Legal Implications for Hospital Boards, In-House Counsel, and Management to Consider to Avoid a Broken Deal

Merger and acquisition activity in the healthcare industry has increased over the past few years. The playbook used in the past has shifted. In this article the authors share their views on whether and when to announce the deal, the importance of conducting pre-deal due diligence, appearing before the Board of Directors, understanding the constituents that are needed to succeed, and conducting pre-market due diligence in anticipation of Federal Trade Commission scrutiny.

Merger and Acquisition activity in the healthcare industry has increased.  Some of the reasons behind this are:

• Healthcare reform – providers lacking in developing accountable care organizations (ACOs) and clinical integration want to align with systems ahead of the curve;
• Payor contracting – providers are seeking partners with better contracts and those moving forward with risk contracting under clinically integrated networks and ACOs;
• Purchasing and Information Technology – providers are combining with health systems with better purchasing power and a more sophisticated IT system; reducing expenses can go directly to the bottom line;
• Access to capital – providers looking to align with parties with better credit ratings to drive greater financing power.

Overall, the playbook used in the past, where community hospitals stay in a particular region, has shifted.  Systems are looking for different revenues and patient bases outside of their primary and secondary market.  Many single community hospitals are losing leverage.  In addition, a number of hospital leaders are looking to leave a legacy in their administration by building new campuses or aligning with a larger provider to support the community.

Therefore, there is significant pressure to structure a transaction to provide for the survival of such independent facilities.  The following sets forth key considerations to keep in mind while pursuing such steps.

Standard Transaction Steps

When pursuing a deal, it is important to understand and implement basic standard transaction steps, including:

• Developing confidentiality agreements with prospective partners – giving the other party the data needed to make an informed decision and offer;
• Identifying the transaction team – hiring experienced attorneys and consultants as appropriate;
• Agreeing upon a timeline for the transaction, which allows the parties to keep the transaction moving forward;
• Signing a letter of intent with potential partners – may include exclusivity or “stay steady” agreement;
• Conducting internal audits and “housecleaning” – understanding what you have before a potential partner gets access;
• Signing a definitive agreement – binding on the parties to move forward but will still be subject to conditions to closing (e.g., new hospital license, provider agreement, financing), where the definitive agreement will include closing and post-closing obligations

Lastly, never announce the deal until due diligence is complete and all closing conditions have been satisfied.  We have seen too many deals that have been announced, only to be pulled back or unwound before it ever got off the ground.  Sometimes, an untimely announcement can do significant harm to the reputation of the facility.

Pre-Transaction Considerations

Pre-transaction considerations apply regardless of the structure of the transaction.  The application of careful pre-transaction preparation will generally lay the foundation for a successful consummation of the deal and will prevent placing the seller in a worse position than it was in prior to undertaking the transaction.

These considerations include:

• Solidifying key constituencies – making sure the people that have been important to the success of the organization in the past will remain important in the future;
• Conducting pre-market diligence;
• Understanding the process to select the right partner.

Each of the foregoing are discussed in greater detail below.

Solidify Key Constituents

Board of Directors

Every hospital has a board of directors.  It is important to make sure to develop a strategic plan to present to the board of directors that answer the following questions:

1. What are the weaknesses and threats to the organization and how would a potential partner help mitigate these?
2. What are the potential opportunities that a partner brings to the organization?
3. Who are the right partners that can help the organization achieve its goals and what is the potential partner’s track record in similar transactions?
4. What issues might arise during the course of the deal and how might these be mitigated?

Please also keep in mind that not only will there be obstacles to overcome that are outside the organization (e.g., reimbursement forecasts, other competing health systems, and so on), but also some of the toughest challenges might come from within the organization and at the board level.  As such, it is important to present the strongest argument to assure that a united front can be achieved when pursuing a partner.

Key Managers

Employees, particularly the organization’s management team, will need to be on board with the proposed transaction.  In many cases, such individuals may be placing their positions at jeopardy while pursuing the best interest of the organization (since some positions may be eliminated as part of a contemplated consolidation with a partner).  As such, when involving key management team members in this process, obtaining non-disclosure agreements are critical.  Further, it may not be inappropriate to construct retention or other incentive plans tied to the success of the transaction, consistent with applicable law.  For example, the organization could consider entering into “stay steady” agreements with key managers to require them to stay in their current positions for a certain amount of time post transaction.  Such efforts may allow for greater efficiency and limited distractions in pursuing a partner for the organization.

Medical Staff

The medical staff of the organization, whether employed or independent, should also be engaged during the process.  This engagement is generally done through the medical staff’s executive leadership, but it may be appropriate to establish ad-hoc advisory committees that provide a “voice” for the medical staff, especially if the relationship with the medical staff is strong enough that having their input will be a benefit to the process versus a distraction.  Regardless of the form and structure of the transaction, leadership should keep in mind that keeping the medical staff informed and involved prior to and during the transaction generally results in quicker integration and greater retention following the closing of the transaction.

