WEEK 2 DISC 2 HMGT 372

CHAPTER

99

3THE ORGANIZATION AND MANAGEMENT OF A CORPORATE HEALTHCARE INSTITUTION

After reading this chapter, you will

• understand that a corporation is a “person” for many legal purposes, but not an “individual” or a “citizen”; therefore, laws that apply to persons also apply to corporations, but laws that specify individuals or citizens do not,

• appreciate that incorporation has many advantages, the most significant of which is limiting the liability of the individuals who own the corporation,

• know that the powers of a corporation are limited to those specified in state law and the corporate charter,

• be able to explain why the governing board must be actively involved in overseeing the affairs of the company without meddling in management’s control of day-to-day operations,

• realize that various factors have led to the development of multi- institutional healthcare systems rather than stand-alone hospital corporations, and

• see that health reform legislation has provided an impetus for another round of corporate reorganization, especially in the area of hospital–physician relations.

M ost institutional healthcare providers are corporations; thus, this chapter focuses on the fundamental nature of the corporate form of organization. However, healthcare is also provided by sole propri-

etorships, partnerships, and other types of business entities. In a sole proprietorship, an individual (e.g., a family physician in solo

practice) assumes all organizational roles: employer, employee, and owner. The proprietor usually retains any profits or suffers any losses and bears the full risks of the enterprise. A partnership exists if someone joins the proprietor and shares in the rewards and risks. Partnerships are governed by state law and by an agreement between the parties.1 The parties have great latitude to develop an agreement that suits their needs.

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C o p y r i g h t 2 0 2 0 . H e a l t h A d m i n i s t r a t i o n P r e s s .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

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The simplest kind of partnership is a general partnership. In this arrangement, the partners usually receive equal shares of profits or losses, are entitled to equal voting rights, and are personally liable for the debts of the venture. On the death or departure of a partner, the partnership is automati- cally dissolved, but the business operation does not necessarily end. General partners ordinarily control the business by consensus; however, as the volume of business and number of partners increase, this arrangement may become cumbersome. As a result, the owners often change the business to a limited partnership or a corporate structure.

A joint venture is a special form of partnership created by contract for a specific purpose and for a limited duration. A joint venture is thus one way of integrating two or more business organizations. In joint ventures, the par- ties have fiduciary responsibilities to each other, and depending on the con- tractual terms, each usually has a right to participate in management. Profits and losses are shared according to the agreement, and each participant may be liable to third parties. Although somewhat similar, a joint venture differs from a general partnership in that its participants are not agents of each other.

Because of their flexibility, joint ventures have become popular in the healthcare sector and have been used, for example, to effect hospital– physician integration (discussed later). The rest of this chapter focuses pri- marily on corporations, the predominant form of healthcare organization.

Other organizational forms such as limited partnership, limited liabil- ity company, professional limited liability company, and professional corporation may also be used by licensed individuals such as physicians, psychologists, midwives, and others to protect their personal assets from lawsuits brought against their practices. The requirements for creating these entities vary from state to state, and the implications for taxation and tort liability may differ from one type to another. The details are too many to describe here, and it is sufficient to say that competent legal and accounting advice should be sought before creating any business entity.

Formation and Nature of a Corporation

A corporation is “an artificial being, invisible, intangible, and existing only in contemplation of law. Being the mere creature of the law, it possesses only those properties which the charter confers on it, either expressly or as incidental to its very existence.”2 In England and the United States, early corporations were ecclesiastical, educational, charitable, or even govern- mental in purpose and were usually created by special act of the legislature. The American Red Cross, for example, is a corporation chartered by the US Congress.

corporation An organization formed with governmental approval to act as an artificial person to carry on business (or other activities), able to sue or be sued, and (unless not-for-profit) able to issue shares of stock to raise capital.

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C h a p t e r 3 : T h e O r g a n i z a t i o n a n d M a n a g e m e n t o f a C o r p o r a t e H e a l t h c a r e I n s t i t u t i o n 101

The modern corporation came into prominence in the late nineteenth century with the passage of state statutes regarding business incorporation. These laws allow any group of persons (or in some states, a single individual) to incorporate an enterprise for any lawful purpose, as long as it meets statu- tory requirements. These corporation laws eliminate the need for special leg- islative action each time a corporation is created.

General business corporation acts provide for the formation and operation of a wide range of commercial activities, such as manufacturing, wholesaling, and retailing. Most states have a separate corporate statute for not-for-profit organizations and additional laws governing particular types of business, such as banking; public utilities; and the practice of law, medicine, dentistry, accountancy, and similar professions.

Corporate executives need to know the relevant statute under which they operate because it will limit the conduct of the corporation’s affairs. The organization has only the powers granted to it by its charter and as specified or implied in the relevant statute.

The Corporation Is a “Person” Because corporations are legal entities distinct from the individuals who created or manage them, they fall within the definition of “person” for most constitutional and statutory purposes. For example, the Fifth and Fourteenth Amendments to the US Constitution provide that no person shall be deprived of “life, liberty, or property without the due process of law.” Similarly, the Fourteenth Amendment provides that no state “shall deny to any person . . . the equal protection of the laws.” Corporations are protected by these fundamental doctrines (see Legal Brief). Person- hood also enables a corporation to acquire, own, and dispose of property (including stock in other corporations) and to sue and be sued. In short, a corporation is an independent entity with rights and responsibilities of its own.

On the other hand, a corporation is not a “citizen.” It cannot vote in an election and is not protected by the Four- teenth Amendment’s provision that “no state shall make or enforce any law which shall abridge the privileges or immunities of citizens of the United States.” Neither is a corporation protected by the Fifth Amendment’s prohibition against self- incrimination because that right applies only to real people (individuals). Simi- larly, a corporation is not a person for

Legal Brief

Corporations’ constitutional rights were confirmed again in the 2010 Citizens United case when the US Supreme Court held that corporate funding of political broadcasts during election campaigns is a form of free speech protected by the First Amend- ment. “Political speech does not lose First Amend- ment protection ‘simply because its source is a corporation’” (Citizens United v. Federal Election Commission, 558 U.S. 310 [2010]).

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the purpose of licensure statutes because it cannot meet the educational requirements or standards of personal character required for professional licensure.

Forming a Corporation A corporation is formed by filing articles of incorporation with the secretary of state or other designated official of the state in which incorporation is sought. On approval, a corporate charter is issued. Although requirements regard- ing the specific content of the articles differ from state to state, the articles must typically include the following:

• Name of the corporation • Address of the corporation’s office • Name of the registered agent authorized to accept delivery of writs,

summonses, or other legal papers • Names and addresses of the incorporators • Duration of corporate existence (which is usually unlimited) • Purpose of the corporation • Names of the initial members of the governing board (also known as

board of directors and board of trustees) • Number and classification of shares of stock (in a for-profit

corporation) or the designation of members, if any (in a not-for-profit organization)

The incorporators are those who prepare, sign, and file the articles of incorporation. Some states require a minimum number of incorporators, while others permit an individual to act as the incorporator.

Advantages of the Corporate Form of Organization There are five principal advantages to incorporation:

1. Limited liability. Normally, the owners of a corporation are not personally liable for the corporation’s contracts or torts. A shareholder of a for-profit corporation is not personally liable, with a few exceptions, for corporate debts beyond the extent of the shareholder’s investment in the corporation’s stock. Similarly, employees generally are not personally liable for corporate obligations as long as they act in the scope of delegated authority.

2. Perpetual existence. Unlike a sole proprietorship or partnership, a corporation’s continued legal existence and operational capabilities in most instances are not affected by the death or disability of an owner.

corporate charter The fundamental document (usually articles of incorporation) of a corporation’s legal authority.

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3. Free transfer of ownership interests (at least if the corporation is for- profit). Shareholders in the organization can sell their interests to fellow shareholders or the general public (unless special provisions are made and noted on the stock certificates). Free transferability increases the liquidity and value of corporate investments. State statutes usually provide that membership interests in not-for-profit corporations may not be transferred.

4. Taxation separate from individual income taxes. The corporate tax rate is generally lower than the personal income tax rate, and the persons who own the corporation are taxed only on the distributions of income (dividends) they receive, not on their proportionate shares of the entire corporate profit.

5. Ability to raise capital. Access to equity capital, as distinct from borrowing and creating debt, is a major consideration when undertaking new or expanded ventures.

Powers of a Corporation A corporation may act only within its corporate authority, and its powers are limited to those consistent with its charter (articles of incorporation) and the statute under which it was formed.

There are two kinds of powers: express and implied. Express powers are those specifically designated by charter or statute. The relevant statute under which the corporation is formed enumerates express powers, such as the power to buy, lease, or otherwise acquire and hold property and the power to make contracts to effectuate corporate purposes. Implied powers are those reasonably necessary to carry out the express powers and achieve the corpora- tion’s purposes and objectives.

