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					4    Whistling Pas
                                          Gr v yard: Th
                                             r e of
                           O n R e ~ t ~ c aa uation
     The heightened regulatory enuironmentfor the healthewe indLLFtry&&IS   the development and reporting of
     dualion opinions related to healthcare entities.

        eco clling Val e                      dica 'on3 for
20 L ~ u s t n aPachaes
                       charwferislicsshould be carejdly considered when interpm6ing value indimlions provided from
     the WSL and income valuahn approache&

27   G& and Estate Tax Valuation
     L. PAUL H O O D . J R .
     Who Says Appmuerr Agree on E u e m Ten Issues that AJect V&ahns (Part TWO)

32   Machinery & Equipment
     Determining the Value of Solar h r g y S'xlerns

34   Valuation Practice
     The Need for InternatioMf Yalualion S

38   Current Developments
     Prop. Regs. Issued for Gi/l Valitahn Dispir~es
     k f k r of S k k to FLP IYw Not an Indirect G$
     T m Cour? Determines Value of FLP Interesh

 3   From the Editor
Healthcare is arguab
inwduswtry. uDi ated
 -1.     -
        ;h- g--- --ern
                       -mA                7
                                          ,      L         

                                                                                                            1       P        6
                                                                                                       (3) how future operations may be a d
Legal constraints and regulatory con-
side rat ions related to fraud that
uniquely affect healthcare enterprises
                                                         nature of Medicare fraud and abuse
                                                         enforcement as it relates to physician
                                                         self-referral laws have turned the trans-
                                                                                                       to the terms of the transaction.  w
                                                                                                          In each case, the appraiser must con-

have often had a great impact not only                   actional market for provider entities         sider the subject healthcare entity's
on the value of healthcare entities, but                 that provide "designated health ser-          ownership structure, and sources of
also on the valuation process itself.                    vices" (DHS) into an area of significant      referrals and revenue, and other aspects
Business appraisers often consider the                   uncertainty, thereby resulting in greater     of its operation, within the context of
term "fraudn within the context of the                   perception of risk of the valuation of        the existing and forecasted regulatory
misrepresentation of financial infor-                    these enterprises.                            environment. Adjustments to the rev-
mation. However, fraud has several                          The heightened regulatory envi-            enue stream or the addition of invest-
faces within the context of healthcare                   ronment for the healthcare industry           ment risk premiums (to reflect investor
enterprises; specificuaspects of fraudn                  affects the type of data required, the        expectations of uncertainty and sub-
may affect the profitability and sus-                    methodology employed, and the entire          sequent expectations of investor return)

tainability of healthcare enterprises,                   process of developing and reporting a
and thus, the ultimate value of these                    valuation opinion related to healthcare
enterprises going forward. According-                    entities. As a result, appraiser work files
ly, an understanding of fraud-related                    must be diligently maintained and the
issues in the healthcare regulatory envi-                important relationship between the
ronment is a prerequisite to conduct-                    appraiser and healthcare legal counsel
ing a healthcare business valuation.                     must be clearly defined.
    Increasing government scrutiny of
the activities of healthcare providers
over the past 25 years has led to tight-                 Healthcare R e g ~ l a t ~ ~
ened restrictions and increased regu-                    Environment O V ~ W ~ ~ W
latory enforcement,with both civil and
criminal penalties, related to such areas
as: Medicare fraud and abuse, kick-
backs, self-referral, and abuse of tax-
                                                         The extensive regulatory framework to
                                                         which healthcare enterprises are sub-
                                                         ject exists at both the state and federal
                                                         levels of government. As the largest
exempt status. It should be noted that                   payor of healthcare in the U.S., the
many types of business arrangements                      federal government is the central play-
that would be regarded as typical moti-                  er in the determination of reinn-
vations inherent in commercial rela-                     bursement patterns and trends, which,
tionships between parties in other                       in turn, have a controlling influence
industries, are perceived as exhibiting                  on the expectation of future revenue
the potential for a significant risk of                  streams and earnings. The govern-
fraud in the healthcare industry. For                    ment's efforts at cost containment
example, referral relationships that                     strongly influence its healthcare reg-
would be both lawful and expected in                     ulatory agenda, both in terms of reim-
other financial industries may violate                   bursement for healthcare services
both federal and state anti-kickback                     (which comprises the revenue stream
and/or self-referral laws when they are                  of these entities), as well as the per-
found to exist between healthcare                        missible structures of transactions
providers. Changes in the scope and                      entered into by healthcare enterpris-
                                                         es. The transaction structures affect
                                                         the              process as they define
CM&AA, CMP, isprestdent of Health Capital Con-           (1) the economic relationship between
sultants, a natzonally recognized healthcare and         buyer and seller; (2) how the trans-
financial economic consulting$rm headquartered
 in St. Louis, Missouri, which has served clients in     action may affect the lega1 c o m ~ l i -
 more than 45 states.                                    ance of the corporate structure; and,

6     VALUATION STRATEGIES      September/October 2008                                                                           HEALTHCARE
may be required to refled thre regula-        2. Increased business risk for health-     who are not otherwise in a position to
tory risk profile of the &jed entity.            care enterprises due to uncertain       generatebusinessfor the other party,on the
    Beyond the issues a f e m e m e n t          investment time horizons.               date of acquisition of the asset or at the
and transactions, ppmmmental regu-            3. Growing complexity of the entities      time or the service agreement."z The
lation of healthcare en&& extends to             being valued.                           response of Centers for Medicare & Med-
almost every other aspect of these enter-     4. Increased administrative burden of      icaid Services (CMS) (the governmental
prises, including the legality of the very       regulatory reporting requirements.      subdivision of the Department of Health
existence of physician provider-owned            Because the penalties for running       and Human Services which is responsi-
entities. Consequently, the ability to sur-   afoul of the Medicare and Medicaid         ble for regulating Medicare and Medic-
vive in today's competitive healthcare        fraud and abuse laws are substantial       aid) to commentators regarding the
environment has required facilities and       (often terminal), healthcare investors,    determination of fair market value as it
physician providers to form new rela-         financial managers, operators, and         relates to Stark law included the position
tionships to support development and          healthcare appraisers should be aware      thatC'to establish the fdir market value (and
acquisition of new technologies, to           of what commercial conduct is pro-         generalmarketvalue)ofatransaction that
secure market position, and to compete        hibited and what is permissible in         involves compensation paid for assets or
efficiently. The current restrictive reg-     order to opine on the fair market val-     services,we intend to accept any method
ulatory environment for physician-            ue of a healthcare provider.               that is commerciallyreasonable and pro-
owned providers affects the market for                                                   vides us with evidence that the compen-
transactions, and thus the valuation of                                                  sation is comparable to what is ordinarily
those healthcare entities, in a variety of    Scope of Fair Market Value                 paid for an item or service in the location
ways, including:                              and its Application to                     at issue, by parties in arm's length trans-
1. Restrictions on the number and             Healthcare Valuation                       actions who are not in a position to refer
    type of potential purchasers.             Fair market value is typically defined     to one another.-
                                              as the most probable price that the            Similarly,anti-kickback regulations
                                              subject entity should bring if exposed     define fair market value in reference
                                              for sale on the open market as of the      to specific safe harbor provisions.' For
                                              valuation date. The fair market value      example, fair market value related to a
                                              standard assumes a hypothetical trans-     real property lease agreement for safe
                                              action in which the buyer and seller       harbor is defined as:
                                              are each acting prudently and knowl-
                                              edgeably, and assumes that the price is      [Tlhevalue of the rental property
                                              not affected by any undue stimulus.         for general commercial purposes,
                                                 The standard of fair market "lue is      but shall not be adjusted to reflect
                                                                                          the additional value that one par-
                                                      t undemding fraud k d~~
                                                      '                              con- ty (either the prospective lessee or
                                              text of the healthcare industry The Stark   lessor) would attribute to the prop-
                                              Law prohibits physicians who have a         erty as a result of its proximity or
                                              "financial              with an entity from convenience to sources of referrals
                                                         their patients to the entity for or business otherwise generated
                                                                                          for which payment may be made in
                                              designated          services that are       whole or in part under Medicare,
                                              ered by either Medicare or Medicaid. An     Medicaidand all other Federal
                                              appraiser5 failure to understand the Stark  health care programs.6
                                              Law and Section 501(c)(3) requirements
                                              for exempt organizations may lead to a
                                              valuation of an impermissible or iuegal     The definition of fair market value
                                              business arrangement that in fact has a related to equipment leases is some-
                                              greatly diminished value or none at all. what different and is defined as:
                                              For example, regulations under the Stark
                                              Law define"fair market value" as"an arm's    [Tlhevalue of the equipment when
                                              1 4 transaction,              withthe gen-  obtained from a manufacturer or
                                              era1 market value? "General market val-     professional distributor, but shall
                                                                                          not be adjusted to         he addi-
                                              ue" is         defined as           that an tional value one party (either the
                                              asset would bring as the resultofbonafide   prospective lessee or lessor) would
                                              bargaining between well-informed buy-       attribute to the equipment as a
                                              ers and sellers who are not otherwise in a  result of its proximity or conve-
                                              position to generate bushess for the oh-    nience to sources of referrals or
                                              er parv Or the                              business otherwise generated for
                                                                              that would  which paymentmay be made in
                                              be           in a         qeement whole or in part under Medicare,
                                                                                   as he
                                              result of bona fide bargaining between      Medicaid or other Federal health
                                              well-informed parties to the agreement      care programs.6

