joint operating agreements in healthcare -...

Joint Operating Agreements in Healthcare Complying With Regulatory Requirements and Maintaining

Tax-Exempt Status in Structuring Virtual Merger Arrangements

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TUESDAY, JUNE 4, 2013

Presenting a live 90-minute webinar with interactive Q&A

Elizabeth M. Mills, Senior Counsel, Proskauer Rose, Chicago

Jan Murray, Of Counsel, Foley & Lardner, Boston

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Joint Operating Agreements: Back to the Future

Jan E. Murray

Foley & Lardner

Boston, MA

617.226.3132

[email protected]

4832-5546-6004

©2013 Foley & Lardner LLP

Agenda

Pressures Driving Hospital Affiliations

Range of Hospital Affiliations: Mergers,

Acquisitions, Joint Ventures and Joint Operating

Agreements (JOA)

– Definition of JOA

– Differences among Affiliation Models

Tax and antitrust considerations in forming and

operating JOAs

Other legal issues in forming and operating JOAs

Pitfalls of JOAs

Strategic and practical considerations

6


Pressures Driving Hospital

Affiliations

“The healthcare industry is undergoing a

period of fundamental transformation in

which the very model of healthcare

delivery is being questioned and

changed.”

Moody’s Investors Service (quoted in

American Hospital Association (AHA)

Fundamental Transformation of the

Hospital Field, 2012)

7



Affiliations

Health care reform forcing increasing

collaboration among hospitals,

physicians and other providers

Limited access to capital

– Particularly for non-profits, capital markets

have not fully recovered from financial

meltdown

– In addition to other capital needs, IT

requirements are expensive to fund

8



Affiliations

Reimbursement pressures

– According to industry analysts, “the

median hospital revenue growth rate is the

lowest in two decades…”

– Moody’s rated hospital outlook as negative

for at least next several years in 2012.

(Moody’s Investors Service, quoted in

AHA publication, Fundamental

Transformation of the Hospital Field,

2012)

9


Increasing Consolidation

According to the AHA Trendwatch

Chartbook 2013 the number of

hospitals in hospital systems has grown

steadily from 2001-2011 (nearly 3,000

hospitals up from under 2600 in 2001);

and

The number of hospital M&A deals has

increased in every year from 2000-

2011 (90 announced deals)

10


What Does All This Mean?

“In addition to the increase of hospital mergers, other forms of hospital transactions are also increasing. According to [AHA] data, while the number of hospitals has only marginally increased since 1999 (up less than 1%), the number of hospitals affiliated with a system has increased 16%...This means that while the number of hospitals is not growing, the number of health system affiliations is rising, highlighting the trend of existing hospitals to consolidate in some way.” (Dixon Hughes Goodman, “What Hospital Executives Should be Considering in M&A”)

11


Increasing Consolidation

First quarter of 2013 has seen some

slowdown in M&A activity; 23 deals

down from 34 in last quarter of 2012

Activity picking up at end of first quarter

though and is expected to rise when

effects of sequestration are better

known (FierceHealth Finance, “Healthcare M&A

Tumbles,” 4/26/2013)

12


Range of Hospital Transactions

Forms of hospital consolidation can

take the form of loose affiliations all the

way to absorption of an entity by

acquisition

Joint Operating Agreements (JOA) lie

on the “looser” end of the spectrum

somewhere above an affiliation or joint

venture but below mergers and

acquisition

13


Range of Hospital Affiliations

Affiliation/Joint Venture

– Typically either by contract or by creation of a

NewCO that has limited purpose (e.g., joint

purchasing only)

Merger/Acquisition – Two corporations combine with one surviving

For profit: may occur by purchase of shares of an entity

Non profit: typically occurs by substitution of a member

Alternative: Purchase of assets

Consolidation

– Merger of two entities into a new entity

14


Joint Operating Agreement

Definition

– Typically involves the formation of a new entity,

super parent, by existing hospitals seeking to

affiliate and is jointly “owned” by existing hospitals

– Existing hospital corporations and boards remain

intact with certain powers that may still be

exercised

Contrast to merger/acquisition where a subsidiary or the

surviving shell corporation is absorbed and wound down

or treated as mere operating division

– Super parent is given certain obligations and

powers to manage certain aspects of the whole

enterprise

15


Joint Operating Agreement versus

Merger

Powers of the parent in merger-type

transaction if wholly owned sub

survives

– Structural and actual control ceded to new

parent which:

Appoints and removes board members

Approves amendments to articles or bylaws

Authority over asset transfers, budgets and

strategic plans

Approval of mergers, acquisitions or affiliations

of subsidiaries 16



Merger

Hospital boards maintain some level of autonomy in JOA in relation to a “super parent” which may or may not be a pass-through entity

Significant variances can exist among JOAs with respect to sharing of responsibility for governance/management issues

IRS analyzes control under facts and circumstances to determine whether the dealings under the JOA are “merely matters of accounting between related organizations rather than rising to the level of unrelated trade or business” (See Darling R., Friedlander M., “Virtual Mergers Hospital Joint Operating Agreement Affiliations,” 1997 EO CPE Text)

