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Extent of State’s Power at Issue in Nonprofit Hospital’s Asset Sale

A recent bankruptcy case in Southern California has raised significant questions about the limits, if any, on the power of state governments in approving or rejecting sales of assets of not-for-profit healthcare industry entities. With Congress focused on repealing the Affordable Care Act (ACA), which some experts suggest would reduce revenue to hospitals by more than $165 billion between 2018 and 2026,1 this issue is likely to arise repeatedly across the country moving forward. Increasing financial distress in the U.S. healthcare industry, which includes more than 2,800 nongovernmental not-for-profit community hospitals, is likely to lead to growing numbers of workouts and restructurings.

Until the U.S. Bankruptcy Code2 was amended by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA),3 bankruptcy courts frequently determined that they alone decided issues arising in connection with the application of the code to the sale of not-for-profit healthcare businesses.4 However, the 2005 amendments added provisions in three different places in the code dictating that the sale of not-for-profit assets in bankruptcy cases must be done in accordance with applicable nonbankruptcy law.5 

There is little legal precedent on these provisions,6 so the issue of what exactly they mean is unresolved. Do they mean that a state attorney general can impose conditions on the sale of a not-for-profit that effectively gut federal bankruptcy law protecting debtors? Do they mean that a state attorney general can impose conditions on a sale which require that the state, as a creditor owed money, be repaid either by the debtor or the buyer without regard to the effect of the Bankruptcy Code on its claim? Do they mean that a state attorney general’s review is beyond the scope of the bankruptcy court’s review? These issues have now been squarely raised in the bankruptcy case of Gardens Regional Hospital and Medical Center.7

Gardens is a nonprofit public benefit corporation that operates a hospital in California. Gardens has an institutional provider agreement and corresponding hospital enrollment and certification with the state of California, which enables it to receive payments from the state for services provided to Medi-Cal8 beneficiaries.

Gardens filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code in June 2016 and in July 2016 auctioned off its assets under Section 363 of the Bankruptcy Code for approximately $19.5 million. In addition to cash, the winning bid, among other things, provided for the continuation of the hospital’s medical services, including its emergency department; for the continued employment of at least half of the hospital’s nearly 300 employees; and for the transfer of the debtor’s Medi-Cal relationship to the buyer.

Because this was a sale of not-for-profit assets, under California law it was subject to review and approval by the state attorney general.9 In accordance with Section 363(d)(1), Gardens prepared and submitted an application to the attorney general seeking permission to close the sale, as required by applicable nonbankruptcy law. Eventually, the attorney general approved the sale but imposed numerous obligations on the buyer as conditions to the sale. 

Among the conditions were requirements that the buyer (a) continue to participate in the state’s Hospital Quality Assurance Fee (HQAF)10 program by “assuming all known and unknown monetary obligations under the Medi-Cal program” owed by Gardens, and (b) sign a financial responsibility agreement with the state, which also imposed successor liability on the buyer. Gardens allegedly owed approximately $2.4 million in unpaid prepetition fees related to the HQAF to the state.11

During the case the state timely filed a claim in an “undetermined” amount against the Gardens’ estate. The sole basis asserted for the state’s claim was described as “overpayment of Medi-Cal (Medicaid) program reimbursement payments for fiscal years ending December 31, 2014, -2015, and - 2016.” No claim was filed on behalf of the state for the amounts allegedly owed for the HQAF fees before the applicable deadline had passed. 

Violation of Automatic Stay or Lawful Condition?

Section 362 creates an automatic stay, which stops all efforts by creditors to collect on prepetition debt. Section 363(d)(1) requires sales of not-for-profit healthcare businesses to submit to applicable nonbankruptcy law, and California law allows the attorney general to impose conditions on the sale of not-for-profit assets. But if the attorney general can impose a condition requiring payment of a prepetition debt owed to the state, is that a violation of the automatic stay as set forth in Section 362 or a lawful condition imposed pursuant to the rule set by Section 363(d)(1)? 

Section 362(a) imposes a stay on any acts to collect on prepetition obligations, but Section 362(b)(4)
contains an exception to the automatic stay, which exempts the commencement or continuation of action to enforce police or regulatory powers. This exception is not unlimited, however.12 Courts have developed tests for whether a government act falls within this exception.

