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Trends come and go. By definition, that is why they are trends. In the late 1980s, continuing through much of the 1990s, one trend in the health care industry was the creation of integrated delivery systems. While the personalities and legal structures differed depending upon the deal dynamics, the end result was typically an integrated health system. There were numerous drivers behind this trend. One driver was the rapid growth of for-profit hospitals. Many communities, justified or not, were fearful of having a for-profit entity own their local hospital because the out-of-town for-profit parent would simply strip profits out rather than reinvest them in the community, like the traditional nonprofit entity. Another driver was the consolidation of managed-care companies, such as health maintenance organizations (HMOs). Given antitrust restrictions, independent hospitals believed that they would simply be pitted against each other by stronger managed-care companies and, with this disparity in leverage, would not be able to adequately compete in the marketplace. Lastly, health care delivery systems allowed individual hospitals to achieve scale in back-office operations and expensive technologies. Once the delivery system was created, the struggle was making it an integrated delivery system. Health systems struggled to turn facilities that were once competitors into collaborators, responding to local needs for capital dollars and generally figuring out how to take advantage of the scale that they created. Eventually, many health systems thrived, taking advantage of their scale to reduce back-office costs, eliminate duplicated services, more effectively negotiate with managed-care companies and invest in technologies that individually they may not have been able to acquire. In the face of rapid industry consolidation, many hospitals chose to remain independent. Often, these were strong, community-based hospitals that had a loyal physician and patient base. As a result, the hospital boards felt the costs of joining an integrated delivery system, which included loss of control, potential diversion of profits to what were formally or formerly competitors and contribution to programs that otherwise may not have been undertaken outweighed the benefits of consolidation. But the more things change, the more they stay the same. Today, independent hospitals and smaller health systems are examining ways they can grow. And larger health systems are discovering, especially in areas of low population growth, that in order to grow, they need to gain market share or expand the service area, which can be difficult in ultra-competitive health care markets or areas where there is little population growth. So they seek to partner. But rather than immediately jumping into a full-fledged consolidation, community hospitals or smaller health systems may seek initially to go halfway, wanting some type of affiliation for collaboration but wary of a consolidation for any number of reasons. Hospital affiliations can be an effective mechanism for collaboration and are often an effective way to determine whether the collaborators can be effective partners for a full-fledged consolidation. However, affiliations have their limitations, and are often not effective in achieving what the parties may initially perceive to be their ultimate goal. This article will discuss in greater detail certain drivers behind hospital affiliations, and business and legal considerations that must be carefully examined by both the parties prior to entering into an affiliation so that the affiliation’s potential is maximized. Starting point: Why affiliate? There are any number of reasons a smaller hospital or health system may want to affiliate. These are discussed below. Often, a primary reason a hospital board may want to affiliate with a larger health system is to gain negotiating clout with managed-care payers. However, under applicable antitrust laws, this is often difficult to accomplish. Under � 1 of the Sherman Act, certain agreements among competitors may be summarily condemned without extensive inquiry into their actual or likely anti-competitive effects. Summary condemnation generally applies to “naked” agreements among competitors that restrict competition or reduce output, such as agreements on price, agreements allocating customers or territory, and agreements not to compete. 15 U.S.C. 1; See generally, “Comments on the Antitrust Aspects of Virtual Mergers: When might the antitrust laws condemn joint negotiation with managed care plans as per se illegal?,” presented by Mark J. Botti, U.S. Department of Justice, July 1, 1998. In the Statement of Antitrust Enforcement Policy in Health Care, the Department of Justice and the Federal Trade Commission stated that they will not necessarily view joint agreements on price between previously competing providers as unlawful price-fixing � even without risk sharing � if the competitors are sufficiently integrated. It is unclear what constitutes integration sufficient to permit joint negotiations; the enforcement statements do not provide solid guidance. In the context of a hospital affiliation, the question becomes whether there is sufficient clinical and/or financial integration so that they are a single entity, thereby eliminating the possibility of an agreement. See Copperweld Corp. v. Independence Tube Corp., 467 U.S. 752 (1984). A strong affiliation is often considered to be a virtual merger, and the issue for antitrust purposes is whether the virtual merger entails sufficient economic and clinical integration and control to permit it to be treated as a true merger, rather than merely a joint venture. The difference is critical: A merger integrates the parties so that they