Regulatory Oversight of the Conversion Process

T here are several early hospital conversion cases in which millions of dollars of charitable and public assets were lost due to a lack of adequate knowledge and oversight of the conversion process. Without adequate oversight, conversion negotiations conducted in secrecy without community input can result in lost community assets and a hospital run by a new owner with no obligation to continue the community benefits historically provided. Such decisions may have a tremendous impact on the community, yet they typically are binding and, once made, provide no public recourse for change.

To provide a mechanism for oversight of conversion transactions, many states have enacted legislation setting forth standards to guide various facets of the conversion process. Much of the early legislation, such as Nebraska's pioneering Nonprofit Hospital Sale Act (1996), focuses on the conversion of not-for-profit hospitals to for-profit status. However, legislators in Congress and statehouses across the nation currently are considering laws to cover conversions more broadly. As each state approaches this regulation at its own pace, the variation among states is tremendous.

In states such as North and South Carolina, which have not passed hospital conversion statutes, hospital conversion is regulated by federal and state antitrust laws, tax law, federal Hill-Burton obligations and state Certificate of Need (CON) regulations. This section summarizes the major regulatory issues of conversion: the statutes that govern them, the requirements they impose and how they are enforced.

REGULATING NOT-FOR-PROFIT HOSPITAL CONVERSIONS

The passage of legislation such as the 1996 Nebraska Act reflects strong public concern about protecting the charitable nature of a hospital's assets. Many states have not passed such legislation, including North and South Carolina. Nevertheless, even for states without specific hospital conversion statutes, the conversion of not-for-profit hospitals may be governed through several areas of current law, including: 1) charitable trust laws that regulate the use of charitable assets, 2) corporation law (e.g., state nonprofit corporation statutes), and 3) the authority of state attorneys general to enforce the fiduciary responsibilities of hospital boards or regulate the disposition of charitable assets.

The Role of Tax Law
Because federal tax laws regulate the exempt status and operation of Section 501(c)(3) not-for-profit corporations, they may also play a role in the regulation of hospital transactions that change tax status, i.e., when a not-for-profit hospital partners with a for-profit firm.

As described later, much of the basis for the development of a conversion foundation lies in the way the organization's bylaws and articles or incorporation meet the tests of organizational and operational function, as described in the federal tax code. These tests determine whether or not an organization may be tax-exempt. The organizational test limits an organization to pursuing only activities that are charitable, religious, scientific or educational in nature, satisfied by hospitals through the charitable nature of operating a hospital and the providing health care services. The operational test prevents a person or an entity from engaging in private benefit or inurement, which occurs when a person in a position to influence decisions ultimately benefits unreasonably.

These provisions in the federal tax code may prompt the Internal Revenue Service (IRS) to become involved in the conversion of a not-for-profit hospital. Typical IRS focus may be the inappropriate use of charitable assets resulting in private benefit or inurement through improper valuation of assets or lucrative "sweetheart deals" for the hospital's board or management.

Revenue rulings are published IRS guidelines designed to answer questions regarding hospital transactions that result in changes in taxable status. Additionally, the IRS may issue private letter rulings in response to the specific questions of individual hospitals. For example, not-for-profit Mary Black Memorial Hospital received such a ruling regarding its sale to a for-profit hospital chain. However, hospitals seeking private letter rulings must use these as guidelines only, as they are not binding in court.

In the past, the IRS has not taken an active role in the regulation of hospital conversions for several reasons. In addition to requiring time-consuming and confidential review processes, involvement by the IRS may only take place after a conversion transaction is complete. However, in 1995 the IRS issued its field agents directives regarding points to examine in transactions, including 1) adequate valuation to assure receipt of fair market value; 2) scrutiny for inappropriate side negotiations resulting in unreasonable compensation; and 3) future foundation support of indigent or Medicaid services.

More recently, it was announced that hospital sales, conversions and joint ventures would be getting greater IRS attention focused on the level of private benefit that might be occurring in the transaction.

In addition, until recently, if the IRS found a hospital conversion transaction to be improper, the agency was limited only to terminating an organization's tax-exempt status or refusing to issue tax exempt securities. This has changed with the passage of the 1996 Taxpayer Bill of Rights 2, under which the IRS may impose stiff excise taxes upon those engaging in excess benefit transactions with public charities. This may be the case in the sale of property by a tax-exempt organization for less than fair market value – in which case excess benefit taxes might be levied against the purchaser, potentially as well as those approving the transaction.

