The last few years have seen a precipitous rise in the number of bankruptcies filed by health care providers such as hospitals, clinics, nursing homes, home health agencies and rehabilitation facilities. In 1997, Congress enacted the Balanced Budget Act to reform the Medicare system. This act included a new prospective payment system for Medicare reimbursement. Under the prospective payment system, Congress was trying to decrease Medicare long-term care payments by $8 billion to $9 billion, but by its own estimates, it reduced payments to the industry by almost $30 billion. In 1999, Congress enacted the Benefits Improvement and Patient Protection Act, which restored some of the money to the health care industry. Unless these enhancements are renewed by Oct. 1, however, they will be phased out, and the health care industry will be faced with another round of business failures.¹

For most health care debtors, Medicare and Medicaid reimbursements constitute a substantial portion of their income. When Medicare or Medicaid reimbursements are terminated (or are threatened to be terminated), the tourniquet of bankruptcy often gives way to massive financial hemorrhaging by the debtor, and hopes of a successful reorganization or meaningful liquidation by the health care provider are dashed.

Pursuant to the Medicare Act, health care providers that provide services to Medicare patients are entitled to receive payment for their services.² For a health care provider to receive Medicare funds, it must enter into a "provider agreement" with the Centers for Medicare and Medicaid Services (CMS). In order to ensure that the health care provider is paid promptly, the provider agreement and the Medicare Act establish a payment system whereby the provider receives periodic payments for its services on an estimated basis. On an annual basis, the health care provider is required to file a cost report with an intermediary under contract with CMS. The intermediary conducts an audit of the cost report and the health care provider. The audit reveals the precise amount of any underpayment or overpayment made to the health care provider as part of the estimated periodic payment system. Upon the conclusion of the audit, a retroactive adjustment is made. To the extent that there are underpayments owing to the health care provider, the intermediary pays the difference to the provider. If the health care provider has been overpaid, then the intermediary can demand immediate repayment of the overage, or as is usually the case, the intermediary can deduct the overpayments from future estimated monthly reimbursements. Thus, if a health care provider is overpaid for its Medicare services in 2001, its estimated monthly payments for 2002 will be reduced to compensate for the overpayments of the previous year.

This payment system is efficient and practical, and works well outside the bankruptcy context. However, at the point that a bankruptcy petition is filed and a line is drawn between pre-petition and post-petition claims, the streamlined reimbursement system of the Medicare Act becomes a muddied quagmire.

If a Medicare provider agreement is assumed by a debtor pursuant to §365 of the Bankruptcy Code, then, as a condition of assumption, the debtor is obligated to cure the default by honoring its pre-petition obligations under the provider agreement. Consequently, upon the assumption of a Medicare provider agreement, there is no impediment to the government's ability to offset pre-petition Medicare overpayments against post-petition Medicare reimbursements. However, because it may be prohibitively expensive for the debtor to pay such cure amounts³ and because claims under an assumed executory contract are elevated from general unsecured to administrative priority status,⁴ bankrupt health care providers usually are not eager to immediately assume their provider agreements. After all, the Bankruptcy Code affords chapter 11 debtors a substantial period of time—until plan confirmation—to assume or reject executory contracts. Often, it behooves the debtor to see whether reorganization is feasible before the debtor assumes and obligates itself to perform under a pre-petition provider agreement.

So what happens when a Medicare provider agreement is not assumed by the debtor pre-confirmation? Despite non-assumption, the debtor may elect to provide post-petition Medicare services and seek reimbursement for those services. Does the automatic stay prohibit the collection of the pre-petition overpayments? Is the government relegated to the unenviable position of a general unsecured creditor with respect to its pre-petition claim for overpayments? Or can the government extinguish its pre-petition debt by setting off against post-petition reimbursements? The courts are split on how these questions should be answered.

