Editor’s note: Success in the restructuring and insolvency arena requires more than an understanding of the law—it requires the ability to address issues specific to a debtor’s industry and business. Below, two Reed Smith partners with extensive experience representing health care institutions and creditors discuss issues unique to hospitals facing financial distress.

Hospital bankruptcies are on the rise. In several states, regulators facing overcapacity have developed lists of hospitals and other health care institutions that are deemed not vital to the delivery of public health care services, and therefore are recommended for closure. Such a recommendation can be a death sentence to a health care institution that lands on the list. Many institutions so targeted are forced to shut down or sell.

Creditors should be aware that whether a hospital actually enters chapter 11 or seeks to restructure in the face of looming insolvency, many issues specific to this industry will need to be considered and addressed.

For-profits versus Nonprofits. Some states have laws restricting operation of hospitals by for-profit companies, thereby reducing the pool of potential purchasers for a nonprofit distressed hospital. Nonprofits are often run very differently from for profits. The board of a nonprofit hospital may consist of local business people, religious leaders, and others who place more weight on community interests than on the interests of creditors. Further, hospital management may not have the expertise to deal with severe financial constraints, and may require consultants that have that expertise.

Regulatory Oversight. State regulators may play a decisive role in determining the future of a distressed institution. The state attorney general is responsible for oversight of nonprofit institutions, and as such, attorneys general often are involved in the decisions as to whether a hospital should sell its assets or shut down. Further, a state may be the only source of funding for a hospital experiencing cash flow shortages or losses. In a bankruptcy situation, the health care ombudsman also plays a role in the process of hospital wind-downs, as well as in sale transactions and mergers.

Offset Issues. The primary payors for hospital services are ordinarily the federal and state agencies that oversee Medicare and Medicaid programs. Because of the way they pay for services, they may be owed significant sums because of overpayments prior to a bankruptcy filing. Often, the administrators of these programs are able to offset from future payments the amounts they believe are owed because of prior overpayments without seeking relief from the automatic stay. These offsets can wreak havoc on a hospital’s cash flow.

Collateral. Secured creditors should take a hard look at their collateral, including gross revenues, proceeds, accounts receivable, to determine whether they are properly perfected and whether they can be primed by creditors with rights of setoff or recoupment. Conflicts can develop between creditors holding security interests in receivables and creditors holding security interests in proceeds from sales of real property, and allocation issues may arise between equipment financers and other creditors.

Labor/Pension Issues. Whether a hospital is being shut down or sold, issues are likely to arise under collective bargaining agreements, ERISA or the Worker Adjustment Retraining Notification (WARN) Act.

Insurance. Issues particularly tend to arise with workers comp and malpractice (often covered via a captive offshore company). Creditors should check to see whether the entity is properly insured. If the policies are “claims made,” often a tail will need to be purchased. Staff physicians, nurses and other medical personnel will be concerned about ongoing malpractice coverage.

D&O Issues. Look at directors and officers’ insurance policies to determine coverage and when claims must be made. Be alert to possible claims. Is the board up to the task of restructuring the institution? 

Other Assets. Hospitals often hold assets in different entities, including foundations (the assets of which may be beyond the reach of creditors). Creditors may want to review intercompany transfers.

Bond Defaults. Often hospitals have bond debt as well as traditional debt from a lending institution. Be aware of the interplay between these obligations, as well as the role and rights of bond insurers.

Public Relations. Appropriate communication with the hospital’s major constituencies is important. Creditors should remember that they are in a fight to keep doctors and skilled nurses, as well as patients.

Distressed health care institutions often are faced with a host of issues unique to the industry. Creditors of hospitals in financial distress can increase opportunities for recovery by ensuring that they have a detailed understanding of the industry-specific issues involved, and by creating a detailed plan of action that addresses those issues.