A Sweet Win for Hershey Medical Center s Proposed Merger: District Court Denies FTC s Attempt to Block Pennsylvania Hospital Merger

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1 A Sweet Win for Hershey Medical Center s Proposed Merger: District Court Denies FTC s Attempt to Block Pennsylvania Hospital Merger CLIENT ALERT May 16, 2016 Barbara T. Sicalides sicalidesb@pepperlaw.com Megan Morley morleym@pepperlaw.com The U.S. District Court for the Middle District of Pennsylvania recently denied the Federal Trade Commission s (FTC s) motion to enjoin preliminarily the merger of two central Pennsylvania hospital systems. 1 This ruling brings an end to the FTC s recent winning streak in blocking hospital mergers at the preliminary injunction stage. As a result, the court s opinion serves as a guide to health care providers that are analyzing potential mergers. THIS PUBLICATION MAY CONTAIN ATTORNEY ADVERTISING The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Please send address corrections to phinfo@pepperlaw.com Pepper Hamilton LLP. All Rights Reserved.

2 The Proceedings In spring 2015, Penn State Hershey Medical Center (Hershey) and Pinnacle Health System entered a strategic affiliation agreement. Hershey is a 551-bed academic medical center, located in Harrisburg, Pennsylvania, that offers a wide array of tertiary and quaternary care services. It operates the region s only children s hospital and one of only three Level 1 trauma centers in Pennsylvania. Pinnacle, on the other hand, operates 646 licensed beds across three community hospitals two of which are located in Harrisburg and the other in Cumberland County, Pennsylvania. Pinnacle offers a limited number of higher-end services. The hospitals notified the FTC of the merger, and, after an investigation, the FTC issued an administrative complaint, alleging that the merger may substantially lessen competition. In addition, in March 2016, the FTC moved for a preliminary injunction to prevent the hospitals from closing the proposed merger. After a period of expedited discovery, the district court conducted a five-day evidentiary hearing on the preliminary injunction motion and issued its ruling on May 9. The FTC sought a stay of the court s order denying its requested injunction, pending its appeal. The Decision In deciding whether to grant a preliminary injunction, the district court was required to (1) determine the likelihood that the FTC will ultimately succeed on the merits and (2) balance the equities. The court concluded that the FTC failed in both respects. To succeed on the merits, the FTC had to prove that the merger may substantially lessen competition in a relevant product and geographic market. In this case, the parties agreed on the product market general acuity services sold to commercial insurers. However, they were at odds on the geographic market in which to examine the merger. The FTC argued that the geographic market should be limited to the four counties that comprised the Harrisburg metropolitan area. According to the FTC, the merged hospitals would have a 76 percent share of the four-county market. It contended that general acute services are inherently local in nature because people want to be hospitalized close to their homes and families. Accordingly, the FTC theorized that patients who live in Harrisburg overwhelmingly chose hospitals close to their homes, primarily Hershey and Pinnacle. The FTC also argued that the two main commercial insurers in the Harrisburg area recognized Harrisburg as a distinct area. The hospitals, on the other hand, contended that the FTC s geographic market definition was too narrow and ignored commercial realities.

