State Regulators Order Financially Distressed Health Care Businesses to Cease and Desist

State Regulators Order Financially Distressed Health Care Businesses to Cease and Desist

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A quick glance at the headlines of newspapers around the country illustrates the uncertainty in the health care industry today. No sector of the health care industry seems to be immune from the turmoil. For example, many health maintenance organizations (HMOs), hospital chains, physician practice management companies, home health agencies and therapy companies are experiencing financial difficulty as a result of many factors, including the failure to integrate recently acquired companies, changes in Medicare reimbursement rates and excess beds in particular areas of the country. As a result, many health care companies are restructuring their operations or simply closing their doors.

The restructuring of a health care business raises unique issues, many of which arise as a result of the unique set of players involved in a health care business. In all bankruptcy cases, the cast of characters involved generally includes the banks, employees, taxing authorities, general unsecured creditors, official committee of unsecured creditors and the equity holders. In a health care restructuring, generally all of the foregoing constituencies are involved, but new players are thrown into the mix--namely doctors, nurses, therapists and other health care providers who have a set of interests somewhat unique from the typical employee, patients, community and, most importantly, Medicare, Medicaid and other state and federal agencies charged with regulating the health care industry.

In recent months, as the number of health care restructuring situations has continued to rise, federal and state regulators have become heavily involved. For example, based on several newspaper reports, on March 5, 1999, the California Department of Corporations (DOC) issued a cease-and-desist order against MedPartners Provider Network Inc. (MPN), appointed a conservator to operate the business and ultimately plunged MPN into bankruptcy.

The Knox-Keene Act

To accomplish this feat, California utilized its powers under the Knox-Keene Health Care Service Plan Act of 1975.1 California requires managed care companies to obtain a limited license under the Knox-Keene Act so that the state can regulate and monitor the financial condition of those entities and ensure patient care and physician financial security. A Knox-Keene license can take more than one year to obtain and can cost upward of $1 million. Further, a Knox-Keene applicant must meet rigorous financial standards.

Pursuant to the Knox-Keene Act, the DOC is given broad latitude to develop and enforce regulations on managed care. The DOC's responsibility is to make certain that health plans are financially capable of delivering promised services to patients and to promote the delivery of health and medical care and services to the people of California who are enrolled in the health care plans. Specifically, in furtherance of those goals, the Knox-Keene Act directs the DOC to accomplish this by:

  1. Assuring the continued role of the professional as the determiner of the patient's health needs, which fosters the traditional relationship of trust and confidence between the patient and the professional.
  2. Assuring that subscribers and enrollees are educated and informed of the benefits and services available in order to enable a rational consumer choice in the marketplace.
  3. Prosecuting malefactors who make fraudulent solicitations or who use deceptive methods, misrepresentations or practices that are inimical to the general purpose of enabling a rational choice for the consumer public.
  4. Helping to assure the best possible health care for the public at the lowest possible cost by transferring the financial risk of health care from patients to providers.
  5. Promoting effective representation of the interests of subscribers and enrollees.
  6. Assuring the financial stability of the health care business by means of proper regulatory procedures.
  7. Assuring that subscribers and enrollees are able to access and receive health and medical services rendered in a manner providing continuity of care.

The Knox-Keene Act also enables the commissioner of the DOC to adopt any rules or issue any orders deemed necessary and appropriate to accomplish those goals if they are in the best interests of the public and are not detrimental to the protection of the subscribers, enrollees and persons regulated under the Knox-Keene Act. It is through this aspect of the Knox-Keene Act that the DOC issued a cease-and-desist order against MPN.

Restructuring Situations

Under the Knox-Keene Act, the DOC has the right to take the reins of any corporation that fails to maintain adequate financial reserves or otherwise endangers patients (or enrollees) under the capitation arrangements. Pursuant to these provisions of the Knox-Keene Act, the DOC has attempted to enforce the provisions of the act in two high-profile cases. The DOC ordered a financial audit that reportedly uncovered that MPN had posted sizeable losses in late 1998. The audit allegedly also found that MPN itself was in a troubled financial position, having amassed significant liabilities and debts. State regulators were concerned that MPN would be unable to continue to pay its providers, and by issuing the cease-and-desist order, the DOC claimed to be taking steps to ensure that MPN continued to meet its obligations to provide health care services in accordance with the Knox-Keene Act. In practical terms, the main purpose of the cease-and-desist order appeared to be to prohibit MPN from upstreaming funds to its parent company or affiliates. These actions were consistent with the provisions of the Knox-Keene Act, which requires licensed health care service plans to maintain independent financial integrity and viability.2

Subsequently, the DOC took further actions by appointing a conservator to manage MPN for the benefit of enrollees and providers in California. Shortly thereafter, the conservator filed a voluntary chapter 11 bankruptcy case on behalf of MPN. One of the DOC's goals in placing MPN in bankruptcy reportedly was to protect the assets of MPN for the benefit of the California enrollees and the providers who render health care services to those enrollees.

