United States: Corporate Law & Governance Update - April 2018

Oversight of Innovation-Styled Joint Ventures

Several new developments highlight the special oversight obligations of directors in connection with health system investment in new technology ventures.

For example, a recent article in The Wall Street Journal, Hospitals Gamble on Start-Ups," provides an interesting overview of the technology investment activities of several leading national nonprofit health systems, with particular focus on "start up" enterprises and other creative approaches. System leaders describe such investments as strategic in nature, with favorable implications for patient care and financial return.

However, these innovation ventures will often benefit from specialized director oversight at the health system level; i.e., independent, conflict-free board or committee members who have familiarity with the financial and operational characteristics of these types of investments, and thus may be more capable of tracking results and spotting "red flags." Such specialized directors can be expected to be increasingly in demand by boards.

The value of such specialized oversight is underscored by the ongoing Theranos controversy, in which prominent and respected individuals (e.g., General James Mattis and George Shultz) were heavily criticized for their alleged failure to identify the extent to which technological problems with the company's blood testing technology would affect its business model feasibility.

The Role of the Board Chair

The critical—but often overlooked—role of the board chair is featured in the current issue of the Harvard Business Review, and may serve as useful reading for board leaders.

The role of the board chair and the powers associated with the position are often the subject of state nonprofit corporation law and specific bylaw provisions influenced by traditional governance principles. These generally relate to matters such as the call and notice of meetings and executive sessions, presiding over board meetings, setting the meeting agenda, approving materials sent to the board, and coordinating the actions of committees.

The HBR article is beneficial, as it identifies a series of highly practical "core principles" for being a good board chair: (i) "Be the Guide on the Side" (i.e., help others shine), (ii) "Practice Teaming—Not Team Building", (iii)"Own the Prep Work," (iv) "Take Committees Seriously," (v) "Remain Impartial," (vi) "Measure the Inputs, not the Outputs," (vii) "Don't Be the Boss," and (viii) "Be a Representative with Shareholders, Not a Boss" (i.e., how best to relate to the corporations constituents).

Even though it was primarily focused on public company boards, the HBR article might serve as the basis for a more in-depth, "refresher" discussion within the board on the role and function of the chair, as well as those of other non-executive officers.

The Nexus Between Director Age and Board Skills

An important new survey from the consulting firm Equilar provides informative guidance on the sensitive subject of age-based director effectiveness.

 A primary message from the survey is that while the age of corporate directors may not have a direct impact on performance, certain skills are increasingly associated with particular age groups. For example, while some skills (e.g., public company experience) come with age, younger directors are valued for providing new perspectives to the board. The survey also noted that many companies are now pursuing a more active approach to refresh "stale and aging boards," and are appointing younger directors in order to revitalize their strategic direction and remain proactive.

There is no "best practice" when it comes to matters such as term limits and mandatory age-based retirement requirements. Leading governance principles encourage companies to clearly articulate their approach on term limits and retirement age, whatever they may be. These principles also recommend a transparent explanation whenever exceptions are made to related policies, especially when it comes to matters of board assessment of its performance and composition.

Awareness of factors relating to director age, and the skills associated with age, are critical to effective board structuring and refreshment. The Equilar study may thus be useful for members of the board's governance and nominating committee.

Caremark, Twenty Years Later

A recent scholarly paper provides an important retrospective on the seminal 1996 Caremark decision, which continues to define much of the board's compliance and risk oversight responsibilities.

Decided by the Delaware Chancery Court, the ongoing influence of Caremark on corporate governance and the exercise of fiduciary duties has been extraordinary, especially as matters of compliance program oversight evolve into broader concepts of risk management. Given the decision's lasting relevance, it is important that board members—especially those who serve on the Audit & Compliance Committee—understand the Chancery Court's expectations of directors, with respect to the maintenance of a corporate compliance program, responsiveness to "red flags," and the application of the business judgment rule to decisions on the scope of such program.

The paper also provides the general counsel with a new and important opportunity to advise the Committee on the limitations of Caremark's (arguably lenient) expectations for board conduct. This advice would project the possibility that, in jurisdictions outside of Delaware and given particularly egregious fact patterns, a court may hold directors retrospectively to a more fulsome, engaged standard of conduct, and thus be more willing to find breaches of fiduciary duty where Delaware courts may be less willing to do so. The advice would also educate directors on how to better identify developments and circumstances that, in hindsight, courts might interpret as "red flags" of potential misconduct.

