Background on Stark and the Big 3
By way of background, most readers already will know that the Stark law establishes significant civil penalties for certain financial arrangements between physicians and entities they refer federal program patients to, unless the otherwise prohibited arrangements fit into one of the law’s many exceptions. The intent of the law is to ensure that medical decisions are made without improper consideration of the financial impact those medical decisions may have on the physicians who make them. Much has been said, written, and adjudicated in connection with the Stark law over the years, and this discussion assumes that the reader has some familiarity with that extensive history and commentary.
The updated regulations went into effect in January 2021, and included important updates and commentary for what the regulators now are colloquially referring to as the “Big 3” Stark requirements. For veteran health lawyers, the Big 3 are the familiar concepts of (1) “fair market value,” (2) “commercially reasonable,” and (3) the “volume or value” standard. The regulators have long acknowledged that the Big 3 are the core requirements of many of the major exceptions to the Stark law (versus the more “technical violations” – also a term CMS has used colloquially to describe some of the other requirements).
History of the Commercial Reasonableness Concept
Despite the long-accepted importance of the Big 3, until the final rule went into effect in January 2021, one of the Big 3 was not even defined in the regulations at all. That was the concept of commercial reasonableness. CMS had been asked to define it in the past, but declined to create a regulatory definition, discussing its meaning only in the associated preamble commentary, on two separate occasions:
1998 CMS Commentary: “We are interpreting ‘commercially reasonable’ to mean that an arrangement appears to be a sensible, prudent business agreement, from the perspective of the particular parties involved, even in the absence of any potential referrals.”
2004 CMS Commentary: “An arrangement will be considered ‘commercially reasonable’ in the absence of referrals if the arrangement would make commercial sense if entered into by a reasonable entity of similar type and size and a reasonable physician (or family member or group practice) of similar scope and specialty, even if there were no potential DHS referrals.”
It is clear from both of these earlier CMS comments that the concept of commercial reasonableness asks parties to examine the purpose for transacting to ensure it makes business sense. However, the lack of a regulatory definition and the two different commentary statements led to quite a bit of confusion over the years, due to the uncertainty of the perspective from which commercial reasonableness needed to be determined.
The first statement, made in the 1998 proposed rule, suggested that commercial reasonableness is determined from the perspective of the actual parties to the transaction – a “subjective” standard. It suggested that one must ask the question of whether the transaction makes business sense to the actual parties, given their specific situation, characteristics, and circumstances.
As part of the major revision to the regulations in 2004, CMS was asked by a commenter if the regulators really meant for the commercial reasonableness requirement to be so subjective (based on the 1998 CMS statement), or rather, if CMS would prefer for it to be more of an “objective” standard. That is, the commenter asked whether commercial reasonableness should turn on whether the transaction would make sense to any hypothetical reasonable parties that might face similar circumstances.
That was not a strange question to ask, particularly given that one of the other Big 3 concepts – fair market value – has long been determined from the perspective of hypothetical parties to a similar transaction, rather than the actual parties. There also was some confusion at the time about whether fair market value and commercial reasonableness were separate elements or somehow interrelated (which has also been helpfully clarified in the new 2020 final rule – they are indeed separate elements).
While there was some discussion in CMS commentary (in the 2019 proposed rule) with respect to whether fair market value also should be a more “subjective” concept, the 2020 final rule stuck with the “objective” formulation for the fair market value definition. Furthermore, the IRS guidance on its similar standard for fair market value, which significantly predates the Stark law version, is crystal clear that fair market value is a hypothetical construct. Under the IRS formulation, consideration of the value of a transaction to the actual parties is referred to as “strategic value” or “investment value,” and is generally distinguished from the hypothetical construct of fair market value.
So, faced with the subjective vs. objective question in 2004, CMS responded with the second commentary statement set forth above, which was a much more objective statement, and CMS continued to decline the opportunity to create a regulatory definition for the term. Additionally, the 2004 commentary, although more recently stated, did not constitute an outright rejection of the more subjective version set forth in the 1998 commentary to the proposed rule, leading to some confusion about which statement applied and what perspective should be used to evaluate commercial reasonableness (subject, objective, or perhaps both).
