The amount of attention devoted to the health care system seems to be increasing every day as affordable care legislation implementation and its attendant costs continue to attract attention both in Washington and on Main Street.

While the politics are sorted out, the day-to-day operation of the Medicare reimbursement system and its impact on providers continues. When a provider files for bankruptcy, the debtor-creditor relationship between the Medicare system and provider sometimes plays out in interesting ways. Given the importance of Medicare payments to the continued operation of a hospital, the Medicare administrator must balance the government’s right to obtain repayment of overpayments to a hospital with the need to continue providing cash flow to allow the facility to continue operations.

An example of how this unusual creditor’s rights relationship can play out was addressed in a decision by the U.S. Bankruptcy Court for the Eastern District of Michigan in In re Community Memorial Hospital, No. 12-20666, (Bankr. E.D. Mich. 2013), where the Centers for Medicare and Medicaid Services (CMS) attempted to obtain a super-priority administrative claim over all creditors for amounts owed for Medicare overpayments. In a holding that distinguished the concepts of recoupment and setoff, the bankruptcy court held that CMS could not assert a super-priority claim in the case because the ability to assert recoupment was not a claim.

Super-Priority Claim for Medicare Overpayments

The debtor’s operating entities consisted of a critical-access hospital, a skilled nursing facility and three rural health clinics. According to the opinion issued July 12 by the court, each operating entity had a Medicare provider agreement. These agreements provide the terms by which CMS pays health care providers for services rendered to Medicare patients.

According to the opinion, as of the petition date, the debtor had substantial liability to CMS for Medicare overpayments. As is typically the case when a provider files for bankruptcy with liability for Medicare overpayments, after the bankruptcy filing, CMS placed an “administrative freeze” and stopped making Medicare payments to the debtor, and the debtor, CMS and the creditors’ committee entered into a stipulation in connection with the debtor’s continued use of CMS’s cash collateral. The stipulation provided that as adequate protection of the recoupment and setoff rights held by CMS against post-petition Medicare payments made to the debtor by CMS, CMS was granted first priority replacement liens on future Medicare payments not to exceed $400,000.

According to the opinion, the replacement liens provided to CMS proved to be insufficient adequate protection for the funds paid by CMS to the debtor. Like other secured creditors that are provided adequate protection that ends up being insufficient to cover the debtor’s use of collateral, CMS filed a motion for an administrative priority claim with “super-priority status” under Section 507(b) of the Bankruptcy Code. If allowed, this administrative claim would be paid ahead of other administrative and prepetition unsecured claims. The creditors’ committee objected, arguing the only recourse CMS had was the replacement liens and the adequate protection payments made under the stipulation. The committee asserted the liens having proved to be insufficient, CMS was attempting to obtain more than what it had bargained for.

CMS Did Not Hold a Claim

The court began its analysis by stating that Section 507(b) provides super-priority to a claim if three criteria are met: (1) the trustee or debtor must provide adequate protection under Sections 362, 363 or 364(d) of the Bankruptcy Code to the holder of a claim; (2) the creditor must have a claim allowable under Section 507(a)(2); and (3) the claim must have arisen from a stay of action under Sections 362 or 363, or from the granting of a lien under Section 364.

In order for a claim to be allowed under Section 507(a)(2), it must qualify as an administrative expense under Section 503(b) of the Bankruptcy Code. The opinion described the basis for claims under Section 503(b).The court quoted a U.S. Court of Appeals for the Sixth Circuit opinion for the proposition that certain administrative expenses, such as the actual, necessary costs and expenses of preserving the estate, including wages, salaries or commissions for services rendered after the commencement of the case, are granted priority under the Bankruptcy Code. Such claims are strictly construed because priority claims reduce the funds available for general unsecured creditors and other claimants.

The court observed the relationship between CMS and the debtor is not typical of a creditor and debtor, and stated, “What must be remembered is that the relationship between the secretary and a provider is no ordinary business relationship. A provider is the secretary’s surrogate in implementing an important governmental social welfare program and to treat the secretary as an ordinary creditor and the provider as an ordinary debtor substantially distorts that relationship.”

The court noted that CMS’s rights, as set by Congress, are recoupment and setoff, and the Bankruptcy Code does not override those rights. The opinion states, “Recoupment rights are not an interest in property but are instead a statutory adjustment that defines the proper payment due to a provider.” Furthermore, “Recoupment is a defense, not a claim, and does not result in an affirmative recovery.”

Turning to the case at hand, the court noted that the stipulated cash collateral orders provided CMS would forgo its recoupment and setoff rights it might otherwise have exercised immediately in exchange for replacement liens on future Medicare payments. The court reiterated that recoupment did not create a claim, and holding a claim is a necessary condition to receiving super-priority status under Section 507 of the Bankruptcy Code, or even a priority claim under Section 503(b).

The opinion also observed that CMS’s right to setoff did grant it a secured claim under Section 506(a) of the Bankruptcy Code, but only to the value of the amount subject to setoff. Here, the right of setoff alone could not form the basis for a super-priority administrative claim.

The court noted that CMS and the debtor could have added language to the cash collateral orders that expressly granted CMS a claim as additional adequate protection of its interest in the debtor’s property, but the stipulation and orders did not provide such additional rights and claims. Instead, CMS “obviously did not want to infringe on its contractual rights and therefore disturb or distort its relationship with the debtor.” The court reasoned that the use of liens “at best gave CMS protection from interference by this court of that relationship.” The court denied the CMS motion.

Government’s Rights as a Creditor

As fiscal pressures on government spending increase and implementation of affordable care legislation moves forward, providers will continue to be under increasing pressure to manage their declining cash flow under government programs. Ultimately, many providers will need to be reorganized or sold by utilizing bankruptcy proceedings, and how the government asserts its rights as a creditor in these proceedings will have an increasing impact on the success of such reorganizations and sales. The Community Memorial Hospital decision is a reminder that these rights will need to be defined in the early stages of the proceeding.

Andrew C. Kassner is the chair of the corporate restructuring practice group of Drinker Biddle & Reath, practicing in the firm’s Philadelphia and Wilmington, Del., offices. He can be reached at andrew.kassner@dbr.com or 215-988-2554.

Joseph N. Argentina Jr. is an associate in the firm’s corporate restructuring practice group in the Philadelphia and Wilmington offices. He can be reached at joseph.argentina@dbr.com or 215-988-2541.