HEALTHCARE                                                                              Septsmber/October 2008   VALUATION STRATEBIES   7
visions do not include an explicit def-         chasing organizations.
inition of fair market value, thereby           Coinsurance waivers to Medicare
leading to further regulatory uncer-            services for patients qualifying for
tainty.7                                        certain Public Health Service pro-
                  b w s Enacted in 1972,        grams
federal anti-kickback legislation crim-         Certain risk-sharing and arrange-
inalized physician self-referrals. The          ments with managed care organi-
statute makes it a felony for any per-          zations.10
son to "knowingly and willfully" solic-         "Safe harbors" protect practices
it or receive, or to offer or pay, any unlikely to result in fraud or abuse.11
"remuneration" directly or indirectly in They detail specific regulatory criteria
exchange for the referral of a patient that must be met to shield the arrange-
for a healthcare service paid for by the ment from liability. Failure to comply
federal government.8 It is violated when with every requirement does not mean
a provider compensates another that the arrangement is illegal12 if there
provider to induce a referral.             is a low risk of fraud and abuse.13
    The statute was amended in 1987             The MMPPPA directed HHS to pro-
with the passage of the Medicare and mulgate regulations specifying payment
Medicaid Patient & Program Protec- practices that did not violate the statute.
tion Act of 1987 (MMPPPA) to These safe harbors were intended to
include an alternative civil remedy, "permit physicians to freely engage in
exclusion from the Medicare pro- business practices and arrangements
gram. The Balanced Budget Act of that encourage competition, innovation
1997 added a civil monetary penalty and economyl'l4 HHS has created a
of treble damages, or three times the number of safe harbors since 1989 and
illegal remuneration, plus $50,000 per clarified existing safe harbors in 1999.
violation. Civil penalties, which In 1999, HHS added safe harbors pro-
required a criminal prosecution, were tecting investments in healthcare enti-
believed to be a more effective way ties located in underserved areas,
of enforcing the statute because the investments in Ambulatory Surgical
government need not prove the vio- Centers (ASCs), and investments in
lation by the criminal standard of group practices.15
proof beyond a reasonable doubt.                For the purposes of physician inte-
Instead, to impose a civil penalty the gration, the most important safe har-
government need prove only.the vio-
.~      .   .   .           .       .
lation by the lesser standard of pre-
                                           1 Barbum, "Fair Marketvalue & ~~Issues:                  l2 "Medicare and State Health Care Programs: Fraud
ponderance. of.the evidence.
                      .~    . .               A Healthcare Attorney's F'erspective," presented at       and Abuse; Clarification of the Initial OIG Safe
    Due to the breadth of the statute,        the Physicians and Physician Organizations Law            H a h r Provisions and Establishment of Additional
                                              Institute. 2/9/05, Tucson. AZ, p.1, compiled in           Safe Harbor Provisions Under the AntCKidtback
legitimate business arrangements could        "Phys~ciansMospitals:  Recruiient, Compensation.          Statute; Final Rule," Department of Health and
be prohibited. For example, if the statute    and Contracting Issues," American Health                  Human Services, 64 Fed. Reg. 63518 (1999).
was interpreted literally, a physician - Law~ers        Association (May 2005); 42 CFR 411.352      13 Office of lnspector General Advisory Opinion

would not be allowed to receive divi-      ° Id.                                                        6.3.04.
                                              66 Fed. Reg. 856,944 (20011.                          l4 Note 9, supra.
dend payments from a publicly traded 4 "Exceptions:' 42 C,ER, m i o n 1001,952, (2006).             15 Note 11 supra.
pharmaceutical company if the physi-          "Exce~tions:' 42 C.F.R. section 1001.952(b)(6).       l6 Note 9, supra.
cian prescribed products produced by          (2006):                                               l7 Note 11, supra, pp. 635356.
the company9 Therefore, Congress ere-         "Exceptions," 42 C.F.R. section 1001.952(~)(6).       1 Id., p. 63536.
                                              (2006).                                               '9 Id., p. 6353:
ated a number of statutory exceptions
                                              For example. the personal services and manage         20 Id., p. 63536.
and gave the Department of Health and         ment contracts exception found in 42 C.ER. seo        21 Id., p. 63532
Human Services (HHS) authority to             tionlOOI.952(d).(2006).
                                                                                                    22 Id., p. 63536.
protect other business                        "Criminal Penalties for Acts Involving Federal
                                                                                                    23 "Medicare and State Health Care Programs;
                                              Health Care Programs" 42 U.S.C. section 1320a-
through "safe harbors."                       7b(b).                                                    Physicians' Referrals to Health Care Entitii With

    CongreSS created the following statu- 9 "Medicare and Medicaid Programs; Fraud and
tory exceptions to the anti-kickback          Abuse OIG A n t i - K i M ~roviions:' Department
                                                                                                        Which They Have Financial Relationships; Final
                                                                                                        Rule" 66 Fed. Reg. 895 (2001).
                                                                                                    24 "Special Fraud Alerts:' Office of lnspector
                                              of Health and Human Services, 54 Fed. Reg.                General, Department of Health and Human
statute protecting legitimate business        (1989).
                                                                                                        Serviqs, 65 Fed. Reg. (1994).
arrangements:                              lo "Criminal Penalties for Acts Involving Federal        25 "Rental of Space in Physician Offices by Persons
                                              Health Care Programs," 42 USC section 1320a-
    Properly disclosed discounts.             7b(b)(3).
                                                                                                        or Entities to Which Physicians Refef M i c e of
                                                                                                        lnspector General, Department of Health and
               to bOna fide                1 "The Public Health and Welfare:' 42 C.ER. section
                                            1                                                           Human Services (2000),
    for employment.                           1001.952.                                                 *~cs/alertsandbulletins/office%20space.      htm.

