Source: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-caDC-96-05074/USCOURTS-caDC-96-05074-0/pdf.json

Nature of Suit Code: 151
Nature of Suit: Overpayments under the Medicare Act
Cause of Action: 

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United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued September 2, 1997 Decided January 20, 1998 

No. 96-5074

THE KIDNEY CENTER OF HOLLYWOOD, ET AL.,

APPELLANTS

v.

DONNA E. SHALALA, SECRETARY,

UNITED STATES DEPARTMENT OF HEALTH AND HUMAN SERVICES,

APPELLEE

Appeal from the United States District Court 

for the District of Columbia 

(No. 94cv01459)

Eugene A. Massey argued the cause for appellant, with 

whom Richard J. Webber was on the briefs.

Janice L. Hoffman, Attorney, U.S. Department of Health 

& Human Services, argued the cause for appellee, with whom 

Frank W. Hunger, Assistant Attorney General, U.S. Department of Justice, Eric H. Holder, Jr., U.S. Attorney at the 

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time the brief was filed, Harriet S. Rabb, General Counsel, 

U.S. Department of Health & Human Services, Robert P. 

Jaye, Acting Associate General Counsel, Henry R. Goldberg,

Deputy Associate General Counsel, and Thomas W. Coons,

Attorney, were on the brief.

Before: WALD, WILLIAMS, and GINSBURG, Circuit Judges.

Opinion for the Court filed by Circuit Judge GINSBURG.

GINSBURG, Circuit Judge: The ten appellants in this case 

provide outpatient kidney dialysis services to patients who 

are suffering from end-stage renal disease, or ESRD. They 

dispute the amount of money to which they are entitled from 

the Secretary of Health and Human Services as reimbursement for medical services rendered under the Medicare program. Specifically, the appellants challenge (1) the Secretary's decision that the merger of their parent company with 

another corporation was a related-party transaction, such that 

certain costs associated with the merger were not reimbursable under Medicare; and (2) the regulation capping reimbursement for "bad debts" at a provider's actual cost of 

providing dialysis service, which they claim is inconsistent 

with the statutory requirement that Medicare reimburse each 

dialysis provider in a prospectively set amount.

The district court upheld the Secretary's decision with 

respect both to the merger transaction and to the bad debt 

regulation. We agree with the district court that the merger 

was a related-party transaction. We reverse the district 

court, however, with respect to the validity of the bad debt 

regulation because we cannot tell, upon the present record, 

whether the regulation is based upon a reasonable interpretation of the Medicare statute. Therefore we vacate the rule 

and remand this matter for the Secretary to provide a more 

adequate explanation of her rationale for the rule.

I. Background

Under the Medicare program the Secretary reimburses 

providers of ESRD dialysis services at 80% of a prospectively 

set rate and the Medicare beneficiary is responsible for the 

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remaining 20% as a co-payment. See 42 U.S.C. 

§ 1395rr(b)(2)(A); 42 C.F.R. § 413.170(b)(1), (d) (1996).1If, 

after making reasonable collection efforts, the provider is 

unable to collect the 20% co-payment, then the uncollected 

amount is considered a "bad debt." 42 C.F.R. § 413.80(b)(1), 

(e). At the end of the year the Secretary reimburses the 

dialysis provider for bad debts, but she caps total reimbursement per treatment at the particular provider's cost of providing the service. Id. § 413.170(e)(1).

During the relevant time period (1984-85) National Medical 

Care, Inc. owned, either directly or through a subsidiary, the 

ten dialysis providers that press this appeal. NMC itself 

changed ownership during that period, and the NMC subsidiaries reported, as reimbursable Medicare costs, certain costs 

associated with the acquisition of their parent company. If 

those costs are allowable, then the effect will be to increase 

those providers' bad debt cap. The Secretary disallowed the 

merger-related costs, however, on the ground that the merger 

was between related entities. The NMC subsidiaries then 

filed this lawsuit challenging both that determination and the 

regulation providing for the cap upon reimbursement of bad 

debts.

A. Statutory and Regulatory Background

The Congress established the ESRD program in § 299I of 

the Social Security Amendments of 1972, Pub. L. No. 92-603, 

__________

1 After the parties had briefed this case the Secretary amended 

and re-numbered some of the relevant regulations. See Medicare 

Program; End-Stage Renal Disease (ESRD) Payment Exception 

Requests and Organ Procurement Costs, 62 Fed. Reg. 43,657, 

43,668-69 (1997). During the fiscal year at issue, 1985, the regulation challenged here was codified at § 405.439(e)(1); it is currently 

codified at § 413.170(e)(1), and pursuant to the 1997 amendments 

will be codified as amended at § 413.178(a). The 1997 amendments 

also changed the numbers of the following sections cited in this 

opinion: § 413.170(b)(1) will be codified as amended at § 413.172(a), 

and § 413.170(d) will be codified at § 413.176. At the time of the 

release of this opinion, title 42 of the 1997 Code of Federal Regulations had not been released. Accordingly, the court will cite to the 

1996 version of the regulations (or an earlier version if appropriate).

