Financially Distressed Healthcare Facilities: and ...media.straffordpub.com/products/financially... · 11/16/2011 · § 1113(b), (2) the union rejected the pro-posal without good

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Financially Distressed Healthcare Facilities: Financially Distressed Healthcare Facilities: Restructuring and Insolvency Options Evaluating Bankruptcy and Other Alternatives While Preserving Quality of Care

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WEDNESDAY, NOVEMBER 16, 2011

Today’s faculty features:

Samuel R. Maizel, Pachulski Stang Ziehl & Jones, Los Angeles

Richard J. Zall, Partner, Proskauer Rose, New York

Hector G. Calzada, Jr., Managing Director, Deloitte Corporate Finance, Atlanta

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JournalA M E R I C A N B A N K R U P T C Y I N S T I T U T EThe Essential Resource for Today’s Busy Insolvency Professional

Contributing Editor:Samuel Maizel1

Pachulski Stang Ziehl & Jones LLPLos [email protected]

Also Written by:Mary LanePachulski Stang Ziehl & Jones LLPLos [email protected]

Daniel SpitzerPepperdine University School of LawMalibu, [email protected]

Labor laws, although applicable to most businesses, may wreak partic-ular havoc in the restructuring of a health care business under the Bankruptcy Code. Labor law issues in health care busi-ness cases are perhaps more important than in other kinds of cases because the industry is labor intensive and growing,2 and repre-sents a significant national employer on a macro-level.3 Among the many labor law-related traps waiting for a health care busi-ness entering bankruptcy are liability under the Worker Adjustment and Retraining Notification Act (WARN Act)4 and issues associated with the rejection of collective-bargaining agreements (CBAs). Two recent decisions in the U.S. Bankruptcy Court for the Central District of California illustrate how these issues may be resolved.

Liquidating Hospitals and the WARN Act The WARN Act generally requires any “employer” of 100 or more employ-

e e s t o p r o v i d e 60 days advance wr i t ten no t i f ica-t i o n b e f o r e a n y “mass layoff.”5 The WARN Act defines an employer as “any business enterprise that employs 100 or more employees.”

Although the statute fails to define “business enterprise,” the pertinent Department of Labor comment explains that a “fiduciary whose sole function in the bankruptcy process is to liquidate a failed business for the benefit of credi-tors does not succeed to the notice obli-gations of the former employer because the fiduciary is not operating a ‘business enterprise’ in the normal commercial sense.”6 Damages for violations of the WARN Act are calculated as up to 60 days of the covered employee’s pay, plus civil penalties of $500 per day.7 Thus, for a large hospital, with a rela-tively highly compensated staff,8 this

liability could rep-resent a significant s u m . M o r e o v e r , u nde r s ome c i r -cumstances , tha t sum may become an administrative claim,9 significantly changing the cal-culus of the bank-ruptcy process. Two

cases from more than a decade ago have established the framework for evaluat-ing a debtor’s liability under the WARN ACT in the context of a chapter 11 case where the debtor is liquidating: In re United Healthcare Systems Inc.10 and In re Jamesway Corp.11 In United Healthcare, the Third Circuit held that a debtor-hospital was not liable for back pay to employees

under the WARN Act, where the debtor-hospital filed a chapter 11 petition 16 days before it laid off 1,200 of its 1,300 employees.12 The court of appeals rea-soned that whether a chapter 11 debtor in possession (DIP) is an “employer” for purposes of the WARN Act depends on the “nature and extent of the enti-ty’s business and commercial activities while in bankruptcy, and not merely on whether employees continue to work ‘on a daily basis.’”13 The court of appeals found that a “liquidating fiduciary” was

Repercussions of the Collision of Labor Law and Health Care Industry Bankruptcies

Intensive Care II

About the Authors

Sam Maizel is a partner and Mary Lane is of counsel in Pachulski Stang Ziehl & Jones LLP’s Los Angeles office. Dan Spitzer is a summer associate at Pachulski Stang Ziehl & Jones LLP and is a full-time student at the Pepperdine University School of Law, working toward a J.D. and Masters in Dispute Resolution.

1 The authors express their appreciation to Felice Harrison for herassistanceinthepreparationofthisarticle.

2 “Ten of the20 FastestGrowingOccupationsAreHealthcareRelated,”Bureau of LaborStatistics, U.S.Department of Labor,Career Guide to Industries, 2010-2011 Edition, Healthcare (BLS Career Guide), at 1,availableatwww.bls.gov/oco/cg/cgs035.htm(lastvisitedJuly28,2010).

3 “As one of the largest industries in 2008, healthcare provided 14.3millionjobsforwageandsalaryworkers.”Id.Additionally,“[h]ealthcarewillgenerate3.2millionnewwageandsalaryjobsbetween2008and2018,morethananyotherindustry,largelyinresponsetorapidgrowthintheelderlypopulation.”Id.at7.

4 29U.S.C.§2101,et seq.

5 Id.at§2101.6 54Fed.Reg.16,042,16,045(1989).7 29U.S.C.§2104(a).8 BLSCareerGuide,at9(“Averageearningsofnonsupervisoryworkersinmost

healthcaresegmentsarehigherthantheaverageforallprivateindustry,withhospitalworkersearningconsiderablymorethantheaverage.”).

9 See In re Hanlin Group Inc.,176B.R.329(Bankr.D.N.J.1995)(findingWARN Act claims asserted by employees who were terminated post-petition entitled to priority status); but see In re Jamesway Corp.,235 B.R. 329 (Bankr. S.D.N.Y. 1999) (finding employees terminatedpost-petitionwerenotentitledtoadministrative-expenseprioritystatusbecauseemployer’sWARNActnoticeobligationarosepre-petition).

10 In re United Healthcare Systems Inc.,200F.3d170(3dCir.1999).11 In re Jamesway Corp.,235B.R.329(Bankr.S.D.N.Y.1999).12 United Healthcare,200F.3dat172.13 Id.at178.

Mary Lane

Samuel Maizel


not an “employer,” which the WARN Act defines as a “business enterprise.”14

By con t r a s t , t h e J a m e s w a y c o u r t granted summary judgment finding the “liquidating fiducia-ry” debtor liable as an employer under the WARN Act. 15 The court noted that although the status of “liquidating fidu-

ciary” could relieve a DIP from WARN Act liability, in this case the debtor (1) decided to liquidate, (2) identified which employees would be terminated, (3) planned the schedule for the layoffs and (4) proceeded to terminate the laid-off employees a full six days before filing its chapter 11 petition. The court found that the employer was liable under the WARN Act prior to the chapter 11 fil-ing because the employees became enti-tled to notification at the time of these events.16 As with so many things, timing is everything. Although these cases deal with a liquidation under chapter 11, this issue was recently addressed in the context of a chapter 7 liquidation in In re Century City Doctors Hospital LLC.17 In Century City Doctors Hospital, the bankruptcy court found that, under the facts of the case, the chapter 7 trustee was not act-ing as an “employer” within the meaning of the WARN Act, and was not subject to its requirements in causing layoffs of the debtor’s employees without the required notification,18 even though the trustee operated the business of the debt-or-hospital for approximately one week following the filing of the petition.19 The court reasoned that the trustee operated the business for the limited purpose of shutting down the debtor’s operations and complying with government regu-lations relating to disposal of medical waste and hazardous materials, with the intention of closing the facility at the ear-liest reasonable time and liquidating its assets for the benefit of creditors.20 The court found that the trustee acted solely as a liquidating fiduciary, rather than as an employer operating a business enter-prise in the normal commercial sense. The court’s decision was not predi-cated on either the status of the trustee

under chapter 7 or on how long the busi-ness remained in operation, but rather on the nature of the operations. The court noted that the trustee did not operate the business “in the normal commer-cial sense.”21 Had the trustee operated the hospital “for business purposes” for even a short period of time, the decision might well have been different. In fact, the court stated, “it appears possible that a WARN Act claim could be prop-erly asserted if a chapter 7 trustee were to continue to operate a business for a period of time.”22

Thus, it is critical for the debtor and counsel to closely analyze any prospec-tive layoffs or hospital closures in light of the WARN Act. When hospital clo-sures and “mass layoffs” are necessary, it is critical to consider the timing of not merely the layoffs themselves, but the planning as well. Substantial risk exists for an estate that plans significant employment terminations while still operating as a business enterprise, not purely as a liquidating fiduciary.

