Defending Against Unwarranted Damage Claims in a Medical Practice Dissolution

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Not all marriages are made in heaven and neither are all business partnerships. Inevitably, the practitioner will encounter a break-up of a client medical practice or be asked to serve as an expert in assessing damage claims. This article highlights some of the typical goodwill and damage claim issues, how to identify their weaknesses, the importance of regulatory review, and how to defeat the claim in appropriate circumstances.

A typical damage claim (and, typically, an unsophisticated one) involves a claim against one party for loss of goodwill by the other. A typical measure of this goodwill is accomplished through an excess earnings approach. (Note: We assume a going concern, fair market value standard for purposes of this discussion. The excess earnings approach as applied to medical practices typically does not include a return on tangibles since that return is assumed to be included in the statistical baseline earnings. If you want to use a return on tangibles in your model, you would need to remove that return on tangibles from the statistical earnings. This is true because physicians generally withdraw all of the earnings from their practice in the form of compensation.) (Practitioners must also be aware of the definition of Fair Value as used in the statutes in the state in which the damage case is filed)

Example: 3-person practice, one partner expelled

When presented with such an "analysis", the first thing to ask is who among the doctors was earning the $900,000? What was the compensation formula? What do the employment contracts say? How many services did each physician provide by CPT (physician billing) code (technical vs. professional)? Did the practice provide any ancillary services (e.g., lab and x-ray)? Were these services a source of profits? Were there any physician extenders (e.g., nurse practitioners)? If so, were they profitable?

Is there a buy-sell agreement? Typically buy/sell agreements exclude accounts receivable to permit entry and exit with much lower cash amounts than would be the case if accounts receivables are being purchased. Whether partnership interests or stock shares, the practice should annually ratify the value of each unit of ownership, although few do, despite the old adage that "An ounce of prevention is worth a pound of cure."

Assume that the $900,000 of income in the example was earned $400,000 by Dr. Allday, $300,000 by Dr. Begood, and $200,000 by Dr. DoLittle. Dr. DoLittle is the plaintiff. The damage claim presented effectively redistributes $200,000 of Dr. Allday’s "excess earnings" to the entire practice, and accounts for $1,000,000 of the valuation. If Dr. Allday is producing that income through a disproportionate number of the total encounters, it will be difficult to convince a court that Dr. DoLittle is entitled to the fruits of Dr. Allday’s labor. In fact, Dr. DoLittle is earning only $200,000 and contributing no excess earnings to the practice. Dr. Allday’s counsel might ask Dr. DoLittle if he was ever paid any portion of Dr. Allday’s income, or whether he ever expected to be paid a portion.

If the doctors in the example were, in fact dividing income equally, Dr. DoLittle might have a better argument, since, as the lowest producer, he would be getting the fruits of someone else’s labor. Whether the damages are for loss of equity or earnings would still be open to question. (See discussion of Stark Anti-Referral issues below regarding the dangers of distributing the technical component of referred procedures based on production.)

Another line of inquiry involves whether the damage claim is for loss of an asset – goodwill - or whether it is for loss of income due to wrongful discharge from employment. These are two different claims. If the plaintiff presents expert testimony as to the loss of an asset, it may be possible to defeat that claim, whereas an improper discharge claim may be more difficult to defeat.

It is important to analyze the underlying intent of the parties with respect to any "excess earnings" and whether the value of same was to be considered equity, or a liability to the producer of that excess for compensation. Perhaps the first inquiry should be whether any prior buy-in transaction included Accounts Receivable (A/R) as part of equity, or whether the A/R is reallocated via the compensation system and employment contracts.

The typical employment contract in a small practice will provide that upon retirement, or other termination of employment for defined reasons, the physician will be entitled to receive his/her share of A/R as collected, or over a period of time. (A cost of collection may be charged against the receivables to determine the amount due.) Paying the specific receivables of a physician to him or her at retirement or other termination clearly puts the offsetting credit on the right side of the balance sheet in the liability class, not equity. On the other hand, if the total A/R were included in the buy back of stock under the Shareholder’s Agreement, equity would clearly be indicated. If the retiring shareholder were entitled to a pro-rata share of the A/R regardless of who produced them, this would enhance Dr. DoLittle’s claim of loss of equity if he did not get paid out.