At first glance, it seems that the automatic stay of §362 would prohibit the recovery of pre-petition overpayments—which are simply pre-petition claims—from post-petition Medicare receivables. Even the setoff provisions of §553 are of no avail to CMS, since that provision disallows setoff when the respective claims span the pre-petition/post-petition line. However, in an attempt to skirt the limitations imposed by §362, CMS has successfully argued that the right to credit pre-petition Medicare overpayments against post-petition Medicare reimbursements is founded on the doctrine of recoupment, an equitable exception to the automatic stay that allows post-petition payments due to a debtor to be applied against pre-petition debt owed by the debtor.

Generally speaking, recoupment is the setting off of an obligation arising from the "same transaction" as the plaintiff's cause of action, strictly for the purpose of abatement or reduction of such claim. As explained by one court, "[t]he doctrine is justified on the grounds that where the creditor's claim against the debtor arises from the same transaction as the debtor's claim, it is essentially a defense to the debtor's claim against the creditor rather than a mutual obligation, and application of the limitation on setoff in bankruptcy would be inequitable."⁵ Thus, the distinction between setoff and recoupment is that recoupment requires not only that the claims be mutual (as in setoff), but also that the claims arise from the same transaction or occurrence that gave rise to the liability sought to be enforced by the debtor.

The first appellate court to consider the applicability of the recoupment doctrine to post-petition Medicare reimbursements was the Third Circuit in In re University Medical Center.⁶ In that case, a chapter 11 debtor operated its hospital as a debtor-in-possession for three months before finally closing its doors and ceasing its operations. CMS then sought to recoup pre-petition overpayments against post-petition Medicare reimbursements, and the debtor filed an adversary proceeding arguing that the withholding of post-petition reimbursements to recover amounts overpaid violated the automatic stay of §362. The debtor also sought turnover of the post-petition reimbursements pursuant to §§542 and 543. The bankruptcy court and the district court both held that the failure to turn over the post-petition reimbursements was a violation of the automatic stay.

On appeal, the Third Circuit first considered the argument of CMS that because the debtor operated under its Medicare provider agreement for a period of three months, the provider agreement was assumed by the debtor for purposes of §365. The court rejected this argument, holding that formal court approval is a prerequisite to a debtor's assumption of an executory contract.

Turning to the question of recoupment, the court reviewed the applicable Medicare regulations, noting that the relevant regulations state that each providers' cost year is subject to a distinct annual audit, following the submission of a separate cost report for each fiscal year. According to the Third Circuit, "[t]hese regulations indicate that reimbursement payments made for any one year arise from transactions wholly distinct from reimbursement payments made for subsequent years."⁷ The court continued:

For the purposes of recoupment, a mere logical relationship is not enough: The "fact that the same two parties are involved, and that a similar subject matter gave rise to both claims...does not mean that the two arose from the same transaction." Rather, both debts must arise out of a single, integrated transaction so that it would be inequitable for the debtor to enjoy the benefits of that transaction without also meeting its obligations. Use of this stricter standard for delineating the bounds of a transaction in the context of recoupment is in accord with the principle that this doctrine, as a non-statutory, equitable exemption to the automatic stay, should be narrowly construed.⁸

The court went on to determine that the post-petition reimbursements were independently determinable and were due for services completely distinct from those reimbursed during prior years. As explained by the court,

The relationship between HHS and a Medicare provider entails transactions that last over an extended period. However, each of these transactions begins with services rendered by the provider to a Medicare patient, includes payment to the provider, and concludes with HHS's recovery of any overpayments. Recovery of the 1985 overpayments, therefore, is the final act of the transactions that began in 1985. [The debtor's] 1988 post-petition services were the beginning of transactions that would stretch into the future, but they were not part of the 1985 transactions.⁹

Accordingly, the Third Circuit held that CMS had violated the automatic stay by withholding the debtor's post-petition reimbursements and applying them to pre-petition overpayments, and directed that the post-petition reimbursements be turned over to the debtor.

