With the introduction of managed care, the health care industry was transformed. The industry was flooded with new types of health care delivery systems such as the IDS (integrated delivery system), the IPA (independent physician association), the MSO (the management services organization) and the PPM (the physician practice management group). These new health care delivery systems went on acquisition frenzies and attempted to acquire as many businesses as possible. By acquiring multiple businesses, in theory, the costs of operating these large health care conglomerates would decrease as economies of scale were achieved.

As the health care industry continued to evolve, various sectors of the industry began to suffer financial difficulty—in particular, the PPMs. Under the PPM rubric, a management company acquires physician practice groups. Some PPMs are organized geographically, some PPMs are organized by practice groups and still others are organized on a less coordinated basis with no clear strategic plan.

To acquire the practice, the management company would enter into a long-term management services agreement (MSA) with the physician group. Pursuant to the MSA, the management company agrees to provide all of the "back office" support needed by the physicians—in particular, accounting, billing and collection. In addition, the management company assumes primary responsibility for negotiating the managed care contracts with the third-party payors (namely, the insurance companies). In exchange for these services, the management company receives a percentage of the practices' operating revenues. The management company also acquires the hard assets of the physician practice and, in exchange, the physicians receive cash and/or stock in the PPM.

A typical PPM was FPA Medical Management Inc. (FPA), one of the first large PPMs to seek relief under chapter 11. At the time of filing its bankruptcy case, FPA had contracts with approximately 7,900 physicians in 29 states and provided health care services to approximately 1.4 million patients. FPA suffered from one of the common problems of PPMs—FPA effectively acquired physician groups around the country, but was unable to fully integrate operations and achieve necessary economies of scale. In addition, FPA, like most other PPMs, did not have great success negotiating with the insurance companies to achieve profitable managed-care contracts.

The Reorganization or Liquidation of a PPM

One of the biggest challenges facing bankruptcy practitioners is how to reorganize a PPM or salvage some value from its assets. To reorganize, the PPM must be able to assume the MSAs. However, the MSAs may not be assumable without the physicians' consent. Similarly, to liquidate a PPM through an asset sale, the PPM will need to assume and assign the MSAs. Again, this may not be possible without the physicians' consent.

The Assumption and Assignment of Executory Contracts

In determining whether the MSA is assumable and assignable, the main question is whether the MSA is a personal services contract that cannot be assumed or assigned pursuant to §365(c) of the Bankruptcy Code.

Generally, pursuant to §365(a), a trustee or debtor-in-possession may assume any executory contract that benefits the estate and reject any executory contract that is burdensome to the estate. Furthermore, §365(f) authorizes the trustee or debtor-in-possession to assign an executory contract that has been assumed. Section 365(f) states that:

Except as provided in subsection (c) of this section, notwithstanding a provision in an executory contract...of the debtor, or in applicable law, that prohibits, restricts or conditions the assignment of such contract...the trustee may assign such contract or lease...

11 U.S.C. §365(f)(1) (2000). Therefore, §363(f) generally nullifies the anti-assignment provisions that prohibit, restrict or condition the assignment of contracts or non-bankruptcy laws that do the same.

Section 365(c), however, contains exceptions to that general rule. It provides that:

The trustee may not assume or assign any executory contract...of the debtor, whether or not such contract...prohibits or restricts assignment of rights or delegation of duties, if—
(1)(A) applicable law excuses a party, other than the debtor, to such contract...from accepting performance from or rendering performance to an entity other than the debtor or the debtor-in-possession whether or not such contract...prohibits or restricts assignment of rights or delegation of duties; and
(B) such party does not consent to such assumption or assignment...

11 U.S.C. §365(c) (2000). Therefore, §365(c) is an exception to the general rule that anti-assignability provisions and laws are not enforceable in bankruptcy. Section 365(c) protects the rights of third parties that contract with a debtor and that would be prejudiced by having the contract performed by some entity other than the debtor.

What Types of Contracts Are Not Assignable Under the Code?

Based on §365(c), certain types of executory contracts cannot be assumed or assigned. Personal services contracts (e.g., recording contracts or publishing contracts) cannot be assumed and assigned by a debtor, and some courts have held that personal services contracts are the only types of contracts that cannot be assumed or assigned by a debtor. See, e.g., In re Taylor Mfg. Inc., 6 B.R. 370, 372 (Bankr. N.D. Ga. 1980) (§365(c) only applies to personal service contracts).

