UNIQUE ISSUES IN THE DEVELOPMENTOF HEALTHCARE FACILITIES

BySusan J. Bryson1

Wiggin and Dana LLPNew Haven, CT

Background - The Evolving Healthcare Delivery System

The healthcare delivery system and its associated real estate have been in a state of rapid transition and flux for well over a decade. For the five years from 2002 through 2007, the dominant trend involved expansion of physician practices with physician ownership and equity participation in the associated real estate. Swept away by the precipitous real estate crash of 2008, the unsettled state of healthcare regulation and reimbursement practices, the sheer cost of sophisticated medical technology, and new medical record-keeping requirements, the desire of physicians to take on the economic risks associated with ownership of the practice, the real estate, and/or the equipment, including, notably, the reimbursement risk, has diminished if not evaporated. Instead, the trend is solidly in the direction of hospital ownership of physician practices and the development by or for hospitals of medical office buildings and small, scattered ambulatory clinics, expansion and upgrading of existing hospital campuses and consolidation of hospitals through mergers and acquisitions.

In addition to the restructuring of the delivery system through hospital-owned or controlled physician practices, there are three notable drivers to the expansion of hospital-related healthcare facilities: (1) the oft-cited aging of the baby-boomers resulting in perennial bed shortages in core hospital facilities, (2) advances in medical treatment of illnesses such a cancer resulting in longer lives with treatment of chronic illnesses extending over years and even decades, and (3) the Patient Protection and Affordable Care Act (the “Affordable Care Act” or “ACA”) enacted in 2010, estimated to result in medical insurance coverage for more than 30 million previously uninsured Americans, many of whom previously used emergency rooms for primary healthcare, increasing the need for both space and services. Competition among hospitals in specific areas adds a new focus on patient service and amenities, leading to outpatient clinics in suburban areas that are readily accessible for the treatments, tests and procedures available on an outpatient basis, and reducing the length of hospital stays.

1 *Assisted by Wiggin and Dana partners, Rebecca Matthews and Norman Fleming

The result is significant real estate activity by or for hospitals of varying degrees of risk as the delivery system continues to adjust to considerable need and uncertainty. This paper will focus on the development of healthcare facilities by hospitals or for the use of hospitals and their increasingly wide swath of physician practices. The development or expansion of core hospital facilities within the central campus continues and may include on-campus medical office buildings (MOBs) and medical testing and research facilities with associated parking facilities. Hospitals are also developing, either on their own or through third-party private developers, specialty hospitals and ambulatory clinics in outlying communities. The issues associated with development in either venue overlap, but there are issues unique to the development of large urban hospital campuses that bear special mention.

EXAMPLES: In September 2012, the City of New York signed an agreement with the Memorial Sloan-Kettering Cancer Center (“Sloan Kettering”) and the City University of New York (“CUNY”) for the sale of a 66,000 square-foot City-owned site for construction of two state-of-the-art science and medical facilities on Manhattan’s Upper East Side: Sloan Kettering will construct an up-to-750,000 square foot cancer care facility to enhance its existing campus within walking distance; CUNY Hunter College will build an up-to-336,000 square-foot Science and Health Professions building to upgrade its science and nursing facilities, allowing its own students, researchers and faculty to benefit from the close proximity to its main campus.

A month later, Montefiore Medical Center, the academic medical center and University Hospital for Albert Einstein College of Medicine, announced an agreement to lease for 16 years with renewal options an eleven-story, 280,000 square feet building, to be constructed by development partner, Simon Development. The proposed building will include an ambulatory surgery center, featuring operating rooms, an advanced imaging center, onsite laboratory services, a pharmacy, as well as new primary and specialty care practices.

Development Within Urban Medical Center – Context and Stakeholders

Over the past several decades, hospitals and educational institutions have become the surviving, even thriving, stalwarts in many urban areas, particularly those in the older parts of the country once dominated by industry. As the populations of these inner cities have declined, the central medical centers have expanded, both in terms of core facilities and also through the associated development of medical research and medical testing facilities that benefit from close proximity to sophisticated medical personnel, state-of-the-art equipment and technology and nearby or intertwined medical schools.

The potential for conflict between a medical center and its surrounding community is clear. Residents are concerned about the impact on their community of large institutional buildings in terms of pedestrian safety and interest, community amenities (the loss of open spaces), traffic safety, the encroachment of street parking, the

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quality of air, the preservation of light. Both hospitals and residents are equally aware of the potential for mutual benefit particularly in terms of economic impact, jobs and job benefits and the potential for civic involvement by the hospital in supporting community resources.

