Recent appellate decisions confirm the uphill battle hospitals face when merging with other hospitals.

On October 31, the U.S. Court of Appeals for the Seventh Circuit overturned the district court’s ruling in Federal Trade Commission v. Advocate Health Care, No. 15-cv11473 (N.D. Ill. June 14, 2016). That decision found that the government had not properly defined the geographic area of competitive significance and, consequently, denied the FTC’s requested preliminary injunction of the merger of two Chicago-area hospital systems. However, the Seventh Circuit reversed and ordered the district court to reconsider its preliminary injunction ruling in light of the Seventh Circuit’s instructions and findings on the definition of a relevant geographic market.1

For almost a decade, the FTC successfully blocked the hospital mergers it challenged. Then, only one month before the Advocate district court decision, a Pennsylvania federal court was the first court since 20072 to rule against the FTC at the preliminary injunction stage in a case involving a merger of hospitals.3 The FTC appealed the Pennsylvania decision to the Third Circuit and won in late September.4 With the decision in Advocate, the Seventh Circuit followed suit by embracing the FTC’s market definition framework and reinstated the FTC’s winning streak.

The Facts and Proceedings

In September 2014, Advocate Health Care Network and NorthShore University HealthSystem entered into a strategic affiliation agreement. The Advocate health care system consists of 11 hospitals. More than two-thirds of Advocate’s revenues from commercial insurers (payers) come from risk-based contracts. The NorthShore health care system consists of four hospitals. Its commercial payer revenues are generated primarily through fee-for-service agreements.

A key touchstone of all antitrust counseling or advice is the goal or purpose of the client’s proposed conduct, whether that conduct is an acquisition or a loyalty discount program. Here, Advocate’s stated rationale for the merger is to develop “a new, lost-cost, high-performing network (HPN) insurance product” to be sold throughout the Chicago area. According to Advocate, it needs the NorthShore assets to offer an HPN product. NorthShore’s stated rationale is that the merger will permit it to “engage in large-scale full risk contracting,”5 which it is unable to do presently because it lacks sufficient geographic scope and utilization and care management tools that Advocate can offer.

The hospitals notified the FTC of the merger, and, after an investigation, the FTC issued an administrative complaint in December 2015, alleging that the merger may substantially lessen competition. Additionally, in February 2016, the FTC moved for a preliminary injunction in the Northern District of Illinois to prevent the hospital systems from closing the proposed transaction. After a multiday evidentiary hearing on the preliminary injunction motion, the court issued its ruling. The FTC appealed to the Seventh Circuit immediately, and the district court stayed the merger pending the appeal.

The District Court Decision

In deciding whether to grant a preliminary injunction, the district court was required to (1) determine the likelihood that the FTC will ultimately succeed on the merits and (2) balance the equities. The court concluded that the FTC failed to demonstrate that it would succeed on the merits.

To succeed on the merits, the FTC has to prove that the merger may substantially lessen competition in a relevant product and geographic market. In this case, the parties agreed on the product market — general acute care services sold to commercial payers and their insured members. However, the parties diverged on the geographic market in which to analyze the merger’s effects. The FTC’s expert argued that the geographic market should be limited to the “North Shore Area.” This area consists of six of the 15 merging hospitals as well as five additional hospitals not associated with the merging entities. All of these facilities are located in northern Cook County and southern Lake County. The FTC’s geographic market is based on the theory that patients want care from local providers and the location of the hospitals, and the market includes (1) local hospitals while excluding “destination hospitals,”6 (2) hospitals “with at least a two percent share in the area from which the relevant Advocate and NorthShore hospitals attract patients,” and (3) hospitals that draw patients from the same area as both Advocate and NorthShore rather than those that overlap with just one of the systems.

