Analysis

Managing Constituent Interests in Healthcare Joint Ventures

By Michael W. Peregrine and Robert A. Schreck Jr., McDermott Will & Emery LLP, Chicago, IL
Management of constituent board relationships is critical to the success of many healthcare joint ventures. These relationships arise when individuals are elected to a joint venture board by, and are perceived to represent, specific constituencies of the joint venture. Because constituent relationships often reflect interests that can diverge from those of the venture owners generally, their presence can create unique tensions. To whom or what are constituent board members beholden? How can the expectations of those constituencies be appropriately addressed? How can related conflicts of interest be effectively identified and resolved in the best interests of the joint venture? These are questions that should attract the attention of counsel to the venture, as well as counsel to the venture investors.1 Fortunately, many constituent director conflicts can be anticipated. However, the risks of inattention to these issues can be significant.2 Constituent interests are particularly prevalent in healthcare. Providers have historically invested in diversified enterprises through joint ventures with shared ownership with physicians, physician groups, and/or other companies. Many hospitals and health systems have multiple investments of this type. Looking forward, the Accountable Care Organization (ACO) is an example of new models of joint venture arrangements arising in direct response to health reform initiatives. In addition, many hospitals are choosing to partner with each other, or with larger systems or proprietary companies. In most of these ventures, the governing board reflects the interests of multiple constituenciesincluding, but not limited to, the principals/owners/investors/members, the community, and the medical staff. Often, the right to appoint a proportionate number of board members is a condition of a partys venture investment. The expectation is that the constituent board member will represent the investors interest through close communication and consultation on venture operations, oversight, and governance decisions. The involvement of multiple constituencies on the venture board creates unique governance challenges to be overcome if joint venture goals are to be achieved without fiduciary controversy. These challenges are principally duty of loyalty-related: conflicts of interest, appropriation of corporate opportunity, and confidentiality. Thus, venture planners should concentrate on (a) selecting a venture form that may by its nature facilitate resolution of conflicts (e.g., the limited liability company); and once a venture form is selected, (b) identifying the constituent interests implicated by venture structure; (c) anticipating the divergent interests arising from those constituencies; and (d) implementing agreements and protocols intended to resolve any looming conflicts and related issues.

Typical Venture Structures

Constituent relationships arise across the spectrum of traditional legal structures by which healthcare providers participate in joint ventures. These structures include, but are not limited to: (1) a limited partnership, in which the provider is likely to participate at least as a general partner; (2) a limited liability company, in which the provider acts as a member; (3) a closely held company, in which the provider acts as an investor/ contributor/member; (4) a for-profit corporation, in which the provider is likely a majority or leading shareholder; (5) some form of nonprofit affiliation or co-membership arrangement, in which the providers hold proportionate controlling interests; (6) emerging new partnership models in which the nonprofit provider or its successor takes a minority interest in the partnership together with a for-profit hospital company to operate the hospital; and (7) the more amorphous unincorporated association, in which the provider interests are most likely to be articulated in association governing documents.

Examples of Constituent Relationships

Depending upon the nature of a particular venture, constituent relationships can develop from many different classes of interests. These would include the obvious, e.g. majority owners, participating providers, sponsoring (religious) bodies, preferred interest holders, and other profit participants. It would also include the less obvious, e.g., vendors/creditors, debt holders, community representatives, licensors, residual owners, and private equity/portfolio entities. The unifying interest is not an ownership interest, but rather the presence of sufficient leverage or influence in the selection of venture governance or executive management. What is critical is that venture participants make the effort to identify such constituent relationships and address them in the venture structure.

Examples of Divergent Interests

The ability to reduce constituent representation tensions will depend in large part on the extent to which divergent interests can be identifiedin advance. Such divergent interests often arise from differences with respect to the following: business or personal priorities; timing and investment horizon; competitive considerations; conflicting regulatory positions; business strategy; corporate opportunities; vendor/business relationships; capitalization requirements; ownership of enterprise value; internal reporting relationships; unique tax positions/ requirements (e.g., for a tax-exempt organization venture owner); social /moral/religious considerations; and exit strategy.

