If you are, or have interest in becoming, a director of any organization, you should heed the May 17, 2013, decision in the United States District Court for the Western District of Pennsylvania in Official Comm. Of Unsecured Creditors ex rel. Lemington Home for the Aged, (the Lemington Home Case). The Lemington Home Case upheld a jury’s award to the plaintiff creditors’ committee of
- $2,250,000 in compensatory damages jointly and severally against 13 of the 15 directors and the CEO and CFO of the Home; and
- $350,000 in punitive damages against 13 directors for breach of their duty of care principally by reason of failing to ask questions.
Directors’ Right of Reliance
Most states’ laws give directors of a board or of a committee composed of directors the right to rely, and protection when relying, upon:
- Officers or employees as to matters for which the director reasonably believes they are reliable and competent;
- Professionals such as lawyers or accountants as to matters that the director reasonably believes are within the person's professional competence; and
- Duly established committees of a board to matters within its designated authority, which committee the director reasonably believes to merit confidence.
Courts generally require that, in order to have such a reasonable belief for a matter, board members must ask questions. For example, when relying upon officers and employees for a matter, directors should ask questions that verify the reliability and competence of the officer or employee for the matter.
The Lemington Home Case
In the Lemington Home Case, the Bankruptcy Court denied the defendant directors’ and officers’ motions for judgment as a matter of law and for a new trial, and let stand the compensatory and punitive damages described above.
Over a period from 2001 to 2005, the CEO failed to properly manage the Home in her position as nursing home administrator. The Home failed to timely provide medication to patients; medical records did not contain sufficient information about whether patients had received the correct medication; the CEO went from working full time to part time without hiring a replacement nursing home administrator as authorized by the board; and the CEO did not properly oversee the CFO or his actions in failing to keep required financial records or to bill Medicare and Medicaid for services provided by the Home. Patient census fell from the lack of quality of care and debts increased from the lack of Medicare and Medicaid revenues resulting in the closing of the Home and its filing for bankruptcy.
The jury found that all defendants (except for two directors who had not received communications received by others) were liable for a claim of deepening insolvency, allowing debt to increase and failing to follow advice of bankruptcy counsel so that no potential buyer could be found for the Home to avoid its liquidation. In addition, the CFO failed to provide due diligence to buyers, apparently in an attempt to favor his church as a potential buyer. The board was aware that an advisor to one potential buyer found inadequate financial records, including the lack of a general ledger, which resulted in the potential buyer’s withdrawal.
The jury found that 13 of the 15 directors “breached their duty of care by acting recklessly.” These directors relied upon reports of the CEO and CFO for which there was “good reason to doubt the validity, including, as an example, the CEO’s not hiring a nursing home administrator” with the funds that had been given for that purpose.
The Bankruptcy Court found that the directors’ failure to question reports of officers was evidence of "sustained patterns of inattention to obligations by directors... or unreasonable blindness to problems that later cause substantial . . . exposure to liability,” which justified the jury’s compensatory and punitive awards. The Bankruptcy Court also found justification in the jury’s awards because the directors:
- Ignored advice given by the Home’s bankruptcy counsel that actions being taken by the board would deepen the Home’s insolvency and deter the interest of potential buyers; and
- Failed to form, as required by the Home’s bylaws, a finance committee to oversee the Home’s finances and financial operations.
Guidance for Directors’ Questions
Courts generally require that, in order to have such a reasonable belief for a matter, board members must ask questions verifying the reliability and competence of persons relied upon for the matter. Directors should be guided by some basic tenets of corporate governance — as well as their duties and role as directors — not only in considering, “What questions should be asked,” but also, “How should questions be asked,” and, perhaps most importantly, “When can we stop asking questions?”
What questions should be asked?
Your role as a board member is to oversee that direction is provided, but not to execute that direction or mange the organization, unless you believe that the CEO and management are not reliable and competent to do so. As a board member, you do this by asking sufficient questions to determine whether you reasonably believe that the CEO and management are reliable and competent in what they are authorized or directed to do.
Your questions should not generally be, “How are you going to do this?” Management should have the authority to determine “how.” Your questions are to verify or confirm their reliability and competence in making the “how” determination: “How does this benefit the best interests of the business?” “Is it consistent with our business model and strategy for the future?” “What financial, legal, ethical, strategic and reputational issues have been considered?”
