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NORTHWEST HOSPITAL, INC. v. HOSPITAL SERVICE CORP.

United States District Court, Northern District of Illinois, E.D


October 29, 1980

NORTHWEST HOSPITAL, INC., PLAINTIFF,
v.
HOSPITAL SERVICE CORPORATION ET AL., DEFENDANTS.

The opinion of the court was delivered by: Shadur, District Judge.

MEMORANDUM OPINION AND ORDER

Plaintiff Northwest Hospital, Inc. ("Northwest") has challenged the determination by the Commissioner of Social Security ("Commissioner") denying payment of certain items claimed as reimbursable costs under the Medicare program for Northwest's fiscal year ended April 30, 1974. With the facts not in dispute, each side has moved for summary judgment. For the reasons stated in this memorandum opinion and order, the motion by defendants is granted in part and denied in part, and Northwest's motion is denied.

Facts

Northwest has participated in the Medicare program since its inception in 1966. Under the federal statute, a "provider" facility such as Northwest is reimbursed for the reasonable costs of providing care to the program's beneficiaries. 42 U.S.C. § 1395f(b). Generally a fiscal intermediary such as Hospital Service Corporation is used to determine proper reimbursement for a provider.*fn1 42 U.S.C. § 1395h. To avoid liquidity problems, estimated payments are made to the provider at least once a month with subsequent adjustments for overpayments and underpayments. 42 U.S.C. § 1395g, 1395x(v)(1)(A)(ii). Final determination of a provider's reimbursable costs is made by the fiscal intermediary based on the submission of a cost report after the end of each fiscal year. 42 C.F.R. § 405.406(b).

After a dispute arose regarding the April 30, 1974 fiscal year,*fn2 Northwest requested a hearing before the Provider Reimbursement Review Board ("PRRB"). 42 U.S.C. § 1395 oo(a). PRRB's determination was then reviewed by the Commissioner, and it is his decision of May 28, 1976 that Northwest asks this Court to review. 42 U.S.C. § 1395 oo(f).

Northwest challenges four determinations by the Commissioner:

  1. Northwest is not entitled to depreciation expense
     based on the fair market value of the assets
     acquired from its corporate predecessor, a
     for-profit corporation with the same corporate
     name ("Northwest I"). Instead, the depreciation
     expense must be based on the depreciated
     historical cost to Northwest I.

  2. Northwest is not entitled to deduct interest
     expense on notes given in exchange for the stock
     of Northwest I.

  3. Northwest is not entitled to claim as allowable
     cost the payments made to its auxiliary for the
     services of certain nonpaid workers.

  4. Northwest is not entitled to claim as allowable
     cost the interest expense incurred on loans used
     for the construction of a parking lot and
     professional building.

  Depreciation; Interest on Purchase Price Notes

Each of the first two issues arises from the manner in which Northwest acquired ownership of its hospital operations. Northwest I was a for-profit corporation owned and administered by three men: Pasquale DeMarco (its hospital administrator), Dr. Michael J. Nechtow (its medical director) and John T. Ryan (its legal counsel). In 1965 they proposed a plan to convert the hospital to a not-for-profit institution and ordered appraisals of its assets for that purpose.

On January 18, 1966 the three owners of Northwest I joined with four civic leaders from the community and formed Northwest as a non-profit corporation (all seven men were its directors, with DeMarco, Dr. Nechtow and Mr. Ryan retaining their operating positions). On January 27, 1966 Northwest and Northwest I's stockholders executed an agreement under which Northwest agreed to purchase all the stock in Northwest I, paying $100,000 in cash and delivering $4,900,000 in 14-year notes bearing 4% interest.

That agreement was specifically conditioned on Northwest's receipt of an Internal Revenue Service ruling granting it Section 501(c)(3) tax-exempt status. Northwest did not receive the tax ruling until December 20, 1967, and the purchase transaction was closed January 2, 1968.

As a threshold matter, Northwest argues that the Medicare regulations covering depreciation and interest are not applicable to this case. Both the Medicare statute and the regulations took effect in 1966 (the statute in July and the regulations in November). Northwest argues that the sale of the hospital took place on January 27, 1966 (the date of the contract), so that the regulations do not apply.

However, execution of the agreement was not the legally operative fact. Consummation of the sale was conditioned on obtaining a favorable IRS ruling — and that was a critical substantive condition, for the entire purpose of the transaction would have been frustrated if tax-exempt status had not been forthcoming. It is purchases of hospitals that the regulations govern; and while there was a conditional agreement to purchase before the enactment of the statute and its regulations, it is clear that the actual purchase was not completed until January 2, 1968.

