Hospital/Physician Ancillary Services Joint Ventures: What’s Legal and What Works

J. Reginald Hill

Waller Lansden Dortch & Davis, LLP

Nashville, Tennessee

William W. Horton

Johnston Barton Proctor & Rose, LLP

Birmingham, Alabama

Texas Health Law Conference, October 15-16, 2012

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“It Was 20 Years Ago Today . . .”

“People are still gonna do deals.” -- Ivan Wood, NHLA Annual Meeting 1992 (on the promulgation of the AKS safe harbors)

Regardless, hospital/physician JVs have been dead since Stark II, right?

And the change in the “entity” definition effective in 2009 was the final nail in the coffin, wasn’t it?

And yet, deals still occur

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What We’re About

Today’s joint ventures may take a variety of forms, but present common legal issues Structure Governance Healthcare compliance Securities compliance Others

And business issues must be considered as well Legal compliance isn’t enough; JV must work as a business

deal as well

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What We’re About (cont.)

Using two hypotheticals, we will explore how a variety of legal and practical issues play out in JV deals today

And remember . . . These are just hypotheticals. Figments of our imagination. You should never expect to see something like this in real life. Really.

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The Ethical Framework

“Papering up the deal” when a party is unrepresented or underrepresented

Legal conflicts and practical conflicts Model Rule 1.3 – “Zealous advocacy” Model Rule 1.6 – Confidentiality Model Rule 1.7(a) – Limitations on representation –

adverse interest, obligations to other party, personal interest

Model Rule 4.3 – Duties to unrepresented persons

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The Ethical Framework

Even when the parties “have a deal”, they may notDrafting choicesConflict resolution

The “sponsored” counsel arrangement

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Hypothetical #1:A Matter of Urgency ACMC = Hospital on the west side JC = 2-doc-owned urgent care center on the

east side (near ACMC’s competitor) ACMC’s proposal to JV west side center and

new east side center with docs, + syndicate to 12 or more new docs

The CEO’s rationale The back-of-the-envelope calculation

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Hypothetical #1:A Matter of Urgency The conversation with the GC

FMV issuesGetting the message out about the offeringE-Z financing termsGovernance/control issuesThe real estate pieceACO/bundled payments strategy

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Hypo #1: Valuation Issues

May valuation of JC include: Physician owners’ referrals to JC through use of income

method/discounted cash flow model? Physician owner’s referrals to ACMC (same method)?

Answer depends on proper characterization of transaction If it’s a physician practice acquisition, then first answer is

probably “no” and second answer is definitely “no” If its acquisition of a business not dependent upon the owner-

physician’s referrals, then first answer may be “yes” . . . But second answer is still “no”

Note that the risk is in valuing the referrals; should still be possible to structure relationships among the parties so that referrals to ACMC would be permissible

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Hypo #1: Valuation Issues

In financial arrangements between providers and referral sources, Stark and AKS will both generally impose requirements that transaction terms be:• Consistent with fair market value;• Not based on volume or value of referrals or

other business generated by the parties; and• Commercially reasonable even in the absence

of referrals.

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Hypo #1: Valuation Issues

Generally, three approaches are used by valuation firms (sometimes in combination): Income approach – The valuation firm, working with the parties to the

transaction, prepares a projection of future income and discount the projected income stream to present value using a discounted cash flow mode. A discount factor that takes into account an assumed rate of investor return and risk assessment is used.

Market approach – The valuation firm considers sales of comparable businesses. In valuing services, the valuation firm uses survey data, if available for the services at issue.

Cost or asset approach – The valuation firm determines the fair market value of the assets of the business.

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Hypo #1: Valuation Issues

Characterization of transaction If considered a practice acquisition, must take into

account Mac Thornton “no goodwill” letter from 1992 (and concern about payment for intangibles as disguised payment for referrals in 1999 sale-of-practice safe harbor preamble)

Some view this as meaning purchaser can only pay for hard assets

Use of discounted cash flow method where target includes DHS may be permissible under Stark Law (see Stark II preamble), but still presents problem under AKS

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Hypo #1: Valuation Issues

Characterization of transaction Would “intangibles” analysis under AKS change if transaction involved a

business (arguably) not dependent on the physicians’ referrals, such as an ASC?

OIG says “No”; see AO 09-09 And remember Bradford Regional Medical Center (valuation by an

accountant concluded that the lease payments on nuclear camera were “reasonable,” in part because of the revenue expected from the physicians’ referrals; court says Stark violation)

Valuation experts disagree on what types (if any) of intangibles can be taken into account in a practice acquisition

But if the transaction can truly be characterized as a “no owner referrals” business acquisition (e.g., owner-physicians act only as financial investors and do not refer to the business), an income valuation may be more defensible

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Hypo #1: Investment Issues

What is the appropriate process for identifying and bringing additional physicians in as owners of JC? Can ACMC “help” physicians pay the purchase price for their interest in JC by loaning funds to them or valuing the interest below fair market value?