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Divergent interests can arise from the full scope of duty of loyalty principles. For example, an issue may surface when a business opportunity is presented to the joint venture that one of the constituent representatives believes its constituent could obtain value pursuing the interest on its own, rather than through the venture. Another example arises when the constituent representative is presented with confidential information at the venture board level that, if disclosed, would be of material interest to its constituency, in terms of its separate strategic, operational, or financial platform.

Core Fiduciary Concerns

Most state laws apply a consistent approach to the fiduciary duties of joint venture governance, regardless of the specific venture form. Generally speaking, the venture board owes its duties to the venture owners/partners/members, as the case may be, and is responsible for representing the interests of all ownership interests.3 Case law refers to an uncompromising duty of loyalty, applicable to all directors, constituent or otherwise.4 For example, in the context of the corporation, the directors owe their duties to the corporation, and to its shareholders (for-profit) or to its mission (nonprofit). In the context of a limited liability company, the duties are owed to the LLC and to its members/investors. Generally speaking, these relationships are grounded in the traditional fiduciary concept of a relationship reposing special trust and confidence in the judgment of another. However, constituent directors face unusual duty of loyalty challenges, with their duties typically owed both to the joint venture, and to the designating owner. In these situations, the prudent assumption is that the primary duty will most always be owed to the venture itself.5 This duty of loyalty standard is not diluted by constituent relationships, or by dual or multiple directorships.6 However, there may be some situations in which the constituent director is faced with the unpalatable choice of breaching a duty owed to either the venture, or to his or her constituency.7 This can create issues of expectation management; where the constituent director may believe he/ she is obligated to serve only the interests of the particular constituent who designated that director (and who is likely to share the belief as to that directors obligations). The presence of specific constituent conflict resolution processes in venture policies may help resolve the conflict (see discussion below), but there will be instances in which recusal (or, potentially, resignation) is the best prophylactic to breach of duty exposure.8 Yet the presence of conflicting relationships does not always give rise to fiduciary concern. For example, depending upon the jurisdiction, directors may be authorized to consider the perspectives of other constituencies (to the extent they are different from that of the stockholders or investors) when making venture decisions.9 Furthermore, conflicts might not arise from governance decisions that implicate opera-

In every case, any board member representing a nonowner constituency should retain separate counsel to advise on the exposure to liability and negotiate appropriate indemnification.

tions or compliance issues (e.g., those involving day-to-day business issues) or other decisions intended to maximize the long term financial viability of the venture.10 These are issues around which divergent interests often coalesce. If the ultimate economic interest is the same, the differences between the approaches of constituent directors to a particular issue may be more a matter for business judgment rule, rather than conflict of interest, analysis.11

Special ACO Issues

ACOs created under the Medicare Shared Savings Program offer the perfect incubator for constituent governance issues. As provided in the Centers for Medicare and Medicaid Services (CMS) Final ACO Rule,12 ACOs must be formed through a legal structure recognized and authorized to conduct business under applicable state law (e.g., a corporation, partnership, LLC, etc.). The ACOs governing body must possess adequate authority to implement and enforce all applicable requirements under the Affordable Care Act and Final ACO Rule. Most importantly, the ACOs governing body must (a) provide for meaningful participation in its composition and duties for ACO Participants (e.g., providers, suppliers, physician group) or their representatives; (b) include at least one Medicare beneficiary representative who is served by the ACO; (c) include at least one patient advocate; and (d) have not less than 75% control held by ACO Participants. ACO governing board members owe a fiduciary duty to the ACO (presumably including the duty of loyalty, although the Final ACO Rule is silent on this point). All of this is in addition to the rights and duties provided by state law of the entitys organization. To add to the mix, governing board members are permitted to serve in a similar or complementary governance capacity for an ACO Participant. Quite a recipe for divergent interests!

