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AHLA's Speaking of Health Law
Trends and Developments in Director/Officer Liability: Concept of Officer and Director Liability and Related Standards of Care
In the first episode of this three-part series focusing on director/officer liability, Rob Gerberry, Senior Vice President & Chief Legal Officer, Summa Health, speaks with Michael Peregrine, Partner, McDermott Will & Emery LLP, about the basic concept of officer and director liability and related standards of care. They discuss the importance of director and officer liability in today’s health care environment, basic standards of conduct, the kinds of circumstances that most typically create liability exposure for officers and directors, and defenses and protections available to officers and directors. From AHLA’s Business Law and Governance Practice Group.
Listen to the second episode, which discusses parties with primary jurisdiction to challenge officer and director conduct, here.
Listen to the third episode, which discusses new developments in officer and director liability matters, here.
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Speaker 2:Hello, everyone. I'm Rob Gerber. I'm the Senior Vice President and Chief Legal Officer at Suma Health, and a member of the American Health Law Association Board. I'd like to welcome you to a first in a series of three podcasts on the important topic of trends and developments and director and officer liability profiles. This three part podcast series is designed as a supplement to the popular 2022 series of podcasts, which explored basic governance issues affecting hospitals and health systems. In this new series, we plan on addressing three specific elements of the officer and director's liability profile. First, the subject of today's podcast, the basic concept of officer and director liability and related standards of care. Second, the parties with primary jurisdiction to challenge officer and director conduct. And lastly, new developments and officer and director liability matters, including the Delaware Chancellor Court's recent decision in the McDonald Corporation's stockholder derivative litigation. And as before, I'm joined by my colleague and our governance expert at hla Michael Peregrine of McDermott, will and Emory, who's here to share some of his perspective with us on these important topics. Michael, thanks for joining me again.
Speaker 3:You bet, Rob. Delighted to be with you and our members.
Speaker 2:So, Michael, to start, I guess the overarching question is, why is there a need for us to have a discussion about director and officer liability and today's healthcare environment? Have we not gotten past these concerns? Well,
Speaker 3:You would think so, Rob, but I think there are two points we wanna make here for our members. One is, uh, director and officer. Liability in the healthcare industry is very rare. It's always been rare. It continues to be rare. But the second point is we're in a different environment now, and one which, um, is, is going to, is relevant to your question. We are asking so much more of our corporate directors in terms of their engagement and their commitment, uh, to the organization. The responsibilities that they have are more significant. The tasks that they have are broader. The best practices that are being released are suggesting, again, more engagement by the board because it's better oversight. So I think in a situation where, uh, we have the courts and legislatures and policy statements asking more for directors, it's logical to realize that the more involved directors get and are required to get the more exposed they are, um, uh, to, uh, third parties questioning their performance. And I think that's the environment we find ourselves in that together with the fact that, uh, as you know, uh, in your position, um, so well, uh, the stakes are so much higher. So the combination of greater engagement expectations and higher stakes, I think is, is combining to increase the liability profile of corporate officers and directors in our industry.
Speaker 2:Great. Thank you, Michael. So as we look at the basic standards of conduct upon which officers are and directors are generally held, how would you outline that, uh, for folks interested in that question?
Speaker 3:Well, I, and I think we're, you know, we're kinda talking in two levels, but at, at the high level, what are we concerned about? We're concerned, I think fundamentally, uh, uh, uh, gross negligence and bad faith in the performance of our duty of care with respect to decision making and our duty of care with respect to oversight. Uh, we're also very concerned with respect to, uh, similar instances of, uh, gross negligence, bad faith to the extent they apply in our duty of loyalty. In particular, uh, the extent to which we, uh, participate in conflict of interest transactions. Uh, and this is, uh, Rob, where we get involved to the, to the, uh, in the, uh, lesser known aspects of the duty of loyalty relating to corporate opportunity and breach of confidentiality. Uh, it's a situation in which we also have to, uh, be aware of, uh, of the concept and the definition of what really is good faith as opposed to bad faith, because those are the, the real, um, key factors here, the markers. And we also have to be mindful of, uh, of, uh, essentially practicing towards the business judgment rule. Uh, when we're in situations that involve actual decisions by the board, uh, ha has, has governance staff set the board up to, uh, make a decision that should satisfy the business judgment rule. Those are the basic concepts that are, uh, an application here. And going back to your first question about why is the need to look at these in the future, I think that there are more parties with skin in the game who actually care about how boards exercise their decisions. And we know from the decisions in Delaware and elsewhere that there's, there, there's a very large universe of people who like to, who are in a situation, who are willing to second guess oversight decisions. Where was the board? That remains a popular question and not always will be. And especially as we struggle to evaluate what's the red flag and how do we respond to red flags,
Speaker 2:Right. So as we get more granular, what kind of circumstances are you seeing right now that are driving, uh, typical liability exposures for officers and directors?
