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Legalities of selling a nonprofit

By Charles R. Brodbeck, Esq. & Mark R. Stabile, Esq.

As managed care continues to take root in the nation’s health care delivery system, an increasing number of nonprofit health care providers (such as hospitals) are considering selling their operating assets to for-profit businesses. When a nonprofit health care provider is sold to a for-profit business, both the sale itself and the proposed use of the sale proceeds often place the members of the board of directors of the nonprofit in the limelight. Physicians involved with nonprofits, particularly those who are board members of a nonprofit contemplating such a sale, should understand the duties imposed on a nonprofit’s board of directors, as well as federal and state safeguards designed to protect the public interest during such sales. A clear understanding of these duties and requirements will better equip those involved in the process to evaluate their own role and determine, given the inevitable varying interests that arise in such a sale, when independent professional advice and counsel may be warranted.

Board Obligations

The Pennsylvania Nonprofit Corporation Law of 1988 (the “Pennsylvania Nonprofit Law”) broadly outlines the standards governing the conduct of nonprofit directors, the duties they owe to their corporations and the information that a director may consider or rely upon in carrying out such duties. An awareness of these standards is important both for those directly involved in a sale of a nonprofit, as well as those on the outside looking in.

Basically, Pennsylvania Nonprofit Law states that directors must act in good faith and in a manner that they reasonably believe to be in the best interests of the corporation. The Pennsylvania Nonprofit Law provides directors with considerable leeway in determining the factors relevant to the consideration of the “best interests” of the corporation. In fact, the Pennsylvania Nonprofit Law expressly states that the board may consider any factors it deems relevant in evaluating a proposed transaction. As a result, the “best interests of the corporation” is an extremely broad concept, which is not limited to financial or other specific interests of the business itself.

For example, the Pennsylvania Nonprofit Law permits, but does not require, the directors to consider the interests of various “constituents” or parties having relationships or business with the corporation. In that regard, the interests of employees, suppliers, customers (e.g. patients of a nonprofit health care provider), creditors and communities in which the corporation operates may be considered if deemed relevant by board members. Under the Pennsylvania Nonprofit Law, the price to be paid by the purchaser of the business clearly need not be the primary factor considered by the board.

This latitude given to nonprofit directors permits them to consider both long term and short term interests. In many cases, the very reasons that a sale is considered are the perceived long term risks to a nonprofit that can result from its inability to secure access to capital or achieve economies of scale; the latter are the hallmarks of many successful for-profit health care providers.

The Pennsylvania Nonprofit Law permits directors, in fulfilling their duty to act in the best interests of the corporation, to rely on information provided by others, both inside the corporation, such as corporate officers and other board committees, as well as outside legal counsel and accountants. According to the law, a director will not be held legally liable for aspects of a good faith decision made in reliance upon information provided by others within the area of their expertise. As such, the law actually reinforces the need for directors to obtain expert legal and financial advice.

The duty to act in the best interests of the corporation often is referred to as the “duty of care.” Directors also are charged with a “duty of loyalty,” which generally requires directors to place the interests of the corporation above personal interests. When a nonprofit is sold to a for-profit business, physicians and physician practice groups often are caught in the middle. Thoughtful analysis and advice often are necessary to sort through the resulting divided loyalties that physician board members may encounter.

Federal Oversight

Federal oversight of any nonprofit sale is handled by the Internal Revenue Service (IRS). The IRS primarily is concerned that the nonprofit is sold at fair market value and that the funds of the nonprofit are not used for the benefit of private individuals.

The IRS does not require pre-approval of the sale of a nonprofit, but the IRS may question the sale through, among other things, an audit of the nonprofit’s tax return for the year in which the sale is reported. A nonprofit can voluntarily seek IRS approval in advance of the sale, but the ruling may take from three months to a year to obtain.

If pre-approval is not sought, the nonprofit’s board of directors should understand that the IRS can impose financial penalties after the transaction if the sale price is less than fair market value. To ensure the transaction can withstand such post-sale scrutiny, the board should accurately value the transaction and determine whether the purchase price is fair. This is known as a fairness opinion, and it can be invaluable if the transaction is later questioned by the IRS.

The nonprofit’s board also should analyze any severance arrangements for departing executives. This analysis would look at current market conditions and the benefits provided to similarly situated executives in order to determine that such benefits are not excessive. Although “golden parachutes” often are viewed with disdain, in many cases there are sound reasons for providing existing management with such protections. For example, it often is impossible to maintain the continuity necessary for a successful sale and transition without the assistance of existing senior management; appropriate severance arrangements may better enable existing senior management to perform such duties by mitigating the distractions and pressures otherwise accompanying such a transaction. As a result, an outside analysis of such arrangements often is a key in determining what is appropriate and what is excessive.

