ABA Health eSource
August 2009 Volume 5 Number 12

Avoiding Valuation of Referrals - Interpreting OIG Advisory Opinion 09-09
By James Pinna, Hunton & Williams LLP, Richmond, VA

AuthorOnce again, this summer, the Office of Inspector General (“OIG”) has waded into the subject of ambulatory surgery center (“ASC”) transactions and disproportionate returns on invested capital. As many may remember, the OIG issued the somewhat controversial Advisory Opinion 07-05 in the summer of 2007, taking the surprising position that a hospital’s purchase at fair market value of ownership interests in an existing ASC from certain physician owners could potentially generate prohibited remuneration under the federal Anti-Kickback Statute (the “AKS”) 1 and that the OIG could potentially impose administrative sanctions on such transaction. 2 This result turned in part on the fact that the hospital and the physicians would not receive investment returns directly proportional to the dollar amount of their invested capital (although returns would be directly proportional to percentage ownership interests).

Advisory Opinion 09-09, posted by the OIG on July 29, 2009, takes the position that the independent development of ASCs by a hospital and a group of physicians and the merger of those ASCs into a joint venture could potentially generate prohibited remuneration under the AKS, but that the OIG would not impose administrative sanctions on such transaction. 3 Although the hospital and the physicians in this transaction may possibly receive investment returns that are not directly proportional to invested capital, the OIG concludes that the risk of abuse from such difference is low, in part because the valuation of the ASCs contributed to the joint venture is based on a tangible asset valuation. 4 More surprisingly, the OIG notes that, under certain circumstances, it might be concerned if the valuations of the ASCs are based on a cash flow analysis as opposed to a tangible asset valuation. 5

Before jumping to any conclusions based on this recent opinion, it is important for healthcare providers and their advisors to understand the unique structure of the transaction at issue. Moreover, despite this recent opinion from the OIG, a cash flow based valuation should still be considered a reliable valuation approach, and in many cases, the necessary approach to ensure that none of the parties to a transaction give or receive improper remuneration by transacting at other than fair market value (“FMV”).

Advisory Opinion 09-09 deals with a unique, multi-step transaction that appears intended to avoid state certificate of need restrictions. The first step of the transaction involves a limited liability company (the “Surgeon LLC”) owned by a group of seven orthopedic surgeons (the “Surgeon Investors”) developing a single operating room ASC (the “Surgeon ASC”) in a medical office building owned by and located on the campus of a local hospital (the “Hospital”). The second step involves the Hospital developing a single hospital operating room (the “OR”) located in the same building and contributing the assets used to operate the OR to a company owned by the Hospital (the “Company”), after which the OR will be operated as an ASC (the “Hospital ASC”). The third step of the transaction involves the Surgeon LLC purchasing 50 percent of the membership units in the Company by contributing the Surgeon ASC. Prior to this contribution, appraisals will be conducted to determine the FMV of the Company and the Surgeon ASC. If the FMV of the Surgeon ASC is less than the FMV of the Company, the Surgeon LLC will make a cash contribution to the Company in the amount of the difference. If the FMV of the Surgeon ASC is greater than the FMV of the Company, the Hospital will make a cash contribution to the Company in the amount of the difference. At the conclusion of these steps, the Hospital and the Surgeon LLC will jointly own the Company, which will own and operate a two-operating room ASC. The requestors of the Advisory Opinion indicate that the independent development of single operating room ASCs by the Surgeon LLC and the Company (as opposed to the joint development of a two operating room ASC) does not require a certificate of need in the applicable state.

