Preserving Local Control over Charitable Assets in the Face of National Industry Consolidation

Common Goals is pleased to introduce HEALTH LAW NOTES with this overview of some key issues which many hospital executives and board members will be facing as the new millennium approaches. Once the decision to consolidate with a regional or national partner is made, whether on the basis of advantage or due to perceived need, those governing a local hospital must address a raft of issues related to the future of charitable assets which have a decidedly local history. In this article, Mr. Nash reports on recent regulatory initiatives and one model which has actually enhanced local charitable activity. Future issues of HEALTH LAW NOTES will highlight key regulatory developments, landmark legal decisions and current strategic issues which have legal implications.

As we approach the year 2000, consolidation is transforming the face of health care finance and delivery. Whether driven by regional “turf battles”, the growth of the “for-profit” sector or simply by the desire to achieve greater efficiencies, market forces continue to foster acquisitions, mergers, joint operating agreements and other forms of affiliation. This is true across the full spectrum of the industry. Hospitals, physicians and managed care organizations are all participants in the process.

As the rate of hospital consolidation seemingly accelerates, it is not surprising that both federal and state regulators are showing increasing interest in whether the historically charitable nature of hospital assets is receiving short shrift. But while the regulators have a legitimate interest in focusing on issues such as “valuation” and “continued charitable dedication”, recent experience shows that properly structured consolidations can actually enhance local charitable missions.

In the face of the recent rash of proposed acquisitions and mergers of currently non-profit hospitals in California, the state legislature has enacted the California Non-Profit Public Benefits Corporation Law. This law took effect on January 1,1997, as part of an effort to strengthen the state’s authority over conversion or sale of non-profit health facilities to for-profit firms. The California Attorney general has just issued companion guidelines that will require nonprofits to prepare a ” health impact statement” and to demonstrate that they have considered alternatives like mergers or alliances with other nonprofits before sale or conversion to “for-profit status” will be approved.

The legislation stems from concerns that as the number of sales or other conversions accelerates, the public is being short-changed by undervaluation of the non-profit facility’s assets, which typically revert to a charitable foundation as part of such a transaction. The key issue is whether the non-profit entity’s assets, or its “going concern” value, are “marked to market”, or whether the value was merely the subject of private negotiation. From discussions with the California Attorney General’s Office, it is apparent that they will look closely at whether the non-profit facility has been “aggressively marketed” in an effort to generate multiple bids and thus maximize value. Concern is justified in view of a number of recent California transactions in which “negotiated value” has proved to be substantially less (sometimes less than half) of “market value.”

The non-profit entity will also have to show that it thoroughly considered “all realistic alternatives”, including mergers and/or strategic alliances with other locally and regionally based non-profit entities, as well as alternative forms of transactions (e.g., sales of assets, joint operating agreements, leases or management agreements) with potential for-profit partners. In the case of hospitals that are part of an integrated delivery system, an evaluation of the transaction and its impact on each non-profit component of the IDS will be required.

The new California law also authorizes the state attorney general to consider the broader public policy issue of whether the transaction is in the public interest. This includes a determination of whether the transaction will “affect the availability or accessibility of health care in the affected community.” Accordingly, non-profits seeking to change status will have to prepare and file a “health impact statement.”

This increased level of regulatory interest in protecting historically charitable assets/operations is further exemplified by the precedent setting agreement announced at the end of January between Central Benefits Mutual Insurance Co. (“CBMI”) formerly Blue Cross of Central Ohio and the Ohio state attorney general’s office. In a “first of a kind” agreement, CBMI has agreed to fund a new foundation, dedicated to providing care for the indigent, in the amount of $5,100,000. This amount represents the “net asset value” of Blue Cross of Central Ohio, in 1987, the year it converted from a non-profit corporation to a mutual insurance company by consolidating with CBMI.

The focus of the Internal Revenue Service runs parallel to that of the several state attorneys general, and centers generally on the integrity of an organization’s tax-exempt status, and prohibition of the diversion of charitable assets from the tax-exempt purposes to which they are supposed to be dedicated. Over the last few months, the IRS has issued a number of private letter rulings dealing with the continued viability of the tax-exemption of organizations formerly operated as hospitals, and the tax-exempt bonds they issued prior to sale or conversion. More recently, the IRS has promised guidance on the topic of “whole hospital joint ventures.”

When regulators flex their muscle, the courts inevitably pop into the picture. For example, in January, a Michigan Circuit Judge confirmed with written opinion an earlier “bench ruling” that a non-profit hospital’s proposed joint venture with Columbia Healthcare Corporation would violate a state law prohibiting the mingling of non-profit and for-profit assets. Similar prohibitions are also at issue in a joint venture with Columbia proposed by California based Sharp Health System, and the Ohio attorney general is actively opposing a number of proposed transactions.

This increasing involvement of various state attorneys general is benefitting from some coordination through their national association. Some are speculating that California’s new law will serve as a prototype for other states. Certainly, the law in many states could benefit from additional clarification as to the nature of the non-profit hospital as a charitable trust and the non-profit board’s twin duties of “care” and “loyalty.” For example, unlike California, most states lack specific guidance as to whether non-profit boards must seek the highest possible price, or whether noneconomic factors can also be considered.

Notwithstanding all of this regulatory activity, there is a substantial body of post-transaction experience now, some of it very encouraging, associated with non-profit sales and conversions. For example, consider the 1995 joint venture between Columbia and The Sisters of Charity of St. Augustine Health System. Recent discussions with Peter G. Reibold, who was CEO of the System and is now the President of the Ohio Division of Columbia CEO, disclosed that by careful segregation of assets and functions, the parties managed to satisfy the “hard to please” Ohio attorney general.

Perhaps more importantly, the Sisters report a substantial increase, post transaction, in the actual amount of “charitable assets” available for use for traditionally charitable purposes such as care of the indigent. This was accomplished at the bargaining table, then carefully documented, and results primarily from the segregation and retention of complete future control, in the hands of the Sisters, of the “deal value” of the formerly charitable assets and operations. The same techniques are available to local non-profit boards concerned with the erosion of local control over their “local” charitable assets.

This careful approach to preserving future control over the charitable “deal value” of a conversion transaction holds substantial promise against increasing regulation of the massive movement of non-profit health care entities and their assets to for-profit status.