3 The district court agreed with the hospitals, concluding that the FTC s definition of the relevant geographic market was too narrowly drawn. In so doing, the court examined the area from which the hospitals drew their patients and the alternative providers to which patients could turn if prices increased or quality suffered at the merging hospitals. Of particular importance to the court s analysis was the fact that 43.5 percent of Hershey s patients traveled to Hershey from outside the FTC s purported geographic area. In fact, more than half of Hershey s revenues originated outside of Harrisburg. In addition, thousands of Pinnacle s patients live outside the Harrisburg area. Accordingly, these facts contradicted the FTC s arguments that general acute services were local in nature and indicated that the FTC s geographic market did not account for where the hospitals drew their business. The court also noted that there are 19 hospitals within a 65-minute drive of Harrisburg. In fact, some of these hospitals are closer to patients who currently use Hershey. Further, given the rural nature of central Pennsylvania, residents often drive significant distances for specific goods and services. Thus, these other 19 hospitals provide realistic alternatives should prices rise or quality suffer as a result of the merger. Finally, the court explained that the merging hospitals took steps to prevent post-merger price increases with the two largest commercial insurers in central Pennsylvania, accounting for 75 to 80 percent of the commercial patients. Specifically, the hospitals entered a five-year contract with one payer and a 10-year contract with the other payer that maintain the existing rate structures and price differentials between the hospitals. With these agreements in place, the court opined that the FTC was essentially asking it to prevent a merger based on what might happen to prices five years in the future. The court was not persuaded by the FTC s argument and, instead, found the agreements entered into between the hospitals and insurers compelling. As a result, because the court determined that the FTC failed to define a proper relevant geographic market, it denied the FTC s request for injunctive relief as the FTC could not demonstrate a likelihood of success on the merits. Although the court already determined that an injunction should not be granted, it proceeded to examine the equitable considerations and focused on three factors that pointed to denial of the injunction. First, the court noted that the hospitals presented a compelling efficiencies argument in favor of the merger that the merger would alleviate some of Hershey s capacity constraints. Hershey s capacity averaged above the optimal occupancy rate for hospitals. Without the merger, Hershey intends to build a $277 million

4 bed tower. However, with the merger, Pinnacle has sufficient capacity to allow Hershey to transfer lower acuity patients to Pinnacle. Hershey can then focus on treating more high-acuity patients, who benefit from Hershey s greater offering of complex services. In this way, the merger will prevent Hershey from expending capital to build the tower and allow patients and services to be properly allocated between the providers. Second, the court explained that the repositioning of competitor providers will constrain the merged hospitals ability to increase prices. Numerous nearby hospitals recently were acquired or partnered with larger hospitals or health care systems. In this way, these competitor hospitals are better situated to constrain the merged entity. Third, the court discussed the growing use of risk-based contracting in the health care industry. 2 To perform best under these risk contracts, hospitals must offer a total continuum of care. On this subject, the court found persuasive the testimony of Hershey s CEO, who explained that it was advantageous to spread the costs of risk contracting over a larger health care system. Additionally, risk-based contracting benefits the community by allowing Hershey to continue to use its revenues to fund the College of Medicine and bring high-quality medical students and teachers to the area. Overall, the court determined that the equities weighed in favor of the merger, concluding that Hershey and Pinnacle patients would benefit from a combined entity. In so doing, the court also recognized the growing need for all those involved to adapt to an evolving landscape of healthcare. Notably, the court was not afraid to rebuke the FTC for its position. It stated: Our determination reflects the healthcare world as it is, and not as the FTC wishes it to be. We find it no small irony that the same federal government under which the FTC operates has created a climate that virtually compels institutions to seeks alliances such as the Hospitals intended here.... It is better for the people they treat that such hospitals unite and survive rather than remain divided and wither. Although the district court s decision rested on the geographic market definition, the above quote and the court s careful review of the developing health care marketplace (more affiliations, risk-based contracting and the importance of academic medical centers) may mark a turning point away from purely formulaic reliance on the FTC s preferred approach and the testimony of self-interested payers. 3

