California Court Decision Further Scrutinizes the Friendly PC Model – Now What?

From the West Coast Healthcare Desk is an ongoing series of Holland & Knight Healthcare Blog articles and alerts focused on healthcare industry developments and points of interest in the West Coast healthcare marketplace. Holland & Knight's nationally ranked healthcare practice has been focused on healthcare compliance, transactional, reimbursement and operational trends that have often started in California before spreading nationwide – managed care and various capitated and quality-based reimbursement models being the most obvious examples. With the growth of the firm's West Coast-based healthcare team serving regional for-profit and not-for-profit healthcare providers, suppliers and complex integrated payer/provider networks, Holland & Knight is able to provide timely insight into the developments and trends that will impact the healthcare sector both regionally and nationally into the future.

Stay tuned for more West Coast-focused healthcare news and analysis to come.

The Friendly Professional Corporation (PC). As reviewed in a previous Holland & Knight alert (see "Federal Bankruptcy Court Stays Envision Healthcare Litigation in California" Aug. 3, 2023), the Friendly PC Model allows medical groups and physician organizations to access affordable capital (whether from private equity (PE), other non-physician investors or lenders) and provide equity-based compensation packages for their nonclinical personnel, while also allowing clinicians to focus on providing high quality care, all in compliance with a state's Corporate Practice of Medicine (CPOM) prohibitions. Through the use of a contractual arrangement – the management services agreement (MSA) – the management services organization (MSO) provides nonclinical/administrative services (e.g., space, equipment, back-office personnel and support, etc.) to the PC in exchange for a fee that is commensurate with the value of the services furnished. In addition, many MSOs may agree to provide working capital loans to the PC to fund the payment of the PC's expenses, including physician compensation; those MSOs are then dependent on the PC to generate sufficient revenue, in excess of the PC's expenses, to recoup the capital outlay made for the benefit of the PC and its employees.

Often, the MSO, PC and owner of the PC enter into a "Continuity Agreement" (or similar type of agreement, such as a "directed transfer agreement" or "stock transfer restriction agreement") to provide for continuity of ownership and operation of the PC and patient care for the benefit of all stakeholders, including patients, if certain defined events happen that could otherwise harm continuity of care or the success of the arrangement for the parties and other stakeholders.

The textbook use case for a Continuity Agreement would be to address successorship in the event that the PC owner dies, loses their medical license, is placed on the Office of Inspector General's (OIG) "exclusion list" or otherwise becomes legally disqualified from continuing to own the PC. In those cases, a typical Continuity Agreement might provide for the MSO to assist the PC in identifying a willing and able physician who would then purchase the deceased or disqualified PC owner's shares in the PC.

Sometimes, the PC owner may, in addition to their clinical duties for the PC, also serve as an officer, director or consultant for the MSO. Because this role would require the PC owner to agree to provide the MSO with nonclinical services (separate and apart from any clinical role that the owner has for his or her own PC), the MSO often agrees to separately compensate the PC owner for as long as he or she serves in that nonclinical role at the MSO.

State law varies in the relative degree of sensitivity to Continuity Agreements and similar types of agreements that contemplate the transfer of PC ownership. Even within the same state, court decisions can vary depending on the facts of the case presented, the breadth of the language contained in the applicable agreement, and the presence or absence of safeguards for protecting clinical autonomy. An example of this analysis from an appellate court that found that a succession agreement was not problematic, even in a state with a relatively strong corporate practice doctrine, is discussed in Holland & Knight previous alert, "NJ Appellate Court Gives DSOs a Much-Needed 'Win'," Sept. 8, 2021.

Current Challenges to the Friendly PC Model and Private Equity Participation in Healthcare. Currently, there are two primary forums in which various actors have sought to challenge the Friendly PC model in California and, in turn, the participation of private equity in the provision of healthcare in the state: judicial and legislative.

The underlying complaint in American Academy of Emergency Medicine Physician Group, Inc. v. Envision Healthcare Corporation, et. al., Case No.: 3:22-cv-00421-CRB, as filed in the U.S. District Court for the Northern District of California on Dec. 20, 2021, claims that Envision Healthcare uses shell business structures to retain de facto ownership of emergency room staffing groups in violation of California's CPOM prohibition. A detailed discussion of Envision and its CPOM implications is included in the aforementioned Holland & Knight alert.

