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The Metropolitan Corporate Counsel
March 2004
Is Your Hospital Board Vulnerable?
Judy J. Hlafcsak
Stephen A. Timoni
and Leigh J. Rubinstein
KIRKPATRICK & LOCKHART LLP
The duties, responsibilities and failures
of institutional directors and boards of
directors have never been more focused in
the public’s eye. Failures and scandals
have raised questions of the roles of boards
and how they undertake and discharge their
duties. We continue to read of corporate
scandals of varying proportions - from
allegations of widespread fraud at HealthSouth to self-revelations of a lack of basic
attentiveness, as in the recent claims of
New York Stock Exchange directors,
wherein the directors were shocked to
learn the total compensation of their CEO
(despite the fact that they approved the
employment agreement). This article
briefly summarizes the roles and responsibilities of hospital directors and offers several steps to building a better board.
The Role Of The Board
Being an effective director of a health
care system is a difficult task. The industry
is complex and heavily regulated. Hospitals are under increasing financial pressure;
reimbursement continues to decrease;
investment income cannot be counted upon
to cushion operations; lenders are less tolerant; physicians are seeking more and
more financial assistance from hospitals;
medical malpractice issues are creating
new complexities; regulatory compliance
continues to be expensive; physical plants
are aging; and information systems and
equipment needs are expensive.
Directors are “fiduciaries” and accordingly, have a duty to act primarily for the
benefit of the hospital in good faith.
Although directors may rely upon information provided by management, they should
exercise independent judgment and should
not hesitate to take a different position.
Every person who has an interest in the
health system – its employees, its patients,
its vendors, its physicians, its lenders, and
its donors – is placing its, his, or her trust
in the board to do the right thing. Doing
the right thing means that the board’s
actions are defensible – that the directors
believed, in good faith and after reasonable
diligence, the actions taken to be the best
solution given the constraints that the organization faced.
Building A Better Board And Being A
Better Director
The board is charged with defining and
overseeing the implementation of the hospital’s mission. In fulfilling this role, the
board must be able to demonstrate that it:
(1) understands the issues presented; (2)
understands available options; and (3)
relies upon the board’s committees, consultants, and senior management’s advice in
an appropriate manner. A director needs to
know enough to ask questions, to raise
Judy J. Hlafcsak and Stephen A. Timoni
are Partners in the firm’s Pittsburgh and
Newark offices, respectively. Leigh J.
Rubinstein is an Associate resident in
Newark. They are all members of K&L’s
corporate and health care practice groups.
Ms. Hlafcsak may be reached at (412)3558920. Mr. Timoni may be reached at
(973)848-4020 and Ms. Rubinstein may be
reached at (973) 848-4042.
issues, and not to be 100% dependent on
management’s position. Being an effective
director comes down to three basic concepts: knowledge, faithfulness to your duty,
and well-founded trust. Below is a summary of six steps to building a better board.
Step One – Educate
Understanding the moving parts of a
hospital is a difficult task and not intuitive.
Management and senior board members
need to help new directors understand the
business and the mission. Board education
should include a practical orientation program that: highlights the system’s structure, corporations, boards, and services;
and explains service area demographics
such as the populations served and their
medical needs, competition, and unmet
medical needs. The board should provide
each director with the corporate organizational chart, board structure and committees, bylaws, key statistics such as number
of admissions, key clinical services, and
service area demographics. It is important
to have this information in writing
(updated annually) for reference purposes.
Speakers from within and outside of the
organization can offer valuable perspectives on issues such as strategic trends,
financial performance, quality indicators,
programs, and services.
The education provided should be documented. The primary benefit of education
is that it enhances the board’s ability to
make decisions. A secondary benefit is that
it demonstrates that directors have a solid
foundation for making logical, educated
decisions, thereby undercutting the veracity of any allegations of negligence or mismanagement.
Step Two – Disseminate Information so
It Informs
A common problem is that financial
information is often not conveyed in a
meaningful way to directors so that their
attention is called to significant items or
trends. Understanding the information and
putting it into context is a huge undertaking, made even more onerous if management is not highlighting items of concern.
Financial reporting for health care systems is complex. It is unrealistic to think
that every board member will have an intimate working knowledge of the financials.
That is acceptable as long as:
(a) the entity has a finance/audit committee that is primarily responsible for
understanding and conveying the key
financial information to the rest of the
board;
(b) the finance/audit committee is composed of members with financial expertise
(described further in Step Three) ; and
(c) the external auditors are auditors
only and have no consulting responsibilities (described further in Step Three).