Pre Market Due Diligence

While “due diligence” generally describes the review of various aspects of an organization’s operations, including legal and governance compliance, with respect to pre-market diligence, the organization should focus on those areas that are likely to create the most questions and concerns from a potential partner.

For example, depending on the composition of the market, antitrust issues can go from being an important issue to the most important consideration.  No party wants to be involved in a protracted fight with the Federal Trade Commission (FTC).  As such, in order to avoid this issue, the organization should identify likely partners beforehand and analyze whether any particular partner may pose a risk to the transaction not receiving FTC clearance.

The parties should also adopt an antitrust protocol to ensure sensitive, non-public information is not shared between competitors.  An effective antitrust protocol contains guideposts to the board of director and management.  This document would support the position that the parties made a good faith effort to comply with the law and shows strong intent to keep such considerations in mind when pursuing the transaction.

Public information can be freely exchanged, but please note that the organization may also:

• Exchange historical information about vendors and cost, but only to the extend and level strictly necessary for planning the transaction;
• Exchange general descriptive information about products and services;
• Exchange historical sales data;
• Discuss personnel matters which may be effected by the transaction;
• Discuss each parties assets and investments;
• Discuss possible efficiencies and activities that can be undertaken jointly.

Importantly, an organization cannot exchange strategic plans or current pricing.

In an effort to navigate antitrust issues, some parties use a third party to analyze current market data to assess the benefits of the transaction.

Moreover, if the seller is tax exempt, the seller should also:

• Review organizational documents to ensure they are in compliance with the Internal Revenue Service (IRS) requirements;
• Review and test debt covenants;
• Review real estate tax considerations.

Once a transaction is contemplated with a partner, any presentation to the board must include an explanation of the benefits to the partnership including:

• The reputation of the partner;
• The ability of the partner to mitigate weaknesses and threats and built on strengths and opportunities.

A transaction committee may be formed as a separate committee of the board of directors to deal directly with the transaction team.  The transaction team is usually made up of the organization’s management and drives the transaction, although it is not unusual to have advisors who can bridge the competing interest of the organizations (e.g., that of the medical staff).  However, one of the key requirements is that the transaction team be a small core team responsible for negotiating the transaction.  Having a larger group is likely to create inefficiencies.  It is the responsibility of the transaction team to keep the board appraised through the transaction committee, but be nimble enough to keep the momentum of the transaction moving forward.

The board of directors will retain ultimate oversight and control over the transaction.  The board of directors will evaluate the transaction in relation to the best interests of the organization.

Finding the Right Partner

The organization should understand the purpose of the affiliation and the goals of where the entity should be in the near and the long term.  The purpose of the affiliation may be clinical or operational, but one may take precedent over the other depending on the needs of the organization.

In addition, finding the correct method or model of working with a partner is important.  A full merger may not be the best solution.  Joint operating agreements are an alternative that allows for allocation of resources and sharing of risk.  One of the most important facts is that a non-religious, sponsored organization is not required to follow the tenets of a religious organization.

Overall, any significant transaction is complicated.  Following the appropriate steps to pursuing the transaction helps ensure compliance with regulatory concerns and solidify the overall success of the transaction.

Curtis H. Bernstein, ASA, CPA/ABV, CVA, MBA, is a Director of Valuation and Transaction Services for Altegra Health. He specializes in providing valuation, transaction advisory, strategic and operational consulting services to clients. Mr. Bernstein is a physician integration expert for the CFO forum of the Healthcare Financial Management Association, and was listed in the July/August 2009 Becker ASC Review as one of the Top 127 People to Know in the ASC Industry. Hecan be contacted by calling (720) 240-4440 or (310) 776-4500 or by e-mail at Curtis.Bernstein@altegrahealth.com.

Ethan E. Rii is a partner with Katten Law based in Chicago and focuses his practice on health care transactions and regulatory matters surrounding mergers and acquisitions, corporate restructurings, and joint ventures for hospitals, health systems, multi-specialty and large physician practices, specialty and ancillary care providers, managed care organizations, private equity firms and financial institutions investing in the health care space.

Mr, Rii can be contacted by e-mail at ethan.riikattenlaw.com or by calling (312) 902-5522.Thomas J. McFadden serves as Of Counsel with Katten Law in Chicago and counsels governing boards and senior management of major hospitals and hospital systems, charitable foundations, associations, large multi-specialty physician groups, organ procurement organizations, and ancillary care providers in a variety of strategic, transactional, and corporate healthcare matters. He also serves as outside special healthcare regulatory counsel to a select group of companies. Mr. McFadden can be reached by e-mail at Thomas.McFadden@kattenlaw.com or by calling (312) 902-5428.

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