[co-author: Brittany Walter - Summer Associate]

In a May 15, 2017 Bankruptcy Court decision (Gardens Decision) from California’s Central District (In re Gardens Regional Hospital and Medical Center, Inc. (Bankr. C.D.Cal., May 15, 2017, No. 1617463), Judge Ernest M. Robles wrote that the grant of oversight and approval authority given to California’s Attorney General over buy/sell and change-in-control transactions between nonprofit sellers of health facilities and for-profit buyers of health facilities (see, California Corporation Code Section 5914 (Section 5914)) is limited to those situations in which a nonprofit seller has an active California health facility license at the time of closing. As written by Judge Robles, the Gardens Decision concludes that transactions between nonprofit sellers and for-profit buyers fall outside the scope of Section 5914 if the assets at hand do not include an operating, California-licensed health facility. As a nonoperational, unlicensed health facility, the transaction at issue is not a health facility transaction subject to Section 5914 and, in turn, Attorney General oversight and approval.

The Gardens Decision is currently being considered, discussed, and appealed for its conclusions regarding the California Attorney General’s ability to oversee and approve nonprofit/for-profit health facility transactions. Yet, the decision at the heart of the case—to close the hospital—was made by a debtor, Gardens Regional Hospital and Medical Center, Inc. (Gardens), without any consideration of how the closure of Gardens’ eponymous general acute care hospital (Hospital) would impact the Attorney General’s ability to exercise its Section 5914 oversight and approval authority in the event of a future change-of-ownership or change-in-control transaction between Gardens and a for-profit entity.

According to Gardens, the decision to terminate Hospital operations resulted from Gardens’ realization that, with no remaining Hospital operating funds, and a lack of willing lenders to provide Gardens with new financing to continue Hospital operations, it had no choice but to cease Hospital operations, close and lock the Hospital’s doors, and request that its general acute care hospital license be placed in suspense by the California Department of Public Health.

And the Question is….

If the Gardens Decision has set forth a new option for nonprofit sellers and for-profit buyers to negotiate and close health facility transactions without Attorney General oversight and approval, the proper inquiry at the outset of negotiations between a nonprofit seller and a for-profit buyer is:

Are the benefits that may arise from avoiding Attorney General oversight and approval of health facility transactions greater than the unavoidable difficulties and financial consequences of closing a health facility?

Gardens Regional Hospital and Hospital – The Abridged Edition

The Hospital, as owned and operated by Gardens, was a 137-bed facility with an intensive care unit, a cardiac unit, and an emergency department, located in Hawaiian Gardens, California. When operational, the Hospital served a patient population that included a significant number of California Medicaid (Medi-Cal) beneficiaries, uninsured/under-insured patients, and indigent patients. In June of 2016, facing financial difficulty, Gardens commenced a voluntary Chapter 11 case. The following month, after Gardens went through a multi-day auction process, the Bankruptcy Court approved the sale of the Hospital to one of the Hospital’s bidders—a for-profit entity.

As required by Section 5914, Gardens submitted the proposed sale transaction to the Attorney General for review and approval. The Attorney General approved the sale subject to specific conditions, including a requirement that the buyer provide $2.25 million per year in charitable care for six years—a significant increase above the amount of charity care historically provided by the Hospital, as well as by similarly-situated community hospitals.   As a result of this and other conditions applied by the Attorney General to the for-profit buyer, the acquisition cost to the buyer effectively increased over $20 million; the buyer walked away from the transaction.

In January of 2017, the Court granted an emergency motion to close the hospital based upon the Court’s finding that Gardens’ ongoing financial struggles could potentially place the Hospital’s patients at risk. By February of 2017, all patients had been discharged from the Hospital and/or transferred to alternate facilities. Notwithstanding the negative financial impact on any future Hospital sale transactions (e.g., the loss of the Hospital’s value as a going concern), Gardens decided to close the Hospital and place the Hospital’s general acute care license in suspense. With the Hospital closed, Gardens sought to sell off its Hospital assets—including the building lease, the suspended license, furniture, and inventory—without Attorney General oversight.

The Bankruptcy Court and the Gardens Decision

As described in the Gardens Decision, the Attorney General contended that, by permitting the sale to proceed without Attorney General oversight and approval, the sale would encourage other health facilities to temporarily cease operations in order to evade regulatory oversight—thereby defeating the public health benefits envisioned by Section 5914. The Court countered that since the Hospital assets at issue suffered a significant loss in value (see above), “it defies credulity to assume that other nonprofit hospitals would voluntarily close to escape the Attorney General’s review of a sale, when closure results in such significant value destruction.” Further, the Court concluded that the Attorney General’s position, “ignores the reality that closing a hospital is time-consuming, costly, and requires fastidious planning.” Finally, the Court asserted that its ruling did not conflict with the legislative intent of Section 5914 because, “with [Gardens’] charitable assets being exhausted, nothing remains to be protected by the Attorney General.”

The Attorney General has filed an appeal with the U.S. District Court for the Central District of California to overrule the Gardens Decision and the Bankruptcy Court’s conclusion that the closed Hospital did not qualify as a health facility. In re Gardens Regional Hospital and Medical Center, Inc., Docket No. 2:17-cv-03750 (C.D. Cal. May 18, 2017).