State Regulation

Most states exercise some authority and oversight when the assets of a nonprofit corporation are sold to a for-profit business. In some states, state attorneys general may initiate litigation in an attempt to exercise control over such transactions; in other states, specific statutes require prior approval of such transactions. For example, the Ohio state attorney general brought a lawsuit against the Blue Cross and Blue Shield plans in Ohio when those plans sought to merge with for-profit Columbia HCA Healthcare Corp.; the attorney general asked that the plans be placed into receivership and an independent trustee be appointed to safeguard their charitable assets. California recently enacted legislation that requires any transaction in which a nonprofit merges with or converts to a for-profit business to receive prior approval of its state attorney general.

In Pennsylvania, the Orphans’ Court Division of the County Courts of Common Pleas has jurisdiction over matters involving charitable organizations. Many sales of nonprofit assets to for-profit businesses must be approved by this court because state law mandates that assets dedicated to a charitable purpose cannot be diverted from that purpose without court approval.

To obtain court approval, the selling nonprofit must file a petition with the Orphans’ Court and provide a copy to the Pennsylvania attorney general, who is charged with representing the public interest. The Charitable Organizations Bureau and, in large transactions, the Antitrust Division of the Pennsylvania state Attorney General’s office will consider whether the sale may cause an impermissible reduction in health service to an area and if the proceeds will be used for a charitable purpose.

It is wise to work with the attorney general’s office in advance of the Orphans’ Court hearing on the transaction. Generally, the seller and its legal representatives will meet with the attorney general’s office to identify potential problems that would hinder court approval. These advance negotiations can be critical to a smooth approval process.

During the public hearing at the Orphans’ Court, the inquiry generally will focus on whether the selling nonprofit is receiving fair value for the assets sold and whether the sale proceeds will continue to be used for similar charitable purposes. In many instances where advance discussions have already occurred, the Pennsylvania state Attorney General’s office does not send a representative to the hearing. Instead, the office sends a letter to the court stating that the attorney general’s office will not object to the sale. If the court approves the transaction, the seller generally will be protected from future public challenge, since the court and attorney general acted as representatives of the general public.

Proceeds

When a nonprofit is sold to a for-profit, the sale proceeds must remain “charitable assets” that are dedicated to a similar mission. Difficult issues often are presented where particular assets or funds of the nonprofit were donated for specific, named purposes. For example, an individual or foundation may donate funds that must be used by the nonprofit health care provider to conduct research in a specific field. In those cases in particular, a concerted effort must be made to continue the use of those assets for a purpose faithful to the specific intent of the donor. In most cases, because the nonprofit is selling to a for-profit, donor-restricted funds will not be available to support the for-profit business in the same manner as they supported the nonprofit. Therefore, creative solutions may be required to continue the use of such funds in a manner as consistent as possible with the donor’s original intent.

There are many ways that the proceeds of the sale of a nonprofit corporation may be used to continue the mission of the selling corporation. The most common ways to return the benefit to the community are to:

• Continue as an operating charitable organization providing other charitable benefits and services that are consistent with the organization’s original mission.

• Establish a new, stand-alone foundation to make charitable grants to be used for purposes consistent with the organization’s original mission.

• Give the proceeds to the nonprofit’s existing foundation (if applicable).

• Form a relationship with a community foundation.

• Give the proceeds to an unrelated organization whose mission is aligned with the selling corporation.

In each of these cases, the goal should be to continue to apply the sale proceeds for charitable purposes similar to or consistent with those provided by the assets that were sold. The purpose may be a narrow one. For example, proceeds from the sale of a nonprofit cardiac care center could be used to establish a heart research foundation. On the other hand, a hospital typically has a broad mission directed at improving health care, and perhaps also conducting health-related education and research. The range of opportunities for a charitable foundation formed after the sale of such a hospital obviously can be quite broad.

The path chosen often depends upon the goals of those involved and their desired level of involvement after the sale. Regardless of how the proceeds are to be used following the sale, those involved should recognize at the outset that the organization or individuals responsible for post-sale activities often will have very different issues and concerns in the sale than the management or even the board of the selling organization.

There are many complex issues involved in selling a nonprofit to a for-profit business. But if the nonprofit recognizes the existing legal safeguards and obligations, the community will be the ultimate beneficiary. This is particularly true if the nonprofit was at risk of failure or decline on its own. The community may actually end up with a net benefit since the services that remain likely will be provided by a financially stronger organization and the proceeds of the sale will be used to provide other charitable benefits.

Charles R. Brodbeck, Esq., is a Director and Mark R. Stabile, Esq., is an Associate with the national law firm of Cohen & Grigsby, headquartered in Pittsburgh.

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