During the 1990s, securitization became one of the most important methods for businesses that generate assets to obtain liquidity and financing at substantially lower borrowing costs than might otherwise be available from more traditional forms of financing, as well as to allow for off-balance sheet accounting. In the health care finance context, this generally involves the sale of Medicare, Medicaid and private insurance accounts receivables from a provider (or seller) to a so-called bankruptcy remote entity (BRE), also called a special purpose vehicle (SPV). The BRE obtains capital to purchase receivables through the issuance of bonds or certificates that generally are payable from the receivables proceeds, which are also available to repurchase new receivables during the term of the receivables program.

The size and projected growth of the health care market, resulting at least in part from favorable demographics, the seeming predictability of cash flows from governmental and other payers and a lack of other types of financing, made securitization seem particularly attractive to the health care industry. However, for a variety of reasons, health care securitization did not take off to the degree of other types of securitization and, in fact, has been susceptible to and undermined by two major debilitating frauds—Tower Financial in 1993 and National Century Financial Enterprises (NCFE), which unraveled starting in late 2002.

The recent bankruptcy filing by NCFE and its affiliates NPF VI and NPF XII (NPFs) (collectively, National Century), exposed some of the structural issues in securitizations and, particularly, health care securitizations. These include the difficulty in detecting or preventing fraud, the overbroad dependence on third parties who in reality have limited ability and authority to monitor and control servicer conduct, and lockbox structures that resulted in or allowed the commingling of funds. In addition, the National Century case illustrates several potential problems for bondholders in defaulted securitizations, including multiple-case conflicts that arose when providers largely cut off by National Century in turn filed chapter 11 cases and sought to use the proceeds of securitization receivables as cash collateral, arguably in derogation of the true sale characterization of those receivables.

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The size and projected growth of the health care market, resulting at least in part from favorable demographics, the seeming predictability of cash flows from governmental and other payers and a lack of other types of financing, made securitization seem particularly attractive to the health care industry.

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The Downfall of National Century

A crucial feature to the credit rating of securitized transactions is the deposit or transfer of assets (receivables, contracts, etc.) into a BRE or SPV. The purpose is to isolate those assets from the other assets of the provider/seller and thus remove them from becoming part of the provider's/seller's estate, should the provider become a debtor in a bankruptcy case.

In the case of the National Century securitization programs, after purchasing receivables from health care providers, NPFs, as servicers, were to collect on the receivables from payors, such as Medicare and Medicaid and third-party insurers. The proceeds collected by the servicers included those for both purchased and non-purchased receivables. Those proceeds then were remitted to NCFE, which effectively commingled the funds before remitting the funds to the trustees for the respective securitization trusts.

Following the heightened scrutiny on off-balance sheet financing in the wake of the Enron and other scandals in the summer of 2001, National Century's outside auditors, Deloitte & Touche, declined to sign off on National Century's audit letter for 2001. This led to National Century's inability to obtain new bond issuances, and in turn, its inability to make scheduled note payments. Shortly thereafter, severe deficiencies in National Century's reserve accounts were discovered, and the indenture trustees declared events of default. National Century generally stopped funding its providers, many of which were thus cash-starved, leading a number to attempt to divert their receivables to themselves instead of to National Century's lockboxes. These attempted diversions and National Century's continuing deterioration and revelations of scandal led to the filing on Nov. 18, 2002, of chapter 11 cases by National Century, NPF VI and NPF XII, as well as other affiliates.¹

In light of NCFE's inability to continue full funding of its provider clientele, some providers ultimately also filed for bankruptcy and sought use of the proceeds of their receivables, including those that had presumably been sold to NCFE, on the grounds that the proceeds were cash collateral. In order to press these motions, the debtors in those cases (including Doctors Community Healthcare Corp., Michael Reese Medical Center Corp. and Mid Atlantic Home Health Network) generally needed not only the right to use the receivables from their bankruptcy courts, but to seek relief from stay in the NCFE bankruptcy. The essence of these debtors' claims that the funds were cash collateral was the argument that the sales were not true sales but, in essence, secured loans. In every such case, the bankruptcy courts of both the providers and National Century allowed use of the funds in order to maintain essential patient care. The issue of whether the transactions between National Century and the providers were "true sales" or secured borrowing was not litigated or decided by those bankruptcy courts, but was reserved for determination at a later time. The outcome of these cases is being closely watched by the health care finance and securitization industries, as these cases may have a significant precedential effect on how such financing structures will be treated and characterized in the future.

