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Focus on Health Care Provider Bankruptcies

After reaching a four-year high in 2018, the volume of heath care and medical industry bankruptcy filings in the United States continues to be significant. According to statistics provided by New Generation Research's bankruptcydata.com, as of the end of 2020, bankruptcies in health care and medical sector companies—including hospitals, physicians' offices and clinics, specialty outpatient facilities, assisted-living facilities, and other providers—numbered 752, of which 458 were chapter 11 filings, compared to 678 total filings (405 chapter 11 cases) in 2019, and 937 total filings (668 chapter 11 cases) in 2018. With the special challenges posed by the COVID-19 pandemic, other industries (i.e., real estate, restaurant, construction, oil and gas, and entertainment) led the way in the number of bankruptcy filings in 2020. Even so, health care provider bankruptcies still made up a large part of the total volume, in part because providers have been hit hard during the pandemic by plummeting revenue due to the curtailment of elective surgical procedures and physician visits. In addition, elder care facilities criticized for their substandard response to the crisis have faced litigation and increased government regulation.

Other than pandemic-driven issues, the financial woes of health care providers can be attributed to a number of factors, including continuing uncertainty concerning the possible collapse, replacement, or defunding of the Affordable Care Act; increased competition; the need for investment in additional personnel and technology; the erosion of profitability due to the evolution from a "fee for service" payment model to a "bundle of services" payment model; liquidity problems caused by government payment disputes; operational changes; and increased pharmaceutical costs. These and other factors have led an increasing number of financially distressed providers to consider bankruptcy as a vehicle for effectuating closures, consolidation, restructurings, and related transactions.

Even if a health care provider seeks bankruptcy protection, its ability to continue operating or consummate a sale of its assets is by no means assured. In part, this is because government authorities have routinely taken the position in the bankruptcy courts that: (i) Medicare and Medicaid provider agreements cannot be sold or assigned without payment of associated liabilities, such as overpayment claims; (ii) government withholding of Medicare and Medicaid payments after a provider files for bankruptcy to recover pre-bankruptcy overpayments is excepted from the automatic stay under the "police and regulatory powers" exception; and (iii) government authorities are not prohibited by the automatic stay from recouping pre-bankruptcy overpayment claims or other liabilities from post-bankruptcy Medicare or Medicaid program payments. Each of these issues has been addressed in recent court rulings.

For example, in some cases generating controversy, courts have held that health care debtors can sell provider agreements in bankruptcy "free and clear" of associated liabilities, but those rulings were later vacated due to settlement of the issues or abandonment of the sale transaction. See, e.g., In re Verity Health Sys. of California, Inc., 606 B.R. 843 (Bankr. C.D. Cal. Sept. 26, 2019) (a provider agreement is a "statutory entitlement" that may be sold under section 363(f) of the Bankruptcy Code free and clear of the debtor provider's liabilities, including overpayments, rather than an executory contract that could be assumed and assigned only if such liabilities were cured), vacated, 2019 WL 7288754 (Bankr. C.D. Cal. Dec. 9, 2019); In re Center City Healthcare, LLC, No. 19-11466 (KG) (Bankr. D. Del. Sept. 10, 2019) (same), appeal dismissed and order vacated sub nom. U.S.A. v. Center City Healthcare, LLC (In re Center City Healthcare, LLC), No. 19-01711 (D. Del. Mar. 17, 2020).

With respect to the second issue discussed above, a bankruptcy court rejected the government's position and held that government withholding of Medicare and Medicaid payments after a provider files for bankruptcy to recover pre-bankruptcy overpayments is not excepted from the automatic stay. See True Health Diagnostics LLC v. Azar (In re THG Holdings LLC), 604 B.R. 154 (Bankr. D. Del. 2019) (ruling that the "police and regulatory powers" exception to the stay in section 362(b)(4) of the Bankruptcy Code did not apply where the evidence indicated that the government withheld the payments to protect its pecuniary interest over the interests of other unsecured creditors and nothing suggested that the government's actions were an effort to enforce public policy), appeal dismissed, 2020 WL 1493622 (D. Del. Mar. 27, 2020).

The third high-profile issue in health care bankruptcy cases noted above—whether government authorities are prohibited from offsetting or recouping overpayment claims or other liabilities against Medicare or Medicaid program payments—was the subject of a recent decision by the U.S. Court of Appeals for the Ninth Circuit in In re Gardens Regional Hosp. and Medical Ctr., Inc., 975 F.3d 926 (9th Cir. 2020). The court reversed in part lower court rulings permitting the State of California to recoup certain fees owed by the debtor hospital from various payments that the state was obligated to make to the debtor under its Medicaid program.

