Ailing Community Hospitals

Is Chapter 11 a cure?

Bankruptcy, once considered a nuclear option, is now increasingly used by struggling non-profit community hospitals. Just like corporate America, the healthcare sector views Chapter 11 as a tool to deleverage a balance sheet or accomplish a sale without full creditor consent.

It’s instructive to know how the healthcare sector, specifically non-profit hospitals, got to this point.

Bankruptcy Backdrop

Many healthcare providers cannot marshal resources to meet the challenges of shifting incentives, changes in requirements from third parties (e.g. government programs and commercial insurers) and the relocation of services outside the hospital. The last trend has been evolving for more than two decades. In 1991, Passaic Beth Israel Hospital CEO Jeffrey Moll noted that “the bed is dead,” as convenience became more important to patients/consumers.

With this as backdrop, struggling community hospitals are forced to look to consolidation or to mergers, acquirers or system membership. More financially sound institutions can evaluate whether they are better served by an acquisition or by closing.

Big picture: hospitals that operate like eleemosynary institutions may be destined for extinction, as there are only so many ways they can cut costs.

For-profit hospitals have popped up as prospective buyers for non-profits, whereas a merger/sale with another non-profit had previously been one of the only ways to survive. Interestingly, the changing healthcare paradigm has made struggling non-profit hospitals less attractive to other non-profits, but profit-making hospitals are now eyeing them as a point of entry or growth.

But a community loses something when a non-profit hospital is sold to a for-profit owner, which is not community based. Service to the underprivileged and underserved is a lower priority. But many non-profit boards believe a sale is better than closure. That said, deleveraging a balance sheet in Chapter 11 does not change the evolution of healthcare. Rather, it is a stop gap.

Debtor Options

The first option for an overleveraged, distressed debtor is an out-of-court composition, a negotiation with individual creditors toward a compromise of their claims. This seeks to reduce liabilities and may be the prerequisite to a sale or merger that avoids a bankruptcy filing, but it requires creditor cooperation. As a result, bankruptcy filings are increasingly used by struggling non-profit hospitals.

Section 363 of the U.S. Bankruptcy Code authorizes the sale of assets “free and clear” of all liens, judgments, encumbrances and claims. “363 orders” can function as title insurance and cleanse assets of unknown claims. In the for-profit world, it is common for acquirers to require a Chapter 11 filing and a 363 order.

Section 365 permits the debtor to shed burdensome leases and contracts with the stroke of a judge’s pen. And, the burden of obtaining an order relieving the debtor’s obligations under a lease or contract is a relatively low demonstration of good business judgment. For a debtor with numerous leases or contracts, this can save time and money spent negotiating. Of course, the delicate and carefully divulged hint of bankruptcy also can be valuable leverage for a hospital seeking lessor concessions to avoid bankruptcy.

Chapter 11 can facilitate the purchase of assets without full payment of secured debt. Technically, a secured creditor must be paid in full to compel the creditor to release its security interests against assets of a Chapter 11 debtor. The secured lender’s leverage in a typical bankruptcy case is the ability to foreclose and take possession of collateral absent receipt of sufficient payment. But how many secured lenders really want to pursue (or accept) a surrender of collateral when the collateral is a hospital with an active patient base? And how friendly will state courts be to granting such relief? Further, bankruptcy courts are courts of equity, and bankruptcy judges (justifiably) like to save hospitals. Thus, there is pressure on the secured lender to compromise.

At the beginning of a typical Chapter 11 case, one of the first issues brought to the court is the debtor’s ability to use cash collected from operations. If a lender has a security interest in receivables, the debtor is prohibited from using cash collections of receivables absent court authorization. The debtor and lender negotiate and debate a budget. The debtor fears the bankruptcy judge may decline the use of cash collateral, in which event it might have to close. The bank really does not want to shut the hospital down. Ultimately, practicality sets in when the parties recognize the unlikeliness of the judge entering an order that closes the hospital, harms the community and/or puts many people out of work.

Chapter 11 Drawbacks

Chapter 11 bankruptcy is not without drawbacks. For a hospital, especially, its Chapter 11 filing will be well-publicized. Patients with a choice of where to go will be concerned about quality of care. And when physicians leave due to concerns about patient flight or inadequate support, they are hard to get back.

Chapter 11 is expensive. Besides professional fees (the debtor also pays the professional fees of the unsecured creditors’ committee and of its secured lender), Chapter 11 consumes a lot of management time. The administrative and transactional costs of bankruptcy should not be underestimated and must factor into settlement negotiations.

Additionally, the transfer of a hospital “certificate of need” requires regulatory approval, which can take months, if not years. In the meantime, the hospital may be bleeding cash. Chapter 11 may help expedite regulatory approval.

There are limitations, though, on how much a bankruptcy judge can pressure regulatory authorities. And, the bankruptcy judge has no power to approve the transfer of a license or certificate-normally the domain of the Department of Health.

Finally, most judges don’t want to be associated with closing a hospital and eliminating hundreds of jobs. Therefore, bankruptcy courts have seen, and are likely to continue to see Chapter 11 filings commenced by distressed hospitals.

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