Advisory Opinion 09-09 takes great care to point out that the appraisals of the Surgeon ASC and the Company will not take into account the volume or value of referrals, but will be based solely on the FMV of the tangible assets of the Company and the Surgeon ASC, consisting primarily of equipment, furnishings and supplies. In footnote 5 of the opinion, the OIG further explains that its conclusion might be different if the valuation of the respective contributions of the investors included intangible assets. The OIG indicates that, given the circumstances of the proposed transaction, it might be concerned if the valuation were based on a cash flow analysis of the Surgeon ASC as a going concern because “a cash flow-based valuation of that business potentially would include the value of the Surgeon Investor’s referrals over the time that their ASC was in existence prior to the merger with the Hospital ASC.” This would result in the Surgeon Investors receiving a greater return on their capital investment than the Hospital. The OIG notes that, in these circumstances, the Hospital ASC would be newly developed and may have little or no cash flow at the time of the proposed merger, but that it would be similarly concerned with a valuation of the Hospital ASC based on a cash flow analysis when the Hospital could influence referrals. The OIG caveats footnote 5 by stating that it does not assert that a cash flow-based valuation or other valuation involving intangible assets would necessarily result in a violation of the AKS and that the existence of a violation depends upon all the facts and circumstances of a particular case.

Purchases and sales of ownership interests in ASCs are relatively common transactions. Parties will typically engage a valuation expert to determine the FMV of the ownership interests to be purchased to ensure there is an equivalent exchange of value and that none of the parties is receiving any extra consideration that could be viewed as remuneration for referrals. Business valuation standards generally require that the valuation expert consider all appropriate valuation approaches, including the asset approach, the income approach (sometimes referred to as a cash flow-based approach) and the market approach. 6 With respect to existing businesses that generate a stream of cash flow, most valuation experts would indicate that the income approach must be considered and, in many cases, is the preferred approach. 7 The OIG’s conclusion in Advisory Opinion 09-09 appears to create an untenable conflict between business valuation standards and regulatory requirements, until one considers the unique structure of the transaction addressed in this advisory opinion.

The key distinguishing feature of the transaction in Advisory Opinion 09-09 is that the contribution of the Surgeon ASC and the Hospital ASC to the Company is agreed to ex ante (“before the event”) by the parties in connection with the overall joint venture between the Hospital and the Surgeon Investors. Absent state certificate of need restrictions, one could reasonably expect that the parties would take the more simple approach of making initial capital contributions to the Company and having the Company develop a two operating room ASC. The OIG takes the position that all of the steps in the proposed transaction should be considered as a single investment in the Company, noting that it considers each investor’s investment to be the amount that the investor contributes to develop the separate ASC, plus any additional cash that the investor contributes at the time the two ASCs are merged. Thus, the OIG is reasonable in its position that the contributions of the ASCs should be viewed as initial capital investments, rather than contributions of going concerns. Using a tangible asset valuation of the ASCs prevents either party from abusing the agreed-to arrangement by directing referrals to a particular ASC to increase the value of their capital contribution. In contrast, if the Surgeon ASC or the Hospital ASC had been in operation for many years, and the proposed joint venture had not been agreed to ex ante by the parties, then the contribution of one of these ASCs, or the purchase of ownership interests therein, should not be viewed merely as an initial capital investment. The same can be said for other ASC transactions where a party is purchasing ownership interests in an existing ASC that has going concern value. In these instances, the purchaser should pay FMV for the ownership interests, and the valuation expert should consider all applicable valuation approaches, including the income approach. Dictating a tangible asset valuation in such circumstances could actually lead to the very situation the OIG wants the parties to avoid - improper remuneration that could be related to referrals. For example, if a physician is buying an ownership interest in an existing ASC based on a tangible asset valuation of the ASC of $1 million when the FMV of the ASC is actually $5 million (based on the income approach), then the physician could be viewed as receiving remuneration (in the form of a discounted purchase price) in exchange for referrals. The same could be true if a hospital were to contribute its interest in an established ASC to a joint venture with physicians for a tangible asset value that is lower than the FMV of such ASC (based on the income approach).