Liquidating Hospitals and Rejection of CBAs Despite the seeming importance of unions serving the health care indus-try such as the Service Employees International Union (SEIU) and the United American Nurses-National Nurses Organizing Committee, the health care industry is not heavily union-ized.23 However, hospitals are the kind of health care business most likely to be unionized,24 and even though they rep-resent only 1.3 percent of all health care industry establishments, they employ almost 35 percent of all health care industry workers.25 Thus, the impact of a debtor’s effort to reject a CBA can be important in one’s efforts to liquidate the assets of a hospital, particularly if the prospective purchaser does not want to take the assets encumbered by the CBA. Section 1113 of the Bankruptcy Code requires debtors, prior to seeking rejection of a CBA, to make a proposal to the union accompanied by sufficient information to permit proper evaluation of the proposal.26 A bankruptcy court may approve rejection of the CBA if it finds that (1) the debtor made a proposal

that meets the statutory requirements of § 1113(b), (2) the union rejected the pro-posal without good cause and (3) the bal-ance of equities clearly favors rejection of the CBA.27 The majority of courts uti-lize a nine-part test to make the determi-nation: (1) the debtor must make a pro-posal to the union to modify the CBA; (2) the proposal must be based on the most complete and reliable information available; (3) the proposed modifications must be necessary to permit the reorga-nization of the debtor; (4) the proposed modifications must assure that the debtor and all affected parties are treated fairly and equitably; (5) the debtor must pro-vide the union such relevant information as is necessary to evaluate the proposal; (6) between the time of the making of the proposal and the time of the hear-ing, the debtor must meet at reasonable times with the union; (7) at the meeting, the debtor must confer in good faith in attempting to reach mutually satisfactory modifications of the CBA; (8) the union must have refused to accept the proposal without good cause; and (9) the balance of the equities must clearly favor rejec-tion.28 As to each of the nine prerequi-sites for rejection of the CBA, debtors bear the burden of proof,29 but once that burden has been met, the union must produce some evidence to show that it was not provided with relevant informa-tion, that the debtor did not bargain in good faith, and that the union’s refusal to accept the debtor’s modification proposal was not without good cause.30 In the chapter 11 case of In re Karykeion Inc., d/b/a Community and Mission Hospitals of Huntington Park, currently pending in the Central District of California, the bankruptcy court was recently forced to review the application of § 1113 in the context of the liquidation of a chapter 11 debtor that had been oper-ating two acute-care hospitals. Because chapter 11 cases frequently include either the liquidation of assets through a sale under § 363 or through confirmation of a liquidating plan of reorganization pursuant to § 1129, the case is interesting in that it evaluates what a debtor must do when liquidating to satisfy § 1113 when the buyer is seeking to acquire the hospi-tal without its CBAs. At the time of filing its chapter 11 case, the debtor was a party to CBAs

14 29U.S.C.§2101(a)(1).15 Jamesway,235B.R.at335.16 Id.at343-44.17 417B.R.801(Bankr.C.D.Cal.2009).18 Id.at802.19 Id.at805.20 Id.

Daniel Spitzer

21 Id.22 Id.at804.23 BLSCareerGuide,supra,n.1,at10.24 BLSCareerGuide,supra,n.1,at10(“In2008,17percentofworkersin

hospitalsweremembersofunionsorcoveredbyunioncontracts,whileallotherhealthcaresectorshadratesbelowthe14percentaverageforallindustries.”).

25 BLSCareerGuide,supra,n.1,at2,Table1.26 In re Maxwell Newspapers Inc.,146B.R.920(Bankr.S.D.N.Y.),aff’d in

part and rev’d in part,149B.R.334(S.D.N.Y.),rev’d,981F.2d85(2dCir.1992).

27 11U.S.C.§1113(c);see Maxwell Newspapers Inc., supra.28 See, e.g., In re National Forge Co., 289 B.R. 803 (Bankr. W.D. Pa.

2003);In re Alabama Symphony Ass’n,155B.R.556,573(Bankr.N.D.Ala.1993);In re Bowen Enterprises Inc.,196B.R.734(Bankr.W.D.Pa.1996);In re American Provision Co.,44B.R.907,909(Bankr.D.Minn.1984)(alldiscussingindetailthiswidelyacceptednine-parttest).

29 Bowen Enterprises, supra,196B.R.at741.30 American Provision Co., supra,44B.R.at910.

with SEIU and the California Nurses Association (CNA). Both CBAs had provisions that required the debtor to ensure that a new employer would retain the bargaining-unit employees, recognize the union and assume the CBAs (usu-ally referred to as “successorship provi-sions”). By the time the motion to reject the CBAs was filed, the debtor’s CBA with SEIU had expired by its own terms, but its CBA with CNA was still extant. The debtor entered into a memoran-dum of understanding (MOU) to sell the hospital, which required the debtor to reject both of the CBAs. After signing the MOU, the debtor provided a copy of the MOU to the unions’ attorneys and met with the unions’ representatives, among other things, to explain the sale process, and then, within a month, filed a motion to reject the CBA pursuant to § 1113. At the three meetings with the unions, the debtor’s chief reconstructing officer (CRO) explained that he had tried to make the buyer assume the CBAs, but the buyer refused. The union made certain offers to the CRO, all of which were rejected by the buyer. During this same timeframe, the CRO testified that the debtor’s cash reserves were nearing the point at which sufficient funds might not be at hand to close down the hospital without risk to patients. In fact, the buyer was forced to make a bridge loan to the debtor to enable it to operate until the purchase of the hospital could be closed. After a seven-hour evidentiary hearing, the bankruptcy court granted the debtor’s motion to reject the CBAs. First, the court disagreed with the SEIU’s contention that the court lacked jurisdiction to modify an expired CBA because jurisdiction lay exclusively with the National Labor Relations Board (NLRB). Finding conflicting case law in other jurisdictions and that decisions by the Bankruptcy Appellate Panel for the Ninth Circuit (BAP) were non-binding dicta, the court looked to the language of § 1113, the legislative history sur-rounding § 1113 and the BAP’s state-ments, and concluded that the purpose of § 1113 was to allow a debtor “to termi-nate or modify its ongoing obligations to its organized workforce, whether those obligations arise as a result of a current or expired CBA.”31

The court then concluded that, although the Ninth Circuit had never specifically adopted the nine-step approach, that analysis was appropri-

ate. The court found that (1) a proposal had been made, (2) it had been based on as complete and reliable informa-tion as could be obtained in a severe-ly distressed situation with changing information, (3) the modification was necessary because the buyer would not purchase the hospital without rejection of the CBAs, (4) despite the shared “pain,” the modification would treat all parties fairly and equitably, (5) the unions had the relevant information necessary to evaluate the proposal, “sufficient in light of when things were definite and how fast things were mov-ing,” (6) the debtor had met with work-ers at reasonable times,32 (7) the debtor had conferred in good faith,33 (8) the unions did not show adequate cause for refusing the debtor’s proposal, having made no counterproposal on the succes-sorship provision34 and (9) the balance of the equities clearly favored rejection because if the buyer walked away, the debtor would liquidate and only secured creditors would see any recovery, all employees would lose their jobs and the hospital would close.

Conclusion Hospitals are labor-intensive entities, and labor law issues can have an impor-tant impact on efforts to maximize the return to creditors, whether in chapter 7 or 11. These two decisions show that there are still new issues to be decided and that old issues can re-surface in dif-ferent contexts. As hospitals deal with the uncertainty created by national health care reform the risk of financial issues-and labor difficulties can only increase, so counsel should expect to hear more of these issues in the future. n

Reprinted with permission from the ABI Journal, Vol. XXIX, No. 7, September 2010.

The American Bankruptcy Institute is a multi-disciplinary, nonpartisan organization devoted to bankruptcy issues. ABI has more than 12,500 members, representing all facets of the insolvency field. For more information, visit ABI World at www.abiworld.org.


31 MemorandumofDecision,CaseNo.l1:08-bk-17254-MT,at14[DocketNo.957](emphasisadded).

32 To the argument that the workers should have been afforded morereasonabletimetonegotiatewiththebuyer,thecourtnotedasfollows:“Section 1113 does not require the debtor to engage in futile acts—[the buyer] would not meet with the unions and [CRO] was clearlymaking no progress with getting [the buyer] to accept any of eitherhisor theunions’ ideasonhow togetanypartof theCBAsacceptedby [the buyer]...the decision of a CRO not to spend hours in fruitlessnegotiationswasnotunreasonable.”Id.at26.

33 Thecourtaddressedthedebtor’sgoodfaithasfollows:“TheUnionsarecorrect that beginning negotiations when one party is already lockedinto a position does not constitute good faith... This [sic] debtor was,however, not locked in. This situation differs from Lady H Coal bothbecause thedebtorpassed theunionsoffersalong to [buyer], tried tonegotiate further with [buyer] on behalf of the unions, and the debtoronlysignedaMOUwith[buyer]beforenegotiatingunder1113,notanasset purchase agreement. The MOU states...that except for [three]sections inapplicable here, the MOU did not create ‘any binding legalobligations between the Parties, and each Party reserves the rightto approve the definitive Agreement and to address the results ofany diligence in connection with developing a definitive Agreement.’Significantly, the creditor’s committee was still providing informationto ‘Rose Avenue,’ as unlikely as that potential bid appeared to be.No break up fee to [buyer] was ever approved, nor was pre-approvalsoughtbythedebtor.”Id.at27.

