Paul R. DeMuro

Bad debt is rising while cash on hand is declining. Hospitals should understand the legal implications of the economic downturn.

At a Glance

The economic downturn can lead to many types of legal issues, including: 

  • The need to negotiate forbearance agreements
  • Failure to pay vendors in a timely manner
  • Difficulty fulfilling charity care policies
  • The need for salary freezes or staff reductions


Healthcare financial leaders are advised to be familiar with debt/bond documents, track compliance, retain expert counsel, and keep management informed of key issues.

Some of the implications of the economic downturn and credit crisis are obvious, including the failure to meet certain debt covenants, thereby placing an entity in technical default under its debt documents. A healthcare organization may have experienced a decline in its reserves because of losses in the stock and/or bond market. (Certain district and governmental hospitals may not have experienced declines to the same extent where they are prohibited by statute from investing in equities.) These declines in reserves may prevent certain healthcare entities from meeting the reserve requirements of their debt documents.

Many prospective patients are deferring elective surgeries as a result of the economic downturn. Many who have lost their jobs no longer have health insurance coverage. Those who do have health insurance may see their copayment and deductible amounts increase. As a result, many healthcare organizations are experiencing a rise in bad debt and increasing requests for charity care. Thus, cash on hand at many healthcare organizations has declined along with its liquidity, raising the likelihood of breached covenants.

Forbearance Agreements

If a healthcare organization cannot be brought into compliance with its debt covenants before a certain trigger date, it may have to negotiate with a lender, bond insurer, letter of credit bank, and/or bondholders for a forbearance agreement. Part of those negotiations may be over issues such as whether a turnaround consultant must be retained, who to retain, and the nature of the engagement.

In some instances, current healthcare management might try to convince its lenders and others that such a turnaround consultant is not necessary because management has the situation under control and the costs associated with the turnaround consultant are not necessary. Some considerations include what contract or contracts might the troubled healthcare organization enter into with the consultants. What will be the deliverable for the consultants, and in what time frame? How will the compensation of the consultants be structured, and how will they interface with management?

Another consideration may be that the financially troubled organization may look for a "financial partner." Such a financial partner might be a lender that will refinance the healthcare organization's debt on more favorable terms, a not-for-profit healthcare system with which the troubled organization might "affiliate" by becoming part of such system, or an investor-owned healthcare system that might acquire the financially troubled organization. Such entities face a plethora of legal issues.

Management and the board of directors of the financially troubled organization need to ensure that the organization acts consistently with its fiduciary duties (including the duties of care, loyalty, and obedience of purpose) in exploring its alternatives. In doing so, it will be necessary to determine whether the healthcare organization is in the "zone of insolvency" to determine to what stakeholders and/or creditors its fiduciary duty will be owed. The organization should consult with experienced counsel in such situations.

Whether a new lender, a not-for-profit organization, or an investor-owned health system is identified as a potential financial partner, the troubled financial organization often must convince the current lenders that a new financing transaction will be accomplished, or that the affiliation with the not-for-profit entity or the sale to the investor-owned entity will be closed. Often, the troubled healthcare organization needs to negotiate a forbearance agreement with its lender to ensure that the lender does not declare a default, and agrees not to take certain other steps for some period of time, subject to specified conditions. If a healthcare organization cannot successfully negotiate a forbearance agreement, it might consider whether it would make sense to file for bankruptcy to reorganize its operations, whether in a traditional or prepackaged manner.

The parties to a forbearance agreement likely will include all lenders, bond insurers, letter of credit banks, and bondholders, if there are such multiple parties. A default with one lender or entity generally results in cross-defaults with the others. Obviously, the troubled healthcare organization should try to negotiate the agreement to ensure that the lenders will not trigger a default under the debt documents.

The negotiation of a forbearance agreement often results in the creation of new covenants that must be met during the term of the forbearance agreement. Such covenants can include maintaining cash reserves above a particular level and approval over certain transactions. The forbearance agreement might be for a short period of time, and in contemplation of the lender's debt being paid off through a recapitalization, new lenders, the proceeds from an affiliation or sale, or some form of restructuring or management change. Compliance with forbearance agreements can be quite difficult because of the constraints often put on the healthcare organization.

A financially troubled organization exploring a transaction with a healthcare system may look to negotiate with a not-for-profit entity with which it might affiliate or an investor-owned entity regarding a commitment of resources to its community and/or to its facilities going forward. Such commitments might include, for example, enhancing the troubled organization's current facilities, expanding them, adding new services, and ensuring the provision of emergency and/or trauma department services and certain charity care.

It is important to note that these desires on the part of the financially troubled organization may conflict with the desires of the lenders negotiating the forbearance agreement. Such negotiations take time, can affect the funds available to pay off the lender, and result in certain regulatory hurdles, such as the transfer of any certificates of need.

Delay in Payments to Vendors and Delays in Capital Expenditures

Trying to meet the conditions of a lender providing a forbearance agreement or trying to conserve cash to ensure the ability to continue to meet certain debt covenants also can create legal considerations. For example, a healthcare organization seeking to preserve cash may not pay its vendors in a timely manner. This approach can trigger certain rights of the vendors under the applicable contract or purchase order. These rights might include the charging of penalties and interest, and/or the providing of certain products and services in the future on a cash-on-delivery basis.

