Corporate Law & Governance Update - June 2019
AHA GOVERNANCE SURVEY
The governance and board development committee will benefit from an overview of the American Hospital Association (AHA) 2019 National Heath Care Governance Survey Report, which describes a governance field in transition.
“Positive trends” identified by the report:
Consistent growth in use of routine executive sessions over the past three years, considered [by the report] a governance best practice
Some growth in racial and ethnic diversity of board members
A solid majority (about two-thirds) of all responding boards engaging in restructuring efforts to improve governance
Increased use of board portals, also considered [by the report] a governance best practice
Inclusion, by almost half of responding system boards, of board members from outside of communities served to add fresh perspectives to board deliberations
“Opportunities for improvement” identified by the report:
Almost one-third of all respondents did not use term limits.
More than 75% either did not replace board members during their terms or continued to reappoint them when eligible during the past three years, resulting in low levels of board turnover.
More than 70% of responding boards did not have a continuing education requirement for their members.
Some 31% did not conduct board, board member, or board or committee chair assessments in the past three years.
Boards surveyed indicated a growing number of older members and fewer younger members.
Almost half (49%) of respondents did not have a
formal CEO succession plan.
The chief legal officer, chief compliance officer and chief governance officer may team to brief the board and its relevant committees on the AHA’s valuable new report.
The recently released results of an internal investigation of director-as-vendor relationships at a large nonprofit medical system provide an informative perspective on potentially problematic relationships and conflicts review processes, and on the personal and organizational costs arising from them.
The internal investigation was prompted by media allegations that 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 was also a system board member).
The investigation report concluded, among other things, that there were multiple instances in which business relationships involving medical system board members were not fully vetted by the system’s governing board before being implemented by management and/or were not subjected to competitive bidding. Other conclusions were that some implicated transactions did not appear to have been presented to the board (or an appropriate committee thereof), in contravention of existing system policies, and, indeed, that members of the management team may have taken, upon their own authority, the right to enter into vendor agreements with board members that resulted in personal gain. In response to the report, the UMMS leadership has adopted a new conflicts of interest process designed to address the identified concerns with process.
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, many of the implicated directors have resigned. Just as significantly, the CEO and four other senior executives (the chief administrative officer, the general counsel, the compliance officer and the chief performance improvement officer) have also resigned. Separate federal and state investigations are ongoing with respect to the contracts with the former mayor, and the state legislature has considered several proposals to prohibit or at least further regulate such arrangements in the future. Other state legislatures, and especially their charity regulators, have surely taken notice; the climate for director-as-vendor relationships is quite inclement at this time.
This controversy should prompt boards to reconsider current policies on director-as-vendor relationships, re-evaluate the process for vetting such 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.
THE BOARD’S CAREMARK DUTIES
The audit and compliance committee may benefit from awareness of elements of the recently released US Department of Justice (DOJ) Compliance Program Guidance that directly affect the board’s Caremark obligations for compliance plan oversight.
The new guidance contains several references to the role of governance in the oversight of an effective corporate compliance program:
Oversight of Culture of Compliance: whether employees are “convinced” of the corporation’s commitment to compliance
Informed Oversight: whether the board is “knowledgeable” about, and exercises reasonable oversight of, the company’s compliance and ethics program
Board Composition: whether compliance expertise is available on the board of directors
Information Flow: whether the board/committee receives timely information on legal compliance matters
Reporting Relationships: whether the CCO has direct access to the full board or its audit committee
Board Meetings: the frequency and format of meetings between compliance/control functions and the board/its audit committee
The new guidance also sets forth several significant new DOJ evaluation themes of which the committee, in its oversight, may wish to be made aware. These include:
Emphasis on corporate risk assessment (especially with respect to high-risk areas)
The ongoing vitality of compliance policies and procedures
The scope of employee compliance training
The continuing value attributed to well-functioning whistleblower programs
Emphasis on effective and transparent internal discipline (relevant to the board’s oversight of the activities of senior management)
The extent to which compensation arrangements are used to achieve compliance goals
BUSINESS DISRUPTION DEVELOPMENTS
A new survey from Corporate Board Member and EY offers an interesting perspective for the strategic planning committee on how boards are currently positioned to address the opportunities and risks related to disruptive technology.
The new survey, “How Boards are Governing Disruptive Technology,” reflects the perspective of 365 corporate directors. A main theme of the survey was directors’ need to stay informed on the topic of disruptive technology in order to better exercise oversight of management’s assumptions and strategy. Other key survey findings included the following:
A substantial majority of directors believe that oversight of emerging technologies resides with the full board.
Directors are divided as to whether their boards have the appropriate resources to move their companies forward in this era of digital disruption.
Most boards rely on management as their primary source for staying current on industry trends, emerging technologies and innovation.
Directors say the biggest challenges to adopting emerging technology are those related to integration and talent.
Boards can help their organizations mitigate risks brought on by disruptive technology by including the topic on the full board agenda and reviewing the organization’s enterprise risk management framework.