With the assistance of the external auditors, the board should select several initial
financial indicators for the full board to
track. For example, examining the organization’s liquidity ratios, days of cash on
hand, or debt service ratios and comparing
them against recommended standards and
peer hospitals on a monthly basis helps to
put the organization’s performance in perspective. Every board member need not
be an expert, but should have a working
knowledge of the organization’s financial
picture.
Step Three – Adopt Some of the Sarbanes-Oxley Principles
The Sarbanes-Oxley Act provides for
corporate accountability and investor protection and by its terms, is applicable only
to public companies. The principles that it
promotes and the values it seeks to preserve, however, are equally applicable to
charitable corporations. While charitable
corporations do not have shareholders, they
do have communities that rely on them,
community donors that fund them, and
bondholders that have invested in them.
Perhaps more importantly, the SarbanesOxley principles and many of the rules
emanating from those principles evidence
good corporate governance practices and
help to ensure that the board performs
meaningful oversight.
Sarbanes-Oxley requires at least one
member of the audit committee to be an
audit committee financial expert. This person must understand accounting principles
and financial statements, assess the application of those principles, have experience
preparing financial statements, understand
internal controls and financial reporting,
and understand audit committee functions.
Having an audit committee financial expert
helps to ensure that the audit committee is
competent to question the external auditors
and management.
Sarbanes-Oxley also promotes a direct
relationship between the external auditors
and the audit committee so that all significant communications regarding the audit
and the treatment of certain funds are not
solely between the auditors and management. The audit committee needs to have
the direct perspective of the auditors as to
the quality of the company’s accounting
principles, significant matters that were the
subject of consultation between management and other accountants, disagreements
with management over the application of
accounting principles, and the like.
Auditors should be exclusively auditors.
Audit functions and consulting functions
are too often at odds with each other.
External auditors should not have any other
role that could create a conflict for the performance of the audit function. Auditors
should not be in a position where they: (a)
audit their own work; (b) perform management functions; or (c) act as an advocate for
the corporation.
Step Four – Make Sure Your Baseline
Systems are Functional
The board should consider performing
baseline reviews of policies and procedures
in high-risk areas. Such areas include, but
are not limited to: (a) medical staff appointments and reappointments; (b) donor solicitation materials and the procedures for
utilizing donor funds; (c) relationships with
key physician groups, contractors, and
employees; and (d) medical business purchases and disposition strategies, and
recruitment deals. This review should be
conducted by legal counsel so that the work
product can be protected under an attorneyclient privilege.
Finally, a board should make sure that:
the hospital system’s legal corporate structure reflects actual operations; the organizational documents (articles and bylaws) are
consistent with each other and reflect the
reality of how they function; the tax exemption information is correct; all necessary
corporate and Internal Revenue Service
(“IRS”) filings have been made; and corporations that are no longer functional have
been dissolved appropriately.
Step Five – Promote Board Independence
The board must be independent in its
decision-making. 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 objective 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. 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, such as physicians who
have allegiances to competitor hospitals or
who serve in a physician leadership capacity at a competitor hospital.
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. Hospitals may reach different conclusions as
they consider these issues, each of which
may be reasonable given each hospital’s
particular circumstances. The outcome is
less important than the process 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 and 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 party-allegation that the interested
director was unfit to serve.
A conflict or the appearance of a conflict must be disclosed and discussed
within the board and be documented in the
board meeting minutes. It should be noted
in the minutes if a director abstains from
voting because of a conflict or leaves the
room. 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 the hospital’s policy, can have significant ramifications.
Step Six – Know What Your CEO Earns
and Evaluate Your CEO
Every board member should be familiar
with the CEO’s compensation 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 ensure that
the hospital does not run afoul of the IRS
excess benefit regulations. A hospital must
ensure that the compensation committee
and procedures function well and can withstand scrutiny. Among other things, this
committee should be comprised of independent directors and should have documented support for its compensation
decisions.
The compensation committee must
transmit this information to the entire
board. 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 board
or a board committee must annually evaluate the CEO. It may help to have a thirdparty consultant assist in creating tools for
evaluation. 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.
Please email the authors at jhlafcsak@kl.com or stimoni@kl.com or lrubinstein@kl.com
with questions about this article.