The Bottom Line

The Bankruptcy Court for the Central District of California examined the scope of the doctrine of recoupment for Medicaid and related payments, allowing the deduction by the state. The court held that the California Department of Healthcare Services (“DHCS”) is authorized to withhold a percentage of Medi-Cal Payments and supplemental hospital quality assurance payments (“Supplemental HQA Payments”) owed to the Debtor for the purpose of recovering unpaid hospital quality assurance fees (“HQA Fees”) that the Debtor failed to pay pre- and post-petition. In allowing the deduction, the court reasoned that the Debtor’s obligations to pay the HQA Fees and California’s obligation to distribute Supplemental HQA Payments arise from the same transaction or occurrence and are therefore logically related.

What Happened?

In In re Gardens Regional Hospital and Medical Center, Inc., Case No. 16-17463 (Bankr. C.D. June 21, 2017), the Debtor previously operated a general acute care hospital in California. The Debtor relied upon Medicaid reimbursements, which are generally costs shared between the state and federal government. California’s Medicaid benefits are administrated through the California Medical Assistance Program (“Medi-Cal”). In order to help fund the state’s costs to cover its share of Medi-Cal costs, California enacted the Medi-Cal Hospital Reimbursement Improvement Act of 2013 (the “Reimbursement Act”). The Reimbursement Act requires most general acute care hospitals to pay a quarterly HQA Fee. The federal government matches the Medi-Cal contributions (i.e., funds raised from the HQA Fee) dollar-for-dollar. After the HQA Fees are collected and combined with the federal matching funds, the DHCS redistributes these funds (the “QA Payments”) to hospitals through a variety of types of payments, including Medi-Cal Payments and Supplemental HQA Payments. As a non-profit hospital, the Debtor qualified for both Medi-Cal Payments and Supplemental HQA Payments.

As of the Petition date, the Debtor accrued $699,173.15 in unpaid HQA Fees. To recover these unpaid prepetition HQA Fees, the DHCS withheld a percentage of Medi-Cal Payments and Supplemental HQA Payments owed to the Debtor. Even after the DHCS recovered the unpaid pre-petition HQA Fees, the DHCS continued withholding because the Debtor failed to pay post-petition HQA Fees.

The Debtor sought to compel the return of approximately $4.3 million withheld by the DHCS. The Debtor argued the DHCS violated the automatic stay in withholding the QA Payments because the DHCS did not obtain stay-relief and the Bankruptcy Code does not permit post-petition obligations to be setoff against pre-petition debt. The Court found that although the Debtor had not sought relief from the automatic stay to exercise setoff rights, the separate doctrine of recoupment may be employed to recover pre-petition and post-petition claims that “arise from the same transaction or occurrence” and share a “logical relationship.” Unlike setoff, which requires mutuality and is also subject to the automatic stay, recoupment does not require mutuality – meaning that pre- and post-petition obligations can be deducted/offset against each other – nor does the automatic stay apply. In essence, recoupment is viewed as a defense to a payment obligation, so long as the specific test for its application is met. (In contrast, setoff allows for obligations to be offset even under separate agreements or transactions, so long as there is mutuality of the parties to each of the transactions or agreements.)

The Court determined the doctrine of recoupment allowed the DHCS to withhold the Supplemental HQA Payments. The Court found a logical relationship existed between the HQA Fees and the Supplemental HQA Payments because without HQA Fees, the DHCS would not collect sufficient federal matching funds in order to make Supplemental HQA Payments. The Court highlighted that the Ninth Circuit has given the term “transaction” a “liberal and flexible construction, requiring only that 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.” Even though the HQA Fee and Supplemental HQA Payments were calculated using different formulas, there was a “fundamental logical connection.”

The Court also determined the DHCS properly withheld the Medi-Cal Payments. The Court relied on the pre-petition provider agreement the Debtor entered into with the DHCS (the “Provider Agreement”). Under the Provider Agreement, the Debtor agreed to comply with California Welfare and Institutions Code. Section 14169.52(h) of the Cal. Welf. & Inst. Code explicitly provides that when a hospital fails to pay the HQA [F]ee on or before the payment due date, the DHCS may “immediately begin to deduct the unpaid assessment and interest from any Medi-Cal Payments owed to the hospital.” Because the Debtor’s eligibility to participate in the Medi-Cal program was conditioned on its compliance with the Provider Agreement (i.e., compliance with applicable law), the Provider Agreement “creates a sufficient logical relationship between the Debtor’s HQA Fee liability and its Medi-Cal Payments . . . .”

Why This Case is Interesting

Recoupment has become a powerful tool over the years, especially in the healthcare sector. The doctrine of recoupment is especially nuanced in the context of healthcare restructurings where the Government has been successful in recouping significant Medicaid and Medicare overpayment liabilities. Overpayment liabilities and state mandated quarterly fees may produce a material liability for a healthcare system. When a distressed healthcare operator is relying upon government payables for liquidity, reducing liquidity – via recoupment – for historic liabilities can have a material impact on the restructuring. At a minimum, it puts the government payor into a position of dictating post-petition funding through withholding its payables, requiring providers to negotiate with the government on continued access to funds to operate. While setoff is sometime easier to determine when it applies, the doctrine of recoupment varies significantly from jurisdiction to jurisdiction in healthcare cases. For example, there is a split among jurisdictions as to whether different provider “cost report years” are part of the “same transaction or occurrence” for purposes of calculating a healthcare system’s overpayment liability. Healthcare providers entering bankruptcy with significant overpayment liabilities or unpaid Medicare/Medicaid fees need to be mindful of each jurisdiction’s position on recoupment and proactively deal with the prospects of reduced liquidity by reaching out to the government and negotiating a repayment plan that allows sufficient liquidity to operate post-petition.