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How to Convert a Nonprofit Hospital to a Physician Joint Venture

Joseph A. Sowell III and John C. Tishler, April 20, 2009

Over the last two years, a number of nonprofit hospitals have filed for bankruptcy protection. In some instances, those hospitals were able to reorganize successfully and in others, the hospital closed or its assets were sold to a proprietary hospital company or another nonprofit. In many instances, the nonprofit hospital could have been saved if hospital and physician incentives could have been aligned.

A whole hospital joint venture with physicians is perhaps the most powerful way to align incentives. In such a venture, the physician owners are incentivized not only to send patients to the hospital, but also to manage length of stay, pressure payers to provide attractive reimbursement, manage quality of care, and complete medical records in a timely manner. As a side note, at the present time, it is lawful for physicians to own an interest in a whole hospital. Legislation has, however, been introduced on a number of occasions to make it unlawful for a physician to own an interest in a hospital to which patients are refered. That legislation typically bans physician ownership of an interest in any hospital, not just a specialty hospital. All legislation that has been introduced includes some form of grandfathering provision. Many of these, however, restrict the hospital's ability to increase the number of physician owners and/or increase the services offered by the hospital.

Physicians as investors will supply capital to the enterprise. The nonprofit hospital can preserve all of the fundamental aspects of its mission. Numerous constituencies must be considered in the conversion of any nonprofit hospital, including the community, the physicians, hospital personnel, the board, and the hospital's creditors.

What to expect after you file for bankruptcy protection

Once a hospital files for bankruptcy protection, it will be subject to the jurisdiction of the bankruptcy court. Once a Chapter 11 bankruptcy case has been filed, the hospital will be subjected to heightened scrutiny from at least four constituencies, often with competing interests:

  1. The board of directors
  2. The United States Trustee's Office
  3. The secured creditors of the hospital
  4. A creditors' committee, appointed by the United States Trustee's Office for the benefit of unsecured creditors.

The Bankruptcy Code, as amended in 2005, also includes additional constituencies such as a patient ombudsman, and gives certain expanded rights to the community in which the hospital is located.

The principal objective of the creditor's committee is to obtain the largest possible recovery for the creditors. Typically, the bankruptcy trustee and the creditors' committees will consider either liquidating the assets for a cash purchase price and using the proceeds from that sale to discharge indebtedness or restructuring the existing debt and continuing operations of the hospital. The benefit of the liquidation approach is that the creditors receive a sum certain, even if that is only 10% of the debt. In the earlier stage of bankruptcy cases, the view is often that the recovery to creditors can be maximized by liquidating the assets prior to the expenses of the bankruptcy case that is eating into recovery. Liquidation gets another hard look late in cases where it appears to be the only viable option left after a reorganization has been thoroughly vetted and has failed.

Restructuring debt

Where the debt is restructured and the hospital reorganized, there is uncertainty as to the creditors' ultimate recovery. But typically there is a possibility of a greater recovery than what would be received upon a liquidation. A restructuring frequently returns 100% recovery to all constituents (although for unsecured and equity claimants, much of it may be taken in the form of equity or installment payments). The problem with restructuring the debt is that this does not address the fundamental underlying operational issues that contributed to the hospital's poor economic performance, and resulted in its inability to pay its debt. However, a conversion of the hospital to a physician-owned joint venture provides a framework in which a high return can be given to creditors and the fundamental operational problems can be addressed.

One hurdle in converting a nonprofit hospital to a physician-owned joint venture is that the tax-exempt debt of the hospital will become taxable upon the conversion. Since the holders of the bonds are typically the single largest secured creditor, and since the conversion of the hospital to a joint venture requires the approval of the secured creditors, the bondholders have to be convinced that their after-tax return—taking into account that the interest on the debt will now be taxable—will exceed the after-tax return they would receive from a liquidation or restructuring of the tax-exempt debt.

First steps in converting to a physician joint venture

Certainly the first step in determining the viability of a conversion to a physician joint venture is determining the level of physician interest and quantifying the impact that this might have on the economic performance of the hospital. There are a number of companies that can assist in making those determinations. If the initial analysis appears compelling, a new limited liability company will be formed to take over the operations of the hospital and units of ownership in the new limited liability company will be offered to physicians (and possibly unsecured creditors) through a private placement.

As part of the bankruptcy process, the nonprofit hospital will be able to discharge or reduce some portion of its indebtedness. The newly formed limited liability company will only become responsible for those obligations it agrees to assume. Additionally, since the newly formed limited liability company will become the employer of all of the hospital employees, there is an opportunity to revisit staffing and eliminate or revise union contracts. The same goes for vendor or supplier agreements. New vendors and suppliers can enter the process, while older ones could have their agreements rejected and may receive very little on their claims.

The offering of ownership interests to physicians must be structured to comply with federal and state laws governing securities offerings. Generally, an exemption from registering the securities should be available so long as units of ownership are not sold to more than 35 unaccredited investors in a single offering. Generally, an investor is accredited, either if he has a net worth of $1 million, excluding certain assets such as his home or automobile, or has annual income in the last two years of $200,000 or $300,000 jointly with a spouse, and expects that level of income to continue in the current year. Most physician specialists meet the accredited investor definition by virtue of their income level. The challenge is that primary care physicians, who are crucial to the success of the hospital, often are not accredited.

Care must be taken to ensure that the ownership mix, both in terms of ownership percentage and number of owners, is not unduly weighted toward specialists. In the event that more than 35 unaccredited investors wish to participate in an offering, a secondary offering can be conducted at any time after the first anniversary of the closing of the initial offering, and an additional 35 unaccredited investors can be sold interests in the secondary offering. The ownership interests sold in the secondary offering will have to be sold at the current fair market value, which may exceed the initial offering price. All offerings must be conducted pursuant to a private placement memorandum that provides investors with the information required under applicable securities laws and which includes all facts material to an investment. Typically, the private placement memorandum will include forecasts that provide examples of financial results. Because the financial results are so dependent on volumes, generally forecasts are prepared for several different volume levels.

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