Saving Their Assets: How to Stop Plunder at Blue Cross and Other Nonprofits

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.



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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.



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