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Conversion of health care organizations from non -profit to for -profit status
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CONVERSION OF HEALTH CARE ORGANIZATIONS FROM
NON-PROFIT TO FOR-PROFIT STATUS
by
Pari Velji
A Dissertation Presented to the
FACULTY OF THE SCHOOL OF
POLICY, PLANNING, AND DEVELOPMENT
UNIVERSITY OF SOUTHERN CALIFORNIA
In Partial Fulfillment of the
Requirements for the Degree
DOCTOR OF PUBLIC ADMINISTRATION
December 2002
Copyright 2002 Pari Velji
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UMI Number: 3093932
Copyright 2002 by
Velji, Pari
All rights reserved.
®
UMI
UMI Microform 3093932
Copyright 2003 by ProQuest Information and Learning Company.
All rights reserved. This microform edition is protected against
unauthorized copying under Title 17, United States Code.
ProQuest Information and Learning Company
300 North Zeeb Road
P.O. Box 1346
Ann Arbor, Ml 48106-1346
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UNIVERSITY OF SOUTHERN CALIFORNIA
SCHOOL OF PUBLIC ADMINISTRATION
UNIVERSITY PARK
LOS ANGELES, CALIFORNIA 90089
This dissertation, written by
............................
under the direction o f k er... Dissertation
Committee, and approved by all its
members, has been presented to and
accepted by the Faculty o f the School o f
Public Administration in partial fulfillment
o f requirements for the degree o f
DOCTOR OF PUBLIC ADMINISTRATION
Dean
Date.. \ P . I p f T j . .\3 ru .
DISSERTATION CO:
• ' Cha, '.rson
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D e d ic a t io n
This dissertation is dedicated to my family:
my spouse, Anvar Velji, M. D.,
and my two wonderful sons, Jamel and Badier.
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A c k n o w l e d g e m e n t s
❖ I would like to express my gratitude to the members of my dissertation
committee—Professor Ross Clayton (Chair), Professor Chester A.
Newland, and Dr. Sarah Whitis—whose critical and insightful comments,
suggestions, and corrections improved the quality of this study. Special
thanks are due to Dr. Ross Clayton for encouraging me to explore a very
complex topic. Special thanks are also due to Dr. Chester Newland whose
wisdom has been my constant source of inspiration, encouragement, and
support.
❖ I would also like to thank Mr. Steven Thompson, Mr. Emery “Soap”
Dowell, and Mr. Philip Isenberg for taking the time from their busy
schedules to talk with me. Their firsthand experience in the conversion of
Blue Cross of California brought tremendous insight into the study.
❖ This study could not have been possible without the support of my family,
especially my spouse who has sacrificed a great deal to help me achieve my
objectives. Lastly, I would like to offer my gratitude to the Almighty who
guides us in strange ways and without His inspirations very little is possible.
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T a b l e o f C o n t e n t s
Dedication.......................................... ii
Acknowledgements...................................................................................................... iii
List of Tables ..................................................................................................................ix
List of Fig u r e s.................................................................................................................xi
Abstra ct.......................................................................................................................... xii
C h a p t e r 1: H is t o r ic a l D e v e l o p m e n t in C o n v e r s io n s o f
H e a l t h C a r e O r g a n iz a t io n s ......................................................................1
1.1 Introduction.......................................................................................1
1.2 Listing of Abbreviations................................................................ 4
1.3 Historical Development of the Conversion
Environment.................................................................................... 4
1.4 Elements of the Competition..........................................................8
1.4.1 Institutional Access to Capital..........................................8
1.4.2 Survival...............................................................................13
1.4.3 Desire to Monetize Community Assets........................ 16
1.4.4 Greed (Personal G ain)..................................................... 17
1.5 Types of Conversions.................................................................... 18
1.5.1 Conversion in Place..........................................................18
1.5.2 Asset Sales.........................................................................19
1.5.3 M erger................................................................................19
1.5.4 Drop-Down Conversions................................................ 20
1.5.5 Joint V enture.................................................................... 21
1.6 Scope of Conversion A ctivity......................................................22
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Chapter 2: Literature Re v ie w .......................................................................... 28
2.1 The For-Profit/Not-for-Profit Distinction.................................28
2.1.1 For-Profit Organizations (Investor
Ownership)........................................................................29
2.1.2 Not-for-Profit Organizations........................................ 30
2.2 The Value Question....................................................................32
2.2.1 Health Care as an Economic Good................................ 32
2.2.2 Health Care as a Social Good....................................... 33
2.3 Legal Authority........................................................................... 33
2.3.1 Applicable L aw ..............................................................34
2.3.2 Conversions and Charitable Assets..............................36
2.3.3 Federal Role in Non-Profit Conversions.....................41
2.3.4 A California Perspective on the Conversion
of Non-Profits.................................................................. 42
2.4 Agency Theory.............................................................................45
2.4.1 Asset Valuation................ 45
2.4.2 Conflict of Interest..........................................................50
2.4.3 The Health Care D ollar................................................. 51
2.5 Impact of Conversions on Community Benefit........................53
2.6 Utilization of Conversion Revenue............................................55
2.7 Organizational Change and the Need for
Regulations..................................................................................60
2.7.1 Factors Affecting Regulation of Conversion............... 62
2.7.2 Need for Federal Regulations........................................66
2.7.2.1 Exit Tax.............................................................. 68
2.1.22 Intermediate Sanctions......................................71
2.7.2.3 Qui Tam Action.................................................73
C h a p t e r 3: R e s e a r c h P r o b l e m , E x p e c t a t io n s, D e s ig n ,
M e t h o d o l o g y , a n d T h e o r e t ic a l F r a m e w o r k .............78
3.1 The Non-Profit/For-Profit Argument.................................................. 78
3.2 Research Questions and Expectations.................................................81
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3.3 Research Design and Methodology...........................................82
3.4 Theoretical Framework...............................................................84
3.4.1 Valuation of Assets......................................................... 84
3.4.2 Valuation Methodologies...............................................84
3.4.2.1 Equity Capital....................................................86
3.4.2.2 Total Invested Capital....................................... 86
3.4.2.3 The American Society of
Appraisers Classification....................................... 87
3.4.2.3.1 The income approach.......................... 87
3.4.2.3.2 The market approach........................... 88
3.4.2.3.3 The asset-based approach....................88
3.5 Importance of the Study............................................................. 91
3.6 Limitations of the Study............................................................. 93
C h a p t e r 4: A n a l y s is o f D o c u m e n t s — H e a l t h N e t ................................................94
4.1 Introduction.................................................................................. 94
4.2 Summary Description of Company and Operations................ 95
4.3 HealthNet Valuation Analysis.................................................. 97
4.3.1 Appraisal of Fair Market Value of Non-
Profit Benefit Corporation in Conversion......................97
4.3.2 Premise of Value............................................................ 98
4.3.3 Valuation Approaches....................................................98
4.3.3.1 Discounted Cash Flow.....................................99
4.3.3.2 Capitalization of Earnings..............................102
4.3.3.3 Adjusted Net Asset Approach........................ 103
4.3.4 Reconciliation of Methodologies and
Recommendation of Fair Market V alue......................106
4.4 Ernst & Young’s Valuation Challenged.................................. 106
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C h a p t e r 5: A n a l y s is o f D o c u m e n t s— B l u e C r o s s o f
C a l if o r n ia ........................................................................................................... 113
5.1 Introduction............................................................................... 113
5.2 Historical Perspective.............................................................. 113
5.3 Proposal for Restructuring.......................................................119
5.4 Restructuring or Conversion?..................................................126
5.5 Conversion of Blue Cross and the California Law ................135
5.6 Why AB 1784?.......................................................................... 138
C h a p t e r 6: A n a l y s is o f R e s p o n s e s— I n t e r v ie w s ............................................... 143
6.1 Introduction................................................................................143
6.2 Analysis of Interview Responses............................................ 144
6.2.1 Valuation of Charitable Assets.................................... 144
6.2.2 Regulations....................................................................146
6.2.3 Conversion Revenue..................................................... 147
6.2.4 Community Benefit...................................................... 148
6.2.5 Major Experience from Conversion............................149
6.3 Responses to Interview Questions...........................................150
C h a p t e r 7: C o n c l u s io n s, Im p l ic a t io n s a n d S u g g e s t io n s f o r
F u t u r e R e s e a r c h ............................................................................................164
7.1 Introduction................................................................................164
7.2 Who Benefits?........................................................................... 164
7.3 Agency Theory and Asset Valuation...................................... 166
7.2.1 HealthNet Market Value...............................................168
7.2.2 Conversion Versus Restructuring................................176
7.4 Conversion Foundations and Charitable Assets...................... 181
7.5 Regulation and Organizational Change..................................185
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7.6 Analysis of Expectations for the Impact of Non-
Profit Conversions....................................................................192
7.7 Implications of Results of this Study...................................... 194
7.8 Conclusion.................................................................................195
7.9 Suggestions for Future Research..............................................196
B i b l i o g r a p h y .............................................................................................................. 198
A p p e n d i x : Interview Questions............................................................................... 207
viii
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L is t o f T a b l e s
Table 1-1 List of Abbreviations........................................ 5
Table 1-2 Types of Conversions............................................................................ 22
Table 1-3 Distribution of Conversions, by State and Year of
Conversion, 1981-1995........................................................................24
Table 1-4 Status of Blue Cross Health Plan Conversions...................................25
Table 2-1 Comparison of Charitable Donations among
Converted Health Organizations.........................................................49
Table 2-2 U.S. Hospitals by Uncompensated Care and
Ownership Type: 1988.........................................................................54
Table 2-3 Conversion Foundations by Asset Size................................................57
Table 2-4 States With Laws Affecting Conversions and Their
Key Provisions..................................................................................... 67
Table 3-1 Valuation Approaches and Methods.................................................... 89
Table 4-1 HealthNet: Discounted Cash Flow Analysis...................................101
Table 4-2 HealthNet: Historical Earnings Analysis........................................102
Table 4-3 HealthNet: Capitalization of Earnings Approach ........... .103
Table 4-4 HealthNet: Adjusted Net Assets Approach.....................................105
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Table 5-1 Blue Cross of California: Consolidated Balance
Sheet.....................................................................................................129
Table 5-2 Blue Cross of California: Consolidated Statement of
Earnings.............................................................................................. 130
Table 5-3 Blue Cross of California: Investment Transactions—
Stock Sales.......................................................................................... 131
Table 5-4 Blue Cross of California: Investment Transactions—
Bond Sales........................................................................................... 132
Table 6-1 Interviews............................................................................................. 150
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L ist o f F ig u r e s
Figure 1-1. Number of Hospital Conversions 1990-1993........................................23
Figure 5-1. Blue Cross of California—Corporate Structure Prior to
Restructuring....................................................................................... 123
Figure 5-2. Blue Cross of California—Corporate Structure After
Restructuring........................................................................................124
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A b s t r a c t
Intense competition in the health care industry has made it increasingly
difficult for non-profits to meet the challenges of market forces. Financial
arrangements and delivery of medical care have undergone profound changes since
the late 1970s. To support these changes, non-profit health care organizations have
looked to the investment community for capital, leading a number of non-profit
health plans and hospitals to convert to for-profit status.
This research analyzes the conversion of Blue Cross of California from a
non-profit to a for-profit form of organization. It also discusses the conversion of
HealthNet with specific reference to the valuation of its assets in the conversion
process. Valuation theory forms the theoretical framework of this study as it
applies to the conversion process in health care organizations.
The specific research question addressed is the benefits question: Who
benefits from the conversion of non-profit to for-profit status in health care
organizations? Closely tied to the benefits question is the valuation question: How
are the assets of the converting entity valued?
This study indicates that the conversion process is fraught with legal issues.
The answers to the benefits question depend on whether the terms of agreement are
fair and reasonable, whether a transaction serves the public interest, whether the
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value of the charitable assets remains dedicated to promoting charitable health care,
whether private benefit translates to any private person or entity, and whether the
converting entity receives fair market value in the transaction.
Results of this study reveal that the value established for the assets of the
converting entity ultimately determines the charitable assets that are transferred to
the subsequent foundation. Asset valuation methodologies are riddled with
estimates and business judgments, and the final value depends on whether fair
value or fair market value is used, what discount rate and price/earnings multiple
are used, and whether accounting, economic, political, or organizational
rationalities are utilized. The potential for undervaluing the assets of the converting
entity is enormous, and public participation is important to the final outcome of the
valuation process when conversion occurs.
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C h a pt e r 1
H ist o r ic a l D e v el o p m e n t in C o n v e r sio n s of
H ealth C a r e O r g a n iza tio n s
1.1 Introduction
Few changes in the organization of health care in the United States have
stimulated more interest and alarm than the rise of a new form of entrepreneurship,
investor-owned, for-profit organizations that provide health services as a business.
Although the concept of proprietary health care organizations is not new, the
concept of publicly traded health care companies has evolved only since the 1970s
(Gray 1986).
During the 1990s, the delivery of health care services was increasingly
influenced by the demands of investors and investor-owned firms. A growing
number of hospitals, health maintenance organizations (HMOs), nursing homes,
home-care services, and hospices became for-profit companies, publicly traded on
the stock market. Companies that formed to fill particular niches, such as those
that manage physician practices and utilization-review firms, became Wall Street
favorites. The buying and selling of health industry assets as fungible commodities
intensified. In the meantime, traditional for-profit entities such as medical-device
and drug companies continued to thrive. In the early part of the decade, the
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performance of health care stocks exceeded that of the market as a whole (Kutter
1999).
Intense competition in the health care industry made it increasingly difficult
for the non-profits to meet the challenges of market forces. It has been argued that
efficiencies necessary to be competitive are less available to non-profits than they
are to for-profits. Thus, one of the main reasons that the non-profits convert to for-
profit is to raise capital by selling stock. Conversion allows them to finance
expansion and be more competitive (Vannoy 1996).
In California, as in an increasing number of states, billions of dollars for
charitable assets have been redirected as a result of transformations of health plans
and hospitals from non-profit to for-profit organizations. As the stakes in these
transformations grow, so does conflict between public and private interests. On
one side are legislators, regulators, and consumer advocates; on the other are
entrepreneurs anticipating large profits from the reorganized US health industry.
With their rapid growth and diversification, the for-profit entities represent a
challenge to established interests, practices, values, and ideals.
In 1992, Blue Cross of California (BCC) applied to the Department of
Corporations (DOC, now known as Department of Managed Care) to restructure its
business entity. This dissertation documents and analyzes the conversion of Blue
Cross of California from a non-profit to a for-profit form of organization. It also
discusses the Conversion of HealthNet with specific reference to the valuation of
its assets in the conversion process. Valuation theory forms the theoretical
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framework of this study as it applies to the conversion process of health care
entities. Agency theory, asymmetric information theory, and theory of change are
also discussed where relevant.
Specific research questions addressed in this study are the following: Who
benefits from conversion of non-profit to for-profit status in health care
organizations? How are the assets of the converting entity valued? How are the
charitable assets generated as a result of the conversion utilized? Are more
stringent federal regulations required for an appropriate conversion process?
While the analysis in this dissertation focuses essentially on describing the
process of conversion by Blue Cross of California, it also attempts to address the
issue of how one shapes and controls this tidal wave of change so that the public
interest will be served and charitable assets preserved to the maximum extent
possible. The success or failure of the conversion process is determined by its
impact on the community it serves.
This dissertation is organized in seven chapters: Chapter 1 provides an
introduction and describes the historical development of the conversion
environment. Chapter 2 discusses the literature review. Chapter 3 describes
valuation theory that forms the theoretical framework of the study and also
describes research problems, expectations, design, and methodology. Chapters 4,
5, and 6 summarize the findings of the study (analysis of official records, reports,
and other documents filed with the DOC, and responses to personal interviews with
individuals who greatly influenced policy outcomes in the Blue Cross conversion).
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Chapter 7, the final chapter, discusses the conclusions and implications of the work
and provides suggestions for future research.
1.2 Listing of Abbreviations
The listing of abbreviations for organizations and terms is prevalent in both
health care and accounting fields. Hence, a listing of abbreviations used in this
study is presented in Table 1-1 for those readers who may not be familiar with their
meanings.
1.3 Historical Development of the Conversion Environment
The phenomenon of HMO conversion to for-profit status began in the late
1970s. It accelerated during the late 1980s and early 1990s, and it is expected to
continue in the next few years. In 1986, it was estimated that of the 25 conversions
nationwide, 17 occurred in California (Wallace 1986). McMahon (1996) suggests
that HMOs in other states will follow the lead of their California counterparts and
abandon non-profit status. Since the early days in California, the trend of HMO
conversions has continued. In 1994, approximately 66% of the HMOs in this
country were for-profit concerns, compared to about 20% in 1981. By 1995, for-
profit plans made up 71% of the market (Bisesi 1997).
The incentives for conversion, such as access to capital markets and the
desire to sell to large national companies, still exist. The increasingly competitive
health care market may hasten these conversions. The recent competitive health
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care market has been causing HMOs to run at a loss. Such competitive markets
may increase acquisition trends and, in turn, the conversion trend (Bisesi 1997).
Table 1-1
List of Abbreviations
AICPA American Institute of Certified Public Accountants
BCC Blue Cross of California
BCBSA Blue Cross Blue Shield Association
BCBS Blue Cross Blue Shield
CCH Commerce Clearing House
CEO Chief Executive Officer
CMA California Medical Association
DCF Discounted Cash Flow
DOC* Department of Corporations
DRG Diagnostic Related Group
EBIDTA Earnings before Interest, Depreciation, Taxes and Amortization
EBIT Earnings before Interest and Taxes
HCSP Health Care Services Plan
HMO Health Maintenance Organization
IPO Initial Public Offering
IRC Internal Revenue Code
PPO Preferred Provider Organization
RCN Replacement Cost New
R&D Research and Development
* On July 1, 2000, the name of DOC was changed to Department of Managed Care.
For this dissertation, the name DOC is utilized since conversions of both HealthNet
and Blue Cross occurred under the name Department of Corporations.
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HMO conversions were initially driven by several factors. First,
elimination of state laws prohibiting for-profit ownership of HMOs made it
possible to convert. In the early years of managed care, some states had laws
which required HMOs to be organized as non-profit entities. The repeal of these
laws made it possible to contemplate for-profit status (Kellough 1997).
Second, the federal government encouraged growth in the managed care
industry in the 1970's by offering loans and grants to HMOs. The federal HMO
Act of 1973 provided for loans and grants to HMOs, but these loans were primarily
provided to non-profit HMOs. Thus, most HMOs originated as non-profit
corporations in order to take advantage of this funding. The conversion of non
profit HMOs began when this funding began to dry up in the early 1980's (Bisesi
1997; Kellough, 1997).
Third, conversions were driven by HMOs' need for access to capital through
equity financing, joint ventures with for-profit companies, or by acquisitions of for-
profit companies. Other contributing factors included ambiguous IRS standards for
maintaining non-profit status and the desire by some physicians to profit by selling
their plans to large national companies. Most of the early HMO conversions
occurred in California. One reason for this was that California regulators strongly
encouraged HMO conversions to for-profit status. Regulators also believed that
non-profit managers should not be displaced in the conversion process. Finally,
California regulators relied primarily on the dissolution or liquidation value of the
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non-profit health care entity in its valuation. This made the buy-out price
considerably lower than fair market value. In some conversions, non-profit
directors bought the HMO at an under-valued price and benefited greatly when the
HMO was sold as little as a year later for millions of dollars (Bisesi 1997;
McMahon 1996).
Beyond doubt, the health care industry has undergone one of the largest
reforms ever to have occurred in any industry in the United States. No sector of the
health care industry is untouched. Physicians and other formerly independent
providers find themselves forced by market economics to aggregate, if not to sell,
their practices to hospitals, insurance companies, and proprietary management
companies. Led by a bevy of seemingly wealthy proprietary organizations, insurers
and health maintenance organizations have undergone massive consolidation in the
payor sector. Suppliers, whether drug companies, equipment manufacturers or
purchasing agencies have also not been immune and have been driven by large
health care systems or alliances to provide significant discounts if they desire to
attract sales. Hospitals have been particularly hard-pressed and are increasingly
viewed as a locus of expensive care that should be significantly downsized to drive
high costs out of the system. Overlaying all of this, of course, is a new breed of
nimble, well-capitalized competitors searching to produce or bundle services in an
ever more attractive manner (Singer 1997a).
It is easy, therefore, to attribute the recent spate of hospital and HMO
conversions to the overall competitive environment confronting health care
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delivery. Competitive pressures can take different forms and affect organizations
in a myriad of ways. An examination of the hospital arena reveals that at least four
distinct elements comprise the competitive force, any combination of which may
drive a particular entity to explore conversion.
1.4 Elements of the Competition
1.4.1 Institutional Access to Capital
Institutional delivery of health care services has always been a capital-
intensive enterprise, and in recent years, hospitals and HMOs have faced
difficulties in maintaining traditionally large capital budgets. These budgets are
consistent with the relative sizes of hospitals. Among large hospitals, 54% have
annual capital budgets in excess of $5 million. Of these, approximately 20% have
annual budgets of between $10 million and $50 million (Singer 1997a).
In the past, hospitals were fully reimbursed by the federal government for
capital costs related to inpatient care of Medicare recipients. Beginning in October
1991, Medicare began a transition from a cost-based system of reimbursement for
capital expenditures, based on interest and depreciation, to a system of fixed
payment per patient based on assignment to a diagnostic related group (DRG),
often resulting in lower levels of capital reimbursement. This reduction in
reimbursement made alternative sources of capital much more important to
hospitals. Historically, exempt hospitals have also been able to satisfy their capital
needs through a combination of internally generated funds and charitable
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contributions. With the advent of tax-exempt financing in the 1960s, hospitals had
a ready and attractive source of capital for major needs. Exempt hospitals had a
competitive advantage over their for-profit competitors because exempt financing
generally resulted in a significantly lower cost of borrowing than that available to
proprietary entities (Fishman 1998).
HMOs and Blue Cross/Blue Shield plans also faced similar restrictions.
Early HMOs were often organized as non-profit, exempt organizations in order to
benefit from federal legislation that encouraged HMO formation. In 1973, a federal
statute initially gave federally qualified HMOs substantial advantages over
nonqualified HMOs, including access to federal grants, loans, and loan guarantees.
Blue Cross/Blue Shield plans initially were organized as exempt organizations, as
these plans were started by exempt hospitals seeking an insurer to provide
reimbursement for needed hospital services. As the plans developed, they were
granted federal and state exemption, with the understanding that they would
provide coverage to beneficiaries who might be denied insurance from commercial
insurers (Singer 1997a).
This competitive advantage remained largely unchecked until the Tax
Reform Act of 1986. Prior to the Reform Act, there were two prime limitations on
hospital borrowing. First and foremost was the organization's ability to service the
debt. Second, and typically of lesser importance, were the so-called “use
restrictions” imposed on the borrowed funds. These restrictions limited the amount
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of the funds that could be used for nonexempt purposes, such as construction of a
medical office building.
The 1986 Tax Reform Act changed and limited the use of tax exempt
financing. Pre-1986, 25% of tax exempt bonds could be used for unrelated
business operations. These might include physicians' offices, management
contracts with private companies, and cooperative ventures. With the Tax Reform
Act of 1986, there was a 5% limit on unrelated business operations. There was also
a $150 million limit imposed on any Section 501(c)(3) organization that borrows
money for other than hospital purposes (IRC 1986a).
The initial established restriction threshold of 25% of total proceeds enabled
large sums to be devoted to non-hospital projects. This source of capital became
especially important to hospitals, many of which turned to build physician office
buildings as a major strategy to develop physician loyalty and accessibility to the
hospital. With the Reform Act and the lowering of the use restriction to
approximately 5%, the availability of funds for non-hospital projects was greatly
reduced. The imposition of a $150 million cap on non-hospital uses further limited
previously available funds. For large multi-hospital systems, these tighter
restrictions become a significant impediment to growth. On reaching the $150
million ceiling, these systems found themselves removed from their only
significant source of funding outside of internally generated funds (Fishman 1998).
In contrast, for-profit hospitals of suitable financial standing were able to
tap into both the debt and equity markets. Debt (with no federally mandated use
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restrictions) could be borrowed premised solely on an entity's ability to service the
loan. In addition, access to the equity market provided the hospital or hospital
chain with the ability to generate capital at a relatively low cost. Moreover, the
ability to grant an equity interest in the institution becomes a significant mechanism
to develop employee and physician loyalty. The result was that the exempt
hospital, having reached its use restriction ceiling, found itself pitted against an
organization with a seemingly endless capital supply. Conversion, therefore, may
be viewed as an essential strategy to combat the capital resource imbalance.
Fishman (1998) suggests that conversions of non-profit health care
providers allow the new for-profits to avoid increased Internal Revenue Service
regulation and scrutiny; take advantage of current operating losses; compete better
and seek profits aggressively; provide equity incentives to service providers, such
as physicians; engage in unlimited lobbying and political activity; take advantage
of private and public equity capital markets; and allow weaker hospitals to
consolidate and replace antiquated equipment and heavy debt load.
Therefore, the fundamental reason for health care providers to move to for-
profit status is easier access to capital. Historically, non-profit health care
organizations raised capital through the use of tax exempt financing, which enabled
non-profit health care borrowers to pay a lower cost of interest than if the regular
capital markets were used. In the early 1980s, there were significant savings over
entering the taxable bond market. A second benefit from tax exempt financing was
arbitrage investment profits. The proceeds from tax exempt financing were
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invested in taxable securities earning a greater rate of interest—the profits of which
went to the exempt organization. Congress caught up with this and required that if
a non-profit borrowed with tax exempt bonds, it could not reinvest the funds to
receive a taxable rate of interest. Still, there were other loopholes.
One loophole was the incentive to borrow in advance of one's need.
Institutions would invest in for-profit vehicles and then use the dollars when they
needed them. Much of the overcapitalization and the overbuilding in the hospital
sector resulted from the use of this technique. The money was there and could be
used for certain periods of time for anything, but eventually hospitals had to build
something. Thus, these tax law changes made tax exempt financing less valuable
to the non-profit organizations and limited a hospital's flexibility.
Additionally, the spread between tax exempt financing and for-profit
financing (which was 70-80% in the 1980s) moved to 85-90% in the 1990s,
narrowing the significance of interest savings. Further, bond-rating agencies, such
as Moody's and Standard and Poor's, downgraded tax-exempt financing requiring
lenders to pay higher rates of return, thereby reducing the advantage of tax-exempt
financing. At one time, the tax-exempt agencies were perceived to be relatively
risk-free investments. However, bond-rating agencies began to view these
organizations as financially unstable because of increased competition in health
care, and possible large cuts in Medicare and Medicaid reimbursement. The tax
exempt marketplace became over-saturated with tax exempt paper of financially
weak hospitals, leading to a downgrading by bond rating agencies and making the
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regular capital markets more comparable in terms of the cost of borrowing. All in
all, the desirability of non-profit status diminished for hospitals, and their
competitive position in the for-profits markets deteriorated as the latter had easier
access to capital (Fishman 1998; Singer 1997a).
1.4.2 Survival
For some hospitals, closure of their facility may be inevitable, whether the
result of poor management, an aging physical plant, weak market demographics or
a strong competitive environment. These institutions may latch onto the promise of
sale to a for-profit entity, as a means either to ensure some level of continued health
care services to the community or to provide a return to the community for the loss
of its institution. Singer (1997a) suggests that with their ability to raise capital
quickly, proprietary owners can often return these hospitals to profitability. In
addition, a facility with little chance of reaching profitability may have worth to a
for-profit chain with facilities nearby, because the hospital could be closed to
solidify the market share of its former competitors.
Sometimes an entity may find that even if it could tap into additional
capital, its market has coalesced in a way that makes independent survival
impossible. An institution may find itself in a market with relatively few, if not a
single, dominant system. In markets with high managed care penetration,
unaligned institutions may be foreclosed from key managed care contracts, leading
to a significant decrease in hospital revenues (Krause 1997).
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For exempt institutions in a for-profit dominated market with a high degree
of managed care, sale to the proprietary may be the only recourse, even if loss of
exempt status is not a preferred outcome. Even in markets without significant
managed care penetration, hospitals may aggressively join systems, so that they are
positioned to begin managed care contracting. The wave of mergers and
consolidations sweeping the hospital sector is testimony to the fact that unaligned
institutions, or even small systems, may be unable to maintain their independence.
In the 1990s, much of the growth of for-profit chains, such as
Columbia/HCA and Tenet (the nation's two largest proprietary hospital companies),
was attributed to this phenomenon, with both organizations enjoying unfettered
dominance in select markets. Columbia/HCA, for example, with facilities in thirty-
six states, was the largest hospital provider in south Florida, Tennessee, and Texas
(Bisesi 1997).
In addition, certain types of hospitals face unique pressures and, thus, may
be particularly susceptible to purchase or joint ventures with proprietary entities.
Academic medical centers, for example, are especially vulnerable to competitive
pressures, given their historically high costs of care, because the training of medical
students and residents requires resource usage that may deviate from a “highest
efficiency” standard of care. Moreover, recent changes in federal reimbursement
for graduate medical education through Medicare have had an adverse impact on
many teaching hospitals. A number of these medical education centers have also
failed to develop strong system linkages with community hospitals, mistakenly
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believing that by virtue of their special expertise and reputation they would always
play a dominant role in the market. For these hospitals, which may not be able to
compete effectively for contracts premised on lowest pricing, sale to or joint
venture with a for-profit is an important strategy to attract capital resources and the
community hospital linkages necessary to assure institutional survival. So too, the
promise of what is often a significant cash payment is an irresistible lure to
universities facing declining enrollments and tuition revenues (Bloche 1998).