Frankly, the advice many gave to parties was to consider it from both perspectives, subjective and objective, to ensure compliance with the commercial reasonableness requirement. That is, parties were often advised to ensure both that the transaction made sense to them under their particular circumstances (subjectively), and that the transaction also would make sense to any similar parties (objectively).
Regulatory Sprint Leads to the New Definition
Fast forward to 2018, when the government engaged in what became known as the “regulatory sprint to coordinated care,” and the Stark law was identified as a substantial impediment to achieving coordinated care, in particular citing the many challenges with the Big 3 requirements. Confusion around the commercial reasonableness requirement was certainly a central complaint, given the lack of regulatory definition and conflicting commentary.
So, CMS set out to update the Big 3 with the aim to clarify and simplify them and make them less of an impediment to completing healthcare transactions. The result was the 2020 final rule, which made significant updates to the fair market value and volume or value concepts (with important new commentary as well), and created the all new regulatory definition of the term “commercially reasonable.”
While stakeholders may debate the success of some of the changes to the Big 3, the new definition of commercial reasonableness is an unquestionable triumph, particularly in its simple statement and practical approach to the problems parties had previously faced. The new definition states:
Commercially reasonable means that the particular arrangement furthers a legitimate business purpose of the parties to the arrangement and is sensible, considering the characteristics of the parties, including their size, type, scope, and specialty. An arrangement may be commercially reasonable even if it does not result in profit for one or more of the parties.
The new definition has two main elements: (1) the parties must have a legitimate business purpose to enter into the transaction; and (2) the transaction must be sensible under the circumstances. The definition goes on to point out that lack of profitability of the transaction does not, per se, cause the transaction to fail the definition. The statement on profitability (and associated commentary), while outside the scope of this discussion, was a key and welcome acknowledgement of what many stakeholders had been noting was previously a point of significant debate and confusion in practice (including among the enforcement community and courts).
Importantly, the definition is clear that the perspective from which one considers whether a transaction is commercially reasonable is clearly the subjective perspective – that is, the perspective of the actual parties. It is not an objective definition; rather, it more closely resembles the original 1998 commentary (though there are differences, which, frankly, improve it).
That makes it very different from the fair market definition, which remains an objective standard. Thus it is very important that in the 2020 final rule CMS also clarified that while fair market value and commercial reasonableness have some similar aspects, they are indeed separate elements. In fact, they are determined from different perspectives (subjective for commercial reasonableness vs. objective for fair market value).
Because the elements are separate, transactions theoretically can be commercially reasonable without being fair market value. The distinction is somewhat theoretical in many cases, particularly if both elements are required to meet the relied-upon Stark exception, as those transactions that meet one element but not the other would still fail to meet the exception. However, there are some exceptions that do not require both elements (e.g., the new “value-based arrangements” exception, which requires commercial reasonableness but does not require fair market value).
The Extra Requirement Not in the New Definition
So, as stated, the new definition brings welcome clarity to the concept of commercial reasonableness. However, there is one remaining wrinkle. Many of the legacy Stark law exceptions contain an additional requirement. Some of the most commonly used compensation arrangement Stark exceptions require that the transactions “would be commercially reasonable, even if there were no referrals between the parties.” That additional requirement is stated slightly differently in different exceptions, but the net effect is generally the same, which is that the arrangement must meet the extra regulatory test, which is not part of the new definition of commercially reasonable, but is a requirement just the same to meet those exceptions.
When you unpack the extra requirement, it really serves to bring the objective analysis back into play. Thus, while the new definition of commercially reasonable is clearly a subjective test, as written in the regulation, the extra step in the legacy exceptions is effectively an objective test requiring the stakeholders to ensure that the deal would still be commercially reasonable, even if it were between hypothetical parties that have no referrals between them. So, in order to meet the legacy Stark exceptions with this extra requirement, we are back to the two-part test – both subjective and objective, with all of the potential to be confusing to transactors and other stakeholders (relators and enforcers included).