EXAMPLE: An economic impact study issued by the Connecticut Economic Resource Center in 2005 demonstrated that the then-proposed Yale-New Haven Hospital cancer hospital would have more than a $1 billion positive impact on the State’s economy when taking into account the additional direct and indirect jobs, new visitors to the city, increased purchasing power in the community, and new private development resulting from the new facility.

The municipality in which a medical center exists is, of course, a key player. Often, today, these cities are financially burdened, with insufficient tax revenues to meet escalating expenses and unfunded pension obligations. Not surprisingly, these cities welcome the economic activity generated by medical center expansion and this expansion is viewed as an economic opportunity typically with benefits to be negotiated as through a development agreement or land disposition agreement (if city-owned land is involved) or through the process of securing zoning and land use approvals. Add to this the stakeholder groups with particular issues: unions, environmental activists, animal rights groups (where animal research is involved), bicycle and pedestrian advocates, and those aligned groups favoring public transportation.

Internally, hospitals are complex institutions in their own right with multiple stakeholders, from members of the governing board to the physicians, nurses, staff, medical students and residents, and, not least, patients. In the planning and implementation of the expansion of hospital and related healthcare facilities by hospitals, there are multiple interests to be considered.

Increasingly, hospitals undertake planning and development of campus expansions within a dynamic context, acting in varying ways and degrees in cooperation or direct collaboration with external stakeholders, balancing the goals of the institution, including the needs and desires of its internal stakeholders against the needs and demands of the surrounding city and community.

Master Plan Medical Center Campuses

Land Issues:

Urban medical centers typically are constrained by available land in the vicinity of the main hospital campus. When possible, hospitals acquire directly or by a surrogate vacant or available land in the vicinity of the hospital to land bank for future use with interim surface parking use. The interplay between transparent master planning and the increase in the price of privately owned land shown on a master plan for future development is obvious, but sometimes inevitable, particularly in jurisdictions that

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require long-term master planning as part of the land use approvals for institutional development.

The limitation on available land and the difficulty of retrofitting old hospital buildings for new service and technology-driven state-of-the-art medical facilities leads planners to propose either demolition of existing but antiquated facilities within the campus, or additions to height on existing but fully functional structures. In either case, the logistics, although not prohibitive, are especially challenging because hospitals, by definition, operate 24/7, treating the most frail patients all of the time. Safety, noise, air quality, street closures- all issues in any large-scale urban development- take on larger proportion in the hospital arena.

Economic Issues:

Not surprisingly, economic issues are a key driver in decisions about what will be built and where and what will be renovated to what end. Healthcare is a highly regulated and competitive business, responsive to the regulatory scheme governing reimbursements and, currently, to the requirements of the Affordable Care Act for increased cost-efficiency. Although hospitals are always desirous of serving the health needs of a community, it is indisputable that a significant driver among competitive hospitals is the desire or economic need to capture market share of more profitable treatments.

Impact of the Affordable Care Act – Design and Function:

The Affordable Care Act’s emphasis on reducing healthcare costs may have some impact on design. The Act sets limits on the amounts that can be charged for certain services and also ties reimbursement to performance. This could lead to prioritizing less costly approaches to achieving efficiency, such as renovating existing facilities and to implementing “green” practices that result in both a healthier environment and decreased overall life cycle costs.

The health care industry established its own self-certifying green building standards, the Green Guide for Health (“GGHC”) created by the American Society for Healthcare Engineering, in 2002. The U.S. Green Building Council (“USGBC”) recently issued a LEED for Healthcare (LEED-HC) rating system specifically for medical buildings. The system awards credits for both building performance (e.g. energy-savings) and features that improve occupant health and well-being (e.g. “connection to the natural world” – shown to improve health and recover times - and the use of least-polluting combustion equipment (furnaces and boilers) to enhance air quality). The LEED-HC rating system also mandates integrated project planning and design.

EXAMPLE: In April of 2013, the Group Health Puyallup Medical Center was the first building to earn a LEED-HC rating, earning LEED Gold based on such features as a

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landscaped ground floor area for visitors and a green roof and covered patio extension to the staff lounge.

