1. Obtaining a Judgment

Collection actions are commenced by the filing of a form complaint. A defendant typically has 30 days after the service of the collection complaint to respond by filing an answer. If no timely response is filed, the plaintiff may request a default judgment. To obtain a default judgment, the creditor typically must file a request to enter default, and then file a motion to prove up the default and obtain entry of the judgment. If the defendant answers the complaint, the plaintiff will be required to carry his case to trial, unless there is no dispute regarding the facts surrounding an obligation, in which case, the plaintiff may be able to obtain a summary judgment.

When faced with financial problems, debtors often file general denials to collection complaints, which give them additional time to attempt to work their way out of their financial problems.

2. Provisional Remedies

A provisional remedy is an order entered that grants the plaintiff some protection that assets will exist when a judgment is eventually entered. The chief provisional remedy available to an unsecured creditor is an order for a writ of attachment, which operates to attach some asset of the debtor. Through the attachment procedure, the plaintiff can obtain a lien on one or more of the defendant’s assets while the complaint is prosecuted in court. If a judgment is eventually obtained, the judgment is considered secured by the attached assets as of the date of the attachment rather than the date of judgment.

In a health care setting, where a troubled facility is likely to be under threat of being closed by the applicable regulators, the prospect of attaching assets, such as a payroll account, might well prompt immediate payment of a past due invoice. On the other hand, a wrongful attachment (i.e. an. attachment for a claim which is later disallowed), which forces the closure or the bankruptcy of the entity, could lead to enormous damages. Because of the drastic consequences of an attachment, great care must be taken in deciding on a strategy that could prompt the regulators to close the entity.

Another consideration in deciding whether to seek an attachment is the cost. There are many procedural requirements for attachments, but in a case where assets exist to be attached, and the creditor is owed a substantial sum, an attachment is well worth the cost. However, obtaining an attachment may force the debtor into bankruptcy.

From the point of view of representing a troubled MCO, there are many technical defenses to a writ of attachment.

3. Post-Judgment Remedies

Once a judgment is obtained, the creditor must find and execute on nonexempt assets. One of the first steps is to conduct a computerized asset search, from a number of data services and search firms, including Information America and Lexis. These searches can reveal if the debtor owns any real property.

Once assets are discovered, the judgment creditor must move as quickly as possible to secure the judgment amount by property of the debtor. There are numerous mechanisms for perfecting the judgment by recording liens on various assets owned by the debtor.

For example, in California, a judgment creditor can record an abstract of judgment in a county recorder’s office, which creates a lien in favor of the judgment creditor on all real property located in that county. Cal. Civ. Proc. Code §674. It also acts as a lien against real property to which the judgment debtor may obtain title in the future. Id. In addition to abstracts of judgment, judgment creditors can usually become secured by all the personal property owned by a judgment debtor through a filing with the Secretary of State, and can execute on specific assets that are discovered by obtaining writs of execution issued by the Court and enforced by the applicable authority, typically the local sheriff.

Speed is especially important when one considers that once a company begins to allow judgments to be entered against it, such companies are likely candidates for bankruptcy. By securing a judgment, the creditor can move ahead of the defendant’s other creditors, as long as the security is obtained more than ninety (90) days prior to the bankruptcy filing (see below for discussion of preference issues).

If assets are not readily available, the creditor can also examine a principal of the judgment debtor under oath as to its assets. Third parties owing money to the creditor can also be examined. After these examinations, the creditor again must move very quickly to attach or levy on any available assets.

4. Receivership

In the health care area, where preservation of the value of a facility as a going concern is often the only mechanism for being paid,. the appointment of a receiver may be the best solution to prompt payment of an unsecured claim that has been reduced to a judgment.

5. Limited Collection Strategy

Instead of immediately seeking an attachment on an asset, which is essential to the debtor’s survival, or a receiver after entry of judgment, the judgment creditor could take limited collection action. For example, recording an abstract of judgment (to become secured by any real property owned by the debtor) and filing a notice of lien with the Secretary of State (to become secured by the personal property), are non-obtrusive collection actions, which might not prompt the bankruptcy filing. If 90 days elapse (the bankruptcy preference period for non-insiders, see below) before the debtor seeks bankruptcy protection by filing a chapter 11 case, the judgment creditor enters the bankruptcy as a fully secured creditor as opposed to an unsecured creditor, and might recover 100% of its claim as opposed to little or nothing.

In collecting from a healthcare organization, one must constantly examine the impact of collection activities on the going concern value of the business, as well as the ultimate priority of payments in a chapter 11 bankruptcy case.

B. Secured Creditor Remedies

Secured creditors are obviously in much better shape then unsecured creditors. They, however, may face even greater risk. The secured creditors exposure could be much higher, depending on whether the going concern value of the debtor can be maintained. The ability to repay all creditors is frequently much greater if the debtor can continue as a going concern. Chapter 11 restructuring frequently requires secured creditors to permit the debtor to continue to use their secured collateral.

As such, even though at first glance the holder of the first priority security interest on the real and personal property appears well protected, this creditor probably also faces the most risk of any of the creditors in the case. Set forth below are some of the issues that face a secured creditor when dealing with a troubled MCO.

1. Cash Generation at Creditors’ Expense

Creditors whose collateral is inventory and/or receivables should be wary of the possibility that the debtor will sell inventory and collect receivables to generate the funds for its bankruptcy. Also, a large inventory order from the debtor when it is delinquent on previous orders may be an indication that the debtor is building inventory in anticipation of bankruptcy.

2. Claim and Delivery.

Claim and delivery (referred to as replevin in most states) is the procedure by which a secured creditor obtains possession of its collateral during an ongoing lawsuit. It is very similar to a writ of attachment, except that the creditor already has a security interest in the asset to be repossessed, and the creditor may sell the asset during the pendency of the litigation whereas an attached asset cannot be sold until after a judgment is entered.

Even though the secured creditor sells the collateral, the lawsuit continues, and if it is later determined that the secured creditor was not entitled to take the collateral, the secured creditor is liable for any resulting damages to the debtor.

3. Foreclosure on Real Property

Foreclosure on the real property is strictly a creature of state law and each state has different procedures that a secured creditor must follow in order to complete the foreclosure sale, and, if possible, to obtain a deficiency judgment.

4. Foreclosure on Personal Property

Healthcare debtors often hold significant personal property, including equipment, beds and food inventory. When a secured creditor (including a landlord) attempts to foreclose on these assets, it must, if the state has adopted the UCC, comply with section 9504 of the Uniform Commercial Code. Section 9504 requires a public or private auction after specified notices to the debtor and a sale in a commercially reasonable manner.

If a secured creditor forecloses on the real property, obtains a deficiency judgment, but simply retains the personal property collateral without complying with section 9504, it may result in the secured creditor’s loss of its right to collect on the deficiency judgment. Retaining collateral in satisfaction of a debt is called a "strict foreclosure." UCC §9505(2). Failure to comply with notice and sale requirements will also result in loss of the right to a deficiency. UCC §§9502, 9504.

Another typical example with regard to insolvent provider facilities would involve a landlord who is also secured by all the personal property located at the facility. The tenant may voluntarily relinquish control of the facility back to the landlord, and the landlord simply retains all the equipment, inventory, beds, linens, and other personal property assets, and relets the facility to a replacement operator (who initially operates under a management agreement with the prior tenant). The act of retaining the personal property collateral, will probably be deemed to be a strict foreclosure under section 9505, and any deficiency claim against the debtor, and possibly any guarantors will be lost.

