2009 Update on Corporate Governance
Kathleen M. Boozang
Seton Hall Law Center for Health & Pharmaceutical Law & Policy
This unit provides an overview of four of the “hottest” areas related to nonprofit corporate governance in 2009:
Governance and the IRS
- Governance and the IRS, focusing on the Governance section of the new Form 990 and executive compensation
- Governance and Corporate Compliance
- Governance and Quality
- Governance and the Economy
IRS Revised Form 990. While not every tax-exempt entity is required to file an information return with the IRS, health care providers tend to be required filers. The IRS Information Return Form 990 for tax exempt organizations has undergone significant revision for tax year 2008. Relevant to corporate governance, the form includes a new section on governance (Part VI). Many would argue that the IRS has moved into a significant accountability gap by requiring the submission of this information; many entities subject to the new information return complain that the IRS has exceeded its jurisdiction and created confusion about whether entities are legally required to have structures and policies about which the IRS is inquiring.
While the IRS does not per se have jurisdiction over entities’ governance structures, it represents that good governance increases tax compliance. “The absence of appropriate policies and procedures may lead to opportunities for excess benefit transactions, inurement, operation for non-exempt purposes, or other activities inconsistent with exempt status.”
Unsurprisingly, the mere existence of the IRS questions is causing many exempt organizations to engage in structural reform.
- Is the IRS exceeding its jurisdiction?
- IRS perspective is that good governance and accountability increases tax compliance and furtherance of exempt purposes. See generally IRS statement on Governance.
- Seeks to ensure governance that will not misuse or squander assets.
- IRS focus is structure, not implementation of governance.
- Its governance questions do not imply a mandate of correct governance. However, IRS will use information collected to select entities for examination or for participation in studies.
- The IRS will share information with state charity officials. Consequently, while the IRS may find an entity’s submissions to be unproblematic, a state may raise problems as a result of the entity having changed mission or activities but failed to properly notify the state; the entity could also face challenges to state tax-exempt status, particularly property taxes.
- Questions in the 990 governance section.
- The IRS asks whether the entity made any significant changes to its organizational documents since the filing of its prior 990 – this is likely to be of interest to state charity offices seeking to confirm mission and control of charitable assets.
- Board size and structure
- The IRS seeks assurance that the board is engaged.
- Goldilocks Principle. According to the IRS, small boards may not sufficiently represent broad public interest, and may not encompass the skill set required for quality governance But “[v]ery large boards may have a more difficult time getting down to business and making decisions.”
- At bottom, the IRS wants to ensure boards are not dominated by employees.
- It is also interested in the level of delegation to management companies, which is frequently relevant in health care, particularly if the management company is for-profit.
- See generally Health Alliance of Greater Cincinnati v. Jewish Health System, 2008 Ohio App. LEXIS 4191 (management entity in joint operating agreement “was in the position of a fiduciary to its member hospitals, and it owed TCS a duty to act for its benefit. Certainly the Alliance owed TCH a duty not to actively harm it. As a fiduciary, the Alliance had a duty to ‘exercise the utmost good faith and honesty in all dealings and transactions related’ to its member hospitals.” Id. at *P21.).
- Conflicts of interest management
- The duty of loyalty requires directors to avoid conflicts of interest detrimental to the T/E entity. Entities need to have a process to elicit information about conflicts, and to manage conflicts when they are implicated. See http://www.irs.gov/instructions/i1023/ar03.html
- A charity may not pay more than reasonable compensation. The 990 asks whether the process used to determine the compensation of top management and key employees “included a review and approval by independent persons, comparability data, and contemporaneous substantiation of the deliberation and decision.”
- The IRS is particularly concerned about what entities are being used for comparability analysis, specifically, whether for-profit comparators are being employed (this was a major issue in the Grasso case).
- Expanded attention in Revised Form 990: Part VII and Schedule J
- Many current (and some former) Officers, Directors and Trustees (whether or not compensated)
- What practices are employed for approving CEO compensation?
