ONE OF THE MAJOR ISSUES inherent

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1 PERSPECTIVE 112 The Conversion Game: High Stakes, Few Rules A close observer of scores of hospital conversions asks, "Who really benefits from these deals?" by Linda B. Miller ONE OF THE MAJOR ISSUES inherent in the acquisition of nonprofit hospitals by for-profit companies is the process by which these conversions occur. The resurgence of conversions of nonprofit hospitals to for-profit status represents the largest potential redeployment of charitable assets in the nation's history. Conversion activity, in turn, signals significant change in the structure of the health care industry in general and will affect the health care delivery systems in hundreds of communities across the country. Some analysts argue that the sale of notfor-profit hospitals to for-profit chains will reduce the nation's oversupply of hospital beds and the high costs associated with them. Even if this argument proves to be true, the selling off of not-for-profit hospital assets raises numerous other issues regarding how these sales are occurring and who is getting rich from the proceeds. The Process: A Game With Few Rules Federal and most state laws require that when section 501(c)(3) charitable assets are sold and converted to for-profit status, the value of those assets must remain "in the charitable stream." Simply put, this means that the price paid for a nonprofit hospital must reflect the fair market value and go to another charity. Oversight and policing of the conversion and sale reside primarily with the states and usually in the office of the attorney general, the state's chief law enforcement officer and guardian of charitable assets. Although the sale formula sounds simple, the process is anything but. The sheer number of sales of not-for-profit hospitals has proved to be a logistical challenge to state attorneys general. Traditional valuation methodologies for nonprofit entities are cumbersome and of questionable use in the context of hospital sales today. In addition, many hospital sale deals are exceedingly complex, involving multiple collateral transactions and requiring sophisticated financial analysis and expertise not routinely found in the offices of attorneys general. The fast pace, short time frames, and growing number of proposed sales have seriously taxed resources and sent several states to the legislative drafting board. The absence of guidance from the U.S. Department of the Treasury, the Internal Revenue Service (IRS), the Health Care Financing Administration (HCFA), or any other federal agency has exacerbated the oversight burden on attorneys general and raised the stakes for affected communities. In a perverse sense, it has enabled the formation of new health care and not-for-profit tax policy by default absent rules, reason, or debate. The result has Linda Miller is president of the Volunteer Trustees Foundation for Research and Education, an organization that seeks state oversight of the sale and conversion of nonprofit hospitals, and of the Volunteer Trustees of Not-for-Profit Hospitals, a related membership organization. She was a special assistant to Health, Education, and Welfare (HEW) Secretary Joseph Califano during the Carter administration and has worked for the New York City and District of Columbia governments in health care. H E A L T H A F F A I R S - V o l u m e 16, N u m b e r The People-to-People Health Foundation, Inc.

2 PERSPECTIVE: HOSPITALS been a Pacman-like assault on communityowned hospitals that is conducted, for the most part, without any agreed-upon parameters for acceptable or appropriate behavior. To the extent that parameters exist, they are imposed on the not-for-profit seller and stated in terms of fiduciary duty, private inurement, conflict of interest, and personal liability. The for-profit buyer has been free to induce, seduce, promise, and reward secret deals. Nearly all of the sales deals have been shrouded in secrecy, barring communities from access to any information. They are privy to neither price, nor terms of the deal, nor alternatives and options considered. Valuation procedures have allowed purchases of not-forprofit hospitals at prices that substantially undervalue their worth. As Steven Hollis notes: "We have witnessed a surprising number of transactions in which it appears that sellers have delivered to buyers more assets than might have been required, to justify the value received." 1 Thus, the community, the beneficiary of the sale, is being shortchanged, and the hospital sales are inuring to the benefit of the buyer. "[A]ggressive representation of the community interest is... not met by the financial advisers who are counseling in favor of the deals." language of partnering often masks the reality of the conversion to for-profit status and the surrender of control by the community. In reality, from the perspective of the community, the fifty-fifty joint venture is not much different from an outright sale. From the buyer's perspective, you cannot beat the price. Although the IRS has remained largely silent about these deals, a growing contingent of state attorneys general are publicly questioning the appropriateness of the joint venture transaction. Recently, for example, a Michigan state court held that the fifty-fifty joint venture's commingling of charitable assets with profit-making entities violates laws enacted to protect charitable assets. The judge sustained the attorney general's assertion that "the core assets that previously gave it a charitable mission" would now be used to earn a profit. 