June 29, 2018, Steven Horowitz, Jane VanLare, Joshua Panas and Benjamin Beller, LAW360 - Operators of health care businesses are already feeling recent industry-specific changes on their bottom lines. Whether it’s recent regulatory change, business model disruption, technological advances, or new forms of competition, companies in the health care space have increasingly been pursuing out-of-court restructurings and, in some instances, even bankruptcy filings.
Short of a bankruptcy filing, a health care operator in financial distress may consider a number of options to streamline its operations, dispose of underperforming assets, monetize profitable business lines and otherwise improve its position. A distressed operator may also look to (or be a target of) a significant corporate transaction to reshape its business, whether through a merger, sale of assets, equity infusion, or other transaction.
However, an operator or an owner of an operator with significant assets in a master lease may find that the lease imposes a variety of restrictions on its options or creates potential landlord holdup value through lease provisions that may extend beyond their intended purpose. Below we discuss the applicability of typical master lease provisions to several nonbankruptcy restructuring options.
Major Corporate Transactions
The structure of the master lease is relevant because, even if the master lease is not directly assigned as part of such a restructuring transaction, in virtually all master leases a change of control involving the tenant or its parent company (even potentially indirect changes of control) is deemed an assignment of the master lease and therefore subject to the same anti-assignment provisions as a direct assignment of the lease.
In addition to triggering a landlord consent requirement, there are a number of potential adverse consequences of falling under these provisions:
- A requirement to deliver advance notice to the landlord, including the material terms of a proposed transaction. If the operator is a public company, it will not want the risk of the landlord refusing to consent to the transaction after the deal is publicly announced. A consent may therefore need to be negotiated with the landlord prior to signing the corporate transaction, which introduces another party into the negotiations and potentially implicates securities law restrictions on disclosure of material nonpublic information prior to announcement of a transaction.
- A request for consent to assignment may trigger a landlord right to terminate the master lease (referred to as a “recapture right”). Landlord recapture rights exist on the theory that a landlord should have the right to take back leased space and find a new tenant if its current tenant expresses a desire to assign the lease or sublease a material portion of the space for the remainder of the term. In a master lease in which a change of control is deemed an “assignment” and assignments are subject to landlord recapture, a waiver of the recapture right should be negotiated assuming the tenant wants to preserve at least some of its master leased facilities.
- Assignments (deemed or direct) may also be subject to profit-sharing provisions. Such provisions exist to ensure that a tenant does not receive excessive profit from below-market rent by subleasing or assigning to others for a profit. In the context of a single sublease, the application of the provision is relatively clear. However, application to a change of control or similar transaction is problematic. The profit sharing provision must be limited to the value of the leasehold and not, for example, capture profit received by the operator in a business transaction that has value attributed to multiple business components and services beyond the transfer of the leasehold.
- Depending on the structure of the transaction and the parties to the master lease, there is also a risk of an acquiring party stepping into the master lease provisions as tenant or guarantor. For example, a master lease may require the entity with ultimate control of the tenant to guaranty the master lease, which could be an undesirable result for an acquiring entity, whether it is a private equity fund facing the prospect of its general partner as a guarantor or a strategic purchaser not wishing to have its parent company guaranty the lease. The master lease may also have noncompetition provisions preventing the tenant or its affiliates from owning or operating competing facilities within a certain radius of the master lease facilities. The acquirer’s business could become subject to these provisions by virtue of becoming an affiliate of the tenant upon closing, a result that, depending on the master lease, may create an immediate default or require the acquirer to divest assets.
Because of the broad implications of anti-assignment provisions, the master lease needs to be reviewed carefully to determine if a contemplated transaction will constitute an assignment or deemed assignment and trigger landlord rights. A full discussion of anti-assignment provisions is beyond the scope of this article, but one should keep in mind that “control,” when used in a change-of-control provision, has a spectrum of meanings under applicable case law and other contexts to which courts may look for guidance if a transaction is litigated.
For example, under the most expansive definition of “control,” a new holder of even just 25 percent of voting power, or one with special rights to information, consultation or the right to designate a member of the board of directors of the tenant or any other entities picked up in the anti-assignment restriction could constitute a “change in control,” as could a change in the majority of board members of the tenant or other applicable entities.