Catholic hospitals face special circumstances, making them vulnerable to
proprietary entities. Their mission of service to the poor often leads to providing
services in rural and urban areas unable financially to support a health care
institution. Beyond encountering the competitive pressures affecting all health care
institutions, Catholic institutions face the additional dynamic of declining numbers
of sisters, brothers and priests willing and able to continue Catholic sponsorship.
Recognizing this potential gap in the availability of future sponsors,
Columbia/HCA specifically targeted the Catholic hospital sector for acquisition,
promoting itself as an entity able to continue the health care legacy begun by the
religious community. The Church hierarchy, along with the Catholic Health
Association, took strong measures to condemn partnerships and mergers between
Catholic hospitals and for-profit providers. To date, few Catholic hospitals have
partnered with investor-owned entities, although several have been sold to for-
profits (Singer 1997b).
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1.4.3 Desire to Monetize Community Assets
Yet another reason to sell or convert is to enable the local community to
redeploy assets tied up in acute care institutions for uses that may have a higher
community value. As opposed to a survival motivation, this market force is
characterized by the realization by a non-profit board that the value it can receive
on sale or conversion of the hospital outweighs the advantages of continued
community ownership. With many areas of the country severely overbedded, the
ability to secure a large pool of funds through sale or conversion, which can then be
used to enhance the welfare of the community, presents an attractive alternative to
continued ownership of an acute care hospital.
Further, the large dollar amounts involved would suggest that the charitable
foundations created as a result of sale and conversion of hospitals can have a major
impact on local community life. However, Singer (1997a) suggests that
conversions being fairly recent phenomenon, this area is not yet fully examined.
While many foundations have as their central mission a continued focus on health
care services, they have often adopted a broader definition of community welfare.
For these foundations, monies have been used on projects as varied as school
improvements, public parks, cultural events, and assorted community outreach
efforts.
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1.4.4 Greed (Personal Gain)
While never explicitly stated as a motivation for sale or conversion, a
review of sales and conversions suggests that the pursuit of personal gain by
executives and/or board members may influence the desire to sell or convert a not-
for-profit hospital. Although the literature abounds primarily with examples of
HMO conversions that ultimately resulted in lucrative gains to company insiders,
reports on the sale and/or conversion of tax-exempt hospitals indicate that similar
motivations may be at play.
The ability to secure stock options and other forms of deferred
compensation may be an important inducement to seek conversion. Moreover,
because many times a non-profit organization's executives will retain their
positions once it has become for-profit, the higher compensation that for-profits
historically pay their executives perhaps prompts favorable reviews of the
conversion option. For example, in May 1996, the Wall Street Journal reported
allegations that the president of a Florida hospital intentionally devalued the
hospital in an attempt to sell it at an attractive price to a proprietary chain. His
employment was terminated, and he subsequently took a management position with
that chain (Gerlin 1996).
In another transaction, involving the sale of a 50% interest in four hospitals
to a major hospital corporation, two former members of the non-profit hospital
system's board of directors brought allegations against the system's chief executive
officer (CEO) and chairman regarding their conduct during the transaction. The
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former members described the CEO as intent on forcing the sale and refusing to
consider any other options (such as changes in management). The directors also
alleged that important information regarding the sale—including the final sale price
and other potentially higher bids—was withheld during the decision making. Other
accounts hint at impropriety, such as an entire hospital sale negotiated and
completed in under a month (Gerlin 1996).
1.5 Types of Conversions
Conversions can take many forms. Although the ultimate structure of the
business transaction used to convert the exempt corporation to a taxable entity can
vary based on business considerations, regulatory requirements, and other factors,
the conversion process itself is largely governed by state law. Conversions can
generally be categorized into one of five types.
1.5.1 Conversion in Place
A conversion in place refers to a process by which the board recommends
an amendment to the corporation's articles of incorporation, deleting its non-profit
aspects and adding for-profit powers. The newly converted for-profit corporation
is empowered to issue stock, permitted to conduct all lawful business, and allowed
to pay dividends. In a conversion in place the legal entity remains in place, the
“xyz charitable corporation” merely becomes the “xyz business corporation.”
Existing contractual relationships remain. Conversion in place is permitted only in
a few states. Typically, it is favored by HMOs, Preferred Provider Organizations
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(PPO), and other managed care organizations not dependent on fixed assets like
real property (Fishman 1998; Singer 1997a).
1.5.2 Asset Sales
Another conversion approach is a sale of assets, also refereed to as “Type
A” conversions, whereby a non-profit corporation, exempt under Section 501(c)(3)
of the Internal Revenue Code, sells its operating assets to a for-profit corporation
for fair market value. Unlike a conversion in place, an asset sale requires the for-
profit to obtain appropriate state licenses. After the sale, the for-profit corporation
owns the charitable corporation's assets, which in return may receive stock, notes,
or other property in addition to cash as consideration. This transaction structure is
typical for the acquisition of a non-profit hospital by a for-profit acquirer. Federal
and state laws require that the proceeds from the sale continue to be held in
charitable trust and used for charitable purposes. Foundations are usually the post
conversion holders of these charitable assets (Fishman 1998).
1.5.3 Merger
Another technique for conversion involves a merger of a non-profit
corporation into a for-profit. The charity forms a new for-profit corporation to
which it contributes its assets in exchange for cash, notes, and stock. Thereafter,
the non-profit corporation merges into the for-profit corporation. Here again, state
and federal laws require the exchange proceeds to remain in the charitable stream
and to be used for charitable purposes. A foundation or non-profit corporation is
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created to receive the cash or stock from the surviving corporation. After the
conversion, there are ordinarily two organizations: the for-profit corporation and a
private foundation (Fishman 1998).
1.5.4 Drop-Down Conversions
Organizations wanting to convert without the loss of institutional identity,
which often results from an asset sale or merger, may choose to engage in a “drop
down” conversion. This approach is used when an organization, such as an HMO,
desires to convert some or all of its assets into a for-profit. Drop-down conversions
involve the transfer of some or all of the operating assets and liabilities of a hospital
or HMO to a wholly or partially owned subsidiary in exchange for stock and/or
notes. After the transaction is completed, the for-profit subsidiary may enter the
equity markets through an initial public offering. The original owner of the assets
usually retains a substantial percentage of equity in the newly formed corporation.
This type of conversion, when used by an HMO, is usually a preliminary step to
another form of transaction, such as a takeover by another health plan. After the
conversion, three organizations may exist: in addition to the for-profit corporation
and the foundation, a Section 501(c)(4) organization may be created to receive and
hold the stock for later sale and to remit the proceeds to the foundation (Fishman
1998; Singer 1997a).
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1.5.5 Joint Venture
A more recent approach, often used by Columbia/HCA called the joint
venture model, has been gaining favor. In this type of conversion, the entity is
converted to for-profit status, but only a percentage of its assets are sold to a for-
profit corporation. A new, charitable entity receives the cash value of the assets
sold and retains the ownership interest in the for-profit entity, equal to the
percentage of assets not purchased. In this manner, the community arguably
maintains an ownership interest in its hospital, presumably enabling it to better
control the institutions’ future (Singer 1997a).
Table 1-2 identifies types of hospital conversion that occurred after 1990
from three major investor-owned corporations: Columbia/HCA Healthcare
Corporation, Quorum Health Group, and Tenet Healthcare Corporation.
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Table 1-2
Types of Conversions
Not-for-Profit Hospital For-Profit Company
Conversion
Type
Year
Alabama
Baptist Memorial Hospital
Jacksonville Hospital (city-owned)
Lloyd Noland Hospital
Quorum Health Group
Quorum Health Group
Quorum Health Group
Asset sale
A sset sale
A sset sale
1993
1996
1996
California
Good Samaritan Health System Columbia/HCA Healthcare Corp. Asset sale 1996
Louisiana
Mercy Baptist Medical Center
Tulane University Hospital
Tenet Healthcare Corporation
Columbia/HCA Healthcare Corp.
A sset Sale
Joint venture
1995
1995
South Carolina
Mary Black Memorial Hospital
Carolinas Hospital System
Hilton Head Hospital
Quorum Health Group
Quorum Health Group
Tenet Healthcare Corporation
A sset sale
Asset Sale
Joint venture
1996
1995
1994
Tennessee
Goodlark Regional Medical Center
St. Francis Hospital
Columbia/HCA Healthcare Corp.
Tenet Healthcare Corporation
A sset Sale
A sset Sale
1995
1994
Virginia
The Arlington Hospital Columbia/HCA Healthcare Corp.
John Randolph Medical Center (public) Columbia/HCA Healthcare Corp.
The Retreat Hospital Columbia/HCA Healthcare Corp.
Joint Venture
Asset Sale
A sset Sale
1996
1995
1995
Source: General Accounting Office 1997.
1.6 Scope of Conversion Activity
Conversion activity has proceeded at different paces and in different ways
across non-profit health care organizations. The distribution of hospital beds by
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ownership has remained markedly stable. In 1994, as in 1984, about 70% of all
beds were non-profit, 20% were public, and 10% were for-profit. Nevertheless,
there has been significant change in a number of states. In New Hampshire, Utah,
Idaho, and New Mexico the for-profit share of beds in 1994 was about 10% higher
than in the previous decade. Perhaps more significant, after more than a decade in
which approximately nine hospitals conversions occurred per year, thirty-four
occurred in 1994 and fifty-nine occurred in 1995 (Claxton et al. 1997). According
to a Health Affairs study by Needleman, Chollet, and Lamphere (1997), public
hospitals account for nearly 32% of all conversions between 1990 and 1993.
Figure 1-1 illustrates the number of hospital conversions between 1990 and 1993.
Of the total conversions, almost 20% converted from non-profit to for-profit status.
Public to Non-profit
Figure 1-1. Number o f Hospital Conversions 1990-1993.
Source: Needleman, Chollet, and Lamphere 1997.
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In 1999, Young and Desai conducted a study of a sample of forty-three
conversions that occurred between 1981 and 1995 in California, Florida, and
Texas. These states were chosen because of the high level of conversion activity in
the states. At the time of conversions, all of these hospitals were community-based
facilities. Of the sample of forty-three conversions, almost 50% occurred in
California. Table 1-3 summarizes the distribution of conversions by state and year
of conversion.
Table 1-3
Distribution of Conversions, by State and Year of Conversion, 1981-1995
Years California Florida Texas Total
1981-1984 10 5 0 15
1985-1989 2 6 0 8
1990-1995 8 4 8 20
Overall 20 15 8 43
Source: Young and Desai 1999.
Conversion activity also increased among Blue Cross/Blue Shield plans.
Historically the Blue Cross and Blue Shield Association (BCBSA) required that
licensees of its trademark be non-profit. That requirement was eliminated in June
1994 to permit plans to better adapt to the changing marketplace and to obtain
access to the equity capital. As of 1999, five of the sixty-three plans (Georgia,
California, Missouri, Puerto Rico, and Virginia) had converted to for-profit
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ownership. Other plans including those in Colorado, Maryland, Massachusetts,
New York Wisconsin, and Ohio were considering conversion (Claxton et al. 1997,
Jacob 1999). Table 1-4 below shows the Blue Cross health plans that had
converted to for-profit companies or were in the process of converting as of 1999.
Table 1-4
Status of Blue Cross Health Plan Conversions
Plan Name Year Converted
Blue Cross of California 1996
(WellPoint Health Networks)
Blue Cross Blue Shield of Georgia 1996
Blue Cross Blue Shield of Missouri
(Transferred 80% of managed care business into
1994
RightChoice, a for-profit subsidiary)
Trigon Blue Cross Blue Shield
(Blue Cross Blue Shield of Virginia)
1997
Triple-S
(Seguros de Servicio de Salud de Puerto Rico Inc.)
Plans in the Process of Conversion as of 1999
Blue Cross Blue Shield of Colorado
Blue Cross Blue Shield United of Wisconsin
Empire (New York) Blue Cross Blue Shield
1999
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The HMO industry presents a different picture. The industry began almost
exclusively as non-profit fueled in part by the availability of federal grants for non
profit organizations and BCBSA policies. However, since the mid-1980s and
through the 1990s, the HMO market became predominantly for-profit. In 1981,
82% of HMOs (accounting for 88% of all memberships) were non-profit. By 1995
the proportion of non-profit plans fell 29% (accounting for 41% of members)
(Claxton et al. 1997).
Fishman (1998) suggests that the conversion of non-profit health care
providers to for-profit status received its greatest impetus with the emergence and
aggressiveness of Columbia/HCA. Columbia Hospital Systems was formed in
1987. Within a decade, it grew to a corporation with $20 billion in revenues with
approximately 350 hospitals, 500 health Care Offices, and scores of other medical
businesses in 38 states. Columbia not only expanded by acquiring for-profit
hospitals, but in 1995, they acquired thirty-three tax-exempt hospitals as well. In
1996, seventeen of its twenty-eight acquisitions or joint ventures involved tax-
exempt hospitals with an additional fourteen pending. In 1997, Columbia was
charged with Medicare Fraud and settled with Alabama’s Medicaid program for
$40 million. Because of the projected settlement and fines, bond rating agencies
placed Columbia/HCA debt under review for a potential downgrade. Despite the
humbling of Columbia and slow down of conversion process, the underlying
rational of efficiency and cost containment remain.
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Though prepaid medical services have existed since the 18th century, in the
second half of the 20th century their use widened because HMOs were seen as
devices to hold down the ever-increasing costs of health care. Through the HMO
Act of 1973, the federal government served as a venture capitalist for non-profit
HMOs providing loans to financial guarantees. Because of the availability of
federal assistance, non-profit HMOs dominated. In 1983 the federal loan program
ceased, and HMOs with growing capital needs began to convert to for-profit status.
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C h a pt e r 2
L it e r a t u r e R e v ie w
2.1 The For-Profit/N ot-for-Profit Distinction
In the highly decentralized and pluralistic health care system, a mixture of
for-profit, secular and religious not-for-profit, and public institutions, some of
which are independent and some of which are a part of multi-institutional systems,
provide health care. Different types of ownership typify different types of
institutions. Nursing homes have long been predominantly proprietary, for-profit
institutions. Acute care general hospitals are typically not-for-profit institutions.
Among certain specialized types such as psychiatric and tuberculosis institutions,
governmental ownership is typical because of public health and safety concerns
(Gray 1986).
For-profit (investor owned) institutions have been distinguished from not-
for-profit institutions based on a variety of aspects. For-profit corporations are
typically owned by investors. They distribute some proportion of profits (net
revenue less expenses) to the owners and pay property, sales, and income taxes.
Their sources of capital include equity capital from investors, debt, and retained
earnings. Management is ultimately accountable to stockholders; its legal
obligation is to enhance the wealth of shareholders within the boundaries of law.
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Revenues are derived from sale of services, and their mission is usually stated in
terms of growth, efficiency, and quality (Commerce Clearing House 1991).
Not-for-profits on the other hand are corporations without owners or are
owned by “members” and they cannot distribute surplus (net revenue less
expenses) to those who control the organization. Generally not-for-profits are
exempt from property and income taxes. Their sources of capital include charitable
contributions, retained earnings, and government grants. Management is
accountable to voluntary, often self-perpetuating boards. Not-for-profits have a
legal obligation to fulfill a stated mission, such as provide services, research,
teaching, etc., and they must maintain economic viability to do so. Revenues are
derived from the sale of services and from charitable contributions. Their mission
is often stated in terms of charity, quality, and community service, but they may
also pursue growth.
2.1.1 For-Profit Organizations (Investor Ownership)
The purposes of investor-owned corporations in general are to make a profit
for the investors and to preserve and enhance the economic value of invested
capital. This purpose is built into the corporate governance structure. An investor-
owned corporation is ultimately governed by its owners (stockholders), who elect
the board of directors. The stockholders accept the risk of purchasing stock in the
expectation of gaining economic return that is larger than would be available
through non-equity forms of investment such as purchase of bonds. Profits for the
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stockholders come in the form of dividends and appreciation in the value of their
investments (Blumstein 1984).
The board of directors makes broad policy decisions and employs the top
management of the corporations. In health care and other fields, top officials of the
corporation not only serve on the board but also have significant holdings of the
corporation’s stock. The dividends that the officers and other stockholders receive
and the value of their holdings depend on the corporation’s earnings. In addition to
accountability and incentive ownership present for management, other profitability
incentives also exist. Many companies tie large incentives for management to the
company’s performance. For top executives, such incentives in the form of cash
and stock options often run into millions of dollars (Siegriest 1983).
According to Bloche (1998), the demand for performance from equity
investors offers managerial flexibility as compared to stringent financial disclosure
laws that apply to publicly traded companies and can yield competitive advantage.
2.1.2 Not-for-Profit Organizations
Although state laws under which not-for-profit organizations are
incorporated vary in their requirements, a not-for-profit corporation is governed by
a “non-distribution requirement” by which it is barred by its charter from
distributing its net earnings, if any, to individuals who exercise control over it
(Hansmann 1980).
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Thus, the key characteristic of a non-distribution requirement is thought to
control the management and organizational behavior of non-profit entities.
Hansmann (1980) suggests that not-for-profit organizations are a response to
contract failures in circumstances that make contracts between consumers and
suppliers impractical to write or too costly to monitor. On the other hand, the non
distribution constraint is sometimes alleged to cause indifference by management
to consumers and inattention to efficiency, except where resources are scarce.
Not-for-profit organizations are not prohibited from earning a profit from
operations; however, these profits must be reinvested in production of the services
that the organization was formed to provide. Not-for-profit organizations can be
distinguished from each other by two attributes: their control and their financing.
“Membership” or “mutual” not-for-profit organizations such as country clubs and
professional associations are controlled by the organization’s members
(Mulholland and Horty 1983). Non-membership organizations are controlled by
self-perpetuating boards, which is a common pattern among nursing homes and
hospitals. On the financing side, not-for-profit organizations can be distinguished
according to the degree to which they derive their income from donations or from
charges for the services they provide (Ginzberg 1984).
The exemption from income and property taxes provides a major financial
benefit; it gives the organization the ability to pay tax-free interest on borrowed
funds. Bloche (1998) suggests that these tax advantages compensate to some
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degree for non-profits' main financial handicap: the inability to raise capital by
selling an ownership interest to investors.
2.2 The Value Question
Although this dissertation examines the conversion process, the argument
about for-profit health care is as much about values as it is about facts. A deep
division about values underlies and affects all discussions of the implications of the
growth of investor-owned health care.
2.2.1 Health Care as an Economic Good
The view that personal health care is much like other consumer goods
implies that marketplace forces and for-profits motive are beneficial. Furthermore,
it has been argued that medical institutions and physicians respond to economic
incentives, and it seems realistic to view health care in these terms. In this view,
competition and market forces are seen as providing the best outcome for all—a
system that is responsive to consumers, in which the producers of inferior services
will be pushed out of the market. The hard test is the bottom line, which will
restrain capital expenditure for equipment and facilities if demand is lacking. Such
a system is thought to lead to maximum efficiency in production of services, except
in circumstances where revenues are based on reimbursement of costs (Yoder
1986; Colombo 1994).
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2.2.2 Health Care as a Social Good
A contrasting set of views opposes the idea that health care is an economic
good which can be bought and sold in the marketplace with its competitive forces.
This view holds that health care should be seen as a “social good.” In this view,
health care is a community service, and the ideal is that the needs of the sick and
unfortunate should be met by persons who are acting out of caring rather than
expectations of economic gain (Blumstein 1984). The business orientation that is
seen as a concomitant of for-profit health care also is regarded as a threat to the
very ethos of health care. There is a fear that a multi-tier system will become
socially acceptable, and providers will come to feel no shame in refusing to serve
those who cannot pay. Thus, there is fear that the move toward for-profit health
care will affect the moral and ethical climate of healthcare (Gray 1997).
2.3 Legal Authority
This recent wave of conversions of non-profit health care organizations to
for-profit status has brought new challenges to state officials whose job it is to keep
an eye on such transactions. States traditionally have regulated insurers and
hospitals, and often their capabilities are stretched by the complexities surrounding
non-profit to for-profit conversions, and the magnitude of the dollars involved
raises the stakes still higher. Chief among states’ duties is to protect consumers,
who often fail to grasp the significance of a plan’s conversion until the deal is in its
final stages.
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The major argument in favor of conversions to for-profit status has been
that the American health care environment has become highly competitive, and the
only way these non-profit entities can survive is to raise additional capital by going
to the capital markets. It has also been argued that the state will gain a tax-paying
health care entity and thus add to the tax base of the state. However, it is critical
that these conversions be administered effectively to ensure that the charitable
assets are valued and applied appropriately. Regulation of the conversion process
is an art not a science and is influenced by the environment of state regulators and a
state’s body of law.
2.3.1 Applicable Law
The task of intervening in conversions is complicated by two basic
deficiencies in the law: the absence of a clear statement of who owns non-profit
organizations, and the lack of a clear definition of charity as a requirement to
register with the state. With no clear definition of ownership, one must search for
clarity among obtuse legal concepts, such as charitable trusts and governing legal
theories. Without a definition of charitable law, regulators have too many
authorities and too little guidance.
Four major and potentially overlapping areas of law apply to conversions:
(1) corporate law; (2) laws speaking directly to the powers of the attorney general
or the insurance commissioners; (3) laws pertaining to health maintenance
organizations (HMO), insurance, and hospitals or Blue Cross-specific law; and (4)
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charitable trust law. A number of other sources of authority may be used by states
with conversions, including state constitutions; for-profit and not-for-profit laws
governing charter, formation, dissolution, merger, sale, joint ventures and
partnerships, holding company, and mutual insurance statutes; certificate of need
statute; charity laws; codes of civil procedure; state and federal tax and property
laws; and statutes of public records. Much authority is based on common-law
doctrines developed through the decisions of the courts. The list of authorities is
long because conversions involve many issues. Often no one statute provides
enough guidelines on how to consider a conversion (Shriber 1997).
The most common authority for viewing hospital conversion cases is the
charitable trust doctrine. Under this doctrine, a non-profit entity is viewed as
belonging to the public, with the directors and the state’s attorney general acting as
its representative. According to common law, the creation of non-profit
organization with charitable or other welfare purposes results in a charitable trust
that is irrevocably dedicated to the organization’s original mission {Queen o f
Angels Hospital v Younger, 136 Cal. Rptr. 36 [Cal. App. 1977]).
According to Shriber (1997), Robert Boister in his work on the sale of non
profit hospitals and HMOs best articulates the authority under common and
statutory law that rests on the broad common-law authority of the attorney general
to review charitable organizations on two related principles. The first principle is
the requirement of court approval for a change in the corporate purpose under cy
pres doctrine. Under cy pres, charitable organizations are impressed with a trust
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that survives anything that happens to the organization. Historically, cy pres was
applied when it became impossible for a charity to carry out its mission. It
provides that the charitable assets then should be devoted to carrying out a purpose
as near as possible to the entity’s original mission. Should these conditions be
violated, the attorney general would have the authority to hold directors personally
liable.
The second principle is that the entity’s directors have a duty to act as
fiduciaries and to exercise care in their dealings on behalf of the non-profit
corporation. The directors must act in the interest of the non-profit corporation,
avoiding conflicts that might compromise that interest, and must exercise
reasonable judgment in carrying out their duties. Thus, they would undertake the
conversion only if they viewed it as the best alternative for continuing to carry out
the purposes for which the hospital was established.
2.3.2 Conversions and Charitable Assets
Conversions not only affect health care organizations; they also affect the
communities’ access to and use of charitable assets. Yet, most states have neither
enacted specific legislation nor instituted any specific process to oversee health
industry conversions. Under current law, state policies have been highly variable.
As conversion activity has increased, so has the call for greater oversight of and
public participation in the process.
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State laws generally establish the legal framework under which
corporations, including charitable organizations, are established. These laws
establish the procedural requirements for changes in corporate structure. In
addition, the transfer of assets of a non-profit organization is governed by state
charitable trust law because the assets are considered to be held in charitable trust
for the public. When a charitable organization is dissolved, however, the
transaction is structured, and its assets must be transferred to a non-profit
organization that will carry the original purpose of the charitable trust as nearly as
possible. In many cases, a new foundation is formed for that purpose (Claxton et
al. 1997).
The application of legal principles regarding conversions varied
considerably among the states. In some states, public officials have aggressively
pursued their interpretations of charitable trust and other laws to oversee
conversions and promote public involvement. Consumer and other advocacy
organizations have taken a lead in calling attention to the importance of oversight
when conversions occur.
For example, in California, the HMO’s articles of incorporation must state
that none of the assets of the corporation shall inure to the benefit of a private
person. California requires that the following language be included in the articles
of incorporation: “The corporation is a non-profit public benefit corporation and is
not organized for the private gain of any person. It is organized under the Non-
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profit Public Benefit Corporation Law for charitable purposes” (Cal. Corp. Code,
Sec. 5130, West 1990).
California law also mandates that “all of a corporation’s assets shall be
disposed of on dissolution in conformity with its articles or bylaws” (Cal. Corp.
Code, Sec. 6716, West 1990). Thus, upon liquidation, dissolution, or
abandonment, the assets of a public benefit corporation must be distributed
exclusively to another charitable organization. Once converted, the HMO ceases to
exist as a public benefit entity. The value of the converting HMO, therefore, must
be fixed in order to allow the corporation to discharge its responsibilities under its
articles of incorporation. The valuation of an HMO will set the amount that the
public will receive for permitting the conversion. Although a number of valuation
approaches have been suggested and employed in appraising HMOs, many of these
procedures have consistently and seriously understated the actual market value of
the converting HMOs (Bailey 1994b).
In California and Massachusetts, attorneys general believe that strong
common law authority exists for asserting charitable trust principles but that it must
be interpreted in light of clear statute. Other states such as New York have unique
statutory interpretations. In New York, a statute governing for-profit corporations
is used to regulate conversions of HMOs. However, operating a hospital as a for-
profit corporation is forbidden, so conversions of hospitals to for-profit status are
generally not an issue (Shriber 1997)
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In New Hampshire, common law, including cases dating back to 1901, is
the primary basis of intervention. The attorney general’s office also relies on a cy
pres statute, which recently was modified to place all such proceedings before the
probate court. In Texas, on the other hand, the relevant authorities are
exceptionally complicated. A major source of authority in Texas is the
Miscellaneous Corporations Act, which permits the attorney general to investigate
the books and records of any corporation doing business in Texas. Further, the
property code requires that the attorney general must be notified if there is a
proceeding involving a charitable trust. Although charity law in Texas, as in many
states, is based on the common law, there is no specific Texas legislation that
pertains to protecting the charity-related assets (Vinson 1997).
Since 1995, twenty-four states and the District of Columbia have enacted
legislation regarding conversions. In 1996 California and Nebraska passed laws
which gave the attorney general greater authority to review transactions where
significant portions of the non-profit entity’s assets are transferred to for-profit
organizations. Legislative bills were also introduced in thirty states. Many states,
such as Arizona, Connecticut, Georgia, Louisiana, New Hampshire, Ohio, Rhode
Island, Virginia, and Washington, adopted conversion laws. While most of these
laws only deal with non-profit hospital conversions, a few are broad enough to
encompass other non-profit healthcare organizations such as conversions of HMOs
and Blue Cross and Blue Shield (BCBS) plans. In addition, some states have
adopted laws that deal specifically with the conversion of BCBS plans; however,
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these laws seldom provide clear guidance as to how conversions should be
processed or how these laws should be read in conjunction with state statues and
common law (Bisesi 1997).
Changes in non-profit status have federal tax implications as well. Section
501(c)(3) of the Internal Revenue Code grants federal tax exemption to
organizations formed and operated exclusively for charitable purposes, provided
that no part of the organization’s earnings inure to the benefit of any private
shareholder or individual. Penalties are imposed for violation of these rules
(Commerce Clearing House 1996).
While virtually all non-profit hospitals are organized as charities under
Section 501(c)(3) of the Internal Revenue Code, many non-profit HMOs and Blue
Cross and Blue Shield Plans are not. Laws applicable to charitable trusts may not
apply to these organizations unless they have dedicated their assets for charitable
purposes through their corporate article, bylaws, or some other means (Bailey
1994b).
For example, some Blue Cross and Blue Shield plans are organized as
“mutual benefit” organizations, which generally are operated for the benefit of their
members rather than for charitable purposes. When a mutual benefit organization
converts from non-profit to for-profit status, the members of the organization,
rather than the community, may be entitled to the proceeds of the transaction. A
controversy may arise, however, if the mutual benefit organization was originally
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incorporated as a charity, or if a mutual benefit organization’s corporate documents
state that the organization is operated for the benefit of the public.
The ambiguity in the law has produced a surfeit of legal theories. Some
theorists have taken the position that chartering legislation defines the plans as
having a charitable mission. Others insist that the key to understanding the plans’
ownership lies in their articles of incorporation. Others argue that Blues plans have
metamorphosed so many times and are such unique creatures that their ownership
is unclear. Still others insist that Blue Cross plans are not-for-profit corporations
subject to the common law doctrine of charitable trusts. In contrast, plans such as
Blue Cross in Missouri and Ohio insist that they are not subject to charitable law.
They, like many Blue plans, assert that ownership can be determined by the terms
of the latest transaction (Shriber 1997)
2.3.3 Federal Role in Non-Profit Conversions
During the 1970s, the federal government encouraged growth in the non
profit HMO industry by making grants, loans, and loan guarantees to federally
qualified HMOs (McMahon 1996). The financial support was based on the view
that HMOs tended to emphasize preventive medicine and encourage
comprehensive coverage; it was hoped this would help reduce spiraling health care
costs. The federal government eventually extended the loan program to include
for-profit HMOs as well. This access to capital spurred growth in the HMO
industry. By the 1970s, the number of HMOs had increased from 26 serving
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approximately 3.25 million people, to 175 with over 6.5 million members. By
1980, this figure had grown to 235 HMOs with enrollment of over 9 million, and
by 1985, the membership approached 32 million (McMahon 1996).