In 1997, the D.C. Circuit Court of Appeals authored an opinion rejecting the Third Circuit's analysis in University Medical Center, determining that post-petition Medicare reimbursements can be recouped against pre-petition overpayments. In U.S. v. Consumer Health Services of America Inc.,¹⁰ a chapter 11 debtor operated its home health care business for a year before converting to chapter 7. The chapter 7 trustee submitted a claim for reimbursement for Medicare services performed during the period that the debtor was operating under chapter 11. The government brought a motion before the bankruptcy court requesting that the court affirm its right to recoup pre-petition overpayments against post-petition receivables. The court determined that the government should be allowed to recoup the amounts owed, basing its decision on the language of a Medicare statute that provides as follows:

The secretary shall periodically determine the amount which should be paid under this part to each provider of services with respect to the services furnished by it, and the provider shall be paid, at such time or times as the secretary believes appropriate (but not less often than monthly) and prior to audit or settlement...the amounts so determined, with necessary adjustments on account of previously made overpayments or underpayments.¹¹

The Consumer Health Services court criticized the Third Circuit for overlooking the plain language of this statute, maintaining that the Third Circuit assumed that the amount due on post-petition services was to be determined by the regulations detailing how much a provider normally gets paid for the services rendered.

Only then, after that determination, did the [Third Circuit] inquire into whether the prior overpayments could be deducted from the amount due... [W]e disagree with the premise that the "amount due" should be calculated with reference to the fee schedule set out in the regulations. That fee schedule only determines what "should be paid;" the amount actually due under the statute is the amount which "shall be paid"—which includes necessary adjustments for prior overpayments.¹²

The Consumer Health Services court concluded its analysis by stating:

Unlike the Third Circuit, we do not think the frequency of the audit appropriately defines the "transaction." The audit is simply the mechanism by which the intermediary determines whether and by how much it ought to adjust subsequent periodic payments to a particular provider... An audit is nothing more than a snapshot in time—whether it is monthly, annual or decennial is, in our view, irrelevant.

In determining whether the pre-petition and post-petition services should be thought of as one transaction, the key to us is the Medicare statute. Since it requires the secretary to take into account pre-petition overpayments in order to calculate a post-petition claim—as we have described above—Congress rather clearly indicated that it wanted a provider's stream of services to be considered one transaction for purposes of any claim the government would have against the provider.¹³

In 2000, the Ninth Circuit followed the lead of the D.C. Circuit and held that the government could recoup pre-petition overpayments against post-petition Medicare reimbursements. See In re TLC Hospitals Inc., 224 F.3rd 1008 (9th Cir. 2000).

The Third Circuit, the D.C. Circuit and the Ninth Circuit are the only circuit appeals courts to have considered the issue of whether Medicare overpayments can be recouped against post-petition reimbursements. However, a number of lower courts have considered this issue with a slight majority allowing recoupment to some degree.¹⁴

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Courts will need to balance the legitimate interest of the government to repayment with the equally legitimate right of the debtor to attempt to reorganize.

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One case that is of particular interest is In re Healthback LLC, 226 B.R. 464 (Bankr. W.D. Okla. 1998). In that case, the court's decision that recoupment should not be allowed was heavily influenced by the fact that the debtor was still operating and that an order allowing the government to recoup pre-petition overpayments would cause the destruction of the debtor as a viable business entity, leaving hundreds of employees without jobs and thousands of patients without adequate medical care. The court explained:

The doctrine of recoupment is an equitable doctrine. But equity goes both ways. In this matter, the harm to both parties must be balanced. If the secretary is granted her request...then there is little doubt that the debtor will cease to exist. Thus, the harm to the debtor, its 200 employees, patients and creditors will be the highest degree of harm possible. On the other hand, if the debtor is granted its remedy, the harm to the Department of Health and Human Services will only be a delay in the accounting and recovery of any overpayments. The harm to the debtor clearly and unequivocally outweighs any inconvenience to the Department of Health and Human Services.