Involves both healthcare and securities law analysis

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Hypo #1: Investment Issues

AKS small entity investment interest safe harborHow close can you get? Importance of valuation (again)

No correlative Stark ownership exception Is there DHS involved?Rural provider exception available?

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Hypo #1: Investment Issues

Securities law issues – must have an exemption from registration under federal (and state) securities laws Regulation D (esp. Rule 506 exemption)

See detailed comparison of rules in outline Other exemptions discussed in outline

Key concerns Accredited investor status/other “sophistication”

requirements No general solicitation Disclosure/information requirements

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Hypo #1: Investment Issues “Crowdfunding” under the JOBS Act:

The aggregate amount sold to all investors by the issuer, including any amount sold in reliance on the crowdfunding exemption during the 12-month period preceding the date of the transaction, is not more than $1,000,000;

The aggregate amount sold to any investor by the issuer, including any amount sold in reliance on the crowdfunding exemption during the 12-month period preceding the date of the transaction, does not exceed:

the greater of $2,000 or 5 percent of the annual income or net worth of the investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; or

10 percent of the annual income or net worth of an investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000;

The transaction is conducted through a broker or funding portal (a new kind of intermediary to be regulated by the SEC) that complies with the requirements of the exemption; and

The issuer must file with the SEC and provide to investors and intermediaries specific information about the issuer.

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Hypo #1: Governance Issues

Selection of new entity (if existing entity to be used, consider liability issues) – likely to be an LLC

Operating Agreement Member qualifications Capital contributions/ownership percentages Voting rights (including supermajority requirements) Form of governance and allocation of control among

members or member-designated managers Capital calls/debt guaranty requirements

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Hypo #1: Governance Issues

Operating Agreement (cont.) Transfer restrictions Hospital “buy-up” option Restrictions on competing ventures Fiduciary duty issues Termination events (and associated valuation

process) Note that governance is a key area for conflicts

of interest (and thus a key area to be sensitive to ethics concerns)

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Hypo #1: Other Issues

ACMC’s ability to contribute land for new center; lease land, building and equipment to JC; “help” docs buy in?

ACMC’s ability to charge rent or providing financing to JC on favorable terms?

Potential tainting of referrals to ACMC (not just JC)?

Potential role of JC in ACMC’s accountable care/bundled payment strategies?

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Hypothetical #2:In Search of Excellence RMC (Wilma Flintstone) – Urban nonprofit

hospital BONES (Dr. “Red” Skeleton) – Big-dog ortho

group The effort by Happy Valley to attract BONES Wilma’s response – the Orthopedic Institute of

Excellence and OMM (JV between RMC and BONES) – clinical co-management agreement

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Hypothetical #2:In Search of Excellence Wilma’s view:

Both parties put up capitalGovernance “weighted toward docs”, but both

would share management feesManagement fee – 50% fixed, 50% based on

(prorated) incentives; divided between RMC and docs based on pro rata ownership

Need to include other orthopods

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Hypothetical #2:In Search of Excellence Red’s view:

RMC funds capital; docs’ share withheld from profit distributions

Incentive structure needs to take into account growth in RMC’s ortho revenues

BONES buys in first, then others later (at higher price)

All BONES docs get Medical Director fees “… help make up for that money we won’t get from

Happy Valley surgery center . . .”

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Hypo #2: Threshold Questions

What laws do RMC and BONES need to worry about? Stark? AKS? Tax exemption? Antitrust/unfair competition

And is this really a “joint venture” (and does that matter)?

And again, the issue of who’s representing whom . . . .

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Hypo #2: Stark/AKS Issues

Multiple layers:Start-up capital/valuation issuesCompensation arrangement/valuation issuesCommercial reasonableness of services (i.e.,

“real” management) Incentive targets

Are the Stark and AKS analyses different?

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Hypo #2: Stark/AKS Issues

Funding start-up costs Entity formed only to provide management services – is

that the same as a “full-service” joint venture? If not, why can’t hospital fund all of it (since hospital bears

all costs of management under status quo)? Incentive comp targets

How set? Can you take into account revenue growth? A proxy for

revenue growth? And what happens when all the benchmarks are met?

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Hypo #2: Stark/AKS Issues

Medical director servicesHow does co-management arrangement affect

“traditional” medical director services?Who can get compensated?

Participating physiciansWho can be included? Who must be included?Can you use “differential pricing”? What laws

should you worry about?

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Hypo #2: Governance Issues

Structure and governance of co-management entity

Refer to Hypo #1; are there different considerations here?

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Hypo #2: Other Issues

Tax exemption laws Antitrust/unfair competition Securities laws . . . And counsel must be conscious of

where the parties’ interests differ and converge

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Questions?