Speaker 3:Well, let me answer your question, Ron, with a bit of a qualification. Again, I think we start from the premise that some type of liability action against an officer director is extremely rare. That's, that's the, the foundation from which we operate. Uh, and the burden is, is always gonna be on the third party to, uh, to demonstrate that the directors acted in a manner apart from the standard of care. Uh, uh, we, we wanna be careful not to suggest that, uh, the sky is falling here in terms of liability concerns. That notwithstanding, I think that there's a laundry list of, of actions that, uh, the al that could lead to allegations, uh, of direct reliability. And I think we, we start with the obvious one, which would be, uh, gross negligence or worse in the exercise of our duties and responsibilities under the duty of care. Um, you get into situations where, uh, of inattentiveness of, uh, a director really not being able to demonstrate that their action was based on reasonable belief that the decision they make was in the best interest of the organization. Uh, you see a situation of, of conscious disregard, of conflicts, of interest rules, uh, uh, the failure to recuse or abstain from a, a transaction in which conflict of interest was present. Uh, I think the concept of the abdication of duty or neglect of duty as opposed to just simply not paying attention in a particular matter, uh, is, is an element of all this. Um, the excess benefit transactions that drive the tax issues under section 49 58 will always be a situation which attracts regulatory attention and third party attention, any type of suggestion of financial impropriety. And that ties back into conflict of interest issues. Um, then I think we have a series of, of, of related issues that involve financial benefit, which will, will be at least yellow flags to a third party, uh, the unauthorized use of corporate property. Uh, I, I think there's a situation in your state right now where, uh, there's been substantial investigation, uh, in a, in a regional health system about that, uh, the, uh, corporate opportunity or the unauthorized use of a corporate opportunity, uh, unfair comp or inappropriate competition with the organization, unlawful distributions. Um, most boards have avoided exposure to investment risk liability. I'm not sure, given some of the dramatic losses we've seen with the market over the last several years, if, if that is, uh, you know, if that is more, uh, uh, good luck as opposed to, uh, a formal application of law enforcement by the attorney generals. In other words, have some hospital boards become lucky, uh, uh, in terms of not having, uh, been exposed to liability for investment losses that, uh, because simply the state ags have been too busy to pursue those matters, I don't know, but I, I do worry about that. Um, I think there's also a potential for, uh, liability exposure, uh, in terms of mission creep, where the board fails to monitor, uh, the evolution of the organization's mission beyond what its articles and incorporations say. Uh, similarly, the, uh, I think a, a a under-recognized area of exposure is, um, misappropriation of funds solicited for a particular purpose. Um, and then we have the, the favorite waste of assets, uh, again, a tough claim to sustain. Uh, but sometimes, uh, uh, it's a situation where a transaction is so bad, uh, or so poorly formed, or such an incredible waste of money that it can sustain a waste claim. But ultimately, Rob, I think that the greatest area of exposure has been, as it always has been, is, is just bad faith in the context of oversight, complete ignorance of what's going on, failure to informs oneself of, uh, the status of matters. Uh, and again, serious inattentiveness, uh, and a, a, a serious failure to be make an informed decision. Those are always going to be the two key ones.
Speaker 2:Great. Thank you. So, Michael, are we talking about monetary liability here, or are you seeing other types of exposure?