As has been mentioned, the Affordable Care Act imposes additional electronic record-keeping requirements, making the IT infrastructure an essential design element in new and renovated buildings. Finally, the Act encourages healthcare institutions to support wellness through programs and activities that focus proactively on everyday health. As a result, wellness programs and exercise facilities are likely to be incorporated into hospital campuses and buildings.

The Entitlement Process – Land Use Approvals (Medical Center Campuses)

Planning and Zoning Approvals:

Hospital campuses today are significantly more than a building or several buildings connected by sky bridges and tunnels with associated parking. Rather, they are more like small cities or large mixed-use developments, with multiple uses and often multiple owners with shared uses. In addition to the core hospital patient and administrative facilities and adjacent parking structures, other uses may separate medical office buildings and may include street-level retail, specialty hotels tailored to use by patients or hospital guests, affiliated or unaffiliated research centers and laboratories, specialized ambulatory service centers with valet parking, and combined health and educational facilities with full-size assembly halls. In addition, there may be stand-alone but shared central utility plants.

In traditional Euclidean zoning in which uses were specified as permitted as of right or by special permit, hospital use is designated for specific areas. Today, with the scale of hospital campuses and the multiplicity of uses, zoning ordinances commonly treat hospital campuses as comprehensive planned developments or as existing within zoning districts specifically tailored to medical center campus use, with wide latitude for adjustment over the entitlement process.

EXAMPLE: Zoning Ordinance of the City of New Haven, State of Connecticut, Article V., Section 41:

Business D-2 Districts—Central Business/Medical. This district includes appropriate areas in and around the city’s hospitals and medical centers having high density medical institutional uses including hospitals, clinical, laboratory or bioscience research space, patient care medical offices, and supportive accessory uses, with pedestrian-friendly ground floor retail uses in some buildings. The district allows intensive use of land for such uses subject to site plan approval to further the city’s policy of encouraging dense development of institutional uses within concentrated areas in and around the Central Business District while maintaining a human-scale streetscape. It is the purpose of these regulations to allow such intensity of hospital, medical, research and medical institutional uses

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in combination with street-level retail uses encouraging pedestrian connections between the medical areas and adjacent neighborhoods and business districts, and to exclude uses which are incompatible with or would have a negative effect upon the functioning of hospital, medical and research and medical institutional uses.

State statutes and local planning and zoning ordinances vary considerably in detail and process, but most involve multiple stages in which issues relating to compliance with design and zoning standards and the impacts of projects (traffic, parking, environmental, open space) are reviewed and addressed.

EXAMPLE: In October 2012, the Boston Children’s Hospital submitted to the Boston Redevelopment Agency what is known as a an Institutional Master Plan Notification Form and Project Notification form, proposing the addition of three projects (a 445,000 square feet clinical building, a 212,000 square feet medical office building with ground floor retail and close to 500 parking spaces within a new garage) to its Institutional Master Plan (“IMP”) within the Longwood Medical and Academic Area (LMA). The Plan also sought to initiate review of the projects under Article 80 of the Boston Zoning Code, a review process applicable in Boston to most large projects to examine the impacts of a project on the neighborhood and the city as a whole. For interesting elaboration on this project and the process followed in Boston, see http://www.childrenshospital.org/about/Site1394/Documents/IMPA-CH1 and http://www.bostonredevelopmentauthority.org/DevelopmentProjects/devprojects.asp?action=ViewProject&ProjectID=1575

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The Process and Community Engagement

Whatever the precise process, invariably it involves public hearings in which the multiplicity of goals and interests are raised and addressed within the approval context.

As with other large scale projects, there is considerable concern about community impacts, and many regulatory schemes expressly provide for considerable public review and participation.

Over the last decade, community groups have sought community benefit agreements (“CBA”s) from those proposing to build large-scale projects in primarily urban areas. In consideration for project support, the developer/hospital will agree to a variety of obligations, ranging from employment and reporting requirements to financial subsidies. The first of these agreements, signed in 2001 by the developer of the Staples Center sports arena (home to the Los Angeles Lakers), included two hotels, a convention center, apartment buildings and a theater. The agreement included among its obligations payments for parks and recreational facilities, employment requirements, job training and hiring requirements, and support for affordable housing, including a set-aside for affordable units within the project and no-interest loans to non-profit housing developers. This CBA was incorporated into the development agreement between the developer and the community redevelopment agency.

