Corporate Law & Governance Update: May 2018
Major Workforce Culture Controversy
A recent, highly-publicized controversy provides a near-worst case scenario of how workforce culture issues can damage corporate reputations and raise questions about board oversight.
The controversy involves widespread allegations of inappropriate workforce behavior by management-level employees of a major US-based international sports apparel company. The focus of the controversy was a series of female employee complaints of harassment and discrimination against women. It was ignited in large part by an internal survey, prepared and led by several female executives and distributed among the company’s female employees. The focus of the survey was on whether the respondents experienced sexual harassment or bias at the company.
Three factors make this controversy particularly unusual and noteworthy: First, it has been the subject of intensive national media scrutiny, with attendant reputational harm to the company. Second, the delivery of the survey prompted an internal investigation which, in turn, has led to the departure of more than 10 senior managers. Third, the company’s CEO has made a public apology to employees for allowing a corporate culture that tolerated inappropriate behavior, and for failing to take seriously complaints regarding workforce misconduct.
These and other related factors should serve as a prompt to corporate boards to seriously consider their workforce culture oversight obligations.
The board’s audit and compliance committee should be alerted to a series of recent Department of Justice (DOJ) statements, policies and initiatives relating to the importance of effective compliance plans and to the continued focus on individual accountability.
This series speaks to several new compliance-related policies and initiatives. First is the proposed application of the “leniency” portions of the DOJ’s 2016 Foreign Corrupt Practices Act (FCPA) Enforcement Policy to other criminal enforcement actions to which the FCPA does not directly relate (e.g., domestic health care fraud investigations). Second is the new DOJ policy that encourages coordination within DOJ and with other enforcement agencies when imposing multiple penalties for the same conduct (i.e., no “piling on”). Third is the formation of a new DOJ Working Group on Corporate Enforcement and Accountability, in order to promote consistency in white collar efforts. The Working Group will make internal recommendations with respect to white collar crime, corporate compliace and related issues.
These new initiatives are moving forward against consistent DOJ public comments that speak to the importance attributed to robust corporate compliance programs, and to the value DOJ attributes to corporate cooperation in the context of investigations. All of these topics are worth discussing with the audit and compliance committee (perhaps with the assistance of white collar counsel) for their relevance to program oversight and effectiveness.
The Return of "Waste of Corporate Assets"
A recent decision of the Delaware Chancery Court breathes new life into the hoary corporate law theory of “waste of assets,” which from time to time has been used with some degree of mischief against large corporations.
The general concept of “waste of assets” refers to transactions and other kinds of financial relationships, where the consideration received by the corporation “is so disproportionately small” that the arrangement could be seen as a “gift in part.” In that regard, “waste” has been held to be the equivalent of “bad faith,” with the associated pleading barriers.
The “waste of assets” theory has historically served to empower courts to “scrutinize corporate transactions that did not clearly violate fiduciary duties, but also did not appear to be the products of careful business judgment or disinterested decision-making.” In the past, this was an attractive theory to those seeking to challenge expansive transactional strategies and compensation arrangements of very large nonprofit corporations.
In the latest case—a derivative action—the plaintiffs argued that compensation payable to the company’s controlling stockholder and Chairman Emeritus amounted to corporate waste when the Chairman Emeritus was allegedly in a debilitated and incapacitated state and unable to make any contributions to corporate affairs. Recognizing that “it takes an extreme factual scenario for a plaintiff to state a claim for ...waste,” the Court nevertheless concluded that the compensation arrangement was sufficiently unusual as to state a claim for relief, especially when, as alleged, the board knew he could not provide the bargained for services.
The University of Louisville has filed a hybrid derivative and fraud-styled civil complaint in state court, seeking to recover substantial sums from former officers and directors of the University of Louisville Foundation.
This complaint is the latest development in the long running scandal involving the University and the Foundation, its fundraising support organization. The scandal is grounded in multiple allegations that Foundation executives took a series of loan and investment actions without board approval, paid themselves excessive compensation and improperly applied endowment funds, among other claims. A number of the allegations appear largely based on information that was uncovered from a prior forensic audit conducted by an outside audit firm; the Foundation’s board was alleged to have failed to oversee foundation spending, to correct known issues, and to monitor management, among other claims. The suit now seeks to hold certain former officers and directors personally accountable for their actions in violation of their duties to the Foundation.
