When companies ignore the risks under their noses

May 17, 2011, 2:34 PM UTC

By Eleanor Bloxham, contributor

FORTUNE — In the rush to adopt sophisticated approaches to risk management, some companies are missing the risks sitting right in front of them.

Last year, the safety issues that engulfed Toyota (TM) damaged their reputation and customer trust, and they were issues the automaker should have been aware of. The company had ignored warnings from one of their unions in 2006. BP ignored warning signs from their workers. The result was the largest oil spill in U.S. history.

Shareholders will decide today whether the risk oversight practices of the directors of hospital operator Community Health Systems (CHS) have been sufficient. CHS vigorously defends their practices, but the Change to Win Investment Group (CtW), which works with the pension funds of union workers, is convinced that they have not been.

CtW sent a letter to CHS’ (CYH) board in September 2010 (with a CC to the U.S. Department of Health and Human Services) outlining its concerns with the company’s reportedly aggressive Medicare billing practices, a topic that has attracted considerable attention amid debates surrounding the national deficit.

CtW requested that CHS’ board immediately establish a special committee to investigate the issues.  Specifically, the letter asked that the “Special Committee of independent directors … investigate the risks to future earnings and potential liabilities” of CHS’ “aggressive and unsustainable” Medicare billing practices, and “provide a preliminary report to shareholders on the findings of the investigation no later than October 31, 2010,” including next steps and a timeline.

A trail of billing concerns

CtW was not alone in its misgivings. On January 7, 2009, a whistleblower filed a lawsuit against CHS related to the company’s admissions and billing practices. And on November 15, 2010, CHS received Civil Investigation Demands (CIDs) from the Texas Attorney General concerning emergency department procedures and billing.

Questions really started to mount this year when, on March 31, 2011, CHS received a subpoena from the Department of Health inquiring about the company’s Medicare billing practices.

In April, Tenet Healthcare, a company that CHS was looking to acquire, filed a lawsuit related to CHS’ billing practices. And the investigations have since expanded and now include the Department of Justice, several United States Attorneys’ offices, and the Department of Health and Human Services.

In a filing with the SEC, CHS said, “We responded to CtW’s letter on October 12, 2010 and invited them to meet with senior executives of the Company.”

The letter CHS sent to CtW was not as welcoming as the above might sound: “It is our belief … that we are further constrained by the National Labor Relations Act from engaging with you in furtherance of your correspondence other than by this reply,” the letter said. “We do welcome interested investors to meet with designated senior executives … if one or more of the pension funds referred to in your letter would like to set up a meeting, please let me know.”

Tomi Galin, spokesperson for CHS, says this kind of offer to shareholders was normal and that the organization’s management makes itself accessible to meet with investors.

But the matter CtW had addressed was an issue for the board, not the management team. When shareholders ask for action from a company’s board, they are not seeking meetings with management.

In addition, the CHS letter did not include any substantive discussion of the issues CtW raised, the board’s reactions and comments, or next steps.

“This letter was promptly disclosed to the CHS Board of Directors, and in accordance with Company policy, responsibility for follow-up and response was assigned to the Audit and Compliance Committee,” the company wrote in a later filing on April 29, 2011.

The CHS spokesperson, however, declined to to provide a timeline of the board’s involvement in the investigation of CtW’s concerns. Given the magnitude of shareholder concerns and the sense of urgency they conveyed, CHS made a serious misstep in not providing a substantial response from the board.

Behind the foot dragging

There may be several reasons why CHS was not as forthcoming as desired in its response to CtW’s letter. Perhaps CHS was caught off guard because the message came from a union-affiliated group and was not taken as seriously as it might have been (a la Toyota). Perhaps they did not provide a full response to CtW because CHS is not used to having issues with its investors, according to a CHS spokesperson.

In fact, a press release dated February 3, 2011 on the company’s website said that Institutional Investor named CFO Larry Cash as best CFO in the healthcare facilities and managed care sector, CEO Wayne T. Smith as the number two CEO, and CHS as the number two company. The press release didn’t offer a ranking for its head of investor relations, however.

Or it may have been that the company was distracted. The company fiddled with an acquisition of Tenet Healthcare Corporation while its billings allegations burned.

Regardless of the reason, the lack of attention to shareholder concerns put the company behind the eight ball. And given all that has happened since CtW’s letter, CtW’s call for the formation of a special committee in September certainly seems prescient.

So far, CHS has rejected that request. CtW sent a letter on April 15 saying they intended to recommend against the reelection of three directors up for election, “absent your willingness to offer substantive responses to our concerns by April 20.”

The road ahead

CtW has moved forward to recommend against all three directors. Two of the members, James Ely and John Fry, sit on the audit and compliance committee, and the third board member is Larry Cash, the CFO. This is the first “vote no” campaign the company has ever faced, according to its spokesperson.

While CtW is recommending against all three directors, proxy advisory firm Institutional Shareholder Services (ISS) has recommended against just Ely and Fry. Their reasoning, according to ISS head of publications and governance counsel Ted Allen, is that while there may be issues with Cash as a manager, he did not have specific responsibility for audit and compliance oversight as a board member.

That reasoning seems strange since Cash oversees investor relations and the financial functions of the company, two areas that would likely require his full attention, given the lawsuits, unhappy shareholders, and billing inquiries by regulators. Sitting on the board might not be the best use of his time right now.

While CHS argues that Tenet’s allegations are “meritless” and CtW’s efforts are part of a “self-serving union organizing strategy,” there are major governance issues that CHS ought to address.

Bill Patterson, executive director of CtW Investment Group, says that his group aims to protect pensioners, not organize unions, and that, since 2008, the group has been most active in the financial sector, where there are no or virtually no unions.

Whatever the outcome at the annual meeting, even if investors do vote to reelect the directors, regulators may require the company to take another look at these issues.

The lesson for companies and boards? Even if you are highly successful, when someone raises questions related to your practices, take a careful look and move swiftly to address concerns. In the end, it’s not who the messenger is that matters; it’s what they are saying that deserves your attention. Listening carefully to the message and responding deliberately and respectfully to early warnings before they snowball into bigger issues will determine a company’s success or failure.

Eleanor Bloxham is CEO of The Value Alliance and Corporate Governance Alliance (http://thevaluealliance.com), a board advisory firm.