Options and Opportunities: Section 363 Transactions for Distressed Healthcare Companies
The twin hammers of the credit crisis and impending global recession pose significant challenges for healthcare organizations; particularly those that are smaller and others already challenged by capital shortages. As market turmoil makes capital elusive, most markets, including various sectors of the healthcare industry, will likely see acceleration in business failures, restructurings and in some cases, closures.
For companies caught in the turmoil, and particularly distressed companies, success will depend on how effectively boards use the tools available to them. Even before the current turmoil in the financial markets, healthcare providers—especially hospitals—have faced severe economic challenges. A 2008 report issued by Alvarez & Marsal found that more than half of the 4,500 hospitals analyzed were "technically insolvent or at risk of insolvency."
In some regions of the country, the situation is even more dire. In Southern California, more than 50 community hospitals have closed since 1996. And well before the current market conditions took root, a gap was developing between the financially strong and those with less staying power. Organizations with fewer resources, including the majority of the healthcare industry, are more dependent on cash flows, grants, and philanthropy for survival—all of which have become less abundant under current credit market conditions.
Larger healthcare systems enjoy the advantage of lower costs of capital, better economies of scale, and corresponding price leverage with vendors. These advantages, however, may not be enough for larger systems. At the same time, it is clear that smaller providers will remain challenged for the foreseeable future.
The bankruptcy option
As lifelines dwindle, the list of options for management typically grows to include the tools of bankruptcy and reorganization. Between distress and liquidation lies the opportunity for rational reorganization or consolidation. The U.S. Bankruptcy Code gives companies in financial distress tools that permit them to either continue operations as a going concern or to maximize the value realized on their assets through a sale process. A well-informed board of directors can use these tools to restructure debt and obligations in a work-out, or to sell the business free and clear of liens through an organized sale process. Meanwhile, for savvy acquirers, a distressed healthcare organization can offer assets and operations at a desirable price point. Ultimately, success depends on the ability to act in a timely manner.
Many roads can lead a board and its management to discuss bankruptcy alternatives, but the decision to pursue a bankruptcy strategy is never an easy one. As a company becomes increasingly capital-starved, the natural course is to seek additional capital through equity infusion or credit, or to find a friendly buyer. If none of these options work, bankruptcy may be the only remaining solution. The bankruptcy option can also arise through an acquisition discussion for buyers who are unwilling to go forward with a transaction due to successor liability and credit risks that can be addressed by a bankruptcy process. Or, bankruptcy may simply offer the practical protection and time required to get a transaction done before the company's cash needs outstrip availability. Lastly, unless the distressed company is a nonprofit and benefits from a specific exception under the bankruptcy code, creditors may force a company into bankruptcy.
Once a company files for bankruptcy protection, it becomes subject to the jurisdiction of the bankruptcy court. The court oversees the rights of the primary constituencies, which are the board of directors, the company's secured creditors, the unsecured creditors represented by a creditors' committee appointed by the United States Trustee's Office, and the United States Trustee's Office itself. For certain healthcare companies such as hospitals, the Bankruptcy Code can add a patient ombudsman and gives certain expanded rights to the community in which the hospital is located.
As a general matter, the primary negotiators on the company's side in any transaction are the company itself and the creditors' committee. The principal objective of the creditor's committee is to obtain the largest possible recovery for the creditors. Typically, the bankruptcy trustee and the creditors' committees will consider liquidating the assets for a cash purchase price and using the proceeds from that sale to discharge indebtedness or restructuring the existing debt and continuing operations of the hospital, including a sale of the assets. The benefit of the liquidation approach is that the creditors receive a sum certain, even if that sum certain is only 10% of the debt.
The benefit of a reorganization or sale of the company through a court-managed process is the greater value of the going concern. Liquidation gets another hard look late in cases where it appears to be the only viable option left if a reorganization has been thoroughly vetted and has failed. Correspondingly, Chapter 11 provides the debtor with the opportunity to control the restructuring or sale process as a "debtor-in-possession." This means that the debtor continues to remain in possession and in control of its assets throughout the bankruptcy process until a reorganization plan is confirmed or the assets are sold either via a bankruptcy sale under Section 363 of the Code or through a plan of reorganization confirmed pursuant to Section 1129 of the Code.
Section 363 sale
Section 363 of the Bankruptcy Code defines the rights that an organization has, acting as debtor-in-possession of its assets, to use its property while operating under the protection of bankruptcy. The most significant power granted to the debtor-in-possession is the power to sell some or all of its assets pursuant to an order of the bankruptcy court, free and clear of any interest in such assets, so long as one of five enumerated conditions set forth in Section 363 (f) is met. While there are exceptions in certain jurisdictions, examples of interests that can generally be stripped from assets in a sale pursuant to Section 363 include a wide variety of liabilities, such as liens, judgments, tort claims, vendor claims, tax claims, and equity interests. The liens and other interests once attached to the assets that are sold now attach to the proceeds of the sale in the hands of the seller, and are distributed to creditors and equity holders under the supervision of the Bankruptcy Court.
The goal of a Section 363 sale is to obtain the highest and best offer for the assets offered for sale by means of an auction process. Practically, a Section 363 sale can provide the means to complete an ongoing negotiated acquisition of distressed assets, or in a designed process whereby the debtor-in-possession seeks what is known as a "stalking horse" bidder, and in rare situations, through a process where the debtor-in-possession opens an auction to bids without a stalking horse.
Negotiating the 363 sale
In the typical scenario, the seller negotiates with the stalking-horse bidder, and enters into an asset purchase agreement with the debtor that serves as the floor against which other bids for the debtor's assets will be made at auction. The scope and depth of transactional documents in a Section 363 transaction vary a great deal from one transaction to the next.
As in a traditional deal, the agreements provide a framework for establishing consideration for the purchase, covenants to establish the obligations of the parties, and conditions to those obligations. In contrast to typical corporate deals, however, the nature of the bankruptcy process sometimes allows parties to go with significantly lighter documentation than would be typical in most transactions. Factors driving the paperwork reduction include the free-and-clear nature of the sale, the content and force of the parallel sale order, and the general absence of resources from which to derive meaningful post-closing remedies.
In exchange for coming forward and negotiating the initial asset purchase agreement with the debtor, the stalking horse is often granted certain bidding protections in the asset purchase agreement and the sale order to compensate it for the effort that it expended in negotiating the agreement and the risk that it will be outbid for the assets at auction. Examples of bid protections include typical corporate deal protection mechanisms, such as expense reimbursements, and break-up fees that must be paid by a successful bidder to the stalking horse if the stalking horse's bid is bested.