First it was hospitals and nursing homes, ambulatory care centers and health maintenance organizations (HMOs). Now it is Blue Cross plans and major teaching institutions. In an accelerating rush to the marketplace, many of America's largest health care nonprofits are being converted into profit-making organizations. As this wave continues—and nothing, currently, seems likely to stop it—billions of dollars in charitable assets are at risk. If we follow one course, state regulators and an aroused public can at least force converting nonprofits to transfer the value of their assets to new charitable foundations. But if regulators fail to act, the charitable legacy will be lost and more executives of nonprofits will become overnight millionaires by capturing the assets for themselves and their investors.
Recent experiences in California and Georgia illustrate the contrasting possibilities. California now has two new grant-making foundations with a total endowment of $3.3 billion, transferred from the nonprofit Blue Cross of California when it converted into a for-profit company. The foundations, which resulted from years of advocacy by consumer groups, regulators, and a few outspoken legislators, will be devoted to improving health care and public health. Georgia, on the other hand, enacted legislation in 1995 that made it much easier for the state's Blue Cross and Blue Shield plan to go for-profit and to argue successfully that it had no obligation to use its assets for any public benefit. Instead of establishing a foundation, Georgia Blue Cross is likely to provide its executives and investors with a windfall amounting to hundreds of millions of dollars.
Blue Cross and Blue Shield plans in at least 17 other states are either contemplating converting to for-profit operation or are already in the process, and more will undoubtedly follow. Conversions of other health care nonprofits are continuing at breathtaking levels. Nationally, the number of nonprofit hospitals merging with or being acquired by for-profit businesses climbed from 18 in 1993 to 176 in 1994. A November 1995 review by the Chronicle of Philanthropy found at least 65 conversions of nonprofit health care institutions pending around the country. Columbia-HCA Healthcare, the nation's largest for-profit hospital chain, said in 1994 that it planned to acquire as many as 500 more hospitals in the next few years, and in 1995 it purchased or began joint ventures with 41 nonprofit hospitals; on March 29, 1996, Columbia announced it would start a joint venture with Blue Cross and Blue Shield of Ohio, pending approval by state regulators.
The Blue Cross plans alone represent an enormous treasure. As of the end of 1991, according to a U.S. Senate committee report, Blue Cross and Blue Shield plans had assets of $30.1 billion and reserves of $9.8 billion. A national spokesperson for the Blues recently claimed that the plans' asset value is now double, about $60 billion. The value of a nonprofit hospital can easily exceed $100 million.
The commercialization of health care raises many troubling questions. The culture of health care used to value the care of the vulnerable; now it is increasingly devoted to the care of the shareholders. One issue in this turn toward the market is simply what happens to all the public resources that have gone into building America's health charities: Will the executives and investors simply be allowed to walk off with billions of dollars? Or will the public at least reclaim the value of the assets? At the west coast regional office of Consumers Union, which I codirect, we have sought for more than 12 years to preserve the charitable assets of converting nonprofit health care companies. Our project, originally focused in California, is now a joint effort with Families USA (Boston) in 50 states and involves hundreds of people across the country. As more health care nonprofits seek legal approval to go for-profit, what we have learned is of growing importance.
THEY CAN'T TAKE IT WITH THEM
The directors and executives of nonprofit institutions are not legally entitled to any of the organization's assets. Under virtually all state laws, the assets of nonprofit organizations must be permanently dedicated to charitable purposes. Nonprofit health care organizations were established and grew, in large part, through relinquished taxes and access to public start-up and investment funds, including tax-free bonds. Charitable contributions as well as volunteer time and effort have also been invested in nonprofit hospitals. In effect, the public is the "shareholder" of every nonprofit. Nonprofits receive their special legal status, including their tax exemption, not for any executive's private benefit, but to serve broad public and charitable missions, which the executives are supposed to put ahead of any financial return. The Blue Cross plans and hospitals now seeking to convert to for-profit status want to free themselves of their original public mission so they can raise capital, grow larger, and make the financial return to investors their governing interest. It is this change that requires them to give up the assets they have received for charitable purposes.