8   VALUATION STRATEGIES    SeptemberIOctober 2008                                                                                      HEALTHCARE                 1
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tors would otherwise not use his ser-
vice. Critics of the ^one purpose" test
                                                    for a designated health service.43 Des-
                                                    ignated health services include:
                                                                                                   self-referrals imited by a h m b e r of
                                                                                                   statutory exceptions.
claim that it treats a legitimate rela-             1. Clinical laboratory services.               intended to promote pr
tionship with a referral component in               2. Physical therapy services, occupa-          and to protect arrangements where there
the same manner as an arrangement                       tional therapy services, and speech        is little risk of abuse.a One exception
primarily intended to violate the                       language pathology services.               protects "traditional and commonplace"
statute.30 Critics also argue that it is            3. Radiology services and certain oth-         referrals within group practices. Con-
impossible for providers to expect refer-               er imaging services (including mag-        gress intended to protect group practices
rals but not consider referrals when                    netic resonance imaging (MRI),             to avoid "chill[ing] group practice inte-
entering into a business arrangement.31                 computerized axial tomography CT           gration that is crucial in an increasingly
    9 b r ~ md 1 . Prohibitions of physi-
          I       1                                     scans, and ultrasound services).           managed care environmentl'49 Another
cian self-referral are similar to the anti-         4. Radiation therapy services and sup-         exception, commonly known as the
kickback legislation in that they are                   plies.                                     "whole hospital" exception, allows a
concerned with the same conduct. The                5. Durable medical equipment and               physician to have an ownership interest
difference between the two statutes is                  supplies.                                  in a hospital if the physician performs
that the self-referralprohibition address-          6 . Parenteral and enteral nutrients,          services at the h0spital.w Additionally,
es the financial incentives of the physician            equipment, and supplies.                   the statute gives the HHS authority to
who makes a referral, while the anti-kick-          7. Prosthetics, orthotics, and pros-           promulgate additional exceptions. One
back statute is concerned with financial                thetic devices and supplies.               significant difference between the anti-
relationships between providers.= The               8. Home health services.
other important difference between the              9. Outpatient prescription drugs
statutory schemes is that the self-referral         10.Inpatient and outpatient hospital
prohibitions apply only to Medicare and                 services.44
Medicaid while the anti-kickback legis-                 A"referral" is any request by a patient
lation applies to all federally funded state        for a healthcare service." Specifically,
healthcare programs.33                              referral means a physician's request for,
    The statutes establishing the physi-            order, or certification or recertification
cian self-referral prohibitions are com-            of the need for or the establishment of a
monly known as "Stark I" and "Stark 11"             plan of care that includes designated
after Congressman Fortney "Pete" Stark              health services covered by Medicare. A
(D-Cal.), who was the legislation's chief           referral also includes a request by a physi-
supporter. Congressman Stark relied on              cian for a consultation (as specifically
studies indicating that despite the broad           defined) with another physician, and
scope of the anti-kickback statute, self-           any test or procedure ordered or to be
referrals were prevalent in the health-             performed by, or under the supervision
care industry34 For example, the OIG                of, that other physician, but does not
published a study in 1989 on physician              include any designated health services
investments in healthcare facilities. It            personally performed or provided by
found that patients at physician-owned              the referring physician. This means that
laboratories received more services than            a referring physician can receive pro-
other Medicare patients.35 The OIG                  duction credit under employment com-
report was followed by other studies                pensation arrangements with designated
which reported similar findings.%                   health services entities for referred des-
    The regulations interpreting and                ignated health services personally per-
enforcing the Stark law have been pub-              formed by the physician.
lished in stages from 1995 through 2004:                CMS stated in the Stark Phase I reg-
1. Stark I Final Regulations.37                     ulations that a request for a consulta-
2. Stark I1 Proposed Rule.38                        tion is not necessarily a referral "to an
3. Final Rule for Advisory Opinions                 entity" unless the referring physician
    Concerning Stark Compliance                     "knows or has reason to suspect that
    (authorized by the Balanced Budget              the consultant will order the DHS from
    Act of 1997).3s                                 an entity with which the referring physi-
4. Phase I of the Stark I1 Final Rule.*             cian has a direct or indirect financial
5. Phase I1 of the Stark I1 Final Rule.41           relationship to which no exception
6. Phase 111of the Stark I1 Final Rule.42           allies."& Financial relationshivs include

10   VALUATION STMTEBIES   SeptemberfOctober 2008
                 kickback legislation and Stark is that        information regarding the employer's
                 under Stark any financial relationship        procedures for preventing and detect-
                 between a healthcare entity and a physi-      ing fraud, waste, and abuse, as well as
                 cian must fall within one of the statuto-     applicablewhistleblower protection pro-
                 ry or regulatory exceptions.51                visions from the False Claims Act, in its
                     The "whole hospital" exception is one     Employee Handbook if it has one.%
                 of the most important exceptions for              On 9/5/07, CMS issued the final Stark
                 appraisers to be familiar with because it     I1 Phase I11 regulations, which contains
                 is crucial to a physician's ability to        many changes that are predicted to have
                 engage in a joint venture or have an          a significant impact on existing, as well
                 ownership interest in a hospital. The         as future, healthcare provider relation-
                 exception allows a physician to have an       ships.57 The changes with perhaps the
                 ownership interest in a hospital (not in      most significant expected impact are
                 a subdivision of the hospital) if the         those related to provider compensation
                 physician is authorized to perform ser-       arrangements. To comply with the Stark
                 vices at the hospital.=                       regulations, entities with certain finan-
                     The specialty hospital moratorium         cial arrangements must be classified as
                 contained in the Medicare Prescription        having an indirect compensation
                 Drug, Modernization, and Improve-             arrangement or fall within one of the
                 ment Act of 2003 (MMA), restricted            Stark exceptions. If a valid indirect
                 the development of new physician-             arrangement agreement was signed pri-
                 owned specialty hospitals. The 18-            or to 9/5/07, CMS will allow this
                 month specialty hospital moratorium,          arrangement to continue until the term
                 which began on 12/8/03,53 officially          of the arrangement expires.
                 ended on 6/8/05.54 However, the Deficit           One requirement, set out in the
                 Reduction Action (DRA), enacted on            Phase I regulations, stipulated that there
                 2/8/06, continued the suspension of           exist at least two financial relationships
                 CMS's enrollment of new specialty hos-        in between the physician and the des-
                 pitals until the earlier of six months        ignated health services (DHS) entity
                 after enactment or CMS's release of a         The Phase I11 regulations change the
                 final report on specialty hospitals           definition of an indirect compensation
                 required by the DRA.                          arrangement so that physician mem-
                     The DRA requires CMS to consider          bers, employees, and contractors of the
                 the provision of specialty hospital care      physician organization are now deemed
                 to: Medicaid patients; patients receiving     to have identical (i.e. direct) compen-
                 medical assistance under a state demon-       sation arrangements as the physician
                 stration project approved under Title XI      organization itself. A hospital that has
                 of the DRA; and patients receiving char-      a contract for professional services with
                 ity care.55 The DRA requires additional       a physician group (considered indirect
                 employee training and compliance              under the Phase I regulations because
                 requirements for those entities that          there was a financial relationship
                 receive or make $5 million in annual          between individual physicians and their
                 Medicaid payments.Written policies and        group practice, as well as a relation-
                 procedures are required to be provided        ship between the group practice and
                 to all employees, including management,       the hospital) is considered to have a
                 as well as anyone who could be consid-        direct compensation arrangement. The
                 ered a contractor or agent of the entity.     effect of this change is that a physician
                 The written policies and procedures           organization will not be considered an
                 must include information on the feder-        intervening entity for purposes of
                 al False Claims Act (the federal statute      establishing an indirect compensation
                 which allows punishment of any vendor         arrangement, and to avoid Stark liabil-
             1   or subcontractor who fraudulently sub-        ity, it may need to be structured dif-
                 mits monetary claims to the govern-           ferently.56 It should be noted that this
                 ment); federal administrative remedies        change applies only to physician orga-
             1   for false claims and statements; state laws   nizations, while other arrangements
                 regarding civil or criminal penalties for     e.g., an arrangement between a DHS
             1   false claims and statements; and federal      entity, a leasing company, and a physi-
             1   and state whistleblower provisions. In        cian, are analyzed as an indirect com-
                 addition, an employer must provide            pensation arrangement.59

HEALTHCARE                                                                         VALUATION STRATEGIES   11
when the hospital contracts with a third      used to enforce Stark Laws and the anti-
party (typicallya joint venture owned, at     kickback statute. Originally enacted dur-
least in part, by physicians who may refer)   ing the Civil War, it was intended to
to provide a hospital service, and the        prevent fraud by military contractors.
hospital then bills and is reimbursed by      Since Congress amended the FCA in
Medicare for those services and pays the      1986, it has become the government's
supplier or joint venture.                    most important weapon in its fight
    Under "per-click" or block leasing        against fraud.67 The 1986 amendments
arrangements, hospitals lease equip-          strengthened the statute's qui tam, or
ment and facilities to a physician group      whistleblower, provision, which allows
for specific time blocks, or share space      private citizens reporting fraud to share
and equipment with other lessees.60           a portion of the government's recovery.=
The physician using the facility pays a       Under the statute's qui tam provisions,
small lease fee, and then he or she bills     any private person may enforce the FCA
the payor as if the physician provided        by filing a complaint alleging fraud
the services, keeping the monetary dif-       against the federal government.@ The
ference between the lease payment and         Department of Justice (DOJ) assumes
insurance reimbursement. Through the          primary responsibility for prosecuting
arrangement, the technical fee that           the claim if it believes the claim has mer-
used to be paid solely to the imaging         it.70 The whistleblower is entitled to a
center is now being shared with the           portion of any recovery the government
referring physicians.61                       makes.71 Since the 1986 amendments,
    Currently, this type of "arrangement"     the government's recoveries have
is permitted under Stark, as theaentity"      increased substantially. Between 1986
to which the physicians refer patients is     and 2000, more than $3 billion was recov-
the hospital, not the joint venture, i.e.,    ered under the FCAs whistleblower pro-
the "entity" is deemed to be the one that     vision. More than half of the amount
submits the reimbursement claim to            recovered involved healthcare fraud.72
Medicare.62 However, buried in a 2008             The Act provides for treble damages
proposed rule about the Medicare physi-       plus an additional penalty for each false
cian fee schedule,= CMS included revi-
sions to the Stark regulations that would
prohibit space and equipment lease
                                              "Gordon. "Moratorium onJournal, 6/20/05.
                                               Expires:' Dallas Business
                                                                         Specialty Hospitals           lmpact~of~2008~Medicare~Physician~Fee~Sch
                                                                                                       edule pdf
arrangements when per-click payments          55 "Payment Provisions in the Original Medicare       63 Proposed Revisions to Payment Policies Under
                                                 Program Immediately Affected by the Deficit           the Physic~an Fee Schedule, and Other Part B
are made to a physician lessor who refers                                                              Payment Policies for CY 2008, 72 Fed Reg
                                                 Reduction Act:' CMS Fact Sheet, 2/10/06.
patients to the lessee.@Specifically, CMS     56 Bloomquist, e t a/., "United States: Unheralded
                                                                                                       38,112-38,395 (proposed 7/12/07) (to be codified
has proposed to broaden the definition           Provisions of 2005 DRA Will Require Additional        at 42 C FR pt 409,410, et al )
                                                 Employee Fraud Training Effective January 1,       64   Id
of"entity" to include the person or enti-
ty that performs the designated health
                                                 2007:' (Reedsmith. 2006), available at: hnp://
                                                                                                    " Payment Policies Under the Physic~anFee
                                                                                                      "Medicare Program, Proposed Revisions to

