PPMs and the Affiliate Conundrum under the CARES Act—Including April 3, 2020 SBA Affiliate Guidance
Practice Management Companies (PPMs) and similar organizations that acquire physician practices have been significantly impacted in a COVID-19 world, with many practices partially or completely shutting down. This is particularly true in the dental, ophthalmology, endoscopy and pain management space where many elective procedures can be kicked until some other time in the future. With the lack of patient volume (or substantially reduced volumes reserved for emergency cases only), many PPM organizations have had to furlough clinical and administrative staff, and physician compensation has crashed or soon will—particularly for those PPM models where the physicians’ compensation or the management fee is based upon a % of net collected revenue (either directly or indirectly as in the case of a flat management fee structure). The question arises as to where these organizations fit in the most recently enacted financial and disaster assistance afforded too many organizations in light of the COVID crisis. The answer, regrettably, is that many PPMs will find themselves between a rock and a hard place unless and until additional Congressional relief or broader flexibility from the Treasury Department can be obtained.
The Current SBA and EIDL Loan Programs
Under the Paycheck Protection Program (PPP), additional funding through loans (which may be forgiven if used for certain specified purposes) is available to any business, nonprofit organization, veterans’ organization, or Tribal business, which employs up to 500 employees (except in the limited case where the SBA size standard allows more than 500 employees for a specific industry). Loan amounts under this program are capped at the greater of $10 million per entity or 2.5 times monthly payroll costs (with payroll calculated with a maximum of $100,000 per employee). There is another SBA administered Economic Injury Disaster Loan (EIDL) program that makes loans up to $2 million to businesses that meet the SBA size standards. These loans have 30 year terms and bear interest at the annual rate of 3.75%.
The PPM eligibility test is subject to longstanding SBA aggregation tests with affiliates, which should be considered carefully. The SBA affiliation test is complicated, but generally includes aggregation of investors that have certain controls features over the subject company and includes management controls over entities. Once an entity is deemed an ‘affiliate’ of another larger (i.e., a non-qualifying) entity, it cannot ‘unplug’ itself from such entity. Put another way, once an affiliate, always an affiliate for testing purposes. Therefore, if a small entity is controlled by management agreement with another entity that does not satisfy the SBA’s size limitations, the controlled entity would be aggregated under the affiliation rules and neither would qualify for assistance under the SBA programs.
Unfortunately, the recently enacted CARES Act does not change the longstanding SBA guidance relating to what types of entities constitute an “affiliate” nor has the SBA indicated, to date, any willingness to do so. Longstanding SBA guidance indicates that an affiliation may exist based upon contractual relationships or economic dependency. In particular, SBA guidelines dating back to March of 2014 indicate:
A concern that is economically dependent upon another person or concern may be found to be affiliated with that concern. It may also be found affiliated with other concerns controlled by the individual or concern to which it is dependent. It may be found affiliated on the basis of control or power to control, an identity of interest, the newly organized concern rule, or a combination of these.
Longstanding guidance indicates that the SBA considers business concern affiliates based upon the “totality of the circumstances” test—a test that the SBA would apply by evaluating a variety of facts and circumstances, with no specific weighting of any single factor in order to determine whether one entity is controlled by another. The SBA would consider both ‘affirmative’ control (actions that the managing entity has such as setting employment compensation) or ‘negative’ control (actions that the managing entity may have the right to block such as taking on debt, acquiring new equipment or assets, or modifying or changing shareholder agreements).
Late on April 3, 2020, the SBA issued updated guidance on the affiliation rules as they apply to businesses under the PPM. As of this date, the new guidance waives the affiliation rules for (1) any business concern with not more than 500 employees that, as of the date on which the loan is disbursed, is assigned NAICS code beginning with 72; (2) any business concern operating as a franchise that is assigned a franchise identifier code by the SBA; and (3) any business concern that receives financial assistance from an SBIC. In addressing the issue of affiliates, the SBA effectively re-states longstanding policy relating to management agreement control:
Affiliation based on management. Affiliation arises where the CEO or President of the applicant concern (or other officers, managing members, or partners who control the management of the concern) also controls the management of one or more other concerns. Affiliation also arises where a single individual, concern, or entity that controls the Board of Directors or management of one concern also controls the Board of Directors or management of one of more other concerns. Affiliation also arises where a single individual, concern or entity controls the management of the applicant concern through a management agreement.
