Planning for a "Soft" Yates Repeal
Forthcoming changes to the Department of Justice’s “Yates Memorandum” offer unanticipated legal compliance consequences for health systems that merit proactive consideration by the board.
These changes are expected to make nuanced revisions to Yates, without forgoing DOJ’s fundamental enforcement commitment to individual accountability. While this is welcomed news, the related risk is that some directors, executives and managers may misinterpret the nuanced changes as a total repeal of Yates, with potentially unfortunate consequences for the health company’s legal compliance and risk evaluation efforts. These are individuals who are either unwilling to believe the government will enforce applicable penalties, or who calculate that the likely benefit of breaking the rule outweighs the potential penalty. They exist in every organization.
The board may respond by sending a clear message to all organizational constituencies that corporate policies on legal compliance, corporate conduct and legal risk evaluation of business initiatives, will not change. It can also direct management to continue to timely share with the board important information relating to legal compliance, organizational ethics and corporate reputation. In addition, the board should demonstrate support of the General Counsel and the Chief Compliance Officer should they encounter internal push-back to legal compliance efforts in the wake of a partial Yates repeal.
The Governance Implications of the Weinstein Company
The messy and complicated Weinstein Company controversy nevertheless provides an important governance teaching opportunity on critical, if less familiar, fiduciary concerns.
These include (i) the rapidly developing “best practice” of board responsibility for oversight of workforce culture (read more below in “Oversight of Corporate Culture”); (ii) the obligation of fiduciaries to share with the full board information of which they become aware that relates to the corporation, and the duties and functions of the board; (iii) the effectiveness of internal risk reporting protocols, and their relationship to the “we-didn’t-know-about-it” defense; (iv) the challenges associated with addressing “willful blindness” allegations; (v) and the limitations on the ability of directors to reduce their personal liability exposure through resignation from the board.
The Weinstein matter is particularly relevant given the extent to which it involves allegations involving sexual harassment by and of employees. Issues involving sexual harassment in the workforce increasingly require special board focus given the nature of the potential harm to all involved parties. The board should be conversant with legal obligations intended to protect both the victim and the accused in such instances. It should also confirm with the general counsel that legally compliant policies are in place and communicated to all organizational constituents, and that complaints are processed accordingly.
As a recent article in The New York Times suggests, boards need to be particularly sensitive to the risks of retaining “toxic” employees—even if the employee in question is a “high performer.” Studies cited in The Times article concluded that retaining such an employee comes with great cost to the company (e.g., driving out other employees).
The amfAR/ART Controversy
An adjunct of the Weinstein Company controversy is the intense public focus on an alleged arrangement involving Harvey Weinstein and amfAR, the well-known charity focused on an AIDs cure. According to news reports, an intra-board dispute over the arrangement prompted a review by the New York Attorney General.
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.)
According to various media reports, the amfAR board conducted two separate outside counsel investigations with respect to the arrangement. The first investigation concluded that the arrangement exposed amfAR to material financial and reputations risks. The second investigation concluded that the transaction was legitimate and lawful. According to The New York Times, four amfAR board members objected to the arrangement and complained to the Attorney General’s office that the board chair had approved the arrangement over the objection of the management team. Two other directors subsequently resigned due to the transaction, The Times reported.
The Scope of Director Liability Exposure
The sheer number of corporate controversies reported lately is prompting an uptick in concern about director liability exposure. This is driven in large part by intense media coverage of the controversies, and express criticism of the related role of the governing board.
The most obvious source of liability exposure arises from shareholder derivative actions, and attorney general actions, based on breach of duty claims. The recent corporate controversies contain the seeds of such actions and claims. Other sources include director resignation in the midst of corporate crisis; SEC enforcement (particularly at the Audit Committee level); creditors’ rights actions; industry debarment; ban on future board service; regulatory sanction (e.g., fine as adjunct to FCA settlement); “Yates” related individual accountability; “intermediate sanctions” excise tax penalties; and, more practical, individual reputational damage.