services.65 Of note, CMS has criticized          39916&l k=l&login= true&print=l; ; "Deficit           Schedule and Other Part B Payment Pol~c~es    for
                                                 Reduction Omnibus Reconciliation Act of 2005,"        2008:' Centers for Medicare & Medicaid, 72 Fed
certain types of these arrangements as           S.1932, 110th Cong., section 6024 (2006).             Reg 133 (2007).
"inherently susceptible to abuse because      57 Barnes, et a/., "Phase Ill Regulations Result in   66 "CMS Proposes Sign~ficant     Changes to Stark
the physician lessor has an incentive to         Dramatic Changes to Stark Law," 16 Health Law         Regulation:' Hinshaw Health Law Alert, Hinshaw &
                                                 Reporter 1220 (10/11/07), p. 1220.                                          i
                                                                                                       Culbertson, LLp July l:2007, w hlnshawcm
profit from referring a higher volume         58 Id.                                                67 Bauman, note 34, supra, p 113
of patients to the lesseel'66                 59   Id.                                                 31 U S C section 3730(bl.
    Although the public comment period        "Valenza,for"Outpatient lmaging Centers: Building
                                               Blocks       Survival,"
                                                                               Economics (April
                                                                                                    69 31 U S C section 3730(b)(:
expired on 8/31/07,the final rule has not        2007); Hinesly, "Accreditation Ensures Quality,
                                                                                                    70 31 U S C sectlons 3130(b)(4)and (c)(l)
yet been released. While the proposed                                                               71 31 U S C section 3730(d)(2)
                                                 Guarantees Payment," lmaging Economics
                                                 (March 2007).                                      72 "Just~ceDepartment Recovers Over $3 B~ll~on    in
Stark provisions (as well as arrangements                                                              Whistleblowers False Cla~ms Awards and
                                              6' Haule, 'Assault on Lease Deals Could BringTheir
in which the physician is the lessee and         Demise:' Diagnostic lmaging (April 20071, p. 1.
                                                                                                       Senlernents," Department of Justice, 2124/00,
rents space from a hospital or other enti-                                                             www usdoj g o v / ~ 1 / 2 0 0 0 / F e b ~ 4 ~ . ~ .
                                              e2 Greeson and Zimmerman. "Potential Impact of        73 "False Cla~ms Act" 31 U S C secWm 372MXB.
ty on a per-click basis) contained in the        2008 Medicare Physician Fee Schedule Proposed
                                                                                                    74 Furrow, note 26, supra, p 629
                                                 Rules on lmaging Arrangements," Reed Smith ,
proposed 2008 physician fee schedule             Health Lawyers Weekly, available at hRp://         75 Hansen, "Senate Heanng ckit?&w &xtcdTm
did not appear in the final rule that was -db/-documents/Potential-            to Medical Re%e Makers: AMk+%, dir4ZB9,
                                                           claim; thus, potential liability is quite                               specify that the organization is limited
                                                           1arge.n Potential violations of the FCA                                 to tax exempt charitable purposes.78
                                                           include upcoding and billing for unnec-                                     Increased scrutiny of Section
                                                           essary services.74 Physician acceptance                                 501(c)(3) status has affected the marke
                                                           of such kickbacks from medical device                                   for selling practices to charitable insti-
                                                           manufacturers,i.e., monetary bribes, free                               tutions, e.g., hospitals and foundations
                                                           travel, and various other perquisites, has                              Many arrangements under the fraud and
                                                           recently come under increased scrutiny                                  abuse laws also raise issues under the
                                                           as violation of the FCA. The Physician                                  tax laws governing exempt organiza-
                                                           Payments Sunshine Act was introduced                                    tions. Under Section 501(c)(3), health-
                                                           by Senator Herb Kohl in 2007 to address                                 care tax-exempt organizations must (1)
                                                           illegal kickback activities. The Act would                              satisfy the "community benefit" stan-
                                                           exempt drug sales and clinical trial fund-                              dard; (2) avoid violating the "private
                                                           ing from the reporting requirements, and                                inurement' restrictions; and, (3) demon-
                                                           failure to comply with disclosure rules                                 strate that their practices are consisten
                                                           would induce fines on companies of up                                   with "public policy considerations,
                                                           to $100,000 for each violation. Physicians                              including federal regulatory statute gov-
                                                           would not be liable for payment of fines.75                             erning healthcare providers."79
                                                                                Sootion I 0 1(c)(S)Tax-Exempt Status.                  Recently, the issue of charity care
                                                                           In addition to the fair market value has become the primary inquiry con-
                                                                           standards imposed in the Stark and oth- cerning the tax-exempt status of
                                                                           er fraud and abuse laws, Section healthcare providers.80 The IRS relies
                                                                           501(c)(3) likewise uses a fair market on the community benefit standard in
                                                                           value standard. Tax exemption is often determining whether a tax-exempt
                                                                           viewed as a public subsidy to the exempt organization "promotes health in a
                                                                           organization.76 Section 501(c)(3) pro- charitable mannerl'sl An organization
                                                                           vides for federal tax exemptions for cor- does not qualify for Section 501(c)(3
                                                                           porations "organized and operated tax exemption unless it serves a pub-
                                                                           exclusively for religious, charitable, sci- lic rather than a private interest.
                                                                           entific.. .or educational purposes."77 Although private benefit is not entire-
                                                                           The organization must meet an orga- ly prohibited, as is private inurement
                                                                           nizational and an operational test in it must instead be "incidental, both
                                                                           order to obtain tax-exempt status. The qualitatively and quantitatively rela-
                                                                           organizational test requires the organi- tive to the public benefit served."*2
                                                                           zation's articles of incorporation to                       The tax law contains prohibitions
                                                                                                                                   against "private inurement" for tax-
                                                                                                                                   exempt entities. Healthcare organizations
   h ~ ~ J ~ . a m a - a s s n . o r ~ / a m e d n e w S n O 0 8 / 0 3 I 1 7 I Allen and Wilhelm, "The Impact of the 1980
   gvsb031Zhtm.                                                                Depository Institutions Deregulation and            do not qualify for Section 501(c)(3) sta-
78 Furrow. note 26, supra, D. 39.
                            .      .                                           Monetary Control Act on Market Value and Risk:      tus if any part of their net earnings inure
   Section 501(c)(3).                                                          Evidence from the Capital Markets," 20 J. of        to the benefit of any private shareholder
                                                                               Money, Credit, and Banking 373 (1988).
78 Reg. 1.501(c)(3tl(b).
                                                                           (n Becker and Koch. "Hospitals and Health
                                                                                                                                   or individual. Under this rule, certain
   Davidson, a,Addressing                           Systems, Tax                                                                   "insiders"of a tax-exempt entity, includ
                                                                               Systems: The ~~~t of Times and the Worst of
   Exemption Problems," Healthcare Financial
   Management (January 1995).
                                                                               Times," 32 J. of Healthcare Finance 1 (2006).       ing &-ectors/trmtees,           and certain
80 Note 26, supra, p. 40.
                                                                           s3 "Capital Financing: Financial and Operating physicians, may not engage in a non-fair
                                                                               Metrics Anaiysis," prepared for the Illinois Health
81 Stuart, "Latest IRS Ruling on Hospital and                                  Facilities Planning Board by the Governors State    market-value transaction with the tax-
   Physician Jointventures:'                             10/18+04.             University Health Administration Program,           exempt entity. If the entity allows Such
82 Broccolo, note 41, supra, p. 4.                                             (September 2004), p. 8, see     inurement and the private benefit con-
83 Id.                                                                     94 Larson and Gulliford, "Stark Regulations and
                                                                               Health Care in Rural America," (American
                                                                                                                                   ferred on an individual is not merely inti-
84 Id., p, 10.
86 Id., p. 21: IRS Manual 4233, section 232.2.                                 Academy of Medical Administrators) available at     dental to the exempt activities of the
                                                                               ht~J/ organization,the organization may have
86 "A~~lying 501 (c)(3)Ta*Exem~t                 Status:' (IRS). p.
   3, available at:                                                                                    its exempt status revoked by the IRS.
                                                                           95 Id.
   pdWp4220.pdf                                                                                                                        However, an exempt organization is
s7 "Activities That Are Illegal or Contrary to Public S6 McDowell* "Physician Self                                Anangements:
              1985 IRS EO C P E T ~ p,3, availableat:
                                                ~~,                            Legitimate Business or Unethical "EntrepreneulwC permitted to pay RX30nab1e compen-
   http:/                                                  J L. & Med.61
                                                                                              .                                    sation to those who provide services for
88 Broccob, note 41, supra, W. 2 and 46.                                   g7 Pratt and Niculita, "Valuing a Business: The         the organization. While the determina-
                                                                               Analysis and Appraisal of Closely Held
89 "Advisory Opinion No. 01-10, pp. 1-12.
                                                                               Companies" (McGmw Hill, 2008). pg 446.              tion of the "reasonableness" of the com-
   Shipper and Thompson, "The Impact of merge^                                                                                     pensation is based on a totality of the
                                                                           ge TCM 1995255,
   Related Regulations on the Shareholders of
   Acquiring Firms," 21 J. of Accounting Research 99 Note 94 supra, P.449,                        p                                facts and circumstances, as a general
   216 (Spring 19831.                                                      lwld., p. 446.                                          rule "reasonable" compensation is what

