Conflicts of Interest: Requiring a Closer Governance Focus

Posted by Noam Noked, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Saturday November 24, 2012 at 9:22 am
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Editor’s Note: The following post comes to us from Michael W. Peregrine, partner at McDermott Will & Emery LLP. This post is based on an article by Mr. Peregrine.

A series of broad based developments over the last year combine to encourage governing boards to apply closer attention to conflicts of interest issues. These developments include several prominent judicial decisions; a series of focused articles in The New York Times; a highly public state attorney general investigation; the SEC internal investigation of its general counsel — and the subsequent investigation of its own Inspector General. Collectively, they draw new attention to the proper identification, disclosure and resolution of potential conflicts of interest. This new attention is consistent with an increasing lack of public, judicial and regulatory tolerance for perceived ethical lapses by corporate fiduciaries, their advisors, and others in a position of trust and confidence.

One of the first of these developments was the notable decision of the Seventh Circuit in CDX Liquidating Trust v. Venrock Associates. Here, dealing with highly complex facts, the appeals court made the important clarification that, while disclosure of a director’s conflict of interest may “insulate” [a transaction or] agreement from challenge, it does not automatically protect a director from a breach of fiduciary duty claim. The appeals court overturned a district court decision, that had ruled that a director’s original disclosure to the company of his conflict excused any breach of duty that may have arisen in the context of the director’s subsequent actions. The appeals court drew a distinction between having a conflict of interest (which in and of itself is not actionable) and actually committing a disloyal act (which would be actionable). The act of disloyalty is not excused merely by the initial disclosure. In this way, Venrock offers important — and very practical — implications for board conflicts of interest review processes. While disclosure is always to be encouraged, it has limits in terms of the protection it affords. Directors should understand that the simple act of disclosure does not automatically insulate future related actions from liability.

Another key development was the public attention attributed to potential conflicts of corporate executives and external financial advisors in the merger/acquisition context. Much of the attention arose from the February 29, 2012 Delaware Court of Chancery decision in In re El Paso Corporation Shareholder Litigation, in which Chancellor Leo E. Strine, Jr. was critical of what he perceived as potentially disloyal conduct. These unique potential conflicts issues were also the subject of a series of commentaries in The New York Times’ DealBook publication, discussing the duty of loyalty implications of executives, and of their legal and financial advisors, in major transactions. This judicial and media attention served to underscore the importance of broad-based conflicts analysis as part of transaction preparation, to protect against actual or apparent conflicts — including those of executives and advisors — from jeopardizing the underlying fairness of the transaction process.

The nonprofit sector has also contributed to recent conflicts of interest developments. This past summer, the conflict review process proved to be a significant “sidebar” to a state attorney general investigation of a prominent Midwestern non-profit health system’s contract with a revenue management company. According to published reports, the health system’s board had considered and approved — pursuant to policy — potential conflict-of-interest relationships involving two senior corporate executives. Both of the executives had adult children working for the revenue management company. In addition, one of the executives owned stock in the company. Again, according to published reports, these interests were disclosed to and approved by the health system board, before the contract was authorized with the revenue management company. (The author is aware of no suggestion that either the disclosures, or the board’s review and approval process, was made with anything less than good faith.)

The situation changed dramatically with the release of the attorney general’s multi-volume, highly critical analysis of the activities of the revenue management company on behalf of the health system. When viewed from that context, the board’s judgment in approving the disclosed conflicts was subjected to substantial media criticism. This was exacerbated by reports that at least one of the children was working for the management company in connection with the health system account. Observers expressed concern that the board’s oversight of the revenue management company could have been unintentionally biased by familial loyalty or the financial relationship, the executives’ reputation for integrity notwithstanding. Ultimately, the contract was terminated, and one of the executives left the health system. The controversy served to underscore the unintentional consequences that may arise from decisions made in good faith to approve conflict of interest relationships.

Another notable conflicts development of the last year was the scrutiny — and ultimate vindication — of former Securities and Exchange Commission (SEC) General Counsel David Becker. The fundamental issue was whether Mr. Becker had a conflict of interest in Madoff-related proceeds inherited from his mother’s estate. Mr. Becker argued that he had fully disclosed the interest to multiple different parties within the SEC and had received approval from the SEC’s chief ethics officer to participate in SEC activities involving the establishment of a compensation formula for Madoff victims. The SEC Inspector General, H. David Kotz, nevertheless conducted an investigation and ultimately made a criminal referral to the Department of Justice, alleging that Mr. Becker had violated conflict of interest laws involving government employees. Mr. Kotz dismissed the value of the ethics officer’s opinion on the grounds that the ethics officer reported to Mr. Becker. Ultimately, the Department of Justice declined to pursue the matter. Despite its unique facts, the Becker matter helped to underscore from a broader governance perspective the merits of full and complete conflicts disclosures, the potential for conflicts to arise from executive reporting relationships, and the benefits of recusal as opposed to proceeding under a conflicts management plan.

More recently, Mr. Kotz himself became the subject of an ethics inquiry. Conducted by the U.S. Postal Service Inspector General at the request of the SEC, the inquiry focused on allegations of impropriety in connection with several probes and audits for which Mr. Kotz was responsible while at SEC. The USPS IG concluded that Mr. Kotz maintained “personal relationships” with several individuals closely connected with probes he was conducting on behalf of the SEC, including the Allen Stanford and Madoff (but not Becker) matters. These relationships created a conflict of interest related to both the imitation and supervision of those, and other, investigations. While the USPS IG found no evidence that Mr. Kotz’ conflicts had a material effect on any of the investigations, it concluded that they should have prompted his recusal in each instance. While it is tempting, the practical lesson from the Kotz investigation is not “what goes around comes around”. Rather, the investigation is an important reminder that material conflicts can arise from personal (not just financial) relationships, and that the appearance of a conflict can potentially be as damaging as an actual conflict.

Viewed collectively, these and similar developments over the past year should prompt governing boards to apply more serious focus to the conflicts of interest process, and to the potential that unresolved bias may jeopardize the sustainability of board actions. What is unique about these developments is the extent to which they address issues and relationships sometimes thought to be at the “fringe” of the conflicts review process; e.g., to whom within the organization should disclosure be made; what is the acceptable amount of detail expected from a disclosure; are non-financial relationships subject to the conflicts process (and when do personal relationships “cross the line” and create potential conflicts); conflicts issues involving transactional advisors; when is recusal appropriate, and when does proceeding with a conflicts management plan provide reasonable comfort; valid procedural concerns with the “appearance” of a conflict; conflicts that may arise from executive reporting relationships; and the limitations of disclosure as a prophylactic. These are all issues which require more consideration when evaluating board conflicts issues.

Corporate governance is subject to a broader environment in which finger-pointing, and efforts to assign personal accountability, is increasingly the order of the day from the perspective of governance regulators and corporate constituents. It is thus incumbent on boards and their governance committees to have an expansive vision when it comes to identifying, reviewing and determining whether certain arrangements and relationships have the potential for creating significant conflict of interest issues for the organization. To paraphrase a comment by SEC Chairwoman Mary Schapiro (made in the context of Becker-related Congressional testimony), corporate boards ‘have to be looking around the next corner, looking beyond the horizon, and thinking above and beyond what may be appropriate advice’ in order to protect the sanctity of the board decision making process.

In other words, when it comes to addressing conflicts of interest issues, it is important to “have your head on a swivel”.

 

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