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86 Stat. 1329, 1463-64, by extending Medicare coverage to 

patients who have permanent kidney failure and require 

either dialysis or a kidney transplant. See Medicare Programs; End-Stage Renal Disease Program; Prospective Reimbursement for Dialysis Services, 47 Fed. Reg. 6,556, 6,556-

57 (1982) (history of ESRD program). Medicare Part A, 42 

U.S.C. §§ 1395c to 1395i-4, covers inpatient dialysis services 

provided by hospitals, while Medicare Part B, 42 U.S.C. 

§§ 1395j to 1395w-4, covers outpatient dialysis treatments by 

hospital-based and independent providers (such as NMC).

Under the Part B reimbursement system in place before 

1983 the Secretary paid an independent provider of outpatient services 80% of the provider's "reasonable charge" (up 

to $138 per treatment). See 42 C.F.R. pt. 405, subpt. E 

(1982); 47 Fed. Reg. at 6,557. The Secretary paid an outpatient hospital-based provider 80% of the "reasonable cost" per 

treatment (also subject to a maximum of $138). See 42 

C.F.R. pt. 405, subpt. D (1982); 47 Fed. Reg. at 6,557. The 

Medicare beneficiary was responsible for the remaining 20%. 

See 47 Fed. Reg. at 6,557.

Medicare also treated independent providers and hospitalbased providers differently for the purpose of reimbursing 

"bad debts" run up by patients who did not pay their 20% 

share. Medicare reimbursed hospital-based facilities for bad 

debts as part of the reasonable cost reimbursement system. 

See 42 C.F.R. § 405.420 (1982); 47 Fed. Reg. at 6,568. The 

Secretary expected independent providers, however, "to absorb bad debts within the level of their charges." 47 Fed. 

Reg. at 6,568.

The cost of the ESRD program rose significantly in the 

1970s. Id. at 6,556. In order to contain that cost the 

Congress passed the ESRD Program Amendments of 1978, 

Pub. L. No. 95-292, 92 Stat. 307 (codified as amended in 

scattered sections of 42 U.S.C.), in which it directed the 

Secretary to prescribe by regulation methods and procedures 

to "determine the costs incurred" by ESRD facilities, and to 

"determine, on a cost-related basis or other economical and 

equitable basis ... the amounts of payments to be made" for 

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dialysis services. 42 U.S.C. § 1395rr(b)(2)(B). The second 

sentence of this new provision (which was deleted in 1981), 

required that the new regulations provide incentives for cost 

reduction and set either prospective or target rates. See

Pub. L. No. 95-292, § 2, 92 Stat. at 309.

In 1980 the Secretary proposed to adopt a prospectively 

determined reimbursement rate, which the provider "would 

retain, even if its costs were below that rate." Medicare 

Program; Incentive Reimbursement for Outpatient Dialysis 

and Self-Care Dialysis Training, 45 Fed. Reg. 64,008, 64,009 

(1980). The Secretary rejected the "target rate" approach 

under which there would be a "retroactive adjustment" to the 

prospective rate at the end of the year so that the Government and the provider would share in any cost savings. The 

Secretary believed that this approach would not have the 

same incentive for cost reduction as a prospectively set rate. 

Id.

In the 1980 proposal the Secretary opined that it was 

"appropriate to reimburse the facility for Medicare bad 

debts," id. at 64,010, and considered two options for doing so. 

The first was to "allow for the payment of bad debts written 

off during the year in a special payment at the end of the 

year." The second option was not to "allow a specific writeoff of bad debts" but to "include an allowance for bad debts in 

the dialysis charge and the calculation of the [prospective] 

rate." The Secretary chose the former option because it 

"would permit [her] to pay each facility the exact amount of 

its bad debts." Accordingly the 1980 proposal did not cap the 

amount of bad debt that could be reimbursed per treatment.

Before the Secretary had issued a final rule implementing 

the 1978 amendments, however, the Congress amended the 

statute again, see Omnibus Budget Reconciliation Act of 1981, 

Pub. L. No. 97-35, § 2145, 95 Stat. 357, 799-800 (codified at 

42 U.S.C. § 1395rr), requiring the Secretary to adopt a 

prospective payment system. See 42 U.S.C. § 1395rr(b)(7). 

The Congress also modified sub-paragraph (b)(2)(B) of 42 

U.S.C. § 1395rr by deleting the option of target rates and the 

requirement that the Secretary promulgate regulations to 

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implement "appropriate incentives" for efficiency. As amended this subsection reads:

The Secretary shall prescribe in regulations any methods 

and procedures to (i) determine the costs incurred by 

providers of services and renal dialysis facilities in furnishing covered services to individuals determined to 

have end-stage renal disease, and (ii) determine, on a 

cost-related basis or other economical and equitable basis 

(including any basis authorized under section 1395x(v) of 

this title) and consistent with any regulations promulgated under paragraph (7), the amounts of payments to be 

made for part B services furnished by such providers and 

facilities to such individuals.

