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Legal Differences Between Investor-Owned and Nonprofit Health Care Sons John F. Horty and Daniel M. Mu~holIand TI! In recent years there has been a substantial increase in the number of investor-owned enterprises in the health care field, particularly hospitals.) This development has challenged some of the prevailing concepts and traditions of the field and of the professions engaged in it, particularly physicians. An increase in investor-owned enterprises in health care may have a number of political, economic, and social implications for the nation in general and the field in particular, but these implications cannot be adequately evaluated without an un- derstanding of the basic legal differences between investor-owned and nonprofit health care institutions. This paper will examine these legal differences with respect to organization, finances, and miscellaneous factors. Organizational Differences With few exceptions, both investor-owned and nonprofit hospitals are organized as corporations. A handful of investor-owned hospitals may still be set up as general or limited partnerships (mostly those owned by a few physicians), and a few nonprofit hospitals may be organized as unincorporated associations, but the corporate form is so over- whelmingly prevalent in the field that this paper will address only the legal issues arising out of the use of the corporate form. 17

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18 Investor-Owned Hospitals JOHN F. HORTY and DANIEL M. MULHOLLAND III Investor-owned hospitals are generally operated as either a separate proprietary "business" corporation or as subsidiaries of multihospital systems.2 Even among the hospitals that are subsidiaries of holding company chains, however, many individual hospitals are separate corporations and responsible to a certain degree for their own affairs, subject to the ultimate control of the holding company. Thus, the discussion that follows is equally applicable to freestanding investor- owned hospitals and those integrated into hospital chains. It should be noted that while a substantial majority of investor-owned hospitals are freestanding the vast majority of investor-owned beds are owned by chains. In short, the chain investor-owned hospitals are consider- ably larger than the freestanding hospitals in the number of beds and thus in operating expenses. All investor-owned corporations, regardless of whether they operate hospitals, are governed by the business corporation laws of the state in which they are incorporated. They must also register with other states in which they do business. Because of the relatively unobtrusive provisions of the business corporation laws of some states, e.g., Del- aware, with respect to internal corporate operations, many corpora- tions doing business in more than one state are incorporated under the laws of a state other than where they conduct the bulk of their business.3 Corporations that only do business within one state, how- ever, are more often than not incorporated only under that state's business corporation law. There are certain basic attributes shared by all business corpora- tions. All business corporations are ultimately governed by their shareholders, i.e., individuals or corporations who possess a proprie- tary interest in the assets and income of the corporation that is sig- nified by the ownership of stock. The shareholders, as owners of the corporation, elect a board of directors, which is responsible for the conduct of the corporation. The board of directors in turn employs various individuals who are responsible for the day-to-day operations of the corporation. These individuals are referred to as officers or agents of the corporation. In most cases, at least with respect to investor-owned companies, the officers of the corporation also are members of the board of directors. This is most frequently true of the chief executive officer of the cor- poration. Beyond this, it is difficult to identify any other general pat- terns of organization because the titles, functions, and relationships of the various elements of corporations differ from state to state as well as from corporation to corporation.

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Legal Aspects of Nonprofit Status 19

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20 JOHN F. HORTY and DANIEL M. MULHOLLAND III curities laws, such as the Securities Act of 19335 and the Securities Exchange Act of 1934.6 Corporations whose shares are available only to a limited number of shareholders and are not offered to the public are not subject to this regulation. One of the major advantages of the chain holding company mode} for operating hospitals is that removing central management of the corporation from the local sites of the hospital allows major fiscal and operating decisions to be made free of local pressure, either from the community or from physicians. Thus, the local hospital is more likely to conform to the corporate fiscal plan with greater efficiency. In effect, local management has less discretion and is less likely to be manip- ulated by local community or physician interests through the board, because management is electively employed and evaluated by the holding company. These are significant differences between the legal operation of the chain investor-owned hospital and the locally owned and operated nonprofit hospital. Nonprofit Hospitals The majority of hospitals (which represents the majority of hospital beds) are organized and operated as nonprofit corporations. They are subject to the nonprofit corporation laws of the states in which they are incorporated. Compared with business corporation laws, nonprofit corporation laws are far more varied through the country. Some gen- eral observations can nevertheless be made. There are two basic types of nonprofit corporations: membership and nonmembership.7 A membership corporation is more closely analogous to the investor- owned corporation in terms of its organization. A body of individuals known as the members is given the authority to elect a board of directors (or trustees as they are frequently called). In the case of a hospital the members may include individuals from the local com- munity, representatives of a religious group affiliated with the hos- pital, physicians on the medical staff, or even other corporations. The board is responsible for the conduct of the corporation. The board in turn employs officers and agents to run the day-to-day affairs of the corporation. These individuals are known as either management or administration of the corporation. The very use of the term administration instead of the generic cor- porate term management denotes the tradition in the nonprofit hos- pital corporation of giving the administrator the individual who is the equivalent of the chief executive officer in a business corporation- less authority than his business counterpart. This tradition is chang-