On the legislative front, Assembly Bill (AB) 3129 – which was introduced in the California Assembly in February 2024 and, on May 29, 2024, was referred to the California Senate Health and Judiciary committees – would, if enacted, require private equity groups and hedge funds to receive consent from the California attorney general before transacting business with healthcare facilities or provider groups. AB-3129 would also prohibit some management services arrangements between private equity groups/hedge funds and physician practices. (For detailed discussions on the bill, see Holland & Knight's previous alerts, "Private Equity Healthcare Transactions Under Scrutiny," March 14, 2024, and "New Bill Would Empower California AG to Curtail Healthcare Private Equity Transactions," June 12, 2024.) On June 19, 2024, an amended version of AB 3129 was released. Holland & Knight's Healthcare & Life Sciences Team is closely reviewing the amended bill and will provide updates.

Background of Art Center Holdings

Art Center Holdings, Inc. et al. v. WCE CA Art, LLC et al., 24SMCV01185, involves several affiliated defendants that make up WCE, an MSO. Pursuant to a MSA between the parties, WCE provides management and administrative services to Southern California Reproductive Center (SCRC), a California PC, that provides women's health, reproductive and fertility services. SCRC and various affiliated practice entities and doctors are the plaintiffs.

One of the plaintiffs, Dr. Mark Surrey, owned 100 percent of SCRC and signed a Continuity Agreement with SCRC and WCE. Additionally, Dr. Surrey signed a Consulting Agreement to provide nonclinical consulting services to WCE. Among other things, the Continuity Agreement contemplated that if the Consulting Agreement were terminated, Dr. Surrey would relinquish his shares in SCRC to another licensed physician to be identified by WCE. By its terms, the Consulting Agreement could be terminated by WCE at any time for any reason, which would then trigger the procedures under the Continuity Agreement.

In 2020, BC Partners acquired WCE and its affiliated companies. Soon thereafter, a number of disputes arose between SCRC and WCE. The plaintiffs allege the MSO mismanaged the business operations of the practice, including by under-collecting accounts receivable, firing or causing nonclinical staff to resign and underinvesting on equipment and other nonclinical expenses. The plaintiffs further allege that this mismanagement caused declining compensation for physicians and, as a result, clinical staffing shortages. Moreover, the plaintiffs allege that the MSO asked the PC to terminate some of its physicians, and when the PC refused to do so, the MSO terminated the Consulting Agreement as a pretext to justify changing ownership of the PC through the procedures set forth in the Continuity Agreement.

The plaintiffs filed their complaint in Los Angeles County Superior Court citing five causes of action: 1) breach of contract, 2) breach of the implied covenant of good faith and fair dealing, 3) gross and negligent mismanagement, 4) conversion and 5) intentional interference with prospective economic advantage. They sought declaratory relief, accounting, injunctive relief, and punitive and exemplary damages. In the midst of litigation, the plaintiffs filed a motion requesting that the court appoint a receiver for SCRC to transfer control back to Dr. Surrey to ensure compliance with legal and regulatory standards.

Court's decision in Art Center Holdings

The court ultimately granted the motion appointing the receiver solely for the purpose of transferring control of SCRC back to Dr. Surrey.

The court's reasoning for granting the receivership motion was that the plaintiffs met "their burden of establishing that the Receivership Entities are in danger of being lost, removed or materially injured. The continued operation of SCRC – where a non-physician, WCE, directly controls the physicians in charge of SCRC – would be against public policy and subject the parties to the risk of professional and criminal repercussions." In short, the court found that WCE used the Continuity Agreement as a means to control the firing of the PC's physicians, which violated California's CPOM laws.

When analyzing whether WCE had engaged in the unlawful practice of medicine the court looked to precedent in three other cases and relied on the California Medical Board's guidance to practitioners. Ultimately, the court found that the forced transfer terms in the Continuity Agreement provided WCE with "undue control of a medical practice" that violated California law. The hiring, firing and disciplining of clinical personnel was supposed to be an undisputed right reserved to Dr. Surrey. The court stated, "WCE had the contractual ability to remove Dr. Surrey from his position in SCRC if they disagreed with his actions. If they have such a right, then WCE necessarily had undue control over the doctor-owner of SCRC, even if they did transfer SCRC to another California-licensed doctor." Accordingly, the court found that the exercise of the broad terms in the Continuity Agreement and Consulting Agreement to be violative of California law. In dicta, the court goes further to suggest that even the mere presence of the Continuity Agreement is violative of California law.

However, the court refused to grant a receivership over the nonclinical business, which implied that WCE could retain control over the nonclinical assets needed to operate the practice. As a practical matter, this means that the continued viability of the practice and its ability to serve patients will likely depend on whether WCE and Dr. Surrey can reach a deal, since each still depends on the success of the other.

WCE has since appealed the ruling, but for the time being, the court appointed a receiver and the lawsuit continues.

Where Do MSOs in California Go from Here?