Relatedly, the sale of all or substantially all of the tenant’s assets may be deemed an assignment requiring the landlord’s consent, even if such a sale does not involve a direct assignment of the master lease itself. For example, a master lease provision preventing an indirect change of control may also prevent a sale of all or substantially all of the parent company’s assets, on the basis that such a sale is equivalent to a change of control.
An asset sale restriction could implicate a number of business strategies. For example, the tenant’s parent company or an acquirer of the parent company may be looking to sell off more profitable business lines while leaving the master lease in place.
Unless the master lease specifically discusses what constitutes substantially all of the tenant’s assets, the question is subject to a quantitative and relatively subjective qualitative standard, introducing uncertainty into the potential transaction. Quantitatively, while there is no bright line, the case law looks at the percentage of value, revenue and operating profit represented by the assets being transferred.
Thus, if a transaction involves the transfer of assets comprising less than 50 percent of the entity’s value, revenues and profits, such transfer generally will not be considered a transfer of “all or substantially all” of that entity’s assets. Qualitatively, courts have looked at the importance of transferred assets to the business of the transferor.
This analysis typically includes determining whether the transferor would retain valuable and profitable economic assets after the transaction, remain a profitable going concern, and have the business components necessary to meet its obligations after giving effect to the proposed asset transfer.
The parties will also need to be mindful of financial covenants in the master lease, which may be implicated based on the financing of the transaction and the general financial health of the tenant going forward. Some master leases may provide cure rights for any breach of such covenants, and the cure period may be sufficient for the contemplated transaction, but there will often be limits on the number of times such cures can be exercised.
Finally, depending on the transaction structure (for example, in an asset sale), the existing tenant and/or guarantor may want to be released from its obligations after the closing. As a matter of law, an assignor is not released from its obligations by virtue of an assignment.
Furthermore, it is common for a master lease to indicate that the tenant and guarantor remain liable following any assignment. Any prospective release will therefore most likely require negotiations with the landlord and disclosure of the creditworthiness of the proposed replacement guarantors and the assignee.
Disposing of Underperforming Properties
Instead of a major corporate transaction, the tenant may seek to unload underperforming master leased facilities. Because master leases are structured as a unitary lease, the tenant will have little flexibility to cherry-pick the good and bad facilities under the lease. Indeed, a landlord will resist such flexibility in drafting the lease to ensure that the tenant is forced to lease the good with the bad properties and to ensure that the tenant cannot reject individual leased facilities in a bankruptcy filing rather than the master lease itself. Therefore, a tenant will not have the right to assign the master lease as to a particular facility. However, the tenant may still be able to pursue other options:
- Buy out. A master lease may occasionally give the tenant the right to buy out underperforming assets based on a fair market value formula, often with a gross up to the landlord to account for any capital gains on the sale. Such formulas will typically assume the properties are in good order and repair (notwithstanding any tenant failure to perform its maintenance and repair obligations) and deem the facility to have a certain level of occupancy, even if actual occupancy is lower.
- Sublease. Subleasing a portion of a leased facility may help a tenant consolidate its operations and find a party to bear some of its rental burden. Master leases will typically permit some level of subleasing without landlord consent (or subject to a reasonable consent standard), but because a subtenant will be subject to all terms and conditions of the master lease the range of potential subtenants will be limited to the permitted use under the master lease. A master lease may occasionally permit subleases for uses “ancillary” to the permitted use, which creates somewhat greater flexibility. If a master lease requires consent or notice for a sublease, the master lease should be reviewed to identify a recapture provision (as discussed above) and the tenant should consider the consequences of the landlord exercising such a right to take back the space proposed to be sublet. A landlord recapture may not be an undesirable result, but care should be taken that the recapture right does not apply to the entire facility (versus the proposed sublet space).
- Shut down. The tenant may have leased facilities where operational costs exceed profits and subleasing or terminating are not an option. In these cases, shutting down a facility, closing a wing or otherwise curtailing operations might be considered. The master lease should be reviewed for any applicable continuous use or operating covenants. The tenant will also need to consider ongoing maintenance, repair, security and related obligations, which will not typically cease during a closure. A master lease may also require the tenant to maintain a certain number of licensed beds at each facility, and nonuse of licensed beds may impact licensure. A master lease may permit what is referred to as “bed banking,” in which licensed beds are voluntarily removed from service but may be reactivated at the leased facility without new governmental approval. A master lease will typically contain specific caps on licensed bed reductions by facility and across the entire master lease, and any historical reductions will need to be considered to determine what additional bed banking or similar rights are still available.