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Legal Aspects of Nonprofit Status 21 ing, and the nonprofit manager now has greater authority, in part as a result of the growth of chain investor-owned hospitals. State nonprofit corporation laws usually grant some degree of pro- tection to the rights of members with respect to actions taken by the board or corporate management, e.g., prohibiting the board from uni- laterally adopting any bylaws, amendments, or fundamental corporate changes that would affect the rights of the members or requiring that the books and records of the corporation be open for inspection by the members.9 In most states, however, nonprofit corporations do not have to be organized as membership organizations, and, even where they are, it is permissible to have the membership and the board of trustees com- posed of the same individuals.~ Thus, nonprofit corporations can be governed by self-perpetuating boards answerable only to themselves (and to state law) with respect to the internal affairs of the corporation. Although it would seem that a board and management of a corporation without members would have a far freer hand than their investor- owned counterparts in operating the corporation, generally there is little practical difference. Shareholders in business corporations sel- dom care about or exercise their prerogatives to change or restrict managements, as Tong as profits continue at an expected rate. Where members are present, the board and management may pos- sess less freedom, depending on the environment in which the cor- poration finds itself. This is especially true in the health care field. For example, hospitals located in areas with a strong tradition of community involvement by means of membership in the corporation will often have boards and management that are reluctant to embark on aggressive new or nontraditional hospital ventures for fear of up- setting some elements of the community, particularly the physicians. In such a situation the hospital corporation can become almost as highly politicized as a unit of local government. Other hospitals have corporate memberships composed completely or partially of the phy- sicians on its medical eta. This places the board in the rather pe- culiar position of having to answer to the same group whose medical quality it is responsible for overseeings Corporate membership bodies can also provide a vehicle for certain factions within the hospital to wrest control from boards or manage- ment that they are displeased with. In many instances, anyone can become a member of the corporation upon payment of token dues, often as little as $5.00 per year. Thus, a group that is interested or astute enough can gather a substantial following and attempt a coup. i3 Some states even provide for derivative suits by membership Fortu-

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22 JOHN F. HORTY and DANIEL M. MULHOLLAND III nately for boards and management, this threat is largely diminished by the usual inertia of the membership, and it can be further blunted by carefully crafted bylaws that provide for more stringent member- ship requirements or that allow the board to approve new members or remove current oneself The courts generally have protected the rights of boards and man- agement in such situations. For instance, in one case where a segment of the corporate membership of a hospital, during a dispute with the board, attempted to call a meeting on their own to remove the current board and elect a new one, an Illinois court invalidated that action and ruled in favor of the existing board, emphasizing that the hos- pital's bylaws did not permit that action. The court went on to rule that members of nonprofit corporations have no constitutional right to elect or remove board members because, unlike shareholders in business corporations, they possess no property interest in the cor- poration. In hospitals, perhaps more than other nonprofit institutions, it is essential that the board and management retain real control of the hospital. This is so not only because the nature and size of the business demand tight entrepreneurial control but also because various reg- ulatory and accreditation bodies, as well as the courts, have placed the responsibility for running the hospital squarely on the shoulders of the board. For example, the Joint Commission on Accreditation of Hospitals requires that each hospital have "an organized governing body . . . that has overall responsibility for the conduct of the hospi- tal...."~7 Likewise, the Conditions of Participation for the federal Medicare program require that each hospital receiving reimburse- ment from the program have "an effective governing body legally responsible for the conduct of the hospital as an institution." Many state licensing regulations have similar statements.~9 While revoca- tion of license or accreditation for these reasons is rare, the threat is there and is perceived as real. Most compelling, however, is the increasing number of judicial de- cisions in recent years holding that a hospital board is responsible for the quality of medical and hospital care rendered in the institution, even by nonemployees,20 as well as for the fiscal integrity of the cor- poration.2i If a hospital board is to fulfill] its responsibilities in this area, it must exercise the ultimate authority within the corporation. In light of these realities, corporate bylaws that dilute the authority of the board, in favor of corporate members who may not be concerned with profit or the dynamic future of the corporation, are a threat to the well-being of the institution.