Recoupment and Setoff Under Provider Agreements

Medicare and Medicaid were created by the Social Security Amendments of 1965. The programs are subject to certain provisions in the Social Security Act of 1935, as amended, 42 U.S.C. Ch. 7 ("SSA"), which originally omitted medical benefits, as well as other regulations. The Medicare program is administered by the Centers for Medicare & Medicaid Services ("CMS"). CMS, in turn, contracts with regional providers, called "fiscal intermediaries," to review, process, and pay Medicare claims. Medicaid is generally administered by state agencies through medical assistance programs.

Under Medicare's and Medicaid's periodic interim payment system, reimbursement payments under provider agreements are made before the government agency has determined whether the provider is fully entitled to reimbursement. See 42 C.F.R. § 413.60. Section 1395g(a) of the SSA provides that:

[t]he 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 … the amounts so determined, with necessary adjustments on account of previously made overpayments or underpayments.

42 U.S.C. § 1395g(a). The provider is legally obligated to return any overpayments.

If a provider files for bankruptcy before remitting overpayments to CMS or a regional agency, the automatic stay may or may not prevent actions by CMS or the agency to recover the overpayments. The answer to this question largely depends on whether the attempted recovery represents a "setoff" or a "recoupment." Both are equitable doctrines that predated the enactment of the Bankruptcy Code, but only setoff is expressly recognized in the statute. Section 553(a) provides that, subject to certain exceptions, the Bankruptcy Code "does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case."

Thus, for a creditor to be able to exercise setoff rights in bankruptcy, section 553(a) requires on its face that: (i) the creditor has a right of setoff under applicable nonbankruptcy law; (ii) the debt and the claim are "mutual"; and (iii) both the debt and the claim arose prepetition. Although some courts have permitted the setoff of mutual postpetition debts (see, e.g., Official Comm. of Unsecured Creditors of Quantum Foods, LLC v. Tyson Foods, Inc. (In re Quantum Foods, LLC), 554 B.R. 729 (Bankr. D. Del. 2016)), the remedy is available in bankruptcy only "when the opposing obligations arise on the same side of the … bankruptcy petition date." Pa. State Employees' Ret. Sys. v. Thomas (In re Thomas), 529 B.R. 628, 637 n.2 (Bankr. W.D. Pa. 2015).

The Bankruptcy Code does not define "mutual." However, debts are generally understood to be mutual when they are due to and from the same persons or entities in the same capacity. See Collier on Bankruptcy ("Collier") ¶ 553.03[3] (16th ed. 2020). With exceptions for certain kinds of financial contracts, post-bankruptcy setoff under section 553 of the Bankruptcy Code is subject to the automatic stay (see 11 U.S.C. §§ 362(a)(7), 362(b)(6), and 362(b)(7)), but the bankruptcy court will generally permit it if the requirements under applicable law are met, except under circumstances where it would be inequitable to do so. See In re Ealy, 392 B.R. 408 (Bankr. E.D. Ark. 2008).

Many courts have concluded that setoff applies only to debts arising from separate transactions, although the issue is murky. See Collier at ¶ 553.10. By contrast, if mutual prepetition debts arise from the same transaction, the creditor may have a right of "recoupment," which has been defined as "a deduction from a money claim through a process whereby cross demands arising out of the same transaction are allowed to compensate one another and the balance only to be recovered." Westinghouse Credit Corp. v. D'Urso, 278 F.3d 138, 146 (2d Cir. 2002); accord Newbery Corp. v. Fireman's Fund Ins. Co., 95 F.3d 1392, 1399 (9th Cir. 1996) (recoupment is "the setting up of a demand arising from the same transaction as the plaintiff's claim or cause of action, strictly for the purpose of abatement or reduction of such claim"); In re Matamoros, 605 B.R. 600, 610 (Bankr. S.D.N.Y. 2019) ("recoupment is in the nature of a defense and arises only out of cross demands that stem from the same transaction"). Unlike setoff, recoupment is not subject to the automatic stay (see In re Ditech Holding Corp., 606 B.R. 544, 600 (Bankr. S.D.N.Y. 2019)) and may involve both pre- and postpetition obligations. See Sims v. U.S. Dep't of Health and Human Services (In re TLC Hosps., Inc.), 224 F.3d 1008, 1011 (9th Cir. 2000) (citing Collier at ¶ 553.10).

