WHAT DOES THE RESEARCH SAY ABOUT HOSPITAL TAX STATUS CONVERSIONS?

Cain Brothers, September 6, 2002

Is It Okay to Think the Unthinkable?
Hospital Tax Status Conversions

A Guide for Health Care Executives and Trustees



S O L U T I O N S T H R O U G H F I N A N C I A L I N N O V A T I O N



TABLE OF CONTENTS PAGE

EXECUTIVE SUMMARY 1
INTRODUCTION 1
IMPACT OF CONVERSION TO FOR-PROFIT STATUS 2
Impact on Vital Community Missions 2
Characteristics of Nonprofit versus For-Profit Hospitals 4
HOW FOR-PROFIT CONVERSIONS LIVE UP TO EXPECTATIONS 6
1 - Improved Financial Performance 6
2 - Increased Efficiency (Superior Management) 10
3 - Defensive Strategies that Maintain Independence 11
4 - Inappropriately Promote Self Interest 11
5 - Preserve Culture 12
6 - Implement a Strategy Change through a Foundation 13

THE FOR-PROFIT / NONPROFIT LANDSCAPE 15
Fiduciary Duty 15
Change of Control Transaction Structures 17
Conversion Numbers 19
Valuation 22
"Trustworthiness" 23
Proactive or Reactive Sale 24





TABLES PAGE
1 Number of Foundations Created from Hospital Conversions 14
2 Hospital Mergers and Acquisitions 1998-2001 20
3 Proportion of Hospital Transactions, Comparison of Conversion Types 21




EXECUTIVE SUMMARY Is it okay to think about selling your hospital or health system and converting its tax status to for-profit? If you are a trustee, it is your duty to use nonprofit assets to best meet the mission laid out in the organization's charitable trust. Fulfilling that duty can arguably include periodically considering the pros and cons of selling. Medical care policy researchers and writers have studied the implications of converting health care provider tax status from nonprofit to for-profit, and their conclusions are reassuring. The research indicates that for most community hospitals, measurements such as the provision of indigent care and emergency room visits are not harmed by an asset sale to a for-profit operator. In many cases, especially those that involve hospitals that are underperforming or capital-constrained, missions actually benefit from a sale to a stronger organization. The conversion of tax status in a sale transaction can transform a hospital into a grant-making organization through the establishment of an endowment from the net proceeds of the sale. Grant-making activities can then fulfill otherwise unmet community health care needs, while the hospital continues in its traditional role of providing acute care services. Researchers have also found that prices paid for nonprofits by for-profits have been fair. Cain Brothers' experience is that continued nonprofit ownership will be the best decision for many situations, and sale to an investor-owned organization will be the best decision in other cases. In any case, trustees who are more knowledge-able about the experience under a variety of ownership models before making that decision will be better prepared to meet their fiduciary responsibility.


INTRODUCTION Between 1970 and 1995, 7% of nonprofit hospitals nationwide converted* from nonprofit to for-profit status. The distribution of hospital beds by ownership has remained markedly stable. In 1994, as in 1984, about 70 percent of all beds were nonprofit, 20 percent were public, and 10 percent were for-profit. These new for-profit hospitals can remain an important resource for their communities with operations that are often indistinguishable from those of similar neighboring nonprofit hospitals even though for-profit managers owe their first fiduciary duty to generating returns on the investments of their shareholders, not to the mission to the community.

After several years of consolidation and selective divestiture, investor-owned, for-profit hospital companies are once again interested in acquiring new nonprofit hospitals. Some nonprofit health systems have also been purchasers of other nonprofits. Stewardship of community interests in nonprofit hospitals is a bedrock of the United States health care system, and trustees and executives of nonprofit hospitals have a fiduciary duty to act in the best interests of the charitable trust as set forth when the hospital gained its nonprofit status. Leaders of nonprofit hospitals therefore need to understand the implications of possibly converting their tax status from nonprofit to for-profit. In the coming months and years, we expect that many nonprofit hospitals will be presented with opportunities to sell their hospitals to both for-profit and nonprofit owners and generate significant endowment funds that can benefit health care in their communities in the future. Some nonprofit hospitals will identify joint venture alternatives that can allow capital investment to strengthen the organization in ways otherwise not possible. Still others will face desperate financial circumstances and need to consider whether a sale provides advantages for keeping some hospital presence and jobs in the community. In all of these cases, leaders will be faced with one of the most difficult of all decisions: TO SELL OR NOT TO SELL COMMUNITY ASSETS.

This Strategies in Capital Finance white paper provides a framework for those facing these kinds of decisions. Fortunately, a considerable amount of research is now available that evaluates the results of hospital conversions over the past twenty years. With this information in hand, decision-makers will be better prepared to consider their own alternatives.

There is no one-size-fits-all answer to the question of what is the health system's best alternative. There is also no magic substitute for the difficult leadership process of carefully weighing all the circumstances for an individual organization. Continued nonprofit ownership will undoubtedly be the best decision for many hospitals. But, we have also seen many circumstances where trustees and managers of nonprofit hospitals have dissipated precious resources that could have otherwise been made available from the net proceeds of a sale at an early stage to meet health care needs in the community.

By law, the fiduciary duty of nonprofit trustees is not to perpetuate their current organization in its current form. Rather, it is to consider how to use the assets of the organization to best meet the health care needs of the community consistent with the charitable trust of their organization. If alternative models of ownership allow a hospital to better meet its charitable mission, trustees arguably have a duty to periodically consider the pros and cons of those models. This consideration should not be based on rhetoric or emotional attachment to a particular model of health care delivery, but rather based on the best available information matched to particular circumstances. This paper will provide the starting point for that consideration.


IMPACT OF CONVERSION TO FOR-PROFIT STATUS

IMPACT ON VITAL COMMUNITY MISSIONS

While some sales of nonprofit hospitals to for-profit owners anticipate that the property will be converted to other non-hospital use after the sale, the vast majority of transactions are concluded with the expectation that the acute care hospital will continue to operate in its community after the sale. Trustees, therefore, often start the analysis of their options by trying to understand whether there is likely to be an impact on mission if a sale takes place. Trustees cannot evaluate the pros and cons of this decision without some perspective on the likely impact of for-profit conversion on those community missions.


Jack Hadley and his colleagues studied whether converting hospitals were likely to reduce community access to important services. They concluded that "…there were no statistically significant differences between converting hospitals and similar control hospitals in either the percentage changes in births or emergency room visits, both before and after conversion…With very few exceptions, the fixed-period (1993-1996) comparisons found almost no difference either between the conversion hospitals and the set of control hospitals, or between the neighbors of the conversion hospitals and the neighbors of the set of control hospitals."

Frank Sloan and colleagues also looked at changes with conversion and found increased likelihood of providing special medical services and MRI with conversion and decreased likelihood of providing open-heart surgery. They concluded: "In sum, conversions resulted in a mixed pattern of adoption of services. Judging from the empirical evidence, it would be inappropriate to attribute much of the change in service offerings or value to a particular type of change in ownership status."