HEALTHCARE                                                                                                                                       VALUATION STRATEGIES      13
cumstances existing at the time the con-             is determined; and (3) helping the IRS          compensation paid for physician ser-
tract for services is made. When                     to learn more about how exempt orga-            vices related to on-call coverage. It stat-
reasonableness cannot be determined                  nizations set and report their compen-          ed that the key inquiry for determining
based on the circumstances existing at               sation arrangements on annual Form              whether the compensation arrangement
the date the contract was entered into, the          990 returns. Specifically, the IRS focused      for providing emergency on-call cover-
determination is made based on all facts             on loans and sales, as well as exchanges        age violates the anti-kickback statute "is
and circumstances, up to and including               or leases of property, to officers and oth-     whether compensation is: (i) fair market
the date of payment, but not including               er insiders.Violators will likely face inter-   value in an arm's length transaction for
the date when the contract is ques-                  mediate sanctions, Form 990 reporting,          actual and necessary items or services;
ti0ned.a The Internal Revenue Manual                 and potential revocation of their tax           and, (ii) not determined in any manner
lists the following factors to be consid-            exempt status.=                                 that takes into account the volume or
ered by an examining agent in making a                   Also in 2004, the IRS implemented           value of referrals or other business gen-
reasonable compensation determination:               an executive compensation compliance            erated between the parties."-
1. Nature of employee's duties.                      initiative to review the compensation              The contested arrangement involved
2. Employee's background and expe-                   practices of public charities and private       a non-profit hospital experiencing a
    rience.                                          foundations. Many reporting errors and          shortage of physicians providing emer-
3. Employee's knowledge of the business.             omissions were found through compli-            gency department and follow-up care
4. Employee's contribution to the prof-              ance check letters and examinations due         due to the high volume of indigent
    it of the business.                              to confusion about the instructions on          patients unable to pay for services. Some
5. Time devoted by employee to the                   Forms 990 and 990-PF. Then in 2006,
    business.                                        the Government Accountability Office
6. Economic conditions in general and                reported that of the 65 hospitals
    locally.                                         responding to a survey, 40 hospitals had
7. Character and amount of respon-                   written executive compensation crite-
    sibility of employee.                            ria, with the majority of reporting hos-
8. Time of year when compensation                    pitals having a committee that approved
    is determined.                                   the CEO's base salary, bonuses, and pre-
9. Relationship of shareholder-officer's             requisites. Examinations of 25 exempt
    compensation to stock holdings.                  organizations found excessive salary and
10. Whether alleged compensation is in               incentive compensation, payments for
    reality, in whole or in part, payment            vacation homes, personal automobiles,
    for a business or assets acquired.               personal meals, and gifts. Many organi-
 11. The amount paid by similar size                 zations also incorrectly reported com-
    businesses in the same area to equal-            pensation on one or more forms.
    ly qualified employees for similar                   In March 2007, the IRS reported that
    services.85                                      of the 1,826 tax-exempt organizations
    In addition to the charitable purpose            involved in its executive compliance ini-
and public benefit requirementsjust dis-             tiative, 782 audits were conducted and
cussed ,a tax-exempt organization must               $21 million in excise taxes was levied
not have purposes or activities that vio-            against 40 individuals and 25 different
late a fundamental public policy.= This              organizations for engaging in excess
includes not only engaging in illegal activ-         benefits transactions. Several key issues
ities, but also in those involving the plan-         were factors in causing these assess-
ning or sponsoring of illegal activities.87          ments, including: excessive salary and
    In 2004, the IRS announced a tax-                incentive compensation; payments to
exempt compensation project in an                    an officer's for-profit corporation in
effort to identify tax-exempt organiza-              excess of the value of the services pro-
tions that pay excessive compensation                vided by the corporation; and payments
and benefits to officers and other insid-            for personal legal fees, vacation homes,
ers. The IRS planned to contact approx-              and personal automobiles not reported
imately 2,000 exempt organizations to                as compensation. The report also indi-
obtain additional information on com-                cated that loans to officers and other
pensation paid to officers and other                 executives would be the subject of sin-
insiders. Goals for the project included:            gle-issue compliance checks and audits
(1) addressing compensation of specif-

14   VALUATION STRATEGIES   SepternberlOctober2008                                                                               EYEALTHCARE       I
                   hospitals have responded to certain spe-       Keeping these considerations in min
                   cialists' refusal to provide services with-    and within the context of the dynam
Traditional        out compensation by paying per diem            healthcare industry milieu, one shou
healthcase         rates to physicians who entered into a
                   two-year contract to provide care in the
                                                                  remember also that:
                                                                     Because uncertainty breeds the pe
vd~ation           emergency department.                             ception of risk, which in turn lea
methodologies7         While the OIG found that the con-
                   tested arrangement did not meet the
                                                                     potential purchasers to demand
                                                                     higher rate of return, even high-qu
while forward-     requirements of the safe harbor for per-          ity, risk-averse, stable-growth, hig
I O Ohave  ~       sonal services and management contracts
                   because the amount of compensation
                                                                     ly profitable, and eminent
                                                                     transferable healthcare entities a
s & s m 7 d Yreliedwas not set in advance and varied month-          often stigmatized by the percepti
0n the ~ J S ~ S   ly, the compensation arrangement was
                   nevertheless deemed low risk because:
                                                                     of overall market uncertainty, as w
                                                                     as by risk related to the subject ent
of hlstori         1. The per diem rates were at fair mar-           prise's industry sector.
a ~ c o u n ~ d        ket value without regard to referrals,        Other market-motivating facto
other data . m         and the physicians were required to
                       treat any patient who entered the
                                                                     such as investors' fear of being sh
                                                                     out of their ability to maintain or s
past operab ns as

                       emergencydepartment u t l discharge
                                                 ni                  their investment legally, often dri

