Distressed Medical Facilities: A Guide to Section 363 Transactions

Section 363 transactions—while you may have heard of them, you may not fully understand the power and benefits these transactions can provide. Medical facilities, including skilled nursing homes, urgent care centers, doctor’s offices, assisted living facilities, and others in the health care industry, have faced a recent surge in Chapter 11 bankruptcy filings. High initial operating costs in conjunction with a lack of capital and operating losses have left many medical facilities with few options, short of selling off assets to pay multiplying creditors. As a result, 363 sales are an attractive option for both the distressed entity and potential buyer. This article will explore the function of a 363 transaction, as well as the process, strategies and concerns involved in acquiring distressed medical facilities through Chapter 11 bankruptcies.

What Is a 363 Sale?

Section 363 of the Bankruptcy Code lays out the rights and limitations a debtor-in possession (“DIP”) has with respect to its property under the jurisdiction of the Bankruptcy Court. A powerful tool for a DIP, Section 363 allows a DIP to sell some, or all, of its assets to a buyer “free and clear of any interest.” As a result, the DIP will act as the seller in a 363 sale. Unlike the frequently protracted process of a Chapter 11 sale, which requires a DIP to propose (and obtain) approval of a plan of reorganization before disposing of its assets (which can take years upon years), 363 sales enable a DIP to sell its assets to a buyer in what is generally an expedited transaction. Court approval of a Section 363 sale is required, and rarely denied.

In order for the DIP to generate funds to pay off creditors, the Bankruptcy Code requires that a 363 sale be executed through an auction process in order to obtain the highest offer. Practically speaking, however, 363 sales are usually carried out through ongoing negotiations of the distressed asset.

Benefits of a 363 Sale

 1.
Free and Clear of all Liens and Liabilities

For distressed medical facilities, the most attractive benefit of a 363 sale is the ability to sell the asset free and clear of all interest in the asset which depending on the jurisdiction, can include judgments, tort claims, tax claims, vendor claims, liens, and potential litigation claims. This is a significant deviation from the laws surrounding typical mergers and acquisitions, which generally require that all claims, liens and other liability surrounding the asset be resolved by the seller before the transaction can become final. Section 363(f) allows the sale of an asset free and clear of all interest as long as one of the following five enumerated conditions is satisfied:

• (1)  applicable non-bankruptcy law permits sale of such property free and clear of such interest;
• (2)  such entity consents;
• (3)  such interest is a lien and the price at which such property is to be sold is greater than the aggregate value of all liens on such property;
• (4)  such interest is in bona fide dispute; or
• (5)  such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.

Many of these facilities are so encumbered by claims, that a sale outside the bankruptcy court would not be prudent, or even possible. Indeed, a bankruptcy court may approve the sale of a distressed medical facility even when the proceeds will not be sufficient to satisfy the claims of all lienholders. Practically speaking, the claims that were once attached to the asset now attach to the proceeds of the sale and are distributed to the creditors and equity holders under the direction of the bankruptcy court. This enables a buyer to purchase the asset, subject to some exception as discussed below, without worry of third-party claims.

 2. Ability to “Cherry Pick” Contracts and Leases

Another benefit of a 363 sale is the ability for a buyer to either assume, or reject, certain contracts and/or leases associated with the asset. Section 365 of the Bankruptcy Code permits a DIP to assume or reject most executory contracts and/or leases without regard to consent or non-assignment provisions. This essentially compels vendors associated with the asset to continue to honor the contracts they had in place with the seller/DIP, with the new buyer, so long as the buyer can provide adequate assurance, and the executory contract or lease has been cured of defaults. This provision enables the buyer to identify and “cherry pick” contracts that are beneficial (i.e. a vendor with favorable rates), and reject other contracts that are above-market (i.e. an overpriced employment contract). The ability to accept favorable contracts and reject unfavorable ones is a powerful tool, giving the buyer an advantage it would usually not have in a traditional sale.

