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OCR for page 17
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
OCR for page 18
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.
OCR for page 19
Legal Aspects of Nonprofit Status
19
OCR for page 20
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-
OCR for page 21
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-
OCR for page 22
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.
OCR for page 23
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-
OCR for page 24
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,
OCR for page 25
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-
OCR for page 26
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.
OCR for page 27
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
OCR for page 28
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
OCR for page 31
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.
OCR for page 34
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.
Representative terms from entire chapter:
nonprofit corporations