No additional waivers were added and no further clarifications are expected at this time.
The PPM Conundrum
A typical PPM structure is most often built around a ‘controlled’ or ‘friendly’ professional corporation (PC) and a management services organization (MSO) (which may be owned in part by a selling physician or physician group as rollover equity). The MSO owns the non-clinical assets and provides a full suite of management services back to the PC that typically include the furnishing of non-clinical employees, billing and collection services, equipment, leased space, supplies and other general and administrative services including accounting, legal and human resources functions.
While there are variations on the theme with all PPMs, the friendly or controlled PC typically is subject to a share transfer, restricted share, or similar agreement (e.g., succession agreement) that expressly permits the MSO (or the majority owner of the MSO) to appoint a replacement physician owner of the PC in the event of the physician’s death, disability, violation of applicable laws, a breach of the management services agreement, or the original purchase agreement between the parties (including any applicable reps and warranties in the purchase agreement). This degree of management control by the MSO may result in the aggregation of the employees of the PC, the MSO and any majority owner of the MSO (aka, the PPM holding company) under the current affiliation test(s). To the extent the ‘combined’ entities’ employees exceed 500, none of the PC, the MSO or the majority owner of the MSO is likely to qualify for SBA loans, even the PPP under the Cares Act.
Features of the ‘typical’ PC/MSO that may need to be considered for revised or eliminated prior to an application for SBA administered programs include the following:
Controls in the management agreement that establish the compensation of the physicians that remain employed at the PC level, including both affirmative controls and negative or blocking controls.
Controls in the management agreement that would prohibit the execution of debt instruments by the PC or the purchasing or leasing of equipment.
Unlimited or extremely long terms of a management agreement, such as a management agreement that can only be terminated by the PC except for a very narrow set of factors perhaps limited to the exclusion of the management company from Medicare participation, or the charge or conviction of criminal actions by the management company or the majority shareholder (i.e., PPM holding company) of the management company.
The use of a standard restricted shareholder agreement that would require the nominee physician employee to transfer the shares to another physician of the management company’s designation—particularly if the nominee physician is an employee of the parent holding company such as the Medical Director of the company or one of the founding physicians/dentists. In the latter option used by a number of DSOs, the nominee shareholder of the PC is often the founder of the PPM or another senior member of management of the company, frequently with equity in the PPM itself.
Deficit Loan Funding Agreements which may be used to ensure that the MSO is paid the full management fee or that the PC is effectively ‘loaned’ the money to pay the MSO back.
While it is certainly possible to look at each of these contractual requirements in the various agreements that bind physicians and PPMs together and substantially amend or eliminate (or terminate such as in the case of a restricted shareholder agreement), this would require a fundamental revision to the tightly wound management control that typically exists in these models — an essential component of the transactional value of the acquisition of the physician business itself. In making some or all of these changes, the MSO would have significantly weakened controls and MSO contractual enforcement rights in a post-COVID world—particularly those contemplated as a necessary component of the original transaction acquiring the practice(s). Moreover, certain controls that the SBA could consider are virtually impossible to eliminate such as ‘revenue consolidation’ at the PC level—the ‘de facto’ standard for PPMs that use management and ownership control to consolidate revenue for aggregation purposes and business valuation.
Section 7(a) Loan Limitations Regardless of the Affiliation Tests
For an organization considering these factors, the structure of the PPP loans and EIDL loans may not be worth the potential long-term complications associated with fundamental revisions to these tightly integrated models. Specifically, under the PPP, the amount available is capped at 2.5X monthly payroll costs and can only be used for payroll, mortgage interest, rent, and utilities. Further, it is only forgivable to the extent the amount borrowed is used to pay payroll, rent, mortgage interest or utilities during the 8 week period after the loan is received.
