Although not highly publicized, a factor in this decline is the new financial reporting rules promulgated by the Securities and Exchange Commission ("SEC") and the Financial Accounting Standards Board ("FASB"). These rules are forcing PPMCs to restructure management relationships, rethink acquisition strategies, and alter financial statements. The new rules may also require PPMCs to reduce the purchase price offered to practices they seek to acquire.
In the typical transaction, the PPMC purchases the assets of a physician's practice and enters into a long term management relationship, up to 40 years long, under which it manages the non-medical aspects of the practice for a fee. New PPMCs that are planning an initial public offering ("IPO") often acquire one practice after another in a quest to reach the financial "critical mass" in part because certain accounting rules have permitted them to "consolidate" the net revenues of the practices they manage on their own balance sheets instead of reporting only the management fee earned. Other accounting rules permitted PPMCs to spread the acquisition costs of intangible assets, such as goodwill, over long periods of time. Where stock for stock transactions were involved, the accounting rules permitted PPMCs to "pool" the assets of the acquired practices with their own assets without having to recognize acquired goodwill and attendant charge of such acquisition expense against the PPMC's earnings.
After several years of discussing the matter, the FASB commissioned an "Emerging Issues Task Force" ("EITF"), comprised of representatives from accounting firms, PPMCs, law firms, the SEC, and FASB to study the issue and make recommendations.
In a consensus entitled "Issue No. 97-2," the EITF concluded that physician practice acquisitions do not qualify for pooling of interests accounting at all. Most significantly, the Task force concluded that consolidation is not appropriate unless the PPMC has a long term controlling financial interest in the practices it manages. In order to consolidate revenues, EITF Issue No. 97-2 requires the PPMC to control the acquired practice for at least ten years and to have exclusive decision-making authority over all non-medical operations of the practice. Non-medical practice operations include total compensation of physicians, hiring and firing, operating and capital budgets, and patient intake. In addition, the PPMC must have a "significant" financial interest in the practice, including the right to share in the residual value upon sale or liquidation of the practice, and the right to share in profits. Perhaps most importantly, the management agreement cannot be terminated by the physician practice except in extreme limited circumstances. It is important to note that certain EITF requirements implicate federal Medicare fraud and abuse issues, as well as state laws relating to fee-splitting and the corporate practice doctrine which are beyond the scope of this article.
The EITF's rules apply to PPMC transactions entered into after November 20, 1997, and will become applicable to all other transactions in the fourth quarter of 1998. It is expected that some PPMCs will have to amend their management agreements to gain control over all non-medical aspects of the practices they manage. Others will be forced to change their financial reporting methods. Some may even be forced to restate financial statements from previous years.
In a separate but related move, the SEC, which has long been studying PPMC purchase price allocations, recently declared that it is considering the imposition of a 25-year ceiling on the amortization periods PPMCs use for intangible assets. The SEC believes that harsh market conditions have made many PPMCs unable to sustain long-term survival. Industry consolidation, changing third-party reimbursement, an uncertain regulatory future, and unproven management history have led the SEC to believe that PPMCs cannot justify a lengthy 40-year amortization period for intangible assets. Another concern is that the employment agreements of key physicians of the acquired practice usually include employment terms of no longer than five to seven years. This strongly suggests that the goodwill acquired (or the value of the management agreement) has a life span that is significantly shorter than the 40-year amortization period assigned to it by the PPMCs.
The SEC's and FASB's new rules apparently have already impacted many PPMCs. PPMC industry trendsetter Phycor recently reported that it expects to pay less for medical group assets under a new "affiliation model." In addition, Sheridan HealthCare reportedly cancelled plans for a public offering and instead increased its bank credit facility in an apparent effort to focus more on internal growth of existing practices rather than on new acquisitions. Whatever the reasons behind such activity, the number of acquisitions, as well as the purchase price for those acquisitions, will probably decrease until the PPMC industry adjusts to the new rules.
For PPMCs that cannot justify consolidation or extended lives for intangible assets, it will likely become difficult to acquire lucrative practices when they may not be in a position to offer the most competitive purchase price. In order to make up for the shorter amortization periods, it may be necessary for some PPMCs to increase management fees. Of course, physicians will want management fees lowered in order to make up for the reduction in purchase price. It is clear that the new rules imposed by the FASB and SEC will bring new challenges to PPMCs and will encourage new management strategies. Likewise, the impact of the new accounting rules must be considered by practices now under PPMC management, as well as those contemplating purchase and management offers, in order for them to make well-informed decisions in the ever-changing health care market.