The opinion of the court was delivered by: Shadur, District Judge.
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
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).
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,
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
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
(iii) The combined fair market value of the
individually identified assets at the time of the
(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
. . . 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
This Court agrees with defendants that "bona fide," when viewed
in the context of the statute and its regulations, includes the
concept of unrelatedness.
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.
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.
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
Principle. Necessary and proper interest on both
current and capital indebtedness is an allowable
But Section 405.419(c) provides a "related party" exception to
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.
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
(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
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
(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
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
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
(b) Definitions . . .
(a) Necessary. Necessary requires that the
(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,
, 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.
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.