When Health Care Providers Go Belly Up

When Health Care Providers Go Belly Up
New Jersey Law Journal

When a healthcare provider files for bankruptcy protection under Chapter 11 of the Bankruptcy Code, one of the first, and probably most critical, questions that arise is: Will Medicare payments and/or capitation or other third-party insurer payments continue to flow to the debtor to finance its operations? In order to understand the nature and import of this question, one needs to have a basic understanding of how Medicare, capitation and other third party insurer payments are paid, as well as an understanding of the doctrines of setoff and recoupment.

Healthcare Provider's Main Sources of Income

A healthcare provider's income is primarily derived from (i) federal programs, such as Medicare, which provide health insurance for eligible beneficiaries; and (ii) private sector insurance companies which provide coverage for their enrollees.

For a healthcare provider to be a participant in the Medicare program, 42 U.S.C. § 1395-1395ccc, it must execute an agreement with the United States Department of Health and Human Services ("HHS" or "the Department"). Through executing a provider agreement, a provider becomes eligible for reimbursement payments, in accordance with the terms of the Medicare statute, for services rendered to Medicare beneficiaries. In exchange, the provider agrees to charge these beneficiaries only as allowed by statute and to comply with certain civil rights laws in providing these services.

Medicare reimbursement of inpatient hospital services is governed by a rather complex system which takes into account, among other things, the type of services provided as well as geographical differences in the cost of labor. HHS makes reimbursements through fiscal intermediaries, such as the Blue Cross Association. To insure that providers are paid promptly, the Medicare statute requires that payments be made at least monthly and otherwise at the discretion of HHS. 42 U.S.C. § 1395(g)(a). Under the usual reimbursement procedures, periodic interim payments, which are estimates of actual expenditures, are made by the intermediary upon application by the provider at the discharge of each Medicare patient. The actual expenditures of each provider in rendering medical services are audited by the intermediary annually to determine whether the provider has been over or underpaid by Medicare for that cost-year. HHS then adjusts the provider's Medicare reimbursement payments in the subsequent cost year to account for any prior over or underpayments. 42 U.S.C. § 1395(g)(a). These cost year adjustments are mandated by Medicare's statutory payment system.

Private Insurance Programs And Capitation Payments
With private sector insurance, the payment schemes are equally complex. Under these programs, insurers typically reimburse the patient or make direct payments to the healthcare provider for covered services at established rates. Most payment arrangements involve either payment for specific services, negotiated bids, or fixed reimbursement systems. Commercial insurers, self insured employers, and self pay patients typically pay for medical services on a fee for service basis. The insurer frequently pays only a fixed percentage of the bill rendered by the provider with the remainder of the bill to be paid by the patient.

Managed healthcare systems, such as a health maintenance organization ("HMO"), often make arrangements with hospitals, physician practice management companies and other providers on a uniform fee per person enrolled in the HMO. This is known as capitation. Capitation payments for a given month are determined by reference to the number of enrollees of a HMO that are assigned to the hospital, physician practice management company or other provider in reimbursement for all medical services to be provided to the HMO's enrollees for that month. The provider is then obligated, pursuant to its agreement with the insurer, to pay the medical professionals rendering the services. Under this arrangement, a flat fee per enrolled member is agreed to, regardless of the number or kinds of medical services provided, over the course of a year, although capitation fees are typically assessed and paid on a monthly basis. Under this scheme, the provider may not look to the enrollees for payment over and above the capitation fees paid by the HMO. Often recapture of either overpayments or underpayments by the insurer because of an increase or decrease of enrollees is conducted retrospectively on a monthly basis as part of the agreement between the insurer and the provider. Additionally, an insurer typically contracts to have the right to pay the medical professionals directly in the event the medical professionals are not paid by the provider. Such direct payment by the insurer enables the insurer to seek reimbursement from the provider by reducing future capitation fees.

Each of the foregoing adjustments, whether by Medicare on a cost year basis or by private sector insurers on a monthly basis, depending on the factual circumstances, are examples of setoff or recoupment.

