United States: Fiduciary Duties Of Officers And Directors Of Financially Distressed Nonprofit Hospitals

Changes in the health care marketplace and uncertainties regarding the implementation and future of the Affordable Care Act (ACA) have placed tremendous strain on not-for profit hospitals and health systems. The pressures affect both sides of the ledger, as nonprofits struggle to maintain revenues, to contain costs, and to stay above water.

Officers and directors of these financially distressed nonprofits face a difficult role. As officers and directors, they generally owe fiduciary duties to their nonprofit organization and its charitable mission. However, if the nonprofit is or may be insolvent, uncertainty arises as to whether and to what extent those fiduciary duties may be altered. In the past, those questions were answered with references to terms such as "zone of insolvency" and "shifting duties"—advice that provided little guidance about how to make decisions for their struggling corporations.

Over the past several years, the law in this area has developed, moving away from the "zones" and "shifts" of yore and towards a framework that better defines officers' and directors' duties and defers to their reasonable business judgment, even when their corporations are insolvent.

Nonprofits and their Current Challenges

Stories of financially distressed not-for-profit hospitals are increasingly common. In California, the Daughters of Charity Health System, which operates six hospitals in the Bay Area and Los Angeles County, and Doctors Medical Center, a community-owned safety-net hospital in San Pablo, are engaged in ongoing, well-publicized efforts to sustain their operations through going-concern sales or increased community support. In Georgia, Hutcheson Medical Center, a nonprofit hospital in Oglethorpe, filed for chapter 11 bankruptcy late last year to stave off foreclosure attempts by one of its creditors. Hutcheson continues to operate while it pursues its exit from chapter 11. Other nonprofit hospitals have suffered worse fates. Among those hospitals that have closed their doors this past year are Crittenden Regional Hospital in West Memphis, AR, North Adams Regional Hospital in North Adams, MA, and Nicholas County Hospital in Carlisle, KY.

Health care executives and industry experts alike see no immediate relief in sight. A recent survey of hospital CEOs identified "financial challenges" as their top concern for 2015.¹ Each of the three largest ratings agencies—Fitch, Moody's, and S&P—issued negative forecasts for the not-for-profit health care industry for 2015. Matters soon could get worse, especially if interest rates increase or if the Supreme Court's ruling in the King v. Burwell² case currently pending before the Court adversely impacts the federal insurance exchanges created by the ACA.

The Sources of Distress

Among the factors contributing to nonprofits' problems are:

Declining patient volumes

The general decline in demand for hospital services has depressed hospital revenues. Reduced patient volumes are attributable to numerous factors, including increased competition from alternative models of care such as urgent care centers, stand-alone emergency departments, outpatient surgery centers, and home care and long term acute care providers. The Medicare program's emphasis on reducing patient readmissions, its "two-midnight rule," and its value based compensation reforms all encourage care outside of the hospital environment, exerting additional downward pressures on hospital revenues. Higher deductible insurance plans are causing individuals to evaluate the costs of their health care options more closely than ever before. Many nonprofits, especially rural hospitals, cannot afford the specialty services their community seeks, driving that demand and those revenues elsewhere.

Increased operating costs

The ACA's electronic health record (EHR) meaningful-use criteria have required many nonprofits to invest in expensive information systems upgrades, and the shift from cost-based reimbursement to a value-based compensation model is imposing new tracking and reporting obligations on providers. To remain competitive, nonprofits must invest in upgrades to their aging equipment and facilities and in recruiting and retaining physicians, especially those in key specialties. For some nonprofits, above-market collective bargaining agreements and unfunded pension obligations may further strain their coffers.

The move from cost-based to value-based government compensation

Many nonprofits serve high percentages of Medicare and Medicaid patients and, thus, rely on government payments for the disproportionate bulk of their revenues. In the past, hospitals were paid for services provided to these patients through traditional fee-for-service reimbursements. The ACA, however, has shifted the basic payment structure away from fee-for-service reimbursement to a value-based payment model that bases compensation increasingly on the quality of care a hospital provides and the outcomes its patients realize, and not on the services provided. Under programs such as Medicare's Value-Based Purchasing (VBP) and CMS' Hospital Readmissions Reduction Program (HRRP), payments to hospitals that fail to reach specified benchmarks tied to quality of care and patient outcomes are at risk. Nonprofit hospitals stand to be disproportionately affected by these changes, with at least one study showing that safety-net hospitals—the majority of which are nonprofits—are more likely than other hospitals to be penalized under the VBP program and the HRRP. ³

Meanwhile, federal programs that provided additional support to many nonprofits, such as Medicaid's Disproportionate Share Hospital (DSH) program and Medicare's critical access hospital (CAH) designation entitling certain hospitals to receive cost-based rather than standard fixed rate reimbursements, have been rolled back. The cuts in these programs were done with the expectation the ACA would generate additional revenues that would help defray the cutbacks in these programs. However, that expectation has not yet been realized.

