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August 24, 2022

California Friendly-PC Model in the Crosshairs?

Christine Parkins Johnson, Terri D. Keville and Robert Homchick

Recent developments in both the California Legislature and a California district court suggest that the state’s corporate practice of medicine (CPOM) prohibition could evolve in a manner that threatens the “Friendly-PC Model” (also known as the Captive-PC Model).  As a bellwether state in healthcare matters, California’s actions could, in turn, prompt other states to revisit the Model.

The California Legislature has been considering a bill that would bolster the state’s already broad CPOM ban.  Senate Bill 642, if enacted, would change how professional medical corporations (PCs) use management services organizations (MSOs), and curb PCs’ use of stock transfer restriction agreements. The changes reflected in SB 642 would fundamentally alter the Friendly-PC Model in California. The bill had multiple co-authors and was passed by both the Senate Committee on Judiciary and the Senate Committee on Health in 2021.  Based on recent developments (including the bill’s primary sponsor running for Congress), SB 642 will need to be reintroduced in a future legislative session, but that seems likely under the circumstances.

Meanwhile, in the court system, in early 2022 the American Academy of Emergency Medicine Physician Group (AAEM-PG) brought a lawsuit against Envision Healthcare Corporation in the U.S. District Court for the Northern District of California.  AAEM-PG alleges that the operations of Envision’s Friendly PC violate the CPOM, based on the terms of its management services agreements.

California’s Prohibition on the Corporate Practice of Medicine and the Resulting Friendly-PC Model

California law prohibits the “corporate practice of medicine,” meaning that unlicensed individuals or entities, including corporations and limited liability companies, may not own professional medical corporations and may not directly employ physicians.  The Medical Board of California lists on its website the types of healthcare decisions that would constitute the unlicensed practice of medicine if performed by an unlicensed person (e.g., determining how many patients a physician must see in a given period of time or how many hours a physician must work).  The Medical Board also provides examples of the types of business or management decisions that should be made by a California-licensed physician rather than an unlicensed person or entity (e.g., selection, hiring, and firing of physicians, allied health staff, and medical assistants).  The approach to the CPOM varies widely across the United States.  Some states, such as Texas and New York, have CPOM bans similar to California’s, which is among the most robust in the United States.  Other states have narrower limitations, and some states, such as Florida and Hawaii, do not prohibit the CPOM.   

As a result of the CPOM prohibition, physician enterprises in California commonly use the Friendly-PC Model in which an MSO owned by unlicensed individuals or entities provides administrative services to a PC.  These services typically include contract negotiation, accounting, marketing, and human resources, among other services.  The PC retains ultimate control over the hiring and firing of clinical personnel, clinical decision making, financial decisions, choice of medical equipment, the content of marketing, and the MSO’s services.

Currently the Friendly-PC Model, when structured in compliance with the Medical Board’s guidelines as well as California case law and attorney general opinions, is permissible.  The Friendly-PC Model can provide needed administrative and management support to PCs and can be a source of capital when the MSO serves as a vehicle for investment by unlicensed individuals or an unlicensed entity such as a private equity firm.

The Friendly-PC Model is common in California as well as in other states that prohibit the CPOM.

SB-642 Targets Friendly-PC Arrangements

SB-642 would add to the Business and Professions Code a requirement that   “shareholders, directors, and officers of a medical corporation . . . shall manage and have ultimate control over the assets and business operations of the medical corporation.”  The bill further states that a lay entity or unlicensed individual cannot replace, remove, or otherwise control the PC and specifically prohibits the use of stock transfer restriction agreements or “other contractual agreements and arrangements” to exert such control.  Senator Sydney Kamlager introduced the bill, contending it would “protect patients’ medical decisions by preventing private equity firms, health care facilities or any other entity that is not licensed to practice medicine from interfering, controlling or otherwise limiting a patient's medical care for non-medical reasons.”  States periodically consider strengthening or weakening CPOM prohibitions depending on lobbying efforts and the healthcare economic climate in the state. 

If enacted, SB-642 may require existing Friendly PC arrangements to unwind or restructure. Moreover, the broad language in the bill could make it challenging to restructure arrangements in a manner consistent with the parties’ business objectives.   

As noted above, SB-642 would prohibit a Friendly PC from entering into stock transfer restriction agreements or similar contractual agreements. Typically, each Friendly PC shareholder signs a transfer restriction agreement, limiting the sale, transfer, or exchange of the ownership interest in the Friendly PC.  Outside investors own the MSO, which provides back-office services and capital to the Friendly PC.  If stock transfer restrictions are not permitted, it would impair the ability to secure financing for transactions using the Friendly-PC Model, because such arrangements support the investment in the MSO based on the MSO’s ability to control the business operations of the Friendly PC.  If the Friendly-PC Model is not permitted, it will be much more difficult for medical groups to gain access to capital.  Without such access, more groups will fail or seek refuge through some sort of employment arrangement with a hospital or hospital-affiliated foundation.

