Gardens Reg’l Hosp. & Med. Ctr. Liquidating Trustee v. California (In re Gardens Reg’l Hosp. & Med. Ctr., Inc.) (9th Cir.)

The following is a case update written by Mary H. Rose, a shareholder of Buchalter, A Professional Corporation, analyzing a recent decision of interest:

In a case involving California’s Medicaid program for hospitals, the U.S. Court of Appeals for the Ninth Circuit clarified its prior decisions regarding the distinction between setoff and recoupment.  In order to qualify for recoupment in bankruptcy, countervailing claims must arise from the same transaction or occurrence, and the crucial factor in the analysis is the logical relationship between the claims.  Gardens Reg’l Hosp. & Med. Ctr. Liquidating Trustee v. California (In re Gardens Reg’l Hosp. & Med. Ctr., Inc.), 975 F.3d 926 (9th Cir. 2020).

To view the opinion, click here.

FACTS

The debtor, Gardens Regional Hospital and Medical Center (“Gardens”), was a nonprofit hospital that participated in the Medicaid program (known as Medi-Cal in California) managed by the California Department of Health Care Services (DHCS).

Under the Medi-Cal program, Gardens provided hospital services to Medi-Cal covered individuals and was paid on a fee-for-service basis whereby it received a specified payment for each covered service.  As a nonpublic general acute care hospital, Gardens also participated in the Hospital Quality Assurance Fee (HQAF) program.  Under this program, hospitals such as Gardens (regardless of whether they were Medi-Cal providers) were statutorily required to pay HQAF assessments into segregated funds, the federal government added matching funds, and the hospitals received supplemental payments from the fund.

When Gardens filed its chapter 11 petition, it owed $699,173 in missed HQAF assessments to the State.  As authorized by a State statute, the State fully recovered this pre-petition debt by withholding a portion of its Medi-Cal payments to the hospital – both fee-for-service payments and supplemental payments under the HQAF program.  As additional HQAF assessments accrued post-petition, the State continued to deduct a portion of the fee-for-service and supplemental payments to the hospital.  All told, the State withheld a total of $4,306,426 from Gardens and claimed that Gardens still owed it $2,550,667 in HQAF debt.

Gardens filed a motion with the bankruptcy court attempting to compel the State to return the amounts it had withheld.  The hospital argued that the State’s withholding of a portion of the funds due to the hospital constituted an impermissible setoff barred by the automatic stay under Section 362(a)(7) of the Bankruptcy Code.  The State disagreed, contending that its actions were exempt from the automatic stay under the equitable doctrine of recoupment.

The bankruptcy court denied Gardens’ motion, holding that the State had a right to recoup the funds because there was enough of a “logical relationship” between both the fee-for-service payments and the supplemental payments, on the one hand, and the HQAF assessments, on the other hand.  Gardens appealed to the Bankruptcy Appellate Panel, which affirmed the bankruptcy court.

The Ninth Circuit affirmed the judgment of the BAP insofar as it held that the State’s deduction of unpaid HQAF assessments from the HQAF supplemental payments was permissible under the doctrine of recoupment.  However, the Ninth Circuit reversed the BAP with respect to the State’s deduction of unpaid HQAF assessments from the fee-for-service payments, holding that these deductions were setoffs subject to the restrictions of the Bankruptcy Code applicable to setoffs.

REASONING

The right of setoff allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding the absurdity of making A pay B when B owes A.  The defining characteristic of setoff, as opposed to recoupment, is that the mutual debt and claim are generally those arising from different transactions.  In bankruptcy, the right of setoff is limited by the requirement of mutuality under Section 553(a) of the Bankruptcy Code such that each debt or claim sought to be offset must have arisen prior to the petition date.  The right to setoff is also limited by the automatic stay under Section 362(a)(7) of the Bankruptcy Code.

In contrast, recoupment is not the adjustment of mutual debts but is instead the process of adjusting the amount owed under a single claim.  Unlike setoff, recoupment is not limited by the mutuality requirement of Section 553(a) and thus may be employed to recover across the petition date.  Recoupment is also not subject to the automatic stay.

The claims giving rise to recoupment must arise from the same transaction or occurrence, and the critical factor in the analysis is the logical relationship between the claims.  While the same transaction requirement has a flexible meaning, the logical relationship concept should not be applied so loosely that multiple occurrences in any continuous commercial relationship would constitute one transaction.  The test is rather whether the relevant rights being asserted against the debtor are sufficiently logically connected to the debtor’s countervailing obligations such that they may be fairly said to constitute part of the same transaction.

The Ninth Circuit rejected Gardens’ contention that the necessary logical relationship between HQAF assessments and supplemental payments was missing because there is no connection between the amount of assessments a hospital pays and the amount of supplemental payments it receives.  Instead, the Ninth Circuit determined that the HQAF system of managing hospital payments into segregated funds against hospital payments out of those funds is properly treated as a single transaction for purposes of recoupment.  Moreover, it would be inequitable for the debtor to enjoy the benefits of that transaction without meeting its obligations.  Thus, the State properly recouped Gardens’ unpaid HQAF assessments into the segregated funds from the HQAF-funded supplemental payments that the hospital was due to receive out of those same funds.

The Ninth Circuit reached the opposite conclusion with respect to the State’s deduction of unpaid HQAF assessments from the fee-for-service payments and determined that those deductions constituted setoffs.  There were no legal or factual connections between the two that would permit recoupment.  The fee-for-service payments were not drawn from the HQAF segregated funds, and the fee-for-service system was an established part of California’s Medi-Cal plan long before the HQAF program existed.

In reaching this conclusion, the Ninth Circuit rejected two arguments made by the State.  The first argument was that a provision in the HQAF statute authorizes the State to deduct unpaid HQAF assessments from any Medi-Cal or other State payments owed to the hospital.  The Ninth Circuit disposed of this argument by emphasizing that for deductions to qualify as recoupment, rather than setoff, the deductions must rest upon factual and legal connections beyond the mere assertion of a statutory right to make the deductions.  “A state may not choose to define its rights in a way that defeats the ends of federal bankruptcy law.”

The State’s second argument was that the necessary logical relationship between the HQAF assessments and the fee-for-service payments is shown by the fact that they are both rooted in Gardens’ Medi-Cal provider agreement with the State, which requires compliance with all applicable state and federal laws, including the broad statutory right of setoff.  The Ninth Circuit rejected this argument by noting that the assertion of a setoff right, whether by statute or by contract, is subject to the limitations of federal bankruptcy law.  The mere fact that obligations arise under a single contract or government program does not automatically mean that recoupment is warranted.  There must be a close factual link.

AUTHOR’S COMMENTS

The Ninth Circuit got it right in this decision.  The opinion not only clarifies when recoupment is permissible in the Ninth Circuit, but also discusses the different recoupment analysis adopted by the Third Circuit.

Of equal importance, the decision will make it easier for California hospitals to survive in bankruptcy.  The author was involved in the Gardens’ chapter 11 case and observed the financial strain, and ultimate closure of the hospital, due in part to the State’s deduction of HQAF assessments from the Medi-Cal payments that the hospital earned for services rendered during the chapter 11 case.  In the future, California hospitals, like other businesses, will be able to receive full payment for post-petition services.

These materials were written by Mary H. Rose, a shareholder of Buchalter, A Professional Corporation, in Los Angeles (mrose@buchalter.com), with editorial contributions from with editorial contributions from ILC member Summer Shaw, Shaw & Hanover PC.