Creation of Physician Hospital Organizations by Municipal Hospitals

I. BACKGROUND

Managed care’s entrance into North Carolina is changing the way in which hospitals and other health care providers must do business. In a mature market, managed care contracts are based on a "capitated payment" (i.e., set payment per covered individual) system. Under this payment scheme, the hospital or other health care provider assumes the risk that the capitated payment will be sufficient to cover the costs of the services provided. This payment system only generates a profit for providers if the capitated payments exceed the costs incurred by the providers in taking care of covered individuals. Thus, there is a built-in incentive to keep people healthy and to use services appropriately in order to contain costs. This system is very different from the traditional fee for service arrangement by which hospitals generated profits on patient volume or on very sick patients requiring extensive services. In other words, under a managed care system, the fewer services the hospital provides, the more successful it is. Under the traditional system, the more services the hospital provides, the more successful it is.

In order to remain competitive in the managed care industry, it is critical for the health care provider to be able to control its costs and utilization of services. To accomplish this, hospitals are joining forces with physicians to form PHOs at a rapid pace. Most PHOs are designed to address several important problems faced by hospitals competing in the managed care industry.

First, the PHO allows the hospital to realign economic incentives by imposing joint risk on the hospital and the physicians. Presently, economic incentives for hospitals and physicians are often out-of-line. Physicians are not usually focused on business concerns or long-term strategic planning; their primary concern is treating patients and managing the quality of health care services provided. Hospitals, however, must run a business and must focus on minimizing costs and managing utilization. By jointly contracting for managed care services, the PHO can impose a joint economic risk on all parties which will provide a strong incentive for hospitals and physicians to work together to reduce costs, improve management of utilization, and improve management of quality.

Second, the PHO provides a forum for joint decision-making by the hospital and its physicians. Nowhere is joint decision making more important than the highly-competitive managed care industry. As the hospital and physicians are faced with difficult issues regarding managed care services, they typically have little or no input into each other’s decisions about managed care. Such a break-down in communication leads to inefficiencies which are detrimental to success in a capitated payment system where costs must be minimized. In simple terms, the hospital and physicians need to understand each other’s practices and cost schemes in order to identify areas of waste and adjust their behavior accordingly. By establishing a PHO, the lines of communication are opened up and the hospital and physicians are given a voice in most of the managed care decisions and practices. This improved communication should result in greater efficiency for the hospital.

Allowing the hospital and physicians to participate in utilization decisions also ensures that the quality of the care provided will remain constant and not be negatively affected. At present, the HMO or managed care company often makes the final decision on what constitute "medically necessary" services, sometimes contrary to medical judgment. A PHO which becomes its own managed care organization puts the health care providers back into the decision-making process.

Third, the PHO provides a marketable contract package that is attractive to managed care companies and is likely to result in better contract terms for the hospital. Absent a PHO, managed care providers must negotiate contract terms separately with the hospital and with the numerous physicians who will participate, and the negotiation costs are substantial. Managed care companies greatly prefer a PHO because it offers a "one signature contract." In fact, most managed care companies pick the provider that is able to offer a package of services rather than merely its own. Thus, the PHO is able to market a very attractive package as a single entity offering a continuum of services on behalf of the hospital and physicians. This gives the PHO greater leverage in negotiations with managed care companies and is likely to yield better contract terms for the hospital and, ultimately, reduce costs for their patients.

In sum, public hospitals need to be able to form PHOs in order to remain competitive in the managed care arena. Forming PHOs will allow public hospitals to better ensure quality care, to offer choice in providers and, ultimately, to reduce the cost of health care for their patients.

For the reasons discussed above, private hospitals, which have no public purpose constraints, are currently joining forces with physicians to form PHOs at a rapid rate. If public hospitals are prohibited from organizing PHO’s, they will be at a significant competitive disadvantage as more and more patients are covered by managed care arrangements. Ultimately, if they are unable to participate in those cost-saving arrangements, there is a possibility that smaller public hospitals will be unable to remain competitive and will go out of business.

Although it is possible that the same end could be achieved through the acquisition of physician practices by hospitals, for many public hospitals the cost would be prohibitive. Even if they have sufficient funds, many public hospitals may view the spending of their limited dollars on the purchase of physician practices as an unwise use of their resources. Thus, in many cases, a PHO is the best and most workable alternative for public hospitals.