Speaker 3:Uh, I'm, I'm glad you asked that question. I should have thought about this before, Rob, because I, I believe that we, as health lawyers in working with our boards and our senior management, um, in evaluating liability exposure, uh, the most important iss, uh, issue at risk here is not monetary liability. Uh, I just could not faithfully say to you that there's a significant risk, or, or there is a real trend in direct reliability for monetary exposure here. The great risk that I see arising from the kinds of issues we're talking about this mo morning, is in reputational damage to the director. And I think that's a, a growing risk, uh, being named in a newspaper story, being subject to a subpoena or other information request for the, from the attorney general being subject to litigation from a third party or, uh, or, or books and records request from a disgruntled director. Uh, the great concern, I think, and, and what we should probably practice too, are the optics of a situation which board members are subject to third party criticism. No one signs up for that. And I think in today's, um, media situation, especially Rob, with the new media, uh, the, the outside, the old mainline publications, the new media where I think they shoot first and ask questions or confirm facts later, this is a real significant risk. And I wanna underscore that, uh, we have seen, I think, in a lot of the news stories over the last nine months that have been exceptionally critical of the hospital industry, um, a a, a substantial variance between fact and fiction. Um, it's discouraging, and we've seen individuals, uh, named and in these reports where it's very unfair. We're also seeing, I think, in a couple of situations in, in judicial opinions, um, uh, and, and allegations, for example, uh, antitrust authorities, a rule, a greater willingness to, to be critical of the board, of the governing boards of organizations, uh, in enforcement actions. So it's this broader world of reputational risk that I think is, this is the significant, uh, concern we have here and why, where, uh, health lawyers can play an enormous role in pointing out when we do the risk profile analysis on a particular transaction, we're not worried so much that a director will be exposed to financial liability here, but we are worried about the potential that in this environment, uh, reputation may, may be placed at risk. The other, uh, area of non-financial risk that I would point out, and it's kind of related, there are some states, including New York and others who will use in their settlements with not-for-profit corporations and boards, uh, the penalty that directors will not be allowed to serve on a not-for-profit board in that particular state in the future. Can you imagine the, uh, the, the pain, uh, of such a stain, uh, in that situation? It's, that's just awful. And I think the, uh, state charity officials know with some degree of, of experience that, uh, in many cases, that provides greater mo uh, motivation for compliance than, than the risk of monetary damage, uh, because you can't indemnify against, uh, damage to your reputation. Rob. So long-winded answer, but only because I believe this is the$64 question, will I be subjected to having my reputation criticized for the actions I'm taking here? And
Speaker 2:I would agree with your comment, Michael. I see seeing our directors, they are more, uh, interested in making sure they're fulfilling their community mission and protecting, uh, the organization, and not only their own reputations, but that of those that they serve. So, Michael, in this challenging environment, when officers and directors come to you and say, can you advise me on what kind of defenses or protections are available to me in this space? What type of counsel do you provide on that topic?
Speaker 3:Well, I think the number one response, uh, Rob, I would say, and we're, we're of course in an environment now where the Department of Justice, uh, and their, uh, E C C P guidelines and their, uh, renewed commitment to corporate accountability and corporate fraud enforcement, uh, where, where, where the, the meter on effective compliance programs is, is pointing, uh, up, uh, I, I would say number one is the best protection for our officers and directors, uh, is a, a clear discussion at the board level, what the risk, what an acceptable risk profile is for the organization generally, and on individual transactions, uh, a clear vetting, uh, of, uh, compliance matters with respect to transactions and investments, um, and supporting the board in its ability to make, uh, informed good faith, uh, disinterested decisions. In other words, uh, a commitment to effective decision making, a commitment to effective oversight will always be the best offenses to any third party liability exposure. Uh, and, and here's where our, where our health lawyer membership can play an enormous role. What you worry about is, and it always just, it drives me crazy, uh, when we see business people rushing to get deals done because of artificial deadlines, uh, cutting corners on deals, uh, limiting the ability of the board to make informed decision making, asking for streamlined decisions to hurry up and get something done, those are always yellows, uh, I think warning signs and, and are this, are the, uh, uh, foundation of problems later on. So that's, I think the, the general answer to your question, more specifically, I think we can look to, uh, there's a universe of, uh, uh, potential areas of defenses and protection that are available to board members that they should know about. Uh, we have in some states specific, uh, Delaware law, like protection limit li uh, liability limitations built into the statute, which are available to officer and officers and directors under specific circumstances. So we to make, be sure that you