Although the economy is robust, the health care industry continues to suffer from financial difficulties. Particularly hard-hit are skilled nursing facilities (SNFs). SNFs are generally likely to fail more often than the industry because the federal government has changed the reimbursement method for Medicare and Medicaid patients. The new prospective payment system (PPS) was instituted by the Balanced Budget Act of 1997. PPS is a payment methodology that applies a fixed per diem payment system. Previously, providers were reimbursed for all reasonable costs. This change is having a substantial and detrimental financial impact on SNFs. When Texas Health Enterprises, which operates more than 85 nursing homes in Texas, Arkansas and Michigan, filed its chapter 11 petition, the firm stated that implementation of PPS "has been a debacle for nursing home operators."¹

Modern Healthcare magazine surveyed long-term care facilities and was told that the for-profit nursing home systems responding had an average net loss of $64 million in 1998, down from an average net gain of $33.1 million in 1997. The survey respondents blamed those losses on the implementation of PPS. The non-profit nursing home systems responding to the survey with financial data did not fare any better, reporting that their average net income dropped by half in 1998.

Despite the negative impact of PPS, the SNFs' most valuable assets generally remain their relationships with the Medicare and Medicaid programs because the services provided to many of their patients are paid for by these programs. These relationships are captured in written agreements called Provider Agreements.² In the past, debtors have been limited in their ability to realize substantial value for the Provider Agreements because the Provider Agreements have been treated as executory contracts. To transfer a Provider Agreement, courts have required debtors to assume and assign their interests pursuant to §365 of the Bankruptcy Code.³ This reduces the value of the Provider Agreements because assumption requires the cure of existing defaults, which typically include repayment of prior overpayments.⁴ Additionally, the federal government typically asserts successor liability for unpaid liabilities against any entity taking the assignment of a Medicare Provider Agreement.

However, a recent bankruptcy court decision approved an approach that allows debtors and their counsel to maximize the value of the Provider Agreements by selling such assets "free and clear" of government claims. Such treatment greatly increases the value of these assets and increases the likelihood of a distribution to general creditors in the bankruptcy cases of health care entities, especially SNFs.

In In re BDK Health Management Inc.,⁵ the court granted a debtor's motion to sell, pursuant to §363(f), virtually all of the debtor's assets of various home health care agencies, including its Provider Agreements, free of all liens, claims and encumbrances, including any recoupment rights of the federal Health Care Financing Administration, the Florida Department of Health and Human Services, various liens asserted by the debtor's secured lender, and the Internal Revenue Service. The federal government opposed the sale by asserting that, among other things, (1) Provider Agreements are executory contracts that must be assumed and assigned, and (2) cure of any defaults prior to assumption included the repayment of any alleged pre-petition and post-petition overpayments.

The debtor responded by pointing out that, in the absence of the ability to sell the Provider Agreement, its other assets would have little or no value. Because the government had asserted recoupment rights against future Medicare payments, the debtor had no available cash for operations. If the debtor could not sell its assets, it would immediately cease operations, terminate its employees and discharge all patients. If the agencies closed, the Provider Agreements would be terminated and lose all value. On the other hand, the purchaser was offering net proceeds in excess of $1 million if the sale included the Provider Agreements.

The court approved the sale, noting that outside of bankruptcy the government expressly disclaimed that the Provider Agreements established contractual relationships between the government and a health care provider. The court also noted that the Provider Agreements imposed no obligations and conferred no benefits on the debtor or the government other than establishing that the debtor was entitled to operate and be reimbursed in accordance with the applicable Medicare statutes and regulations. The court found that the Provider Agreements created "statutory entitlement" relationships rather than contractual relationships.

The court in In re Kings Terrace Nursing Home and Health Related Facility⁶ reached a similar result; it held that a Medicaid provider agreement was not an executory contract. In Kings Terrace, the bankruptcy court reviewed the relationship between a SNF and the state government created by a Medicaid Provider Agreement. The court noted that the provider's reimbursement entitlement rested not on the Provider Agreement but rather on certain provisions of the Medicaid statute. For example, in order to contest a reimbursement decision or audit findings, a provider cannot bring a civil contract action but must pursue the remedies created by the applicable statutes and regulations.

The court in Kings Terrace noted that under applicable New York State law, an action required by law is not "magically transformed" into a contractual obligation, even if the obligation is mentioned or required in a contract between the parties. The Kings Terrace court relied on the Second Circuit's decision in Hollander v. Brezenoff,⁷ where the court held that claims relating to reimbursement issues between Medicaid providers and states arose not out of Provider Agreements but rather out of the statutes and regulations requiring reimbursement.