The Debtor-In-Possession And the Doctrines of Setoff And Recoupment

To understand the nature and scope of the doctrines of setoff and recoupment, it is helpful to illuminate some key bankruptcy concepts, as well as to distinguish the legal doctrines of setoff and recoupment from each other.

The Debtor and the Debtor-In-Possession
The filing of a bankruptcy petition creates a bright line demarcation between the debtor's pre-petition past and its post-petition future. The debtor enters into a bankruptcy case burdened with its pre-petition obligations which are owed to its pre-petition creditors. However, upon the bankruptcy filing, all the debtor's pre-petition assets are vested in a post-petition debtor-in-possession which is protected by the automatic stay of the Bankruptcy Code (11 U.S.C. § 362). The automatic stay is a statutory injunction which prohibits any pre-petition creditors from taking any action against either the post-petition debtor-in-possession or the assets which have now been vested in the debtor-in-possession in payment of the creditors' pre-petition claims. As frequently expressed, the purpose of the automatic stay is twofold: (a) it protects creditors from the dismemberment of the debtor's assets by reason of a race to the courthouse; and (b) it provides the debtor-in-possession with a breathing spell in which to reorganize its affairs.

One area in which creditors may be provided with relief from the injunction of the automatic stay is found in the Bankruptcy Code's recognition of a creditor's right of setoff.

The doctrine of setoff, incorporated in Bankruptcy Code Section 553, entitles a pre-petition creditor to offset any pre-petition debt owed by the debtor to the creditor in payment of the creditor's pre-petition claims, provided that four conditions exist: (1) the creditor holds a "claim" against the debtor that arose before the commencement of the case; (2) the creditor owes a "debt" to the debtor that also arose before the commencement of the case; (3) the claim and debt are "mutual"; and (4) the claim and debt are each valid and enforceable. 5 Collier On Bankruptcy 553.01[1], 553-7 (15th Ed. Revised 1998). The "mutuality" requirement of Section 553 limits the extent of setoff solely to claims which the creditor and debtor could assert against each other in the pre-petition period. Generally, the mutual debts arise from separate and different factual transactions, e.g., the creditor may be the debtor's landlord seeking payment of two (2) months pre-petition rent and the debtor may have provided the landlord with landscaping services pre-petition that remain unpaid. To effect the setoff, however, a creditor pursuing this right must petition the bankruptcy court for relief from the automatic stay.

In contrast to setoff, recoupment allows a creditor to reduce its post-petition obligations to the debtor by the amount of the creditor's pre-petition claim, provided that both the claim and the debt arise from the same factually integrated transaction which straddles both the pre- and post-petition periods. As a result, recoupment has the potential of (i) allowing some pre-petition creditors to be paid in full from a debtor's post-petition assets to the detriment of other creditors and (ii) depriving a debtor from receiving post-petition payments which would enable it to reorganize its business. This recoupment chain of events recently led one bankruptcy judge to remark: "From a bankruptcy perspective, that is as bad as it gets." St. Francis Physician Network, Inc. v. Rush Prudential HMO, Inc. (In re St. Francis Physician Network, Inc.), 213 B.R. 710, 714 (Bankr. N.D. Ill. 1997). See also Shalom L. Kohn, "Recoupment Re-examined," National Conference of Bankruptcy Judges Educational Program, 1-3 (1998) (contending recoupment doctrine should not be interpreted as permitting a pre-petition creditor to be paid by recouping against goods or services provided by the debtor post-petition).

