Short Case Analysis: In re Gardens Regional Hospital and Medical Center Inc.

Hospitals and health care providers now face intensified pressures arising from the pandemic, with the American Hospital Association reporting that the cumulative impact of such conditions could raise the serious threat of bankruptcy or closure for providers.[1]

While bankruptcy provides a potential mechanism to address financial distress through protections such as the automatic stay, debtor-providers may face challenges from government agencies, which — as repeat players in industry restructurings — typically have a strong incentive to litigate their positions. Such challenges often concern Medicare and Medicaid program payments, which are critical to many hospitals.

In a September 2020 decision, In re Gardens Regional Hospital and Medical Center Inc. (hereinafter, “Gardens Regional”),[2] the Ninth Circuit examined one such issue — specifically, whether California’s Department of Health Care Services (the “State”) violated the automatic stay by deducting unpaid fees from payments that were due to the debtor pursuant to Medi-Cal, the State’s Medicaid program.

As the appellate court recognized, the Bankruptcy Code imposes significant limitations on deductions if they constitute a “setoff,” but courts have consistently recognized an exception where the deductions fall within the equitable doctrine of “recoupment.”

However, the Ninth Circuit rejected the overly broad concept of recoupment applied by the bankruptcy court and the Ninth Circuit Bankruptcy Appellate Panel (BAP), and concluded that certain deductions claimed by the State constituted setoffs, not recoupment. In reaching this decision, the appellate court reasoned that the mere fact that both payment streams arose within the overarching context of the larger Medi-Cal program was not enough to justify characterizing them as arising from the same transaction. To do so, the court reasoned, would otherwise expand the concept of equitable recoupment in a way that would undermine the fundamental purposes of the Bankruptcy Code’s express limitations on setoffs.

Medi-Cal Payments Withheld from Gardens Regional

Gardens Regional represents an attempt to use the automatic stay to compel the State to return portions of Medi-Cal payments that it had withheld from the debtor-hospital, so that the funds could be made available for the benefit of the bankruptcy estate and other creditors.

Pursuant to a California statute, certain hospital facilities, including Gardens Regional, are required to pay a periodic “Hospital Quality Assurance Fee” (HQAF). Pursuant to the statute, the State could immediately deduct a hospital’s unpaid HQAF assessment from any Medi-Cal or other state payments owed to the hospital.

Due to significant financial difficulties, Gardens Regional stopped paying its HQAF assessments in March 2015. According to the State, Gardens Regional owed almost $700,000 in unpaid HQAF assessments by the time it filed for chapter 11 bankruptcy in June 2016.

Following the petition date, the State sought to recover the unpaid HQAF assessments by withholding a portion of payments otherwise owed to Gardens Regional on account of its role as a participating provider of Medi-Cal services. Garden Regional was entitled to two types of payments from the State: (1) “fee-for-service” payments earned by treating Medi-Cal patients; and (2) supplemental payments from a segregated fund created by HQAF assessments.

After the pre-petition debt was fully recovered, the State continued to make deductions on account of Gardens Regional’s unpaid post-petition assessments. Ultimately, the State withheld a total of approximately $4.3 million from Gardens Regional and asserted that a debt of more than $2.5 million was still owed.

Litigation Over the Withheld Medi-Cal Payments

In May 2017, Gardens Regional moved to compel the return of the amounts withheld by the State, asserting that the State’s conduct constituted an impermissible setoff and violated the automatic stay imposed by § 362 of the Bankruptcy Code.

The State argued that its actions were exempt from the automatic stay under the nonstatutory equitable doctrine of “recoupment,” because the unpaid HQAF assessments and the Medi-Cal payments arose from the same transaction or occurrence.

The bankruptcy court denied Gardens Regional’s motion, finding that the State’s deductions from both the fee-for-service payments and the supplemental payments qualified as permissible recoupment, because there was enough of a “logical relationship” between the HQAF assessments and both payment streams.

The BAP subsequently affirmed, and Gardens Regional appealed to the U.S. Court of Appeals for the Ninth Circuit.

Ninth Circuit Opinion

On appeal, the Ninth Circuit affirmed the judgment of the BAP insofar as it held for the deduction of unpaid HQAF assessments from the supplemental payments, but reversed its judgment as to the fee-for-service payments.

The appellate court identified a strong logical relationship between the HQAF assessments and the supplemental payments arising from the unique features of the HQAF program, including the central feature of a segregated fund and the legislative purpose. The court concluded that this justified characterizing the HQAF assessments and the supplemental payments as arising from the same transaction for purposes of equitable recoupment.

However, the court determined that the bankruptcy court and the BAP relied on “an overly generous conception” of what qualifies as the “same transaction or occurrence” when holding that all of the State’s withholdings of unpaid HQAF amounts constituted legitimate instances of equitable recoupment rather than setoff.

Instead, the Ninth Circuit determined that the fee-for-service payments lacked direct factual or legal connections to the HQAF assessments, ultimately finding that the State’s deduction of unpaid HQAF assessments from fee-for-service payments constituted a setoff, subject to the restrictions of the Bankruptcy Code, and not a permissible equitable recoupment. In reaching its decision, the court noted that Gardens Regional earned fee-for-service payments by providing treatment to covered individuals pursuant to a program that was established long before the HQAF program was implemented.

The court was unpersuaded by the State’s argument that the fee-for-service payment deductions constituted recoupment, either due to the statute authorizing the deductions or due to the contractual requirement that a provider comply with all applicable state and federal laws, including the setoff right found in the statute. As the Court explained, the recitation of a broad setoff right — whether by the statute or by contract — does not by itself establish that the resulting deduction is actually a recoupment for the purposes of bankruptcy law. Rather, there must be factual or legal connections upon which to base a determination that a deduction constitutes recoupment, rather than setoff. To allow otherwise would “effectively obliterate” the distinction between recoupment and setoff.

The Ninth Circuit remanded the matter to the BAP with instructions to remand to the bankruptcy court for further proceedings.