United States: Structuring a Sound Securitization of Healthcare Receivables

By Mark Spradling, JD

This article originally appeared in the February 2003 issue HFMA, a publication of the healthcare financial managment association.

The recent financial collapse of NCFE brought the issue of securitization of healthcare receivables into the spotlight for healthcare providers. Provider CFOs face a multitude of challenges related to cash management, not the least of which are the difficulties they often must overcome in obtaining financing for ongoing operations and new projects. The practice of securitizing receivables gives providers an additional funding source by converting a stream of future receivables into an immediate advance of cash. It also gives healthcare providers a tool to manage cash flow, reduce borrowing costs, and maximize value. The recent experience of NCFE and its clients, however, underscores the need for provider CFOs to structure a securitization arrangement with care.

Securitization allows healthcare providers to aggregate their accounts receivable into pools and to sell the pools to investors. The investors set a purchase price for the receivables based upon the pool’s credit characteristics the remaining payment term (or "average life") and expected default rate. By contrast, obtaining traditional bank financing involves satisfying stringent standards related to credit worthiness of the provider. Because the payers on a substantial portion of a provider’s healthcare receivables may have a credit rating higher than the provider, securitization has the potential to lower a financially burdened healthcare provider’s total cost of capital.

Healthcare providers can facilitate their use of this valuable financing technique by understanding accepted structures for securitizing Medicare and Medicaid receivables as well as private insurance receivables. Ensuring that a securitization is properly structured to avoid the problems faced by NCFE and its clients is not the only concern. The HIPAA privacy standards, which will require providers’ compliance by April 14, 2003, also have raised new issues regarding securitization. The privacy standards’ restrictions on using or disclosing patient health information may impair certain audit and inspection rights that lenders typically reserve in securitization documents.

Exhibit 1 (below) shows a typical securitization of healthcare receivables.

After the Social Security Amendments of 1972 were enacted, healthcare providers avoided transferring their Medicare and Medicaid receivables to investors because federal laws restricted the assignment of healthcare payments made under the Medicare and Medicaid programs. A 1985 decision by the U.S. Court of Appeals for the Fifth Circuit, In re Missionary Baptist Foundation of America, Inc., approved a strategy to monetize healthcare receivables without violating federal anti-assignment laws. Under Missionary Baptist, so long as healthcare providers retain control over the initial receipt and disposition prerogatives regarding Medicare and Medicaid payments, they will not be in violation of the federal anti-assignment laws.

The double lock box. To satisfy Missionary Baptist’s requirement of retaining control over receipt and disposition of Medicare and Medicaid payments, providers have developed a specialized securitization technique, structured to satisfy the federal anti-assignment provisions and the limited exceptions to the provisions. Specifically, as shown in Exhibit 1, the provider directs government payers to pay all Medicare and Medicaid payments into a new account (lock box #1) owned and controlled by the provider. Private payers are directed to make payments into a second account (lock box #2, or the collection account) owned and controlled by the receivables purchaser. The provider instructs the depositary bank for lock box #1 to sweep all funds from lock box #1 into lock box #2 daily. Although the provider must have the right to change these instructions, purchasers often provide that any such change will trigger a default under the provider’s contract with the purchaser. In policy statements and private decisions, CMS has approved the double-lock-box technique, stating that the key issue is whether the healthcare provider has actual control over the funds and thus discretion about the funds’ transfer to a private financing entity.

Recent amendments to the Uniform Commercial Code (UCC) will also facilitate providers’ securitization of private healthcare insurance receivables. A substantial revision of Article 9 of the UCC, effective in most states July 1, 2001, introduced a new type of "account" covered by Article 9, a "healthcare-insurance receivable." The language of the revision makes clear that securitizations by healthcare providers of accounts to be paid by private insurance policies are now covered by the UCC. By filing a financing statement, a provider can "perfect" the assignment of healthcare-insurance receivables to the purchaser, thereby making the assignment superior to third-party claims (such as claims of the providers’ other creditors). Significantly, the revisions provide that any contractual or statutory restrictions on such assignments by healthcare providers, as between the assignor (the provider) and assignee (the purchaser), are ineffective. Taken together, these amendments make the rights of a purchaser of healthcare-insurance receivables much more certain, thus facilitating the provider’s securitization and lowering the risk premium that purchasers may have charged in the past when their rights were more uncertain.

