In today's health care environment, most health care facilities participate in the Medicare program by virtue of Health Insurance Benefit Agreements (Medicare Provider Agreements) with the U.S. Department of Health and Human Services (HHS) and/or the Health Care Financing Administration (HCFA). Medicare Provider Agreements are the vehicle by which HCFA, through fiscal intermediaries, reimburses health care providers for services rendered to Medicare patients. When a health care provider files for bankruptcy relief, one issue that practitioners should consider is whether a Medicare Provider Agreement is an "executory contract" subject to assumption or rejection as provided in §365 of the Bankruptcy Code. Although most courts answer that question in the affirmative, some courts have questioned the conventional wisdom.

It behooves everyone involved with a bankrupt health care facility to consider this issue carefully before automatically treating Medicare Provider Agreements as executory contracts; the costs of assuming a Medicare Provider Agreement can be astronomical if a debtor has received overpayments in prior cost years (which, by the way, currently accrue interest at the rate of 13.5 percent per annum). However, rejection is not necessarily an option, as one needs a Medicare Provider Agreement in order to treat Medicare patients and receive Medicare dollars. Accordingly, an analysis of this issue is essential.

In order to understand the dispute, it is necessary to re-examine a few basics regarding executory contracts. Over the years, several definitions of "executory contract" have been developed by the courts, in the absence of an explicit definition in the Bankruptcy Code. The most common of these, the so-called Countryman test, states that an executory contract is a contract that is so far unperformed that the failure of either the debtor or the non-debtor party to the contract to complete performance would constitute a material breach excusing the performance of the other. See Countryman, "Executory Contracts in Bankruptcy: Part I," 57 Minn. L. Rev. 439, 460 (1973). Cases adopting the Countryman test include In re Texscan Corp., 976 F.2d 1269 (9th Cir. 1992); Sharon Steel Corp. v. Nat'l Fuel Gas Distribution Corp., 872 F.2d 36 (3d Cir. 1989); and In re Newcomb, 744 F.2d 621 (8th Cir. 1984). In enacting the current Bankruptcy Code, Congress appears to have adopted at least some portion of the Countryman test, as the legislative history to §365 indicates that "executory contracts include contracts under which performance remains due to some extent on both sides." S. Rep. No. 95-989, 95th Cong., 2d Sess. (1977).

One line of authority questioning the Countryman test is the so-called "functional approach." See Westbrook, "A Functional Analysis of Executory Contracts," 74 Minn. L. Rev. 227 (1989). They hold that the Countryman test is helpful, but not necessarily dispositive. Courts applying the functional approach utilize a more flexible definition that works backward from an examination of the purposes to be accomplished by rejection; if these have already been accomplished, then the contract cannot be said to be executory. The only circuit court to explicitly adopt the functional approach is the Sixth Circuit, which first did so in In re Jolly, 574 F.2d 349 (6th Cir. 1978); see, also, Rieser v. Dayton Country Club Co. (In re Magness), 972 F.2d 689 (6th Cir. 1992). Whichever test the bankruptcy court adopts, if a Medicare Provider Agreement is found to be an executory contract, then the debtor may only assume or reject such agreement with court approval.

As noted above, the majority of courts have generally held that because Medicare Provider Agreements typically require performance on both sides, such agreements are executory contracts. See, e.g., University Medical Center v. Sullivan (In re University Medical Center), 973 F.2d 1065 (3d Cir. 1992); In re Advanced Professional Home Health Care, 94 B.R. 95 (E.D. Mich. 1988); In re Memorial Hospital of Iowa, 82 B.R. 478, 479-80 (W.D. Wis. 1988); In re Visiting Nurse Association of Tampa Bay Inc., 121 B.R. 114 (Bankr. N.D. Fla. 1990); In re Tidewater Memorial Hospital Inc., 106 B.R. 876, 884 (Bankr. E.D. Va. 1989). Under this line of authority, in order to assume a Medicare Provider Agreement, the debtor would have to assume the obligation to repay all prior years' overpayments.