Mark McClellan and Douglas Staiger compared quality across the two sectors by examining mortality from acute myocardial infarction. "On average, we find that for-profit hospitals have higher mortality among elderly patients with heart disease, and that this difference has grown over the last decade. However, much of the difference appears to be associated with the location of for-profit hospitals. When we compare hospital quality within specific markets, for-profit ownership appears, if anything, to be associated with better quality care… Overall these results suggest that factors other than for-profit status per se may be the main determinants of quality of care in hospitals."

David Cutler and Jill Horwitz summarize this type of finding from their research. "…[W]e find no evidence that for-profit hospitals reduce quality or cut back on access to the poor, although our measures of these effects are admittedly crude." Other similar summaries include Sara Collins and colleagues: "In broad terms, researchers have found that conversions have had little impact on uncompensated care and other types of community benefit activities."

The good news for decision-makers considering a conversion opportunity is that after two decades of conversion activity, there is increasing evidence that many hospital conversions can move forward without fear that the model itself will destroy vital community services and mission commitment to the uninsured.

The research makes a distinction, however, between different types of hospitals. Research findings on the mission impact from conversion of nonprofit hospitals that have a disproportionate share of "public good" services such as uncompensated care is more mixed. Since few hospitals with a predominant research and teaching mission have converted, it is also premature to draw conclusions on the impact of conversion in these areas.


Jack Needleman and colleagues articulate this distinction for uncompensated care (charges to bad debt and charity care divided by total charges): "Among hospitals whose provision of uncompensated care is low, the risk to mission following conversion also is low. But among hospitals that sustain greater rates of uncompensated care, the risk of reduction following conversion to for-profit status is greater." They support this conclusion with a finding that public hospitals in Florida that have provided a historic safety net "greatly reduced their rates of uncompensated care following conversion."

Bradford Gray summarizes the results of recent literature on this topic: "To broadly generalize across studies... there are similar levels of uncompensated care where need is low, but different levels and different geographic patterns of ownership where the need is high. There are large sectoral differences in organizational involvement in educational and research activities, which contain an element of public good. There are similar levels of quality in hospitals (where normative pressures from physicians are strong), but there are differences in nursing homes…and perhaps, in HMOs."

Researchers have suggested that these different characteristics of for-profit and nonprofit hospitals may mean that hospitals with heavy research and teaching missions (academic health centers or "AHCs") should approach conversion with open eyes. Collins and colleagues cited the experience of two hospitals, including Chicago teaching and research hospital, Michael Reese Hospital, and noted, "…[T]here was evidence of a decline in teaching and research and care to the uninsured in years since conversion." David Blumenthal and Joel Weissman, on the other hand, presented case studies of the impact of conversion on teaching hospitals and concluded, "We detected no measurable adverse effect of change in ownership on the social missions of the three AHC hospitals."

While the jury is perhaps still out for conversions of hospitals with heavy public good burdens, there are positive ways to address concerns. Trustees and managers considering conversion will need to pay particular attention to understanding their missions and determining options to preserve essential mission either through negotiation of transaction terms or identification of other resources that may be focused on these missions after the sale.

CHARACTERISTICS OF NONPROFIT VERSUS FOR-PROFIT HOSPITALS

330 hospitals converted from nonprofit to for-profit between 1970 and 1995 totaling about 7 percent of nonprofit hospitals converting nationwide. There are large geographic variations in conversions, which have made conversions an important factor in some locations and rare exception in others.

Needleman and colleagues studied converting hospitals in Florida and concluded, "Converting hospitals were different from noncoverting hospitals of the same type… specifically… converting hospitals were smaller than their nonconverting counterparts, they were less likely to have a medical school affiliation, and they were more likely to be located in a nonmetropolitan area."

Hadley and colleagues found that hospitals were more likely to convert if they were located in a state with more for-profit hospitals, located in a county with more HMO enrollment, located in a county with higher population change during the prior five years, were part of a chain or had contract management, or had open heart surgery. They also found lower probability of conversion with lower per capita income, lower number of beds, transplant capability, and level two or three obstetrics.

Tami Mark concluded, "Descriptive statistics indicate that hospitals that convert are more likely to have experienced a financial loss prior to conversion than the average hospital. Eighty percent of the profit margins of nonprofit hospitals that converted to for-profit status were negative in the two years before they converted. Similarly, 50 percent of the profit margins of for-profit hospitals that converted to nonprofit status were negative in the two years prior to their conversion. In comparison, over the same time period only 33 percent of all private acute care hospitals had negative margins."

William Gentry and John Penrod also note a difference in financial performance between the two groups: "…FP [for-profit] hospitals are more profitable than NFP [nonprofit] hospitals. Relative to the NFP hospitals, the FP hospitals have $1.3 million more in net income, a 5.4 percentage point higher return on assets, a 15 percentage point higher return on fixed assets, and a 7.9 percentage point higher operating margin." They conclude that "…FP are more capital intensive than NFP hospitals: On average, relative to NFP hospitals, the FP hospitals have 0.6 fewer employees per bed, 0.06 higher fixed asset to revenue ratios, $838 more fixed assets per discharge, and 0.023 higher capital cost as a fraction of total costs." Gary Claxton and colleagues report that "Prices charged by nonprofit hospitals are generally lower than those charged by for-profit counterparts for similar services."

There are clear differences between converting and nonconverting hospitals and we should therefore not be surprised that there are differences between the overall characteristics of all nonprofit and for-profit hospitals. For-profits are more likely to be located in certain regions and in more suburban locations, and, although they have similar costs, they earn higher profits through higher payment rates. As a group, for-profit hospitals deliver less uncompensated care and community benefits. But, Needleman and colleagues help put one important reason for these differences into perspective: "Converting nonprofit hospitals do not look like the average nonprofit hospital. Instead, for-profit companies appear to select nonprofit hospitals that resemble other for-profit hospitals. If this is true nationwide, then the conversion of nonprofit hospitals may have much less impact on mission than has been generally supposed."



HOW FOR-PROFIT CONVERSIONS LIVE UP TO EXPECTATIONS

If they are to meet their stewardship responsibility, trustees considering conversion must go beyond satisfying themselves that for-profit operations provide a reasonable way to provide quality of care and access for low-income patients. Trustees need to be convinced that a conversion will be a better way to meet their fiduciary responsibility than other alternatives. To assist that analysis, we next outline the reasons hospitals convert and summarize the research on the reasonableness of those expectations.

Cutler and Horwitz outline those expectations: "Our case studies suggest two principal factors driving hospital conversions. The first is financial considerations. While profits are certainly important, financial considerations are not limited to concerns about profitability. Having a large debt load and gaining access to cheaper sources of capital are also important in conversion decisions. Second, we find that the culture of the not-for-profit hospital influences the conversion decision. Both of our case study institutions had boards of directors consisting primarily of businessmen, many of whom believed they were ill trained to run a major hospital. Businessmen may also be more tolerant of the for-profit ownership form than people with a more religious or not-for-profit orientation."

Cutler and Horwitz frame the reasons for conversion into six explanations. We will use a modified version of this framework to summarize the literature on those reasons below.