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Legal Aspects of Nonprofit Status 23 in most multihospital systems (both investor-owned and nonprofit) the authority of the board of each individual hospital within the sys- tem is necessarily circumscribed to some degree by the reserved pow- ers ofthe controlling entity of the system. Nevertheless, the individual hospital boards will still be held legally responsible for the conduct of their respective institutions. Thus, in order to avoid an increased potential for liability, enough discretionary power to deal with inter- nal concerns, especially medical staff affairs and quality assurance, must be given to the individual boards. There are, however, some multihospital systems (mostly investor- owned) in which the individual hospitals are not separately incorpo- rated. Rather, one corporation with one board owns all the hospitals collectively. This kind of arrangement, while possessing some tax advantages, has some serious drawbacks. The single corporate board will be held legally responsible for the conduct of each individual hospital, even though it is not as close to the day-to-day operations of the hospital as a local board would be. Also, creditors and tort ciaim- ants who are awarded judgments against one of the hospitals in the system can satisfy those judgments by attaching the assets of some or all of the other hospitals. This generally would not be possible if each hospital were separately incorporated. Another factor that creates an important organizational distinction between investor-owned and nonprofit hospitals are the strictures im- posed on the purposes for which nonprofit corporations can be orga- nized and operated. First of all, almost all nonprofit corporation statutes require that the corporation be for a limited number of purposes, generally charitable, scientific, educational, benevolent, religious, etc.22 Second, and this is probably the most fundamental difference between investor-owned and nonprofit corporations, the income and assets of the nonprofit corporation are not permitted to inure to the benefit of any private individual.23 This does not mean the corporation's board and management must serve without pay. It simply means that no private individuals, in- cluding the board and members, can exercise "ownership rights" in the corporation's assets as shareholders would with respect to the assets of a business corporation.24 Other provisions in nonprofit cor- poration statutes can require judicial supervision of the dissolution of nonprofit corporations.25 These statutes effectively prevent a whole range of entrepreneurial partnership arrangements that could bring equity capital into the corporation and that are routinely open to investor-owned hospitals. Despite the fact that nonprofit corporations are subject to this re-

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24 JOHN F. HORTY and DANIEL M. MULHOLLAND III strains against private inurement, nonprofit corporations are not ap- pendages of state or local governments. They are private institutions created pursuant to a statute but with a separate legal existence of their own. Therefore, it is incorrect to characterize their assets or operations as "public" assets or operations. Although those assets or operations may be devoted to a generally public or charitable purpose, and private individuals are prohibited from "profiting" from them, they are owned by and are the responsibility of a private nonprofit corporation. As previously implied, the restraint against private inurement has been said to be a primary source of operational differences between investor-owned and nonprofit health care institutions. Some observers have concluded that the absence of a profit motive in nonprofit cor- porations leads managers of such institutions to seek "prestige" among their peers in lieu of monetary rewards.25 This may channel energies, for good or bad, into expanding the physical plant or adding sophis- ticated technological equipment, without the requirement of profita- bility. This may be good for the availability of health care to the community but may be a risk to the long-term financial viability of the corporation. It has also been asserted that the professional be- neficiaries of nonprofit institutions (in the case of hospitals, the med- ical staff) often fill the vacuum left by an absence of shareholder proprietors and dictate policies of the institution.27 This is especially true where the board or management fails to exercise proper lead- ership. At least one study has concluded that nonprofit hospitals are less efficient than their investor-owned counterparts in the ratio of per- sonnel to the occupancy rate.28 Other studies support the conclusion that managers in investor-owned hospitals perform better than those in nonprofit institutions because of the latter's lack of proprietary incentives.29 Current statistics seem to bear this out, although the data unfortunately are not controlled for the mix and severity of cases. In 1981 investor-owned institutions had a lower average length of stay (6.5 days to 7.~) and lower full-time equivalent personnel per 100 adjusted census (322 to 348) than nonprofit hospitals.30 And, while average daily expenses were slightly higher in investor-owned hos- pitals than in nonprofits ($299.02 compared with $285.61), labor costs were significantly lower in investor-owned hospitals than in non- profits ($140.32 to $164.01 per inpatient day).3i These figures, which are commonly viewed as indices of efficiency in the health care field, would seem to indicate a marked advantage associated with the investor-owned form of organization. However,

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Legal Aspects of Nonprofit Status 25 they must be viewed in light of the fact that many investor-owned institutions tend to have a higher proportion of"paying" patients as opposed to those whose bills are paid by third-party programs, such as Medicare, that reimburse at or below actual costs and that nonprofit hospitals are more likely to be engaged in costly teaching or training programs programs whose costs center in the nonprofit field but whose benefits accrue to all. Some investor-owned hospitals (as well as some nonprofits) have chosen not to participate in Medicare or accept charity patients at all or to set quotas (stated or unstated) on the number of such patients who will be treated. This had led to charges that some investor-owned hospitals have been "dumping" Medicare, Medicaid, and charity pa- tients on their nonprofit neighbors, especially in areas such as south- ern Florida.32 A larger percentage of Medicare patients, who because of age or type of illness, generally stay in a hospital longer and require more intensive nursing care, could explain, at least in part, the dif- ference in "efficiency" figures between investor-owned and nonprofit hospitals. Thus, the meaning and explanation of reported differences between different types of hospitals is not clear, and more empirical research is warranted. Where dumping of Medicare, Medicaid, or charity patients has al- legedly taken place, the medical staffs of the nonprofit and investor- owned hospitals involved often consist of virtually the same physi- cians. This means that for one reason or another, the physicians have made a conscious decision to treat one segment of their patients in one hospital and others in another. Where the physicians own a pro- prietary interest in the investor-owned hospital, the reason behind their decision to admit only paying patients there is rather obvious. However, where the hospitals are all nonprofit, or where an investor- owned hospital chain is involved, the physician's actions may be dic- tated by policies adopted by the hospitals or by the expressed feeling of one of the hospitals that it has a "duty" to receive and care for all patients regardless of their ability to pay. Once again, too little em- pirical data are available to make a definitive analysis of the subject, but clear anecdotal examples exist. To summarize, there are a number of significant differences in the way the law treats investor-owned and nonprofit hospitals with re- specs to their organization. While there also seem to be some statistical differences in the efficiency with which the two types of hospitals conduct their operations that favor the investor-owned form, it is not clear that these differences can be causally linked to the legal differ- ences between the two forms except where the corporate decision mak-