34 The court held as follows: “While the unions cannot be expected toaccept a proposal which rejects their entire CBA, the debtor did offera reasonable accommodation that was above what employees wouldreceivehaditjustcloseddown.Theproposalthedebtormadewasthebestitcoulddoundercircumstanceswhere[thebuyer]wouldnotagreetomore,andanyrejectionofthatproposalmeansthatachancetokeepthehospitalopentobenefitcouldfail.”Id.at30.


JournalA M E R I C A N B A N K R U P T C Y I N S T I T U T EThe Essential Resource for Today’s Busy Insolvency Professional

Contributing Editor:Samuel R. MaizelPachulski Stang Ziehl & Jones LLPLos [email protected]

Also Written by:Mary D. Lane1

Pachulski Stang Ziehl & Jones LLPLos [email protected]

According to many experts, the Patient Protection and Affordable Care Act2 promotes the consoli-dation of the hospital industry.3 Many health care industry consultants believe that smaller, stand-alone hospitals will be forced to merge with larger hospital systems to survive. A significant percent-age of America’s hospitals are nonprofit hospitals,4 and those hospitals—if stand-alone facilities—are significantly weaker financially than their for-profit peers. Because of the likelihood of nonprof-its being financially weak and having to merge, potentially with for-profit hospital chains,5 the rules governing the acquisition of a nonprofit hospital by a for-profit enti-ty will become more important commer-cially. Because many of these facilities are financially distressed and buyers want to avoid successor liability if possible, many of these acquisitions may also occur in the context of a bankruptcy proceeding.

Acquisitions of non-profits by for-profit h o s p i t a l c h a i n s has occurred with increasing frequen-cy. For example , since the beginning of 2010, there have been t he se l a rge transactions: (1) the

sale of Forum Health, a three-hospital system based in Youngstown, Ohio, for more than $100 million to Community Health Systems;6 (2) the sale of Detroit Medical Center for financial consider-ations of approximately $1.5 billion to Vanguard Health System;7 and (3) the sale of Boston’s Caritas Christi Health Care to private-equity group Cerberus Capital Management LP.8

Sales of Nonprofit Assets Before the 2005 Amendments The financial and regulatory issues facing the hospital industry put the issues related to the transfer of nonprofit hos-

pitals on the “front burner” in the mid-1990s.9 Not surprisingly, these issues surfaced in bankruptcy cases as well.

In 1997, a bankrupt-cy court in a highly publicized case dealt directly with a state regulator’s power to oversee the transfer of a nonprofit hos-pital to a for-profit ent i ty. In United Healthcare Systems, the debtor solicited

bids pre-petition, selected a winner and signed a sale agreement that contemplated a chapter 11 filing. The commissioner of Health and Senior Services for the State of New Jersey authorized the debtor’s closure and authorized the purchaser to operate the hospital. Post-petition, unsuc-cessful bidders challenged the sale on the

basis that the “highest and best” offer was not selected during the process. The bank-ruptcy court agreed, ordering the state to reverse the regulatory action in approving the transfer. The district court overruled, finding that in addition to considering the economics of the transaction, the bank-ruptcy court must take public health con-cerns into account.10

These issues arose again in 1998 when Allegheny Health Education and Research Foundation (AHERF) filed for

About the Authors

Sam Maizel is a partner and Mary Lane is of counsel in Pachulski Stang Ziehl & Jones LLP’s Los Angeles office.

Intensive Care

The Sale of Nonprofit Hospitals through Bankruptcy: What BAPCPA Wrought

1 The authors thank Karen Cordry, Bankruptcy Counsel at the NationalAssociationofAttorneysGeneral,forherthoughtfulandinsightfulcom-mentsinreviewingadraftofthisarticle.

2 Pub.L.111-148,124Stat.119-1025(2010).

3 See, e.g., “The Impact of Healthcare Reform on HospitalConsolidation,” Becker’s Hospital Review (Sept. 16, 2010) (“[H]ealthcare reform will affect hospital consolidation in three ways: bydecreasing revenues, increasing costs and rewarding integration”),www.beckershospitalreview.com/hospital-transactions-and-valua-tion-issues/the-impact-of healthcare-reform-hospital-consolidation.html(lastvisitedonApril27,2011).

4 Oftheapproximately5,795hospitalsinAmericain2009,approximately2,918 were nonprofits, or more than half. Am. Hospital Assn., “FastFacts on U.S. Hospitals,” www.aha.org/aha/resource-center/statistics-and-studies/fast-facts.html(lastvisitedonApril27,2011).

5 Anne Law, “Health Reform Sparks Hospital Merger Madness,”Bizmology (Dec. 10, 2010) (“After weathering the economic stormof 2008 and 2009, many hospitals that managed to hang on to theirstatus as not-for-profits...continue to struggle financially, and somearedeterminingthatgoing italone isnot thewisestcoursewithmoreuncertainties to come. Others are choosing to consolidate to meetObama’sinitiativesforcost-controlmeasuresandregionalcooperationamong facilities.”), www.bizmology.com/2010/12/10/health-reform-sparks-hospital-merger-madness/(lastvisitedonApril27,2011).

6 “CHSOutbidsArdentforForumHealth,”Aug.5,2010,www.wytv.com/content/news/local/story/CHS-Outbids-Ardent-for-Forum-Health; LarryRingler, “AG Cordray Stresses Role in Forum Sale,” July 20, 2010,www.tribtoday.com/page/content/detial/id/539819.html?nav=5021(lastvisitedonApril27,2011).

7 “A New Partnership for Detroit,” Dec. 30, 2010, www.dmc.org/new-partnership/(lastvisitedonApril27,2011);“MichiganAttorneyGeneralCox Approves DMC/Vanguard Deal,” Nov. 15, 2010, www.dmc.org/newpartnership/; Mike Cox, Attorney General of Michigan, “Report ontheProposedSaleoftheDetroitMedicalCenterHospitalBusinessestoVanguardHealthSystemsInc.,”Nov.13,2010,www.dmc.org/newpart-nership/(lastvisitedonApril27,2011).

8 Suzanne Sataline, “Cerberus Takeover of Caritas Christi Gets Judge’sOkay,”Wall Street JournalHealthBlog(Oct.29,2010),http://blogs.wsj.com/health/2010/10/29/cerberus-takeover-of-caritas-christi/; LindseyDunn,“MassachusettsAttorneyGeneralApprovesCaritasChristiSale,”Becker’s Hospital Review, www.beckershospitalreview.com/hospital-transactions-and-valuation-issues/(lastvisitedonApril27,2011).

9 SeeU.S.GeneralAccountingOffice,“Not-for-ProfitHospitalsConversionIssues Prompt Increased State Oversight,” GAO/HEHS-98-24 Not-for-ProfitHospitalConversions(December1997).

10 In re United Healthcare System Inc.,1997U.S.Dist.LEXIS5090(March26,1997).

Samuel R. Maizel

Mary D. Lane


bankruptcy in Pittsburgh.11 In October 1998, the Pennsylvania attorney gener-al became concerned that a trustee was going to be appointed to sell the debtor’s assets, and so sought and obtained—in the state’s orphan’s court—an ex parte order enjoining the debtor from taking certain actions with regard to its direc-tors and assets. In response, the bank-ruptcy court issued an injunction, find-ing that it had sole jurisdiction over these issues and enjoining the attorney general from taking further actions in connec-tion with the orphan’s court proceed-ings, and declaring the orphan’s court ex parte order “null and void.” On appeal, the district court found that the attorney general’s actions were exempt from the automatic stay as a “police or regula-tory power” and stayed the bankruptcy court’s orders pending appeal.12 Given the nationwide attention being drawn during this period to the transfers of nonprofit assets to for-profit entities, attorneys general encouraged Congress to amend the Bankruptcy Code to preserve what they saw as their rightful position over the disposition of charitable assets. Congressman George Gekas (R-Pa.) sponsored H.R. 3150, the Consumer Bankruptcy Reform Act of 1998, which included language that ensured that charitable entities could not use bankruptcy as a means of evading the states’ long-standing role in control-ling the disposition of charitable assets. In evaluating the inevitable conflict between the bankruptcy policy of maxi-mizing return for creditors and the desire of regulators to ensure that charitable assets are used to maximize the benefit to the community, Congress opted to come down on the regulators’ side. These proposals were included in the 1998 House-Senate Conference Report version of H.R. 3150.13 The report was approved in the House on Oct. 9, 1998, by a vote of 300-125, but due to the lateness of the session in an election year and cloture issues, it did not come to a vote in the Senate. For the next six years, the proposals regard-ing amending the Bankruptcy Code vis-a-vis nonprofit asset sales sat without action on Capitol Hill until they were included in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), which passed in April 2005.14