However, by the early 1980s, the federal government’s support for non
profit HMOs began to fade. The new administration’s philosophy was that
financial support for HMOs should come from the private sector. Thus, the federal
grant and loan programs to the HMOs were discontinued in the early 1980s. This
decrease in federal support prompted many HMOs to seek private sector capital
funds (McMahon 1996).
2.3.4 A California Perspective on the Conversion o f Non-Profits
Under the Knox-Keene Health Care Service Plan Act of 1975, the
Department of Corporations is responsible for administering health care services
plans. The purpose of the Knox-Keene Act is to promote the delivery of health
care to Californians who subscribe to the services rendered by health care service
plans. The provisions of the Act apply to both non-profit and for-profit health
service plans (Health Care Service Plans 1996).
As a result of amendments to the Corporations Code in 1980, “conversions”
of health plans from non-profit to for-profit were authorized. California first
authorized the conversion of non-profit public benefit corporations to for-profit
status in 1979 (Cal. Corp. Code, Sect. 5813.5). From 1980 to 1983, the attorney
general had primary responsibility for administering the conversion process for
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health service plans. However, as a result of state legislation, the Department of
Corporations (DOC) assumed responsibility in 1984 for administering the health
plan conversion process (Senate Committee on Insurance 1994).
As stated previously, the Corporations Code requires a non-profit public
benefit corporations, such as a non-profit health service plan, to state in its articles
of incorporation that it is “not organized for the private gain of any person.” In
addition, the Corporations Code requires a non-profit corporation, upon dissolution,
to dispose of its assets in conformity with its non-profit articles of incorporation.
This disposition is referred to as the converting corporation’s “charitable trust
obligation.” It is interesting to note that the Corporations Code section that permits
the conversion of non-profit corporations to for-profit status does not specify how
to administer the conversion process.
Through its interpretation of the code sections and its reliance on legal
precedents, the DOC requires the newly converted for-profit health organization to
donate the fair value of the old converting non-profit health plan to charity as a
condition of the conversion (Health Care Service Plans 1996). Prior to 1996, there
was no statutory provision on this obligation. This was done as a matter of policy
to compensate the public for the tax exemptions and other public benefits received
due to the health plan’s prior non-profit status.
In addition, the Department applies the cy pres doctrine, where courts direct
gifts to charities whose purposes are “closely related” to those of the donor
organization, in requiring that the donation be made to a charity whose purpose is
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similar to that of the converting health plan. Thus, the donations must be utilized
for health related purposes (Senate Committee on Insurance 1994).
The Department of Corporations is also responsible for approving the
valuation of assets to be donated, the terms of the donation, and the selection of the
charity. The Auditor General’s Audit Report issued in 1992 found that the
Department of Corporations was using appropriate valuation methods, obtained
reasonable donations for charities, and ensured that the charities received the
donations. The Auditor General reviewed four conversions to determine whether
the DOC complied with the law and applied departmental procedures objectively
and consistently (Auditor General’s Report 1992).
The Auditor General determined that the DOC used accepted business
valuation methods in determining the fair value of the health plans, required the
charities to be “substantially unrelated” to the converted health plan, and prohibited
the charities from funding or supporting the for-profit health plan. The report also
concluded that the law provided little guidance for the administration of
conversions and that the DOC did not have formal, written procedures governing
the conversion process. However, it did follow an informal set of requirements in
reviewing and evaluating conversion applications. Most of the department’s
procedures covered aspects of the conversions not specifically addressed in the law,
including the methods for determining the fair value of the converting health plan,
the development of reasonable terms for making the donation, and the selection of
an appropriate recipient of the donation (Auditor General’s Report 1992).
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Many have criticized the Auditor General’s conclusion under the DOC’s
“informal” process that DOC had secured “reasonable donations” for charities. In a
number of significant conversion cases, questions have been raised as to the
valuation of the assets dedicated to charity. Consumers Unions alleged that in
some cases the DOC accepted valuations that later proved to be grossly
understated. The actual “market” values of these health plans proved to be
dramatically higher than estimated at the time of the conversion. These alleged
under valuations by the DOC resulted in a windfall to for-profit health plans and a
loss of needed funds that should have been directed to charitable purposes. The
amount of actual dollars that eventually are transferred into charitable trusts
depends on the valuation methodologies utilized.
2.4 Agency Theory
2.4.1 Asset Valuation
The most critical and difficult component of the conversion process is
determining the value of non-profit HMOs. No issue is more critical to this than
the valuation of assets in conversion of a non-profit organization. Valuation is at
the heart of two key policy issues raised by conversions: (1) the potential for
insiders to realize inappropriate financial gains (inurement) and (2) the level of
funding that will be available for future charitable activities. Yet, most states have
neither enacted specific legislation nor instituted any specific process to oversee
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health industry conversions. Under current law, state policies are highly variable
(Claxton et al. 1997).
At the heart of conversion controversy are difficult issues of valuation:
How can one attain a fair market value of the converting organization? Non-profit
entities present greater valuation difficulties than for-profit firms. Non-profit
valuation is more complex and uncertain than the valuation of a comparably sized
for-profit.
One factor is that there is no readily ascertainable market value. Another is
that securities analysts and investment advisors that follow for-profit counterparts
do not regularly scrutinize non-profit firms. Valuation, then, rests upon the
appraisers’ craft, inherently a subjective process. The subjectivity of the valuation
process is overlaid by the very human and economically rational behavior by
appraisers who may use their discretion to serve the interests of those who hire
them (Fishman 1998; Rubin 1999).
Generally, valuation of a non-profit entity is calculated as a multiple of the
firm’s earnings before the expense of interest, depreciation, taxes, and amortization
(EBIDTA). Appraisers generally place a value on non-profit hospitals at five to
seven times EBIDTA. However, valuation is severely tested in the health care area
where there has not been a market and in which the conversion is followed
thereafter by a substantial increase in value of a publicly traded health care
company in comparison to its non-profit value (Fishman, 1998).
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Since the valuation process involves judgment and estimation if the states
are not diligent regarding conversions, there can be substantial loss of non-profit
charitable assets that rightfully belong to the community. Inherent in agency theory
are the characteristics of asymmetric information and conflicts of interest
(Williamson 1991). The theory of asymmetric information proposes that managers
know more about their firms’ future prospects than the investors do (Gapenski
1993). It has been alleged that during 1970s and 1980s, when various non-profit
health-care service plans converted to for-profit status, managers of health care
service plans intentionally undervalued the assets of the non-profit corporation and
enjoyed an enhanced value of the for-profit entity (Isenberg 1993).
These conversions, which required an irrevocable dedication of the
corporations’ assets to charitable purposes, generated substantial litigation,
including allegations of self-dealing and private inurement by the directors of
corporations (Van De Kamp v Gumbiner, 1990, 221 Cal. App. 3d 1260).
In Van De Kamp, it was alleged that the manager of the non-profit health
care service plan corporation intentionally undervalued the assets of the non-profit
corporation. Accordingly, when the non-profit was converted to for-profit status
and public offering was made, the manager enjoyed increases in value of the for-
profit corporation to the detriment of non-profits’ charitable beneficiaries.
Bailey (1994a) found that investors who were often former managers of
non-profit plans persuaded state regulators to accept wildly low estimates of the
value of the dissolving corporations. The evidence of under valuations is that only
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a year or two after their conversions, the new for-profit health plans were worth
considerably more than the foundation they left behind. Bailey’s data published in
1994 reveal that the market value of Foundation Health Plan (FHP) was 305 times
higher in 1986 than the assets it gave to charity in 1984. Inland Health Care had a
value in 1985 that was 56.6 times its contribution in 1981. The value of PacifiCare
grew 125.8 times between 1984 and 1985.
Comparisons of charitable donations among converted HMOs are presented
in Table 2-1. The total market value of these corporations in mid-1995 was
estimated to be $7 billion. By 1991, these numbers had dismayed the leaders of
several advocacy groups.
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Table 2-1
Comparison of Charitable Donations among Converted Health Organizations
Health Organization
Estimated Value
($) at Time o f
Conversion (Year)
(Amount to Charity)
Sale or Later
Value ($)
Charity
as % o f
Later
Value
1994 Value ($)
Anclote Psychiatric Ctr. 6,300,000
1983
29,600,000
1985
21.28 n/a
Family Health Plan 38,457,000
1984
135,628,000
1986
28.35 745,684,000
Foundation Health Plan 78,000,000
1984
302,479,000
1991
25.79 691,913,000
Greater Bridgeport Foundation 4,419,376
1986 1986
100.00 150,680,000
Greater Delaware Valley Health Care 100,000
1984
20,000,000
1986
0.50 n/a
Group Health Association 5-10,000,000
1993
50,670,000
1993
n/a n/a
Group Health Plan Greater St. Louis 4,000,000
1985
40,000,000
1986
10.00 46,170,680
HEALS (Herrick Alta Bates Study) 2,100,000
1987
24,500,000
1990
n/a n/a
HealthNet 300,000,000
1992
300,000,000
1992
100.00 1,700,000,000
Inland Health Care 663,000
1985
37,500,000
1986
1.77 n/a
Irvine Medical Center 15,000,000
1986
15,000,000
1986
100.00 n/a
Montefiore Hospital 75,000,000
1989
75,000,000
1989
100.00 n/a
Nashville Memorial Health System 108,000,000
1994
108,000,000
1994
100.00 108,000,000
Northwest Area Community Systems 8,000,000
1984
8-11,000,000
1984
n/a n/a
PacifiCare Health System 360,000
1984
45,300,505
1985
0.79 6,936,460,000
Presbyterian/St. Lukes Healthcare Corp. 123,000,000
1985
180,000,000
1985
68.33 n/a
Ridgeway Hospital 10,500,000
1984
10,500,000
1984
100.00 n/a
Saint Francis Hospital 130,000,000
1994
130,000,000
1994
100.00 130,000,000
Wesley Medical Center 200,000,000
1985
265,000,000
1985
75.47 n/a
Source: Bailey, The Chronicle o f Philanthropy, June 14, 1994a.
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2.4.2 Conflict o f Interest
A fundamental problem with conversion is that directors of a non-profit
entity may be involved with the for-profit company. The directors may be
promised stock or already be substantial shareholders of the for-profit venture. The
acquiring corporation may offer bonuses, salaries, or “golden parachutes” to the
directors joining the for-profit organization. There may be contingency
compensation based upon the success of completing the transaction. In its non
profit guise, the fiduciary obligation of the director is to obtain the highest value for
the non-profit and to assure that the community is provided with healthcare. That
individual’s interests as a for-profit shareholder or a future employee may be in
conflict.
Fishman (1998) suggests that conflict of interest has been a particular
problem in hospital and Blue Cross conversions, where executives of non-profits
were promised substantial bonuses and long-term compensation agreements.
For example, in Ohio, the management of Blue Cross of Ohio accepted an
offer to be sold to Columbia/HCA. Four executives were to receive S19 million in
payout as part of the transaction, and seven former directors were to receive $3
million (Fishman, 1998). Generally, these conversions are friendly transactions as
viewed by management. The governing body and key staff of the converting non
profit usually work closely with the for-profit entity. This raises questions about
the integrity of the organization’s decision making process and the quality of
information provided by the staff to the board. The charity may be operated during
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the period leading up to the transaction in a way that potentially devalues the
organization’s business or assets in order to make the acquisition more attractive to
a potential future employer (Ono 1998; Tower 1997).
2.4.3 The Health Care Dollar
One of the main criticisms of for-profit health care organizations has been
that the profit which should go toward providing health services is diverted to high
executive salaries, advertising, administrative costs, and payment of dividends to
the shareholders. Agency theory posits that the dividend mechanism provides an
incentive for managers to reduce costs associated with the principal/agent
relationship. Dividend policy was also found to be a function of firm size, rate of
growth, operating/financial leverage mix, intrinsic business risk, and ownership
structure (Moh’d et al. 1995).
Thus, with profits and returns on investment for publicly traded HMOs
declining, will additional health care dollars be diverted to dividend payment and
executive salaries? In recent years, the average return on HMO investments has
declined to 15% from 25%. Some analysts suggest that the HMO industry will
continue to grow by attracting more Medicare and Medi-Cal patients. However,
patient advocates argue that publicly traded HMOs will not be successful in
delivering care to government beneficiaries. With Medi-Cal patients, one issue is
reimbursement. The capitation rate, the amount that is set aside to pay for Medi-
Cal beneficiaries, is relatively low. The amount gets reduced significantly by the
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administrative costs and profit rates that go to the HMOs. Another issue is the
future of public hospitals, which are funded by Medi-Cal patients when HMOs take
away those dollars (Bland 1996).
In addition, both federal and state regulations appear to encourage conflict
of interest behavior among managers. For example, as a non-profit public benefit
social welfare organization, HealthNet was subject to both state and federal
oversight. Because interpretations of California law have permitted the conversion
and the resulting enrichment of HealthNet’s officers and directors, United States
Representative Peter Stark of California turned to federal law to discover whether it
prohibited this type of transaction. He found that HMOs, although subject to
regulation as tax exempt organizations, were not prohibited from engaging in
interested-party transactions such as for-profit conversion. While HMOs must be
recognized as exempt organizations under IRS provisions in order to obtain
favorable federal tax treatment, HMOs are not usually classified as traditional
charities under Internal Revenue Code Section 501(c)(3). Generally, non-profit
public benefit HMOs are considered “social welfare” organizations and operate
under the provisions of Internal Revenue Code Section 501(c)(4), under which
there are no specific prohibitions against self-dealing or private inurement
(Sheppard 1993).
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2.5 Impact of Conversions on Community Benefit
A major concern that communities have when their non-profit hospital is
taken over by a for-profit is whether the for-profit will provide community benefit
to the community that it is entering. Part of the non-profit mission is to provide
community benefit. Debate about non-profit versus for-profit community benefit is
longstanding. Research has not resolved this controversy, in part because of the
considerable variation in the way community benefits have been defined and
measured. A comparison of studies is difficult because their definitions of
community benefit differ widely.
The items that might be included in the measurement of community benefits
are charity care, bad debts, losses from serving public program enrollees, losses
from subsidizing necessary community services such as bum units and twenty-four
hour trauma centers, net cost of research and education, lower prices, community
control and accountability, non-profit orientation and trustworthiness, and taxes.
The most salient of these is uncompensated care, which is comprised of charity care
and bad debt. Charity care is defined under Rev. Rul. 56-185 as “providing
services at no charge or reduced rates to those who otherwise would be unable to
afford them,” i.e., meet the financial ability standard (IRS Coursebook 1995).
In 1990, the U.S. General Accounting Office undertook a study to assess the
role of non-profit hospitals in providing acute medical care to those who are unable
to pay. The study analyzed the distribution of uncompensated care among hospitals
in five states to determine the role of non-profit hospitals in supplying
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uncompensated care. The five states (California, Florida, Iowa, Michigan, and
New York) were selected to include a broad range of different factors. The study
defined uncompensated care as including free care and bad debt. The study
concluded that, as a group, non-profit hospitals provided more uncompensated care
than for-profit hospitals. However, the burden of providing uncompensated care
was not equally distributed among non-profit hospitals. Government-owned and
teaching hospitals provided a higher percentage of the uncompensated care expense
than the other non-profit hospitals (General Accounting Office 1990). The
breakdown of uncompensated care by hospital type, amount, and percentage is
summarized in Table 2-2 below.
Table 2-2
U.S. Hospitals by Uncompensated Care and Ownership Type: 1988
Type
Number
o f
Hospitals
Total Uncomp,
Care
(in Billions o f $)
% Distribution Average
o f Uncomp. Uncomp. Care
Care Rate a s % o f
Revenue
Non-profit 3,440 8.4 58 4.8
For-profit 1,149 1.4 9 5.2
State & Local Government 1,849 4.8 33 7.6
Total 6,438 14.6 100
Source: General Accounting Office 1990.
According to Kramer (1998), other studies by Clement, Smith, and Wheeler
(1994), Reiman (1988), and Sanders (1993) also found variations across non-profits
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in the level of charity care provided. Comparative studies suggest that non-profits
provide on an average more uncompensated care than do other investor-owned
counterparts.
With respect to effects of conversions, Young, Desai, and Lucas (1997)
used data from 1980 to 1992 to examine three-year average levels and trends in
uncompensated care provision by seventeen non-profit California hospitals before
and after the acquisition by for-profit. Before acquisition the acquired hospitals as
a group had significantly lower levels of uncompensated care compared to similar
hospitals. The study identified no significant difference in uncompensated care
after acquisition.
Although the study suggests that for-profits are not skimping on
uncompensated care, Shactman and Altman (1997) suggest that the study
underscores the importance of the types of hospitals that for-profit traditionally
purchase. For-profits generally buy hospitals in favorable locations. For example,
from 1993 to 1995 Columbia annually received only 6% of its revenue from
Medicaid. Although Columbia and other for-profits might not provide less
uncompensated care after conversion, they certainly do not provide more.
2.6 Utilization of Conversion Revenue
Conversion of non-profit health care organizations to for-profit status can
yield substantial resources for alternative charitable uses. A survey conducted by
the Center for Health and Social Policy, Grantmakers in Health, and Institute of
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Health Policy at Brandeis University identified eighty-one conversion foundations,
with nine in the process of forming as of October 1, 1997. Together these
foundations have $9.3 billion in assets, about half of which ($4.5 billion) are
concentrated in California. If they gave away 5% of their assets a year as
organizations classified by the IRS as “private foundations” are required to do, it
would amount to more than $450 million for philanthropic purposes annually.
Conversion foundations range in size from $4 million from the Truman Heartland
Foundation to $2.2 billion from the California Healthcare Foundation. The median
asset size is $57 million (Isaacs et al. 1997). Table 2-3 lists the nations’ twenty-
five largest conversion foundations by asset size.
Sixty-nine of the eighty-one conversion foundations established to date
have resulted from hospital conversions. Ten were created from conversions of
managed care companies or HMOs, and two arose from conversions of Blue Cross
of California. Although one conversion foundation was established in 1973, a
trend developed in the 1980s when twenty-two conversion foundations were
formed. Between 1990 and 1993, conversion foundations were established at an
average rate of one to three a year. In 1994, spurred by an increase in the number
of health care conversions and greater vigilance by state regulators and public
interest groups, the number shot up to ten. Nineteen such foundations followed in
1995 and seventeen in 1996 (Isaacs et al. 1997).
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Table 2-3
Conversion Foundations by Asset Size
Foundation Asset (in Millions o f $)
California Health Care Foundation 2,200.0
California Endowment 975.4
California W ellness Foundation 880.0
Kansas Foundation 377.0
Colorado Trust 320.0
Rose Community Foundation 185.0
Rapides Foundation 175.0
Paso del Norte Health Foundation 170.0
Baptist Community Ministries 163.4
Presbyterian Health Foundation 142.0
Arlington Health Foundation 140.0
Methodist Health Care Ministries o f Southwest Texas 140.0
Quantum Foundation 140.0
Sierra Health Foundation 138.0
The Memorial Foundation 132.0
The Assisi Foundation o f Memphis 130.0
Jewish Healthcare Foundation o f Pittsburg 120.0
St. Davis Health Foundation 118.0
Venice Foundation 109.0
Drs. Bruce and Lee Foundation 105.0
Winter Park Health Foundation 105.0
Archstone Foundation 88.1
St Luke's Charitable Health Trust 83.0
Sisters o f Charity Foundation o f South Carolina 82.5
Source: Isaacs et al., Health Affairs 1997.
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How these charitable assets are utilized is determined by the missions and
the governance structures that newly established foundations adopt. The cy pres
doctrine requires that the mission of a charitable foundation bom of conversion be
as closely related to the charity’s original mission as possible, In practice, however,
the cy pres doctrine is not always honored. In some cases conversion foundations
have explicitly broadened their missions.
For example, the Jackson Foundation in Tennessee, bom of hospital
conversion, is reported to be considering financing a sports training complex, an
arts center, and a foreign language program. One of the earlier grants by the
Colorado Trust (a foundation bom of a 1985 hospital conversion) was a $1 million
donation to establish a sports medicine program at the Olympic Hall of Fame in
Colorado Springs. The Rose Foundation’s mission is to enhance the quality of life
in the greater Denver community; two of its six program initiatives might be
considered outside health care: civil rights/anti-discrimination and Jewish
community. The hospital that converted had been associated with the Jewish
community (Kane 1997).
Kane (1997) suggests that most of the foundations resulting from hospital
conversions have retained a health focus but have redefined themselves to have
broader public health purposes than providing direct patient care. For instance, in
October 1995 the newly endowed Rose Foundation adopted the following mission
statement: “The new Rose Foundation exists to enhance the quality of life of the
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greater Denver community through its leadership, resources, traditions and values”
(232). The mission of the Kansas Health Foundation is “to improve the quality of
health in Kansas” (232). The Winter Park Health Foundation’s mission is to
establish support and promote quality health care and related human services
programs for Winter Park, Florida and surrounding communities. Foundations
resulting from HMO and Blue Cross conversions have been similarly devoted to
broad public health purposes (Kane 1997, 232).
Policy debates also arise over potential conflicts of interest in foundation
missions. The question is, What role should the new foundations play in funding
charitable projects that overlap the interests of for-profit converted organizations?
Standish (1998) sites “circular grants” as the most obvious misuse of the funds due
to conflicts of interest among members of foundation board. A circular grant
occurs when a new foundation uses its authority to grant funds to the new for-profit
entity. A circular grant was attempted after the conversion of Blue Cross of
California. One of the largest initiatives proposed by the new foundation created
by restructuring was $15 million grant to California Kids, a subsidiary of Blue
Cross. This was an insurance subsidy for low-income children who were then
enrolled in a WellPoint subsidiary. Proposals to fund health services research
related to managed care clinical outcomes and building provider networks in
disadvantaged areas prompted (Consumer Union representatives to call the public
benefit plan proposed, the R&D arm of the HMO industry (Standish 1998).
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2.7 Organizational Change and the Need for Regulations
Elements of change have been filtering through the ownership and
configuration of health care organizations since the late 1970s. Although the
emergence of investor-owned hospital chains has been an important part of change,
there also has been substantial growth in multi-institutional arrangements among
non-profit hospitals and the investor ownership. These multi-institutional
arrangements are seen in psychiatric hospitals, nursing homes, health maintenance
organizations, home health agencies and various types of ambulatory care centers
(Gray 1986).
This transformation in health care organizations could perhaps be explained
by the theory of organizational change. As March (1981) suggests, although
organizations often appear resistant to change, they are frequently transformed into
forms remarkably different from the original. The organizational responses to
environmental events are broadly adaptive and mostly routine, but the response
takes place in a confusing world. As a result, prosaic processes sometimes have
surprising outcomes. Many of the stable procedures in an organization are
procedures for responding to economic, social, and political contexts. If the
environment changes rapidly, so will the responses to stable organization. Change
driven by such shifts will be dramatic if shifts in the environment are large.
Organizations are also combined into an ecology of competition, in which
actions of one competitor become an environment of another. Each competitor,
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therefore, partly determines its own environment as the competitors react to each
other (March 1981).
In his characterization of closed and open-system strategies for studying
complex organizations, James D. Thompson (1967) argues that in the open-system
strategy one cannot be fully knowledgeable of all the variables that may influence
the organization. Therefore, one cannot predict and control their influences. The
open-system suggests that one expects surprise or uncertainty. As a natural system,
the complex organization is a set of interdependent parts that together make up a
whole because each contributes something and receives something from the whole
which, in turn, is interdependent with a larger environment. The survival of the
system is obtained through an evolutionary process of development. Although
changes do occur, the overall tendency of the system is toward balance.
The emergence of multi-institutional organizations in health care is a result
of such open-systems. Sanchez and Heene (1997) point out that these
organizations compete for limited resources and become systematically
interrelated: “Organizations competing in market segments, product markets, and
industries are embedded in larger open systems of interacting organizations” (23).
These organizations then develop strategies designed to provide sufficient strength
to cope with the environment, acquire scarce resources, allow organizational
stability, and enhance an organization’s competitive market position. With such
volatile changes in the health care industry, should conversions be regulated at a
federal level to bring stability to the process?
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2.7.1 Factors Affecting Regulation o f Conversion
A number of factors affect how and when a conversion is regulated. These
include how much regulators know about possible pending conversions through
either formal notice, discussions with other regulators, or other means, and whether
regulators have sufficient resources and expertise to carry out their responsibilities
to protect the public trust.
Regulators agree that, if they are to become involved in a conversion, it is
best to do so early. Shriber (1997) suggests that early intervention prevents
disrupting a transaction that is nearly complete and wasting resources that have
gone into it. Early intervention also prevents unlawful conflicts of interest, allows
the use of experts on matters such as valuation, and improves the chances of a
cooperative relationship between the regulators and entity undergoing conversion.
Regulators learn of potential conversions in a variety of ways that may or
may not be related to statutory notice requirements. In some states, word of mouth
serves adequately to appraise regulators of potential conversions. For example, in
New Hampshire the law does not require notice to regulators, but the attorney
general’s office reports that attorneys representing health care providers do so
much other business with the attorney general’s office that they cannot pass a
conversion by them without timely notification. In Ohio, the attorney general’s
office complains of learning of hospital conversions through the media as there is
no requirement of notice. The attorney general has asked the Ohio Hospital
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Association and Columbia/HCA to involve its office early with conversion
proposals. In Texas, because there is no statutory notice requirement, regulators
often learn of transactions close to the point at which they are scheduled to be
consummated and sometimes from the media. Regulators report that a large
number of transactions have already passed them by and they may not be able to
review them (Shriber 1997).
Notice may be of little value if the regulator is not prepared to act
thoughtfully and decisively and does not understand the potential impact of
conversion. A striking number of regulators report that they received notice from
entities of their intent to change their status but did not comprehend the
significance of the change. Particularly with regard to the Blue plans, regulators
have failed to comprehend fully the implications of certain actions that may have
been precluded by conversions (Shriber 1997).
Many state agencies lack the resources to devote to conversions. This
affects how and when regulators intervene. Some report giving smaller cases
relatively little scrutiny. Many are unable to study the implications of subtle or
complex transactions and thus allow them to go forward without study. Many rely
on staff attorneys or officials who have little time to devote to these highly complex
matters. They report extreme frustrations at having limited resources to face what
they see as the near-infinite resources of the private entities that are seeking to
convert. Often they must rely heavily on the representations of the regulated
entities because of lack of resources expertise (Shriber 1997).
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State laws often lack clear guidance on the precise roles of regulators in
health care conversions, particularly those involving the Blues. The office of the
attorney general is traditionally the lead agency in interpreting and enforcing
charitable law and hospital conversions, but the insurance departments typically
oversee the Blues. The attorney general may pursue other theories of law while
aggressive insurance commissioners may pursue charitable doctrine. The
continuous nature of conversions may force legislators to define the roles of
regulators more neatly. However, some legislators are reluctant to do this because
they do not want to tamper with what they perceive to be the broad authority
derived from common law (Coverdale 1998).
In many states, regulators are just beginning to define their respective roles.
In some states, efforts to clarify jurisdiction have been undertaken thorough
legislation. Widespread publicity and concern over conversions of non-profit
health care facilities has caught the attention of state legislatures and officials. At
the Spring 1997 meeting, the National Association of Attorneys General passed a
resolution endorsing legislation to improve notice to the public and attorney
generals of proposed conversions. As of November 1997, twelve states and the
District of Columbia had passed legislation intended to ensure greater state control
over such transactions (Coverdale 1998).
In response to growing concerns about conversions, Congress also asked the
General Accounting Office (GAO) office to review the process that some not-for-
profit hospitals had used in converting to for-profit status. The GAO selected six
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states and fourteen sites, and included the following in their review: asset sales and
joint venture transactions; state and sites with multiple conversions, conversions
involving multiple investor owned companies, or both; and transactions in which
proceeds were directed to foundations. The study determined what processes were
used to value a hospital’s assets and derive a final selling price. The study,
however, did not determine whether the hospitals were sold at fair market value.
In December 1997, the GAO issued a report regarding non-profit hospital
conversions. The GAO report confirmed many of the concerns voiced by
consumer advocates. The report concluded that most of the hospital conversions
occurred without disclosure to the public and were carried out between boards and
executives of selling hospitals and representatives of for-profit purchasers. GAO
also highlighted several problems with the conversion process. It found that except
for the members of the Board of Directors, community involvement in conversion
decisions was limited, with broader community involvement in only 5 of the 14
transactions. Although the hospitals involved disclosed the final purchase price,
the report found that most of the hospitals would not provide a copy of the
complete contract to GAO due to confidentiality agreements. Finally, the report
concluded that most conversion foundations had broadly defined missions and
some charitable foundations were not using their money for health related purposes
(General Accounting Office 1997).
The report concluded that a growing number of states are recognizing that
the public interest is at stake and becoming more involved in overseeing the
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conversion process and reviewing terms of conversion transactions. GAO found
that in most states attorney generals had authority to monitor and oversee hospital
conversions through common law and not-for-profit corporation law. For the nine
conversions reviewed, state attorney generals in Alabama, California, South
Carolina, Tennessee, and Virginia exercised their authority to review the
conversion process. However, at the time of the review none of the six states had
specific conversion legislation. As of August 1997, GAO reported twenty-four
states and the District of Columbia had enacted legislation to address some
conversion concerns in the areas of public disclosure and community benefit
(General Accounting Office 1997). Key provisions of this legislation by state are
summarized in Table 2-4.
2.7.2 Need fo r Federal Regulations
Although some states have tried to enact legislation, inconsistencies exist in
the treatment of Fair Market Value and the establishment of foundations. Despite
state legislation in Nebraska and California, there appears to be no standard for and
understanding of how to regulate non-profit conversions. To establish more
interstate consistency of conversions in ensuring fair market value, clarifying the
role of the attorney general, and creating foundations, authors such as Colombo and
Coverdale have argued in favor of federal regulation of the conversion process.
