Pardon me: that's our money! Healthcare organizations need to protect their not-for-profit corporate assets from charitable trust treatment

Healthcare Financial Management, Oct, 2004 by Michael W. Peregrine, James R. Schwartz

Not-for-profit hospitals and health systems and other tax-exempt healthcare providers are under increasing financial stress--much of it the result of the government's mandates and its refusal to pay fair value for services it purchases or otherwise requires hospitals to provide. From low payment rates for Medicaid and Medicare to HIPAA costs to mandatory emergency services to the uninsured, government has been a major contributor to the financial distress affecting many community and faith-based providers as they carry out their charitable missions. Now, unfortunately, not-for-profit healthcare systems face another government impediment to fiscal responsibility: an attempt by certain state attorneys general to apply questionable legal theories under the charitable trust doctrine to the business decisions of boards of directors of not-for-profit healthcare corporations.

The successful imposition of such legal theories, which were never intended to apply to the business decisions of corporate entities, would threaten the ability of not-for-profit providers to effectively financially manage the delivery of healthcare services while both the number of uninsured and the need for such services are rising. As such, it is important for not-for-profit healthcare providers to ask: What really is at stake here? Is this just another exaggerated legal risk threatening to divert scarce corporate resources, or is it a legitimate threat to an institution's financial flexibility?

Experience suggests it is the latter, particularly since the typical targets of such aggressive charitable trust treatment are:

* Decisions as to the specific healthcare services to be provided at individual institutions

* Allocations of acute care services between specific campuses in a system

* Closure of certain campuses and reallocation of services at other campuses to improve financial viability of the system as a whole

* Cross-guarantees in master trust indenture financings

* Intra-system financing arrangements, such as loans, loan guarantees, and other internal credit arrangements

* Corporate treasury and cash management programs

* Intra-system distribution of specific sales proceeds

* Allocation of headquarters costs

* Assessment of system fees

* Mandatory transfers to fund strategic initiatives

All in all, the issues involved here are fundamental to the ability of a not-for-profit health system to apply its assets in the manner it believes is consistent with its charitable purposes and necessary to ensure its continued financial viability.

Fortunately, by implementing several reasonably simple and relatively effective measures, not-for-profit healthcare providers can help resist these challenges and protect the integrity of the corporation's decision-making process and the right of the board of directors/trustees to manage the private not-for-profit assets that have been entrusted to their care. To be effective, however, these measures need to be implemented before the problem arises. The challenge: committing scarce corporate resources in the immediate near term to address a nonimmediate problem.

The Legal Concept

The charitable trust controversy has its roots in the complex and often-misunderstood distinctions between the laws governing corporations and those governing charitable trusts. You don't have to be a lawyer to appreciate the basis for--and the implications of--the distinctions. Not-for-profit status generally refers to a corporation formed under a specific state law (e.g., a not-for-profit corporation statute) to pursue a charitable purpose, rather than profits. The general characteristics of not-for-pofit corporations are twofold: (1) their corporate activities are limited to those set forth in their articles of incorporation and, in the healthcare area, are generally limited to charitable or social welfare purposes, and (2) their net income must be retained and applied for the purposes for which the corporation was formed (e.g., promotion of health, operation of acute care hospital). A not-for-profit corporation is created by filing organizational documents with the secretary of state or similar state official. The corporation may also seek federal and state tax-exempt status under the Internal Revenue Code and applicable state law.

A charitable trust is a trust relationship created by a donor (individual, corporate, or otherwise) for donative and/or tax planning purposes. The charitable trust may be created by a living trust agreement, declaration of trust, or will. Typically, the donor must expressly intend to treat property as subject to the trust and the trust document must set forth a specific charitable purpose. In many states, charitable trusts are subject to specific state charitable trust acts and charitable registration and solicitation laws. The attorney general is typically empowered to supervise both not for-profit corporations and charitable trusts.

The Problem

The problem--and legal ambiguity that is at the heart of the current controversy--is historical in nature. Before the enactment of specific state not-for-profit corporation laws (which occurred mostly in the 1970s and 1980s), there was uncertainty as to whether corporate law or trust law should apply to not-for-profit charitable corporations. Federal courts throughout the country reached different conclusions on the issue in the mid-1980s. However, for at least 20 years, courts have repeatedly ruled, virtually without exception, that not-for-profit corporations, and the actions of their directors, are governed by not-for-profit corporate law standards, not by trust law standards. These decisions have profound significance, because trust law is generally more restrictive and provides less decision-making autonomy than does not-for-profit corporation law. Charitable trust law may also offer a wider range of enforcement remedies than is available under not-for-profit corporation law.