1. IMPROVED FINANCIAL PERFORMANCE
One of the leading reasons for conversion is an expectation that the for-profit model will lead to improved financial viability for the hospital. Cutler and Horwitz identify three specific aspects of improved financial performance, which we will examine separately.

a) Greater Access to Capital
James Fishman identified easier access to capital as "…the fundamental reason for health care providers' moves to for-profit status…" Many other researchers have also identified access to capital as a leading reason for conversion to a for-profit model. Nonprofit hospital trustees who are frustrated by the difficulty of gaining access to capital markets may look to a conversion as a way to bring investments in necessary facilities and programs to their communities.

Sloan and colleagues found that "Eight of the 10 transactions included an explicit commitment to invest in the hospital…with the exception of one hospital, every facility had either undertaken investment or had explicit plans to do so at the time the interviews were conducted." Cutler and Horwitz also found an ability of for-profits to provide capital not done under the nonprofit model. James Robinson is more skeptical. "…[T]here are no capital-market advantages to for-profit conversion…"
Perhaps these views can be reconciled by understanding the differences between typical nonprofit and for-profit capital structures. Different capital structures that could make for-profit hospitals more likely to invest capital in areas where they believe there will be demand and innovate as the market changes, may also make it more likely those for-profit hospitals will curtail investment or sell the hospital if performance is not up to par. Even if there may not be a capital markets advantage, purchasers almost always have greater financial strength and resources to bring to the converting not-for-profit.

Lifepoint, for example, is a public for-profit hospital company that was created by a spin-off of 23 non-urban hospitals from HCA in 1999. Lifepoint projects significant capital expenditures of $65 million in 2002 in those hospitals, which is about double the 1998 to 2000 level. Many of these hospitals would have found it difficult to make this level of capital investment if they operated on a stand-alone nonprofit basis. But, this example also illustrates that the capital investment level in the for-profit sector is influenced by expectations of return. The capital investment for these same hospitals had been significantly lower under the previous for-profit owner, HCA. By focusing its operating strategy on generating a return from stand-alone nonurban hospitals, it makes sense for Lifepoint to invest capital in hospitals that may not have had the same potential for return under HCA's operating strategy.

Nonprofit trustees considering conversion should remember that capital access from for-profit hospital companies will be best assured when it can generate a return consistent with the purchaser's strategy. Purchasers may be willing to guarantee capital investments in the hospital after conversion that don't meet this hurdle when they are consistent with an overall strategy (such as entering a geographic area or market segment like academic medical centers), but common sense dictates that long-term viability of a hospital's access to capital under both the for-profit and nonprofit model must be driven by its ability to generate a reasonable return on the investment.

b) Higher Profits
If long-term access to capital requires a return on that investment, expectations for improved financial performance after conversion could hinge on whether conversion can improve margins and profits. Researchers have reported that profits do increase following conversion. "…[T]he only known study to examine the effect of hospital conversions on financial performance were the case studies conducted by Mark and colleagues…[They] found that six of eight hospitals that converted had higher profit margins after converting." And, also, "Those NFP [nonprofit] facilities that converted to for-profit experienced an increase in their profit rate (5.6 percent)."

When profits increase after conversion, the improvement is much more likely to be attributed to improvements in revenue generation than to expense control. Adding new services to the hospital, increasing reimbursement from managed care and government payors, implementing better collection of accounts receivable, and increasing patient charges for services are all cited as approaches for-profit hospital companies use to increase profits.
Some of the revenue generated by for-profit owners of hospitals must be used to pay taxes. Uwe Reinhardt identified that for-profits need to generate between 4% and 7% more revenue through price increases to pay income taxes, assuming no other changes in operations were made. Sloan and colleagues found that "One mechanism stated for improving financial viability was to increase bargaining power with managed care organizations." Gary Young and Kamal Desai summarized pricing: "Although some evidence from the state-specific analysis suggests that conversion leads to faster price growth in the short-term, in the long-term the direction of this price effect appears to reverse itself in favor of potentially lower prices over time."

There can be legitimate policy discussion about the benefits and costs of increased hospital revenue that comes from price increases, negotiating clout, and efficient collection of amounts due. Unfortunately, some researchers have also identified some more questionable sources of increased revenue.

Cutler and Horwitz identified a dramatic increase in profits after conversion of Wesley Medical Center in Kansas from nonprofit to for-profit ownership under Columbia/HCA. "While we do not have definitive data on why this [increase in profits] occurred, we suspect Columbia-Wesley increased reimbursements by effectively exploiting common Medicare loopholes." Collins attributed an improved profit margin at Metropolitan General Hospital, Pinellas Park, Florida to revenue from a Medicaid substance abuse program with many out-of-state patients that ultimately resulted in a fraud investigation and scandal.

Neither for-profit nor nonprofit managers should be criticized for seeking legitimate ways to collect the revenues owed to their organizations, but there have been some abuses in the past. In 1999, HCA pleaded guilty to defrauding government health care programs and paid large criminal fines, civil penalties and damages to put the charges behind them. The public hospital companies that are emerging from this period have refocused their operations and the priority of compliance to avoid a repetition of those events. Government oversight will also continue to monitor this important area.

c) Relief from Unmanageable Debt Service
Low profits that constrain cash flow can result in poor access to capital. When this makes it impossible for a hospital to keep up with community needs for modern plant and equipment, a negative spiral of financial distress often results. Trustees and managers of nonprofit hospitals may tolerate these circumstances for many years, but when debt service payments are at risk, they will need to consider alternatives.

Purchasers can step in, acquire the hospital's assets, relieve the hospital's debt service burdens, and invest in postponed capital expenditures. If debt service obligations are higher than the value purchasers are willing to pay for the hospital, bankruptcy or debt restructuring accompanying the sale may be the only options to create an ongoing hospital organization freed of unmanageable debt burdens. In some cases, for-profit operators of the hospital are expected to generate a higher level of profits and cash flow than the nonprofit hospital has been able to do. This improved performance is then expected to provide for sufficient cash flow for debt service payments in the short run and to allow for needed capital investments in the longer run.

Research shows that conversions can relieve debt burdens. Cutler and Horwitz found that for-profits "…relieve debt burdens which not-for-profit hospitals could not otherwise do." In a case study on five nonprofit to for-profit hospital conversions, Sloan and colleagues judged that in two of the five, the conversion had an effect of helping to avoid threatened closure. One hospital, Hilton Head, had already defaulted on bonds. In a previous white paper (Cain Brothers' "Lessons From a Health Care Bankruptcy: South Fulton Medical Center," July 2001, Vol. 34), we presented the case study of a hospital that fell into bankruptcy, but is now able to continue serving its community following a sale to Tenet.

Inability to meet debt service is usually the result of a whole series of financial issues. The Healthcare Advisory Board described a financial "flashpoint" for hospitals that experience a 5% or greater drop in overall margin over two years or less, negative total margin, and less than 30 days cash on hand. They identified 60 hospitals that experienced such financial distress and stated, "The damage wrought by most financial crises should not be overstated; news stories withstanding, very few institutions are pushed to bankruptcy or closure by financial flashpoints, and most fully recover margins within 2-3 years." But, fully 45% of these hospitals were sold into larger systems and in 19% of the cases the entity was broken up and the pieces sold.