- Aggregate compensation of officers and employees who provide services to multiple exempt organizations that have proportionate salary/benefits responsibility – the IRS is collecting this information much more carefully.
- The IRS desires exempt organizations to rely on the rebuttable presumption test of § 4958 of the IRC and Treasury Rev. 53.4958-6 when determining executive compensation. Compensation is presumed reasonable if
- Approved in advance by an authorized body of non-conflicted individuals
- The body relied upon appropriate data to determine comparability
- Compensation consultants should be independent; the IRS will also look at the quality of the survey or study used.
- The body adequately documented the basis for its determination
- An important resource to provide context to the discussion about executive compensation is the IRS Exempt Organizations Hospital Compliance Project Final Report. Nearly all hospitals reported substantial adherence to the rebuttable presumption procedure. The average and median total compensation amounts reported for top management were $490,000 and $377,000, respectively. The average and medians for the 20 hospitals subject to IRS examination were $1.4 million and $1.3 million respectively. The IRS indicated that,while compensation amounts appeared high in some contexts, they “appear supported under current law.” The report also indicated that the IRS would dedicate further analysis to the use of for-profit comparables.
- Director independence – Definitional question:
- 990 Instructions
- For religious providers, are members of religious orders who are board members considered independent. See the IRS answer at Part VI Instructions at 16.
- Rev. Rul. 69-545 (1969)
- Some state laws regulate board independence. See, e.g., Cal. Corp. Code 5227 (West
- See generally, Carter Bishop, , 57 CATH. U. L. REV. 701 (2008); Kathleen M. Boozang, Board Independence and Transparency: Searching for the Key to Good Governance, 1 J. HEALTH & LIFE SCI. L. 127 (2008). Kathleen M. Boozang, Does an Independent Board Improve Nonprofit Corporate Governance?, 75 Tenn. L. Rev. 83 (2007); Dana Brakman Reiser, Director Independence in the Independent Sector, 76 FORDHAM. L. REV. 795 (2007); Evelyn Brody, The Board of Nonprofit Organizations: Puzzling through the Gaps between Law and Practice, 76 Fordham L. Rev. 521 (2007); Michael W. Peregrine & Bernadette M. Broccolo, “Independence” and the Nonprofit Board: A General Counsel’s Guide, 39 J. HEALTH L. 497 (2006).
- Transparency of governing documents
- Are organic documents available on the entity’s web site? Alternatively, many organizations’ 990s are available on http://www.guidestar.org/.
- Financial oversight and Audit Committee
- Presumably, health care organizations undergo an outside audit that is overseen by the Audit Committee, which should be comprised of independent directors. The board might also delegate to the Audit Committee review of the 990 prior to its filing. The 990 specifically asks what role the board has had in its review. Finally, in many organizations, the Audit Committee also monitors Corporate Compliance.
TEACHING TIP: HAVE YOUR STUDENTS REVIEW AN ENTITY’S 990 ON GUIDESTAR.
Governance and Compliance
Governance and the Economy
- Significant increase in CIAs and pretrial diversion agreements. See generally Kathleen M. Boozang & Simone Handler-Hutchinson, “Monitoring” Corporate Corruption: DOJ’s Use of Deferred Prosecution Agreements in Health Care, 35 AJLM 89 (2009).
- “Where a decision is made to charge a corporation, it does not necessarily follow that individual directors, officers, employees, or shareholders should not also be charged. Prosecution of a corporation is not a substitute for the prosecution of criminally culpable individuals within or without the corporation. Because a corporation can act only through individuals, imposition of individual criminal liability may provide the strongest deterrent against future corporate wrongdoing. Only rarely should provable individual culpability not be pursued, particularly if it relates to high-level corporate officers, even in the face of an offer of a corporate guilty plea or some other disposition of the charges against the corporation.” The Department of Justice, "Principles of Federal Prosecution of Business Organizations" at 3 http://www.usdoj.gov/opa/documents/corp-chargingguidelines.pdf.