Healthcare providers may attempt to defer capital expenditures. Provided that their decisions are made with respect to those capital expenditures that have not already been committed through contract, the result may merely be loss of the ability to compete with other organizations with state-of-the-art facilities and equipment or develop new services for such purposes. When a healthcare organization seeks to curtail a capital project already committed, there can be legal ramifications. For example, the vendors may have certain rights against the healthcare organization for breach of contract and be entitled to a number of different remedies.

A healthcare provider that contractually commits to the purchase of an electronic health record (EHR) system may face specific time frames for periodic payments at the time of defined milestones in the contract. The vendor may have expended certain resources in preparing to meet those milestones. The healthcare provider may not be contractually permitted to just halt the development and the delivery of the EHR system. The healthcare organization's failure to cooperate with the implementation of the EHR system and to make timely payments could result in the organization being held liable for damages for breach of contract.

Many healthcare organizations are planning on or in the process of remodeling and construction programs. The longer the delays in construction, generally the greater the costs. Where healthcare providers have entered into certain construction contracts, including those attempting to employ the principles of lean construction, the healthcare provider's failure to timely pay for and proceed with the project may result in further costly delays and the ability of the contractor to seek certain remedies. All such contracts should be reviewed carefully before making a decision to "slow down" construction. Not only may there be potential breach of contract considerations, but also the additional costs may result in the healthcare provider not being able to complete the project, absent additional borrowing, which may not be available, or substantial fund-raising, which may not be realistic.

As a further consideration, a healthcare organization may need to discontinue a particular program or service as a result of minimizing its capital expenditures. There may be state and local laws governing how an organization must close a particular service, which might include a requirement of notice to the community and hearings. Healthcare organizations will need to comply with such legal requirements.

If the healthcare provider has made representations and warranties about the project, its costs, and completion, it will want to ensure that they are correct. It also may have an obligation to update them. If it does, it will want to make sure they are realistic and consistent with a revised workable plan of finance. A healthcare provider would not want to raise money from prospective donors, advising them of a project that will be built if there is no reasonable expectation that it can be built, given the financial considerations.

Charity Care Policies

Healthcare providers that developed charity care policies in response to the public and congressional outcry about their charges, class action lawsuits, their zeal to retain their tax-exempt status (if they are tax-exempt), or just because they believed it was the right thing to do are starting to find that many more patients are seeking to take advantage of these charity care policies because of their family's economic circumstances. A question may arise as to whether the healthcare organization can continue to comply with the charity care policies it developed in better economic times. If it does not, it may be subject to lawsuits alleging breach of any settlement agreement or alleging it should not retain its tax-exempt status, if it is a tax-exempt entity.

With health plans continuing to raise their cost sharing amounts, such as copayments and deductibles, and declining economic conditions, patients with insurance will find it more difficult to meet those cost sharing amounts, leading healthcare providers to face higher levels of bad debt. Even if a healthcare organization could tighten its charity care policies so that many patients who previously would have been eligible for charity care are no longer eligible, it may merely be transferring what would have been charity care into bad debt, with the result that the tax-exempt entity may have difficulty justifying its tax-exempt status and why its property should not be subject to taxes and/or alternative assessments.

With the declining numbers of individuals with healthcare coverage, healthcare organizations may find that their emergency departments (EDs) will be stressed even more than they are today. The result may be greater difficulty in seeing patients on a timely basis, greater subsidies to ED physicians, and more difficulty in meeting an organization's EMTALA obligations.

Hospitals should seek to two-tier their ED departments and provide urgent care and-if they are not doing so-facilitate the development of "medical homes" though community clinics. Yet many may not have the resources to do so, further threatening their economic survival and increasing potential malpractice and EMTALA liability.

Salary Freezes and Staff Reductions

Healthcare organizations facing financial difficulties may seek to freeze salaries of their employees, cut staff, and enter into other actions that may have labor relations implications, particularly if they are subject to collective bargaining agreements. Across-the-board cuts in staff can result in decreases in professional or allied health practitioners in areas where shortages exist. The result can be higher costs rather than lower costs through the increased use of locum tenens (physicians) and travelers (nurses). Contracts for same will have to be negotiated.

Severance and/or termination obligations for departing employees will have to be addressed, along with whether a healthcare organization has all the necessary funds to meet its termination obligations. If the costs are too high, will a healthcare organization stage such payoffs to enable the financial organization to continue to meet certain debt covenants? Thus, careful consideration should be given to freezing salaries and layoffs and to both their business and legal effect.

Effect on Compliance Plans, Community Outreach, and Healthcare Education

Likely but most unfortunate casualties of these economic times are the depth and breadth of compliance programs, community outreach, and health education programs. When cuts are considered, why not cut or delay some of the compliance and privacy training and delay implementation of monitoring or a review, community outreach, and health education, as they are not seen as generating any revenue? If personnel in such areas have departed a healthcare organization, why not delay replacing them? There may be a short-term cost savings, but the long-term costs may be much greater as a result of issues such as employees not receiving adequate compliance training, problems not caught early, and prospective patients not receiving needed health education.


