As I often tell clients, there is nothing you can do to absolutely prevent someone from suing you. As counsel, we have to try to anticipate causes of potential disputes, and provide the client with appropriate tools to diminish the effects of such disputes. Over the past several years, I have assisted physicians countless times in the formation of new practice groups or entities, and in handling the departure or expulsion of a group member. The departure of a member, whether voluntary or involuntary, is foremost among the contexts in which litigation between or among the group and/or its members most often occurs.
When forming a practice entity, it is vital that physicians agree up front on provisions governing their ownership interest and how it will be handled in the event of death, retirement, disability, withdrawal, or expulsion. Contractual language addressing these issues can be incorporated into the organizational agreement or bylaws, or contained in a separate agreement. If an existing group is operating without any such provisions, they can enact them in a separate buy/sell agreement. While there are many other issues that can be addressed in buy/sell agreements, this article is limited to those relating to the transfer of ownership interests and the departure of group members.
A. Transfer of Interests.
Most buy/sell agreements contain intricate provisions governing the transfer of ownership interests to third parties. Such language can be very important in the context of regular business entities, and is often required by securities laws. But in the context of a medical practice entity, such intricate structures are much less important. First, due to the very nature of medicine, the number of possible third party transferees is limited only to other physicians. Second, most physician groups are relatively small cadres of professional equals who will very carefully consider anyone they might take on as a new partner. For physician groups, the most efficient way of handling the transfer of ownership interests to third parties is to require that if any member wants to divest his or her interest, he or she must sell it back to the group. The purchase price and conduct of this transaction can then be addressed under the provisions relating to withdrawal or retirement. Such provisions should also state that the group will not be under any obligation to sell the reacquired shares to any third party, or abide by any agreement made between the withdrawing member and any third party, and any purported transfer of interest to a third party without the consent of the group is void ab initio.
Litigation often arises in connection with departures from a group (death, disability, retirement, withdrawal, expulsion). There are many possible causes for such disputes, but the most frequently seen basis for departure litigation is financial. In all departures, the group will be paying the departing physician or the estate for his or her ownership interest. The crucial question is how that interest is valued. Most buy/sell agreements value ownership interests for purposes of buy-out in variations of two methods: based on an appraised or determined value of the practice as a whole, or based on a pre-set percentage of the departing physician's accounts receivable.
C. Valuation of Ownership Interests.
Appraisal. The appraisal method is most useful for physician groups with significant physical assets, such as a building. Appraisal can more accurately take into account the debts and liabilities of the group, and if done by an independent third party, appraisal is more difficult to dispute. If a group chooses the appraisal method, the most efficient set-up is to provide that (a) the appraisal will be performed by an independent third party, (b) the appraisal will be performed at some longer regular interval, i.e., three to five years, and (c) the value of a membership interest upon any departure will be based upon the most recent appraisal. The agreement should also include some mechanism to account for extraordinary changes in the value of the group (i.e. a malpractice judgment or taking on significant debt) in the interval between the last appraisal and the applicable departure.
Percentage of Accounts Receivable. The accounts receivable method is probably the more efficient method for most physician groups. Most groups do not own significant physical assets; accounts receivable therefore make up the majority of their value. The A/R method most often provides that a departing physician will be paid some pre-set percentage of his or her accounts receivable as of the date of departure, the percentage retained by the group being intended to account for the departing physician's share of group debts and liabilities. The A/R is then collected by the group over some pre-set period, usually four to six months, and the applicable percentage is paid to the departing physician. Some buy/sell agreements also provide that the group may calculate the departing physician's total share of existing accounts receivable and pay the physician in a lump sum at departure, or in a series of payments for a short period thereafter, i.e., two or three months. The A/R method is more objective than the appraisal method in that a physician's accounts receivable as of a given date is generally a known or easily verified quantity, and it involves much less extraordinary expense for the group: collecting A/R is something the group would have been doing anyway. Also, this cost can be paid out over an extended period of time. Any buy/sell agreement should prescribe dates for closing of all such transactions, and in all cases other than the payment of the full purchase price at closing, should provide for promissory notes and security agreements to document the outstanding obligations, and return of any documents representing ownership upon the full payment of the buy-out amount. Any buy-out provisions should also provide that the departing member will be paid any other amounts to which the member was entitled, i.e. applicable proceeds from any group retirement account in which the member participated.
