Winter 2002

LEGALLY SPEAKING
A Quarterly Report of Important Legal Matters

APPLYING SARBANES-OXLEY TO THE NON-PROFIT HOSPITAL BOARD

BY: Edward J. Krill, Esq.

THE RECENTLY enacted federal legislation that responds to the Enron, Global Crossing and WorldCom financial scandals, the Sarbanes-Oxley Act of 2002 , applies only to publicly traded corporations. This legislation is designed to ensure that investors are not given a rosy financial picture by outside auditors, internal financial officers, investment banking firms or stock rating agencies, when the financial facts are dismal. Congress concluded that there need to be new checks on the power of financial interests who benefit from the overvaluation of traded stock, and therefore have used fraudulent financial information to accomplish published overstatements of value, net revenue and debt. This legislation attempts to restore the integrity of financial reporting, and to improve the confidence that investors have in the information provided by traded companies.

Non-profit hospitals have faced financial stress for decades. In recent years, with the consolidation of third party payers, only large regional health systems have any substantial bargaining power vis-à-vis these large health plans and managed care organizations. Costs have continued to increase as the use of expensive, sophisticated technology has expanded and revenues have leveled off, or even dropped. This squeeze has put many non-profit hospitals into forced sale or even bankruptcy. Projections of reimbursement practices for the future do not reverse this trend.

Hospitals are players in various financial markets. They arrange and draw on lines of credit to maintain cash flow, they issue tax exempt industrial revenue bonds, they borrow for expansion and renovation and they attempt to present themselves as attractive merger or acquisition partners. These financial steps normally require the same kind of "due diligence" that would preceed the same transaction if done by a publicly traded company. These steps are not the issuance or sale of stock, nor the maintenance of the market for the company's stock, but these transactions do depend on the accuracy and completeness of the hospital's financial statements.

In the same way that a bank, revenue authority, financial institution would review the books of a for-profit stock corporation, a non-profit hospital can expect the same kind of scrutiny of its financial reporting documents. Therefore, some of the measures that Sarbanes-Oxley requires may improve a hospital's attractiveness as a borrower, partner, affiliate or candidate for merger or sale.

Many of the measures in this legislation are designed to empower the Finance/Audit functions of the Board of Directors, and to diminish the control that executive management has over financial reporting. Sarbanes-Oxley is based on the premise that qualified, independent directors are the best locus for oversight over both the internal financial staff and the external auditors. Sabanes-Oxley is further based on the belief that control over external auditing functions should not rest with company management, but instead with the Audit Committee of the Board.

Our business culture is coming out of a cycle where short term, quarterly, financial performance ruled the market. Managers were driven from quarter to quarter to achieve expected or desired results. Much hinged on the bottom line now, rather than where the company was headed long term. This focus drove some managers to show current quarterly results that accelerated income, postponed expense and ignored losses. Financial analysts have been suggesting that this focus is responsible, in part, for the recent poor performance of the stock market, because of the lack of credibility that financial reports come to enjoy. If credibility in financial reporting is desired by a hospital, some the of the requirements of Sarbanes-Oxley may be of interest.

This legislation rests on the conclusion that management has exercised far too much control over the external audit function, with the result that the major accounting firms have frequently made the financial outcome generated by management look good, when the true financial picture was, in reality, dismal.

Applying the requirements of Sarbanes-Oxley to the non-profit hospital setting, these would be the changes in responsibility and structure:

· The Audit Committee of the Board would be composed of independent trustees with no link to the Hospital or any of its affiliates by reason of employment, independent contractor status or Medical Staff membership.

· Members of the Audit Committee would be qualified in loans and finance, business, reimbursement, managed care contracting or financial management

· The Audit Committee would select the external auditor, set the terms of the audit and compensation for the work.

· A Code of Ethics would be approved by the Audit Committee dealing with financial impropriety, conflicts of interest and mandatory disclosure of financial irregularity.

· Hospital policy would direct persons with complaints regarding financial impropriety, fraud & abuse, questionable reimbursement practices or other concerns regarding Hospital business practices directly to the Audit Committee.

· The Hospital's Internal Audit function would be supervised by the Audit Committee. Internal Audit staff would report to and perform services directly for the Hospital Audit Committee in a confidential manner, with limited disclosure to Hospital management.

· Any consulting work to be done by the External Audit Firm must be approved by the Audit Committee and charges for this work should not exceed, for example, 10% of the annual audit fees.

· A budget is provided to the Audit Committee that permits it to hire accounting, legal and other financial consultants in confidence.

· At the time that the annual independent audit is begun, the External Audit Firm meets with the Audit Committee to review what is expected. The External Audit Firm is informed that any "management letter" issues, discrepancies in internal financial reporting or other irregularities should be reported first to the Audit Committee and not to Hospital executive management.

· The draft Financial Statements and Management letter is presented first to the Audit Committee for comment prior to release to Hospital executive management. Hospital staff review of the draft external audit report is conducted and supervised by the Audit Committee.

· One of the Audit Committee's regular tasks is to compare current financial performance with last year's financial reports and with the current and preceding budgets.

· Valuations of Hospital assets, especially Accounts Receivable, is performed using methodologies expressly approved by the Audit Committee.