1. Evaluate MSAs and Operations to Ensure that MSOs Steer Clear of Clinical Decision Making. An MSO must limit its role in the management of a medical practice to administrative aspects of the business, while the practice remains solely responsible for all clinical functions, including all clinical decision-making relating to patient care. In California, the Medical Board maintains well-known guidance that the hiring and firing of practice physicians is a clinical function to be reserved for the PC. Even if an MSO desires for the PC to terminate bad actors (e.g., a physician engaging in sexual harassment), it must still honor the line separating clinical vs. nonclinical decision-making.
   
   In practice, however, discerning the difference between a purely administrative function and one that crosses the line into the clinical realm may be difficult to accomplish with certainty. Therefore, it is imperative for participants in such arrangements to focus on Medical Board guidance when drafting and carrying out their obligations under MSAs.

2. Proactively Agree on Successor Owners Before Issues Arise. MSOs and PCs depend on one another's success and should, like all businesses, have a succession plan in place should something happen to key leaders within their respective organizations. As a best practice, PCs should identify suitable and acceptable successor owners early – before they are needed – rather than rely solely on the MSO to find a successor. That way, a dispute that arises between an individual owner and the MSO or PC can be addressed on its own terms, rather than escalating it into a challenge that could disrupt all parties' interests and the best interests of patients. For example, a PC could have two physician owners. In addition, with multiple owners and agreed-upon internal procedures for resolving employment matters, PCs can be assured that clinical autonomy is safeguarded, and MSOs can be assured that the PC has appropriate procedures to deal with bad actors (rather than leave it solely in the discretion of a single PC owner, who may have a personal relationship with the bad actor or may themselves be the bad actor).
   
   
3. Carefully Craft Continuity Agreements. Whereas some have raised concerns as to whether a CPOM-compliant Friendly PC arrangement can include any type of continuity/equity transfer arrangement, the court in this case did not declare all such arrangements to be violative of the California CPOM prohibitions. Instead, the court declared that the violation was the result of how such an agreement was utilized by a lay entity (the MSO) to influence a professional entity when making a clinical decision.¹ This case does not represent a new criticism of the Friendly PC model or private equity transactions in healthcare, but the case serves as a reminder that separating clinical and nonclinical functions and carefully crafting Continuity Agreements and other safeguards is integral to complying with CPOM law in California.
   
   Although such revisions may serve to lower CPOM risks for the parties, parties to such arrangements need to carefully consider the impact that the CPOM-focused revisions could have on the ability of the parties to engage in financial and tax consolidation – such consolidation often relying on the existence of the continuity arrangement. By limiting the ability of the lay entity to effectuate a transfer of the professional entity's equity from one professional to another, the ability to consolidate for financial and tax purposes may be impaired. Therefore, the parties may find themselves engaged in a delicate balancing act to meet both regulatory compliance and financial/tax goals. As always, balancing acts require a carefully considered, fact-specific analysis involving the parties and their respective legal and financial advisors.
   
   
4. Implement Other Best Practices for Aligning Interests. The Friendly PC model is not static. To the contrary, it has evolved – in some cases significantly – over the years and across state lines, all with the goal of improving access and quality of care, reducing the cost of capital and further aligning interests so that all stakeholders can succeed. MSOs and PCs need to work together, collaboratively, to understand and execute on best practices and lessons learned over the years from other companies. Simply recycling old agreements, and not paying attention to the evolution of the Friendly PC model, will put both MSOs and PCs, and all of their stakeholders, at a competitive disadvantage.

Conclusion

In light of the ongoing scrutiny and challenges to private equity participation in the California healthcare marketplace generally and the use of the Friendly PC Model and MSOs specifically, current or prospective participants to such investments and arrangements should consult with sophisticated counsel about their growth plans to ensure compliance with California's CPOM law and other healthcare-related rules and regulations. Since private equity participation in the California healthcare sector is being challenged on multiple fronts – new legislation and regulation, court decisions interpreting existing legislation and regulation, and new policies/interpretations from governmental and private actors – strategic planning and implementation should be carefully scrutinized on a proactive basis to avoid the possibility of difficult adjustments being made on a reactive basis.

For additional information, please contact the authors or another member of Holland & Knight's Healthcare & Life Sciences Team.

Holland & Knight Partners David G. Marks and John Arnold also contributed to this alert.

Notes

¹ This decision is consistent with a New Jersey court decision that found a succession agreement not to violate the corporate practice of dentistry as long as the broader arrangement between the MSO and PC complied with New Jersey law. See "NJ Appellate Court Gives DSOs a Much-Needed 'Win'," Holland & Knight alert, Sept. 8, 2021.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.