Any departure from express or implied corporate power is said to be ultra vires (Latin for “beyond the power” of the corporation). For example, Charlotte Hungerford Hospital v. Mulvey, although not involving a typical corporate charter, illustrates the importance of knowing the limits of cor- porate power. (To read this case, see The Court Decides at the end of this chapter.) Therefore, in planning for the future and in making commitments, the governing body of the corporation must keep a close eye on the cor- poration’s legal authority, and legal advice regarding this issue is of utmost importance. For example, if a not-for-profit corporation makes a donation or transfers assets to another institution for a purpose not included in its own charter, the donation or transfer is ultra vires. As such, it could be challenged in a suit for an injunction and would likely be held void.

An ultra vires transaction is distinguished from an illegal act. The latter is an absolutely void transaction; an example is employment by the hospital of an unlicensed professional person to act in that professional capacity.3

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Some hospital transactions that may raise questions about corporate power include:

• Lending credit or guaranteeing the debts of another corporation • Issuing loans to its corporate trustees, officers, or members • Forming a partnership with another corporation or an individual • Consolidating or merging with another corporation • Leasing publicly owned facilities to a private corporation • Engaging in independent private business enterprises (if a public

hospital) without statutory authority to do so

These transactions are not necessarily ultra vires, but the authority to engage in them must be verified with legal counsel. (Corporate consolida- tions and mergers are discussed later in this chapter.)

Not-for-Profit Corporation A general business corporation is owned by shareholders, who are entitled and expect to receive dividends from the earnings of the corporation and to share in assets should the corporation be dissolved. However, no part of the net earnings of a not-for-profit corporation may be distributed for the private gain of its members, directors or trustees, officers, or other private individuals. However, a not-for-profit corporation can earn income and make a profit (see Legal Brief) without sacrificing its not-for-profit status, as long as it uses that profit for institutional purposes. Moreover, it can, without question, pay its employees; as long as the compensation paid is reasonable, salaries are not “private gain” that would jeopardize the corporation’s not- for-profit status.4

Motive is important in determining not-for-profit status. In a not-for- profit institution, motives of ethical, moral, or social purposes predominate and profit is secondary to the overall purpose. However, a mere declaration of not-for-profit purpose in a corporate charter is never conclusive if the

entity is being used as an alter ego for private gain.5 For this reason, the purpose clause in the articles of incorporation of a not-for-profit corporation is usually restric- tive. Although a not-for-profit corporation can be organized for many lawful aims, the incorporators normally state a specific pur- pose, such as establishing a hospital, sym- phony orchestra, or museum of fine arts.

Although charitable status is contingent on not-for-profit status, a

not-for-profit (or nonprofit) A type of organization in which legal and ethical restrictions prohibit distribution of profits to owners or shareholders.

Legal Brief

The terms not-for-profit and nonprofit are syn- onymous. The former expression is preferred, how- ever, because it emphasizes that the purpose of the corporation is not to make a profit even though it may (and usually does) do so. Clearly, no corpo- ration can long survive with a negative bottom line.

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not-for-profit corporation need not have a charitable purpose. Many social clubs and similar organizations that provide services exclusively to members are organized and operated as legitimate not-for-profit corporations without charitable or benevolent purposes. Such corporations do not qualify for the tax-exempt status that charitable corporations enjoy (see chapter 12). Not- for-profit status is a prerequisite to tax exemption not only under federal law but also under the various state statutes providing for taxes on sales, income, and real or personal property.6

Not-for-profit corporations do not have shareholders, but they may or may not have “corporate members” (depending on the provisions of the law under which they are incorporated). These members are roughly equivalent to a business corporation’s shareholders, but they are not entitled to receive dividends. Like shareholders, however, they hold certain reserved powers, such as the authority to

• elect directors to the governing body; • approve merger or dissolution of the corporation; • amend the articles of incorporation and bylaws, including the corporate

purpose; • set the corporate philosophy and mission; and • adopt annual budgets, unless the board of directors is given this power.

In most states, members must meet at least annually to conduct business. In a corporation without members, the board of directors is the sole govern- ing authority, and it has the statutory power to exercise the reserved powers. In any event, the reserved powers are set forth in the not-for-profit corpora- tion law and the articles of incorporation. On the dissolution or merger of a not-for-profit corporation, the assets of the corporation must be distributed in accordance with state law and the provisions of the articles of incorporation.

Internal Management of a Corporation Corporate bylaws contain rules for the internal management and governance of corporations. Unless state statutes or a corporation’s articles of incorpora- tion provide otherwise, the power to adopt and amend a corporation’s bylaws lies with its members or shareholders. In short, the governing body of a corporation cannot adopt or amend corporate bylaws unless state statutes or the corporation’s charter have specifically granted it this power. The bylaws define the rights and duties of the corporate members or shareholders, the powers and responsibilities of the governing body, and the rights and duties of the major corporate officers. Corporate bylaws are an internal document; hence, they need not be filed in any public office or otherwise made available for public inspection (unless state law so requires).

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As noted earlier, certain extraordinary matters normally require the vote of members or shareholders. As discussed in the following section, other major powers reside with the governing board. Otherwise, the day-to-day management of the corporation is the responsibility of its CEO and other management staff.

Responsibilities of the Governing Board The governing body of a healthcare institution has four major functions:

1. Develop policy and strategic plans 2. Appoint senior administration and medical staff members 3. Delineate clinical privileges 4. Oversee the professional performance of lay administrators and the

medical staff

To fulfill these functions properly, the board must ensure the proper organization of its own committee structure. For example, the board must ensure that the executive committee is properly executing corporate policy in the interval between board meetings, and this committee must not assume the decision-making power legally reserved for the whole board or for corporate members or shareholders. Moreover, the executive committee is usually not permitted to delegate its responsibilities to any single member of the committee. In addition to the executive committee, other standing committees often include committees on finance, medical staff relations, corporate compliance, buildings and grounds, personnel, public relations, and education.

Having set policy for the institution, the board must ensure that the medical staff and management execute it effectively. The board should not become involved in the details of day-to-day operations—these responsibili- ties should be delegated to hospital administration and the medical staff—but it must have mechanisms in place to review performance and hold account- able the corporation’s agents (employees or others authorized to act on the organization’s behalf). When authority for implementing policy is delegated, it can be revoked if performance is unsatisfactory. The board must monitor delegated powers; it cannot abdicate its oversight responsibilities.

Board Composition and Meetings The board’s size is determined by the articles of incorporation or bylaws.7 Some states require a minimum number of directors—usually three—while others allow as few as one board director. In a not-for-profit corporation of the membership type, the corporate members elect the governing board. In a not-for-profit corporation without corporate members, the board may

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select new directors; boards that do so are referred to as “self-perpetuating.” In some situations, such as in a state or county hospital, a public official or body may appoint the directors. Terms of office and qualifications of these directors are determined by charter or bylaw provisions drafted in accordance with statutory requirements. For example, local statutes may require that directors be of majority age and that a certain number be residents of the state of incorporation.8

Removal of directors for cause and special elections to fill vacancies on the board are governed by provisions of state law and the corporate charter. Legal counsel should be sought in such situations.

Directors usually cannot be paid or compensated for their services unless local law and the corporate charter permit it. This rule is particularly relevant to not-for-profit corporations because of the fundamental doctrine that members and directors of not-for-profits must not derive personal finan- cial gain from the corporation. (This prohibition does not exclude the salary paid to a director who is also a corporate employee.)

A unique provision exists in West Virginia. A licensing statute enacted in 1983 requires that at least 40 percent of the governing boards of local government and not-for-profit hospitals be equal numbers of individuals who operate small businesses, belong to labor organizations, are elderly, and are low income. The statute was meant to control healthcare costs, but there is no evidence that the presence of consumer representatives on health- care organizations’ boards helps reduce healthcare expenditures. Only one reported case exists in which the law was much of an issue, and even then it was not especially significant.9

In managing the affairs of the corporation, the board must act in properly constituted, formal meetings. Independent action by one or even by a majority of directors does not bind the corporation. Except for regular meetings provided for in the articles of incorporation or corporate bylaws, proper notice (usually in writing) of a meeting must be given to each director. Unless such notice is given, the meeting is invalid. There is one exception: If all directors attend a meeting that was called without proper notice, they have, in effect, waived the notice requirement. Even so, decisions made at a casual, unannounced gathering of the board may lack legal effect. If the statutes permit, meetings can be held by teleconference; otherwise, directors must attend in person.10

A written record (minutes) should be made of the actions taken at each board meeting. Directors who object to a proposed action should make certain that their dissents are noted in the record. The frequency of meetings depends on provisions in the charter or bylaws and on particular circumstances. Unless the local statutes, charter, or bylaws provide otherwise, the location of the board meeting may be at the discretion of the board.

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Meetings may even occur outside the state of incorporation, as long as the place is a reasonably convenient destination.

The charter or bylaws fix the number of directors necessary for a quorum. In the absence of a provision, the rule is that a quorum is a simple majority of the board and that a majority vote is sufficient to bind the corpo- ration. Directors may not vote by proxy in the absence of a specific statutory or bylaw provision because each director has a fiduciary duty to attend meet- ings personally and exercise independent judgment.