Unlike setoff, the Bankruptcy Code does not contain a statutory provision authorizing recoupment. Rather, recoupment is an equitable doctrine that attempts to reconcile the law of contracts and bankruptcy law. This doctrine has been justified on the grounds that when "the creditor's claim against the debtor arises from the same transaction as the debtor's claim [against the creditor], it is essentially a defense to the debtor's claim . . . rather than a mutual obligation, and the application of the limitations of setoff in bankruptcy would be inequitable." Lee v. Schweiker, 739 F.2d 870, 875 (3d Cir. 1984). In the bankruptcy context, recoupment has often been applied when the relevant claims arise out of a single contract "that provide[s] for advance payments based on estimates of what ultimately would be owed, subject to later correction, . . ." Ashland Petroleum Company v. Appel (In re B&L Oil Co.), 782 F.2d 155, 157 (10th Cir. 1986). Although the usual posture of recoupment cases involves a defensive invocation of recoupment in response to a debtor filing suit to recover sums owing post-petition, a creditor may use recoupment in an "offensive" posture. See, e.g. Megafoods Stores, Inc. v. Flagstaff Realty Associates (In re Flagstaff Realty Associates), 60 F.3d 1031, 1035 (3d Cir. 1995) (allowing creditor tenant to use recoupment against the debtor landlord when tenant's repair costs claim arose from same lease as landlord's rent claim and it would be inequitable for landlord to receive rent without compensating tenant for undertaking repairs).

Recoupment's Genesis in the Third Circuit

In 1944, in In re Monogahela Rye Liquors, Inc., 141 F.2d 864, the Third Circuit discussed recoupment in addressing whether two claims were sufficiently related that a state's filing of a claim as to one waived its sovereign immunity as to the other. In its this analysis, the Third Circuit observed: "The rule of recoupment in bankruptcy derives from the rule that the trustee takes the bankrupt's property subject to the equities therein." 141 F.2d at 869.

Monogahela Rye Liquors spawned the seeds for the Third Circuit's decision in Lee v. Schweiker, 739 F.2d 870 (3d Cir. 1984). In Lee, the debtor, a social security recipient, received an overpayment of benefits prior to her filing for bankruptcy protection under Chapter 13. As a result of a pre-petition agreement between the debtor and the Social Security Agency, the Social Security Agency reduced its monthly payments by an amount designed to recover the pre-petition overpayments. After the debtor's bankruptcy filing, the Social Security Agency continued to pay the debtor the reduced amount. In response, the debtor sued the Social Security Agency to compel full payment of her social security benefits without any deduction for the pre-petition overpayment. The bankruptcy court upheld the Social Security Agency's actions by relying upon the agency's statutory right of setoff contained in the Social Security Act (42 U.S.C. § 404(a)(1)) without any reference to the mutuality restrictions of the Bankruptcy Code.

On appeal, the Third Circuit rejected the government's argument that its statutory right of setoff was not limited by the Bankruptcy Code's restriction of mutuality. Furthermore, the Third Circuit rejected the Social Security Agency's attempt to invoke the doctrine of recoupment as justifying its reduced payment. The Third Circuit held recoupment was inapplicable because there was no contract involved between the debtor and the Social Security Agency which could form the basis for a recoupment. Rather, the Third Circuit concluded that the payments arose from the debtor's statutory entitlement to income based solely upon her qualification for the statutory benefits:

  . . . Social welfare payments, such as social security, are statutory "entitlements" rather than contractual rights. The purpose of these payments is to provide income to qualifying individuals. Although the paying agency can ordinarily recover overpayments, just as creditors can ordinarily obtain payment from a debtor's future income, the Bankruptcy Code protects a debtor's future income from such claims once a petition has been filed, and the [Social Security Agency] violated the automatic stay in continuing to withhold part of Lee's benefits after she had filed her petition. 739 F.2d at 876.

Recoupment Refinement In Healthcare Provider Bankruptcies

In 1992, against the backdrop of Monogahela Rye Liquors and Lee, the Third Circuit was presented with University Medical Center v. Sullivan (In re University Medical Center), 973 F.2d 1065. On January 1, 1988, University Medical Center ("UMC") filed for bankruptcy protection under Chapter 11. UMC derived a significant portion of its income from rendering services to Medicare beneficiaries pursuant to UMC's provider agreement with HHS.