II. DESCRIPTION OF THE PROPOSED STATEWIDE PROVIDER NETWORK.

New Hanover Regional Medical Center, Pitt County Memorial Hospital, Durham Regional Hospital, and Cape Fear Valley Medical Center ("the Hospital Corporations") are all nonprofit, tax-exempt corporations that operate hospital facilities on premises leased from a North Carolina county. They propose to enter into joint ventures with local physicians, or physicians’ organizations ("POs"), to create local PHOs. These local PHOs will then join together to create a Statewide PHO. A total of ten local PHOs are expected to join the Statewide PHO. The local PHOs and the Statewide PHO would all be taxable nonprofit corporations.

The local PHOs would be organized in one of two ways. A PHO could be created jointly by a hospital and a PO or it could be created as a wholly owned subsidiary of a hospital. In the former instance, the PHO would be capitalized in equal shares by the hospital and the PO. In the latter, the PHO would be capitalized solely by the hospital. In both instances, the PO would be given equal representation on the governing board. Thus, the PHOs would be jointly controlled by the hospitals and the private physicians. The local PHO would capitalize the Statewide PHO. If the Statewide PHO were to borrow capital, the Hospital Corporations or their local PHOs might be required to guarantee pro-rata portions of the debt. The capital contributed by the Hospital Corporations would come from hospital revenues.

The primary purpose of the Statewide PHO would be to help its members pursue managed care contracting opportunities, develop insurance relationships, develop managed care products, and develop supporting services and systems. The Statewide PHO would seek to be licensed by the North Carolina Department of Insurance to accept capitated payments for insureds. It would also contract with an insurance company, or other payor, to develop or purchase a managed care product. The relationship between the Statewide PHO and the insurance company might take the form of a corporation, a partnership, or a joint venture.

ANALYSIS

For purposes of this analysis, we assume that each of the hospitals operated by the Hospital Corporations was originally organized as a municipal hospital pursuant to Part A of Article 2 of Chapter 131E of the North Carolina General Statutes, or antecedent law. We also assume, without deciding, that a municipal hospital that is leased to, and operated by, a nonprofit corporation remains a municipal hospital and that the nonprofit corporation operates the hospital subject to the limitations placed upon municipal hospitals by Part A of Article 2 of Chapter 131E of the North Carolina General Statutes and the Constitution of North Carolina.

In their request, the Hospital Corporations have argued that a September 19, 1986 advisory letter issued by this Office erred when it concluded that Onslow County Hospital Authority could not enter into a joint venture with local physicians to operate an ambulatory surgical facility pursuant to N.C. Gen. Stat. § 131E-23(a)(19). It is not necessary for us to decide that issue because the powers of municipal hospitals are separate and distinct from those of hospital authorities and you have orally confirmed that none of the Hospital Corporations operates a hospital owned by a hospital authority.

I. A MUNICIPAL HOSPITAL HAS THE AUTHORITY, PURSUANT TO N.C. GEN. STAT. § 131E-7(b), TO ENTER INTO A JOINT VENTURE WITH LOCAL PHYSICIANS TO CREATE A LOCAL PHO THAT WILL THEN JOIN WITH OTHER PHOs TO CREATE A STATEWIDE PHO.

A municipal hospital has implied statutory authority to enter into a joint venture with local physicians or POs to create a PHO that will then join with other PHOs to create a Statewide PHO. The Municipal Hospital Act specifies that:

A municipality or a public hospital may contract with or enter into any arrangement with other public hospitals or municipalities of this or other states, the State of North Carolina, federal, or public agencies, or with any person, private organization, or nonprofit corporation or association for the provision of health care. The municipality or public hospital may pay for or contribute its share of the cost of any such contract or arrangement from revenues available for these purposes, including revenues rising from the provision of health care.