Intended and unintended consequences of the ACA

When the ACA was enacted, one of its central features was its mandate that each state must expand Medicaid eligibility within their borders as a condition to the state's receipt of federal matching funds. With Medicaid expansion mandated, the amount of uncompensated care provided by hospitals was expected to decrease markedly. That expectation has not been realized, however, due to the Supreme Court's invalidation of the ACA's mandatory Medicaid expansion provisions in 2012.⁴ With expansion optional for each state rather than mandatory, only 28 states and the District of Columbia have expanded their Medicaid programs since the ACA's enactment.⁵ In those 22 states that have not opted to expand Medicaid, many health care providers have been particularly hard hit by both the loss of the DSH payments they previously received and the unrealized increase in revenues that Medicaid expansion promised. Evidencing that impact is the change in bad debt rates in those states that did and did not expand their Medicaid programs, with median bad debt down by 5.6% through 2014 in those states (including the District of Columbia) that expanded Medicaid eligibility, and bad debt up by 6.8% during the same period in those states electing not to expand.⁶

Nonprofit and for-profit providers alike are concerned about another looming Supreme Court decision regarding the ACA. Earlier this year, the Court heard arguments in King v. Burwell, which questions the legality of federal subsidies provided to individuals who enroll for insurance through federally-run insurance exchanges. An adverse ruling could block federally-run insurance exchanges from providing subsidies to individuals in at least 34 states that have not adopted their own state-operated exchanges. Without such subsidies, some experts estimate that insurance premiums sold on the federal exchanges could increase by an average of 255% and, in some states, by as much as 774%, with approximately 7.5 million individuals potentially affected. ⁷ If premiums increase, more people will qualify for a hardship exemption from the ACA's individual insurance mandate, relieving them from their current obligation to secure health coverage. This potential increase in uninsured individuals would cause health care providers to lose yet another source of revenues they anticipated receiving when the ACA was passed.

The Duties of Nonprofit Officers and Directors

Fiduciary Duties with respect to Solvent Nonprofits

Nonprofit officers and directors owe fiduciary duties to the nonprofit they serve. Those duties include a duty of care and a duty of loyalty. Under the latest iteration of the Model Nonprofit Corporation Act,⁸ the duty of care requires a director of a nonprofit to perform his or her duties as a director in good faith and in a manner the director reasonably believes to be in the best interests of the nonprofit corporation.⁹ When becoming informed in connection with a decision-making function or devoting attention to an oversight function, a director must discharge his or her duties with the care that a person in a like position would reasonably believe appropriate under similar circumstances. The duty of care generally permits a director, in discharging his or her duties, to rely on information prepared or presented by officers, employees, or volunteers of the nonprofit, legal counsel, public accountants, committees of the board, and, in the case of a nonprofit engaged in religious activity, religious authorities, provided those sources are believed to be reliable and competent and provided that the director not have knowledge that makes reliance unwarranted. A director's duty of loyalty arises out of the mandate that directors act in good faith and in a manner the director reasonably believes to be in the best interests of the nonprofit corporation,¹⁰ and generally requires directors to act in a manner that promotes the interests of the corporation and not their own. In the nonprofit context, the duty of loyalty includes a duty of obedience to the corporation's charitable mission, compelling them to act in a manner they reasonable believe will further such mission.¹¹

As for officers, the Model Act requires each officer with discretionary authority to discharge his or her duties: (1) in good faith, (2) with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and (3) in a manner the officer reasonably believes to be in the best interests of the nonprofit.¹² An officer also has a duty to inform his or her superior officer, another appropriate person, or the directors, of material information about the affairs of the nonprofit known to the officer with the scope of the officer's functions, or of any actual or probable material violation of law involving the nonprofit or material breach of a duty owed by another person to the nonprofit that he or she believes has occurred or is likely to occur. Like directors, in discharging their duties, officers may rely on information prepared or presented by certain other people affiliated with the nonprofit, provided those sources are believed to be reliable and competent and provided that the officer not have knowledge that makes reliance unwarranted.