3 California Attorney General Daniel E. Lungren raised similar concerns in his review of a fifty-fifty joint venture. In a letter to Sharp HealthCare, San Diego, he wrote: "In our view, the transfer of these hospitals into the for-profit LLC [limited liability corporation] constitutes an abandonment and breach of... trust." The Joint Venture: Shortchanging The Community Perhaps no sale deal better exemplifies this assault on community assets and interests than the "joint venture." This structure, refined by Columbia/HCA and now used by other for-profit companies as well, allows a for-profit buyer to pay less than full and fair cash value for a hospital by styling the transaction as a "partnership." In the most egregious of these structures, the fifty-fifty joint venture, the for-profit buyer pays out only 50 percent of the fair market value of the not-forprofit hospital. 2 The unpaid other half remains as a passive investment in the new forprofit entity. The psychological appeal of the Creating A Buyer's Market An extremely unsettling part of the conversion process has been the nature of the financial advice apparently being sold to the boards of nonprofit hospitals involved in these sales. The Wall Street firms that specialize in these deals seem to have exacted very little from the for-profit buyers, while defining a punitive marketplace for the nonprofit sellers. Community boards do one of these deals in a lifetime and come to the table already outgunned by the big for-profit corporations whose lawyers and sales agents do scores of them. The need for aggressive representation of the community interest is great and is not met by the financial advisers who are counseling in favor HEALTH AFFAIRS - M a r c h I A p r i I

3 PERSPECTIVE 114 of the deals. It may well be a serious oversight on the part of nonprofit hospital boards not to retain their own counsel, as independent corporate directors often do in such major transactions. In the joint venture structure, for example, boards are counseled not only to forgo immediate receipt of the fair value of the asset being sold but also to invest the balance in the same venture. This is a high-risk investment strategy, which leaves the community foundation with greatly reduced liquidity and raises legitimate questions about the duty of the board in serving the best interests of the community. California Attorney General Lungren confirms this view in his letter to Sharp: We doubt that it is ever prudent for a non-profit public benefit corporation to invest virtually all of its assets in a single investment, let alone an LLC in which it is not the managing partner, which has virtually no capital appreciation potential, which is virtually unmarketable after three years, and which yields a return which the charity itself projects as well below the expected rate of return of a properly-managed portfolio. 5 The advice given boards in the process of developing partnership criteria and analyzing merger options is likewise suspect. The purpose or mission of a nonprofit hospital is service to the community, and nonprofit hospital boards need to be supported, not thwarted, in recognizing that institutional preservation and the needs of the community may not always be the same. Is maximizing price, for example, without assuring ongoing service delivery, an appropriate goal? Such criteria as equity investment opportunities for physicians or exclusive franchises and market domination bias the disposition in favor of a for-profit venture and are of questionable application to the mission of the institution. 6 Wall Street financial advisers know that boards of for-profit companies have a duty to shareholders as well as to the company. Likewise, boards of nonprofit entities have a duty to their stakeholders the community as well as to the institution. The uneven application of the practices of the commercial market has tilted the marketplace in favor of the for-profit buyer. Examples abound: (1) The secrecy that characterizes the sale deals is counter to the interests of the seller and the community in promoting a bidding contest. If these were publicly traded companies, full disclosure of the terms of the deal and the interests of the parties would be required. If these were stock transactions, the disclosure requirements would be even stiffer. It is ironic that because these are communityowned institutions, there is apparently no such duty a disturbing distinction between the rights of stockholders of publicly traded companies and the rights of stakeholders of community-owned institutions. (2) Valuation procedures understate hospitals' value by using a "trailing" cash-flow analysis. This methodology examines a hospital's performance historically as a charity and when it was providing free care and other community services to which the new buyer has no ongoing obligation or commitment. The procedure results in a price that is reflective of neither performance expectations in the hands of the buyer nor the value to the purchaser in terms of stock price multiples of the earning stream acquired. 7 (3) The economic value of control is not factored into the sale of not-for-profit hospitals. In commercial transactions, financial experts exact "control premiums" of up to 35 percent when, as in a joint venture, less than the whole asset is being sold. (4) The process by which debt reduction is apportioned in the joint venture structure skews the price to benefit the for-profit buyer at the expense of the community. In joint venture deals, the cost of paying off bonds appears to come out of the hospital's portion of the proceeds only. Covenants: Hedging Bets Against The Future Several boards of nonprofit hospitals have tried to negotiate protections and assurances of ongoing service delivery into the sales deals by exacting contractual commitments or covenants from the buyer as a condition of sale. While covenants may be better than H E A L T H A F F A I R S - V o l u m e 16, N u m b e r 2