The foregoing general principles of corporate law are reflected in the hospital accreditation standards published by The Joint Commission. Note also that many public hospitals (e.g., those owned by counties, cities, tax dis- tricts) are governed by the provisions of open-meetings legislation (“sunshine laws”) as to the frequency, location, and public notice of meetings and the public’s right to attend.

The Governing Board’s Duties Directors have fiduciary duties—special responsibilities owed to the corpora- tion, its members (if any), and its intended beneficiaries. For the governing board of a hospital corporation, these duties include the following:

• Acting with loyalty and due care • Protecting hospital property • Not engaging in self-dealing and conflicts of interest • Establishing and overseeing the hospital’s strategic goals • Selecting the CEO • Selecting a qualified medical staff • Monitoring the quality of medical care • Establishing operating budgets

Fiduciary duties can be summarized in two words: loyalty and responsibility.

Members of the governing board of charitable corporations are fre- quently called trustees. They are not trustees in the formal sense, however, because a traditional trustee holds legal title to property and manages that property for the benefit of others. In a corporation, however, the title to prop- erty is vested in the corporation itself. Furthermore, under trust law, the duty of a trustee is generally higher than the duty of a corporate director. For example, the trustee of a trust may be liable for poor business judgments in the manage- ment of the property held for the beneficiaries’ benefit. A corporate director would generally be held liable only for actual negligence, willful disregard of duty, or wrongful acts. Throughout the following discussion, we use the term director to encompass board members of charitable corporations generally.

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Duty of Loyalty Loyalty to the organization is the paramount duty. It requires the individual to put the interests of the corporation before self-interest. Specifically, no director is permitted to gain personally, accept bribes, or compete with the corporation.11

The duty of loyalty also raises the question of whether a director can personally contract with the corporation. Can directors, for instance, sell sup- plies or services to the hospital? The answer is yes if certain high standards are met. A director may usually contract with the corporation if the contract is fair, if full disclosure of all personal interest is made, and if utmost good faith is exercised. A director should never vote on or participate in the board’s decision to approve or veto the transaction, either directly or through an agent. Competitive bids should be solicited to establish the fairness of the contract. The burden of proving the fairness of a contract and disclosing self-interest is always on the individual director, and the court will closely scrutinize the transaction if the matter is challenged. For a director, buying from a hospital and then reselling at a personal profit is riskier than selling personal property or services to the institution at fair market value. A contract with a director that does not meet the aforementioned standards is not void, but it is voidable.12

There may be specific state statutes pertaining to directors’ contracts with the corporation they serve.13 In a government hospital, state law may prohibit all transactions between a director and the corporation, even if full disclosure is made and the contract is fair. Whenever directors wish to con- tract with the corporation they serve, they and the board should seek careful legal advice based on local law.

Every hospital should have and follow conflict-of-interest policies. Each director must be required to file a written declaration of possible con- flicts of interest and disclose gifts, gratuities, and lavish entertainment offered by companies that do business with the hospital.

Duty of Responsibility The duty of responsibility is to act with due care in every activity of the board. Good faith and honesty are the major tests in determining whether due care has been exercised. This same standard of care is imposed on the director of a business corporation.14

Directors of a hospital corporation must take an active role in direct- ing the company. Merely preserving corporate property as caretakers is not enough; they must use corporate property to achieve corporate objectives. Directors must attend meetings of the board and actively participate in decision-making by learning about the issues, asking appropriate questions, and demonstrating complete rectitude in their decisions.

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The duty of responsibility also includes exercising reasonable care in selecting and appointing the CEO and other corporate agents, such as out- side legal counsel.15 Directors must use reasonable care in supervising the agents they appoint and in holding them accountable, and they have a duty to remove an incompetent CEO or other agent.

Directors also have a duty to use reasonable care in appointing indi- viduals to the medical staff. Per case law, a corporate duty exists to restrict clinical privileges or to terminate an appointment when the board knows, or should have known, of incompetence on the part of a medical staff member (see chapters 7 and 8). A corporation may be held liable if the board knew of professional malpractice—or should have known about it from the managers and medical staff departments charged with reviewing each staff physician’s clinical performance—but did not take action.

In reaching their decisions, directors may rely on written, documented reports and recommendations from responsible professional sources such as medical staff committees, accountants, and legal counsel. They need not personally verify all items in these reports if no activity arouses suspicion or question,16 but they face potential liability if they fail to obtain professional advice when a problem becomes apparent—for example, if they fail to obtain competent legal counsel when the hospital has a recognizable legal issue.

In general, directors are not personally liable for honest errors in business judgment. This standard is consistent with that applicable to the directors of for-profit corporations and means that board members must exercise the judgment that reasonably prudent directors or trustees would be expected to exercise under similar circumstances. An example of dishonest business judgment that could render a director personally liable is permitting institutional funds to remain in a bank that she knew or ought to have known was in financial straits.17

A famous case involving Sibley Memorial Hospital in Washington, DC, illustrates the kinds of responsibilities board directors carry and the dif- ficulties that can arise when directors do not adhere to them (see The Court Decides: Stern v. Lucy Webb Hayes National Training School for Deaconesses and Missionaries at the end of this chapter). As you read this case, remember that its facts occurred more than 50 years ago. For this reason, the sanc- tions the court meted out are mild compared with what would be ordered if a board today abdicated its responsibilities in the way Sibley Memorial’s board did.

Protection Against Liability In general, hospital directors’ personal liability is not a serious financial risk as long as they regularly attend board meetings, vote personally, avoid conflicts of interest, and exercise utmost good faith and honesty in overseeing the corporation’s affairs. The best means of establishing good faith and honesty

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C h a p t e r 3 : T h e O r g a n i z a t i o n a n d M a n a g e m e n t o f a C o r p o r a t e H e a l t h c a r e I n s t i t u t i o n 111

is a written record of all the board’s deliberations, including the votes of indi- vidual directors on transactions that involve personal interests. Any director who dissents from majority actions of the board should make sure that his dissent is part of the written record.

Individual directors and corporate officers have two means of protect- ing themselves: (1) purchasing liability insurance and (2) making sure that the corporation has appropriate indemnification provisions to protect them in the event they suffer personal loss as a result of exercising their (good faith) board responsibilities.

Many not-for-profit corporations favor indemnification plans or a combination of insurance and indemnity. Insurance for directors and officers (D&O coverage) may exclude coverage for gross negligence, intentional acts, and criminal activity. Indemnification is corporate reimbursement of a trustee’s personal expenses in the event the trustee faces a civil suit or criminal prosecution for alleged violation of fiduciary responsibilities. The trustee may be reimbursed for attorneys’ fees and possibly for amounts paid as a result of a judgment against the individual. The hospital may, in turn, purchase insur- ance covering the costs of indemnification. Careful legal advice is necessary to ensure that directors understand the circumstances under which insurance and indemnification can and cannot be provided. Drafting the corporate char- ter or bylaw provisions covering these issues with utmost care is imperative.

Responsibilities of Management

Under the overall guidance of the governing board, a group of people known collectively as “management” (see Legal Brief) run the day-to-day operations of the corporation. Management is an art, and, like art, it is hard to define. From Adam Smith and John Stuart Mill in the eighteenth and nineteenth centuries, to Frederick Win- slow Taylor and Henri Fayol around the turn of the twentieth century, and through Peter Drucker more recently, many have tried to define management in scientific terms. All have failed to some degree. No matter how one describes management, however, it is the function of an organization that is concerned with leadership: setting goals (strategy), cre- ating an action plan to achieve those goals (tactics), measuring outcomes, and reassess- ing the strategy and tactics on the basis of those outcomes.

Legal Brief

The word management comes from the Latin manu agere, meaning “to lead by the hand,” as in train- ing horses, for example. We prefer to think of enlightened leaders as people who set goals and empower others to reach those goals, not as task- masters who pull employees along by the bridle. Regardless of the metaphor, the fact remains that the job of management (or leadership, if you pre- fer) is to enable people to get things done. Admin- istration is derived from the Latin administration, a compound of ad (“to”) and ministratio (“serve”). The term is also the source of the verb to minister.

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T h e L a w o f H e a l t h c a r e A d m i n i s t r a t i o n112

In a healthcare organization, management functions begin with senior administrative positions, including those of CEO, vice president, and depart- ment director (or similar titles). Their responsibilities include the following:

• Supporting the governing board in its strategic planning and policymaking activities

• Carrying out (implementing, administering, executing) the board’s policies and strategic goals

• Communicating board policies and the strategic plan to employees and the medical staff

• Overseeing day-to-day operations, including personnel functions and personnel records

• Measuring the quality of patient care • Managing operating funds • Selecting qualified junior executives • Conducting necessary business transactions

Management must report regularly to the governing board on the general status of these activities while maintaining a distinction between the board’s governance role and management’s day-to-day operations.