The actions of the DOC against MPN may seem drastic, even draconian. However, the DOC also took fairly aggressive action in the chapter 11 cases commenced by FPA Medical Management Inc. (FPA) and certain of its affiliates. Last year, California physicians employed by FPA criticized the DOC for failing to promptly intervene when FPA encountered financial problems. FPA subsequently declared chapter 11 last summer after falling behind in payments to creditors, including doctors and other health care providers. (In re FPA Medical Management Inc. et al., Case No. 98-1596 (PJW).)

One of FPA's affiliates held a Knox-Keene license, and as a result of the bankruptcy filing, many doctors were not paid for services provided to patients in California prior to the commencement of the bankruptcy cases. In the FPA chapter 11 cases, the DOC was involved primarily in opposing the entry of an order approving the post-petition financing. Based upon the post-petition financing arrangement, FPA and all of its affiliates and related companies were required to guaranty the full amount of the post-petition financing, including the entity holding the Knox-Keene license. In addition, FPA and all of its affiliates and related companies indicated that the cash management system in place would continue, which resulted in the upstreaming of monies from the entity holding the Knox-Keene license to FPA, the parent corporation.

The DOC argued that the entity holding the Knox-Keene license could not guaranty the post-petition financing or upstream any monies because these actions directly violated the Knox-Keene Act. In making these arguments, the DOC expressly relied upon 28 U.S.C. §959(b), which provides that a debtor must comply with all applicable state law, including the Knox-Keene Act:

[A] trustee, receiver or manager appointed in any cause pending in any court of the United States, including a debtor-in-possession, shall manage and operate the property...according to the valid laws of the state in which the property is situated.

Ultimately, the bankruptcy court overruled the DOC's arguments, noting that those provisions of the Knox-Keene Act regulating the financial condition of a health care business in no way impacted the health, safety or welfare of patients. Generally, cases interpreting 28 U.S.C. §959(b) have limited a debtor's requirement of complying with state laws to those state laws that are reasonably calculated to protect the public's health or safety from imminent or immediate harm.3

Furthermore, those provisions of the Knox-Keene Act regulating the financial condition of a health care entity overlap with various provisions of the federal Bankruptcy Code; in particular, the Code contains many provisions "regulating" the financial condition of a debtor, including 11 U.S.C. §364, which allows for post-petition financing. As a result, federal bankruptcy law, and not the state Knox-Keene Act, was held to be determinative of whether the post-petition financing was appropriate.

Finally, the bankruptcy court also noted that under the Knox-Keene Act, providers of health care services, such as doctors, were entitled to be paid before other general unsecured creditors. Based upon the Knox-Keene Act, if the DOC had intervened prior to the bankruptcy filing, doctors and other health care providers likely would have held claims of higher priority than other general unsecured creditors. While policy reasons exist for paying health care providers in order to ensure continuity of care, the bankruptcy court noted that this priority in payment clearly conflicted with federal bankruptcy law. As a result, based upon the pre-emption clause of the Constitution, the court held that the federal bankruptcy law, not state law, governs the priority of payments to creditors.


It is clear that California, through the Knox-Keene Act, is intent on entering the distressed health care world and playing a role as both a supporter of providers and protector of patients. However, in a bankruptcy case, the enforceability of state laws such as the Knox-Keene Act is not so clear, and may at times conflict with the bankruptcy laws. It will be interesting to see how the DOC and other states react to and address the rising tide of health care insolvencies.


1 Cal. Health & Safety Code, §§1340 et seq. Return to article

2 Cal. Health & Safety Code, §§1340 et seq. Return to article

3 Midlantic Nat'l Bank v. New Jersey Dept. of Env. Protection, 106 U.S. 755, 762 n.9 (1986). Return to article

Journal Date: 
Tuesday, June 1, 1999