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Healthcare
regulatory diligence can be critical where a real estate investment trust (REIT)
or other buyer acquires a portfolio of properties such as a medical office
building from a hospital or other provider. Leases between a hospital and tenants
can be invalidated by tenants if the relationships are not structured property.
In other situations, a tenant may not be able to utilize space as intended or
its business may not remain viable due to reimbursement, legal or regulatory changes.
This article provides an overview of certain key diligence issues in such transactions.
The
healthcare industry is heavily regulated on both the state and federal level. Violations
by a provider of laws such as the Ethics
in Patient Referrals Act, 42 U.S.C. §1395nn, commonly referred to as the Stark
Law, and
Federal Fraud and Abuse Statute, 42 U.S.C. §1320a-7b(b) (the Fraud and Abuse
Statute) (both of which restrict the ability of health care providers to refer
to entities with which they have a financial relationship) could subject that
provider to substantial fines, imprisonment and the loss of his or her license
to practice medicine. Real estate transactions involving healthcare entities
should include a thorough review of the relationships between providers,
particularly where the landlord, such as a hospital, and a tenant, such as
practice refer business to one another.
This article focuses on how
to conduct a regulatory diligence review in connection with a healthcare real
estate acquisition when the landlord and tenant are healthcare providers and
often have some level of relationship among them. The typical purchaser may be
a healthcare REIT. When a potential purchaser conducts a regulatory diligence review
of landlord-tenant relationships and tenant operations, the review should focus
on the following issues:
Overview
A. Summary of the Space Rental
Safe Harbor
A lease arrangement between two providers can be
structured so that it will not violate the Fraud and Abuse Statute. A rental payment
from a tenant to a landlord will not violate the Fraud and Abuse Statute, as
long as the following six standards, which make up the Space Rental
Safe Harbor,
are met:
1.
The lease
agreement is set out in writing and signed by the parties;
2.
The lease covers
all of the premises leased between the parties for the term of the lease and
specifies the premises covered by the lease;
3.
If the lease is
intended to provide the lessee with access to the premises for periodic
intervals of time, rather than on a full-time basis for the term of the lease,
the lease specifies exactly the schedule of such intervals, their precise
length, and the exact rent for such intervals;
4.
The term of the
lease is for not less than one year;
5.
The aggregate
rental charge is set in advance, is consistent with fair market value in
arms-length transactions and is not determined in a manner that takes into
account the volume or value of any referrals or business otherwise generated
between the parties for which payment may be made in whole or in part by
Medicare, Medicaid or other federal healthcare programs; and
6.
The aggregate
space rented does not exceed that which is reasonably necessary to accomplish
the commercially reasonable business purpose of the rental.
Fair market value for purposes
of this Safe Harbor means the value of the rental property for general
commercial purposes, but shall not be adjusted to reflect the additional value
one party (either the prospective lessee or lessor) would attribute to the
property as a result of its proximity or convenience to sources of referrals or
business otherwise generated for which payment may be made in whole or in part
under Medicare, Medicaid or other federal healthcare programs. In performing a diligence review, one
should ensure that lease agreements comply with the Safe Harbor
B. Diligence Review
Issues
1.
Fair market value. For regulatory compliance purposes, rental amounts
for leases should be set in advance at fair market value, and should not change
based on the productivity of, volume or value of referrals made by, or number
of patients of, a particular tenant. Ideally, the rental amount would be supported
by an independent, third-party valuation. Here, one should assess variations in
rental rates across tenants, the way in which rental rates are determined, the
overall leasing approach, whether the rental rates specified in the lease
represent the fair market value of the space, and whether there is any systematic
approach to under-price leases in exchange for the referral of health care
business.
Various courts have found leases and other agreements
between health care providers to be void if they violate the Fraud and Abuse
Statue. For example, in Vana v. Vista Hospital Systems, Inc., a
California state trial court ruled that below-market-rate leases between a
hospital and physician tenants in a hospital-controlled medical office building
violated the Fraud and Abuse Statute, even though one of the parties did not
know the leases were below fair market value and were thus not induced to
refer. 1993 WL 597402 (Cal.
Super. Ct. Riverside County, Nov. 15, 1993). Similarly, in Alpha Real Estate
Co. of Rochester v. Delta Dental Plan of Minnesota, a Minnesota appellate
court stated that a contract violating public policy is void, but ultimately
held the lease agreement in question did not violate the Fraud and Abuse
Statute. 671 N.W. 2d 213 (Minn.
App. 2003). Therefore, to the extent the existing leases are deemed to violate
state or federal law they could be deemed void by a court and the tenant could
be relieved of his or her obligations thereunder.
2.
