Lessons from the Bradford Case on Structuring Acquisitions
By Jim Pinna, Hunton & Williams LLP, Richmond, VA and Elliott Jeter, VMG Health, Dallas, TX
United States ex rel. Singh v. Bradford Regional Medical Center involved a qui tam action brought by physician relators against Bradford Regional Medical Center (“BRMC”) and a local physician group and its physician owners (collectively, the “Physicians”) relating to a nuclear camera sublease arrangement (the “Sublease”) between BRMC and the Physicians.1 In its opinion, the court concluded that the Sublease created financial relationships between the parties that did not meet an exception under the federal Ethics in Patient Referrals Law (the “Stark Law”) and resulted in prohibited referrals by the Physicians to BRMC under the Stark Law. Central to this conclusion was the court’s determination that payments under the Sublease, which included substantial amounts attributable to a noncompete agreement, took into account the volume and value of referrals by the Physicians and were not fair market value (“FMV”). As discussed below, the Bradford case raises significant issues to be considered in structuring and valuing acquisitions of physician-owned ancillary businesses.
The Sublease and the Valuation Report
BRMC entered into the Sublease with the Physicians to lease the nuclear camera to provide nuclear imaging services for BRMC patients in response to the competitive threat of the Physicians using the camera to provide nuclear imaging services through their medical practice. The Sublease included a noncompete agreement that prohibited the Physicians from competing with BRMC’s nuclear imaging services during the term of the Sublease. BRMC paid the Physicians $6,545 per month for the lease of the camera (reflecting the amount paid by the Physicians to lease the camera from General Electric) and $23,655 per month for the noncompete under the Sublease.2
Before entering into the final version of the Sublease in October 2003, BRMC engaged an accountant to perform an assessment to determine whether BRMC was paying FMV under the proposed Sublease.3 The accountant’s report concluded that the amounts payable under the Sublease for the lease of the camera and the noncompete reflected FMV.4 To reach this conclusion, the accountant used the “Competitive Business Valuation Method” to analyze the FMV of noncompete payments. To apply the Competitive Business Valuation Method, the accountant first compared estimated cash flows to BRMC for nuclear imaging and related services with the noncompete versus estimated cash flows without the noncompete to determine the benefits of the noncompete, and then compared the present value of those benefits to the present value of the noncompete payments.5
The accountant’s calculation of economic benefits of the noncompete included anticipated revenues for CT/MRI, inpatient and outpatient services “based on the assumption that the Physicians would likely refer this business to the Hospital in the absence of a financial interest in their own facilities or services, although they are not required to do so by virtue of any of the covenants contained in the Agreements or otherwise.”6 Based on the foregoing analysis, the accountant estimated that the present value of benefits from the noncompete exceeded the present value of noncompete payments by approximately $3,794,000, and thus supported the conclusion that the noncompete payments were FMV consideration for the noncompete.7
The Court’s Analysis
In its analysis, the court concluded that the Sublease created an indirect compensation arrangement between BRMC and the Physicians that did not meet an exception under the Stark Law. To reach this conclusion, the court examined whether compensation under the Sublease varied with, or otherwise took into account, the volume or value of referrals from the Physicians to BRMC to determine whether such compensation created an indirect compensation arrangement and whether such compensation was FMV for purposes of the Stark Law.
Although payments under the Sublease were fixed and did not vary up or down with referrals, and nothing in the Sublease required the Physicians to refer to BRMC, the court found that the accountant’s report and other evidence analyzing projected benefits of the noncompete indicated the noncompete payments took into account anticipated referrals by the Physicians and thus resulted in an indirect compensation arrangement between the parties.8 In analyzing whether such payments were FMV, the court noted that “fair market value” is specifically defined under the Stark Law as “the result of bona fide bargaining between well-informed parties to the agreement who are not otherwise in a position to generate business for the other party. . . where the price or compensation has not been determined in any manner that takes into account the volume or value of anticipated or actual referrals.”9 Even absent a valuation opinion from the relators to challenge the report of BRMC’s accountant, the court was able to conclude that compensation under the Sublease was greater than what would be paid in the absence of the ability of the Physicians to provide referrals to BRMC and was inflated to compensate the Physicians for their ability to generate revenues for BRMC.10 Thus, the noncompete payments were not FMV for purposes of the Stark Law because the amount of such payments was arrived at by taking into account anticipated referrals of the Physicians.
The Bradford decision underscores the complexity in valuing noncompetes and other intangible assets. While there is inherently some subjectivity and judgment in the valuation of intangible assets, there are widely accepted methodologies designed to assist the valuator in assessing the value of intangible assets. The proper application of these valuation methodologies by a valuator that understands the regulatory framework surrounding healthcare transactions helps to ensure that the transaction complies with the Stark Law and Anti-Kickback Statute.
The Competitive Business Valuation Method is a widely accepted methodology for analyzing the value of a noncompete in the context of a larger assemblage of assets and, when properly applied, will yield a useful and separable noncompete value in relation to the larger transaction.11 To apply this method, the valuator must subjectively assess the economic damage to the buyer if the seller were allowed to compete. In order to quantify this scenario, the earnings (not revenues) of the business purchased (in the Bradford case, only the earnings derived from the nuclear camera) should be compared to the expected earnings, assuming no competition by the seller. The damages to the business are calculated as the present value of the after-tax earnings lost from competition. The result of the Competitive Business Valuation Method must confirm or fit into the context of the overall purchase price for the business. For example, if the total enterprise value of the business was $100, the logical FMV of the noncompete would be significantly less than $100 after accounting for the value of working capital, fixed assets and other identifiable intangible assets included within the enterprise value.