C. Receivership

In the health care context, receiverships are often the pre-foreclosure or pre-unlawful detainer remedy of choice. Simply, the great damage that can occur to the value of the real property from the closure of a health care facility almost mandates that a landlord or a secured creditor act to preserve the going concern value of the facility. Landlords and secured creditors are often much more willing to extend additional funds to preserve the value of a facility once a receiver is in place.

Once appointed, the receiver operates under the court’s instructions not the instructions of the secured creditor. The receiver will maintain the business, pay obligations, and otherwise do as instructed by the court. The receiver must prepare a final accounting and inform the court as to disposition of all funds collected and spent during his tenure.

D. Involuntary Bankruptcy

The Bankruptcy Code allows three creditors (one if the debtor has less than 12 total creditors) who have claims that aggregate in excess of $10,000, to file an involuntary bankruptcy case. 11 U.S. C. §303. If regulators are about to close a healthcare facility because of health care violations or because of fraud allegations, unsecured and undersecured creditors probably have an identity of interest in moving quickly to file an involuntary chapter 11 and move immediately for a chapter 11 Trustee, who may have more credibility with the regulators. See generally Bankruptcy Section, below. In the Matter of New Center Hospital, 179 B.R. 848 (E.D. Mich. 1994) concerned a hospital that created a health services corporation and several cliriic corporations, transferred substantial hospital funds to them to acquire practices, and was subsequently put into involuntary chapter 11 bankruptcy. The reported opinion concerned a motion by goverrunent creditors to consolidate assets of the related corporations, due to the hospital’s operation of them as "alter egos," and its "shameful conduct" in transferring funds among entities and bank accounts to avoid creditors’ liens. A wrongful filing, however, can subject the filing creditors to significant damages. 11 U.S.C. § 303(i) (if bad faith is shown, can include punitive damages).

A. Asset Testimony

Assume that an insolvent IPA offers creditor-providers 40% of the amount owed immediately in full satisfaction of their claim. Initially, the creditors could ask the IPA to voluntarily submit to an examination or deposition regarding its assets and liabilities. If, after reviewing all the assets, liabilities, and the risks of going forward with a collection action, the providers decide to accept the 40% in full satisfaction of their claim, it could include in the settlement agreement a specific warranty as to the truth of the testimony, and if hidden assets are later discovered, the amount written off might be reinstated as a claim.

B. Release

If the defendant requests any modification to the credit terms, the creditor will usually request a complete release from the defendant of any known or unknown claims. Although a debtor is often willing to execute such a release to gain just a little more time to work its way out of its immediate problems, the giving of the release may not be worth the short delay without a full evaluation of all potential claims against the lender.

C. Preference Concerns

If a creditor accepts 40% in full satisfaction of its claim, executes a mutual release of all known or unknown claims, and if the IPA then files bankruptcy in the next 90 days, it is very likely that the creditor will be sued by the IPA or by a successor trustee for a preference in the amount received, and its claim in the case might be limited to the 40% not the full 100% claim amount because of the mutual release.

To avoid this result, the release should have a "pop up" feature that revives the full claim if the creditor is later forced to disgorge the preference. Second, one can be somewhat creative in attempting to document a settlement to avoid the preference risk. For example, can a $250,000 claim be sold to the owner of the debtor for $100,000, who then settles directly with the IPA for $100,000. From the owner’s perspective this is a very bad deal, because insiders are subject to a one year preference period as opposed to a ninety day preference period.

D. Security Interest and/or Guarantees

If an immediate discounted payment is not possible, the debtor will likely be requesting a structured repayment plan. The creditor should seek to obtain as much security or additional security for the obligation as can be obtained, whether by obtaining new collateral for the obligation, or by having a principal personally guarantee the obligation. However, both are potential preferences.

The debtor is typically unrealistic about the likelihood of the proposed workout’s success, and therefore are often willing to give up valuable collateral to obtain a deal that will never work. Many chapter 11 cases follow 91 days (i.e. just after the 12 preference period has elapsed) after a failed workout. As counsel for a debtor, one must always ask the debtor or its financial advisors, whether the business should file now, or accept the workout. During a workout, the debtor should probably hire either bankruptcy counsel, or a financial workout specialist who has significant bankruptcy experience.

In a workout, the creditors might seek a blanket security interest in the real and personal property, general intangibles, contract rights, and any other type of asset that a talented transactional attorney can draft into the collateral description. Although the debtor would probably grant such security to avoid an immediate filing, it probably would be better served to file the chapter 11 immediately with a lower amount of secured debt.

E. Integration Clauses

Beware of informal settlement negotiations. The debtor may later answer the collection complaint by stating that the creditor defaulted on an oral agreement to give the defendant more tirne to repay the obligation. Any workout agreement should be in writing and include a detailed integration clause that supplants any prior oral discussions.

F. Pre-Packaged Bankruptcy Case

At times, creditors will enter into significant discussions with a debtor with respect to the debtor’s plan of reorganization that would emerge when a bankruptcy is filed. These global agreements are typically entered into by the debtor, a secured creditor or creditors, and a committee of unsecured creditors. By negotiating outside of bankruptcy, the costs of the bankruptcy may be reduced, and the creditors may be able to recover a higher percentage of their claims.

Often, a pre-packaged bankruptcy will involve a sale of the business as part of a consensual liquidation plan. PCLI, a former publicly traded clinical lab, recently completed a pre-packaged bankruptcy in which a new buyer invested working capital for a controlling equity interest, disadvantageous leases and other liabilities were shed, the successor to a secured creditor took new equity and new secured notes, and the old equity was essentially wiped out. In re Physicians Clinical Laboratory, Inc., SV96-23185-GM (C.D. Calif. 1997).

1. Debtor in Possession ("DIP")

A debtor in possession is a debtor who retains possession and control of its business and property which is what happens in the vast majority of chapter 11 cases. The DIP is authorized to continue to operate its business and may manage the assets of the bankruptcy estate, without court approval, as long as the transactions entered into are in the "ordinary course of business." 11 U.S.C. §§1107-08. Any transactions outside the ordinary course of business require bankruptcy court approval.

(a) HMOs As "Domestic Insurance Company" Exempted from Bankruptcy Jurisdiction.