The first test is the “pecuniary purpose test,” which holds that governmental actions protecting or promoting public health and safety or other police or regulatory interests are exempt. However, if the government action is one to protect or promote pecuniary or financial interests, the exception does not apply.13

The other widely used test to determine if the governmental action is exempt from the automatic stay is the “public policy test.” Proceedings that adjudicate and effectuate public policy, as distinguished from those that adjudicate or vindicate private rights, are exempt from the stay.14 

Because there are no cases interpreting the scope of or limits on the state’s powers under Section 363(d)(1), theoretically the state could impose conditions on a sale requiring repayment of prepetition debts as a condition to the sale in bankruptcy, as California did with regard to the sale of Garden’s assets. However, the authors suggest that courts should apply the same tests as have been developed vis-à-vis Section 362(b)(4) so that the state could take acts or impose conditions as a prerequisite to the sale only in furtherance of a valid police or regulatory goal, not merely to advance its pecuniary interests as a creditor above the interests of other creditors.

Conflict with Section 525?

As part of its condition that the buyer cure the debtor’s claims to the Medi-Cal program, the state threatened to bar the buyer from further participation in that program if it failed to do so. Such a ban would result in the buyer forfeiting millions of dollars that would otherwise be paid to the hospital under the HQAF program. If the state could impose such a condition outside of bankruptcy, Section 363(d)(1) suggests that it could impose such a condition even in a bankruptcy sale. However, the authors think that such a result would run afoul of the protections of Section 525 of the Bankruptcy Code.

Although there is no precedent on point, blocking the buyer from participating in the HQAF program because of its failure to pay the prepetition HQAF claims of the state could constitute a violation of Section 525.15 That section provides that a government unit may not “deny, revoke, suspend, or refuse to renew a license, permit, charter, franchise or other similar grant to…a person that is or has been a debtor under this title…or another person with whom such bankrupt or debtor has been associated, solely because such bankrupt or debtor is or has been a debtor under this title or…has been insolvent before the commencement of the case…or has not paid a debt that is dischargeable in the case under this title….”16 

Except as it specifically provides, Section 525 prohibits a “governmental unit” from, among other things, discriminating against a party under a government program solely because the debtor has failed to pay a dischargeable debt. Perhaps the leading case interpreting Section 525 is the U.S. Supreme Court’s decision in Federal Communications Commission v. NextWave Communications, Inc.17 In Nextwave, the Federal Communications Commission (FCC) cancelled certain licenses owned by the debtor but denied that the proximate cause for its cancellation of the licenses was the failure to make payments due to the FCC. Instead, the FCC contended that Section 525 did not apply because the commission had a valid regulatory motive for the cancellation.

The Supreme Court gave short shrift to this argument, stating that the FCC’s motive was “irrelevant.” The court did not believe that the statute’s reference to a failure to pay a debt as the sole cause of cancellation of a license could be reasonably interpreted to include the governmental unit’s motive in effecting the cancellation. “Section 525 means nothing more or less than that the failure to pay a dischargeable debt must alone be the proximate cause of the cancellation — the act or event that triggers the agency’s decision to cancel, whatever the agency’s ultimate motive in pulling the trigger may be.”18 

The FCC contended that NextWave’s license obligations to the commission were not “debt[s] that [are] dischargeable” in bankruptcy. First, the FCC argued that regulatory requirements, such as a full and timely payment condition, are not properly classified as “debts” under the Bankruptcy Code. In the view of the FCC, the financial nature of a condition on a license did not convert that condition to a debt. The Supreme Court characterized this argument as nothing more than a retooling of the FCC’s argument that “regulatory conditions” should be exempt from Section 525. The court again dismissed this argument, saying “a debt is a debt,” even when the payment obligation is a regulatory requirement.19

The FCC also argued that NextWave’s obligations were not “dischargeable” in bankruptcy because bankruptcy courts did not have the jurisdictional authority to alter regulatory obligations.20 Noting that dischargeability is not tied to the existence of such authority, the court stated that a preconfirmation debt is dischargeable unless it falls within one of the exceptions to dischargeability contained in the Bankruptcy Code.

On several occasions, other courts have also held that Section 525(a) supersedes other provisions of the Bankruptcy Code with respect to government entities.21 Turning specifically to the interplay between Section 525(a) and other provisions of the Bankruptcy Code, courts have found that Section 525(a) was the more specific statute, and it was a “basic principle of statutory construction that a specific statute…controls over a general provision.”22 For example, in the housing context, the court found that Section 525(a) was more specific because, while Section 365 authorized landlords to evict debtor-tenants for nonpayment of discharged prepetition rent, Section 525(a) “specifically prohibits landlords who are also governmental units from evicting debtor-tenants solely because of nonpayment of discharged prepetition rent.”23 

With regard to Gardens, it seems that the conditions imposed by the California attorney general, albeit seemingly consistent with Section 363(d)(1), are in violation of Section 525, and the latter should control.24 If it does, the attorney general’s decision to compel repayment or be barred from the HQAF program is a violation of Section 525.

