Creating Value in the Bankruptcy Case of a Physician Practice Management Company Can the Management Services Agreements Be Assumed and Assigned

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Jul/Aug 2000

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With the introduction of managed care, the health care industry was transformed. The industry was flooded
with new types of health care delivery systems such as the IDS (integrated delivery system), the IPA
(independent physician association), the MSO (the management services organization) and the PPM (the
physician practice management group). These new health care delivery systems went on acquisition
frenzies and attempted to acquire as many businesses as possible. By acquiring multiple businesses, in
theory, the costs of operating these large health care conglomerates would decrease as economies of scale
were achieved.

As the health care industry continued to evolve, various sectors of the industry began to suffer financial
difficulty—in particular, the PPMs. Under the PPM rubric, a management company acquires physician
practice groups. Some PPMs are organized geographically, some PPMs are organized by practice groups
and still others are organized on a less coordinated basis with no clear strategic plan.

To acquire the practice, the management company would enter into a long-term management services
agreement (MSA) with the physician group. Pursuant to the MSA, the management company agrees to
provide all of the "back office" support needed by the physicians—in particular, accounting, billing and
collection. In addition, the management company assumes primary responsibility for negotiating the
managed care contracts with the third-party payors (namely, the insurance companies). In exchange for
these services, the management company receives a percentage of the practices' operating revenues. The
management company also acquires the hard assets of the physician practice and, in exchange, the
physicians receive cash and/or stock in the PPM.

A typical PPM was FPA Medical Management Inc. (FPA), one of the first large PPMs to seek relief under
chapter 11. At the time of filing its bankruptcy case, FPA had contracts with approximately 7,900
physicians in 29 states and provided health care services to approximately 1.4 million patients. FPA
suffered from one of the common problems of PPMs—FPA effectively acquired physician groups around
the country, but was unable to fully integrate operations and achieve necessary economies of scale. In
addition, FPA, like most other PPMs, did not have great success negotiating with the insurance companies
to achieve profitable managed-care contracts.

<h3>The Reorganization or Liquidation of a PPM</h3>

One of the biggest challenges facing bankruptcy practitioners is how to reorganize a PPM or salvage
some value from its assets. To reorganize, the PPM must be able to assume the MSAs. However, the MSAs
may not be assumable without the physicians' consent. Similarly, to liquidate a PPM through an asset sale,
the PPM will need to assume and assign the MSAs. Again, this may not be possible without the physicians'
consent.

<h3>The Assumption and Assignment of Executory Contracts</h3>

In determining whether the MSA is assumable and assignable, the main question is whether the MSA
is a personal services contract that cannot be assumed or assigned pursuant to §365(c) of the Bankruptcy
Code.

Generally, pursuant to §365(a), a trustee or debtor-in-possession may assume any executory contract that
benefits the estate and reject any executory contract that is burdensome to the estate. Furthermore, §365(f)
authorizes the trustee or debtor-in-possession to assign an executory contract that has been assumed. Section
365(f) states that:

<blockquote>
Except as provided in subsection (c) of this section, notwithstanding a provision in an executory
contract...of the debtor, or in applicable law, that prohibits, restricts or conditions the assignment of such contract...the trustee may assign such contract or lease...

</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §365(f)(1) (2000)</a>. Therefore, §363(f) generally nullifies the anti-assignment provisions that
prohibit, restrict or condition the assignment of contracts or non-bankruptcy laws that do the same.

Section 365(c), however, contains exceptions to that general rule. It provides that:

<blockquote>
The trustee may not assume or assign any executory contract...of the debtor, whether or not such
contract...prohibits or restricts assignment of rights or delegation of duties, if—

(1)(A) applicable law excuses a party, other than the debtor, to such contract...from
accepting performance from or rendering performance to an entity other than the debtor or
the debtor-in-possession whether or not such contract...prohibits or restricts assignment of
rights or delegation of duties; and

(B) such party does not consent to such assumption or assignment...
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §365(c) (2000)</a>. Therefore, §365(c) is an exception to the general rule that anti-assignability
provisions and laws are not enforceable in bankruptcy. Section 365(c) protects the rights of third parties that
contract with a debtor and that would be prejudiced by having the contract performed by some entity other
than the debtor.

<h3>What Types of Contracts Are Not Assignable Under the Code?</h3>

Based on §365(c), certain types of executory contracts cannot be assumed or assigned. Personal services
contracts (e.g., recording contracts or publishing contracts) cannot be assumed and assigned by a debtor,
and some courts have held that personal services contracts are the only types of contracts that cannot be
assumed or assigned by a debtor. See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Taylor Mfg. Inc., 6 B.R. 370, 372 (Bankr. N.D. Ga. 1980)</a> (§365(c) only applies to personal service contracts).

