Use of Proceeds: Guide to Communities Considering Hospital Conversion in the Carolinas

O ne of the most difficult decisions communities must make after a conversion is how to spend the proceeds from the transaction. There are strict legal requirements governing what can be done with charitable assets resulting from conversion of a not-for-profit organization, but differing interpretations of what these imply for hospital conversions. There are no parallel rules governing how to use the proceeds from conversion of a public hospital.

PUBLIC HOSPITAL CONVERSION PROCEEDS
In the conversion of not-for-profit hospitals, trust and nonprofit law clearly state that charitable purpose of these assets must be maintained, typically accomplished through the use of a foundation. However, for public hospitals in North and South Carolina, no laws exist to guide a community on how best to protect the public's investment in the hospital for future benefit.

The ambiguity in how to use the proceeds from public hospital conversions is the same in both North and South Carolina even though North Carolina has a statute to regulate the conversion of public hospitals. Ironically, while North Carolina's Municipal Hospital Act addresses many aspects of the conversion process and continued operation of the converted facility, the law does not provide any direction in the "appropriate" use of the resulting funds. Thus, localities can and do differ on whether such funds are segregated into a fund to be use solely for health-related activities, are placed into the general fund for any purpose or instead go back to taxpayers in the form of tax relief.

* In the Piedmont Regional Medical Center case, conversion proceeds were not invested for continued use, and, instead, have been nearly exhausted after primarily being used for non-health expenditures.
* In the Upstate Carolina Medical Center case, the funds from the sale of Cherokee County Memorial Hospital were segregated and interest earnings used to provide tax relief. Although not taken from this dedicated fund per se, the county spent roughly half the amount received from the hospital sale in renovating the old hospital facility part of which houses the Peachtree Centre, a skilled nursing facility for the elderly.

Through recent media attention on the sheer magnitude of the resources being shifted due to not-for-profit hospital conversions, the use of foundations to manage the proceeds from such transactions has become a commonly recognized phenomenon. As of September 1, 1997, 69 foundations had been established nation-wide from the conversion of a not-for-profit hospital or health system, with a median asset size of $57 million. Clearly, as not-for-profit hospitals make the conversion decision, they will also have to consider how to best develop the foundation as a resource for the community. A great many issues are involved, some of which are discussed in the following section.

Legal Basis for Foundation Formation
The Role of Tax Law
Among other means for identifying a hospital as a not-for-profit organization (rather than a for-profit corporation) is a hospital's compliance with the Internal Revenue Service tax code. In order to qualify as a tax exempt not-for-profit organization (rather than a for-profit corporation), an entity must meet two primary principles set forth in the Code: that 1) no earnings of the organization be distributed to an individual or private shareholder, and 2) the organization must be guided by a religious, educational, or other charitable purposes., The IRS routinely considers health care to be a qualifying charitable purpose, subsequently extending this umbrella of charitable status to all the entity's assets.4 In addition, hospitals with religious affiliation may be exempt through both its religious and health purposes. It is the need to preserve the resulting blanket of charitable status covering the hospital's assets that prompts the oversight of regulatory mechanisms in the conversion process.

The Role of Trust Law
States regulate the conversion of charitable not-for-profit hospitals based in part upon trust law, which seeks to preserve the nature of the charitable assets of a not-for-profit corporation.5 While not always treated as a trust, the courts have ruled more recently that the assets of a charitable not-for-profit corporation are impressed with charitable nature, thereby effectively granting states the authority to regulate their use. Trust law not only protects the charitable assets of a hospital as defined through their tax-exempt status, but also more broadly by assuring that the donor intent of charitable gifts made to the not-for-profit hospital is maintained. Trust law requires that assets of equal value to those transacted in a hospital conversion be safeguarded for perpetual charitable use; such as through a foundation.4

Hospital Conversion Foundations
The following are general questions related to the use of a foundation to handle the proceeds from a hospital conversion.

