Squeeze-Out Mergers: An Effective Tactic for Eliminating Non-Utilizing Physicians

Squeeze-Out Mergers: An Effective Tactic for Eliminating Non-Utilizing Physicians

BY JERRY SOKOL AND JOSHUA M. KAYE

Many ambulatory surgery centers (ASCs) around the country are desperate for strategies for eliminating physician owners who are no longer utilizing the ASC as an extension of their practice. Such non-utilizing physicians (commonly referred to as “dead weight”) act as a drain on ASC profits, which is a common cause for physician frustration in ASCs and often serve as an impediment to a sale of a significant equity stake to an ASC management company or health system.

It is clearly in an ASC’s best interest to be able to terminate the ownership of these dead weight physicians. ASCs struggling with this issue may now be afforded some relief through a tactic new to the ASC industry known as a “squeeze-out merger.”

ASCs typically fall into one of two categories. The first is comprised of ASCs that have very specific contractual provisions in their governing documents (e.g., operating agreement, shareholders’ agreement, or partnership agreement) which set forth an agreed upon mechanism for buying out physicians who no longer perform procedures at the ASC. These redemption provisions not only include a listing of the events that trigger a buy-out (e.g., death, disability, retirement, relocation, failure to meet the one-third use and revenue tests, for cause, upon a vote of the other owners, etc.), but also describe how the redemption price is calculated and how it will be paid.

The other category is comprised of ASCs that do not have these specific redemption provisions in their governing documents. ASCs falling into this latter category often scramble for strategies for eliminating the deadweight physicians in the absence of a specific contractual right to do so. There are several existing strategies that many ASCs follow to address such a situation.

1. Negotiating a buy-out. The first step that is typically taken is for the ASC to try to negotiate with the dead weight physician in an attempt to repurchase his or her interest. However, it should be no surprise that a major obstacle in such negotiations is typically the purchase price. The non-utilizing physician likely has heard of the large purchase prices that are being paid by the national ASC management and development companies, and the amount that the ASC is willing to pay is typically based on a much lower valuation. Further, the non-utilizers figure that the value of their investment will always be there, and if they liquidate that value now, they will likely not receive an “ASC-type return” on the proceeds that they receive and then invest in another investment (and they’re probably right).

There are a number of reasons why the value that a corporate investor will pay for equity in an ASC far exceeds what the ASC and the utilizing physicians can and will offer the non-utilizers. The primary reason is that any purchase by a large national company typically involves a purchase of a majority controlling interest in the ASC. This “control” factor, combined with the fact that the purchased interest will be completely transferable by the buying company, creates a “premium” that is not present in the sale of an individual interest. Explaining this valuation difference to non-utilizing physicians may work, but it often falls on deaf ears. These physicians will often decide that they would rather continue to hold their interest and receive healthy profit distributions from the ASC, with the hope of one day participating with the utilizing physicians in a sale to one of these national companies for a much higher price.

2. Using the law to the ASC’s benefit. Assuming the parties are unable to agree on a price, ASCs often try to take a more aggressive stand, such as having an attorney send a letter to the non-utilizers. Such a letter will generally state that the ASC wants to comply with the federal anti-kickback statute ASC safe harbor, and that the ASC needs to buy out the physicians’ interest, so that there will not be any physicians who do not meet the ASC safe harbor requirements, that all physician owners generate a substantial portion of their professional fees from performing outpatient procedures, and that they utilize the ASC that they own as an extension of their practice.

These requirements, known as the “onethird tests” require that each physician owner of the ASC: generate at least one-third of his or her professional revenue from the performance of ASC procedures (i.e., one-third revenue test), and perform at least one-third of his or her ASC procedures at the ASC in which such physician is an owner (i.e., one-third use test). The one-third revenue test applies to both single and multi-specialty ASCs. The one-third use test applies only to multi-specialty ASCs (and arguably a single specialty that has sub-specialties (e.g., ophthalmology).

However, failing to comply with the ASC safe harbor does not necessarily mean that the ASC is in violation of the federal anti-kickback statute. As a result, while such a letter may work, it often is either ignored or receives a response from legal counsel for the non-utilizing physician explaining how continued ownership by his or her client would not create any material anti-kickback risk for the ASC.

