MERGERS, ACQUISITIONS AND REORGANIZATIONS
OF
COMPLIANCE DUE DILIGENCE – HOW TO SATISFY
THE BOARD
AND UNDERWRITERS THAT IT IS A GOOD DEAL
Presented at the Health Care Compliance
Association’s 2000 Compliance Institute
New Orleans, LA
September 26, 2000
Karl
A. Thallner, Jr. is a partner in the Philadelphia office of Reed Smith Shaw
& McClay LLP, where he heads the firm’s Philadelphia health care law
practice. Mr. Thallner’s practice is
focused on providing business and regulatory advice to hospitals and other
clients in the health care industry, including assisting on compliance with the
federal Anti-Kickback Law and Stark II.
He is a member of American Health Lawyers Association and other health
industry professional associations. Mr.
Thallner graduated cum laude from the
Dickinson School of Law in 1986, where he served on the Editorial Board of the Dickinson Law Review. He also received an M.S. degree in chemical
engineering from Carnegie-Mellon University in 1982, and earned his B.A. degree
cum laude from Gettysburg College in
1980. He can be contacted by phone at
215-851-8171 or by e-mail at KThallner@ReedSmith.com.
Kathleen
McDermott is a partner in the Health Care Department of Blank Rome Comisky
& McCauley, LLP, where she represents health care providers on health care
enforcement and compliance issues, including investigations under the False
Claims Act and its whistleblower provisions.
Ms. McDermott served as an Assistant U.S. Attorney and Health Care Fraud
Coordinator for the U.S. Attorney’s Office in Maryland from 1991-1999, where
she was responsible for coordinating the health care fraud task force. She has conducted investigations involving
hospitals, nursing homes, laboratories, physicians, suppliers, home health
agencies, ambulances and other health care providers. Ms. McDermott has served on several enforcement policy committees
in Washington, including the FBI Health Care Fraud Working Group and the
Attorney General’s Advisory Health Care Fraud Subcommittee. She lectures extensively fraud and abuse
issues and can be reached at 410-659-3957, and mcdermott-k@blankrome.com.
MERGERS,
ACQUISITIONS AND REORGANIZATIONS OF
COMPLIANCE DUE DILIGENCE – HOW TO SATISFY THE BOARD
AND UNDERWRITERS THAT IT IS A GOOD DEAL
Karl A. Thallner, Jr.
Partner, Reed Smith Shaw &
McClay (Philadelphia)
Kathleen McDermott
Partner, Blank Rome Comisky
& McCauley (Baltimore)
I.
OVERVIEW OF DUE DILIGENCE
A.
Background.
Consolidation and integration activity in the health care industry has
continued for much of the last decade.
This activity has been spurned by a number of factors. The prospect of increasing managed care
penetration, for example, caused hospitals to acquire physician practices and
other health care businesses in order to be able to contract with managed care
organizations on a risk-assuming basis.
In addition, reduced revenue due to governmental and managed care
payment cuts has forced many to come together to seek to capitalize on
economies of scale. Search for
additional revenue has also prompted health care providers to pursue synergies
with others engaged in complementary lines of business. The internet and technological advances have
forced health industry players to rethink the future of their businesses and
acquire necessary skills. In many
cases, the purchasers of health care businesses have limited experience with
the types of businesses that they are buying, and sometimes only limited
experience with the health care industry.
B.
Compliance
Due Diligence. More recently, the issue of due diligence
has taken an urgent turn in response to government investigations of health
care providers, particularly publicly-traded health care companies. Many of the major False Claims Act
settlements of the last several years have been executed by successor in
interest corporations that inherited compliance or potential fraud issues in an
acquisition transaction. For example,
many of the LabScam settlements had successor liability issues. Media reports on the record breaking $486
million Fresenius Medical Care settlement referenced conduct by a
predecessor corporation. In the past,
due diligence reviews frequently have discounted any real compliance evaluation
to the detriment of the successor corporation.
Today, the issue of compliance due diligence is not simply an issue of
indemnification negotiation between the transacting parties. Financial institutions and syndicates
financing health care transactions may conduct their own compliance due
diligence as a condition of financing a particular transaction.
C.
What is
Due Diligence?
1.
Definition.