Other courts have stressed that §365(c) applies to more than personal service contracts:

It may well be that the impetus for Congress' enactment of §365(c) was to preserve the pre-Code rule that "applicable law" precluding assignment of personal service contracts is operative in bankruptcy...However, the drafters actually codified a much broader principle. Surely if Congress had intended to limit §365(c) specifically to personal service contracts, its members could have conceived of a more precise term than "applicable law" to convey that meaning.

In re Braniff Airways Inc., 700 F.2d 935, 943 (5th Cir. 1983). However, these courts have struggled to identify what types of contracts fall within the purview of §365(c) other than personal services contracts. They have tended to focus on the duties delegated by the contracts and whether those duties arise out of a "special relationship," "special knowledge," "unique skill or talent" or "trust and confidence." See In re Compass Van & Storage Corp., 65 B.R. 1007, 1011 (Bankr. E.D.N.Y. 1986); In re Bronx-Westchester Mack Corp., 20 B.R. 139, 143 (Bankr. S.D.N.Y. 1982); In re Varisco, 16 B.R. 634, 639 (Bankr. M.D. Fla. 1981).

In trying to narrow the types of contracts that fall within §365(c) and, therefore, cannot be assumed or assigned, some courts have held that corporations cannot be parties to contracts that fall within the purview of §365(c). See New England Iron Co. v. Gilbert (Metropolitan) Elevated Railroad Co., 91 N.Y. 153, 167 (1883). But, see In re Rooster Inc., 100 B.R. 228, 233 n.12 (Bankr. E.D. Pa. 1989) ("it is possible for a corporation to contract where the basis of the bargain is the personal performance of individuals within that company, the delegation of which would be ineffective").

Assumption of Contracts that Cannot Be Assumed—Hypothetical vs. Actual Test

If a contract is the type of contract that cannot be assigned pursuant to §365(c), will the debtor be able to assume the contract in connection with its reorganization? In analyzing this issue, courts have adopted either the "hypothetical" test or "actual" test.

Under the "hypothetical" test, courts consider whether, under applicable non-bankruptcy law, the non-debtor party would be excused from performing the contract if the other party to the contract was not the original party with whom it contracted. If so, the assumption is barred without regard to who is assuming the contract. In re West Electronics Inc., 852 F.2d 79 (3d Cir. 1988). Thus, if non-bankruptcy law precludes assignment to a third party, §365(c) precludes the debtor from assuming the contract even though the debtor is not seeking to assign the contract to a third party. See In re Catapult Entertainment Inc., 165 F.3d 747 (9th Cir. 1999); In re Catron, 158 B.R. 629 (E.D. Va. 1992), aff'd., 25 F.3d 1038 (4th Cir. 1994). The hypothetical test has been justified on the distinction between a debtor and a debtor-in-possession. Catron, 158 B.R. at 637-38.

Under the "actual" test, the debtor can assume the contract so long as it is basically the same entity performing the contract pre-petition as post-petition. See Texaco Inc. v. Louisiana Land & Exploration Co., 136 B.R. 658 (M.D. La. 1992); In re Cajun Elec. Power Co-op. Inc., 230 B.R. 693 (Bankr. M.D. La. 1999); In re GP Express Airlines Inc., 200 B.R. 222 (Bankr. D. Neb. 1996); In re American Ship Bldg. Co., 164 B.R. 358 (Bankr. M.D. Fla. 1994); In re Hartec Enterprises Inc., 117 B.R. 865 (Bankr. W.D. Tex. 1990), vacated on other grounds, 130 B.R. 929 (W.D. Tex. 1991); In re Cardinal Industries Inc., 116 B.R. 964 (Bankr. S.D. Ohio 1990). In adopting the "actual" test, one court noted that:

The proposition that the debtor-in-possession is a different legal entity from a debtor is a non-sequitur in the context of §365. While it is true that for certain purposes the debtor-in-possession is a legally distinct entity from the debtor, it is clearly a successor of interest of a debtor, and a debtor-in-possession is not required to obtain an assignment from the debtor in order to acquire all rights and assets of a debtor, including all rights under an unexpired executory contract.