Because corporations can act only through people, members of man- agement find they spend large portions of their time dealing with person- nel issues: recruitment, performance reviews, dispute resolution, discipline, terminations, and myriad related subjects. All of these situations implicate employment law, which covers such things as wages and overtime, non- discrimination, sexual harassment, disabilities, relationships with unions, workplace safety, and many others.18 Chapter 4 covers employment law in some detail.

Piercing the Corporate Veil

A corporation is a legal entity that has rights and responsibilities separate from those of its owners. It is a convenient legal fiction, and because it can limit legal and financial liability, it has been an invaluable vehicle for encour- aging investment in for-profit and not-for-profit activities. On the other hand, if a corporation is used to “defeat public convenience, justify wrong, protect fraud, or defend crime,” the law will disregard the corporate fiction and place liability on the owners of the corporation.19 This action is known as piercing the corporate veil. Most litigated cases in which the corporate veil has been pierced have involved closely held corporations or parent–subsidiary relationships.

employment law The collection of laws and rules that regulate the employer– employee relationship.

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For a court to pierce the corporate veil, the party challenging the cor- poration normally must prove three elements:

1. The corporation’s owners dominated it completely. 2. The owners used their control of the corporation to commit fraud

or perpetrate a wrong, violate a statutory or other duty, or commit a dishonest or unjust act.

3. Corporate control was the proximate cause of the injury that is the subject of the suit.20

Although precedent for piercing the corporate veil is more than a century old, courts are reluctant to look beyond the corporate form.21 Accordingly, as a general rule, all three of these elements must be proven to the satisfaction of the “trier of fact” (the judge or the jury).

Complete domination of the corporation means domination of finances, business practices, and corporate policies to such an extent that the entity has no mind or will of its own. Mere directorship of the corporation by a sole shareholder entitled to corporate profits is not enough to justify piercing the veil. Courts look, on a case-by-case basis, for unity of interest and ownership sufficient to destroy the separate identities of the owner or owners and the corporation. Evidence of this unity is found in such factors as the following:

• Mingling of corporate assets with the owner’s personal funds • Neglect of business formalities, such as failure to file separate tax

returns, hold regular board meetings, and keep adequate corporate minutes

• Having a mere “paper corporation” with nonfunctioning officers and directors listed in the articles of incorporation

• Insufficient investment of capital in the corporation22

The decision whether to disregard the corporate fiction, however, does not rest on a single factor. Courts most often look for several factors suggesting that the corporation and owner should be treated as one and the same.23 United States v. Healthwin-Midtown Convalescent Hospital is a good example.24 Defendant Israel Zide owned half of the stock of Healthwin, a con- valescent center that provided skilled nursing care in return for payments from Medicare. Zide also had a 50 percent interest in a partnership that held title to the real estate occupied by Healthwin and the furnishings of the nursing home. Concluding that the nursing home had been overpaid, the government brought suit against Healthwin and against Zide for the amount of the alleged overpayment. Zide defended the claim against him on the basis that the debt was solely the corporation’s and that he was entitled to limited liability.

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T h e L a w o f H e a l t h c a r e A d m i n i s t r a t i o n114

In rejecting Zide’s defense, the court noted these factors:

• He alone controlled the corporation’s affairs. • He was a member of the board, the president of the corporation, and

the administrator of the nursing facility. • He alone signed corporate checks without concurrence of another

corporate officer. • The governing board did not meet regularly. • He failed to maintain an arm’s-length relationship with the corporation

by permitting Healthwin’s funds to be “inextricably intertwined” with his personal accounts and other business transactions.

• The corporation was seriously undercapitalized, having liabilities consistently in excess of $150,000 and an initial capitalization of only $10,000.

• He diverted corporate funds to the detriment of creditors.

In the court’s opinion, these facts demonstrated that Zide used the corpora- tion to accommodate his personal business dealings. The court held that to allow him to escape liability in these circumstances would be unfair to his creditors (including Medicare). Accordingly, Zide was found personally liable for the amount due the federal government because the corporation was a mere alter ego of its principal shareholder.

In addition to the various factors showing a unity of interest and ownership strong enough to outweigh the separate identity of the corpora- tion, for the corporate veil to be pierced, limited liability must result in an inequity. An inequitable result is often found when a statutory duty has been violated or fraud or other wrongful action has been perpetrated (see The Court Decides: Woodyard, Insurance Commissioner v. Arkansas Diversified Insurance Co. at the end of this chapter for another case that illustrates judi- cial application of the doctrine of piercing the corporate veil).

Multi-institutional Systems and Corporate Reorganization: The Independent Hospital as Anachronism

For many years the hospital was a single legal entity, and its purpose was merely to provide doctors with a building, equipment, and supplies so they could treat their patients. Today, however, these former “doctors’ work- shops” operate as multifaceted organizations with teams of people who work toward a new vision: promoting health rather than merely treating illness.

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Achieving this organizational vision (see Legal Brief) required restructuring stand-alone hospitals into multi-institu- tional systems that would permit them, for example, to add new service lines, partner with physicians or other organizations, increase market share, and improve the bottom line.

A multiorganizational system can diversify operations and engage in a wide range of activities that a single institution cannot. Subsidiary entities can provide special services or perform functions not related to healthcare without being hampered by hospital-focused regula- tions, restrictive corporation laws, and third-party reimbursement regulations.

Multi-institutional system and corporate reorganization are generic terms, and no single definition, model, or form exists that describes either concept. The AHA defines multihospital systems as “two or more acute care hospitals that are owned, leased, sponsored, or contract-managed by a central organization,” and it distinguishes them from networks, which are “group[s] of hospitals, physicians, other providers, insurers and/or community agencies that work together to coordinate and deliver a broad spectrum of services to their community.”25 This distinction reminds us that healthcare systems now include skilled nursing facilities, extended care facilities, ambulatory care centers, outpatient surgical centers, hospital-owned physician practices, home health agencies, managed care plans, and various other health-related organizations (see exhibit 3.1 for an example of a multi-institutional health- care system).

Systems may comprise both not-for-profit and for-profit (proprietary) entities. For example, a not-for-profit system corporation may own not-for- profit and for-profit subsidiaries. A system may also be owned and managed by state or local government. Whether consisting of multiple corporate enti- ties or a single corporation with multiple divisions, all multi-institutional sys- tems have a corporate office responsible for activities that are best performed centrally, thus providing efficiency and economies of scale. Some functions commonly managed at the corporate level include the following:

• Finance and billing • Legal and risk management • Quality assurance • Compliance • Legislative advocacy

Legal Brief

The vision statement of the American Hospital Association (AHA) reads: “The AHA vision is of a society of healthy communities, where all indi- viduals reach their highest potential for health.”

This is typical of most healthcare organizations today (American Hospital Association, Mission and Vision [accessed Feb. 20, 2019], at https://www. aha.org/about/mission-vision).

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T h e L a w o f H e a l t h c a r e A d m i n i s t r a t i o n116

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• Human resources and benefits administration • Health information management • Strategic planning • In-service education

Alternative Corporate Strategies

Sale of Assets For various reasons, corporations sometimes sell all or a substantial portion of their assets to another corporation. This transaction is relatively straight- forward, except that local law must be followed carefully when the seller is a charitable corporation. Normally, the stockholders or members and the governing boards of both the buyer and the seller must approve the terms of the sale. If the seller is a charitable corporation, state laws may require that a designated state officer approve the final arrangement because the state has the ultimate responsibility to enforce the terms of charitable trusts. After the sale is completed, the selling corporation may dissolve or may continue to operate on a restricted scale.

Merger and Consolidation Corporations also sometimes wish to join forces with others. They can do so in various ways, including merger, consolidation, and joint venture.

In a merger or acquisition, two or more corporations are joined, whereby one or more of the organizations transfers assets to another (the survivor) and then is dissolved. A consolidation, in contrast, is a transaction in which two or more organizations combine to form a new corporation, thereby dissolving the predecessor companies. The terms are often used interchangeably in casual conversation, but keeping this distinction in mind is advisable: In a merger or acquisition, one company survives after taking over one or more other corporations; in a consolidation, two companies blend into a completely new entity.

Before completing any type of corporate integration, each party must carefully scrutinize state corporation law; certificate-of-need legislation; the state and federal statutes relevant to charitable organizations, if applicable; and other regulatory requirements. Normally, the governing boards of the corporations involved and the shareholders or members must approve the plan. The terms of any bond documents may require approval of the bond- holders. When the interested parties approve the plan, articles of merger or consolidation are prepared and filed with the appropriate state officer responsible for enforcing the relevant corporate law, who then issues a cer- tificate authorizing the transaction. Once the certificate is issued, the new

merger (or acquisition) The joining of two or more corporations, whereby one or more of the organizations transfers assets to another (the survivor) and then is dissolved.

consolidation A transaction in which two or more organizations combine to form a new corporation, thereby dissolving the predecessor companies; sometimes used as a general term inclusive of merger and acquisition.