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26 JOHN F. HORTY ant! DANIEL M. MUBHOLLAND Ill ing can be more "objective" when removed physically and organiza- tionally from the local scene. Financial Differences Another set of possible determinants of different patterns of behavior between for-profit and nonprofit hospitals are the legal incentives and disincentives affecting their financial affairs. These factors, which include tax exemptions, reimbursement mechanisms, available sources of equity capital, and restrictions on certain transactions, are often the guiding force behind the major decisions made by health care institutions. Tax Exemptions The most significant factor affecting the financial affairs of nonprofit hospitals is the availability of an exemption from federal income tax under Section 501(c)~3) of the Internal Revenue Code. This exemption gives nonprofits an advantage by allowing them to devote more of their gross revenues to internal operations and expansion of the same. It also frees them from the necessity of basing decisions on tax im- plications, except where possible unrelated business taxable income may be involved.33 Even when the actual amount of tax would not be great (as is more and more the case with declining revenues and tax rates), an exemp- tion under Section 501(c)~3) is important for other reasons. For one thing, it is a prerequisite to obtaining an exemption from federal Social Security taxes,34 which can result in tremendous savings for hospitals because they tend to be labor-intensive operations. Also, it provides access to sources of support that otherwise would not be available, i.e., tax-deductible donations35 and tax-exempt bond financing.36 Almost as valuable as federal tax exemptions are exemptions from state taxation. Traditionally, the most important of these are property tax exemptions, which are usually available to nonprofit corporations organized for charitable purposes in general or for hospitals in par- ticular. Recently, however, tax exemptions for hospitals in a few states have been successfully attacked by local taxing authorities using the theory that because hospitals receive reimbursement from third par- ties for almost all the care they provide they are no longer "charitable" operations.37 Other state tax provisions of significance to nonprofit hospitals include exemptions from state sales taxes (for hospital pur- chases) and corporate income taxes.

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Legal Aspects of Nonprofit Status Reimbursement Factors 27 Until recently, conventional wisdom held that nonprofit hospitals had a decided financial advantage over their investor-owned counterparts because of their tax exemptions. Lately though, it has been observed that certain factors involved in third-party reimbursement schemes, particularly Medicare, favor investor-owned hospitals and may coun- terbalance or even outweigh the tax advantages of nonprofits.38 As a result of repeated budget cuts, the Medicare program now reimburses all hospitals at less than their actual costs for treating Medicare patients. This is largely due to the reimbursement limits imposed on routine inpatient costs by Section 223 of the Medicare amendments of 1972 and the regulations thereunder.39 If these limits are extended to ancillary services, this shortfall will be exacerbated. Faced with inadequate reimbursement from major third-party payers, hospitals are forced to make up the difference from paying patients or commercial insurance carriers. Many nonprofit hospitals are re- luctant or unable to do this, either because of their historical mission to serve the poor, their location in predominantly poor or aging neigh- borhoods, or legal requirements that they render a certain percentage of their services without compensation in return for having received federal construction funds under the Hill-Burton Act.40 Investor-owned hospitals, on the other hand, are in most cases under no obligation to provide charity care and are more likely to accept only patients for which they will be reimbursed in full. Furthermore, investor-owned hospitals are entitled to third-party payments that nonprofits are not. The most prominent of these is reimbursement for a reasonable "return on equity" in addition to costs under the Medicare program.4~ This return on equity recently has been paid at rates up- ward of 22 percent of net equity.42 Investor-owned hospitals are there- fore guaranteed a "profit" that is denied nonprofit hospitals. In addition, many federal and state taxes are allowable costs under the Medicare program,43 so the tax advantage of the tax-exempt nonprofit hospital is further reduced. Sources of Capital At first glance, nonprofit hospitals would seem to have an advantage in attracting new capital because of the tax deductibility of contri- butions to them and the availability of tax-exempt bonds. Indeed, this latter category of financing has become almost crucial to the survival of the nonprofit side of the industry. As of 1981 it is estimated that