 3. Quick and Final Process

Section 363 sales can usually be accomplished in 60-90 days. Depending on the circumstances, however, the process is often shorter. A seminal example is the liquidation of Lehman Brothers Holdings, Inc., in 2008, when the company filed for Chapter 11 bankruptcy, with assets valued in excess of $600 billion dollars 20 BBLR 1077, 9/18/08. Within seven days of filing, Barclays purchased a majority of Lehman Brothers Holdings, Inc. pursuant to a 363 sale. Lehman eventually appealed the sale order, arguing that Barclay was able to secure a “sweetheart” deal in connection with the fast-paced sale of Lehman’s assets. The court nevertheless refused to void the sale, noting that a final sale order entered under Section 363 is “worthy of greater protection” from a subsequent reopening 21 BBLR 393, 3/26/09. This not only highlights a 363 sale order’s integrity, but it also reassures potential buyers that they can rely on the finality of these transactions.

Cautions of a 363 Sale

 1. Successor Liability

While Section 363 permits assets to be sold free and clear of all interests, successor liability is a sticking point of which practitioners and professionals need to be aware. This issue is of particular concern with respect to creditors and/or claimants who have not been given notice of the sale or bankruptcy proceedings. While courts over the years have wavered on how far “free and clear of all interest” will extend under the umbrella of bankruptcy, creditors or claimants who do not have notice of the bankruptcy proceedings, and who are not provided for in the debtor’s Chapter 11 plan, are likely beyond Section 363’s restriction on successor liability claims. Thus, when the asset for purchase is a medical facility, it is imperative that notice of the bankruptcy reaches as far as possible, including, among others, all current and past employees and vendors. Moreover, advance notice of the sale and publication of any claim bar dates should be liberally broadcast to give adequate notice to any and all potential claimants.

 2. Medicare and Medicaid Liability

Medicare and Medicaid are also considerations for buyers purchasing medical facilities. The Centers for Medicare and Medicaid Services hold the view that a buyer in a Section 363 sale who assumes the seller/DIP’s Medicare provider number is a successor in interest to the seller, and is therefore liable to CMS for the seller/DIP’s liability. This can include delinquent fees, overpayment and/or obligations. Thus, it is critical that buyers pay careful attention during the due diligence period if they intend to assume the DIP’s Medicare provider number as part of the 363 sale. Working in conjunction with Medicare and Medicaid representatives to assess claims against the DIP is strongly advised so that a discount for amounts owed can be taken into consideration with respect to the purchase price of the distressed medical facility.

How to Begin the Process of a 363 Sale

In a common scenario, the DIP negotiates with an initial “stalking horse bidder.” The DIP and the stalking horse bidder will enter into an asset purchase agreement which will serve as the starting point for other interested buyers. To the extent the DIP believes that it can garner interest from multiple buyers prior to auction, it may choose to engage in marketing efforts during this time. In many 363 sales involving medical facilities, a broker with experience in these kinds of transactions will usually be brought on board to garner and manage multiple offers prior to submitting anything to the bankruptcy court. Interested buyers will typically make a contingent offer or provide a letter of intent outlining the parameters of an acceptable deal. Then the broker, on behalf of the DIP, will accept the best bid (usually the highest). From there, the DIP and the potential purchaser, who is now the stalking horse bidder, will negotiate the terms of an acceptable purchase and enter into an asset purchase agreement which, again, will serve as the stepping point from which any other bidder can outbid at the auction.

The stalking horse bidder will usually seek to impose substantial restrictions on subsequent bidding. These typically include a breakup fee that is paid to the stalking horse bidder in the event that he is later outbid. This fee is intended to compensate the initial bidder for costs associated with due diligence and negotiations regarding the terms of the sale, and range from 1% to 3% of the purchase price. The DIP and the stalking horse bidder will give notice of the sale and auction date. Bidding procedures will also be submitted and must be approved by the bankruptcy court. Then, the auction will occur, where if there are any other interested parties, they will be given the opportunity to outbid. The debtor will then select the bid and enter into an asset purchase agreement with the buyer. The DIP will then file a motion for court approval of the asset purchase agreement, allowing creditors and interested parties a 21-day time period to object. If no party objects, the bankruptcy court will usually approve the sale.