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Table 2-4
States W ith Laws Affecting Conversions and Their Key Provisions
Key Provisions
State Advance Notice State Official Review
and Approval
Public
Disclosure/Hearing
Arizona X X
California X X X
Colorado X X X
Connecticut X X X
District o f Columbia
Florida
X X X
X
Georgia X X X
Illinois X X
Indiana X X
Kansas X X X
Louisiana
Maine
X X
X
X
Nebraska X X X
N ew Hampshire X X X
N ew Jersey X X X
North Carolina
North Dakota X
X
Ohio X X X
Oregon X X X
Rode Island X X X
South Dakota
Texas X
Vermont X X X
Virginia X X X
Washington X X X
Source: General Accounting Office 1997.
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2.7.2.1 Exit Tax
Colombo (1998) suggests that governments that have conferred economic
benefits in the form of tax exemptions on these organizations have a valid legal
claim to a portion of the economic value produced by a conversion transaction, and
that sound policy reasons exits for supporting such a claim. He proposes that
federal, state, and local governments should enact an “exit tax” on conversion
transactions designed to recapture some of the economic benefit of tax exemptions
previously given to the converting enterprise.
Colombo (1998, 789) further argues that there are two legal rationales for
justifying the exit tax. First, under economic theories of existence of non-profit
organizations, a conversion signals that the converted business has not needed the
economic benefits of exemptions for some period of time and hence these
economic benefits should be “recaptured” in the conversion. When a non-profit
converts to for-profit status, it implies that the non-profit’s business is capable of
surviving in the private market. If it were not, no for-profit entity would buy it. He
further suggests that there is not currently any rush to convert classic private market
failure enterprises such as Red Cross and the Salvation Army or other classic poor-
relief charities to for-profit status. The reason is these classic charities cannot
survive in the private market. In contrast, the multi-billion dollar prices being paid
for non-profit hospitals and HMOs confirms that these businesses for some time
have not suffered the classic kinds of private market failure that justify exemption
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and these businesses could survive if properly managed in the private market. That
is precisely why for-profit companies are attempting to buy them. This lack of
market failures justifies the federal, state, and local governments which previously
had given tax exemptions to these entities on the assumption that they suffered
from private market deficiencies to step in and “recapture” a part of the previously
conferred tax benefit.
Second, Colombo (1998) views their tax exemption as arising from a
partnership between the exempt entity and the government. He, therefore, argues
that when a partnership is dissolved by the decision to discontinue the business of
exempt organization, the proceeds should be shared by the partners as in any
business dissolution.
According to Colombo, an exit tax has some public policy implications and
may produce better results than simply regulating the receipt and use of proceeds
by an existing charity. First, an exit tax would enhance current regulatory efforts
by giving government an economic stake in conversion transaction, which could
enhance regulatory efforts. He suggests that federal regulators will be more likely
to develop an interest in the conversion transactions as most Attorneys General
have innumerable enforcement duties that strain their resources; oversight of
charitable organizations may not be a priority.
Second, an exit tax would provide flexibility in addressing community
needs prohibited by current regulatory interpretations of the cy pres doctrine.
Interpretation of the cy pres doctrine by states varies. For example, California
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interpreted cy pres doctrine more strictly and blocked grants by Good Samaritan
Charitable Trust, which was created by the sale of Good Samaritan Health System
in San Jose. The grant was blocked because the Trust had proposed using the
earnings on its endowment in part to fund health prevention and wellness programs
such as inoculation and antismoking drives. California’s attorney general argued
that cy pres demanded that money be spent on “real health care” such as
hospitalization and physician care for the sick, particularly for indigents (Colombo
1998).
Other states interpret the cy pres doctrine more flexibly. This creates a
curious conundrum in which one of the most powerful tools available to the
attorney general for limiting poor spending decisions by conversion foundations is
through the assertion of a legal doctrine that prevents such foundations from
satisfying legitimate community needs in non-health care areas.
Finally, the exit-tax would provide a structured system for federal
government participation in the proceeds of conversion and would avoid the ad hoc
behavior of taxing authorities designed to simply thwart certain transactions or fill
budgetary holes. For example, Washington University announced plans to sell its
hospital to a for-profit group. The city council of Washington, D.C., immediately
undertook discussions regarding enactment of an ordinance that was initially
designed to block the sale. Part of this ordinance would impose a $5 million fee on
any non-profit hospital sale transaction, an amount which Frank Smith, Jr., the
primary sponsor of the legislation, admitted was arbitrary. Ultimately the council
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voted for a fee equal to 10% of the hospital’s real estate taxes for the past five
years, which amounted to $500, 000 (Colombo 1998).
Similarly, Virginia state government required the monies set aside as a
result of Blue Cross plans conversion be paid to the state, rather than a newly
created foundation. The fact that one state picked an arbitrary tax rate designed to
kill the deal and another proposed to confiscate the entire proceeds of a conversion
should be a frightening notion for anyone involved in these transactions. Colombo
(1998, 797) thus, argues that whether a recapture paradigm or co-investment
paradigm is used, it would establish that the exit tax should not exceed the
economic contribution of exemption to the converting enterprise at each level of
government.
2.7.2.2 Intermediate Sanctions
Every legal source of scrutiny for a non-profit, tax-exempt entity is
concerned about conflicts of interest. This concern is based upon the desire that
non-profit tax exempt organizations performing a public service not be abused by
private interests or give the impression that they are permitting private interests to
abuse public interest. Until the enactment of intermediate sanctions, the sole
penalty for violation of the private inurement prohibition of Code Section 501(c)(3)
was revocation of the exempt organization’s exempt status. The IRS rarely
invoked this sanction because revocation of exempt status would adversely affect
the entire community served by the exempt organization while leaving the
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individual wrong doers unpunished. Thus, the principal goal of intermediate
sanctions legislation is to ameliorate this enforcement gap by imposing a tax on
individuals who receive improper personal benefits from their relationship with a
tax-exempt entity.
Intermediate sanctions introduced a new level of penalties as part of the
Taxpayer Bill of Rights in August 1996. The new IRC Section 4958 provision
created an intermediate step between revoking exempt status and no sanction at all.
The code section establishes a 25% federal excise tax on activities that produce an
“excess” private benefit and 200% excise tax when the private benefit transaction is
not undone. The tax is assessable against all officers, directors, and other
“disqualified persons” (insiders) who in the five years prior to the transactions were
in a position to exercise substantial influence over the affairs of the organization
(Bryant 1998).
Hernandez (1998) suggests that even though intermediate sanctions are
directed at a variety of abuses on the part of directors, officers, and other insiders of
exempt organizations, they are more suited to reducing improper personal benefits
realized through non-profit hospital conversions. The severity of this potential
penalty will probably give pause to those who might consider making “sweetheart”
deals or undervaluing hospital assets. The large volume of these transactions,
combined with the limited availability of IRS resources, casts doubts on the
service’s ability to provide sufficient oversight to curb the excess benefit problem
significantly (Hernandez 1998, Coverdale 1998).
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2.7.2.3 Qui Tam Action
Coverdale (1998) argues for federal action because, according to him, the
state laws on conversion continue to be spotty and irregular. Many states have not
enacted legislation and continue to rely entirely on common law remedies whose
efficacy is very much open to question. Even in states where the legislature has
taken an interest in the problem, an adequate legislative response is far from certain
as evidenced by the fact that conversion bills in twelve states have either died in
legislatures or on the governor’s desk. Not all states that have enacted legislation
have followed California’s example of adopting strong legislation. Virginia, for
example, has enacted a skeletal statute that leaves open many questions, including
the extent of an attorney general’s powers of enforcement. In addition, states that
enact adequate legislation may lack resources and personnel to oversee some of the
very complex transactions in conversion (Coverdale 1998).
Coverdale further argues that the federal government has made a significant
contribution to the accumulation of assets of tax-exempt, not-for-profit entities by
providing an exemption from federal income tax, a deduction to donors, and in
some cases financing at favorable rates through tax-exempt bonds or various types
of aid to these institutions. The federal government, therefore, has a distinct
interest in preserving the assets for charitable purposes and preventing
appropriation by private parties.
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As stated earlier, until intermediate sanctions were enacted in 1996, the only
federal tax remedy for private inurement was revocation of tax-exempt status of
not-for-profit organizations. This was not an effective remedy as it did not directly
affect insiders who diverted to themselves the funds of not-for-profit organizations
and did nothing to recover the assets of the community. The IRS viewed
revocation as an extreme penalty to be invoked only in egregious cases, and IRS
agents were reluctant to propose revocation of exemption because the sanction of
revocation of a hospital’s exempt status greatly outweighed the private gain of few
individuals (Coverdale 1998).
In the early 1990s, flagrant cases of not-for-profit conversions began to
receive media attention, and the Treasury, IRS, and Congress began to look for
more efficient federal sanctions to prevent this abuse. The result was the enactment
of intermediate sanctions in 1996 under the Taxpayer Bill of Rights.
The belief was that the intermediate sanctions would be self-enforcing and
would work like the private foundation self-dealing rules, where a few well-
publicized cases proved sufficient to bring most private foundations into voluntary
compliance. Coverdale (1998) argues that this presumption overlooks the essential
difference between the two provisions. The self-dealing penalties are based on
objective and easily determinable criteria. The transactions that constitute self-
dealing are objectively defined without regard to fairness of price involved; they
are easily detected on audit, and there is little room for argument whether a
particular transaction falls into forbidden category or not. Similarly, disqualified
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persons are defined by objective criteria. By contrast, the critical definition for
purposes of intermediate sanction requires an examination of facts and
circumstances. For example, a transaction constitutes an excess benefit transaction
not because it falls into an objectively defined category of transactions, but because
it takes place at a price different from a fair market price. It is extremely difficult
to determine fair market value in complex transactions involving multiple assets,
including intangibles and going concern values. Furthermore, a person is
disqualified for purposes of intermediate sanctions not because he/she occupies an
objectively identified position or has made contributions of a certain amount but
rather because he/she is actually in a position to influence the organization’s
decision.
The complex inquiry often required for application of intermediate
sanctions suggests that they will not be self-enforcing. It also seems unlikely that
IRS will mount the kind of enforcement effort that would be required for
intermediate sanctions to succeed in curbing abuses during conversions of not-for-
profit organizations.
Coverdale (1998) suggests that the problems stemming from inadequate
enforcement activity by IRS would be solved by allowing qui tam actions in which
private parties would act as regulators bringing suit on behalf of the United States
for excess benefit transactions.
The Civil False Claims Act authorizes a private party to bring civil actions
in the name of the government “for the person and United States Government” for
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false claims against the government. Such suits must be filed under seal to allow
the government to ascertain whether it is already investigating the claims and to
decide whether to intervene. If the government intervenes, the relator is entitled to
at least 15% and not more than 25% of the proceeds of the settlement depending on
the importance of the relator’s contribution. Coverdale (1998) suggests that the qui
tarn provision of intermediate sanctions could be patterned on the existing qui tam
provisions of the Civil False Claims Act with jurisdiction in the U.S. Tax Court.
Exit tax, intermediate sanctions, and qui tam provisions may perform
regulatory functions by ensuring that regulators pay attention to the conversion
transactions; however, these sanctions may also impose excessive administrative
burdens on the parties to the conversion transactions, and may prevent conversions
that may be beneficial to the communities.
The focus on conversion transactions has resulted both from an exponential
increase in the number of conversions and staggering dollar amounts involved.
Although authors such as Colombo and Coverdale have argued in favor of federal
legislation, conversions represent a major restructuring of the health care industry
and affect the delivery of health care in the communities where conversions occur.
Conversions may also precipitate the largest potential re-deployment of charitable
assets in the community.
In addition, in light of many legal issues that arise during the conversion
process, a variety of opinions exist on the subject of conversions from non-profit to
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for-profit status, and these opinions further raise numerous issues regarding how
the conversions are structured and who benefits from the process.
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C h a p t e r 3
R e se a r c h Pr o b l e m , E x p e c t a t io n s, D e sig n , M e t h o d o l o g y,
a n d T h e o r e t ic a l Fr a m e w o r k
3.1 The For-Profit/Non-Proflt Argument
Financial arrangements for the organization and delivery of medical care
have undergone rapid and profound changes over the past twenty years. The need
for capital to support these changes has been great among health care organizations.
Looking to the investment community for capital has led a number of non-profit
health plans and hospitals to convert to investor-owned organizations. Over the
past twenty years, the health care industry has seen conversions of health care
organizations such as Foundation Health Plan, PacifiCare, MaxiCare, HealthNet,
etc., primarily as a result of competition in the health care field.
Proponents of for-profit enterprise in health care have defended conversions
and the for-profit form with a number of arguments. First, the proponents claim
that non-profits are inherently inefficient, and conversions result in rationalization
of health care delivery. They also argue that for-profit hospitals give away a great
deal of charity care and provide a range and quality of services similar to those
offered by non-profit entities.
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Proponents also suggest that for-profit hospitals create value for their
shareholders and pay taxes and that most of the criticism of for-profit health care is
said to be unjustified as these entities satisfy their civic obligation by paying taxes.
For-profit advocates further argue that the regulatory initiatives are broad and
burdensome and result from hostility to the for-profit form rather than concern with
misappropriation of resources. Further they argue that consumers do not seem to
care whether their health care provider is for-profit or non-profit (Hyman 1998).
Critics of for-profit enterprise argue that medical care is undermined when
hospitals convert to for-profit status. This argument operates on two levels. First,
by adding a profit motive to former not-for-profits, conversions of not-for-profit
hospitals prevent them from acting as fiduciaries and destroying their socially
beneficial values and characteristics. At best, converted hospitals become tom
between a professional service orientation and profit-making motivations.
Professionalism is then eroded. At worst, critics suggest that for-profit hospitals
sacrifice patient care to maximize revenues. In either case, converted hospitals
allegedly engage in economically pmdent but socially undesirable practices, such
as dropping bad-debt patients and denying care to all unsponsored patients. These
practices leave some individuals without medical care, which undermines the goal
of providing health care to all persons, regardless of wealth. For-profit hospitals
supposedly raise prices and provide inferior service to their remaining patients.
Consequently, even those who can afford to pay for treatment receive poor service.
In short, all consumers of medical services suffer (Krause 1997, 533).
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Critics also contend that converted hospitals become less responsive to the
geographic communities they serve. For-profits discontinue services that are not
profitable but upon which communities depend, such as emergency and obstetric
services. Moreover, communities are left constantly vulnerable because investor-
owned hospitals must always show a profit to shareholders; communities are
always in danger of losing hospitals when they provide services in an area that
becomes unprofitable. The community then loses both provider of medical
services and a major employer (Krause 1997).
Finally, critics argue that surviving not-for-profit hospitals adopt the
practices of for-profit firms to compete and survive. In so doing, not-for-profits
abandon their charitable missions and dedication to professionalism and contribute
to the “commodification” of health care. As a result, some patients lose access to
service because they cannot pay, and others who can pay fail to receive adequate
care. Society then fails in its moral obligation to tend to the sick (Krause 1997).
Supporters of conversions counter the above claims by arguing that the
substantive fears are without merit. First, the concerns about access to health care
due to the growth of the for-profit industry are overstated. Without the conversion
process, many not-for-profit hospitals would be forced to go out of business,
leaving communities without any medical care at all. Conversion proponents note
that for-profit chains tend to purchase from small and unsophisticated operators,
many of whom are already in financial difficulty. Converted hospitals have
themselves explained that without corporate buyers, they would have been forced
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out of business. As a result, conversions arguably preserve community medical
care rather than put it at risk, and conversions ensure that more patients have access
to health care rather than fewer (Krause 1997).
Many critics of conversions, however, have expressed alarm over the
number of not-for-profit organizations that have converted to for-profit institutions.
They claim that these conversions threaten to restrict access to and undermine the
quality of medical care in the United States. These critics suggest that conversions
are too laxly supervised, which undermines charitable trusts and public interest.
3.2 Research Questions and Expectations
In this study, conversion of Blue Cross of California from non-profit to for-
profit status is analyzed to provide a case study of the experience of one of the
nation’s oldest non-profits and the second largest non-profit organization in
California. The study also analyzes the conversion of HealthNet with specific
reference to valuation of its assets in the conversion process. The main question
addressed in this study is, Who benefits from the conversion of non-profit to for-
profit status in health care organizations? Additional questions, closely tied to the
main question, include the following: How are assets of the converting entity
valued? How are the charitable assets generated as a result of conversions utilized?
The millions of dollars involved in the conversion process raises a policy question:
Should this process be regulated at a federal level?
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Conversion from non-profit to for-profit in health care organizations is
expected to impact the way the charitable assets are valued and utilized. These
expectations are
1. Charitable assets of the converting entity have a potential for being
under valued.
2. Charitable assets generated from the conversion process will be utilized
for purposes other than the original intent of the converted entity.
3. Because of the large amount of charitable dollars involved in the
conversion process, there will be a push for conversions to be regulated
at the federal level.
3.3 Research Design and Methodology
The research design for this dissertation is a case study method. Case
studies provide detail that shows how and why something happened. Potential
value of case studies is that they provide rich details, and the reader may gain
greater insight into how to approach or solve a problem. Case studies generally
involve multiple sources of information and give a more complete picture of the
study. However, multiple sources of information are also a drawback of case
studies because they require different research techniques and may require large
research teams.
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Two approaches were utilized to gather information: (1) analysis of
documents, and (2) interviews. This study is primarily documents-based research,
and the conclusions are based on the analysis of documents filed by Blue Cross of
California and HealthNet with the DOC. Interviews were conducted with key
people who greatly influenced legislation in California as a result of the Blue Cross
controversy.
Analysis of documents included examination of financial statements and
other business correspondence and analysis of proposals filed with the DOC by the
converting entity and other interested parties such as CMA, Consumers Union,
accounting and consulting firms, and other potential buyers. Specifically two
health plans, HealthNet and Blue Cross of California, were reviewed. For
HealthNet, documents were reviewed to determine what methodologies were used
in valuing the assets of the corporation during conversion. For Blue Cross, in
addition to the financial statements and business correspondence, documents of
legislative hearings were also reviewed. Reviewing documents regarding the
proposal to restructure provided insight into the motivation that prompted BCC’s
action. Examination of protests filed by advocate groups were useful in
documenting the controversy surrounding the BCC conversion.
Personal interviews were conducted with an officer of CMA, a former
board member of BCC, and the chair of the Judiciary Committee of the California
Assembly. These individuals were instrumental in the policy outcomes
surrounding the Blue Cross conversion. The objective of the interviews was to
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serve as a validity check on information obtained from the analysis of official
records and papers, as well as to gain insight into subsequent policy decisions as a
result of Blue Cross conversion controversy.
3.4 Theoretical Framework
3.4.1 Valuation o f Assets
Determining the proper valuation of a non-profit health care institution’s
assets is one of the key steps in the review of a conversion proposal. Proper
valuation is the only way to ensure that charitable assets are not lost in individual
enrichment or used to fund for-profit ventures. A converting public benefit
corporation generally must transfer full fair market value of its assets to a similar
non-profit entity or foundation. The value of a non-profit’s assets depends on the
valuation method that the regulators rely on and the independence of those
completing the valuation. Different valuation issues and approaches apply to non
profit hospitals and health plans contemplating a conversion.
3.4.2 Valuation Methodologies
The definition of value, purpose of the valuation, and type of ownership
interest generally affect the selection of valuation methods. Depending on the type
of engagement, a company will be valued based on relevant statutes and case law.
That value may be equivalent to fair market value, investment value, or some other
definition. Thus, the definition of value used is especially critical to the valuation
process.
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The value of a business is equal to the present worth of the future benefits
of ownership. This statement is a fundamental principle of business valuations. A
rational buyer normally will invest in a company only if the present value of the
expected benefits of ownership are at least equal to the purchase price. Likewise, a
rational seller normally will not sell if the present value of those expected benefits
is more than the selling price. Thus, a sale generally will occur only at an amount
equal to the benefits of ownership (Copeland, Koller, and Murrin 1990).
The valuation process is full of judgments and estimates. No one can
predict with certainty the amount of benefits a company’s owners will receive.
Informed investors may have different opinions about the amount of those benefits.
In addition, the investors may require different rates of return based on their
opinions about the risks of owning the company. A company’s value depends on
each person’s assessment of the benefits and risks relating to that company.
Generally, an accountant or a consultant will determine a most likely point where a
buyer and seller will meet (Fishman, Pratt, Griffith, and Wilson 1996, 2-3).
Value is based on a specific point in time—the Valuation Date. An
investor’s required return and the amount of available benefits usually are
estimated at a single point in time. In addition, the estimate of value is based solely
on information that is discernible and predictable at the valuation date. When
estimating the future benefits of ownership, one needs to determine the specific
ownership interest to be valued. Different interests that may be used include equity
interests and investment interests.
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3.4.2.1 Equity Capital
Generally the value of a company is determined on a net-of-debt basis, that
is, value is equity capital. The rights of a particular ownership interest and the
ability of a controlling interest to exercise its rights generally depend on state law.
1. Controlling Interests. The following terms are commonly used to
describe the extent of an owner’s control.
• Operating control is the ability of an ownership interest to elect a
majority of the board of directors.
• Absolute control is the unrestricted ability of an interest to exercise
all the rights typically associated with ownership , including the
right to liquidate the company.
2. Minority Interests. Minority interests are all interests that have less than
50% of the voting interest in a company.
3.4.2.2 Total Invested Capital
Sometimes the value of the company is determined based on total invested
capital, both interest-bearing debt and equity (sometimes referred to as a debt-free
valuation basis) (Fishman et al. 1996).
In valuation theory, the benefits an owner receives are represented by the
net cash flow the owner receives from operating the business through dividends,
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withdrawals and/or salary, and benefits beyond a normal level. However, this
assumes the business retains enough cash to fund its expected level of operations.
The amount of benefits an investor receives will depend on the company and the
size and type of ownership interest. During the valuation, the amount of benefits
accruing to the interest being valued is an estimate, and these benefits cannot be
measured with certainty. Companies have different risks and earnings’
characteristics. Their owner’s goals and expectations vary. No single formula can
be used to determine the value of every company in every situation. Therefore,
different approaches and methods have evolved for estimating future benefits and
companies’ values (Fishman et al. 1996).
3.4.2.3 The American Society o f Appraisers Classification
The American Society of Appraisers classifies valuation methodology into
three approaches: Income Approach, Market Approach, and Asset-Based
Approach.
3.4.2.3.J The income approach.
The income approach is closest to the basic valuation principle. The term
income does not refer to income in an accounting sense but to future benefits
accruing to owner. Under the income approach, the consultant estimates the future
ownership benefits and discounts those benefits to present value using a rate
suitable for the risks associated with realizing those benefits (Fishman et al. 1996,
2-5).
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3.4.2.3.2 The market approach.
The market approach assumes that value can be estimated from analyzing
recent sales of comparable assets. In business valuation, this approach analyzes
comparative public companies (and private companies whenever possible) and/or
comparative transactions to determine a company’s value. This approach requires
thorough search for comparatives and analysis and adjustment of the comparative
data, both public and private (Fishman et al. 1996).
3.4.2.3.3 The asset-based approach.
The asset-based approach assumes that an asset’s value is indicated by the
cost of reproducing or replacing it, less the allowance for physical deterioration and
obsolescence. The approach is commonly used for assets that are not sold on an
active market, such as land improvements and special purpose equipment. For
business valuations, the approach generally applies to companies with little value
beyond the value of their tangible assets, such as holding companies. It is also used
when valuing individual components of a business enterprise (Fishman et al. 1996).
To apply the valuation approaches, one or more valuation methods may be
used depending on the benefit stream used to estimate the value. Table 3-1
summarizes valuation approaches and methods.
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Table 3-1
Valuation Approaches and Methods
Approaches Valuation Methods
Income Capitalized returns
Discounted future returns
Capitalization o f earnings
Capitalization o f net cash flow
Capitalization o f gross cash flow
Discounted net cash flow
Discounted future earnings
Market Value multiples using
« comparative company data
• or transactions
Price/eamings
Price /dividends
Price/gross cash flow
Price/book value
Price/revenue
Price/net asset value
Asset-based Underlying assets
Other
Net asset value
Liquidation value
Excess earnings
Rules o f thumb
Multiple o f discretionary earnings
When doing a business valuation, generally two or more valuation methods
are selected. The actual number of methods depends on the purpose of the
valuation, definition of value, type of company, available data, and any other
factors that may be applicable. Every method cannot be used in determining the
value of a business because of time and resource constraints. However, the
selection process is important because accountants may be asked to defend their
choice of methods if the valuation is challenged.
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The two authoritative guidelines that provide guidance regarding the
selection of valuation methods are Uniform Standards of Professional Appraisal
Practice and Revenue Ruling 59-60.
Standard 9 of Uniform Standards of Professional Appraisal Practice
reprinted in Fishman et al. 1996 (2-10, 2-11) discusses selection of business
valuation methods. However, the guidance is very broad and general. The rules
relating to Standard 9 state that
1. The appraiser must be aware of, understand, and
correctly use the recognized methods and techniques
that are needed to produce a credible appraisal (Rule 9-
1 ).
2. In determining the value of a majority interest, the
appraiser must investigate the possibility that the
company may be worth more in liquidation than as a
going concern. If liquidation is the indicated valuation
premise, then real estate and personal property should
be valued using the appropriate standard (Rule 9-3).
3. The appraiser must value the company using appropriate
method or technique (Rule 9-4).
4. The appraiser must select one or more approaches that
apply to the specific engagement and assess the quality
and quantity of data available to apply the applicable
approaches (Rule 9-5).
Revenue Ruling 59-60 provides guidance on several aspects of business
valuations for tax purposes. Its guidelines may also be used for other fair market
value appraisals because it combines the operating characteristics that buyers and
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sellers normally consider. Section 4 of the revenue ruling lists eight factors that are
fundamental and require careful consideration.
1. The nature of the business and the history of the
enterprise from its inception.
2. The economic outlook in general and the condition and
outlook of the specific industry in particular.
3. The book value of the stock and the financial condition
of the business.
4. The earnings capacity of the company.
5. Whether or not the enterprise has goodwill or other
intangible value.
6. Sales of the stock and the size of the block of stock to
be valued.
7. The market price of stocks of corporations engaged in
the same or similar line of business having their stocks
actively traded in a free and open market, either on an
exchange or over-the-counter.
8. The company’s dividend paying capacity.
Selecting valuation methods is a very complex, judgmental process and the
consultants consider several factors in determining which methods are appropriate
for each specific engagement.
3.5 Importance of the Study
Although most of the HMOs in California have gone through conversions,
it is expected that HMOs in other states will follow the lead of their California
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counterparts and abandon their non-profit status. As of 1997, there were
approximately sixty Blue Cross and Blue Shield plans in the United States.
However, this number has continued to shrink as a result of conversions or
mergers. The most important factor in pushing the Blues toward conversion was
the Blue Cross Blue Shield Association’s move in 1994 to allow its plans to
become for-profit corporations. This reversed a sixty-year tradition of non-profit
health care service on the part of the Blues. The board of governors of the Blue
Cross Blue Shield Association cited several reasons for the switch, including the
importance of access to capital markets and the need to allow changes in corporate
structure to make it easier to partner with hospitals and physicians.
Hospitals, HMOs, and Blue Cross and Blue Shield plans are all driven by
the competitiveness of the health care marketplace and their own unique
motivations to convert to for-profit status. The commonality among them is that
they are all considering conversions. The shift from non-profit status to for-profit
status has also affected other sectors of the health care industry. Several issues
greatly concern consumer groups and regulators about these non-profit
conversions. In addition to the increased number of conversions, the amount a non
profit organization receives for its assets is of paramount concern. As the leader in
HMO and Managed Care markets, California and its HMO conversion process will
likely serve as a model for the manner in which HMO and hospital conversions are
structured in other states.
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3.6 Lim itations of the Study
This is a case study of experience of an exceptionally large Blue Cross
organization as it went through the conversion process, and HealthNet, as the latter
went through the process of valuing its assets before undergoing conversion. Thus,
broad generalizations cannot necessarily be made to other situations or settings.
This study can only describe what occurred as two non-profit organizations
struggled along the uncharted territory of conversions in California. Each type of
transaction presents unique issues and concerns for the converting entity and the
state regulators, and they must become versed in health care accounting and
valuation procedures and in the intricacies of the for-profit business world.
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C h a p t e r 4
A n a ly sis o f D o c u m e n t s— H e a l t h N et
4.1 Introduction
This chapter documents the conversion process of HealthNet with specific
reference to the valuation methodologies used by the company in establishing the
value of its assets for purposes of converting from a non-profit to a for-profit status.
Ernst & Young, an international accounting firm, was retained by HealthNet, a
California non-profit benefit corporation, to perform a valuation analysis of the
company. The objective of the engagement was to provide HealthNet with
recommendations, as of December 31, 1990, of the value of its net assets
underlying the business enterprise. The report was prepared to support HealthNet’s
filing with DOC in connection with the proposed conversion from non-profit to a
for-profit corporation. Valuation was needed to assist in determining the amount
required to be donated to a charitable foundation upon conversion.
The chapter analyzes the documents filed with the DOC and gives a
perspective on the company’s operations followed by analysis of different
valuation methods used in the conversion process. Analysis of documents included
examination of Annual Financial Reports of HealthNet filed with the Department
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of Corporations for the years 1989-1991: valuation analysis by Ernst & Young,
correspondence between DOC and HealthNet and HealthNet attorneys, a revised
valuation analysis by Salomon Brothers, and correspondence between DOC and
Qual-Med, Inc. Other business and legal documents filed in four boxes at the DOC
were also examined. Documents were examined to understand the methodologies
used in the valuation of assets when converting from a non-profit to for-profit
status.
