Northwest Hospital, Inc. v. Hospital Service Corp., 75 C 2803.

• Decision Date: 29 October 1980
• Docket Number: No. 75 C 2803.,75 C 2803.
• Citation: 500 F. Supp. 1294
• Parties: NORTHWEST HOSPITAL, INC., Plaintiff, v. HOSPITAL SERVICE CORPORATION et al., Defendants.
• Court: U.S. District Court — Northern District of Illinois

500 F. Supp. 1294

NORTHWEST HOSPITAL, INC., Plaintiff, v. HOSPITAL SERVICE CORPORATION et al., Defendants.

No. 75 C 2803.

United States District Court, N. D. Illinois, E. D.

October 29, 1980.

George R. Bieber, Bieber & Spitzer, Chicago, Ill., for plaintiff.

Mary A. Thomas, Asst. U. S. Atty., Chicago, Ill., Stephen B. Weiss, Health Care Financing and Human Development Services Division, Baltimore, Md., for defendants.

MEMORANDUM OPINION AND ORDER

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 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.¹ 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,² 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).³ 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):⁴

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.⁵ 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.⁶

Section 405.427 defines "related parties," and that definition should be equally applicable to section 405.415. It provides that "related 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...