Effective director recruitment and retention efforts include an organized response to anxieties concerning individual liability exposure. An obvious step is to assure availability of comprehensive insurance and indemnification coverage for board members. More substantive responses relate to assuring that decision making processes satisfy business judgment rule requirements; oversight processes are substantive and based on effective information reporting systems; and that directors are trained to recognize and respond to “yellow” and “red” flags of risk.
The ACC and Ben Heineman, Jr. on the Role of the General Counsel
Further clarification on the role and responsibilities of the modern general counsel is provided in a new white paper from the Association of Corporate Counsel.
The white paper identifies five indicators to apply when evaluating whether the General Counsel is well situated to influence corporate culture: (i) does the GC report directly to the CEO and is she considered part of the executive leadership team; (ii) does the GC have regular contact with the board; (iii) whether the GC is viewed as independent from the executive leadership team (in terms of privity of ethical duty); (iv) is the GC expected to advise on less traditional topics such as ethics, reputation management and public policy; and (v) whether business units include the legal department in decision making.
The white paper is consistent with other scholarship supporting a prominent, broad role for the General Counsel. Among that is a newly published excerpt from Ben Heineman, Jr.’s well-received 2016 book, “The Inside Counsel Revolution.” Among the interesting portions of the excerpt are Mr. Heineman’s focus on the broad leadership role and final decision-making authority of the general counsel, and a reprise of his noteworthy comments on how general counsel can manage the ever-present “partner-guardian tension.” These perspectives are increasingly important given the proclivity of some in the organization to (unintentionally or intentionally) pursue structural initiatives that reduce or impinge upon the authority of the general counsel.
Oversight of Corporate Culture
Several new developments evidence continuing focus on the obligation of the board to exercise vigorous oversight of the organization’s workforce culture.
First is the extent to which “culture” has been central to prominent recent controversies involving corporations in the ride sharing, corporate finance and entertainment sectors. In addition, there is an increasing policy-level awareness of how matters of culture and reputation correlate to the success of an organization and to the board’s efforts to sustain long-term corporate objectives. In this context, “culture” is intended to describe how values and actions establish a unique business environment. However, as The Wall Street Journal noted recently, most boards have yet to adopt a formal approach to cultural oversight.
Significantly, on October 4, the National Association of Corporate Directors issued a new report encouraging boards to actively measure and monitor the cultural foundations of their organization; i.e., that oversight of corporate culture should be a leading governance imperative for the board. The NACD report offers ten specific cultural-based recommendations for boards to pursue. These recommendations include (but are not limited to) a regular assessment of organizational culture; the incorporation of culture into ongoing board-management communications relating to strategy, risk and performance; utilization of quantitative and qualitative information from external sources; and establishing culture as a specific factor to be considered in the selection and evaluation of the CEO and other senior executives.
Of particular note to the General Counsel is the recommendation that the “chief legal officer and other officers in key risk-management, compliance and internal control roles are well positioned within management and in relationship to the board to support an appropriate culture.”
Audit Committee and New "EO" Tax Concerns
The general counsel will want to brief the Audit Committee on several new developments that elevate organizational focus on exempt organization tax issues.
For example, on October 12, the Internal Revenue Service (IRS) provided links to 30 technique guides used by IRS exempt organization examiners—including those applicable to public charities, such as nonprofit hospitals and health systems. These “Audit Technique Guides” are intended to provide guidance for IRS employees, and have historically been located only in the Internal Revenue Manual. In this more accessable form, they can be particularly helpful to the nonprofit health system general counsel in educating the board’s Audit & Compliance Committee on specific examination techniques, and on tax issues common to certain types of exempt organizations that qualify for nonprivate foundation status as public charities.
In addition, in an October 13 speech, the IRS Exempt Organizations Director confirmed the five core strategic areas of IRS focus on potential exempt organization noncompliance: (i) engaging in private inurement or conducting nonexempt activities; (ii) self-dealing; (iii) excess benefit transactions; (iv) unrelated business income; and (v) employment taxes. In a separate presentation, a senior IRS Tax Exempt official confirmed that the IRS is now conducting more in-depth analyses of compliance with the financial assistance requirements of IRC 501(r)(4).