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2~3 JOHN F. HORTY and DANIEL M. MULHOLLAND III over $5 billion worth of tax-exempt hospital bonds have been issued.44 These bonds are the primary source of funding for hospital construc- tion, financing 49.3 percent of such activity in 197S, compared with 6.2 percent from philanthropy and 8.6 percent from government funds.45 The tax-exempt feature enables nonprofit hospitals to issue bonds with higher ratings and lower interest rates than would otherwise be pos- sible, thereby increasing their marketability and decreasing ex- penses.46 The concept of tax-exempt bonds is under increasing federal government scrutiny, and the future is uncertain. Private charitable contributions to nonprofit hospitals have de- creased in importance over the years, mostly as a result of the advent of Medicare and the consequent shifts of donor interest to other fields. This trend probably will accelerate, as recent tax code changes reduce the incentive for taxpayers to contribute to charities. The Economic Recovery Tax Act of 198147 reduced the maximum rates of both federal income and estate taxes, which could work to discourage some larger donors from contributing, because the value of the deduction they would receive is less. Also, the general economic downturn during 1982 can be expected to diminish charitable giving. At the same time, investor-owned hospitals are not as disadvan- taged by the lack of access to the tax-exempt bond market as one might expect. In the first place, tax-exempt financing is available under limited circumstances to investor-owned hospitals under the so-called small issue exemption.48 Moreover, third-party payers, in- cluding Medicare, usually reimburse hospitals for their borrowing costs.49 Some observers have even claimed this fact renders normal borrowing more beneficial to the hospital than tax-exempt borrowing since the savings realized from the tax exemption are passed on to the third-party payers.50 Investor-owned hospitals also can resort to the most traditional method of raising capital issuing stock which is unavailable to nonprofit hospitals in most states.5i However, some of the larger inves- tor-owned chains have reduced their reliance on this method of fi- nancing in recent months, opting instead for bonds, debentures, and short-term notes, because of a downward trend in their stock prices caused by government indecision over reimbursement.52 This provides further support for the theory that debt financing is not as unattrac- tive to investor-owned hospitals as was previously thought. Restrictions on Transfers of Property Many state laws governing nonprofit corporations prohibit the trans- fer of funds restricted for specific charitable purposes without judicial

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Legal Aspects of Nonprofit Status 29 approval.53 For example, if a nonprofit hospital solicited and received donations that were earmarked by their terms for the construction of a new surgical suite and some of those funds were left over after the suite was constructed, the hospital would have to obtain a court order allowing it to use the excess funds for other purposes. These restric- tions, which find their origins in the law of charitable trusts, can be burdensome in the sophisticated business environment in which hos- pitals find themselves. They could also give rise to significant prob- lems when hospitals needing to convert dormant assets, such as real estate, into ready cash face restrictions that were attached to the use of the asset when it was donated. Some states have laws that permit the state attorney general to institute investigation and enforcement actions concerning alleged misuse of charitable gifts by nonprofit corporations, presumably even where there are no explicit restrictions imposed by the donor.54 Others require membership approval before transfers of property can be made.55 Such statutes have the potential of hindering the financial conduct of nonprofit corporations, although in practice they may not be strictly enforced.56 Moreover, because the majority of nonprofit hospitals are small, independent, local corporations, they lack the ability of the investor-owned chains to transfer assets between hospital units as needed and to guarantee large loans and bond issues, very important fiscal tools in today's financial market. It is impossible to generalize whether the nonprofit or the investor- owned form is most advantageous for hospitals with respect to their financial transactions. While it is true that many advantages histor- ically possessed by nonprofit institutions have eroded over the years, the tax exemptions that are usually available to nonprofits still pro- vide a powerful incentive for them to retain that status. Only a careful analysis on an institution-specific basis can determine which form best suits a hospital from a financial point of view in light of current or forecast legislative or regulatory realities. In the end, given in- adequate reimbursement for care of the elderly and poor, the major fiscal disadvantage of the nonprofit hospital may be community, state, and federal expectations of the role of such hospitals. Other Legal Differences Another set of legal differences between investor-owned and nonprofit hospitals are laws requiring a greater degree of public "accountability" from nonprofit hospital governing boards. West Virginia, for instance, has enacted a law requiring nonprofit hospital board meetings to be open to the public,57 much the same as board meetings of govern-

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30 JOHN F. HORTY and DANIEL M. MULHOLLAND II! mentally owned and operated institutions must be in a number ot states. Investor-owned hospitals are excluded from this requirement, presumably to protect their business data and plans from competitors, which in most areas are nonprofit hospitals. In contrast, Pennsylvania requires all hospitals to provide "some opportunity for the general public to attend meetings of the governing body on occasion...."58 The problem with such open-meeting requirements is not that board meetings will be overwhelmed by a flood of spectators; most people couldn't care less what goes on with a hospital board. Rather, the presence of reporters or possibly competitors who are more likely to attend than the general public will hamper the board if it has to discuss sensitive or confidential matters, such as financing options, legal positions, or medical staff credentialing. Nonprofit hospitals previously enjoyed fairly broad exemptions from certain federal regulatory schemes, but these have been crumbling as of late. For example, in 1974 most federal labor laws, including the National Labor Relations Act and the wage and hour laws, were made applicable to nonprofit hospitals. Previously, only proprietary hospi- tals had been covered. Likewise, many federal antitrust laws have only recently been applied to nonprofit hospitals. In Hospital Building Company v. Trustees of Rex Hospital,59 the Supreme Court ruled for the first time that the activities of a nonprofit hospital had enough impact on interstate commerce to bring the hos- pital under the jurisdiction of the Sherman Act.60 In another case that same year,6i the Court ruled that the Robinson-Patman Act, which forbids price discrimination in favor of large buyers over smaller ones, applied to nonprofit hospitals under certain circumstances despite a provision of the act that exempted sales to charitable institutions.62 About the only antitrust law that has not been applied to nonprofit hospitals is the Federal Trade Commission Act, which by its terms applies only to investor-owned institutions.63 This has not prevented the FTC from successfully attacking certain actions of health-related trade groups, such as the American Medical Association,64 or from aggressively challenging certain acquisitions made by investor-owned hospital chains.65 Conclusion As this paper has shown, there are a number of differences in the way the law treats investor-owned and nonprofit hospitals. While many of these differences can reasonably be expected to influence the opera- tions of hospitals, as well as their finances, it is impossible to identify