Based upon the commonly recognized duties and roles of a director, here are some guidelines for what you, as a board member, may consider asking:
- How does this action further the corporation’s best interests? Both you and management have a duty of loyalty to act in the best interests of the corporation. If you are not clear from management’s presentation on a matter, appropriate questions for your protection and to assure management’s reliability include, “How does this further the best interests of the organization?” More specifically, “How does this action benefit shareholders as a whole?” for stock corporations; or “members” for a membership organization; or “stakeholders of the organization’s mission,” for non-member charitable organizations.
- Who else benefits from the action? Directors are held to higher scrutiny of transactions in which another director or an officer or other insider may have a personal or economic interest. Accordingly, appropriate questions could include, “Who other than the corporation benefits from this transaction?” Also, “Is the transaction fair from an economic point of view to the corporation despite any interest of such insiders?”
- How does this further the organization’s strategic direction? A corporation’s board, as the highest corporate authority, is ultimately responsible for the strategic direction of the corporation. Accordingly, appropriate questions could include, “Is the action consistent with the overall strategic direction of the business of the organization?” If not, “Is the strategic direction being changed as a result of the action?”
- What is being asked of us as the board? Directors, as well as management, have a duty of care to act as an ordinarily prudent person in a like position would act under similar circumstances. Accordingly, appropriate questions could include, “What is the nature of the action we are being asked to take?” and “What is our role going forward?” Equally important is the extent that continued board oversight is necessary or appropriate.
- What is to be expected of management? Management also has the same duty of care with respect to matters delegated to them. Accordingly, appropriate questions could include, “What discretion does management have to execute or not execute the action?”, “What additional authority does management need from directors in the future and when?” and, “What is expected of management in terms of reporting back to the board?”
- What if things don’t go as expected? As a director, you should take into account the premise of Nassim Nicholas Taleb’s book, “Black Swan, The Impact of the Highly Improbable” – that policy makers, such as board members, must consider all of the possibilities, especially those that could have a high impact, albeit remotely probable, and not just the normal. The current “Great Recession” is likely the result of a failure to take into account the highly improbable, but high-impact, occurrence: “What happens if real estate prices fall?”
Accordingly, the most important questions that a board should ask are “what if” – most importantly, “What happens if things don’t go as expected?” and, “What financial, legal, ethical, strategic and reputational issues are involved?”
How should questions be asked?
Both you, as a board member, and management have the same duty of care and nearly the same duty of loyalty. Therefore, unless you believe that the CEO and management are not reliable and competent for a matter; your questions should be non-confrontational and non-judgmental.
For any action upon which you as a board member are relying upon more than the CEO or a single member of management, a good practice is to ask your questions separately of each management member upon whom you believe you will be relying. The same questions should be asked separately of each management member.
In addition, you are entitled to rely upon professionals or other experts for matters which you reasonably believe are within their professional or expert competence. Such professionals or experts could include the person serving in the internal auditor function, representatives of the external auditor, outside legal counsel and outside experts with experience in the matters under consideration.
The consistency of the different answers should be compared. The answers among different constituencies are unlikely to be the same. For example, management is more likely to view certain business issues more positively than the external auditor or chief legal officer. On the other hand, the external auditor and chief legal officer are more likely to view risks of liability as more material than management. Often a chief financial officer views a matter from a different perspective than the chief executive or chief operating officer. Accordingly, answers will differ, but there should be a consistency.
When to stop asking questions?
The skill is to learn when to stop asking questions. Nothing is more bothersome to management than irrelevant, unnecessary questions. As a general rule, you should stop asking questions and accept the answers when those answers are consistent. On the other hand, you should delve deeper when the answers to the questions are inconsistent.
Directors and management should expect that there will be some tension between them during this process. Management needs to understand that board members must ask questions to determine whether management is reliable and competent for the matters delegated to them. The board should understand that management will fear “being micromanaged” or “not being trusted.” For this reason, the chair or lead director of the board should, from time to time, remind management that directors are required to ask such questions to fulfill their duties and that management should not necessarily view this as an adversarial process.
An additional way to relieve this tension is for the board to have regular executive sessions separately with different members of management so that it becomes part of the routine operation of the board. A board should consider meeting regularly with the CEO, CFO, chief legal officer, internal auditor and representatives of the external auditor. Doing so will not only increase the familiarity of the board with management other than the CEO, but also the familiarity of those members of management with the board, which is probably the best defense against mismanagement and fraud.
If the Home’s directors had received and followed this guidance, they would not have been found liable for the compensatory and punitive damages awarded by the jury in the Lemington Home Case.