While these actions may not reflect more aggressive IRS focus on tax exempt organizations, they certainly reflect an increased willingness of IRS officials to discuss these issues in a public forum. For that reason alone, it is worth a briefing to the Audit & Compliance Committee. Exempt organization tax compliance has, for perhaps too long, been relegated to the bottom of the committee agenda and organizational risk evaluation process.
For the Executive Search/Succession Committee
The general counsel may want to alert the board’s Executive Search and Succession Committee to the important new academic survey on the “incredibly small” pool of qualified CEO talent currently available to run major US corporations.
The survey, conducted by the Stanford Graduate School of Business and The Rock Center for Corporate Governance, indicates that directors of the largest publicly traded US companies believe that the available pool of executive level talent in their particular industry is “extremely tight”; that there is significant risk that a new CEO may not prove to be a good “fit”; and that the “downside risk” of making the wrong choice in terms of CEO selection is significant. Other observations included that ”visionary founder” CEOs are much more difficult to replace than “professional CEOs,” and that executive search consultants have a “modestly more optimistic” view of the CEO labor market.
While the Stanford/Rock survey was focused on the largest publicly traded companies, most of its data and conclusions are no doubt of relevance to large, financially sophisticated nonprofit hospitals and health systems with high annual revenues. This is particularly the case with regard to survey comments on the board’s obligations with respect to talent development and executive compensation; i.e., grooming senior executives, planning for CEO succession and structuring executive compensation based on the availability of replacement talent.
Director Discontent and Fitness to Serve
The value of a comprehensive director refreshment program—that includes “fitness to serve” and other self-executing removal provisions—is demonstrated by the results of a recent consulting firm survey.
A leading observation from PwC’s 2017 Annual Corporate Directors Survey is that corporate directors are increasingly discontented with their peers. Nearly half (46 percent) of surveyed directors believe that one or more of their fellow directors should be replaced, and one-fifth of those surveyed believe that two or more directors on their boards should be replaced. According to PwC, this suggests directors’ strong interest in assuring that they provide value, and a related awareness (particularly amongst less tenured directors) that not all of their fellow directors are doing so. While this survey was conducted among directors of public companies, its results are highly relevant to boards of sophisticated nonprofit corporations.
The survey results speak to the value of well-crafted director refreshment policies that provide for automatic board turnover to avoid entrenchment, as well as truly effictive director evaluation methodologies—and the willingness of governance committees to heed the results of those policies. Unqualified removal rights, and self-executing policies to address specified incidents of director unfitness, are also increasingly useful ways to remove directors who for certain clear reasons are disruptive to ongoing board effectiveness.
The Quality of the "Board Book"
A recent academic paper offers valuable guidance on typical deficiencies in board briefing books, and on measures to improve their quality.
The basic theme of the paper is that this important director education tool often suffers from at least three fundamental limitations: first, it prioritizes the director’s duty to oversee financial reporting and the quality of financial statements above the need to understand the factors affecting financial performance (a critical factor in health care giving the evolution of payment models); second, it tends to include “an abundance of information but a dearth of metrics that could lead to true insight”; and third, the traditional approach to board books tends to result in more formulaic board presentations over time. The overarching concern is that board books and similar regular briefing vehicles fail to evolve with the business environment and marketplace—which prevents directors from truly comprehending how the specific industry, and the corporation’s business strategy and investments—may require change.
The paper also offers a series of recommendations intended to improve the quality of board books and other briefing material: using analyses that reflect “true economic realities” and are not unduly constrained by accounting conventions; present metrics in a manner consistent with the way in which management actually operates the business; presenting data in an appropriate context (e.g., historical trends, customer behavior and external benchmarking); emphasizing long term plans as opposed to annual budget allocations; and aligning performance statements with internal areas of responsibility in order to better hold individual managers accountable for results, where appropriate to do so.
The quality and utility of board briefing materials is directly within the scope of the general counsel’s core obligations to support the board in making informed decisions and exercising oversight. This new commentary is especially important given the need to provide health care boards with effective briefings in the context of emerging and widespread business disruption facing the sector.