know the extent to which, uh, we have those available in our state, and we have the necessary charter revisions, uh, in our articles of incorporation to incorporate those, uh, the extent to which we follow in conflicts of interest transactions, the specific, whether you call it safe harbor's or rebuttable presumptions, uh, of reasonableness in those, that's usually provided in state law in that regard. Similarly, um, it, it's very important, I think, to have a clear understanding with the board on what corporate o the corporate opportunities are of the organization, and then to, to remind the board that in most states, there is a safe harbor process for a board member to participate in a corporate opportunity transaction. No reason to fall into that trap. Um, I think, uh, going back to my original comment on compliance, Rob, that, that another just absolute laid down defenses is working with the, um, senior management and certainly the chief legal officer on a decision making process that's designed to satisfy the business judgment rule. Uh, you can't lose by that. If, if we have, uh, if the dis organization's decision making private process is looser or truncated or unnecessary, uh, unnecessarily vague, we need to tighten that up. And again, uh, plan for as if we are going to need to apply the business judgment rule that is in a, from a procedural perspective, a tremendous, uh, cultural board boardroom cultural process that will yield good defensive results. And then of course, we have the whole world of, uh, indemnification whether, um, uh, in whatever form, whether it's mandatory or discretionary on behalf of the board, those are discussions, Rob, that I think should be had, for example, periodically with the governance committee. So there's no misunderstanding about how indemnification is applied and in what situations, what are its limitations, what are the availability of advances from the organization for defense costs, the availability of, uh, ensure d n o insurance and the limitations on that. Uh, those I think, are critical nuts and bolts questions that the board should not have any question in terms of what's available to them and what's not. And then always the availability of affirmative defenses and the argument of good faith. But bottom line, I want to come back and reemphasize nothing works like good practice, nothing works like com a attention to compliance, risk mitigation and transaction. Nothing works like commitment to a, a decision making process that satisfies the business judgment rule, and nothing works better than oversight based on engagement, commitment, and useful information to directors.
Speaker 2:So, Michael, as we're navigating these unprecedented financial challenges in the healthcare space, one of the questions that I've heard posed by a lot of board members is related to your comment on the business judgment role. How do I exercise the right duty of care? Some of the initiatives that management are putting in place have a more, uh, elongated timeline for them to make an impact. So can they sit back and wait and meet their duty of care standards? Can they rely on management's assertions that these are the right affirmative steps to take? Do they need to bring a third party in front of the board to make sure, uh, that they're meeting their, their standards, that they're around the duty of care? How would you advise a board member that had those concerns?
Speaker 3:Well, I, I think first of all, we want to make sure that any concerns on a global basis are appropriate. We don't wanna have our directors gun shy. We don't want to have them, uh, afraid of making informed risks. I think the best answer in these, in circumstances, Rob, is to focus on the process, have the, you know, like in any, uh, sports a activity, you focus on the fundamentals, you learn the basic blocking and tackling. You, you, you run the base as well. Um, and you play the field well, in other words, again, focusing on a process of making decisions, whereby the board is in a position to understand the rationale for the transaction, how it supports the mission, as the opportunity to directly or through a committee, review the materials, understand the legal risks, talk to counsel about those risks, uh, and then again, make a vote based on without conflict of interest, uh, satisfying the business judgment rule. Similarly, putting the board in a position where they get enough information on the compliance risks of the organization to be able to have their finger firmly on the pulse of the, uh, operations of the company, and, uh, understand when they, when recognize the yellow flag, when they see it and act when they see a red flag. What's critical to all this? I think, Rob, to answer your question specifically, uh, it's incumbent upon having a relationship with senior management so that senior management understands the role of the board and the potential exposure of the board. Oftentimes, uh, in, in a C-suite situation. I think that's the missing link that for, for, for whatever reason, management does not fully appreciate the expectations of the law on the board, and therefore they are, uh, unintentionally insensitive to the, to the scope of information that is necessary for the board to take a decision or the scope of information that's necessary for the board to exercise proper oversight. So I think it's, that's, again, that's the basic, uh, blocking and tackling we need isn't an appreciation by the senior leadership team that the board is not trying to meddle in, uh, management affairs necessarily the board's trying to do its job, and that there is, there is legal exposure to the board that's legitimate and sincere if they don't do it. So again, getting management to appreciate the real role, the board, I think is fundamental to mitigating board member liability in all respects.