Section 109(b)(2) exempts a "domestic insurance company" from the class of persons eligible to be a debtor in bankruptcy. This is because alternate provision is made for their liquidation under state laws. Whether an HMO is a "domestic insurance company" is a question of state law under the law of its state of incorporation, and different results have been obtained in different states. See, In the Matter of Estate of Medcare HMO, 998 F.2d 436 (7th Cir. 1993)(Medcare found to be an Illinois domestic insurance company); In re Family Health Services, Inc,, 143 B.R. 232 (C.D. Calif. 1992) (Maxicare found to be a Wisconsin domestic insurance company, on motion by the Wisconsin Insurance Commissioner, and therefore not eligible for bankruptcy court protection.) (the authors were counsel of record to CalPERS); In re Beacon Health, Inc., 10 B.R. 178 (D.N.H. 1989) (Beacon Health not eligible for bankruptcy as a domestic insurance company under New Hampshire law); In re Portland Metro Health, Inc., 15 B.R. 102 (D.Ore. 1981)(Portland Metro Health held to be a domestic insurance company); In re Master Health Plan Inc., M. C. 197-021 (S.D. Ga. June 18, 1997)(Georgia HMO held to be ineligible for bankruptcy court protection); In re Grouphealth Partnership, Inc., 137 B.R. 593 (E.D. Penn. 1992)(Pennsylvania HMO not excluded from bankruptcy court protection where insurance commissioner consented to bankruptcy court jurisdiction); In re Michigan Master Health Plan, Inc., 90 B.R. 274 (E.D.Mich. 1985)(Michigan Master held not to be a domestic insurance company, and therefore was subject to involuntary bankruptcy). In California, HMOs are regulated by the Department of Corporations rather than the Department of Insurance, and it is an open question whether they are domestic insurance companies. Many courts examine the McCarran-Ferguson Act, 15 U.S.C. Section 102, for definitional support in considering whether the "business of insurance" is involved. E.g., In re Grouphealth Partnership, Inc., Id., at 599. (See also, In the Matter of Miami General Hospital, Inc., 111 B. R. 363 (S. D. Fla 1990), where the HMO parent of a hospital went into state court receivership as an insurance company, but the Receiver ran the subsidiary hospital, which later was placed in involuntary bankruptcy by its creditors, and where the Receiver’s expenses for running the hospital in bankruptcy were not allowed as administrative expenses. Finally, see Garcia v. Island Program Designer Inc., 875 F. Supp. 940 (D. Puerto Rico 1994), in which the court found an insolvent HMO’s $100,000 deposit with the Department of Insurance for the benefit of policy holders to be subject to the IRS’s priority statutory lien under 31 U.S.C. Section 3713, as against claims by providers, who stood in second place behind policy holders under the insurance laW. The court found that, while the local jurisdiction’s insurance law might have preempted federal law as to the policy holders’ claims under McCarran-Ferguson, the providers’ claims were not the "business of insurance," and therefore federal law prevailed.)

2. Bankruptcy Judge

The bankruptcy judge’s role in the chapter 11 case is usually limited to applying the law to the facts as issues are presented by the parties. However, judges also have the power to take actions on their own to enforce or implement court orders or rules, or to prevent an abuse of process. 11 U.S. C. §105.

A recent trend has developed where bankruptcy judges are taking a much more active role in the management of chapter 11 cases. They have been using section 105 for a variety of purposes, including the setting of status conferences, and the sua sponte appointment of chapter 11 trustees.

3. United States Trustee

The office of the United States Trustee ("U.S. Trustee") is part of the U.S. Department of Justice. The U.S. Trustee was created to reduce the administrative burdens on the bankruptcy courts and to supervise the administration of cases. 28 U.S.C. §586(a)(3). For example, if a debtor fails to follow the laws and rules governing its conduct as a debtor in possession, the U.S. Trustee may bring a motion to dismiss the case or to convert the case to a chapter 7. 11 U. S. C. §112.

The U.S. Trustee also appoints the chapter 7 trustees and, when ordered by the bankruptcy court, a chapter 11 trustee. However, the role of the U.S. Trustee and the role of a chapter 7 or a chapter 11 trustee should not be confused.

If appointed, the chapter 11 trustee takes possession of the debtor’s assets and either liquidates the assets or continues to operate the company in the ordinary course of business. The chapter 7 trustee usually closes the business and liquidates the debtor’s assets. The U.S. Trustee serves mainly as an interested bystander in the case. The U.S. Trustee may act as a chapter 7 or 11 trustee, if no chapter 7 or chapter 11 trustee can be appointed. 28 U.S.C. §§586(a)(1) and (2).

4. Creditors’ Committees

(a) Unsecured Creditors’ Committee

As soon as possible after the filing of each chapter 11 case, the U.S. Trustee appoints a committee of the seven largest creditors from a list of the twenty largest unsecured creditors provided by the debtor. These twenty creditors will receive notice of the formation of a committee and an invitation to join it. If they respond affirmatively, they will receive notice of their appointment. The creditors. however, can choose not to serve on the committee.

The committee meets at various times during the bankruptcy case and may retain counsel to represent it. The counsel is generally paid from funds of the bankruptcy estate as an administrative expense. The existence of an unsecured creditors’ committee gives smaller unsecured creditors a vehicle for bargaining and negotiating within the bankruptcy case that the creditors would not possess individually.

Even if the case were a 100% repayment case, and even if the unsecured creditors were operating under a contract that allowed for the payment of attomeys fees and costs for collection activities, unsecured creditors as a general rule are not entitled to reimbursement for their post-petition attomeys fees and costs. 11 U.S.C. §506(b) (only secured claimants are allowed attomeys fees and costs to the extent of their security).

(b) Other Committees

The bankruptcy court may order the appointment of additional committees of creditors or of equity security holders "if necessary to assure adequate representation" of their interests. 11 U.S.C. § 1102(a)(2).

5. Secured Creditors

Many chapter 11 cases have one primary lender, which will have a security interest in virtually all the debtor’s assets. In non-health care cases, the secured creditor’s agenda is often to force a liquidation of the business, and/or to seek relief from stay to foreclose on its collateral. Therefore, it often will be in the unsecured creditors’ best interest to side with the debtor in possession against the secured creditor and to support the reorganization. To decide, the unsecured creditors must compare the liquidation value of the debtor’s assets with the amount of the claims secured by those assets.

In a health care case, where a liquidation of the business may result in the loss of licenses to operate, it is usually not in any creditor’s best interest to liquidate the business. In these cases, the secured creditor (or the landlord) is often as concerned with who is going to manage the business going forward as with when the creditor is to be paid.

6. Chapter 11 Trustee and Examiner

Because of the overwhehning concern with the ongoing management of an MCO, and especially if allegations of fraud are involved, healthcare cases may prompt a motion to appoint a chapter 11 trustee. When appointed, chapter 11 trustees take over all responsibilities of the debtor in possession for operating the business, and they have added responsibilities to investigate the conduct of the debtor.

Specific grounds for the appointment of a chapter 11 trustee include dishonesty, incompetence, or gross mismanagement of the debtor’s affairs. The Bankruptcy Court, however, need not find any wrongdoing before appointing a trustee. If the Court only finds that "... such appointment is in the interest of creditors ..." it may order the appointment of a trustee or, in the alternative, the appointment of a chapter 11 examiner. 11 U. S. C. §1104. For example, in In re Triad Healthcare, SV94-14055 AG (C.D. Calif. 1994) (the authors were counsel to OSHPD), a trustee was appointed on motion by OSHPD, the primary secured creditor, shortly after the chapter 11 filing.

7. Priority Creditors

The Bankruptcy Code grants certain types of creditors priority in payment over unsecured creditors, and, in some cases, secured creditors. The first priority involves "administrative claims." These claims basically include the post-petition expenses incurred by the debtor and post-petition professional fees. Lower in priority are certain types of pre-petition employee claims and pre-petition taxes. 11 U.S.C. §507(a)(1-9).

These priority claims are typically subject to any liens held by secured creditors. However, those administrative expenses incurred to protect a secured creditor’s collateral may sometimes be charged against the secured creditor. 11 U.S.C. §506(c).