Courts disagree as to what constitutes the "same transaction" in distinguishing setoff from recoupment. See Collier at ¶ 553.10[1] ("Not surprisingly, in the absence of a common understanding of the requirement, courts do not always agree on what kinds of obligations qualify as arising out of the "same transaction."). They have generally applied one of two approaches to this question:

  • The "logical relationship test" articulated by the U.S. Supreme Court in Moore v. New York Cotton Exchange, 270 U.S. 593, 610 (1926), where the Court stated that the concept of a "'[t]ransaction' is [one] of flexible meaning. It may comprehend a series of many occurrences, depending not so much upon the immediateness of their connection as upon their logical relationship." Under this standard, a court will allow "a variety of obligations to be recouped against each other, requiring only that the obligations be sufficiently interconnected so that it would be unjust to insist that one party fulfill its obligation without requiring the same of the other party." Collier at ¶ 553.10[1]. The Ninth Circuit adopted this approach in Newbery.
  • The more restrictive "integrated transaction test," under which the obligations in question must "arise out of a single integrated transaction so that it would be inequitable for the debtor to enjoy the benefits of the transaction without also meeting its obligations." In re Univ. Med. Ctr., 973 F.2d 1065, 1081 (3d Cir. 1992); accord Malinowski v. New York State Dep't of Labor (In re Malinowski), 156 F.3d 131 (2d Cir. 1998).

Many courts have concluded that a provider's participation in the Medicare program involves a single, integrated, and ongoing transaction between the government and the provider, such that the government's recovery of overpayments is a recoupment rather than a setoff. See, e.g., In re Slater Health Ctr., Inc., 398 F.3d 98 (1st Cir. 2005); In re Holyoke Nursing Home, Inc., 372 F.3d 1 (1st Cir. 2004); In re Doctors Hosp. of Hyde Park, Inc., 337 F.3d 951 (7th Cir. 2003); Sims, 224 F.3d at 1011; United States v. Consumer Health Servs. of Am., Inc., 108 F.3d 390 (D.C. Cir. 1997). But see Univ. Med. Ctr., 973 F.2d at 1081 (reasoning that because each government payment provides compensation for services performed in a set time span, each payment concerned different services rendered and thus constituted a separate transaction).

The Ninth Circuit examined recoupment and setoff with respect to Medicaid overpayments in Gardens Regional Hospital.

Gardens Regional Hospital

Gardens Regional Hospital and Medical Center, Inc. ("debtor") operated a general acute-care hospital in California. In 2014, the debtor entered into an agreement to provide Medicaid services under the California Medical Assistance Program, more commonly known as "Medi-Cal," which is administered by the California Department of Health Care Services ("State"). The debtor provided health care to Medi-Cal beneficiaries on a fee-for-service basis and, as a result, was entitled to receive Medi-Cal fee-for-service payments ("Medi-Cal payments"). The debtor was also entitled to receive supplemental hospital quality assurance payments ("HQA payments") on account of certain services provided to Medi-Cal beneficiaries.

As a condition to participating as a Medi-Cal provider, the debtor, like other acute-care hospitals, was obligated under California law to pay quarterly hospital quality assurance fees ("HQA fees").

In March 2015, the debtor stopped paying its quarterly HQA fees, and it filed for chapter 11 protection in the Central District of California in June 2016. As of the petition date, the debtor owed nearly $700,000 in HQA fees. After the bankruptcy filing, to recover the unpaid prepetition HQA fees, the State began withholding 20% of the Medi-Cal payments owed to the debtor, as well as an unspecified percentage of the HQA payments owed to it.

By July 2016, the State had recovered all of the unpaid prepetition HQA fees as a result of its withholding. However, the State continued withholding because the debtor failed to pay postpetition HQA fees. During the case, the State withheld a total of approximately $4.3 million in HQA payments and Medi-Cal payments and applied the withheld funds to unpaid HQA fees. Even with the withholding, the debtor still owed more than $2.5 million in postpetition HQA fees.

The debtor sought a court order compelling the State to disgorge the approximately $4.3 million in payments it had withheld, claiming that the withholding was a setoff that represented an ongoing willful violation of the automatic stay. The debtor further argued that the State could not have effectuated the setoff even if it had obtained stay relief because section 553 of the Bankruptcy Code does not permit postpetition obligations to be set off against prepetition debt.

The State countered that the withholding was a recoupment rather than a setoff because the HQA fees, the HQA payments, and the Medi-Cal payments all arose from the same transaction. In response, the debtor argued that its HQA fee obligation did not arise from the same transaction as its entitlement to HQA payments and Medi-Cal payments because: (i) the HQA fee liability exists whether or not a provider participates in the Medi-Cal program; and (ii) different statutory formulas are used to calculate the HQA fees and the entitlements to HQA payments and Medi-Cal payments.

