Business Law

9th Circuit clarifies distinction between setoff and recoupment in context of bankruptcy (Gardens Regional Hospital and Medical Center Liquidating Trust v State of California

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The following is an update analyzing a recent case of interest:


By affirming in part and reversing in part the bankruptcy court and the Ninth Circuit BAP, both of which had allowed total recoupment, the United States Court of Appeals for the Ninth Circuit demonstrated the fine line distinction between setoff, which is subject to the automatic stay, and recoupment, which is not, and the difficulty the lower courts have in applying the distinction.  Gardens Regional Hospital and Medical Center Liquidating Trust v State of California, 2020 WL 5541387 (9th Cir. 9/16/20).  To view the opinion, click here.


Under the Medicaid program (known as MediCal in California), the federal government provides financial support to qualifying state plans that provide medical services to defined classes of low income individuals.  MediCal participates in Medicaid with fee-for-services providers under which a covered individual may receive treatment at a participating provider and then MediCal pays that provider a specified amount for each covered service.  Debtor Gardens Regional Hospital was a MediCal provider before it filed a chapter 11 petition in June 2016.  The amount MediCal pays is determined either by a specific contract between the hospital and the State or, if no contract, then based on various regulatory formulas, the latter being the case for the debtor.  The State is also required to contribute financially to the program, so the fees paid any provider include both state-sourced funds and the federal funds.

The federal government has placed limits on how states can raise their share of Medicaid funding.  California uses a permissible scheme by which it imposes a “Hospital Quality Assurance Fee” (HQAF) on most non-public acute care hospitals, whether or not they participate in MediCal.  The money collected from this fee are placed in a segregated account which may only be used for specified purposes.  One use of the funds is to make Supplemental payments to providers, like the debtor, which therefore receive funds from two sources, the ordinary fee-for-services payments and the Supplemental payments from the HQAF funds. HQAF.  The statute implementing the HQAF program specifies that if a provider does not pay its HQAF fees, the State may deduct those unpaid fees from any MediCal payments owed to the hospital.

In the year before it filed its chapter 11 petition, the debtor experienced cash flow problems and stopped paying the HQAF fees. According to the State, on the petition date the debtor owed almost $700,000 in unpaid HQAF assessments.  During the bankruptcy proceeding, which resulted in a sale of the assets and closure of the hospital, the State recovered all this prepetition debt by withholding a portion of its MediCal payments to the hospital, which included both the normal fee-for-service payment and the Supplemental payments under the HQAF program.  It used the same withholding method to collect all the postpetition accruing HQAF fees.

The debtor filed a motion to compel the State to return the withheld amount as impermissible setoffs, in violation of the automatic stay, which in section 362(a)(7) specifically prohibits such setoff at without stay relief.  The State countered that the withholdings were not setoffs, but rather were recoupment, a judicially-created equitable remedy which is not subject to the automatic stay.  The bankruptcy court, in a published opinion, denied the debtor’s motion, holding that the State had a right to recoup the funds because there was a sufficient “logical relationship” between both types of payments, on the one hand, and the HQAF assessment, on the other.

The debtor appealed to the BAP, which affirmed in an unpublished disposition.  Upon further appeal, the Ninth Circuit affirmed in part and reversed in part, finding a sufficient logical relationship between the HQAF fees and the Supplemental payments to allow recoupment, but an insufficient relationship between the fees and the regular fee-for-services payments, making them impermissible setoffs.


The Circuit took exception to the conclusions of the bankruptcy court and the BAP that both the regular fee-for-services payment and the Supplemental payments arose from the same transaction or occurrence, the key test for recoupment, as did the HQAF fees, saying those holdings rested on “an overly generous conception of what qualifies as the same transaction or occurrence for purposes of recoupment.”  The Circuit defined setoff as a creature of common law pleading which allows mutual debts to be applied against each other even if they arise from different transactions.  Setoff is subject to the automatic stay under section 362(a)(7).  Recoupment, on the other hand, is an equitable concept, used not for the adjustment of separate mutual debts but as part of the process of defining the amount owed under a single claim, essentially a kind of accounting internal to a transaction.  Recoupment is not subject to the automatic stay.  For recoupment to apply, prior Ninth Circuit case law had determined that the claims or rights giving rise to it must arise from the same transaction or occurrence that gave rise to the liability sought to be enforced by the bankruptcy estate.  At minimum, there must be a logical relationship between the transactions such that a compulsory counterclaim would be required if a party sued on one of the claims.

Against this backdrop, the Circuit reasoned that since the HQAF program created the segregated funds from which the Supplemental payments were made, there was a sufficient logical relationship for recoupment to apply to withholding the unpaid fees from the Supplemental payments to the debtor.  However, since the fees-for -services payments were to be made notwithstanding the existence of the HQAF fess or program, the facts which linked the Supplemental payments to the collection of HQAF fees were missing.  They would be made even if the State had no HQAF program at all.  Therefore, withholding the HQAF fees owed from those normal payments was an impermissible setoff.  The Circuit reversed in part and remanded for those monies to be returned to the bankruptcy estate.


After reading the Circuit’s discussion in this case, under these particular facts I can understand the distinction which the Circuit was making between the two types of payments to the debtors.  The tie between the HQAF fees and the payments made possible by the collection of those fees is apparent.  No such “logical relationship” connects the unpaid fee debt to the regular medical fee-for-services payments. However, the cases which the Ninth Circuit relied on to come to its conclusions were known to both the bankruptcy court, which wrote and published a carefully crafted and analytical opinion, and the BAP which affirmed, agreeing that both types of payments were closely tied to the existence of the HQAF program.  Yet, even after discussing the relevant case law, these courts came up with a different conclusion than the Circuit.  Both reasoned that since the debtor was compelled to participate in the HQAF program, it would never have qualified to receive any MediCal payments if it had not done so.  The bankruptcy court found the fee debt was “inextricably tied up” in the claim to MediCal payments and recoupment applied.  The BAP agreed with this equitable analysis of the bankruptcy court.

My take is that the standard is too ambiguous to be uniformly applied.  What we have is an equitable doctrine.  Equitable doctrines are often applied within the sound discretion of the bankruptcy courts.  Yet, here the application is subject to de novo review and thus subject to reversal if the Circuit has a different view of what is equitable under these facts.  That scenario seems doomed to create chaos, not uniformity.  A bright line rule might be nice, but that takes exercise of discretion out of the picture and seems to run counter to an equitable principle.  Indeed, the “bright line” is itself not so bright.  Something needs to be clarified if knowledgeable courts cannot follow the standard as set.  Perhaps the standard of review should be revisited.

The Commercial Finance Newsletter is written by an ad hoc group of the California Lawyers Association (CLA) Business Law Section.  These materials were authored by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal. Ret.), a member of the ad hoc group, with editorial contributions by Adam A. Lewis, Senior Counsel, Morrison & Foerster LLP, a member of the ad hoc group.  The opinions expressed herein are solely those of the author. Thomson Reuters holds the copyright to these materials and has permitted the Commercial Transactions Committee of Business Law Section of the California Lawyers Association to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.

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