Unresolved Issue

While the Gardens case is still pending, it raises serious issues in the interpretation of Section 363(d)(1), on which precedent provides little guidance at the moment. In the current circumstances the only seemingly certain thing is that this issue will be raised again. 

  1. “Estimating the Impact of Repealing the Affordable Care Act on Hospitals,” American Hospital Association, aha.org/content/16/impact-repeal-aca-report.pdf.
  2. All references to “section” are to sections of the Bankruptcy Code, 11 U.S.C. §§ 101-1530.
  3. Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. 109-8, 119 Stat. 23.
  4. One of the most publicized cases dealing with this issue was the Chapter 11 bankruptcy of Allegheny Health Education and Research Foundation in 1998. For a detailed discussion of this case, see L.R. Burns, J. Cacciamani, J. Clement and W. Aquino, The fall of the house of AHERF: the Allegheny bankruptcy, Health Affairs 19, no. 1 (2000), content.healthaffairs.org/content/19/1/7.full.pdf+html?sid=2eafd938-3671-4d48-9051-547793d6a22e. In AHERF the Bankruptcy Court refused the requests of the attorney general to allow it to investigate AHERF’s use of restricted endowments, to appoint an interim trustee, and to allow it to review any bids before the assets were sold. In re Bankruptcy Appeal of Allegheny, Health, Education and Research Foundation, Appeal of Order Staying/Enjoining Orphans Court Proceedings, 252 B.R. 309 (W.D. Pa. 1999).
  5. 11 U.S.C. Subsection 363(d)(1) (Trustee may use, sell or lease property of the estate “only in accordance with applicable nonbankruptcy law that governs the transfer of property by a corporation or trust that is not a moneyed, business or commercial corporation or trust.”); 541(f) (Property held by a debtor that is a not-for-profit corporation under Internal Revenue Code § 501(c)(3) may be transferred to an entity that is not such a corporation “only under the same conditions that would apply if the debtor had not filed a case” under the Bankruptcy Code.); 1129(a)(16) (A Chapter 11 plan can only be confirmed if all transfers of property are “made in accordance with any applicable provisions of nonbankruptcy law that govern the transfer of property by a corporation or trust that is not a moneyed, business, or commercial corporation or trust.”) 
  6. An earlier article on these provisions is Samuel R. Maizel and Mary D. Lane, “The Sale of Nonprofit Hospitals through Bankruptcy: What BAPCPA Wrought,” ABI Journal, Vol. XXX, No. 5, June 2011.
  7. In re Gardens Regional Hospital and Medical Center, Inc., Case No. 2:16-bk-17463-ER (Bankr. C.D. Cal.). 
  8. Medi-Cal is California’s Medicaid program. It provides healthcare services for, among others, low-income individuals. www.dhcs.ca.gov/services/medi-cal/pages/default.aspx. 
  9. Cal. Corp. Code Sections 5914-5925; 11 Cal. Code Reg. Section 999.5. Examples of the kinds of conditions imposed by the California Attorney General can be found at California Department of Justice, Nonprofit Hospital Transaction Notices, available at oag.ca.gov/charities/nonprofithosp.
  10. HQAF imposes a fee on certain general acute care hospitals to make supplemental and grant payments and increased capitation payments to hospitals. www.dhcs.ca.gov/provgovpart/Pages/HQAF.aspx (“The program provides funding for supplemental payments to California hospitals that serve Medi-Cal and uninsured patients. Revenue from the HQAF also provides funding for children’s health care coverage, pays direct grants to public hospitals, and reimburses DHCS for the direct costs of administering the program. The program has been very successful, providing billions of dollars in supplemental payments to California hospitals.”).
  11. The state “assesses a fee on certain general acute care hospitals to be used, for the most part, as the non-federal share of supplemental Medi-Cal payments to eligible hospitals for inpatient and outpatient services. The money collected is deposited into the hospital quality assurance revenue fund.” Id.
  12. See State of Missouri v. U.S. Bankruptcy Court, 647 F.2d 768, 776 (8th Cir. 181) (“[W]e believe that the term ‘police or regulatory power’ refers to the enforcement of state laws affecting health, welfare, morals, and safety, but not regulatory laws that directly conflict with the control of the res or property by the bankruptcy court.”).
  13. In re Medicar Ambulance Co., Inc., 166 B.R. 918 (Bankr. N.D. Calif. 1994). 
  14. Medicar Ambulance Co., Inc., 166 B.R. at 926-27.
  15. Hiser v. Blue Cross of Greater Philadelphia (In re St. Mary Hospital), 89 B.R. 503, 513 (Bankr. E.D. Pa. 1988) (Court held that Section 525(a) barred the Medicare Program from requiring the debtor to repay prepetition obligations as a condition for remaining in the Medicare Program.).
  16. 11 U.S.C. Section 525(a). See In re Sun Healthcare Group, Inc., 2002 U.S. Dist. LEXIS 17868 (D. Del. 2002); In re Psychotherapy & Counseling Ctr., Inc., 195 B.R. 522, 531 (Bankr. D.C. 1996) (“were HHS’s exclusion [from Medicare and state health care programs] based solely on the debtor’s nonpayment of debt, it might run afoul of the Code’s antidiscrimination provision under 11 U.S.C. § 525(a) . . . . This sort of government action, which would interfere with the debtor’s breathing spell and fresh start, is just the sort of discriminatory activity 11 U.S.C. § 525(a) was intended to prevent.”).
  17. 537 US 293, 123 S.Ct. 832 (2003). 
  18. 123 S.Ct. at 838-39.
  19. Id. at 839. See also Bradley v. Barnes (In re Bradley), 989 F.2d 802 (5th Cir. 1993) (“Section 525 does not prohibit a state from denying or revoking a license based upon a determination that the public safety would be jeopardized by granting or allowing continued possession of a license, but it does prohibit a state from exacting a discharged debt as the price of receiving or retaining a license.”).
  20. Courts have noted the broad jurisdiction of bankruptcy courts in general, and when ruling pursuant to Section 525 in particular.  See, e.g., Applegate v. March, 64 B.R. 448, 450 (Bankr. E.D. Va. 1986) (“No court in the realm holds such a wide subject matter jurisdiction as does the Bankruptcy Court … the entirety of §525, every word, is utterly sweeping.”).
  21. See, e.g., 315 F.3d 80 (2d Cir. 2002).
  22. Id. at 93 (quoting HCSC-Laundry v. United States, 450 U.S. 1, 6 (1981)).
  23. Id. See also In re Aikens, 503 B.R. 603, 607-08 (Bankr. S.D.N.Y. 2014) (finding that Section 362(b)(22) was the “more general” statute because it “applies to all landlord and tenant relationships, public and nonpublic alike,” whereas Section 525(a) applies “to the subset of such relationships that are with government units alone”).
  24. See, e.g., In re St. Mary Hospital, 89 B.R. at 512 (Court held that Section 525(a) “eliminates” the right of the Medicare Program to compel a debtor to accept Medicare’s recoupment of prepetition obligations as a condition for utilization of its Medicare provider agreement, even though Section 365(b)(1) would otherwise require it.).
Sam Maizel