N.C. Gen. Stat. § 131E-7(b). As described by the Hospital Corporations, a PHO is a joint venture between a hospital and its physicians through which they jointly market their health care services to managed care companies. As such, it is an arrangement between a hospital and other persons for the provision of health care as contemplated by N.C. Gen. Stat. § 131E-7(b). Although N.C. Gen. Stat. § 131E-7(b) does not expressly authorize municipal hospitals to join PHOs, it must be broadly construed to permit them to do so because the Municipal Hospital Act contains internal guides to its interpretation that mandate a liberal interpretation of the powers of municipal hospitals to carry out the purposes of the act. See Homebuilders Ass’n of Charlotte v. City of Charlotte, 336 N.C. 37, 43-44, 442 S.E.2d 45, 49-50 (1994). The act provides that "[t]his part shall be construed liberally to effect its purposes." N.C. Gen. Stat. § 131E-5(d) (emphasis added). The act specifies further that "[a] municipality shall have all the powers necessary or convenient to carry out the purposes of this Part . . . ." N.C. Gen. Stat. § 131E-7(a) (emphasis added). Finally, the purposes of the act are identified as follows:

The purpose of this Part is to authorize municipalities to construct, operate and maintain hospitals and other facilities which furnish hospital, clinical and similar services to the people of this State. It is also the purpose of this Part to authorize municipalities to cooperate with other public and private agencies and with each other. Additionally, it is the purpose of this Part to authorize municipalities to accept assistance from State and federal agencies and from other sources.

N.C. Gen. Stat. § 131E-5(b) (emphasis added).

Participation in the local and Statewide PHOs described above would involve the cooperation described in N.C. Gen. Stat. § 131E-5(b) and would help the Hospital Corporations operate and maintain their respective hospitals. Therefore, a municipal hospital has implied statutory authority to enter into a joint venture with local physicians or POs to create a PHO that will then join with other PHOs to create a Statewide PHO. For the same reason, a municipal hospital has implied authority to enter into a corporate relationship, partnership or joint venture with an insurance company – either directly or through a PHO – in order to provide a managed care product, so long as the municipal hospital is directly or indirectly a contracting provider of health services to the corporation, partnership or joint venture.

II. THE EXPENDITURE OF MUNICIPAL HOSPITAL REVENUES TO ESTABLISH LOCAL AND STATEWIDE PHOs IS AN EXPENDITURE FOR A PUBLIC PURPOSE, PURSUANT TO ARTICLE V, SECTION 2(1) OF THE NORTH CAROLINA CONSTITUTION.

The expenditure of municipal hospital funds to establish local and Statewide PHOs is an expenditure for a public purpose, pursuant to Article V, Section 2(1) of the North Carolina Constitution, which provides that "[t]he power of taxation shall be exercised in a just and equitable manner, for public purposes only, and shall never be surrendered, suspended, or contracted away." The General Assembly has expressly stated that the exercise of the powers granted by the Municipal Hospital Act "are public and government functions, exercised for a public purpose and matters of public necessity." N.C. Gen. Stat. § 131E-12 (emphasis added). However, while such an expression by the General Assembly is given great weight by the courts, it is not conclusive. Foster v. Medical Care Comm’n, 283 N.C. 110, 125, 195 S.E.2d 517, 527 (1973). It is the "duty and prerogative" of the courts "to determine whether an appropriation of tax funds is for a purpose forbidden by the Constitution of the State . . . ." Id. This is especially true when the power being scrutinized is an implied power rather than an express power.

The Supreme Court is guided by two principles when it determines whether a particular undertaking is for a public purpose. First, it asks whether there is a reasonable connection between the activity on the one hand and the convenience and necessity of the municipality on the other. Madison Cablevision, Inc. v. City of Morganton, 325 N.C. 634, 646, 386 S.E.2d 200, 207 (1989). Second, it asks whether "the activity benefits the public generally, as opposed to special interests or persons." Id. Each case is determined on its own merits on a case-by-case basis. Id.

The direct disbursement of public funds to private persons is constitutionally permissible as long as the object of the expenditure is a public purpose and the requisite statutory authority exists.

N.C.

Const. art. V, § 2(7), construed in Hughey v. Cloninger, 297 N.C. 86, 95, 253 S.E.2d 898, 904 (1979). Therefore, the fact that municipal hospital revenues would be used to capitalize a venture that involves private physicians and POs is not determinative. Rather, the question is whether the public will benefit from the cooperative venture.