are a single entity incapable of conspiring with each other as a result of the integration, while competing entities that have not integrated remain fully subject to � 1 of the Sherman Act. In New York v. St. Francis Hospital, 94 F. Supp. 2d 399 (S.D.N.Y. 2000), two hospitals in Poughkeepsie, N.Y., with the approval of the state health department, created a joint venture and empowered the venture with shared operational and management authority for certain new clinical services for each of the two hospitals. The new venture had no physical facility or staff of its own. Later, the hospitals entered into an agreement to broaden the scope of the joint venture “in order to more closely integrate [the hospitals] to carry on further activities to eliminate costly duplication of services.” The two hospitals agreed not to compete with the venture, or with each other, for the provision of “the same or substantially similar services,” and to “unify substantially all hospital operations, including creating a single parent board, merging medical staffs into [the venture], combining development and control over clinical services and integrating administrative services.” The hospitals proceeded to allocate services and jointly negotiate managed-care contracts, but never created a single parent board or merged medical staffs. Id. at 403-07. The district court struck down the arrangement as a per se violation of � 1 of the Sherman Act. The court stated that it “is acutely sympathetic with defendants’ struggle to survive so that they may continue providing quality medical services to their shared community.” Id. at 422. The court also noted that a formal merger was “apparently out of the question” due to the hospitals’ different bond-financing sources, which could not be commingled, and the religious affiliation of one of the hospitals. The court then distinguished between the lawful, pro-competitive joint provision of new services and the unlawful integration of existing operations, holding that while the state had “wisely permitted defendants to provide certain capital-intensive services jointly,” the hospitals “went beyond that license and divided the market for most health care services between themselves; they even effectively fixed prices for most services provided to health insurers by negotiating jointly with them.” Id. One alliance that passed muster The most in-depth discussion of this issue to date is that in Healthamerica Pennsylvania Inc. v. Susquehanna Health System, 278 F. Supp. 2d 423 (M.D. Pa. 2003). There, two competing health care systems had formed an “alliance” of their hospitals controlled by a board of directors drawn from the two systems. The arrangement resulted in a very integrated single system in the sense that the alliance operated the hospitals on a day-to-day basis, the medical staffs were combined, all significant business functions were combined and services were moved and consolidated on two campuses so they were no longer duplicated. The alliance contemplated that ultimately, it would build a single hospital to replace the two facilities. Each of the two systems retained ownership of its hospitals and reserved some powers with regard to its hospitals. The alliance negotiated and contracted on behalf of the hospitals with managed-care plans. The court ultimately held that the alliance functions as a single entity and thus the collective activities could not constitute price-fixing. It is very difficult to achieve an affiliation that can jointly negotiate managed-care contracts but provide the entities the autonomy that caused them to consider the affiliation model rather than full integration. Therefore, a critical question for any board considering an affiliation is whether the benefits of joint managed-care contracting can achieve the desired goals and whether the benefits outweigh the perceived detriments of integration. Beyond managed care, however, there are significant drivers for hospital affiliations. First, independent hospitals and smaller systems often seek affiliations for better access to tertiary care services. Larger systems generally have broader availability of specialty services and are able to bring those services out to the hospital in an affiliation, allowing the smaller hospital to avoid the high investment required to add the services through an arrangement to purchase the service so that it is scaled to the hospital’s needs. Under a purchased service arrangement, the smaller hospital can bill and collect for the services, and pay the larger affiliated hospital a fee. Additionally, care paths are often developed so that patients needing more intensive services are transferred to the tertiary care facility in a more coordinated fashion. Second, an affiliation allows parties to develop a “green zone,” where they agree to jointly develop new services. These affiliations often involve hospitals that have bordering service areas, and the smaller hospital often doesn’t have sufficient access to capital to invest in the border area, while the larger competitor has adequate resources to enter the bordering service areas, but not necessarily a sufficient market share to justify the investment. Thus, the parties agree to collaborate on investment in facilities and new programs but, for antitrust purposes, they do not agree to restrict either party’s investment in the territory. Rather, the restriction is structured as a right of first refusal. Another affiliation driver is the reduced costs available to the smaller hospital or health system from the scale achieved by integrating it needs with the larger system’s back-office capabilities, purchasing power and management skills. Of course, these affiliation drivers are often balanced against local control. However, some of the more successful affiliations