The bankruptcy court ruled that the doctrine of recoupment allowed the State to withhold the HQA payments without obtaining stay relief. The court explained as follows:

For recoupment purposes, a transaction may include a series of many occurrences, depending not so much upon the immediateness of their connection as upon their logical relationship, … provided that the "logical relationship" test is not applied so loosely that multiple occurrences in any one continuous commercial relationship would constitute one transaction.

The court found that a "logical relationship" existed between the HQA fees and the HQA payments because, without HQA fees, the State could not collect federal matching funds in an amount sufficient to make HQA payments. According to the bankruptcy court, even though different statutory formulas are used to calculate HQA fees and HQA payments, a "fundamental logical connection" exists between them.

The bankruptcy court also determined that the State properly recouped the HQA fees by withholding the Medi-Cal payments. The court explained that the debtor's eligibility to participate in the Medi-Cal program was conditioned on compliance with its provider agreement, including the statutory obligation to pay HQA fees, failing which the State was expressly authorized to deduct unpaid fees from Medi-Cal payments. Thus, the court found that the provider agreement "create[d] a sufficient logical relationship" between the debtor's HQA fee liability and its Medi-Cal payments. After a bankruptcy appellate panel affirmed the decision, the debtor appealed to the Ninth Circuit.

The Ninth Circuit's Ruling

A three-judge panel of the Ninth Circuit affirmed in part, reversed in part, and remanded the case below.

Writing for the panel, Circuit Judge Daniel P. Collins explained that, after adopting the logical relationship test in Newbery, the Ninth Circuit in Sims expressly rejected "the Third Circuit's narrow definition of 'transaction'" in Univ. Med. Ctr. because it "improperly gave dispositive weight to the temporal immediacy of the countervailing claims rather than to their logical relationship." Moreover, quoting Sims, he wrote that, although the same transaction requirement has a "flexible meaning," the logical relationship test should not "be applied so loosely that multiple occurrences in any continuous commercial relationship would constitute one transaction."

The Ninth Circuit concluded that the State properly recouped the debtor's HQA fees from the HQA payments. According to Judge Collins:

In view of the strong logical relationship among payment streams that is reflected in these unique features of the [HQA fee program], we conclude that this "distinctive … system" of continuously managing hospital payments into segregated funds against hospital payments out of those same funds is properly treated as "a single transaction" for purposes of recoupment.

However, the Ninth Circuit reached the opposite conclusion regarding the Medi-Cal payments, ruling that those deductions constituted a setoff barred by the automatic stay. Judge Collins explained that the legal and factual connections linking the HQA fees and the HQA payments were "simply not present" with respect to the Medi-Cal payments, which were not drawn from the same segregated fund as the HQA fees. According to him, "[t]o recognize a logical relationship between the [HQA fees] and the [Medi-Cal payments] would be to ignore Sims's admonition that the "'logical relationship' concept is not to be applied so loosely that multiple occurrences in any continuous commercial relationship would constitute one transaction."

In so ruling, the Ninth Circuit rejected the State's argument that it was entitled to recoup everything owing to the debtor-hospital because state law and the provider agreement specifically allowed the State to deduct unpaid HQA fees owed by a hospital to the HQA fund from any Medi-Cal payments or other state payments owed to the hospital. "Were we to accept [the State's] contention that its statutory assertion of such a sweeping right of setoff alone establishes a sufficient logical relationship to warrant recoupment," Judge Collins wrote, "we would effectively obliterate the distinction between recoupment and setoff" and exempt the State from the Bankruptcy Code's restrictions on setoff.

The Ninth Circuit accordingly reversed the lower courts' determination that the State was permitted to recoup the HQA fees from the Medi-Cal payments and remanded the case below.

Outlook

The Ninth Circuit's ruling in Gardens Regional Hospital is instructive regarding the distinction between the two most common approaches applied to the setoff/recoupment issue. Although the Ninth Circuit's "logical relationship" approach may be more flexible than the Third Circuit's bright-line "integrated transaction" test, Gardens Regional Hospital illustrates that it may be more difficult to apply, particularly in situations involving ongoing payments under Medicare and Medicaid provider agreements. This and other rulings are also emblematic of the aggressive strategy adopted by government authorities in many health care provider bankruptcy cases.

A version of this article was previously published in Lexis Practical Guidance. It has been reprinted here with permission.

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