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Legal Aspects of Nonprofit Status 31 any general trends along these lines in the absence of empirical studies conducted on a large-scale, institution-specific basis. The distinction between nonprofit and investor-owned hospitals has been blurred by the recent move toward corporate restructuring by many nonprofit hospitals. The usual corporate restructuring plan has a single-hospital corporation evolve into a holding company with a number of subsidiaries, one of which is the hospital. The other sub- sidiaries may be investor-owned or nonprofit, depending on the activ- ity to be conducted. However, even in this area, nonprofit hospitals lag behind those that are investor-owned. Because business corpora- tions are owned by shareholders, it is relatively easy to merge them into multicorporate systems under the umbrella of a holding company that owns all of their stock. Moreover, as stated earlier, it is relatively easy to transfer assets between parent and subsidiary business cor- porations. Nonprofit corporations, however, are not technically owned by any- one, so the holding company idea is somewhat foreign to them. Only quite recently have nonprofit hospitals ventured into the restructur- ing arena and even then with a good deal of reluctance. One fairly popular method of nonprofit restructuring creating a nonprofit hold- ing company and making it the sole member of the hospital corpo- ration will not work in those states discussed earlier that prohibit the transfer of nonprofit corporate income to corporate members. Thus, other, more unfamiliar methods must be employed. Nonprofits also have been far slower than investor-owned companies to establish hos- pital chains for the same reason. Although the original impetus for restructuring was a desire to enhance reimbursement by spinning off nonreimbursible activities into sister corporations, many hospitals have begun to realize that even greater benefits can be obtained by restructuring to positioning themselves for competition with other hospitals, especially those af- filiated with investor-owned chains or other multihospital systems. Increased competition may ultimately break down many of the ex- isting differences between investor-owned and nonprofit hospitals. If third-party reimbursement levels continue to decline, or if legislation mandating price competition between providers, such as the National Healthcare Reform Act of 1981,66 is adopted, hospitals of all stripes will be forced to act like business corporations if they are to survive. Under such circumstances, existing laws and regulations restricting the activities of nonprofit hospitals will become anachronisms, des- tined to fall in the wake of new realities.