17


Joint Operating Agreements

Financial Matters

– Revenues of hospital corporations flow to

“parent”

– Joint contracting for managed care takes

place through parent

– Over time, debt may be secured by parent

18


Shared Governance and

Management Features in JOA

– Hospital boards may maintain

responsibility for religious directives

– Hospital entities continue to own assets

– Local hospital boards and management

may direct some local services

– Some local level of budget authority may

be exercised by Hospital Boards

– May appoint, remove some board

members

19



Merger

If JOAs are designed to permit

negotiating jointly with managed care

companies then must meet certain

requirements from an antitrust

standpoint

If JOA “parent” is to receive tax exempt

treatment and/or avoid UBIT on

transfers of revenue from hospital

members, must meet certain IRS

requirements. 20


Why do JOA rather than Merger?

Preserve special mission in system—

e.g., religious directives

Avoid legal restrictions arising from

public status—i.e., permit public

hospital to be joined in system

Permit joint action without surrendering

complete independence

21

22

Joint Operating Agreements in Healthcare

Elizabeth M. Mills, Esq.

Senior Counsel

Proskauer

Three First National Plaza

70 West Madison

Chicago, IL 60602-4342

[email protected]

(312) 962-3538

June 4, 2013

22

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Federal Income Tax Exemption Issues

23

24

What's The IRS Got To Do With it?

• Section 501(c)(3) tax-exempt organizations must operate for

exempt purposes

• 501(c)(3) organizations can endanger their exemption if they

conduct a trade or business unrelated to exempt purposes ("UBI")

as a substantial part of their activities

• 501(c)(3) organizations can't share profits with non-exempt

entities or provide an equity-type interest to non-exempt entities

• With very limited exceptions, tax-exempt bond-financed property

can't be used, occupied, or owned by non-exempt entities

- Or by tax-exempt organizations in UBI activities

24

25

Why do they care about control?

• "Actual" hospital merger

- Hospitals are brought together under common tax-exempt

parent

- Parent exercises structural control through director

appointment and reserved powers

- Related organizations are an "integral part" of each other and

can share services and management without UBI

25

Joint Operating Company

Delegated Hospital Board Selection

Parent A

Hospital

A1**

Joint

Operating

Company*

Parent B

Hospital

A2

Hospital

B1 Hospital

B2

* JOC board makes decisions for hospitals as their parent; supermajority requirements, but not class voting, permitted

** Each hospital retains its license, governing board, and assets

Appoint JOC directors

Reserve powers over

JOC organic changes

Appoint directors and exercise reserve powers

26

Why do they care about control?

• A JOA often doesn't have this type of structural control

• Thus, the IRS examines four factors to determine whether

JOC has equivalent of parent-subsidiary relationship with

the participating hospitals

27


Parents Retain Board Selection

Parent A

Hospital

A1**

Joint

Operating

Company*

Parent B

Hospital

A2

Hospital

B1

Hospital

B2




Reserve powers over

JOC organic changes

reserve powers

Appoint

hospital

directors

Reserve powers

over hospital

organic changes

Appoint

hospital

directors

Reserve powers

over hospital

organic changes

exercise

28

IRS Factor 1: Delegation of Significant Authority

over Participating Entities

• JOC should have power to, e.g.;

- Establish budgets

- Establish strategic plans

- Approve debt

- Reallocate income among entities (financial integration)

29

IRS Factor 2: Permanence

• A temporary relationship doesn't look like a parent-

subsidiary relationship

• Is there glue to hold the parties together through disputes

- E.g., arbitration or other dispute resolution

• Are there disincentives to voluntary termination

- E.g., penalties for walking

30

31

IRS Factor 3: Veto Rights

• JOC exercises control, not just veto, over participants

- Can initiate action, not just react

• JOC members have limited ability to veto JOC decisions

31

IRS Factor 4: Limited Reserved Powers

• Members have limited powers over JOC

• Only shareholder-type powers

• Member powers over JOC aren't exercised indirectly

though class voting on JOC board

32


Parents Retain Board Selection

Parent A

Hospital

A1**

Joint

Operating

Company*

Parent B

Hospital

A2

Hospital

B1

Hospital

B2




Reserve powers over

JOC organic changes

reserve powers

Appoint

hospital

directors

Reserve powers

over hospital

organic changes

Appoint

hospital

directors

Reserve powers

over hospital

organic changes

exercise

33

Partial System JOAs

• Affiliates not participating in JOA aren't integrated

• Services to them may be UBI

34


Partial Hospital System Participation

Parent A

Hospital

A1**

Joint

Operating

Company*

Parent B

Hospital

A2***

Hospital

B1***

Hospital

B2


** May be unincorporated division of Parent

*** Each hospital retains its license, governing board, and assets


Reserve powers over

JOC organic changes

reserve powers

Appoint

hospital

directors

Reserve powers

over hospital

organic changes

Appoint

hospital

directors

Reserve powers

over hospital

organic changes

exercise

Exercise all Parent

powers

35

Antitrust Issues

36

Antitrust Issues Dovetail with Tax Exemption

Issues

• In each case, the test is whether the parties have created a

unity of economic interest through the JOA

37

Reason for Antitrust Concern

• If JOA members are competitors, their joint planning and

pricing through the JOA is anti-competitive

• Sherman Act Section 1 prohibits contracts, combinations

and conspiracies between two or more parties that

unreasonably restrain trade

- Such as price fixing

- Such as market allocation

• Note that unity of economic interest doesn't help with

Sherman Act Section 2 monopolization issues

38

What is Unity of Economic Interest?