The case that is the closest factually to the instant case is Foster v. Medical Care Comm’n, 283

N.C.

110, 195 S.E.2d 517. In Foster, the Supreme Court held that "the expenditure of public funds raised by taxation to finance, or facilitate the financing of, the construction of a hospital facility to be privately operated, managed and controlled is not an expenditure for a public purpose . . . ." Id. at 127, 195 S.E.2d at 529 (emphasis added). The instant case is distinguishable, at least in part, on the ground that the PHOs would be jointly controlled by the municipal hospitals and the private physicians.

In Mitchell v. North Carolina Industrial Development Financing Authority, 273 N.C. 137, 159 S.E.2d 745 (1968), Justice Susie Sharpe wrote that "[a] slide-rule definition to determine public purpose for all time cannot be formulated; the concept expands with the population, economy, scientific knowledge, and changing conditions." Id. at 144, 159 S.E.2d at 750. More than 22 years have passed since the Supreme Court issued its opinion in Foster. During the intervening years, the health care delivery and reimbursement systems have changed immensely.

We believe that the PHOs described by the Hospital Corporations meet the two prongs of the Madison Cablevision test. The PHOs are intended to help the Hospital Corporations compete in the managed care market. They will allow the hospitals to realign economic incentives by imposing joint risk on hospitals and physicians and thus keep costs down. They will provide a forum for joint decision-making among hospitals and physicians in a way that will balance the economic interests of the hospitals with the medical judgment of the attending physicians. They will provide a marketable contract package that is attractive to managed care companies and is likely to result in better contract terms for the participating hospitals. Without PHOs, the Hospital Corporations will be at a competitive disadvantage vis a vis private hospitals as more and more patients are covered by managed care contracts. For these reasons, we conclude that there is a reasonable connection between the formation of PHOs on the one hand and the convenience and necessity of the Hospital Corporations on the other.

The public will benefit from the formation of the PHOs because municipal hospital costs will be contained, quality will be maintained, and municipal hospitals will be able to compete in the growing managed care market with private hospitals. On the other hand, if municipal hospitals are not permitted to form PHOs and to compete for managed care contracts, those hospitals could be closed to the segment of the population that is covered by managed care arrangements. In the most extreme scenario, some smaller municipal hospitals could even be forced out of business. Therefore, we conclude that the expenditure of municipal hospital funds to establish a PHO is an expenditure for a public purpose, pursuant to Article V, Section 2(1) of the North Carolina Constitution, whether the PHO is created jointly by a hospital and a PO or is created as a wholly owned subsidiary of a hospital. We also conclude that the expenditure of municipal hospital funds to capitalize a Statewide PHO is an expenditure for a public purpose.

III. THE EXPENDITURE OF MUNICIPAL HOSPITAL FUNDS TO ESTABLISH LOCAL AND STATEWIDE PHOs IS NOT PROHIBITED BY N.C. GEN. STAT. § 159-30.

Finally, the expenditure of municipal hospital revenues to establish local and Statewide PHOs is not prohibited by N.C. Gen. Stat. § 159-30. This provision of the law is entitled "Investment of Idle Funds" and its provisions address the deposit or investment of the cash balance of local governments and public authorities. It seems clear that the statute is intended to restrict only the investment of "idle funds" and not the capitalization of entities that are integrally related to the provision of health services by a hospital. Moreover, N.C. Gen. Stat. § 131E-7(b) demonstrates the legislature’s intent that municipal hospitals be allowed to enter into arrangements for the provision of health care and to pay for their share of the costs of such arrangements with hospital revenues.

Conclusion Based upon the analysis set forth above, we conclude that:

(1)

A municipal hospital does have the authority, pursuant to N. C. Gen. Stat. § 131E-7(b), to enter into a joint venture with local physicians to create a local PHO that will then join with other PHOs to create a Statewide PHO;

(2)

The expenditure of municipal hospital revenues to establish local and Statewide PHOs is an expenditure for a public purpose, pursuant to Article V, Section 2(1) of the North Carolina Constitution; and

(3)

The expenditure of municipal hospital funds to establish local and Statewide PHOs is not prohibited by N.C. Gen. Stat. § 159-30.

John R. McArthur Chief Counsel

James A. Wellons

Special Deputy Attorney General