Jody A. Bedenbaugh
Nelson Mullins Riley & Scarborough LLP; Columbia, S.C.
An asset sale is an important strategic option for hospitals and other health care facilities in financial distress. Whether pursuant to § 363 of the Bankruptcy Code or a confirmed reorganization plan under § 1123(b)(4), a sale in chapter 11 can offer great benefits, including the potential ability to sell assets free and clear of interests. When a hospital is faced with significant False Claims Act (FCA) liabilities, a sale to a new provider is often the only viable option to keep the hospital operating as a going concern.
How the government’s claims are to be treated in the sale process will determine such important issues as potential cure obligations and successor liability issues, which in turn often impact key deal terms such as price and feasibility. Although the government will often favor (or force) a sale of a distressed hospital to a new provider in this context, the government has taken the position, on at least one occasion in a bankruptcy case and outside the bankruptcy context, that a successor is liable for FCA liabilities of the predecessor/seller.
The FCA imposes civil liability on any person who knowingly presents, or causes to be presented, a false or fraudulent claim for payment or approval to the government. Violations of the FCA can result in awards of treble damages and significant penalties, which (depending on the severity) can cripple a provider’s ability to sustain operations. Misconduct giving rise to treble damages and penalties includes knowingly presenting claims for services that were not provided as claimed, knowingly retaining an overpayment, and Stark Law violations.
The Stark Law, as a general principle, prohibits physician referrals to an entity in which he/she has a financial relationship, which includes referrals to a hospital that provides compensation to a physician that varies with or takes into account the volume or value of the physician’s referrals or other business generated by the referring physician. If a physician makes a prohibited referral, a hospital may not submit a bill for reimbursement from Medicare and the government is prohibited from paying for any health service provided in violation of the Stark Law. Because the Stark Law does not create its own right of action, the government typically seeks relief under the FCA, which provides a right of action with respect to false claims submitted for Medicare reimbursement, as well as under equitable theories such as unjust enrichment.
The Tuomey case provides a recent example of Stark Law enforcement proceedings that resulted in a prohibitive judgment (in excess of $273 million), including penalties and treble damages against the hospital. In this case, a concurring circuit judge described Stark as “[a]n impenetrably complex set of laws and regulations that will result in a likely death sentence for [the] hospital.” Ultimately, the Fourth Circuit upheld a determination that the hospital’s part-time contracts with doctors violated Stark because they provided compensation based on the collection of facility fees, which varied with the volume or value of physician referrals.
It was anticipated that the government would assert successor liability for Tuomey’s FCA judgment. However, the parties ultimately reached a settlement based on the hospital’s ability to pay, which permitted a sale and allowed the hospital to continue operating in a community that critically needed its services. In the absence of a settlement with the government over the treatment of FCA liabilities, this article discusses three novel — but untested — arguments for limiting the government’s right to recover FCA penalties and treble damages via recoupment or otherwise against the purchaser of the hospital’s assets in bankruptcy.
Argument for Denying Recoupment of FCA Penalties and Treble Damages
Assuming that the provider is not successful in arguing that the bankruptcy sale is entirely free and clear of the government’s right of recoupment, the provider may alternatively argue that, at a minimum, the right of recoupment is limited to actual overpayments (if any) and does not apply to the FCA penalties and treble damages. The right of recoupment is limited to situations in which a debtor and creditor have claims against each other that arise out of the same transaction.
Courts have developed two tests for determining whether claims arise out of the “same transaction”: (1) the more liberal “logical relationship” test, which interprets “same transaction” broadly to include a series of occurrences depending not on their immediate connection but rather than a logical relationship to each other; and (2) the more conservative “integrated transaction” test, which requires the obligations to arise out of a single integrated transaction such that it would be inequitable for the debtor to retain the benefits of the transaction without also meeting its obligations. Under either test, however, the provider could assert that FCA penalties and treble damages do not arise out of the same transaction as the government’s future reimbursement obligations.
Like in Tuomey, a typical FCA judgment is solely comprised of penalties and treble damages under the FCA — not direct, contractual damages. These claims are not contractual claims arising from alleged breaches of the provider agreements, as the government often admits in nonbankruptcy FCA litigation. Rather, these are derived from a federal statute (the FCA), which is independent from the Medicare statutes and regulations.
