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4 Whistling Pas
.
,
Regulation
Gr v yard: Th
r e of
O n R e ~ t ~ c aa uation
ROBERT JAMES C l M A S l
V!rt
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
l
R I C H A R D K. ELLSWORTH
charwferislicsshould be carejdly considered when interpm6ing value indimlions provided from
Indus~r;al/Dcildies'
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
R I C K DAUBENSPECK
Determining the Value of Solar h r g y S'xlerns
34 Valuation Practice
DAVID FAWCETT
-
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 --..dm.
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)
r
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
e
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
ROBERT JAMES CIMASI, MHA, ASA, CBA, AVA,
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.
.A!
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.
8
(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), oig.hhs.gov/fraud/
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:
$f
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
I
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://
www.mondaq.com/ article.asp?article-id=
" 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,"
lmaging
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
Act
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 w.reedsmith.com/ -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
91
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 w.idph.state.il.us. 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/www..aameda.org/Memberse~~s/Exec(A organization,the organization may have
for
86 "A~~lying 501 (c)(3)Ta*Exem~t Status:' (IRS). p.
ticle~inte~5JStarkandRuralHealthCare,~,
3, available at: http://www.irs.gov/pub/irs- 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:/~.irs.gov/pub/irs-tege/eotopic85.p 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
A
emergencydepartment u t l discharge
ni their investment legally, often dri
2
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
~
I
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,
w
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
Healthcare
(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
www.ssm.com, (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
members'
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).
hap:,~enerwmmerce~h~,CHAMPiFINAL
ments for Medicare certification on those spe- 114"Regulations G o v e r n ~ n gt h e Pra
%20c~~Mp$620section'01bb~lby%20section'pdf'
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
Conclusion
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
