The Law and Other Anomalies

How does a board of directors, faced with a pending acquisition which has management enthused, discharge its duties to shareholders? This discussion was one topic at the June 9^th meeting of the New England Chapter of the National Association of Corporate Directors in Boston. An experienced panel of directors seemed to agree on a wide variety of approaches:

The board should first establish a strategic articulation of which kinds of acquisitions they believe will build value of the company. Proposed acquisitions should be tested back against this strategic approach, notwithstanding management impetus to the deal. Management can get very competitive, may be in love with the deal and may also want to “win” the fight to capture the target. The board must control that tendency.

But what about opportunistic acquisitions? They are the hardest to evaluate; they may indeed be valuable but if they don’t fit the prior strategic discussion, that means no preparatory work has been done. The board’s role: work really really hard because you have to drill down and do both the strategic work and the operational work to evaluate the deal. One director noted that sometimes the company will have one M&A advisor and the board will have its own separate advisor.

What is the board’s role in diligence? As with many things, the board should be performing the function of a monitor. Directors should identify the biggest issues, the biggest risks, and should ask questions that address those risk parameters. Also, questions should be asked concerning post-acquisition planning; is it in place? Has management evaluated the human talent being acquired, does management have the bandwidth to integrate the acquisition?

Finally, the board has a role in interrogating the post-acquisition financial model that is presented. That model must be based on a variety of assumptions. Those assumptions should be fully understood by the board.

See the next blog post to address questions of integration and focus on “the culture” of the two enterprises; whatever “culture” means. . . .”

Directors of non-profit organizations generally take their responsibilities seriously. But directors of non-profits are motivated by fulfilling the mission, often while facing serious financial pressures.

All directors, including those of non-profits, are protected from lawsuits for breach of fiduciary duty in two ways. First, virtually all states have statutory limitations on the liability of non-profit directors, reflecting a policy of encouraging people to serve non-profit undertakings. Second, the so-called “business judgment rule” protects all directors (in both profit and non-profit companies) from liability for mismanagement provided the directors use reasonable judgment and do not self-deal.

Between these legal protections and contractual exonerations from liability typically \written into charter documents, directors rightfully have felt reasonably secure from litigation risk even as they guided their organizations along the narrow path of economic viability.

Enter the Third Federal Circuit Court of Appeals, reviewing the contentions of creditors claiming in two cases that the non-profit trustees/directors breached their duty by reason of imprudent management when on the verge of insolvency. (Creditors of bankrupt entities have the power to commence an adversary proceeding against the directors or trustees of any bankrupt company, including a non-profit, for breach of the fiduciary duty of care and loyalty, where the trustees/directors may have knowingly or carelessly expended monies and incurred indebtedness while the company was sinking financially.)

All such cases are highly fact-dependent. A company is insolvent when it is unable to pay its debts as due, or when its balance sheet is under water. In these recent cases, a 130 year old home for the elderly and a well-known women’s college each filed for bankruptcy, the trustees of each were sued, and the Circuit Court in each instance has allowed the cases to go forward (no final resolution as to liability yet).

Non-profit directors may be particularly susceptible to this kind of law suit; non-profits generally lack robust independent incomes streams. They are often dependent on donations and/or fundraising events (each of which may be quixotic given the general economy or other extrinsic factors).

No standard of how board members should act, beyond “prudently” and in the reasonable interest of creditors where insolvency seems imminent, can be generally stated, as facts and the alleged degree of grievous insensitivity to financial issues will vary wildly. We can say that boards should be particularly sensitive if endowment gives no adequate cushion, and if costs have run ahead of income over time. Attention to cash flow projections as well as the balance sheet is wise. Failure to collect receivables, undertaking major new products or services, granting high pay to management, and executive self-dealings could be significant indicators of liability where the non-profit has sunk into bankruptcy and the creditors are looking backwards in time to see “who is to blame.”

Yet another reason for non-profit boards to be formally educated in their technical fiduciary duties.

Last week, I was speaker at a program at Massachusetts Continuing Legal Education, a Boston-based non-profit bringing new developments and best practices to members of the Bar. The discussion among panelists and attendees bubbled up a few interesting observations:

First, there are just a lot of bad contract forms out there. Companies use older forms of contracts, often prepared in-house by lay people and pasted together from a variety of sources. These agreements contain self-contradictory provisions, often make no sense, and may not represent the state of the “market.”

