With pressures on reimbursement rates, from the Affordable Care Act, patient mix issues and other challenges facing institutions and businesses who deliver health care services, we are often asked what alternatives there are to traditional reorganization, whether internal or through legal proceedings.
This alert provides some examples of structures through which businesses or institutions can improve their finances, their footprints or other attributes by aligning or otherwise combining business lines with those of other providers. These structures can be very useful where the two providers have relatively different financial resources, and/or operate in separate markets (with different geographies or lines of service), but acting together they would have a combined service delivery entity that could provide greater market share and financial stability.
For a first example, assume for discussion a health care business or institution (“Provider 1”) has lines of service that use certain locations (either owned or with real property leases) and equipment leases/agreements. In the same region, there is another business, institution or hospital (“Provider 2”) that has similar lines of service and professionals, but does not operate in the municipal areas covered by Provider 1.
Provider 1 enters into an alignment transaction by which it transfers substantially all of the assets of one or more of its business lines to a wholly owned subsidiary LLC (“Provider 1 Sub”). Provider 1 Sub in turn transfers those assets to another LLC (“MSO LLC”), a newly formed management services organization (“MSO”), in exchange for an ownership interest in MSO LLC. Simultaneously, through a contribution agreement between Provider 1 Sub and another unrelated entity connected with Provider 2 (“Provider 2 Affiliate”), Provider 2 Affiliate transfers substantially all of its assets to MSO LLC in exchange for an ownership interest in MSO LLC.
In turn, MSO LLC licenses the assets and locations it received, and provides certain services, to Provider 2 in exchange for, among other things, a usage fee, pursuant to an appropriate license agreement between MSO LLC and Provider 2. Specifically, pursuant to the license agreement, MSO LLC (1) licenses to Provider 2 the locations previously owned or leased by Provider 1 and/or Provider 2 Affiliate; (2) provisions to Provider 2 the services of nurses, certain non-physician and clerical personnel; and (3) delivers clinical services and other business line services to patients at those existing locations.
As to professionals, depending upon applicable law Provider 1 may need to continue to employ the professionals involved, if state law prohibits an MSO from doing so. As a result, Provider 1 and Provider 2 may also need to contract among themselves to address payment/ reimbursement for the relevant professional services. Alternatively, Provider 1 may prefer to have a newly formed professional corporation employ those professionals.
More typical in states with stringent regulatory requirements for institutional health providers is the formation of a common corporate parent. In this model, Providers 1 and 2 form a third entity, which either owns the stock of Provider 1 and Provider 2 or, in nonprofit arrangements, is the sole corporate member of Providers 1 and 2. The parent may have extensive or limited powers over Providers 1 and 2. At the very least, Providers 1 and 2 retain considerable autonomy, but their boards of directors are appointed by the parent entity.
Among other synergies, this accommodates nonprofits and allows some autonomy for the smaller partner; there are management and operational efficiencies that can be gained from shared central services; and the bigger institution can provide clinical and other support not available to the smaller institution standing alone.
To the extent a typical merger, change in control or holding company model option is unworkable for two or more hospitals or health systems seeking to affiliate, the parties could consider a joint operating company model.
Many health care system integrations are inherently contradictory. The participants want the benefits of integration but do not want to give up self-governance, relinquish title to their assets or assume unwanted liabilities, or they require a certain level of autonomy for other reasons. An alternative integration model—the joint operating company—may well resolve some of these concerns.
Joint operating companies (“JOCs”) are established pursuant to joint operating agreements (“Affiliation Agreements”), which typically bring together two or more health care systems (or individual hospitals) to create a jointly governed entity to manage and operate the affiliating providers. This entity, the JOC, sits above the applicable legal entities on a corporate organizational chart with certain controls over the JOC members (for example, a community hospital (the “Secular Organization” and a Catholic-sponsored hospital, the “Catholic Organization”) and their respective affiliates. With tax-exempt affiliating parties, we recommend that the JOC is formed as a nonprofit corporation, with 501(c)(3) status under the Internal Revenue Code.
Unlike an ordinary merger or consolidation, title to the providers’ assets remains with each affiliating entity. In other words, the facilities and other providers managed and operated by the JOC would continue to be owned separately, as they are currently, by each of Secular Organization and Catholic Organization. A critical component of the JOC model is that it financially integrates the parties. The net income or loss derived from operations managed by the JOC would be apportioned between the parties in accordance with a formula set forth in the Affiliation Agreement. This formula, the “Presumptive Split,” would be established based upon the value each party brings to the JOC, with a percentage allocation accordingly. For example, if a valuation shows a 60–40 percent of overall value allocation, the parties would share 60–40 in revenue and expenses through an annual (or more frequent) reconciliation payment from one party to the other as indicated. Financial integration of the participants in the JOC could be further achieved by a contractual agreement to share in future capital expenditures according to a predetermined formula. These income/loss and capital formulas would also be based upon the Presumptive Split. There would not be any combination or refinancing of the parties’ existing bonds (or other debt structure), as parties typically stay within their respective obligated group, as further discussed below.