1. Depreciation

Depreciation costs, like all other elements of reimbursable costs, are a function of the "reasonable cost of . . . services" delivered by the provider. 42 U.S.C. § 1395x(v).*fn3 In turn, the specifics of the reimbursement program are governed by the regulations issued by the Secretary. In this case Northwest argues that the purchase price under its contract should be the base for calculating depreciation, while the Commissioner held that Northwest I's depreciated historical cost was the proper measure.

Depreciation allowances generated by the sale of an ongoing facility are calculated on a basis defined by 42 C.F.R. § 405.415(g):*fn4

    Establishment of cost basis on purchase of facility
  as an ongoing operation — (1) Assets acquired after
  July 1, 1966 and before August 1, 1970. The cost
  basis for the assets of a facility purchased as an
  ongoing operation after July 1, 1966, and

  before August 1, 1970, shall be the lowest of:

    (i) The total price paid for the facility by the
  purchaser, as allocated to the individual assets of
  the facility; or

    (ii) The total fair market value of the facility at
  the time of the sale, as allocated to the individual
  assets; or

    (iii) The combined fair market value of the
  individually identified assets at the time of the
  sale.

    (3) Transactions other than bona fide. If the
  purchaser cannot demonstrate that the sale was bona
  fide, in addition to the limitations specified in
  paragraphs (g)(1) and (2) of this section, the
  purchaser's cost basis shall not exceed the seller's
  cost basis, less accumulated depreciation.

As might be expected, the dispute focuses on the meaning of the term "bona fide":

  (1) Northwest argues that "bona fide" means nothing
      more than bargaining conducted between well
      informed buyers and sellers. Thus, it contends,
      the fair price and favorable terms are conclusive
      as to the bona fides of the sale, so that
      Northwest must be permitted to use the $5 million
      purchase price as its depreciation base.

  (2) Defendants assert that a "bona fide" sale must
      consist of an arm's length transaction between
      unrelated parties. Because the three
      stockholder-director-operators of Northwest I
      continued as directors and as the controlling
      operators of Northwest, Hospital Service argues
      the transaction was between related parties and
      thus not a "bona fide" purchase, so that
      Northwest I's depreciated historical cost must be
      the depreciation base. To buttress that position,
      defendants rely on a 1972 interpretative letter
      sent by the Department to all fiscal
      intermediaries:

      . . . A number of proprietary providers have
      recently converted to a nonprofit status. Such
      conversion, of course, constitutes a change of
      ownership for Medicare certification purposes.
      The change of ownership would not, however,
      necessarily constitute a bona fide sale that
      would result in revaluation of provider assets
      under Medicare regulations. To be considered a
      bona fide sale, a transaction must result from
      arm's length bargaining between distinct and
      unrelated buyer and seller entities and result in
      a change in the actual control of the assets.
      Where the purchaser cannot demonstrate that
      change in ownership constituted a bona fide sale
      of assets, the new owner's cost basis shall not
      exceed the previous owner's cost basis less
      accumulated depreciation recognized under the
      program.

This Court agrees with defendants that "bona fide," when viewed in the context of the statute and its regulations, includes the concept of unrelatedness.*fn5 Where unrelated parties deal with each other at arm's length, there can be no question of the legitimacy of the cost to the provider as a base for future depreciation. But where self-dealing is involved, the same assurances do not exist to mandate an exception to the general rule prohibiting a revaluation of assets.*fn6

Section 405.427 defines "related parties," and that definition should be equally applicable to section 405.415. It provides that "[r]elated to the provider means that the provider to a significant extent is associated or affiliated with or has control or is controlled by the organization. . . ."

Northwest challenges the finding of the Commissioner that Northwest and Northwest I were related parties. But because the proper standard was applied, the Commissioner's determination that the parties were related is a finding of fact. Under the provisions of the Administrative Procedure Act a court can only overturn that kind of finding if "unsupported by substantial evidence . . ." 5 U.S.C. § 706 (2)(E). As the PRRB hearing established, Northwest's Board of Directors comprises the three owners of Northwest I plus four additional members chosen by the original owners. Those three original owners retained their positions in the hospital, and the Commissioner found that Hospital Administrator DeMarco has been the "dominant figure in both Providers [and] has the power to influence and direct the operations and policies of the non-profit Provider." Several courts have upheld findings of relatedness in similar situations. See Medical Center of Independence v. Harris, 628 F.2d 1113 (8th Cir., 1980); Chelsea Community Hospital v. Michigan Blue Cross, 436 F. Supp. 1050 (E.D.Mich. 1977); Hillside Community Hospital of Ukiah v. Mathews, 423 F. Supp. 1168 (N.D.Cal. 1976); Schroeder Nursing Care, Inc. v. Mutual of Omaha, 311 F. Supp. 405 (E.D.Wis. 1970).