In this way, FCA liabilities are in contrast to the more common situation in which the bankruptcy court must decide whether the doctrine of recoupment applies to actual overpayments received by a debtor. For example, in In re Fischbach, the bankruptcy and district courts determined that actual overpayments received by the debtor in 2009 were part of the same transaction as subsequent year reimbursements and consequently, not subject to the debtor’s discharge received in 2010. The bankruptcy court, in distinguishing the Fourth Circuit’s decision in In re Thompson, found that ongoing provider payments for which the government sought recoupment were the “same form of payments as the previous overpayments and arose from the same Medicare reimbursement agreement.” In contrast, a provider can logically assert that civil penalties and treble damages comprising a FCA judgment arise from statutory fraud claims, as opposed to a breach of contract claims, and therefore are not the “same form of payments” as the following-year reimbursements under the provider agreement. In short, the provider’s argument is that to construe statutory penalties and subsequent-year payments to “arise out of the same transaction or occurrence” stretches the term beyond any reasonable bounds under whichever test is employed.
Further, unlike the overpayments in Fischbach, a provider may assert that the FCA penalties and treble damages are not “overpayments” within the government’s statutory right to recoup. Thus, 42 U.S.C. § 1395g(a) governs payments to providers and authorizes the secretary of the Department of Health and Human Services to make the “necessary adjustments on account of previously made overpayments or underpayments.”
In addition, 42 U.S.C. § 1320a-7k(d)(4) defines “overpayments” to mean “any funds that a person receives or retains under title XVIII or XIX [42 U.S.C. §§ 1395, et seq. or 1396, et seq.] to which the person, after applicable reconciliation, is not entitled under such title.” By this definition (and the ordinary meaning of the term), FCA penalties and treble damages are not overpayments because they are not funds or payments actually received by the provider. Such claims also arise from the FCA, 31 U.S.C. §§ 3729, et seq., and not under 42 U.S.C. §§ 1395, et seq. or 42 U.S.C. § 1396. Consequently, the provider has a persuasive argument in response to an attempt by the government to exercise its alleged statutory right of recoupment to recover FCA penalties and treble damages.
Argument for No Successor Liability under the “Fraud Exception”
Notwithstanding whether the court determines that the provider agreements are executory contracts or assets that can be sold under the Bankruptcy Code, a provider faced with FCA liabilities may also assert that the purchaser of its provider numbers is not responsible for the civil penalties and any related overpayments under the “fraud exception” to successor liability under applicable law. Citing 42 C.F.R. § 489.18, the government generally takes the position that applicable Medicare regulations require a purchaser to succeed to the seller’s overpayment and Medicare civil liability. This section provides that where there is a change of ownership, the provider agreement is automatically assigned to the new owner “subject to all applicable statutes and regulations and to the terms and conditions under which it was originally issued, including, but not limit[ed] to ... any existing plan of correction.” Nonbankruptcy courts have interpreted this provision to find successors liable for the predecessor’s liability for overpayments under 42 U.S.C. § 1395g, as well as civil monetary penalties.
Under the government’s interpretation of this provision, contained in chapter 3 of the Medicare Financial Management Manual, however, “the new owner assumes all penalties under the Medicare program, including the repayment of any accrued overpayments, regardless of who had ownership of the Medicare agreement at the time the overpayment was discovered unless fraud was involved.” The Manual further states the following exception to its rule that the new owner has responsibility for outstanding and future overpayments:
If any of the overpayments determined for a fiscal year when the previous owner had assignment were discovered due to fraud, the responsibility for the repayment of the overpayments does not shift to the new provider. It stays with the old provider.
The Manual does not expressly state that the exception applies to penalties and treble damages under the FCA, but the language broadly encompasses all fraud-related penalties and overpayments. An agency’s interpretation of its own regulations in the Manual is entitled to deference from the court unless it is clearly erroneous or conflicts with the regulation. The authors have not identified a reported case applying this fraud exception, but the plain language of CMS’s own manual makes a persuasive argument that fraud-related claims do not automatically attach to the new provider. The policy rationale that is presumably behind the exception makes imminent sense (and is consistent with certain policies underlying the Bankruptcy Code): encouraging new (presumably non-fraudulent) providers to take over the operations of a fraudulent provider while keeping the liability for the fraud with the culpable party.
