exempt entity were acting as lessor of the property, enforcing the lease covenants concerning the operation of the hospital facility, and monitoring the hospital facility operations. The revocation was based on a determination that the tax exempt organization was no longer operated exclusively for exempt purposes, but by the operation of the lease was extending impermissible private benefit to the lessee. The IRS interpreted the lease terms as leaving the tax exempt entity in basically an advisory role. (This revocation action is separate and distinct from an earlier 2017 revocation action, which was based on the hospital’s noncompliance with IRC Sec. 501(r)).

The principal tax planning lesson from this revocation action is the importance that should be attributed to articulating the requisite extent of control retained by the tax exempt organization over the charitable facilities in any relationship (e.g., management contract or joint venture) with a for-profit entity. It is an issue that should be discussed in the initial planning for the relationship and reflected in sufficient detail in the definitive agreements.

© 2018 McDermott Will & Emery

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