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T h e L a w o f H e a l t h c a r e A d m i n i s t r a t i o n118

corporation owns all the property of the former entities, has all their rights and privileges, and is liable for all their debts.26

If the merger or consolidation significantly affects competition in the relevant market, it may invite charges of antitrust law violation. (The anti- trust aspects of asset acquisitions, consolidations, and mergers are thoroughly discussed in chapter 13.) Most consolidations and mergers, however, benefit the community at large and the institutions involved. Such arrangements not only enhance competition but also enable the surviving corporation(s) to provide a wider range of services, improve quality assurance and risk manage- ment, and have greater economies of scale. These arrangements are especially beneficial when one or more of the corporations would have failed had they not combined.

Joint Venture In contrast to a merger or consolidation, a joint venture is a mutual endeavor by two or more organizations for a specific purpose or for a limited dura- tion. This term is loosely applied to a variety of relationships (e.g., between a hospital and a physician practice) for purposes such as

• diversifying both parties’ activities, • providing new or additional services to the community, • seeking capital from interested investors, • maximizing revenues, or • gaining tax benefits.

Although the joint venture participants are not agents of each other, other rules of a general partnership normally apply. That is to say, the property is jointly owned and the parties owe fiduciary duties to each other. Each has a right to participate in management. They share profits and losses according to their agreement. Each can be held liable to third parties for the negligence and financial obligations of the venture. As discussed in the following sections, outright employment of physicians is on the rise, but historically joint ven- tures have been the most common form of hospital–physician collaboration.

Collaborative Strategies with Physicians

Medicare as a Driver At its inception, Medicare basically paid hospitals and physicians their usual rates for the services they provided. Obviously, under such a system, the more services you provide, the more you get paid. This arrangement was an advantage for both hospital and physician providers, and Medicare spending

joint venture A mutual endeavor by two or more organizations for a specific purpose or for a limited duration.

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rose at an annual rate more than twice that of inflation during the 1970s and early 1980s.27

Concerned about these sharply ris- ing costs, Congress replaced Medicare Part A’s cost-based reimbursement system with a prospective payment system (PPS) in 1983. (See Legal Brief for a summary of the various “parts” of Medicare, which are also discussed in chapter 2.) Under PPS, hospi- tals were paid a fixed amount per diagnosis as assigned to a diagnosis-related group, regardless of the length of the patient’s stay or the complexity of the treatment rendered. In theory this change would give hospitals reasons to provide services more efficiently and shorten inpatient stays, but it actually created an incentive to increase the number of hospital admissions and diagnoses.

Furthermore, the theory of PPS overlooked certain basic principles. First, physicians—not hospitals—determine most Medicare spending; only physicians can decide when a patient will be admitted or discharged, and only they can order the services the hospital will provide. Second, physicians have traditionally been independent members of hospital medical staffs; they have admitting privileges and may order services, but they are not under the hospital’s direct control (see chapter 8).

When Congress imposed PPS on hospitals, it made no fundamen- tal changes to Medicare Part B (the physician payment system). It placed some minor limitations on the physician fee schedule, but the net result of the Medicare amendments of the early 1980s was a set of perverse incen- tives (see Legal Decision Point): Hospitals were encouraged to be more efficient, but physicians had few reasons to limit—and many reasons to increase—the number of services provided. As the Congressional Budget Office noted in 1986:

Although part of the increased volume of services provided per enrollee that

has occurred since Medicare’s inception has been a desirable response to the

greater needs of an aging population, aided by remarkable improvements in

medical technology, some increases may have been motivated more by physi-

cians’ attempts to maintain revenues in the face of fee constraints or insuf-

ficient patient-initiated demand for services than by expected benefits for

patients.28

Legal Brief

Medicare Part A pays for medically necessary hospitalization, hospice care, skilled nursing, and home health care. It is provided, without premi- ums, to individuals aged 65 or older.

Medicare Part B functions as a health insur- ance plan, paying for physician visits, outpatient care, medical supplies, and other necessary ser- vices. Part B is funded by contributions from the federal government and by monthly enrollee premiums.

Medicare Part C (also known as Medicare Advantage) is an alternative to the parts A and B combination.

Medicare Part D covers prescription drugs.

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T h e L a w o f H e a l t h c a r e A d m i n i s t r a t i o n120

Congress attempted to address these problems when, in the Balanced Budget Act of 1997, it mandated the sustainable growth rate (SGR) method to control the cost of physician services. Under SGR, the physician fee schedule was to be adjusted each year on the basis of the previous year’s gross domestic product. If Medicare’s expenditures exceeded the target amount, SGR mandated a cor- responding decrease in payments for the

following year. Reductions in physician payments were predicted to occur every year as a result.

Implementation of the SGR formula could be suspended by Congress, and in fact, physician groups, including the American Medical Association, successfully lobbied for its suspension and even a modest pay increase each year from 1997 onward. This annual “doc fix,” as it was called, ultimately led to the SGR being permanently repealed in 2015. In return, policymakers hope that under the Affordable Care Act (ACA), accountable care organiza- tions (more about this later in the chapter) will help reduce Medicare costs by promoting prevention and primary care.

The First Wave of Hospital–Physician Integration Recognizing the difficult situation they faced, and considering the increas- ingly competitive and cost-conscious environment of the late 1980s, many healthcare institutions attempted to develop business arrangements with groups of physicians to share risk and reap economic rewards. Most common, hospitals integrated with members of their own medical staffs, but sometimes hospitals acquired the practices of previously unrelated physicians—either by contracted services or through direct employment. Typically, the goals of these collaborative efforts were to

• reduce costs, • provide a full range of services along the continuum of care, • provide practice management and administrative support, • negotiate contracts with payer organizations, • generate economies of scale, • provide access to capital, • improve quality, • conduct utilization reviews, and • provide staffing for particular hospital departments (e.g., radiology,

anesthesiology, emergency).

Legal Decision Point

Consider the unfairness (from a hospital’s per- spective, at least) of the perverse incentives that resulted from the Medicare Part A reforms of the early 1980s. What might have caused this out- come? What political factors do you suppose were involved?

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The arrangements took different names, such as management services organization, physician–hospital organization, integrated delivery system, and health maintenance organization. They were sometimes organized as joint ventures but were more commonly set up as corporations.

Regardless of their organizational form, many well-intentioned hospital–physician collaborations met with limited success, if not outright failure. Hospital executives discovered that managing a physician practice is different from running a hospital, that salaried physicians sometimes do not work as many hours as their contracts require, and that they may actually increase the hospital’s costs. Physicians, on the other hand, discovered that hospitals are large bureaucracies that can stifle their independence and limit their autonomy. For various reasons, each side was often skeptical of the other; thus, many of the arrangements fell apart.

To be successful, collaboration between physicians and hospitals requires more than a written contract and a lofty mission statement. It requires true congruence of interests. Both groups must have common val- ues, shared governance and management, and common data systems. Full openness and complete trust must exist. Physicians and hospitals learned this lesson the hard way in the 1990s, and interest in hospital–physician collabo- ration waned for a time.

The Second Wave of Hospital–Physician Integration However, the healthcare environment changed as the twenty-first century approached, and for various reasons there was a second wave of interest in hospital–physician cooperation. One reason was the Clinton administration’s health reform initiative, which—despite its failure as public policy—spawned a boom in hospital mergers and physician practice acquisition. In addition, declining incomes and the increased cost and stress of running a private prac- tice prompted many older physicians to retire or switch to concierge medicine. During the Great Recession of 2008–2010, younger physicians became more open to hospital employment than those of the baby boom generation had been.29 As older physicians retired and the prospect of medical staff shortages appeared, hospitals made physician recruitment and retention a higher priority.

Then came what has been perhaps the most significant factor in hospital–physician integration: passage of the ACA in 2010. Its Shared Savings Program (SSP) encourages creation of provider networks—called accountable care organizations (ACOs)—that manage the full continuum of care for their Medicare patients in return for bonuses based on cost sav- ings.30 These networks came in several forms:31

• The basic SSP: for fee-for-service beneficiaries • The ACO Investment Model: for ACOs to test prepaid savings in rural

and underserved areas

concierge medicine A relationship between a patient and a primary care physician in which the patient pays an annual fee in return for direct, personalized care; also known as boutique medicine.

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T h e L a w o f H e a l t h c a r e A d m i n i s t r a t i o n122

• The Advance Payment ACO Model: for certain eligible providers already in or interested in the Medicare SSP

• The Comprehensive ESRD [End-Stage Renal Disease] Care Initiative: for Medicare beneficiaries receiving dialysis services

• The Next Generation ACO Model: for ACOs experienced in managing care for populations of patients

• The Pioneer ACO Model: for healthcare organizations and physician providers already experienced in coordinating care for patients across care settings. (This model was a test project that began with 32 ACOs and ended December 31, 2017, with 9 ACOs.)32

The payment details for each of these types of ACOs are not essential here. Suffice it to say that all ACOs are accountable for the quality and cost of the care they provide to Medicare beneficiaries. If they are successful, they share in the savings. For the better part of a decade, they have been an incentive for hospitals and physicians to work together and to invent new organizational arrangements for doing so. They must agree to participate for at least three years, and by statute they must have a “formal legal structure that would allow the organization to receive and distribute payments for shared savings.”33

As ACOs take hold and the ACA becomes fully operative (if it sur- vives various political challenges), the organization and management of corporate healthcare institutions should become more efficient and cost- effective. Healthcare executives will need to work closely with their attor- neys and other consultants to analyze carefully both the business arguments and the legal reasons for undertaking a particular venture before embarking on it.