The effects of commercializing America's health care system are unclear. Studies comparing nonprofit and for-profit health care companies—many of them funded by the industry itself—have been inconclusive. Some research suggests for-profits behave no differently from nonprofits or are more efficient. Curiously, this information often comes from conservative economists or business school professors. Other studies suggest that nonprofits provide higher-quality care and devote more of their resources to health care (relative to administrative costs and income) than do for-profit companies.
As health care charities convert to for-profit businesses, the Republican Congress has not raised any questions about the conversions; instead it has turned a critical eye on the remaining nonprofits. Congressional hearings have questioned whether nonprofits deserve tax-exempt status and have singled out the high salaries and generous benefit packages of some nonprofit executives. A report by the investigating agency of Congress, the General Accounting Office, estimates that in three states about 57 percent of the nonprofit hospitals spent less on indigent care than they would have paid in taxes if they were taxable.
On the other hand, studies by the California Medical Association suggest that nonprofit operation of HMOs makes a positive difference. In 1995 the state's largest nonprofit, the Kaiser Foundation Health Plan, devoted 96.8 percent of its revenue to health care and retained only 3.2 percent for administration and income. In the same year, the newly converted for-profit California Blue Cross plan spent only 73.03 percent on health care while devoting 26.97 percent to administration and profit. Of the ten HMOs that in 1994 spent the highest proportion of revenue on medical care, seven were nonprofit; in 1995, nine out of ten were nonprofit.
Nonprofit organizations seeking to convert typically argue that they need investment capital to expand and that nonprofit status is a barrier. Historically, private donations, government grants, and tax exemptions were important sources of capital; in recent decades, nonprofits have obtained capital primarily from retained earnings and debt. Supposedly, the cutthroat competitive market now requires access to equity investment for survival. Yet the recent history of America's nonprofit hospitals and health insurers does not suggest they have suffered from any capital shortage; in fact, most analysts agree that the hospitals overexpanded. What is certain, however, is that turning nonprofits into profit-making businesses has generated enormous gains to the people involved in the transactions.
When a nonprofit decides to convert to for-profit, merge, or be acquired by a for-profit company, state laws typically require that the value of the nonprofit's assets be transferred to another nonprofit pursuing similar charitable goals. The responsibility for overseeing and approving these transactions usually lies with the commissioner of insurance and the attorney general. In most states, the insurance commissioner is responsible for nonprofit HMO and insurance company conversions, while the attorney general oversees hospital and nursing home transactions. In California, the corporations commissioner regulates HMOs.
Unfortunately, the regulatory agencies typically lack the experience and staff to oversee these complex transactions. In some cases, regulators do not recognize the distinctive public-benefit responsibilities of nonprofits and fail to enforce the laws governing the use of a nonprofit's assets upon conversion. For instance, until the Baltimore Sun highlighted the proposed conversion of Maryland Blue Cross, the state insurance commissioner was not even planning to hold public hearings on the transaction. New York's insurance commissioner refused to release any records about Empire Blue Cross's creation of two for-profit subsidiaries until the transaction was approved.
In general, a conversion should result in the transfer of the full value of the nonprofit's assets to a charitable foundation or nonprofit organization with similar goals to those of the dissolving nonprofit. These transactions, however, are not straightforward. Past conversions, mergers, dissolutions, and joint ventures have been riddled with problems. Even when regulators have insisted on a transfer of assets to a new foundation, they have often undervalued the assets and allowed millions of dollars to be squandered on huge windfalls in executive stock options.
THE GREAT HMO TURNOVER
The HMO industry graphically illustrates the trend toward for-profit control and the problems raised by the conversion of nonprofits. Most HMOs began as nonprofits; many were formed to take advantage of government subsidies that were reserved for nonprofits. The federal HMO Act of 1973, for example, provided grants only to nonprofit HMOs. Many HMOs also sought nonprofit status to enjoy the benefits of tax exemption and to receive tax-deductible donations. Government invested public resources to help achieve a public good: lower cost and increased access to health care.