1. Automatic Stay

The filing of a bankruptcy petition automatically stops, or stays, all activities by creditors to collect an obligation against the debtor. 11 U.S.C. §362(a) The stay does not depend on notice to the creditor. It acts as a stay pending appeal without posting a bod, and it displaces a state court receiver. As a practical matter, when a creditor hears of a bankruptcy filing, even via rumors, it is best to halt collection activity until determining whether a bankruptcy has been filed. Violation of the automatic stay may result in the award of punitive damages and attorneys’ fees in addition to actual damages. 11 U.S.C. § 362(h).

However, secured creditors often seek relief from the stay to foreclose on their collateral. Grounds for obtaining relief includes that the debtor has no,equity in the collateral and the collateral is not necessary to a reorganization. 11 U.S.C. §362(d)(2)(AB).

Relief is also warranted for "cause" including a lack of adequate protection. 11 U.S.C. §362(d)(1). A lack of adequate protection exists when the value of the collateral is decreasing during the bankruptcy case and the creditor’s claim is larger than the value of the collateral. When the secured creditor is not adequately protected, but the collateral is necessary to a debtor’s reorganization, the court can order the alternative relief, including adequate protection payments. These payments should be in an amount that will compensate the creditor for the decrease in the value of the collateral.

From the perspective of a troubled MCO, there are two important automatic stay issues. First, a "police or regulatory power" exception to the automatic stay allows the applicable regulators to close facilities for health care law violations. 11 U.S.C. §362(b)(4). This power does not permit state or federal agencies to enforce contractual rights without seeking relief from the automatic stay. University Medical Center, 973 F.2d, 1065 (3d Cir. 1992). Second, with respect to HCFA recoupments of Medicare overpayments, there is a conflict among the circuits as to whether the automatic stay prevents HCFA from recouping post-petition. See, e.g., Id. (withholds of, interim payments for hospital who participated in Medicare Part A program was a violation of automatic stay); In re Tidewater Memorial Hospital 106 B.R. 876 (Bankr. E.D. Va. 1989) (post-petition recoupment held to be violation of automatic stay); In re Medicare Ambulance Company, 166 B.R; 918, 926-28 (Bankr. N.D. CA 1994) (recoupment under Medicare Part B from an ambulance service was a violation of automatic stay). But see, United States v. Consumer Health Services of America, Inc. 108 F.3d 390 (D.C. Cir 1997)("provider’s claim against federal government for amount due under its Medicare provider agreement for medical services that it had provided during pendency of its chapter 11 case could not be calculated without reference to prior overpayments that it had received; and ... prior overpayments that provider received were part of ’same transaction,’ for equitable recoupment purposes, as provider’s claim against government for medical services it provided during its chapter 11 case.")

2. Reclamation

Reclamation allows a creditor to recover product sold to an insolvent debtor within ten days of the bankruptcy filing as long as service of a reclamation demand is made on the debtor within twenty days of the date the product was delivered. 11 U.S.C. §546(c) and U.C.C. § 2702. Reclamation also applies outside of bankruptcy, but the demand must be made within ten days of delivery, and usually, the creditor does not learn of the insolvency within ten days of shipment. 

For a creditor selling product on an unsecured open book account immediately prior to a bankruptcy filing, the most important immediate step that must be undertaken in the bankruptcy case is to serve a reclamation demand on the debtor. Each day that the creditor delays in serving a reclamation demand may limit the reach-back period against which delivery of goods may be subject to reclamation.

As an alternative to actually returning the reclaimed product to the creditor, the bankruptcy court can grant an administrative priority claim to the reclamation creditor, or create a lien on the debtor’s property in the amount of the reclamation claim. 11 U. S. C. § 546(c)(2)(A) and (B).

3. Cash Collateral

A secured creditor that has a floating lien on the debtor’s cash, inventory, and accounts receivable (the "cash collateral") must be concerned about retaining that lien after the filing of the bankruptcy case. The debtor has an obligation not to use cash collateral unless (1) it has the consent of the secured creditor, or (2) a court order allows the use of the secured creditor’s cash collateral. 11 U.S.C. § 363(c)(2)(A)-(B). If the debtor uses the cash collateral without permission or a court order, however, the secured creditor may lose its interest in that collateral because the Bankruptcy Code cuts off security interests in after-acquired property. 1 1 U.S. C § 552(a).

The secured creditor and the debtor routinely stipulate to the use of cash collateral. These stipulations often grant the secured creditors liens on post-petition accounts, inventory and cash. Because chapter 11 cases normally involve the continued operation of the debtor, the cash collateral issue arises within the first few days of the bankruptcy filing, and the court is authorized to approve emergency cash collateral orders on little or no notice.

If the secured creditor and the debtor cannot agree to the terms of a cash collateral stipulation, the court can approve the use of cash collateral if the secured creditor is "adequately protected." 11 U.S.C. § 363(c)(2)(B)(4). In order to provide adequate protection, the court can order an additional or replacement lien on the debtor’s property. 11 U.S.C. § 361(2).

The cash collateral hearing can provide useful information to unsecured creditors about the debtor’s projections for future operations and the amount of the secured creditors’ claims.

4. Debtor in Possession ("DIP") Financing

Often, secured creditors will force a filing, to obtain the protections of a Bankruptcy Court order approving additional advances. Or new lenders will step up to provide a line of credit to the DIP to enable the business to continue operating after the bankruptcy filing. Significant protections for these loans can be obtained through a postpetition borrowing order, including the priming of senior liens. 11 U.S.C. § 364.

(a) Schedules

The debtor is required to file its schedules and statement of affairs with the first fifteen days of the bankruptcy filing. 11 U.S. C. §521 (1) and Bankruptcy Rule 1007. These documents, which are executed by the debtor under penalty of perjury, describe in detail, among other things, the debtor’s assets and liabilities.

(b) First Meeting of Creditors

After the case is filed, the U.S. Trustee sets a hearing at which creditors may ask the debtor questions under oath regarding the business operations of the debtor. The date of the first meeting of creditors also determines the timetable of other events in the chapter 11 case.

The first meeting of creditors is an excellent opportunity for creditors to learn about the debtor’s present operations and plans. Creditors can ask questions directly and do not need to be represented by counsel. A good preparation for the first meeting is to review the debtor’s schedules and statement of affairs.

(c) Dischargeability Actions

If a creditor believes an individual debtor acted fraudulently, the creditor can ask the court to rule that the debtor’s liability to the creditor is not discharged in the bankruptcy. 11 U.S.C. § 523(a)(2, 4, or 6). The grounds typically involve fraud or other willful misconduct. Id. If the debt is not discharged in the bankruptcy case, the creditor can continue collection activities against the debtor after the bankruptcy. The last day to file a dischargeability action is usually set forth on the notice of the first meeting of creditors.

(d) Proofs of Claim

In practically every case, a creditor should file a proof of claim. The rare case where one would decide not to file a proof of claim would probably involve the creditor not wishing to consent to the jurisdiction of the Bankruptcy Court and be deemed to have waived the creditor’s right to a jury trial in some dispute with the debtor. See, e.g. Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989) (filing of a proof of claim results in consent to jurisdiction of bankruptcy court and waiver of jury trial right).

Once a claim is filed, it represents prima facie evidence that the claim is valid. 11 U.S.C. §502(a). The claim is thereafter allowed unless a party objects to it. 