4.2 Summary Description of Company and Operations
HealthNet, located in Woodlands Hills, California, was incorporated as a
California non-profit corporation in 1977 and had been classified by the Internal
Revenue Service as a non-profit corporation under Code Section 501(c)(4) of the
Internal Revenue Code. HealthNet received a license to operate as a prepaid health
care plan through the Department of Insurance in 1979 and is federally qualified to
operate as an HMO. By the end of 1990, HealthNet had approximately 775,000
members located in eight market areas throughout California. The company
maintained regional offices throughout California and had contracts with
approximately 5,400 employers. These contracts were marketed directly to
employers, employee benefits consultants, and insurance brokers. Although
initially regulated by Department of Insurance, on March 7, 1991, HealthNet
received a license under the Knox-Keene Act to operate as a Health Care Service
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Plan and, on March 12, 1991, filed an application to withdraw from regulation by
the Department of Insurance (Ernst & Young 1991).
Upon approval of the conversion, HealthNet filed with the California
Secretary of State Amended and Restricted Articles of Incorporation. The
Amended and Restricted Articles of Incorporation would have the effect of
changing HealthNet’s non-profit status to that of a California business corporation,
pursuant to Section 5813.5 of the California Non-profit Corporation Law.
HealthNet Foundation For Wellness Education, a California non-profit public
benefit corporation, was formed on September 5, 1990. The Foundation was the
proposed charitable transferee designated to receive the value of the HealthNet
business enterprise pursuant to the conversion process. HN Management Holding
Inc., a Delaware corporation (the “Parent Company”), was formed on June 7,1990,
by certain key members of the HealthNet board of directors, management, and
administrative team. All of the current shareholders of the Parent Company were
officers, directors, and key employees of HealthNet. The parent company would,
upon effectiveness of the conversion, acquire all of the outstanding shares of capital
stock of HealthNet (McDermott and McDermott 1991).
The structure of the transactions by which HealthNet proposed to effect the
conversion was governed by the following fundamental goals and considerations,
which were identified by HealthNet’s Board of Directors:
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1. The appropriate fair market value of HealthNet must be
determined for purposes of determining the amount of
the charitable contribution to the Wellness Foundation.
2. The integrity of HealthNet’s provider network must be
maintained and plan subscribers must be protected.
3. The terms of the conversion must not jeopardize the
financial well-being of HealthNet and its ability to
provide quality services to its subscribers, and, to that
end must be sensitive to the uncertain and economic
conditions facing the health industry.
4. The conversion must be structured to encourage the
continued participation of current HealthNet
management and key personnel so as to best ensure the
unrestricted provision of quality services by HealthNet
to its subscribers. Maintain the integrity of HealthNets’
provider network, and continued financial well-being of
HealthNet to best assure payment in full of the
charitable settlement to the Foundation. (McDermott
and McDermott 1991, 4)
4.3 HealthNet Valuation Analysis
4.3.1 Appraisal o f Fair Market Value o f Non-Profit Benefit Corporation in
Conversion
Pursuant to the HealthNet’s plan to convert to a for-profit corporation, all
assets and liabilities of the company would be acquired by the successor for-profit
corporation. The business enterprise value relating to these assets and liabilities
would represent the interest valued (Ernst & Young 1991).
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4.3.2 Premise o f Value
The valuation recommendation was derived using valuation approaches that
were in accordance with the State of California Department of Corporations’
acceptable approaches for use in determining Fair Market Value of a Non-profit
Public Benefit Corporation in Conversion. The Fair Market Value recommended
was based on the price, in terms of cash or its equivalent, that represented
consideration for the charitable assets held by an entity converting from non-profit
to for-profit status under the procedures promulgated by California DOC.
Specifically, it equated to the value that the converting entity could expect to derive
from ownership of the charitable assets based on the premise that management
would employ only those prospective operational and financial strategies that
would maximize earnings. Additionally, Fair Market Value represented the total
worth of the charitable assets on a stand alone basis without regard to potential
increased earning power that would result from synergies, economies of scale, or
other benefits accruing from their union with other enterprise (Ernst & Young
1991).
4.3.3 Valuation Approaches
Ernst & Young (1991) used three methodologies for valuation purposes in
the conversion process: the Discounted Cash Flow method, the Capitalization of
Earnings method, and the Adjusted Net Assets method.
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4.3.3.1 Discounted Cash Flow
In the Discounted Cash Flow (DCF) approach, the free cash flows of the
subject entity are estimated for a period of years. Free cash flows represent the
cash that could be distributed to the owner of the entity without impairing future
operations or profitability. In determining free cash flows, revenues and operating
costs of the business are developed based on past experience as well as expected
future developments that could change the business’s operating performance
(Blackman 1995).
In utilizing the Discounted Cash Flow approach, HealthNet’s financial data
were analyzed to obtain an understanding of the company’s operations. In
addition, a Five-Year Business Plan was utilized as a basis for the future
performance estimates. In applying the DCF approach to HealthNet, it was
assumed that the future cash flows could be paid out to investors without impairing
the future operations or profitability of HealthNet. In estimating future free cash
flows, sources such as the future sale of all or an interest in the net assets of the
company were not considered. Arithmetically, free cash flow available for
distribution was defined as
NET INCOME
minus
TAXPAYMENTS
plus
DEPRECIATION & AMORTIZATION
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minus/(plus)
CHANGES IN WORKING CAPITAL
minus
CAPITAL EXPENDITURES
equals
FREE CASH FLOW AVAILABLE FOR DISTRIBUTION
The above formula was calculated for each future estimation period through
December 31, 1995. Utilizing a discount rate of 20%, the then present value of the
future estimated free cash flows was computed to be $45,300,000. At the end of
the future estimation period, the terminal value of HealthNet utilizing the estimated
ongoing cash flow of the company was computed. Discounting the terminal value
to the present, resulted in the value of approximately $27,100,000. Cash required
for operations was defined as cash and marketable securities at December 31, 1990,
which would maintain a current ratio of 1.25. This ratio was determined to be
adequate to provide sufficient liquidity. The sum of present values of the future
estimated free cash flows, the terminal value and the cash not required for
operations resulted in an indicated value of $104,000,000 for the business
enterprises of HealthNet (Ernst & Young 1991). Table 4-1 provides detailed
calculations.
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Table 4-1
HealthNet: Discounted Cash Flow Analysis
$ in Thousands
Years Ending December 31
1991 1992 1993 1994 1995 Ongoing
Net Premium Revenue $ 1,062,241 $ 1,208,154 $ 1,370,893 $ 1,555,587 $ 1,760,867 $ 1,760,867
Operating Expenses
Medical Expenses 924,261 1,065,844 1,219,563 1,387,976 1,575,905 1,575,905
General and Admin.
Expenses 110,336 121,544 133,312 147,180 162,856 162,856
Depreciation 5,044 8,900 7,185 6,593 7,387 7,387
Amortization 1,544 1,544 1,544 1,544 1,544 0
Operating Income 21,056 10,322 9,289 12,294 13,175 14,719
Investment Income 13,582 16,077 18,441 21,035 23,920 23,920
Net Income 34,638 26,399 27,730 33,329 37,095 38,639
Less: Tax Payments (14,895) (10,560) (11,092) (13,332) (14,839) (15,456)
Add: Depreciation 5,044 8,900 7,185 6,593 7,387 7,387
Add: Amortization 1,544 1,544 1,544 1,544 1,544 0
Less: Changes in Working Capital (8,565) (7,287) (7,929) (8,753) (9,809) (9,809)
Less: Capital Expenditure (4,215) (3,400) (4,600) (6,593) (7,387) (7,387)
Tax Free Cash Flow 13,551 15,596 12,838 12,788 13,991 13,374
Terminal Value 78,671
Expected Growth 3%
Present Value Factor 1.0000 0.9129 0.7607 0.6339 0.5283 0.4402 0.4019
20%
Present Values $ 12,371 $ 11,864 $ 8,138 $ 6,756 $ 6,159
Sum o f Present V alue $ 45,287
Present Value of Terminal Value $ 31,618
Cash Not Required for Operations $ 27,111
Indicated Value $ 104,016
Rounded $ 104,000
Source: Ernst & Young 1991.
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4.33.2 Capitalization o f Earnings
The Capitalization of Earnings method uses the average earnings of some
period of time and capitalizes them at an appropriate capitalization rate to estimate
the value of the company. Audited revenues and expenses for the years ended
December 31, 1988, 1989, and 1990 were utilized for the evaluation of HealthNet’s
earnings experience (Table 4-2).
Table 4-2
HealthNet: Historical Earnings Analysis
In Thousands of $
Fiscal Year
Net Income (Loss) Premium Revenue % o f Revenue
1981 $ (523) $ 56,479 $ -0.93%
1982 (217) 87,612 -0.25%
1983 16,713 135,555 12.33%
1984 33,983 221,066 15.37%
1985 26,408 300,217 8.80%
1986 9,129 363,095 2.51%
1987 (22,597) 390,994 -5.78%
1988 (37,955) 494,616 -7.67%
1989 14,171 708,209 2.00%
1990 42,594 886,035 4.81%
Ten Y ear A verage 8,171 364,388 2.24%
Five Y ear A verage 1,068 568,590 0.19%
Source: Ernst & Young 1991.
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HealthNet’s earnings trends since 1981 were also analyzed. The two most
recent years were weighted proportionately greater due to the increasing positive
trend. The most recent year’s earnings were weighted heavier than the prior year’s
because the current year was considered more representative of HealthNet’s
earnings capacity. Table 4-3 summarizes the application of the Capitalization of
Earnings Approach.
Table 4-3
HealthNet: Capitalization of Earnings Approach
Year Weight Net Income (Loss)
1990 .60 $ 42,594,000
1989 .30 14,171,000
1988 .10 (37,995,000)
Weighted average earnings before tax $ 26.008.000
Estimated average earnings after tax at 40%
$ 15.605.000
Capitalization rate
17%
Capitalized earnings value indication S 91.793.000
4.3.3.3 Adjusted Net Asset Approach
In the Adjusted Net Assets Approach, an analysis of the fixed and financial
assets was conducted to arrive at an estimated value for the tangible assets of the
entity as part of a going concern. The value was then netted against the value of all
liabilities of the firm, resulting in a net tangible value. The fixed and financial
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assets identified as being part of HealthNets’ ongoing business were categorized as
furniture, fixtures and equipment, leasehold improvements, computer hardware,
computer software, and net current assets. In deriving values for the financial
assets and liabilities of HealthNet, the company’s current book values were utilized
as a proxy for those values. In analysis of the fixed asset of HealthNet values, Cost
Approach to value was utilized. The cost approach recognizes that the value of an
asset cannot exceed the cost to reconstruct or replace the asset with another of like
utility. Replacement Cost New (RCN) usually establishes the highest amount that a
prudent investor would pay for an asset. To the extent the asset being valued
provides less utility than a new similar asset, the value of that asset is less than the
RCN. RCN is adjusted to reflect losses in value due to physical deterioration,
functional obsolescence, and economic obsolescence. Physical deterioration is loss
in value due to factors such as wear and tear from use, structural defects and
exposure to the elements. Functional obsolescence refers to the loss in value
caused by new innovations where operation of old equipment may not be
economical. Economic obsolescence is the loss in value caused by forces external
to the property itself, such as changes in optimum use, legislative enactment, and
changes in supply/demand relationship (Ernst & Young 1991).
In applying the Cost Approach, an indexing technique was utilized, wherein
the original equipment cost of assets is multiplied by an appropriate index factor to
arrive at an estimate of the RCN of the asset. A depreciation factor was also
applied to the RCN to obtain an estimate of value reflecting the Replacement Cost
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New less depreciation. Index and depreciation factors may be obtained from
indexes published by such sources as Marshall & Swift, Means, Federal
Publications, Kelly Blue Book, and Orion Blue Book. Based on the above
described methodology, the total recommended value of HealthNet’s fixed assets
(including computer software) was estimated to be $23,624,000. The estimated
valuations of property and equipment combined with other categories of assets and
liabilities, including in-house developed software, resulted in a value indication for
the adjusted net assets of the business enterprise of $93,297,000 (Ernst & Young)
(Table 4-4).
HealthNet:
Table 4-4
Adjusted Net Assets Approach
($ in Thousands)
Estimated Net Assets at December 31.1990
Current Assets S 225,835
Current Liabilities 158,979
Net Working Capital 66,856
Property, Plant and Equipment 17,115
Company Developed Software 7,509
Total Adjusted Net Assets $ 93,297
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4.3.4 Reconciliation o f Methodologies and Recommendation o f Fair Market
Value
In arriving at the recommendation of Fair Market Value, Ernst & Young
gave consideration to relevant factors concerning the Fair Market Value of
HealthNet. Based on the three methodologies, Ernst and Young arrived at the
following value indications:
Discounted Cash Flow Approach $ 104,000,000
Capitalization of Earnings Approach $ 91,793,000
Adjusted Net Asset Approach $ 93,297,000
In Ernst & Young’s opinion, the Discounted Cash Flow Approach provided the
most appropriate and reliable indication of value. Therefore, Ernst & Young relied
primarily on the results of this approach in arriving at the final recommended Fair
Market Value of $104,000,000 for HealthNet.
When HealthNet first proposed converting in March 1991, it submitted a
valuation, prepared by Ernst & Young, that set its value at $104 million. This offer
was widely criticized as grossly undervaluing HealthNet. As a result of criticism,
on June 3, 1991, HealthNet had Ernst & Young prepare another valuation, which
set HealthNet’s value at $108 million.
4.4 Ernst & Young’s Valuation Challenged
After HealthNet’s original offer of $108 million to charity, which the DOC
at first seemed willing to accept, several organizations offered to buy HealthNet for
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a much higher price. The highest offer was $300 million (McMahon 1996).
Although these offers were rejected by the DOC, they did result in the DOC getting
a better understanding of the “market” value of HealthNet’s assets. Perhaps the
strongest critic of Ernst & Young’s valuation methodologies was Qual-Med Inc.,
headed by Dr. Malik Hasan.
Qual-Med Inc. engaged Salomon Brothers, an investment banking firm, to
advise and assist in the possible acquisition of HealthNet. As part of the
engagement, Salomon Brothers prepared a valuation analysis in order to provide a
range of fair value, as defined by the DOC. Salomons Brothers’ valuation of
HealthNet was based solely on a review of publicly available information,
including the following:
• The current and historical financial performance and results of operation
of HealthNet. Audited financial statements for HealthNet for the fiscal
year ended December 31, 1990 and for the five-month period ended
May 31, 1991, the latest period for which such information was publicly
available, as detailed in Ernst & Young’s Valuation Analysis submitted
to DOC.
• The financial and business prospects of the company as outlined in
HealthNet management’s Five-Year Plan and detailed in Ernst &
Young’s Valuation Analysis.
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In arriving at a range of Fair Value for HealthNet, Salomon Brothers, Inc.
employed three valuation methodologies:
1. Discounted Cash Flow methodology
2. Market Valuation methodology
3. Capitalization of Earnings methodology
Based on the financial information and valuation methodologies, Salomon
Brothers’ range of Fair Value for HealthNet was estimated to be as follows:
Salomon Brothers’ recommendation of Fair Value for the business enterprise of
HealthNet as of July 31, 1991, was between $275 million and $325 million.
Salomon Brothers, Inc. argued that the Discounted Cash Flow methodology, in
theory, provided a more precise measure of value as it is based upon actual forested
cash flows. However, because of concerns as to the validity and credibility of the
assumptions underlying HealthNet management’s Five-Year Plan, it was important
to give consideration to both the Market Valuation and Capitalization of Earnings
methodologies (Salomon Brothers Inc. 1991).
Discounted Cash Flow methodology
Market Valuation methodology
Capitalization of Earnings methodology
Ranse o f Fair Value
(Dollars in Millions)
275-350
250-325
275-330
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The firm further argued that the Market Valuation methodology was
particularly appropriate in this situation because four of the HealthNet’s seven
primary competitors (FHP International Corporation, Foundation Health
Corporation, PacifiCare Health Systems, Inc., and TakeCare, Inc.) were publicly
traded companies. In addition to operating in the same industry group, these four
companies competed with HealthNet for many of the same employer groups and
employees, many of the same hospital and physician providers, and under the same
demographic conditions and regulatory environment. Moreover, the Market
Valuation methodology is particularly appropriate because of HealthNet’s stated
goals in connection with its proposed conversion is access to the capital markets,
including the public equity market (Salomon Brothers, Inc. 1991).
Salomon Brothers, Inc. was also critical of Ernst & Young’s application of
discounted cash flow methodology, which it asserted was based on a number of
assumptions and theoretical constructs which were inappropriate or inconsistent
and served to reduce the fair value of HealthNet on discounted cash flow basis.
They argued that Ernst & Young’s discount rate of 19% was too high, largely as
the result of an arbitrary and inappropriate add-on of an “unsystematic risk factor”
of 4% to the estimated cost of equity. A reduction in the discount rate to 15.5%
resulted in an increase in Ernst & Young’s valuation of approximately $10 million
(Salomon Brothers, Inc. 1991).
In addition, it was argued that Ernst & Young’s terminal value of $104
million was understated by a factor of two to three times. Ernst & Young’s
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terminal value implied a price/eamings multiple of projected “ongoing” earnings of
4.0 times. This was significantly less than the average price/eamings multiple of
16.6 times on projected 1991 earnings of HealthNets’ most comparable publicly-
traded competitors, such as FHP International Corporation, Foundation Health
Corporation, PacifiCare Health Systems, Inc., and TakeCare, Inc. The application
of more appropriate price/eamings multiple of 16.6 times would increase Ernst &
Young’s estimated terminal value by approximately $330 million to approximately
$433 million and, in turn, increase their fair value estimate for HealthNet under the
discounted cash flow methodology by approximately $138 million on present
dollar basis (Salomon Brothers Inc. 1991).
During the course of the conversion process, no less than seven health care
entities proposed either to purchase HealthNet or to merge it into their
organizations. HealthNet rejected all of these proposals. Some of the proposals are
worth noting. On June 13, 1991, HealthNet declined an offer by the for-profit
hospital chain Humana to purchase HealthNet for $225 million in cash. HealthNet
deemed Humana’s offer unacceptable because of differences in organizational
goals and ideals. On July 1, HealthNet rejected Foundation Health Corporation’s
(FHC) offer to purchase its assets for $250 million, consisting of $100 million in
cash and $150 million in FHC stock. HealthNet maintained that this deal would
seriously dilute HealthNet’s equity. Finally, on July 12, 1991, Qual-Med, Inc.
offered to buy HealthNet for $300 million—a proposal rejected by HealthNet due
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to board’s determination that Qual-Med had a troubled financial and earnings
history (McMahon 1996).
DOC ultimately settled upon a figure of $300 million as the fair value of
HealthNet’s operations.
Among other factors, the value of a non-profit’s assets depends on the
valuation methods utilized, the discount rate used in computing the present value of
estimated future free cash flows, and the price/eamings multiple. Salomon
Brothers, Inc. argued for the use of market valuation methodology in arriving at a
fair value for the business enterprise of HealthNet. Salomon Brothers argued that
the market methodology estimates the stand-alone fair value of a business
enterprise on a going concern basis by analyzing how selected companies
exhibiting comparable operating and financial characteristics are valued in the
public market. The use of market valuation methodology, therefore, would
demonstrate how the public market would value HealthNet on a stand-alone basis.
Solomon Brothers was also critical of Ernst & Young’s use of a discount
rate of 19% as too high. In their opinion, a discount rate of 15.5% was more
appropriate and would result in an increase in Ernst & Young’s valuation by
approximately $10 million.
Salomon Brothers also believed that Ernst & Young’s terminal value or
$104 million was understated by a factor of two to three times. Ernst & Young’s
terminal value implied a price/eamings multiple of 4.0 times which was
significantly less than the average price/eamings multiple of 16.6 times on
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projected 1991 earnings of HealthNet’s comparable publicly traded companies.
The application of a more appropriate price/eamings multiple of 16.6 times would
increase Ernst and Young’s estimated terminal value by $330 million.
The valuation process is full of judgments and estimates, and an integral
part of ensuring proper valuation is making the valuation process public and
requiring the converting non-profit to consider competing bids. With the method of
valuation and price open to public review, the reaction of competitors and possible
buyers could be an important indicator of whether fair market value has been
obtained.
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C h a p t e r 5
A n a l y s i s o f D o c u m e n t s — B l u e C r o s s o f C a l i f o r n i a
5.1 Introduction
Analysis of documents included examination of the Knox-Keene Plan
License Application for Blue Cross of California and Affiliated HCSPs (Health
Care Services Plans) and several amendments to the original license application
filed with the DOC by BCC. Audited financial statements by Coopers & Lybrand
for years 1991-1994, comments submitted by CMA and Consumers union,
correspondence between CMA and DOC and Consumers Union and DOC and
responses by BCC, and other legal and business documents filed in ten boxes at
DOC were also examined. In addition to the above financial reports and business
correspondence, documents of legislative hearings and applicable statutory codes
were also examined.
5.2 Historical Perspective
Blue Cross of California (BCC) was founded as a non-profit public benefit
corporation in 1937. During the Great Depression, California hospitals faced
financial ruin because few could afford to pay hospital bills. The California State
Legislature, in collaboration with private hospitals, sought a way in which
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employers and employees could set aside modest monthly payments to cover
hospitalization costs. Thus, Blue Cross was created as a non-profit, quasi-public
enterprise to prevent the financial collapse of private hospitals in California. For
sixty years Blue Cross had been a legislatively created entity to act in the public
interest to ensure stable financing of hospitals. Blue Shield was created later
primarily to insure non-hospital related costs. The corporate organization of BCC
prior to 1990 was a result of a 1982 merger between Blue Cross of Southern
California and Blue Cross of Northern California. Thus, up until 1990, Blue Cross
of California operated as a California non-profit public-benefit corporation under
chapter 11(a) part 2 division of the California Insurance Code Section 11491-11517
(Exhibit E-l 1991; Thompson 1992).
As the health care market moved more toward managed care plans during
the 1970s and early 1980s, indemnity plans, such as Blue Cross, found that they
occupied a decreasing share of the market. In addition, because indemnity plans
provided a wide range of provider choices, the market share of Blue Cross and Blue
Shield was composed of higher risk members making competition on cost much
more difficult. Thus, in 1980s Blue Cross took a number of steps to address its
precarious financial position:
1. It merged its Northern and Southern California operations in a single
corporation located in Woodland Hills.
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2. It updated and revamped its computer, billing, and management
information systems.
3. It brought in Leonard Schaeffer who headed a new management team
that had extensive health insurance experience centered in managed
competition and aggressive marketing and underwriting practices.
4. It obtained legislative approval to sell the non-profit company
(TakeCare) to a for-profit entity and used the proceeds to bolster
depleted, legally required reserves.
5. It sold real estate assets for the same reason that TakeCare was sold.
By the late 1980s, Blue Cross had turned its financial situation around (Thompson
1992,2).
In 1990, SB 785 (Robins) was enacted which provided that Blue Cross
would have the option of joining the Insurance Guaranty Fund (a requirement for
all companies licensed through the Department of Insurance) or be licensed as a
Knox-Keene Plan. As a result, in July 1991, BCC applied to become a full-service
health care service plan (HCSP) under the Knox-Keene Act of 1975. The
Department of Corporations was responsible for administering health care service
plans under the Knox-Keene Health Care Services Plan. The purpose of the Knox-
Keene Act was to promote the delivery of health care to California citizens who
subscribed to the services rendered by health care service plans. The provisions of
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the Act applied to both non-profit and for-profit health services plans (Health Care
Services Plans 1996; Amendment to Exhibit E-l 1993; Thompson 1992).
At the time of its application, BCC was the largest provider of health
benefits in the State of California. BCC provided health benefits to approximately
2.5 million enrollees and, through all of its programs, served approximately 5
million Californians. It offered a full range of health benefits products including
dental, mental health, and pharmacy (Exhibit E-l 1991).
BCC’s largest single product was its Prudent Buyer Plan. The Prudent
Buyer Plan was a preferred provider organization (PPO) product under which
enrollees were provided with a certain level of coverage for services provided by
contracting providers but were also provided with a lower level of coverage when
seeing non-contracting contractors. BCC also offered CalifomiaCare, a full-service
health maintenance organization product and a traditional full-service product
under which enrollees were free to go to the providers of their choice (sometimes
referred to as an “indemnity” product even though services are provided by
hospitals under contract to Blue Cross). In addition to its full service products,
BCC also made available its prepaid Dental Net product, an “indemnity” dental
product, a mental health product known as Behavioral Health Access and certain
pharmacy and vision products. All these products were made available not only to
the employer groups but also to a large populace of individual subscribers (Exhibit
E-l 1991).
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BCC made these products available through an extensive network of health
care providers. The company had had contracts for hospitals for decades; it
significantly expanded its network to contracting providers with the introduction of
its Prudent Buyer Plan contracts in the 1980s. It had Prudent Buyer Plan contracts
with over 31,000 physicians and approximately 465 hospitals, and “standard”
contracts throughout the state of California. The other products offered by BCC
were made available through large networks of physicians, hospitals, dentists,
mental health practitioners, and other providers and suppliers of health care
services (Exhibit E-l 1991; Exhibit E-2 1991).
BCC wished to improve its ability to address the cyclical nature of the
health care industry and to increase its operational flexibility to address the many
lines of business it operated as a non-profit corporation. In order to address these
concerns and provide needed flexibility, BCC sought to obtain five separate
licenses under the Knox-Keene Act of 1975. The five separate licenses would
encompass all of BCC’s then current operations, but it intended to divide these
operations into the operating units described below and form four separate non
profit public benefit corporations, each of which would have BCC as its sole
corporate member. Certain of BCC’s operations would then be transferred to each
of these non-profit public benefit corporations. However, in order to maintain
continuity and generate efficiency, the business of the licensees would be
conducted as one integrated operation. With the new structure BCC would be
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restructured with the following five operating units, each of which would be
separately licensed:
1. Blue Cross of California, which would operate Blue Cross’s Prudent
Buyer Program and a number of fee-for service and other programs
within the purview of Section 1396.5 of the California Health and
Safety Code.
2. CalifomiaCare, a full-service HCSP, which in 1991 had 325,000
enrollees.
3. Dental Net of California, a specialized dental HCSP, which in
1991 served approximately 198,000 enrollees.
4. Behavior Health Access of California, a specialized mental health
HCSP, which served approximately 72,000 enrollees.
5. BCC Pharmacy Plan of California, a specialized HCSP that would offer
only pharmacy
The structure of these five units would be such that they would be integrally
intertwined. All five HCSPs would be operated under common management,
although each HCSP would have a separate board of directors and officers BCC
would provide the organizational and administrative capacity both for itself and
other affiliated HCPs .
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The structuring proposal above reflected the results o f initial stages of
detailed study and analysis of the mission of Blue Cross, the California health care
environment, and the capacity of Blue Cross to adapt to projected market trends.
Blue Cross continued and expanded its study after filing the Knox-Keene Plan
Licensure Application on July 1, 1991. The results of its study indicated to Blue
Cross that measures beyond the initial restructuring proposals were required to
ensure that the company would survive in the California health care market in its
historic role. In April 1992, BCC submitted an amendment to Exhibit E-l to the
Department of Corporation to approve a proposal for restructuring the organization
(Amended Exhibit E-l [April 6] 1992a).
5.3 Proposal for Restructuring
In its amended proposal, BCC argued that, in order to better carry out its
mission of providing affordable healthcare to Californians and to have access to the
same resources as its competitors, the organization considered it necessary to
undergo restructuring. The company further argued that these resources were
required for survival in a competitive marketplace which was being increasingly
dominated by large, well-financed enterprises (Amended Exhibit-1 [April 6]
1992a).
BCC had historically served a broad spectrum of providers throughout the
Californian society and had been one of the principal providers of individual
coverage to Californians. A non-profit public-benefit corporation, it was qualified
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under Section 501(c)(4) of the Internal Revenue Code but, by reason of Section
501(m) of the Internal Revenue Code, was not entitled to a federal tax exemption.
In its proposal, BCC argued that, because of its corporate structure and tax status, it
was unable to access either the equity markets or the tax-exempt debt markets. In
contrast, its principal competitors were either publicly traded for-profit companies
able to access equity markets and taxable tax markets or, in the case of Kaiser, were
tax exempt under Section 501(c)(3) of the Internal Revenue Code and thus able to
access tax exempt debt markets. BCC further argued that, while these competitors
enjoyed benefits of accessing capital from outside sources, Blue Cross had to rely
on its operations for funding its capital needs (Amended Exhibit-1 [April6] 1992a).
This inability to raise capital was a major threat to BCC’s ability to compete
effectively in the market according to BCC officials. The competitive disadvantage
of not being on a level playing field with its competitors with regards to the capital
formation was compounded by the fact that BCC’s competitors were growing
through acquisitions financed through the same capital markets from which BCC
was barred. BCC strongly believed that not only did it need to raise capital, but it
also needed to have its own securities available as a form of acquisition power
without adversely affecting its operating capabilities (Amended Exhibit-1
[September 9] 1992b).
In addition, BCC was a member of the Blue Cross and Blue Shield
Association (BCBSA), whose Blue Cross and Blue shield members had expressed
concerns about the competitive healthcare market. A number of BCBS Plans had
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experienced very clear and consistent three-year cycles of gain and loss over the
past decades. BCC argued that even though it had improved its financial condition,
many other BCBS Plans were not so fortunate. Failure of some BCBS Plans and
negative financial conditions experienced by BCBS plans all pointed to a need for
Blue Cross to insulate itself from such results. BCC believed that having
appropriate access to capital could provide it with that insulation (Amended Exhibit
E-l [April 6] 1992a).
In view of the issues described above, Blue Cross determined that it needed
to take affirmative steps to forestall a deterioration in BCC’s competitive position
in the marketplace and prevent adverse financial results. BCC did not think that it
could respond to its competitors and adequately protect itself in an adverse
financial environment without access to additional sources of funding (Amended
Exhibit E-l [April 6] 1992a).