Term. The safe harbor for space rental promulgated under
the Fraud and Abuse Statute and the corresponding exception to the Stark Law
require that each lease be for a term of at least one year. This means that the
parties may not amend the key economic provisions of the lease (i.e., rental
rate, square footage) during the first year of a lease term nor can the parties
enter into a new lease agreement on different terms during this time period.
3.
Tenant
type-specific issues. Here, one must examine
the types of tenants and assess the typical regulatory issues that potentially
may arise from leases with such type of tenants. A review of the leases would
often focus heavily on the relationships between the related owner-provider (or
landlords) and the tenants as set forth in the lease documents. It is difficult
to review, in most cases, the internal business operations of the tenants or
other relationships that they may have with an owner-provider. One would have
to inquire more deeply into the internal business operations of certain large tenants
in situations where the non-compliance of one tenant could materially affect
the medical office building leases and the strength of a specific building. Below
are some examples of tenant-specific issues that a thorough regulatory
diligence review might include.
a.
Physician practice
leases. Leases between an
owner-provider and referral source tenants, such as physician practices, are a
potential source of regulatory concern if not properly structured. Here, one
would examine whether rental rates are fixed, whether the leases expressly
require referrals, and whether there is vast differences in rent amounts
amongst different tenants. Further, one should look at whether an
owner-provider systematically undervalued leases to obtain tenants that would
refer to the owner-provider. A review of data used by the owner-provider in
setting the rental rates would be helpful in supporting the fair market value
of the rental rate where referring physician practices comprise a substantial
portion of the tenants in a particular building. One may not be able to review
the internal business operations of the physician practices, nor evaluate other
relationships between these tenants and owner-provider. The other relationships
between the parties (e.g. arrangements for the referral of patients or
provision of items or services) can create regulatory risk not addressed by a
lease review.
b.
Imaging center
leases. Agreements for imaging
services recently have been the target of significant governmental scrutiny. The
potential risk associated with these leases is often greater if the tenants are
independent, third-party imaging providers, and less if they are hospital-owned.
Certain types of imaging ventures are used as a means to allow physician
practices to profit from the use of or referrals to the center. These types of
ventures can be very effective in attracting medical practice tenants to
medical office buildings. Unfortunately,
these types of relationships are under significant attack. If a practice is
profiting from services such as MRIs and the acquiring landlord requires the
imaging center to change or stop the way it is doing business, leasing space in
the medical office building could become less attractive to current and
prospective tenants. Here, one may ask if imaging is used to attract practices
and as a profit center for practices. If so, the reviewer should also determine
whether these arrangements include per click leases or if time blocks are
leased to practice tenants. The long-term viability of the structures currently
used for many freestanding imaging centers remains open to question.
c.
Urgent care leases. As with imaging center tenants, leases with urgent
care centers may pose little risk if the tenant is owned and operated by a main
hospital system. Such leases, however, may pose heightened risk if the tenant
is an independent third party, especially if owned by physicians or other
potential referral sources for the landlord.
d.
ASC leases. Here, one initially focuses on the general lease
issues common to health care provider tenants (including fair market value rent,
a term of one year, etc.). But if the review is limited to the lease, a
reviewer may not have sufficient information to evaluate the internal business
operations of the ASC tenant (i.e., whether it is a traditional ASC or is
structured as a more risky model).
e.
Physical therapy
leases. A reviewer would first focus
on general lease issues common to health care provider tenants. For example,
one should determine if physical therapy is independently operated or if
resources are shared.
f.
Cardiac center
leases. As with imaging center and
urgent care tenants, leases with cardiac centers owned in part or in whole by
physicians or other referral sources may entail heightened risk from a
regulatory or liability perspective. Further, recent and proposed regulatory
changes would invalidate the structure and operations of certain independent
entities in the business of providing cardiac catheterization services. One should ask who owns the cardiac catheterization
labs and how they are operated.
g.
Pharmacy and optical
shop leases. The typical primary
concern with these types of tenants relates to lease terms that include rental
payments that are in excess of fair market value or structured as a percentage of
revenues, either of which could be viewed as a payment for easy access to the
owner-provider’s patients.
h.
Lab services leases. Here, one often focuses on the lease terms, and not
on the internal business operations of these types of tenants. Various
structures used for laboratory service companies, including “pod” laboratories
and joint ventures between physicians and laboratory suppliers, have come under
increased governmental scrutiny. We recommend evaluating whether such laboratory
tenants are being operated as true independent labs or as per click or pro rata
rental leased labs.
i.
Certificate of
need and licenses. In some states,
providers are required to obtain a license or certificate of need to operate. However,
very few, if any, require a certificate of need. This is important because a
certificate of need can be difficult or impossible to obtain. Thus, if a purchaser
needs to evict a tenant it could be impossible to procure a replacement tenant if
a certificate of need is required.