A majority of directors agree that boards can enhance their oversight of disruptive technology through tailored board training and education.
A substantial majority of directors would support potentially disruptive innovation projects that offer long-term value even if they create additional risks and may not produce short-term results.
BOARD DECISION-MAKING PROCESS
A recent article in The Wall Street Journal describes how a corporate culture of frugality and risk avoidance at a major home products retail chain hindered its ability to take risks with technology, leaving it vulnerable to e-commerce competition.
The company’s problems ultimately led to a challenge from activist investors, which resulted in a recent settlement, the unseating of senior officials and a reconfiguration of the board.
According to the Journal, the famous company’s crisis with e-commerce was years in the making and grounded in a culture of frugality developed when it was building a network of stores. While that culture was effective in the company’s development and expansion stages, former employees stated that it left the company poorly positioned to transition to e-commerce opportunities. Indeed, those interviewed by the Journal commented that such frugality, combined with risk-averse leadership and a lack of urgency, became problematic when it came time to modernize and invest heavily in technology. For example, a website upgrade took three years, and a loyalty program took two years to implement.
In many ways, this company’s saga (and the challenges of retail in general) offers a cautionary lesson for health care systems and other health sector companies that have been unable to identify and implement a pathway for competing in the new, digital/disruptive environment. This includes a willingness to invest in technology to any considerable degree, and an ability to take risk.
OVERSIGHT OF CONSUMERISM
Kaufman Hall’s 2019 Healthcare Consumerism Index provides a useful platform from which governance can educate itself on the challenges that legacy providers face when responding to increasing health care consumer needs and expectations.
The Index results offer thoughtful observations on health industry performance related to consumerism, based on survey responses from health systems nationwide reflective of what Kaufman Hall identifies as the four pillars of consumerism: access, experience, pricing and infrastructure. The results conclude that while a majority of hospitals and health systems seek to increase their efforts to become more consumer focused, significant opportunities remain for improvement across the four core pillars. Some systems seek to develop consumer-centric capabilities internally, while others are seeking help from outside organizations with expertise in specific areas (e.g., partnerships for virtual health services, digital experience tools, outpatient imaging or lab services, retail clinics or urgent care, and digital scheduling tools). Interestingly, 13% of respondents said they have no partnerships aimed at building capabilities for consumerism.
For health care boards, a key takeaway from the Index results is that consumer-centric strategies and capabilities—whether built internally or in conjunction with external partners—are essential to health systems’ ability to compete with increasingly larger industry contenders and innovative new entrants. The Index warns that the “industry’s historically slow, measured pace of change is working against legacy organizations, causing them to fall further and further behind in a race where the competitors already have significant advantages of greater agility, flexibility, and resources.”
Boards should carefully consider the Index’s recommendation for legacy health systems to rethink their overall delivery model and seek opportunities to meet consumer needs and expectations directly. Implicit in this recommendation is the prompt for boards to become more attentive to consumerism issues, so that they are able to engage with management directly on such issues and related opportunities.
FACILITATING COMPLIANCE OFFICER AUTONOMY
The new compliance program guidance recently released by the US Department of Justice’s Criminal Division provides direction on the important yet sensitive topic of compliance officer autonomy and reporting relationships.
The new guidance directs prosecutors to examine whether those charged with a compliance program’s day-to-day oversight have, among other factors, “sufficient autonomy from management, such as direct access to the board of directors or the board’s audit committee.” What is “sufficient” will depend on the company’s size, structure and risk profile. Related areas of prosecutorial focus include the frequency with which compliance authorities meet with the board, whether members of senior management are present for such meetings, and other steps taken by the corporation to ensure the independence of compliance and control personnel.
The new guidance offers no specific perspective on the autonomy implications of compliance-officer-to-chief-legal-officer (CLO) reporting relationships. Rather, prosecutors are encouraged to ask where within the company the compliance function is housed (e.g., within the legal department, under a business function, or as an independent function reporting to the CEO and/or board). They are also encouraged to ask to whom the compliance function reports.
But, consistent with DOJ’s “facts and circumstances” approach to program effectiveness, the new guidelines neither recommend nor proscribe a specific reporting relationship; the emphasis is more generally on autonomy. This is notable in the context of compliance-officer-to-CLO reporting relationships, which have long been a controversial topic. The New Guidelines suggest that there is no “one size fits all” approach to compliance officer autonomy; certain types of reporting relationships that support program effectiveness in some circumstances may hinder effectiveness in others.
Organizations that seek to implement innovative enterprise risk management structures that envision more horizontal and vertical communications between officers with legal, compliance and risk responsibilities can thus refer to the new guidelines when designing such structures to ensure a satisfactory level of CCO autonomy.
THE SHADOW BOARD
A new article published in the Harvard Business Review makes an intriguing suggestion for how boards of large organizations may use a management and governance structure to address challenges with disengaged younger employees and a weak response to changing market conditions.