Revised Article 9 also resolves the vexing question of determining how and where financing statements should be filed to perfect assignments of healthcare-insurance receivables from account debtors (the insurance companies) located in multiple jurisdictions. The combination of UCC Sections 9-301 and 9-307 provides for one central filing of a financing statement, generally in the state under the laws of which the debtor (the provider) is organized. Revised Article 9 has removed the uncertainty that healthcare providers faced in securitizing their private insurance receivables; a clear, uniform statutory framework has now replaced outdated common-law principles.

As Exhibit 1 indicates, in some securitizations, the provider sells the receivables to the purchaser for a combination of cash and an equity interest in the purchaser. Such a structure is particularly useful if the lenders and the provider cannot agree on the appropriate discount to apply to the "face amount" of the receivables in determining the purchase price. By retaining equity interest, the provider is entitled to recover any collections on the receivables in excess of the portion of the price funded by the lender. The combination of the loan proceeds and the equity interest that the purchaser issues to the provider often makes it easier to conclude that the provider has received fair value for the receivables. The equity interest makes up any difference.

Not-for-profit providers may find it more difficult to resolve a disagreement over an appropriate discount, because in some transactions there may be regulatory, tax, or other impediments to a not-for-profit healthcare provider’s forming a for-profit subsidiary. The resulting dilemma is sometimes overcome by the formation of a stand-alone, not-for-profit entity to which the parent or an affiliate of the not-for-profit provider makes a deeply subordinated loan. The purchaser uses the subordinated loan, together with the lenders’ funds, to purchase the healthcare receivables. The lenders lend what they consider to be an appropriate discount to fair value, but through the subordinated debt, the originator receives what it considers fair value for the sale.

The experience of NCFE provides a particularly valuable lesson in how a healthcare securitization should be structured. Upon initial review, NCFE’s securitization structure appears to be very similar to that shown in Exhibit 1. News stories explained that NCFE bought receivables at a discount from healthcare providers that were "cash-short" and did not want to incur the long delays inherent in collecting Medicare and Medicaid payments. Instead, the providers received cash up front, and NCFE collected the receivables over time. However, upon closer inspection, it appears that NCFE may have strayed from the securitization paradigm.

First, NCFE appears to have grossly overestimated the expected collections on some receivables pools, thus wreaking havoc with the cash flow of the securitization vehicles. Second, NCFE and its clients appear to have executed "evergreen" receivables sales agreements without adequate provisions for the clients to terminate the arrangements, thus severely adversely affecting the clients’ financial viability, as the receivables continued to be paid to NCFE. Even after default, cash from unsold receivables was directed into accounts controlled by NCFE for the benefit of its special-purpose securitization vehicles rather than the providers. NCFE’s first departure from the securitization paradigm - the failure to calculate the purchase price for the receivables resulting in the financial default by the securitization vehicle - is a credit underwriting issue that should not necessarily have led to the NCFE programs’ second shortcoming.

Theoretically, if the providers had received payment in advance for all receivables sold to NCFE, had retained control of all receivables not so purchased, and had retained the servicing function on all receivables (or had retained a clearer right in their contract with NCFE to terminate the lock-box arrangement when NCFE stopped purchasing receivables), then the providers’ right to receive collections on unsold receivables would have been clearer.

To avoid the dilemma faced by the healthcare provider clients of NCFE, providers should retain the right to terminate a revolving securitization program at any time, as to receivables not yet sold, and to direct the collections on any such unsold receivables to a new account controlled exclusively by the provider. Instead, by agreeing to a securitization structure that appears to have lacked such safeguards, some of NCFE’s healthcare provider clients became, in effect, lenders to NCFE.