Samuel R. Maizel

Dentons US LLP

Samuel R. Maizel is a partner in Dentons US LLP’s Restructuring, Insolvency and Bankruptcy group in Los Angeles and leads the firm’s healthcare industry restructuring efforts nationwide. He has served as lead bankruptcy counsel to healthcare debtors and creditors committees in Chapters 9 and 11 cases, and as counsel to Chapter 7 and 11 trustees. Maizel also has served as an examiner, Chapter 11 trustee, patient care ombudsman, and consumer privacy ombudsman. He previously was a partner in a national bankruptcy firm and a trial attorney in the U.S. Department of Justice.

Khoi Ta

Khoi Ta

Dentons US LLP

Khoi Ta is a managing associate in Dentons US LLP’s San Francisco office. His practice focuses on the structuring and negotiation of healthcare transactions, and he advises hospitals and providers on complex regulatory compliance issues and operational matters. Ta holds degrees from the University of California at Berkeley School of Law and the Woodrow Wilson School of Public and International Affairs at Princeton University.

Matthew Weiss

Matthew Weiss

Dentons US LLP

Matthew Weiss is a managing associate in the Atlanta office of Dentons US LLP, where he focuses on bankruptcy, insolvency-related litigation, and governmental and regulatory litigation. He attended the University of Georgia and later its law school, where he served as the executive notes editor of the Georgia Law Review. Before joining Dentons, Weiss clerked for U.S. District Court Judge Marvin H. Shoob in the Northern District of Georgia. 

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