Note that Federal 501(c)(3) status does not provide an automatic exemption from state or local taxes. If organized under a nonprofit corporation statute, the hospital is exempt from state income or other corporate taxes. However, to receive exemption from municipal, county or special district property taxes, the hospital must meet an additional standard of charitable status (defined by state law separately from nonprofit corporation law). Thus, ensuring that a transaction meets IRS standards for tax exemption is only the first step in determining that the hospital's historical tax exemption status has been properly taken into account. Because of the complexity of laws of tax exemption as applied to hospitals, hospitals concerned with taxation issues in the conversion of their facility are strongly encouraged to seek expert advice from tax attorneys and accountants.

The Role of Charitable Trust Law
As discussed earlier, charitable trust law is often the basis for individual states' efforts to preserve the charitable use of the assets of a not-for-profit hospital or other entity during conversion to for-profit status. Two aspects of the not-for-profit status of hospitals make these hospital transactions eligible for regulation under trust law: 1) the charitable intent of any donations made to that entity and 2) the resulting umbrella effect of that entity's tax-exempt status upon the hospital's assets. Trust law regulates the charitable purpose of conversion proceeds by mandating that the charitable intent of the donor be maintained and that assets equal in amount to those undergoing conversion retain their original charitable mission. Consequently, charitable trust law largely has been responsible for the development and use of foundations as vehicles for assuring that the proceeds from hospital conversions are maintained appropriately.2

The Role of Corporation Law
Several aspects of corporation law regulate the conversion of a not-for-profit hospital to for-profit status, as set forth in state nonprofit corporation codes. These include requirements to notify the Attorney General, and the use of fiduciary duties of hospital board members as a basis for review of conversion transactions.

The following table (Table 12) compares the provisions of the North and South Carolina nonprofit statutes used to guide the process of hospital conversion transactions.

Attorney General Notification Requirements
In both North and South Carolina, the Nonprofit Corporation Act helps protect the public's interest by requiring that not-for-profit entities seeking to convert notify the Attorney General 20 days prior to the completion of the agreement. According to statutes in both states, this notification requirement applies to any arrangement that would result in the disposal of all or substantially all of a corporation's assets. Note that in joint venture arrangements, it may be unclear whether there has been a transfer of "all or substantially all" property or assets, in which case Attorney General notification may not be required.4 However, even when notification clearly is unnecessary, hospitals often voluntarily provide this information to the Attorney General.

While the time frame for notification is clearly defined, it may be wise for hospital officials to submit all required information sooner rather than later. Doing so may prevent a transaction from being stopped or substantially slowed due to potential conflicts that become evident during review, saving a considerable amount of time and money for all involved.

While the Nonprofit Corporation Act in North and South Carolina requires notice of a transaction, strictly interpreted, the statutes do not grant the Attorney General the authority to review the transaction. However, individual Attorneys General may opt to do so based on their authority to oversee the preservation of charitable assets—an expanded role which can include ordering public hearings. Review may be prompted by a special request to the Office of the Attorney General or significant public interest in the issue.

The potentially broad role of the Attorney General is illustrated in the review of the conversion of Cape Fear Memorial Hospital by North Carolina Attorney General Michael Easley. In its notification of the pending agreement, Attorney General Easley requested that the hospitals include additional information regarding the terms of the agreement, including the decision-making process and evidence of provisions to avoid conflict of interest.4 Similarly, the compliance of not-for-profit hospitals with the notification procedure set forth in the South Carolina's Nonprofit Corporation Act initiates an active review by the Office of the Attorney General. Typically, hospitals seeking approval are asked to submit a copy of their charter, the minutes of related hospital board meetings, documentation of authority to make the hospital transfer and valuation results.

Note that some other states (e.g. Nebraska) require a proposed conversion transaction be submitted to the state's Department of Health, whose job it is to assess the vulnerability of and monitor changes in the access to continuing health services. This is not the case in the Carolinas (and most other states), where not-for-profit conversions only require the notification of the Attorney General, primarily for the purpose of protecting charitable assets. However, in North and South Carolina, each state's health agency does play a role in the antitrust review of conversion transactions for those hospitals seeking federal antitrust exemption through each state's Health Care Cooperation Act (discussed later in this section).