In connection with the NCFE’s bankruptcy, one commentator observed that new federal privacy rules might end the practice of securitization of healthcare receivables, even if NCFE’s troubles did not.^a The privacy standards prevent covered healthcare providers from using or disclosing certain patient health information without the patients’ prior written consent. Covenants in securitization documents may contain audit and inspection rights, and default provisions may provide for self-help remedies that involve lenders having access to such patient health information. Covered healthcare providers are required to comply with HIPAA privacy standards by April 14, 2003.

One exception to the privacy standards appears to allow a carefully crafted securitization program for healthcare receivables to proceed. The privacy standards permit a covered healthcare provider to use and disclose protected health information for the provider’s own payment operations without obtaining any patient authorization. Significantly, the preamble to the privacy standards appears to endorse sales of accounts receivable without patient authorization. Providers should carefully structure the sales and servicing agreements, audit and inspection rights, and reporting requirements in a securitization transaction to comply with the privacy standards’ use and disclosure exceptions.

In addition to establishing a method for the transfer of healthcare receivables that does not run afoul of federal anti-assignment provisions, parties seeking to set up a securitization structure should also shield the value of the receivables to be transferred from the potential bankruptcies of the originator and the purchaser. In doing so, the lenders look only (or principally) to the creditworthiness of the payers on the receivables (often, federal and state governments and large insurance companies). If the securitization structure is not bankruptcy remote, lenders will evaluate it principally on the creditworthiness of the provider, and a significant advantage of securitization will be lost.

To reduce the likelihood of the purchaser being the subject of a voluntary or involuntary bankruptcy petition, the lenders generally impose constraints on the purchaser’s ability to incur debt other than the lender debt or to grant security interests in receivables to parties other than the lenders. Lenders also may require that the consent of independent directors of the purchaser, or independent holders of beneficial interests in the purchaser (so-called "golden shares"), be obtained prior to its filing of a voluntary bankruptcy petition.

Additional bankruptcy-remoteness issues involve the effect of a bankruptcy of the provider on the purchaser. If the provider’s transfer of the receivables is determined under law to be a secured financing provided by, rather than a sale to, the purchaser, the healthcare receivables are still the property of the provider. Upon a bankruptcy of the provider, if the lenders do not have a perfected security interest in the receivables, the receivables would be available to satisfy the provider’s general unsecured creditors. Alternatively, if the purchaser can be shown to have its business and affairs so intertwined with those of the provider as to be one business, the provider’s bankruptcy trustee might use equitable principles to substantively consolidate the assets and liabilities of the purchaser with those of the provider. The limited-purpose nature of the purchaser and the securitization structure are designed to protect against both such outcomes.

The effectiveness of a securitization structure depends upon two factors: the purchaser’s independence or "separateness" from the provider and whether the receivables have been transferred to the purchaser by means of a transaction that will be treated as a sale under applicable law. In each case, counsel to the provider is usually called upon to provide an opinion that if the provider were to become subject to a bankruptcy proceeding, a bankruptcy court would conclude that the assets and liabilities of the purchaser would not be substantively consolidated with those of the provider, and that the provider’s transfer of the receivables to the purchaser would be treated as a "true sale," and not financing. If both tests can be met, the lenders can take comfort that the provider and the purchaser should not be treated as a single entity and that the purchaser, not the provider, owns the receivables. Collections on the receivables would thus be shielded from the provider’s bankruptcy.

Securitization is a useful financial tool that healthcare providers can use to their benefit. Properly structured, securitizations of healthcare receivables give healthcare providers access to a broad array of capital sources. The double-lock-box structure is generally recognized as being effective to securitize governmental healthcare receivables, and revised Article 9 of the UCC has recently resolved the uncertainty surrounding private insurance receivables in favor of allowing securitization and providing a single filing location to perfect assignments of those receivables. The HIPAA privacy standards, set to go into effect in April 2003, will require that securitizations be carefully structured to permit the parties to exercise their rights in the same manner as they have in the past. However, once the proper structure has been put in place, healthcare providers should be well-positioned to take advantage of the benefits that securitization has provided to numerous other asset classes.

^{a. Lubove, Seth, "Risky Business," Forbes.com, October 28, 2002, www.forbes.com/forbes/2002/1028/150.html.}

Mark Spradling, JD, is chair of the structured finance practice group, Vinson & Elkins LLP, Houston.