Ultimately, the scholarly paper is a reminder that awareness of board compliance oversight duties is an active, engaged and inquisitive practice.

Access our Health System Compliance Program Oversight: Elements of Governance Effectiveness, prepared by McDermott partners Michael W. Peregrine and Tony Maida.

The Latest Business Model Threat

An important new article in The New York Times, "The Disappearing Doctor: How Mega-Mergers Are Changing the Business of Medical Care," may offer helpful education for board members on emerging trends that are affecting primary care physician practices and, perhaps ultimately, the integrated delivery system model.

The article monitors the increasing utilization of retail clinics and urgent care centers (including those located in "strip malls") by patients with "simple health needs" as an alternative to office visits to primary care physicians. Consumer accessibility and neutrality of cost are cited among the catalysts.

Notably, the article identifies this shift in preference as one reason why many of the major new entrants into health care (e.g., insurance companies, pharmaceutical companies and retailers) are pursuing business combinations with each other. These giant, yet diverse, companies envision partnerships that would expand their respective health consumer base, and better manage patient care. The article also references how large firms are investing in new enterprises intended to create alternative primary care models that rely more heavily on technology.

It is understandable that many health system/IDS board members feel challenged by the rapid pace of business disruption that seems to be overtaking the sector. Yet it is absolutely critical for these board members to have a fundamental appreciation for the scope of the disruption and the factors that are prompting it, if they are to be effective fiduciary partners to management. This is particularly the case if the health system is heavily committed to integrated delivery arrangements.

Access our Surviving Disruption Thought Leadership Series

The Board and Human Capital Management

The board's human resources committee may want to give greater consideration to the concept of human capital management (HCM), following a recent position paper from the asset manager BlackRock.

As defined by BlackRock, HCM encompasses a company's approach to such matters as "employee development, diversity and a commitment to equal employment opporttunity, health and safety, and supply chain labor standards, amongst other things." BlackRock's perspective is that effective board engagement with HCW is a factor in business continuity and success, and may provide a competitive advantage during periods of shortages of skilled labor, uneven wage growth and technology.

The emphasis on HCW is part of a larger BlackRock effort to promote corporate governance best practices at the companies in which it invests. It perceives the strategic implementation of HCM throughout the organization as a topic on which the board should be deeply engaged. In its position paper, BlackRock identifies a series of HCM-related practices it may choose to discuss with corporate boards. These include, but are not limited to, (i) policies designed to protect employees from unethical corporate conduct; (ii) emphasis on promoting a healthy corporate culture that prevents unwanted behavior; (iii) incorporation of HCW factors into the company's risk management oversight process; and (iv) incorporating HCM performance within executive compensation incentive targets.

BlackRock's concepts on HCW are consistent with broader board efforts to exercise oversight over corporate workforce culture. The correlation between strong relationships with employees, and corporate growth, are well established and apply equally to both for-profit and nonprofit companies. The human resources committee may wish to consider emphasizing HCW elements within workforce culture oversight guidelines it may be preparing for the board.

Understanding "Best Practices"

A recent Delaware Chancery decision helps boards better understand the distinction between the requirements imposed by corporate law and governance "best practices."

In the derivative litigation Wilkin v. Narachi, the Chancery Court granted a motion to dismiss brought by defendants (the directors and officers of biopharmaceutical company) for failure to plead demand futility. The plaintiff had claimed that the defendants breached their fiduciary duties and wasted corporate assets in connection with the company's application for expedited market approval of a particular drug product. The court acknowledged that the directors' actions in connection with the clinical trial process could have violated applicable best practices, but nevertheless held that the plaintiff failed to prove that the directors violated any legal obligation in the process.

"This case is a prime example of the difference between a best practice and a legal obligation. The plaintiff has not pled facts that give the Court reason to doubt that [the board's less successful process] stemmed from rational, good faith decisions of faithful, loyal directors."

The concept of "best practices" generally refers to behavior or conduct beyond that required by basic, accepted methodologies or minimum legal standards. The diligent pursuit of governance best practices is generally considered to be the most effective prophylactic for director liability—and the efforts of health care boards to implement governance best practices is laudatory. Yet as the Delaware decision notes, "best practices" are aspirational goals, not legal requirements. There exists no overwhelming legal mandate for their adoption, and a decision not to do so is not indicative of a breach of fiduciary duty.