A failure to file a proof of claim can result in the disallowance of a creditor’s claim. For example, if a debtor lists the creditor’s claim as "disputed" on its schedules and if the creditor fails to file a proof of claim prior to the deadline for filing claims, the creditor’s claim may be disallowed. The first meeting notice usually states the last day to file a proof of claim. A proof of claim may also be printed on the back of the first meeting notice. 

(e) Assumption/Rejection of Executory Contracts and Leases

The Debtor in a chapter 11 has the choice of assuming or rejecting ongoing, executory contracts under Section 365, while its contracting partners may not be able to terminate the relationship due to the Bankruptcy filing. In fact such termination could violate the automatic stay.

(1) Definition of Executory Contract

"Executory contract" is not defined in Section 365 or elsewhere in the Bankruptcy Code. The legislative history simply notes that "there is no precise definition of what contracts are executory, it generally includes contracts on which performance remains due to some extent on both sides." H.R. Rep. No. 595, 95^th Cong., 1^st Sess., sec. 365, 347 (1977). Professor Vern Countryman, Executory Contracts in Bankruptcy, 57 Minn. L. Rev. 439, 460 (1973) defines it as:

[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.

See also Keith J. Shapiro and James T. Markus, Health Care Bankruptcy Issues: Provider Aereements as Executory Contracts, American Bankruptcy Institute A annual Spring Meeting (April 30, 1994). Essentially, both parties to the contract must have remaining performance obligations beyond the mere payment of money.

(2) Assumption or Rejection

A debtor in possession, or the chapter 11 trustee, is given wide leeway to assume or reject "any executory contract or unexpired lease of the debtor" after the bankruptcy case is filed. 11 U.S.C. § 365(a). Rejection permits the debtor to avoid unfavorable contracts that are a financial burden. Assumption permits the debtor to continue the favorable components of its business while it reorganizes, but it too must perform under any executory contract that it assumes.

The party whose contract or lease has been rejected is usually left with a pre-petition unsecured claim for the lease or contract rejection damages. However, if the debtor uses the leased property or continues to operate under an executory agreement without formally assuming it after the bankruptcy case is filed, a portion of the claim -- relating to post-petition operations -- should have priority as an administrative expense.

To assume an executory contract, the debtor in possession or the trustee must cure or offer adequate assurance of a prompt cure of all defaults under the contract or lease. Essentially by having its executory contract assumed the non-debtor party claim is having its claim elevated from an unsecured claim to an administrative claim that will be paid immediately or in the near future. 11 U. S. C. § 3 65 (b).

(3) Non-residential real property leases

Non-residential real property leases are special types of executory contracts that must be assumed within 60 days after the chapter 7 or 11 petition is filed or they will be deemed rejected by operation of law. If a lease is deemed rejected, the landlord may demand that the debtor in possession "immediately surrender" the property to the lessor. 11 U.S. C. § 365(d)(4). However, before making this demand, the landlord should obtain relief from the automatic stay.

Many health care facilities involve long term real property leases, which may be extremely valuable. If a debtor files without competent counsel, and the sixty day period elapses without a motion to assume or to extend the time to assume the lease, the later appointment of a chapter 11 trustee will not cure the rejection of the lease.

The question is whether such leases are "non-residential." Although bankruptcy courts have on occasion held that a long term skilled nursing facility with residents was not a "non-residential parcel of real property," see, e.g., In re Care Givers, 113 B.R. 263, Bankr. 268 (N.D. Texas 1989), the much safer position is to assume that the court would hold that such a property would be deemed rejected after sixty days.

(4) Medicare and Medicaid Provider Agreements as Executory Contracts

Medicare

The Medicare Program is frequently an important creditor of healthcare providers. Medicare reimburses various institutional providers that have been certified to participate in the Medicare program, have signed a provider agreement and have been issued a provider number, pursuant to cost reporting processes. The rules vary considerably, depending upon the type of provider, but frequently they are based on the actual reasonable and allowable costs related to patient care incurred in treating Medicare beneficiaries. Medicare’s fiscal intermediaries make interim payments based on invoices received from participating providers, paying based on DRGs for inpatient operating costs in hospitals; estimated per them rates times the number of program days for hospital capital costs, routine and capital costs in skilled nursing and PPS exempt facilities; per visit costs for HHAS-, and based on an estimated ratio of costs to charges for SNF ancillary and hospital outpatient ancillary costs. Part B providers, such as professionals, labs, therapy companies, or other ancillary providers are usually paid based on a modified fee for service method. All of these systems are superceded by capitation payments in Medicare risk contracts. These different complex payment systems are all part of the relationship between a debtor-provider and Medicare, and not all reported bankruptcy cases focus clearly on what can be important distinctions in these payment methods. Interim payments are reconciled with actual allowable costs in the annual cost reporting process, which can result in Medicare being owed substantial sums due to overpayments.

These interim payments are estimates based largely on prior year costs, and unstable financial conditions, such as those associated with operating problems, failed licensing or certification surveys, increases in charges, False Clairns Act settlements, changes in census or case mix, or various other problems or operational changes, can cause these estimates to be off substantially. The fiscal intermediaries are entitled to recoup overpayments from ongoing interim payments, and these recoupment decisions have rendered many institutional providers insolvent, and driven many to bankruptcy- court in an effort, through the automatic stay, to prevent Medicare from cutting off the cash flow from current operations to make up the prior years’ overpayment. (In addition, the rise of anti-fraud and false claims act enforcement presents the situation where providers find themselves owing substantial fines, penalties or settlement amounts relating to the Medicare program to resolve proceedings that could otherwise put the provider out of business. In In re First American Home Health of Georizia, Inc. cited in Samuel R. Maizel, United States Department of Justice, The Government as Creditor and its Current Focus on Fraud: A Government Bankruptcy Lawyer’s Perspective, materials prepared for the American Bar Association Task Force on Health Care Related Bankruptcy Issues at 1 (Oct. 19, 1997), the provider used the bankruptcy stay to prevent exclusion from the Medicare program, and settled its Medicare fraud liability for $225 million, raised through the sale of its home health chain out of the bankruptcy.)

HCFA and the courts typically consider the Medicare provider agreement to be an executory contract. As a result, if the provider wishes to continue treating Medicare beneficiaries, it must assume the provider agreement and repay any overpayments and otherwise comply in full with the terms and conditions of the Medicare program. If a provider assumes the Medicare provider agreement, "there is no question that HHS could withhold [a provider’s] post-petition reimbursement in order to recover pre-petition overpayments without violating the automatic stay. "University Medical Center, 973 F.2d at 1075. Bankruptcy court approval is required, however, to assume a contract. Id. at 1076; In re Memorial Hospital of Iowa County, 82 B.R. 478, 483-84 (Bankr. W.D. Wis. 1988); In re St. Mary Hospital, 89 B.R. 503, 507 (Bankr. E.D. Pa. 1988); but see, In re Advanced Professional Home Health Care, 94 B.R. 95, 96-97 (Bankr. E.D. Mich. 1988); In re Yonkers Hamilton Sanitarium, 34 B.R. 385 (Bankr. S.D. N.Y. 1983). Debtors may sometimes continue to participate in the Medicare program without assuming the provider agreement. Where this occurs, HCFA may force the issue by moving to compel assumption or rejection of the provider agreement.

