Health Law
FEBRUARY 2004
Is Your Board Vulnerable? Part III
This article is the third part in a series of three articles, detailing steps to a better board.
STEP FIVE OF SIX –
Promote Board Independence
Allegations in a number of corporate scandals
(HealthSouth and the New York Stock Exchange
are two recent examples) charge that the board
lacked sufficient independence and criticize the
interrelationships among the organization, its
CEO, and its board members. When a director’s
business success is linked in a measurable way to
management, the relationship is vulnerable to a
claim of conflict. The concern is that the director
is essentially beholden to management in order to
assure a continued stream of business — to take a
position contrary to management risks the
director’s business relationship.
The Internal Revenue Service, the Pennsylvania
Non-Profit Corporation Law, and now the
Sarbanes-Oxley Act all stress the need for board
independence in decision-making. The SarbanesOxley Act imposes certain independence
requirements on public companies. The duty of
loyalty – that a director act in the best interest of
the corporation and not in his or her own best
interest – is a key legal duty of a director.
While having objectively independent directors
is important, it is also important to have a board
that understands how hospitals function. For
hospital systems, some of the most
knowledgeable and valuable directors may not
be independent. For example, physicians who
practice at the hospital are generally not
independent but bring an important perspective
because they understand the hospital in a way
that a true “outsider” cannot.
While most hospital boards conclude that the
benefit of having physicians as directors
outweighs any risks, it is important that, in
selecting physician directors, the board evaluate
whether there are characteristics that would
disqualify a physician from board services. For
example, a hospital may decide that it does not
want physicians on its board who have
allegiances to competitor hospitals or who serve
in a physician leadership capacity at a
competitor hospital.
S
. . . some of the most knowledgeable
and valuable directors may not be
independent. For example, physicians
who practice at the hospital are
generally not independent but
bring an important perspective
because they understand the hospital
in a way that a true “outsider” cannot.
Additionally, when a board is undertaking
significant strategic actions, it needs to
understand that the director physician may have
loyalties to the medical staff at large or specific
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members of the medical staff that could
influence the director physician’s position. It
may be difficult for director physicians to be
involved in a decision-making process (such as
a sale of the hospital or closure of a service)
where the decision has a direct and profound
impact on the physicians and not have the
ability to discuss that process with the other
members of the medical staff. These problems
are not insurmountable, but they do require
awareness and discussion at the board level as
to how to handle these issues.
e
Similarly, a hospital’s outside legal counsel
brings a knowledge base of the organization that
other outside directors of the hospital will not
have. There is some concern that counsel to the
hospital, because his or her services are
generally requested by management, is
beholden to management and may not be able to
be an objective director. Whether disclosure of
the relationship to the board is sufficient to
offset these concerns is uncertain and may be
dependent upon the amount of legal work
generated by the hospital for the director’s firm,
the comfort level of the remaining directors
with the quality of the direct relationship
between counsel and the board, and the
independence of counsel from management.
D
Director claims of ignorance on a
critical and controversial topic like
CEO compensation do not engender
confidence that the board is doing
its job.
The goal is to create a functionally independent
board. It may not make sense to obtain
objective independence if you lose valuable
directors in the process. Hospital systems may
reach different conclusions as they consider
these issues, each of which may be reasonable
given that hospital’s particular circumstances.
The outcome is less important than the process
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Summary Points
If your governance is effective, every director
should be able to answer “yes” to each of the
following questions when he or she is voting on a
matter:
1. Do I understand the background, facts, and
context surrounding this decision sufficiently
to make a decision?
2. Do I understand the available options and the
risks and benefits of each of them?
3. Can I trust the reports of other directors,
management, and consultants on this subject
as being fair and objective and can I rely on
their recommendation?
the board undertakes in its consideration of this
issue. The determinative issue is whether the
board is able to reasonably conclude that
“interested” directors are able to look beyond
their own interests, look beyond their ties to
management, evaluate a decision in terms of the
best interest of the organization, and whether
the board believes it can offset a third partyallegation that the interested director was unfit
to serve.
Every hospital has a conflict-of-interest policy and
a disclosure form that its directors and, sometimes,
senior management complete annually. Make sure
that your organization uses the conflict-of-interest
policy and the disclosure form as functional tools,
not administrative burdens. Rethink your
disclosure form to ensure that you are asking
meaningful questions. If you are concerned about
having physician directors who practice at other
hospitals or who are in physician leadership
positions on other medical staffs, ask for
disclosure of those issues.
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ACTION ITEMS:
4. Am I making this decision considering only
the best interest of the hospital and its
constituent groups and not my own interests?
5. If the decision turns out disastrous, am I
confident that I can justify (through
testimony, backed up with documentation)
that the decision was appropriate?
Effective governance yields the primary benefit
of strengthening your organization and the
secondary, but critical, benefit of protecting the
directors and officers from liability when things
go wrong. Take an objective, critical review of
your governance and evaluate how a reporter, a
lawyer, a bondholder, or a judge would view your
organization’s leadership and decision-making.
Where there is a conflict or the appearance of a
conflict, make sure the conflict is disclosed and
discussed within the board (not just filed away).