The Balancing Act – Avoiding Attorney General Oversight and Approval v. Accepting a Reduction in the Seller’s Asset Value

Before deciding to relinquish or suspend a health facility license to avoid the Attorney General’s oversight and approval authority as set forth in Section 5914, the nonprofit seller and the for-profit buyer must consider such a strategy’s costs and benefits.

The Benefits

If the parties to such a health facility transaction are willing to relinquish or suspend the hospital’s license and terminate hospital operations prior to the time of closing, the nonprofit seller and the for-profit buyer will not have to enter into the often protracted negotiations with the Attorney General and will not have to accept the often onerous ongoing requirements that the Attorney General may impose on the buyer to get approval for the buyer’s acquisition of the hospital assets.

The Attorney General posts its most recent decisions granting conditional consent to nonprofit hospital transactions on its website at https://oag.ca.gov/charities/nonprofithosp. Although a review of past Attorney General decisions shows that the Attorney General develops unique conditions to address every transactions’ distinct facts and circumstances, there are common Attorney General consent conditions that are routinely applied for a period of five to ten years after the close of a transaction. For example, the Attorney General often imposes the following conditions on buyers:

1. Maintain the facility as a general acute care hospital and continue certain specialty services deemed essential (e.g., emergency medical services);
2. Provide a minimum amount of charity care and community benefit services;
3. Participate in the Medicare and Medicaid (Medi-Cal) programs;
4. Comply with any capital investment commitments in the Definitive Agreement; and/or
5. Submit yearly compliance reports to the AG.

The application of the above conditions, as well as any unique conditions that the Attorney General may apply on a case-by-case basis, may compel a buyer to demand purchase price reductions and other concessions from the seller in order to close a transaction. As in the case of Gardens, such reductions and/or concessions may cause either the seller or the buyer to walk away from the transaction.

In order to avoid the imposition of such Attorney General conditions, as well as the financial hits that often come from such conditions, the parties may conclude that avoiding Attorney General conditions—in Gardens style—may be the best way to ensure that the parties consummate the transaction.

The Detriments

If the parties to a transaction decide to walk down the Gardens path, the seller will need to undertake an onerous hospital closure process as required under California law. For example, the State-mandated closure process includes: (i) submission of a written notice to CDPH and to the public at least 30 days prior to hospital closure; (ii) participation in public hearings; (iii) transfer of all hospital patients to appropriate health facilities prior to closure in accordance with CDPH regulations and policies; (iv) submission of written notices to all hospital patients regarding the impending hospital closure and the procedures to be implemented by the seller for the transfer of hospital patients; and (v) numerous other requirements made necessary under California law. In addition to the foregoing, before a seller decides to close its hospital in order to avoid Attorney General oversight and approval, the seller must balance the potential negative financial impact that may result. For example, if the hospital is closed prior to the sale transaction, the value of the hospital assets may be significantly diminished based on the hospital’s nonoperational status. In the present case, Judge Robles acknowledged that the Hospital assets suffered an approximately $8 million loss in value as a result of the Hospital closure.

Balancing the Benefits and the Detriments

This balancing of potential financial impacts of the acceptance or avoidance of Attorney General oversight and approval will undoubtedly prove difficult for the parties to a health facility transaction—whether done in the bankruptcy context or otherwise. Prognostication is always a tricky business, even with the best of expert advice and guidance. Nevertheless, it is worth considering whether, after the Gardens Decision, a decision to avoid the Attorney General’s oversight and approval at the outset of a transaction will create the same level of risk that Gardens experienced.

In the Gardens case, Gardens submitted notification to the Attorney General and, as a result of the Attorney General’s conditions, Gardens eventually decided to close the Hospital to avoid the ongoing costs of Hospital operations and to avoid the Attorney General’s participation in a subsequent transaction. Because of the foregoing, the Attorney General’s attention was already focused on Gardens when Gardens determined that there was no need to notify the Attorney General regarding the subsequent asset sale. Moreover, it is worth noting that even if Gardens had not submitted the notification, the Attorney General would have likely been aware of the situation through its review of bankruptcy notifications and filings on a routine basis.

If the seller to a nonprofit/for-profit transaction decides to suspend or terminate its hospital license at the beginning of a transaction, the Attorney General will not be on notice of the proposed transaction. This fact may prevent the Attorney General from asserting its authority over the transaction under Section 5914.  Therefore, the parties and the transaction may not be subject to the same level of Attorney General scrutiny in the case of Gardens.

Conclusion

Is the lack of Attorney General oversight reason enough to pursue the Gardens’ course of action? No, but the Gardens Decision may tip the scales in favor of the termination or suspension of a hospital’s license to avoid the potential pitfalls associated with Attorney General review.

The ultimate decision for buyers and sellers in healthcare transactions rests in significant part on the ultimate results of the Gardens Decision’s pending appeal. Nevertheless, the Gardens Decision, as it stands today, creates an option that may have not been considered by nonprofit sellers and for-profit buyers before its issuance.