Can MSAs Be Assumed and Assigned Pursuant to §365(c)?

Based on existing case law, it is not clear whether MSAs can be assumed and assigned or whether MSAs are the types of contracts that are not assignable absent the consent of the non-debtor party.

In In re Antonelli, 148 B.R. 443 (D. Md. 1992), aff'd., 4 F.3d 984 (4th Cir. 1993), the court considered whether a partnership agreement could be assumed and assigned, and focused on whether the identity of the debtor (general partner) was important:

[T]he question of whether or not management power in a partnership is assignable turns not upon the status which "applicable law" generally accords to partnership agreements, but upon the materiality of the identity of the partners to the performance of the obligations remaining to be performed under the partnership in question...In certain circumstances, the identity of a general partner will be critical to the limited partners and to the prospect of a successful investment. Examples of such circumstances include: (1) a real estate development partnership in which the general partner must administer the planning, construction and leasing of a building; (2) an investment partnership in which the general partner is to identify and evaluate investments of the partnership; and (3) any partnership in which the general partner is required to contribute capital to the partnership and, indeed, may have control over the issuance of capital calls to all...On the other hand, partnerships exist in which the identity of a general partner is less significant. These may include (1) real estate partnerships owning matured projects that require only routine management and leasing functions and (2) certain large syndication operations that administer a network of separate partnerships. In these cases, it is arguable that another organization with sufficient resources could take over the work of the original general partner without material detriment to the limited partner investors...

Partnership agreements are somewhat analogous to MSAs. Under the MSA, certain mundane tasks are delegated to the management company, such as bookkeeping, billing, maintaining files and records, and maintaining all fixtures and equipment. Other delegated responsibilities are not so mundane. Under the MSA, the management company may help recruit physicians, negotiate managed care and third-party payor contracts, prepare business plans and projections, and generally render business and financial advisory services. Although the MSA is not what one normally characterizes as a personal service contract, presumably, when physicians enter into an MSA, they enter into the agreement because they have confidence in the financial stability, negotiating leverage and skill of the management company. Thus, should physicians, who built their practices over several years and have now entrusted the management of their practices to a particular company, be forced to turn over the management of their company to a new entity without their consent?

This is exactly what the court sanctioned in the BMJ Medical Management Inc. case, which is pending in Delaware. Early in the case, the bankruptcy court entered an order finding that "BMJ's MSAs...are not personal service contracts that cannot be assumed or rejected under §365(c) and that under the assignment provisions of the MSAs, [the physicians'] consent is not required for BMJ to assume or assume and assign the MSAs in bankruptcy." In re BMJ Medical Management Inc., et al., Case Nos. 98-2799 through 98-2804 (MJW) (jointly administered) (order (1) denying (A) motion by Lighthouse Orthopedic Associates and Orthopaedic Surgical Associates to compel immediate rejection of management services agreements and (B) joinder motion by Seaview Orthopaedic and Medical Associates, and (2) fixing the date by which the debtor must assume or reject management services agreement). This ruling gave BMJ tremendous negotiating leverage in its bankruptcy case. BMJ now had the ability to assume the MSAs if it chose to reorganize, to assume and assign the MSAs if it sold the company or part of the company or, most importantly, to negotiate with the physicians. If the physician did not want to contract with BMJ or any potential purchaser, the physician would have to negotiate a termination of the contract and essentially buy back the practice. Thus, BMJ was able to create a substantial value in the MSAs.

Conclusion

Whether a MSA can be assumed and assigned is not a settled area of the law. Presumably, physicians who enter into a MSA select a particular management company based on that company's negotiating leverage with third-party payors, financial strength, access to the capital markets, management efficiency and reputation in the industry. Often, the physicians turn over all of the assets and the management responsibilities to this management company in exchange for an investment in the management company, namely stock. These considerations suggest the MSA may not be assumable and assignable pursuant to §365(c).

For a PPM attempting to reorganize and maintain value, the PPM's ability to assume and/or assign the MSAs will create tremendous negotiating leverage with the physicians and potentially create a large value that can be assigned to a buyer. As more and more PPMs seek protection under chapter 11, this contract issue will certainly be addressed as it may be the key to creating a dividend for creditors.