Padilla v. Cmty. Health Sys.
| Docket Number | 3:19-cv-00461 |
| Decision Date | 17 August 2022 |
| Parties | CALEB PADILLA, individually and on behalf of all others similarly situated, Plaintiff, v. COMMUNITY HEALTH SYSTEMS, INC., et al., Defendants. |
| Court | U.S. District Court — Middle District of Tennessee |
Pending before the Court is Defendants' Motion to Dismiss (Doc No. 65, “Motion”), which is accompanied by a supporting Memorandum of Law (Doc. No. 66). Plaintiffs[1] have responded. (Doc. No. 69). Defendants have replied. (Doc. No. 70). Plaintiffs also filed a Notice of Supplemental Authority (Doc. No. 76).
For the reasons discussed herein, the Court will deny Defendants' Motion.
BACKGROUND[2]
This putative class action[3] is grounded on alleged violations of the Securities Exchange Act of 1934 (15 U.S.C. § 78a et seq., “Exchange Act”). Defendant Community Health Systems, Inc. (“CHS” or “the Company”)[4] is one of the largest publicly traded hospital companies in the United States. (Doc. No. 61 at ¶ 25). As of December 31, 2016, Defendant CHS's affiliates owned or leased 155 hospitals in 21 states, with roughly 26,222 hospital beds. (Id.). Defendant CHS generates revenue from general and specialized hospital and outpatient healthcare services, such as general acute care emergency room care, surgery, critical care, internal medicine, obstetrics, diagnostic, psychiatric, and rehabilitation. (Id. at ¶ 26). The patients Defendant CHS serves have private insurance, Medicare Medicaid, or are uninsured (which Defendant CHS refers to as a “selfpay” patient). (Id.).
Between 2007 and 2014, Defendant CHS grew rapidly via acquisition of other companies, which it financed by debt. (Id. at ¶ 27). In order to avoid default, Defendant CHS had to adhere to strict financial ratio covenants. (Id.). In 2014, Defendant CHS acquired Health Management Associates Inc. (“HMA”) for roughly $7.3 billion, including assuming $3.8 in indebtedness. (Id. at ¶ 29). This exacerbated Defendant CHS's already precarious financial position. (Id. at ¶¶ 2931). In 2015, Defendant CHS lost approximately one-third of its value when its earnings were substantially below expectations, in part due to an increase in self-pay patients. (Id. at ¶ 32). In 2016, the spin-off of thirty-eight hospitals severely underperformed expectations. (Id. at ¶ 33).
The real problems started in 2017, according to the Complaint. In February 2017, Defendant CHS reported a net loss attributable to shareholders of $1.7 billion for 2016, and its fourth quarter earnings before interest, taxes, depreciation, and amortization (“EBITDA”) of $564 million, about 6.6% higher than analyst's average estimate. (Id. at ¶¶ 34, 100). The next day, Defendant Cash's resignation as Chief Financial Officer (“CFO”) was announced, and Defendant Aaron was appointed the Executive Vice President and CFO of Defendant CHS. (Id. at ¶ 35). Defendant Aaron had been Defendant CHS's independent auditor at Deloitte & Touche LLP. (Id.). Defendant Smith, Defendant CHS's CEO, remained in his position and was the highest earner among hospital executives. (Id. at ¶ 38). (Plaintiffs refer to Defendants Cash, Aaron, and Smith collectively as the “Individual Defendants,” (Id. ¶ 23), and the Court herein will do likewise). That year, Defendant CHS sold thirty hospitals in order to pay down its debt, but it faced criticism for selling some of the best hospitals in its portfolio. (Id. at ¶ 36).
During this time, Defendant CHS faced internal problems. A confidential witness who worked at CHS between March 2016 and December 2017 reports that Defendant CHS attempted to automate the process of billing payors, which required hiring people to fix the resulting mess. (Id. at ¶ 39). This confidential witness's job at CHS was to find errors in the automated system, and there were often bills with underpaid claims of tens of thousands of dollars. (Id. at ¶¶ 40, 41). This confidential witness also reports that self-pay patients would often speak with the billing department and agree on a fee lower than the fee at which the services were. (Id. at ¶ 44).