- Criminal prosecution and the availability of pre-trial diversion depend upon assessment, inter alia, of
- Pervasiveness of wrongdoing, including complicity of management
- Existence and effectiveness of compliance program
- Such programs, even if they prohibit the specific conduct at issue, will not absolve the corporation of criminal liability.
- Has the corporation provided sufficient staff to audit, document, analyze, and utilize results of compliance program?
- Even in the current economic downturn, attorneys are counseling clients AGAINST budget cuts in compliance, for fear that this would send a bad signal to enforcement agencies regarding the entity’s seriousness about compliance.
- Disclosure and cooperation
- This factor unquestionably involves the board which, among other questions, will have to determine how to construct an internal investigation of alleged wrong-doing that presents a potential for significant criminal and/or civil liability; what remedial actions are appropriate; whether to self-report; and/or whether to waive attorney-client privilege
- The existence of an effective corporate compliance program, including the role of governance, also affects the corporation’s culpability score and any sanction it may receive. See 2007 Federal Sentencing Guidelines, Chapter 8 – Part B – Remedying Harm from Criminal Conduct, and Effective Compliance and Ethics Programs
- An effective compliance program requires Board of Directors oversight of implementation and effectiveness.
- Heightened Governance Responsibilities Reflected in Most Recent Corporate Integrity Agreements
- Eli Lilly
- Corporate Compliance Officer may not report to or be subordinate to CFO or GC
- Requires not only Compliance Officer but Compliance Committee comprised of senior managers of key departments
- Board of Directors (or Board Committee comprised of independent directors) responsible for review and oversight of matters related to compliance with Federal health care program requirements and CIA
- Periodic board/committee review of performance of Compliance Program, with copy of review report provided to OIG
- Periodic board/committee resolutions summarizing review and oversight of compliance with Federal health programs, or, if unable to attest to compliance, reasons why, with enumeration of steps to resolve
- Management Accountability and Certifications: Certain employees, such as CEO and VPs involved with marketing and sales, must annually certify that their units comply with the CIA, FDA requirements and Federal health care program requirements
- Requires not only Compliance Officer but Compliance Committee comprised of senior managers of key departments
- Board of Directors (or Board Committee) responsible for “review and oversight of matters related to compliance with Federal health care program requirements…”
- Quarterly board/committee review of performance of Compliance Officer and Department
- Periodic board/committee resolutions summarizing review and oversight of compliance with Federal health programs, or if unable to attest to compliance, reasons why, with enumeration of steps to resolve
- Board covered by Code of Conduct and educational requirements
- State False Claims Acts. As amended by § 6031 of the Deficit Reduction Act of 2005, § 1909 of the Social Security Act provides a financial incentive for States to enact false claims acts that establish liability to the State for the submission of false or fraudulent claims to the State’s Medicaid program. If a State false claims act is determined to meet certain enumerated requirements, the State is entitled to an increase of 10 percentage points in its medical assistance percentage, as determined by § 1905(b) of the Social Security Act, with respect to any amounts recovered under a State action brought under such a law. Excerpted from http://www.oig.hhs.gov/fraud/falseclaimsact.asp
- Potential actions by state attorneys general against directors and/or corporate entity. HHS OIG & AHLA, Corporate Responsibility and Corporate Compliance: A Resource for Health Care Boards of Directors at 3 (2003)
2009 has already witnessed severely economically distressed hospitals, with bankruptcies occurring in some parts of the country on a regular basis. Important to governance is the understanding that, once entities enter the zone of insolvency or become insolvent, the for profit board’s fiduciary duties may expand to include the entity’s creditors and other beneficiaries – in short, another constituency potentially has standing to sue the board for breach of its fiduciary duties. How this plays out in the nonprofit setting is not at all clear for several reasons. See generally, Michael W. Peregrine & Miles W. Hughes, Organizational Financial Distress: Evolving Duties for Healthcare Directors, AHLA WEBSITE.