Post-BAPCPA Transfers of Nonprofit Assets BAPCPA made three significant amendments to the Code relating to the transfer of nonprofit assets, in §§ 363(d), 541(f) and 1129(a)(16). Section 363(d) now provides that the trustee may only sell or lease property under subsections (b) and (c) in accor-dance with applicable nonbankruptcy law that governs the transfer of property by a nonprofit entity. Section 1129(a) (16) was added to provide that in confirming a plan, the court must similarly find that all transfers of property under the plan are made in accordance with applicable nonbankruptcy law that governs the transfer of property by a nonprofit entity. Section 541(f) was added to provide that a debtor’s property that is a tax-exempt, nonprofit charitable corporation under § 501(c)(3) of the Internal Revenue Code may be transferred to an entity that is not such a corporation, but only under the same conditions as would apply if the debtor had not filed a bankruptcy case. There are also two BAPCPA provi-sions that may affect such transactions that were not codified. Section 1221(d) of BAPCPA expressly states that “the court shall not confirm a [chapter 11] plan...without considering whether this section would substantially affect the rights of a party in interest... The par-ties who may appear and be heard in a proceeding under this section include the attorney general of the State in which the debtor is incorporated, was formed, or does business.” Additionally, § 1221(e) expressly states that “[n]othing in this section shall be construed to require the court in which a [chapter 11] case...is pending to remand or refer any proceed-ing, issue or controversy to any other court or to require the approval of any other court for the transfer of property.” Outside of bankruptcy, states have many laws restricting the transfer of nonprofit hospitals. For example, many states have enacted “conversion” laws that regulate the conversion of nonprofit hospitals to for-profit hospitals.15 Many other states allow an attorney general to use common law or general laws govern-ing trusts or nonprofits to provide over-sight over the conversion of nonprofit assets even in the absence of express statutory authorization. The attorney

general of a state typically oversees the operation and disbursement of charitable assets, including the sale of a nonprofit hospital, under the parens patriae or cy pres doctrines. This review is required because “not-for-profits, unlike their for-profit counterparts...do not have share-holders to whom profits are distributed. Given the absence of shareholders, prof-its and other market devices to ensure the efficacy of contracts and regularity of operations...[applicable nonbankrupt-cy law] contemplates significant public oversight of the finances and major trans-actions” of nonprofit entities.16 While in many states, including California, the attorney general carries out this role; in other states, such as New York, some nonprofit corporations must obtain leave of the New York Supreme Court before disposing of all or substantially all of their assets. The applicable guidelines for review by a state’s attorney general differ from state to state, but those in § 5917 of the California Corporations Code are typi-cal. This statute states that the attorney general may consider any factors deemed relevant, but expressly mentions the fol-lowing factors: (1) whether the terms and conditions of the proposed transaction are fair and reasonable to the nonprofit corporation; (2) whether the proposed transaction will result in inurement to any private person or entity; (3) whether the proposed transaction provides a fair-market value to the nonprofit; (4) wheth-er the market value has been manipulated by the parties’ actions in a manner that causes the value to decrease; (5) whether the proposed use of the assets from the proposed transaction is consistent with the “charitable trust” or mission of the nonprofit entity; (6) whether the pro-posed transaction constitutes a breach of trust; (7) how the proposed transaction affects the public; (8) whether the pro-posed transaction creates a significant effect on the availability or accessibility of health care services to the public; and (9) whether the proposed transaction is in the public interest. The pending case of Victor Valley Community Hospital (VVCH) presents a good example of how this approval process works after BAPCPA. VVCH, located in Victorville, Calif., filed its chapter 11 petition on Sept. 13, 2010, and obtained court approval to hold an auction of substantially all its assets with a nonprofit stalking-horse bidder on Nov.

11 CaseNos.98-25773through98-25777(Bankr.W.D.Pa.).12 In re Bankruptcy Appeal of Allegheny Health, Education and Research

Foundation, Appeal of Order Staying/Enjoining Orphans CourtProceedings,252B.R.309(W.D.Pa.1999).

13 SeeH.R.105-794,Cong.Rec.H9954-9985(Section733).14 Pub.L.No.109-8.

15JillR.Horowitz,“StateOversightofHospitalConversions:PreservingTrust or Protecting Health?,” The Hauser Center for NonprofitOrganizations, The Kennedy School of Government HarvardUniversity (September 2002), available at Social Science ResearchNetwork Electronic Paper Collection, http://ssrn.com/abstract_id=XXXXXX(discussingindetailhospitalconversionsfromnonprofittofor-profitentities).

16 64th Assocs. LLC v. Manhattan Eye, Ear & Throat Hospital, 2 N.Y. 3d585,813N.E.2d887(2004).

5, 2010. Under applicable nonbankruptcy law, the debtor was required to notify the attorney general of the proposed sale and submit a lengthy application seeking the attorney general’s approval of the trans-fer. Although the attorney general usu-ally will not allow submissions until they are complete, given the debtor’s time constraints the attorney general agreed to allow the debtor to submit the appli-cation in parts: The parts that dealt with the debtor could be completed before the auction; the remainder, dealing with the transaction and the buyer, would be submitted promptly after the auction. At the auction, the stalking-horse bidder was overbid by a for-profit entity. After the auction’s results were approved by the debtor’s board of directors (which included consideration of non-monetary aspects of the bids) and by the bankrupt-cy court, the remainder of the application was submitted to the attorney general. As part of its review of the transac-tion, the attorney general retained the services of a health care consulting firm (at the debtor’s expense) to do a review of the buyer and the proposed transaction and provide a written recommendation to the attorney general. Additionally, the attorney general solicited written com-ments from the public and held a public hearing on the proposed sale. The attor-ney general’s office had agreed to expe-dite the review of the application, which normally takes several months, and pro-duced a “conditional approval” on Dec. 29, 2010. Unfortunately, the attorney general’s conditional approval imposed several conditions on the buyer that sig-nificantly increased the economic cost of the transaction to the buyer. At press time, the resolution of how the debtor and the buyer will deal with those condi-tions is still unresolved.

Conclusion BAPCPA’s amendments brought about a significant legislative imposition on a nonprofit entity seeking to sell its assets through bankruptcy to a for-profit entity. However, the changes in many ways were consistent with the rulings of courts nationwide at the time the chang-es were first proposed. While a debtor’s arguments may be more limited than they were before 2005, in practice courts had already been respectful of the power of regulators to oversee the disposition of nonprofit assets. While the obliga-tions are not insignificant and add some delay and expense to the transaction, they are also not insurmountable. All in

all, the utility of selling a nonprofit hos-pital’s assets through bankruptcy is not destroyed by BAPCPA. n

Reprinted with permission from the ABI Journal, Vol. XXX, No. 5, June 2011.

The American Bankruptcy Institute is a multi-disciplinary, nonpartisan organization devoted to bankruptcy issues. ABI has more than 13,000 members, representing all facets of the insolvency field. For more information, visit ABI World at www.abiworld.org.


Journala m e r i c a n b a n k r u p t c y i n s t i t u t e

issues and information for today’s busy insolvency professional


Contributing Editor:Samuel R. MaizelPachulski Stang Ziehl & Jones; Los [email protected]

Also Written by:Shane A. PassarelliHealthcare Finance Group Inc.; Los [email protected]

George D. PillariAlvarez & Marsal Healthcare Industry Group; San [email protected]

Editor’s Note: Part I appeared in the December/January 2009 issue and provided an overview of the impact of the credit crisis on financing hospitals, as well as the micro- and macroeconomic drivers of financial distress for hospitals. Part II discusses the state of the capital markets for hospitals nationwide.

Ca p i t a l f o r maintenance, t e chno logy and growth is a r e q u i r e m e n t t o maintain market share in the competitive hospital industry. The hospital industry i s p a r t i c u l a r l y dependent on capital access because its

ability to provide quality service (and produce operating revenue) is heavily dependent on monetizing tangible assets such as land, facilities, medical equipment and information technology. Hospitals finance themselves through a variety of capital sources including operating cash flow, existing liquid investments and cash, bond debt (both tax-exempt and taxable), commercial banks, specialty finance companies (such as equipment leases, lines of credit, real estate), philanthropy, investor equity and various government subsidies.Hospital lending and borrowing entails

many unique issues. Hospitals typically have slow collection cycles, an average of 75 to 120 days, compared to 30 to 60 days for most industries. For asset-based lenders, this factor is important because it effectively lengthens the duration of an exit during a forced liquidation scenario. For bonds and other types of financing, increased liquidity (versus most industries) and a strong balance sheet tend to be requirements from bond investors. For all hospital lenders, the enforceability of liens

is an important issue.Given the importance of government

payors, a lender’s inability to obtain a fully-perfected lien on government accounts receivable typically reduces the amount that can be borrowed. The widely accepted right of Medicare and Medicaid to recoup past overpayments or

other liabilities from ongoing payments, even if the hospital is in bankruptcy, also creates significant issues for lenders. Examples of situations in which future payments may be offset include Medicare Cost Report liabilities, lien- or appeal-

based payments such as personal injury or worker’s compensation claims, or risk pools that have unpredictable costs such as capitated payments from health plans. The increasing emphasis on finding and punishing health care fraud by the

federal government, which can result in the imposition of treble damages and dismissal from the Medicare Program, also adds uncertainty to the hospital’s ability to borrow in the capital markets and increases costs for

those that do. Bankruptcy workout costs tend to be significantly higher in health care cases due to the potential numerous stakeholders and constituents involved, with examples including Medicare, Medicaid, health plans, regulatory agencies, accreditation entities, shareholders,

community members, secured creditors, financial guarantors, vendors, patient care ombudsmen and unsecured creditors.In the end, lenders often cannot lend as aggressively to hospitals compared to most industries due to quality-of-earnings issues and higher bankruptcy workout costs, otherwise they face the risk that they may not recover their original investment. As Ben S. Bernanke, the Federal Reserve Chairman, told the U.S. House of Representatives a year ago:

[A]s the rising rate of delinquencies of subprime mortgages threatened to impose losses on holders of even highly rated securities, investors were led to question the reliability of the credit ratings for a range of financial products, including

The Financial Crisis Facing America’s Hospital Industry: Part II

About the Authors

Sam Maizel is a partner in Pachulski Stang Ziehl & Jones LLP’s Los Angeles office. Shane Passarelli is a senior vice president of Healthcare Finance Group Inc. in Los Angeles. George Pillari is a managing director of Alvarez & Marsal’s Healthcare Industry Group in San Francisco.

Intensive Care

George D. Pillari

Shane A. Passarelli

Samuel R. Maizel


structured credit products and various special-purpose vehicles. As investors lost confidence in their ability to value complex financial products, they became increasingly unwilling to hold such instruments. As a result, flows of credit through these vehicles have contracted significantly.1

To say that credit in America has “contracted significantly” is an understatement. Many believe that America may be on the verge of suffering through its worst financial crisis since the Great Depression. During the current credit crisis, capital—even from the most reliable of sources—has evaporated. An unprecedented era of credit stability has been replaced by a frightening deterioration of credit quality among commercial banks and debt investors. Through December 2008, 25 banks and thrifts have failed (including Washington Mutual, the largest bank failure in history2) compared with three in 2007 and zero for 2006 and 2005.3 Major money center banks such as Citibank have survived by diluting shareholders with massive capital raises and government-funded bailouts.4 Bear Stearns needed a bailout sale to avoid bankruptcy,5 and Lehman Brothers, one of the most prestigious institutions on Wall Street, declared bankruptcy.6 The government seized control of mortgage finance companies Fannie Mae and Freddie Mac, which own or guarantee approximately half of the nation’s $12 trillion in outstanding home mortgage debt because of mounting home loan losses.7 This credit crisis has and will continue to wreak havoc on the capital markets and the availability and cost of capital to hospitals.8 Access to capital was robust relative to historical metrics before the credit crisis. For health care in general and hospitals in particular, there were many options available, including the taxable

and tax-exempt bond market, commercial banks, bond insurers, specialty health care lenders, philanthropy and investor equity via real estate investment trusts (REITs), private-equity firms and physician-equity syndications. Further, before the credit crisis, the supply of capital exceeded demand for credit. Competition for quality assets was fierce among all asset classes. Due to low levels of credit losses relative to historic metrics, debt sources increasingly pushed the envelope, providing capital to weaker and less-creditworthy borrowers. While the hospital industry was traditionally identified by investors as undervalued due to its complexities and inefficiencies, more dollars began to flow into the sector due to a lack of acceptable investment opportunities in other industries. Health care facilities traditionally operated at low or near-zero default rates and were regarded by investors as a noncyclical safe haven. As attractive risks, they were easily insured by financial guarantors such as MBIA or Ambac. Since most health care facilities were viewed as essential community assets and as one of the largest employers in town, lenders and debt guarantors slept well with these risks in their portfolios. But times have changed. Perhaps this really is the beginning of the end for many hospitals that loaded up on debt when money was cheap and easily available. In recent years, there has been an increasing level of health care defaults and, as previously mentioned, facilities continue to be shuttered on a regular basis. “Standard & Poor’s has taken a meat-ax to the credit ratings of not-for-profit hospitals of late. During the first six months of 2008, credit downgrades for nonprofit hospitals and health systems rated by S&P almost doubled, while upgrades fell, compared with the same period during the previous year. The agency downgraded 31 not-for-profits during that six-month period and upgraded only 11.”9 This trend continued into the fourth quarter of 2008 as credit availability continued to tighten. Moody’s downgraded 18 hospital bond ratings in October and November 2008 while upgrading only one.10 Further complicating matters is the lack of financial covenants (commonly referred to as “covenant-lite”) in many transactions completed in the past several years. While many lenders were chasing deals and competing with each other, credit standards became relaxed and many

lenders were willing to waive the inclusion of financial and other kinds of covenants. Without the early warning system of covenant breaches, however, lenders and other players that rely on the hospital to provide financial information end up facing the immediate risk of insolvency or a defensive bankruptcy filing without prior notice. Lenders are now realizing that they do not have as much protection in their existing lending agreements as they would like and are frequently trying to establish more restrictive covenants, in exchange for allowing “workouts” of existing troubled loans or bonds. Few hospitals that historically obtained financing through the taxable and tax-exempt bond markets used fixed-rate debt.11 Similar to an adjustable-rate vs. a fixed-rate home mortgage, many hospitals took on interest-rate exposure with variable-rate securities. Similar to adjustable-rate home mortgages, in the short-term, there were potential interest-rate cost savings using variable-rate securities. However, as the taxable and tax-exempt bond market became less reliable, borrowing costs soared. Few hospitals had hedges in place against interest-rate risk.12 As a result, many hospitals saw their borrowing costs jump significantly. As is the case with a homeowner, if one were to take a risk of a potential increase in interest rates, one should have adequate cash flow and/or liquidity reserves to absorb potentially higher borrowing costs. Unfortunately for many hospitals that used variable-rate debt, they did not reserve adequate liquidity to absorb increased borrowing costs.13 Compounding the problem for hospitals is an exotic class of securities known as Auction Rate Notes (ARNs). Many hospitals borrowed through the use of such notes without fully understanding the risks involved in these transactions. The market for ARNs effectively disappeared in the weeks following the subprime mortgage meltdown. ARNs work much like the commercial paper market in that borrowers enter the market

1 Chairman Ben S. Bernake, “The Economic Outlook,” before the Committee on the Budget, U.S. House of Representatives, available at www.federalreserve.gov/newsevents/testimony/bernanke20080117a.htm (Jan. 17, 2008).

2 Eric Dash et al, “Government Seizes WaMu and Sells Some Assets,” The New York Times on Sept. 25, 2008, available a t www.ny t imes .com/2008 /09 /26 /bus iness /26wamu.html?scp=1&sq=government%20seizes%20wamu&st=cse.

3 FDIC, “Failed Bank List,” www.fdic.gov/bank/individual/failed/banklist.html (last visited Dec. 29, 2008).

4 “Citigroup Raises $6 Billion in Capital Markets,” available at dealbook.blogs.nytimes.com/2008/04/22/citigroup-raises-6-billion-in-capital-markets; Joint Statement by Treasury, Federal Reserve and the FDIC on Citigroup,(Nov. 23, 2008), available at www.federalreserve.gov/newsevents/press/bcreg/20081123.htm.

5 BusinessWeek, “Bear Stearns’ Big Bailout,” available at www.businessweek.com/bwdaily/dnflash/content/mar2008/db20080314_993131.htm (March 14, 2008).

6 CNNMoney.com, “The Meltdown,” available at money.cnn.com/2008/09/15/news/companies/lehman_brothers/index.htm (Sept. 21, 2008).

7 CNBC.com, “Government Takes Control of Fannie, Freddie,” available at www.cnbc.com/id/26590793 (Sept. 8, 2008).

8 See, e.g., Reed Abelson, “Disappearing Credit Forces Hospitals to Delay Improvements,” The New York Times at B1 (Oct. 15, 2008).

9 www.fiercehealthfinance.com/story/s-p-downgrades-non-profit-hospitals-rise-sharply/2008-08-27 (Aug. 27, 2008).

10 www.fiercehealthfinance.com/story/moodys-downgrades-18-

Intensive Care

hospital-bond-ratings-two-months/2008-12-17 (Dec. 17, 2008).11 See, e.g., Harvey Lipman “Financial Crisis Affects Local

Hospitals” (Oct. 10, 2008), northjersey.com/health/financial_crisis_affects_local_hospitals.html; Elizabeth O’Brien, “Hospitals Going Variable,” from The Bond Buyer, available at www.accessmylibrary.com/coms2/summary_0286-12364541_ITM.

12 See, e.g., Ross Kerber, “Subprime Crisis Filters to Mass. Nonprofits,” The Boston Globe, Feb. 15, 2008, available at www.boston.com/business/articles/2008/02/15/subprime_crisis_filters_to_mass_nonprofits.