The courts generally agree that the provider agreement is an executory contract. University Medical Center, 973 F.2d 1065; In re Monsour Medical Center, 11 B.R. 1014 (Bankr. W.D. Pa 1981); In re Heffernan Memorial Hospital District, 192 B.R. 228, 231 n.4 (Bankr. S.D. Ca. 1996); In re Visiting Nurse Association of Tampa Bay, 121 B.R. 114 (Bankr. M.D. Fla. 1990); Tidewater Memorial Hospital, 106 B.R. at 883; In re Willington Convalescent-Home, Inc., 39 B.R. 781 (Bankr. D. Conn. 1984), rev’d on other grounds, 72 B.R. 1002; Memorial Hospital of Iowa, 82 B.R. 478.

An argument can be made, however, that the Medicare provider agreement is as much in the nature of certification to participate in the Medicare program as it is a contractual relationship. and that the relevant "transactions" for purposes of assumption or rejection, and for recoupment analysis, are either the individual Medicare patient stays that occur and are billed to and paid for by the fiscal intermediaries, or annual aggregations of these individual patient transactions rolled into the annual cost report for purposes of determining the final payment rate applicable to each of the individual patient stays during the year. Support for this argument lies in the fact that the provider agreement is the culminating document (along with the provider number) in the certification process, and the provider agreement itself specifies neither the quantity of services to be provided, nor the specific payment rate to be paid. These crucial contractual terms are driven by the individual patients transactions and by the annual cost reporting process. Compare, In re California Canners & Growers, 62 B.R. 18, 21 (9th Cir.BAP 1986) (Distribution agreement held not to be one transaction for recoupment purposes: "The agreement between the parties shows that the arrangement was intended to establish an overall relationship between the parties. The agreement contemplates that the parties might enter into transactions for the sale and purchase of goods. The agreement does not address terms and conditions for the purchase of specific quantities of goods, delivery, price, or payment terms ... "which instead appear in individual invoices issued for each individual transaction); with. In re B&L-Oil Co., 782 F.2d 155, 159 (10th Cir. 1986) (Oil shipment arrangement held to be one, ongoing transaction, likened to a Medicare provider agreement), both discussed in In re Heffeman, 192 B.R. 228. Obviously, this analysis favors providers against HCFA, because, after the end of each fiscal year, the transaction (or aggregate of individual transactions) represented by that year, is no longer executory for purposes of assumption or rejection, and clearly not the same transaction, for purposes of recoupment. There is little support for this analysis in the Medicare cases dealing with assumption or rejection, although somewhat more success in the recoupment context and in the Medicaid context, as discussed below.

(1) Recoupment/Setoff

Several cases have held that Medicare cannot recoup pre-petition overpayments from post-petition interim payments, without violating the automatic stay. See, e.g., University Medical Center, 973 F.2d at 1079-82. Setoff and recoupment are related concepts. Setoff permits a creditor to offset a mutual debt owing by such creditor to the debtor against claims by the debtor against the creditor, if both debts arose before the petition and they are in fact mutual. See, e.g., In re Davidovich, 901 F.2d 1533, 1537 (10th Cir. 1990). The debts usually arise from different transactions. Bankruptcy Code Section 553 prohibits a creditor from setting off pre-petition claims owed by the debtor against post-petition debts owed to the debtor. See Collier on Bankruptcy Section 553.03. Although there is no specific Bankruptcy Code section discussing it, the doctrine of recoupment provides an exception to this prohibition, where the pre-petition claim against the debtor and the post -petition obligation to the debtor arise from the same transaction, and where it would be inequitable to prevent setoff under the circumstances.

The cases are divided as to whether the provider agreement is one transaction for this purpose, or a series of annual agreements tied to the annual cost reporting process. Compare University Medical Center, 973 F.2d at 1082 (each year constitutes separate transaction); Tidewater Memorial Hospital, 106 B.R. at 882 (provider agreement is a series of contracts; with United States v. Consumer Health Services of America, Inc., 108 F.3d 390 (D.C. Cir. 1997), Heffernan, 192 B.R. at 230-32 and cases cited therein at n.5. Generally, the cases permitting recoupment characterize the relationship between provider and Medicare as an ongoing series of interim payments subject to periodic adjustments to correct for overpayments or underpayments, while the cases prohibiting recoupment look at each cost year as a separate transaction (or grouping of the many transactions involving individual Medicare patients during a year into separate cost years for final determination of the payment amount owing for all of the services delivered during the year).

A very recent IPA bankruptcy case analyzed setoff in the complex tripartite context of an HMO offsetting from its capitation payments direct payments it had made to the IPA’s providers who had not been paid by the IPA and were billing the HMO’s enrollees. The HMO was only permitted to setoff pre-petition capitation payments against pre-petition payments to providers. The bulk of deductions taken by the HMO were from post-petition capitation payments, for pre-petition debt, and had to be repaid to the bankruptcy estate. In re St. Francis Physician Network, Inc., _ B.R. - (N.D. Ill. Oct. 10, 1997).

(2) Multiple provider agreements

When a change of ownership occurs, under Medicare regulations and according to its own terms, the provider agreement is automatically assigned to the new owner. 42 CFR Part 498. However, eventually, a new provider agreement is typically issued to the new owner. The issue then arises whether assumption of the new provider agreement brings with it the obligation to repay pre-petition amounts owed to Medicare that arose under a prior provider agreement. United States v. Vemon Home Health, Inc., 21 F.3d 693, 696 (5th Cir. 1994), cert. denied 115 S. Ct. 575 (1994), held that the assumption of the provider-agreement, and Section 498.18(d), Title 42, Code of Federal Regulations, automatically brought forward to the new owner all the liability for Medicare overpayments owed by the prior owner. The D.C. Circuit, in Consumer Health Services, found that the assignment carried with it all liabilities and obligations of the prior provider, as spelled out in the Medicare statutes and implementing regulations and policies. However, neither Vernon nor Consumer do not discuss the subsequent provider agreement, and it may have been decided while the successor was operating under the prior owner’s provider agreement. Where a new provider agreement is issued prior to the petition, then HCFA has a more difficult case in arguing that pre-petition overpayments under the old provider agreement are part of the same transaction as the post-petition payment stream. This issue is currently being litigated by the authors, on behalf of the chapter 11 trustee, in In re East-West Healthcare, No. 96-22902-B-1 I (Bankr. E.D. Cal). Debtors, and buyers of insolvent providers should consider whether assumption of the existing provider agreement, or application for a new one, or termination of participation in the Medicare program for a period of time, can most advantageously position the provider with respect to Medicare overpayments.

Medicaid

In certain Medicaid cases, providers have had substantial success in prohibiting recoupment of pre-petition overpayments against post-petition interim payments. The court in In re Kings Terrace Nursing Home and Health Related Facility. No. 91 B 11478 (FGC), 1995 Bankr. Lexis 157 at para. 26 (Bankr. S.D. N.Y. January 26, 1995) found that the Medicaid provider agreement did not control reimbursement; rather, the controlling statutes and regulations did. There the court held: "Debtor’s right to reimbursement and the Department of Social Service’s ("DSS") right to recover payments do not arise from any contract, but rather from statutory and regulatory requirements completely independent of a contract. Therefore, no executory contract with respect to such a right could have been assumed by the Debtor, as DSS suggests."