Should a New Foundation be Created?
The foundation used to manage conversion proceeds may be either an existing entity, or a newly created one. Due to the overhead costs associated with establishing and running a foundation, creation of a new foundation is more likely when the proceeds are significant, Nevertheless, use of a new foundation is fairly typical in hospital conversions.

* Among the Carolinas cases involving the use of foundations to handle conversion proceeds, a new foundation was created from the conversion in half the cases (Byerly Hospital, Cape Fear Memorial Hospital and Roanoke-Chowan Hospital).
* In two cases (Providence Hospital and Mary Black Memorial Hospital), funds went into an existing hospital foundation (both were restructured as previously they were used principally to raise funds for hospital capital needs). In contrast, proceeds from the sale of the Hilton Head Hospital went into an existing community foundation. Despite the sizable amount of proceeds, hospital board members thought the community would be better served by placing these assets in an existing foundation with an ongoing presence in the community.

In What Form Can Conversion Proceeds be Put into a Foundation?
Conversion proceeds can take many different forms, including cash, stock, or an ownership interest in a joint venture. Due to concerns about charitable assets not being used for public gain, it has been recommended that the fortunes of the converted hospital and the receiving foundation be separated as much as possible. For this reason, it is advisable that proceeds from a conversion be paid in cash rather than stock. In instances where full payment in cash would be too damaging to the purchaser in the short term, any stock received should be sold by the foundation in a reasonable period of time.

Are All of the Proceeds from the Conversion Put into a Foundation?
Not necessarily. Before an amount is invested in a foundation for giving purposes, the purchase price may be used to settle any remaining debt or payment of other liabilities owed by the hospital. So, the gross purchase price may not equal the amount invested in a charitable foundation.

The purchase price for the Providence Hospital joint venture was never disclosed, but the funds received by the foundation were after evaluating the liabilities and providing for the former hospital corporation.

Can the Foundation's Assets be Used to Buy Back a Hospital?
If a new owner defaults on its obligations or decides to sell, it is possible in theory for the foundation to buy back the facility, but this depends on the terms of the conversion arrangement.

* While this situation has not arisen in the case studies, several examples illustrate how foundations keep tabs on hospital performance after conversion. For example, the Byerly Hospital Foundation deliberately delayed making grants until there was visible construction progress on the new hospital facility required by the conversion agreement.
* Other protective measures were used by the Hilton Head Hospital Foundation, which held a 20% equity stake in the hospital after conversion in order to maintain some level of influence on its operation. After two years, the foundation board felt that it was satisfied with the operation of the hospital and thought the foundation's charitable resources could be better invested, opting to sell its equity stake to the hospital. At this point, the foundation, felt that the hospital's activity and movement "off Island" was no longer in line with its strong focus of charitable giving to benefit the Island.
* After Presbyterian/St.Lukes (Denver, Colorado) was sold to AMI, and following subsequent financial problems by AMI, the Colorado Trust helped finance a not-for-profit buyback of the hospital by doctors and hospital administrators. 2
* Rapides Regional Medical Center (Alexandria, Louisiana) entered into a joint venture with Columbia/HCA Healthcare Corporation in 1994. The hospital's medical staff, unsatisfied with changes in the facility, voted in December 1996 to return the hospital to local ownership. However, this plan has been opposed based on the fact that the return of assets would entail the dismantling or greatly reducing the size of the Rapides Foundation, endowed with 50% of the joint venture. In addition to the tremendous impact that the foundation has made upon the community through projects such as the formation of a family practice residency program, museum renovations and prescription drug programs for the poor, neither the Foundation Board nor Columbia is interested in selling. The impasse has culminated in expanded physician involvement in the hospital's decisionmaking through changes to the hospital board's representation (now divided equally among Columbia representatives, physicians and Foundation board members)., Whether the push to regain control of the hospital will continue remains to be seen.

Although a hospital buy-back may be possible in theory, the latter case illustrates the potential difficulty a community may have in changing or eliminating a foundation in order to re-focus on work of the hospital.