The defendants in the civil litigation include the former University President (who also served as Foundation President), several other executives, and the Foundation’s law firm. The central allegation in the complaint is that the defendants fraudulently appropriated and diverted Foundation assets for personal use and conspired to conceal their actions, violating their fiduciary duties as officers and directors of a nonprofit organization under Kentucky law.
The University of Louisville Foundation scandal is perhaps the most significant nonprofit controversy in recent years, at least with respect to the kinds of governance and financial matters that arise in many sophisticated nonprofit organizations. This is particularly to the extent that the scandal implicates issues relating to effective board oversight of management; fulsome management reporting to the board; prudent investments, proper application of endowment assets, and intra-corporation conflicts of interest.
It is noteworthy that the University elected to seek this form of relief. An open question is whether the University’s complaint will be a reference point for other strained relationships between nonprofit organizations and supporting organizations.
Matters of age, among other components of director diversity, are increasingly becoming an important board composition issue for the board’s nominating and governance committee.
The leading governance principles recommend that director candidates “be drawn from a rigorously diverse pool” that accommodates a broad spectrum of skills, backgrounds and experiences. This reflects an expectation that the value provided by those with experience with the company’s business should be balanced by the ideas, insights and contributions provided by those who offer other experiences. Often times, those different experiences reflect matters of gender, race and other elements of ethnicity.
However, there are multiple indications that age—and especially, relative youth—is playing a more important role in the composition of governing boards. As a recent survey notes, many boards are concerned that the absence of board refreshment and age diversity can negatively impact board effectiveness and, ultimately, corporate performance. At the same time, boards are coming to recognize that younger directors provide different perspectives and often can share different experiences than those offered by older and longer tenured directors. In some cases, their level of engagement with the company’s business model (e.g, inpatient and outpatient health) provides unique insight.
As a leading survey notes, however, that heavy emphasis on matters of age can be misleading, as it is a composition factor that is particularly dependent on the circumstances of a particular corporation on its board.
A recent article from the Stanford Graduate School of Business, “Netflix Approach to Governance: Genuine Transparency with the Board,” provides a fascinating review of Netflix’s “unique and innovative” governance practices, which may offer interesting options for the health system board.
The article focuses on two notable boardroom practices: (1) fostering director attendance at management meetings; and (2) the manner in which the company provides information support to directors. According to the article, both practices are very popular with the board.
More specifically, Netflix provides for directors to periodically attend (in an observation capacity only) monthly and quarterly executive and senior executive management meetings. These attendance opportunities are education-focused. The expectation is that the opportunity to directly observe management will provide directors with a greater understanding of the range of issues facing the company, the decision making process of management, and the advantages and disadvantages of the options.
In addition, Netflix board communications are made through narrative-styled, quarterly online memos (averaging 30-pages) that incorporate links to supporting information, and provide access to all data and information on the company’s internal shared systems. In addition, the format includes the ability to pose clarifying questions to the subject authors. Notably, the memo is written by and distributed to a substantial portion of the leadership team, as well as the board.
As described in the article, the “Netflix approach to governance” applies highly innovative ways to support director responsibilities. Yet these practices may run counter to long-established approaches adopted by the board and senior leadership of many health systems (especially in with respect to access to management discussion and documentation). Indeed, the authors express due caution on the broad application of these practices. However, the report would be highly interesting reading for health system board governance committees, if only to spark renewed discussion on how best to support informed oversight and decision-making.
The board’s governance committee may wish to consider a new report on corporate governance principles, "Tenets of Good Corporate Governance,” released on May 9 by the The Association of Chartered Certified Accountants (ACCA).
The ACCA report speaks to the importance of proper corporate governance in fostering a positive relationship between business and society. It has a broad scope, addressing governance issues on a global scale and across industry sectors. Nevertheless, its concentration on matters of greater diversity and balance on corporate boards and the compensation gap between the top and the bottom of the company have increasing relevance to health systems and other health industry companies.