After defining the market, the FTC tested that geographic area using the “hypothetical monopolist test.” This test examines whether a hypothetical monopolist, which controlled all the hospitals in the alleged geographic market, could sustain a small but significant price increase (SSNIP) for services provided by the merging hospitals. An alleged geographic market passes the test if the hospitals located there are close enough substitutes that it would be profitable for the monopolist to impose that price increase. The FTC calculated the diversion ratio, or the percentage of patients that would switch to another hospital in the North Shore area for general acute services if their first choice were no longer available, to be 48 percent. According to the FTC’s economist, this intramarket diversion ratio, or substitution level, was sufficiently high to pass the hypothetical monopolist test.

The hospital systems, though, argued that the FTC’s geographic market definition was too narrowly drawn and that its definition arbitrarily excluded six destination hospitals and other facilities providing services in the Chicago area. Specifically, they argued that the market definition should include hospitals that are outside the North Shore area, but that are associated with doctor’s offices and outpatient facilities within the area and refer significant inpatient volume for general acute services hospitals outside the North Shore area. In support of this contention, the hospital systems used the FTC’s own diversion ratios to demonstrate that Northwestern Memorial Hospital, which is located outside the North Shore area, is the second or third choice for patients that use five of the six merging hospitals in the area.

The district court agreed with the hospital systems, concluding that the criteria used by the FTC to define the geographic market were flawed. The court noted that the FTC provided no economic basis for excluding “destination hospitals” from the geographic market. The court explained that the FTC merely assumed that these “destination hospitals” were not substitutes for Advocate and NorthShore because patients prefer to receive general acute care services closer to home. The court, however, found the testimony regarding customer preference ambiguous, with some witnesses agreeing that patients like to receive care closer to home (especially for more routine services) and other witnesses testifying that patients go to facilities closer to their jobs in the city. Further, the court noted that exclusion of “destination hospitals” from the relevant market ignored “commercial realities.” Commercial payers negotiate a single contract with a hospital system for both inpatient and outpatient care. These outpatient services are on the rise and impact where a patient chooses to receive inpatient care. The presence of doctors and outpatient facilities located in the North Shore area that are affiliated with hospitals outside of the North Shore area drive patients to these outside hospitals for inpatient services.

In addition, the court criticized the FTC economist’s third criterion, explaining that hospitals need not overlap with both Advocate and NorthShore in order to constrain pricing post-merger.

Citing the U.S. Supreme Court’s 1962 decision in Brown Shoe, 7 Judge Alonzo wrote, “There is no formula for determining the geographic market; rather it should be identified in a ‘pragmatic [and] factual’ way and should ‘correspond to the commercial realities of the industry.’” From this opinion, it appears that the court was focused on these “commercial realties” of the market more than the economic test presented by the FTC’s expert. For the above reasons, the court determined that the FTC failed to prove a relevant geographic market that conformed to the commercial realities of health care services in the Chicago area and, thus, denied the FTC’s preliminary injunction motion.

The Appeal

As noted above, a day after the district court’s decision, the FTC appealed to the Seventh Circuit Court of Appeals. The FTC then moved for, and the district court entered, an injunction to prevent the closing of the Advocate-NorthShore transaction pending appellate review.8

In its appeal, the FTC principally argued that the district court erred, as a matter of law, when it failed to take into consideration the results of the hypothetical monopolist, or SSNIP, test. It noted that both the FTC’s and hospitals’ experts agreed that the SSNIP test was the appropriate economic measure of the market definition. In addition, it pointed to court decisions that relied on the hypothetical monopolist test to define the geographic market in cases involving health care-related transactions.9 Accordingly, the FTC contended that the district court erred by focusing on patient rather than commercial payer preference and how the FTC’s geographic market was constructed, as opposed to whether the market passed the hypothetical monopolist test. Because the FTC’s geographic market passed the SSNIP test, it was properly defined.

In response, the hospitals first pointed out that the district court’s market definition decision is subject to deference on appeal, given that it is highly fact-specific and the result of a thorough examination of a voluminous record. In addition, they contended that the court’s opinion correctly determined that the FTC failed to provide evidentiary support for the crucial assumptions it made in constructing the geographic market and that the FTC’s request for an injunction pending appeal did not offer any facts to contradict the court’s conclusion that the FTC’s geographic market ignored commercial realities.