Section 525 Discrimination

11 U.S.C. Section 525(a) creates an anti-discrimination rule potentially applicable to HCFA in these cases:

[A] governmental unit may not ... refuse to renew a license, permit, charter, franchise or other similar grant to, [or] condition such grant to ... a debtor ... solely because such ... debtor is ... a debtor under this title ... or has not paid a debt that is dischargeable in the case under this title ...

A few cases that have considered Section 525(a) in the context of Medicare recoupment hold that HCFA is prohibited from recouping pre-petition debt as a condition for postpetition continuation of participation in the Medicare program. In re St. Mary Hospital, 89 B.R. 503, 504 (Bankr. E.D. Pa 1988) ("We believe that the two fundamental principles pervading all bankruptcy law -- equality of treatment of creditors and providing a ’fresh start’ to a beleaguered debtor -- cut strongly in favor of the Debtor. We therefore conclude that, principally due to the impact of 11 U.S. C. Section 525(a) upon this controversy, the Debtor cannot be compelled to pay pre-petition obligations to HHS as a condition for continued participation by HHS in the Medicare program at the Debtor-hospital. "); University Medical Center, 93 B.R. at 416 ("We continue to believe, as we reasoned in St. Mary, that, even if the Benefits [provider] Agreement is an executory contract, the ’burden’ of requiring the Debtor to pay an otherwise dischargeable obligation to reimburse HHS for past overpayments as a condition to receive the ’benefit’ of rights otherwise enforceable by the Debtor under the Benefits Agreement in the future is an example of precisely the sort of governmental discrimination against debtors prohibited by Section 525(a)."). But see, University Medical Center v. Sullivan, 122 B.R. 919, 924 Bankr. (E.D. Pa. 1990) (district court questions record substantiating finding of discrimination in these cases, declining to remand due to other grounds for affirmance). The D.C. Circuit in Consumer Health Services does not discuss this issue. In In re First American, the OIG sought to exclude the provider from the Medicare program, a death-knell for any Medicare HHA. The bankruptcy process permitted an orderly sale of the house health businesses as goin concerns, and then exclusion of the corporation and its owner (who are now in jail) after it was out of business.

(1) What is a Plan

In a chapter 11 case, the intended result is the confirmation of a plan of reorganization or liquidation. A "plan" dictates how much and when each class of creditors and equity security holders will be paid. If the court confirms the plan, the plan becomes a new contract between the debtor and the debtor’s creditors.

(2) Exclusive Periods

The debtor in possession has the exclusive right to file a proposed plan for the first 120 days of the bankruptcy case. If a plan is timely filed, the debtor in possession also has the exclusive right to confirm a plan for the first 180 days of the bankruptcy case.

If a plan is not timely filed, if a trustee is appointed, or if the exclusive period is not timely extended, any party in interest can file a proposed plan. Litigation in the bankruptcy court will likely follow the filing of competing plans.

(3) Disclosure Statements

Along with the plan, the proponent must draft a disclosure statement, which is supposed to describe the content of the proposed plan in "plain English." The disclosure statement is often analogized to the prospectus portion of a registration statement t hat must be filed with and approved by the SEC prior to its circulation to potential purchasers at a public offering.

(4) Approval of the Disclosure Statement

Until the disclosure statement is approved, the plan proponent cannot ask creditors to vote for the plan. Thus, the first step in the plan approval process is for the proponent of the plan to seek court approval for the disclosure statement. A notice of a disclosure statement hearing must be served on all creditors. However, the disclosure statement itself can not be served on all creditors until after it is approved, or unless the creditors specifically request a copy of the proposed disclosure statement and plan. See generally 11 U.S.C. § 1125.

The disclosure statement should give a background of why the debtor filed the chapter 11 case, what has happened in the case, and what is projected to occur after confirmation. It must also describe how much each class of creditors is to be paid. Additionally, it must include an analysis of whether the creditors will receive more under the plan than they would under a chapter 7 liquidation. Id.

The hearing to approve the disclosure statement is set approximately 30 days after the disclosure statement is filed. Creditors often object to approval of the disclosure statement on the basis that additional information is needed.

At the hearing, the Court should only approve a disclosure statement if it actually gives creditors adequate information so that they may make an informed decision on whether to vote to accept or reject the proposed plan. In reality, disclosure statements tend to be too legalistic, and many creditors don’t read them carefully.

(5) Plan Confirmation Process

After the disclosure statement is approved, a plan confirmation schedule is set, which includes time periods for voting and objections, and the setting of the first confirmation hearing (typically 30 - 40 days after the disclosure statement hearing). If the plan is contested, the first confu-mation hearing is usually a trial setting conference. The Court sets a trial date, along with discovery and briefing deadlines.

The order approving the disclosure statement (which sets the preliminary time deadlines) along with the plan and the disclosure statement, as well as a ballot, are served on all creditors and equity security holders. Creditors and equity security holders, who are placed into separate voting classes (e.g. unsecured creditors, secured creditors, shareholders) then vote to accept or reject the plan. 

In order for a class to accept the plan, 67 % in amount of clairns voting in the class, and 50% in number of creditors voting in the class, must vote to accept the plan. In addition to obtaining acceptances of the plan by the various classes of creditors, the debtor must comply with the numerous other requirements of 11 U.S.C. § 1129(a)(1-12).

If sufficient votes are not obtained in all classes to confirm a plan, the plan may still be "crammed-down" on dissenting classes if the plan is "fair and equitable" to the objecting classes, and if at least one class of non-insider creditors voted in favor of the plan. 11 U.S. C. § 1 129(b). To be fair and equitable, the plan must pay the dissenting class the indubitable equivalent of what it would receive in a chapter 7 liquidation.

In addition to voting against a plan, the creditors may object to confirmation of the plan on numerous grounds. For example, a common objection is that the equity owners are retaining their interests even though a senior class of impaired creditors voted against the plan and that impaired class is not receiving 100% payment under the plan. This objection raises what is called "the absolute priority rule". Other common objections often assert that the plan is not feasible based on the debtor’s projections, or that the interest rates being paid do not compensate for the risk being imposed on the secured and/or unsecured creditors.

(6) Effect of Plan Confirmation

After the plan has been confirmed, creditors are entitled to receive payments according to the plan. If these payments are not made, grounds exist to request that the bankruptcy court convert the case to a chapter 7 liquidation or dismiss the case. Additionally, a creditor can usually file a collection action in state court based on a breach of the terms of the plan. 11 U.S.C. §1141.

(a) Sales of Assets

In many chapter 11 cases, the final result is not confirmation of a plan, but a sale of assets during the case, and then either a conversion or dismissal of the case. The Bankruptcy Code even allows the sale of assets free and clear of all liens and encumbrances, which is a definite advantage in many complicated sale transactions. 11 U.S.C. § 363(f). There are several grounds for selling free and clear of a secured creditors claims. but oiie of the more useful grounds is if the security interest is in bona fide dispute. 11 U.S.C. §363(f)(4).

(b) Reviewing Monthly Operating Reports

During the chapter 11 case, the debtor must file monthly reports of its post-petition business operations with the court. These monthly reports detail the debtor’s cash receipts and expenses. They can be a valuable tool in determining whether the debtor has any prospect for reorganization. Monthly reports can usually be obtained from the debtor’s attomey or by copying them at the bankruptcy court clerk’s office.

