Distress in Health Care – Risk and Remedy
By: Carolyn J. Johnsen, Senior Partner, Dickinson Wright, PLLC
Financial distress in the health care sector has reached a new high as demonstrated by the number of bankruptcies filed by health care-related companies in the past year. Many analysts have attributed the cause of this massive increase to the Pandemic era when various government protection and stimulus programs provided entities with much-needed cash that in many cases was depleted without the recipient addressing and solving its internal problems. The pre-Pandemic problems unfortunately still have persisted in many instances and health care administrators and professionals are now challenged with developing solutions. A bankruptcy may provide the best strategic option.
WHAT CAN A BANKRUPTCY ACCOMPLISH?
A common misconception is that an entity or individual must be insolvent in order to file bankruptcy. That is not the case and in fact, a solvent entity may file for any number of reasons simply to take advantage of bankruptcy code provisions designed to assist it with a reorganization plan. Clearly, the negative stigma of filing a bankruptcy no longer exists as it has now been recognized as a valuable business tool. Bankruptcy offers a means to an end whether the goal is to stabilize and continue operations or sell or merge the business. The bankruptcy provides the time necessary to structure a realistic solution that benefits all stakeholders. Another misconception is that upon filing, a bankruptcy trustee will take over the business and immediately liquidate the assets. This is also untrue. A Chapter 11 bankruptcy is designed to allow current management to remain in place as a “debtor-in-possession” to either reorganize the business or sell it in an orderly fashion to maximize proceeds for the benefit of all constituents. Overall, a bankruptcy can provide the path to attain a company’s short term or long term goals, particularly in this distressed environment – all with less or controlled risk.
STEP ONE – ESTABLISHING THE GOAL
The most common feature of a financially distressed business is likely a shortage of liquidity. But, what is the cause? In general the across-the-board external factors have included a rise in labor costs, increase in interest rates and overall inflation, and, of course, the persistent and fluid regulatory overlay that affects reimbursement rates. All affect cash flow. While these problems are not within immediate control, a health care company needs to be prepared to react to this pervasive stress. On an internal basis, problems may vary but consistently involve management’s juggling of compliance and patient needs with the plain and simple challenges of paying lenders, landlords and vendors. Solutions for these issues are within reach.
First and foremost, the entity’s or group’s mission must be determined or repurposed. Some hospitals want to grow; others are happy to merge. Some physicians what to become employees; others do not. Some entities are saddled with an outdated legacy operating model; others have solvable cost containment issues. In all cases, just like any business outside of the health care space, there needs to be a business plan. The focus should be that if today, the business is at point A, what is point B. Is it trying to grow, is it trying to shrink, is it trying to reduce debt and stay in business, is it in need of a management succession plan, is it time to sell? Once these basic goals are established, then the granular problems can be analyzed to develop a solution.
STEP TWO – PINPOINTING THE PROBLEM
By statute, (the federal Bankruptcy Code), a debtor in bankruptcy has at its disposal certain valuable powers. These include an instantaneous stay of all payments to creditors and all lawsuits that may have been levied against the debtor. The so called “automatic stay”[1] gives the entity a respite from its current cash drain and the chance to negotiate with its creditors and perhaps its shareholders. In addition, the debtor has the ability to reject, thereby cancelling burdensome contracts and leases[2], may be able to modify its secured debt, and may be able to reduce past vendor liabilities. Thus, initially it is critical to analyze cash in and cash out: can the revenue stream be increased by rejecting a poor provider agreement or by better collections; is the entity suffering under a lease which is above market rent; are there staffing issues? Once these issues are identified, the entity can weigh its options of whether to restructure its debt and equity structure and continue operations or effectuate a sale or merger. Again, bankruptcy may be the appropriate strategy.