In summary, this Court finds the Commissioner's finding of related parties supported by highly probative substantial evidence and upholds the Commissioner's determination that Northwest must use Northwest I's depreciated historical cost of the hospital in calculating its own depreciation.

2. Interest on the Purchase Price

Interest on the unpaid purchase price of the hospital involves considerations similar to those just discussed. Generally 42 C.F.R. § 405.419(a) provides for reimbursement of interest payments:

  Principle. Necessary and proper interest on both
  current and capital indebtedness is an allowable
  cost.

But Section 405.419(c) provides a "related party" exception to that rule:

  Borrower-lender relationship. (1) To be allowable,
  interest expense must be incurred on indebtedness
  established with lenders or lending organizations not
  related through control, ownership, or personal
  relationship to the borrower. Presence of any of
  these factors could affect the "bargaining" process
  that usually accompanies the making of a loan, and
  could thus be suggestive of an agreement on higher
  rates of interest or of unnecessary loans.

For the same reasons already stated regarding depreciation, this Court upholds the Commissioner's finding that the parties were sufficiently related so as to prevent full reimbursement of interest expenses under Section 405.419.

However, under the circumstances of this case, the total disallowance of interest urged by defendants exceeds the statutory mandate that requires the reimbursement of reasonable costs. As already discussed, the 4% interest rate is unquestionably not a prohibited "higher rate of interest." As for the other factor mentioned by the regulation, the loan clearly cannot be characterized as "unreasonable."*fn7

To parallel the treatment already approved for depreciation, the allowable amount of the loan should be treated as the excess of Northwest I's depreciated historical cost over the $100,000 paid in cash when the transaction was closed. Interest is allowable on that excess at the 4% rate under Section 405.419(a). To that extent Section 405.419(c) is unreasonable and invalid as applied to this case, and to the same extent defendants' motion for summary judgment is denied.

Non-Paid Workers

42 C.F.R. § 405.424 covers the third issue presented for review, involving the work performed in the hospital by members of a volunteer women's auxiliary:

  (a) Principle. The value of services in positions
  customarily held by full-time employees performed on
  a regular, scheduled basis by individuals as nonpaid
  members of organizations under arrangements between
  such organizations and a provider for the performance
  of such services without direct remuneration from the
  provider to such individuals is allowable as an
  operating expense for the determination of allowable
  cost subject to the limitation contained in paragraph
  (b) of this section. The amounts allowed are not to
  exceed those paid others for similar work. Such
  amounts must be identifiable in the records of the
  institutions as a legal obligation for operating
  expenses.

  (b) Limitations; services of nonpaid workers. The
  services must be performed on a regular, scheduled
  basis in positions customarily held by full-time
  employees and necessary to enable the provider to
  carry out the functions of normal patient care and
  operation of the institution. The value of services
  of a type for which providers generally do not
  remunerate individuals performing such services is
  not allowable as a reimbursable cost under the title
  XVIII health insurance program. For example, donated
  services of individuals in distributing books and
  magazines to patients, or in serving in a provider
  canteen or cafeteria or in a provider gift shop,
  would not be reimbursable.

Based on that regulation, the Commissioner denied reimbursement for the value of the work performed by the members of the women's auxiliary.

At various phases of the administrative proceeding, three different arguments were made in support of defendants' position. First, defendants argue that the services performed were of the kind normally undertaken by volunteers and not related to patient care or essential administrative tasks. Second, defendants relied on Section 704.1 of the Provider Reimbursement Manual, which permits reimbursement for volunteer workers only if the individuals work for a minimum of twenty hours per week, a requirement not met by the members of Northwest's women's auxiliary. Finally, defendants point out that all of the money that the hospital paid to the women's auxiliary was returned in the form of donations to the hospital, so that there was no actual cost to Northwest.

