How to Convert a Nonprofit Hospital to a Physician Joint Venture

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.

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.