Gone are the days when funding a new wing at a hospital was enough to earn someone a seat on its board of directors. To compete with their for-profit competitors, today's not-for-profit hospitals and systems require financially savvy directors who realize that doing good in the community is not enough to keep a hospital afloat.
In an increasingly litigious environment marked by several high-profile hospital bankruptcies, greater state involvement in hospital closures and increasingly aggressive creditors, hospital board members more frequently are a target of blame for a hospital's financial demise, legal experts say.
The healthcare landscape is dotted with legal land mines for directors involving their potentially contradictory responsibilities when a hospital is in financial trouble.
"On the one hand, they have the charitable mission, a duty to run this place like a hospital," says Michael Peregrine, a healthcare lawyer with Gardner, Carton & Douglas in Chicago. "But they also have to think of the interest of creditors. It's a perplexing challenge."
If a hospital is approaching insolvency, should a board be focusing on how to continue to provide care for its community? Should it be doing what is best financially for the corporate owner of the hospital? Or should it be concentrating primarily on how to bring in the most cash to pay its creditors? As it turns out, the answers to these fundamental questions are about as clear as mud and vary from state to state, legal experts say. Furthermore, directors may be unaware of impending problems or may not deal with problems until it is too late to make strategic decisions that can satisfy all those involved.
Take the example of the 30-bed Manhattan Eye, Ear and Throat Hospital, which tried to exit the acute-care business and sell its real estate assets for $41 million several years ago, only to be challenged in the courts by New York Attorney General Eliot Spitzer. In December 1999, the New York Supreme Court prohibited the hospital's board of trustees from going forward with the deal, despite six months of deliberations, the hiring of a financial adviser and consideration of alternative bids. The reason, according to Justice Bernard Fried, was that the board breached its fiduciary responsibilities by not considering competing offers that would have allowed the hospital to continue its mission as a specialty facility (Dec. 13, 1999, p. 10).
"The question that was raised in the Manhattan Eye, Ear and Throat case is a question that could easily recur," says John Aerni, the lawyer who represented the hospital. "Ultimately, the judge in our case said directors have a duty to maintain the mission of the not-for-profit, even if that mission has been met or the mission no longer makes any sense."
In a January report on trustee responsibilities that touched upon the decision involving the Manhattan hospital, investment banking firm Cain Brothers said the ruling shows how important it is that the full board of a hospital be involved in the process involving any merger or acquisition. The analysis also suggested boards review the fees paid to advisers, give full consideration to alternative proposals and document the process in case it is challenged.
Peregrine says the executives-particularly the chief financial officer-of any hospital that has suffered significant bond-rating downgrades or could see insolvency looming should draw the attention of the board to these kinds of perplexing possibilities sooner rather than later. Some recent bankruptcy cases and state attorney general actions, he says, indicate that directors of not-for-profits may be held up to the same standards of oversight that apply to for-profit directors, and that they even may be personally liable for any failure to address problems that lead to their hospital's financial distress.
The largest and one of the most highly publicized healthcare bankruptcies, the July 1998 filing by Allegheny Health, Education and Research Foundation, provides another example of a board's conflicting obligations.
Peregrine says one of the lessons likely to be drawn from AHERF-once the dust settles from the tangle of pending litigation-is the acknowledgment that directors may face conflicts of interest as hospitals shift into what he calls a "zone of insolvency" that arises when the hospital can no longer pay its debts, and not necessarily when it files for bankruptcy protection. At that point, which is often difficult to define, board members are legally bound to shift their fiduciary responsibility from the corporation's interests to those of its creditors, Peregrine says.
But in the AHERF case, not all of the hospitals in the system were part of the bankruptcy filing, and board members who found themselves representing the hospitals that weren't losing money had different fiduciary interests from those representing the hospitals that were losing money. In some cases the various AHERF organizations had some common directors. As a result of the bankruptcy, Peregrine says, these directors suffered irreconcilable conflicts of interest because they were charged with satisfying claims of the creditors while at the same time fulfilling the charitable mission of the corporation.
Pennsylvania Attorney General Mike Fisher sued several former executives and trustees of AHERF, seeking repayment of $78.5 million in funds allegedly diverted from restricted charitable assets to keep the financially troubled system afloat (Feb. 28, 2000, p. 12).
The threat to a not-for-profit hospital's endowment when it approaches insolvency brings board members into the fray, Peregrine says.
"There's a need to put protections in to cordon off restricted gifts and endowments so they can't be accessed for inappropriate use," he says, "so the board couldn't even by accident tap into those funds for operating purposes. That's something people can do right now."
Bernard Katz, a partner at Roseland, N.J.-based J.H. Cohn, an accounting and consulting firm that has advised both creditors and financially strapped hospitals, says the way to deal with such situations is to establish guidelines for board members so they cannot bury their heads in the sand.
Katz's firm represented unsecured creditors of South Fulton Medical Center in East Point, Ga., which filed for bankruptcy protection in April 2000.
"The board did not police management appropriately, and as a result, the hospital ultimately had to file a Chapter 11" bankruptcy petition, Katz says. "There we believe that if people had been watching, they may not have had to file a Chapter 11 to fix their problem" (March 19, p. 36).
James Schwartz, a partner at Manatt, Phelps & Phillips, Los Angeles, who has represented not-for-profit systems, says board members' shifting duties during insolvency will likely become a major issue in coming years. It could hit California especially hard as hospitals struggle to find the capital to comply with the state's seismic retrofitting mandates, he says.
"An awful lot of hospitals are looking at that situation, and to my knowledge, nobody has been giving them much guidance," he says.
Still, there are ways boards can practice better preventive medicine, says Karma Bass, director of research and publications for the Governance Institute in La Jolla, Calif.
Board members should insist on financial information and reports that inform them on strategic issues, possibly in a "dashboard" format that provides two to five pages of indicators that show various revenue trends for both immediate and long-term periods. These reports, which should alert them to any problems down the road, should be different in format from those that hospital managers use to do their jobs, she says.
Various types of decision-support software also can help boards plug in their numbers to help determine whether they should be looking at selling a facility or whether they have enough resources and patient volume to stay open during times of financial hardship.
"Unfortunately, what happens in many cases is that boards are not aware there's a problem until it's far too late," Bass says. "If things are going on and you're being informed about them after the fact, that should be a red flag. As a board member, you want to ask a lot of questions and make changes, or you want to get off that board."