Fiduciary Duties with respect to Insolvent Nonprofits

For decades, courts and legal scholars have wrestled with whether and how the fiduciary duties of officers and directors may change when their corporation is or may be insolvent. In Delaware – the state in which many corporations are formed – and other jurisdictions, a line of case law developed holding that, when a for-profit company became insolvent or entered the "zone of insolvency," the fiduciary duties of the company's directors "shifted" to include the company's creditors such that the board members owed fiduciary duties directly to those creditors.¹³ The reasoning underlying these opinions was that, when a for-profit corporation became insolvent or close to insolvent, the company's creditors were the stakeholders who truly stood to gain or lose from the decisions made by the company's leaders since shareholders were no longer "in the money."

Extrapolating from these cases, courts and commentators concluded that the same result should apply with respect to officers and directors of insolvent not-for-profits that were in the "zone of insolvency" and that they, too, owed fiduciary duties to creditors of their insolvent or potentially insolvent company.¹⁴ These conclusions were reached without much discussion or analysis, even though the reasoning underlying the for-profit fiduciary duty opinions—i.e., that creditors of an insolvent for-profit are the de facto shareholders of the company—was clearly not analogous to nonprofits that, by definition, have no shareholders. Moreover, the analogy failed to account for a nonprofit's obligation to maintain and pursue its charitable mission as a condition to its tax-exempt status, a condition which may be jeopardized if a nonprofit's leadership was compelled to put the interests of its creditors ahead of furthering that mission. While the concept of "owing" fiduciary duties to creditors was problematic in the for-profit context, it was simply untenable when extended to nonprofit entities.

The New Line of Cases

Over the past several years, a new line of Delaware decisions— the most recent being the Quadrant opinion last year—has broken from the old "zone of insolvency" and "shifting duties" cases in many material respects.¹⁵ First, these cases reject the notion that directors of insolvent corporations ever owe fiduciary duties directly to creditors. Rather, the fiduciary duties of officers and directors always run to their corporation. While the beneficiaries of those duties may shift, the duties themselves do not "shift" back and forth between shareholders and creditors depending upon their balance sheet. Second, the Delaware courts now deem irrelevant whether a corporation is in the amorphous "zone of insolvency." A corporation's actual insolvency—not just the prospect of it—is relevant, as a corporation's demonstrated insolvency will provide its creditors with standing to maintain derivative claims on the company's behalf against directors for breaches of fiduciary duties.

Finally, this newer line of Delaware opinions recognizes that an insolvent corporation's officers and directors are not compelled by the corporation's insolvency to reflexively pursue liquidation or to forego business opportunities that, in the board's properly-exercised business judgment, might enhance the enterprise's value despite entailing some risk to the company's creditors. In Quadrant, for example, the court dismissed derivative claims brought by senior creditors of the bankrupt company against its directors. The creditors' derivative claims alleged the directors breached their fiduciary duties by adopting a new, but riskier, investment strategy for the insolvent company rather than pursuing liquidation. The senior creditors asserted that the directors pursued the more speculative course of action solely for the benefit of the junior debt and equity holders, with which many of the directors were affiliated. The Quadrant court found that the board's decision to pursue the riskier, but potentially more lucrative, business strategy was protected by the business judgment rule, and that the plaintiffs failed to rebut the business judgment rule simply by alleging that the directors pursued that strategy to benefit the equity owners and junior debt holders with which they were related.

No court has explicitly extended the rulings in Quadrant and its predecessor cases—all of which involved for-profit companies—to a case involving an insolvent nonprofit corporation. However, the basic holding in Quadrant—that directors of insolvent companies are not compelled to make decisions to pursue actions solely for the benefit of creditors and to forego opportunities that reasonably might further the corporation's underlying objectives (enhancing corporate value, for a for-profit company)—should apply equally to not-for-profit enterprises. Nonprofits should not be compelled to pursue liquidation simply by virtue of their insolvency if the board concludes, in its reasonable business judgment, that other business opportunities should be pursued that will further the company's charitable mission.