Healthcare providers often find themselves in disputes with managed care plans. The result can be litigation in the courts where providers are fortunate enough not to have agreed to arbitration provisions, or arbitration where they have. In their zeal to "settle" these matters, healthcare organizations may agree to accept amounts from such health plans in settlement lower than they typically would have accepted and to more egregious terms than they otherwise might have considered. The result could be less monies realized by the healthcare organization, further disputes, and more litigation.

A likely result of the economic times is more lawsuits by patients, vendors, joint venture participants, and the like, whether or not covered all or in part by insurance. Additional lawsuits represent new costs, and where possibly covered by insurance, a potential lawsuit against the insurance company if it refuses to cover the matter.

Effect on Physician Relations

Healthcare organizations that once survived and thrived as a result of vibrant physician practices and groups in their community may determine it necessary to find some way to "bail out" financially troubled physician groups. Can a healthcare organization permit physician groups that are in financial trouble because of departing physicians, increasing expenses, decreasing reimbursement, and no financial wherewithal to recruit replacement physicians, to disappear?

Physicians will seek more hospital financial assistance whether through increased on-call payments, medical directorships, or just the purchase of their practices. The regulatory ramifications of assisting such physician groups and physicians should be considered, including the Medicare and Medicaid fraud and abuse considerations, Stark self-referral issues, and-for not-for-profit healthcare organizations-tax-exemption considerations.

Representations, Warranties, and Conflicts of Interest

One can be sure that the representations, warranties, and disclosures made by a healthcare organization will be scrutinized at some time if a financially troubled healthcare organization is unable to pay its debt. Government regulators, lenders, and bondholders will want to ensure that the healthcare organization has made the necessary and proper disclosures. If not, and the financial position of the healthcare organization deteriorates, legal actions may be filed against the entity and certain individuals making such representations and warranties.

As government regulators, lenders, and bondholders scrutinize the representations and warranties, they also will scrutinize any potential conflicts of interest that management and the board of directors of the healthcare organization may have. The effects of such conflicts of interest will be to have not only any transactions that might have been entered into scrutinized, but also the actions of such individuals with such conflicts of interest. Where conflicts of interest exist, there may be myriad legal ramifications, including repudiation of certain transactions, as well as findings of liability.

Executive Compensation

Executive compensation has increasingly been a hot button for healthcare and other organizations. Recently, it was reiterated in the IRS Exempt Organizations (TE/GE) Hospital Compliance Project Final Report (page 145) that one issue that may be delved into further is the question of when the rebuttable presumption of reasonableness under the IRS provisions may be relied upon. The tax-exempt healthcare provider must demonstrate three factors-an independent body to review and establish the amount of compensation in advance of actual payment, use of permissible comparability data to establish the compensation, and contemporaneous documentation of the process used to establish this compensation in the particular instance. Few things are more precious to executives than their compensation. The financial crisis will exacerbate such focus and healthcare organizations should be able to demonstrate not only that they have passed the test for rebuttable presumption of reasonableness, but also that the compensation of their executives is reasonable and fair market value.

Having a healthcare organization's human resources director set the compensation of the CEO to whom he or she reports will not suffice. An independent committee of the board of directors or the board itself should make such determinations with the assistance of consultants and experts in such matters who are not beholden to the CEO and the human resources department for much of their consulting work. The failure to approach executive compensation in this manner can lead to increased scrutiny of same and questions about whether a healthcare organization should be entitled to its tax-exempt status, if it has one.


Key finance personnel at healthcare organizations should be intimately familiar with the provisions of the debt/bond documents and the covenants within them. They should track compliance and plan for when a covenant is likely to be triggered. They should retain counsel expert in financial issues to assist them, and such counsel should know their debt/bond documents and how to address issues as they might arise.

It is insufficient to merely have regulatory counsel who concluded at the time of the closing of the debt or bond transaction that there were no known regulatory impediments to closing, and if the healthcare organization is tax-exempt, that its activities are consistent with that status. Counsel should be expert in financial issues and be able to assist finance personnel in navigating through the documents, and working with such personnel to anticipate issues in advance, and if necessary, assist in negotiating with lenders for forbearance or other agreements, if such becomes necessary.

Financial personnel should ensure that senior management is kept abreast of any key considerations that might affect the healthcare organization as a result of the financial meltdown. It may be too late to bring issues to senior management and then to the board of directors if a healthcare organization is already in default under its debt/bond documents. As concerns come to the forefront, they should be discussed with senior management, and plans put in place with legal counsel to determine how to address the considerations, including the implementation of a turnaround plan, potential retention of a management consultant, and/or discussions with the lenders.

Such actions are consistent with the fiduciary duty of financial personnel, senior management, and the board of directors of a healthcare organization. It is much easier to address potential problems before they occur than to wait until a default is experienced.


Paul R. DeMuro, JD, FHFMA, CPA, is a partner, Latham & Watkins LLP, San Francisco and Los Angeles, and a member of HFMA's Southern California Chapter ( 

Publication Date: Friday, May 01, 2009

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