Due diligence is the process whereby a buyer of a business seeks to
obtain relevant information about the business being purchased.
2.
Purposes.
The principal purposes of conducting due diligence are:
a.
To protect
the buyer’s Board of Directors, who must fulfill fiduciary obligations. In In re Caremark, the Delaware
Chancery Court’s opinion dated Sept. 25, 1996 approving the settlement of a
derivative action, the court concluded that a director does have a general duty
to ensure that a company has effective compliance and control systems and that
the failure to do so could, at least under some circumstances, “render a
director liable for losses caused by non-compliance with applicable legal
standards.”
b.
To enable
the buyer to determine the risks associated with completing a transaction. For example, will problems with the seller’s
pre-closing activities subject the buyer to post-closing liabilities?
c.
To enable
the buyer to assume operation of the business as efficiently and with as little
disruption as possible.
d.
To enable
the buyer to identify particular issues to be addressed in the definitive
agreement for the transaction.
e.
To enable
the buyer to confirm that the value of the business is consistent with the expected
purchase price.
f.
To uncover
information that would affect the structure of the transaction or its decision
to proceed with the transaction.
3.
Categories
of a buyer’s due diligence investigation.
a.
Categories
by Discipline.
(1)
Legal.
(2)
Financial.
(3)
Operational.
b.
Examples of
Areas of Investigation.
(1)
Areas of
particular interest in health industry transactions.
(a)
Regulatory,
Reimbursement, Tax, Financing (see below).
(b)
Payor
contracts.
(2)
Other
areas: Corporate and Business Law, Real
Estate, Litigation, Employment/ERISA, Environmental.
4.
Who is
Involved?
a.
Businesspersons
and administrative personnel of buyer.
b.
Lawyers.
c.
Accountants.
d.
Other
consultants (e.g., billing and
environmental).
e.
Compliance
officers.
5.
Scope.
Many wasted dollars have been spent as lawyers and consultants spend
time conducting unnecessary due diligence.
Due diligence dollars should not be viewed as infinite; rather, the due
diligence effort should be focused on investigating the areas that will have
the greatest effect on achieving the purposes of due diligence, and foregoing
due diligence that will not be relevant to those purposes.
a.
Importance
of Knowing the Business.
b.
Importance
of Understanding the Audience.
c.
Importance
of Prioritizing the Areas of Investigation.
6.
Timing.
Almost invariably, a buyer will want to have completed its due diligence
before it is bound to enter into the transaction. This will mean either that the due diligence must be completed
prior to the time that the parties enter into a definitive binding agreement,
or that the definitive binding agreement contain a condition to the buyer’s
obligation to close the transaction that the due diligence investigation be
completed to the buyer’s satisfaction.
Sellers will often object to the latter approach, since it effectively
leaves the buyer with an option.
7.
Allocation
of Responsibility.
a.
Among buyer
and its advisors.
b.
Between
buyer (and its advisors) and seller (and its advisors).
D.
Relationship
Between Due Diligence and the Transaction.
1.
Effect
of Structure.
a.
Asset
Purchase. In an asset purchase transaction, a buyer
generally does not automatically become responsible for the liabilities of the
seller; rather, the buyer becomes liable
for only those obligations that it contractually assumes. (There are some exceptions to this rule,
such as in the products liability, environmental and reimbursement (see
discussion below) areas, and where necessary to protect creditors (fraudulent
conveyances, bankruptcy).) Accordingly,
the buyer’s concern about non-recurring pre-closing liabilities may be reduced.
b.
Merger.
In a merger, the selling corporation and the buying corporation (or a
related corporation) are merged into one entity, with the separate existence of
one corporation ceasing and the existence of surviving corporation
continuing. As a result of a merger, the surviving corporation automatically
inherits all of the assets and liabilities of the other corporation. Therefore, a buyer’s concern about the
pre-closing operations of the selling corporation is heightened.
c.
Stock
Purchase or Transfer of Corporate Membership. A for-profit
business owned by a corporation can be sold through means of the sale by the
stockholders of the stock of the corporation.
Similarly, control of a nonprofit corporation can change as a result of
the transfer of corporate membership.