Summary

This chapter reviews some basic concepts of corporation law, including a cor- poration’s status as a legal “person,” its ability to shield owners from personal liability, the foundation of corporate power, and the duties of a corporation’s governing board. The concept of piercing the corporate veil and the vari- ous reasons for restructuring a healthcare corporation, and means by which restructuring can occur, are also explored.

The powers of a corporation are limited by state corporation law and the company’s organizing documents (the corporate charter). Healthcare executives must be aware of those powers and help—within their limits—the governing board accomplish corporate objectives.

accountable care organizations (ACOs) Groups of doctors, hospitals, and other healthcare providers who come together voluntarily to give coordinated high- quality care to the Medicare patients they serve. A successful ACO will share in the savings it achieves for the Medicare program (Centers for Medicare & Medicaid Services, Accountable Care Organizations (ACOs): General Information (updated July 11, 2019), at https:// innovation.cms. gov/initiatives/ aco/).

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C h a p t e r 3 : T h e O r g a n i z a t i o n a n d M a n a g e m e n t o f a C o r p o r a t e H e a l t h c a r e I n s t i t u t i o n 123

Particular attention is given to the phenomenon of hospital–physician joint ventures, the wax and wane of the trend in the 1990s and beyond, and its potential for renewal in the coming years because of the effects of the ACA.

Discussion Questions

1. Why is a corporation considered an “artificial person” under the law? What are the consequences of this concept?

2. Describe the advantages of incorporation as opposed to organization as a partnership.

3. Where does one look to find the powers of a corporation? 4. What are the functions and responsibilities of the governing board of a

healthcare corporation? 5. Why is the concept of piercing the corporate veil important to any

corporation and its subsidiaries? 6. What are the pros and cons of hospital–physician joint ventures? 7. How has health reform legislation affected the organization and

management of corporate health institutions?

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T h e L a w o f H e a l t h c a r e A d m i n i s t r a t i o n124

The Cour t Decides

Charlotte Hungerford Hospital v. Mulvey 26 Conn. Supp. 394, 225 A.2d 495 (1966)

MacDonald, J.

The plaintiff in this action for a declaratory judgment is a nonstock corporation which for many years has owned and operated a volun- tary general hospital in a complex of build- ings located on a 120-acre tract of wooded land about one mile from the center of the city of Torrington. The land was acquired under a deed of trust providing that the prem- ises thus conveyed “are to be held and used by said grantee for the purpose of maintain- ing and carrying on a general hospital and, if a majority of corporators so elect, a training school for nurses in connection therewith may be established, and for no other purpose whatsoever.” The deed of trust in question, executed in 1917, specifically provided that “if the land herein granted shall cease to be used for the [stated] purposes, title . . . shall thereupon pass to and vest in said town of Torrington . . . to be used forever as a public park.” [A state statute later chartered the hos- pital subject to the “terms, conditions, restric- tions and provisions” of the deed of trust.]

Plaintiff [now wants to erect] a medi- cal office building on the hospital grounds [because it] would be of great convenience and advantage both to the individual doctors and to the hospital. . . .

. . . [However,] various questions have arisen with respect to the right, power and authority of plaintiff, under the terms of said deed of trust and special act, to proceed with such a project. . . . The specific questions which the court is requested to answer . . . are (a) whether plaintiff is authorized . . . to construct and operate, as an integral part of its general hospital complex, a medical office building for members of its medical staff;

(b) whether such a medical office building may, under the terms of the aforesaid deed of trust, be located on a portion of the land held by plaintiff thereunder; (c) whether . . . the plaintiff is authorized and empowered to lease . . . a portion of the land included in the aforesaid deed of trust [to a subsidiary cor- poration that will operate the medical office building]; [and] (d) whether, in addition to offices and office suites for members of plain- tiff ’s medical staff, said building may contain facilities related to or supporting such offices and suites, such as medical laboratories, pharmacies and dispensaries.

The court, after hearing the evidence and the arguments of counsel with full participa- tion by counsel representing the only inter- ested parties, namely, the attorney general of the state of Connecticut, as representative of the public interest in the protection of trusts for charitable uses and purposes . . . and the city of Torrington, contingent benefi- ciary, has no hesitation in answering all four of the questions posed in the affirmative. It is clear . . . that the proposed project would materially aid the plaintiff in more efficiently carrying out the stated purposes of the trust deed under which it was founded. . . . It is equally clear from the extremely impressive testimony of [the president of the AHA and another witness] that the modern trend is almost universally toward the practice of hav- ing nonprofit hospitals provide physicians’ private offices for rental to staff members, either in the hospital buildings themselves or on the hospital grounds. . . .

The language of the deed of trust is to be construed in light of the settlor’s purpose.

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The Cour t Decides

Stern v. Lucy Webb Hayes National Training School for Deaconesses and Missionaries

381 F. Supp. 1003 (D. D.C. 1974)

Gesell, J.

[This is a class action suit in which patients of Sibley Memorial Hospital, known officially by the name shown, challenged various aspects of the hospital’s management and governance. The defendants were certain members of the hospital’s board of trustees and the hospital itself. For a summary of the differences between trustees of a trust and directors of a corporation, see the discussion in this chapter.]

The two principal contentions in the complaint are that the defendant trustees conspired to enrich themselves and certain financial institutions with which they were affiliated by favoring those institutions in financial dealings with the Hospital, and that

they breached their fiduciary duties of care and loyalty in the management of Sibley’s funds. . . .

[The court explains that the hospital was begun by the Methodist Church–affili- ated Lucy Webb Hayes School in 1895 and eventually became the school’s main activity.]

In 1960 . . . the Sibley Board of Trustees revised the corporate by-laws. . . . Under the new by-laws, the Board was to consist of from 25 to 35 trustees, who were to meet at least twice each year. Between such meet- ings, an Executive Committee was to repre- sent the Board [and in effect had full power to run the hospital]. . . .

(continued)

And reasonable deviations and expanded interpretations must be made from time to time in order to keep pace with changes in recognized concepts of the proper sphere of general hospital operations. . . . Such deviations are recognized by our Connecticut

courts even though the elements for apply- ing cy pres principles are not present. A decree may enter advising plaintiff of its rights, powers and authority herein by answering the four questions propounded in the affirmative.

Discussion Questions

1. Why is the state attorney general an “interested party” to these proceedings? 2. What is a settlor? 3. What are cy pres principles? 4. How does this case enhance your understanding of the limits of corporate power?

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T h e L a w o f H e a l t h c a r e A d m i n i s t r a t i o n126

In fact, management of the Hospital from the early 1950s until 1968 was handled almost exclusively by two trustee officers: Dr. Orem, the Hospital Administrator, and Mr. Ernst, the Treasurer. Unlike most of their fel- low trustees, to whom membership on the Sibley Board was a charitable service inci- dental to their principal vocations, Orem and Ernst were continuously involved on almost a daily basis in the affairs of Sibley. They dominated the Board and its Executive Com- mittee, which routinely accepted their recom- mendations and ratified their actions. Even more significantly, neither the Finance Com- mittee nor the Investment Committee ever met or conducted business from the date of their creation until 1971, three years after the death of Dr. Orem. As a result, budgetary and investment decisions during this period, like most other management decisions affect- ing the Hospital’s finances, were handled by Orem and Ernst, receiving only cursory super- vision from the Executive Committee and the full Board.

[It was only after the deaths of Dr. Orem and Mr. Ernst (in 1968 and 1972, respec- tively) that other trustees began to assert themselves and exercise supervision over the financial affairs of the hospital. At that point, it became known that over the years “unnec- essarily large amounts of [Sibley’s] money” had been deposited in accounts bearing little or no interest at banks in which trustees had a financial interest. At the same time, the hospital bought certificates of deposit that paid lower-than-market rates and took out loans with interest rates higher than the interest rates being paid on funds deposited.

Because there was no evidence that the trustees, other than Dr. Orem and Mr. Ernst, had ever actually agreed to engage in or profit from these activities, the court found insufficient evidence to prove a conspiracy among them. The court then proceeds to discuss the allegations of breach of fiduciary duty.]

III. Breach of Duty. Plaintiffs’ second contention is that, even if the facts do not establish a conspiracy, they do reveal serious breaches of duty on the part of the defendant trustees and the knowing acceptance of benefits from those breaches by the defendant banks and sav- ings and loan associations.

A. The Trustees. Basically, the trustees are charged with mismanagement, nonmanagement and self- dealing. The applicable law is unsettled. . . . [H]owever, the modern trend is to apply corporate rather than trust principles in determining the liability of the directors of charitable corporations, because their func- tions are virtually indistinguishable from those of their “pure” corporate counterparts.