pre *ctive oPiuturr    with no additional compensation, in
                       addition to providing certain volun-
De o x ~ ~ ~ ~ ~ c e a n d
indicative of value.
                       teer (uncomvensated) services.
                   2. The emergency department was
                       understaffed prior to on-call com-
                                                                     transactional pricing multiples. Th
                                                                     represent an undue stimulus or sp
                                                                     cial motivation and synergy that m
                                                                     drive the deal, resulting in pric
                                                                     below or above value.
                       pensation being paid, which meant             Selection of risk-adjusted rates w
                       the likelihood that the arrangement           which to capitalize an earnings
                       was instituted to provide remuner-            benefit stream into value, requir
                       ation to physicians for referrals was         more than just a cursory analy
                       minimal.                                      of underlying data related to ma
                   3. All physicians were required to work           ket-systematic risk, as a nonsy
                       the same number of hours each                 tematic, subject-enterprise ri
                       month for providing on-call services,         adjustment may also be appropria
                       irrespective of the number of refer-          Given the impact of the rapid
                       rals they provided to the hospital.        changing healthcare reimburseme
                       ~ h Vaiuo Pyramid. An understand-
                             o                                    and regulatory environment on
                   ing of how the key "value drivers" of          investor's perception of risk and t
                   healthcare enterprises may be affected         resulting impact on the valuation
                   by the foregoing regulatory edicts             the subject healthcare enterprise, t
                   should be viewed within the context            most important consideration for t
                   of Exhibit 1's "Value Pyramid.'' Finan-        healthcare appraiser may be to ha
                   cial valuation of these enterprises can        an in-depth understanding of the cu
                   generally be discussed within the con-         rent state of those issues. The valu
                   text of two determinants:                      tion expert must be further aware th
                       "I"-the appropriate "income1 earn-         assessment of risk by investors
                       ingslbenefit stream" for the subject       related to both the actualities a
                       enterprise.                                (perhaps more substantially) the pe
                       "R"-the appropriate "risk-adjusted         ceptions of the market, related
                       required rate of return:' typically        external economic, demographic, a
                       expressed as a discount rate, capital-     industry conditions, as well as
                       ization rate, or multiple, to apply to     operational aspects of the speci
                       the income stream selected.                subject enterprise.
                       Aspects of the rapidly changing               Selection of the appropriate ri
                   reimbursement and regulatory envi-             adjustment to market-derived requir
                   ronment related to each determinant,           rates of return used in developi
                   are key to developing both a forecast          selected discount rates, capitalizati
                   of the subject enterprise's future income      rates, and market multiples in healt
                   stream as well as an appropriate risk          care valuation, requires a thorou
                   adjusted discount ratelcap ratelmultiple       understanding of several underlyi
                   to apply to that selected benefit stream.      investment concepts:

HEALTHCARE                                                       SeptemberJOctober 2008   VALUATION STRATEGIES
     1   * IncomelEamingdBenefit Stream as defined by appraiser 8 appropriate
            to assignment
     R   I Risk
          ,      Adjusted Discount RateICapRatelMultipIertsk adjusted and
            applicable to selected income stream
     \/ +VALUE

1. Investors in healthcare entities have                  In addition, the most probable ben-
   alternative investments available to               efit stream forecasted to be available for
   them. Therefore, the investment jus-               return to the subject enterprise's
   tification for the subject healthcare              investors should be carefully analyzed to
   entity should be considered in com-                determine appropriate adjustments to
   parison to rates of return available               reported results derived from historical
   from a broad array of other types of               performance. These adjustments should
   investments.                                       reflect the most accurate and appropri-
2. High risk factors (e.g., reimburse-                ate information available on the valua-
   ment and regulatory) are consid-                   tion date of the most probable future
   ered to have a greater-than-average                performance, often referred to as nor-
   chance of negatively affecting the                 malized earnings. To arrive at an esti-
   enterprise's earning power, while                  mate of the normalized earnings for the       most probable benefit stream, are inex-
   low risk factors are considered less               subject enterprise, the adjustments con-      orably related to, should be based on,
   likely to reduce the enterprise's abil-            sidered should include, but not neces-        and must be carefully correlated to an
   ity to generate profits and cash flow              sarily be limited to:                         informed, realistic, and unsparing
   as a future benefit of ownership.                  1. Actual or expected increases or            assessment of a universe of typical buy-
   Accordingly, elements that increase                    decreases in fees and reimburse-          ers' current "perceptions of the mar-
   risk decrease the value of the enter-                  ment for services by regulatory edict     ket" as to the future performance of the
   prise, and conversely, elements that                   or competitive market pressures.          subject enterprise, as well the market's
   decrease risk increase value.                      2. Projected increases or decreases in        assessment of risk related to an invest-
3. Knowledgeable investors in a sub-                      operating expenses based on new           ment in such an enterprise. According-
   ject healthcare entity with a high                     operating parameters and market           ly, valuation of a healthcare enterprise
   degree of risk should require a                        realities, e.g., provider taxes or dis-   sensitive to government interventions
   greater return on investment to                        closure requirements.                     that would have an impact on the liq-
   compensate for the greater risk.                   3. Expectations of the future stability       uidity of capital, either by disrupting
4. There will be differences of opin-                     and growth of the revenue streams         the makeup of the market investor pool
   ion as to how much risk is repre-                      and the sustainability of the sub-        or the expected investment holding
   sented by any single characteristic of                 ject enterprise's earnings within the     period time horizon, may also require
   the enterprise, and the risk toler-                    context of a chaotic healthcare           a significant additional discount for lack
   ance of each individual investor is,                   industry and marketplace.                 of control, lack of marketability,or both.
   to a large extent, dependent on the                    In the final analysis, both the               Value is Forward Looking. One of the
   return on investment required to                   appraiser's assessment of an appropri-        fundamental tenets of financial valua-
   compensate for the level of risk that              ate risk-adjusted required rate of return     tion is that value is the expectation of
   the investor perceives.                            for investment and the forecast of the        the future economic benefits of own-

16    VALUATION STRATEGIES   September/October 2008                                                                             HEALTHCARE
                                               EXHIBIT 2
                                               Reliance on Hiderical Data

                                                                      RELIANCE OM HISTORCAL DATA

                                                                                 'AS 0 F" DATE
                                                    PAST                                                                     FUTURE

                                                                                Price to Earnings


                                                           Q: HOW USEFUL IS PAST IN DETERMINING VALUE?

                                             dieting future performance. Exhibit 2           highly regulated and w a m i c industry
                                             provides an illustration of how several         environment affecting healthcare enti-
                                             issues related to regulatory changes,           ties, historical underlying assumptions
                                             might have an impact on the reliance to         and past operating performance of
                                             be placed on historical accounting data         these entities may no longer be a valid
                                             from past operations.                           tool for predicting future performance
                                                 The appraiser's consideration of the        and value. Consequently,the "road map
                                             relevant regulatory constraints and             of historical performance" has become
                                             fraud considerations affecting health-          less predictive of future performance.
                                             care entities is a critical aspect of devel-
                                             oping the healthcare valuation, in
                                             forecasting future revenue streams and           Impact of Regulationon Universe
ership, and the importance of adher-         the assessment of risk, as well as in            of Potential Purchasers
ence to this basic principle is never more   defining the market universe of poten-          Implicit in the definition of fair mar-
evident as in the increasingly complex       tial purchasers who can lawfully acquire        ket value are the following assump-
world of healthcare entity valuation,        and operate the subject entity.Accord-          tions as they relate to the hypothetical
where expectations as to the future are      ingly, working with healthcare legal            sale transaction:
burdened by regulatory forces that are       counsel, while maintaining a thorough           1. The hypothetical transaction con-
both dynamic and uncertain. Tradi-           knowledge of regulatory environment                templates a universe of potential pur-
tional healthcare valuation method-          and enforcement trends in the health-              chasers, and not specific purchasers
ologies, while forward-looking, have         care industry, may be as important as              or a specific class of purchasers.
substantially relied on analysis of his-     valuation methodology itself.                   2. A sufficiently reasonable amount of
torical accounting and other data from           Keeping in mind that business prac-            time is allowed for exposure in the
past operations as predictive of future      tices resulting in lawful revenue                  open market.
performance and indicative of value.         streams in most industries (e.g., pay-          3. Buyer and seller are typically moti-
However, the turbulent status of the         ing for business referrals) are now                vated.
healthcare industry over the past ten        almost always unlawful forhealthcare            4. Both parties are well informed and
years has introduced numerous inter-         entities and subject to increased scruti-          professionally advised, and acting
vening events and circumstances that         ny by the OIG, the principal fraud                 in their own best interest.
may have had a dramatic effect on the        investigating body for Medicare and             5. Payment is made in cash or its equiv-
current and future lawful availability of    other governmental healthcare pro-                 alent.
certain -we        or benefit streams for    grams. There are also many other fed-              A smaller pool of purchasers may
                                             eral agencies that engage in fraud              result in less competition for acquisi-
                                             enforcement, such as the IRS and the            tions and therefore lower purchase
                                             Federal Trade Commission. Within this           prices. The universe of potential pur-

