General Publications September 1, 2020

“PE Credit Considerations After IntegraMed Ch. 7 Ruling,” Law360, September 1, 2020

Extracted from Law360.

In recent years, medical practices have increasingly attracted private equity investors seeking to consolidate various specialty practices, which typically borrow money to effectuate their strategy.

A controversial ruling in a recent Chapter 7 case in the U.S. Bankruptcy Court for the District of Delaware, In re: IntegraMed Holding Corp.,[1] has caused both private equity investors and secured lenders to reexamine the perceived collateral packages securing such credit facilities.

The IntegraMed Case

 IntegraMed, a private equity-backed manager of physician clinics and specialty outpatient health care facilities, routinely entered into management service agreements, or MSAs, with medical practices whereby the physicians associated with the practice would practice medicine and IntegraMed would manage billing and collections, long-term strategy, budgeting, marketing, hiring and business development.

IntegraMed filed for Chapter 7 bankruptcy on May 20. With the intent to liquidate assets for the benefit of IntegraMed's creditors, the Chapter 7 trustee filed a motion to sell substantially all of IntegraMed's assets free and clear of liens, claims and encumbrances under Section 363(f) of the Bankruptcy Code.

As part of the sale motion, the trustee sought to assume and assign the MSAs to a prospective third-party purchaser. Nine medical practices counterparty to MSAs with IntegraMed objected to the sale, arguing that Section 365(c)(1) barred the trustee from assuming and assigning the MSAs without their consent. The IntegraMed court held that Section 365(c)(1) of the Bankruptcy Code barred the trustee from assuming and assigning certain of the MSAs as part of an upcoming auction of IntegraMed's assets.

As a general rule, when a debtor files for bankruptcy, the trustee, or debtor-in-possession, has the option of assuming, assuming and assigning, or rejecting the debtor's executory contracts, despite any provision in the contract that limits its assignability. This is a valuable tool for a debtor or trustee, especially in a sale of substantially all the debtor's assets.

Section 365(c)(1), however, provides one of the few limitations on the debtor's ability to assume and assign its executory contracts. Specifically, the trustee may not assume or assign an executory contract, whether or not the contract prohibits or restricts assignment of rights or delegation of duties, if applicable nonbankruptcy law excuses a nondebtor party to the contract from accepting performance from or rendering performance to an entity other than the debtor or debtor-in-possession.

The classic example of a type of contract that falls within the Section 365(c)(1) exception is a personal service contract, which is a contract unique to the performer.

In a July 10 bench ruling, the Delaware bankruptcy court held that the debtor's MSAs fell within the scope of Section 365(c)(1) and therefore could not be assumed and assigned as part of the trustee's sale of IntegraMed's assets.

In particular, the court opined that the MSAs "involve relationships of personal trust in which the character, reputation, skill and discretion of [the debtor] is necessary to render performance" and were therefore barred from assignment under Section 365(c)(1). In other words, the court held that the MSAs were personal service contracts.

MSO Structural Overview

To protect the public from perceived dangers of layperson influence, many states prohibit nonphysicians from owning medical practices or controlling the practice of medicine.

Private equity firms, however, may establish management services organizations, or MSOs — sometimes referred to as a physician practice management company or an administrative services organization — to execute on their investment strategy, in part, in those states.

An MSO generally refers to an entity that provides nonclinical practice management services to a medical practice, e.g., billing and collections, payroll, and IT services. In exchange for the ongoing provision of management and administrative services, the MSO receives a management fee.

The extent of the relationship between the medical practice and the MSO has traditionally varied depending on the type of MSO arrangement. On one end of the spectrum, an MSO might provide a limited set of services, such as revenue cycle management and IT — a vendor-like MSO structure. In this arrangement, the MSO relationship is similar to a vendor or other outsourced service provider, and the management fees are priced accordingly.

On the other end of the spectrum, an MSO might provide all services necessary to operate a medical practice short of employing professionals and overseeing the clinical operations — a comprehensive MSO structure. In this arrangement, the MSO relationship is similar to the relationship a medical practice may have with its parent companies in a vertically integrated platform (e.g., a medical practice owned by a hospital system or insurance company) in states where nonphysician ownership of a medical practice is permitted.

In each case, the medical practice enters into an MSA with the MSO. Under most comprehensive MSO structures, the medical practice, the physicians that own the medical practice and the MSO also enter into a stock transfer restriction agreement, or STRA, which is a crucial agreement governing the relationship among them.

Upon the occurrence of a triggering event (e.g., any breaches of obligations owed by the physician to the MSO or the medical practice), STRAs permit the MSO to require the transfer of a breaching physician's equity in the medical practice to another physician that is acceptable to the MSO.[2] Many MSOs and their lenders and equity investors view these additional agreements as necessary for the MSO to invest substantial resources into the practice.

Private equity firms often seek financing from banks or alternative lenders to fund (1) a portion of the initial investment by their MSO portfolio company into a platform medical practice; and (2) a growth strategy of providing management services to other medical practices in the sector.