STEP THREE – IMPLEMENTING A SOLUTION
Out-of-Court
The terms “restructuring” or “work-out” are part of the financial distress lexicon. These concepts refer to out-of-court efforts to negotiate better terms with problematic lenders, landlords or vendors. To be sure, this alternative is less expensive and should be considered and attempted prior to resorting to bankruptcy protection which necessarily involves multiple parties—secured creditors, unsecured creditors, equipment lessors, investors, employees, landlords—not to mention a judge who referees everything. However, often the various issues cannot be resolved out of court because a counter party demands unreasonable concessions that would not have to be given up in a bankruptcy or because the problems are easier resolved in a single forum.
Classic Reorganization
Commencement of a Chapter 11 bankruptcy case[3] is procedurally the same whether the debtor desires to continue operations or sell or merge its business. In the case of a debtor that is going forward or merging with another entity, the ultimate strategy is embodied in a plan of reorganization. That plan will set forth how the business will be financed, how creditors will be paid, and how equity will be structured. It may be a lengthy process, certainly no shorter than a year, and will undoubtedly involve negotiations with the various factions involved. At the end, however, the entity has the opportunity to emerge revitalized with a new balance sheet.
Case in point: An example of a successful plan of reorganization that incorporated multiple bankruptcy tools and strategies is the case of a 32-bed surgical hospital in Phoenix owned by a group of 15 physicians. The entity was in financial distress because of flailing management, poor performing provider contracts, and shareholders who were not engaged. At the time of filing, the unsecured debt to vendors had grown exponentially and there was little hope that creditors could be repaid any significant amount of their claims. A Chapter 11 was filed, bad contracts were rejected, management was replaced, and a merger partner was located. The ultimate plan provided for payment to creditors in full and a 13 percent return to equity.
Sub-Chapter V for Small Debtors
A Chapter 11 bankruptcy can alleviate pressures a company is experiencing with its creditors and provide a chance to continue its operations. But, it can be a complicated, lengthy, and expensive process that makes it difficult for a small business to actually reorganize. However, one benefit emanating from the Pandemic crises was an amendment to the Bankruptcy Code that provides for a streamlined version of a Chapter 11 reorganization known as a Sub-Chapter V. Sub-Chapter V is designed to increase access and the ease of reorganization for small business debtors by relaxing the requirements of an ordinary Chapter 11 and allowing business owners to retain more control over their companies. It may offer the ideal solution for a small physician practice, a small hospital or nursing facility.[4]
A Sub-Chapter V Debtor can be an individual or a company so long as it is engaged in commercial or business activity and at least 50 percent (50%) of the debt arose from such activity. The debtor can only have a maximum aggregate liquidated non-contingent secured and unsecured debt totaling $7,500,000.[5] Although a Chapter V Trustee is appointed, the debtor remains a debtor-in-possession of its assets and the plan process is extremely pared down. The Trustee’s principle obligation is to facilitate a consensual plan of reorganization. Simplistically, the debtor can confirm a plan if it pays its unsecured creditors its projected “disposable income” (defined as funds not reasonably necessary to ensure the continued operation of the business) over a period of three to five years. The debtor can still implement other aspects of the Bankruptcy Code to modify secured claims and reject contracts.
The Bankruptcy Sale
In the past decade, sales in bankruptcy have become predominant. The term “363 sale” refers to the section 363 of the Bankruptcy Code which permits a debtor to sell its assets free and clear of liens and interests. For buyers, a bankruptcy sale provides the opportunity to grow or enhance business, find synergies, or acquire assets at a reduced price. For sellers, a bankruptcy sale provides the opportunity to regain financial stability in a period of decreased revenues and lack of cash, divest some or all assets, and pay debt. Most important is that the sale is blessed with a court order approving the sale that likely will include findings that there is no successor liability for the buyer and that the sale process was completed in good faith and for adequate consideration. Many buyers insist on a sale occurring in a bankruptcy because of the protections it offers and may be willing to finance it.