HEALTHCARE         s,
                                                                                            SeptemberlOctober 2008   VALUATION STRATEGIES   17
the purchaser pool; the availability of               are commonly referred to as discounts        enterprises by discounting their value
capital; and the perceived potential                  for lack of marketability.                   for a perceived lack of marketability97
value of healthcare entities as a stable                  Past studies relating to the impact of   For example, in Mandelbaum,9*the Tax
mechanism of investment return.                       regulatory events on business value          Court listed nine acceptable variables
These factors may be related to the                   typically use empirical pricelreturn         that affect discounts for lack of mar-
state of the general economy, as well as              data from the public capital markets.        ketability, one of which was restric-
to the healthcare capital markets.                    Most of these studies use ex-post            tions on the transferability of the
Notwithstanding the impact of these                   results, i.e., they measure differences      asset.99 Additionally, Shannon Pratt
factors on the pool of potential pur-                 using data and variables "after the fact."   has noted that "the existence of a rea-
chasers and therefore the "marketabil-                For example, Katherine Schipper and          sonable number of potential buy-
ity" of these enterprises, the impact                 Rex Thompson calculated a -6.0% total        ers.. .could dampen the discounts for
on transactions for many healthcare                   return impact on acquiring companies         lack of marketability."loo
business enterprises (e.g., profession-               after enactment of the 1968 Williams            The duration of any restriction
al practices) that may already have a                 Act amendments to the Securities and         placed on the transferability of an asset
limited pool of qualified purchasers or               Exchange Act of 1934,so while Paul           will affect the asset's marketability dis-
investors is greatly exacerbated due to               Allen and William Wilhelm calculated         count. All else being equal, the longer
regulatory constraints related to anti-               losses of -4.3% and -4.4% for stock          the period that an asset is non-mar-
fraud enforcement.                                    portfolios of non-Federal-Reserve-           ketable, the lower the value will be. As
   Discount for Lack of Control. A Con-               affdiated banks, and savings and loans
trol premium is an increase to the pro                institutions, respectively, for the week
rata share of the value of the business               during the passage of the 1980 Depos-
that reflects the value inherent in the               itory Institutions Deregulation and
management and financial power that                   Monetary Control Act.91
can be exercised by the holders of a con-                 Similarly, in the healthcare market-
trol interest of the business (usually the            place, regulations that limit physician
majority holders). In contrast, a dis-                ownership may act to limit the poten-
count for lack of control or minority                 tial investor and buyer pools and
discount is the reduction from the pro                decrease the number of joint ventures
rata share of the value of the business as            between physicians and hospitals.92
a whole that reflects the impact on val-              Specifically, increased regulation affect-
ue of the absence or diminution of con-               ing physician investment, i.e., Stark I1
trol that can be exercised by the holders             and anti-kickback legislation, results
of a subject interest. Accordingly, any               in physician providers having limited
intervention to limit the extent of physi-            access to capital, thereby being rele-
cian ownership to a minority interest                 gated to cope with aging equipment;
may require a significant discount for                and decreased ability to attract, recruit,
lack of control if enacted.                           and retain quality physicians, with a
     Discount for Lack of Marketability.              resulting loss of market share, revenue,
There are inherent risks relative to the              and profit.93 Moreover, multiple com-
liquidity of investments in closely held,             mentators have argued that self-refer-
nonpublic companies. Investors in                     ral regulations have led to the exclusion
closely held companies do not have the                of physicians as major investors in new
ability to dispose of an invested inter-              "health market initiatives,"94 thereby
est quickly if the situation calls for it,            reducing the investor pool in health-
e.g., forecasted unfavorable industry                 care markets in which physicians seek
conditions or the investor's personal                 to have an ownership interest. One
immediate need for cash. This relative                commentary on the impact of the Stark
lack of liquidity of ownership in a                   provisions on the physician investor
closely held company is accompanied                   pool stated that "the overall effect of
by risks and costs associated with the                'Stark laws' has been to chill a large
selling of an interest of a closely held              source of investment in our healthcare
company: locating a buyer, negotiation                system.. . by [excluding] physicians as
of terms, advisor or broker fees, risk of             major investors:'95 while another cri-
exposure to the market, etc. Thus, a                  tique of self-referral laws has argued

18   VALUATION STRATEGIES   Septernber/October 2008                                                                            HEALTHCARE
                        leading commentators have explained,              The proposed legislation was not lirn-
                        "the marketability of an asset refers to      ited to specialty hospitals, but grandfa-
                        the degree to which an asset can be           thered hospitals that were operating with
                        converted to cash quickly, without            Medicare provider agreements as of the
                        incurring large transaction costs or          date its introduction. However, i
                        price concessions."l01 Additionally, in       required those grandfathered hospitals to
                        the words of other observors,"the more        meet certain standards within 18 months
                        severe the marketability restriction.. .      of the enactment of the bill. Those stan-
                        the greater the discount."lo2 As              dards included: "preventing growth
                        explained by Professor Ashok Abbot:           requiring disclosure of ownership, lim-
                                                                      iting physician ownership to an aggregate
Anv intervention            The small number of potential             of no more than 40% of the facility and
to h t the extent           buyers decreases the competition
                            inherent in an auction market,
                                                                      no more than 2% individually, and dis
                                                                      closing to patients if they fail to have 24
of physician                therefore lack of depth and
                            resiliency force a higher price           hour physician coveragel'l"
ownerslu~ ato               impact of trading. Consequently
                            the seller has to choose between a
                                                                          Recent attempts to pass limitations
                                                                      on physician ownership, such as the
minority bterest            long liquidation period (lack of
                            immediacy) with attendant price
                                                                      amendment to the 2008 supplementa
                                                                      appropriations bill do not include the
                            risk and the immediate price pres-
                                                                      individual ownership limitation and
s+&t        hunt            sure attributable to lack of depth.
                            It is important to note that price        instead only limit total physician own-
for lack of contml.         risk is not only the risk of a decline
                            in selling price but also the risk of
                                                                      ership to 40% or the percentage owned
                                                                      by physicians when the act took effect.'"
                            not being able to realize the high-       Attempts have also been made to include
                            er prices that might occur during         similar language in another bill, the Pau
                            the period of liquidation. The two
                            components of the discount for
                                                                      Wellstone Mental Health and Addiction
                            lack of liquidity can, thus, be iden-     Equity Act of 2008.107
                            tified as the price pressure caused           If enacted as part of future legislation
                            by additional supply of the stock         provisions such as those in CHAMP
                            and the price risk faced by the           could have a significant impact on physi-
                            holder as a result of the long liq-       cian investment time horizons, as well as
                            uidation period. Optimal trading
                            strategy for a seller is to minimize
                                                                      on the valuation of physician-owned
                            the total cost of the price pressure      equity interests in hospitals to which
                            and the price risk by selecting           those physicians refer patients.1" Specif
                            appropriate levels of trade size and      ically, provisions such as those in
                            frequency over the anticipated liq-       CHAMP may have the effect of obviat-
                            uidation period.103                       ing the economic ownership interests
                                                                      of physicians in legally held property
                                                                      under the valuation standard of fair
                                                                      market value and the valuation premise

                    I   CHAMP and Valuation of Hospitals
                        Currently, the "whole hospital" excep-
                        tion to the Stark law allows physicians to
                                                     - .
                        have an ownership interest in a hospital
                                                                      of value-in-use as a going concern. This
                                                                      would result instead in lower values
                                                                      under the premise of value-in-exchange
                                                                      through forced liquidation (or through

                        to which those physicians refer patients,     orderly disposition) because of the
                        provided the physician is invested in the     insufficient exposure to market tha
                        whole hospital and not a subdivision of       would result from the limitation of the
                        the hospital, with no limitations as to       18-month compliance period, and an
                        the amount or extent of physician own-        asymmetric shift of information and
                        ership, on either an aggregate or indi-       leverage toward buyers to the potentia
                        vidual basis. Provisions contained in the     economic detriment of sellers.
                        Children's Health and Medicare Protec-            Additionally, if enacted, provisions
                        tion Act of 2007 (CHAMP)lM effective-         such as those included in CHAMP would
                        ly proposed a change to the "whole            result in the subsequent remaining physi-
                        hospital" exception, which would have         cian investors' holdings being placed in
                        prohibited physicians from having an          a minority position, leaving physicians
                        ownership interest in a hospital to which     unable to control invested capital. The
                        those physicians refer patients, thereby      resulting lack of physician investor con-
                        eliminating the exception.                    trol may affect (Continued on page 47