4 PERSPECTIVE: HOSPITALS nothing, they are unlikely to provide effective assurance of continuing services, access, or quality. They are always time limited and short term, and the lack of public disclosure prohibits communities from knowing about them. A board is unlikely to have the power or resources to enforce compliance, and because the hospital (once it is converted to a forprofit entity) is no longer under the purview of the attorney general, compliance monitoring is likely to fall through the cracks. In Massachusetts the attorney general required that as a condition of the sale of MetroWest Health System (Framingham), the buyer financially support a monitor for three years to ensure compliance with promises exacted in the transaction. 8 Even the best covenants, however, are only hedged bets against the future. What board could have foreseen the acquired immunodeficiency syndrome (AIDS) epidemic, the 1990s' influx of immigrants from war-ravaged countries, or the amazing expansion of perinatal technologies that save lives but are unprofitable as business ventures? It is the notfor-profit organizations that have provided services in real time to respond to changing community needs. State Responses: Markers Of Growing Concern The increasingly active role of state attorneys general in policing conversions is a significant, telltale marker of just how high-risk the conversion and sale of nonprofit hospitals has become for communities. In Texas, Michigan, and Florida the attorneys general have sued to stop sales from going forward; in California the attorney general threatened to bring suit if a deal closed without further scrutiny; and in Massachusetts the attorney general interceded and negotiated extensive protections on behalf of a community before allowing a joint venture to close. Several state attorneys general have required full public disclosure of sale documents, and three states have held public hearings to give communities the opportunity to understand and judge a proposed sale. As a result, the pace of sales has slowed greatly, major revisions have been made to the terms of the deals, and several pending sales have been terminated. Ironically, the community generally does not have legal standing to intervene on its own behalf in the conversion and sale of community-owned assets. Lawsuits in several states, brought by hospital incorporators, boards, founders, and donors, have been thrown out of court. All sought information on sale price or terms, and all were dismissed, not on substance, but for lack of standing. This has intensified the burden on attorneys general, who are generally the only party who can represent the community and therefore are the last resort for protecting the community interest. Another marker of the growing concern over these deals at the state level is the number of states involved in the legislative process to expand the oversight authority of attorneys general. In a strikingly bipartisan effort, numerous states are moving quickly to draft, introduce, and enact legislation. All of these states seek to clarify the attorney general's role in the oversight process and ensure public accountability. Each has recognized the need for a monitoring mechanism to ensure compliance with covenants and has carved out a referral pathway to the state's senior health officer. Two states, Nebraska and California, passed legislation in 1996 without a single negative vote. More than half of the states are now engaged in the legislative process, which reflects the broad perception that expanded rules are needed. Communities At Risk Legislation and increased oversight by state attorneys general together provide answers to the question of how to protect communities in the process of converting and selling notfor-profit hospitals. However, neither answers the more basic question: Is the selling off of not-for-profit assets in the interest of the community in the first place? These sales are clearly making the for-profit companies 115 HEALTH AFFAIRS - M a r c h I A p r \ I

5 PERSPECTIVE 116 rich, but are they enriching the communities as well? Somewhere in the rhetoric of free markets, for-profit efficiencies, and Wall Street, we have forgotten to ask what is at stake in the conversion of the health care system to for-profit status. In the end, the community is left with the proceeds of the hospital sale and a for-profit hospital owned and controlled by an investorowned chain. The community is now subject to the new brand of competition the for-profit company may introduce and must live with the buyer's need to manage hospital operations to produce a percent return. Service mix, personnel, and access to the facility itself may all be subject to change. Historically, for-profit hospital companies have had relatively short-term commitments to communities, reselling often, exiting the acute care business, or selling out when profit margins got compressed. Several communities have been left with closed facilities or with successive new owners, each with their own agenda. In some cases, foundations have had to use all available funds to buy back the hospital when the for-profit company put it up for sale. 9 Nor have the for-profit hospital chains historically provided the critical high-technology and nonremunerative services to which communities are accustomed. These services such as burn units, perinatal intensive care units, transplantations, and other sophisticated medical interventions exist overwhelmingly in the nonprofit sector and represent an investment in a social good, not potential financial returns. For-profit chains historically have charged higher prices, located selectively, and provided minimal care for the poor and uninsured and few services for which reimbursement is low or nonexistent, such as AIDS care and mental health care for the poor. To the extent that past experience is a valid forecaster of the future, there is little to give comfort to communities selling not-for-profit hospitals to for-profit chains. It is unlikely that the economics of managed care will support a system in which forprofit chains skim the wealth and not-forprofit hospitals provide the expensive hightech services and treat those who do not