Introduction

Across the United States, nonprofit health systems are facing a convergence of financial pressures. Rising labor costs, inflationary headwinds, shifting payer mixes, and lingering operational disruptions have placed many hospitals in a state of financial distress. For health system boards charged, this raises critical questions about fiduciary duties, strategic decision-making, and legal exposure when considering affiliations, restructurings, or closures. Understanding the scope and application of these duties is essential for any health system board navigating turbulent waters.

The Financial Landscape Driving Distressed Transactions

The financial health of hospitals has deteriorated markedly in recent years. Labor expenses, which represent the single largest cost category for most health systems, have surged due to workforce shortages and reliance on contract staffing. At the same time, reimbursement from the government and other third-party payers has not kept pace with rising costs. Many community hospitals operate on thin margins or run sustained operating losses.

These dynamics have led to an increase in strategic transactions. Health systems are increasingly exploring mergers, acquisitions, affiliations, management agreements, and possible closures. Each of these options carries distinct legal implications for a health system board, particularly when it is organized as a nonprofit with obligations to its stakeholders and the communities it serves.

Fiduciary Duties of Nonprofit Health System Boards

Board members of nonprofit health systems owe fiduciary duties that are rooted in state nonprofit law and, in many jurisdictions, are informed by the charitable trust doctrine. The two foundational duties are “the duty of care” and “the duty of loyalty.”

The duty of care requires board members to act with the level of care that a reasonably prudent person would exercise in a similar position. In the context of a distressed transaction, this means the board must engage in a deliberate, well-informed decision-making process. Board members should ensure they have access to reliable financial data, engage qualified legal and financial advisors, and carefully evaluate all reasonably available strategic alternatives before committing to a particular course of action. Courts and state attorneys general will scrutinize whether the board conducted adequate due diligence and whether its process was thorough and reasonable under the circumstances.

The duty of loyalty requires board members to act in the best interests of the organization and the community it serves, rather than in their own personal or financial interests. In distressed transactions, conflicts of interest can arise in a variety of ways. Any physician board members may have referral relationships or employment arrangements with a prospective acquirer. Community leaders on the board may face political pressures that conflict with the institution’s financial realities. Boards must identify, disclose, and appropriately manage these conflicts, including through recusal from deliberations and votes when necessary.

Heightened Scrutiny in the Zone of Insolvency

When a health system enters or approaches the zone of insolvency, the board’s fiduciary obligations take on heightened significance. While board members of a solvent nonprofit generally owe duties to the organization and its charitable mission, financial distress can expand the universe of stakeholders whose interests the board must consider. Creditors, employees, patients, and the broader community all have legitimate interests in the outcome of a distressed transaction.

Boards operating in this environment should be particularly attentive to the risk of deepening insolvency. Continuing to operate a facility without a viable turnaround strategy may expose board members to claims that they failed to act prudently. Conversely, rushing into a transaction without adequately exploring alternatives or negotiating reasonable terms may also give rise to liability. The key for the board is to demonstrate a disciplined, good-faith process that balances urgency with thoroughness.

The Role of the State Attorney General

In most states, the attorney general has oversight authority over transactions involving nonprofit and charitable assets. When a nonprofit health system proposes to sell, merge, or otherwise transfer its assets, the attorney general’s office will typically review the transaction to ensure that charitable assets are being preserved and that the transaction serves the public interest. In fact, many states now have laws requiring pre-transaction notification. This review can be extensive and may result in conditions being imposed on a transaction, including requirements to maintain certain service lines, continue charity care commitments, or preserve community governance structures.

Boards should engage with the attorney general’s office early in the process and anticipate the types of concerns that are likely to arise. Proactive communication and transparency can facilitate a smoother review and reduce the risk of delays or objections that could jeopardize a time-sensitive transaction.

Best Practices for Boards Navigating Distress

Health system boards facing financial distress should take deliberate, concrete steps to fulfill their fiduciary duties, protect themselves from legal exposure, and position the institution for the best achievable outcome.

• Engage Advisors Early and Strategically. The board should retain experienced healthcare transaction counsel and an independent financial advisor at the first signs of sustained financial deterioration, not after a liquidity crisis has already taken hold. Advisors should be engaged under clearly defined scopes that include preparation of a comprehensive financial assessment, evaluation of all reasonably available strategic alternatives, and, if appropriate, a formal fairness opinion. Waiting too long to bring in outside expertise is one of the most common and consequential missteps a board makes in distressed situations.
• Establish a Special Committee. When a specific transaction is under consideration, the board should ensure decisions are considered by non-conflicted board members to lead the evaluation process.
• Conduct a Rigorous Alternatives Analysis. The board should evaluate and document the full range of strategic options, including standalone turnaround plans, affiliations or joint ventures short of a full merger, asset sales, management arrangements, and potential acquisition partners. Each alternative should be assessed against defined criteria such as financial sustainability, preservation of the charitable mission, continuity of patient care, and workforce implications. A decision to pursue a particular path is far more defensible when the board can demonstrate it was chosen from among meaningfully evaluated alternatives.
• Document Every Step of the Process. Detailed, contemporaneous documentation is the board’s strongest shield against future legal challenges. Meeting minutes should reflect the information presented to the board, the questions board members asked, the advice of counsel and financial advisors, and the reasoning behind each material decision.
• Review and Strengthen D&O Insurance Coverage. Directors and Officers liability insurance, commonly referred to as “D&O coverage,” should be reviewed well in advance of any transaction announcement. The board should confirm that policy limits are adequate for the size and complexity of the anticipated transaction, verify that coverage extends to claims arising from the sale or restructuring of the entity, and consider obtaining tail coverage that will protect board members after the transaction closes. Distressed transactions frequently generate claims from creditors, employees, community groups, and regulators, and gaps in coverage discovered after the fact can have personal consequences for individual board members if not covered.
• Proactively Manage Stakeholder Communications. The board should develop a stakeholder engagement plan that identifies key constituencies, including medical staff, employees, patients, community leaders, elected officials, and the state attorney general, and that establishes a timeline and strategy for outreach. Early and transparent communication by boards that engage stakeholders proactively are far better positioned to build the support necessary to see a transaction through to completion.
• Plan for Post-Transaction Accountability. Where the transaction involves a transfer of control or assets to a new operator, the board should negotiate enforceable post-closing commitments that protect the institution’s charitable mission. These may include minimum periods for maintaining essential service lines, charity care obligations, capital investment requirements, and community board representation. Structuring these commitments as binding contractual provisions, rather than aspirational statements, gives them “teeth” and demonstrates the board’s commitment to the community beyond the closing date.

Conclusion

The current financial environment presents significant governance challenges for nonprofit health system boards. By understanding the scope of their fiduciary duties, engaging qualified advisors, conducting a rigorous and well-documented process, and proactively managing stakeholder relationships, board members can navigate challenging transactions in a manner that fulfills their legal obligations and serves the long-term interests of the communities that depend on them.