The JOC would assume responsibility for other mutually agreed upon and more overarching management and operational matters. Typically, the members would delegate (in the Affiliation Agreement) to the JOC their respective rights to approve the annual budgets, strategic plans, service line changes, material asset transfers and any loans, expenditures, indebtedness, contracts or transfers of assets in excess of pre-determined dollar amounts with respect to the JOC members and their subsidiaries/affiliates. Appointments to the board of directors of the new entity (the JOC) typically are made jointly by the affiliating parties and likely would include key board members of each of the respective JOC members. The JOC would not be separately licensed and may or may not employ the affiliating entities’ personnel. Typically, the majority of staff stays in place within each respective organization. However, executive leadership may move to the JOC level so as to facilitate a truly merged sense of management and operations. Moreover, this would allow the parties to consolidate leadership, eliminating duplicative positions in management across the board, with corresponding cost savings. The role of the JOC is to coordinate strategic decisions regarding the operations of the affiliating providers and combined leadership at the JOC level helps to accomplish this and also further facilitates compliance with antitrust laws as the parties works toward single entity treatment for the purposes of contracting, service line allocations, etc.
From a Catholic organization, such a model facilitates continued compliance with the Ethical and Religious Directives for Catholic Health Care Services (the “Directives”) for its providers. The individual boards of directors of the affiliating providers—Secular Organization and Catholic Organization—would retain certain powers over mutually agreed-upon matters, which typically include decision-making regarding mission or ethical matters, medical staff appointments, hospital staffing and certain other day-to-day matters. The Directives would continue to apply to the Catholic Organization providers and Secular Organization would have certain leeway under the Directives as permitted by the applicable Bishop.
While many medical practices are simply being acquired by hospitals, health systems and other providers, some physicians are not inclined to give up all autonomy yet would benefit from the consolidation of operations within a larger practice or system. Another approach that hospitals, health systems and other acquiring parties utilize is to affiliate through an exclusive clinic staffing services agreement with one or more medical groups to staff owned clinics and practices (i.e., completely independent physicians would service practice locations of the acquirer, established either as a division of the acquirer or through an affiliate). We often utilize this independent contractor arrangement model where an existing group would like to get out of the business of managing a practice and/or would like to cash in on the value of its practice but is not yet ready to retire or to give up its autonomy altogether.
For example, an acquiring entity may identify a group that would like to remain intact (e.g., to maintain current benefit and retirement plans or to continue as a partnership of physicians able to choose its new recruits as it grows or physicians retire), yet join the acquirer as independent contractors. The acquirer (or an affiliate) may acquire practice assets for fair market value from existing physicians who would then remain employed by the legal entity that had formerly held the practice assets, with such entity entering into a long-term exclusive professional services agreement with the acquirer to staff the clinics/practices then owned by the acquirer. If the existing practice is newer or has very few assets, an acquisition may not be necessary. Rather, the practice may simply contract with the group to service its practice locations.
The professional corporation (or other legal entity as applicable) remains under the governance authority of its physician shareholders. Any controls by the acquiring party would be contractual in nature. For example, the services agreement could provide that the acquirer sets the physician fee schedules; that the physician group will take Medicare, Medicaid and charity care patients; and that physician compensation will be based on an approach set by the acquirer, but corporate practice of medicine and fee splitting laws may dictate certain adjustments to the model in order to comply with state law. To the extent an exempt organization is contracting for these services, and its goal is to maintain the group’s clinics and practices as exempt, such contractual obligations would be required.
The financial relationship could take one of several forms, but regardless of the approach the physicians cannot receive more than fair market value for their services, regardless of any volume or value of referrals to the acquiring party. For example, in exchange for the group retaining its physicians and assigning its professional services revenue to the acquirer, the acquirer could agree to pay the group the costs and expenses it actually incurs in fulfilling its duties and responsibilities (here, the acquirer may assume more financial risk if income exceeds expenses). In the alternative, it could simply pay a fixed hourly or per patient fee to the physicians, with the physicians assigning to the acquirer the rights to billing and collections. The compensation arrangement must factor in the limited overhead of the group as they are now servicing practices and clinics no longer owned by the group (i.e., it would generally be inappropriate to simply allow such physicians to bill directly and keep all resulting collections).
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.