• Copperweld Corp. v. Independence Tube

- Wholly owned subsidiaries can't conspire with parent

• As with tax exemption, the objective is to make the JOC

akin to a parent and the hospitals in the JOA akin to

subsidiaries

39

What is Unity of Economic Interest?

• Control over appointment and removal of directors and officers

• Control over hospitals' corporate documents

• Ability to operate and control the hospitals' assets and clinical programs subject to typical shareholder powers

• JOC control over JOA budget and strategic plan and those of hospitals

• Limited rights of members or hospitals to terminate, and it's hard to to do so

- FTC/DOJ guidelines suggest 10 years

• JOC can allocate profits and losses, assess capital contributions, and negotiate managed care contracts

40

Partial System JOAs

• As in tax exemption, the system parts not controlled by the

JOC remain competitors of the JOC

41


Potential Pitfalls of JOAs

Tension between super parent and active hospital subsidiaries – May be dissonance between the mission of the

super parent and the mission of a member hospital corporation or between the member hospital corporations that is played out at super parent level

– Hospital may be generating revenue that is directed to other entities in the system

More complex from a regulatory standpoint to manage because discrete entities remain in place

42


Anatomy of Failed JOA

Some have been unwound because of

tension between the hospital

corporations and the new “parent”

– In 2008 Health Alliance in Cincinnati was

sued to permit two hospitals to exit the

JOA

– Ultimately state court of appeals permitted

the hospitals to terminate their relationship

with the JOA because Health Alliance was

determined to have defaulted on the JOA

43



Health Alliance was formed in 1995 by a JOA

and ultimately included four hospitals: Christ

Hospital, Saint Luke’s Hospitals, Jewish

Health Systems and Fort Hamilton

Certain powers were reserved to hospital

corporations: ownership of plant, property,

equipment and ultimate responsibility for

fulfilling respective charitable missions

(Health Alliance of Greater Cincinnati v.

Christ Hosp., 2008 Ohio-4981)

44



Christ Hospital accounted for some 40% of the revenues of the Alliance but very few funds were directed to Christ Hospital

Trustees of Christ Hospital feared that the Alliance planned to close their Auburn Hospital

Christ Hospital would take on new debt through tax exempt bond financing that would not generate funds for its use

Provided termination notice based on breach of the Joint Operating Agreement

45



Health Alliance dispute also points to

potential tension arising from exercise of

fiduciary duty in system with significant

governance powers still residing at local

corporate level

Ohio appellate court noted that the Christ

Hospital directors were exercising their

fiduciary duties in attempting to preserve

assets

Court also ruled that Alliance had a fiduciary

responsibility to the member hospitals 46


BUT—JOAs Work and Have a

Future

Saint Joseph/Candler hospitals in Georgia

are still operating under a JOA since 1995

Several new JOAs have been formed in the

last few years

– Poudre Valley Health System/University of

Colorado Hospital

– KentuckyOne and University of Louisville Hospital

– Saint Joseph’s Hospital and Emory Healthcare

47


Other Legal Issues in Formation of

Joint Operating Agreement

Antikickback (AKS): Broad federal statute

that prohibits offering or soliciting anything of

value in return for referrals (42

U.S.C.§1320a-7b(b))

Stark: prohibits physicians from referring

patients for the designated health services

from entities with which the physician has a

financial relationship unless an exception

applies (42 U.S.C. §1395nn)

48


JOAs and AKS and Stark

JOAs typically do not include physician groups as owners so does not usually raise new Stark issues that would not have been resolved at the direct financial relationship level

– Although JOA may create a new “link” for Stark purposes, should not create new indirect relationship if physicians are not compensated on the value or volume of referrals to the entity billing/providing DHS

49


Stark and Antikickback

AKS issues may be implicated because JOAs involve financial relationships among referral sources that remain discrete entities – Need to examine each arrangement among

participating entities to ensure that funds flow mechanisms do not act as an impermissible inducement for referrals—e.g., physician groups affiliated with one hospital member entering into an arrangement with another hospital member

– OIG provided safe harbor for Cooperative Hospital Service Organizations—payments to these from the member hospitals for service provided by CHSO thought to implicate AKS (42 CFR 1001.952(q))

50


JOAs – Strategic/Practical

Considerations

Clearly identify strategic goals to be achieved

by a partnership

– Need to fill in service gaps on a continuum?

– Need strong financial partner?

– Need stronger management capability?

What is the appropriate model to meet the

strategic goals?

– Strongly centralized governance versus local

control

– High level of system integration versus

divergence in management or clinical services

51


JOAs—Strategic/Practical

Considerations

Any limitations to merger to be

considered?

– Religious mission?

– Public Status?

– Community political factors?

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