NOTE: The recent U.S. Supreme Court decision in Koontz v. St. Johns River Water Management District (11-1447), decided in June 2013, has cast some doubt over the validity of community development agreements to the extent that a regulatory land use commission (in that case, a wetlands commission) declines to approve a project unless or until a community benefits agreement is executed. Koontz holds that a land use commission may not condition the approval of a land-use permit on the owner’s relinquishment of a portion of his property unless there is a “nexus” and “rough proportionality” between the government’s demand and the effects of the proposed land use. The corollary, of course, is that conditions or obligations may be imposed on a developer proposing a development if they are reasonably related to the impact of the proposed project.

Other Project Approvals:

In some states, Connecticut being one, approval of a state traffic authority is required, due to the significant impact of hospital campus-related traffic on the nearby state highways. This is an engineering-driven process, often taking up to a year, and usually resulting in requirements for intersection modifications and changes to the signalizations systems.

Accommodating traffic and parking is one of the big challenges for these facilities. There has been an increasing trend towards requiring hospitals to establish

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transportation demand management (TDM) plans that include parking facilities with valet parking, shuttle services to more distant parking or to public transportation systems, accommodation for bicycles, incentives to encourage car-pooling among employees, all in an effort to reduce traffic and the number of necessary parking spaces within the medical area.

State authorities may also require air permits and permits relating to generation facilities. The review process regarding environmental conditions and impacts varies widely. An environmental impact statement (EIS) may be required. The National Environmental Policy Act (NEPA) requires an EIS for all federal/public projects and some states have established mini-NEPA requirements. An EIS generally describes the project, its purpose and potential impacts with an analysis of those impacts and available alternatives.

Regulation of the Expansion of Healthcare Institutions

Finally, hospitals are extensively regulated and each state has its own requirements for permitting the expansion or renovation of healthcare facilities. In 1973, federal legislation was adopted requiring each state to establish a Certificate of Need (CON) program for certain hospital acquisitions, expansions and divestments in order to reduce duplication of services and to ensure broad-based access to costly medical technology. The federal law was subsequently repealed, but most states retain a version of the CON program. While the content and process vary by state, the CON requirement is typically triggered by either a minimum projected project cost or by the proposed acquisition of specialized equipment such as an MRI. The essential purpose of a CON as the name suggests is to justify the need for the expense proposed.

State agencies also govern the licensing of medical facilities, as well as the related provision of social services (in connection with Medicaid reimbursement services). Approvals related to licensure and reimbursements may apply generally to all significant expansions; expansion by merger adds additional levels of approval.

EXAMPLE: In September 2012, Yale-New Haven Hospital (YNHH) acquired the assets of the Hospital of St. Raphael (“HSR”), a Catholic hospital located just blocks from the YNHH medical area shared with the Yale University Medical School. With the merger, YNHH became a single 1,541-bed hospital and one of the largest hospitals in the country. In addition to securing approval from the Federal Trade Commission (antitrust) and the State Attorney General (antitrust division and charitable funds division) required because the expansion involved acquisition of the assets of another hospital, approval was secured from the Department of Public Health (licensure), the State Department of Social Services (for Medicaid reimbursement) and from the federal Centers for Medicare & Medicaid Services (for Medicare reimbursement). Approval of the Vatican was also required.

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Municipal Contracts – Land Disposition Agreements and Development Agreements

If a hospital acquires land or easements from a municipality for its expansion, it may be required to enter into a land disposition agreement or a development agreement with the municipality that impose obligations on the hospital as the quid pro quo for the agreed-upon leasing or sale of property to the hospital. As with other large-scale projects, financially strapped municipalities increasingly have imposed obligations that may be related to the development and will decrease its impact on the surrounding area (e.g. commitments re public transportation), as well as others that, although unrelated to the development, are beneficial to the community but beyond its financial capacity (e.g. funding of an after-school program or a city health coordinator). Unlike conditions on permits and approvals, these are in the nature of privately negotiated contracts.

Development and Ownership Structures:

Historically, hospitals have owned their on-campus core facilities and have constructed new buildings or renovations using tax-exempt bond financing (See “Bond Financing for Healthcare Institutions – An Introduction”, attached as Schedule A). Many states have bonding authorities specifically designated for funding healthcare facilities, sometimes in tandem with educational institutions.