First, what is the relationship between the duty to creditors and the nonprofit mission? Some case law dealing with the insolvent corporation refers to the directors’ duties to the corporate entity that might be relied upon to emphasize a nonprofit board’s continuing duty to mission:
their duty is to serve the interests of the corporate enterprise, encompassing all its constituent groups, without preference to any. That duty, therefore, requires directors to take creditor interests into account, but not necessarily to give those interests priority. In particular, it is not a duty to liquidate and pay creditors when the corporation is near insolvency, provided that in the directors' informed, good faith judgment there is an alternative. Rather, the scope of that duty to the corporate enterprise is “to exercise judgment in an informed, good faith effort to maximize the corporation's long-term wealth creating capacity.”
In re Ben Franklin Retail Stores, 225 B.R. 646 (Bankr. N.D. Ill. 1998) overruled in part 2000 WL 28266 (N.D. Ill.). See also, Production Resources Group v. NCT Group, 863 A.2d 772, 790 (Del. Ch. 2004); Credit Lyonnais Bank Nederland v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch.).
Second, while it is next to impossible to successfully pursue a breach of the duty of care case against a Delaware corporation – whether solvent or insolvent – most nonprofit hospitals are incorporated locally, and may therefore be governed by state law more amenable to torts against directors who delayed filing for bankruptcy to the detriment of the corporate entity. On the relative absence of risk of liability for breach of the duty of care generally, see Stephen J. Lubben & Alana Darnell, Delaware’s Duty of Care, 31 DEL. J. CORP. L. 589 (2006).
Third, the nonprofit is subject to the ultimate oversight of the state attorney general, who may employ fiduciary duty law to remove or sue directors for breach of their duties in a situation of insolvency – an attorney general might argue that the business judgment rule is irrelevant to a removal action, or that trust law is more apt than corporate law when considering directors’ execution of their duties in preserving the nonprofit’s assets.
Fourth, to the extent that any state rejects a cause of action against the board of an entity in the zone of insolvency for fear that it will discourage the board from taking the business risks necessary to potentially generate the profits necessary to salvage the firm, such rationale is arguably inapplicable to the charitable organization, which should focus on mission and asset preservation.
Finally, insolvent health care providers considering bankruptcy might very well encounter resistance by the state departments of health, which prefer not to lose control over to a bankruptcy judge over the on-going operations of a hospital, especially one whose financial distress may pose safety and quality risks to patients. At the very least, departments of health prefer not to be surprised by a hospital insolvency that results in elimination or services or closure. New Jersey has established a system to facilitate state involvement as early as possible in an entity’s financial distress so that a) the entity might receive assistance in obtaining the expert advice helpful in salvaging operations; b) the state is not surprised; c) the state has the ability to help identify alternative providers as the failing entity begins to eliminate services.
The following provides a brief summary of current corporate law regarding directors’ fiduciary duties in a situation of insolvency. No case involves a nonprofit.
Governance and Quality
- Directors’ General Duties.
It is well established that the directors owe their fiduciary obligations to the corporation and its shareholders. While shareholders rely on directors acting as fiduciaries to protect their interests, creditors are afforded protection through contractual agreements, fraud and fraudulent conveyance law, implied covenants of good faith and fair dealing, bankruptcy law, general commercial law and other sources of creditor rights. Delaware courts have traditionally been reluctant to expand existing fiduciary duties. Accordingly, “the general rule is that directors do not owe creditors duties beyond the relevant contractual terms.”
North American Catholic Educational Programming Foundation, Inc., v. Gheewalla, 930 A.2d 92 (Del. 2007)
- Insolvency Exception to Directors’ Fiduciary Duties. Directors’ fiduciary duties expand to encompass preservation of assets for benefit of creditors upon insolvency in fact, not merely upon the actual filing for bankruptcy. At this point, the creditors replace the stockholders as residual claimants on a corporation's cash flow. However, this does not necessarily mean that the corporation must cease doing business or be incapable of continuing its operations. Jewel Recovery v. Gordon, 196 B.R. 348, 355 (N.D. Tex. 1996) (citations omitted); North American Catholic Educational Programming Foundation, Inc., v. Gheewalla, 930 A.2d 92, 101-02 (Del.2007).