Financial distress can be an important cause of for-profit conversion. This fact is illustrated by Collins and colleagues: "Finally, conversion resulted in the creation of charitable foundations in just three of our eight cases since most of the hospitals were in such poor shape that their sale price was largely comprised of the assumption of the hospital's debt." Of the eight hospitals, two flourished and four were subsequently closed following conversion.

Unfortunately, health policy researchers examining the results of for-profit conversion of distressed hospitals have emphasized the issues of closure, subsequent sale, and absence of net assets available to serve community missions that characterize these conversions. If creditors can be fully or partially repaid as a result of a sale in amounts that would not otherwise have been possible, the sale will represent a valuable societal benefit from the conversion. Just as trustees need to expand their stewardship responsibility to include repayment to creditors in time of financial distress, health policy researchers need to consider designing research to better understand how this piece impacts health care services.

More recently, Silvers has put this history into a broader societal perspective, "Interestingly, the last acquisition cycle in hospitals had the effect of preserving massive amounts of community capital that otherwise might have disappeared through the losses of the marginal not-for-profit facilities acquired by for-profits. In fact, many were ultimately closed as their underlying weakness became apparent to the new owners. Fortunately, the cash paid was safe in conversion foundations formed to accept the payment from for-profit chains that acquired them in their drive for growth in earnings. The culling of poor performers and the preservation of invested capital for other social uses are somewhat surprising benefits from the speculative role of private equity capital in this sector."


2. INCREASED EFFICIENCY (SUPERIOR MANAGEMENT)
Productivity efficiencies might be expected from a horizontal integration strategy when a for-profit hospital management company purchases a small hospital. The larger acquirer can bring economies of scale in specialized management talent, supply purchasing and technology investment to bear for the benefit of the smaller hospitals. Many of these same advantages, however, may be available from a similar merger or sale with a larger nonprofit system.

There are opportunities to achieve efficiency benefits through economies of scale. Heather Spang and colleagues state, "…[two studies] provide compelling evidence that horizontal mergers under certain circumstances hold potential for beneficial cost and price effects. However, our results suggest that merger-related savings are likely to be smaller than originally anticipated."

Some expect, however, that a for-profit hospital will be more efficient and productive than the same hospital operating in a nonprofit mode regardless of size. They believe that the incentives of the for-profit model are more likely to result in superior management and more efficient execution of operating strategy. Access to better management talent and the ability to enter and exit markets is expected to result in improved profits and operations. Cutler and Horwitz state: "For-profit hospitals are likely to be better at maximizing shareholder value than not-for-profit hospitals are at maximizing operating surpluses." And, "…we find some efficiencies associated with conversion to for-profit form. For-profit hospitals cut costs when not-for-profit hospitals cannot do so."

Others do not agree with this conclusion. Collins and colleagues state, "In six of our eight cases, sale to a for-profit owner failed as a permanent solution to the financial decline of the hospitals. Although benefits of the purchasers' managerial expertise and access to capital were clear for the one sole community provider in our sample, they did not materialize for most hospitals in over-bedded suburban or urban markets….The hospitals purchased by systems in those environments tended to have high turnover among administrators and were more likely to undergo subsequent mergers or sales than were hospitals purchased by individual investors."

Clearly, superior management is not associated with one model of hospital organization. Examples of superior management performance exist in the for-profit and nonprofit hospital worlds. We have, however, seen compelling case studies where a for-profit conversion has significantly improved hospital operations in ways the nonprofit hospital could not seem to do. Recent positive financial performance in the for-profit sector can be contrasted with the more mixed financial performance of nonprofit hospitals. We hope that future research will carefully examine this issue to identify the role that governance and incentives play in these results.


3. DEFENSIVE STRATEGIES THAT MAINTAIN INDEPENDENCE
Nonprofit hospitals always have a history. While all nonprofit hospitals are rooted in a charter that serves a community mission, that history may include differences in culture, religious affiliation, academic status, and socioeconomic orientation. Often these differences have created a climate of competition with neighboring nonprofit hospitals, differences in cultural perspective on community mission for hospital services, and, in some cases, active mistrust of neighboring nonprofit hospitals.

When one nonprofit hospital sees its mission as creating an integrated delivery system by merging with other nonprofit hospitals it does not necessarily follow that the target hospitals will agree that such an "opportunity" represents their best course for meeting their fiduciary responsibility. Merger activity, negotiations with managed care organizations, and capital investments that create competing services can all put a nonprofit hospital in a defensive position. In these circumstances, nonprofit trustees may see the for-profit conversion as a preferred means to meet their charitable trust responsibility by sustaining an independent hospital in their community.

While it seems quite obvious that these cultural and defensive strategies influence conversion decisions, there is little research that explicitly examines the impact of these "softer" factors on for-profit conversion.

4. INAPPROPRIATELY PROMOTE SELF-INTEREST
Nonprofit trustees and managers must make decisions that benefit the community mission of their organization. Those decisions should not be influenced by a desire to benefit an individual or for-profit corporation. Violation of this principle against private inurement has been a long-standing prohibition, but recent Internal Revenue Service regulations that have imposed excise tax sanctions against managers or board members have raised the penalties for misuse of charitable funds by tax-exempt organizations. These intermediate sanctions introduced in the Taxpayer Bill of Rights Act of 1996 apply to many transactions in the ongoing operations of tax-exempt organizations, but will also come into play in the case of sale.

Since imposition of these intermediate sanctions on individuals requires that they "knowingly and willingly" agree to the excess benefit transaction, "Hospitals employing good business practices - which include finding comparable compensation data, negotiating at arm's length, obtaining fair market value and documenting the process through board minutes and corporate compensation policies - should not fear IRS scrutiny, most experts said."
Starting in the mid-1990s, many states have also developed guidelines and regulatory efforts to attempt to manage the risk of self-interest in the conversion process. These efforts respond to public concerns that nonprofit boards cannot be completely trusted to meet this standard. Managers may be interested in obtaining job security through conversion, physicians may be interested in capital investments on favorable terms, and board members may be interested in consulting fees. There have been allegations of this kind of activity in some conversions. Regulatory oversight by the states has been identified as one public response to these concerns of these potential conflicts of interest, but there is enormous state-by-state variability in its implementation.

Trustees and managers need to be constantly aware that self-interest can never be a legitimate part of a merger or acquisition decision and they need to work with their state's legal and regulatory system to assure the public that they have met this standard.


5. PRESERVE CULTURE
Cultural considerations can be an important legitimate factor in the conversion decision. Because they are hard to measure and based on deeply-held beliefs, cultural constraints can also challenge trustees and managers trying to meet their stewardship responsibility. We believe that if decision-makers are aware of common cultural challenges they will be better prepared to sort through the inevitable judgments involved in this area.

Cutler and Horwitz's case studies identified business-friendly culture on the board as leading to comfort with the for-profit model. Regional culture also clearly contributes to differences in attitudes to conversion across the country.