13 See, e.g., Tiffany Beck, “Bondwoes Take Toll on Local Hospitals,” Orlando Business Journal, March 14, 2008, available at orlando.bizjournals.com/orlando/stories/2008/03/17/story2html.


for short-term variable-rate debt and must continue to borrow new funds every few weeks to pay off the old funds. In stable markets, variable-rate securities are an inexpensive form of financing, but this was not the case in volatile markets where investors were running scared. In the absence of willing purchasers, hospital and health systems quickly saw their borrowing costs jump from approximately 5 percent to 15 percent, choking off the supply of capital. Suddenly, the taxable and tax-exempt bond markets were no longer stable and consistent sources of capital for investment-grade hospitals. The news is much more severe for sub-investment-grade and distressed hospitals. There is a limited appetite for noninvestment-grade credits from retail and institutional bond buyers. Today, there is a relatively small universe of active institutional buyers. In the authors’ estimation, there are perhaps 50-75 total accounts nationally with only 30-35 active, and even fewer that are willing to buy bonds at the range of BBB or below. The active “market place” for hospital bonds has severely reduced its size. In addition to a smaller group of potential purchasers, the credit crisis has made the bond purchasers more careful. Bond purchasers are (1) imposing tighter covenants, (2) asking for more security (debt-service reserve-funding, lockboxes, etc.), (3) expanded reporting and disclosure requirements, and (4) increased transparency through more frequent and direct institutional-investor interactions. All of these hurdles make issuing bonds all the more difficult. Bond insurers, suffering massive losses from the subprime mortgage exposure, are pulling back from or moving out of the market. MBIA and Ambac, two of the largest insurers of municipal debt, have themselves been downgraded and no longer issue the AAA rating on their guarantees.14 In addition to creating liquidity problems for hospitals, the absence of bond insurance makes the purchasers of bonds more cautious as well because they cannot purchase additional credit protection for their investment decisions. Finally, the municipal market for bonds has been severely debilitated by the credit deterioration of most monoline bond insurers, primarily due to guarantees provided by the monolines on subprime-

related mortgage securities. As rating actions continue with monolines,15 the municipal bond market will continue to remain volatile. Debt-rating agencies are paying close attention to the fundamentals of underlying credits compared to a year ago. As hospitals attempt to sell bonds in support of their operations, credit-rating agencies such as Moody’s, Standard & Poor’s and Fitch assign credit ratings for issuers of certain types of debt instruments, as well as for the debt instruments themselves. These rating agencies are supposed to conduct a thorough review of the many business aspects of each hospital or hospital system that is issuing debt and grade its credit-worthiness. This grade has a direct and real impact on the hospital’s cost of borrowing. A higher rating, which indicates better credit quality, translates into a lower cost of funds for the borrower. The collapse of the bond insurers, and the loss of confidence in hospitals as noncyclical safe havens, have crippled the industry’s ability to raise money at the record pace in the last decade. Alternative sources of direct capital for noninvestment grade and distressed hospitals have become limited, more expensive and more restrictive than in the past. While there were many specialty health care finance companies and REITs competing for business before the credit crisis, now only a handful are left standing with an active interest in the health care industry. These specialty finance companies and REITs were providing lines of credit, operating and capital leases, sale leasebacks and mortgages to fund vital working capital, capital expenditures and plant expansion and improvements for many of the noninvestment grade and distressed hospitals before the credit crisis. Credit standards have tightened and interest rate spreads have widened 100-500 basis points during this financial crisis. Fewer entities are willing to lend in risky situations. For example, many lenders historically perceived debtor-in-possession (DIP) financing to be a lucrative line of business because of its low risk and high return value proportion. DIP loans tended to be structured as last-in and first-out vehicles because they have a super-priority, fully-perfected lien from the bankruptcy court and tend to be over-collateralized by all the assets of the borrower. In addition, despite a lower risk profile, lenders are typically able to charge borrowers higher

interest rates and fees on short-term loans. According to the Wall Street Journal, credit has now become so scarce that many companies filing bankruptcy are unable to obtain DIP financing.16

It may well be that credit is running out for hospitals. The

credit crisis has resulted in intense pressure on hospitals nationwide. Access to capital

is critical in financing hospitals because they are capital-intensive businesses with

thin profit margins and slow collection cycles. There will

be few safe havens in the sector... In a system in which the flow of funds is controlled

by a handful of insurance companies and the federal government, it is difficult

to see how many of today’s hospitals will make it out to the other side of the current credit

crisis.

With regard to bank letters and lines of credit (LOC), most commercial banks, especially foreign banks, have retreated from this market. Bank letters are much more difficult than LOCs due to credit default exposure. LOCs are no longer considered a profitable business line by many banks. Borrowers should expect (1) a much-higher degree of selectivity, (2) shorter LOC renewal terms (one, three or five years), (3) more restrictive and highly-negotiated covenants and security provisions (similar to bond insurer requirements, but sometimes more or different requirements), and (4) explicit

14 TheStreet.com, “S&P Downgrades MBIA, Ambac,” available at www.thestreet.com/story/10420062/1/sp-downgrades-mbia-ambac.html (June 5, 2008); Reuters.com, “Moody’s cuts MBIA Insurance to ‘Baa1’,” available at www.reuters.com/ar t ic le / rbssFinancialservicesandRealEsta teNews/idUSN0737320320081107 (Nov. 7, 2008); The Bond Buyer.com, “Moody’s Drops Ambac Insurer Rating,” available at www.bondbuyer.com/article.html (Nov. 6, 2008).

15 A monoline guarantees the timely payment of bond principal and interest when an issuer defaults. For further reference, see en.wikipedia.org/wiki/Monoline_insurance (last visited on Oct. 31, 2008).

16 Wall Street Journal, “DIP Loans Are Scarce, Complicating Bankruptcies” (Oct. 17, 2008).

ABI Journal April 1995 4


tie-ins with other banking services, such as investment management. Hospital borrowers are seeing much less use of LOC-backed variable-rate demand note structures. Many of the failed or failing hospitals are municipally owned in places like Texas and California, or are health care districts (quasi-governmental entities). These entities have been hurt disproportionately by the credit crisis due to their reliance on government funding. “Hospitals supported by state and local governments have become a significant drain on state and county tax dollars. In some cases, budget shortfalls at small, county-supported community hospitals could threaten the financial viability of the entire county,” according to the A&M study. As tax revenues decrease, one would expect to see an increase in the financial failures of these hospitals.

Conclusion A former chairman of the Federal Reserve said about the Great Depression: “As in a poker game where the chips were concentrated in fewer and fewer hands, the other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped.”17 It may well be that credit is running out for hospitals. The credit crisis has resulted in intense pressure on hospitals nationwide. Access to capital is critical in financing hospitals because they are capital-intensive businesses with thin profit margins and slow collection cycles. There will be few safe havens in the sector. Today, many highly-rated hospitals with significant cash on hand still hit the panic button and freeze capital spending or institute a hold on new hires when there is a 400-point drop in the Dow Jones Index. Is this unnecessary anxiety or a real fear of losing the access to capital necessary to execute on a mission? Perhaps it is a bit of both. In a system in which the flow of funds is controlled by a handful of insurance companies and the federal government, it is difficult to see how many of today’s hospitals will make it out to the other side of the current credit crisis. n

Reprinted with permission from the ABI Journal, Vol. XXVIII, No. 1, February 2009.

The American Bankruptcy Institute is a multi-disciplinary, nonpartisan organization devoted to bankruptcy issues. ABI has nearly 11,700 members, representing all facets of the insolvency field. For more information, visit ABI World at www.abiworld.org.

17 Marriner S. Eccles, Beckoning Frontiers: Public and Personal Recollections, at 499 ( New York: ed. Alfred A. Knopf, 1951).

JOURNALA M E R I C A N B A N K R U P T C Y I N S T I T U T EIssues and Information for Today’s Busy Insolvency Professional


Contributing Editor:Samuel R. MaizelPachulski Stang Ziehl & Jones; Los [email protected]

Also Written by:Shane PassarelliHealthcare Finance Group Inc.; Los [email protected]

George D. PillariAlvarez & Marsal Healthcare IndustryGroup; Los Gatos, [email protected]

Throughout most of 2008, news ofthe presidential election andAmerica’s two pending wars have

taken second billing to the world’spotentially greatest financial crisis sincethe Great Depression. America’s hospitals,which for many years have operated undersignificant financial stress and survivedon razor-thin profit margins,1 have felt theimpact of the financial crisis in asignificant and damaging way. This articlewill explore the micro- andmacroeconomic factors that createfinancial difficulties for hospitals generally,as well as the impact of the currentfinancial crisis on the capital markets forhospitals nationwide. Finally, the authorsoffer their prognosis of what to expectfrom the health care industry in the comingyear.