Over the past fifteen years, hospitals have engaged private developers to construct ancillary on-campus facilities. Various ownership structures are used (private ownership with lease by the hospital or condominium unit ownership by the hospital), but perhaps the dominant approach has been a lease/lease-back structure under which the hospital ground leases the land to a developer who constructs the facility (perhaps a mixed use parking facility with retail and office components or, less frequently, a special-use extended stay facility) and leases it back to the hospital. There are variations on this theme (e.g. the developer acquires the land in fee), but most include the hospital’s right ultimately to acquire fee title to the land and building at some point in the future. The development financing is secured by the private owner/developer based on the creditworthiness of the hospital. If properly structured, the asset and associated debt are not included on the hospital’s financial statements. Recent proposed changes in the applicable accounting rules will make it more difficult to treat such leases as operating leases. Rents previously treated as expenses will be booked as amortization and interest expenses. Other advantages of ownership by a third party remain, however, including the fact that the hospital is relieved of the need for significant capital outlay up front and is not taking on significant development and real estate risk. Notwithstanding some diminished financial benefit, this structure is likely to continue for medical office building development.

Note: On May 16, 2013, FASB issued a proposed Accounting Standards Update, Leases (Topic 842): a revision of the 2010 proposed Accounting Standards Update, Leases (Topic 840). For a complete explanation of the changes, see

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http://www.fasb.org/cs/ContentServer?pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=900000011123

Hospital Mergers and Acquisitions – Another Expansion Opportunity

In recent years, the financial pressures on hospitals have led to the merger of hospitals into ever-larger systems. There are obvious advantages in terms of efficiency and, in some cases, mergers can offer the best way for a strong hospital to expand without the need for many of the approvals otherwise required for the development of new facilities, although State approvals and possibly federal anti-trust issues may require review and approval. In the typical situation, where a financially strong hospital or system acquires another less so, the acquiring entity has the financial capacity to renovate the acquired entity’s buildings, sometimes obviating the need for new construction to accommodate expansion.

EXAMPLE: In early July 2013, the governing boards of Mt. Sinai Medical Center and Continuum Health Partners, a network of community-oriented hospitals, approved a merger of the two institutions. The combined entity, to be known as the Mount Sinai Health System, would operate more than 3,300 beds in seven campuses throughout Manhattan, Brooklyn and Queens, making it New York’s largest private hospital system. The Federal Trade Commission, responsible for reviewing antitrust issues, has approved the merger, leaving only regulatory approval by the State Health Department and, with respect to some hospital debt, by the federal Department of Housing and Urban Development.

CONCLUSION:

The development and expansion of hospital campus facilities has a multitude of unique challenges: its 24/7 operations, its high neighborhood impact in terms of traffic and parking, its extensive use of energy and water, its peculiar waste and disposal requirements, its particular need for infection control and the privacy of its patients and records, and its highly regulated status, all combine to create a complex set of development and approval issues. That said, there is ample reason to believe that growth in the healthcare sector in general will continue and, more specifically, that the expansion of core campuses and hospital-owned or hospital-used facilities will constitute an ever-increasing part of that growth.

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Reference Materials: Print Resources

1. Connecticut Economic Resource Center, Inc. Economic Impact of Proposed New Cancer Facilities at Yale-New Haven Hospital. Rocky Hill, CT: 2005.

2. Carpenter, Dave, Hoppszallern, Suzanna“Time to build? Reform uncertainties drive financial scrutiny for new projects.”Health Facilities Management. 2012 25(2):12-18, 20.

3. Joint Commission ResourcesPlanning, Design, and Construction of HealthCare Facilities, Second Edition2009

4. Madden, Kathryn, and Gamble, David. "Accommodating Institutional Growth." Urban Land. 2011 70(9/10): 134-37.

5. Shattuck Hammond Partners. Strategies in Health Care: Real Estate Monetization and Development: Answering the Question of Who, What, Why, When and How?. 2005.