Collins and colleagues identified a different aspect of culture as one of the reasons for conversion: "In half of our cases, the actions of physicians had a powerful influence on the ultimate decision by boards to sell to for-profit purchasers by thwarting other options that had been preferred by trustees. An overriding impulse among physicians was the desire to maintain their autonomy in institutions they had grown accustomed to." In some situations physicians may have cultural biases against a for-profit purchaser, but in others physicians may prefer a for-profit culture that they judge is more likely to view them as important customers of the hospital. Although we have identified this as a cultural issue, it may also be motivated by physician self-interest. In reality the two are hard to separate.

The Health Care Advisory Board description of financial flashpoints identifies yet another cultural perspective that may lead, although unwittingly, to conversion. "The most prevalent single cause of crisis-for both large health systems and stand-alone hospitals-is what the Advisory Board has termed a 'culture of conservatism'….While board intransigence underlies this conservatism in some cases, principal responsibility lies with the executive team

(not trustees) in approximately two-thirds of the cases in which this factor applied." When a conservative nonprofit culture leads to financial distress and that distress leads to conversion, conversion may be driven indirectly by culture.

Blumenthal and Weissman point to another variant of culture. University administrations in three case studies of Academic Health Centers (AHCs) chose for-profit options only after merger discussions with nonprofits broke down. "For the most part, the nonprofits were local competitors in overbedded markets and saw no advantage in upgrading rival institutions. They sought to close the AHC hospitals completely or demanded greater control than for-profits did over their clinical activities (including appointments of department chairs) which AHCs were not willing to cede." Perhaps surprisingly, the for-profit option in these cases was seen as providing a better way to preserve the academic culture so central to the mission of these hospitals.


6. IMPLEMENT A STRATEGY CHANGE THROUGH A FOUNDATION
The final reason for conversion is a strategy change whereby a hospital decides to get out of the business of acute care operations and create a foundation with the residual or net proceeds from the sale. Hospitals have become extremely complicated businesses because they combine high capital intensity, high labor intensity, and heavy regulation. A strategy change that puts hospital operations in the hands of a company with expertise in this area and establishes a foundation whereby trustees oversee the allocation of financial assets to community needs can be a reasonable response to these challenges.

Cutler and Horwitz named this reason for conversion as a "mission change." We have relabeled the final reason a strategy change because we believe it better captures the intent of many nonprofit trustees that select this strategy as a different way to fulfill their unchanged community mission. While many hospitals have successfully made this choice as shown below, trustees considering this option must start with an examination of the organizational mission as described in the charitable charter and bylaws. States vary widely in their process of oversight in this area so it is vital that organizations understand the particular local circumstances as they formulate options.

The Foundation Numbers
As of 2000, Grantmakers in Health, a nonprofit foundation that follows the endowment sector, identified $9.4 billion dollars in assets associated with 109 foundations created when hospitals or systems converted since 1973. While consistent data for the number of nonprofit to for-profit conversions during that period is not available, conversions resulting in creation of foundations still in existence in 2000 probably represent somewhat less than a quarter of all such conversions. The remaining three-quarters of hospital conversions during that period either used all net proceeds of the sale to repay debts, transferred the net proceeds of the sale to other nonprofit organizations (such as a university sponsor or local community government), or dispersed all the assets of a foundation that had been created.
Table 1 shows that 73% of these foundations were created after 1993, and an additional 14% were created from conversions in 1984 and 1985. The Grantmaker's data shows a spike in activity in 1995 and 1996, but a moderate level of continued activity through 1999, if we extrapolate for delays in reporting the information to the Grantmakers survey. 2000 appears to have returned to a lower level, but it is hard to get an accurate picture of that activity because of reporting delays.

Table 1. Number of Foundations Created from Hospital Conversions, by Year of Conversion. Reported in 2000.



















Source: Grantmakers in Health 2001 actual count of reported number of foundations through 2000 (solid bars). Cain Brothers extrapolation (light bar) increment to estimate reporting delay.

Protecting Charitable Missions

Nonprofit hospitals are obligated to use assets that have been entrusted to them by the public in ways that are consistent with the original intent of donors. When a nonprofit hospital is sold and a foundation set up to steward the net assets from that sale, the legal doctrine of cy pres (interpretation of original intent when literal fulfillment is illegal, impracticable, or impossible) will guide the mission of that charitable foundation. In these circumstances, it can allow a somewhat different use, but one that is as close to the original intent as possible. "The cy pres doctrine requires that the mission of a charitable foundation born of conversion be as closely related to the charity's original mission as possible." This legal doctrine should be used to evaluate the disposition of assets to a nonprofit foundation after conversion and to evaluate whether the mission of the newly formed foundation is consistent with that standard. There may be some alternatives to alter or broaden the original mission in forming a new foundation, but careful review and approval will be required that is dependent on each state's particulars.

Once the mission of the new foundation is determined, the formation of a board becomes the public's way to assure that mission is carried out. Trustees of nonprofit hospitals considering conversion often have a strong interest in seeing how those assets are used in the future. If the new foundation board is formed entirely from former hospital trustees, conflicts can arise. In addition, community leaders best qualified to guide the operations of a hospital may not be the individuals best qualified to oversee a grant-making foundations. To address these concerns, Nancy Kane states that the foundation board "…should consist of a majority of new, independent directors chosen because of their foundation or relevant health or community program expertise." Fishman suggests that "a majority of the trustees should not be affiliated with the former nonprofit or for-profit successor; and …in determining the foundation's mission, there should be some public input and representation on the board" See also "The Effects of Revenue Rule 98-15 on Joint Ventures" on page 18.

To facilitate this aspect of foundation independence, hospital trustees may want to engage separate legal counsel to represent the interests of the foundation during its formation.

THE FOR-PROFIT / NONPROFIT LANDSCAPE

FIDUCIARY DUTY

Many health policy writers consider nonprofit provider organizations as the historic basis of our nation's health care system. Fishman states, "from the time of the Elizabethan Statute of Uses, the promotion of health has been considered a charitable purpose, and in the United States, hospitals and other health care providers have always been tax exempt. Nonprofit hospitals seemed so much the symbol of charitable purpose that many states specifically granted them exemption from taxation." These tax preferences include the historic exemption from property taxes in many localities, exemption from sales taxes, exemption from paying income taxes on profits, access to borrowing using tax-exempt debt structures, and the ability to attract donations to the enterprise that are tax-deductible for the donor.

But, as nonprofit hospitals have changed in response to payment system changes and medical advances, they have come to look and act more like businesses. As nonprofit hospitals changed, they have retained many of their historic tax preferences, but the rationale for the exemption shifted. Rather than being linked with charity care exclusively, the Internal Revenue Service adopted a 'per se' rule of hospital exemption that embraced "…an entity engaged in the promotion of health for the benefit of the community such as indigents."

Critics of the current, more business-like operations of nonprofit hospitals have noted little difference between the operations of nonprofit and for-profit hospitals in some communities and cite this as a justification for removing the tax exemptions nonprofit hospitals currently enjoy. While operations may be similar, nonprofit and for-profit organizations provide very different legal models: "The core legal distinction between the for-profit and nonprofit forms is that only the former can distribute earnings (that is, revenues that exceed expenses) to individuals. Nonprofits must retain or eventually spend their earnings. For-profits can pass portions of their earnings to persons who invest equity capital in exchange for the prospect of financial reward." Managers and trustees of nonprofit organizations hold the fiduciary duty to act in a manner consistent with the community mission as defined in the organization's charter, while for-profit managers and directors owe their primary duty of loyalty to maximizing return on investment to the shareholders of the organization.