For the most part, bankruptcy sales are always subject to higher and bidder bids and therefore the debtor will establish bid procedures and an auction date. The debtor will have to demonstrate that its assets were marketed sufficiently. It may have a stalking horse bidder whose bid establishes a floor price. The stalking horse bidder may seek bid protections such as a break-up fee and expense reimbursement. The entire process is typically an expedited procedure requested by the debtor often under pressure and at the insistence of a secured creditor.
In the sale context, the debtor works with the proposed buyer to assign to it the contracts and leases it desires for the continued operation of the business. The funds required to cure the monetary defaults for those assigned contracts are typically part of the purchase price[6]. The remainder are rejected by the debtor.
For buyers, the benefits of a bankruptcy sale include speed (although due diligence is on a shortened time frame), price, and the reduced risk of successor liability or claw-back. It obtains the assets without the liabilities which stay with the debtor. The detriments include the risk of overbid by another buyer that drives the price up or wins the deal, difficulty in dealing with all the competing interests in the case, and competition and public disclosure.
For the seller debtor entity, the benefits include speed and the re-payment of a greater amount of debt from the proceeds of the sale. The detriments include whether the debtor can survive in a bankruptcy case long enough to complete the sale and whether stakeholders are willing to consent and/or negotiate through the process
Case in point: In August, a 33-bed community hospital filed Chapter 11 in Dallas, Texas and immediately sought to have a sale of all of its assets. The hospital was built in 2019 but its business plan did not anticipate the high costs to “ramp up” before revenues could increase and stabilize and it was suffering large losses. In order to have the time necessary to hold an auction and complete a sale, the debtor had to obtain financing so the hospital could continue operations prior to sale. After extensive marketing, the debtor held a robust auction at which time a large hospital chain that was anxious to expand its footprint in the Dallas market purchased the hospital at a higher price than was originally projected. The debtor subsequently filed a plan to distribute the proceeds of the sale.
OVERALL CONSIDERATIONS FOR HEALTH CARE ENTITIES
In health care bankruptcies, judges are exceptionally cognizant of the need to protect patients. In fact, in almost every case involving patients, the judge will appoint a patient ombudsman who is tasked to regularly inspect and report on the operations of the debtor and its standard of care. While this may seem an intrusion to the debtor’s operations, the debtor’s relationship with and assistance to the ombudsman can be beneficial to the debtor’s goals in the case.
Although Bankruptcy Courts are courts of equity, judges typically disdain fraud. Consequently, problems that have occurred with improper billings or reimbursements will likely not be remedied in a bankruptcy case. Nonetheless, for the honest debtor, the court is likely to be empathetic with the debtor’s need to keep operations alive, whether through its own actions or a sale, the need to pay physicians and staff, and the need to protect the community interest for which the debtor may serve.
CONCLUSION
No one can predict what lies ahead for the health care industry as a whole, and although external factors cannot be solved, from distress may come opportunity. Bankruptcy alternatives may provide the right business strategy and legal tools for solving financial issues.
[1] Section 362 of the Bankruptcy Code.
[2] Section 365 of the Bankruptcy Code.
[3] For purposes of this article, the author is assuming that the entity or group is seeking to either reorganize its operations or is seeking a sale or merger and hence, a Chapter 11 is appropriate. Pure liquidations under Chapter 7 of the Bankruptcy Code in which a trustee is appointed to seek full control of the debtor’s business and sell its assets is not discussed here.
[4] For example, in mid-March 2024, a group of four skilled nursing facilities filed a Sub-Chapter V in Eastern Texas to address severe cash problems.
[5] When the bill was passed, the original debt ceiling was $2,725,625 but was increased by amendment during the Pandemic. The current $7.5 Million ceiling is set to revert to the original ceiling in June 2024; however, bankruptcy analysts and experts predict that Congress will act to preserve the current amount.
[6] Bankruptcy Courts are not entirely consistent in how Medicare provider contracts overseen by the Health and Human Services Department are treated in sale situations. It is important to be aware of how HHS may treat the contract in a particular jurisdiction and also to be prepared to negotiate its particular issues.