Commercial Reasonableness Analysis for an Increasingly Regulated Healthcare Environment

By Joshua Lefcowitz and Kristin Fox

With all the effort that goes into increasingly complex healthcare transactions, the last thing decision-makers want is to be hit with regulatory sanctions once the agreement is signed. Healthcare transactions are increasingly vulnerable to regulators’ scrutiny because of the increased rate of mergers and acquisitions, a changing and more complex regulatory environment, and the increased frequency of qui tam occurrences in recent years in the healthcare industry. Any proposed arrangement must be deemed “commercially reasonable” or face costly penalties.

Obtaining a commercial reasonableness analysis can be an effective means of combating this vulnerability.

The first step in determining whether a transaction is commercially reasonable is determining whether the transaction was consummated at fair market value (or at a level no more than necessary for the business purpose of the arrangement), that there was no payment for referrals, and that the basis for the arrangement is not to drive referrals to the organization. Next, a more in depth examination of all aspects of the arrangement must be performed to ensure the transaction is both legally permissible and accomplishes a business purpose. Finally, a quantitative analysis, also known as a financial feasibility test, must be performed to determine whether the transaction is commercially reasonable.

Fair Market Value (without referrals)

At the core of a commercial reasonableness analysis with respect to a merger or acquisition is a valuation of assets or stock performed under the fair market value (“FMV”) standard of value, with certain adjustments.  For purposes of determining FMV, the income approach should generally be considered assuming the acquired entity’s highest and best use is as a going concern. Within the context of the income approach analysis, we are able to specifically show the removal of any cash flow derived because of referrals expected to be received as a direct result of the transaction.

Qualitative Analysis [1]

As a part of the analysis, we ask whether or not the arrangement accomplishes a business purpose. In order to assess the arrangement we should analyze the following aspects:

Necessity – Are the items and services obtained necessary to achieve a legitimate business purpose, apart from business referrals?

Nature and Scope – Are the costs are reasonable in relation to the services performed and goods provided.

Enterprise/Organizational Elements – Was the consideration paid for the subject property interest “a sensible, prudent business agreement”?

Quality, Comparability and Availability – Are the nature and quality of the services, assets, and enterprises included in proposed transactions reasonably necessary?

Ongoing Assessment, Management Control and Other Elements – Are there other elements of the transaction that may not fit into the previously discussed categories.

Quantitative Analysis

A quantitative analysis should be performed in conjunction with the qualitative assessment.  This analysis should show the bona fide nature of the business arrangement and determine whether or not the financial terms of the anticipated transaction reflect terms that would be reached by other prudent investors without consideration of any referrals that may be gained.

Due to the complexity of healthcare transactions and relationships, a deep dive must be taken during the due diligence process. Professionals must obtain a summary of relationships and understand who the physician and vendor relationships are with and what services are being offered. A thorough investigation of revenue and expenses must be made and considerations such as owners’ compensation at FMV must be understood. During the process, the analyst must examine the services being offered and answer questions related to compensation arrangements and necessity of services.

At times a transaction that was considered to be consummated at FMV may not be able to be considered commercially reasonable. This is because FMV focuses more heavily on range of dollars paid or the financial aspects of the transaction, while commercial reasonableness analyses scrutinize every aspect in isolation as well as the arrangement in its entirety.

Conclusion

Commercial reasonableness analyses are an increasingly important requirement given the increased consolidation among healthcare provider organizations and increased enforcement from regulators. Commercial reasonableness analyses can be viewed as an in-depth critique of every aspect of the transaction to ensure relevant regulations are not violated.

For the full-length version of this article, please head to the Winter 2015 issue of the BDO Knows Healthcare newsletter

[1] Healthcare Valuation:  The Financial Appraisal of Enterprises, Assets, and Services,” By Robert James Cimasi, MHA, ASA, FRICS, MCBA, AVA, CM&AA, Hoboken, NJ:  John Wiley & Sons Inc., 2014, p. 939-958

Joshua Lefcowitz, CPA/ABV/CFF, CVA, CFE, ASA is a Director in the Valuation and Business Analytics practice with BDO Consulting. He can be reached at jlefcowitz@bdo.com.

Kristin Fox, ASA is a Manager in the Valuation and Business Analytics practice with BDO Consulting. She can be reached at kfox@bdo.com.