Can a North Carolina municipal hospital legally join a physician-hospital organization (PHO) and put public money into it, so the hospital can compete in the managed care market?

Plain-English summary

Attorney Noah Huffistetler, representing four NC municipal hospitals (New Hanover Regional, Pitt County Memorial, Durham Regional, and Cape Fear Valley), asked the AG three questions about a proposed managed care joint venture. The hospitals wanted to (1) form local Physician-Hospital Organizations (PHOs) with their physicians, (2) combine those local PHOs into a Statewide PHO, and (3) use hospital revenues to capitalize the ventures so the hospitals could compete for managed care contracts on equal footing with private hospitals.

Chief Counsel John McArthur and Special Deputy AG James Wellons, for AG Easley, answered yes to all three statutory and constitutional questions.

Statutory authority (NCGS 131E-7(b)): Municipal hospitals have express authority to "contract with or enter into any arrangement with ... any person, private organization, or nonprofit corporation or association for the provision of health care," and to pay their share from hospital revenues. The Municipal Hospital Act's interpretation provisions (NCGS 131E-5(d) "construed liberally" and NCGS 131E-7(a) "all powers necessary or convenient") make the implied power to join PHOs clear, citing Homebuilders Ass'n of Charlotte v. City of Charlotte, 336 N.C. 37 (1994), for the broad-construction rule.

Public purpose (Art. V § 2(1)): Under the Madison Cablevision two-prong test, the PHO expenditure passes muster. Prong one: there is a reasonable connection between PHO participation and the municipal hospital's operational needs (managed care is the future of healthcare reimbursement; PHOs are the standard competitive response; private hospitals are forming them at a rapid pace). Prong two: the public benefits primarily, not the participating physicians (cost containment, quality maintenance, continued hospital viability for the population served). The opinion notes that Foster v. Medical Care Comm'n (1973) struck down a different funding arrangement because the resulting hospital would be "privately operated, managed and controlled," whereas PHOs are jointly controlled by the hospital and the physicians, which keeps public oversight intact. The opinion also acknowledges that Mitchell v. Industrial Development Financing Authority (1968) once narrowed the doctrine but has since been eroded by amendments to Art. V § 2(7) and by cases like Maready v. City of Winston-Salem.

Idle funds (NCGS 159-30): The investment-of-idle-funds restriction does not apply because PHO capitalization is integral to the hospital's health care operations, not a sidelined investment. NCGS 131E-7(b) expressly contemplates that municipal hospitals will spend hospital revenues on contractual arrangements for health care.

The 1995 PHO opinion is one of several mid-1990s NC AG opinions reconciling traditional public-purpose doctrine with the new managed care market structure. The healthcare delivery system was undergoing a structural shift from fee-for-service to capitated managed care, and public hospitals needed institutional flexibility to remain viable. The AG provided that flexibility within constitutional limits.

Currency note

This opinion was issued in 1995. Subsequent statutory amendments, court decisions, or later AG opinions may have changed the analysis. Treat this page as historical context, not current legal advice. Verify current law before relying on any specific rule, deadline, or remedy mentioned here. The managed care landscape has shifted substantially since 1995, with PHOs largely giving way to ACOs (Accountable Care Organizations) and other newer models under the Affordable Care Act and Medicare reform. Anyone evaluating a current municipal hospital joint venture should consult the current Chapter 131E statutes, the Maready line of cases, and any subsequent ACA-related federal preemption analysis.

Background and statutory framework

Municipal hospitals in NC operate under Part A of Article 2 of Chapter 131E (NCGS 131E-1 through 131E-20). The statutory framework gives municipal hospitals broad operational authority subject to public oversight. The four hospitals in this 1995 opinion (New Hanover Regional, Pitt County Memorial, Durham Regional, Cape Fear Valley) were all nonprofit corporations operating hospital facilities on premises leased from NC counties. The AG opinion assumed (without deciding) that the leased-but-private-corp form retained municipal hospital character for purposes of the analysis.

The PHO structure the hospitals proposed had multiple layers. Each hospital would partner with local physicians or physicians' organizations (POs) to form a local PHO. The local PHO would be capitalized either jointly (by hospital and PO in equal shares) or as a hospital-wholly-owned subsidiary. Governance would be split equally between hospital and physician representatives. The local PHOs would then combine into a Statewide PHO that would seek a Department of Insurance license to accept capitated payments and negotiate managed care contracts.

The constitutional analysis under Article V § 2(1) (public purpose) and § 2(7) (state contracts with private entities) is the doctrinal core. Foster v. Medical Care Comm'n (1973) was the watershed case for hospital-related expenditures. Foster struck down a Medical Care Commission financing arrangement because the resulting hospital would be privately operated. The 1995 AG opinion distinguishes Foster on the joint-control ground: the PHOs are jointly controlled, not privately controlled.

The Mitchell / Foster line was the high-water mark of public-purpose skepticism toward government-private partnerships. By 1995, that doctrine had been substantially eroded. Maready v. City of Winston-Salem would be decided in 1996 and would explicitly approve industrial recruitment incentive payments to private companies under the same Madison Cablevision two-prong test. The 1995 PHO opinion is part of the doctrinal shift toward greater permissiveness in public-private healthcare arrangements.