In either case, the existence of the corporation that owns the business
continues, and, therefore, the
corporation continues to own the assets it owned prior to closing and to be
responsible for the liabilities relating to the pre-closing operation of the
business.
2.
Effect
on Price. A buyer’s due diligence may uncover
information about the seller’s business that may affect the amount that the
buyer is willing to pay for the business, such as that revenues may not be
sustainable or that the buyer may inherit a material liability of the seller
(or a risk of such a liability).
3.
Effect
on Transaction Documents.
a.
Representations
and Warranties.
b.
Indemnification.
c.
Closing
Conditions.
4.
Third
Party Consents.
a.
Governmental
Authorities. The approval of some governmental
authorities may be necessary for a transaction to be completed. Examples include:
(1)
State
Licensing (see below).
(2)
Medicare/Medicaid
Certification (see below).
(3)
Hart-Scott-Rodino
(e.g., antitrust approval/compliance
and review).
(4)
State
Regulation of Charitable Organizations.
(5)
Bulk
Sales/Tax Clearance.
b.
Private
Parties. The consent of private parties with whom a
seller has a contractual relationship may be required for the completion of a
transaction. Examples of private
parties, the failure to receive the consent of which may have a material
adverse effect on the business, include:
(1)
Lenders
(see below).
(2)
Managed
Care Organizations.
(3)
Licensors
of Intellectual Property (e.g.,
computer software).
(4)
Lessors of
Real Estate or Medical Equipment.
E.
Due
Diligence Process.
1.
Due
Diligence Request List. Often, a prospective purchaser will prepare
and submit to the seller a due diligence request list, which requests
documentation that the purchaser will want to review in connection with its due
diligence investigation. The Request
List is necessarily merely a starting point in identifying the material that
the purchaser will want to review, since information discovered in connection
with the negotiation and due diligence process may lead to further requests for
information. In the health care area,
the Request List may seek detailed information concerning the seller’s
compliance with health care regulatory and reimbursement issues. Article VI below contains some topics that
may be considered in developing a Request List for a health care transaction.
2.
Engaging
Non-Legal Consultants. The conduct of due diligence by a buyer may
uncover risks that will not affect the buyer’s decision to go forward with a
transaction, but which could be used against the buyer if discoverable. Some such information may be included in
communications between an attorney and a client or in work performed by an
attorney in anticipation of litigation, so as to be protected from disclosure
under the attorney client privilege or attorney work product doctrines. Where the buyer directly engages non-legal
consultants to assist in its due diligence, communications with such parties
will not be protected from disclosure under these doctrines. In some cases, it may be advisable for such
consultants to be engaged by the law firm to protect the confidentiality of
certain information.
3.
Preparation
of Due Diligence Report.
a.
Interim
Reports.
b.
Final
Report.
F.
Role of
Compliance Officers in Due Diligence.
1.
Substantive
Issues. Compliance officers often have specific
expertise in areas that should be a focus of due diligence.
a.
Review the
target company’s billing and coding practices.
b.
Examine the
target company’s financial relationships with referral sources or referral
recipients to ensure compliance with federal and state Anti-Kickback Law and
Self-Referral (“Stark”) laws (see below).
c.
Determine
the target company’s compliance with applicable licensure/certification laws
(see below).
2.
Investigate
Target Company's Compliance Program. Actually investigate and assess the effectiveness
of the target company's compliance program to evaluate the strengths and
weaknesses of the program and identify potential compliance problems.
3.
Integration
of Compliance Programs. Prior to the acquisition, plan for the
integration of target company’s compliance program into that of the acquiring
company.
II.
SELECTED REGULATORY DUE DILIGENCE ISSUES
A.
A critical
first step is to identify the particular compliance issues associated with the
businesses of the target company. In
addition to the acquiring company’s own experiences (if it operates in the same
industry segment), valuable sources to identify compliance risk areas include
the OIG’s compliance guidance for the target company’s industry segment, OIG
fraud alerts, and recent enforcement activity by administrative agencies and
prosecutors.
B.
Kickback/Self-Referral
Issues. Among the areas that should be investigated
in nearly every health care acquisition is compliance with the federal
Anti-Kickback Law, the Stark physician self-referral law, and similar state
laws. All financial relationships
between physicians or facilities and potential referral sources or providers of
designated health services must be examined to ensure compliance with federal
and state law. Examination should
include confirmation of the services provided and fair market value of the
consideration. The types of
relationships that should be examined include:
1.