The Seventh Circuit Decision

In deciding to reverse and remand the district court’s opinion, the Seventh Circuit concluded that the lower court’s factual findings with respect to the relevant geographic market were clearly erroneous. The Seventh Circuit explained that the district court’s criticisms of the FTC’s alleged geographic market were incorrect in four ways: (1) overlooking the hypothetical monopolist test results of FTC’s expert and mistaking the test’s iterative process for logical circularity; (2) finding that the FTC lacked a basis for distinguishing local hospitals from academic centers; (3) determining that the evidence about patient preference for local hospitals was ambiguous; and (4) falling prey to the “silent majority” fallacy. The silent majority fallacy is the purportedly incorrect assumption that patients who travel a distance to obtain services constrain the price that hospitals charge to closer patients. This article will explain, in turn, each of these points below.

First, the Seventh Circuit concluded that the FTC correctly used an iterative process — known as the hypothetical monopolist test — to examine whether the proposed market was too narrow. Specifically, the FTC correctly proposed a candidate market, simulated monopolization of the market, adjusted the market if a hospital outside the candidate market could constrain the rates of the hypothetical monopolist in the candidate market, and reran the simulation as necessary. This was not circular, and, if the FTC’s candidate market were too narrow, the iterative testing of that market would reveal that it should be expanded.

Second, the Seventh Circuit did not find support for the district court’s determination that the FTC improperly excluded academic medical centers from the relevant geographic market. Witnesses consistently testified that the demand for academic facilities differed from demand for general acute care hospitals that draw patients from much smaller geographic areas. Both insurance company and hospital executives distinguished academic facilities from community hospitals by the complexity of services they offer. The Seventh Circuit found such testimony “an obvious and sound basis for distinguishing between academic medical centers and other hospitals like those operated by Advocate and NorthShore.”

Third, the Seventh Circuit rejected the district court’s finding that evidence of patient preference for short travel distance was equivocal. The Seventh Circuit determined that the district court incorrectly relied on testimony that work place locations and outpatient relationships influence patient choices and distinguished that testimony from testimony regarding patient hospital care preference. Based on the foregoing, the Seventh Circuit found strong evidence exists that 73 percent of patients living in the FTC’s proposed market receive hospital care there, 80 percent of those patients drive less than 15 miles or 20 minutes to their chosen hospital, and 95 percent drive 30 miles or less. Therefore, the evidence supported Dr. Tenn’s determination that patients generally chose hospitals close to their homes in establishing his candidate market.

Fourth and finally, the Seventh Circuit explained that the district court’s analysis incorrectly relied on certain diversion ratios — the percentage of patients who would choose a hospital outside the relevant market if their first choice was unavailable. Instead, the Seventh Circuit determined that “insurers are the most relevant buyers” of health care services, not the patients themselves. The Seventh Circuit noted that insurers consider whether employers would offer their plans and whether employees would sign up for those plans. Accordingly, diversion ratios or patient substitution measures “do not neatly translate into options for insurers.” The court found persuasive that insurance executives unanimously testified that an insurance network must include either an Advocate or NorthShore facility in the proposed geographic area to be marketable. As such, the hospitals have market power over the payers, which need these facilities to offer marketable products to customers that do not travel far to seek general acute care.

Lessons Learned

It remains to be seen exactly what the district court will do in light of the Seventh Circuit’s ruling and whether the hospitals will continue their fight through the long and expensive FTC administrative hearing process or abandon the merger. However, what is clear is that these recent appellate decisions confirm the uphill battle hospitals face when merging with other hospitals. As health care costs rise and hospital systems look to combine, these entities should assess the risk of a challenge by the FTC and consider the following:

  • Whether collaborations, short of merger, might achieve the same or similar efficiencies.
  • Proof of successful payer plans that do not include the merging parties or that payers were prepared to develop plans without them would be powerful evidence that the post-transaction system could not dictate rates.
  • When one of the merging hospitals is a “destination hospital,” the hospitals should consider whether there are any academic medical centers outside the candidate market to which patients go for inpatient care.