5 The Appeal Typically, the court s denial of the FTC s requested preliminary injunction would mean that the providers could complete their merger, but the FTC filed a motion to enjoin the transaction closing pending the agency s planned appeal of the district court s decision. The district court promptly granted a two-week extension of the original temporary restraining order (TRO), and, on the same date, the FTC filed its appeal. The FTC s principal criticism of the court s injunction decision was that the court s geographic market definition was based, in part, on the location of 43.5 percent of Hershey patients who reside outside the four-county Harrisburg area. Specifically, the FTC claims that taking into account the fact that almost half of Hershey s patients travel from outside the narrower geographic market is akin to applying the Elzinga-Hogarty test. 4 According to the FTC, the district court s analysis does not focus on the dynamics of payer negotiations and the theory that the proposed transaction could increase the merging hospitals bargaining leverage. The agency s arguments are based on its view that payers are the direct customers of the providers, not the patients, and that rates will increase if providers gain too much bargaining leverage. 5 Additionally, the FTC argues that the district court erred by relying on the parties five- and 10-year agreements with the largest commercial insurers in the area. In their brief related to the extension of the TRO, the hospitals point out that the district court s market definition decision is subject to deference, given its highly fact-dependent nature. They argue that consideration of the many patients traveling into the FTC s market and the fact that patient behavior is intimately linked to payers bargaining positions are important to the definition of the relevant market. The hospitals will make more detailed arguments in opposition to the FTC s appeal. The appeal will be an interesting one to watch, not only because the FTC has not faced a hospital merger loss in more than 10 years, but also because the circumstances here undermine some of the FTC s strongest recent arguments. For example, the proportion of Hershey patients from outside the FTC s alleged market is substantial 43.5 percent. To ignore or minimize the health care purchasing patterns of such a large volume of patients and to instead rely on payer testimony that the transaction would harm its bargaining position could make the FTC s typical arguments more difficult to accept in the instant case. In addition, the appellate court might view the long-term agreements reducing or delaying the hospitals ability to increase rates with payers holding 75 to 80 percent of commercial patients for at least five years as mitigating any increased bargaining power of the parties.

6 Some other interesting questions remain. What role, if any, will Hershey s need to increase its capacity and planned affiliations among area facilities, leading to more sophisticated less local systems, play in the court s assessment of the benefits of the proposed transaction? Given the fact-sensitive nature of the trial court s analysis, will the appellate court take head-on the market definition methodology and apply the FTC s preferred approach? What s Next Because of the particular facts at issue here, the Hershey case does not necessarily reflect a tectonic shift in health care merger analysis. Although the final fate of the Hershey/Pinnacle transaction is not yet certain, this opinion can serve as a guide for health care providers contemplating a merger in several ways: First, it remains critically important to develop strong evidence and arguments regarding the geographic market. Hospitals should focus on the actual commercial realities examine where patients are located and all possible alternative facilities. Second, if the deal may be of interest to a government agency, then the entities should consider reaching out to their payers/customers, testing their reactions to the proposed transaction, and, if needed, entering agreements with large payers that reduce the likelihood of rate increases as a result of the proposed transactions. Third, as the court noted, the trend among lower courts is to recognize efficiencies, and the court provided some clear examples of such beneficial provider efficiencies: increasing available capacity in a cost-effective manner capital avoidance resulting from the transaction allowing merging parties to more efficiently engage in risk-based contracting. Fourth, parties should not ignore the positive community benefits derived from the combined entity, including the ability to continue to use revenues to preserve an academic medical institution.

7 Endnotes 1. Fed. Trade Comm n v. Penn State Hershey Med. Ctr., No. 1:15-cv-2362 (M.D. Pa. May 9, 2016), available at opinions/15v2362.pdf. 2. The government intends to shift 50 to 80 percent of payments into risk-based contracts in the next two years. 3. Payer witnesses regularly testify against hospital combinations and provide support for the FTC s narrow geographic market definitions. 4. The Elzinga-Hogarty test focuses on patient inflow and outflow data to define the relevant geographic market. That test was abandoned by the FTC in In re Evanston Northwestern Healthcare Corp., No (FTC Aug. 2007), available at Since Evanston, the FTC s strategy has shifted to proving competitive harm by showing that proposed acquisitions would prevent health insurance companies from excluding the hospitals at issue from their provider networks, which, in turn, increases the merging parties bargaining leverage in contract negotiations. The FTC then argues, with the support of the payers, that the increased provider leverage will necessarily result in rate increases. 5. The FTC explains that health care markets are unlike others because there are four participants: insured patients; their employers, who select the policies offered; providers; and insurance companies. According to the agency, because insurers pay the bulk of the health care costs of their policy holders and negotiate the prices of services, they are the direct customers. Berwyn Boston Detroit Harrisburg Los Angeles New York Orange County Philadelphia Pittsburgh Princeton Silicon Valley Washington Wilmington pepper.law