Although not addressed by the court in its opinion, there were several ways in which the accountant in the Bradford case misapplied the Competitive Business Valuation Method:
- The accountant did not analyze the noncompete within the context of the enterprise value or assemblage of assets of a larger acquisition transaction because there was only a lease. However, the Competitive Business Valuation Method contemplates the valuation of a noncompete between a buyer and a seller of a business in which the seller is restricted from competing with the buyer of the business.12
- The accountant’s calculation looked at total revenues without including operating expenses. However, the Competitive Business Valuation Method requires the valuator to look at projected earnings of the business discounted to present value.13
- The accountant’s calculation included revenues outside of the nuclear camera business. However, the Competitive Business Valuation Method only examines potential damages to the acquired business resulting from competition.14
Lessons from Bradford
Pressures from health reform, declining reimbursement and rising costs have increased the integration of physician-owned ancillary businesses into hospitals and health systems. Some may be coupled with physician employment, while others may be independent acquisitions of in-office diagnostic or surgical services. These integrations pose unique regulatory challenges. Healthcare providers and their advisors are well served to consider the implications of the Bradford case in the context of the overall regulatory framework when structuring and valuing these transactions, particularly with regard to the structure of a transaction, the commercial reasonableness of the arrangement and the regulatory context for determining FMV.
One of the problems in the Bradford case was that BRMC structured what would typically be an acquisition as an equipment lease. While allocation of value for intangible assets such as noncompetes may be common in acquisitions as a component of the overall transaction, they are rarely applicable to leasing arrangements. Moreover, paying for intangible assets over time (through monthly lease or installment payments) increases the risk that such payments may be linked to a continued expectation of referrals.
The fact that BRMC was essentially stepping into the shoes of the Physicians with respect to their lease of the nuclear camera from General Electric called in question the commercial reasonableness of having BRMC sublease the equipment from the Physicians rather than just assuming the lease with General Electric. When evaluating the commercial reasonableness of acquisitions of physician-owned ancillary businesses, it is important to consider whether the location and services of the acquired business are well suited for integration and can provide services for the larger patient base of the purchaser, or if the purchaser will have to relocate or restructure the business, and whether acquiring the business is more cost-effective than developing an independent facility, buying equipment, recruiting staff, incurring start-up losses and competing with physicians.
When considering FMV in the context of acquisitions of physician-owned ancillary businesses, traditional valuation methods may not always comport with the prescriptions of the Stark Law and Anti-Kickback Statute. Parties unfamiliar with the limitations imposed by the Stark Law and Anti-Kickback Statute might normally expect the purchase price paid to physician sellers to account for potential revenues from anticipated referrals. But under the regulatory framework of the Stark Law and Anti-Kickback Statute, anticipated referrals must be excluded from the determination of FMV when the transaction involves parties in a position to refer to one another.
An issue raised by the Bradford case is whether payments for intangible assets (such as noncompetes) may be construed as taking into account the volume or value of referrals from physician sellers when the FMV of such intangible assets is determined based on a discounted cash flow valuation and projected cash flows reflect referrals from physician sellers. Generally accepted valuation standards require the valuator to consider all appropriate valuation approaches, including the asset approach, the income approach (or discounted cash flow approach) and the market approach.15
For a business that generates positive cash flows, generally accepted valuation standards indicate the income approach must be considered and, in many cases, is the preferred approach.16 Under the income approach, it is important that FMV is determined using projected cash flows that reflect the ability of the business to continue generating cash flows in the absence of any obligation of physician sellers to continue referring to the business. The risk that physician sellers will no longer refer should be accounted for in growth rates and the discount rate applied to projected cash flows. This risk will be higher, and the FMV will be lower, if physician sellers are the primary or only source of referrals to the business. Assuming the income approach appropriately accounts for the risk that physician sellers will no longer refer to the business, arguably there will be no consideration tied to anticipated referrals from physician sellers. Interpreting the Bradford case to require that the income approach be disregarded when it includes projected cash flows that reflect referrals from physician sellers could actually lead to a non-FMV purchase price. For example, if a physician-owned ancillary business was sold to another physician-owned entity based on a tangible asset valuation of $100 but was worth $500 based on the income approach, the physician sellers could be construed as giving a discounted purchase price in exchange for referrals from physician owners of the purchaser.
The Bradford case presents a unique case study of the pitfalls to be avoided in structuring and valuing acquisitions of physician-owned ancillary businesses. Healthcare providers and their advisors should take note of the Bradford case and the lessons therefrom when considering the appropriate structure for a transaction, the commercial reasonableness of the arrangement and the regulatory context for determining FMV.
The Health Law Section is hosting a webinar "The Bradford Case: Lessons Learned on Structuring and Valuing Acquisitions of Physician Ancillary Businesses," on October 20, 2011.
752 F. Supp. 2d 602 (W.D. Pa., 2010). Litigation in the Bradford case is ongoing and no appeals have been filed as of the date of this article.
|2 ||Id. at 610.|
Day Report at 13.
Day Report at 17.
Day Report at 18.
|8 ||752 F. Supp. 2d at 623.|
42 C.F.R. § 411.351.
752 F. Supp. 2d at 633.
|11 ||See e.g., Robert F. Reilly & Robert P. Schweihs, Valuing Intangible Assets, 400-09 (1999); IRS Coordinated Issue All Industries Covenants Not to Compete (February 19, 1996); Ansan Tool v. Commissioner, T.C. Memo 1992-121.|
Reilly & Schweihs at 400.
Id. at 402.
See e.g., National Association of Certified Valuation Analysts Professional Standards, Section 3.7; American Society of Appraisers Business Valuation Standards BSV-I, Section IV; American Institute of Certified Public Accountants Statement on Standards for Valuation Services No. 1, paragraph 31.
See e.g., Shannon P. Pratt, Robert F. Reilly & Robert P. Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 40 (4th Ed., 2000).
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