In the past sixmonths, as the “creditcrunch” in Americaworsened, it has aptlyadopted a new name:the “credit crisis.”While some thinkthat the hospitalindustry is insulatedfrom the effects of aweak economy be-

cause “people need health care evenduring tough times,” in fact hospitals arenow especially vulnerable. The obviouschallenge is that it is more difficult toobtain credit, and that situation willworsen in the near future. The credit crisiscontinues to disrupt capital markets,increasing borrowing costs anddecreasing the credit availability for allhealth care borrowers. Nonprofithospitals, nursing homes and other health

care providers that frequently raise capitalby employing variable-rate interest bondshave felt the impact.

Unlike an airline orother capital-intensive servicebusiness, hosp-italscannot pass on therising cost of borrow-ing to their customersin the form of higherprices: Third-partyre-imbursement ratesare set and remain

fixed for long periods of time. Moreover,hospitals cannot easily make draconiancuts to reduce costs, such as reducingstaffing, because staffing levels arefrequently set by statute and wage levels

are often propped up by limited suppliesof credentialed health care workers.

But just as importantly,tax revenues are downdramatically forfederal, state andmunicipal govern-ments2—and those“payors” are still the800-pound gorillaswith regard to healthcare delivery systemsnationwide. They can

delay payments or simply refuse to pay at all,as was the case this past summer in California,3

or decide to recalculate the amount they willpay for various services. Finally, as consumersfeel the pressure from the slowing economy,there will inevitably be more bad debt write-offs, more indigent care and fewerdiscretionary procedures. The net result of thisturmoil? Hospitals that were already infinancial distress will experience higher costs,

lower income and increasing financial stress.The financial prognosis for the hospital

industry has been bleak for a while. As thestate with the most hospitals, California isoften the “early warning system” for thenation’s hospitals. Last year, even beforethe bottom dropped out of the financialmarkets, newspapers were already writingabout the tough financial situation facingCalifornia’s hospitals. Nearly two dozenprivate hospitals in Los Angeles and Orangecounties, accounting for up to 15 percentof beds in the region, were reported to be

The Financial Crisis Facing America’s Hospital Industry: Part I

Intensive Care

About the Authors

Samuel Maizel is a partner in PachulskiStang Ziehl & Jones LLP’s Los Angelesoffice. Shane Passarelli is a senior vicepresident of Healthcare Finance GroupInc. in Los Angeles. George Pillari is amanaging director of Alvarez & Marsal’sHealthcare Industry Group in SanFrancisco.

Samuel R. Maizel

1 See.,e.g., Evelyn Lee, “New Jersey Hospitals Post Narrower OperatingMargins,” available at www.njbiz.com/article.asp?aID=72569 (Nov. 29, 2007).

2 See, e.g., “Cities, states begin to feel economic downturn,” BusinessWeek, available at www.msnbc.msn.com/id/25479690 (July 1, 2008);“The next victim of the Real Estate Crisis,” Business Week, available atw w w . b u s i n e s s w e e k . c o m / l i f e s t y l e / c o n t e n t / j u n 2 0 0 8 / b w20080627_320852 (June 2008).

3 See, e.g., “Budget Crisis in California,” available atwww.sfgate.com/cgi-bin/article.cgi (May 15, 2008); “A deeper woundfor our healthcare system…” available at www.health-access.org/2008/05/deeper-wound-for-our-health-care-system (May14, 2008).

Shane Passarelli

George D. Pillari

in dire financial straits and in danger ofbankruptcy or closure.4 Since then, in thegreater Los Angeles area alone, 420-bedBrotman Medical Center Valley HealthSystem (a three-hospital health care district)and Huntington Park Hospital have filedfor bankruptcy protection and areattempting to reorganize. Century CityDoctor’s Hospital, located in the heart ofthe Century City/Beverly Hills corridor,closed and filed for a forced liquidationunder chapter 7, causing investors to losetens of millions of dollars.

For hospitals nationally, the news duringthe last year has gone from bad to worse.The hospital industry is dominated bynonprofit and governmentally-ownedcommunity hospitals; according to theAmerican Hospital Association, investor-owned hospitals account for only 15.5percent of the total market nationally.However, the number of communityhospitals (hospitals with an average lengthof stay under 30 days) has declined by morethan 1,000 to 4,900 during the last 25 years.5

Part of this decline is certainly based onoverall decline in hospital utilization (moreon that later), but part of the decline is alsodue to the stress of operating hospitals underconstant financial difficulties. Alvarez &Marsal’s Health Care Industry Group(A&M) published a report in April 2008 thatreviewed data for each short-term acute carehospital in the United States with more than25 beds, approximately 3,861 in all.6 Theresults were gloomy: More than half weretechnically insolvent or at risk of insolvency.As to A&M’s prognosis more than sixmonths ago, “as states and municipalitiesbegin to limit spending in the face ofslumping tax revenues and a weakeningeconomy, the financial health of manyhospitals is likely to further deteriorate.Many will encounter serious liquidity crisesand face the prospect of radicallyrestructuring or shutting doors.”7 And thatwas before the especially difficultcircumstances of the second half of 2008.The credit crisis is affecting hospitals moresignificantly than other industries becauseof ongoing micro- and macroeconomicfactors that created financial distress forhospitals even before the current credit crisisarose.

Microeconomic Drivers of Financial Distress

In good times and bad, there are threeprimary microeconomic drivers of financialdistress for hospitals: (1) capital structure, (2)organization and governance and (3) revenue-cycle mismanagement. Many hospitals sufferfrom an inappropriate capital structure, withcapital spending as the most telling metric.A decreasing amount or complete cessationof capital spending can lead to a “death spiral”for a hospital and is a “genetic marker” forlenders and board members that the institutionis in distress. Given the lack of free cash flowfrom operations, investing too much or toolittle can jeopardize a hospital’s long-termsurvival. In a well-managed hospital, the goalis patient, employee and physician satisfaction,and the avoidance of unnecessary capitalspending that leads to a technology arms racewith local competitors. Nonetheless, hospitalmanagers frequently will delay capitalexpenditures first when cash is tight, becausethey are focusing on surviving today. Becausethe hospital industry operates with EBITDAmargins of 10-12 percent (low compared withother industries) and a necessary minimumcapital expenditure of 4-6 percent of netrevenues every year (high compared withother industries), balance sheet strength is akey determinant in measuring a hospital’sability to withstand a financial crisis.Therefore, hospital management must bedisciplined in its capital planning andbudgeting process, ensuring the proper levelof capital expenditures, balanced against theneed for liquidity (cash on hand, lines of credit,sustained credit ratings) in the context of thehospital’s operating performance.

Hospitals with poor organization andgovernance tend to be questionable creditrisks for lenders. In these situations,management is frequently unmotivated as aresult of a lack of clear financial incentivesand a clear “chain of command” with regardto long-term strategic planning accountability.As a result, management teams frequentlyfocus on uncoordinated incremental changewithout any strategic planning or overallcontext, versus coordinated changes as partof a comprehensive strategic plan. Executivesoften find themselves more worried aboutpreserving their jobs than investing in long-term planning or long-term solutions.Additionally, nonshareholder boards are oftenappointed without financial incentives, furtherexacerbating the issue of short-term vs. long-term goals, and further misaligning theinterests of the stakeholders and the hospital.

Century City Doctors Hospital is anoteworthy case because it demonstrates the

range and complexity of strategic issues thathospital operators face in today’smarketplace. Nearly $100 million in capitalwas reported to have been invested in the142-bed hospital from debt and equitysources. The hospital invested significantcapital in property improvements, providingpatients with private rooms, Wolfgang Puckcuisine and flat-screen TVs with on-demandpay television services.

However, in this case, the hospitalprimarily failed because, despite it having a“spa-like” environment, it was unable to pullpatients from nearby well-establishedhospitals. In the end, the hospital discoveredthat whether one serves Wolfgang Puck orfast food, reimbursement from payors is thesame and is dependent on patient volume.

The health care industry is unique becauseof its complicated billing and collectionpractices, usually referred to as “revenue-cyclemanagement.” For example, unlike mostindustries, the customer receiving the servicesis typically not paying for those services. Rather,a third-party payor, such as an insurancecompany, Medicare or Medicaid, is typicallypaying the bills. Thus, making sure that thepatient is entitled to the service per its third-party payor and that the hospital will becompensated for the services is essential.Additionally, the rate of reimbursement for ahealth care service will differ depending on thepayor. In other words, while the hospital mayhave a set rate for a procedure, each payorcontract may set a different rate for the sameprocedure. Other examples include physiciansthat are not properly credentialed with payors,failure to collect insurance information on thefront end and writing off a patient claim asuninsured, or improper coding that understatesrevenue. Unfortunately, there is no easy fix;generally throughout the health care industrythe claims adjudication and payment collectionprocess is complex and often time-consuming.Some health care providers have manuallyintensive, paper-driven systems that tend tocompound already existing inefficiencies.Others invest millions in informationtechnology and implementation, embarkingupon system conversions in which it is difficultto measure returns. Often one hears in the healthcare industry that systems conversions “nevergo well, just hope it’s not a disaster.” The netresult is that while revenue cycle managementis an essential element of the financial successof a hospital, the reality of the situation—thatmany hospitals do this poorly—has led tofinancial distress in the past for hospitals.