The controversy as to whether a Provider Agreement is an executory contract arises out of the government's inconsistent approaches to this issue. Outside of bankruptcy proceedings, the government consistently denies that Medicare Provider Agreements give contractual rights to providers of services to Medicare beneficiaries, and courts have agreed.⁸

However, inside of bankruptcy proceedings, the government has argued—and courts have generally agreed—that Provider Agreements are executory contracts.⁹ The question then is whether a Provider Agreement can be a contract for some purposes and not a contract for other purposes. With all due respect for Humpty Dumpty's thoughts on multiple meanings for the same terms, the question is a difficult one to answer.¹⁰

The Bankruptcy Code does not define "executory contract," but most courts have adopted this definition: "A contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other."¹¹

A "contract" is defined as "an agreement between two or more persons which creates an obligation to do or not to do a particular thing." Its essentials are competent parties, subject matter, a legal consideration, mutuality of agreement and mutuality of obligation.¹² It could be argued that entering into a Provider Agreement creates an obligation on the part of the provider to comply with the Medicare Act and an obligation on the part of the government to pay for that performance in accordance with the Medicare Act. However, the government denies that the Provider Agreement creates any enforceable obligations on either side. If this is true, then the filing of the bankruptcy petition should not alter those rights because "the nature of the debtor's interests in property...are determined by non-bankruptcy law."¹³ If there are no contractual obligations, there is no contract. There is also, then, no executory contract because there are no obligations that would result in a material breach if not performed.

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The government will be hard-pressed to explain why the debtor's rights are converted to contractual rights by the filing of the bankruptcy petition.

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If Provider Agreements are not contracts, then §365 does not apply and Provider Agreements can be sold pursuant to §363(b)(1). Debtors and trustees will be able to obtain more value for the Provider Agreements and more easily dispose of these assets than if they were executory contracts. This is true, in part, because the debtor's "sound business judgment" in the sale of property of the estate is subject to great judicial deference.¹⁴

Section 363(f) permits a sale of Provider Agreements "free and clear of any interest in such property of an entity other than the estate" if, inter alia, (1) the Medicare and Medicaid rights against the Provider Agreements are liens and the price at which the Provider Agreements are to be sold is greater than the aggregate value of Medicare and Medicaid's liens on the Provider Agreement, or (2) Medicare and Medicaid could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of their interest in the Provider Agreements. Section 363(f) is written in the disjunctive; thus, satisfaction of any one of its conditions is sufficient.¹⁵

Section 363(f)(3) would permit the sale of the Provider Agreement free and clear of Medicare and Medicaid's liens if the sale price exceeds "the aggregate value of all liens on the property." Under §363(f)(3), the sale price must be sufficient to ensure that the value of Medicare and Medicaid's liens are adequately protected.¹⁶ The salient provision of §363(f)(3) is "the aggregate value of all liens on the property." Section 506(a) equates the value of a secured claim to the value of the collateral securing the claim. Because the "value of the liens" cannot exceed the fair price of the collateral, courts should permit the sale of Provider Agreements free and clear of liens so long as the proposed sale is justified by the circumstances and the sale price is a fair market price.¹⁷

Section 363(f)(5) provides that assets may be sold free and clear of liens if the lienholders "could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of [their] interest[s]." Section 1129(b)(2) permits a debtor to retain property and cram down objecting creditors upon payment of the actual value of the collateral.¹⁸ As a lienholder could therefore be compelled to accept a monetary satisfaction of its claims pursuant to §1129(b)(2), §506(a) limits the amount of a secured claim to the value of the collateral securing the lien, and renders liens void to the extent that they secure a claim in excess of the value of such collateral. As a result, a fair price for the Medicare and Medicaid Provider Agreements establishes the maximum amount of the Medicare and Medicaid's secured claim. Assuming the court determines that the price obtained by the debtor for the Provider Agreement is the best obtainable under the circumstances, it would seem that Medicare could be compelled to accept money satisfaction of its interests under §§1129(b)(2) and 506(d). If a sale is conducted in this manner, the estate could sell the Provider Agreement for the fair market price and cut off Medicare's rights to assert successor liability against the purchaser¹⁹ and limit Medicare's financial recovery to the fair market value of the Provider Agreement.

Selling Medicare and Medicaid Provider Agreements in bankruptcy free and clear of federal and state claims would greatly increase the value of these assets—and the other assets—of any health care entity, and SNFs in particular. If the debtor must assume and assign a Provider Agreement to realize any value, that value is substantially reduced by the need to cure defaults prior to assumption and the buyer's awareness that Medicare will assert successor liability for unpaid liabilities of the old owner. A §363 sale of the Provider Agreement allows the debtor to cut off those liabilities. The government will be hard-pressed to explain why the debtor's rights are converted to contractual rights by the filing of the bankruptcy petition.²⁰

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Footnotes

¹ Piller, Dan, "Nursing Home Firm Texas Health Enterprises Claims Bankruptcy," The Fort Worth Star-Telegram, Aug. 5, 1999. Return to article

² See 42 U.S.C. §1395(c)(c) (1999). Return to article

³ All references to "sections" herein are to sections of the Bankruptcy Code. Return to article

⁴ See 11 U.S.C. §365(b)(1)(A). Return to article

⁵ Case No. 98-609-B1, Order Authorizing Sale of Assets Out of the Ordinary Course of Business (Bankr. M.D. Fla., filed Nov. 16, 1998). Return to article

⁶ 1995 WL 65531, *7-8 (Bankr. S.D.N.Y. Jan. 27, 1995), aff'd, 184 B.R. 200 (S.D.N.Y. 1995). Return to article