(c) Avoiding Liens

Liens can be avoided for numerous reasons. To avoid a lien, the debtor generally must file an adversary action as set forth in Bankruptcy Rule 7001. For example, if a security interest is not properly perfected on the date of the bankruptcy filing, the debtor in possession can avoid the lien on the grounds that the debtor in possession, by filing the case, is automatically accorded the status of a bona fide purchaser for value without notice of the unperfected security interest. 11 U.S. C. §544.

If, as part of a workout, the surgeons accepted a note secured by the real and personal property, but the security interest was only perfected during the 90 day preference period, the debtor in possession or the trustee would likely avoid the perfection of the security interest as a preference, and then avoid the actual security interest as an unperfected interest pursuant to the " strong arm " powers of 1 1 U.S.C. §544.

(d) Fraudulent Conveyances

(1) State Law

The debtor in possession (or with court approval the unsecured creditors’ committee) may avoid a transfer made by the debtor that could have been avoided by an unsecured creditor under state law in the absence of any bankruptcy case. 11 U.S.C. § 544(b). Typically, the elements required to prevail in a state law fraudulent conveyance action mirror the elements required to prevail under the Bankruptcy Code, except that the state law causes of action typically have a longer statute of limitations (e.g. in California four years, as opposed to one year under the Bankruptcy Code).

(2) Bankruptcy Code

Under the Bankruptcy Code there are two basic types of transactions that may be avoided as a fraudulent conveyance. The first involves a transfer or an obligation incurred with the actual intent to hinder, delay or defraud any entity to which the debtor was indebted. . 11 U.S.C. § 548(a)(1). The second type of transaction is called a It constructive fraudulent conveyance," and requires a showing that (1) the debtor received less than "reasonably equivalent value" for property sold, and (2) the debtor was either insolvent on the date of the transfer, or the transaction rendered the debtor insolvent. 1 1 U.S.C. § 548(a)(2).

(3) The White Knight Problem

The acquisition of a distressed provider or MCO presents significant constructive fraudulent conveyance problems. For example, assume that a provider entity did not own any real property but leased it. Assume also that the value of the leasehold interest, the personal property, in ordinary times would have a going concern value of $1,000,000. With respect to liabilities, the facility owes a total of $1,300,000 in trade debt, $600,000 in tax debt, and has bounced payroll checks. Worse, it has failed its most recent survey, and lacks the resources to make needed corrections.

White Knight management company arrives one week prior to a re-survey at which the facility is in danger of losing its license and/or certification. White Knight quickly executes a management agreement, submits a change of ownership application, infuses $300,000 to remove the facility from the decertification process, and takes over operating the facility.

The change of ownership is approved in 90 days, and the White Knight becomes the new owner of the facility. Assuming there are no state law successor liability issues, the White Knight uses to the extent that they exist, the receivables of the old operator to pay back the $300,000 infused into the facility, some of the tax debt, and the trade debt of certain essential suppliers.

The old operator eventually files a bankruptcy, or its creditors file an involuntary bankruptcy, and the debtor in possession or a chapter 7 or 11 trustee sues the White Knight for a constructive fraudulent conveyance. The debtor in possession or a trustee (hereafter the "trustee") will assert that at the time of the change of ownership, the facility was worth one million dollars even though it would have had no value if the regulators had closed it the next week. The trustee will further assert that the debtor was insolvent at the time of the change of ownership and that the new operator should pay the $1,000,000 market value of the facility.

To avoid this result, the White Knight might decide to use bankruptcy proactively. The White Knight could demand that the old operator immediately file a chapter 1 1 case, and seek court approval for: (1) the interim management agreement; (2) the infusion of funds to cure the health care problems; and (3) the change of ownership to the White Knight.

If the court is faced with the inuninent closure of the facility, the court (and the other creditors) will probably be much more willing to grant the type of immediate relief required to close the transaction. The risk of this option to the replacement operator is that at the hearing to approve the change of ownership (i.e. the sale), the court will likely accept competing overbids. The greater the threat of overbids, the more likely the transaction is actually too good of a deal for the White Knight, which means that the transaction would be later characterized as a constructive fraudulent conveyance. To protect itself, White Knight might build in a "break-up fee" to reimburse its due diligence and transactional costs in the event that an overbid is successful.

(e) Preferences

For many creditors, the most troubling avoidance power the debtor in possession or the trustee possesses is the power to avoid transfers made prior to the filing of the bankruptcy case on account of a past due debt. 11 U.S.C. §547. These transfers are called preferences. The elements of a preference are:

(1) The transfer of the debtor’s property

A transfer of property includes not only direct payments made by the debtor, but also the creation of judicial and non-judicial liens. Any transfer by the debtor of anything having an economic value falls within the definition of transfer.

(2) For the benefit of the creditor

The requirement that payment be to or for the benefit of a creditor is satisfied if the transfer is made to the entity that has a claim against the debtor.

(3) On account of an antecedent debt

Payment on an antecedent debt is a payment made on a past due obligation.

(4) Made while the debtor was insolvent

A debtor is insolvent if its liabilities exceed its assets. The debtor is presumed to be insolvent, subject to rebuttal, during the 90 days immediately preceding the bankruptcy filing. 11 U.S.C. §547(f).

(5) Made on or within 90 days before the filing of the petition

This element strictly limits preference recoveries to those transfers that occurred during the ninety days prior to the filing (or one year if the transfer was to an insider);

(6) Which enabled the creditor to receive more than the creditor would have received if the case had been a liquidation under chapter 7 of the Bankruptcy Code

This element examines whether the transfer actually improved the creditor’s return on its claim. For example, if the creditor has been paid 50% of its total past due claim against the debtor immediately prior to the bankruptcy filing, and in a liquidation bankruptcy case, the creditor would only receive 5 % of its claim, then the creditor’s actual return has been improved as a result of the preferential payment. The valuation must be made in light of "... fair values ...," which may mean going concern value as opposed to liquidation value, at the time the payment was made. 11 U.S.C. §10 1 (32).

(7) Even if all the elements are satisfied, creditor may have a valid defense to the preference

Creditors should consult with bankruptcy counsel if served with a preference suit. Several defenses include a new value defense (i.e. new credit extended after the payment); payments were made in the ordinary course of business; the payment was for a contemporaneous exchange; and/or the payment was for a consumer debt of less than $600.

3. Conversion/Dismissal

If the debtor fails to abide by the law and rules governing its conduct as a debtor in possession or if very little or no progress is made in the case, the case may e converted to a chapter 7 or dismissed for "cause." 11 U.S.C. §1112. For example, the debtor’s failure to obtain confirmation of a plan is one cause for dismissal or conversion. 11 U.S.C. § 1112(b)(2).

D. Discharge

Entry of a discharge eliminates the pre-petition obligation to the creditor. Even corporations can obtain discharges in a confirmed plan of reorganization. Once a debt is discharged, the creditor can no longer pursue any collection activities against the debtor for pre-petition obligations. see, e.g., In re Kings Terrace Nursing Home and Health Related Fa , 184 B.R. 200, 202 (Bankr. S.D.N.Y 1995) (confirmed reorganization plan held to discharge Department of Social Services (DSS) claim for recoupment of medicaid overpayment where DSS did not file timely clairn prior to confirmation of Plan.)