Immediate Lessons/Fallout from National Century Financial Situation

1. Heightened Focus on the True Sale Characterization and the Problem of Stopping Fraud. The extreme collateral deficiency in the NCFE case (estimated at $2 billion or more) has raised questions about how "secure" a securitization or other receivables financing can be when parties overextend credit, engage in insider and affiliate transactions, and are willing to misstate the amount and existence of eligible receivables—in other words, engage in alleged fraud or a Ponzi scheme. NCFE was able to overadvance, i.e., advance funds to certain providers (a number of which were affiliated with or owned by NCFE or its principals) far in excess of the value of receivables sold and pledged by such providers, and to manipulate reserve accounts and move funds in such a way so as to escape the detection of its deteriorating position for many months.

Further, in light of the alleged bad conduct of NCFE (including cessation of funding to providers) and the crucial needs of providers to fund their operations, the fact that providers have been able to obtain use as cash collateral of the proceeds of receivables which had been "sold" to an SPV, has again raised issues of court deference to the "true sale" characterization and further suggests that providers who file bankruptcy may be deemed to retain an interest in the receivables notwithstanding a securitization structure.²

2. SPVs, Bankruptcy Remoteness and the Ability to Keep SPVs Out of Bankruptcy. To the extent that the insulation of an SPV from a bankruptcy filing is an essential element of most securitizations, the National Century case raises practical questions on not only the ability to completely insulate assets through an SPV but on the ability to enforce provisions to keep such SPVs out of bankruptcy. NPF VI and NPF XII, the BREs created by National Century, purchased and held health care receivables pursuant to sale and subservicing agreements with the providers, which also serviced the collection of the receivables. The articles of incorporation of both NPF VI and NPF XII required a unanimous vote of the board of directors of each of those SPVs in order to "institute a proceeding to be adjudicated insolvent...or file or consent to a petition under any applicable federal or state law relating to bankruptcy." The articles of incorporation further state that each board must have at least one independent director not affiliated with the financing entity. However, the independent director of NPF VI and NPF XII resigned from the respective boards in July 2001 and was not replaced prior to the filing of the bankruptcy petitions on Nov. 18, 2002, so that even though the votes to file for chapter 11 were unanimous, there were no independent directors at the time of each vote.

Several provider entities (none of whom arguably are creditors or stakeholders in the National Century bankruptcies) filed motions to dismiss the NPF VI and NPF XII bankruptcies, arguing that the SPVs did not adhere to their own articles of incorporation and bylaws in filing for bankruptcy, and thereby may have violated Ohio law. National Century has argued in response that (i) the boards of directors of NPF VI and NPF XII unanimously authorized the filing of the bankruptcy petitions, as required by their articles of incorporation, (ii) the movants lack standing to move to dismiss the cases, because the corporate resolutions and bylaws are meant to protect investors, not third-party providers, and (iii) that in any event, the earlier challenged votes of the boards of directors were ratified by the NCFE's chief restructuring officer appointed on the same day as the bankruptcy filing and simultaneously appointed the independent director of both NPF VI and NPF XII. At the time this article went to press, the court had not yet ruled on the motions, but the ongoing bankruptcies of NPF VI and NPF XII themselves demonstrate that "bankruptcy remoteness" may not insulate an SPV from becoming a debtor in a bankruptcy proceeding.

3. Rating Agency Response and the Role of Trustees and Servicers. The magnitude of NCFE's unraveling, and in particular, the size of the collateral deficiency, has captured the attention of nearly every player in the health care finance industry, including rating agencies, each of whom has focused on the structuring and assessing responsibility for protecting the securitization structure.