Is there any enterprise or practice goodwill value in a practice that allocates all compensation on a productivity basis and at retirement pays receivables based on who produced them? There may well be, but it will certainly not be determinable by lumping all the "excess earnings" into a single bucket. Some portion of the excess earnings, however, may well be attributable to economies of scale resulting from the three doctors practicing together, to workforce in place or going concern value.

(Note: In the healthcare industry, the term going concern value refers to that portion of the enterprise or practice intangible value (including such intangibles as patient medical and billing records and encounter forms) representing the positive cashflow of an established practice versus the smaller cashflow of a hypothetical start-up of the same practice, less working capital and workforce-in-place. Alternatively, and more relevant for this discussion, some valuators believe that it is the positive cashflow for the practice of the average size in the industry versus the start-up of the average practice. Established practices in excess of the average size would then have "true" goodwill, or excess earning power. Some of the costs involved in starting up a practice include identification of a billing system, leasing of office space, hiring of staff and recruitment of patients. The reader may be familiar with the concept of "going concern value" under the residual method of allocation in section 338 of the IRC or in the instructions to form 8594.)

To measure economies of scale, the valuator might compare the overhead expense per physician in a hypothetical solo practice to that in the contested practice. For example, assume that overhead per physician in a hypothetical solo practice is $150,000 per physician. In the example above, it is $375,000, or $125,000 per physician assuming expenses are shared equally. It may be possible for the plaintiff to successfully argue that $25,000 of each physician’s earnings are attributable to being in a group, for a total of $75,000. Applying a 20% cap rate yields a total practice intangible value of $375,000. (We ignore a return on tangible assets for simplicity.)

Another method of isolating business goodwill as distinct from personal goodwill is to directly value workforce-in-place (trained employees) and the aforementioned "going concern value". This can be done by constructing a cash flow forecast for a hypothetical start-up practice like the industry average and comparing that cash flow to that of the contested practice. If the contested practice is of industry average size than it will have practice (or enterprise) intangible value but no "pure" goodwill, or excess earnings power attributable to the individual physicians. If it is greater than the average, it may have pure goodwill. (The method used to accomplish this is commonly referred to as replication cost or avoided cost.) If the subject is greater than the industry average, four forecasts will need to be done: one each for 1) the start-up of the average practice, 2) the start-up of the subject practice, 3) the established average practice and 4) the established subject practice.

In terms of the actual preparation of the forecast, the present value of the difference between the start-up forecast and the subject practice forecast should consist of three distinct assets: Net Working Capital (accounts receivable less accounts payable), Workforce in Place, and Going Concern Value (whatever is left after the other two are computed). Net Working Capital would typically be allocated based upon the compensation formula rather than as equity. True "goodwill" would exist in the valuation subject only if, for instance, the total enterprise value is greater than the sum of Net Working Capital (accounts receivable less accounts payable), Workforce in Place, and Going Concern Value plus the tangible assets of the average practice. In our "eat what you kill" example, such goodwill or excess earning capacity is considered compensation, not equity, and as such, the replication cost computation for the average practice places a ceiling on intangible value.

There are two principal statutes regulating the referral of Medicare and Medicaid patients for health services: the Fraud and Abuse law, also known as the Anti-kickback statute, and the Stark laws (named for the California Congressman who introduced them). The Fraud and Abuse laws are broad in scope and prohibit, generally, payments in exchange for referral of Medicare or Medicaid patients. The most feared penalty is to exclude offenders from participation in the Medicare and Medicaid programs, even in the absence of a criminal conviction.

The Stark laws prohibit payments in exchange for referrals of designated health services. Basically, a referral is any request by a physician for designated health services that are reimbursable under Medicare Part A or B, whether or not Medicare actually pays for the service. Designated health services include clinical laboratory services, radiology and other diagnostic services and inpatient hospital services, in addition to a number of others. A physician can violate the law and regulations by referring Medicare or Medicaid patients to their group practice for designated health services, unless the group meets the qualifying definition of a "Group" and is excepted from the provision.