After the bankruptcy filing, HHS, through its fiscal intermediary (Blue Cross), informed UMC that it had overpaid UMC in the amount of $276,042 for Medicare services provided in 1985 and that Blue Cross would begin 100% withholding of interim post-petition reimbursement payments unless UMC either made immediate repayment or agreed to a long-term repayment schedule for the pre-petition overpayments. UMC did not respond. As a result, Blue Cross withheld a $58,000 post-petition payment becoming due on February 18, 1988. Prompted by this action, UMC agreed to repay the 1985 overpayment at a rate of $15,000 per month over a period of 18 months. However, approximately a month later on March 28, Blue Cross rejected this payment schedule and announced that it would withhold all post-petition reimbursement payments until the pre-petition overpayment had been paid in full. Three days later, UMC closed its doors and ceased doing business.

UMC then filed an adversary proceeding against HHS seeking, among other things, a turnover of the payments earned by UMC post-petition which were being withheld by Blue Cross. HHS answered by claiming the contractual defense of recoupment. The bankruptcy court rejected this defense, in part, because the provider agreement with HHS had not been assumed by UMC post-petition and thus could not form the basis for an integrated factual transaction for which recoupment could be asserted. The district court similarly rejected HHS' recoupment defense because HHS was unable to establish that the post- petition payments were part of a "single transaction" on which recoupment could be based.

On appeal, HHS argued "that the same 'broad and flexible standard' employed to determine the scope of compulsory counterclaims" should define its transaction with UMC and allow its recoupment claim. In affirming the district court and rejecting HHS' contention, the Third Circuit stated that in order to classify as the "same transaction" for recoupment in the bankruptcy context: "both debts must arise out of a single integrated transaction so that it would be inequitable for the debtor to enjoy the benefits of that transaction without also meeting its obligations." 973 F.2d at 1081. Moreover, the Third Circuit explained that the "se of this stricter standard for delineating the bounds of a transaction in the context of recoupment is in accord with the principle that this doctrine, as a non-statutory, equitable exception to the automatic stay, should be narrowly construed." Id.

The Third Circuit observed that the 1985 overpayments did not arise from the "same transaction" as the 1988 post-petition payments because "[t]he 1988 payments were independently determinable and were due for services completely distinct from those reimbursed through the 1985 payments." Id. Specifically, the court stated:

  The relevant regulations state that each provider cost-year is subject to a distinct annual audit, which follows the submission of a separate cost report for each fiscal year. See 42 C.F.R. §§413.20(b), 413.24(f) (1991). These regulations indicate that reimbursement payments made for any one year arise from transactions wholly distinct from reimbursement payments made for subsequent years.973 F.2d at 1080.

Accordingly, the Third Circuit reasoned that "UMC's post-petition services were the beginning of transactions that would stretch into the future, but they were not part of the 1985 transactions." at 1082. <>

In First American Health Care of Georgia Inc. v. United States Department of Health and Human Services (In re First American Health Care of Georgia, Inc), 208 B.R. 985 (Bankr. S.D. Ga. 1996), FAHC and its subsidiaries were health care providers operating under provider agreements with HHS, which successfully utilized the University Medical ruling to obtain a restraining order from the bankruptcy court to prevent HHS from exercising its alleged right of recoupment to reduce post-petition reimbursement payments by the amount of overpayments made to FAHC for services rendered in preceding years. In February 1996, FAHC was the largest privately owned home health care provider in the United States; employing over 15,000 people and serving 32,000 patients annually. FAHC's February 21, 1996 bankruptcy filing was precipitated by HHS notifying FAHC that its next bi-weekly payment of $22 million and those that were scheduled to follow would be withheld due to allegations of fraud, with the government estimating that it had overpaid FAHC by approximately $25 million for the time period from 1988 to 1992. Because ninety-eight percent of FAHC's revenues originated with HHS, FAHS filed for bankruptcy protection and sought to enjoin HHS from withholding such monies.