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The Final Rule requires the ACO governing board to maintain a conflict of interest policy, but acknowledges that the scope of the policy may differ based on the composition of the governing board.13 The Final Rule makes reference to the Internal Revenue Service template conflict of interest policy for exempt organizations (a model poorly equipped to handle the complexities posed by constituent interests).14 The Final Rule ultimately encourages consideration of applicable state and federal law. Consequently, the Final ACO Rule makes a hot potato of the duty of loyalty concern: it mandates representation of inherently conflicting constituent interests; confirms that governing board members owe an undefined fiduciary duty to the ACO; and essentially punts on the issue of how the conflict of interest issues are to be addressed. And maybe thats all CMS could do under the circumstancesacknowledge the issue but materially understate the importance of its resolution by ACO Participants and their legal advisors. These concernswhich can create serious obstacles to ACO governancemust be mitigated, through perceptive venture structuring and governance.

It is incumbent on venture planners, owners, and counsel to identify these constituencies; the potential divergent interests arising therefrom; and to adopt conflicts resolution and other processes by which duty of loyalty challenges can be addressed.

Governing Considerations
Constituent relationships will arise in any joint venture, regardless of the legal structure chosen. As noted above, the initial challenge is to identify the nature of the possible divergent interests and document the understanding of the parties with respect to the treatment of those interests. The discussion below will utilize the classic corporate solution groupings of owners (stockholders or members), the board (directors or managers), and management (officers or managers). Governance focuses upon the role of the board. The venture parties can choose to retain some board functions at the owner level or delegate others to management or a committee. While the law of the state of organization will control in the absence of a stated understanding among the parties, it is assumed that the venture partners will prefer to document their understanding of identifiable constituency issues. This is particularly true when the board will be expected to take into account the interests of non-ownership constituencies, such as religious sponsors, insurance or physician group interests, or the community. While the facts and circumstances of an individual venture will dictate the best solution, the following governing considerations should be taken into account: Accountability: How to ensure the boards objectivity, and make the board and management responsive to the owners and other constituencies, while enabling them to run the business;  Transparency: Giving owners and other constituencies visibility into the governance process to allow them to evaluate and adjust performance;  Access: Board access to books and records, management, and independent advisors;

 Communication: The breath, depth, and frequency of reporting to the owners and other constituencies;  onfidentiality: Not only protecting proprietary informa C  tion, but also addressing the board members duty of candor;  Business Opportunities: Allocation of opportunities and developments when the joint ventures business overlaps with an owners core business;  Waiver/Exculpation: Make specific statutory protections (i.e. fiduciary duties or business opportunities) inapplicable, with a process for resolving disputes;  Policies: A stated position on issues, such as access to information and business opportunities, with an attention to information, agenda, and strategies that support the board in determining its priorities and focusing on strategy and associated risks; and  Practices: Establishing practices to permit the board to fulfill its duties efficiently and effectively; attention to information, agenda, and strategies that support the board in determining its priorities; and focusing on strategy and associated risks. Traditionally, the board provides a check on management for the absentee owners. An individual who is not beholden to management or the entity is more likely to exercise independent judgment and more willing to oppose management, if need be. The opposite is true in a joint venture context, where an owner is likely to be more involved and will have greater ability to select its nominee for appointment to the board. While such a board member may be disinterested with respect

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to a transaction or the operation of the joint venture, he or she is more likely to be answerable to one particular owner, rather than the owners as a group. An owner will expect its nominee to be its eyes and ears and to assert the owners interests. As an agent of a particular owner, what legal and procedural safeguards can be implemented to assure that a board member acts in the best interests of the joint venture and all of its owners? Can the constituent board member act as an advocate for the interests of the designating owner, vote in favor of the owners interests, and share confidential information with the owner?