Recent reports by Moody's Investors Services ("Moody's Re-examines Trustees' Role in ABS and RMBS," Feb. 4, 2003) and the American Bankers Association (ABA) Corporate Trust Committee, in particular, in the wake of NCFE, have examined the ability and authority of third parties, such as securitization trustees and rating agencies, to uncover covenant breaches, monitor transaction cash flows and prevent fraud.

The Moody's Report

Moody's recently announced that it would begin reconsidering its ratings of asset-backed and mortgage-backed securities transactions in light of what it now understands is the role of trustees in securitized transactions. According to its report, when Moody's initially reviewed and rated many of these and other similar transactions, it believed that trustees played a more proactive role in overseeing the application of transaction cash flows and in monitoring transactions for covenant breaches. The Moody's report takes the position that securitization trustees should exercise a heightened degree of oversight to monitor and "prevent" the misappropriation of cash collections by servicers, especially non-investment-grade-rated seller/servicers. The report also states that "Moody's believes that the trustee has a duty to investigate credible indications that a servicer is in default and notify rating agencies of any claims of a possible default."

The ABA Corporate Trust Committee Position Paper

The ABA responsive Position Paper, issued on March 10, 2003, sets out to clarify the nature and scope of the trustee's role in typical asset-backed securities transactions, emphasizing that the trustee's role is limited strictly by the terms of the indenture or pooling and servicing agreement. The ABA position paper also emphasizes the crucial roles played by other participants to a securitization transaction, including the seller or depositor, the underwriter and the servicer, all of whom are to have greater knowledge about the transaction, the assets, and the receivables than the trustee. "Transaction documents virtually never give the trustee any substantive oversight over the servicer and its activities. Any such oversight would necessarily be limited to matters susceptible of feasible ascertainment and verification on a cost and time-sensitive basis."

The ABA Position Paper further notes that the duties of the trustee in a securitization transaction may be complex, but they are all ministerial, not discretionary. "[T]o suggest that there are implied or vague oversight duties imposed on trustees is financially unfair to trustees, legally indefensible as an abrogation of their right of contract and destructive to the certainty of debt terms that underlies successful capital markets... If there are identifiable, additional services of value to the asset-backed market, which may be performable by trustees, trustees are willing to consider such if appropriately defined in transaction documents and with reasonable compensation." ABA Position Paper at 13.

The ABA Position Paper concludes by noting that at least one other rating agency, Fitch, "believes that unrealistic reliance on trustees increases the risk to investors by potentially masking other more important considerations when evaluating structured finance investments. Specifically, Fitch believes it is important to consider the critical role played by the seller/servicer" (Fitch, "Seller/Servicer Risk Trumps Trustee's Role in U.S. ABS Transactions," FitchRatings Press Release, Feb. 24, 2003).

Conclusion

While the failure of NCFE may create new opportunities for those interested in entering the health care asset-backed lending market, it has also exposed certain challenges for those players currently involved, as well as those wishing to remain in or become involved in the health care securitization market, including not only lenders, but seller/servicers, underwriters, securitization trustees, investors and rating agencies. The outcome of the National Century case may guide and will likely impact the evolution of this important industry.

Footnotes

¹ In re National Century Financial Enterprises, et al., Case No. 02-65235 (S.D. Ohio). Return to article

² In re National Century Financial Enterprises et al., Case No. 02-65235 (S.D. Ohio). See, also, e.g., In re LTV Steel Company Inc., et al., Case No. 00-43866 (N.D. Ohio), where the debtors sought to use as cash collateral to fund future post-petition operations the proceeds of inventory and accounts receivables ownership of which LTV earlier had transferred to two securitization financing subsidiaries of LTV, claiming that the assets of the two securitization financing subsidiaries were part of the debtors' estate because the transfer of assets did not constitute "true sales" but rather a secured financing. In a 19-page memorandum opinion, issued Feb. 5, 2001, the court held generally in favor of the debtors' position, noting that "there seems to be an element of sophistry to suggest that debtor does not retain at least an equitable interest" in the inventory and receivables. (274 B.R. 278 Bankr. N.D. Ohio, 2001). Return to article