INSIGHT: New Decision Impacts Health-Care Director & Officer Liability

An Aug. 2, 2018 federal court decision addresses important principles of fiduciary conduct, the limitations of the business judgment rule, the risks of director conflicts of interest, the importance of talent development, and the benefits of statutory-based exculpatory provisions in the articles of incorporation.

While the case arose in the context of federal bankruptcy court proceedings, its conclusions are relevant from a general corporate law perspective. As such, the decision is worthy of officer and director discussion on the appropriate level of fiduciary engagement in particular circumstances.

Background

The case involved claims of negligence and breach of fiduciary duty by members of the board and management team of Cheboygan Memorial Hospital (“CMH”), a Michigan not-for-profit corporation, filed by the hospital’s liquidating trust. The claims were based on allegations that management and the board “systemically and consistently failed to address” multiple signs of institutional distress, resulting in significant financial losses.

These included the failure to (i) address losses from employed physician practices; (ii) address billing and coding issues; (iii) ensure the organization received adequate compensation from the sale of its interest in a joint venture; (iv) prevent excessive senior management turnover; (v) prevent excessive compensation of physician board members; and (v) resolve a conflict of interest arising from a debt refinancing with a bank of which a board member was president.

Procedural History

CMH filed for Chapter 11 Bankruptcy on March 1, 2012. The federal Bankruptcy Court confirmed a Plan of Liquidation for the hospital on Aug. 7, 2013. According to the terms of the Plan, the CMH Liquidating Trust (the plaintiff in this case) was vested with all causes of action that CMH held against the former officers and directors of the hospital. The liquidating trust filed the particular complaint on Feb. 27, 2014 (in what can fairly be assumed was an action for recovery from the officers and directors liability insurance coverage).

The decision arose from a motion to dismiss amended complaints. The Court had previously ordered the Plaintiff to amend its complaint to include more definitive statements regarding the basis for the Defendants’ alleged breaches of duty and/or negligence. It had found that the Plaintiff’s original complaint made no distinction between the various defendants, their different roles, and the time period in which they served CMH. The court also at that time declined to address the substance of the Defendants’ arguments that liability could not be assessed against them based on the business judgment rule and the volunteer director immunity provisions under the Michigan Nonprofit Corporation Act. This is notable from both timing and relief perspectives.

The Decision

The Court granted the motions to dismiss filed by of the volunteer directors, except those who were conflicted, on the grounds that they were excluded from liability under certain exculpatory language in the articles of incorporation. This followed a determination that the Plaintiff had alleged facts sufficient to (a) state a claim for breach of fiduciary duty and/or negligence against many of the volunteer directors (and also against the compensated directors); and (b) overcome the business judgment rule. The compensated directors’ motion to dismiss was denied.

In support of its breach/negligence/business judgment rule decisions, the Court referred to the allegations of both the board’s approval of the “quick sale” of CMH’s joint venture interest for roughly $2.7 million less than its actual worth, and its decision to continue making monthly payments on the bank loan when the bank was under secured and at risk of losing money if CMH defaulted on the loan.

Practical Lessons

1. The case is an ugly example of the slow pace of breach of fiduciary duty proceedings. It arises from a motion to dismiss amended complaints, with the ruling coming six and a half years after CMH filed Chapter 11; five years after a plan was confirmed; four and a half years after the original filings; and almost a year after the initial motion to dismiss ruling. Indeed, it has been an active lawsuit with much discovery, because the court is demanding a high level of specificity to the allegations of wrongdoing and to the defenses. In effect, there has been a mini lawsuit to whittle down the real lawsuit with, presumably, sizable litigation costs.

It is a truly powerful example of the refrain that “you may avoid the result, but you will not avoid the ride.” This ride comes with significant financial and representative costs to many volunteer directors and to the executive team. It surely is a reminder for the general counsel to confirm the availability of sufficient “D&O” coverage, and defense cost advancement and indemnification protections.

2. The case is also a stark example of the limitations of the business judgment rule. The Court was not willing to let the claims proceed merely on the general allegation that a defendant knew of the problem but did nothing. However, where the plaintiff demonstrated that it could prove actual knowledge, the general allegation was enough to defeat the business judgment rule as a defense, finding that there is no protection where a director abdicates authority or fails to act in the face of known or obvious risks.

3. The case is also noteworthy for its strict treatment of the conflicted director, refusing to dismiss a volunteer director (the bank president) from the complaint and subjecting her to additional proceedings.

4. The case demonstrates the power of statutory-based exculpatory provisions that protect volunteer directors from general negligence and other claims. However, it should be noted that the Michigan statute is fairly unique among state nonprofit statutes. In addition, many fiduciary duty breach claims are grounded in allegations of gross negligence, which may fall outside the scope of such exculpatory protection.

5. It would be a mistake to attribute this decision strictly to circumstances involving financial distress or bankruptcy. The core of the action raises the same types of fiduciary duty issues as would be presented by another party (e.g., the state attorney general; other directors in a derivative action) claiming breach of oversight or duty of care obligations.

That notwithstanding, financial distress is often a “breeding ground” for director liability exposure. As with the 2015 decision of the U.S. Court of Appeals for the Third Circuit in Lemington Homes, creditors (in whatever form) are often relentless in their pursuit of claims based on breach of fiduciary duties by directors of financially distressed entities

6. In these and other ways, the decision is a testimonial for greater diligence by directors, given the increasing pressures on the financial model of health care providers. Directors who are “over boarded,” distracted by their personal employment challenges, or otherwise unable to provide the requisite commitment to their board duties will find themselves under uncomfortable performance pressures.

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Michael W. Peregrine and William P. Smith are partners in the Chicago office of McDermott Will & Emery LLP, where they practice in the corporate governance and health care restructuring areas, respectively. Michael can be reached at mperegrine@mwe.com. William can be reached at wsmith@mwe.com. Their views do not necessarily represent the views of their law firm and/or its clients.