There are, however, differing views. For example, in the Medicaid context, some courts have held that because provider agreements with state Medicaid agencies can be viewed as constituting a series of one-year contracts, each one is a separate contract. See, e.g., In re Willington Convalescent Home Inc., 39 B.R. 781, 791 (Bankr. D. Conn. 1984), rev'd on other grounds, 72 B.R. 1002 (D. Conn. 1987); In re Dartmouth Nursing Home, 24 B.R. 256, 260. Presumably, a debtor need not assume prior years' contracts in order to receive the benefits of the current year's contract. Of course, these courts are still of the view that provider agreements are executory contracts subject to assumption or rejection under §365. Nevertheless, under this line of authority, a debtor's exposure should theoretically be limited to the current year's contract and any overpayments received under that year's contract.

In some sense, this theory has been adopted and applied to Medicare Provider Agreements by those courts that hold that HCFA cannot recoup pre-petition overpayments from post-petition Medicare payments where they arise from different cost years. See, e.g., University Medical Center, 973 F.2d 1065; In re Sun Healthcare Group Inc., 245 B.R. 779 (Bankr. D. Del. 2000); In re Healthback L.L.C., 226 B.R. 464 (Bankr. W.D. Okla. 1998); First American Healthcare of Ga. Inc. v. United States Dep't of Health and Human Services (In re First American Healthcare of Ga. Inc.), 208 B.R. 985 (Bankr. S.D. Ga. 1996), vacated by settlement. See, generally, Conoco Inc. v. Styles (In re Peterson Distrib. Inc.), 82 F.3d 956 (10th Cir. 1996) (assignment of credit card invoices and sale of products are not part of the same transaction even though both agreements are embedded within the same contract); California Canners and Growers v. Military Distribs. of Va. Inc. (In re California Canners and Growers), 62 B.R. 18 (Bankr. 9th Cir. 1986) (different and distinct transactions were embedded within one single agreement). To some extent, these courts are holding that each cost year constitutes a new contract. Taking this argument to its logical end, a debtor should be permitted to effectuate a severance of the various "cost-year contracts" embodied in the single Medicare Provider Agreement, and only be required to assume the current year's "contract."

Authority does exist for severing independent contracts that are all contained within the body of one physical contract. See Byrd v. Gardinier Inc. (In re Gardinier Inc.), 831 F.2d 974 (11th Cir. 1987). The court must look to non-bankruptcy law to determine whether severability is permissible. See Id. at 976 (court looks to Florida law to determine severability of contract); Stewart Title Guaranty Co. v. Old Republic Nat'l Title Ins. Co., 83 F.3d 735 (5th Cir. 1996) (court looked to Texas law). For example, in Georgia, "[w]hether a contract is entire or severable depends on the intent of the parties." Turnipseed v. Jaje, 477 S.E.2d 101, 104 (Ga. 1996); Abernathy v. Grant, 209 S.E.2d 210 (Ga. 1974). This test is similar to the test employed by other states. See Stewart, 83 F.3d at 739; see, also, Gardinier, 831 F.2d at 976. Accordingly, it may be possible to argue that severing the various cost-year contracts embedded in the single Medicare Provider Agreement is appropriate, and that the debtor need only assume the current year's "contract" (and cure overpayments thereunder) in order to continue in the Medicare program. It is difficult to predict how the intent issue would play out in this context, however.

Yet another approach to determining the issue of whether a Medicare Provider Agreement is an executory contract appears in an unreported decision by the Middle District of Florida Bankruptcy Court. In In re BDK Health Management Inc., Case No. 98-609-B1 (Bankr. M.D. Fla.), the bankruptcy court entered an Order Authorizing Sale of Assets Out of the Ordinary Course of Business (filed Nov. 16, 1998). In the order, the court considered the debtor's motion to sell its assets, including its various Medicare Provider Agreements, to a third-party purchaser, free of all liens, claims and encumbrances (including recoupment and set-off rights, if any, of HCFA and the Florida Medicaid agency), pursuant to §363(f) of the Bankruptcy Code. HCFA objected to the motion, arguing that the Medicare Provider Agreements were executory contracts that must be assumed and assigned to the third party purchaser pursuant to §365 of the Bankruptcy Code. HCFA further argued that any order granting the assumption and assignment of the Medicare Provider Agreements would have to provide for repayment of all overpayments, whether pre-petition or post-petition. In reply, the debtor put forth a "necessity" argument, contending that the assets sought to be sold would have little or no independent value apart from the Medicare Provider Agreements. The debtor flatly stated that if it could not sell its assets, including the Medicare Provider Agreements, the debtor would be forced to cease operations and liquidate, thereby almost certainly guaranteeing little or no distribution to unsecured creditors. This is in contrast to $1 million in net proceeds if the sale were allowed to go forward.