- The practical challenge for a board is to identify when the entity is insolvent for these purposes. “The first test is commonly referred to as the ‘balance-sheet test.’ Under the balance-sheet test, a corporation has entered the zone of insolvency at the point in time when the liabilities of the corporation exceed the corporation's assets. This is a straightforward test that many courts have adopted. The second test is simply a “cash-flow test.” Basically, when a corporation is unable to pay its debts as they become due, the corporation has entered the zone of insolvency. Finally, the third test is a transactional analysis. When the corporation enters a transaction that results in unreasonably small capital remaining in the corporation, and the corporation faces an unreasonable risk of insolvency, it has entered the zone of insolvency.” Nancy A. Petterman & Sheri Morissette, Directors' Duties in the Zone of Insolvency: The Quandary of the Nonprofit Corp., 23-MAR AM. BANKR. INST. J. 12 (2004).
- What state law principles govern the insolvent nonprofit director’s fiduciary duties? The question for the nonprofit corporation is how this shift in obligations comports with duty to pursue the entity’s mission. State law governs the question of whether the directors owe their duties exclusively to creditors, or whether the corporate mission may still predominate in the board’s analysis. State law also dictates whether the fiduciary principles of trust law or the business judgment rule govern the directors’ conduct. See generally, Harold L. Kaplan & Michael W. Peregrine, Health Care Enters the Zone of Insolvency, 21-OCT AM. BANKR. INST. J. 32 (2002).
- Zone of Insolvency/Vicinity of Insolvency. Questions persist as to whether and when directors may be liable for failing to file for bankruptcy in a timely manner and, if so, who has standing – the Trustee, the corporation, or creditors. For purposes of this discussion, the contours of the board’s fiduciary duties and directors’ potential liability are what matters. According to the Delaware Supreme Court:
the need for providing directors with definitive guidance compels us to hold that no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency. When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.
North American Catholic Educational Programming Foundation, Inc., v. Gheewalla, 930 A.2d 92,100 (Del. 2007)
- Deepening Insolvency Theory. Originally a theory of damages, states are split over the existence of an independent cause of action for “deepening insolvency,” which "refers to the 'fraudulent prolongation of a corporation's life beyond insolvency,' resulting in damage to the corporation caused by the increased debt." The tort seeks to hold directors liable for these unpaid debts. In re Greater Southeast Hosp. Corp., 333 B.R. 506, 516 (Bkrtcy. D. Dist. Col. 2005). See also, NCP Litigation Trust v. KPMG, 945 A.2d 132, 141 (N.J.Super. 2007) (surveying courts that accept and reject deepening insolvency theory). See, e.g., Official Committee of Unsecured Creditors v. R.F. Lafferty, 267 F.3d 340 (3d Cir. 2001) (citations omitted). “Aside from causing actual bankruptcy, deepening insolvency can undermine a corporation's relationships with its customers, suppliers, and employees. The very threat of bankruptcy, brought about through fraudulent debt, can shake the confidence of parties dealing with the corporation, calling into question its ability to perform, thereby damaging the corporation's assets, the value of which often depends on the performance of other parties. In addition, prolonging an insolvent corporation's life through bad debt may simply cause the dissipation of corporate assets. These harms can be averted, and the value within an insolvent corporation salvaged, if the corporation is dissolved in a timely manner, rather than kept afloat with spurious debt.” 267 F.3d at 350 (emphasis added).