Speaker 2:Michael, one of the other common questions that I'm hearing asked is, with the large body of work in front of boards right now, if the board is delegated to different board committees, key issues like workforce, a strategy like compliance, how much can a board member that's not on those committees rely on report outs at the board versus having to undertake any of their own, uh, investigation to ensure the organization's meeting its obligations there?
Speaker 3:Rob Dun Wright, um, delegate delegation to committees, uh, with board delegated powers. Uh, and it is in a very effective way of distributing the workload. Uh, it, it, the state's state law recognize it. It's a, it's a good system, uh, and it can be hard to screw up. So in, in, uh, you know, if you look at it when you write it up on the whiteboard, the board can reduce the burden on its own agenda by delegating certain matters to committees with, with appropriate charters, filled with members who have the time and the expertise and the judgment to make decisions on those. That's the way it's supposed to work, and it should work that way. How do you screw that up? Um, the committees don't need an, uh, the committees aren't, uh, are aren't full, don't have enough members to satisfy the, their agendas. The, the committees don't have people who have the necessary expertise. Uh, the committees aren't staffed properly by the management team. They don't need enough. There. There are a number of ways, all dumb ways to screw up the reliance process. But, but basically, uh, the ability of the board to rely on the advice of management, to rely on the advice and recommendations of, uh, committees with board delegated powers and to advise on the re uh, on the advice of outside advisors are all legally recognized methods of reducing the board's workload and, uh, and proper agenda management. And it's just dumb when we don't do that. Right.
Speaker 2:So, Michael, in conclusion for today, we always talk about risk along a continuum is we think about how to quantify for board members that approach us on what is the risk that they really face operating in this space currently. How would you advise them on, on that topic,
Speaker 3:Rob? I would say the risk is greater than it was five years ago. Uh, and it has, and and that's, again, as I said at the top of our discussion, and that's a combination of the, uh, increased focus of third parties in pursuing directors for exposure. It's part of the increased focus by the new media, uh, and, and how carefully or or unca carefully it, it looks at the facts. It's part of the s greater, uh, and much more pressure packed board agenda. Uh, it's part of the laws much a more increased expectation of director engagement, and it's a factor also of greater stakes, uh, matters coming towards the board. All of those factors combined to say the, the risk environment for officers and directors is much greater than it was five years ago. But you cannot make that statement without saying at the same time that the ability to mitigate those risks is still very much available to the board. It, the board just has to have the opportunity and support to take advantage of all those mitigation risks. There. No, there is zero downside to doing so. And I, again, the ultimate answer is, yeah, the general counsel and an organization is gonna know this call and, and to make sure that he or she has a voice in this, uh, to make sure that the decision making and oversight processes are run appropriately. And again, it's the, it's the senior leadership team. It's the C E O, the c O o, and the C F O, especially understanding what's at stake for the board members. If we can overcome that hurdle, I think we're gonna really be able to successfully mitigate, uh, director exposure, uh, in the way it used to be. But ultimately, right now, is there greater risk? Yes. Are there measures to eradicate that risk? Yes. Is it easy to do so? No.
Speaker 2:Great. Well, Michael, thank you once again for sharing your insights with our membership here at H L A. We appreciate your counsel and guidance on these important issues.
Speaker 3:Thanks, Rob. Always good to be with you.
Speaker 1:Thank you for listening. If you enjoy this episode, be sure to subscribe to a H L A speaking of health law wherever you get your podcasts. To learn more about a H L A and the educational resources available to the health law community, visit American health law.org.