Tuesday’s decision by Judge Richard Leon of the U.S. District Court for the District of Columbia categorically approving the merger of AT&T and Time Warner, without imposing any conditions or limitations and rejecting granting a stay for appeal purposes, will, unless blocked if there is an appeal, open the way for a series of pending vertical merger deals.

A “vertical merger” is a merger of two companies that do not compete and that are at different levels of the product or service-provision process. Such mergers do not reduce the number of competitors in a given market and, by producing efficiencies, generally have been considered productive and far less economically threatening than horizontal mergers among competitors. Indeed the Department of Justice (DoJ) had not challenged such a merger since the early 1970s. In challenging AT&T, DoJ argued that economic harm was threatened by the purported ability of the acquiring company to control downstream access to product and thus cause raised prices to consumers.  Judge Leon rejected DoJ’s arguments in all regards.

The communications industry has been patiently awaiting the outcome of the case. But that isn’t the only economic sector that is going to see energetic activity. The health care sector stands right beside it, and we expect to see vertical merger action there too.

There are many major deals in the wings and, especially in the health care space, a number of them involve potential vertical relationships. As health care costs continue to rise and both public and private payers move towards value-based and other models, vertical integration is expected to become more attractive.

We at Epstein Becker Green will be writing in greater detail in the days to come, but our antitrust team already is gearing up for counseling and litigation defense matters generated in the wake of the AT&T case. We’ll continue to report on any subsequent activity in that matter as well, with the deal set to close on June 21, unless a higher court intervenes. That team, consisting of Stuart Gerson, John Steren, Trish Wagner, and Mark Lutes, among others, scored a recent victory in an important merger case on behalf of its client Palmetto Health* in the Fourth Circuit case of SCPH Legacy Corp. v. Palmetto Health, in which the U.S. Court of Appeals rejected claims of antitrust standing and antitrust injury, two fundamental issues in merger analysis.

*Prior results are based on the merits of the case and do not guarantee a similar outcome.

The pace of health care transactions is robust, purchase price multiples are increasing, and many health care businesses are taking advantage of a sellers’ market.  Recently, our clients have increasingly turned to representation and warranty (“R&W”) insurance, finding a market more amenable to the nuances of health care deals than in the past. In the right deal, R&W insurance can limit risk to both seller and buyer and increase value to a seller by allowing for “walk-away” or “naked” deals.  R&W insurance may also be used as a tool by a buyer to increase the attractiveness of its offer in a competitive environment.

The acquisition of a company or its assets is typically governed by a purchase agreement and related transaction documents. The purchase agreement will contain various representations and warranties by the seller regarding a variety of matters, such as the seller’s assets and financial performance (including growth projections), and the accuracy of its billings for services, and its compliance with law (including healthcare laws and regulations). The buyer must do its own diligence before consummating a transaction, but in connection with such diligence it also relies on the seller’s representations and warranties. Following the closing of the transaction, if it is determined that one of the seller’s representations was incorrect (i.e., breached) and the buyer suffers damages as a result, the buyer usually has a right to compensation pursuant to the purchase agreement and related transaction documents.  Frequently, however, those agreements limit the amount that the buyer may recover, either in total, or by using various formulas, deductibles, and/or caps.   Even in the absence of these limits, if the cash purchase price has been distributed by a seller to its creditors and owners, a buyer seeking recovery may face a complex and difficult process.

The most common way to protect a buyer from potential losses that may be difficult to recover using simple indemnification is to escrow a portion of the purchase price from which claims may be paid. The amount of the escrow and how long it must be held are important negotiated terms in the purchase agreement. At the conclusion of the agreed-upon escrow period, the funds remaining in the escrow account will be released to the seller. Naturally, a buyer will want the most protection (and a large escrow amount), while a seller will want to retain the largest portion of the purchase price (and a small escrow amount). That’s where R&W insurance comes in.

R&W insurance shifts the risk of liability for breaches of representations and warranties from the seller to the insurance company in order to provide the parties to the transaction with greater protection post-closing. By utilizing R&W insurance, a buyer will be more comfortable placing a smaller portion (or even none) of the purchase price in escrow, resulting in a larger portion of the purchase price being paid to the seller at closing. In the event a breach of covered representations and warranties by the seller is discovered post-closing, the buyer may look to the insurance company rather than to the escrow (and therefore to the seller) to be made whole.

