Mid-Atlantic Health Law TOPICS

As the number of acquisitions of freestanding hospitals by nonprofit health care systems continues to increase in response to health care reform, executives and directors of the parent entities in these multi-hospital systems should be mindful of the fiduciary duties owed by the system parent to the subsidiary hospitals.

The fiduciary relationship between a system parent and its controlled, but separately incorporated, subsidiary hospitals was highlighted in the recent decision in Lifespan v. Tufts, in which a health care system was found to have owed and breached its fiduciary duties of care and loyalty to one of its subsidiary hospitals.

A. The Facts

In 1996, Lifespan Corporation (Lifespan), a network of nonprofit hospitals in Rhode Island, and Tufts Medical Center (f/k/a New England Medical Center) (Tufts), a freestanding nonprofit hospital in Boston, Massachusetts, began discussing a potential affiliation arrangement.

Lifespan viewed the proposed affiliation as an opportunity to expand its health care system into Massachusetts, while Tufts viewed the proposed affiliation as a means to improve its financial condition, reduce its corporate overhead, gain leverage in its negotiations with health insurers, and increase its volume of complex medical cases.

After thorough due diligence, Lifespan and Tufts entered into a definitive affiliation agreement in October 1997, resulting in Lifespan effectively becoming Tufts' corporate parent, and Tufts, in turn, becoming one of the hospital subsidiaries in Lifespan's system.

By late 2002, however, Tufts and Lifespan recognized that the affiliation was not working, and agreed to disaffiliate. As part of the disaffiliation arrangement, Tufts was required to make a series of payments (totaling $30 million) to Lifespan.

When Tufts refused to pay the final two installments, Lifespan filed suit. Tufts, together with the Massachusetts Attorney General (who intervened in the case in her capacity as supervisor of public charities), filed a counterclaim asserting, among other things, that
Lifespan owed the fiduciary duties of care and loyalty to Tufts, and that Lifespan had breached those duties.

B. The Ruling

The Lifespan court held that (1) a fiduciary relationship existed between Lifespan and Tufts by virtue of Lifespan's control over Tufts, and the faith, confidence and trust that Tufts placed in Lifespan's judgment, and (2) Lifespan breached the fiduciary duties of care and loyalty that it owed to Tufts during the affiliation.

In finding that a fiduciary relationship existed between Lifespan and Tufts, the court focused on the level of control that Lifespan exercised over Tufts.

Specifically, the court noted that a Lifespan subsidiary was the sole voting member of Tufts; Lifespan had the power to oversee and control Tufts' operations, including major financial decisions, budgeting, strategic planning, policymaking and contractual negotiations with health insurers; and Lifespan had the power to appoint and to remove members of Tufts' board of directors, as well as the ability to hire, fire and set the compensation of Tufts' key executive officers.

With respect to the court's conclusion that Lifespan had breached its fiduciary duties of care and loyalty to Tufts, the court found Lifespan breached its duty of care to Tufts by: failing to renegotiate certain payor contracts to obtain inflationary increases in reimbursement rates; failing to negotiate certain payor contracts jointly on behalf of all hospital subsidiaries in the Lifespan system so as to maximize their leverage with payors and obtain the highest possible reimbursement rates (as opposed to negotiating Tufts' contracts separately from the Rhode Island hospitals' contracts); and failing to share certain rate information with Tufts.

The court also found that Lifespan breached its duty of loyalty to Tufts through a series of acts and omissions by Lifespan's chief financial officer, all of which were done for the purpose of advancing his personal self-interest, and in knowing disregard of Tufts' interest, which ultimately caused Tufts to enter into an ill-advised and money-losing interest-rate swap transaction.

C. Practical Guidance

The Lifespan decision makes clear that the traditional governance structure in nonprofit health care systems creates a fiduciary relationship between the system parent and the subsidiary hospitals.

Given this fiduciary relationship, and in light of state attorneys general increasing willingness to intervene in interstate hospital affiliations to protect the interests and charitable assets of their state's nonprofit hospital, health care systems across the country are well-advised to be proactive in ensuring that their executives and directors are sufficiently familiar and comfortable with their fiduciary obligations, particularly as they pertain to the system parent's relationship with its subsidiary hospitals.