Under the EIDL, the loan must be personally guaranteed and the proceeds may only be used for payroll, rent, utilities, interest, accounts payable, inventory and some bills that could have been paid had the disaster not occurred.
Since the only possible borrower (even in a restructured arrangement) likely to fall below the 500 employee test in most large PPM organizations is the friendly PC, it is necessary to look at the expenses for which the borrower is responsible. In most cases, the only eligible expenses would be payroll and would be subject to caps. Alternatively, the restructured arrangement could shift more risk and expense to the PC, but that would come with all of the attendant risk.
The typical PPM model presents a conundrum under the CARES Act. The structure of these arrangements, by their very nature, involve a very tightly integrated PC and MSO and the PC’s obligations are limited to physician employment, payor contracting, Medicare participation, and billing for clinical services furnished. The assets and ‘meat’ of the practice are held by the MSO with the MSO providing virtually every business function that the PC requires to deliver clinical services in consideration of its receipt of the PC’s net revenue (subject to corporate practice of medicine and fee splitting laws in various states), other than an amount sufficient to compensate the physicians.
This level of control ultimately may lead the SBA to conclude that the PC, MSO and majority owners (e.g., the PPM structure), are affiliates, therefore aggregating all employees of the three legal entities. To the extent that the combined entities’ employees were to exceed 500, none of the three entities would qualify under the newly enacted PPP for SBA loans. The EIDL program would be a viable option; however, personal guarantees are required and the funds can only be used for limited purposes.
Restructuring—quickly—may be an option; however, the degree to which control needs to be eliminated may ultimately defeat the integration of the model itself. This could lead the entire PPM structure subject to fracture in a post-COVID world and, presumably, most physician practices would likely not ‘give back’ the measure of pre-COVID control held by the MSO once regained as part of a substantial amendment of the parties’ agreements. And, even if PPMs effectively relaxed most of the core measures of control, the PPM model is predicated upon revenue consolidation. It is highly unlikely that any PPM would (or could) drop revenue consolidation from a financial and economic valuation perspective.
The most recently issued SBA guidance on the eve of April 3, 2020, effectively re-incorporates longstanding management control guidance and simply does not provide the type of relief that many PPMs and private equity sponsors had hoped. This leaves PPMs and their friendly PCs looking for other financial alternatives including debt relief from existing lenders and creditors (including lessors and other vendors). Alternatively, PPMs may be staring down the barrel of restructuring, dependent upon cash reserves and the duration of the COVID crisis. At the end of the COVID crisis, the ownership and equity holders’ may need to put additional money into PPM’s to ‘re-start’ the organizations, or they may need to do so now in order to maintain existing infrastructure personnel, PPM leadership and physician retention.
While the result with the SBA and EIDL programs is disappointing for PPMs, additional stimulus programs may yet be on the horizon, some of which may help PPMs. We are awaiting the details – which are due any day now – for the Federal Reserve’s Main Street lending program and the Health and Human Services (HHS) grant program. . We also expect at least one more program from Treasury that may help companies that do not qualify for SBA Loans. We anticipate releasing information on these and other stimulus programs as soon as they are available on the www.covid19.polsinelli.com blog. Further, we continue addressing contingency planning with clients and friends on what is fast becoming the COVID19 business playbook -- business interruption insurance, force majeure clauses, rent and mortgage planning, cost cutting, revenue acceleration, and human resource management.
 The North American Industry Classification System (NAICS) developed by the Office of Management and Budget (OMB) as the standard for use by Federal statistical agencies in classifying business establishments for a wide variety of statistical data and analysis relating to the United States economy. https://www.census.gov/eos/www/naics/faqs/faqs.html#q1 According to OMB guidance, NAICS code 72, the Accommodation and Food Services sector, “comprises establishments providing customers with lodging and/or preparing meals, snacks, and beverages for immediate consumption. The sector includes both accommodation and food services establishments because the two activities are often combined at the same establishment.” See, https://www.naics.com/naics-code-description/?code=72