How to Convert a Nonprofit Hospital to a Physician Joint Venture

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

Structuring a conversion

The nonprofit will generally retain complete discretion over whether to close the offering and proceed with the conversion of the hospital to a physician-owned joint venture. If the offering does not attract adequate capital or the right number and the right mix of physicians to make the project successful, the nonprofit would elect not to close the offering and would return any money raised from the investors.

There is no one right way to structure a nonprofit hospital conversion. All structures should, however, ensure:

• Sufficient capital for the capital expenditure needs of the operating entity
• Sufficient working capital to provide a long enough runway to turn around operations
• Significant input in governance by the physicians
• A tax-free stream of income to the nonprofit
• A commitment to make operational changes, including expense reductions, necessary for the joint venture to be successful.

To the extent the hospital had issues with regulators, those issues should be addressed also by the new management of the organization. Sometimes penalties and setoffs under Medicare and Medicaid programs can be ameliorated by the new managers through early contact with and a cooperative working attitude toward the intermediaries.

Operational control and tax-exempt status

Early Internal Revenue Service rulings seemed to state that a nonprofit entity could only retain its exemption in a hospital joint venture if it had absolute control over the governance of the entity. Subsequent court cases and rulings make it apparent, however, that absolute control is not necessary. Rather, what is necessary is for the nonprofit entity to have control over those items that are the cornerstone to its tax-exemption. Key items over which the nonprofit must have absolute control include charity care policies and community outreach.

It is not necessary for the nonprofit to have complete control over operational decisions, such as operating budgets, capital expenditures, and incurrence of debt, to maintain its tax-exempt status. As a practical matter, it will be difficult to attract physician participation unless the physicians have a significant voice in the operation of the hospital. Physician participation will be driven as much by the physicians' desire to have greater control over the environment in which they practice as the potential for economic return. Consequently, a typical structure would be for the joint venture to be owned equally by physician investors and the nonprofit entity. The physicians and the nonprofit would each have the right to appoint 50% of the joint ventures' governing body. Although, the nonprofit entity would have reserve powers that give it unilateral control over charity care and community outreach. Even though the nonprofit should be able to maintain its federal tax-exemption, it may lose its state and local property tax-exemption.

Working out the details of capital

The physicians and the hospital will each contribute their pro rata share of the necessary capital to the joint venture. In general, the amount of capital required should equal the amount of capital, which along with anticipated working capital financings and other borrowings, will be sufficient to carry the institution to positive cash flow based on a conservative proforma plus a substantial reserve. Sources of capital include capital contributions from the physicians and the nonprofit hospital, working capital financings, equipment loans, and equipment leases. The hospital's capital contribution will typically be comprised of cash obtained from debtor-in-possession financing and/or a contribution of existing accounts receivables.

The plant, property, and equipment owned by the nonprofit will be leased to the joint venture pursuant to a long-term agreement, with rent payments structured to provide a sufficient return to the nonprofit's creditors and to ensure, based on the joint venture's pro forma and initial capital, that it has sufficient time to improve operational performance for any conversion. The nonprofit's indebtedness will be restructured so the required payments on its indebtedness match the required payments pursuant to the lease—this will be taxable.

Generally, the lease should provide for a stepped rent structure with nominal rent during the early years of the joint venture, increasing annually to match the anticipated improved performance by the hospital. The rental stream will be pledged to and provide a source of funds to pay the nonprofit's creditors.

Additionally, if the joint venture is successful, the nonprofit will also be entitled to 50% of the cash distributions. To the extent in excess of amounts payable to creditors, this will be held by the nonprofit in a foundation generally used to meet the community's healthcare needs. The amount that creditors participate in the cash flow distributions is a matter of negotiation. Typically, the greater the creditor's participation in cash distributions, the smaller the fixed rent obligation. However, the ability for the creditors to participate in the cash flow distributions creates significant flexibility for structuring and can give the creditors significant upside potential that the creditors do not have in most traditional nonprofit bankruptcy restructurings.

In the event the joint venture is unsuccessful, the nonprofit still owns the underlying assets that can be sold to discharge its debts. Regardless, the nonprofit might still consider selling the real property to a REIT or other real estate investor to generate immediate cash to discharge indebtedness and fund the foundation.

The lease of the hospital to the joint venture will be a change of ownership for Medicare and state licensure purposes. As a result, there will be state and federal filings that must be completed prior to the effective date of the lease. In certificate of need states there will be, at minimum, a notice requirement. In many states, the change of ownership filing is ministerial and not subject to challenge. There are states, however, in which the change from the nonprofit to the joint venture will require approval of the state healthcare regulatory authority—this approval may be discretionary.

Finally, some states have enacted nonprofit conversion statutes that will require filings with the state attorney general in order to convert the nonprofit hospital into a joint venture. In some states, complying with the conversion statutes can be time consuming and costly. Since the joint venture will be a new provider of healthcare services, not only will it be required to obtain a new provider number, but it must also enter into new contracts with managed care payers. Often managed care payers have a vested interest in seeing failing hospitals survive because of their desire for in-market competition. Additionally, physician owners can be persuasive in encouraging the managed care payers to contract with the joint venture at attractive rates.

Struggling nonprofit hospitals can be saved by joint venturing with physicians in the community. By doing so, the hospital's mission can be preserved, key community healthcare services retained, and creditors will often enjoy a greater recovery than is typically the case when the organization is sold or its debt restructured.

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Joseph A. Sowell III and John C. Tishler are partners with Waller Lansden Dortch & Davis in Nashville, TN. They may be reached at joe.sowell@wallerlaw.com and john.tishler@wallerlaw.com, respectively.

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