Options and Opportunities: Section 363 Transactions for Distressed Healthcare Companies
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.
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.
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 email@example.com and firstname.lastname@example.org, respectively.
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