Reference Materials: Web Resources

1. ALI-ABAMedical Facility Leasing (Including Ground Leases and Medical Space Leases)Dow, T. Andrew and Goldberg, Richard R. , 2011 (Webinar)

http://files.ali-cle.org/thumbs/datastorage/skoobesruoc/source/TSUF04_Dow_and_Goldbereg--Medical_Facility_Leasing_Including_Ground_Leases_and_Medical_Space_Leases_thumb.pdf (link last visited 8/1/2013)

2. American Hospital Association - TrendWatch The Cost of Caring: Drivers of Spending on Hospital CareMarch 2010http://www.aha.org/research/reports/tw/11mar-tw-costofcaring.pdf(link last visited 7/17/2013)

3. American Institute of ArchitectsHealthcare 101: Master PlanningEgea, Eduardo S. and Sykes, James E., 2010 (Presentation)http://www.aia.org/aiaucmp/groups/aia/documents/presentation/aiab086383.pdf (link last visited 8/1/2013)

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4. Deloitte Center for Health Care SolutionsHospital Consolidation: Analysis of Acute Sector M&A Activity2013http://www.deloitte.com/assets/Dcom-UnitedStates/Local%20Assets/Documents/Center%20for%20health%20solutions/us_dchs_2013HospitalConsolidation_05292013.pdf(link last visited 7/18/2013)

5. Ernst & Young - Provider Post Rethinking real estate strategies: responding to the new catalysts for change.2010http://www.ey.com/Publication/vwLUAssets/Rethinking_real_estate_strategies/$FILE/Provider_Post_Real_Estate.pdf(link last visited 7/17/2013)

6. Georgia Institute of TechnologyA Project Planning Guide for Healthcare Facility OwnersWalrath, Bryan and Augenbroe, Godfried, May 2007http://herg.gatech.edu/Files/lsu_report.pdf(link last visited 8/1/2013)

7. Green Real Estate Law JournalGreen Building Basics for the Healthcare Industry: A Legal PerspectiveWhite, Geoff, 2009http://www.greenrealestatelaw.com/2009/07/green-building-basics-for-the-healthcare-industry-a-legal-perspective/(link last visited 8/1/2013)

8. HFM MagazineBuilding for Tomorrow: Decentralized care provides model for hospital planning, design and constructionHrickiewicz, Mike, December 2012http://www.hfmmagazine.com/hfmmagazine/jsp/articledisplay.jsp?dcrpath=HFMMAGAZINE/Article/data/12DEC2012/1212HFM_FEA_TrendsDesign

9. NuWire Investor“Obamacare to Impact Medical Office Space Growth?”Janssen, Mike, April 11 2012http://www.nuwireinvestor.com/articles/obamacare-to-impact-medical-office-space-growth-59046.aspx(link last visited 7/17/2013)

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10. PricewaterhouseCoopers, LLCDoing More with Less: Making More Effective – And Cost Effective – Capital Investments In Healthcare Facilities February 2012http://www.pwc.com/en_US/us/capital-projects-infrastructure/publications/assets/capital-investments.pdf(link last visited 8/1/2013)

11. Urban Land “How Changing Healthcare Delivery Will Affect Land Use.”Braunstein, Leslie, May 2013http://urbanland.uli.org/Articles/2013/May/BraunsteinHealthCare

12. Urban Land Institute (ULI) ReportThe Outlook for Health CareShilling, Gary, 2011http://www.uli.org/wp-content/uploads/2012/06/Shilling-Healthcare-Outlook.ashx_.pdf(link last visited 7/17/2013)

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SCHEDULE A

BOND FINANCING FOR HEALTHCARE INSTITUTIONS – A PRIMER

By Norman Fleming, Partner, Wiggin and Dana

Tax-exempt healthcare facilities such as hospitals, nursing homes, assisted living facilities and continuing care retirement communities frequently utilize bond financing because the interest on such bonds can be issued in a way that it is exempt from tax, and, in such circumstances, it often provides the lowest cost financing. As discussed below, proprietary for-profit healthcare providers also utilize taxable bond financing, particularly when a medium-term bridge to long-term financing is desired. A bond is a debt instrument that may have a maturity from a few years to 20 or 30 years. Bonds may or may not be rated by rating agencies, and are purchased by institutional investors, banks or individuals. Many bond issues for healthcare facilities, particularly bonds that are unrated, are sold primarily to high-income individuals or are privately placed with banks2. In many cases, as discussed below, the healthcare facility seeking financing will engage a financial advisor, placement agent or underwriter to assist in the financing process, particularly in the placement of the bonds with potential investors and the selection of suitable covenants in the loan documents. Although facilities can issue taxable bonds directly to investors, it is often more efficient to arrange for a governmental agency to issue bonds that bear tax-exempt interest, thereby lowering the interest rate. The agency then loans the proceeds of the bond offering to the provider. This kind of bond is called a “conduit bond” because the proceeds of the issuance of the bonds flow through the issuing agency to the healthcare provider that is the ultimate borrower.