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32 References and Notes JOHN F. HORTY and DANIEL M. MULHOLLAND III 1. As of 1981 there were 6,933 hospitals in the United States. Of this number, 5,813 were described by the American Hospital Association as community hospitals, i.e., hospitals not owned by the federal government or devoted solely to treating pyschiatric or respiratory problems. Of the community hospitals, 3,340 were owned by nonprofit organizations, 1,744 by state or local governmental units, and 729 by investor-owned companies. Interestingly, the number of investor-owned hospitals has actually decreased in recent years, as well as over the long term, but the number of beds owned or managed by them has increased dramatically, from approximately 57,000 in 1972 to 88,000 in 1981. By the same token, the number of nonprofit beds only increased from 617,000 to 706,000 during the same period, and state and local government beds increased from 205,000 to 210,000. (Source: American Hospital Association, Hospital Statistics, 1982 edition, Table 1, pp. 5-7.) Using a different definition and different data collection methods, the Federation of American Hospitals the trade association of the investor-owned hospitals reported that in 1981 there were 1,376 investor-owned hospitals with 159,314 beds. Ofthese, 942 hospitals (with 121,741 beds) were owned by the investor-owned management companies. (Source: 1982 Directory: Investor-Owned Hospitals and Hospital Management Companies (Little Rock, Ark.: Federation of American Hospitals, 1982), p. 9.) 2. A recent survey of 172 multihospital systems revealed that 107,765 acute care hos- pital beds in the United States are controlled by investor-owned chains, 170,866 by nonprofit multihospital systems, and 18,453 by governmental systems. The Hospital Corporation of America alone controlled 48,484 beds. See Donald E. L. Johnson and Linda Punch, "Mul- tihospital Systems Survey," Modern Healthcare 12 (May 1982), pp. 67-130. 3. Del. Code Ann. Tit. 8; see H. Henn Corporations (2d ea.) Sec. 93, p. 138, et seq. 4. See, JCAH, Accreditation Manual for Hospitals, 1982 ea.; ADA Requirements and Interpretative Guide for Accredited Hospitals, 1982. 5. 15 U.S.C. Sec. 77. 6. 15 U.S.C. Sec. 78. 7. These have also been referred to as "mutual" and "entrepreneurial" nonprofits, re- spectively. See Henry B. Hansmann, "The Role of Nonprofit Enterprise," Yale Law Journal 89 (April 1980), pp. 835-901. 8. 15 Pa. C.S.A. Sec. 7504. 9. Ohio Rev. Code Sec. 1702.15; Wis. Stat. Ann. Sec. 181.27. 10. See Fla. Stat. Ann. Sec. 617.025. 11. This is especially true for many osteopathic hospitals founded by osteopathic phy- sicians during the 1940s and 1950s, when allopathic institutions refused to grant them privileges. Such discrimination recently has been ruled invalid by the courts see, e.g., Greisman v. Newcomb Hospital, 192 A.2d 817 (N.J. 1963) and Don v. Okmulgee Memorial Hospital, 443 F.2d 234 (lOth Cir.1971)- but its legacy, the osteopathic hospital, still exists. 12. It is universally acknowledged that the governing board of a hospital is responsible for the overall conduct of the hospital, including the medical staff. See, e.g., Khan v. Sub- urban Community Hospital, 340 N.E.2d 398 (Ohio 1976) and Schulman v. Washington Hospital Center, 222 F.Supp. 59 (D.C. 1963). 13. In one unreported instance this was attempted by the nurses at a hospital who persuaded enough of their relatives and friends to become corporate members and oust a group of trustees perceived as hostile to the nurses. 14. Wis. Stat. Ann. Sec. 181.295, N.Y. Not-For-Profit Corp. Law Sec. 631. See also Atwell v. B~de-a-Wee Home Association, 299 N.Y.S.2d 40 (Sup. Ct. 1969), which gave contributors who are not members of a nonprofit corporation the right to bring derivative actions. 15. Needless to say, the fact that nonprofit boards have the ability to control the cor- poration's membership has not met with approval in all quarters. See, generally, Jane L. Davis, "Membership Rights in Nonprofit Corporations: A Need for Increased Legal Rec-

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Legal Aspects of Nonprofit Status 33 ognition and Protection," Vanderbilt Law Review 29 (1976), p. 747; Robin Dimieri and Stephen Weiner, "The Public Interest and Governing Boards of Nonprofit Health Care Institutions," Vanderbilt Law Review 34 (May 1981), p. 1029. 16. Harris v. Board of Directors of Community Hospital of Evanston, 370 N.E.2d 1121 (Ill. App. 1977). 17. JCAH, Accreditation Manual for Hospitals, 1982 ea., p. 51. 18. 42 C.F.R. Sec. 405.1021. 19. E.g., 28 Pa. Code Sec. 103.1 (1982); Hospital Licensing Requirements, Illinois De- partment of Public Health, Sec. 2-1.1 (1981). 20. E.g., Darling v. Charleston Community Hospital, 211 N.E.2d 253 (Ill. 1965); Johnson v. Misericordia Community Hospital, 294 N.W.2d 501 (Wis. App. 1980); affd 301 N.W.2d (Wis. 1981). 21. Stern v. Lucy Webb Hayes National Training School of Deaconesses and Missionaries, 381 F.Supp. 1003 (D.D.C. 1974). 22. While some states permit nonprofits to be organized for "any lawful business" see, e.g., New York Not-for-Profit Corporation Law Sec.201 corporate purposes must be limited to charitable, educational, religious, or scientific pursuits to qualify for a federal tax ex- emption under Sec. 501(c)(3) of the Internal Revenue Code. 23. Howard Oleck, Nonprofit Corporations, Organizations and Associations, ad ed. (En- glewood Cliffs, N.J.: Prentice-Hall, 1979), p. 10. This prohibition against private inurement is also a prerequisite to an exemption under Sec. 501(c)(3) of the Internal Revenue Code. 24. Or as one observer put it: "The sources of equity capital retain no proprietary interest in it." Richard D. Wittrup, "Economic Behavior of Social Institutions," Hospital Adminis- tration (Winter 1975), pp. 8-16. 25. E.g., Pa. Const. Stat. Ann. Tit. 15 Sec. 7968(b). 26. Bruce C. Vladeck, "Why Nonprofits Go Broke," Public Interest 42:1 (1976), p. 86. See also Joseph P. Newhouse, "Toward a Theory of Nonprofit Institutions: An Economic Model of a Hospital," American Economic Review 60:1 (1970), p. 64. 27. Richard D. Wittrup, supra at 11. 28. William Rushing, "Differences in Profit and Nonprofit Organizations: A Study of Effectiveness and Efficiency in General Short Stay Hospitals,"AdministrativeSciertce Quarterly 19 (1974), p. 474. 29. Kenneth W. Clarkson, "Some Implications of Property Rights in Hospital Manage- ment," Journal of Law Economics 15 (1972), p. 363; See, generally, Robert C. Clark, "Does the Nonprofit Form Fit the Hospital Industry?" Harvard Law Review 93 (1980), pp. 1417, 1460-1462. 30. American Hospital Association, Hospital Statistics, 1982 ea., Table 3, pp. 12-13. 31. Id. One possible explanation for the slightly higher overall expense figure is that many investor-owned hospitals, especially those in chains, are newer and therefore are still depreciating large capital expenditures. 32. With further cuts in Medicare funding an almost certain prospect, it can be expected that this trend will be exacerbated. See Rich~ard L. Johnson, "The Resurgence of a Two Tier Health Care SysteIr`," Action-KitNewsletter (Pittsburgh: Action Kit for Health Law, August 1982). Linda K. Demkovich, "Urban Voluntary Hospitals Caught in Price Squeeze Face a Bleak Future," National Journal 15 (June 26, 1982), p. 1131. 33. Sec. 512-513, Internal Revenue Code. 34. Sec. 3121(b)(8)(B), Internal Revenue Code. 35. Sec. 170(b)(1)(A)(iii), Internal Revenue Code. 36. Secs. 103(b)(2)(A) and (3)(B), Internal Revenue Code. 37. See, In re Appeal of Doctor's Hospital, 414 A.2d 134 (Pa. Commw. 1980); West Alle- ghenyHospital v.Board of Property Assessment, No.1171 C.D.1980 (Pa. Commw. December 31, 1981). The latter case ~s currently on appeal to the Pennsylvania Supreme Court.