Leases for
space and equipment.
2.
Employment/independent
contractor relationships.
3.
Management/services
agreements.
4.
Loans.
C.
Federal
Anti-Kickback Statute (42 U.S.C. § 1320a-7b).
1.
Prohibits
soliciting, receiving, offering or paying remuneration directly or indirectly,
overtly or covertly, in cash or in kind in return for referring or inducing the
referral of patients, or the furnishing, arranging, leasing, purchasing,
ordering or recommending of any good, item, facility or service for which
payment may be made in whole or in part under a federal program.
2.
Statutory
Exceptions - Generally.
a.
Employees.
b.
Certain
reported discounts.
c.
Group Purchasing
Agent payments.
d.
Coinsurance
waiver by a federally qualified health center.
e.
Items or
services provided pursuant to an agreement with a Medicare contracting managed
care organization, or with a non-contracting risk bearing managed care
organization (new exception added in the Health Insurance Portability and
Accountability Act of 1996).
3.
Regulatory
Safe Harbors. If each element of the Safe Harbor is met,
payments made by that entity and accepted by a party will be deemed not to
constitute illegal remuneration.
However, failure to comply with a Safe Harbor does not necessarily mean
that the arrangement or conduct violates the Federal Anti-Kickback
Statute. Categories are:
a.
Large,
Publicly Traded Entity Safe Harbor.
b.
Small
Entity Safe Harbor.
c.
Space and Equipment
Rentals.
d.
Personal
Service and Management Contracts.
e.
Sale of
Practice.
f.
Referral
Services.
g.
Warranties.
h.
Discounts.
i.
Employees.
j.
Group
Purchasing Organizations.
k.
Waiver of
Beneficiary Coinsurance and Deductible Amounts.
l.
Increased
Coverage, Reduced Cost Sharing Amounts, or Reduced Premium Amounts offered by
Health Plans.
m.
Price
Reductions Offered to Health Plans.
n.
Practitioner
Recruitment.
o.
Obstetrical
Malpractice Insurance Subsidies.
p.
Investments
in Group Practices.
q.
Cooperative
Hospital Service Organizations.
r.
Ambulatory
Surgical Centers.
s.
Referral
Agreements for Specialty Services.
t.
Price
Reductions Offered to Eligible Managed Care Organizations.
u.
Price
Reductions Offered By Contractors with Substantial Financial Risk to Managed
Care Organizations.
D.
Stark.
1.
Federal
Physician Self-Referral Ban (“Stark”) (42 U.S.C. § 1395nn).
a.
Prohibits a
physician from making referrals to an entity in which he has a financial
relationship for the furnishing of designated health services paid for by
Medicare or Medicaid.
b.
Designated
Health Services include:
(1)
Clinical
laboratory services.
(2)
Radiology,
including MRI, CAT scans and ultrasound services.
(3)
Physical
therapy services.
(4)
Occupational
therapy services.
(5)
Radiation
therapy services and supplies.
(6)
Durable
medical equipment and supplies.
(7)
Parenteral
and enteral nutrients, equipment and supplies.
(8)
Prosthetics,
orthotics and prosthetic devices.
(9)
Home health
services and supplies.
(10)
Outpatient
prescription drugs.
(11)
Inpatient
and outpatient hospital services.
2.
“Financial
relationship” is defined to include both compensation arrangements and
ownership and investment interests.
3.
Exceptions
to both ownership and compensation prohibitions:
a.
Physicians'
Services (provided or supervised personally or within same group practice).
b.
In-Office
Ancillary Services.
c.
Prepaid
Plans.
4.
Ownership
Exception for Publicly Traded Securities and Mutual Funds.
5.
Additional
Ownership Exceptions.
a.
Hospitals
in Puerto Rico.
b.
Rural
Providers.
c.
Hospital
Ownership.
6.
Additional
Compensation Exceptions.
a.
Rental of
Office Space or Equipment.
b.
Bona Fide
Employment Relationships.
c.
Personal
Service Arrangements (including physician incentive plans).
d.