1. Mismanagement. . . . Since the board members of most large charitable corporations fall within the cor- porate rather than the trust model, being charged with the operation of ongoing busi- nesses, it has been said that they should only be held to the less stringent corporate standard of care. More specifically, directors of charitable corporations are required to exercise ordinary and reasonable care in the performance of their duties, exhibiting hon- esty and good faith.

2. Nonmanagement. . . . A corporate director . . . may delegate his investment responsibility to fellow directors, corporate officers, or even outsiders, but he must continue to exercise general supervi- sion over the activities of his delegates. Once again, the rule for charitable corporations is . . . the traditional corporate rule: direc- tors should at least be permitted to del- egate investment decisions to a committee of board members, so long as all directors assume the responsibility for supervising

(continued from previous page)

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such committees by periodically scrutinizing their work.

Total abdication of the supervisory role, however, is improper even under traditional corporate principles. A director who fails to acquire the information necessary to supervise investment policy or consistently fails even to attend the meetings at which such policies are considered has violated his fiduciary duty to the corporation. While a director is, of course, permitted to rely upon the expertise of those to whom he has delegated investment respon- sibility, such reliance is a tool for interpreting the delegate’s reports, not an excuse for dis- pensing with or ignoring such reports. . . .

3. Self-dealing. Under District of Columbia Law, neither trustees nor corporate directors are abso- lutely barred from placing funds under their control into a bank having an interlocking directorship with their own institution. In both cases, however, such transactions will be subjected to the closest scrutiny to deter- mine whether or not the duty of loyalty has been violated. . . . . . .

Trustees may be found guilty of a breach of trust even for mere negligence in the mainte- nance of accounts in banks with which they are associated while corporate directors are gen- erally only required to show “entire fairness” to the corporation and “full disclosure” of the potential conflict of interest to the Board.

Most courts apply the less stringent corporate rule to charitable corporations in this area as well. It is, however, occasion- ally added that a director should not only disclose his interlocking responsibilities but also refrain from voting on or otherwise influencing a corporate decision to transact business with a company in which he has a significant interest or control.

[The court goes on to point out that the hospital board had recently adopted the

AHA’s policy guidelines that essentially imposed the standards described earlier: (1) a duality or conflict of interest should be disclosed to other members of the board, (2) board members should not vote on such matters, and (3) the disclosure and absten- tion from voting should be recorded in the minutes.]

. . . [T]he Court holds that a director . . . of a charitable hospital . . . is in default of his fiduciary duty to manage the fiscal and investment affairs of the hospital if it has been shown by a preponderance of the evi- dence that

(1) . . . he has failed to use due diligence in supervising the actions of those officers, employees or outside experts to whom the responsibility for making day-to-day financial or investment decisions has been delegated; or

(2) he knowingly permitted the hospital to enter into a business transaction with himself or with any [business entity] in which he then had a substantial interest or held a position as trustee, director, general manager or prin- cipal officer [without disclosing that fact]; or

(3) except [with disclosure], he actively participated in or voted in favor of a decision . . . to transact business with himself or with any [business entity] in which he then had a substantial interest or held a position as trustee, director, general manager or princi- pal officer; or

(4) he otherwise failed to perform his duties honestly, in good faith, and with a rea- sonable amount of diligence and care. Apply- ing these standards to the facts in the record, the Court finds that each of the defendant trustees has breached his fiduciary duty to supervise the management of Sibley’s invest- ments. . . .

[In conclusion, the court noted that the plaintiffs pushed for strict sanctions against the various defendants: the removal of certain board members, the cessation of

(continued)

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T h e L a w o f H e a l t h c a r e A d m i n i s t r a t i o n128

The Cour t Decides

Woodyard, Insurance Commissioner v. Arkansas Diversified Insurance Co. 268 Ark. 94, 594 S.W.2d 13 (1980)

Hickman, J.

The appellant is Arkansas Insurance Commis- sioner W. H. L. Woodyard, III. The appellee is Arkansas Diversified Insurance Company (ADIC).

ADIC sought a certificate of authority from Woodyard to sell group life insurance to Blue

Cross and Blue Shield . . . subscriber groups. Woodyard denied the application. On appeal, his decision was reversed by the Pulaski County Circuit Court as being arbitrary and not supported by substantial evidence. We

all business transactions with their related firms, an accounting of all hospital funds, and awards of money damages against the individual defendants. However, the court declined to adopt these rather severe measures.

The court points out the factors that it considered significant: (1) the defendant trustees are a small minority of the board, whereas all board members were in some way guilty of nonmanagement; (2) the defec- tive practices have been corrected, and those who were most responsible for them have either died or been dismissed; (3) the defendants did not profit personally from the transactions; (4) the defendants will soon

leave the board because of age, illness, or the completion of a normal term; and (5) this case is essentially the first in the District of Columbia to discuss these issues compre- hensively, and thus no clear legal standards previously existed.

For these reasons, the court declines to remove the defendants from the board, to assess money damages, or to take other more severe actions. Instead, it requires new policies and procedures to make certain that all present and future trustees are aware of the requirements of the law and that they fully disclose all hospital transactions with any financial institutions in which they have an interest or position.]

Discussion Questions

1. If this case were decided today, would the outcome be different? If so, how? 2. As the CEO or board member of a not-for-profit hospital corporation, what measures

would you put in place to prevent a repeat of the activities that led to the lawsuit involved here?

3. How would you summarize the duties of board members on the basis of the holding in this case?

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(continued from previous page)

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find on appeal [that] the circuit court was wrong and [we] reverse the judgment. We affirm the commissioner.

The only evidence before the commis- sioner was presented by ADIC. The appellee candidly admitted it was a wholly owned subsidiary of a corporation named Arkansas Diversified Services, Inc. (ADS) which is a wholly owned subsidiary of Blue Cross and Blue Shield, Inc.

. . . ADIC candidly admitted it was cre- ated solely to serve Blue Cross customers. It would provide services that could not other- wise be provided by law. . . . ADS wanted its own life [insurance] company to better com- pete in the market place.

Blue Cross owns all the stock of ADS, which in turn owns all the stock of ADIC. The president of Blue Cross is the president of both ADS and ADIC. Other Blue Cross officials hold positions in ADS and ADIC. The compa- nies use the same location and similar statio- nery. ADIC will use Blue Cross employees to sell insurance. Underwriting for ADIC will be done by a division of ADS.

There was no real controversy over the commissioner’s findings of fact. He con- cluded that:

[1] That [Arkansas law] would apparently authorize a hospital and medical service corporation [of which Blue Cross is one] to invest in a wholly owned subsidiary insur- ance corporation with the Commissioner’s consent.

[2] That Blue Cross is limited by [law] to transact business as a non-profit hospital and medical service corporation.

[3] That ADIC is not a separate corporate entity from Blue Cross since Blue Cross through ADS owns all the capital stock of ADIC. ADIC has common Officers and Direc- tors with Blue Cross, Blue Cross pays the sal- ary for the Officers and employees of ADIC, ADIC will sell its products only to Blue Cross subscriber groups and the record indicates

that ADIC is to be treated as a division of Blue Cross. The evidence indicates that ADIC’s management will not act indepen- dently but will conduct the affairs of ADIC in a manner calculated primarily to further the interest of Blue Cross. . . .

The commissioner found that since Blue Cross could not sell life insurance itself, it should not be able to do so through corpo- rate subsidiaries. We find that decision nei- ther arbitrary nor unsupported by substantial evidence. . . .

We agree with the commissioner’s find- ing that [Arkansas law] limits the power of medical corporations to providing medical service. If it did not, they could not only sell life insurance, but automobiles or anything else. Clearly, an insurance company orga- nized under a charter or statute empowering it to sell one kind of insurance lacks authority to sell another.

The appellees argue that even if the com- missioner was right in ruling Blue Cross could not market its own life insurance poli- cies, Blue Cross could . . . invest in a wholly owned subsidiary which would [have that power]. The statutes, however, provide that such an investment can be made only with the commissioner’s consent. . . .

Blue Cross is a tax exempt, non-profit corporation enjoying a financial advantage over conventional insurers. Allowing it to sell, through subsidiaries, its own life insur- ance policies, could be unfair to competitors. While the commissioner did allow Blue Cross to invest in ADS, we can see why he disap- proved of ADIC. ADS, unlike ADIC, could sell only policies written by insurance companies which lacked the competitive advantages of Blue Cross.

The appellee argues the commissioner arbitrarily pierced the corporate veil of these subsidiaries. . . . [C]ourts will ignore the

(continued)

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T h e L a w o f H e a l t h c a r e A d m i n i s t r a t i o n130

corporate form of a subsidiary where fairness demands it. Usually, this will be where it is necessary to prevent wrongdoing and where the subsidiary is a mere tool of the parent. We believe both criteria were met here. . . .