⁷ 787 F.2d 834, 835-39 (2d Cir. 1986) ("Signing a provider agreement does not convert statutory mandates into a contract claim;" "[a]lthough the [Medicaid] relationship may be effectuated by means of a provider contract, all rights to reimbursement arise under the applicable statutes."). Return to article

⁸ See, e.g., Memorial Hosp. v. Heckler, 706 F.2d 1130, 1136-37 (11th Cir. 1983) (Existence of the provider agreement "did not obligate the secretary to provide reimbursement for any particular expenses."); 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); Greater Dallas Homecare Alliance v. United States, 10 F. Supp. 2d. 638 (N.D. Tex 1998) (Provider 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."); Germantown Hosp. and Med. Ctr. v. Heckler, 590 F. Supp. 24, 30-31 (E.D. Pa. 1983) ("There is no contractual obligation requiring H.H.S. to provide Medicare reimbursement."). But, see, Heckler v. Community Health Svcs. Inc., 467 U.S. 51, 55, 104 S.Ct. 2218, 81 L.Ed.2d. 42 (1984) (referring to the provider agreement as a "contract"). Return to article

⁹ See, e.g., In re University Med. Ctr., 973 F.2d 1065 (3d Cir. 1992); In re St. Johns Home Health Agency Inc., 173 B.R. 238 (Bankr. S.D. Fla. 1994). Return to article

¹⁰ "'When I use a word,' Humpty Dumpty said, in a rather scornful tone, 'it means just what I choose it to mean—neither more nor less.' 'The question is,' said Alice, 'whether you can make words mean so many different things.' 'The question is,' said Humpty Dumpty, 'which is to be master—that's all.'" Carroll, Lewis, Through the Looking Glass (C.L. Dodgson, ed.) 205 (934). Return to article

¹¹ Countryman, Vern, "Executory Contracts in Bankruptcy: Part I," 57 Minn. L.R. 439, 460 (1973); In re Murexco Petroleum Inc., 15 F.3d 60 (5th Cir. 1994); In re Texscan Corp., 976 F.2d 1269 (9th Cir. 1992). Return to article

¹² Black's Law Dictionary at 292. Return to article

¹³ King, Lawrence P., Collier on Bankruptcy, ¶ 541.LH[3][a], at 541-91 (15th ed. rev. 1999). Return to article

¹⁴ In re WPRV-TV Inc., 143 B.R. 315 (D. P.R. 1991), aff'd in part, rev'd in part, 983 F.2d 336 (1st. Cir. 1993); In re Moore, 110 B.R. 924 (Bankr. C.D. Cal. 1990). Return to article

¹⁵ See, e.g., Citicorp Homeowners Svcs. Inc. v. Elliot (In re Elliot), 94 B.R. 343, 345 (Bankr. E.D. Pa. 1988); Mutual Life Ins. Co. v. Red Oak Farms Inc. (In re Red Oak Farms Inc.), 36 B.R. 856, 858 (Bankr. W.D. Mo. 1984). Return to article

¹⁶ In re Terrace Gardens Park Partnership, 96 B.R. 707, 713 (Bankr. W.D. Tex. 1989) ("So long as a creditor's interest is adequately protected, the debtor is permitted to sell property of the estate."). Return to article

¹⁷ See, e.g., In re Beker Indus. Corp., 63 B.R. 474, 477 (Bankr. S.D.N.Y. 1986) ("collateralized property might be sold for less than the amount of a lien over the objection of a secured creditor where justified by special circumstances."); In re Hatfield Homes Inc., 30 B.R. 353, 355 (Bankr. E.D. Pa. 1983) ("if the proposed sale price is the best price obtainable under the circumstances of a particular case, then the fact that junior lienholders may receive little or nothing from the proceeds of the sale would not, standing alone, constitute reason for disapproving the proposed sale."). Return to article

¹⁸ See, e.g., In re Terrace Chalet Apartments Ltd., 159 B.R. 821, 829 (N.D. Ill. 1993); WPRV-TV, 143 B.R. at 321; In re Perroncello, 170 B.R. 189, 191 (Bankr. D. Mass. 1994) (all holding that a creditor who could be crammed down under §1129(b) could be compelled to accept a money satisfaction of its interest under §363(f)(5)). Return to article

¹⁹ See In re Leckie Smokeless Coal Co., 99 F.3d 573 (4th Cir. 1996) (The bankruptcy court may authorize a sale of a coal company's assets under §363(f)(5) free and clear of any successor liability of the purchaser under the 1992 Coal Industry Retiree Health Benefit Act for financial obligations of the debtor.). But, see, Royal Ins. Co. v. Smatco Indus. Inc., 201 B.R. 755 (E.D. La. 1996) (The non-bankruptcy law of successor liability was applicable even though the assets were acquired in a bankruptcy sale.). Return to article

²⁰ For an in-depth discussion of this and related issues, see Borders, Sarah Robinson and Moore, Rebecca Cole, "Purchasing Medicare Provider Agreements in Bankruptcy," California Bankruptcy Journal, Vol. 24, No. 3 (1998). Return to article