In ruling on FAHC's "substantial likelihood of success on the merits" in granting the injunction, the First American court cited University Medical to conclude that HHS' recoupment defense based on the 1988-1992 overpayments would fail: "as recognized by the Third Circuit, Medicare payments are made on an annual basis, therefore, 'reimbursement payments made for any one year arise from transactions wholly distinct from reimbursement payments made for subsequent years.'" 208 B.R. at 990 (quoting University Medical, 973 F.2d at 1080). "Thus, any payments made for previous years are 'independently determinable' and were made 'for services completely distinct from those reimbursed' for other years." Id. Consequently, the court held that HHS may only recoup post-petition any overpayments made for services provided from January 1, 1996 to the petition date, i.e., February 21, 1996. Id. [Note: Subsequently, FAHC and HHS entered into a Consent Order providing, inter alia, for the continuation of post-petition payments and prohibition on the government's exercise of recoupment for pre-petition overpayments. First American Health Care of Georgia, Inc. v. U.S. Department of Health and Human Services, 1996 WL 282149 (Bankr. S.D. Ga. March 11, 1996).]

Several courts, however, have disagreed with the holding and analysis of University Medical and have allowed HHS to recoup pre-petition overpayments from a debtor's post-petition services. In U.S. v. Consumer Health Services of America, Inc., 108 F.3d 390 (D.C. Cir. 1997), the D.C. Circuit allowed recoupment in a case nearly identical to University Medical. Consumer Health Services of America ("CHSA") was a provider of home health services, which owed over $32,000 to HHS for 1981-1982 overpayments when it filed for Chapter 11 protection in 1987. In considering HHS' motion to exercise its right of recoupment, the D.C. Circuit relied on the Medicare statute's grant of the power of adjustment to HHS:


  The Secretary shall periodically determine the amount which should be paid under this part to each provider of services with respect to the services furnished by it, and the provider of services shall be paid, at such time or times as the Secretary believes appropriate (but not less often than monthly) and prior to audit or settlement the amounts so determined, with necessary adjustments on account of previously made overpayments or underpayments. 42 U.S.C. § 1395g(a).

The D.C. Circuit held that the Medicare statutory scheme mandated recapture of past overpayment and, as a result, the overpayments and post-petition services were part of the same integrated transaction required for recoupment. The crux of the D.C. Circuit's disagreement with the Third Circuit was not the fact that a single integrated transaction was a prerequisite for recoupment but the D.C. Circuit's view that the Medicare Statute should define the nature of the "transaction" for recoupment purposes.

Since the rulings by the Third Circuit and D.C. Circuit on HHS' recoupment for prior cost year overpayments, the lower courts are split on the issue.

Following University Medical: In re Healthback, L.L.C., 226 B.R. 464, 476 (Bankr. W.D. Okla. 1998) ("[T]he defining boundary for separate transactions in this matter will be the pre- and post-petition periods, . . . Any post-petition withholdings by [HHS] will be considered violations of the automatic stay"). Following Consumer Health: Sims v. U.S. Dep't of Health and Human Services (In re TLC Hospitals, Inc.), 225 B.R.709, 714 (N.D. Cal. 1998) ("This interim payment procedure is based upon the continuing legal relationship between the provider and the program . . . Rather than delineate one transaction from another, the process merely reflects the realities of the complexity of the Medicare Program"); AHN Homecare, LLC v. Home Health Reimbursement, et al. (In re AHN Homecare, LLC), 222 B.R. 804, 812 (Bankr. N.D. Tex. 1998) ("The contract between [debtor] and HHS, despite individual delivery of services and payment of costs, constitutes 'one transaction' for purposes of recoupment"); In re Southern Institute for Treatment And Evaluation, Inc., 217 B.R. 962, 965 (Bankr. S.D. Fla. 1998) ("[T]he ongoing flow of payments and subsequent yearly adjustments constitutes one single transaction, irrespective of the periodic filing and auditing of a cost report"). See also Malinowski v. New York State Department of Labor (In re Malinowski), 156 F.3d 131, 134 (2d Cir. 1998) (adopting University Medical's narrow recoupment standard for purposes of New York's unemployment insurance benefits but stating, in dicta, "n the case of federal benefits, Congress is certainly able to decide on what terms it will grant benefits, since it is able to override its own bankruptcy laws at will").