To lower operational costs (for example, employee-related costs), a tenant may consider engaging a manager to operate the facility on a day-to-day basis. Even if the lease does not expressly require consent for such a manager, the master lease should be reviewed to determine whether the arrangement would constitute a cessation of operations, an assignment of an interest in the lease, or use or possession by another. A structure in which the tenant maintains regulatory licenses and authority to make major decisions related to operations is more likely to withstand scrutiny under the typical master lease provisions this structure would implicate.
In many cases, a master lease provision such as the ones described above may not specifically apply or there may be ambiguity, but the provision is enough to create deal uncertainty due to landlord holdup value. Even if the landlord would have trouble enjoining a transaction, risk of litigation and potentially limited remedies against a landlord based on the terms of the lease may force the tenant to reach a deal with the landlord rather than face uncertainty, which could result in the landlord demanding concessions, such as a new guarantor, addressing deferred maintenance and any other deficiencies the landlord sees in the lease and the tenant’s operations.
Despite some of these obstacles to a successful resolution of master lease obligations with a landlord, operators are still likely to find in certain circumstances that their landlords are amenable to work cooperatively with their tenants in financial distress to avoid a bankruptcy, which can be time-consuming and expensive. In addition to the cases mentioned above, there have also been instances where landlords have (a) agreed to extend lease expiration dates and provide rent credits in exchange for certain control rights over the operator; (b) provided financing to the operator as part of an overall restructuring; and (C) permitted tenants to sell its interest in the leased facilities in exchange for a portion of the proceeds.
Distressed health care companies should think about these issues early enough so that they preserve all options to negotiate with their landlords and come to a mutually beneficial solution. An operator that waits to engage with its landlord and other creditors until it is moving quickly down a short runway is less likely to arrive at the most efficient solution and preserve maximum value.
Steven G. Horowitz and Jane VanLare are partners, Joshua Panas is a senior attorney, and Benjamin S. Beller is an associate at Cleary Gottlieb Steen & Hamilton LLP.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
 See Emerald Partners v. Berlin, 726 A.2d 1215, 1221 (Del. 1999) (finding 25 percent shareholder who also served as chairman and CEO of company to be a controlling shareholder). It is also conceivable that a court could look to the thresholds for voting power constituting “control” used by existing regulatory regimes, such as by the U.S. Securities and Exchange Commission and/or the New York Stock Exchange, which employ a “significant influence” test based on “facts and circumstances” under which a 10 percent voting power threshold has been found sufficient to constitute “control.”
 See, e.g., Markettxt Holdings Corp. v. Softbank AM Corp., 361 B.R. 369 (Bankr. S.D.N.Y. 2007) (finding preferred shareholder who held the right to appoint directors to two seats on board of directors and therefore controlled the board’s ability to obtain a quorum exercised “control” over the corporation).
 For a more fulsome discussion of potential issues with healthcare master leases in bankruptcy, see “Healthcare Master Leases in Bankruptcy: Out of One, Many?” 14 Pratt’s Journal of Bankruptcy (LexisNexis A.S. Pratt), July 2018 (forthcoming).
 In any plan to attempt to consolidate operations, it should be kept in mind that a master lease may prevent moving patients from leased facilities to nonleased facilities.
 Restructuring of Ventas and Brookdale Senior Living leases in April 2018. https://www.prnewswire.com/news-releases/brookdale-enters-into-mutually-beneficial-agreements-with-ventas-300637893.html.
 Restructuring of Sabra Health Care REIT Inc. and Signature HealthCARE leases in May 2018. https://globenewswire.com/news-release/2018/05/07/1497975/0/en/Sabra-Restructures-its-Contractual-Relationship-with-Signature-HealthCARE.html.
 Sale of assets by Kindred Healthcare Inc. to BM Eagle Holdings LLC. https://www.businesswire.com/news/home/20170630005847/en/Kindred-Announces-Definitive-Agreement-Divest-Skilled-Nursing.