The Madison Cablevision test has two parts. First, is the activity within the scope of governmental involvement and reasonably related to communal needs? Operating a hospital is clearly a traditional government function; PHO participation is necessary for the hospital to keep operating. Second, does the activity benefit the public generally rather than special interests? The AG opinion identifies multiple public benefits: cost containment, quality maintenance, continued availability of public hospital services to managed-care-insured patients. The fact that participating physicians also benefit incidentally is not disqualifying; Maready explicitly endorsed incidental private benefit when the primary beneficiary is the public.

Common questions

What is a Physician-Hospital Organization (PHO)?

A joint venture between a hospital and a group of physicians (or a physicians' organization) that negotiates managed care contracts on behalf of both. The PHO offers a "one signature contract" to managed care payers that includes both hospital services and physician services, which simplifies the payer's negotiation and gives the PHO more leverage in pricing negotiations. PHOs were the dominant managed care contracting vehicle in the mid-1990s. They have since been substantially replaced by ACOs and other newer models, but the basic structure (provider integration for joint contracting) persists.

Did municipal hospitals actually form PHOs after this opinion?

The opinion was issued in 1995 specifically to clear the legal way for the four hospitals to proceed. Whether the proposed Statewide PHO ever launched, and whether it succeeded in the managed care market, is not part of the opinion. The AG opinion gave the hospitals the legal cover they needed to try.

How does this opinion fit with the Maready case?

Maready v. City of Winston-Salem was decided in 1996, after this AG opinion. Maready upheld an industrial recruitment incentive program under the same Madison Cablevision two-prong test the AG had used here. So the AG opinion anticipated the doctrinal trajectory that Maready would confirm a year later. By 1997, the AG could cite Maready directly in similar opinions (as in the State Revolving Fund opinion of March 25, 1997).

Could municipal hospitals form for-profit subsidiaries?

The opinion does not directly address that. The proposed structure had the local PHOs and Statewide PHO as "taxable nonprofit corporations," which sit in an unusual statutory space (nonprofit corporate form, but taxed because they engage in unrelated commercial activity). A for-profit subsidiary would face different statutory and constitutional issues. The opinion is keyed to the specific PHO structure presented, not to broader joint-venture authority.

What does the "liberal construction" rule mean in practice?

NCGS 131E-5(d) says the Municipal Hospital Act "shall be construed liberally to effect its purposes." This is a statutory canon that tells courts to read powers broadly when ambiguity arises. Homebuilders Ass'n of Charlotte v. City of Charlotte (1994) is the AG's cited authority for the liberal-construction principle. The result is that municipal hospitals have implied powers in addition to expressly enumerated ones, as long as the implied powers serve the Act's purposes (operating hospitals, providing health care, cooperating with public and private agencies).

Source

• Landing page: https://ncdoj.gov/opinions/creation-of-physician-hospital-organizations-by-municipal-hospitals/

Citations

• N.C. Const. art. V, § 2(1), § 2(7)
• N.C. Gen. Stat. §§ 131E-5(b), 131E-5(d), 131E-7(a), 131E-7(b), 131E-12, 159-30
• Homebuilders Ass'n of Charlotte v. City of Charlotte, 336 N.C. 37, 442 S.E.2d 45 (1994)
• Foster v. Medical Care Comm'n, 283 N.C. 110, 195 S.E.2d 517 (1973)
• Hughey v. Cloninger, 297 N.C. 86, 253 S.E.2d 898 (1979)
• Mitchell v. North Carolina Industrial Development Financing Authority, 273 N.C. 137, 159 S.E.2d 745 (1968)
• Madison Cablevision, Inc. v. City of Morganton, 325 N.C. 634, 386 S.E.2d 200 (1989)

Original opinion text

The NCDOJ-published opinion begins in medias res. The questions presented and conclusions are reproduced below as published.

• (1) Does a municipal hospital have the authority, pursuant to N. C. Gen. Stat. § 131E-7(b), to enter into a joint venture with local physicians to create a local physician-hospital organization ("PHO") that will then join with other PHOs to create a Statewide PHO?
• (2) Is the expenditure of municipal hospital revenues to establish local and Statewide PHOs an expenditure for a public purpose, pursuant to Article V, Section 2(1) of the North Carolina Constitution?
• (3) Is the expenditure of municipal hospital funds to establish local and Statewide PHOs prohibited by N.C. Gen. Stat. § 159-30?

For the reasons set out below, we conclude that:
- (1) A municipal hospital does have the authority, pursuant to N. C. Gen. Stat. § 131E-7(b), to enter into a joint venture with local physicians to create a local PHO that will then join with other PHOs to create a Statewide PHO;
- (2) The expenditure of municipal hospital revenues to establish local and Statewide PHOs is an expenditure for a public purpose, pursuant to Article V, Section 2(1) of the North Carolina Constitution; and
- (3) The expenditure of municipal hospital funds to establish local and Statewide PHOs is not prohibited by N.C. Gen. Stat. § 159-30.

[STATEMENT OF THE FACTS and ANALYSIS sections follow on the NCDOJ landing page; the analysis traces the Municipal Hospital Act's express and implied authority, the Madison Cablevision two-prong test for public purpose, and the inapplicability of the idle funds statute. The opinion concludes by reaffirming each of the three answers.]

John R. McArthur
Chief Counsel

James A. Wellons
Special Deputy Attorney General