- Delaware rejects deepening insolvency. Trenwick America Litigation Trust v. Ernst & Young, 906 A.2d 168 (Del.Ch. 2006) involved an action against former directors of holding company, former directors of subsidiary, and various third-party advisors, alleging claims including breach of fiduciary duties, deepening insolvency, and fraud. While my favorite quote from the court is, “The concept of deepening insolvency has been discussed at length in federal jurisprudence, perhaps because the term has the kind of stentorious academic ring that tends to dull the mind to the concept's ultimate emptiness,” Id. at 204, there is oh so much more:
Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept. Even when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red. The fact that the residual claimants of the firm at that time are creditors does not mean that the directors cannot choose to continue the firm's operations in the hope that they can expand the inadequate pie such that the firm's creditors get a greater recovery. By doing so, the directors do not become a guarantor of success. Put simply, under Delaware law, “deepening insolvency” is no more of a cause of action when a firm is insolvent than a cause of action for “shallowing profitability” would be when a firm is solvent. Existing equitable causes of action for breach of fiduciary duty, and existing legal causes of action for fraud, fraudulent conveyance, and breach of contract are the appropriate means by which to challenge the actions of boards of insolvent corporations. Id. at 174, 204-05.
The court’s rationale, grounded strongly in the business judgment rule, raises the question of whether its holding should extend to the nonprofit entity: “The incantation of the word insolvency, or even more amorphously, the words zone of insolvency should not declare open season on corporate fiduciaries. Directors are expected to seek profit for stockholders, even at risk of failure. With the prospect of profit often comes the potential for defeat.” Id. (emphasis added).
- Academic Commentary: Michelle M. Harner & Jo Ann J. Brighton, The Implications of North American Catholic and Trenwick: Final Death Knell for Deepening Insolvency? Shift in Directors' Duties in the Zone of Insolvency?, 2008 ANN. SURV. OF BANKR. LAW Part I § 1; Kelli A. Alces, Enforcing Corporate Fiduciary Duties in Bankruptcy, 56 U KAN L. REV. 83 (2007) (arguing that appointment of bankruptcy trustee is superior to reliance on state law to address breach of fiduciary duties and mismanagement problems of bankrupt entity); Jonathan C. Lipson, The Expressive Function of Directors’ Duties to Creditors, 12 STAN. J.L. BUS. & FIN. 224 (2007); Royce de R. Barondes, Fiduciary Duties in Distressed Corporations: Second-Generation Issues, 1 J. BUS. & TECH. L. 371(2007) (arguing that “the application of the business judgment rule to directors' operation of a distressed firm should be, if anything, stronger than the corresponding provision applied to a solvent firm”). See also articles cited in North American Catholic Educational Programming Foundation, Inc., v. Gheewalla, 930 A.2d 92, 99 n 28 (Del.2007) (all discussing directors’ duties in zone of insolvency). On fiduciary duties more generally, see Carter G. Bishop, The Deontological Significance of Nonprofit Corporate Governance Standards: A Fiduciary Duty of Care without a Remedy, 57 CATH. U. L. REV. 701 (2008).
- Tort for Dissipation of Assets. Smith v. Arthur Andersen LLP, 421 F.3d 989 C.A.9 (Ariz. 2005) declines to take a position on tort of deepening insolvency but finds sufficient basis to proceed on basis of dissipation of assets. Trustee alleges that the defendants (not necessarily intentionally) breached duties owed to Debtor, and that if they had not concealed Debtor’s financial condition from its outside directors and the investing public, the firm might have filed for bankruptcy more promptly. Further, additional assets might not have been spent on a failing business. This allegedly wrongful expenditure of corporate assets qualifies as an injury to the firm which is sufficient to confer standing upon the Trustee
- Potential Liability of General Counsel to the Insolvent Entity. General Counsel need to attend to the duties imposed on them by the relevant rules of professional responsibility, SOX (if a publicly traded entity), and the tort duties that arise from GC’s fiduciary role as an officer, as well as other rules that apply to the insolvent entity.
- CAL PENAL CODE § 531 criminalizes fraudulent conveyances to protect assets from creditors:
FRAUDULENT CONVEYANCES. Every person who is a party to any fraudulent conveyance of any lands, tenements, or hereditaments, goods or chattels, or any right or interest issuing out of the same, or to any bond, suit, judgment, or execution, contract or conveyance, had, made, or contrived with intent to deceive and defraud others, or to defeat, hinder, or delay creditors or others of their just debts, damages, or demands; or who, being a party as aforesaid, at any time wittingly and willingly puts in, uses, avows, maintains, justifies, or defends the same, or any of them, as true, and done, had, or made in good faith, or upon good consideration, or aliens, assigns, or sells any of the lands, tenements, hereditaments, goods, chattels, or other things before mentioned, to him or them conveyed as aforesaid, or any part thereof, is guilty of a misdemeanor.