Implementing Solutions
Since no servant may serve two masters, an advisory committee can be used to defuse conflict. A committee could be empowered to control functions of concern to a particular constituency. The structure could be used to limit a board members involvement to a higher level of oversight on matters delegated to the committee, assuming the board member reliance on the committee was justified. Likewise, a committee could be used to recuse an interested board member, permitting perhaps a more open and objective discussion of certain issues. The law of the entitys state of organization can raise obstacles to the parties expectations with respect to a constituent director. Section 8.31(a)(iii) of the Model Business Corporation Act, for example, makes a director liable if it can be established that the directors conduct consisted or was the result of a lack of objectivity due to the directors familial, financial or business relationship with, or a lack of independence due to the directors domination or control by, another person having a material interest in the challenged conduct (A) which relationship or which domination or control could reasonably be expected to have affected the directors judgment respecting the challenged conduct in a manner adverse to the corporation, and (B) after a reasonable expectation to such effect has been established, the director shall not have established that the challenged conduct was reasonably believed by the director to be in the best interests of the corporation. Statutory provisions such as this would place the representative board member in a mine field of potential liability. With respect to information, a board member is customarily and statutorily entitled to access to books and records and contact with senior management. A single interest representative would not need access to this broad range of information. Also, board members have an obligation to assure that adequate information and reporting systems exist to allow the board to reach informed judgments concerning compliance with law and business performance. This gives rise to confidentiality concerns, which may be addressed by using an advisory committee structure. It may be inappropriate to deliver sensitive information to a single interest representative. This is particularly true, if that representative is simultaneously subject to a separate obligation to disclose that information to his or her constituency. Further, in the context of board deliberations, most state statutes require an interested board

member to disclose the material facts of his or her relationship or interest with respect to the matter under consideration. While all of the foregoing concerns are applicable in any joint venture arrangement where owners elect board members, they are particularly acute where a board member is representing a non-owner constituency. The board member charged with representing a non-owner constituency will bear the burden of proving (1) proper disclosure of the related interest, (2) having acted in the best interest of the entity and its owners, and (3) that the transaction was fair to the entity. The representative board member could also be denied the benefit of the business judgment rule, which presumes that a board member acted in the best interest of the entity and requires the claimant to approve otherwise. An interested board members breach of the duty of loyalty may not receive the benefits of traditional indemnification and may be excepted out of many director and officer insurance policies. In every case, any board member representing a non-owner constituency should retain separate counsel to advise on the exposure to liability and negotiate appropriate indemnification.

Conclusion
Significant duty of loyalty issues may arise in joint ventures that incorporate constituent governance. It is incumbent on venture planners, owners, and counsel to identify these constituencies; the potential divergent interests arising therefrom; and to adopt conflicts resolution and other processes by which duty of loyalty challenges can be addressed. The failure to do so may expose the venture to governance dysfunction, and the board members to breach of duty of loyalty risk.

About the Authors

Michael W. Peregrine (mperegrine@mwe.com) is a partner in the law firm of McDermott Will & Emery LLP and is based in the firms Chicago, IL, office. He focuses his practice in the representation of nonprofit corporations in connection with governance, corporate structure, and change-in-control matters. Mr. Peregrine is outside governance counsel to many leading nonprofit corporations. He has served as special counsel in connection with numerous confidential internal reviews and investigations. He also has substantial experience with complex business transactions, having advised nonprofit clients on over 120 separate mergers, acquisitions, and dispositions. Mr. Peregrine was named an AHLA Fellow in 2006, and is a frequent author and speaker on legal topics affecting tax exempt, nonprofit corporations. Robert A. Schreck Jr. (rschreck@mwe.com) is a partner in the law firm of McDermott Will & Emery LLP and is based in the firms Chicago, IL, office. He focuses his practice primarily on the areas of mergers and acquisitions and corporate governance issues. Mr. Schreck has experience in directing complex, multidisciplinary legal transactions,