The details of qualification are broad, but overhead and income must be distributed according to an "existing methodology," meaning that it must be established in advance of the compensation period and must not incent (provide an incentive for) the volume or value of referrals. In addition, proposed regulations issued in January of 1998 state that this means there must be centralized decision making, with a pooling of revenues and expenses, and the compensation distribution system set in advance. Satellite office structures with separate profit and loss statements for designated health services not allowed.

Any valuation must take these laws into account. It is conceivable that a settlement negotiated outside of a Court with respect to damage claims may violate these laws, subjecting the parties to civil and criminal sanctions. A valuation methodology that takes into account referrals and allocates value upon dissolution in exchange for past referrals would appear to run a clear risk of violating the statutes.

In performing a valuation, the valuator must first assess the liability employment contracts impose on the underlying net assets of the practice. Next, compliance of the compensation system with the various statutes and regulations must be determined, i.e., is the obligation valid under those laws. Assuming the system is found compliant, the valuator must utilize assumptions in constructing the valuation model that respect both the contracts and the regulatory environment.

For facilities, such as an Ambulatory Surgi-Center, which receive a facilities fee from Medicare or Medicaid, the Anti-kickback statute provides special "safe harbor" rules. A "safe harbor" is a structure that, if adhered to, should rule out any violation of the federal statute. A failure to meet the safe harbor does not mean that a violation exists, but rather that one may exist if investigated.

Eight standards were specified in the 60-40 safe harbor:

1. No more than 40 percent of the investment interests can be owned by referring individuals,
2. The same investment terms must be offered to passive investors,
3. Investment terms must not be related to referral volume,
4. Investment terms must not be tied to the need to make referrals,
5. The entity and its owners must not offer or perform services to passive (non-referring) investors differently than to non-investors;
6. Investors may not account for more than 40 percent of the gross revenue of the entity,
7. No loans or loan guarantees may exist for a referring investor, and
8. Payments to investors must be directly proportional their capital investment.

All eight of these standards must be satisfied to reach the 60-40 safe harbor.

Example

Assume the productivity–based compensation system in a multi-specialty practice properly allocates the income from endoscopy to the gastroenterologist who performs the procedure. Many of the referrals come from his partners in the practice, such as general internists, who do not perform such tests. One of these internists is forced out of the practice and seeks damages. Use of an excess earnings method with respect to the gastroenterologist’s earnings to determine the value to the internist 1) contravenes the productivity-based compensation system and 2) may violate the prohibition against referral payments, depending upon the income streams involved.

Why does the excess earnings method, as described in the example of Dr. DoLittle, risk violating the anti-referral rules? Remember that the valuator must first understand the existing compensation system and then assess the system’s compliance with the regulatory environment. Obviously, the valuator must have some basis for assuming that the existing compensation arrangements among the parties are to be ignored for purposes of the valuation. Having passed that threshold, if the valuation method chosen changes the allocation of compensation or earnings among the parties - as would be the case with the typical application of the excess earnings method – the valuator must (again) assess the compliance of his/her new compensation system with the regulations. If the procedure is also compensated with a facility fee, a separate and distinct analysis is required with respect to those fees. Clearly, performing this assessment requires the valuator to have an intimate knowledge of the various anti-referral laws and regulations.

If the existing compensation system passed muster, the valuator-installed new compensation system must also pass muster, and withstand the clear challenge that it is an attempt on behalf of the plaintiff (Dr. DoLittle) to obtain value for past referrals, which would likely be a violation of the ant-referral legislation. Again, defendant’s (respondent’s) counsel might ask the valuation expert whether the changes to the compensation system are based upon assumptions which attempt to reallocate historical results to compensate DoLittle for past referrals. It is not difficult to imagine the unfamiliar expert answering yes to that question.

Valuators should recognize as well that use of market approaches, such as the Guideline Publicly-Traded Company method, or actual control acquisitions of private group practices by publicly-traded companies, may not be relevant to valuing a minority interest in a dissolution. There are separate considerations under the anti-referral laws when a third party controls the practice and sets or approves compensation arrangements that may be irrelevant to the private control setting where the parties control compensation arrangements among themselves. There is the obvious difference between a nonmarketable minority interest in a private company and a nonmarketable controlling interest in a private company. There is also a valuation difference between a nonmarketable controlling interest in a private company, and the marketable controlling interest represented by the acquisition of a practice by a publicly traded company.

