Article courtesy of David P. Simonds and Edward J. McNeilly (both of Hogan Lovells US LLP)
Gardens Regional Hospital and Medical Center Liquidating Trust v. State of California, and its Department of Health Care Services (In re Gardens Regional Hospital and Medical Center, Inc.), 975 F.3d 926 (9th Cir. 2020)
After Gardens Regional Hospital and Medical Center, Inc. (“Gardens Regional”) filed for bankruptcy, the State of California and its Department of Health Care Services (collectively, “California” or the “State”) deducted certain “fees,” which Gardens Regional had failed to pay to the State prepetition, from various payments that the State was obligated to make to Gardens Regional under its Medicaid program. Gardens Regional contended that the deductions were impermissible setoffs, and California argued that they were instead permissible recoupments. The United States Bankruptcy Court for the Central District of California (the “Bankruptcy Court”) and the Ninth Circuit Bankruptcy Appellate Panel (“BAP”) both agreed with the State, but the Ninth Circuit Court of Appeals concluded that they relied on an overbroad conception of “recoupment.” Because some of the deductions claimed by California constituted setoffs, and not recoupments, the Court of Appeals affirmed in part and reversed in part, and remanded the case for further proceedings.
(1) Factual and Procedural Background
Under the Medicaid program, the federal government provides financial support to qualifying state plans that provide medical services to lower income individuals. California’s approved Medicaid program, known as “Medi-Cal,” provides benefits to covered individuals through two primary methods – a “fee for service” system and a “managed care system.” Under the “fee-for-service” system—which is the relevant payment method for purposes of this case—a covered individual may receive treatment at a participating healthcare provider, and Medi-Cal then directly pays that provider a specified amount for each covered service provided to the individual.
California separately imposes a “Hospital Quality Assurance Fee” (“HQAF”) on non-public hospitals in the State. If a hospital does not pay its HQAF assessments, California law allows the State to “immediately begin to deduct the unpaid assessment and interest from any Medi-Cal payments owed to the hospital, or … from any other state payments owed to the hospital.” Cal. Welf. & Inst. Code § 14169.52(h). Revenue from HQAF assessments is used to fund supplemental Medi-Cal payments to hospitals.
After Gardens Regional began experiencing significant financial difficulties, it stopped paying its HQAF assessments in March 2015, and it ultimately filed for chapter 11 bankruptcy in June 2016. It ceased operations in February 2017. According to the State, Gardens Regional owed California $699,173 in missed HQAF payments at the time it filed for bankruptcy. Thereafter, the State fully recovered this prepetition debt by withholding a portion of its Medi- Cal payments to the hospital, which included both fee-for-service payments and “supplemental” payments under the HQAF program. As additional HQAF assessments accrued postpetition and were likewise not paid by Gardens Regional, the State continued to deduct a portion of both fee-for-service and supplemental payments to Gardens Regional. In total, the State withheld a total of $4,306,426 from Gardens Regional, and claimed that Gardens Regional still owed $2,550,667 in HQAF debt.
Gardens Regional moved to compel the State to return the amounts that it had withheld, arguing that, in withholding the funds, California had violated the Bankruptcy Code’s “automatic stay,” which generally prohibits creditors from attempting to collect on their claims against the debtor after the filing of a bankruptcy petition. The Bankruptcy Court denied Gardens Regional’s motion, holding that California had the 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. Gardens Regional appealed to the BAP, which affirmed the Bankruptcy Court.
(2) Setoff versus Recoupment
Setoff and equitable recoupment have similar effects – both involve party A withholding money that it owes to Party B because Party B owes money to Party A. However, they have different conceptual origins and operate differently when one party has filed for bankruptcy.
- Setoff involves mutual debts and claims that generally arise from different transactions, whereas recoupment involves establishment of amounts owed under a single transaction.
- Section 553(a) of the Bankruptcy Code limits setoff rights to claims that both arose prior to the filing of the bankruptcy petition, whereas recoupment claims may be employed to recover across the petition date.
- Exercise of rights of setoff against a bankrupt debtor is expressly limited by the automatic stay, whereas recoupment rights are generally considered not to be subject to the automatic stay.
In order for recoupment rights to exist, the countervailing claims and rights must have arisen out of the same “transaction or occurrence.” The Court of Appeals for the Ninth Circuit has held that the determining factor in establishing whether competing claims arise out of the same “transaction or occurrence” is whether there is a “logical relationship” between the two. Newbery Corp. v. Fireman’s Fun Ins. Co., 95 F.3d 1391, 1403 (9th Cir. 1996). The test is 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 Court of Appeals affirmed the portion of the decisions of the Bankruptcy Court and the BAP holding that the State properly exercised recoupment rights in withholding supplemental Medi-Cal payments from Gardens Regional for non-payment of HQAF assessments. In light of the legal and factual connections between Gardens Regional’s unpaid HQAF assessments and California’s supplemental payments to the hospital, these countervailing obligations have the necessary logical relationship to justify characterizing them as arising from the same transaction for purposes of equitable recoupment. Because one purpose of HQAF assessments was to fund supplemental Medi-Cal payments to hospitals, there was a direct factual and legal connection between the HQAF payments into the segregated HQAF fund and the supplemental payments made to hospitals from that very same fund.
The Court of Appeals reversed the portion of the decisions of the Bankruptcy Court and the BAP with respect to deduction of unpaid HQAF assessments against fee-for-service payoffs, holding that these deductions were setoffs subject to the restrictions of the Bankruptcy Code and not a permissible equitable recoupment. In contrast to the supplemental payments, the fee-for-service payments are not drawn from the same segregated fund as the HQAF assessments. Rather, Gardens Regional earned the fee-for-service payments by providing services to individuals covered by Medi-Cal, and that fee-for-service system was an established part of California’s Medi-Cal plan long before the HQAF program, with its segregated funding, was established. The fact that the countervailing obligations were rooted in the State’s standard-form provider agreement with Gardens Regional did not, by itself, establish the requisite logical relationship to create rights of equitable recoupment.
While the Ninth Circuit’s “logical relationship” test is makes it easier for creditors to establish rights of recoupment than the Third Circuit’s narrow “single integrated transaction” test, the Gardens Regional makes clear that the “logical relationship” standard is not to be applied loosely. Otherwise, creditors could eviscerate the Bankruptcy Code’s limitations on setoff and the application of the automatic stay in any situation of an ongoing commercial relationship or a single contract.