Though predating Quadrant and its line of cases, an opinion out of the United Healthcare System16 bankruptcy case advanced such a position. In United Healthcare, the directors of a nonprofit hospital, after a thorough marketing process of the hospital's assets, accepted a purchase offer that was not the highest one received. Instead, the board, after conferring with financial advisors and state regulators, accepted as "better" a bid made by a party that promised to keep the hospital in its current location and to make substantial future investments in the facility. The bankruptcy court disagreed with the board's rejection of the higher offer and vacated the sale to the lower bidder. The appellate court, however, overturned the bankruptcy court's decision, finding the nonprofit board's acceptance of the lower, but better, bid to be consistent with their "fiduciary obligation to act in furtherance of the organization's charitable mission."¹⁷

Like Quadrant, the United Healthcare case supports strongly the view that the reasonable and informed exercise of business judgment by a board of directors, whether of a for-profit or nonprofit entity, should be accorded great judicial deference even when the company is insolvent. A recent Third Circuit opinion, on the other hand, shows how severe the consequences can be when nonprofit directors breach their duties of care and loyalty and fail miserably to exercise reasonable business judgment. ¹⁸

That case involved The Lemington Home for the Aged (the Home), a nonprofit nursing home with a long history of financial and operational problems. The Home filed for bankruptcy in April 2005, three months after the Home's board of directors had voted to close the Home due to its financial difficulties and general eroding condition. In the intervening period, the Home's census dropped, and it continued to incur debt without disclosing its bankruptcy plans to creditors. In the years preceding the board's bankruptcy vote, the Home was repeatedly cited for deficiencies at an exceptionally high rate, failed to maintain patient records adequately, did not consistently maintain a general ledger, and mismanaged its billing operations, resulting in the loss of upwards of $500,000 in Medicare payments. The Home's Administrator and CEO served for over 17 years in her position, despite the Home's dismal financial and operational history during her tenure, reports from government inspectors stating that she lacked the qualifications to serve in her position, and her collecting a full-time salary even after moving to part-time status—a move that violated state law which required the Home to maintain a full-time administrator. In addition to neglecting the Home's financial and billing operations, the Home's Chief Financial Officer (CFO) failed to timely generate financial reports and refused to meet with key creditors' representatives while the Home was in bankruptcy. As for the board, it failed to properly supervise and timely remove the Administrator and CFO once their mismanagement became apparent (even though the board had sought and obtained a grant to fund the search for a new Administrator), did not meet regularly or maintain appropriate minutes of board minutes, consciously deferred filing for bankruptcy and depleted the patient census, and failed to establish a reasonable sale process for the Home either before or after bankruptcy.

Against this backdrop, the official committee of creditors in the Home's bankruptcy case sought, and obtained, authorization from the bankruptcy court to pursue derivative claims on the Home's behalf against the two officers and the Home's directors. A jury returned a compensatory damages verdict against 15 of the 17 defendants, jointly and severally, in the amount of $2.25 million for, among other things, breaching their fiduciary duties to the Home. The jury also awarded punitive damages in the amounts of $1 million against the Administrator, $750,000 against the CFO, and $350,000 individually against five of the director-defendants. On appeal, the Third Circuit affirmed all of the jury verdicts, with the exception of the punitive damages verdict against the five directors. The Third Circuit found there was ample evidence to find that the Administrator and the CFO had each breached their duties of care and loyalty and that the director-defendants had breached their duty of care. However, the court found no evidence that the directors had breached their duty of loyalty. The absence of any evidence of self-dealing by the directors, the Third Circuit ruled, weighed heavily against assessing punitive damages against them.

Conclusion

Nonprofit officers and directors may be tempted to disregard Lemington based on the egregious set of facts it presents. That would be a mistake. At its core, Lemington is an extreme example of a rather common fact pattern seen when a company is financially and operationally distressed. Management, fearful for the loss of their jobs and overwhelmed by the situation, fails to communicate timely and fully to their supervisors and their board the full extent of the company's problems. Directors, assuming that "no news is good news," preoccupied with their own full-time jobs or activities, and likely inexperienced with distressed situations, remain disengaged from the situation or, if and when engaged, do not act swiftly or decisively to address the nonprofit's problems. The disengagement of directors can be a particular problem with nonprofits, especially if the nonprofit or the directors themselves have historically viewed board membership as more of an honorary position than one entailing serious oversight and decision-making responsibility.