Initially, state statutes prohibited HMOs from being profit-making businesses. By the mid-1980s, however, HMOs had convinced every state legislature, except in Minnesota, to allow HMOs to be for-profit companies and in some cases to allow nonprofits to convert to for-profit businesses. The stage was set for an explosion of conversions. In California, for-profits went from 16 percent to 65 percent of the HMO market between 1980 and 1994; now all but two of the state's largest HMOs are for-profit. In June 1994, in a dramatic shift, the national Blue Cross and Blue Shield Association voted to allow members to become for-profit companies.
While they have publicly claimed that for-profit status was necessary for expansion, insider executives have made millions of dollars converting nonprofits. The conversion of HealthNet, now called Health Systems International (HSI), shows one reason why top executives find the case for conversion so persuasive. When HealthNet converted in 1992, 33 executives purchased 20 percent of the company for just $1.5 million; as of April 1996, those shares were worth approximately $315 million. Roger Greaves, formerly co-CEO and cochairman, paid only $300,000 for shares that are now worth $31 million, a 10,000 percent gain.
By moving their organization into the for-profit sector, the executives also typically get paid a lot more. In 1994 HSI paid its current CEO, Malik Hasan, $8.8 million; Foundation Health's chief executive received $13.7 million. In contrast, David Lawrence, the chairman of Kaiser Permanente, has a salary of $803,000 even though Kaiser, which remains nonprofit, is the nation's largest staff-model HMO (that is, with group medical practices staffed by its own doctors).
The path to riches is now familiar. In the typical scenario, both the converting nonprofit and the regulators severely undervalue the organization, the executives buy shares of the new company at low prices, and the transaction gets approved by regulators. Executives then become millionaires when the company goes public and its stock climbs to its actual market value. Recent HMO conversions offer many examples of this pattern. Two years after the California Department of Corporations approved a $38 million price tag for Family Health Plan (FHP), the market value of the for-profit was $135 million. When PacifiCare converted in 1984, it was valued at $360,000; less than one year later, the market value of the for-profit was $45 million. Greater Delaware Valley Health Care was valued at $100,000 in 1984, yet the new for-profit was worth $20 million in 1986. Group Health Plan of Greater St. Louis was valued at $4 million in 1985, but the for-profit was worth $40 million in 1986. In each case, the public lost millions of dollars in charitable assets because state regulators failed to ascertain the nonprofit's fair market value.
And no wonder: The methods used by regulators were virtually guaranteed to generate windfall profits to the executives. In some cases, the regulators have valued only tangible property even though an HMO's most valuable assets may be its name recognition, provider contracts, and subscriber lists. Some valuations have failed to include the trademark, effectively making it a gift to the new for-profit business. This is no small matter, particularly for Blue Cross plans. According to trademark experts, Blue Cross may be the most recognized trademark in the United States after Coca-Cola. And, finally, most valuations have not used competitive bidding or stock market value to determine the fair market value of the company. An accurate valuation should focus on the value of the organization as a business, not its prior value as a charity, because it is the organization's profit-generating potential that is at issue.
CALIFORNIA'S NEW PRECEDENTS
The two most recent large California trans actions—the conversions of HealthNet and Blue Cross—should set important national precedents for properly valuing nonprofit assets. When HealthNet announced it wanted to go for-profit in 1991, it had nearly 900,000 members, yet the company said it was worth just $104 million. This paltry estimate ignited demands by Consumers Union for greater public scrutiny. Sure enough, after the California Department of Corporations rejected the valuation, a bidding war broke out among Health Net's competitors, including Blue Cross of Cali fornia, Humana, Qual-Med, and Foundation Health. Even though HealthNet rejected all outside bids, it was forced to raise its valuation of itself to $300 million in cash plus an 80 percent equity interest in the new for-profit. These assets went to a new foundation, the Wellness Foundation, and are now worth between $800 million and $900 million. In other words, the people of California got eight to nine times more than HealthNet's original offer because regulators finally acted to defend the public's assets, and the addition of an equity share captured the true value of the nonprofit far more accurately than did the methods used in previous conversions.
The original proposal for Blue Cross of California's conversion reflected just how successful the HealthNet transaction had been in capturing the nonprofit's assets. Blue Cross came up with a novel legal theory to avoid endowing a new charitable foun dation. It called its plan a "restructuring" and proposed to create a new publicly traded for-profit with 90 percent of the nonprofit's assets. Since the nonprofit would continue to exist and hold the majority of stock in the new for-profit, Blue Cross claimed it was not converting to for-profit. Sup posedly, California law applied only when an entire nonprofit corporation became a for-profit business.