In this Court's view, the last point is dispositive of the matter. As the last sentence of Section 405.424(a) makes clear, reimbursement is permitted only for sums paid to organizations that provide volunteer workers. Section 405.424(c), which provides an example of proper reimbursement bears this out (emphasis added):

  (c) Application. The following illustrates how a
  provider would determine an amount to be allowed
  under this principle: The prevailing salary for a lay
  nurse working in Hospital A is $5,000 for the year.
  The lay nurse receives no maintenance or special
  perquisites. A sister working as a nurse engaged in
  the same activities in the same hospital receives
  maintenance and special perquisites which cost the
  hospital $2,000 and are included in the hospital's
  allowable operating costs. The hospital would then
  include in its records an additional $3,000 to

  bring the value of the services rendered to $5,000.
  The amount of $3,000 would be allowable where the
  provider assumes obligation for the expense under a
  written agreement with the sisterhood or other
  religious order covering payment by the provider for
  the services.

Even more fundamentally, the statute itself only permits reimbursement for reasonable costs. Under the circumstances here, where Northwest has sustained no actual cost, reimbursement would be impermissible.

Interest on Loans Incurred for Capital Improvements

Northwest incurred interest expense in connection with the construction of a parking lot and professional building. Even though it had an unrestricted funded depreciation account of more than $2 million, more than enough to pay for the capital improvements, it chose to fund the project by securing a loan. Accordingly, the question is whether interest, normally an allowable expense under Section 405.419, becomes an unreimbursable cost because the loan was not "necessary":

  (a) Principle. Necessary and proper interest on both
      current and capital indebtedness is an allowable
      cost.

(b) Definitions . . .

      (a) Necessary. Necessary requires that the
      interest:

      (i) Be incurred on a loan made to satisfy a
      financial need of the provider. Loans which
      result in excess funds or investments would not
      be considered necessary.

      (ii) Be incurred on a loan made for a purpose
      reasonably related to patient care.

We thus deal with the proper interpretation of a regulation. In Udall v. Tallman, 380 U.S. 1, 16, 85 S.Ct. 792, 801, 13 L.Ed.2d 616 (1965), the Supreme Court held that deference is to be given to an administrative agency's interpretation of a statute, and that when the interpretation of a regulation is involved "deference is even more clearly in order."

Northwest has failed to demonstrate any basis for overturning the decision of the Commissioner. It had adequate working capital from which the construction project could have been funded. Of course it could exercise its business judgment by obtaining a loan instead, but it cannot fairly impose the cost of that discretionary choice on the Medicare program.*fn8 Accordingly, the Commissioner did not abuse his discretion in determining that the interest was not the "necessary and proper interest" required by Section 405.419.

Conclusion

There is no genuine issue as to any material fact. Defendants are entitled to judgment and are hereby granted final judgment as a matter of law in all respects except for their excess claim for disallowance of interest on Northwest's purchase price, as previously discussed. Defendants are also allowed costs of this action. If defendants desire the entry of a final judgment order other than this memorandum opinion and order, they are directed to present such an order on or before November 14, 1980.

APPENDIX A

(v)(1)(A) The reasonable cost of any services shall be the cost actually incurred, excluding therefrom any part of incurred cost found to be unnecessary in the efficient delivery of needed health services, and shall be determined in accordance with regulations establishing the method or methods to be used, and the items to be included, in determining such costs for various types or classes of institutions, agencies, and services; except that in any case to which paragraph (2) or (3) applies, the amount of the payment determined under such paragraph with respect to the services involved shall be considered the reasonable cost of such services. In prescribing the regulations referred to in the preceding sentence, the Secretary shall consider, among other things, the principles generally applied by national organizations or established prepayment organizations (which have developed such principles) in computing the amount of payment, to be made by persons other than the recipients of services, to providers of services on account of services furnished to such recipients by such providers. Such regulations may provide for determination of the costs of services on a per diem, per unit, per capita, or other basis, may provide for using different methods in different circumstances, may provide for the use of estimates of costs of particular items or services, may provide for the establishment of limits on the direct or indirect overall incurred costs or incurred costs of specific items or services or groups of items or services to be recognized as reasonable based on estimates of the costs necessary in the efficient delivery of needed health services to individuals covered by the insurance programs established under this subchapter, and may provide for the use of charges or a percentage of charges where this method reasonably reflects the costs. Such regulations shall (i) take into account both direct and indirect costs of providers of services (excluding therefrom any such costs, including standby costs, which are determined in accordance with regulations to be unnecessary in the efficient delivery of services covered by the insurance programs established under this subchapter) in order that, under the methods of determining costs, the necessary costs of efficiently delivering covered services to individuals covered by the insurance programs established by this subchapter will not be borne by individuals not so covered, and the costs with respect to individuals not so covered will not be borne by such insurance programs, and (ii) provide for the making of suitable retroactive corrective adjustments where, for a provider of services for any fiscal period, the aggregate reimbursement produced by the methods of determining costs proves to be either inadequate or excessive.


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