Practically speaking, this difference means that for-profit directors and managers can change the missions of their organizations dramatically. A sale or repositioning of mission can be enacted based on its being the best way to increase value to the shareholders over time. If the majority of a firm's shareholders are unhappy about these changes, they can assert their interests by throwing out the board of directors and voting for others who will carry out their preferred strategies, although in practice shareholder influence on directors is usually less direct.

Nonprofit trustees can also consider sale or repositioning, but with different constraints. "According to common law, the creation of a nonprofit organization with charitable or other social welfare purposes results in a charitable trust that is irrevocably dedicated to the organization's original mission. The organization's trustees are supposed to seek court approval if they wish to deviate from these purposes." Nonprofit trustees must therefore start by understanding the mission of their organization as stated in the charter and bylaws. Nonprofit trustees can then consider alternative organizational models that meet their stewardship responsibility. Under any of these alternative models, the net assets held in trust by the original hospital must be preserved to benefit the community, as defined in the charter and bylaws. Trustees who believe that those net assets can better serve the community through a change in mission will need to seek approval for those changes through state legal processes.

Both for-profit directors and nonprofit trustees share an additional fiduciary duty that is often overlooked. They are also charged with the duty of preserving the means to fulfill promises to creditors who have lent the organization money. This duty may seem remote when hospitals are financially sound, but it becomes important when organizations do not have adequate financial resources to meet all of their obligations, which in turn can lead to debt restructuring or bankruptcy.

Creditors understand that nonprofit hospital trustees and state attorneys general will often pay most attention to the community's needs for health services and jobs when a hospital is financially troubled. This situation will therefore force creditors onto the scene to represent their interests, and this can often lead to consideration of a sale to a for-profit organization. Not surprisingly, when sales are undertaken at this stage, there may be insufficient resources from the sale to repay all of the creditors, and, therefore, there are unlikely to be any residual financial resources available to form a foundation to benefit the community.


Trustees in these circumstances will need to balance the needs of their community with repaying creditors. Sale of distressed hospitals to for-profit companies can provide the highest net cash recoveries to creditors in many circumstances. That result should also be seen as a benefit to our health care system. Over the long-term, a financial system that gives creditors a high degree of assurance that they can recover their principal and interest payments is necessary to assure a reasonable cost of capital to the nonprofit health care system.
CHANGE OF CONTROL TRANSACTION STRUCTURES
Four models of hospital change of ownership have been identified using the framework outlined by Steven Hollis.


1) Sale to For-Profit
The most straightforward form of hospital conversion takes place when a nonprofit hospital sells all of its operating assets to a for-profit corporation. Fiduciary and legal principles that guide this transaction dictate that the sale of assets must be done at a price reflecting their fair market value. In addition, Fishman states, "federal and state laws require that the proceeds from the sale continue to be held in charitable trust and used for charitable purposes."

Hollis describes the process of a sale: The access to capital markets of for-profit owners provides cash payments for the nonprofit's assets often not available from potential nonprofit acquirers, although there have been notable cash purchases of nonprofits by other nonprofits. That cash can then be used to retire tax-exempt debt, liquidate all liabilities on the balance sheet and provide for such items as Medicare Cost Report, pension, and malpractice tail liability. Any residual net assets can then be made available through a community endowment to meet the community mission as defined in the organizational charter and bylaws. This is often done through formation of a nonprofit foundation dedicated to investing and distributing those assets and earnings.

2) Joint Venture with For-Profit

Joint venture models of conversion have evolved to meet reservations about the 100% asset sale model above. Most often joint venture models are aimed at retaining some control over the ongoing hospital organization after the sale. The roots of the joint venture model are in the Columbia/HCA and Winter Park Memorial Hospital Florida transaction in 1994. In 1995, HCA did 18 of its 41 purchases as joint ventures. In 1996, nine of its 15 purchases were joint ventures. Other investor-owned hospital management companies also did many joint ventures.
Joint venture transactions vary, but Hollis describes the basics. A for-profit and nonprofit organization "…create a new taxable entity, such as a partnership or limited liability corporation, that will be jointly owned. The not-for-profit contributes the hospital to this new joint venture in return for a payment equal to the agreed-upon percentage of value at which the not-for-profit is willing to sell." These percentages of ownership typically have ranged from 50-50 to 20-80. In this model the nonprofit can retain some ongoing control over continuing operations and economic exposure to those operations.

Further complication can result when payment to the nonprofit from the for-profit comes in the form of stock rather than cash. This form of payment usually means more future performance risk for the nonprofit holding the stock, because the stock may represent the bulk of the foundation's assets and be too concentrated. While this challenge has more often been a large (and often controversial) part of HMO conversion transactions, it also needs to be kept in mind as a source of risk and opportunity for hospital conversions.

Typically, for-profit companies expect considerable latitude in directing operations of the continuing hospital. The Internal Revenue Service has questioned whether some of these arrangements are consistent with continued tax-exempt treatment of the nonprofit share of the joint venture. See the adjacent comments on Revenue Rule 98-15. While the IRS has supplied guidelines, careful planning should be involved in constructing joint venture arrangements, because the guidelines are not black and white.

3) Sale to Nonprofit

One nonprofit hospital can sell its assets to another nonprofit hospital or system. In this case, the assets will stay under the control of a charity and tax status will not change. Historically this type of transaction has been relatively infrequent because neighboring hospitals often did not have sufficient cash to meet fair market offers possible from for-profit companies. The formation of integrated systems in some areas may make this a more viable alternative. The most recent prominent example of this kind of transaction was Ascension Health's purchase of Nashville's Baptist Health System, which created an initial foundation in excess of $100 million. In this kind of sale, fair market value of assets should be the standard, although state attorney general oversight is not generally mandatory.

Recent research by Paul Gertler and Jennifer Kuan suggested that nonprofit hospitals that sell to other nonprofit hospitals or systems may receive a lower price than if the purchaser was for-profit. The researchers explained their finding of a 43% discount to nonprofit purchasers: "One possibility is that nonprofits and government sellers offer discounts to sellers that they believe are more likely to continue non-contractible mission objectives such as not performing abortions, keeping an emergency room open, or treating indigent patients." Nonprofit trustees evaluating alternative purchasers of their hospital should not make their decision based on price alone - mission differences can be important differentiators among purchasers. On the other hand, trustees who accept significant discounts from market price when they sell their hospital should clearly understand the fiduciary tradeoffs they are making.

4) Merger into Nonprofit

Most nonprofit /nonprofit transactions between hospitals take the form of a merger of assets or substitution of membership rather than a sale of assets. Hollis describes the motivation for this transaction. "A hospital board, in choosing this path, opts to pass the ultimate stewardship of the community's assets to a new not-for-profit entity, which it deems better equipped to address the managed care marketplace."

Mergers of this type can occur with neighboring local, regional, or national hospitals and health systems. Issues of management succession, board rivalries and antitrust need to be addressed in these mergers. When the merger is into a system, the merging hospital must often also work through perceptions of paternalism and potential for fiduciary conflicts from transfer of assets from one community to another.