Argument that Cure Requirements of § 365 Do Not Apply to FCA Liabilities
In the event that a bankruptcy court treats a provider agreement as an executory contract, the provider can assert that any cure amount and liabilities assumed by a purchaser under § 365 of the Bankruptcy Code exclude FCA penalties and treble damages. In short, FCA claims do not arise from contracts. Rather than an alleged default under any contract, typical FCA cases against Medicare providers are based on alleged FCA violations and equitable theories of recovery.
Further, the provider may argue that there is a clear distinction between liability arising from contract and liability for fraud and abuse claims, which (unlike contract claims) require a showing of scienter. This scienter requirement further highlights the noncontractual nature of FCA claims and strengthens the argument that such liabilities are not defaults under the provider agreement to which the cure required to be paid upon assumption would attach under § 365.
 The authors thank Graham Mitchell for his assistance with this article. The views expressed herein are not necessarily the views of Nelson Mullins Riley & Scarborough LLP or any of its clients.
 The government, in this context, is usually the U.S. Department of Health and Human Services (HHS), and its component agencies the Office of Inspector General (OIG) and Centers for Medicare and Medicaid Services (CMS). These agencies are represented by attorneys from HHS’s Office of General Counsel and the U.S. Department of Justice.
 See In re Our Lady of Mercy Med. Ctr., Case No. 07-10609 (REG) (Bankr. S.D.N.Y.) (case settled prior to ruling from court). For a discussion of Our Lady of Mercy, see Frank A. Oswald and Howard P. Magaliff, “Transfer of Medicare Provider Numbers in Bankruptcy: Executory Contract or Saleable Asset?,” XXVIII ABI Journal 4, 68-70, May 2009, available at abi.org/abi-journal.
 31 U.S.C. § 3729(a)(1)(A) and (b)(2)(A)(i). United States ex rel. Drakeford v. Tuomey d/b/a Tuomey Healthcare Sys. Inc., 792 F.3d 364, 380 (4th Cir. 2015) (“Tuomey”).
 31 U.S.C. § 3729(a)(1); 42 U.S.C. § 1320a-7a; see also ABI Health Care Insolvency Manual 3d ed., 134-35 (available for purchase at abi.org/bookstore); Tuomey at 373.
 42 C.F.R. § 411.354(c)(2)(ii) (2014).
 42 U.S.C. § 1395nn(a)(1), (a)(1)(B) and (g)(1).
 Tuomey at n.4.
 Tuomey at 379.
 Whether the government’s right of recoupment is an “interest” that can be avoided via sale under § 363(f) is outside the scope of this article, as it has been addressed elsewhere, but that argument (along with the issue of whether the provider agreement is an executory contract) will presumably be one of the first raised by the provider seeking to sell its provider agreements in bankruptcy.
 See, e.g., Georgetown Steel Co. v. Capital City Ins. Co. (In re Georgetown Steel Co.), 318 B.R. 313, 325 (Bankr. D.S.C. 2004). Courts are split on whether Medicaid or Medicaid’s efforts to adjust ongoing payments to recover prior overpayments constitutes recoupment or setoff. In Univ. Med. Ctr. v. Sullivan (In re Univ. Med. Ctr.), 973 F.2d 1065 (3d Cir. 1992), the Third Circuit applied the integrated-transaction test and held that recovering the overpayments constituted a setoff unless it was within the same year covered by the cost report. A majority of other courts, however, including the First, Seventh, Ninth, and D.C. Circuits, have held that Medicare or Medicaid overpayments/reimbursements constitute recoupment and therefore allowed the government to recoup the overpayments post-bankruptcy. See Slater Health Ctr. Inc. v. United States (In re Slater Health Ctr. Inc.), 398 F.3d 98 (1st Cir. 2005); Holyoke Nursing Home Inc. v. Health Care Financing Admin. (In re Holyoke Nursing Home Inc.), 372 F.3d 1 (1st Cir. 2004); Sims v. U.S. Dep’t of Health and Human Servs. (In re TLC Hosps. Inc.), 224 F.3d 1008, 1011 (9th Cir. 2000); United States v. Consumer Health Servs. of Am. Inc., 108 F.3d 390 (D.C. Cir. 1997). The above discussion does not address whether the right of recoupment applies to overpayments, but focuses on the right to recoup penalties and interest.
