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Health Care BankruptciesEligibility Issues

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Market pressures to deliver health care in an economical, more efficient manner, coupled with the threat of legislative reform, have caused major restructuring and reorganization in the health care industry. In order to meet these demands, new and creative group practices and integrated delivery systems are being formed on a local, regional and national level. Although the threat of a massive federal health care program has subsided, the economic pressure on the health care industry continues to cause sweeping changes in the methods of health care delivery.

The result of such market pressures will be the continued restructuring and consolidation of health care providers and, in some cases, reorganizations and liquidations of the least economically viable groups.

The market driven pressure of delivering low-cost health care in a more efficient manner has caused widespread changes in the methods of health care delivery and the structure of the entities providing the health care services. Doctors who previously formed single specialty groups and partnerships are now forming new and creative alliances with hospitals and/or other doctors to reduce overhead expenses and increase revenues. Newly formed alliances include "clinics without walls" and diversified multi-specialty independent practice associations (IPAs). Health maintenance organizations (HMOs) are continuing to grow and exercise ever-expanding leverage over health care providers and hospitals. Similarly, hospitals are entering into relationships with other providers, including other hospitals, physician groups, HMOs and ancillary providers, in order to gain a competitive edge in this tumultuous market. The end result is a dynamic, changing health care marketplace that is consolidating, reorganizing and, in some cases, causing the failure of economically inefficient entities.

Health care providers that may file or seek to file for chapter 11 protection assume they will be afforded the opportunity to reorganize under the Bankruptcy Code. However, as some groups have learned, eligibility for bankruptcy relief is the subject of conflicting case law that could seriously impact or jeopardize any attempted reorganization. If deemed a domestic insurer that is ineligible for bankruptcy relief, health care providers will be unable to pursue reorganization under the Bankruptcy Code. Instead, they will either be liquidated or rehabilitated under the supervision of the state insurance commissioner's office in accordance with applicable state law.

Defining Eligibility for Relief

Eligibility for relief under the Bankruptcy Code is governed by §109. Section 109(b) provides: "A person may be a debtor under chapter 7 of this title only if such person is not...a domestic insurance company..." Under this section, only those persons eligible for relief under chapter 7 are eligible for relief under chapter 11 of the Bankruptcy Code.

Section 101(41) provides that a "person" includes an individual, partnership or corporation. "Corporation" is defined in §101(9) as including (i) an association having a power or privilege that a private corporation has but that an individual or a partnership does not possess; (ii) a partnership organized under a law that makes only the capital subscribed responsible for the debts of such association; (iii) a joint stock company; (iv) an unincorporated company or association; or (v) a business trust.

The legal and economic effects of eligibility are significant. If eligible for federal bankruptcy relief, a health care organization may seek to reorganize under chapter 11. On the other hand, if the health care organization is found to be a domestic insurance company that is ineligible for bankruptcy relief, its rehabilitation or liquidation is conducted under the strict supervision of the state insurance commissioner's office in accordance with applicable state law. Management will lose control of the entity and no longer will be afforded the opportunity to structure a reorganization plan. Usually, the insurance commissioner retains the sole discretion to either rehabilitate or liquidate the entity. Priority in payment issues will have very different resolutions, depending on whether federal bankruptcy laws or state insurance laws control. For example, in the liquidation of an Illinois HMO, an Illinois policyholder's unsecured claims are afforded a third priority after payment of administrative and wage claims, but ahead of other unsecured claims. However, a similar policyholder claim under the Bankruptcy Code may not be afforded a priority and may have only the limited protection afforded a general unsecured creditor.

Unfortunately, the Bankruptcy Code does not define the term "domestic insurance company" or otherwise identify the scope of this ineligible class of debtors. The courts that have addressed whether health care organizations, and in particular HMOs, are eligible for bankruptcy relief are widely split on this issue. Under Louisiana, Arizona, Pennsylvania, Texas, Illinois and Michigan law, HMOs have been held not to be insurance companies and, therefore, eligible for bankruptcy relief. Yet, under Wisconsin, New Jersey, Oregon and, again, Illinois law, HMOs have been found to be domestic insurance companies and, therefore, ineligible for federal bankruptcy protection. This apparent split in authority is discussed below.