Macroeconomic Drivers of Financial Distress

The macroeconomic challenges facing the


4 Daniel Costello and Susannah Rosenblatt, “Financial Woes JeopardizeArea Hospitals,” Los Angeles Times, Sept. 23, 2007.

5 Agency for Healthcare Research and Quality, Healthcare Costs andUtilization Project, available at www.haup-us.ahrq.gov/reports/-factsandfigures/fcts_figures_2005.jsp#ex1_1.

6 Alvarez & Marsal Healthcare Industry Group, “Hospital Insolvency: TheLooming Crisis,” available at www.alvarezandmarsal.com/-en/docs/am_hospital_insolvency_survey_03.2008.pdf (Mar. 2008).

7 “More Than Half of U.S. Hospitals Are Now Technically Insolvent or atRisk of Insolvency, According to New Alvarez & Marsal Study,” aHealthcare News article found at www.alvarezandmarsal.com/-en/global_services/healthcare/news.

hospital industry seem to be contrary to logic.The demographic and economic trends all seemto be poised to create an industry that is large,healthy and growing. Health care is one of thelargest industries in the nation, and its costs—as widely discussed in the past presidentialelection cycle—are staggering. Total nationalhealth expenditures were expected to rise 6.9percent in 2007—double the rate of inflation.8

Health care expenditures in the United Statesamounted to approximately $2.3 trillion in2007, or $7,600 per person (about 16 percentof the gross domestic product), and this trendis not projected to slow down in the near future.9

To the contrary, health care spending is expectedto increase at similar levels for the next decade,reaching $4.2 trillion in 2016, or 20 percent ofGDP. According to NHEA, total hospitalexpenditures were approximately $648 millionin 2006 (or greater than one-quarter of the totalhealth care expenditure figures). In additionto the immense outlays for hospital care, theaging U.S. population (78.2 million estimated“baby boomers” by the U.S. Census Bureauas of July 1, 2005) is a key demographic trendthat is expected to drive overall health carespending nationally.10

Nonetheless, there are many macro-economic factors that create a bleaker financialpicture for the health care industry in generaland the hospital segment in particular, whichinclude: (1) increased labor costs due to an acuteshortage of registered nurses; (2) the loss oflucrative outpatient procedures to freestandingambulatory care centers and specialty hospitals;(3) an increase in bad debts, driven by anincrease in the number of uninsured patients;(4) an overall decline in hospital utilizationbecause of advances in technology and the useof pharmaceuticals; (5) a decline in employer-based health care spending, as industry triesto control growing health care costs; and (6) the“leverage” of health maintenance organizations(HMO), which can negotiate contracts that aresignificantly less favorable to hospitals.

The nation is in the midst of a nursingshortage that is expected to intensify as babyboomers age and health care needs grow.Compounding the problem, colleges anduniversities across the country are strugglingto expand enrollment levels to meet the risingdemand for nursing care. In some states,insurers are providing scholarships and evenfunding nursing-education programs. For

example, Independence Blue Cross ofPennsylvania has awarded millions of dollarsthrough its Nurse Scholar program.11 Accordingto a report released by the American HospitalAssociation in July 2007, U.S. hospitals needapproximately 116,000 registered nurses to fillvacant nurse positions nationwide, translatinginto a national registered nurse vacancy rateof 8.1 percent.12 One report found that 44percent of hospital CEOs had more difficultyrecruiting registered nurses in 2006 than in2005.13 According to a report published by theU.S. Bureau of Labor Statistics, more than onemillion new and replacement nurses will beneeded by 2016. Based on a projection bygovernment analysts, nursing is the nation’stop profession in terms of job growth, citingthat more than 587,000 new nursing positionswill be created through 2016 (a 23.5 percentincrease).14 This shortage of nurses createspressure on wages, increasing labor costssignificantly for hospitals nationwide.

The growth in freestanding ambulatorycare centers and specialty hospitals has poseda significant challenge to traditional, generalacute-care hospitals. Advancement inanesthesia and surgical equipment andtechniques has allowed an ever-increasingrange of procedures to be performed in lowercost and more convenient outpatient settings.The reimbursement rates for cardiovascularand orthopedic surgery procedures arecompetitive for freestanding ambulatoryfacilities and surgical centers, compared tohospitals. Not surprisingly, there has been aproliferation of Medicare-certified ambulatorysurgery centers, and the number of proceduresperformed out of the conventional inpatienthospital setting.15 As a result, increasingnumbers of outpatient surgical proceduresare now performed outside of a hospital-owned facility. This trend is significantbecause hospitals typically report higheroperating margins on outpatient and ancillarybusinesses than they do on inpatient care.

An increasingly uninsured population ispushing bad debt rates higher. According tothe U.S. Census Bureau, more than 47 millionpeople lacked medical insurance in 2006(approximately 16 percent of the population).More than half of those had annual incomesof less than $50,000.16 According to somestudies, medical debt is the single largest

catalyst for personal bankruptcies in the UnitedStates; a recent study found that 50 percentof all personal bankruptcy filings were at leastpartly the result of medical expenses.17 Withunemployment increasing, bad debts are agrowing source of concern for hospitals andtheir lenders.

Despite the demographic trends discussedearlier, hospital inpatient admissions haveremained flat at about 34 million per year andthe average length of hospital stays hasdecreased nearly 25 percent since 1980.18 Thischange in hospital utilization is due to manyfactors, including technolgy advances and theuse of pharmaceuticals that have reduced theneed for and length of inpatient medical care.Breakthroughs in cardiovascular care andcholesterol-management drugs have alleviatedthe need for many hospital admissions. Theresult is that while there are an increasingnumber of older Americans, they use hospitalsless than previous generations.

Most hospitals are paid by a limitednumber of “payors.” The largest of thesepayors are two government programs:Medicare, which generally covers theelderly, and Medicaid, which generallycovers the poor. These two programs payfor nearly half of all hospital services. Theother large payors are HMOs, which caninclude entities such as Kaiser FoundationHealth Plan, Blue Cross/Blue Shield andHealthNet. About one-third of allAmericans are enrolled in an HMO. Insome markets, HMO penetration is morethan 70 percent. This results in whateconomists call a “monopsony,” or a marketdominated by a few or single purchaser ofservices. By aggregating millions ofpatients, HMOs are able to exert collectivebuying power in price negotiations withhospitals. This dynamic leads to moredownward pressure on hospital revenue.

As a result of all these micro- andmacroeconomic issues, the hospital industryhas been under unrelenting pressure formany years. The current credit crisis,however, adds a whole new dimension tothe situation. �

Reprinted with permission from the ABIJournal, Vol. XXVII, No. 10,December/January 2009.

The American Bankruptcy Institute is a multi-disciplinary, nonpartisan organizationdevoted to bankruptcy issues. ABI has nearly11,700 members, representing all facets ofthe insolvency field. For more information,visit ABI World at www.abiworld.org.17 Melissa Jacoby and Elizabeth Warren, “Beyond Hospital Misbehavior:

An Alternative Account of Medical-Related Financial Distress,”Northwestern Univ. L.R. at 535, Vol. 100 (2006).

18 AHA Hospital Statistics, 2007, American Hospital Association, Chicago.


8 Poisal, J.A., et al, “Health Spending Projections Through 2016: ModestChanges Obscure Part D’s Impact.” Health Affairs (21 February 2007):W242-253. The National Health Expenditure Accounts (NHEA) are theofficial estimates of total health care spending in the United States,provided by the Centers for Medicare and Medicaid Services (CMS).These amounts are drawn from the NHEA.

9 Plunkett Research, Ltd., Health Care Trends, available at wwwplunkett-research.com/industries/healthcare/healthcaretrends/tabid/294/default.aspx.

10 U.S. Department of Health and Human Services, Center for DiseaseControl and Prevention, National Healthcare Survey, available atwww/cdc.gov/hchs/data/misc/healthcare.pdf.

11 Nurse Scholars Program, available at www.ibx.com/social_mission/-nurse_scholars/index.html.

12 Dr. Peter Buerhaus, et. al., “The Future of the Nursing Workforce in theUnited States: Data, Trends and Implications” (March 2008).

13 “The 2007 State of America’s Hospitals—Taking the Pulse.” Am. Hosp.Ass’n. (July 2007).

14 U.S. Bureau of Labor Statistics, available at www.bls.gov/opub/mlr/-2007/11/art5full.pdf.

15 National Healthcare Survey, supra, fn. 11.16 See, e.g., Medlines, “45.7 Million Americans without Health Insurance,”

available at www.medlines.com/2008/08/30/457-million-americans-without-health-insurance.

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