The court held that the Medicare Provider Agreements at issue in the case were not executory contracts at all, but simply assets of the debtor's estate. Accordingly, the court granted the debtor's motion and approved the sale. Interestingly, in reaching its conclusion, the court commented on the fact that outside of the bankruptcy courts, HHS and HCFA almost always argued that Medicare Provider Agreements were not contractual relationships in the traditional sense, and that they did not create specific contractual obligations running between the government and the health care provider. For example, the court noted decisions in Memorial Hospital v. Heckler, 706 F.2d 1130,1136-37 (11th Cir. 1983) (holding that "[u]pon joining the Medicare program, however, the hospitals received a statutory entitlement, not a contractual right." Although the hospitals entered into an "agreement" with the secretary that they would abide by the rules of the Medicare program, that agreement did not obligate the secretary to provide reimbursement for any particular expenses such as Hill-Burton costs), cert. denied 465 U.S. 1023 (1984); Harper-Grace Hospitals v. Schweiker, 708 F.2d 199, 201 (6th Cir. 1983) ("[the health care provider] has not shown that the Medicare program established a contractual relationship between the hospital and federal government); Greater Dallas Homecare Alliance v. United States, 10 F.Supp.2d. 638, 647 (N.D. Tex 1998) ("Plaintiffs argue that the Medicare participation agreements between [HCFA] and the [health care providers] are essentially contracts. The court disagrees and finds that the participation agreements are not contracts, for the right to receive payments under the Medicare Act is a manifestation of government policy and, as such, is a statutory rather than a contractual right"); Homecare Ass'n of America Inc. v. United States, 1998 U.S. Dist. Lexis 20515 (W.D. Okla. Aug. 1998) (holding that no contractual obligation existed between government and provider of Medicare services); Germantown Hospital and Medical Center v. Heckler, 590 F. Supp. 24, 30-31 (ED. Pa. 1983) ("There is no contractual obligation requiring HHS to provide Medicare reimbursement. Rather, upon joining the Medicare program, providers gain a statutory entitlement to reimbursement. 42 U.S.C. §1395f(b). Thus, the amount of reimbursement is governed not by contract but by statute—specifically, the Medicare Act's 'reasonable cost' provisions").

The court went on to hold that Medicare Provider Agreements do not look like typical, garden-variety contracts. For example, Medicare Provider Agreements impose no particular obligations on the government, and the government derives no tangible consideration from the health care provider party to the "agreement." Essentially, the agreement boils down to a recognition that the health care provider is entitled to treat Medicare patients and be reimbursed for such treatment in accordance with the then-applicable Medicare statutes and regulations. The court found, consistent with the decisions cited above, that the Medicare Provider Agreements created "statutory entitlement" relationships rather than contractual relationships. Accordingly, the court held that the agreements could be sold free of any prior-year overpayment liability and did not have to be assumed (and overpayment liability cured) pursuant to §365. Obviously, if this decision were adopted by other jurisdictions, it could well pave the way for health care debtors to shed their Medicare liabilities and transfer their assets for their fair value, without regard to the sometimes massive Medicare overpayment liability.

As the above discussion illustrates, a health care debtor may have certain options in making a decision about how to deal with Medicare Provider Agreements that carry with them significant overpayment liabilities. Counsel should be wary of jumping to the conclusion that such agreements must constitute executory contracts subject to assumption or rejection under §365.