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.
