Is Your Hospital Board Vulnerable?

Monday, March 1, 2004 - 01:00

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 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 Sarbanes-Oxley 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 attorney-client 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 third-party 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.

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)355-8920. Mr. Timoni may be reached at (973)848-4020 and Ms. Rubinstein may be reached at (973) 848-4042.

Please email the authors at jhlafcsak@kl.com or stimoni@kl.com or lrubinstein@kl.com with questions about this article.