Hospital and Health System Affiliation Transactions: Critical Legal and Business Issues

We continue to see affiliation activity among hospitals and health systems, albeit at a slower pace than previously experienced, likely due to the COVID-19 pandemic and the resulting slow down in elective care, staffing shortages and a disinclination of some patients to re-engage with their providers. These impacts, we believe, are transitory and will resolve themselves in due course leading to increases in deal volume. The deals we have seen are more “super regional” in nature such as the Intermountain Healthcare/SCL Health transaction reaching across state lines in a significant way.

With that in mind, we think it instructive to visit certain of the critical legal and business issues arising out of the above-described arrangements.

Antitrust

One of the first issues we concentrate on in these transactions is antitrust enforcement. Hospital and health system mergers have long been a focus of federal and state antitrust enforcement agencies. The expressed concern with these deals is the creation of organizations with enough market power, whether it be in hospital services or physician services, to force third party payers to pay higher than market prices that will be passed on to beneficiaries or to foreclose other providers from entering the relevant market.

In early 2021, the Biden Administration issued an Executive Order on antitrust enforcement, specifically identifying hospital mergers as a focus for future enforcement efforts. The Executive Order declares that “[h]ospital consolidation has left many areas, particularly rural communities, with inadequate or more expensive healthcare options,” and a summary of the Executive Order cited a history of “unchecked mergers” in the hospital sector as leading to the ten largest health systems in the United States “now control[ling] a quarter of the market.” The Biden Administration is increasingly looking at mergers from a more holistic perspective than previous Administrations. Thus, we suspect, the Administration will examine hospital mergers not only for their potential effects on customers (e.g., payers and patients), but also for their potential effects on workers and suppliers. We thus expect the Biden Administration to take a harder look at hospital mergers that may have previously passed regulatory review. In some cases, this may even mean reopening the books on hospital deals that previously closed.

Deal Structure

The next issue we often confront is how to structure the affiliation. Because many of these deals are not-for-profit to not-for-profit entity arrangements, the structures employed generally involve so-called “member substitutions” whereby the acquiring entity becomes the new (and generally sole) corporate member of the acquired entity(ies). In the event of a larger transaction where the affiliating parties are closer to “equal” in stature, it is common to see the creation of a “super parent” that becomes the new (and generally sole) corporate member of both parties to the affiliation.

The member substitution structure is popular for a number of reasons, not the least of which is its relative simplicity in execution. Generally, such a transaction only requires the amendment of the articles of incorporation and certain corresponding changes to the bylaws of the acquired entity(ies). Moreover, the structure can sometimes reduce the burden of seeking consents to material contracts held by the acquired entity, depending upon “change in control” and assignment language that may be present in those contracts. Note, that depending upon the state in which the acquired entity(ies) reside(s) there can be licensing and/or certificate of need issues that must be considered. Finally, these sorts of structures generally do not create Medicare changes of ownership, which create the need to file notice with the Centers for Medicare & Medicaid Services (CMS) prior to closing, but, rather, generally only require a timely post-closing notice to CMS.

Governance

As soon as the parties vet the structure issues, they almost always focus on governance of the combined entities. There is usually a strong desire on the part of the governing body of the acquired entity(ies) to “protect” their organization(s). Whether their concerns about being “taken over” are real, or perceived, they often drive negotiations.  Depending upon the relative size and bargaining power of each of the parties, we see varying degrees of initial, post-closing board representation from each party. In addition, we see certain “super-majority” voting protections given to the board appointees from the acquired party, at least for some period of time following closing, usually around ownership changes, reductions or termination of material services, operating and capital budgets, and the like.

Diligence

As discussed above, a great many of these transactions are structured as membership substitutions. Moreover, most of those deals involve no transfer of cash to the acquired entity. In certain instances there may be promises to provide capital or to build new programs or facilities, but generally there are never any direct transfers of remuneration at closing. As a result, except in certain limited circumstances (described below) there often is nothing to claw back after closing should the acquiring entity incur damages that, in a traditional transaction, would give rise to indemnification.

The economics of these deals put stress on the parties’ diligence efforts (both business and legal), especially since, as described above, there often is no escrow or cash from which to seek indemnification. Thus, it is important—most especially for an acquiring party—that diligence efforts are thorough. In this regard, we often see several levels of diligence, the first being a “big picture” effort focused on system structure, financial issues (including capital structure), significant compliance issues, material payer relationships, global labor and employment issues (such as pension and collective bargaining issues) and any other material relationships that could be impacted by the transaction. This diligence effort is “gating” in nature and designed to ferret out issues that could significantly and adversely impact the transaction. Thereafter, second, and supplemental, diligence efforts generally become more granular.

Conditions to Closing

Given the size and nature of hospital and health system affiliations, definitive transaction documents generally are approved and signed by the parties with the closing of the transaction happening subsequent to the signing. Deferred closings are generally necessitated by the need to make regulatory filings such as federal antitrust filings and state certificate of need or licensure filings. In addition, it may be necessary to seek certain third party consents to the transaction including, for example, approvals of third party payers and material service providers.

In most cases, the obligations of the parties to close the transaction are subject to the satisfaction of various conditions to closing including the receipt of governmental approvals and material third party consents.

Deal Protections

As described above, most health system deals involve no cash consideration. However, in addition to diligence, they generally do involve the giving of representations and warranties by each of the parties with respect to its business and operations. These representations and warranties serve several purposes. First, in the event of certain material breaches of the representations, the non-breaching party may have the right to terminate the transaction prior to closing, thus protecting the acquiring party from the liabilities of the acquired party.¹ In addition, in those instances where the acquiring party has agreed to fund capital and/or pay for programs or new facilities, we often see those promises tied to damages arising from breaches of representations and warranties of the acquired party. That is, in the event that, post closing, it is determined that the acquired entity incurs one or more liabilities that were not disclosed and/or can be tied to a breach of a representation or warranty, the acquiring entity may be entitled to reduce its capital commitments, on a dollar-for-dollar basis, by the dollar amount of such liability(ies).

Foley is here to help you address the short- and long-term impacts in the wake of regulatory changes. We have the resources to help you navigate these and other important legal considerations related to business operations and industry-specific issues. Please reach out to the authors, your Foley relationship partner, or to our Health Care Practice Group with any questions.

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¹ As noted above, transactions such as these generally have an executory period (i.e., the period between signing and closing).