Healthcare lending transactions: Key considerations when you are structuring a deal
Much like the healthcare industry itself, the structure and terms of healthcare lending transactions have evolved in recent years, as some borrowers have become more attuned to perceived concerns over the “corporate practice of medicine” doctrine. This alert outlines key considerations for lenders deciding whether to rely on the credit protections provided by a licensed healthcare provider’s management service organizations (MSOs) rather than the healthcare providers that generate revenue for the consolidated borrower entity.
The corporate practice of medicine doctrine
The corporate practice of medicine or CPOM doctrine is a patchwork of state-based statutes and regulations, judicial opinions, and interpretations by state licensing boards and other regulators aimed at maintaining licensed healthcare providers’ control over clinical decision making in connection with patient care.
- CPOM restrictions (and their enforcement) vary by state, but generally prohibit institutional investors from directly owning or controlling the activities of a licensed healthcare provider or its physicians.
- In response to these restrictions, many healthcare companies have established MSOs that provide non-clinical management and administrative services on a contractual basis to their licensed affiliates in exchange for fees.
Healthcare lending practices
Licensed healthcare providers have historically been included as borrowers or guarantors of the primary obligor under secured credit facilities, whereby they grant to the lender a security interest in substantially all of their assets, make certain representations and warranties and agree to comply with certain covenants. Despite the lack of any express regulatory prohibition against this longstanding practice, borrowers are more frequently – and more stridently – arguing that the inclusion of any licensed entities as loan parties unnecessarily increases the risk that regulators might pursue an enforcement action. These borrowers instead propose an alternative lending structure whereby the lender would forgo a direct contractual relationship with any licensed healthcare providers and instead rely on the representations and covenants from, and the security interest granted by, their related MSOs.
Key structuring considerations
This alternative lending structure has gained traction in the market, but creates additional wrinkles for lenders to consider. Accordingly, lenders are advised to (1) thoroughly analyze the contractual arrangements among the licensed healthcare providers and their related MSOs and (2) include provisions in the credit facility’s loan documents to mitigate any credit impact resulting from the exclusion of any licensed entities as loan parties.
Diligence of management documents
The diligence process
Conducting proper diligence is of paramount importance given the management documents’ role in linking the economic wellbeing of the MSO party to the credit facility with that of the revenue-generating licensed healthcare provider.
- Lenders should request copies of all management documents as early as possible to ensure they are able to evaluate any potential risks and address any identified deficiencies to their reasonable satisfaction.
- Lenders should seek guidance from counsel well versed in both CPOM-related regulatory issues and customary market practices for venture-debt credit facilities.
Substantive provisions in the management documents
The scope, terms, and form of a borrower’s existing management arrangements can vary significantly. The following are some key terms that lenders should confirm when undertaking their review of the management documents:
- Security interest matters. The management agreements should provide for a first-priority security interest, and lenders should confirm that the MSO has taken all necessary actions to fully perfect its security interest (ie, it has filed UCC financing statements against each licensed healthcare provider and entered into customary control agreements with respect to each provider’s deposit accounts). This “back to back” security interest approximates a lender’s lien under the traditional lending structure and enables the lender to more easily exercise its rights vis-à-vis the healthcare provider by “stepping into the shoes” of the MSO following an event of default under the loan documents.
- Termination of management documents. The management documents should also prohibit the licensed healthcare provider from terminating such agreements without cause or due to the bankruptcy by the applicable MSO. Limiting the healthcare provider’s termination rights to a clearly defined, well-established standard ensures that the economic link between the revenue-generating healthcare providers (which are not part of the lender’s collateral package) and the loan parties (which are relied upon in underwriting the loan) remains intact absent egregious conduct by the MSO, thus ensuring that the lender receives the benefit of its bargain.
- Accounts and payments. Because a lender using the alternative structure is unable to take a lien in the cash generated by any licensed healthcare providers, the terms of the management documents determine the lender’s access to such cash. Lenders should confirm that all licensed healthcare providers are required (to the extent permitted under applicable law) to sweep sufficient cash to accounts of the MSO on a regular basis and to make payments under the management documents free of counterclaim, deduction or any right to setoff. Doing so limits the amount of cash beyond of the scope of the lender’s lien, as would be the case if such healthcare provider were a loan party. To further enhance a lender’s ability to access cash following an event of default under the loan documents, the management documents should also require that all bank accounts of licensed healthcare providers (including any bank accounts collecting proceeds from Medicare, Medicaid, or other government funded healthcare programs) be held by the lender to the extent such lender is able to hold such accounts, as is commonly required of loan parties under the traditional lending structure.
Definitive loan documentation
In addition to the provisions in the management documents, certain terms are typically needed in the documentation governing the credit facility to place the lender on footing similar to the traditional lending structure but for the CPOM-related concerns.
- Collateral assignment. In addition to the typical suite of loan documents, an MSO loan party should collaterally assign to the lender its interest in the management documents, with such assignment expressly acknowledged and consented to by the related healthcare provider. This collateral assignment clarifies the lender’s rights with respect to such management documents following an event of default under the loan documents and enables the lender to access any fees paid or payable under the management documents (which would typically be required to be held in an account subject to a control agreement in favor of the lender under the traditional lending structure).
- Representations, warranties, and covenants. The MSO loan parties should provide the customary suite of representations, warranties and covenants on their own behalf and on behalf of the licensed healthcare providers. The healthcare providers remain the economic driver of the borrower’s business under the alternative lending structure, and the protections provided by these assurances are no less important because a healthcare provider is no longer party to the credit facility. Indeed, certain provisions (such as representations confirming certain aspects of the management documents and limitations on amounts the loan parties may loan to, or invest in, non-loan parties) may take on additional importance when the licensed healthcare providers are excluded from the credit facility.
Lenders using the alternative lending structure have been willing to accept this approach so long as broad knowledge-based, materiality or other qualifications that inappropriately transfer risk to the lender are not included. Borrowers have likewise been willing to accept this approach, given the MSO’s involvement in the licensed entity’s business as required under the management documents.
- Defaults. Similarly, the triggers constituting an event of default under the loan documents should be expanded to cover similar occurrences with respect to any licensed healthcare providers. For example, a breach or default by a healthcare provider under a management document (including the failure by a healthcare provider to sweep its cash to the accounts of its related MSO) or a breach of any of the representations, warranties or covenants applicable to such healthcare provider under the loan documents should result in an event of default under the credit facility (after taking into account any applicable grace period). Further, the bankruptcy or insolvency of a licensed healthcare provider, the imposition of a judgment by a court of competent jurisdiction against such healthcare provider, the attachment of a lien to assets of such healthcare provider or the occurrence of a default by a healthcare provider under its material agreements should constitute an event of default (taking into account any applicable materiality thresholds), just as it would if such event occurred with respect to a loan party.
- Revolving credit facilities. The lack of privity between the lender and any licensed healthcare providers under the alternative lending structure prevents the lender from directly enforcing its rights with respect to accounts generated by an excluded healthcare provider, even if the back-to-back security interest discussed above is properly established. This is particularly problematic in formula-based revolving credit facilities supported by accounts receivable and, as a result, lenders should give special consideration to whether receivables of non-loan party healthcare providers should be excluded or subject to an additional discount.
If you would like to discuss or have any questions regarding the topics discussed in this alert or related matters, please contact one of the authors or any member of DLA Piper’s Venture and Growth Lending or Healthcare Sector teams.