contribute to profitability. We are kidding ourselves if we think that the foundations created from the leftovers of a joint venture or an undervalued sale will fill those gaps. Developing A Research Agenda If we are to understand the impact of hospital conversions on the communities affected, health policy analysts and researchers will need to develop new models for assessing the strengths and weaknesses of a not-for-profit system. Research will have to examine, for example, how decisions are made, how well institutions meet community needs, what costs are absorbed by the system that otherwise would fall to government or never be expended, and a host of other issues that are unquantified and intrinsic to the not-forprofit model. This would be a change from past research, which has used for-profit hospitals as a base against which not-for-profit hospital performance has been compared. This methodology has defined a lowest common denominator, allowing the research parameters to be defined by the for-profit sector alone. Research has insufficiently addressed what the for-profit sector does not do. In addition, the conversion process is based on a number of assumed outcomes that require rigorous analysis. The research questions should include: (1) How were the proceeds from a hospital sale actually used? The theory posited by sale proponents is that the for-profit hospital company will bring efficiency to the institution while freeing up funds for targeted health care needs. Did the moneys simply relieve the for-profit buyer of expensive services, or was value added as a result, for example, through new or expanded services? (2) How did the selling price or price paid compare to the value of the asset once in the hands of the buyer, as measured by profits exacted? Were the profits reinvested in the HEALTH AFFAIRS - Volume 16, Number 2

6 P E R S P E C T I V E : HOSPITALS community, or did they support acquisitions and/or operations in geographically distant locations? (3) Was the LLC or joint venture profitable? Is it returning the cash value forfeited in the sale or performing as well as alternative investments might have? (4) What is the aggregate impact on the economics of the community? For example, is the remote buyer using local vendors? Is money being left in local banks to support local mortgages? (5) How much of the health care dollar is being siphoned off in corporate overhead and management information systems, and legal, management, and other contracts with buyerrelated companies? (6) How responsive is the hospital to changing community needs? (7) How are high-tech services distributed among providers in the community? How has the distribution changed since the sale, and are nonprofit hospitals carrying these services disproportionately? (8) How do the physician limited partnership and other opportunities for physician investment affect use and referral patterns? (9) How does the for-profit respond to difficult financial times? Have services been cut; has the hospital been resold? (10) Are there identifiable quality concerns? For example, how does patient care staffing change after a sale; how does it compare for specific services with not-for-profit providers? (11) How is capital allocated by the forprofit buyer? The rationale for sale is often tied to access to capital. Is there a positive infusion of capital in the converted institution compared with how it would have performed as a nonprofit? Up to this point the focus of the oversight of nonprofit conversions has been the process of the transaction. The challenge now is to understand and evaluate the outcomes. Before we make the leap of faith that capitalism, free enterprise, and the market will cure an imperfect system, we should more fully understand what we are getting in the trade. NOTES 1. S.R. Hollis, "Strategic and Economic Factors in the Hospital Conversion Process," Health Affairs (March/April 1997): In some cases there is less than 50 percent or no cash payout when the not-for-profit hospital is contributed to a "partnership" to which the forprofit buyer also contributes operating assets. In that instance the community realizes minimal or no cash value. 3. Opinion and Order by Judge James R. Giddings, State of Michigan, Circuit Court for County of Ingham, 3 January 1997, Kelley v Michigan Affiliated Healthcare System, Inc., California Attorney General Daniel E. Lungren to John F. Walker Jr., Latham and Watkins, personal correspondence, 8 November 1996,2. 5. Ibid, Hollis, "Strategic and Economic Factors in the Hospital Conversion Process," Exhibit 1; and "Eden Township Hospital District: Review of Affiliation Proposals for the Board of Directors" (San Francisco: Cain Brothers and Company, 28 August 1996). 7. S.R. Hollis, "Strategic and Economic Factors in the Not-for-Profit Hospital Affiliation Process" (San Francisco: Cain Brothers and Company, September 1996), In the 1996 sale (an eighty-twenty joint venture) of Framingham-based Metro West Health, Inc. to Columbia/HCA, the Massachusetts attorney general required Columbia/HCA to fund an independent analyst to monitor and report as a matter of public record on health care access, including levels of free care, for three years. In addition, Columbia/HCA agreed to provide the attorney general with an annual community benefits report and to commit to keeping emergency rooms open on both (hospital) campuses on a twentyfour-hour basis for three years. Provisions related to maintenance of effort in free care were strengthened over the original proposal. Office of the Attorney General, Commonwealth of Massachusetts, press release (1 April 1996). 9. In Denver, Colorado, for example, Presbyterian/ St. Luke's (now part of HealthONE) used funds from The Colorado Trust, an independent charitable foundation created when the hospital was sold to for-profit American Medical International in 1985, to buy back the hospital in HEALTH AFFAIRS - M a r c h / A p r i I