Under the proposal, which contained a generous stock option plan for top executives, the management of Blue Cross would have been able to reap huge financial rewards and use the remaining nonprofit charitable assets to finance their for-profit ventures. Although Consumers Union and others fought the proposal, the Department of Corporations approved it in December 1992. The new for-profit, Wellpoint Health Networks, took over the vast majority of Blue Cross assets, while the continuing nonprofit, Blue Cross, held 80 percent of the stock in Wellpoint.
The chairman of the State Assembly's Judiciary Committee, Democrat Phil Isenberg, was later able to negotiate a commitment from Blue Cross to make a minimum of $5 million per year in charitable donations for the next 20 years. Then a new corporations commissioner, Gary Mendoza, reignited the debate and dramatically changed the results. In August 1993 Mendoza asked Blue Cross to provide him with a plan for meeting its charitable responsibilities under the law. By May 1994 he made clear that he regarded the answers from Blue Cross as inadequate from the standpoint of Blue Cross's shareholders—the people of California.
Commissioner Mendoza's actions provided public interest groups with the opportunity to marshal support for protecting the public's charitable assets. A campaign started that included letters of protest, administrative petitions, and an onslaught of legal and policy analyses. Somewhat later, the California Medical Association, unions (particularly the Service Employees International Union), and the California Nurses Association also became involved. In September 1994 Blue Cross submitted a "public benefit plan" that included a commitment to use all of the nonprofit's assets to create a new foundation. A careful review revealed, however, that the proposal was self-serving and could turn into a dangerous precedent. The new foundation was to be established under a section of the Internal Revenue Code typically reserved for political organizations, such as the National Rifle Association and Common Cause. The old Blue Cross board of directors would become the board of directors of the new foundation, which would have been able to contribute to election campaigns and sponsor ballot initiatives. Far weaker conflict-of-interest rules would have applied to the new foundation than if it were established as a genuine philanthropy under stricter IRS rules; in fact, funds not used for political purposes could have supported Blue Cross's for-profit business in other ways, such as conducting its research.
Naturally, public interest groups did not accept this sham and questioned the legal status of the new foundation, the lack of a new independent board, and the absence of strict conflict-of-interest rules. In the midst of this contentious debate, the national Blue Cross and Blue Shield Association announced new rules for member organizations that strengthened the hand of California Blue Cross. The new rules protected the management of any Blue Cross plan from being replaced and attempted to maintain the Blue Cross board of directors as a supermajority of the new foundation board and to keep them in control of the sale of any stock. The association's source of power is its ability to deny the license to use the Blue Cross name to any organization that fails to follow its rules. Since the license was a key element of the conversion and the proposed merger, the association could not be ignored.
The corporations commissioner criticized the national Blue Cross and Blue Shield Association but did not succeed in having the rules significantly changed. Nonetheless, the final transaction succeeded in preserving the majority of the company's assets for charitable uses. Under the approved plan, Blue Cross of California will create two new foundations. The first, the Western Foundation for Health Improvement, established under the more restrictive section 501 (c) (3) of the Internal Revenue Code, will ultimately have an endowment of more than $2 billion and be controlled by a board with a majority of new and independent members. The second foundation, Western Health Partnerships, established under the looser section 501 (c) (4), will have a board with a majority of old Blue Cross directors, but it will be prohibited from participating in any political or lobbying activities. It will also be required to follow the strict conflict-of-interest rules that apply to 501 (c) (3) foundations. These protections are included in the foundation's charter documents and may not be changed without the approval of California's attorney general.
The combined assets of the two new foundations represent the tenth largest philanthropic endowment in the United States. In 1996, they will make at least $150 million in grants; thereafter, grants will be at least 5 percent of the consolidated assets of the two foundations—the required minimum for philanthropies. The "independent" board members were chosen under a complex scheme, managed by three search firms and overseen by the corporations commissioner. The attorney general will monitor the new foundations, as he currently monitors other philanthropies. Legislation enacted in 1995 in California, modeled on the final Blue Cross transaction, provides a statutory framework for regulatory review of conversions to ensure that nonprofit HMO assets are preserved for charitable purposes. The approved conversion is not perfect, but it is no small victory for the people of California—and a useful paradigm for other states to build upon as they face proposed nonprofit conversions.