D. Departure Circumstances.
Death. In the context of death, disability, and retirement, physicians are usually inclined to be generous in setting the purchase price for such member's interest. Regarding the buy-out of a deceased member's interest, this usually involves setting a high percentage to be paid to the estate. However, if the buy-out is based solely on A/R, if the deceased member was practicing at a reduced level at the time of his death, as is often the case, the prescribed high percentage may still not amount to much. There is nothing inherently wrong with this, and some groups just accept it as going with the territory, but it can and often does lead to disputes about the value of the deceased member's interest, up to and including litigation. A better way of handling the death of a member is through the use of life insurance. The buy-sell agreement can provide that the group will purchase life insurance policies covering each member at a uniform pre-set amount, with the group as beneficiary. Upon the death of a member and receipt of the life insurance proceeds, the group will then pay the deceased member's estate a pre-set percentage of the proceeds in full and final payment for the member's interest, the idea being that the retained percentage will cover the deceased member's share of the group's debts and liabilities. The percentage of proceeds paid to the estate represents full and final payment for the deceased member's interest, including the deceased member's share of any assets owned by the group and any outstanding A/R. The agreement should also include language providing that it is binding on the members' heirs and assigns. The buy/sell should also provide that the group will periodically re-examine the levels of coverage and may adjust coverage amounts if necessary, and that departing members may purchase their policy from the group.
Disability. As with death, buy-out percentages for disability are normally set relatively high, sometimes up to 100% of the disabled member's A/R. The buy/sell provisions should very clearly define "disability" and state how and by whom disability will be determined, i.e. disability is the inability to provide professional services due to medically determined mental or physical impairment. Disability should be determined by either another member of the group or by an independent physician selected by the group. The buy/sell may also allow the group to cease or reduce payment of salary or A/R upon the commencement of any disability insurance payments.
Retirement. Buy-out percentages for retirement are also usually set very high. As for addressing the possibility of future controversy, the main thing to remember is that "retirement" should be clearly defined, in order to preclude the possibility of a withdrawal disguised as retirement. Also, physicians may want to consider certain provisions to assist in the start-up of a new group, such as a lower buy-out percentage if a member retires or withdraws in the initial few years of the group's existence.
Withdrawal and Expulsion. In considering buy-out provisions relating to a future withdrawal or expulsion, at the outset, most physicians are inclined to be punitive, setting A/R payments at very low percentages, for example. Most litigation relating to the departure of a group member arises in the context of voluntary withdrawal or expulsion, so physicians should be mindful that while they are proposing punitive provisions from the point of view of the group, such provisions may also be directed at them as the member withdrawing or being expelled. There is nothing wrong with ratcheting down the buy-out percentage in the case of withdrawal, as compared to retirement or disability. As with most partnerships and joint business ventures, the main reason for such provisions is to promote the longevity of the group by discouraging withdrawal. However, buy/sell agreements often do more harm than good when they make the buy-out provisions for expulsion even more punitive, i.e., 25% of A/R or less. When a member is expelled from a group, resentment and "bad blood" are almost inevitable. Making the buy-out provisions excessively punitive only exacerbates an already bad situation and substantially increases the likelihood of litigation, the costs of which will undoubtedly far outweigh any ostensible benefit the group may obtain from "making an example." For purposes of valuation, it is much better to treat withdrawal and expulsion the same. For that matter, many buy/sell agreements treat all circumstances of departure the same, i.e. life insurance in the case of death, and X% of the applicable A/R for all other circumstances. Refraining from punishing or singling out an expelled member in the buy-out provisions will go a long way towards ameliorating some of the bad feelings inevitably associated with such events. Any acts of a member that may have caused actual damage to the group can be addressed through indemnification provision elsewhere in the agreement.
For all of the above contexts, the buy/sell agreement should include language specifically describing the group's rights in the event more than one member departs within a short period of time. In such case, the buy/sell will typically give the group the right to extend or otherwise revise the pay-out provisions for the affected members. Also, the buy-out of a member, particularly payments to the estate of a deceased member, may have tax implications, both for the group and for the member. These should be discussed with the group and addressed in concert with tax counsel.
Buy/sell agreements should include language providing that the spouses of the members acknowledge and join in the applicable provisions, including the spouses' signatures on the buy/sell or a separate acknowledgement, and prescribing the rights of the group in the event of the termination of a member's spousal relationship. Addressing these issues in advance, with the written acknowledgement of the spouses will very likely forestall the group's involvement in a member's divorce or a deceased member's estate.
It is inherently difficult to anticipate and address all potential sources of conflict between the members of a physician group, but drafting with clarity, and simplifying procedures wherever possible will substantially increase the group's ability to effectively address future issues. Also, if the physicians will look at these departure provisions both as members of the group and as individuals who may be subject to them, another source of potential conflict can be substantially diminished.
For more information, please contact Daniel Tatum at 972-450-7350 or firstname.lastname@example.org