Other courts have stressed that §365(c) applies to more than personal service contracts:

<blockquote>
It may well be that the impetus for Congress' enactment of §365(c) was to preserve the pre-Code
rule that "applicable law" precluding assignment of personal service contracts is operative in
bankruptcy...However, the drafters actually codified a much broader principle. Surely if Congress
had intended to limit §365(c) specifically to personal service contracts, its members could have
conceived of a more precise term than "applicable law" to convey that meaning.
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Braniff Airways Inc., 700 F.2d 935, 943 (5th Cir. 1983)</a>. However, these courts have struggled to
identify what types of contracts fall within the purview of §365(c) other than personal services contracts.
They have tended to focus on the duties delegated by the contracts and whether those duties arise out of
a "special relationship," "special knowledge," "unique skill or talent" or "trust and confidence." See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Compass Van & Storage Corp., 65 B.R. 1007, 1011 (Bankr. E.D.N.Y. 1986)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Bronx-Westchester Mack Corp., 20 B.R. 139, 143 (Bankr. S.D.N.Y. 1982)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Varisco, 16 B.R. 634, 639 (Bankr. M.D. Fla. 1981)</a>.

In trying to narrow the types of contracts that fall within §365(c) and, therefore, cannot be assumed or
assigned, some courts have held that corporations cannot be parties to contracts that fall within the purview
of §365(c). See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… England Iron Co. v. Gilbert (Metropolitan) Elevated Railroad Co., 91 N.Y. 153, 167
(1883)</a>. But, see <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Rooster Inc., 100 B.R. 228, 233 n.12 (Bankr. E.D. Pa. 1989)</a> ("it is possible for a
corporation to contract where the basis of the bargain is the personal performance of individuals within that
company, the delegation of which would be ineffective").

<h3>Assumption of Contracts that Cannot Be Assumed—Hypothetical vs. Actual Test</h3>

If a contract is the type of contract that cannot be assigned pursuant to §365(c), will the debtor be able
to assume the contract in connection with its reorganization? In analyzing this issue, courts have adopted
either the "hypothetical" test or "actual" test.

Under the "hypothetical" test, courts consider whether, under applicable non-bankruptcy law, the
non-debtor party would be excused from performing the contract if the other party to the contract was not
the original party with whom it contracted. If so, the assumption is barred without regard to who is
assuming the contract. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re West Electronics Inc., 852 F.2d 79 (3d Cir. 1988)</a>. Thus, if non-bankruptcy law
precludes assignment to a third party, §365(c) precludes the debtor from assuming the contract even though
the debtor is not seeking to assign the contract to a third party. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Catapult Entertainment Inc., 165
F.3d 747 (9th Cir. 1999)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Catron, 158 B.R. 629 (E.D. Va. 1992)</a>, aff'd., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 1038 (4th Cir. 1994)</a>.
The hypothetical test has been justified on the distinction between a debtor and a debtor-in-possession.

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 158 B.R. at 637-38</a>.

Under the "actual" test, the debtor can assume the contract so long as it is basically the same entity
performing the contract pre-petition as post-petition. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Inc. v. Louisiana Land & Exploration Co.,
136 B.R. 658 (M.D. La. 1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Cajun Elec. Power Co-op. Inc., 230 B.R. 693 (Bankr. M.D. La.
1999)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re GP Express Airlines Inc., 200 B.R. 222 (Bankr. D. Neb. 1996)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re American Ship Bldg. Co.,

164 B.R. 358 (Bankr. M.D. Fla. 1994)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Hartec Enterprises Inc., 117 B.R. 865 (Bankr. W.D. Tex.
1990), vacated on other grounds, 130 B.R. 929 (W.D. Tex. 1991)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Cardinal Industries Inc., 116 B.R.
964 (Bankr. S.D. Ohio 1990)</a>. In adopting the "actual" test, one court noted that:

<blockquote>
The proposition that the debtor-in-possession is a different legal entity from a debtor is a
non-sequitur in the context of §365. While it is true that for certain purposes the debtor-in-possession is a legally distinct entity from the debtor, it is clearly a successor of interest of a debtor, and a debtor-in-possession is not required to obtain an assignment from the debtor in order to acquire all rights and assets of a debtor, including all rights under an unexpired executory contract.
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Fastrax Inc., 129 B.R. 274, 277 (Bankr. M.D. Fla. 1991)</a>.