THE CONVERSION NUMBERS

The number of hospital conversions from nonprofit to for-profit ownership is surprisingly hard to pinpoint. Many researchers have started with data from ownership status listed by the American Hospital Association. Some studies have adjusted the numbers through a crosscheck on trade sources. Each study uses different groupings of years, and most do not extend to the current time period. Despite these difficulties, there are important trends over time.

There were a few conversions each year before the 1980s. "In the early and particularly mid-1980s, conversion activity increased. There were 29 conversions in 1986 alone….[C]onversion activity slowed; [and] between 1988 and 1991 there were only 8 or 10 conversions a year." Conversions then increased again in the mid 1990s and dropped off dramatically after the fraud investigations of Columbia/HCA in 1997.

Geographically, conversions to for-profit status have been uneven across the country. "Conversions have been regionally concentrated: of 87 confirmed conversions that occurred between 1985 and 1994… more than 60 percent were in the Southeast." There has not been much conversion activity in the Northeast or Middle Atlantic. Florida, Texas, and California are all states that have experienced disproportionately large conversion activity.

Merger and acquisition activity during the last few years is unavailable from these sources. For this, we turn to a compilation of information from quarterly Irving Levin Associates Health Care Reports on Mergers and Acquisitions. The Irving Levin data is more recent and also allows us to track several types of merger and acquisition transactions in addition to the nonprofit to for-profit conversion. This data is generated based on the announcement (not completion) of the transaction, but, nonetheless, it provides some useful trend information about recent activities.

Irving Levin Associates' newsletter points out that mergers and acquisitions of hospitals go far beyond publicly held for-profit companies. "The hospital M&A market has seen the robust participation of nonprofit hospitals over the past five years, both as targets and acquirers. The two largest deals for 2001, in terms of announced price, involved two Catholic providers: Daughters of Charity Health System paid $403 million for seven of Catholic Healthcare West's hospitals and Ascension Health paid $341 million for the four hospitals of Baptist Health." With the exception of 2000 when Triad Hospital's acquisition of publicly traded Quorum Health Group shifted the numbers, Irving Levin Associates points out that "nonprofit hospitals accounted for 65% or better of the total number of facilities acquired" between 1997 and 2001.

To better understand the underlying activity, Cain Brothers analyzed the detailed data from the Irving Levin Associates reports. Table 2 shows that if mergers and acquisitions between different nonprofit hospitals are excluded, the number of transactions fell each year from a high in 1998. Although the downward trend in total number of these transactions continued through 2001, Table 2 shows that the numbers of nonprofit hospitals converting to for-profit began to increase again in 2001, after a decline following the turmoil of the late 1990s. Likewise, the top bar on Table 2 shows that the "portfolio trading" of for-profit hospitals among themselves slowed down in 2001.

Table 2. Hospital Mergers and Acquisitions 1998-2001



















Source: Irving Levin Associates, HealthCare M&A Report, compiled by Cain Brothers.

The Irving Levin data also illustrate an important point sometimes overlooked by nonprofit trustees: conversion does not always mean forever. Table 3 compares the proportion of hospitals converting into and out of for-profit status. From 1998 to 2000, there were more hospitals converting from for-profit to nonprofit than nonprofits converting to for-profit. This trend reflects HCA's downsizing and Tenet's restructuring during this period. In 2001, nonprofit to for-profit conversions predominated.

Table 3. Proportion of Hospital Transactions, Comparison of Conversion Types


Source: Irving Levin Associates, Health Care M&A Report, and Cain Brothers analysis.

This volatility is perhaps not surprising given the financial vulnerability of many of the converting nonprofit hospitals and the movement of deck chairs among investor-owned for-profit hospital companies. Collins and colleagues determined that, for most of the 87 nonprofit hospitals that converted between 1985 and 1994, the initial transaction was not the end of the story. Of those hospitals, 44% changed for-profit ownership at least one more time, 13% closed, 7% converted back to nonprofit status, and 3% changed their acute care mission. Excluding overlapping in the above categories, 60% of hospitals did at least one of the above.

This phenomenon and its implications for trustees considering conversion has been given surprisingly little attention in the health policy literature. Some trustees will take comfort from the experience of communities that were able to return their hospitals to nonprofit ownership when the community determined that model would be a better one. It is clear that recent history has not shown a clear trend toward either the for-profit or nonprofit model for hospital operation. We believe that the recent 2001 trends of more for-profit conversions combined with the results from health policy literature outlined in this paper may represent the beginning of a trend toward increased nonprofit conversion, but the jury is still out.

VALUATION

Much of the discussion of nonprofit to for-profit conversion centers on the question of valuation. Is the amount of money paid by the for-profit purchaser equal to the worth of those assets to the community? Nonprofit trustees have a fiduciary duty to be sure that the assets under their care go to benefit the public and not a private individual or firm. If the purchase price is too low, private parties can benefit in a sale to a for-profit organization.

Those raising the red flag about for-profit conversions have long focused on the difficulty of knowing whether proper value has been paid to the community. Kane reflects this view when she describes the size of foundation assets after conversion as "…substantial, [but] they may not accurately reflect the value of charitable assets converted." Patricia Butler describes the regulatory response to this challenge: "Consequently, the proposed purchase price should not be taken as the best measure of a nonprofit's value. Regulators should be encouraged to consider multiple approaches to valuation, including the value of assets (both tangible and intangible, such as trademark, reputation, provider contracts, subscriber lists, and general benefits to the community), multiples of earnings over several years, discounted cash flow, and future cash-flow projections that take changing market conditions into account."

Those advocating more stringent state attorney general regulation of the conversion process cite the difficulty of assessing comparable market value in these transactions with statements like "Valuation, then, rests upon the appraiser's craft, inherently a subjective process. The subjectivity of the valuation process is overlaid by the very human and economically rational behavior that the appraiser may use their discretion to serve the interests of those who hire them."

Recent research has not found evidence that for-profit firms are getting inappropriate windfalls through purchasing hospitals at values that are too low.

Sloan and colleagues studied ten cases in two states and found: "…the communities typically received more than a fair financial return on their assets when they transacted with a for-profit organization (in five out of seven such cases, the for-profit purchaser had returns below their own cost of capital)…our findings are consistent with a recent U.S. General Accounting office analysis of 14 not-for-profit hospital conversion to for-profit status in which it was found that most of the buyers had overpaid…"

Gertler and Kuan compared the sales prices of nonprofit hospitals with sales prices of for-profit hospitals. "We find that for-profit buyers pay the same price for nonprofit and government hospitals as they do for for-profit hospitals controlling for financial performance. We also find that nonprofits behave like efficient buyers in the market, not over-paying for for-profits…We find no evidence that nonprofits are sold to for-profits for too-low a price."


Blumenthal and Weissman give some context on market prices paid when they report, "Universities found that they could negotiate better prices and retain more academic control with investor-owned partners than they could with local nonprofits."