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34 JOHN F. HORTY and DANIEL M. MULHOLLAND III 38. John S. Hoff and Kenneth I. Schaner, "Government Policies Force Nonprofits to Go For-Prof~t," Modern Healthcare 12 (June 1982), pp. 81-85. 39. 42 U.S.C. Sec. 1395x(v)(1); 42 C.F.R. Sec. 405.460. 40. 42 U.S.C. Sec. 291c(e)(2). 41. 42 C.F.R. Sec. 405.429. 42. Hoff and Schaner, supra n. 42 at 82. 43. Provider Reimbursement Manual Part I, Sec.2122. Excluded are fines and penalties, income taxes, taxes associated with financing, sales taxes collected by the hospital, and taxes on property not used to provide covered services. 44. Taddey and Gayer, "Uses and Effects of Hospital Tax-Exempt Financing," Healthcare Financial Management 12 (July 1982), p. 10. 45. Id. 46. Id. 47. P.L. 97-34. 48. Sec. 103(b)(6), Internal Revenue Code. This exemption will be phased out by 1986 as a result of the Tax Equity and Fiscal Responsibility Act of 1982, P.L. 97-248 Sec. 214(c). 49. See, generally, 42 C.F.R. Sec. 405.419. 50. Hoff and Schaner, supra n. 41, at 82. 51. New York and Pennsylvania, however, permit nonprofit corporations to issue a form of security known as "subvention certificates," which closely resemble preferred stock to members or nonmembers, and to accept capital contributions from members. N.Y. Not-for- Profit Corp. Law Secs. 202(7) and (8), Secs. 504 and 505; Pa. Cons. Stat. Ann. Tit. 15 Secs. 7541 and 7542. These features have been criticized by some observers as making nonprofit corporations too "businesslike," see Oleck, supra n. 23 at 48-49, and there is no evidence that they have been widely used by hospitals in those states. 52. Esther F. Kuntz, "Chains Shy Away from Equity Financing," Modern Healthcare 12 (May 1982), p. 116. 53. E.g., Pa. Const. Stat. Ann. Tit. 15 Sec. 7549(b); W. Va. Code Secs. 35-2-1, 35-2-2. 54. Cal. Gov. Code Sec. 12580 et seq.; Ill. Rev. Stats. Ch. 14 Sec. 51 et seq.; N.Y. Est. Powers and Trusts Laws Sec. 8-1.4; Ohio Rev. Code Sec. 109.33. 55. Tex. Nonprofit Corp. Act, Art. 1396-2.13 requires the approval of the voting members where a quorum of at least one-tenth is present. 56. Oleck, supra n. 23, at 901-904. 57. W. Va. Code Sec. 16-5G-1. 58. 28 Pa. Code Sec. 103.3(10)(iii). 59. 425 U.S. 738 (1976). 60. 15 U.S.C. Sec. 1. 61. Abbot Laboratories v. Portland Retail Druggist Association, 425 U.S. 1 (1976). 62. 15 U.S.C. Sec. 13c. 63. 15. U.S.C. Sec. 44. 64. See Amer~can Medical Association v. Federal Trade Comm~ssion, 638 F.2d 443 (2d Cir. 1981); affd, 50 U.S.L.W. 4313 (March 23, 1982). 65. "Hospital Corporation Faced with Trust Suit by FTC," Wall Street Journal August 3, 1982, p. 6. 66. H.R.850, introduced by Rep. Richard Gephardt (D-MO) and former Rep. David Stock- man (R-MI), now Director of the O*;ce of Management and Budget.