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4 Points for Managing an Efficient, Defensible Transaction

The current healthcare environment is creating one of the most active hospital and health system consolidation markets in decades. This is partially driven by provider responses to the challenges and opportunities created by national and state healthcare reform. In addition to complex business considerations, hospital and health system transactions implicate a vast body of state and federal laws, which complicate a transaction process, leaving many opportunities for missteps.

In order for hospitals and health systems to manage efficient yet defensible transactions, they need to place consideration on four key areas throughout the process. In a webinar hosted by McGuireWoods, Jordan Shields, vice president at Juniper Advisory; Rex Burgdorfer, vice president at Juniper Advisory; Thomas Brown, Jr., JD, partner at McGuireWoods; and Meggan Busshee, JD, associate at McGuireWoods, discuss these four areas hospital executives need to carefully review to help ensure a successful transaction.

1. Board duties and personal liability for directors. Mr. Brown began his discussion of board duties during a transaction by relaying that he often hears directors worrying over the future consequences of their decisions and any liability to which they may be subject to during a transaction.

"Someone on the board of directors will always turn to me and say: We realize that the decisions we are being asked to make have serious and long-term consequences for the hospital as well as its physicians, employees and the entire community," said Mr. Brown. "What legal requirements do we have? What is our personal liability going to be if we make the wrong decision or if in some later years the transaction does not work out?" he continued.

There are variations in legal obligations for boards of directors depending on the hospital's state. While a board must focus on those variations, there are three legal obligations it must adhere to, regardless of location — duty of care, duty of loyalty and duty of purpose, said Mr. Brown.

1. Duty of care. A director or trustee can fulfill this requirement by acting in good faith and in a manner that he/she reasonably believes is the best for the organization. According to Mr. Brown, duty of care allows directors to rely on the advice of different individuals such as hospital personnel, business advisors and legal counsel as well as reports and financial data. In addition, if directors carefully evaluate any and all competing offers, they will be fulfilling their duty of care successfully.

2. Duty of loyalty. In order for a hospital's board to satisfy its duty of loyalty, the following three questions should be covered:

• Is the director acting in the organization's best interests?
• Are there any conflicts of interest that should be disclosed?
• Is the board maintaining the utmost confidentiality?

"It would be unusual for a board to fail in satisfying this requirement. However, I am aware of situations where the argument has been successfully made," said Mr. Brown.

3. Duty of obedience. The duty of obedience requires directors to act in accordance of charitable purposes of the organization, said Mr. Brown.

"The bottom line is that if directors satisfy the duties I've outlined here, there ultimate decision is not going to be second guessed by the court or a state attorney general, and they should not have personal liability for the decisions they make," said Mr. Brown. "The attorney general will focus on the process and will not be interested in second guessing the decision that was made in good faith at the end of the process," he said.

2. Reasons for entering into an acquisition or affiliation. According to Mr. Shields, the biggest driver for healthcare M&A activity right now is the response to healthcare reform. This comes as no surprise. However, while this external driver has been in play for a couple of years, there has been a shift in why organizations are pursuing transactions as health reform arrives. According to Mr. Shields, organizations are now asking: Is independent local governance the best way to ensure the optimal mix of high quality, low cost, personalized services for our community?

"Hospitals are now asking: What are we giving up by maintaining a local board as a sole owner? However, they are also asking: What could we lose if our local ownership became part of a system? While hospitals look for, and receive, quality structure and better access to scale from system partners, they repeatedly note the worry that a system will not understand how important the services are to the community," said Mr. Shields. "It is an interesting juxtaposition. An important tenet to remember is that a change of control makes sense when facing long-term structural, not near-term operational issues," said Mr. Shields.

Structural issues that may lead to consolidation include: the ability to attract, retain and integrate with physicians; access to capital; and efficiencies of scale. According to Mr. Shields, these drivers are in play because transaction objectives are changing and multi-faceted. For instance, there are two types of sellers: the distressed seller and the strategic seller. The distressed seller is looking for someone to assume or retire debt whereas the strategic seller is looking for a partner to help strengthen services, prepare for health reform, improve quality and services and lower costs for the community.

3. How and why to start the process. According to Ms. Bushee, there are generally two reasons that hospitals begin transactions. "Management is either approached by an outside hospital or health system presenting an opportunity to consolidate, or the idea derives from a strategic evaluation, which persuades hospital executives to search for a hospital or health system to partner with," she said.

In addition, there are a couple of "micro" forces driving hospitals toward consolidation. According to Ms. Bushee, they include increasing costs, decreasing revenues, the need for greater integration and the need for greater resources.

4. Structural considerations. Just as there are a variety of reasons hospitals consider transactions, there are a variety of structures transactions can take, ranging from the least amount of change to the most amount of change. However, there are generally two paths that a hospital can take when selecting a transaction strategy, according to Mr. Burgdorfer. The two paths are continuity of ownership and change of ownership, which have associated pros and cons.

1. Continuity of ownership — This strategy includes deals such as joint ventures, asset sales and affiliations. Deals in this group may also include cash transactions, sales of 51 percent to 80 percent equity and continued participation in ownership and governance of a joint ventures.

• Pros — Path of least resistance; most popular politically; retain local control
• Cons — Fragmented industry; inability to survive as standalone; subject to operational challenges; healthcare reform rewarding scale of higher costs and lower prices; capital access

2. Change of ownership — This strategy involves outright sales such as the sale of 100 percent of assets and equity. Mergers are also included, even if it is a cashless transaction.

• Pros — capital access; operational scale; management expertise; sharing of best practices; monetize assets; transfer risk
• Cons — loss of local control; finality; shift in mission; antitrust concerns; solvency issues

"While both strategies have pros and cons, change of ownership is a decision fraught with emotion, political concern and community considerations. A great deal of community value rests in the consideration of a change of ownership transaction. It is a serious issue and we try to respect that," said Mr. Burgdorfer.

These four areas address ideas and actions hospital executives should address before a transaction. A clear understanding of their duties, goals and options will help executives run an efficient and defensible transaction.

More Articles on Hospital Consolidations:

Top 3 Drivers for Hospital M&A Activity
3 Tips for Pondering a Hospital Partnership
4 Communication Strategies During a Hospital Merger or Acquisition

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