The "gold standard" for assuring that a fair price is received for the hospital's assets is to receive multiple comparable competitive bids through an auction process. A second method for determining fair value is through obtaining an appraisal or fairness opinion from an experienced firm that can use comparable value indicators to estimate the appropriate value of the proposed sale. In some states, an extensive regulatory review process including public disclosure and comment has been implemented to assure that trustees consider public interest in this process. While trustees will inevitably need to work within the regulatory constraints in their individual states, the ideal of obtaining both competitive bids and a fairness opinion should be a starting point.

When considering how to best meet their fiduciary responsibility, trustees will need to consider a variety of factors in the deal that are not necessarily captured in price. In some situations, trustees may determine that a negotiated transaction can best meet community needs. When a negotiated transaction (backed up by a fairness opinion) is determined to be a better course, trustees should be careful to assure themselves that they have obtained the best deal possible (incorporating price and other factors) and that there are no questions of private inurement.

"TRUSTWORTHINESS"

The question of for-profit hospital conversion is often clouded with emotional rhetoric. Health economists debate the value of the marketplace as a mechanism for both allocating resources and protecting vulnerable populations. Patients often depend on their physicians to make crucial decisions on their behalf rather than independently acting as consumers. In a post-Enron era, however, for-profit skeptics argue that it is not wise to put something as important as your mother's life into the hands of business people who have an incentive to gain individual wealth. In short, the red flag is about trustworthiness.

Those who advocate even-handed consideration of both the for-profit and nonprofit models for hospital ownership often start with the premise that the marketplace, with its mechanisms of supply and demand is an efficient way to allocate resources. They argue that these forces can result in for-profit hospitals developing quality, patient-friendly services because patients will demand them or go elsewhere. This argument posits that, in responding to the market needs of patients, for-profit operators may actually provide better patient care because they will be more willing to invest in technology, for example, that can improve access to services in the hospital community.

But, an efficient marketplace like this only works if the customers can effectively evaluate the quality and price tradeoffs in their health care providers and can make economically rational choices based on those evaluations. Those who worry about the for-profit model often point out that the health care purchasing decision, unlike the decision to purchase a car, is characterized by so-called information asymmetries (a concept first introduced by Kenneth J. Arrow in a 1963 essay).

Gray articulates this position. "Healthcare is characterized by serious informational asymmetries because of the vulnerabilities of patients and the use of third-party payment. Parties that are at an informational disadvantage must trust that their vulnerability will not be exploited." If patients don't have the access to all of the information they would need to evaluate the quality of services they are getting, then they may prefer to trust a nonprofit hospital rather than a for-profit hospital where the managers can be perceived as having an incentive to skimp on the quality that cannot be evaluated by the marketplace.

While trustees and managers considering hospital conversion will undoubtedly continue to weigh this kind of perspective, more recent scholarship points in other directions. One empirical study found no evidence of these information asymmetries by comparing valuations of nonprofit and for-profit nursing homes.

An entire issue of the Journal of Health Politics, Policy and Law was recently devoted to presenting current thinking on Arrow's ideas. In that journal, Robinson comments, "The most pernicious doctrine in health services research, the greatest impediment to clear thought and successful action, is that health care is different." Needleman also comments, "Arrow's 1963 essay led to the focused attention on issues of asymmetric information, agency, and trust in health care and other aspects of the economy. This in turn contributed to the development of a theory of nonprofits driven by consumer preferences. The data on the history of U.S. nonprofit hospitals and health plans does not support the conclusion that consumers prefer to purchase health services and insurance from nonprofits, but does leave open a role for preferences expressed through private donations and public policy that tilts toward nonprofit organizations."

PROACTIVE OR REACTIVE SALE

During the past twenty years, nonprofit trustees have had to consider options for their hospitals without the benefit of good research on the impact of conversion to guide their considerations. Many boards, therefore, have found it difficult to make the decision to go forward with the sale from a position of organizational strength. Collins describes this phenomenon for a sample of converting hospitals. "These incidents illustrate that the road to a for-profit conversion can be a long one, strewn with lost opportunities and the dashed desires of boards, medical staffs, and community leaders. In nearly all cases, serious financial problems appeared years before the conversion occurred and then festered as boards deliberated over remedies and then faced opposition in implementing their decisions. When for-profit owners finally purchased these institutions, the value of the charitable assets in most cases had dried up, many of the physical plants had suffered severe deterioration, and in many cases public confidence in the hospital's quality of care had eroded."

The fiduciary duty of nonprofit trustees and managers is not only to consider the best way to use their organizational assets to meet their charitable mission when hungry creditors are on the doorstep. Fiduciary duty can arguably also include consideration of how a for-profit sale would impact their charitable mission when the hospital is in a position of strength. Some hospital boards have indeed done this. Some have created sizable financial assets through a sale (both to for-profit and nonprofit organizations) that now serve their community missions through the new foundations.

The CEO and Board of Legacy Health System in Oregon undertook just this kind of analysis of whether the community mission would be better served by sale of the hospital to a for-profit hospital company. They did this analysis from a position of relative strength and considered the opportunity to dedicate net financial assets to the community through a foundation. Their conclusion was that in their circumstance the community was somewhat better off under the existing nonprofit structure, which they decided to retain. "Nevertheless, it is also important to note that the results of the analysis did not overwhelmingly favor ongoing operations and that changes to several key assumptions could tip the scales in favor of conversion." Legacy's approach provides both a model for considering factors in conversion and a positive alternative to waiting for desperate financial circumstances.

This kind of careful consideration from a position of strength, however, has not been the norm. Gray states, "I believe that some HMO conversions have proceeded out of strength and strategy and that hospital conversions have tended to occur out of fear, a choice from a list of unpleasant alternatives."

Many communities are more attached to their hospitals than their local HMOs. If a for-profit conversion is seen as "letting the devil in the door," it may be harder to consider unless circumstances are desperate. If nonprofit boards are able to review the current research that objectively evaluates the impact of for-profit conversion on community mission, however, they may determine that they can serve their communities better if they can consider for-profit conversion from a position of financial strength.

A single nonprofit hospital rooted in a local community may find it difficult to reposition the community capital in that hospital to other emerging health care areas as market circumstances change. Charitable trust laws and the cy pres doctrine can impose constraints. Profitable investments may not be available to that hospital, but the demand for capital investments may nevertheless seem insatiable. For-profit companies have a much greater ability to reposition their capital among different geographic areas and among the industry segments. This repositioning can be more responsive to changes in needs for services and in support of innovation within the health care sector.

Trustees who are able to step back from the nonprofit hospital-centric view of their responsibilities and consider their options within a broader industry perspective may be able to identify opportunities that bring needed health care innovation to their communities. That innovation will need to be rooted in the particular mission of each organization and reflective of the needs of local communities. Trustees who are armed with current information about the industry and use that information to generate a variety of options for their organizations will be better positioned to meet their stewardship responsibility. Even if nonprofit hospital trustees are firmly convinced that a for-profit sale is not in their best interests, thinking through the pros and cons of that option can help clarify mission objectives and serve as a benchmark for discussing value. That process can often lead to identification of innovative for-profit and nonprofit opportunities for the organization that would have otherwise been overlooked. This benefit makes it not only okay, but desirable, to think the unthinkable.




FOOTNOTES