BCC proposed that it be restructured in order to better carry out the non
profit public purposes set forth in its Articles of Incorporation. The proposed
restructuring would have two essential components. First, BCC would develop a
controlled for-profit enterprise as a vehicle for raising capital through an initial
public offering (IPO) immediately following the restructuring. Second, BCC
would control the entire enterprise and would apply the benefits of this control to
expanding its charitable activities and its programs in partnership with government.
The restructuring would be implemented by transferring:
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1. The Prudent Buyer, CalifomiaCare and BHA lines of business to
California Care;
2. The Dental Net lines of business to Dental Net;
3. The Pharmacy line of business to Pharmacy Plan; and
4. The Indemnity Business to Woodland Hills Life. Woodland Hills Life
would also serve BCC and Affiliated HCSPs by making available
certain indemnity insurance coverage and other services required in
connection with various Blue Cross products, such as point of service
products, and out-of-network coverage for certain products.
These commercial lines of business (Pmdent Buyer, CalifomiaCare, Dental Net,
Behavioral Health Access and Pharmacy) would be transferred to Affiliated
HCSPs, which would be organized as California for-profit corporations. The
Affiliated HCSPs, in turn, would be wholly-owned by BCC Holdings Inc. (BCC
Holdings), a for-profit corporation owned and controlled by BCC. Woodland Hills
Life Insurance Company, a California-licensed life and disability insurance
company wholly owned by BCC (Woodland Hills Life), would also become a
wholly-owned subsidiary of BCC Holdings. In short, a non-profit, charitable BCC
would have dominion and control over all of the Affiliated HCSPs and Woodland
Hills through its controlled subsidiary BCC Holdings (Amended Exhibit E-l [File
Nos. 966-0303 to 933-0307] n.d.). Figures 5-1 and 5-2 below summarize the
corporate structure before and after the proposed restructuring.
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W H ! POiVi
MiiAi/mNi: t u o k k s
Public IlfiU'ih
Suhskiiarks
(ulifonnai 'arc
llealih Plans
Blue Cross of California
Figure 5-1. Blue Cross o f California— Corporate Structure Prior to Restructuring.
The reorganization would transfer 8Q%-90% of BCC’s assets to a newly created
for-profit business corporation, WellPoint Health Networks, Inc (WellPoint). In
exchange for BCC’s assets, WellPoint would transfer approximately 80% of its
issued stock to BCC. The remaining 20% of WellPoint stock would be sold on the
New York exchange. The proceeds of the IPO would permit the Blue Cross
enterprise to diversify, augment the programs of the Affiliated HCSPs, and provide
a stable platform for the charitable programs of BCC. Under the envisioned capital
structure of BCC Holdings, BCC would be the sole holder of a class of stock which
would have voting rights designed to ensure BCC’s control over BCC Holdings
(Amended Exhibit E-l [April 6] 1992a).
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Business Operations:
Owns All Commercial Assets
W i n I’OliVl
IlKAI.f H N i l WORKS
( alilorniat a n 1 Health
Plans
dba BCC
O ther Subsidiaries
Public Benefit Activities:
Funded by Public Benefit Assets
Im m ediate linprov rm cnls in Service
Delivery
C alifornia H ealthcare f oundation
(J w ii v .s
Near Terra
System Imp.
Invstm. in 21st
Century
Figure 5-2. Blue Cross o f California— Corporate Structure After Restructuring.
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The reorganization would transfer 80%-90% of BCC’s assets to a newly created
for-profit business corporation, WellPoint Health Networks, Inc (WellPoint). In
exchange for BCC’s assets, WellPoint would transfer approximately 80% of its
issued stock to BCC. The remaining 20% of WellPoint stock would be sold on the
New York exchange. The proceeds of the IPO would permit the Blue Cross
enterprise to diversify, augment the programs of the Affiliated HCSPs, and provide
a stable platform for the charitable programs of BCC. Under the envisioned capital
structure of BCC Holdings, BCC would be the sole holder of a class of stock which
would have voting rights designed to ensure BCC’s control over BCC Holdings
(Amended Exhibit E-l [April 6] 1992a).
As part of the proposed restructuring, BCC would increase its non-profit
and charitable activities in order to augment the provision of services to the
medically underserved and expand its support to government programs for making
available affordable health care coverage. BCC would build upon the charitable
programs it already conducted, such as AIM and MRMIP. AIM is a state
subsidized program for low-income pregnant women and infants who do not
qualify for Medi-Cal, and MRMIP is a state-subsidized medical benefits plans for
persons unable to obtain coverage through other channels. BCC would also seek to
participate in other similar government programs, such as Checkup (Early Access
to Health Care for Kids) (Amended Exhibit E-l [September 9] 1992b).
The restructured BCC, as a non-profit, charitable entity dedicated to public
purposes, would retain its existing programs thereby supporting the activities of
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BCBSA. BCC would also continue to operate as the Part A fiscal intermediary for
the Medicare program, thereby benefiting the elderly. It would also seek to
restructure itself to obtain exemption from federal taxation under Code Section
501(c)(4) of the Internal Revenue Code (Amended Exhibit E-l [December 11]
1992d).
The Consumers Union and CMA viewed the BCC restructuring as a
conversion. However, despite objections from the Consumer Union and California
Medical Association, on January 7, 1993, the Department of Corporations (DOC)
under Commissioner Sayles approved BCC’s proposed restructuring and license
application. Twenty percent of WellPoint stock was sold on the New York
exchange and generated $517 million in capital for WellPoint. The DOC’s
approval was not accompanied by a charitable trust obligation (McLean 1993).
5.4 R estructuring or Conversion?
In BCC’s opinion, the reorganization represented merely an internal
restructuring of the current non-profit public benefit corporation, Blue Cross of
California. It did not constitute a conversion of corporate status from non-profit to
for-profit as it did not amend its Articles of Incorporation pursuit to Section 5813.5
of California Corporation Code and did not involve any attributes of conversion.
Therefore, it argued the analysis applied to the proposed restructuring differed from
the analysis applied to conversions since BCC did not cease to exist (Geiser
1992a).
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The proposal contemplated the restructuring of the ownership configuration
of certain of BCC’s assets and lines of business into for-profit enterprise that would
be owned and controlled by a non-profit, charitable BCC. BCC would then assign
individual and group subscriber agreements applicable to the transferred lines of
business to the appropriate Affiliated HCSPs. The revenue from the Subscriber
Agreements would flow to the transferee Affiliated HCSPs. BCC would also
transfer cash to the Affiliated HCSPs, or would make available to the Affiliated
HCSPs a subordinated line of credit, sufficient to satisfy the DOC that each
Affiliated HCSP would meet the minimum tangible net equity and fiscal soundness
requirements of the Knox-Keene Act and the rules. In exchange for these transfers,
BCC would receive all of the issued and outstanding stock of each Affiliated
HCSP, which it would then transfer to BCC Holdings (Geiser 1993).
The conversion of a non-profit corporation into for-profit entity involves a
dissolution of the former and creation of the later. However, the law at the time
with respect to restructuring was not very clear and Blue Cross was severely
criticized by the Consumer Union and California Medical Association (CMA).
Both organizations urged the DOC not to approve the application of Blue Cross as
a reorganization but to treat it as a conversion.
The CMA argued that, under guise of restructuring, Blue Cross and its
management were attempting to turn the organization into a for-profit corporation
where the corporation would have access to capital public markets and
management would benefit from stock options. CMA’s concerns with the
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restructuring were twofold: first, whether the restructuring was consistent with the
public interest of Californians and, second, whether the restructuring would result
in private benefit or private inurement (Cohen 1992a).
Examination of financial statements (Table 5-1) of BCC indicates that the
company had $1.5 billion in total assets in 1992. Table 5-2 indicates it had net
operating income of approximately $200 million and $300 million in 1991 and
1992 respectively. In his memorandum to the CMA Executive Committee,
Thompson (1992) argued that in the first eight months of 1992 BCC had an
investment income of $82.3 million from stocks and $13.3 million from bonds
(Tables 5-3 and 5-4). Thus, in 1992 BCC would generate $395 million in net
income, which would produce more investment capital than the proposed IPO of
$300 million. The financial condition of Blue Cross, therefore, suggested that,
from an investment capital perspective, the for-profit conversion appeared
unnecessary. Thompson (1992) further argued that, if investment capital appeared
to be unnecessary for the conversion, then other factors were driving the decision to
alter the historical status of Blue Cross as the second largest non-profit health
carrier in the State (Coopers & Lybrand 1994, 1995; Thompson 1992).
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Table 5-1
Blue Cross of California: Consolidated Balance Sheet
December 31
1993 1992
(Thousands o f dollars)
Assets
Current Assets:
Cash and cash equivalents $ 182,509 $ 187,927
Short term investment securities and other 97,198 91,263
Receivables, net 154,788 162,746
Deferred tax assets 31,111
Other assets 9,167 15,843
Total Current Assets
474,773 457,779
Equity securities at market value 92,905 88,535
Fixed maturity investment securities, at amortized cost 1,697,450 921,930
Real estate and mortgages, held for investment 34,174 33,922
Property and equipment, net 52,419 47,446
Long-term deferred tax assets 30,697
Other long-term assets 41,595 12,100
T otal Assets $2,424,013 $ 1,561,712
Liabilities, Minority Interest and Subscribers' Retention
Current Liabilities
Medical claims payable $ 483,421 $ 476,818
Unearned premiums 120,065 130,248
Accounts payable and accrued expenses 118,801 142,546
Experience rated refunds 97,911 75,823
Other liabilities 73,069 67,090
Total Current Liabilities 893,267 892,525
Acrrued public benefit obligation 100,000
Accm ed post-retirement benefits 52,142
Deferred gains 39,464 43,890
Other long-term liabilities 45,634 17,781
Total liabilities 1,130,507 954,196
Minority interest 233,026
Subscribers' retension 1,060,480 607,516
Total Liabilities, Minority Interest and Subscribers' Retention $ 2,424,013 $ 1,561,712
Source: Coopers & Lybrand 1994.
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Table 5-2
Blue Cross of California: Consolidated Statement of Earnings
Year Ended December 31
1993 1992 1991
(Thousands of dollars)
Revenues:
Premium revenue
Management Services revenue
Medicare
Investment income
$ 2,875,370
20,150
7,135,781
105,856
$ 2,637,433
19,762
6,491,340
110,882
$ 2,305,072
16,379
5,750,459
67,919
10,137,157 9,259,417 8,139,829
Operating Expenses:
Health care services
Medicare
Selling expense
General and administrative expense
2,217,836
7,135,781
147,790
280,226
2,050,338
6,491,340
129,194
272,587
1,841,786
5,750,459
105,883
234,190
9,781,633 8,943,459 7,932,318
Operating Income
Other income (expense), net
355,524
(2,404)
315,958
(2,552)
207,511
707
Earnings before Provision for Income Taxes, Extraordinary
Gain, Cumulative Effect o f Accounting Changes, and
Minority Interest
Provision for income taxes
353,120
139,974
313,406
65,872
208,218
47,850
Earnings before Extraordinary Gain, Cumulative
Effect of Accounting Changes, and M inority Interest
Extraordinary gain—tax benefit from utilization
of net operating carryforwards
Cumulative effect of accounting changes SFAS No. 106 and 109
213,146
41,662
247,534 160,368
3,932
Earnings Before Minority Interest
Minority interest in earnings
254,808
(34,097)
247,534 164,300
Net Earnings $220,711 $ 247,534 $ 164,300
Source: Coopers & Lybrand 1994.
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Table 5-3
Blue Cross of California: Investment Transactions— Stock Sales
August-92 Stock Sales
Date Sold Description
Number
o f Shares
Price
PerShare
Book
Value
Sales
Proceeds
Gain or
(Loss)
Provident
03-Aug-92 Rhone-Poulenc Rorer Inc 15,500 53.65 552,255 831,609 279,354
05-Aug-92 Tambrands 10,000 62.40 651,262 623,999 -27,263
11-Aug-92 Duracel Inti Inc 6,400 28.00 192,848 179,175 -13,673
12-Aug-92 Costco W holesale Corp 5,100 25.61 199,650 130,591 -69,059
14-Aug-92 BMC Software Inc 2,000 50.25 139,500 100,500 -39,000
18-Aug-92 United States SurgicalCorp 2,000 73.33 144,100 146,655 2,555
Total—Provident 41,000 1,879,615 2,012,529 132,914
Newbold's
24-Aug-92 Eastman Kodal Co 10,500 44.20 523,605 472,977 -50,627
Total Newbold's 10,500 523,605 A ll,911 -50,627
Grand Total 51,500 2,403,220 2,485,506 82,287
Source: Blue Cross o f California, Annual Statement, 1993; Thompson 1992.
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Table 5-4
Blue Cross of California: Investment Transactions—Bond Sales
Aug-92 Bond Sales
Date Sold Description Maturity Value Book Value Proceeds Gain or (Loss)
Coupon
Rate
03-Aug-92
Scudder, Stevens and Clark
GMAC Mtn $ 5,000,000.00 $ 4,913,540.14 $ 5,416,200.00 $ 502,659.86 8.40%
12-Aug-92 US Treasury Notes 90,000,000.00 93,123,474.35 98,894,531.25 5,771,056.90 7.88%
12-Aug-92 US Treasury Notes 27,000,000.00 27,913,905.15 29,668,359.38 1,754,454.23 7.25%
12-Aug-92 US Treasury Notes 80,000,000.00 80,681,965.71 84,712,500.00 4,030,534.29 6.88%
17-Aug-92 Coca Cola Enterprises 2,000,000.00 1,995,702.25 2,081,000.00 85,297.75 7.88%
17-Aug-92 US Treasury Notes 50,000,000.00 55,177,992.08 55,468,750.00 290,757.92 7.25%
17-Aug-92 US Treasury Notes 58,000,000.00 64,006,470.81 64,343,750.00 337,279.19 8.75%
28-Aug-92 American Gen'l Finance 5,000,000.00 4,997,619.00 5,151,900.00 154,281.00 8.75%
31-Aug-92 Deere(John) Cap Mtn 10,000,000.00 10,000,000.00 10,387,100.00 387,100.00 6.25%
Total—Scudder 327,000,000.00 342,810,669.49 356,124,090.63 13,313,421.14
G rand Total $ 327,000,000.00 $342,810,669.49 $ 356,124,090.63 $ 13,313,421.14
Source: Blue Cross of California, Annual Statement, 1993; Thompson 1992.
The motivation for the decision, according to the CMA, Consumers Union, and
Thompson, was to make money for the senior officers and board of directors of the
company. Blue Cross’s Knox-Keene application provided that 4.5% of total shares
be reserved for purchase option by management, which was also to be the board of
directors of the for-profit converted entity, over a four-year period. With the
proposed initial offering of $300 million, this share reserve would be $13.5 million.
Given the financial soundness of Blue Cross, it was inevitable that the share prices
would increase. If, therefore, the stock value doubled during the four-year period, a
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profit of $13.5 million would accrue to Blue Cross management. In addition, the
application also provided that “persons with a business relationship with BCC . . .
directors, officers, employees, contacting providers” be eligible to exercise Initial
Price Options up to 5% of initial stock offerings or $15 million worth of stock.
Thus, 9.5% of the initial offering was reserved for management, directors of the
board, and others as part of the for-profit conversion. Given that the initial price of
the stock would increase, this would create enormous profits for the management
and directors of Blue Cross (Amended Exhibit E-l [December 10] 1992c;
Amended Exhibit E-l [File Nos. 933-0303 to 9330307] n.d.; Cohen 1992a; Hoge
1992).
The restructuring also raised several federal and state tax issues with
regards to BCC’s status as a tax-exempt entity. Blue Cross was a California non
profit public benefit corporation and was exempt from state taxation. BCC was
recognized as tax exempt by the federal government under Section 501(c)(4) of the
Internal Revenue Code (IRC) for many years. However, since the Tax Reform Act
of 1986 it has been required to pay taxes under IRC Section 501(m). The IRC
Section 501(m) denies tax-exempt status to an organization if a substantial part of
its activities consists of providing commercial insurance (Amended Exhibit E-l
[December 10] 1992c; IRC 1986b).
Under its restructuring proposal, BCC would be transferring all the
commercial insurance operations to its second-tier subsidiaries in exchange for all
of its stock. BCC also indicated that it was exploring the possibility of securing a
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tax exemption under IRC Section 501(c)(3) or (4) (Geiser 1992b). However, CMA
(Cohen 1992a) argued that the Federal exempt organization law was not directly
applicable to BCC.
Historically, prepaid health care plans have been categorized as tax-exempt
social welfare organizations under IRC Section 501(c)(4). In the mid 1990s
prepaid Medicare plans were organized to avoid insurance company treatment
under state laws and to provide health care services at the community level.
However, many in the healthcare community argue that many of the plans in
operation today provide benefit to members rather than the community and do not
meet the requirements for exemptions as social welfare entities because they carry
on their activities with the general public in a manner similar to for-profit
organizations (Colloquim Report 1996).
According to the Tax Reform Act of 1986, a tax-exempt social welfare
organization loses its tax-exempt status if a substantial part of its activities consists
of “commercial” type insurance under IRC Section 501 (m), effective beginning
after December 31, 1986. Prior to 1986 Tax Reform Act, the activity of the exempt
organization in providing commercial type of insurance was treated as unrelated
trade or business activity and taxed under subchapter L of Internal Revenue Code
(IRC 1986b).
BCC in its filing with the DOC claimed that it would qualify for tax-exempt
status under 501(c)(4) except for the enactment of Section 501(m). In their
correspondence to DOC, CMA argued that IRC Section 501(m)(4) was specifically
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enacted to reach organizations such as Blue Cross. As a result, Blue Cross was not
tax-exempt under 501(c)(4), and federal rules relating to prohibitions on private
inurement and private benefit which apply to tax exempt organizations would not
prohibit BCC from its proposed re-structuring and benefiting its members
(management). In addition, the federal government did not address organizations’
uses of funds raised prior to enactment of Section 501(m) (Cohen 1992a; Geiser
1992b).
5.5 Conversion of Blue Cross and the California Law
Virtually all federal restrictions on the activities of exempt organizations
have been incorporated into the California Revenue and Taxation Code. BCC is
exempt from California State taxation under the Revenue and Taxation Code
Section 23701(f) as the organization operated exclusively for promotion of social
welfare. California’s grant of tax-exempt status to organizations which promote
social welfare conforms to federal law. In addition, California Corporation Code
Section 5110 requires non-profit public benefit corporations to dedicate their assets
to public charitable purposes as specified in the company’s Articles of
Incorporation. Furthermore, California law conforms to federal law in denying tax-
exempt status to a tax-exempt organization when any part of that organization’s net
earnings inure to the benefit of any private shareholder or individual (18 Cal. Code
Reg. Section 23701(b); California Revenue and Taxation Code 1996; California
Corporation Code 1996).
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Thus, by virtue of California’s adaptation of the federal approach to tax
exemption, BCC was subject to the following rules: First, it must be operated
primarily for social welfare purposes, and its non-exempt activities may not
comprise more than an insubstantial amount of its overall activities. Second, BCC
cannot be operated for the benefit of private rather than public interests. Third,
BCC is subject to prohibitions on private inurement. In addition, under California
law, BCC’s assets must be irrevocably dedicated to its social welfare purposes.
Irrevocable dedication of assets is established by the social welfare
organization in its Articles of Incorporation providing that if the organization
dissolves or becomes unable to perform its specific purpose, its assets will continue
to be irrevocably dedicated to social welfare purposes. Thus, CMA argued that a
public benefit corporation cannot convert from non-profit to for-profit status
without regulatory approval. Blue Cross, on the other hand, countered that
“restructuring” was not a “conversion,” but it acknowledged that California law
required the Attorney’s General approval before a public benefit corporation may
convert to for-profit status (Cohen 1992a; Geiser 1992b).
CMA also argued that a public benefit corporation cannot dispose of its
assets except in a manner consistent with its charitable or public purpose or with
regulatory approval. BCC again countered that restructuring was not a
“disposition” of assets under California Corporation Code Section 5911, although
notice was required to the DOC under Corporation Code Section 5913 and 10821.
CMA countered this argument by stating that BCC’s transfer of substantially all of
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its lines of business to second tier subsidiaries, and then to a holding company
could be seen as a disposition and, therefore, BCC should give notice under
California Code Section 5913 (Cohen 1992a; Geiser 1993).
BCC further argued that, although the proposed transfer constituted a
transfer of assets from BCC, the transfer did not constitute a transfer of
substantially all of the assets and the transfer was not a disposition because BCC
was receiving a Fair Market Value for the assets being transferred. CMA, however,
pointed out that Section 5913 did not create an exception for cases involving “fair
consideration.” It mandates notice before a corporation sells, leases, conveys,
exchanges, transfers, or otherwise disposes of all or substantially all of its assets
unless the transaction is in the usual and regular course of its activities or unless the
Attorney General has given the corporation a written waiver of this section as to the
proposed transaction (Cohen 1992a).
Under California Corporation Code Section 5110, non-profit public benefit
corporations are required to dedicate their assets to public or charitable purposes.
Under common law and statutory law, when a non-profit corporation “converts” to
for-profit status, it is required to dedicate the value of its assets to a charitable
purpose.
However, the existing law at the time did not address the treatment of a
“restructured” organization and was not sufficient to protect the basic contract that
the citizens and taxpayers entered into with a tax-exempt, public benefit
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corporation. As a result, Assemblyman Phil Isenberg introduced AB 1784 to the
Assembly Committee of Judiciary on March 4,1993.
5.6 Why AB 1784?
AB 1784 required a non-profit public benefit corporation that restructures,
by transferring substantial amounts of its assets to a for-profit entity, to preserve the
charitable assets of the corporation and to maintain or increase charitable
expenditure depending upon the enhanced value of the corporation. The bill was
introduced to ensure that all charitable assets of a non-profit public benefit
corporation and its controlled subsidiaries would be used for public benefit
activities. It applied to all non-profit public benefit corporations (Isenberg 1993).
On January 7, 1993, one of the oldest non-profit health carriers in
California, Blue Cross, converted 90% of its assets to a newly created for-profit
company, WellPoint. Because Blue Cross retained itself as a non-profit holding
company, with 10% of the assets and 80% of the stock in WellPoint, technically
this was not a conversion under the existing law. Thus, Blue Cross avoided the
requirement to “pay back” or set aside funds for public purposes which was
required of every company that converted from non-profit to for-profit status. The
irony of this transaction was that Blue Cross was created by the California
Legislature during the Great Depression as a non-profit company to prevent the
financial collapse of private hospitals when people were out of work and could not
pay their bills (Isenberg 1993).
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According to Isenberg (1993), Blue Cross had enjoyed tax-exempt status for
fifty-seven years and, as a result of a loophole in the law, did not have to set aside
the value of this exemption for public policy purposes. In addition, on January 28,
1993, 19.5% of the stock in WellPoint was offered for sale on the New York Stock
Exchange. The initial trading price amounted to $28.52 per share, which raised
$517 million, thus establishing a total market value for WellPoint of $2.3 billion at
the time of initial offering. Thus, this private ownership value of Blue Cross of
$2.3 billion was created by effective management and fifty-seven years of tax-
exempt status. The citizens and taxpayers of California ended up subsidizing the
activities of the tax-exempt Blue Cross of California (BCC) since its legislative
creation during the Great Depression. There is no question that, if BCC had
converted to for-profit status, it would have been required to dedicate irrevocably a
substantial amount of assets to charitable purposes.
Both the Consumer Union (CU) and California Medical Association (CMA)
questioned the benefit derived to the public by this restructuring; they argued that
any public benefit is negligible. The public derived little benefit by promoting the
interests of the investors in WellPoint. Moreover, the need to satisfy the desire for
profits by shareholders would detract from BCC’s charitable endeavors (Isenberg
1993).
AB 1784 would close this loophole and treat all California companies that
had converted their assets to for-profit status the same. The bill simply would
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assure that Blue Cross devoted a portion of its assets to a public benefit purpose
and filed reports with the Attorney General documenting its charitable activities.
Existing law did not expressly require a restructured non-profit corporation
that would sell or transfer the majority of its assets to a for-profit corporation to
either dedicate any amount of assets for charitable purposes, or expend assets for
charitable purposes in a manner consistent with the increased value of its assets.
AB 1784 pertained exclusively to restructured non-profit public benefit
corporations, which were defined as those corporations that sell, lease, convey,
exchange, or transfer “more than an insubstantial amount of their assets” to a for-
profit business entity. Directors of a restructured corporation would have the duty
to do the following:
1. Preserve the charitable assets of the corporation.
2. Maintain the same level of charitable expenditure as expended by the
corporation prior to restructuring.
3. Increase the restructured corporation’s annual charitable expenditures in
direct proportion to the increase in value of assets owned, or controlled,
by the restructured corporation
4. Periodically prepare a public report that declared the current value of the
corporation, its annual charitable expenditures for the immediately
preceding year, and its compliance with the above-described procedures.
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This bill applied to all restructured corporations for whose government
permits and approvals relating to the restructuring were obtained after
July 1, 1992 (Isenberg 1993).
However, the Isenberg bill passed the Assembly but died in the Senate.
What did result from AB 1784 is that Blue Cross/WellPoint agreed to give $5
million a year in charitable contributions for twenty years. The company declared
its “intent,” as part of restructuring, to expand its non-profit and charitable
activities. In August 1993, a new commissioner of corporations, Gary S. Mendoza,
asked Blue Cross to submit a plan for meeting its obligations to the public as a
result of its restructuring. Blue Cross and the Department of Corporations (DOC)
argued about the size of the charitable trust, and by April 1994 Blue Cross
increased its proposed level of public-benefit expenditure for that year to between
$25 and $35 million. Mendoza, in his letter to Blue Cross, complained that the
proposed payment to charity of $100 million over twenty years, amounted to less
than 0.2% of the then present value of Blue Cross/WellPoint. The Consumers
Union made public a copy of this letter and, in September 1994, Blue Cross
proposed to create a new foundation that would receive the assets of WellPoint,
then about $2.5 billion (Coopers & Lybrand 1995; Fox and Isenberg 1996).
The proposed move followed criticism that the non-profit health plan had
short changed the state and consumers when it spun off its most valuable health
care operations in 1992 into a publicly held for-profit subsidiary. In 1994 Blue
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Cross’s 80 million WellPoint shares had a market value of $2.23 billion. Under the
new proposal, WellPoint would get rights to the Blue Cross license and the blue
logo, along with its few remaining health care businesses. The transfer reflected a
decision by the national Blue Cross and Blue Shield Association to allow its name
and logos to be used by for-profit entities. Thus, Blue Cross had finally completed
its conversion.
The new charitable foundation would assume management of Blue Cross’s
charitable activities as well as its real estate and other investments. However, the
Consumers Union, DOC, and other critics raised issues regarding the tax status and
independence of the foundation. These issues are discussed further in Chapter 7.
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C h a pt e r 6
A n a l y sis o f R e spo n se s— In t e r v ie w s
6.1 Introduction
Interview questions were developed and responses categorized to answer
questions related to specific issues of asset valuation, regulations, public benefit,
and conversion revenue. The interview questions are presented in the Appendix.
Personal interviews were conducted with Mr. Steven M. Thompson, Vice
President, Division of Government Relations, CMA; Mr. Emery “Soap” Dowell,
former board member of BCC; and Mr. Phillip Isenberg, Chair of the Judiciary
Committee of the California Assembly. Interviews were conducted specifically
with these individuals because they were the key players in the outcome of the
conversion of Blue Cross and subsequent legislation that followed in California.
These individuals were closely involved with the restructuring/conversion of Blue
Cross and have an insight into the complexity of the issues. The interviews lasted
from one to two hours each.
Other important players in the conversion of Blue Cross were Leonard
Schaeffer, CEO of BCC, and Gary Mendoza, the then-commissioner of DOC.
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Their views on the conversion of Blue Cross have been made public and are
discussed in various chapters.
6.2 Analysis of Interview Responses
To the general question, Who benefits from the conversions in health care
organizations? responses from the three interviewees differed. In Mr. Thompson’s
opinion, it is generally the directors of a converting company that benefit through
stock options. Mr. Dowell and Mr. Isenberg both indicated that answers to the
question, Who benefits? are not clear, and they depend on how the agreements
between the two entities are structured. However, according to Mr. Dowell, the
social benefit of conversion is not lost.
There was also a difference in opinion regarding the reason for Blue Cross
converting. Mr. Thompson held the view that the main reason BCC converted was
to benefit the top management of the company. Mr. Dowell and Mr. Isenberg, on
the other hand, were of the opinion that BCC needed to be competitive. According
to Mr. Dowell, BCC needed to expand into broader markets and, to do so, it needed
to compete against the HMOs.
6.2.1 Valuation o f Charitable Assets
With regard to the valuation question, all three interviewees seem to agree
that the question of valuing assets is difficult. In Mr. Thompson’s opinion,
establishing the value of assets becomes difficult when there is no stock offering,
and this difficulty may be made even more complicated by a market that moves
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very quickly. Thus, the time lag between the valuation and the initial public
offering may account for the wide fluctuations in value at the time of valuation and
a later date.
Mr. Dowell also pointed out that the valuation process is very subjective,
and it is difficult to say whether the process is fair. In many cases the companies
may not know what they are doing and may be learning as they go through the
conversion process.
In Mr. Isenberg’s opinion, there is no preferred method that gets the
maximum dollars for a company, and the question as to How much should go to the
converting foundation? is even more difficult. However, according to him the
valuation question is important because it determines how much goes to the public.
All three interviewees agreed that the management of the converting entity
has an obligation to solicit competitive bids. However, the management does not
have an obligation to accept the highest bid. Tied to the acceptance of the bid
should be other factors such as performance of the company and other
commitments such as charity care are involved in the agreement. According to Mr.