A few recent healthcare bankruptcy cases, dealing with recoupment in the context of capitation payments by private sector insurers, have followed the narrow construction of recoupment espoused in University Medical. In St. Francis, 213 B.R. 710 (Bankr. N.D. Ill. 1997), the court ordered Rush Prudential HMO, Inc. ("Rush") to continue post-petition capitation payments to debtor St. Francis Physician Network, Inc. ("SFPN") notwithstanding the fact that Rush had pre-petition claims for overpayment against SFPN arising out of its medical provider agreement with Rush. SFPN was an independent practice association of doctors that provided healthcare services under agreements with various HMOs and insurance companies such as Rush. Like most medical provider agreements, the one presented to the St. Francis court required that: (i) Rush pay SFPN a monthly capitation fee for its services, (ii) SFPN provide medical services to Rush enrollees, and (iii) SFPN pay the medical professional who provided the service.

Beginning in September 1996, SFPN failed to pay some medical professionals who had rendered medical services to Rush's enrollees. The medical professionals then billed Rush's enrollees, and they, in turn, complained to Rush. Rush immediately began withholding capitation payments from SFPN and reimbursed the medical professionals directly. Two months later, SFPN filed for Chapter 11 and commenced an adversary proceeding against Rush seeking an injunction directing Rush to turn over all withheld pre-petition capitation fees and, on a prospective basis, refrain from paying any medical professionals directly while withholding capitation fees from SFPN. In response, Rush claimed the right of recoupment.

In granting the debtor's injunction, the Court framed the issue as whether, pursuant to its provider agreement with SFPN, Rush was entitled to pay medical professionals directly and then deduct the amount of such payments from the capitation fees due SFPN. The court noted that "circuit courts have generally recognized the potential inconsistency between recoupment and bankruptcy policies and have attempted to resolve the issue by focusing on the 'same transaction' requirement for recoupment as a means of limiting the reach of the doctrine." 213 B.R. at 718. After discussing University Medical's narrow construction of recoupment in bankruptcy as applied in the context of Medicare payments, the St. Francis court stated that "[s]atisfaction of the 'same transaction' test - requires that there be such a close, necessary relationship between the events that give rise to the debtor's post-petition claim and the events that gave rise to the creditor's pre-petition claim that the amount of the former cannot fairly be determined without accounting for the latter." Id. at 719. Applying this narrow construction of the "same transaction" standard, the court held that Rush should not be allowed to recoup its pre-petition payments to medical professionals through its post-petition capitation payments to SFPN because: (i) SFPN's post-petition capitation fees were calculated according to the provider agreement without reference to any other provisions of the same agreement allowing Rush to pay medical professionals for services in the event they were not paid by SFPN; and (ii) the claims of medical professionals, which Rush paid directly, arose from separate agreements allowing Rush with SFPN, and not Rush, and were for pre-petition services unrelated to the post-petition services that now gave rise to SFPN's claim for the payment of capitation fees. Id. at 720. As a result, the St. Francis court rejected Rush's claim to recoupment.

In the bankruptcy proceedings of FPA Medical Management, Inc. ("FPA") and its subsidiaries (collectively "Debtors"), currently pending in the United States bankruptcy court for the District of Delaware, Case Nos. 98-1596 (PJW) through 98-1685 (PJW), the Honorable Peter J. Walsh dealt with the same issue presented in St. Francis. As part of their "first day motions," the Debtors sought an injunction directing certain HMOs and other pre-paid insurance plans (collectively, "Payors") to continue to pay post-petition capitation fees and to refrain from withholding payments due to the Debtors or to pay the medical professionals directly on account of any pre-petition services and claims. The Debtors were a national physician practice management company which managed primary care physician practices that contracted with various health insurance plans in the private sector as well as Medicare and Medicaid. As of March 1998, the Debtors were affiliated with approximately 7900 primary care physicians, who provided services to approximately 1,416,000 enrollees of 53 Payors in 29 states.