· Interviews are conducted and reports are directly filed by Hospital managers with the Audit Committee on subjects such as "off balance sheet" transactions and strategic relationships, use of the Hospital's line of credit, executive compensation and bonuses, arrangements with hospital-based professionals, cash flow or liquidity indicators and risk-litigation management.

· Employment agreements with senior Hospital executive staff would be disclosed to the Audit Committee prior to final execution. All such agreements would include standards of loyalty to the Hospital during employment and, upon termination, covenants not to compete and non-disclosure of proprietary information.

· Outside activity reports are annually filed by all senior management and trustees with the Audit Committee. Any review of this information is conducted by the Internal Auditor staff and reported back to the Audit Committee.

Not all of these steps fit the typical non-profit hospital, but the thoughtful application of the principles can create a check and balance system that should mitigate against pressures to make the financial condition of the hospital look better than it really is. These steps, as modified for suitability to the particular institution, its culture and leadership, could accomplish the following:

a) improve the effectiveness of a hospital Compliance Program;

b) make the hospital more attractive to lenders and potential partners;

c) reduce the risk of inurement, fraud & abuse and conflict of interest matters;

d) take the pressure off managers to put a positive "spin" on financial data;

e) reduce the cost of unnecessary consulting services designed by management to court favor with the external audit firm; and,

f) strengthen the role of the Board in providing effective leadership for the hospital and the community it serves.

These measures are not for every hospital, and can be expected to be resisted by management as unwarranted where there is no history of sudden financial reversals. Nonetheless, it could be a worthwhile exercise for a Board retreat to go down this list and decide, "would this approach improve everyone's confidence in our financial information?" As draconian as some of these requirements might seem at first impression, these steps can offer a positive response to the emerging financial demands being placed on hospitals.

 

POTENTIAL PITFALLS ASSOCIATED WITH THE OFF-LABEL USE OF PRESCRIPTION DRUGS AND MEDICAL DEVICES

BY: Michael J. Sepanik, Esq.

PHYSICIANS ROUTINELY prescribe drugs and devices for off-label usage. The term "off-label use", as customarily used by health care providers, refers to the use of a prescribed drug or device in a manner that varies in some way from the drug's or device's FDA approved labeling. The term "labeling" encompasses all written, printed, or graphic material on the drug or device itself, containers, or wrappers accompanying a drug or device. It also includes any other form of a drug company's promotional activities, including booklets, pamphlets, bulletins and all other literature that supplements, explains, or is otherwise related to the drug or device.

A manufacturer's exposure to liability for the off-label use of prescription drugs must be considered in tandem with the "learned intermediary" doctrine. Through the well-established learned intermediary doctrine, courts have recognized that a physician stands as a learned intermediary between the drug manufacturer and the patient. Generally speaking, a manufacturer discharges its duty to warn by providing adequate warnings to the prescribing physician. The issue is unclear with respect to whether a manufacturer can be held liable for failure to warn of a known or foreseeable off-label use. This issue will often depend on whether the drug manufacturer in question is actually promoting the product for the off-label use in order to increase sales of the product, or whether it acquiesces in the off-label use in order to gain market share. This behavior can serve to eliminate the learned intermediary defense, as certain courts have held that if a physician's misuse is foreseeable, it cannot then be considered an independent intervening cause insulating the manufacturer from liability. See Richards v. Upjohn Company, 625 P.2d 1192, 1196-97 (N.M. Ct. App. 1980).

On balance, courts tend to impose a duty to warn where the manufacturer knew of and/or promoted the off-label use. Thus, the key factors in a majority of the off-label use decisions are: (1) whether the manufacturer knew of the widespread off-label use of the product in question; (2) whether the manufacturer promoted such off-label use; and (3) whether the off-label use had a harmful side effect of which the manufacturer knew, or should have known. With respect to suits based on off-label drug use, manufacturers should assume that plaintiffs' attorneys will utilize sales data to demonstrate that a company profited by its acquiescence of the off-label use of the product in question.

Once a manufacturer or distributor learns of the off-label use of a certain product, it should initiate a review of all medical literature relating to the off-label use, and identify all potential adverse reactions that are in any manner different and/or more severe than the reactions associated with the intended use. Depending on the results of the search, the company should consider initiating a survey of physicians prescribing the product in question in order to ascertain three pieces of information. First, the survey should determine what percentage of the prescriptions are directed toward off-label use. Second, the survey should query whether the physicians have noted any adverse reactions or side-effects associated with the off-label use that are distinct or more severe than those noted with the intended use. Finally, the survey should elicit whether physicians alter the warnings or instructions given to off-label use patients, and in what manner. Depending on the results of the survey, the manufacturer may then seek to consult with counsel or other professionals knowledgeable on FDA issues to determine whether a clinical trial is required.

 

Employers Should Count Months and Hours Employees Spend in Active Military Duty when Determining FMLA Eligibility.

by Thomas L. McCally and Tina M. Maiolo

According to a recent memorandum issued by the Department of Labor, Employers must count the active military duty time of called-up reservists and National Guard members in determining Family and Medical Leave Act leave eligibility.

Under the FMLA, an employee can take up to 12 weeks of unpaid, protected leave each year for a variety of family and health-related reasons. To be eligible, though, the employee must have worked for his or her employer for at least one year and must have completed at least 1,250 hours of work during that time.

In the recent memorandum, the Labor Department says that employers should count the months and hours employees spend in active military duty toward meeting eligibility requirements to take FMLA leave.

 

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