4.
Delinquent lease
payments. Certain tenants may be currently
or periodically delinquent with respect to lease payments. Here, one must
assess whether the landlord uses or permits ongoing delinquencies as a means of
reducing the “real” rental rate for such tenants, and whether the landlord
enforces payment of rent less stringently with parties that are referral
sources. Assuming that the landlord intends to collect rental payments in full
and that the landlord actually does employ reasonable and standard efforts to
collect such amounts, there is less regulatory concern regarding delinquent
lease payments. However, regulatory concerns could arise if the landlord (or a
successor landlord) relaxes its collection efforts with respect to certain referring
tenants whom the landlord views as particularly valuable, or with whom the
landlord has other relationships (aside from the leases). Thus, the landlord
(and any successor landlord) should generally pursue collection of overdue
amounts with the same vigor that would typically be used to collect from tenants
who do not otherwise generate referrals or other business for the landlord. A purchaser
ought to verify that delinquency and late payment rates are within normal
ranges.
In
addition to the foregoing tenant type-specific concerns, all financial or
referral relationships among the tenants and the landlord and one or more tenants
should ideally be evaluated for compliance with applicable health care laws and
regulations including but not limited to the Stark Law and the Fraud and Abuse Statute.
Accordingly, one should make specific requests for additional documentation relating
to 1) any third-party valuation of the tenants’ rental rates, 2) copies of any other
agreements between the landlord and each tenant, and 3) any information
regarding pending or threatened legal or government action or investigation
against tenants.
II.
Follow Up Questions
Typical follow-up questions to the
seller-landlord might include:
1.
Do you have an
appraisal or other documented support for the lease rates?
2.
Did any tenants
receive lower lease rates due to their importance to the landlord?
3.
Are all leases
fixed per annum or are some per click durations less than a year?
4.
Have any
relationships with any tenants been restructured due to legal concerns?
5.
Do physician
practice tenants have “lease” or other relationships with tenants that are imaging,
lab or therapy providers?
6.
Does the ASC
operate as a traditional ASC or an under-arrangements ASC?
7.
Has the landlord
been subject to any investigation or corporate integrity agreement?
8.
Which tenants are
owned by the landlord or an affiliate?
III.
Tenant Overview
A
sample chart of provider type and percent leased is often used to provide a
snapshot of the materiality of tenant types. This can guide, in part, the
allocation of resources to the tenant-specific review. For example, one might focus
more closely on and seek additional information related to the internal
operation of a tenant renting 20 percent of the building than a tenant renting 2
percent. The charts below provide a sample overview of the types of tenants by
building (in a transaction involving multiple buildings) as well as the key tenants
within each building.
Key Tenants
The following charts are examples of how to list the key tenants
in each of the buildings and the amount of space in the building occupied by
each such tenant. Where tenants account for a substantial portion of the space,
one would often recommend a more detailed examination of their internal
business operations and relationships with the landlord.
IV.
Review of Form Medical Office Lease
A purchaser will need to determine whether to enter
into new leases with the tenants or to take assignment of the existing leases. Where
a core form lease is used, a potential purchaser should understand the form
lease and its key provisions to understand the lease relationship and the
properties. Then, where a core form is used, one should determine whether the leases
reflect the form, in a generally unmodified state, or if modifications are made
to the form, how the landlord and the tenant agreed to the variations to the
form. The key provisions of a form lease often include:
1.
Designation of
the space. A form typically includes the
address of the building, the suite number of the rented space, and the total
square footage rented by the particular tenant. Because knowing the actual
square footage rented by a particular tenant is necessary to determine the fair
market value of the rental rate, one should confirm that the amount of space
designated in the lease is consistent with the space actually being used by the
tenant.
2.
Details of the
term. A form should require that the
term of the lease be for at least one year. The form should list the commencement
date, termination date, length of the initial term and any renewal options for
the particular tenant. In order to comply with the requirements of the safe
harbor for space rental promulgated under the Fraud and Abuse Statute and the
corresponding exception to the Stark Law, the leases must be for a term of at
least one year.
3.
Rental rate. A form should outline the possible types of fees
which will be included in the total rent paid by the tenant, including the base
rent, annual adjustment to such rent, as well as the inclusion of the tenant’s
portion of initial improvements to the leased space. In addition, the form may include
provisions that require the landlord to provide certain services (i.e., heat,
water, utilities). Compliance with fraud and abuse laws requires that the
rental rate be set in advance at fair market value. The form should set the
rental rate in advance, and any variance in the rental rate amongst tenants
could suggest that the rates are not set at fair market value.
4.