Lowering Financing Cost for Nonprofit Facilities through Tax-Exempt Financing

Under current law, tax-exempt healthcare providers usually can issue “conduit” bonds through a state or local governmental agency empowered to sell debt that bears tax-exempt interest3. Since the investor does not need to pay tax on the interest, the rate is typically lower than the interest rate for conventional financing. The many legal requirements for such financings create transaction costs that are not present in conventional financing. For that reason, most tax-exempt “conduit” bonds are for financings in excess of $5 million. As the financing size increases, the impact of the extra costs is diminished. Some of the special procedures applicable to tax-exempt conduit financing that give rise to the extra cost are described below.

2 Banks typically make conventional loans, but may be interested in providing debt financing through a bond structure if the borrower is a tax-exempt entity that can issue bonds with tax-exempt interest and the bank is in a financial position to benefit from receipt of tax-exempt interest.3 There are many deficit-reduction proposals that involve imposing additional restrictions on the use of tax-exempt financing, but there is also strong opposition to such proposals.

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Working with the Governmental Agency

The governmental agency that issues the “conduit” bonds will charge fees for its services and will pass through the cost of its legal counsel (known as “bond counsel” or “special counsel”). The agency will work with a bank trustee that administers certain aspects of the financing, and the fees and legal counsel expenses of the trustee also will be passed along to the borrower. The agency often will have a set of covenants that it imposes on borrowers, including restrictions on additional debt and liens. The agency also may require that its loan of bond proceeds to the provider be secured by a mortgage or other collateral. The agency’s underwriting requirements for any bond to be sold at retail to the general public may include a requirement that such bonds be rated by a rating agency. Obtaining a rating from a rating agency may be impractical for a startup or small provider, and in such cases, it is more common for bonds to be sold to sophisticated investors in “private placements,” as discussed below.

Legal Requirements for Tax-Exempt Financing

The agency’s lawyers, called “bond counsel,” will supervise the process of ensuring that the legal requirements of the U.S. tax code applicable to tax exempt financing are met.4 These requirements include, among others, the following:

Use of Proceeds for Capital Assets Only; Bond Maturity Limitations. In general, tax-exempt financing is available to finance capital assets only, not working capital, except that up to 2% of the bond proceeds may be used to finance costs of issuance, including legal fees, credit enhancement costs, and rating agency fees (subject to the overall cap of 5% on “bad money” as described below). The average maturity of the tax-exempt debt cannot exceed 120% of the useful life of the financed capital assets.

Limitations on Private Business Use; Management Contracts. Tax-exempt financing most commonly is used by nonprofit organizations and governmental units.5 Private business use is not generally financeable, including without limitation costs relating to physician practices or unrelated trades or businesses that may be associated with a nonprofit provider. Because it is sometimes difficult to identify and quantify private use accurately, a safe harbor of 5% of bond proceeds ordinarily may be used for uses that are nonfinanceable with tax-exempt debt (“bad money”). The 5% cap is reduced by any costs of issuance financed by the bonds. Private use issues can arise when outside vendors manage

4 Section 103 of the Internal Revenue Code sets forth the primary requirements for tax-exempt financing, but there are many associated special rules that are set forth in the regulations and revenue procedures issued by the IRS pursuant to Section 103. Other important requirements are set forth in other Code sections, including Section 141 (dealing with private business use, particularly as it relates to nonprofit facilities, Section 147 (limiting bond maturity to roughly match the useful life of financed assets), Section 148 (dealing with investment of bond proceeds, or “arbitrage”), and Section 150 (special rules and definitions). Some of these rules are summarized in general terms in this paper, but there are many exceptions and other limitations that apply in particular circumstances.5 For-profit facilities sometimes can use tax-exempt financing for environmental compliance facilities, industrial or commercial properties that produce jobs, and other purposes.

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functions within the facility under management contracts, such as restaurant services6 or when the use of a facility is subsequently changed. The measurement of private use can be complicated, and may depend, among other things, on the floor area of the space subject to private use as well as its duration.

Qualifying Expenditures for Reimbursement with Tax-Exempt Financing. A prospective borrower may make expenditures for capital assets and later wish to reimburse such expenditures with tax-exempt financing. The Tax Code requires the borrower either to fund those expenditures with conventional financing that is subsequently taken out with the tax-exempt financing or, if it uses its own funds, have its Board adopt a resolution establishing the plan for tax-exempt reimbursement shortly after the expenditure is incurred. There are exceptions for certain “soft costs,” such as architectural services, subject to prescribed caps.