Dowell and Mr. Isenberg, the agreement has the highest responsibility to the public
and should add value to the foundation and the larger public.
With regard to who should fund the valuation process, the consensus
seemed to be that it really did not matter who funded it as long as independent
appraisers were selected by the regulators. Mr. Isenberg also pointed out that, in
California, it is now the non-profits that fund the valuation process.
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All interviewees agreed that the consideration received for BCC was fair.
In Mr. Thompson’s opinion, the consideration received was based on the market
value, and the resulting assets ended up funding two of the largest foundations in
California. In Mr. Dowell’s view, BCC almost went insolvent in 1987 and,
considering that BCC was having difficulty meeting its day-to-day operating costs,
the consideration received was fair and the two foundations did very well.
Mr. Isenberg responded that the consideration received for BCC was
probably fair, but one has to remember that it may not be considered fair by other
groups.
6.2.2 Regulations
Consensus among all three interviewees was that conversions should not be
regulated at a federal level. All three felt that a state agency should handle
conversions in California. In Mr. Dowell’s opinion, however, there should federal
oversight because of the number of interstate corporations. He also indicated that
health care is a local issue and any attempt to change health care financing
legislation would be very slow.
All three were also of the opinion that conversions in California should be
regulated by the Attorney General’s Office. Mr. Dowell added that the Knox-
Keene Act, which is regulated by DOC (now Department of Managed Care), was
written to accommodate the health plans, not the public, and still has no provision
to put the public first.
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All three were of the opinion that a potential conversion should be disclosed
to the public. According to Mr. Thompson, information on whether the valuation is
fair and whether public obligation has been discharged should be made public,
while in Mr. Dowell’s opinion, information to the public should be kept general as
the public might not care about the detail.
All three interviewees also agreed that the conversion of BCC was not
appropriately handled at the beginning. However, after Commissioner Gary
Mendoza got involved, it was. All three commented that a great deal of credit goes
to Gary Mendoza for handling the BCC conversion appropriately and preserving
the public interest.
6.2.3 Conversion Revenue
The opinions as to who should get the revenue from conversion and how
these funds should be utilized differed for all three interviewees. In Mr.
Thompson’s opinion, the conversion revenue should go to a single public
corporation. This according to him would give a single focus and accountability
for the foundation assets. Mr. Thompson would also like to see these funds used to
provide health access to all uninsured in California.
In Mr. Isenberg’s opinion, a statewide foundation should be created to
combine the assets generated by all conversions or restructuring. Mr. Isenberg also
emphasized that the assets of the conversion’s foundation should be managed by an
independent board of directors. The assets of the conversion foundation should be
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used for health care, which is consistent with the charitable purpose of the entity
that converted. However, the foundation can go to court to change its mission, but
citizens should have an opportunity to comment.
Mr. Dowell responded that the conversion assets should not go to the
general fund. However, he was also very emphatic that the conversion foundation
should be fiercely independent of the new entity being created. According to him,
the purpose of the foundation is defined by the statute.
In response to the question whether charitable assets in the Blue Cross
conversion were appropriately utilized, Mr. Thompson and Mr. Isenberg responded
negatively. According to Mr. Thompson, the assets should have been used for a
public purposes and were not. Per Mr. Isenberg, the assets were not wisely used.
The endowment was trapped as it took three and a half years for the conversion
process to be completed, and the purpose of the foundation was not clear. In Mr.
Dowell’s opinion, the assets were appropriately utilized.
6.2.4 Community Benefit
To the question, How did the people of California benefit from the
conversion of Blue Cross? all three interviewees responded that California ended
up with two of the largest foundations in the country and would receive benefit
from the endowment. What was also important was that the people of California
did not lose health care.
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All three responded that there was benefit derived to the management and
trustees of BCC. According to Mr. Dowell, conversion occurs in a stock option
environment, and management generally ends up making a lot more than had the
company stayed as a non-profit.
6.2.5 Major Experience from Conversion
Mr. Dowell responded that he took away two major experiences on a
personal side, when the potential for gain dawned on the board members, they
began to think in dollar terms. On the public side, nobody had realized how
complicated the conversion of BCC was going to be. BCC had entered uncharted
territory where other companies had not walked before, and it survived. Thus,
BCC’s management needs to be complimented for the way it handled the
conversion after the initial controversy.
For Mr. Isenberg, it was a good fight, which put him in a position to pass
the bill in the Assembly. With the support from CMA and Consumers Union, it led
to hospital conversion legislation.
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6.3 Responses to Interview Questions
Table 6-1
Interviews
In t e r v ie w w it h M r . S t e v e n T h o m p s o n
1 Q In your opinion, who benefits from the conversion of a non-profit
organization in health care to for-profit status?
A It is usually the directors of a converting company that benefit
through stock options.
2 Q Why do you think Blue Cross decided to convert to for-profit
status after operating as a non-profit for approximately fifty years?
A The reason Blue Cross converted was that Leonard Schaeffer went
from making $220,000 to a million dollars. When Blue Cross
converted, it did not need capital. The company was just an
intermediary and did not need capital to expand.
Valuation of Charitable Assets
3 Q Are the valuation approaches based on historical performance
(income, market, asset based) used by the accountants,
consultants, and investment bankers appropriate in valuing the
charitable assets of the converting entity?
A If there is a stock offering, then stock price should be the value of
the assets. Establishing the value of the assets becomes difficult
when there is no stock offering. In the case of companies that
have gone through conversions, it is not certain whether the assets
were undervalued, or the market moved very quickly. The time
lag between the valuation and the initial public offering may have
accounted for the fluctuations.
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Table 6-1 (Continued)
Interviews
I n t e r v i e w w i t h M r . S t e v e n T h o m p s o n
4 Q Does the management of a non-profit entity have an obligation to
solicit competing bids to determine the value of the charitable
assets that are being transferred?
A Yes, when converting, the management has an obligation to solicit
competing bids.
5 Q Does the management have an obligation to accept the highest bid
for the assets that are converted?
A However, the management does not have an obligation to accept
the highest bid. It would be fair to say that the company should
accept the middle bid. However, this bid may be considered low
in a couple of years.
6 Q Who should fund the independent valuation of the converting
entity?
A It really does not matter who funds the valuation process as long
as independent appraisers are selected by the regulators.
7 Q Was the consideration received for Blue Cross
reorganization/con version fair?
A Yes, the consideration received by BCC conversion was fair as it
was based on market value. The assets as a result of this
conversion ended up funding two of the largest foundations in
California.
Regulations
8 Q How should the conversion process be regulated to protect the
charitable assets?
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Table 6-1 (Continued)
Interviews
I n t e r v i e w w i t h M r . S t e v e n T h o m p s o n
A Conversions should not be regulated by an agency that regulates
HMOs.
9 Q Which agency should regulate the conversion process?
A In California, the Attorney General’s Office is an appropriate
agency that should regulate conversions.
10 Q Should the public be notified of a potential conversion?
A The Attorney General’s Office should be the one to give public
notice and hold public hearings when a conversion is
contemplated.
11 Q What conversion information should be made public?
A The information that should be made public is whether the
valuation is fair, whether public obligation is discharged, and
whether there was public input in the discharge.
12 Q Do you think the conversion process for Blue Cross of California
was appropriately handled?
A It was handled appropriately after Gary Mendoza’s involvement
and his perseverance.
13 Q Do you think that conversions should be regulated at a federal
level and should there be new legislation that would address
conversions at a federal level for uniformity?
A Conversions should be regulated at a state level. There should not
be any federal involvement.
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Table 6-1 (Continued)
Interviews
I n t e r v i e w w i t h M r . S t e v e n T h o m p s o n
Conversion Revenue
14 Q Who should get the conversion assets (government, existing
community foundation, new foundation)?
A One public corporation. Every conversion asset should go into a
single public corporation. This would give a single focus and
greater accountability.
15 Q Should the existing entity receiving the conversion assets have the
same purpose as the non-profit or have a different purpose?
A The purpose should be to provide public benefit to the taxpayer.
16 Q How should these charitable assets be used?
A To provide health access to all the uninsured in California.
17 Q In the case of Blue Cross conversion/restructuring, do you think
that the converted assets were used for appropriate reasons?
A No. The assets should have been used for public purposes.
Community Benefit
18 Q How did the people of California benefit from the conversion of
Blue Cross of California, and did the restructuring/conversion
serve the public interest?
A Two of the largest foundations were set up.
19 Q In the conversion of Blue Cross was there private benefit derived
by private persons (management and trustees)?
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Table 6-1 (Continued)
Interviews
In t e r v i e w w i t h M r . S t e v e n T h o m p s o n
A Yes, to the management of Blue Cross.
20 Q What was the major experience you took away from the
restructuring/conversion of Blue Cross?
A Mr. Thompson was called away for a conference call and we were
not able to get to this question.
I n t e r v i e w w i t h M r . E m e r y “ S o a p ” D o w e l l
1 Q In your opinion who benefits from the conversion of a non-profit
organization in health care to for-profit status?
A Blue Cross was a large organization and could not compete
effectively. It had a difficult time raising capital. It is not clear
who benefits but the social benefit is not lost.
2 Q Why do you think Blue Cross decided to convert to for-profit
status after operating as a non-profit for approximately fifty years?
A It needed to expand. I do not discount that gains were made by
the CEOs and CFOs, but this was the era of the 1990s and Blue
Cross needed to position itself for a broader market and other
products. Personally, I had no problem with Blue Cross
converting, but it had a public obligation and the assets needed to
be conveyed back to the public.
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Table 6-1 (Continued)
Interviews
I n t e r v i e w w i t h M r . E m e r y “ S o a p ” D o w e l l
Valuation of Charitable Assets
3 Q Are the valuation approaches based on historical performance
(income, market, asset based) used by the accountants,
consultants, and investment bankers appropriate in valuing the
charitable assets of the converting entity?
A The valuation process is very subjective. It is difficult to say
whether the process was fair. In many cases the companies may
not know what they were doing.
4 Q Does the management of non-profit entity have an obligation to
solicit competing bids to determine the value of the charitable
assets that are being transferred?
A Yes, conversions should not have insider trading. It should be
open to the public.
5 Q Does the management have an obligation to accept the highest bid
for the assets that are converted?
A It can accept the highest bid as long as it acquires performance.
The management has to do due diligence and the company that
acquires the non-profit has to perform as the highest responsibility
is to the public.
6 Q Who should fund the independent valuation of the converting
entity?
A There may be a conflict of interest when the acquiring company
funds the process, but it may be okay is there is oversight.
7 Q Was the consideration received for Blue Cross
reorganization/conversion fair?
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Table 6-1 (Continued)
Interviews
I n t e r v i e w w i t h M r . E m e r y “ S o a p ” D o w e l l
A Blue Cross almost went insolvent in 1987. It just had enough to
pay for day to day operations. It laid off three hundred employees
and sold off buildings in Oakland and Woodland Hills. It also
sold off TakeCare. With respect to the political environment,
there was no precedence. So, it has to be assumed that the
consideration was fair. In 1992 the assets may have been worth
more, but the foundations got a good deal.
Regulations
8 Q How should the conversion process be regulated to protect the
charitable assets?
A There are no non-profit HMOs in California left, so there will not
be any conversions in future. However, conversions should be put
back in the Department of Insurance’s hands.
9 Q Which agency should regulate the conversion process?
A Department of Insurance. During the Blue Cross conversion,
DOC, now the Department of Managed Care, was the only game
in town. The Knox-Keene Act was written to accommodate the
plans not the public, and it has not been re-written to put the
public first.
10 Q Should the public be notified of a potential conversion?
A There should be a disclosure to the fullest.
11 Q What conversion information should be made public?
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Table 6-1 (Continued)
Interviews
I n t e r v i e w w i t h M r . E m e r y “ S o a p ” D o w e l l
A General information about the conversion. The public may not
care about the detail.
12 Q Do you think the conversion process for Blue Cross of California
was appropriately handled?
A A. Not in the beginning. After Gary Mendoza got involved, yes.
13 Q Do you think that conversions should be regulated at a federal
level and should there be new legislation that would address the
conversions at a federal level for uniformity?
A It would be very slow to change the health care financing to the
federal level. Healthcare is a local issue and the regulation of
healthcare financing should be left to the state. There should be a
federal oversight because there are so many interstate
corporations.
Conversion Revenue
14 Q Who should get the conversion assets (government, existing
community foundation, new foundation)?
A The funds should not go to the general fund. However, the
foundation that is created should be independent of the converting
entity.
15 Q Should the existing entity receiving the conversion assets have the
same purpose as the non-profit or have a different purpose?
A The purpose is defined by the statute.
16 Q How should these charitable assets be used?
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Table 6-1 (Continued)
Interviews
I n t e r v i e w w i t h M r . E m e r y “ S o a p ” D o w e l l
A The new charity must be fiercely independent of the new
corporation that is formed. The assets need to stay in the health
care system.
17 Q In the case of Blue Cross conversion/restructuring, do you think
that the converted assets were used for appropriate reasons
A With the two foundations that were formed, yes.
Community Benefit
18 Q How did the people of California benefit from the conversion of
Blue Cross of California, and did the restructuring/conversion
serve the public interest?
A California ended up with two of the largest foundations in the
state. The foundations are doing good work. For example, the
Healthcare Foundation in Oakland has fully funded MediCal
research.
19 Q In the conversion of Blue Cross, was there private benefit derived
to private persons (management and trustees)?
A Yes, but the conversion is in a stock option environment and the
management generally ends up making ten times more than if the
company had continued as a non-profit.
20 Q What was the major experience you took away from the
restructuring/conversion of Blue Cross?
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Table 6-1 (Continued)
Interviews
I n t e r v i e w w i t h M r . E m e r y “ S o a p ” D o w e l l
A Two major experiences come to mind. On a personal level, when
the potential of the conversion dawned on to the board members,
they began to see the dollar signs. On the public side, this
conversion was so big and so complicated that nobody was smart
enough to see its consequences. Blue Cross had entered an
uncharted territory, and it survived. Therefore, some compliments
need to go to the management of Blue Cross because the board
had no clue what was going on.
In t e r v ie w w it h M r . P h il ip I s e n b e r g
1 Q In your opinion, who benefits from the conversion of a non-profit
organization in health care to for-profit status?
A That question has not been answered yet. The question is broad,
and it depends on how the agreements are structured and whether
a foundation is set up.
2 Q Why do you think Blue Cross decided to convert to for-profit
status after operating as a non-profit for approximately fifty years?
A Mostly because of competition. The for-profits had a competitive
advantage over the non-profits.
Valuation of Charitable Assets
3 Q Are the valuation approaches based on historical performance
(income, market, asset based) used by the accountants,
consultants, and investment bankers appropriate in valuing the
charitable assets of the converting entity?
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Table 6-1 (Continued)
Interviews
I n t e r v i e w w i t h M r . P h i l i p I s e n b e r g
A Valuation questions lead to how much goes to the California
public. Blue Cross started out with zero dollars being dedicated to
the public benefit. There is no preferred method that gets the
maximum, and the question as to how much should go to the
resulting foundation is even more difficult.
4 Q Does the management of non-profit entity have an obligation to
solicit competing bids to determine the value of the charitable
assets that are being transferred?
A Yes, otherwise they would be breaching a fiduciary duty.
5 Q Does the management have an obligation to accept the highest bid
for the assets that are converted?
A Highest bid may be fine, but what other commitments are
involved. For example, when San Jose Hospital was sold to
Tenet, Tenet agreed to charity care which adds value not only to
the foundation but also to the larger public.
6 Q Who should fund the independent valuation of the converting
entity?
A In California, the non-profit entity.
7 Q Was the consideration received for Blue Cross
reorganization/conversion fair?
A Probably fair, but it may not be considered fair from the point of
view of the Consumers Union.
Regulations
8 Q How should the conversion process be regulated to protect the
charitable assets?
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Table 6-1 (Continued)
Interviews
I n t e r v i e w w i t h M r . P h i l i p I s e n b e r g
A There should a due process set up and due diligence conducted.
9
Q
Which agency should regulate the conversion process?
A In California, the Attorney General regulates the hospital and
other non-profit conversions.
10
Q
Should the public be notified of a potential conversion?
A California law requires that the public be notified.
11
Q
What conversion information should be made public?
A Proprietary information is not available to the public. The
question that becomes important is what is proprietary and what is
not.
12
Q
Do you think the conversion process for Blue Cross of California
was appropriately handled?
A Ultimately. A lot of credit goes to Gary Mendoza.
13
Q
Do you think that conversions should be regulated at a federal
level, and should there be new legislation that would address the
conversions at a federal level for uniformity?
A No, there is a state agency that regulates conversions.
Conversion Revenue
14
Q
Who should get the conversion assets (government, existing
community foundation, new foundation)?
A The assets should be merged into a statewide foundation.
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Table 6-1 (Continued)
Interviews
I n t e r v i e w w i t h M r . P h i l i p I s e n b e r g
15 Q Should the existing entity receiving the conversion assets have the
same purpose as the non-profit or have a different purpose?
A It should be an independent foundation. It should not be under the
control of the for-profit entity.
16 Q How should these charitable assets be used?
A Preferably in health care which is consistent with the charitable
purpose. The foundation can go to court to change the purpose,
but the citizens should have an opportunity to comment.
17 Q In the case of Blue Cross conversion/restructuring, do you think
that the converted assets were used for appropriate reasons?
A The assets were not wisely used. The endowment got trapped,
[and] the foundation was not sure what its purpose was. The
California Health Care foundation was more focused and made
grants for health policy purposes.
Community Benefit
18 Q How did the people of California benefit from the conversion of
Blue Cross of California, and did the restructuring/conversion
serve the public interest?
A People did not lose health care. They also received benefit from
the billions of dollars in endowment.
19 Q In the conversion of Blue Cross, was there private benefit derived
to private persons (management and trustees)?
A Yes
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Table 6-1 (Continued)
Interviews
I n t e r v i e w w i t h M r . P h i l i p I s e n b e r g
20 Q What was the major experience you took away from the
restructuring/conversion of Blue Cross?
A It was a good fight. It gave me a position to pass the bill in the
Assembly. There was support from CMA and Consumers Union,
and it led to hospital conversion legislation.
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C h a pt e r 7
C o n c l u s i o n s , I m p l i c a t i o n s a n d S u g g e s t i o n s
f o r F u t u r e R e s e a r c h
7.1 Introduction
The objective of this dissertation was to document the process of conversion
from non-profit to for-profit by the nation’s second largest HMO, the Blue Cross of
California. The dissertation also documented the conversion of HealthNet from
non-profit to for-profit status with specific reference to valuation of its assets in the
conversion process. The questions addressed in this study were (1) Who benefits
from the conversion of non-profit to for-profit status in health care organizations?
(2) How are the assets of the converting entity valued? (3) How are charitable
assets generated as a result of the conversion utilized? And (4) Should conversions
be regulated at the federal level?
7.2 Who Benefits?
The question, Who benefits from the conversion of non-profit to for-profit
status in health care organizations? was answered through interviews and analysis
of financial statements, conversion proposals, business correspondence, and other
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business documents filed with the Department of Corporation for both Blue Cross
of California and HealthNet Incorporation.
The conversion process is fraught with legal issues. The question as to who
benefits from the conversion is not straightforward and depends on a number of
factors such as whether the terms of agreement are fair and reasonable; whether the
transaction serves the public interest and the value of charitable assets involved
remained dedicated to promoting charitable health care; whether private benefit
results to any private person or entity; whether the transaction reduces the
availability of affordable health care in the community; and whether the converting
entity receives fair market value in the transaction.
According to Mr. Isenberg, the question of Who benefits? is a broad one
and has not been answered. Who benefits depends on the way the agreements are
structured and whether converting foundations are set up. In Mr. Thompson’s
opinion, on the other hand, generally it is the directors of the converting company
who benefit through stock options. Mr. Dowell’s response was that it is not clear
who benefits. He believes that the management of the converting entity benefits
but also that social benefit is not lost in a conversion.
Closely tied to the question of Who benefits in the conversion transaction?
is the issue of asset valuation. The value determined for the assets of the
converting entity ultimately determines the charitable assets that are transferred to
the subsequent foundation.
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7.3 Agency Theory and Asset Valuation
Conversions pose a challenge for the directors and trustees of non-profit
health care organizations. Directors and trustees of these organizations are viewed
as agents of the public and are under severe pressure to act in the best interest of the
community.
Molinari et al. (1993) suggest that, in corporate governance literature, there
has been a divergence in thinking about who should sit on the governing board.
Management and agency theory are the two perspectives that offer different
explanations concerning the roles of insiders on governing boards. Traditionally, it
has been believed that participation by top level management enhances board
decision making and effectiveness. This managerial perspective argues that insider
board participation provides informational advantage necessary to keep boards
informed and capable of making sound decisions. Some theorists such as Moe
(1984) suggest that board participation poses “information asymmetries” that can
lead to opportunistic board decision making. This potential for opportunism
through insider board participation has been further articulated by agency theorists
who argue that, when there is separation between owners (shareholders/public) and
managers, a conflict of interest between management and owners exists (Fama and
Jensen 1983). These theorists posit that it is the governing board’s legal
responsibility to safeguard the owners’ interest and wealth, which can be seriously
impeded when insiders are active on the governing board.
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In their book, Health Care Alliances and Conversions, Schwartz and Horn
(1999) cite cases where management cloaked its strategic planning in secrecy to
prevent the full board from adequately exploring all available options. Then, under
the pressure of perceived fiscal or management crises, the board was asked to
approve a proposed transaction without ever having had the opportunity to explore
alternative options, or worse, to fully understand the terms of the specific
transactions being submitted to them for a vote.
The above authors caution against such crises and argue that this
management style negated the advantage of having board diverse in experience,
talent, and outlook. The decision to convert an organization to a for-profit status
and change the nature of the institution so that it becomes a grant-making
foundation is the single most important decision each board member will ever
consider. The judgment requires the highest, not the lowest level of discussion, and
it is never properly delegated solely to senior management (Schwartz and Horn
1999).
The issue of asset valuation is complicated not only by agency theory, but
also by the behavior of the environment in terms of the advocacy groups, the
market, and the ambiguity of the applicable law. Schwartz and Horn (1999) also
suggest that the board of directors or trustees is the first and most important line of
defense in safeguarding charitable interests once the issue of conversion arises.
The board holds the assets in trust for the real owners—the public beneficiaries of
the institution. Just as for-profit corporations must convince their shareholders that
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a significant change in corporate direction is in their interest, non-profit trustees
should not overlook the importance of convincing the public that a proposed
conversion is in the community’s interest.
The authors further argue that community support for a proposed
conversion may engender confusion, fear, animosity, and opposition, which will
make conversions difficult, if not impossible. Thus, securing the public’s support
for a proposed conversion from the outset is important. The process can be
designed to encourage public support and avoid a nasty fight on the front page of
the newspaper.
This situation was seen in the conversion of both HealthNet and Blue Cross.
7.3.1 HealthNet Market Value
Even though the final outcome of HealthNet conversion was favorable, with
a $300,000,000 California Wellness Foundation being created, the original
arrangement was a leveraged buyout with very little cash involved in the initial
offering. The potential for gross under valuation of assets and loss of charitable
assets to the community was enormous.
Examination of Ernst & Young’s and Salomon Brothers’ valuation analyses
filed with the Department of Corporations revealed that Ernst & Young utilized
methodologies that were in the State of California’s Department of Corporation’s
acceptable approaches for use in determining the Fair Market Value of a Non-profit
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Public Benefit Corporation in conversion. Ernst & Young used three approaches in
determining the value of HealthNet assets.
The Discounted Cash Flow Approach combined the respective values of
HealthNet’s future estimated free cash flows through December 31, 1995, the
terminal value of the company as of December 31, 1995, and the value of assets not
required for operations. Assets not required for operations consisted of cash and
short-term investments. Under this method, Ernst & Young valued the company at
$104,000,000.
The Capitalization of Earnings approach used the average earnings of the
last three years and capitalized them to establish the current value of the company’s
assets. This method indicated the company’s value to be $91,793,000.
Under the Net Asset approach the value indicators of the property and
equipment were estimated under a fair-market value in exchange premise, using
recent purchase/sales data of comparable equipment. Current assets and liabilities
to be assumed were valued at book value. The adjusted net asset value of the
business enterprise was then calculated, considering individual asset values and
liabilities. The value represents the maximum amount of proceeds to be received
under the liquidation scenario. Established value of intangible assets was added to
this amount. Ernst & Young determined the value of HealthNet under this
approach to be $93,297,000.
In Ernst & Young’s opinion, the Discounted Cash Flow Approach provided
the most appropriate and reliable indication of fair-market value of $104,000,000.
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This value of $104,000,000 was submitted to the Department of
Corporations when HealthNet proposed converting to for-profit in March 1991.
The value was widely criticized as grossly undervaluing HealthNet and, as a result,
on June 3, 1991, HealthNet asked Ernst & Young to prepare another valuation
which set the HealthNet’s value at $108,000,000.
As soon as HealthNet’s conversion became public in May 1991, a bidding
war began and HealthNet received offers from at least seven potential buyers, with
the highest bid at $300,000,000 from Qual-Med, Inc. HealthNet rejected Qual-
Med’s deal on the board’s determination that Qual-Med had a troubled financial
and earnings history.
In October 1991, Qual-Med filed an action in Sacramento County Supreme
Court seeking to block HealthNet’s conduct in refusing Qual-Med’s offer to buy
HealthNet. Qual-Med contended that HealthNet executives unlawfully enriched
themselves by more than $48.5 million by arranging to acquire 20% of HealthNet’s
stock for only $1.5 million. Qual-Med contended that this 20% stake was worth
more than $50 million. Qual-Med also alleged that one day after the conversion,
HealthNet violated a conversion order by issuing additional class A stock to its
management team for no consideration. This issuance of shares diluted the stake of
the Wellness Foundation, HealthNet’s Charitable Foundation from 80% to 73% and
violated the conversion requirement that additional shares could only be issued if
the holdings of all shareholders were diluted proportionately and if fair market
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value was paid. The dispute between HealthNet and Qual-Med was ultimately
settled by their merger in 1993.
The value of the restructured and merged corporation, Health Systems
International (HSI), was estimated at $775 million. This amount is an interesting
valuation since HealthNet was prevented from entering into any new ventures
during the pending Qual-Med litigation. When the $775 million estimate of
combined market value of these companies is reduced by Qual-Med’s market
value, the value of HealthNet at time of its conversion was approximately $543
million. Given the subsequent market value of HealthNet, the DOC valuation of
HealthNet’s assets at the time of conversion is difficult to understand.
Prior to the conversion of Blue Cross of California, the DOC focused on a
few key concepts in its valuation of converting HMOs. First, the DOC’s belief was
that conversions were beneficial and should be encouraged. Second, management
of the HMOs was fundamental to the operation of the conversion and should not be
displaced as a result of the status change. Third, financial incentives drive the
conversion process, and, without these rewards, the managers of viable HMOs
would not consider conversion. Finally, the DOC maintained that the valuation of
any converting HMO must be set according to “fair value” rather than the “Fair
Market Value.” The Consumers Union has alleged that the DOC’s interpretation of
fair value of converting HMOs has been the single most important factor to
contributing to consistent under valuation of these entities.
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DOC interpreted “fair value” as the liquidation value of a corporation.
However, where possibilities other then liquidation exist, California law requires
that its courts consider the value of the corporation as a “going concern.” In
particular, the California Corporation Code provides that fair value must contain a
market value component.
When HealthNet converted, it did not include market valuations despite the
fact that, by the time of its conversion, several of HealthNet’s competitors were
publicly traded. When Salomon Brothers, retained by Qual-Med, offered market
information from four of these competitors, the DOC rejected these companies as
not comparable. Salomon Brothers argued that they believed the market valuation
methodology may provide a more accurate measure of fair value of HealthNet than
a strict reliance on discounted cash flow methodology as four of HealthNet’s
primary competitors were publicly traded HMOs.
Arriving at an accurate valuation figure of these HMOs is complicated by
the nature of the conversion process. Interested insiders generally act as both
buyers and sellers of a non-profit corporation and are also responsible for
generating financial data upon which the firm's value will be set. In contrast, if a
company is publicly traded, there is a willing buyer and a seller, and market
valuation processes are applied to these cases.
Salomon Brothers also argued that the discount rate used by Ernst & Young
was too high and the price/eamings multiple too low. As a result HealthNet assets
were undervalued by approximately $330 million.
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Different rationalities are tied into how the assets of the converting non
profit entity may be valued. From an accounting perspective, under the accounting
principle of conservatism in choosing among alternative generally acceptable
methods, the firm may select the set that provides the most conservative measure of
value. The accounting principle of conservatism rests on the conservative measures
of earnings and valuations, thereby reducing the possibility of unwarranted
optimism by the users of financial information.
From an economic perspective, the market forces with a willing buyer and
seller or comparable companies that are publicly traded tend to drive the value of
assets of a converting entity.
Under the political and organizational rationale, the first question that needs
to be resolved is, Who owns the assets of the converting entity? If the public is
determined to be the shareholders of the non-profit entity, then it is in the interest
of the legislators and the public to obtain the highest possible value for the assets of
the converting entity. If, on the other hand, the members or management are
considered to be the owners of the assets, then the tendency generally is to value
the assets at the lowest possible price.
Investment bankers, accountants, and consultants have developed certain
methods to value the assets of non-profit organizations. An important public policy
issue is raised when investment bankers and consultants place a value on non-profit
organizations that is less than society’s historical investment in such organizations.