The Value-Based Version is Different
As noted above, this extra objective requirement is a crucial feature of the legacy Stark exceptions, but importantly, it is not included in a major new exception – the new “value-based arrangement” exception. In the new value-based arrangement framework CMS announced as part of the “regulatory sprint” initiative, there are three new value-based exceptions, which vary based on the level of downside risk taken by the parties. The new “value-based arrangement” exception has become colloquially known as the “no-risk” exception because it requires the least amount of downside risk to be taken by the parties (compared to the other two exceptions: the “full-risk” and “meaningful downside risk” exceptions).
However, to compensate for the reduced risk, the no-risk exception contains an extra requirement that the arrangement must be commercially reasonable (the other two value-based exceptions do not have this requirement). But, perhaps more importantly for this discussion, the no-risk exception does not have the extra language that the legacy exceptions contain – i.e., there is no requirement that the arrangement “would be commercially reasonable, even if there were no referrals between the parties.”
This formulation of commercial reasonableness in the no-risk value-based exception is different from the legacy exceptions, and although CMS did not directly mention that difference in the commentary to the value-based exceptions, CMS did remind stakeholders elsewhere in the commentary about the additional element still found in the legacy exceptions, as well as including it in the regulatory text of the new “limited remuneration to a physician” exception. So, it appears from a reasonable read of the commentary and new regulatory text that the different formulation in the new “value-based arrangement” exception is deliberate (and not inadvertent). The result is that, when parties are relying on the no-risk value-based exception, only the subjective formulation of commercial reasonableness applies (i.e., only what is in the definition of the term commercially reasonable).
That is a significant and helpful accommodation to parties who take advantage of the new value-based framework. For that reason (and other reasons, too), it is likely the no-risk value-based exception will become one of the most important new exceptions. It is one of the most flexible exceptions available to transacting parties.
Two More Perspectives on Commercial Reasonableness
There are two additional observations worth noting about commercial reasonableness. First, the Stark law is still a very complicated law, with tricky requirements and areas for interpretation and confusion. While the changes to the Big 3 requirements, and the commercial reasonableness requirement, in particular, are still welcome as significantly helpful to clarifying the correct perspective transactors must take when reviewing transactions, it is essential to appreciate that compliance still requires careful scrutiny and strong documentation.
Finally, in the end commercial reasonableness is an exercise in examining “why” the parties are doing the deal, to ensure the parties have a legitimate reason to do the deal and are doing it in a sensible way. To help prove a deal was commercially reasonable, it is important to document a good reason to do the deal. But stakeholders also must remember the related Anti-Kickback Statute can be violated in certain cases if the parties also have an improper purpose to reward or induce referrals.
That Anti-Kickback concern is what is known as the “one-purpose” test. The one-purpose test is currently not adopted in all federal jurisdictions (though it is adopted in many of them, and the regulators and enforcers believe it should apply in all jurisdictions). While the Anti-Kickback Statute is mostly outside the scope of this discussion, the point here is that, while the good purpose of the parties can be utilized to establish a transaction is commercially reasonable for purposes of the Stark law, that good purpose may not be relevant or helpful when it comes to the Anti-Kickback Statute, if the parties also have an improper purpose, as the one-purpose test may still fail for Kickback purposes. When transactions have multiple purposes, it is imperative to consider all of them to ensure full compliance.
The purpose of a transaction is central to determining whether a transaction is commercially reasonable, and the 2020 final rule provided needed clarity and commentary on what that all-important term means. Still, despite the welcome new clarity, it is a highly complex concept, with various risk points and considerations required to ensure that transactions are compliant. Most importantly, it is vital to understand the perspective that one must use to evaluate whether an arrangement is commercially reasonable – subjective, objective, or both. The correct perspective can be the difference between compliance and potential headaches down the road.