The holdings in the recent Delaware line of cases and in United Healthcare stand in stark contrast to Lemington. Those opinions show that officers and directors of an insolvent company—including nonprofit hospitals and health systems— can satisfy their fiduciary duties by making informed, reasonable judgments and acting deliberately with the interests of the company at the core, even if those decisions and actions will not necessarily assure the highest or most certain recovery to the company's creditors. To be properly informed, regular board meetings must be had and management reports made. Outside counsel, accountants, and advisors should be consulted when questions arise that cannot be adequately addressed in-house or to help identify options available to the nonprofit to address its financial position, including merger and sale options, affiliation agreements, chapter 11 bankruptcy, or closure and liquidation. Inaction is not acceptable. As the jury in Lemington aptly concluded, the incompetence, disengagement, and indecision of a company's management team and board are indefensible, at any time, and especially when that company is insolvent.

Footnotes

1 Healthcare Finance, Reform Top Issues Confronting Hospitals in 2014, American College of Healthcare Executives, January 12, 2015, available at www.ache.org/PUBS/research/ceoissues.cfm.

2 King v. Burwell, 759 F.3d 358 (4th Cir.), cert. granted, 135 S. Ct. 475 (2014).

3 Matlin Gilman, et al., California Safety-Net Hospitals Likely to be Penalized by ACA Value, Readmission, and Meaningful-Use Programs, Health Affairs (Aug. 2014), at 1314.

4 Nat'l Fed'n of Indep. Bus. v. Sebelius, 132 S. Ct. 2566 (2012).

5 Where the states stand on Medicaid expansion, The Advisory Board Company, Feb. 11, 2015, www.advisory.com/daily-briefing/resources/ primers/medicaidmap.

6 Moody's Investors Service, Moody's: Outlook for US Not for Profit Healthcare Remains Negative, Dec. 2, 2014, https://www.moodys.com/ research/Moodys-Outlook-for-US-Not-for-Profit-Healthcare-Remains- Negative--PR_314203.

7 Caroline F. Pearson, Avalere Observations: Impact of King v. Burwell & Potential Fixes, March 4, 2015, http://avalere.com/expertise/managed-care/ insights/avalere-observations-impact-of-king-v.-burwell-potential-fixes/ print.

8 Model Nonprofit Corporation Act, Third Edition (American Bar Association, Section on Business Law, Committee on Nonprofit Corporations, 2008) (Model Act).

9 Model Act, § 8.30.

10 See Michael W. Peregrine, James R. Schwartz, James E. Burgdorfer, and David C. Gordon, The Fiduciary Duties of Healthcare Directors in the "Zone of Insolvency," J. of Health Law (Spring 2002), available at https://www. healthlawyers.org/Publications/Journal/Documents/2002/April%202002/ The%20Fiduciary%20Duties%20of%20Healthcare%20Directors%20in%20 the%20Zone%20of%20Insolvency%20[JHL,%20April%202002].pdf

11 Id.

12 Model Act, § 8.42.

13 See Bovay v. H.M. Byllesby & Co., 38 A.2d 808 (Del. 1944); Credit-Lyonnais Bank Nederland, N.V. v. Pathe Commc'ns Corp., 17 Del. J. Corp. L. 1099, 1055 n.55, 1991 WL 277613 (Del. Ch. Dec. 30, 1991).

14 See, e.g., In re Lemington Home for the Aged, 659 F.3d 282, 290 (3rd Cir. 2011)( citing Citicorp Venture Capital, Ltd. v. Comm. of Creditors Holding Unsecured Claims, 160 F.3d 982, 987-88 (3rd Cir. 1998) (in case involving a nonprofit, the court cited a case involving a for-profit corporation case as authority for finding that officers and directors of insolvent nonprofit owed fiduciary duties to creditors).

15 Quadrant Structured Prods. Co., Ltd. v. Vertin, 102 A.3d 155 (Del. Ch. 2014);North Am. Catholic Educ. Programming Fdtn., Inc. v. Gheewalla, 930 A.2d 92 (De. 2007); Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006).

16 In re United Healthcare System, Inc., 1997 WL 176574 (D. N.J. 1997).

17 Id. at *5.

18 Official Committee of Unsecured Creditors v. Baldwin (In re Lemington Home for the Aged), 2015 WL 3055505 (3rd Cir. 2015) (applying Pennsylvania law).

Originally published in AHLA Connections on June 2015, June 2015, Volume 19, Issue 6.

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