At all relevant times to this action, Defendant CHS was constrained by covenants in a $1 billion credit facility (referred to by Defendant CHS at times as its “senior secured credit facility”) it maintained and used for financing the acquisition of HMA and refinancing existing indebtedness. (Id. at ¶ 45). Defendant CHS had to satisfy the covenants in order to avoid default: under its agreement with its creditor, Defendant CHS had to keep its “secured net leverage ratio”[5]below a maximum level and its “interest coverage ratio”[6] above a minimum level. (Id. at ¶ 45). Essentially, in order to avoid default, Defendant CHS had to manage its Consolidated EBITDA[7]. (Id. at ¶ 46).
Despite the importance of the metric represented by Consolidated EBITDA, Defendant CHS refused to report its Consolidated EBITDA to investors or explain its process for calculating its Consolidated EBITDA. (Id. at ¶ 47). The Securities and Exchange Commission (“SEC”) requested that Defendant CHS “revise” its EBITDA disclosure to present it “as it is calculated in [the covenant agreement with CHS's senior secured credit facility].” (Id. at ¶ 47-48). In response, Defendant CHS stated that it would not disclose the Consolidated EBITDA and instead would disclose only the “Adjusted EBITDA”[8] to investors, all the while noting that the Consolidated EBITDA was “a key component in the determination of our compliance with some of the covenants under our senior secured credit facility (including our ability to service debt and incur capital expenditures).” (Id. at ¶ 49). Defendants negotiated before the start of the Class Period[9] for the ability to exclude from the debt covenant measurements any charge CHS could attribute to “changes in accounting principles.” (Id. at ¶¶ 50, 51). Defendant CHS also renegotiated its secured net leverage ratio levels and its required interest coverage ratio. (Id. at ¶ 52).
The SEC requires that Generally Accepted Accounting Principles (“GAAP”) be used in the preparation of financial statements, and if they are not, then the financial statements are presumed to be misleading and inaccurate. (Id. at ¶¶ 53, 54). The GAAP requires that an entity with significant receivables (like Defendant CHS) must reflect its assets at their proper carrying value[10] and must regularly assess the collectability of its receivables at each reporting date. (Id. at ¶ 63). An entity must deduct credit losses[11] directly from the allowance[12] when the entity becomes aware that a balance is no longer collectible. (Id.).
Until January 1, 2018, Defendant CHS recognized its revenue under ASC 605.[13] This allows revenue to be recognized if “(a) persuasive evidence of an arrangement existed, (b) delivery had occurred, (c) the vendor's fee was fixed or determinable, and (d) collectability was probable.” (Id. at ¶ 65). Defendant CHS's gross service revenue (i.e., what the revenue would be at the full established rates) was substantially greater than the revenue that Defendant CHS actually expected to collect. (Id. at ¶ 66). Therefore, Defendant CHS reported a figure for “net operating revenue” (gross service revenue less deductions from such revenue, i.e., the sum of its contractual adjustments and discounts). (Id.). As a result of this accounting method, though Defendant CHS's ratio”); United States v. Harris, 331 F.2d 600, 601 (6th Cir. 1964) (“The Court may take judicial notice sua sponte.”); Energy Automation Sys., Inc. v. Saxton, 618 F.Supp.2d 807, 810 n.1 (M.D. Tenn. 2009) (“A court may take judicial notice of the contents of an Internet website.”). To provide background information, the Court herein will refer to the Investopedia website to define or explain certain terms. gross service revenue increased by 12.8%,[14] its net operating revenue decreased in the periods leading up to the Class Period. (Id. at ¶ 68).[15]
The net operating revenue also functions as a component of “adjusted EBITDA,” which is not related to GAAP but is disclosed in Defendant CHS's annual and quarterly financial reports.
As a result, during the Class Period, Defendant CHS:
(Id. at ¶ 70). Considering how adjusted EBITDA is calculated, bad debt impacted Defendant CHS's adjusted EBITDA and net operating income. (Id. at ¶ 71).
Pursuant to ASC 945-605, Defendant CHS reported top-line revenue using the amount it billed for a given service, even if it did not expect to collect the full amount. (Id. at ¶ 72). This meant, essentially, that if an uninsured patient was billed $100, and Defendant CHS expected the patient would pay $10, it could still record $100 as top-line revenue, together with a $90 contrarevenue line item for bad debt. (Id. at ¶ 73)...
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