Obviously, attorneys found to have engaged in such activities also place themselves at risk of professional discipline. See, e.g., In re DePamphilis, 153 A.2d 680 (N.J. 1959); Florida Bar v. Beaver, 248 So.2d 477 (Fla. 1971); Coppock v. State Bar, 749 P.2d 1317 (Ca. 1988).
- World Health Alternatives v. McDonald, 2008 WL 1002035 (Bkrtcy. D. Del.) involves a bankruptcy trustee’s claim against former officers and directors of World Health, a publicly traded corporation. The court’s opinion denying the former general counsel’s motion to dismiss is instructive on several areas of corporate law important to today’s health client and, in particular, legal counsel:
- On Counsel’s liability for breach of fiduciary duty: “The Trustee alleges that as the vice president of operation and in-house general counsel to World Health, Licastro was responsible for failing to implement any internal monitoring system and/or failing to utilize such system as is required by Caremark and Araneta. The material misrepresentations contained in World Health's SEC filings are examples of such failure. Since the SEC adopted a final rule pursuant to § 307 of the Sarbanes-Oxley Act, effective August 5, 2003, a general counsel has an affirmative duty to inspect the truthfulness of the SEC filings. 17 C.F.R. Part 205 (Jan. 29, 2007). Section 307 addresses the professional responsibilities of attorneys. It directs the SEC to issue rules that “set[ ] forth minimum standards of professional conduct for attorneys appearing and practicing before the Commission in any way in the representation of issuers.” Sarbanes-Oxley Act § 307, 15 U.S.C. § 7245 (2005). The standards must contain a rule requiring “an attorney to report evidence of a material violation of securities law or breach of fiduciary duty or similar violation by the issuer up-the-ladder within the company.” Id. Therefore, the Trustee appropriately asserts that Licastro as the in-house general counsel and the only lawyer in top management of World Health during the relevant period, had a duty to know or should have known of these corporate wrong doings and reported such breaches of fiduciary duties by the management.”
- On General Counsel’s responsibility for Corporate Waste of Assets: The court relies upon Delaware precedent to articulate the standard for adjudicating a waste of corporate assets claim: “[W]aste entails an exchange of corporate assets for consideration so disproportionately small as to lie beyond the range at which any reasonable person might be willing to trade.” Brehm v. Eisner, 746 A.2d 244, 263 (Del.2000). As to general counsel’s responsibility, even absent his being a financial officer or any allegation that he personally benefited from the expenditures, the court refused to dismiss the claim because defendant GC “allowed” and “knew or should have known” about the alleged waste. “In his role as general counsel, it seems highly likely that he would have been consulted as to guidelines for out of the ordinary expenditures.” Luxury expenditures and bonuses should never have been approved “when World Health was experiencing negative net income.”
- On General Counsel’s liability for aiding and abetting breach of fiduciary duty by the chief financial officer/board chair, which included false statements to the SEC: “since the SEC adopted the final rule pursuant to § 307 of the Sarbanes-Oxley Act, general counsels have a duty to inspect the truthfulness of the companies' SEC filings. The Complaint also alleges that Defendants, including Licastro, failed to implement financial controls and proper check and balances, including failure to maintain checks and balances to ensure that the information provided . . . to third parties was complete, fair, and accurate.” See generally, In re Adelphia Communications Corp., 365 B.R. 24, *46 n. 50 (Bkrtcy.S.D.N.Y. 2007) (surveying courts that have recognized and rejected tort of aiding and abetting breach of fiduciary duty). See also RESTATEMENT (SECOND) OF TORTS § 876 (1979).