involve the larger systems providing certain management services and support to the smaller hospital or health system, often in exchange for a fee that is based on improved financial performance. Other business considerations There are many business considerations in a comprehensive hospital affiliation. A few are briefly discussed below. • Structure. Hospital affiliation structures range from basic contractual arrangements to more complex arrangements involving a joint operating company in which both parties have either an ownership or membership interest. Decisive factors regarding which structure to use include the current organization structures of the parties and tax-exempt financing that the parties may have (which may limit the ability of a joint operating company to provide long-term management services). Generally, however, legal structure typically follows desired affiliation functions. • Integration and unwind triggers. These are typically the most contentious business issues that need to be addressed. Typically, the end goal of the larger hospital system is a full consolidation or integration in order to achieve symmetry with the rest of its hospitals and allow it to fully integrate the smaller hospital or health system into an integrated delivery system. This is often the goal of the smaller hospital or health system as well. The difficult negotiating points concern when the integration will occur and what the triggers might be. Often they are a combination of time and operational triggers, permitting an earlier integration if certain goals are met and the parties are comfortable joining together permanently. No party wants to enter into an affiliation arrangement with the idea of unwinding it. From a practical standpoint, it is important that there not be an easy unwind, so that the parties have the true level of commitment needed to make the affiliation work. However, the smaller hospital or health system will want protections to unwind the affiliation so that it can ensure that its goals are being fulfilled and can continually put pressure on the larger health system to make the affiliation work. From a lawyer’s perspective, an unwind may be easy to draft, but great thought must be given to its implementation. What if the parties are three or four years down the road and the eggs are fairly scrambled? It is often time-consuming and expensive to implement an unwind for a comprehensive affiliation and, as such, consideration should be given to having the unwind remedy terminate at some point in the affiliation. • Financial commitments. In some affiliations, the smaller hospital or health system may seek some type of investment commitment from the larger hospital or health system. Certainly, this is much more typical in the consolidation scenario, but it has occurred in some affiliation transactions. Meshing the financial commitment with the unwind provisions is essential. A financial commitment often leads to a more comprehensive scrambling of the eggs, and typically a smaller hospital or health system will not have the wherewithal to immediately repay the funds if the deal were unwound. In such instances, any funds advanced could be converted to debt. Alternatively, the smaller hospital or health system could borrow the funds with a guaranty from the larger hospital or health system. This will probably allow the borrower to get a better interest rate and makes unscrambling the eggs a little easier. • Service commitments. The boards of both the smaller hospital or health system and the larger entity must focus on the detail of the service commitments. It is important to describe service commitments in detail, including time lines for implementation and resource commitments from both sides, so that there is a clear pathway for the affiliation. There also needs to be some flexibility with the service commitments because health care is continually changing due to new technologies, reimbursement and access to capital. To address this flexibility, the parties should consider having a committee that is dedicated to reviewing the goals of the affiliation, including the service commitments, and making modifications to them as market conditions and each party’s needs dictate. This will increase the potential for a successful hospital affiliation. • Reporting relationships. More comprehensive affiliations have a management component to them whereby the larger hospital or health system provides certain support services to its affiliated entity. Inevitably, this leads to concern among the managers of the smaller entity. They may feel that their job function will materially change or, worse yet, be eliminated. If this occurs, they may not be supportive of the affiliation either in the formation or implementation stage. Therefore, affiliations should have clear reporting lines between management of each entity and clear job descriptions so that everyone understands his or her role and the affiliation is maximized, not undermined. Typically, the larger hospital or health system will want the ability to provide direction to its affiliate’s management, but ultimately that management should dually report to its board and, on a dotted-line basis, to management of the larger hospital or health system. Finally, an issue of contention may be who has the right to terminate management employees. Hospital affiliations play an important role in today’s health care landscape. It is essential that when considering an affiliation, the parties think through many issues to avoid problems during the implementation, and that they understand the limitations of an affiliation. Steven A. Eisenberg is a partner in the Cleveland office of Baker Hostetler. He can be reached at [email protected].

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