The discussion and the decision of the board
should be documented in the minutes. Directors
who abstain from voting because of a conflict or
who leave the room should be noted in the
minutes. Follow the procedures set forth in the
conflict of interest policy. Having a director
with a potential or real conflict on the board is
not necessarily a bad thing as long as the board
has fully discussed, understands, and has acted
knowingly in dealing with the conflict. Having
a potential or actual conflict, however, and not
following your policy, can have significant
ramifications.
Finally, conflict disclosure is not just an annual
process and not just a form to be filed away. The
need to alert the board chair to a potential conflict
is an ongoing obligation for every board member.
FEBRUARY 2004
1. Review of your conflict-of-interest policy
from a legal as well as a practical
perspective. Does it meet your needs? Are
you asking questions that are meaningful to
your organization? Are all of your
subsidiaries and affiliates covered by a
conflict-of-interest policy?
2. Evaluate the independence of your board and
key committees. If you have directors who
are not objectively independent, decide
whether or not you want those individuals on
key committees (executive, compensation,
nominating), where their influence will be
greater and the risk that you need to defend
their lack of independence is greater. You may
want to check with your D&O insurance
carrier to make sure that you are not
jeopardizing your coverage by having
interested members on certain committees.
3. At least two directors should review the
completed disclosure form of all directors.
The forms should be available for review by
all directors. On large boards, the chairman
should annually review the reported
conflicts with the entire board because some
directors may be unaware of the business
relationships or conflicts of fellow directors.
4. As an adjunct to a conflict-of-interest policy
and disclosure statement, the board should
also adopt a confidentiality policy, which
each director should sign. The policy
should reiterate the importance and
necessity of confidentiality. Even if the
policy is impossible to enforce, it will
highlight the importance of confidentiality
of matters discussed by the board.
STEP SIX OF SIX –
Know What Your CEO Earns
and Evaluate Your CEO
Every board member should know how much
the CEO is being paid and understand the basic
method of compensation. Most hospitals have a
compensation committee and procedures in
place to evaluate the CEO’s compensation and
to assure that the hospital does not run afoul of
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the IRS excess benefit regulations. Make sure
that your compensation committee and procedures
function well and can withstand scrutiny. Among
other things, this committee should be comprised
of independent directors (not tied to management
in any significant way) and should have
documented support for its compensation
decisions (review of peer organizations,
consideration of base vs. bonus components, etc.).
Most importantly, be certain that the compensation
committee transmits this information to the rest of
the board. It never looks good in the newspaper
when directors say they were shocked to learn
their CEO made that much money. The New York
Stock Exchange board is the most glaring example
of this lesson. When information regarding the
compensation for the NYSE CEO was made
public, NYSE directors claimed that they had no
idea their CEO was being compensated so
generously – even though they approved the
employment agreement! Even the chair of the
NYSE compensation committee, who signed the
employment agreement on behalf of the
organization, reportedly did not understand the
details of the compensation arrangement.
Meanwhile the NYSE was exhorting companies
listed on the NYSE to adopt more stringent
corporate governance practices.
Director claims of ignorance on a critical and
controversial topic like CEO compensation do not
engender confidence that the board is doing its job.
As an adjunct to the compensation process, make
sure the board or a committee of the board
conducts an annual evaluation of the CEO. It may
help to have a third-party consultant assist in
creating tools for evaluation (having this objective
input also provides evidence that your process is
sound and reasonable). The reality of sitting on a
board is that directors are dependent on the CEO
and, to a lesser extent, the remaining members of
the senior management team. Despite best efforts,
insights, and a director’s commitment of time, no
director will ever know as much about the
organization as the CEO. As important, the CEO
regulates the information directors receive. To be
effective as a board, directors need to rely on their
CEO to provide them with the relevant information
and to trust their CEO not to spin the information
inappropriately. An annual evaluation helps to
provide some objective to support the validity of
the board’s reliance on its CEO.
ACTION ITEMS:
1. If you have not recently done so, review (and
update as necessary) your CEO evaluation and
senior management compensation methods,
making sure that all directors are invited to
provide input into the CEO evaluation.
2. Make sure that the entire board understands
and approves the entire compensation package
(salary, incentive, deferred compensation,
other benefits (car, country club memberships,
etc.)) for the CEO and senior management.
JUDY J. HLAFCSAK
jhlafcsak@kl.com
412.355.8920
FOR MORE INFORMATION, please contact one of the following K&L lawyers:
Boston
R. Bruce Allensworth ballensworth@kl.com
Edward J. Brennan, Jr. ebrennan@kl.com
617.261.3119
617.951.9143
Harrisburg
Ruth E. Granfors
Raymond P. Pepe
rgranfors@kl.com
rpepe@kl.com
717.231.5835
717.231.5988
Miami
Marc H. Auerbach
William J. Spratt, Jr.
mauerbach@kl.com
wspratt@kl.com
305.539.3304
305.539.3320
Newark
Stephen A. Timoni
stimoni@kl.com
973.848.4020
Pittsburgh
Judy J. Hlafcsak
Edward V. Weisgerber
jhlafcsak@kl.com
eweisgerber@kl.com
412.355.8920
412.355.8980
aberkeley@kl.com
202.778.9050
Washington Alan J. Berkeley
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This bulletin is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
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© 2004 KIRKPATRICK & LOCKHART LLP.
ALL RIGHTS RESERVED.
KIRKPATRICK & LOCKHART LLP HEALTH LAW ALERT