Remuneration
Unrelated to the Provision of Designated Health Services.
e.
Physician
Recruitment.
f.
Isolated
Transactions (including sale of practice).
g.
Certain Hospital
Group Practice Arrangements.
h.
Payments by
Physician for Items or Services.
E.
State
Anti-Kickback and Self-Referral (“Stark”) Laws.
Many
states also have anti-kickback and self-referral (“Stark”) laws covering all
payors.
F.
Regulatory/Licensure/Certification
Compliance.
1.
Obtain, in
as much detail as possible, information about the types of services provided
and the types of equipment used to provide those services.
2.
Research
facility licensing/certification/ reimbursement laws (federal/state/local) to
determine applicable licensing or certification requirements to services being
provided or equipment being used.
3.
Inquire
about and obtain copies of all licenses and certifications to determine current
compliance with applicable licensure/certification laws.
4.
Based on
the structure of the transaction, determine transferability of
licenses/certifications (generally not transferable and if transferable must
think about successor liability issues).
5.
Determine
process to obtain new licenses/certifications, whether must be acquired
pre-closing or can be acquired post-closing and the penalties for failure to
obtain the necessary licenses/certificates in a timely manner.
G.
Billing/Reimbursement
Compliance. Ensure billing/accounting expert review of
billing practices, determine potential problems, including potential
overpayments (i.e., any basis for
false claims actions, proper coding issues, medical necessity determinations)
and ensure that on a going forward basis all billing activities are conducted
properly.
1.
Reimbursement
Philosophy. Compliance due diligence should include a
random review of claims and/or charts to determine, fundamentally, whether the
reimbursement philosophy of the two companies differs and what exposure that
may create. Specifically, an audit of
claims to determine whether codes specific to the practice or business are
utilized in a similar manner that is also consistent with federal reimbursement
policy is essential. Does one
laboratory company bundle and the other unbundle claims for services? A compliance due diligence should attempt to
determine reimbursement philosophy before the transaction is completed.
2.
False
Claims Act. The greatest financial vulnerability in any
transaction from an enforcement perspective is potential False Claims Act liability
or unforeseen overpayment liability.
a.
Civil
Liability. Where an overpayment scenario is projected,
whether by disclosure or a compliance review, the potential for False Claims
Act exposure must be specially evaluated.
The civil False Claims Act, 31 U.S.C. 3729, et seq., imposes civil
liability for the submission of claims for payment, or the use of a statement
to obtain payment, where there is actual knowledge of the falsity of the
statement or claim, or there is deliberate ignorance or reckless disregard that
the claim or statement is false. In
addition, the False Claims Act provides for liability for conspiracy to submit
false claims. 31 U.S.C. 3729(a)(1) to
(a)(7).
b.
No
Intent Requirement. The
False Claims Act does not require specific intent to commit a violation and
provides for the lowest burden of proof-preponderance of the evidence. Damage provisions provide for treble damages
and imposes mandatory minimum penalties per false claim of $5,000 to $10,000
($5,500 to 11,500 for claims submitted after September, 29, 1999).
c.
Whistleblower
Provisions. The False Claims Act contains whistleblower
provisions that authorize private citizens to bring suit on behalf of the
United States and to share in the proceeds recovered as a result of the suit. 31 U.S.C. 3730(b). Whistleblowers may recover 15% to 30% of the proceeds, if the
jurisdictional and other requirements are met.
Whistleblower suits are the single greatest source of health care fraud
investigations against health care providers.
Many successor False Claims Act settlements involve a whistleblower, who
could be an employee of the predecessor.
III.
RESPONSES TO HISTORICAL COMPLIANCE
PROBLEMS
A.
Structuring
the Transaction to Minimize Impact. One possible response is to seek to minimize
the adverse affect on the acquiring company of compliance failures of the
target company.
1.
Successor
Liability. As discussed above, under state corporate
law, certain types of transactions result in successor liability. In addition, even where no successor
liability arises under state law (such as an asset acquisition), Medicare
principles may operate to hold the buyer responsible for pre-closing
overpayments and compliance deficiencies.
a. Certain transactions, such as a sale of stock or the merger of a corporation into a provider corporation are not regarded as a “change of ownership” for Medicare purposes. Both Medicare and state la