To deal with the problem of classification of an HMO for §109 purposes, various courts have come up with three classification tests for defining whether the HMO was not an insurer.

The first is the "state classification test," which looks to the entity's classification under the law in the state in which the entity is incorporated. Under the state classification test, an entity could be excluded in one of two ways: First, the court reviews whether state law classifies the entity as a domestic insurance company or other entity specifically excluded from being a debtor under §109(b)(2); second, the court may perform a functional analysis and review the applicable state law to determine whether the entity is substantially equivalent to one of those entities in the excluded class (such as a domestic insurer).

The second test that courts have employed is the "independent classification test." Under this test, the court looks to the language of §109(b)(2) and construes the specific exclusions using statutory construction techniques developed under federal common law. The test is essentially statutory construction by another name.

The third test, known as the "alternative relief test," emphasizes "congressional intent in factors of practicality and policy" to determine whether, given the state reorganization and liquidation scheme to wind up a particular entity, federal bankruptcy relief still would be a satisfactory alternative to the state procedure.

The following opinions upheld the eligibility of the HMO in question to seek Title 11 relief: In re Family Health Services Inc., 101 B.R. 636 (Bankr. C.D. Cal. 1989) (applying each of the three different tests, the court determined that a Louisiana HMO was eligible for chapter 11 relief); In re Family Health Services Inc., 101 B.R. 628 (Bankr. C.D. Cal. 1989) (applying each of the three different tests, the court determined that an Arizona HMO was eligible for chapter 11 relief); In re Family Health Services Inc., 104 B.R. 268 (Bankr. C.D. Cal. 1989) (applying each of the three tests, the court found that an Illinois HMO, which did business in Illinois, Indiana and Ohio, was eligible for bankruptcy relief); In re Group Health Partnership Inc., 137 B.R. 593 (Bankr. E.D. Pa. 1992) (applying the state classification test, the court determined that a Pennsylvania HMO was eligible for relief); In re Michigan Master Health Plan Inc., 90 Bankr. 274 (E.D. Mich. 1985) (deferring to the opinion of Michigan's attorney general, the court held that a Michigan HMO was not a domestic insurance company and, therefore, was eligible for relief under chapter 11); In re Family Health Services Inc., 101 B.R. 618 (Bankr. C.D. Cal. 1989) (applying the state classification test, the court held that a Texas HMO was not a domestic insurance company and, therefore, was eligible for relief under chapter 11).

On the other hand, the following cases denied eligibility: In re Medcare HMO, 998 F.2d 436 (7th Cir. 1993) (applying the state classification test, the court determined that an Illinois HMO was a domestic insurance company and, therefore, ineligible for bankruptcy relief); In re Family Health Services Inc., 143 B.R. 232 (C.D. Cal. 1990) (applying the state classification test, the court determined that a Wisconsin HMO was domestic insurance company and ineligible for relief and, therefore, reversed the bankruptcy court's contrary finding); In re Beacon Health Inc., 105 B.R. 178 (Bankr. D. N.H. 1989) (applying the state classification test, the court held that a New Jersey HMO was a domestic insurer and, therefore, ineligible for bankruptcy relief); In re Portland Metro Health Inc., 15 Bankr. 102 (Bankr. D. Ore. 1981) (applying the state classification test, the court held that an Oregon HMO was a domestic insurer and, therefore, ineligible for relief under chapter 11).

The Medcare HMO Decision

The Medcare HMO decision, supra, is the only reported appellate decision on the issue. In construing the Illinois Health Maintenance Organization Act, a state statute, the court concluded that Medcare fell within the state statutory classification of a domestic insurance company.