Id. at 476. In order to soften the impact of its decision, the court pointed to the fact that the debtor was not attempting to discharge the overpayments made by the Department of Health and Human Services, but was only seeking to forestall accounting for the alleged overpayments and for "breathing room" to effect reorganization. The court explained:

Indeed, the debtor, at the hearing, merely asked that the current withholdings be released to facilitate survival and rehabilitation of the debtor as a business entity, which is the purpose of a chapter 11 case. Only later in this case would it be proper for this court to undertake any determination of the dischargeability of these overpayments to the debtor from the Department of Health and Human Services as "debts."

Id. In effect, the Healthback court required the government to relinquish its bird in hand (i.e., the post-petition Medicare reimbursements) for a bird in the bush, and hope that the debtor would be sufficiently solvent to be able to fully satisfy the pre-petition overpayments at some later date.

Unlike the circuit court decisions in University Medical Center, Consumer Health Services and TLC Hospitals, where each debtor ceased doing business, Healthback involved the situation where the debtor was still operating and providing necessary medical services to the local community. Faced with the specter of closing a community hospital, it is understandable why a court may be inclined to hold that recoupment should not be allowed.

Conclusion

Medicare and Medicaid receivables are the lifeblood of most health care businesses. If the government is allowed to recoup, then at best, it will control the reorganization of such a debtor. At worst, it can prohibit the reorganization by cutting off the blood supply. Courts will need to balance the legitimate interest of the government to repayment with the equally legitimate right of the debtor to attempt to reorganize.

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Footnotes

¹ For an in-depth look at the current financial state of the health care industry, see the Health Care Industry Market Update, available at www.cms.hhs.gov, the web site for the Centers for Medicare and Medicaid Services (CMS), formerly known as the Healthcare Financing Administration, or HCFA. Return to article

² For the sake of simplicity, this article will focus principally on Medicare reimbursement procedures. Medicare is a government-sponsored health care insurance program for individuals who have certain disabilities or are over the age of 65. Medicaid is essentially health care for indigent individuals. Medicaid regulations generally echo those of the Medicare Act, but can vary from state to state. One important distinction between Medicare provider agreements and some states' Medicaid participation agreements is that some Medicaid participation agreements are only valid for a year and must be renewed annually. Conversely, Medicare provider agreements tend to be perpetual and continue from year to year. Return to article

³ A related problem is that it is often impossible to tell the amount of any Medicare overpayments that may be owed under a given provider agreement. Return to article

⁴ See In re South Motor Co. of Dade County, 161 B.R. 532, 546 (Bankr. S.D. Fla. 1993). Return to article

⁵ In re University Medical Center, 973 F.2d 1065, 1079-80 (3rd Cir. 1992.). Return to article

⁶ 973 F.2d 1035 (3rd Cir. 1992). Return to article

⁷ Id. at 1080. Return to article

⁸ Id. at 1081 (quoting Lee v. Schweiker, 739 F.2d 870, 875 (3rd Cir. 1984)). Return to article

⁹ Id. at 1081-82. Return to article

¹⁰ 108 F.3d 390 (D.C. Cir. 1997). Return to article

¹¹ 42 U.S.C. §1395g(a) (emphasis added). Return to article

¹² Id. at 394. Return to article

¹³ Id. at 395. Return to article

¹⁴ See, e.g., In re AHN Homecare LLC, 222 B.R. 804 (Bankr. N.D. Texas 1998); In re Southern Institute for Treatment and Evaluation Inc., 217 B.R. 962 (Bankr. S.D. Fla. 1998); In re CDM Management Services Inc., 226 B.R. 195 (Bankr. S.D. Ind. 1997); In re Visiting Nurse Association of Tampa Bay Inc., 121 B.R. 114 (M.D. Fla. 1990); but see In re Healthback LLC, 226 B.R. 464 (Bankr. W.D. Okla. 1998); In re First American Healthcare of Georgia Inc., 208 B.R. 985 (S.D. Ga. 1996); In re Tidewater Memorial Hospital Inc., 106 B.R. 876 (E.D. Va. 1989). Return to article