 Id. at 330. A majority of courts have adopted the more liberal “logical relationship” test. See In re TLC Hosp. Inc., 224 F.3d 1008, 1013-14 (9th Cir. 2000); In re Slater, 398 F.3d at 103; and In re Holyoke, 372 F.3d at 4. On the other hand, a minority of courts apply the more conservative “integrated transaction” test. In re Thompson, 182 B.R. 140, 148-49 (Bankr. E.D. Va. 1995), aff’d, 92 F.3d 1182 (4th Cir. 1996); In re Univ. Med. Ctr., 973 F.2d at 1081; and In re Malinowski, 156 F.3d 131, 133 (2d Cir. 1998).
 For example, in the underlying Tuomey litigation, the government took the position that the litigation did not involve a contract, but rather the provider agreement was the provider’s certification that it would comply with all applicable requirements of the Medicare program. For a thorough analysis of the government’s shifting position on whether a provider agreement is a contract, see Samual R. Maizel and Jody A. Bedenbaugh, “The Provider Agreement: Is it a Contract or Not? And Why Does Anyone Care,” The Business Lawyer (forthcoming).
 The debtor in Fischbach had received overpayments for services that were subsequently deemed not medically necessary.
 See Fischbach v. Ctrs. for Medicare and Medicaid Servs. (In re Fischbach), 464 B.R. 258 (Bankr. D.S.C. 2012), aff’d, 2013 U.S. Dist. LEXIS 39855 (D.S.C. March 22, 2013).
 92 F.3d 1182 (4th Cir. 1996), full opinion available at 1996 U.S. App. LEXIS 19051.
 Fischbach, 464 B.R. at 268.
 42 U.S.C. § 1395g(a).
 42 U.S.C. § 1320a-7k(d)(4).
 42 C.F.R. § 489.18(c) and (d). Notably, overpayments and other claims are not expressly included within the list of assigned conditions in 42 C.F.R. § 489.18(d).
 See United States v. Vernon Home Health Inc., 21 F.3d 693 (5th Cir. 1994) (assignee of provider agreement is responsible for adjustments due to overpayments to predecessor); Deerbrook Pavillion LLC v. Shalala, 235 F.3d 1100 (8th Cir. 2000) (holding that predecessor’s civil monetary penalties could be assessed against successor); BP Care Inc. v. Thompson, 337 F. Supp. 2d 1021 (S.D. Ohio 2003) (finding that CMS could collect civil monetary penalties from successor); Delta Health Grp. Inc. v. United States Dep’t of Health and Human Servs., 459 F. Supp. 2d 1207 (N.D. Fla. 2006) (holding successor who assumed provider agreement has successor liability for civil monetary penalties).
 Medicare Financial Management Manual, ch. 3, § 130 (emphasis added).
 Id. (emphasis added).
 See Triad at Jeffersonville I LLC v. Leavitt, 563 F. Supp. 2d 1, 19 (D.D.C. 2008) (internal citations omitted). See also St. Mary’s Hosp. of Troy v. Blue Cross & Blue Shield Ass’n, 788 F.2d 888, 890 (2d Cir. 1986) (explaining that CMS manuals are “interpretive” sources entitled to persuasive weight); Battle Creek Health Sys. v. Leavitt, 498 F.3d 401, 409 (6th Cir. 2007) (analyzing CMS’s Provider Reimbursement Manual and determining that CMS properly relied upon that manual in reaching the at-issue decision).
 According to at least one secondary authority, no successor entity has successfully invoked the exception. See ABI Healthcare Insolvency Manual 146 (Leslie A. Berkoff, et al., eds., 3d ed. 2012).
 See Michael Silhol and Nicole Somerville, “Successor Liability in Healthcare Transactions,” AHLA Connections, March 15, 2012, at 29 (discussing potential arguments for successors to avoid liability scienter-based liabilities).
 See In re TrueStar Barnett LLC, 2008 Bankr. LEXIS 3310, *9 (N.D. Tex. Oct. 3, 2008) (stating that § 365 “does not give the right to the counterparty to an executory contract that is being assumed to demand, as part of the cure of defaults, to [sic] payment of extra-contractual claims.”).
This article was originally published in the November 2016 edition of the Health Care Committee Newsletter. Participation in ABI's committees is one of the many benefits of becoming a member. Committees provide networking and leadership opportunities. For additional information on how you could become involved in ABI and our Committees please visit membership.abi.org