HEALTHCARE                                                           September/October 2008   VALUATION STRATEGIES   1
(Continuedfiompage 19) investors' per-                             Appraiser Liability                                                 Young) resulting from involvem
ceptions as to the risk of investing in the                         Much of healthcare valuation relies                                a false claims lawsuit is the M
subject enterprise, as related to:                                  on the standard of fair market value                               Regional Medical Center qui
 1. Future quality of care.                                         as the nexus of regulatory compli-                                 action. In U S . ex rel. Raugh v. M
2. Efficiency of operations.                                        ance. Application of a different stan-                             Regional Medical Center of the P
3. Convenience of provider and patient                              dard of value may place the healthcare                             Inc.,los a qui tam action was
    scheduling.                                                     entity, as well as the appraiser, at risk                          against McLeod Regional Medica
4. The enterprise's ability to incorpo-                             for legal sanctions and enforcement                                ter, a tax-exempt organization, a
    rate future technological innova-                               actions.                                                           that McLeod submitted false cla
    tions into the venture.                                            M c b d Regional MedPcal Center. An                             Medicare in violation of Stark
5. The possibility of the loss of highly qual-                      example of appraiser liability (Ernst &                            the anti-kickback statute, in conn
    ified, trained, and assembled workforce
    in place, which physician investors have
    developed and which were central to
    attracting patients to physician-owned
    hospitals.This could occur if physician
    participation in the physician-owned
    hospital investor pool is limited or pro-
    hibited, and general hospital systems or
    corporate buyers (to whom such work-
    force may be considered redundant)
    remain as the most probable owners.
    As discussed earlier, there are inher-
ent risks relative to the liquidity of invest-
ments in closely held, nonpublic
companies. Accordingly, elimination of
the "whole hospital" exception has the
potential to have a negative impact on
the economic value of equity interests in
hospital enterprises owned by physicians
who refer patients to those hospitals.
Restrictions on capital formation from
equity investments by physicians a u l d
lead to (1) an increase in the discount
for lack of marketability, which in turn
accounts for the largest impact on the
value of physician-owned shares ceteris
paribus and (2)the decrease in the value
of noncontrohg equity ownership inter-
 ests in the subject hospital enterprise.

lMBajaj e t a/., "Firm Value and Marketability                                   Corporation that IS emailed to PHA association            Comparison t o Language in HR 1
   Discounts;' Social Science Research Network,                                  n~mbers,                                                  Impact of Proposed Amendments to L, (21?6/01), pp. 3,4.                                           107"c~o    still slamming physician ownership:'              in Supplemental," Physician Hosp
                                                                                 Surgicenter Online, http:/hywwhYwwvpico.wmlarticle-       America (5/15/08), from electronic ne
                                         f ~ ~
w & ~for L.& of ~ ~ ~ k~ ~ ~~~~i~~~~~~ i ~ ~ :                       ~ ~
                                                                    ~ ~ b i l                                                              published by Physician Hospitals of
  wJ+hantitative                             Models; Financial Consulting        manager/printerfriendlyYaspx?article=189756.
                                                                                                                                           Corporation that is emailed          as
   Group, LLCwebinar (presented by jim it*^^^,                                108lt should be noted that while the 2007 CHAMP
   5/13/08), p. 46.                                                              provisions were not passed, there have been
                                                                                 several attempts to introduce almost identical        u)gCase No. 39&3178 (DC S.C., 1998).
lwAbbot' ' Quadtaive                                Measure Of           for     prov,sions in legislation throughout 2008, most       110Broccol0, note 41, supra, p.70.
                                               z6 Businessvaluation Review       recently in language added to the Senate ver-
   (Spring 2007).
                                                                                                                                       1 1 , s ~ c ~ e~ d
                                                                                                                                        1              o          ~     centerto
                                                                                                                                                                  ~ ~ d i ~i
                                                                                 slon of the fiscal year 2008 Senate appropria-            Over $15 Million to Resolve False Cl
lwH.R. 3162,IlOth Cow, IstSess.                                                  tions bill, which would effectively remove the            ~      l   ~ U,S, ~D ~of justice, press
                                                                                                                                                                     ~ ~~ ~ i,
lW"HR 3162: The Children's Health and Medicare                                   "whole hospital'' exception to the Stark Law              11/1/02, see w,us~oj,gov,
   Protection Act of 2007v ammittees onways and                                  and restrict future growth of specialty hospitals.
                                                                                 I" addition t o placing several restrictions on       112Br0ccoioz              p.70.
   Means and                                                          2007,
                                                                                 physician ownership percentages and require-             509 U.S. 579 (1993).
                                                                                 ments for Medicare certification on those spe-        114"Regulations G o v e r n ~ n gt h e Pra
                                                                                 cialty hospitals that would be grandfathered.            Attorneys, Certified Public Accounts,
lo6"pH~           Political Update:' Phvssan Hospitals of                        See Memo from Randy Fenninger to Melissa                 Agents, Enrolled Actuaries, and Ap
   America (5/22/07), from electronic newsletter                                 Bartlett Re: Physician Ownership Language in             before the Internal Revenue Service:'
   published by Physician Hospitals of America                                   Senate Supplemental Appropriations Bill,                 Subtitle A. Part 10.

HEALTHCARE                                                                                                                                                      VALUATION STRATE
with its purchase of several physician          through payment directly or indi-        4. Outlined the rules applicable to dis-
practices and subsequent employment             rectly of a kickback or billed in           ciplinary proceedings.
arrangements. The relator additional-           violation of federal law.111             5. Provided general provisions, includ-
ly alleged that the purchase of the                                                         ing those related to the availability
physician practices exceeded fair mar-          The case settled for $15,485,000 in         of official records.
ket value, with the terms of the physi-      October 2002. It is of particular note         The law authorizing sanctions also
cian employment agreements                   that although the relator, who was pre-     gives the IRS the authority to disqualify
evidencing an intent t o buy future          viously the head of physician network       any appraiser, barring them from pre-
referrals.110 Specifically, as the Justice   development at McLeod, was released         senting testimony or evidence in any
Department explained:                        from criminal and civil liability, he       administrative proceedings before the
                                                                                         Department of the Treasury or the IRS.114

                                                                                         The historical performance of healthcare
                                                                                         entities may no longer necessarily serve
                                                                                         as a roadmap to the future value of the
                                                                                         healthcare enterprise because once-law-
                                                                                         ful revenue streams (e.g.,physician own-
                                                                                         ership of specialty and surgical hospitals
                                                                                         under the whole hospital exception to the
                                                                                         Stark Law) are now being questioned and
                                                                                         may soon be impermissible. Since one of
                                                                                         the fundamental tenets of business valu-
                                                                                         ation is that value is the expectation of
                                                                                         future economic benefits of ownership,
                                                                                         knowledge of the regulatory environment
                                                                                         in which the subject entity operates is a
                                                                                         necessary precondition to valuation of
                                                                                         healthcare enterprises. To estimate future
                                                                                         economic benefits of ownership that will
                                                                                         be generated by a subject healthcare enter-
                                                                                         prise, as well as assess the future invest-
                                                                                         ment risk related to those benefits,
                                                                                         investors and healthcare appraisers must
                                                                                         be continuouslyaware of the implications
                                                                                         of the changing regulatory environment,
                                                                                         at both a federal and state levels.
                                                                                             Valuation of healthcare enterprises,
                                                                                         which are sensitive to government inter-
     The claims for services referred,       received no financial share of the set-     ventions that affect the liquidity of capi-
     ordered or arranged by those            tlement paid by the defendant.112           tal, either by disrupting the makeup of
     physicians were alleged to be false        IRS Sanctions. Not only have stan-       the market investor pool or the expected
     in three respects: First, Section       dards applicable to appraisers been sig-    investment holding period time horizon,
     1877 of the Social Security Act, 42
                                             nificantly changed by Daubert v. Merrell    may require significant adjustments for
     USC 139nn (also known as Stark
     I I ) , prohibited McLeod from          Dow Pharmaceuticals, Inc.,ll3 the           risk or discounts for lack of control and
     billing Medicare for items or ser-      Supreme Court's landmark decision           marketability.Accordingly, the appraiser
     vices referred or ordered by physi-     regarding the requirements for expert       should perform thorough research and
     cians w i t h whom i t had such         testimony to be admissible, but the         maintain industry expertise and knowl-
     financial relationships. Second,        regulatory arena for tax-exempt orga-       edge of the ever-changing healthcare reg-
     McLeod forfeited its right to sub-      nizations has also seen an increasing       ulatory environment, while working in
     mit those claims to the federal
     health care programs by paying          shift to heightened appraiser account-      conjunction with healthcare legal coun-
     remuneration intended to induce         ability. In Circular 230, the IRS has:      sel to ensure that the subject entity and the
     those and other referrals in viola-     1. Set forth rules related to the author-   appraiser are complying with applicable
     tion of the Anti-Kickback Statute,         ity to practice before the IRS.          federal and state regulatory requirements.
     42 USC 1320a-7(b).And third,            2. Prescribed the duties and restric-       These efforts are important not only to
     McLeod certified falsely on                tions related to such practices.         produce a credible valuation, but also to
     Medicare cost reports that the ser-
     vices identified or summarized          3. Prescribed sanctions for violating       protect both the client and the appraiser
     were not provided or procured              the regulations.                         from legal liability.

48   VALUATION STRATEGIES                                                                                              HEALTHCARE

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