In determining whether Medcare was a domestic insurance company and thereby excluded from being a debtor under §109(b)(2), the Seventh Circuit noted the wide split in authority regarding the appropriate test to determine whether an entity is a domestic insurance company for bankruptcy purposes. Importantly, the Seventh Circuit determined that the appropriate test for determining whether an entity is to be excluded from the bankruptcy laws was the state classification test. Id. at 440-442. The court reasoned that application of the state classification test with respect to eligibility of domestic insurance companies was a consistent practice prior to the enactment of the Bankruptcy Code and because Congress did not expressly provide its own definitions of the excluded categories, it must have intended state law to fill the interstices, especially because the entities excluded under §109(b)(2) are subject to state regulation.

The Seventh Circuit reviewed the Illinois Insurance Code and HMO Act and determined that Medcare was classified as a domestic insurance company under Illinois law. Id. at 443. First, the court reasoned that Illinois law classifies the operation of an HMO as a form of insurance protection. Id. Next, Illinois law subjects HMOs to state liquidation and rehabilitation schemes created for insurance companies and requires that action be conducted under the supervision of the Director of Insurance. Id. Finally, Illinois law specifies a priority for enrollee claims, a protection routinely conferred by states in the case of entities excluded under §109(b)(2) to safeguard consumers dealing with the entities. Id..Thus, the court held that Medcare was ineligible for relief as a debtor under chapter 11.

The court also found that Medcare was the "substantial equivalent" of an excluded domestic insurance company:

In determining equivalency for purposes of §109(b)(2), however, the issue is not whether the excluded entity mirrors the entity in question, but rather whether the two entities share the attribute prompting exclusion under §109(b)(2). The essential attribute of an insurance carrier under Illinois law, and the attribute prompting deference to state regulation, is the assumption of a third party's risk for a premium.
Id. at 445 (emphasis added). Medcare assumed a significant degree of economic risk by arranging for or providing corrective and protective health services for a fixed monthly fee, irrespective of the enrollee's use. The court reasoned that Medcare's assumption of risk was the "pivotal factor" in applying equivalency analysis, and the court concluded that under the substantial equivalency analysis, Medcare also was a domestic insurance company. Id. at 445-46.

The Medcare decision attempts to clarify the methodology to determine whether an HMO or other type of health care provider is eligible for relief under chapter 11. Rather than eliminating the confusion behind these different tests, the decision may add to the lack of uniformity. The Medcare decision's broad statements that the "pivotal factor" in applying the equivalency test under Illinois law is the assumption of third-party risk might impact the eligibility for relief of other forms of health care providers. In pronouncing such a broad test, the Seventh Circuit may have inadvertently narrowed the scope of eligibility for bankruptcy relief for health care providers who assume risk but are not usually regulated as insurance companies.

Many health care providers, such as integrated delivery systems (IDSs), independent practice associations (IPAs) and physician hospital organizations (PHOs), perform services on a capitated basis. Specifically, they perform services on a fixed fee, per person basis, notwithstanding the amount of health care services which are actually rendered in a given calendar month. By participating in capitated compensation arrangements, these entities assume a significant degree of financial risk in providing health care services. Thus, it is possible that courts following the Seventh Circuit's application of the substantial equivalency analysis may determine that these entities are ineligible for bankruptcy relief, even though they are not regulated nor are otherwise treated as domestic insurance companies.

Conclusion

Economic pressures to deliver low-cost, efficient health care will continue to induce the formation of new and creative alliances between various health care providers. Many of these newly formed alliances are accepting and bearing increasing degrees of risk through capitated contracts. Some of these entities will not be economically viable and may seek to reorganize under the Bankruptcy Code. However, as these entities continue to assume greater degrees of third-party risks, it is possible they that they will be treated as domestic insurers and, therefore, will be ineligible for bankruptcy relief.

Journal Date: 
Monday, December 1, 1997

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