Finally, most of the transactions assume that the acquirer will retain 15% to 20% of what would otherwise be physician compensation (or pre-distribution earnings), a typical structure used by PhyCor, for example, and easily seen in its SEC filings (and now being used by consolidators of accounting firms!). Unless this same 15% to 20% of the earnings is reallocated in the valuation method applied to the group practice and such reallocation is valid under the regulations, it is easy to misuse the data. Given the structure of such transactions, it is multiples of earnings actually purchased from the physicians, and not revenue or other multiples that are the driving the value.

 Ancillary Income

If a portion of the excess earnings arises from ancillary services (imaging, laboratory, other testing), a replication cost valuation analysis should be done to determine practice or business goodwill, with the addition of the inquiry as to compliance with the Stark and Medicare Fraud and Abuse laws and regulations. In the authors’ view, income from supervised tests – those requiring the presence and/or participation of the physician (e.g., colonoscopy, cardiac stress) should be considered separate from those that do not (e.g., blood chemistry panels). Another important analysis is that of the professional and technical component in imaging studies or the facility fee for certain outpatient procedures in a licensed facility setting. Supervised tests tend to generate income more in line with personal goodwill if the compensation system is based upon productivity, while unsupervised tests tend to generate income in line with business goodwill. Neither is an absolute. Under the Anti-Kickback statute, a wholly owned and controlled technical component is treated as an extension of the physician’s office practice. But if another physician with a different specialty becomes a partner or stockholder, then the 60/40 rule described above may well be applicable.

In a radiology practice, the professional component of reimbursement is designed to compensate the radiologist for reading the film or study. The technical component compensates for the use of equipment, supplies, staff and other costs to perform the study. If business goodwill exists, it will likely come from two sources: Net income on the technical side and any profit from paying radiologists less than the professional component. The latter needs to be evaluated in light of the standard of value. Under fair market value, the hypothetical buyer/seller may not be able to sustain a pattern of paying less than the professional component for the services of radiologists.

The Norwalk case (see CPA Expert Special Edition 1999) highlights the proposition that goodwill cannot exist at the entity level unless enforceable non-competes are in place with the owner-employees, at least as far as the Tax Court is concerned. (This likely could extend to key non-owner employees’ inclusion as part of workforce in place.) Any valuation must therefore make some assessment of the enforceability of noncompetes under local law and any relevant shareholder or employment agreements.

In a professional practice, much of the "goodwill" attaches to the individual professional and "Excess Earnings" are often the result of longer hours, more procedures, and/or special skills. In a practice split-up or dissolution, valuation methods that measure undifferentiated intangible value as part of Business Enterprise Value are generally inaccurate with respect to the intangible value owned by the individual versus the entity. If an enforceable covenant not to compete exists between the individual professional and the entity, the professional may have assigned some portion of his/her goodwill to the entity. However, even in that case, only that portion of the individual’s intangible value that inures to the benefit of the other professionals in the entity should be the basis for valuation of damages. Practices in which the earnings are allocated on the basis of production – to whomever did the work – inherently have lower enterprise intangible value. Measuring intangible value through the replication cost or avoided cost methods (cost approaches), seems to avoid the anti-referral problem. Treating a portion of the compensation received by each physician – an equal amount, if equal equity interests are held – as described in the earlier reduced overhead scenario, also seems to avoid the issue.

Medical practices offer a unique valuation challenge since there is a federal statutory ban against paying for referrals of Medicare or Medicaid patients. Many states have analogous and more expansive statutes. Unlike a law firm or accounting firm, rainmaking (for others) may not legally be a direct factor in setting a physician’s compensation. The authors’ believe a number of methods used to compute damages, or goodwill for division in a break-up of a medical practice, may violate federal Anti-referral (Stark) and Fraud and Abuse law. The knowledgeable practitioner should be alert to point out these apparent violations and in so doing assist legal counsel to limit defeat a claim for damages.

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