Rebating Excess Yield on Invested Funds. The reinvestment of bond proceeds at rates exceeding the bond interest rate is heavily restricted by tax law, although in the current low interest rate environment, the lack of attractive reinvestment opportunities reduces the practical impact of these restrictions. Any profit (or “arbitrage”) on the reinvestment must be rebated to the IRS, subject to various special exceptions, including qualified exceptions for construction funds7

and debt service reserve funds. The arbitrage rules also apply to any funds that are pledged to secure the bonds, whether or not the funds are derived from bond proceeds.

Limitations on Tax-Exempt Refinancings. Tax-exempt financings may be refunded in advance of maturity with a second tax-exempt financing only one time. This rule does not apply to current refundings of debt that is callable currently without penalty, as is the case with variable rate debt subject to mandatory tenders. Special rules apply to the use of tax-exempt debt to finance termination payments for interest rate swap agreements in connection with a refinancing, and if it is contemplated that termination payments are to be financed, steps must be taken at the time the swap agreement is entered into to ensure that the swap is qualified for tax-exempt refinancing under the Tax Code.

Reporting on Form 990. The annual Form 990 return of a tax-exempt organization must include detailed information regarding the use of bond proceeds and the facilities financed by such bonds.

Fundraising Materials. Tax-exempt financing is not available to finance

6 Revenue Procedure 97-13 adopted by the IRS (which has been supplemented by additional procedures) set forth a series of “safe harbors” for private use under management contracts whereby the length of the contract, the method of compensation (per unit, % of revenues or expenses or fixed price) are considered in determining whether private use is present allowing private contractors to share in profits generated by the financed facility.7 Use of construction funds over a three-year construction period is usually exempt from arbitrage, provided certain conditions are met, including diligent pursuit of the construction and compliance with specified completion timetables.

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capital assets to the extent the tax-exempt borrower already has raised funds earmarked for those facilities. For that reason, it is important to check fundraising materials and pledge cards used in fundraising activities for a facility to be financed to ensure that those materials do not diminish the amount of allowable tax-exempt financing. In these circumstances it is necessary to check whether the funds are solicited for a limited use, and if so, whether the use extends to working capital or other purposes separate from the capital assets to be financed with bond proceeds.

The foregoing summary is intended to provide a general introduction to some of the principal legal requirements applicable to tax-exempt financing. There are many exceptions, special rules and additional requirements that apply in particular circumstances.

Financing For-Profit Facilities through Taxable Bond Financing

Bond financing can be used to provide funding to for-profit providers when conventional bank financing is difficult to obtain, for instance during the development and start-up period for a new facility. Such bonds typically are not sold to the general public (a “public offering”). Also, the bonds usually are not issued through a governmental agency as “conduit” bonds because tax-exempt interest is not usually available to for-profit providers.8 Underwriters and placement agents who specialize in this kind of financing often have programs where they create special purpose vehicles that issue bonds to appropriate investors and loan the proceeds of the bond offering to the provider.

Public Offerings and Private Placements; Underwriters and Placement Agents

The sale of bonds, whether tax-exempt or taxable, is subject to the restrictions of Federal and state securities laws, particularly laws that mandate full and complete disclosure of all material risks, and especially in the case of taxable bonds, which are subject to additional securities regulation, the laws that govern the suitability of investors. Many investment banks have programs to identify and sell to appropriate bond investors in compliance with applicable securities laws, and some specialty investment banks have particular expertise in assisting smaller healthcare providers. If the investment bank commits to purchase the bonds for resale, it is called an “underwriter.” If the investment bank undertakes to locate investors but does not firmly commit to purchase the bonds itself, it is called a “placement agent.” In a “public offering,” wide solicitation of prospective investors is permitted. Taxable bonds typically are not permitted to be sold in public offerings, and are instead sold in “private placements” in compliance with special

8 For-profit entities may sometimes issue tax-exempt conduit debt under the IRS provisions for “small issues” (particularly for manufacturing) or in other limited circumstances beyond the scope of this paper.

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SEC rules that restrict the type and number of prospective investors who may be solicited and the manner in which solicitation may be conducted. Relatively few providers choose to identify investors and establish procedures for complying with securities laws without the assistance of an underwriter or placement agent.

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