AAEM-PG Suit Against Envision Examines Use of MSO

Although SB-642 is currently tabled, a pending lawsuit in California could similarly strengthen the COPM ban.  AAEM-PG sued Envision, alleging that the terms of Envision’s management services agreement violate California’s CPOM prohibition.  AAEM-PG appears to be an MSO, describing itself as a corporation that “provides business and administrative services to physician groups.”  It also is a subsidiary of the professional society, the American Academy of Emergency Medicine.  Envision Healthcare Corporation is a national medical group, while Envision Physician Services is both a multi-specialty physician group and healthcare management organization (in other words, one branch of Envision is a physician group while another branch is an MSO; together, Envision Healthcare Corporation and Envision Physician Services are referenced as “Envision”).  AAEM-PG alleges that Envision has circumvented California’s CPOM prohibition by using management services agreements to control PCs and, in turn, dictate how physicians practice, including controlling physicians’ billing and coding decisions, marketing, and payor contracting, among other activities.  AAEM-PG alleges that Envision’s actions violate the CPOM ban because Envision, as a non-licensed entity, was controlling the physicians’ practice of medicine.  Because many of the alleged CPOM violations appear to be activities typical of California MSOs in Friendly-PC arrangements (such as arranging work schedules, assisting with advertising for physician vacancies, negotiating payor contracts, and performing billing), this lawsuit directly challenges the use of the Friendly-PC Model.  However, the complaint also alleges that Envision engaged in activities that are less typical of MSOs in Friendly-PC arrangements, such as determining which physicians would be hired, physician work hours, physician staffing levels, the number of patient encounters, and which physicians would be terminated.  It is possible that the court will choose not to comment on the Friendly-PC Model, but instead focus on areas where Envision was allegedly more clearly in violation of CPOM prohibitions.  At the same time, because AAEM-PG has characterized as CPOM violations activities that are typical of Friendly-PC arrangements, the court’s ruling could impact the Friendly-PC Model as a whole in California.

Envision moved to dismiss AAEM-PG’s suit, contending that the Medical Board of California should decide the issues in the case because the Medical Board is charged with investigating CPOM violations.  The court denied the motion to dismiss, finding that the Medical Board lacks the expertise to evaluate Envision’s business structure and contracts.  This case directly challenges the Friendly-PC Model, so it has the potential to be a landmark decision — either blessing a Friendly-PC Model arrangement or prohibiting a structure common across California — and elsewhere.  The case is currently moving forward; Envision filed an answer to the plaintiff’s amended complaint on July 1, 2022, and the parties are engaging in discovery.

The Shifting Landscape

Given the significance of the potential change in the CPOM doctrine in California, physician entities should closely monitor developments.  In addition, it may be prudent for California Friendly PCs to develop contingency plans in case the state legislature or the courts alter CPOM rules.  For instance, a Friendly PC should consider whether it has the ability to restructure its relationship with the MSO under the existing management services agreement.

    Christine Parkins Johnson, Esq.

    Davis Wright Tremaine, LLP, Los Angeles, CA

    Christine Parkins Johnson is an attorney in Davis Wright Tremaine LLP’s Los Angeles office.  Ms. Johnson focuses her practice on healthcare regulatory law with a particular emphasis on operations, compliance, and licensing issues.  She can be reached at [email protected] and 213-633-6838.  

    Robert Homchick, Esq.

    Davis Wright Tremaine LLP, Seattle, WA

    As a healthcare regulatory attorney, Bob Homchick counsels clients in areas such as physician self-referral (i.e., the federal Stark Law and its state law counterparts), regulatory compliance, and fraud and abuse. Mr. Homchick also regularly represents hospitals, physicians, ancillary services providers, and others in a wide variety of transactional matters including mergers, acquisitions, and affiliations, and the formation and operation of joint ventures. He can be reached at [email protected] and 206-757-8063.

    Terri D. Keville, Esq.

    Davis Wright Tremaine, LLP, Los Angeles, CA

    Terri Keville advises healthcare clients on a range of operations and compliance issues including credentialing, peer review, and other medical staff physician issues; consent; privacy/confidentiality; emergency care requirements (EMTALA); and clinical research. Ms. Keville focuses on helping clients avoid and minimize problems and disputes, but she has made favorable healthcare case law in matters involving, e.g., peer review and Medicare preemption.  She may be reached at [email protected] and 213-633-8660.

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