3. New approach: the squeeze-out merger. Many ASC owners have stopped after trying the two strategies described above and have given up, believing that they cannot force a sale by a non-utilizer in the absence of a specific contractual provision that would enable them to do so. Well, there is now a mechanism that applies certain general corporate law principles, taking into consideration applicable healthcare concepts that enable a majority of utilizing physicians to squeeze out the non-utilizers through a properly approved transaction.

The process involves two major steps. In the first step, the utilizers of the existing ASC form a new entity that is owned solely by the utilizers (this can also be done with a corporate sponsor, like a national ASC management company, having ownership in the new entity and providing the funds for the squeeze out). For purposes of this illustration, we will assume that both the existing ASC entity and the newly-formed entity are LLCs. However, this type of transaction could be accomplished with other types of entities, such as corporations.

The utilizers will put enough money into the new LLC (either by contributing their own money, borrowing from a bank, or arranging for it to come from the corporate sponsor) to pay the non-utilizers fair market value for their equity in the existing ASC LLC. It is wise and strongly recommended to get an independent third-party appraiser to issue an opinion that values the interests of the non-utilizing physicians in the existing ASC.

The second step involves both the existing ASC LLC and the new LLC approving a plan to merge the two entities into each other, with the existing ASC LLC (or the new LLC) as the survivor. In any merger, one entity must be designated as the “survivor,” with the other one “disappearing” into the survivor. This is a legal fi ction that results in both entities essentially continuing to exist through the one survivor after the merger is completed.

The corporate approval that is typically needed for a merger is a vote of the holders of a majority of the equity in the entity, unless the governing document (e.g., Operating Agreement) requires some higher voting threshold. Clearly, the utilizers will hold a majority of the new LLC, but they must also be able to cause the existing ASC LLC to obtain the required approval.

Assuming both entities can obtain approval of the merger, then the entities are merged together according to the carefully written “Plan of Merger” that has been approved by both LLCs. This plan will provide that the nonutilizers will receive cash as a result of the merger, while the utilizers will receive equity in the surviving LLC. While at first blush, such a favorable result for the utilizers may seem too good to be true, one must have a detailed understanding of certain general principles of corporate law in order to understand how this can be done and what the downside risk is to the utilizers if the non-utilizers bring a lawsuit against the utilizers.

A general principle of most states’ corporate law is that all owners have to be treated “fairly,” not that they be treated equally. This is the basis for paying the non-utilizers cash as part of the merger, while the utilizers receive equity in the ongoing entity as their merger consideration. So, if properly and carefully done, the only valid claim that the non-utilizers should have is a claim for the difference (if any) between the court determined fair value of their interests in the existing ASC LLC, and the amount that they were actually paid as part of the merger. This concept is often referred to under state law as dissenters’ right claim.

The squeeze-out merger can also be used as a “carrot or stick” tactic to bring the nonutilizers to the negotiating table. The ASC could offer the non-utilizers a slight premium for their interests in exchange for agreeing to an expedited buy-out (i.e., the carrot). If the non-utilizers do not agree, then the ASC could effectuate the squeeze out merger (i.e., the stick). By showing non-utilizers what the ASC could do if the non-utilizers do not cooperate in the buy-out, the non-utilizers may be more inclined to sell since they will realize that they have little or no other option.

Depending upon the existing ownership structure and each state’s corporate laws, the squeeze-out transaction may be structured differently than the example provided above. Tax consequences may also impact the structure of the transaction. Also, a careful review of the existing governing document must be performed to ensure that the minority owners have not been given certain rights that would enable them to block this type of a transaction.

Fortunately for the utilizing physicians, most states’ corporate laws give minority owners in a private company very few rights, other than the rights that they have under the company’s governing document. Clearly, any ASC considering this type of a transaction should only do so under the careful guidance of experienced healthcare and corporate counsel. If properly advised through the process, the squeeze-out merger may be an effective strategy for ASCs to deal with the problem of dead-weight physicians.