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Analysis
such as project finance, mergers and acquisitions, and joint ventures. He has represented publicly held corporations, start-up ventures, not-for-profits, and cooperatives, as borrowers and lessees, in structured finance transactions, tax-exempt financings, and leveraged lease transactions. In addition, Mr. Schreck provides continuing legal advice to a number of the firms clients in the areas of securities law, commercial contracts, and finance. He advises boards and management on fiduciary duties, including those involved in change in control transactions.
5 Veasey and DiGuglielmo, supra note 1; David M. Morris, Lois Herzeca, and Julia E. Kamps, Designated Directors and Designating Investors: Early Planning is Key; Corporation; Aspen Publishers, June 2, 2008 (hereinafter, Morris, Herzeca, and Kamps). Weinberger, supra. Id. Cyril Moscow, Corporate Governance: The Representative Director Problem, Insights, vol. 16, no. 6, June 2002. Morris, Herzca, and Kamps, supra note 5; s ee also, e.g., Unocal Corp v. Mesa Petroleum Co., 493 A.2d 946, 955 (Del. 1985). Veasey and DiGuglielmo, supra note 1. Id. Medicare Program; Medicare Shared Savings Program: Accountable Care Organizations, Final Rule, 76 Fed. Reg. 67816-22 (Nov. 2, 2011) and 42 C.F.R. 425.106. 76 Fed. Reg. 67954 and 42 C.F.R. 425.106(d). Lawrence M. Brauer and Charles F. Kaiser III, Tax-Exempt Health Care Organization Revised Conflicts of Interest Policy, IRS Exempt Organizations Continuing Professional EducationTechnical Instruction Program for FY 2000 (1999), Chapter E, 1999 TNT 169-16, available at www.irs.gov/pub/irs-tege/eotopice00.pdf.

6 7 8 9 10 11 12

Endnotes
1

2 3 4

See generally, E. Norman Veasey and Christine T. DiGuglielmo, How Many Masters Can a Director Serve? A Look at the Tensions Facing Constituency Directors, 63 Bus. L aw 761 (May, 2008) (hereinafter, Veasey and DiGuglielmo). See, e.g., Auriga Capital Corp. v. Gatz Properties LLC, C.A. 4390-CS (Del. Ch. Jan. 27, 2012). Veasey and DiGuglielmo, supra note 1; see also, e.g., Unocal Corp v. Mesa Petroleum Co., 493 A.2d 946, 955 (Del. 1985). Guth v. Loft, 5 A.2d 503, 510 (Del. 1939); see also Weinberger v. UOP, Inc., 457 A.2d 701, 710 (Del. 1983).

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Constituent Representation in Health Care Joint Ventures: Key Fiduciary Considerations

THE ISSUES

EXAMPLES OF CONSTITUENT RELATIONSHIPS

Management Vendors/Creditors Debt Holders IP Licensors Majority Owners Participating Providers Preferred Owners Private Equity Portfolio Entities Residual Owners Profit Participants Governance Participants Community Interests Employers

Unincorporated Association

Limited Liability Company

EXAMPLES OF DIVERGENT INTERESTS

Business/Personal Priorities Timing/Investment Horizon

Nonprofit Co-Membership Affiliation

Joint Venture

Limited Partnership

Competitive Considerations Conflicting Regulatory Positions Business Strategy Corporate Opportunities

For Profit Corporation

Closely Held Corporation

Exit Strategy Vendors/Business Relationships Capitalization Requirements Ownership of Enterprise Value Internal Reporting Relationships Social/Moral/Religious

Considerations

2011 McDermott Will & Emery. This communication may be considered attorney advertising. Previous results are not a guarantee of future outcome.

mperegrine@mwe.com rschreck@mwe.com

MICHAEL W. PEREGRINE ROBERT A. SCHRECK

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