The Fall of the House of AHERF: The Allegheny System Debacle

Lawton R. Burns, John Cacciamani, James Clement, and Welman Aquino


Health Affairs. 2000;19(1) 

In This Article


Restoring Accountability Andoversight

The AHERF bankruptcy suggests a lack of accountability, responsibility, and oversight exercised by AHERF's executives, trustees, and external stakeholders. The basicissue is, "Who is guarding the guards? "The community relies on the trustees and/or the state to protect the system's charitable assets. The trustees rely on auditors to verify the system's financial figures. The auditors rely on the executives for accurate information. The executives rely on the CFO and legal staff to keep within the law, and on bond investors for financing. The investors rely on bond-rating agencies to evaluate bond risks and on the SEC to oversee financial reporting by the firms issuing the bonds. Breakdowns occurred at each of these interfaces.

AHERF's board failed to act as a countervailing force. There were conflicts of interest, a ruling inside clique, a strong alliance between the board chairman and CEO, and no shareholders to hold managers accountable. Nonprofit boards also may be less adept than their for-profit counterparts are at reviewing complex financial matters and statements. This case illustrates that parties may misrepresent financial statements and accounting entries and then transmit them to an unsuspecting board and external auditor, both of whom may trust senior management for accurate information. AHERF management apparently failed to practice a well-recognized dictum in the accounting world of segregating the duties of control, authorization, and recording of transactions. AHERF's auditors failed to detect the accounting irregularities practiced by AHERF's CEO and CFO, perhaps as a result of inaccurate information provided them by these executives or the desire to maintain a favorable relationship with the system and keep its business. The AHERF experience, as well as the emerging problem of "managed earnings" in corporate America, has fostered a growing recognition of the need for board members and their audit committees to more actively engage the external auditors.

The bond-rating agencies and insurers likewise had difficulty discerning the financial health of the institution they were rating, because of AHERF's use of different obligated hospital groups and financial manipulations. Moreover, unlike the stock market, municipal debt is not traded actively and is rated at issuance. Bond ratings may be reviewed as the company's financial health changes, but such reviews are not performed continuously and may be masked by the use of debt insurance. Nevertheless, the bond insurance industry has demonstrated some resiliency following the AHERF bankruptcy, as MBIA has guaranteed its insured bondholders that they will receive all of their principal and interest payments when due. There also is a heightened awareness of risks in the municipal bond market, which may lead to tighter underwriting standards. Tighter bond covenants would permit lenders to have a preferred position in the event of a bankruptcy (ahead of the unsecured creditors). MBIA has announced that it will no longer accept Baa1 or lower-rated hospitals, has placed more stringent limits on its exposure to large single risks, and will increase its use of reinsurers. MBIA will also require additional security on higher-rated credit risks, such as a fully funded debt-service reserve fund, first mortgage loans, and a gross receipts pledge.[62] Bond insurers have begun to raise their premiums. There is now a widening spread on average bond yields (that is, a bigger gap in basis points) for bonds rated BBB +to BBB -.[63] Finally, bond insurers are beginning to pressure hospitals by demanding quarterly audited financial statements and telling hospitals to merge to pay off the bonds, to cut their costs or take other radical measures, and/or to make inspections for performance improvements.[64] Bond-rating agencies also are doing quarterly and monthly reviews to provide earlier warning signals of distress.

General lessons

At the risk of oversimplifying an extremely complex case, we draw five lessons from the AHERF bankruptcy. First, growing the business seems to have trumped fiscal restraint and responsible investment. In its quest to quickly build a statewide system, AHERF acquired several marginally performing hospitals, which (after servicing the associated debt) could not throw off enough cash to support improvements and physician acquisitions. Moreover, there is no evidence of any master management plan for what to do with all of the acquisitions. AHERF erroneously assumed that economies of scale and other efficiencies would flow automatically from its system-building efforts. In fact, such economies typically result from the consolidation of physical capacity and the channeling of larger volumes of output at faster rates of speed through that consolidated capacity.[65] Such measures were not taken systemwide. Growth at any cost does not appear to be the answer for America's hospitals (or, perhaps, any other enterprise). Instead, hospitals may be better off forming systems at the local market level where, according to recent case evidence, they can achieve some countervailing market power over managed care and sufficient purchasing power to direct contract with large suppliers.[66]

Second, AHERF expanded using common strategies -horizontal consolidation, vertical integration, and assumption of capitated risk -with which other hospitals are having problems. More hospitals and health systems are likely to edge toward bankruptcy in the near future and certainly face greater pressures on their margins and credit ratings. This deteriorating financial condition is partly the result of market competition and managed care forces, but it is also the sad result of hospitals 'hopping on managerial bandwagons that lacked documented efficacy or any research base.

Third, changing market conditions can affect the collapse of a hospital chain. The rapid changes in managed care and competition overwhelmed the hospital strategies of consolidation and integration. The former did not provide enough money to support the latter. Developments in Philadelphia, while sudden and concurrent, are occurring in other markets. A similar situation now faces Detroit Medical Center (with its large Medicaid patient base), UPHS, and other AMCs. Significantly, many of the multinotch bond downgrades occurred among Pennsylvania hospitals, where managed care has increasingly penetrated the market and concentrated power in a small number of large plans. Such markets may be particularly hostile climates for the provider strategies noted above.

This point suggests a fourth lesson.[67] If AHERF's troubles were simply the product of managerial decisions that initially succeeded but then failed in the face of new market forces, its bankruptcy is not necessarily an undesirable outcome. AHERF's demise might then be chalked up to a failed consolidation/integration strategy and excessive risk taking, which the market punished. If, however, AHERF's troubles were more the product of unethical behavior, a lack of due diligence, and the presence of rigid institutional forces, then bankruptcy may not be desirable. The poor performance of its integration strategies was cloaked by inaccurate, misleading financial results and certain institutional structures that limited the scrutiny and efficient response of the tax-exempt financial markets. Moreover, other institutional forces (for example, government efforts to find a buyer) may have intervened to preserve the bankrupt hospital assets in a market environment of excess capacity.

Fifth, the AHERF case suggests that the use of insurance and reinsurance vehicles allows financial and market risk to diffuse throughout the health care system and into the future. As the risk is diffused, so is the responsibility. In AHERF's case, these diffused to the point where they seemed to disappear. From a policy perspective, it becomes less clear whether actors beyond AHERF's management team and board are responsible for the collapse of the system.


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