The recommendation is to use a “shadow board” of non-executive employees to work with senior executives on matters such as strategic initiatives, innovation, business disruption and consumerism. The goal is to leverage the insights of younger members of the workforce, and to provide a more diversified perspective than that to which executives (and board members) are otherwise exposed.
The article references several different organizational examples of the successful application of the “shadow board.” In these examples, millennial representation on the shadow board helped to develop targeted branding for specific products, identify improvements for the allocation of assignments among executive leadership, and strengthen corporate efforts to implement an internal digital and cultural transformation.
The shadow board is not a unit of governance in a traditional sense. Its members do not have explicit fiduciary obligations. Instead, it is more of a workplace incubator to tap perspectives of an underutilized constituency. Especially when coupled with CEO sponsorship, the shadow board can provide a vehicle for increasing the visibility of millennials in the workforce.
Given the widespread use of advisory boards and other forms of nontraditional governance bodies in the health care sector, it is conceivable that such a shadow board could be organized along the lines of the more traditional advisory board or advisory committee, with specific responsibilities to advise the board and management on matters of innovation and consumerism.
Such a shadow board would be somewhat responsive to progressive political calls for more worker involvement in corporate governance, and to concerns reflected in recent governance surveys that millennials and other younger constituencies are significantly underrepresented on corporate boards. Indeed, these surveys indicate that companies in the IT/communications/“new economy” sectors have boards with the highest percentage of younger members.
A new Federal Trade Commission (FTC) staff blog post reminds boards and corporate strategy executives about the potential antitrust issues that may arise from interlocking director arrangements with competitors.
Interlocking director and officer arrangements have long been a popular means by which health care systems seek to foster collaborative arrangements. Perhaps their most frequent use is as a “get to know each other” step; i.e., a limited governance connection intended as a prelude to other, more integrated arrangements. Interlocking director arrangements are also used in certain types of corporate restructurings, “spin-off” transactions and acquisitions—especially those involving less-than-a-control position, where the minority ownership stake is supplemented by cross officers and directors. This could conceivably include new innovation spin-off entities.
Yet, as many general counsel know, Section 8 of the Clayton Act not only prohibits a person from acting as an officer or director of two competitors, but also prohibits any one firm from appointing two different people to sit as its agents as officers or directors of competing companies. Unlike the merger rules—with which boards and executives are somewhat familiar—Section 8 is a strict liability provision, meaning violations are per se and do not depend on actual harm to competition.
In its new reminder, the FTC provides three examples of transaction scenarios in which Section 8 issues may arise:
Mergers or acquisitions, when a company is acquiring or merging into a new business line
Spin-offs, where an officer or director retains roles with both the parent and the newly independent firm, if those two companies will compete in a line of business going forward
Certain M&A scenarios, when the company is considering potential restructurings or acquisitions
The FTC’s “reminder” is not an isolated event; it is consistent with prior guidance it has issued on Section 8, and a series of recent speeches given by US Department of Justice Antitrust Division officials on similar issues. There is a clear message from the antitrust enforcement agencies that companies should monitor market developments to ensure that changes in the market do not create unexpected interlocks.
The general counsel is thus well advised to remind officers and directors of Section 8 issues when planning or otherwise considering potential restructurings, “spin-offs” or acquisitions.
SPECIAL PURPOSE DIRECTORS
The concept of “special purpose directors”—i.e., directors who can “spring into action” in unique or challenging governance circumstances—is addressed in a thoughtful new article that is worthy of consideration by the board’s governance committee.
The article, “Calling the Cavalry: Special Purpose Directors in Times of Boardroom Stress,” is premised on the view that boards are currently fully occupied by exponentially increasing duties and responsibilities, and may have little capacity to deal with special situations (e.g., existential crises, transformative transactions, corporate restructuring, regulatory investigation/challenges, enterprise-threatening litigation). The suggestion, in such circumstances, is to form a special committee, with fully delegated powers and staffed in part by special purpose directors, to address the situation.
As suggested in this context, the term “special purpose directors” refers to a subset of individuals with particular temperament, industry experience, integrity, independence and reputation whom the company may call into limited-term board service to staff the special committee and help direct its response and recommendations. Typically they would form a large portion, but not all, of the seats on the special committee, working with some already-serving directors who could help provide leadership, continuity and background.
The article acknowledges that the ability to apply special purpose directors depends in large part on feasibility under state law, and whether the bylaws allow (or could be easily amended to provide) for a range of directors that would accommodate the addition of the special purpose directors. If legally feasible, the actual changes could then be effected by board resolution.
Some nonprofit health system boards have considered the use of special purpose directors as a means of securing independent approval of the establishment, and the determination of reasonableness, of director compensation programs.
As the article appropriately notes, there are several potential barriers to the use of special purpose directors, including the willingness of individuals to serve in that capacity, the compensation and benefits they may seek in return, whether their service creates any conflicts of interest, the speed with which they could become educated on the company and the issues presented to the committee, and the overarching issue of their capacity to render informed decisions.