Within the typical universe of assets pledged to a lender as collateral to secure its loans to an MSO are the rights and interests of the MSO under the MSAs and, in the case of comprehensive MSO structures, the STRAs and other additional agreements among the medical practice, physician owners and MSO.

A key underwriting assumption of most lenders that finance MSO structures is that, in a restructuring, the lenders will have the ability, whether in or out of a bankruptcy proceeding, to foreclose on the MSO's assets (including the MSO's rights in the MSAs, any STRAs and other related agreements), sell the MSO business, and in the case of comprehensive MSO structures, potentially require the medical practice to replace the existing physician owner with another physician owner approved by the lender or buyer.

Given the indirect relationship between an MSO's lenders and the medical practices, this collateral assignment to the lenders of the MSO's rights under the MSAs, STRAs and any other related agreements is critical.

A fundamental consideration of investing in MSO structures, whether through a debt or equity investment, is the need to retain the physicians at the various medical practices to continue the revenue generation and maintain the enterprise value. Restructuring MSOs presents unique challenges, and managing and incentivizing the physicians during financial distress is often a key objective.

The IntegraMed case illustrates just how delicate MSO restructurings can be and highlights why MSO lenders must understand the structure and contracts underpinning their loan.

Distinguishing IntegraMed

At first blush, the IntegraMed ruling appears to be problematic for private equity firms and lenders making equity and debt investments, respectively, in MSO structures. The court did not elaborate on how it might analyze other MSAs in MSO structures.

Any general proposition that MSAs cannot be freely assigned in a bankruptcy sale would eliminate one restructuring approach lenders rely on in a downside case. But certain aspects of the IntegraMed business distinguish it from the comprehensive MSO structures, which likely mitigate concern stemming from the IntegraMed ruling.

First, the IntegraMed business model appeared to resemble a vendor-like MSO structure. The medical practices subject to vendor-like MSO structures are owned by one or more physicians who are not subject to STRAs and, in a distressed scenario, often seek to repurchase their practice or otherwise terminate the MSAs.

In contrast, comprehensive MSO structures greatly reduce the risk that physician owners will attempt to terminate the MSA or object to an assignment of the MSA to a third party because the MSO — and, derivatively under the collateral assignment of the MSA and STRA, a lender — may remove and replace the physicians that own the practice.

It is also customary for the existing physician owners to receive equity in the MSO under comprehensive MSO structures, which naturally aligns interests between the existing physician owners and the MSO.

Second, all but one of the IntegraMed MSAs prohibited assignment. Although it is unclear from the ruling what impact, if any, that fact had on the court's ruling, free assignability is a standard feature of MSAs under comprehensive MSO structures and one that lenders generally require in MSO financings.

At a minimum, assignment provisions of MSAs and STRAs should clearly permit assignment. Going forward, it would be advisable to bolster the assignment provisions to expressly acknowledge that: (1) assignability is intended to apply to a sale under Section 363 of the U.S. Bankruptcy Code; and (2) the contracting parties do not intend such agreements to be considered personal service contracts under Section 365(c).

Third, the court's ruling reflects that the trustee submitted little evidence to support his contention that the IntegraMed MSAs were not personal service contracts. Nor did the court have a record it could rely on to understand the market impact of MSAs.

Armed with testimony, declarations and perhaps expert testimony for how MSAs are critical to MSOs and the financing of these structures, future courts may limit Section 365(c)(1) in MSAs to its normally narrow interpretation.

Fourth, the court stated that the: "equal voice in management of the medical practice ... imbues the management company with the ability to control, through its persuasive powers or by obstruction, the destiny of the practice making the management company, in essence, like a partner or joint venture party even though the contracts say it is expressly not."

In many comprehensive MSO structures, the MSO may have the right to participate on physician advisory committees or policy boards and deliberate and assist the medical practice in making strategic decisions affecting the medical practice, including decisions about budgets, expansion, capital expenditures, long-term strategic plans, and recommendations on recruiting and staffing.

The court noted that IntegraMed, through its participation in the practice management board, had "an equal voice in all or virtually all of the non-medical aspects of the medical practices."

The court's ruling appears to suggest that participation in the medical practice's decision making can position the MSO in the role of a partner whose "singular judgment" and "discretion," as cited by the court, rise to the level of a partner providing personal services to the medical practice. These details and IntegraMed's role in the practice management board may be distinguished from other MSO arrangements.

Following the court ruling, MSOs with participation in practice management boards should revisit participation in any formal advisory committees or policymaking boards of medical practices. Similarly, MSOs should consider whether any power-of-attorney or similar rights in favor of the MSO give the MSO the ability to obstruct a medical practice's operations.

The court's ruling has not yet been appealed. But the private equity community, lenders and health care restructuring advisers are paying close attention to this ruling, and the outcome of any appeal, due to the potential impact on availability of credit, valuations and restructuring strategy.


[1] No. 1:20-bk-11169.

[2] In certain states subject to heightened regulatory scrutiny (e.g., New York), option agreements are used in lieu of STRAs, and the right to replace the "friendly physician" is held by another physician rather than the MSO itself.

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