The Debtors primary sources of revenue were the capitation fees it received pursuant to its agreements with the Payors (the "Payor Agreement(s)"). Similar to the agreement in St. Francis, under the Payor Agreements, the capitation payments for a given month were determined by reference to the number of enrollees of a Payor's plan that were assigned to a Debtor entity. In return, the Debtor entity was obligated to cause medical services to be provided to a Payor's enrollees for that month.

In support of its request to enjoin the Payors, the Debtors made basically two arguments. The first argument was that, in bankruptcy, (a) executory contracts cannot be enforced against a debtor prior to the debtor assuming the contract and (b) Bankruptcy Code Section 365 required continued performance by the non-debtor party pending the debtor's assumption or rejection of the executory contract. See NLRB v. Bildisco & Bildisco, 465 U.S. 513, 532, 104 S. Ct. 1188, 1199 (1984). As a result, the Debtors contended that, even if a Payor Agreement expressly provided for recoupment, enforcement of such contractual language was prohibited before the Debtors assumed the contract and was required to cure. The second argument was that Payors are not entitled to recoupment pursuant to the University Medical and St. Francis decisions. Specifically, the Debtors argued under University Medical that recoupment should be allowed only if: (i) there was a "single integrated transaction" and (ii) it would be inequitable for the debtor to receive the benefits of its contracts with the Payors without enforcement of the contracts as to pre-petition events.

As for the "single transaction," the Debtors relied on the reasoning of University Medical and St. Francis to argue that there was no factual relationship between post-petition capitation fees and the Payors' pre-petition claims for reimbursement by reason of the Payors' direct payment to medical professionals who had contracted with the Debtors. As to any claimed inequity, the Debtors asserted that the objecting Payors offered no reasons why they should be treated differently than any other unsecured creditor on account of their pre-petition claims.

On December 9, 1998, Judge Walsh, in an oral opinion, determined that "the Payors are not entitled, as a matter of equity, to exercise recoupment rights by withholding from the debtor post-petition capitation payments by reason of any pre-petition [medical professional] payments that those Payors may have made." After adopting University Medical's and St. Francis' "very limiting" same transaction requirement, Judge Walsh followed the reasoning in St. Francis to hold "that the pre-petition payments to the [medical professionals] is not sufficiently connected, albeit arising out of the same contract to the post-petition capitation payments in order to invoke the equitable remedy of recoupment."


In the healthcare provider context, whether a court allows a creditor to exercise recoupment can mean the difference between granting the debtor the opportunity to reorganize versus forcing the debtor to immediately liquidate. Consequently, the Third Circuit's narrow construction of the recoupment doctrine, which has recently been followed by the St. Francis and FPA courts, appears to provide a means for effectuating the bankruptcy policies of granting a debtor the opportunity to reorganize while treating all similarly situated pre-petition creditors equally. However, until the recoupment standard is clarified through either the United States Supreme Court resolving the apparent conflict among the circuits or Congress amending the Bankruptcy Code, bankruptcy practitioners should expect motions seeking to enjoin the exercise of the right of recoupment as part of the first day motions in healthcare provider Chapter 11s.


1Mr. O'Grady and Mr. Mairo currently represent First Union, as indenture trustee, in the FPA Medical Management, Inc. consolidated cases discussed herein, which are pending in the Bankruptcy Court for the District of Delaware. =-1>

2 As explained in its legislative history, the automatic stay, is an essential protection for both debtors and creditors:

The automatic stay is one of the fundamental debtor protections provided by the bankruptcy laws. It gives the debtor a breathing spell from his creditors. It stops all collection efforts, all harassment, and all foreclosure actions. It permits the debtor to attempt a repayment or reorganization plan, or simply to be relieved of the financial pressures that drove him into bankruptcy.

The automatic stay also provides creditor protection. Without it, certain creditors would be able to pursue their own remedies against the debtor's property. Those who acted first would obtain payment of the claims in preference to and to the detriment of other creditors. Bankruptcy is designed to provide an orderly liquidation procedure under which all creditors are treated equally. A race of diligence by creditors for the debtor's assets prevents that.

H.R. No. 95-595, reprinted in 1978 U.S.C.C.A.N. 6296-6297.