Blue Cross, through its president and other officials, candidly admitted why they wanted ADIC to sell insurance. Blue Cross can, through its total control of both

subsidiaries by stock, officers and directors, direct all efforts and endeavors of ADIC, and collect all profits.

We cannot say the commissioner was wrong in piercing the corporate veil or in denying the application. The facts are clearly there to support his findings. This order is not contrary to law.

Reversed.

Discussion Questions

1. How does a Blue Cross health plan fall under the definition of a “hospital and medical service corporation”?

2. What is the function of that type of corporation in the healthcare system? (Other states assign different names to those corporations. Do you know what those names are?)

3. What differences in this situation might have led to a different outcome in the case?

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(continued from previous page)

Notes

1. Since 1914, the National Conference of Commissioners on Uniform State Laws has promoted a Uniform Partnership Act (UPA) for adoption by the various states and territories. Louisiana is the only state that has not adopted some version of the UPA. See 6 U.L.A. 1 (Supp. 1986) (table of jurisdictions).

2. Trustees of Dartmouth College v. Woodward, 17 U.S. (4 Wheat) 518, 636 (1819).

3. See, e.g., Tovar v. Paxton Memorial Hosp., 29 Ill. App. 3d 218, 330 N.E.2d 247 (1975) (a physician licensed in Kansas but not licensed in Illinois could not maintain an action for an alleged breach of an employment contract with an Illinois hospital because the contract was illegal and thus void).

4. For example, the Michigan statute specifically states that a not-for- profit corporation “may pay compensation in a reasonable amount to shareholders, members, directors, or officers for services rendered to the corporation.” Mich. Comp. Laws Ann. § 450.2301(3)(a).

5. See 18 C.J.S. Corporations § 10. 6. See I.R.C. § 501 and the discussion of tax issues generally in chapter 12.

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7. See, e.g., Ohio Rev. Code Ann. § 1702.27 (A)(1). The Ohio nonprofit corporation statute states, “The number of directors as fixed by the articles or the regulations shall not be less than three or, if not so fixed, the number shall be three.” See also Mich. Comp. Laws Ann. § 450.2505(1), which states that “the board shall consist of 3 or more directors. The bylaws shall fix the number of directors or establish the manner for fixing the number, unless the articles of incorporation fix the number.”

8. For example, a California statute prohibits anyone who owns stock or has any property interest in a private hospital or is a director or officer of a private hospital from serving as a director or officer of a public hospital serving the same area. Cal. Health & Safety Code § 32110 (West 1973 and Supp. 1986). Accordingly, in Franzblau v. Monardo, 108 Cal. App. 3d 522, 166 Cal. Rptr. 610 (1980), the president of a not-for-profit private hospital was prohibited from serving as a director of the public hospital district.

9. W. Va. Code § 16-5B-6a (1985). The law was upheld in the face of a constitutional challenge. Am. Hosp. Ass’n v. Hansbarger, 600 F. Supp. 465 (N.D.W.Va., 1984), aff’d Am. Hosp. Ass’n v. Hansbarger, 783 F.2d 1184 (C.A.4 (W.Va.), 1986). In Christie v. Elkins Area Medical Center, 366 S.E.2d 753, 179 W.V. 247 (1988), the court reversed a trial court’s finding that a local board was properly constituted and remanded the case for further consideration. The case does not appear in subsequent reports, thus it is surmised that the matter was settled.

10. See, e.g., Mich. Comp. Laws Ann. § 450.2521(3). 11. With respect to the duty of loyalty, see Patient Care Services, S.C. v.

Segal, 32 Ill. App. 3d 1021, 337 N.E.2d 471 (1975). A corporate officer and director who actively engaged in a rival and competing business to the detriment of a corporation must answer to the corporation for injury sustained. The defendant physician was an officer and director of the professional service corporation bringing the charge. He had established another professional service corporation to perform identical medical planning services for a hospital client, thereby attempting to seize an opportunity due the plaintiff corporation.

12. In Gilbert v. McLeod Infirmary (219 S.C. 174, 64 S.E.2d 524 [1951]), the sale of hospital property to a corporation controlled by Mr. Aiken, a hospital trustee, was voided even though there was no actual fraud and in spite of the fact that Aiken had refrained from discussing the matter and had not voted on the transaction. However, the attorney for Aiken, who was also a trustee of the board,

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T h e L a w o f H e a l t h c a r e A d m i n i s t r a t i o n132

had favorably discussed the sale and voted in favor of the proposal. Moreover, Aiken had failed to carry his burden of proof to show fair and adequate consideration for the sale of the property.

13. See, e.g., Wyo. Stat. Ann. § 17-6-104 (1977), and Md. Health-General Code Ann. § 19-220 (1982).

14. For example, Michigan’s relevant statute provides: (1) A director or an officer shall discharge his or her duties . . .

(a) In good faith.

(b) With the care an ordinarily prudent person would exercise under similar

circumstances.

(c) In a manner she reasonably believes is in the best interests of the corporation.

Mich. Comp. Laws § 450.2541.

15. See Reserve Life Ins. Co. v. Salter, 152 F. Supp. 868 (S.D. Miss. 1957).

16. State statutes may specify the items on which directors or trustees may rely in discharging their duties. For example, the Michigan statute (supra note 14) does so by saying that a director or officer is entitled to rely on information, opinions, reports, or statements, including financial statements and other financial data, if prepared or presented by any of the following:

(a) One or more directors, officers, or employees of the corporation, or of a domes-

tic or foreign corporation or a business organization under joint control or com-

mon control, whom the director or officer reasonably believes to be reliable

and competent in the matters presented.

(b) Legal counsel, public accountants, engineers, or other persons as to matters

the director or officer reasonably believes are within the person’s professional

or expert competence.

(c) A committee of the board of which he or she is not a member if the director or

officer reasonably believes that the committee merits confidence.

17. See Epworth Orphanage v. Long, 207 S.C 384, 36 S.E.2d 37 (1945); see also Queen of Angels Hosp. v. Younger, 66 Cal. App. 3d 359, 136 Cal. Rptr. 36 (1977) (improper exercise of sound business judgment and breach of fiduciary duty).

18. See generally 30 C.J.S., Employer–Employee Relationships. Two relevant texts from Health Administration Press are Bruce Fried & Myron Fottler, HuMan resources in HealtHcare: Managing For success (4th ed., 2015), and rita nuMeroF & MicHael aBraMs, eMployee retention: solving tHe HealtHcare crisis (2003).

19. W. FletcHer, cyclopedia oF tHe laW oF private corporations § 41 (perm. ed. 1983).

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20. See, e.g., Lowendahl v. Baltimore & Ohio R.R., 247 A.D. 144, 287 N.Y.S. 62, aff’d, 272 N.Y. 360, 6 N.E.2d 56 (1936).

21. J. J. McCaskill Co. v. United States, 216 U.S. 504, 515 (1910). 22. “In a sense, faithfulness to these [corporate] formalities is the price

paid for the corporate fiction, a relatively small price to pay for limited liability.” Labadie Coal Co. v. Black, 672 F.2d 92, 97 (D.C. Cir. 1982).

23. See Jabczenski v. Southern Pac. Memorial Hosp., 119 Ariz. 15, 579 P.2d 53 (1978) (mere existence of interlocking directorates between a not-for-profit and a for-profit corporation was insufficient to justify disregarding the corporate identities).

24. 511 F. Supp. 416 (1981), aff’d, 685 F.2d 448 (1982). 25. aMerican Hospital association, aHa guide to tHe HealtH care

Field at B2 (Health Forum Publishing 2009). 26. See generally Harry g. Henn & JoHn r. alexander, laWs oF

corporations and otHer Business enterprises at § 346 (West 1983). 27. For a history of total healthcare spending in the United States

dating back to 1960, see Centers for Medicare & Medicaid Services, National Health Expenditure Data: Historical (modified December 11, 2018), at https://www.cms.gov/research-statistics-data-and- systems/statistics-trends-and-reports/nationalhealthexpenddata/ nationalhealthaccountshistorical.html.

28. Congressional Budget Office, Physician Reimbursement Under Medicare: Options for Change at viii (published April 1986), at https:// www.cbo.gov/sites/default/files/99th-congress-1985-1986/reports/ doc13b-entire_3.pdf.

29. See, e.g., Debra Beaulieu-Volk, MGMA Physician Placement Report: 65 Percent of Established Physicians Placed in Hospital-Owned Practices (published June 3, 2010), at https://www.fiercehealthcare.com/ practices/mgma-physician-placement-report-65-percent-established- physicians-placed-hospital-owned.

30. Affordable Care Act, Pub. L. No. 111-148, § 3022. 31. See Centers for Medicare & Medicaid Services, Accountable Care

Organizations (ACOs): General Information (accessed February 21, 2019), at https://innovation.cms.gov/initiatives/aco/.

32. See Centers for Medicare & Medicaid Services, Pioneer ACO Model (accessed August 28, 2018), at https://innovation.cms.gov/ initiatives/Pioneer-aco-model.

33. ACA § 1899(b)(2).

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