<h3>Can MSAs Be Assumed and Assigned Pursuant to §365(c)?</h3>

Based on existing case law, it is not clear whether MSAs can be assumed and assigned or whether
MSAs are the types of contracts that are not assignable absent the consent of the non-debtor party.

In <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Antonelli, 148 B.R. 443 (D. Md. 1992)</a>, aff'd., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 984 (4th Cir. 1993)</a>, the court considered
whether a partnership agreement could be assumed and assigned, and focused on whether the identity of
the debtor (general partner) was important:

<blockquote>
[T]he question of whether or not management power in a partnership is assignable turns not upon
the status which "applicable law" generally accords to partnership agreements, but upon the
materiality of the identity of the partners to the performance of the obligations remaining to be
performed under the partnership in question...In certain circumstances, the identity of a general
partner will be critical to the limited partners and to the prospect of a successful investment.
Examples of such circumstances include: (1) a real estate development partnership in which the
general partner must administer the planning, construction and leasing of a building; (2) an
investment partnership in which the general partner is to identify and evaluate investments of the
partnership; and (3) any partnership in which the general partner is required to contribute capital to
the partnership and, indeed, may have control over the issuance of capital calls to all...On the other
hand, partnerships exist in which the identity of a general partner is less significant. These may
include (1) real estate partnerships owning matured projects that require only routine management
and leasing functions and (2) certain large syndication operations that administer a network of
separate partnerships. In these cases, it is arguable that another organization with sufficient resources
could take over the work of the original general partner without material detriment to the limited
partner investors...
</blockquote>

Id. at 448-49, citing Collier Real Estate Transactions & the Bankruptcy Code, ¦4.07[1] at 4-72 to 4-72.1 (1992).

Partnership agreements are somewhat analogous to MSAs. Under the MSA, certain mundane tasks are
delegated to the management company, such as bookkeeping, billing, maintaining files and records, and
maintaining all fixtures and equipment. Other delegated responsibilities are not so mundane. Under the
MSA, the management company may help recruit physicians, negotiate managed care and third-party payor
contracts, prepare business plans and projections, and generally render business and financial advisory
services. Although the MSA is not what one normally characterizes as a personal service contract,
presumably, when physicians enter into an MSA, they enter into the agreement because they have
confidence in the financial stability, negotiating leverage and skill of the management company. Thus,
should physicians, who built their practices over several years and have now entrusted the management of
their practices to a particular company, be forced to turn over the management of their company to a new
entity without their consent?

This is exactly what the court sanctioned in the BMJ Medical Management Inc. case, which is pending
in Delaware. Early in the case, the bankruptcy court entered an order finding that "BMJ's MSAs...are not
personal service contracts that cannot be assumed or rejected under §365(c) and that under the assignment
provisions of the MSAs, [the physicians'] consent is not required for BMJ to assume or assume and assign
the MSAs in bankruptcy." In re BMJ Medical Management Inc., et al., Case Nos. 98-2799 through 98-2804
(MJW) (jointly administered) (order (1) denying (A) motion by Lighthouse Orthopedic Associates and
Orthopaedic Surgical Associates to compel immediate rejection of management services agreements and
(B) joinder motion by Seaview Orthopaedic and Medical Associates, and (2) fixing the date by which the
debtor must assume or reject management services agreement). This ruling gave BMJ tremendous
negotiating leverage in its bankruptcy case. BMJ now had the ability to assume the MSAs if it chose to
reorganize, to assume and assign the MSAs if it sold the company or part of the company or, most
importantly, to negotiate with the physicians. If the physician did not want to contract with BMJ or any
potential purchaser, the physician would have to negotiate a termination of the contract and essentially buy
back the practice. Thus, BMJ was able to create a substantial value in the MSAs.

<h3>Conclusion</h3>

Whether a MSA can be assumed and assigned is not a settled area of the law. Presumably, physicians
who enter into a MSA select a particular management company based on that company's negotiating
leverage with third-party payors, financial strength, access to the capital markets, management efficiency
and reputation in the industry. Often, the physicians turn over all of the assets and the management
responsibilities to this management company in exchange for an investment in the management company,
namely stock. These considerations suggest the MSA may not be assumable and assignable pursuant to
§365(c).

For a PPM attempting to reorganize and maintain value, the PPM's ability to assume and/or assign the
MSAs will create tremendous negotiating leverage with the physicians and potentially create a large value
that can be assigned to a buyer. As more and more PPMs seek protection under chapter 11, this contract
issue will certainly be addressed as it may be the key to creating a dividend for creditors.

Journal Authors

Matthew T. Gensburg

Nancy A. Peterman

Journal Date

Saturday, July 1, 2000 - 12:00