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Non-profits in health care have benefited from significant investment by
society since the first hospital was built in the United States. For example,
immediately after the Second World War, the federal government provided grants
and low interest loans to many non-profit hospitals as part of the Hill-Burton
program. The tax-exempt status of non-profit hospitals allowed donors to give tax-
deductible gifts, allowed non-profit hospitals to sell tax-free bonds, exempted non
profit hospitals from federal taxation, and increased the probability that they were
also exempt from state and local taxation. Considering decades of community
investments involved, the properly discounted value of society’s investment could
be much greater than those computed by the present methods. The issue is whether
society should expect some return on its investment and examine the terms of sale
to make sure it is receiving an adequate return on that investment.
Asset valuation methodologies are riddled with estimates and business
judgments and, thus, the potential for undervaluing the assets exists for a number of
reasons. First, the organization’ s EBITDA (Earnings before Interest, Depreciation,
Taxes and Amortization) may not accurately reflect its earnings if the conversion
occurs immediately after an unusually bad financial year. Second, this method
relies on the organization’s historical performance rather than potential future
earnings. This is important because while non-profit organizations price/eamings
multiples typically hover around six, most for-profit organizations have had
price/eamings multiples of between fifteen and twenty-five. Thus, the same
organization can be valued at six times its earnings before conversions and eighteen
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times its earnings after conversion. Historically, the DOC has valued these
companies not as companies that were traded on the stock market, but companies
that had not been traded and discounted their value because of their absence of the
ability to trade. Finally, the valuation methods do not adequately factor in market
conditions, competition factors, and human resources; and, because of the
nonexistence of a willing buyer and seller, the experts’ valuations can be different
than what the real world market value is.
Moreover, as Mr. Thompson of CMA pointed out, one also needs to
consider the passage of time. The value of the converting entity may have been
appropriate at the time of conversion, but in an environment when HMOs were
growing as rapidly as they were in the 1990s, there may be a substantial increase in
the size of the company in a matter of a year or two.
Lack of policies that guarantee that the asset valuation process is conducted
properly so that the converting entity’s charitable trust obligation is fully satisfied
also adds to the potential under valuation of assets. In contrasting its own proposal
to former health service plan conversions that were reviewed and approved by the
DOC, Blue Cross of California pointed out significant under valuations approved
by the DOC in the conversions of Family Health Plan (1984), Inland Health Care
(1986), and Pacific Health Systems (1984).
The DOC also informally modified its valuation process in its 1992
approval of HealthNet’s conversion to for-profit status. In HealthNet’s case, the
DOC did not simply take a valuation figure and dedicate those dollars to a
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foundation, but instead it added $300 million by giving the new foundation,
California Wellness Foundation, 80% of HealthNet’s stock. Thus, the actual
market value of the stock would ultimately determine the value of the assets
provided to the Wellness Foundation.
At the time of approval, HealthNet expressed concerns about the DOC’s
unpredictable conversion review process. It maintained that its charitable trust plan
was developed using the same valuation process applied by the DOC in converting
nearly thirty other health service plans since the early 1980s. HealthNet claimed
that the rules of the game changed after HealthNet filed its conversion plan. At the
time HealthNet pursued its conversion, no formal rules, regulations, or written
manuals were in place.
Perhaps nowhere is the issue of potential loss of charitable assets to the
community more prevalent than in the conversion of Blue Cross of California.
7.3.2 Conversion Versus Restructuring
Examination of documents filed with the DOC to convert from non-profit to
for-profit status by Blue Cross, business correspondence (correspondence by
Consumers Union, CMA and financial statements) revealed that conversion from
non-profit to for-profit status posed a problem for the Blue Cross of California
because it had entered into uncharted territory, and the regulatory process to
complete the conversion took three and one-half years. This long regulatory
process was due to the lack of a clear and certain process that governed
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restructuring and for-profit conversions. According to Leonard Schaeffer (1996), a
structure that mixes non-profit and for-profit activities can cause confusion and
lack of confidence for the customers, employers, shareholders and regulators, and
other stakeholders.
In 1992 Blue Cross submitted an application to become a Knox-Keene plan
and at the same time convert a portion of its business to for-profit status with a plan
to sell 20% of the stock in a for-profit company on the New York Stock Exchange.
The non-profit Blue Cross holding company would retain 80% of the equity and
97.5% of the voting control of the for-profit entity (WellPoint). This plan was
approved by the Department of Corporation in January 1993. WellPoint then went
public with the initial public offering, which netted $517 million. Although this
restructuring approved by DOC left non-profit BCC in control of its for-profit
subsidiary, there was no law, regulation, or precedent that defined the public
benefit obligation of a restructured non-profit public benefit entity.
In April 1993, BCC filed a plan with DOC to fund its public benefit
activities, committing a contribution of $100 million over twenty years to health-
related activities. In December 1993, with the coming of a new DOC
commissioner, Gary Mendoza, the DOC informed BCC that committing $100
million for public benefit activities was not sufficient for DOC. At the same time,
there was outrage from the California Medical Association and Consumers Union
that BCC was hiding under the guise of “restructuring,” when in fact it was clearly
converting from a non-profit to a for-profit entity.
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The point of contention in the Blue Cross’s case was whether the company
had merely reorganized itself or had gone through a conversion. In its application
to DOC, Blue Cross clearly stated that the company was going through
reorganization. There was no dissolution and therefore, no charitable trust was to
be set up. Mendoza agreed with Blue Cross that no conversion had taken place but,
in his view, BCC was not absolved of the public charity obligation. In a Senate
Committee on Insurance Oversight hearing, Commissioner Mendoza clarified that
a conversion in the DOCs’ view is a change of organization from a non-profit
status and the non-profit corporation ceases to exist. In contrast, what Blue Cross
had proposed was a reshuffling of its assets so that a substantial portion of its
operating assets were transferred to a new for-profit entity called WellPoint Health
Networks. Blue Cross transferred 423,000 HMO members, its 1.5 million member
Preferred Provider network, and the company’s pharmacy, dental, mental health,
senior and workers compensation programs to WellPoint. Blue Cross retained 80%
of WellPoint and sold the remaining 20% for $571 million. Originally, Blue Cross
held 100% of WellPoint. After the public offering at WellPoint level, they ended
up owning 80% of WellPoint plus $517 million. This was a typical drop-down
conversion where Blue Cross created a for-profit subsidiary, WellPoint Health
Networks and, as a parent company, it retained 80% of WellPoint stock. However,
DOC concluded that, based on the way the transaction was structured, it was not a
conversion and Blue Cross as a non-profit continued to exist.
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In Senate Committee on Insurance oversight hearings, Mendoza
emphasized that it was important for the DOC to follow the law, and that laws
could not be made up as one goes along. Thus, DOC’s conclusion at the time that
BCC’s proposal was not a conversion, but a restructuring was the right legal
conclusion.
In his view, when Blue Cross did the restructuring, that did not end its
public benefit responsibilities. Restructuring changed the nature of the assets that
BC held for purposes of meeting its public benefit responsibilities. Instead of
holding the assets and operating them for the public benefit, they now held and
continue to hold a very valuable financial asset, namely an 80% position in
WellPoint stock.
As part of this re-structuring, in April 1993, DOC requested that BC submit
its plan that demonstrated that it was going to substantially increase the charitable
obligation as it had committed to do with the department. According to Mendoza,
the DOC policy had not changed after his arrival, but it had built on the approach
that DOC had historically taken. Blue Cross took the approach of restructuring
which was different than conversions that other entities had taken, but Mendoza
argued that DOC tried to be consistent in the way it applied the law.
The view that Blue Cross had a public benefit responsibility is also shared
by others. During the interview with Mr. Dowell, he indicated that, as a board
member of Blue Cross, he was in favor of BCC restructuring/converting. However,
he believed that Blue Cross had benefited from its tax-exempt status for several
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years and had a public benefit obligation. Similar thoughts were echoed in his
confidential letter (1993) to Phil Isenberg, in which he stated “the potential loss to
the state is huge, perhaps one of the biggest incidents of lost public assets in the
history” (personal interview with author, Sacramento, CA, 2002). Steve Thompson
of CMA and Phil Isenberg also felt that BCC had a public obligation that it needed
to satisfy.
The outrage by the CMA, Consumer Union, and the public was not because
one of the oldest non-profit organizations in the history of the United States was
converting/restructuring, but the fact that BC had tried to side-step its
responsibilities to the state and consumers under the guise of restructuring. Both
CMA and Consumers Union were critical that Blue Cross’s restructuring had not
addressed how it was going to serve the public interest of Californians and how the
charitable assets of the state would continue to be protected. These organizations
argued that BCC’s restructuring was an equivalent of a conversion and that, absent
imposition of a charitable trust “set aside,” no public purpose would be served or
achieved by the restructuring.
Gary Mendoza viewed the BCC conversion differently. In his view,
conversion of Blue Cross, a non-profit entity, into WellPoint Health Networks was
a self-dealing transaction because certain Blue Cross board members were also
WellPoint stockholders. Generally, if a transaction was self-dealing, the standard
applied is whether the transaction was entered into for the benefit of the corporation
and was fair and reasonable. However, in the Blue Cross conversion, the relevant
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factor was that DOC required proof that a more favorable transaction was not
reasonably available. Consequently, this stringent requirement significantly
impacted the conversion process (Moore et al. 1998).
In May 1994, Mendoza asked Blue Cross to submit a new plan to meet its
charitable obligations to the public. After many months of protest, argument, and
dispute, Blue Cross agreed to create two independent charitable foundations with
an estimated combined value of $3.3 billion. The California Endowment, a
501(c)(3) charity, and the California Healthcare Foundation, a temporary
501(c)(4), which was obligated to sell $2 billion in stock over the next five years
and transfer the proceeds to the endowment.
The conversion of Blue Cross was an important lesson for the regulators of
California. From an initial position of $0 to be contributed to charity, and then an
insufficient amount of $100 million, the regulators were eventually successful in
forcing Blue Cross to create one of the largest foundations in the United States to
serve the public interest.
7.4 Conversion Foundations and Charitable Assets
When a non-profit organization is dissolved, issues arise regarding the
creation, initial governance, independence, and mission of new charitable
foundations that are being established to carry out the original charitable purpose.
Independence from the converted organization is a difficult issue for most
foundations borne of conversions. Strict interpretation of independence suggests
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that the entire board should consist of new appointees with no prior connection to
the converted organization. New members would be selected for their experience
in the areas of public health embraced by the mission statement, or their foundation
expertise in grant making or asset management. Kane (1997), however, suggests
that the boards of many converting non-profits believe themselves to be
representatives of their communities, holding the community’s best interest at
heart. In addition, many of these boards believe that the charitable asset value of
the conversion is a direct result of their stewardship and that it is their obligation to
maintain the charitable mission of those assets in their new form.
To meet its public obligation responsibility, Blue Cross proposed to create
the California HealthCare Foundation under IRC Section 501(c)(4). The 501(c)(4)
section of the IRC covers “social welfare” organizations and is commonly used by
lobbying groups like the Sierra Club and National Rifle Association, not traditional
charities. This proposal by BCC brought immense criticism from the Northern
California Grantsmakers, the Consumers Union, and CMA. They argued that,
generally, the converting organization will seek a Section 501(c)(3) status which
restricts the foundation’s financial activities. In addition, the critics raised a
conflict of interest issue—the current nineteen members of the Blue Cross Board
would also become the board of the new foundation (Green 1994).
Charges began to fly that Blue Cross would use its billions to buy
everything from influence in Sacramento to statewide initiatives and would assist
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causes and practices that enhance Blue Cross business interests (Finberg and Bell
1994).
According to Northern California Grantmakers, the 501(c)(4) tax
classification did not provide adequate safeguards to ensure that the funds would be
used in a manner consistent with their charitable intent. The new organization
would not have to pay out 5% of its assets each year for charitable purposes as the
grant-making foundations are required to do. Nor would it be subject to other
financial controls designed to hold private foundations accountable to the public.
Kirke Wilson of the Rosenberg Foundation in San Francisco stated that “the
foundation should function at arm’s length from BlueCross” (Bailey 1994b, p. 8).
In his view it was difficult to see how a board governed by Blue Cross insiders
could spend the income of $2 billion in a way that was not self-serving or did not
have the appearance of conflict of interest (Bailey 1994b; Green 1994). The
importance of a converting foundation being independent was emphasized by both
Mr. Isenberg and Mr. Dowell.
How charitable assets are used is determined by the mission and governance
structures that newly established foundations adopt. The cy pres doctrine requires
that the mission of a charitable foundation bom of conversion be as closely related
to the charity’s original mission as possible. In practice however, the cy pres
doctrine is not always honored.
When Blue Cross revealed its plans to distribute $100 million as part of its
public benefit obligation, it was criticized for including activities that were not
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charitable but would benefit the HMO industry and WellPoint in particular. In a
hearing by the state Assembly Judiciary subcommittee that oversees public trusts
and corporate charitable activities, Phillip Isenberg, Judiciary Chairman, pointed
out that some who would-be recipients were those who had business ties to Blue
Cross, WellPoint or Leonard Schaeffer, the chief executive of both companies.
Some of the examples cited were
• $15 million to California Kids, which provides subsidized insurance to
poor children in California. WellPoint is the only carrier of this
insurance;
• $2.5 million to the National Health Foundation, where Schaeffer was on
the board of trustees;
• $2.5 million to endow a professorship in “managed care” at the
University of Southern California where Schaeffer also sat on an
advisory board. The University of California, Berkeley, would get the
same amount for the same purpose.
According to Finberg, an attorney for Consumers Union, there were more
subtle conflicts as well. For example, the foundation would donate $5 million in
start-up funds to create the Center for Quality Patient Care. Its goal would be to
cajole physicians into using uniform rules about when to perform medical
procedures and surgeries. Blue Cross argued that the program would promote
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consumer education and more appropriate health care, but Finberg argued it would
give HMOs and other insurers a tool to attempt to wrest cost decisions away from
physicians. Finberg’s fear was that, by having its own board in charge of the
foundation, directors of Blue Cross would make funding decisions with
WellPoint’s interests in mind (Thelen 1994; Sanders 1994).
The issue was ultimately resolved by undertaking exhaustive search by
three executive search agencies and an independent advisory group of three persons
from the public health arena, BCC, and DOC. Both DOC and BCC interviewed all
twenty-four finalists and agreed upon their suitability and independence. Perhaps
Isenberg and Thompson have a point when they argue for one statewide
foundation. For Isenberg, the foundation would manage the assets created by all
future conversions or restructuring and would be used for coordination and
planning for improving the health care of the population. For Thompson the funds
would be utilized to take care of the uninsured in California. Although the BCC
issue was resolved by hiring an outside search firm, there is no clear indication as
to how the conversion revenue will ultimately be utilized. Thus, it is an area for
potential future research.
7.5 Regulation and Organizational Change
Despite the fact that federal regulation could stabilize the tremendous
regulatory variation among states on conversions, the federal government is
unlikely to get involved in regulating the conversion process. In the absence of
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federal regulation of non-profit conversion, it is left up to the states to protect
communities during the non-profit conversion process.
Although common law and existing state non-profit corporation laws
provide regulators with general jurisdiction to oversee many hospital conversions,
some state regulators have found that their authority over conversions is unclear.
Some attorneys general believe that their authority is limited to litigation to stop
conversions that are underway rather than issue advance approval. Furthermore,
Blue Cross’s conversion raised unique jurisdictional issues. Also, authority for
oversight of conversions does not necessarily include authority over advance
notice, public hearings, the use of resources for an independent evaluation, or the
right to impose specific community obligations on either foundations or successor
for-profit entities.
In an effort to protect the public’s interest, a growing number of states have
passed or are considering laws regulating the sale of non-profit or public hospitals.
The laws typically seek to open the conversion processes to the public, strengthen
oversight authority, generally through the Attorney General, and make sure that the
proceeds from such transactions are used appropriately. In 1996, Nebraska and
California passed laws specifically regulating non-profit public hospital
conversions to for-profit entities.
Conversion legislation modeled after California and Nebraska was also
introduced in the U. S. Congress by Representative Peter Stark in 1997. The
legislation would require conversions to be carried out in the “sunshine” of public
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information and debate to ensure that the conversions price was fair. The penalty
for noncompliance would be expulsion from Medicare. Since virtually every
hospital relies on Medicare for a significant portion of its revenues, the effects of
the Medicare Non-Profit Hospital Protection Act of 1997 would be wide reaching.
The bill, however, failed to advance beyond the committee stage.
The American Hospital Association, representing 4,800 non-profit and for-
profit hospitals, does not favor federal regulation. According to the association,
any effort to regulate hospitals should be done on the local level—by community or
state regulators. Similar thoughts were echoed by Mr. Dowell during the interview.
According to him “all health care is local,” and, therefore, conversions do not need
federal regulation. He added that some oversight by the federal government may
be appropriate. During individual interviews, both Mr. Thompson and Mr.
Isenberg also responded against federal regulation.
All three interviewees had a consensus that all conversions in California
should be regulated by the Attorney’s General office. The Attorneys General
historically have been responsible for supervising changes of mission and
dissolution of non-profit organizations. Although some have been more active than
others, there does not appear to be any justification for changing their traditional
role. Most states have drafted statutes to address hospital and health plan
conversions separately, perhaps because of the kinds of conversions that have
received the most attention in the state.
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In California, the DOC is responsible for regulating HMOs, and the
Attorney General regulates every other non-profit public benefit corporation,
including hospitals and other health facilities. Because of the Blue Cross
controversy, Senator Rosenthal introduced Senate Bill 445, which Pete Wilson
signed into law in 1996. The California statute codified the DOC procedure used to
review the Blue Cross conversion and changed the non-profit HMO conversions
rules of the 1980s under which foundations received only a fraction of the
converting plan’s net worth. The statute now applies to both restructuring, defined
as the sale or transfer to a for-profit health plan entity of a “substantial amount” of
the assets of a non-profit health plan or mutual benefit plan holding assets subject
to a charitable obligation and a conversion, defined as a transformation of a non
profit health plan or a mutual benefit plan to a for-profit firm, as determined by the
commissioner (California Health and Safety Code, Sections 1399.70-1399.76,
1996).
After holding a public hearing and considering public comments, the DOC
commissioner must approve the restructuring or conversion based upon a finding
that the transaction will not adversely affect the organization’s public benefit
purpose or result in private inurement. The commissioner also must determine that
the organization’s fair market value is set aside to serve the health care needs of
Californians, one or more foundations that are independent of the plan’s directors,
officers, subsidiaries, or affiliates; that have no conflict of interest, and whose
directors are experienced in grant making. The foundation must file annual reports
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with the attorney general and the commissioner. The commissioner is authorized to
charge the cost of outside experts and internal reviews to the converting plan
(California Health and Safety Code, Sections 1399.70-1399.76, 1996).
As a result of the confusion and controversy surrounding the Blue Cross
case, Phil Isenberg also introduced AB 3101, which Governor Pete Wilson signed
into law in September 1996. AB 3101 significantly expands regulatory authority
over the conversion of assets from a non-profit hospital to a for-profit corporation.
It gives the state attorney general clear statutory authority to “consent” or “not
consent” to an ownership or management change if the public interest is adversely
affected by the hospital conversion. California Corporations Code Sections 5914-
5919 were enacted in 1996; they specifically address the transfer of ownership or
control of non-profit health facilities. These new code sections allow the boards of
directors of non-profits to exercise their business judgment and react to the markets
in a timely manner. The sections also provide adequate safeguards to ensure that
charitable assets are properly valued and used for their charitable purposes. The
key statutory provisions of AB 3101 are as follows:
• Public Input. Prior law contained no formal mechanism for obtaining
community input. Corporation Code Section 5916 requires the attorney
general to hold one or more public meetings in the county in which the
subject facility is located.
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« Attorney general approval. Prior law contained no requirement of
attorney general approval of such transactions but instead required only
that twenty days notice be provided to the attorney general. Corporation
Code 5914 requires the consent of the attorney general for any such
transaction. Moreover, Section 5917 specifically authorizes conditional
consents to permit the non-profit to cure minor transactional problems
without losing its closing date.
• Analysis o f the transaction’ s impact. Prior law contained no basis for
considering the public interest in such transactions, particularly as it
reflected on the impact of the transaction on the availability and
accessibility of health care in the affected community. This was and has
been a matter of great community concern.
• Cost reimbursement. Given the limited funds available to state
governments generally, there rarely is enough money available to obtain
adequate expert advice on such matters as valuation, deal terms, and
health impact. Moreover, it seemed fair that these costs come out of the
transactions and not out of taxpayers’ pockets.
Corporation Code Section 5919 provides for the reimbursement of both
expert and consultant costs and for actual and reasonable direct expenses incurred
by the attorney general in reviewing, evaluating, and making a determination in the
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conversion transactions (Schwartz et al. 1999; Moore et al. 1999; Isenberg et al.
1997).
Although federal regulation of conversion is unlikely, the states are still
struggling with ways to best regulate non-profit conversions. The experience of
Blue Cross and HealthNet in California may provide guidelines for health care
organizations in other states that may be contemplating conversion.
As Alexander and D ’Aunno (1990) suggest that survival in health care
organizations depends on the organization’s conformity to its external environment.
“Conformity is expressed through isomorphism with those actors\agents in the
external environment who are empowered to provide legitimacy and support to
organizations embedded in the institutional system” (65). DiMaggio and Powell
(1983) define isomorphism as a process that compels one organization in a
population to resemble others that face the same set of environmental conditions.
Change as a result of conversions may be conceptualized as the outcome of
an environmental selection process that is outside the control of any individual
organization. Conceptualization of the environment has evolved into two
categories of environmental characteristics: technical and institutional
environments (Meyer & Scott 1983). Technical environments are those within
which a product or service is provided and exchanged in a market. Organizations
operating in technical environments are rewarded for effective control of work
processes. Institutional environments, on the other hand, feature elaborate rules
and requirements to which individual organizations must conform to receive the
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social and political support and legitimization needed to survive. All organizations
are subject to both technical and institutional constraints, although in varying levels
of intensity. Organizations such as schools, health agencies, and law firms operate
in environments characterized by strong institutional pressures and relatively weak
technical controls. These organizations carry on their activities subject to variety of
rules and procedural controls and succeed primarily by conforming to the
institutional requirements (Alexander and Scott 1984).
7.6 Analysis of Expectations for the Impact of Non-Profit Conversions
Expectation 1 Charitable assets of the converting entity have a potential
of being undervalued.
Analysis of the official records and papers, specifically the valuation
analysis of HealthNet and restructuring proposal by BCC, validated this
expectation. When HealthNet initially proposed converting to for-profit status, it
submitted a valuation of S104 million for its assets. It was only after wide criticism
and several other offers to purchase HealthNet at a higher price that the ultimate
value was set at $300 million. Although arriving at an accurate valuation figure for
HMOs is complicated by the nature of the conversion process, the strongest
criticism has been directed at DOC’s methodology in approving conversions. DOC
was consistently criticized for using “fair” and not “fair market value” during the
conversion process. When HealthNet converted, DOC specifically did not include
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any market valuation despite the fact that by this time several of HealthNet’s
competitors were publicly traded. When Salomon Brothers offered market
information from four of the competitors, the DOC rejected these companies as not
comparable. The public pressure that generated a bidding war ultimately forced an
increased valuation of the transaction.
Public participation was also instrumental in changing the initial position
for the BCC conversion where absolutely nothing was set aside for public benefit,
then an insufficient $100 million dollars, and ultimately to creating two of the
largest foundations in the United States.
Expectation 2 Charitable assets generated from the conversion process
will be utilized for purposes other than the original intent of
the converted entity.
Review of the modified proposal to substantially increase the charitable
activities by BCC failed to validate this expectation. The proposal talked in general
terms and did not include any specific plans for the dollar amount to be spent and
the type of charitable projects to be undertaken. Even though there were
allegations of inappropriate use of funds, no clear indication was found as to how
the converting assets were ultimately utilized.
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Expectation 3 Because of the large amount of charitable dollars involved
in the conversion process, there will be a push for
conversions to be regulated at a federal level.
Results of the interviews failed to validate this expectation. All three
interviewees were of the opinion that conversions in California should be regulated
at the state level and that the Attorney’s General Office should be the agency
regulating them. To them health care is a local issue and should not have federal
involvement. Failure of conversion legislation introduced by Representative Stark
to advance beyond the committee stage in the U.S. Congress and absence of
successful efforts to adopt legislation also indicate that regulation at a federal level
is difficult.
7.7 Im plications of Results of this Study
The results of the study indicate that one of the most contentious issues in a
conversion review is the valuation of the non-profit’s assets which determines the
amount of resources that must be set aside in a foundation or other organization to
continue the non-profit mission. The extent to which the non-profit is undervalued
eventually will inure to the benefit of private individuals. In addition, many
conversions are exceedingly complex, involving multiple collateral transactions
and requiring sophisticated financial analysis and expertise. This complexity adds
tremendous responsibility to the board of directors of organizations that are
contemplating conversions.
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Thus, an informed board of directors is essential to the conversion process.
Under federal and state law the boards of not-for-profit organizations have a
fiduciary duty to keep the assets dedicated to their charitable purposes. In
contemplating conversions, the board members must demonstrate that they are
acting in the best interests of the community. They must not be influenced by
conflicts of interest and personal gain and must be sure that they are receiving the
fair market value for the non-profit entity. The members also have an additional
burden of ensuring that the proceeds of conversion are appropriately redirected
within the community.
The results of the study also indicate the importance of public participation
in the conversion process. Public participation made a difference in the final
outcome and the extent of the conversion assets being dedicated for public benefit
in both HealthNet and Blue Cross conversions. It led to re-evaluation of proposed
transactions, ensuring that regulators took into account the public’s concerns.
7.8 Conclusion
Conversions of health care organizations from non-profit to for-profit status
are interwoven into the changes occurring in the U.S. health care industry. Some
conversions may have economic advantage in consolidating excess capacity and
promoting efficiency. Conversions may also pose the risk that communities will
lose valuable charitable assets or important health services. The goal of public
policy should not be to prevent conversions, which could impede desirable change,
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but rather political need to establish an efficient and accountable process through
which possible conversions are evaluated and actual conversions are managed.
The history of HealthNet, Blue Cross/WellPoint, and other plans that
converted to for-profit has important lessons for public policy. The assets of
California and the nation’s non-profit health care institutions belong to the public.
They are irrevocable charitable assets. More importantly, they were dedicated to
health care as a result of public policy that implemented the principle that health
care is a public good rather than a commodity that can be traded in the market. As
the current privatization of non-profit health care accelerates, the public has a claim
on the assets created by non-profit entities with public subsidies. The legislators,
regulators, and leaders of non-profits need to discuss what public purposes are
served by existing non-profits and to consider the implications of the increasing
commercialization of health care. As the wave of non-profit conversions,
restructuring, and joint ventures with for-profit companies sweeps the nation, new
policies may be necessary to protect the public interest.
7.9 Suggestions for Future Research
If administrators are to understand the impacts of conversions on the
communities affected, health policy analysts and researchers need to develop
improved models for assessing the strengths and weaknesses of a not-for-profit
system. Past research has used for-profit organizations as a base against which not-
for-profit performance has been compared. This methodology has allowed the
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research parameters to be defined by the for-profit sector alone. Research has not
sufficiently addressed what the for-profit sector does not do. In addition, the
conversion process is based on a number of assumed outcomes that require
analysis. The research questions should include the following:
1. How are the charitable assets of the conversion foundation utilized?
2. How are the proceeds of the converted for-profit entity actually used?
The theory posited by conversion proponents is that the for-profit entity
will bring efficiency to the institution while freeing up funds for
targeted health care needs. Is value added as a result of new or
expanded services?
3. How much of the health care dollar is being used for corporate overhead;
management information systems; and legal, management, and other
contracts with buyer-related companies?
4. How do for-profit organizations respond to difficult financial times? Are
the services cut or is the organization resold?
Up to this point, the focus of the oversight in non-profit conversions has
been on the transaction process. The challenge now is to understand and evaluate
the outcomes.
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A ppe n d ix
I n t e r v i e w Q u e s t i o n s
207
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Interview Questions
General Overview
1. In your opinion, who benefits from the conversion of a non-profit
organization in health care to for-profit status?
2. Why do you think Blue Cross decided to convert to for-profit status after
operating as a non-profit for approximately fifty years?
Valuation o f Charitable Assets
3. Are the valuation approaches based on historical performance (income,
market, asset based) used by the accountants, consultants, and investment
bankers appropriate in valuing the charitable assets of the converting entity?
4. Does the management of non-profit entity have an obligation to solicit
competing bids to determine the value of the charitable assets that are being
transferred?
5. Does the management have an obligation to accept the highest bid for the
assets that are converted?
6. Who should fund the independent valuation of the converting entity?
7. Was the consideration received for Blue Cross reorganization/conversion
fair?
Regulations
8. How should the conversion process be regulated to protect the charitable
assets?
9. Which agency should regulate the conversion process?
10. Should the public be notified of a potential conversion?
11. What conversion information should be made public?
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12. Do you think the conversion process for Blue Cross of California was
appropriately handled?
13. Do you think that conversions should be regulated at a federal level and
should there be new legislation that would address the conversions at a
federal level for uniformity?
Conversion Revenue
14. Who should get the conversion assets (government, existing community
foundation, new foundation)?
15. Should the existing entity receiving the conversion assets have the same
purpose as the non-profit or have a different purpose?
16. How should these charitable assets be used?
17. In the case of Blue Cross conversion/restructuring, do you think that the
converted assets were used for appropriate reasons?
Community Benefit
18. How did the people of California benefit from the conversion of Blue Cross
of California? Did the restructuring/conversion serve the public interest?
19. In the conversion of Blue Cross, was there private benefit derived to private
persons (management and trustees)?
20. What was the major experience you took away from the
restructuring/conversion of Blue Cross?
209
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Creator
Velji, Pari
(author)
Core Title
Conversion of health care organizations from non -profit to for -profit status
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School of Policy, Planning and Development
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Doctor of Public Administration
Degree Program
Public Administration
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Clayton, Ross (
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