Advisory Opinion 09-09 reinforces the OIG’s general concern, also iterated in Advisory Opinion 07-05, when returns to investors are not directly proportional to capital invested. Unfortunately, Advisory 09-09 still does not address the situation where different returns on invested capital are actually appropriate because the FMV of investment interests purchased by later investors is higher than the price of the original investment interests. To be sure, the OIG could not possibly condone a later investor paying the same price as an original investor when such price is below FMV. The position taken by the OIG in Advisory Opinion 09-09 and 07-05 stands in contrast to its position in Advisory Opinion 01-21, which concludes that the distribution of profit and losses in direct proportion to each investor’s percentage of equity ownership in the ASC (as opposed to original capital investment) does not increase the risk of fraud and abuse, even though it does prevent the arrangement from meeting the ASC safe harbor. 8 In fact, the OIG explains in Advisory Opinion 01-21 that there is a reasonable basis for different prices paid by later investors, namely, the appreciation in value of the ASC over time. It should also be noted that when the OIG originally established the investment interest safe harbor in its July 29, 1991 Final Rule, it explained that “in order to receive protection, dividend payments can only be tied to the number of shares owned by an investor, and not to his or her referrals.” 9 In stating as much, the OIG had to be aware of the fact that corporate dividend payments are never tied to the amount of capital invested, but rather the percentage of ownership interests held.

Healthcare providers and their advisors may be concerned upon first reading the OIG’s statement in Advisory Opinion 09-09 that, under certain circumstances, the OIG might be concerned if the ASC valuations are based on a cash flow analysis as opposed to a tangible asset valuation. However, upon further examination of the unique structure of the transaction at issue, the OIG’s conclusion proves to be a reasonable one in the specific instance where the parties agree to contribute the ASCs to a joint venture ex ante to their development, and these contributions are in effect treated as initial capital investments by parties to the joint venture rather than contributions of going business concerns. Finally, Advisory Opinion 09-09 should not be read in any way to discredit cash flow-based valuation of ASCs, and in many cases a valuation based on the income approach may be absolutely necessary to ensure that the parties to a transaction are receiving FMV consideration.

1 42 U.S.C. § 1320a-7b(b).
2 OIG Advisory Opinion No. 07-05 (June 12, 2007), available at http://oig.hhs.gov/fraud/docs/advisoryopinions/2007/AdvOpn07-05C.pdf.
3 OIG Advisory Opinion No. 09-09 (July 22, 2009), available at http://oig.hhs.gov/fraud/docs/advisoryopinions/2009/AdvOpn09-09.pdf.
4 A tangible asset valuation looks only at the fair market value of hard assets, such as equipment, furniture, fixtures and supplies, and does not consider intangible assets such as goodwill, intellectual property, workforce in place, know-how or contracts.
5 The three most common valuation approaches are the Income Approach, Asset Approach and Market Approach. The Income Approach typically determines the value of a business interest based on the discounted present value of projected future cash flows.
6 See e.g. National Association of Certified Valuation Analysts Professional Standards, Section 3.7 (“Valuation methods are commonly categorized into the asset-based approach, market approach, and income approach or a combination of these approaches. Professional judgment must be used to select the approach(es) and the method(s) that best indicate the value . . .”); American Society of Appraisers Business Valuation Standards BSV-I, Section IV (“The appraiser shall develop a conclusion of value pursuant to the valuation assignment as defined, considering the relevant valuation approaches, methods and procedures . . .”); American Institute of Certified Public Accountants Statement on Standards for Valuation Services No. 1, paragraph 31 (“In developing the valuation, the valuation analyst should consider the three most common valuation approaches: [Income Approach, Asset Approach, Market Approach]”).
7 See e.g. Shannon P. Pratt, Robert F. Reilly, Robert P. Schweihs, Valuing a Business: The Analysis and Appraisal of Closely Held Companies, 4th Ed., McGraw-Hill (2000), p. 40 (“In the simplest sense, the theory surrounding the value of an interest in a business depends on the future benefits that will accrue to the owner of it. The value of the business interest, then, depends upon an estimate of the future benefits and the required rate of return at which those future benefits are discounted back to the valuation date. Thus, the theoretically correct approach is to project some category or categories of the future benefits of ownership (usually some measure of economic income, such as cash flow, earnings, or dividends) and estimate the present value of those future benefits by discounting them based upon the time value of money and the risks associated with ownership”).
8 OIG Advisory Opinion No. 01-21 (November 16, 2001), available at http://oig.hhs.gov/fraud/docs/advisoryopinions/2001/ao01-21.pdf.
9 Medicare and State Health Care Programs: Fraud and Abuse; OIG Anti-Kickback Provisions; Rule, 56 Fed. Reg. 35952, 35970 (July 29, 1991).


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