- On General Counsel’s liability for professional negligence. Finally, the court refused to dismiss the Trustee’s claim for professional negligence stating that General Counsel “became aware or should have been aware of the malfeasance and misdealing and discrepancies in the Company's revenue; however, no actions were taken consistent with their fiduciary duties to remedy or ameliorate the discrepancies until after McDonald's resignation.” Summing up, the court stated that because of the GC’s alleged negligence, World Health suffered damages.
- For the OIG’s perspective on the role of the General Counsel as it relates to compliance in the health care environment, see An Integrated Approach to Corporate Compliance: A Resource for Health Care Organization Board of Directors, released in July 2004.
- Board Duty to Provide Quality Healthcare. Recent Developments in Quality Measurement. In the past, healthcare directors were limited in their quality oversight capabilities by the quality data that was available. Board members could rely only on the performance of individual physicians to measure healthcare quality, thus systemic oversight was left to the medical staff. Beginning in the 1970s, the science of quality measurement has been applied to hospitals to evaluate quality beyond individual practitioner errors. As a result, healthcare directors now have a wealth of quality information at their disposal, and a corresponding duty to use it. See generally, Tracy E. Miller & Valerie L. Gutmann, Changing Expectations for Board Oversight of Healthcare Quality: The Emerging Paradigm, J. HEALTH & LIFE SCI. L., July 2009 (forthcoming).
- Caremark Duties. A board of directors’ duty of care includes the duty to oversee corporate performance. In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959, 961 (Del. Ch. 1996). Directors must have a system in place for gathering and reviewing information about the corporation’s performance and compliance in order to fulfill their duty of care. OIG & AHLA, CORPORATE RESPONSIBILITY AND HEALTH CARE QUALITY: A RESOURCE FOR HEALTH CARE BOARDS OF DIRECTORS (2007).
- Duty of Obedience- Nonprofit board members have an additional duty of obedience to the corporate mission. See DANIEL L. KURTZ, BOARD LIABILITY: GUIDE FOR NONPROFIT DIRECTORS 85 (1988). For healthcare corporations, this generally entails providing quality healthcare.
- External Pressures to Improve Board Oversight of Quality
- Pay-for-Performance and Transparency. Recent trends toward greater transparency in healthcare data has led to an increase in pay-for-performance programs both by the HMOs and the federal government. In this environment, boards have powerful financial and reputational incentives to focus on quality. Miller & Gutmann, at 11–15.
- Federal Regulation. The federal government has authority to regulate healthcare boards through the CMS, federal prosecutions, and recommendations by the OIG. The CMS, through its Hospital Conditions of Participation in the Medicare Program, sets minimum standards for boards of directors. In 2003, the CMS changed these standards to include quality assessment and performance improvement programs. 42 C.F.R. § 482.21 (2003); 42 C.F.R. § 488.5; 42 U.S.C. § 1395bb(a),(b), and § 1395x(e).
The Department of Justice and the OIG have increased prosecutions against healthcare entities for poor quality under the False Claims Act. The theory is that billing Medicare for poor services amounts to fraudulent billing or that the entity billed for worthless services. These prosecutions generally lead to pre-trial settlement agreement such as a Corporate Integrity Agreement or a Deferred Prosecution Agreement. Recently, these agreements have included broad provisions on quality oversight. See, e.g., Tenet CIA).
Finally, in an effort to provide guidance to nonprofit boards, the OIG released a series of joint statements with the AHLA, the most recent of which was released in 2007. This statement outlined steps that a health care board could take to monitor and improve quality. OIG & AHLA, CORPORATE RESPONSIBILITY AND HEALTH CARE QUALITY: A RESOURCE FOR HEALTH CARE BOARDS OF DIRECTORS (2007).
- Relevant Academic Commentary. Joseph P. Mcmenamin, Pandemic Influenza: Is There a Corporate Duty to Prepare?, 64 FOOD & DRUG L.J. 69 (2009) (considers “whether claims may be brought on the theory that corporate leadership is under a duty to prepare for a pandemic by considering whether to provide access to antiviral protection for employees”).