Use. A form may specifically limit the tenant’s use of
the premises.
5.
Compliance. The form should contain a compliance section
pursuant to which all tenants are required to comply with federal, state and
local laws, rules, regulations, ordinances, codes, orders and applicable
guidelines. The form should also explicitly state that tenants will not violate
healthcare-specific fraud and abuse laws and will not engage in illegal
referral relationships.
6.
Assignment, subletting
and change of control. A form may contain
an assignment and subletting provision which requires a tenant to obtain the
landlord’s written consent prior to assigning or subletting the lease or any of
a tenant’s interest in the lease. In addition, a form may also contain an
additional provision which requires the tenant to obtain the landlord’s prior
written consent before any change in or transfer of stock or ownership by the tenant’s
owners.
7.
Events of default. A form may contain a list of actions that if
performed by tenant, constitute a default under the lease. Examples of such
actions include:
(a)
impermissible
transfer, assignment or subletting of the lease;
(b)
failure to
maintain narcotics and controlled substances licenses;
(c)
failure to
maintain clinical privileges or employment with a local hospital;
(d)
failure to
maintain a license to practice Medicine in the state;
(e)
engaging in
unprofessional conduct; and
(f)
unauthorized
change of control.
8.
Membership on
the hospital medical staff and physician joinder. A form may require each tenant and all physicians using
space in the building to maintain membership on the medical staff of a
particular hospital and comply with the duties and requirements associated
therewith. A form may also include a physician joinder which is to be executed
by all physicians who perform services at the leased space.
V.
Due Diligence Review Issues
A review of the leases can highlight
specific issues. For example:
1.
Leases. Do rent rolls reflect all of the leases provided by
the landlord?
2.
Rental rate. Is the rent per square foot consistent from tenant to tenant?
3.
Tenant improvements. Do the leases provide that tenant improvement
allowances will offset the costs of building out, refurbishing or improving the
leased premises? As with the rental rates, one should be concerned about the
regulatory implications of offering substantial tenant improvement allowances
as a means of inducing referral sources to lease space from the landlord. However,
there often are legitimate business reasons for extending tenant improvement
allowances that may vary based on the nature and condition of the leased
premises and its suitability for a particular use.
4.
Clinical privileges. Do the leases require the tenants to maintain clinical
privileges at a local hospital and to adhere to medical staff requirements? The
inclusion of the clinical privileges requirement means that the landlord will
be reliant on the hospital remaining a “desirable” facility at which physicians
desire to practice. If the hospital becomes less attractive to health care
providers, there is a risk that the landlord would not be able to attract and
retain enough tenants who are capable of meeting the clinical privileges
requirement.
5.
Relationships
with (and between) tenants. What are
the relationships between tenants and the Landlord and among tenants? In recent years certain financial
relationships among physicians and between physicians and hospitals and other
health care providers and suppliers have come under scrutiny by government
regulators. Several of the relationships and service models that were
previously viewed by physicians and hospitals as legitimate ways of providing
and billing for ancillary services and sharing the high costs of certain
equipment and services now carry substantial risk. Examples of the types of potentially
problematic relationships that could exist with tenants include “under
arrangements” joint ventures, shared services arrangements utilizing a
centralized building, and “per click” space and equipment leases. Medical
director agreements, management services agreements, employment agreements and
consulting agreements may also be problematic to the extent they involve
compensation that does not reflect the fair market value for services actually
rendered.
6.
Investigations
and litigation. Has there
been any pending or threatened lawsuits involving the landlord or the tenants?
7.
Potential physician
ownership in medical office buildings. Do physicians own interests in the building? Any such offering would
need to be carefully structured to comply with state and federal anti-kickback
and self-referral prohibitions.
8.
Licensure and certificate
of need requirements. Are
license and certificate of needs needed to keep tenant operators? The inability
to secure a replacement tenant who can obtain a license and, if necessary, a CON
could negatively impact the profitability of the landlord.
VI.
Conclusion
Given the complex
regulatory environment governing healthcare providers, and the increased scrutiny of relationships among healthcare providers,
any potential purchaser of a healthcare facility should engage in a thorough
review of the leases and other relationships between the provider-landlord and its
tenants. If these relationships are
structured in a way that violate the Stark Law or the Fraud and Abuse Statute,
then the potential purchaser assumes some risk regarding the continued operations
of the tenants. If a tenant were to be
investigated and found guilty of violation of a healthcare regulatory law, the tenant
could lose its ability to provide healthcare services, and the new landlord
could have difficulty replacing such tenant.
Therefore, even if the potential purchaser is not a healthcare provider
itself, it is important that the potential purchaser fully understands the relationships
of tenants and evaluates the risks associated with purchasing the facility.
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