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.
Effect on contracts
One of the best features of the Section 363 sale for a buyer is the power provided by Section 365 of the Bankruptcy Code, which permits a buyer to assume most executory contracts and leases without regard to non-assignment provisions or consent requirements in the contract itself. In other words, except where applicable law provides otherwise, the non-debtor party to an executory contract or lease with the debtor can be compelled to accept performance from a third party assignee—in this case, the purchaser—so long as the purchaser can provide adequate assurance of future performance and the contract or lease has been cured of defaults.
This tool allows the purchaser, through due diligence, to identify and in effect "cherry pick" either below market or otherwise competitive contracts that it would like to have assigned to it as part of the sale transaction while leaving above-market contracts behind with the debtor to be rejected. For a purchaser with established vendor relationships from other operations, the ability to selectively assume good contracts while leaving bad contracts behind can give the purchaser significant leverage when dealing with the debtor's current vendors who often are willing to waive claims or restructure existing contracts in order to obtain (and in a sense retain) business with the purchaser on a go-forward basis.
Sale motion
Following the entry into the asset purchase agreement by the buyer and the stalking horse, the debtor files a motion seeking the approval of the asset purchase agreement, the bid protections and bid procedures, and the stalking horse bid generally. The motion is typically served broadly on all creditors and other parties with interest in the case in order to put those with a potential interest or claim against the assets the opportunity to raise an objection and be heard.
Upon the approval of the bid procedures (which may be negotiated and modified if objections to the proposed procedures are filed by other constituencies in the bankruptcy case), the debtor will conduct an auction of its assets or seek approval of the stalking horse bid, if no other bids are received. If there is a stalking horse bid, the terms of its asset purchase agreement typically define the standard for agreement terms, with subsequent bids judged in a manner that includes a component of value tied to the extent to which a bidder is willing to increase value or decrease conditionality in the asset purchase agreement. Other bidders, if any, submit competing bids in compliance with the terms of the bid procedures order of the bankruptcy court, which in well-run processes requires the bids to be submitted days in advance of the auction.
Sale order
The bankruptcy court typically approves either the highest bid (if there is an auction) or the stalking horse bid (if there is not) at a hearing set by the court to approve the sale, after addressing objections filed by creditors and other interested parties.
The order that approves a sale under 363 is referred to, not surprisingly, as a "sale order." Often the negotiation of the final terms of the sale order can be as drawn out as the negotiation of the initial asset purchase agreement. If multiple objections to the sale were filed and ultimately resolved either through negotiation or by the bankruptcy court, each objecting party will participate in the drafting of the sale order to ensure that the resolution of its particular objection is properly addressed. Moreover, because the sale order often modifies or controls the language of the asset purchase agreement, it must be drafted carefully to reflect the terms of the transaction that were ultimately approved by the bankruptcy court at the sale hearing.
A bankruptcy court sale order is a powerful title clearing mechanism, providing a purchaser with a clean title to the purchased assets to the furthest extent of applicable law. Because the motion seeking approval of the sale is typically served on all interested parties in the case, the sale order provides a court order that the buyer can use as a shield against parties that assert new claims and interests in the assets after a sale closes.
Sale pursuant to plan of reorganization
In addition to Section 363, a debtor-in-possession can sell assets (typically all of its assets), pursuant to a plan of reorganization confirmed under Section 1129 of the Bankruptcy Code. The advantage to a sale through the plan process rather than the 363 process is the perception and possibility that the discharge of claims and interests through a plan is broader than through a sale order. Therefore, the title to assets obtained through a plan is even cleaner than via a 363 sale. The downside of the plan process is that it is significantly more involved, timely, and costly than a 363 sale and there is a trade-off between the expeditious nature of the 363 sale and the possibly broader protections of a sale process through a plan.
CMS: Medicare and Medicaid recoupment liability
The Centers for Medicare and Medicaid Services take the view that a buyer in a Section 363 sale that assumes the seller's Medicare provider number is a successor in interest to the seller, and is liable to CMS for the seller's recoupment and setoff obligations. The legal nuance is whether such rights are an "interest" such that they are discharged when the assets are sold "free and clear of any interest," as is typically the case with a setoff or an equitable remedy, which is the claim made in favor of recoupment. The weight of judicial authority supports the view that overpayment liabilities are a recoupment, and thus survive the Section 363 sale.
However, the result is less certain when there are special factors that present a danger to the success of the sale should the recoupment rights survive. As such liabilities can often be large for distressed healthcare providers, careful attention to the issue during the due diligence process is necessary for purchasers who intend to take the debtor's Medicare provider number as part of the sale transaction. Such purchasers should determine the scope of potential overpayment liabilities and account for these in pricing the assets.
For those purchasers who desire certainty with respect to cutting off overpayment liabilities, additional structural options exist apart from the due diligence and pricing option discussed above. First, if Medicare/Medicaid does not compose a significant percentage of the payer mix (or if the purchaser has significant free cash flow from other operations), the purchaser can apply for new provider numbers from the government. These provider numbers will be free from recoupment claims that might have been assertable against the debtor's number post-closing.
Other areas requiring careful diligence and review include the debtor's unemployment rating and environmental liabilities. In certain jurisdictions these already sensitive potential liabilities are not cleansed by the Section 363 sale, and can alter the economics of the transaction for a potential buyer.
Converting to physician joint ventures
While a number of not-for-profit hospitals have filed for bankruptcy protection in the last two years, in many instances, the organization could have been saved if the hospital and physician incentives had been aligned. In next week's article, Joseph Sowell III and John C. Tishler, partners with Waller Lansden Dortch & Davis, will focus on aligning incentives by converting ailing nonprofits into physician joint venture facilities.
J. William Morrow and Eric Schultenover are partners with Waller Lansden Dortch & Davis in Nashville, TN. They may be reached at will.morrow@wallerlaw.com and eric.schultenover@wallerlaw.com, respectively.
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