“Closings” of business transactions often no longer occur in person. Electronic closings using the internet have become standard even for complex deals. Gone are the days of everyone gathering in large conference rooms, fidgeting and waiting their turn to sign documents. And indeed, sometimes closings occur not only without the physical presence of the signatories but also even without their actual signatures, as electronic signature execution has become wide-spread. This may be an economically efficient trend, but it avoids people talking with each other and building trust for addressing post-closing issues.

Other developments were noted in drafting for: venture capital investment (growing use of complex documentation for early stage deals); licensing of technologies from universities (solving the problem where licensor wants a solvent licensee and licensee needs the license grant to raise any money); dispute resolution (the choice of arbitration on the sometimes faulty assumption it is faster and less expensive); warranties and representations about cyber security in M&A transactions (a strong trend); and how “earn-outs” in acquisition transactions seem to attract litigation about both the terms of the agreement and the claim of acquiror’s breach of implied covenants of good faith and fair dealing.

Our conclusions: writing almost any contract that is clear and easily enforced is becoming more complicated as the world becomes more complicated; don’t expect a decline in contract litigation any time soon.

A few years ago, virtually all hospital patients in the United States were billed on a fee-for-service basis. Today at Beth Israel Deaconess Medical Center in Boston (a two billion dollar operation), only about one-third of patients are charged on that basis.

Dr. Kevin Tabb, President and CEO of BI Deaconess, discussed the revolution in delivery of hospital care, and its implications for patient care generally, this morning at the Duane Morris law firm office in Boston (which was hosting an investor presentation by emerging life science/health care companies). The new hospital model establishes payment for treatments across the board, and it is up to the hospital to manage its business so that costs are contained and charges for non-essential tests and procedures are dis-incentivized.

Dr. Tabb noted that Boston is far ahead of the rest of the country in coming to terms with the new economics. Recently visiting California, where for example at Stanford the operational model is still fee-for-service, Dr. Tabb warned that this new reality was coming, and that it meant there would be less dollars; thus, delivery models would have to change in order to both maintain quality of service and solvency.

In his words, the “heads in beds” business model was obsolete. There likely would be: fewer hospitals; fewer beds; reorientation on the care delivery front in favor of fewer specialists and more general practitioners; and, greater reliance on mid-level service providers (such as nurse practitioners).

What do you do with an expanding young company, led by a visionary founder, when the time comes to replace that visionary with a CEO who has an eye on the “bottom line?”

This and other knotty interpersonal issues, which arise quite commonly in board governance, were explored at the May 12^th Boston breakfast meeting of the National Association of Corporate Directors-New England Chapter, by a panel of experienced directors who have served on public and private boards.

Boards may be unskilled in reaching the decision to replace a founding CEO. Particularly in technology-driven companies, boards often are not fully tech-savvy. Then there is the matter of timing; when does the vision become less important than the bottom line?

The panel agreed that the ability of a CEO to impart leadership is more important than the bottom line, because the bottom line will follow good leaders. But you cannot tell if someone is a good leader just by attending a board meeting; it is necessary for the effective director to learn about the company by meeting its personnel, having direct reports to the CEO attend some or all board meetings, and educating yourself to understand the industry in which your company functions.

Terry Carleton, a board member of Demoulas and chair and thereafter president of Bentley University (among other numerous board assignments), added that when you have a board issue of replacing a CEO, this goes hand and hand with the strategic question of where the business is situated. Should you go out of business, sell out, look for a change in leadership? Changing the CEO may be a matter of changing the vision for the business, and that involves evaluating the nature of that vision and the way in which the company fits into emerging marketplaces.

Should the CEO also be the chair of the board? There was unanimous agreement that there are two entirely different jobs and should be separated (although it is difficult sometimes to convince a long-tenured CEO-chairman to step down from the of chair).

What about a fixed retirement age? There seemed to be consensus that a fixed retirement age for a public company is appropriate, although the board will sometimes waive that requirement for people with great skills or institutional knowledge. One panelist observed that although wisdom may reside in senior directors, it is foolish to assume that there aren’t a very large number of competent younger people. No one seemed in favor of a mandatory retirement age for privately held companies.

Finally, it was noted that “older people” are often well-connected, and have robust networks which you can tap to help solve problems quickly, a benefit perhaps not shared by shorter-tenure directors.