R&W insurance is an interesting way to shift the risk involved in a transaction and to provide a buyer with greater certainty of collection in the event of a breach. Further, making R&W insurance a component of a bid may provide a buyer a way to favorably distinguish itself from other bidders in a typical “sale process” run by investment bankers (or in auction-style sale). There are many other considerations, however, when deciding whether to use R&W insurance in lieu of the traditional escrow model. Such considerations include, among others:

  • The size of the policy needed for the transaction, and whether the resulting cost of the policy makes good business sense. The size of a policy can range significantly, in theory covering losses up to the full purchase price, which will impact the cost of the insurance.
  • Whether, and the extent to which, the buyer wants the seller to have “skin in the game” post-closing (i.e., in the form of an escrow), potentially making R&W insurance less desirable.
  • Which representations and warranties the policy excludes. If significant claims are excluded (e.g., Medicare claims, HIPAA violations, or specific matters already under government investigation or subject to litigation), there may be a weaker business case for buying R&W insurance.
  • Who will pay for the R&W insurance (buyer? seller? split?).
  • Some healthcare deals are harder to insure for representations and warranties relating to billing and coding compliance, such as providers with a higher percentage of government payor reimbursement and a greater number of “high-end” CPT codes.
  • The policy’s requirements for a buyer to make (and collect) a claim under the policy. For example, does the policy contain a materiality requirement?  Are the policy requirements consistent with the term of the purchase agreement?

Buyers and sellers should be aware of the existence of R&W insurance, as well as the above considerations, when analyzing and negotiating transactions. It may provide a valuable alternative to the traditional indemnification escrow model.

There has been a growing trend of strategic joint ventures throughout the healthcare industry with the goal of enhancing expertise, accessing financial resources, gaining efficiencies, and improving performance in the changing environment. This includes, for example, hospital-hospital joint ventures, hospital-payor joint ventures, and hospital joint ventures with various ancillary providers (e.g., ambulatory surgery, imaging, home health, physical therapy, behavioral health, etc.). Extra precautions need to be taken in joint ventures between tax-exempt entities and for-profit companies.

The Internal Revenue Service (“IRS”) issued a final adverse determination letter revoking a general acute care hospital’s 501(c)(3) status. Although various details have been redacted, it is clear that the hospital entered into a lease agreement with a for-profit entity in a manner found to be incongruent with its exempt status.

The hospital leased its land, property, and equipment to the for-profit, which specialized in operating rural hospitals. Control of the hospital’s operations (including revenue collection) was given to the for-profit. The for-profit agreed to provide charity care in a manner that was to be consistent with the hospital’s past practice.

IRS § 1.501(c)(3) states that an organization must be organized and operated exclusively for one or more exempt purposes. The regulations further note that an organization is not exempt if it fails to meet either the organizational or operational test. Although an argument was made that the for-profit served an exempt purpose by maintaining the hospital’s land, building, and equipment in order to ensure that it would be available to the public, the IRS noted that there was not enough information to sufficiently make the facts at hand analogous to the authorities that support serving such an exempt purpose.

Ultimately, the IRS revoked the hospital’s status because it was not operated exclusively for a tax-exempt purpose. The lease agreement resulted in the for-profit deriving private benefit that is inconsistent with tax exemption. The IRS noted that the hospital operated in a manner materially different than what was originally represented in the Application of Exemption. Sometime in the 1990s the hospital first transferred management and then operational control to the for-profit. Even though the lease agreement had a provision on providing charity care, the IRS focused on the lack of control the hospital had over its own operations.

In giving an example of a permissible and not-permissible level of control, the IRS brought up the two hospital examples provided in Rev. Rul. 69-545. The IRS stated that the hospital in this instance is more similar to the non-exempt hospital described in Situation 2 of Rev. Rul. 69-545, which was controlled by physicians who had a substantial economic interest in the hospital. By comparison, the exempt hospital in Situation 1 was controlled by independent civic leaders who comprised the board of trustees.

The IRS highlighted Rev. Rul. 98-15, which explored how a joint venture may operate between a non-profit and a for-profit. The IRS further noted that the arrangement between the hospital in this situation and the for-profit missed the mark. The Revenue Ruling on joint ventures makes it clear that the tax-exempt organization must retain control of the joint venture. Safeguards from Rev. Rul. 98-15 (as noted by the IRS) include the following components in the governing documents of a limited liability company formed to run a hospital:

  • The limited liability company will be managed by a governing board that has three individuals chosen by the hospital and two individuals chosen by the for-profit partner.
  • Language that effectively prevents the for-profit from amending the governing documents.
  • Requirement that the hospital be operated in a manner that furthers charitable purposes by promoting health for the broad cross section of its community.
  • Conflict language that states in the event of a conflict between the community benefit standard and any duty to maximize profits, the community benefit standard must win (without regard to the consequences of maximizing profitability).

As joint ventures in the healthcare industry become more prevalent, this final adverse determination letter highlights the importance of properly structuring joint ventures between for-profit entities and tax-exempt organizations by taking into consideration this and other guidance, including Rev. Rul. 98-15 and St. David’s Health Care Sys. v. United States, 349 F.3d 232 (2003).