The focuses on five key issues: (1) The relationship between companies and society; (2) Diversity and balance; (3) Enabling an effective board; (4) Executive remuneration; and (5) Gatekeepers of corporate governance. Of particular interest to the health system governance committee are the report’s observations on evolving business models, continued concentration on corporations on social responsibility, pay equity, and board effectiveness.
In many respects, the two statements on governance principles released in mid-2016 (The Business Roundtable and The Commonsense Principles) continue to be superior resources for health system governance committees on governance trends and principles. However, reports such as those prepared by ACCA provide useful balance and direction on global trends in corporate governance. This is a perspective of increasing value to health system governance committees that are rapidly diversifying on both horizontal and vertical levels, including with corporate partners that are global enterprises.
The special report on not-for-profit health care, published on April 23 by Moody’s Investors Service, is useful reading for all board members, not just for those who serve on the finance committee.
The special report, “Preliminary Medians Underscore Negative Outlook,” provides a gloomy projection of profitability metrics for not-for-profit hospitals. Moody’s core observation is that these metrics have continued to decline, with margins falling to “10 year lows,” and below levels seen during the last recession. In addition, “while absolute debt levels declined, debt affordability decreased as the median annual expense growth rate outpaced the revenue growth rate” for the second straight year. Moody’s projects expense pressures, declining reimbursement and a shifting payor mix will increase the burdens on financial performance for the coming year, despite favorable volume indicators.
Not all directors are expected to be financial experts, and there is no expectation that the entire board be familiar with the financial detail typically contained in special reports from credit ratings and other investor service firms. But as financial stewards of the organization, the entire board (not just the financial committee) should be briefed on conclusions and projections contained in well-prepared reports from reliable industry experts, like Moody’s. This is particularly the case when the report reflects financially significant trends and developments.
It is certainly acceptable that the CFO summarize such conclusions and projections for the full board, in an understandable manner. Such information is often best provided in the broader strategic and competitive context; i.e. increasing pressures on the inpatient hospital model, and the fact that competing for-profit and nonprofit hospitals are similarly affected by these trends.
Proper board composition is an increasingly important consideration as health care sector companies create subsidiaries designed to focus on innovation-based initiatives and investments.
There is some recognition that these subsidiaries are more likely to succeed if their governance structure reflects Silicon Valley-styled orientation and expertise. This view is supported by recent tech sector controversies where traditionally-composed boards apparently failed to recognize warning signs of product failures. The Theranos board, composed of a broad cross section of business and former government leaders, is a leading example of this concern. Recent news reports indicate that a group of prominent investors lost more than $600 million they had invested in the company.
Oversight is a particularly critical component of the governance responsibilities of innovative technology-focused subsidiaries. Some subset of directors should have the skills to spot “red flags” that might arise, for example, in product development and roll out. Yet there have historically been subtle differences between the “Silicon Valley” approach to governance, and that which is applied in more traditional industry sectors such as health care. Often times these boards are more focused on performance, and are very involved in matters such as strategy, tactics, hiring and firing, technology, and engineering reviews.
These and other differences of the board’s proper role should be recognized in a properly balanced governance structure for an innovations subsidiary, be it an operating company or an investment vehicle. Such a structure should also incorporate a robust management-to-board reporting relationship.
A ban on future nonprofit board service is one of the more significant remedies available for a state charity official to address breaches of fiduciary duty owed to a nonprofit corporation.
The most recent application of this remedy occured in connection with a settlement between a state Attorney General and the former senior executive of a charity formed to provide free legal services to low income residents of the state. The Attormey General had claimed that the former executive had diverted, over a period of time, substantial sums to other charities he controlled. The Attorney General alleged that the transfers were made to enhance his reputation in the community and as a benefactor of charitable organizations.
The settlement provides for the former executive to reimburse the legal aid charity a certain dollar amount. In addition, the former executive admits to numerous breaches of fiduciary duty. Perhaps most significantly, the settlement also bans the former executive from serving as an officer or director of not-for-profit organizations operating in the state for a period of five years.
The threat of reputational damage is increasingly being recognized by charity regulators as a major incentive for the proper exercise of fiduciary responsibilities. The concept of a “future board service ban” is thus an appropriate option to be applied in settlement of state investigations of alleged breach of fiduciary duty, both on its own and together with financial settlements. Whether the ban is permanent of only for a period of years depends upon the circumstances.