The Most Pressing Issue in Corporate Governance Today

The general counsel may wish to note for the board the recent public comments of SEC Commissioner Robert J. Jackson, Jr. with respect to board oversight of cybersecurity.

Commissioner Jackson's theme is that the cyber threat is a corporate governance issue. "[C]ybercrime is is an enterprise-level risk that will require an interdisciplinary approach, significant investments of time and talent by senior leaders and board level attention." He identified three areas in which corporate counsel, working in conjuction with regulators, can help lead the way in developing effective responses. Two of these areas are particular to public companies (the new Form 8-K disclosure requirements, and insider trading on nonpublic cyberbreach information).

The third area is applicable to public and private companies alike—the development of cybersecurity risk management policies and procedures intended to ensure that relevant information about cybersecurity risks and incidents is reported up the corporate ladder. To achieve this particular goal, Commissioner Jackson encourages a partnership of sort between the general counsel and the company's technology specialists, in a manner similar to the teaming between the company's lawyers and accounting staff to address internal control issues arising from the Sarbanes-Oxley Act.

The current assumption—that the Caremark standard will govern director liability issues in the event of cyberbreach—is certain to be tested by the several ongoing cyberbreach-based derivative actions. Until the law on director conduct solidifies, steps such as those recommended by Commissioner Jackson may be helpful. 

New Antitrust Barriers to "IDS" Strategy

The general counsel may wish to brief the Strategic Planning and Compliance committees on aggressive new efforts by state attorney generals and the Federal Trade Commission to apply antitrust laws to challenge health system-physician acquisition initiatives.

On March 13, a Washington state federal judge denied a motion to dismiss antitrust litigation filed by the Washington state attorney general against a nonprofit, religious sponsored health system and other parties, seeking to unwind two separate physician practice acquistions by the health system in a particular county. The state's complaint also seeks disgorgement of the health system's "ill-gotten gains" from the acquisitions. The state cited emails from the health system's CFO in support of its allegations.

The litigation was originally filed in September 2017, and alleged that the health system's practice acquisitions violated both federal and state antitrust laws prohibiting horizontal price-fixing. In essence, the state is challenging the health system's series of incremental physician practice acquisitions in particular markets, as having the effect of harming competition and raising prices in connection with both orthopedic physician services and adult primary care services. The March 13 decision was not, of course, a final decision by the court on the merits of the state's complaint.

Physician practice acquisitions are a major portion of the integrated strategic plan of many hospitals and health systems. Yet the Washington Attorney General's complaint is a reminder to both the Strategic Planning Committee and the Compliance Committee that certain of these acquisition strategies can present significant antitrust risks. Furthermore, these are risks that have been regularly (and successfully) pursued over the last several years by the FTC and by state attorneys general. Close board awareness of related antitrust risks should be part of any health system physician acquisition strategy.

Workforce Culture and Compliance Oversight

The Board's Audit & Compliance Committee may benefit from collaborating with the Human Resources Committee on how efforts to monitor workforce culture can support the organization's compliance program.

As is now well established, the board is expected to exercise oversight over the workforce culture of the organization, including but not limited to the behaviors of employees at all levels, standards for promotion, incentives and leadership styles. It is increasingly recognized that these and similar elements of culture have an impact on matters of corporate compliance (e.g., how the conflict between organizational ethics and the impliementation of a sales incentive program within a major financial institution led to one of the most consequential corporate controversies of the decade).

Indeed, the National Association of Corporate Directors, in its Blue Ribbon Commission Report, "Culture as a Corporate Asset," specifically recommends the coordination of risk management and corporate compliance activities with efforts to achieve the company's desired cultural foundations. The overlap between these two oversight responsibilities is increasingly obvious and imperative; the Compliance and HR Committees "need to be talking to each other" on a regular basis. This is particularly the case with respect to matters such as ethics-based compensation incentives and sanctions extended to employees who engage in unethical or otherwise noncompliant conduct.

In this regard, a recent article highlights how the "Performance with Purpose" strategy of PepsiCo works to integrate business performance with social responsibility and ethical conduct. According to the article, the "PwP" strategy is based on the presumption that a "purpose driven" business model—that companies can make a difference to the societies in which they operate—will generate higher performance, benefitting all stakeholders. The essence of the program appears to be the "operationalization of compliance and ethics"; that they are at the center of the company's performance-based business model.

Corporate Law & Governance Update - April 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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