THE ROAD FROM CALIFORNIA
The pace of nonprofit HMO and insurance company conversions has dramatically accelerated since the conversion of Blue Cross of California, which was the first state Blue Cross plan to convert after the national association changed its rules to allow for-profit members. Proposed conversions of Blue Cross plans or other large nonprofit HMOs or insurers are now completed, pending, or about to be announced in such states as Colorado, Maine, New York, Missouri, Maryland, Georgia, Virginia, and Oregon. Blue Cross of California has signaled its intention to acquire plans in other states, and the joint venture between Blue Cross and Blue Shield of Ohio with Columbia-HCA, if it occurs, will open an era of mergers and acquisitions that promises to make some executives, financial advisers, and investors very rich.
Public interest groups and regulators around the country should benefit from California's experience. The proposed Missouri conversion, for example, resembles the original gambit of Blue Cross of California. Blue Cross and Blue Shield of Missouri has similarly tried to avoid endowing a new foundation by creating a for-profit subsidiary with about 75 percent of the organization's assets. The Missouri debate has sparked strong language from the state's insurance commissioner and the formation of a new consumer coalition spearheaded by the Missouri Association for Social Welfare.
In other states, such as Colorado, Maine, and New Jersey, Blue Cross plans intending to convert have first attempted to change state laws to make it easier and cheaper. The proposed laws typically eliminate or severely restrict the nonprofit's responsibility to transfer any assets to a foundation upon conversion. In Colorado and Maine, consumer groups were alerted in time to push for important amendments. Trigon, Virginia's Blue Cross plan, succeeded in pushing legislation that allowed it to convert by giving the state $175 million, to be used to fund a shortfall in the state's education budget. The price tag did not reflect any independent assessment of the company and appeared to be a severe undervaluation of the company's fair market value.
Given current trends and the incentives facing top decisionmakers, the future of nonprofits in health care looks bleak. Americans should be asking the basic question of whether it makes sense to turn our health care institutions into for-profit businesses whose fundamental obligation, as a matter of law, is to serve the stockholders. Traditionally we have considered health care to be different from an ordinary business. Patients are vulnerable; they do not have the same ability of most buyers to defend their interests. Stockholder demands for high returns may result in reductions in the quality of care that patients cannot easily detect or anticipate. The drive toward the marketplace also makes it difficult for the remaining nonprofits to continue to serve the charitable mission of delivering care to patients who cannot pay.
Instead of caving in to pressure from Blue Cross plans, state legislators should enact protections for their states' valuable nonprofit resources. Legislation should provide for public notice and hearings and require transfer of 100 percent of the nonprofit's assets based on a fair market valuation. Companies seeking to convert should be required to pay fees so that regulators can seek independent expert advice needed to dissect and digest proposed transactions. To protect the successor foundations from conflicts of interest and to assure that they act as responsible philanthropies, the new foundations should be established under Internal Revenue Code section 501 (c) (3) and governed by a board with all new independent members. Moreover, state statutes should build in mechanisms that ensure that proposed conversions take place in the full light of public scrutiny. Regulators should take a particularly broad view of hospital conversions because of the risk to indigent care and other public services. Congress can eliminate the ability of individuals involved in nonprofit tax-exempt institutions from receiving windfalls from transactions. Today, only some transactions are covered and carefully reviewed by the Internal Revenue Service.
While we may be unable to stop every proposal by a nonprofit institution seeking to go for-profit, regulators and the public can at least protect nonprofit assets for charitable purposes, rather than watching idly as they are lost forever. Public attention and participation can make the difference in whether conversions result in any public benefit. The Blue Cross plans, HMOs, and hospitals seeking to convert typically have highly paid, well-connected lobbyists and executives. To succeed, consumer groups, investigative reporters, and the public at large must raise their voices early and loudly. The lesson from California—in health care as in other things—is that even if flood, fire, and earthquake cannot be prevented, we can still rescue something of value.