The section to which reference is made defines "reasonable 

costs" as the "costs actually incurred" in providing services; 

it also prohibits "cross-subsidization" by requiring that the 

Secretary

take into account both direct and indirect costs of providers of services ... in order that, under the methods of 

determining costs, the necessary costs of efficiently delivering covered services to individuals covered by [Medicare] will not be borne by individuals not so covered, and 

the costs with respect to individuals not so covered will 

not be borne by such insurance program[ ].

42 U.S.C. § 1395x(v)(1)(A).

In the wake of the 1981 amendments the Secretary issued 

another notice of proposed rulemaking, in which she said that 

her

basic approach is to identify the legitimate costs of what 

appear to be economically and efficiently operated dialysis facilities and then, in setting the rates, to make 

adjustments to reflect costs or savings attributable to 

operation as a hospital-based facility or as an independent facility.

47 Fed. Reg. at 6,563. Hence the Secretary audited a sample 

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ment, and proposed that the prospective reimbursement rate 

be based upon a composite figure reflecting the cost of both 

in-facility treatment (for hospital-based and independent facilities) and home dialysis. Id. at 6,561-64.

With respect to bad debts, in contrast, the Secretary 

proposed to reimburse both hospital-based and independent 

facilities retrospectively, but to cap the reimbursement at 

each provider's allowable costs. Id. at 6,568. Apparently the 

Secretary believed that the cap upon bad debt reimbursement 

was required by the prohibition of cross-subsidization:

Since, under Part A of the Medicare program, costs of 

covered services furnished beneficiaries are not to be 

borne by individuals not covered by Medicare, the program will pay that part of uncollectible deductible and 

coinsurance amounts that brings the total of a provider's 

reimbursement up to the costs of these services. Conversely, since the statute requires that the program pay 

only for the costs of services related to care of beneficiaries, reimbursement for bad debts is limited in that we 

will not pay any amounts that would result in total 

reimbursement exceeding a provider's Medicare reasonable costs.... We considered, and discussed in the 1980 

NPRM, the possibility of including an amount for bad 

debts in the rate, but have decided against it. Instead, 

we plan to pay all dialysis facilities 100 percent of 

allowable Medicare bad debts, up to their reasonable 

costs, in a separate payment at the end of each facility's 

cost accounting period.

Id.

The Secretary adopted the proposed rule with only minor 

changes not here relevant. See Medicare Program; EndStage Renal Disease Program; Prospective Reimbursement 

for Dialysis Services and Approval of Special Purpose Renal 

Dialysis Facilities, 48 Fed. Reg. 21,254 (1983). The bad debt 

reimbursement provision, which the appellants now challenge, 

stated:

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HCFA will reimburse each facility its allowable Medicare 

bad debts, up to the facility's costs as determined under 

Medicare principles, in a single lump sum at the end of 

the facility's cost reporting period.

Id. at 21,278 (currently codified at 42 C.F.R. § 413.170(e)(1) 

(1996)). In the preamble to the Final Rule the Secretary 

justified the cap upon reimbursement for bad debts, as she 

had in the 1982 NPRM, solely by reference to the statutory 

prohibition of cross-subsidization. 48 Fed. Reg. at 21,273. 

The Secretary also clarified the process by which bad debts 

will be reimbursed: the Secretary subtracts the provider's 

revenue, including both the 80% payment and any co-payment 

or deductible actually collected, from its reasonable cost, in 

order to determine the provider's "unrecovered costs." If the 

provider has made reasonable efforts to recover these 

amounts, then the program pays the lesser of the provider's 

unrecovered costs or the amount of the uncollected coinsurance and deductible.

B. The Transaction

In April 1984 NMC entered into negotiations with W.R. 

Grace & Co. regarding the possibility of Grace's acquiring 

NMC through an exchange of stock. Eventually the parties 

agreed to structure the transaction as a leveraged buy-out. 

The parties met on July 23 to negotiate the terms of such a 

deal in which Grace and certain members of NMC's management would participate. These so-called "Management Investors" included Dr. Constantine L. Hampers, Chairman and 

CEO, as well as certain senior officers and directors.

When the parties had tentatively agreed upon a price of 

$19.50 per share of NMC, Dr. Hampers presented the transaction to NMC's board of directors. The board instructed 

Dr. Hampers to continue negotiations and appointed a committee of independent directors to evaluate the proposal and 

to make a recommendation to the full board. The independent directors retained their own legal counsel and investment bankers.

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In August the parties agreed to a final price of $19.25 per 

share. After obtaining various changes to the form of the 

transaction the independent directors recommended the 

merger to the full NMC board, which approved, as did the 

shareholders of NMC.

Pursuant to the merger agreement, NMC (called "Old 

NMC") was acquired through the use of two newly formed 

entities, NMC Holding Corporation and its wholly owned 

subsidiary, NMC Acquisition Corporation. In December 

1984 Old NMC was first acquired by and then merged with 

NMC Acquisition. The resulting company in turn merged 

with NMC Holding in June 1985 and the surviving corporation changed its name to National Medical Care, Inc. ("New 

NMC"). By January 1990, five years after the merger, Grace 

had acquired all of the shares of New NMC.

At its formation in 1984 the voting securities of NMC 

Holding were owned 49.99% by Grace, 37.20% by the Management Investors, and 12.81% by the so-called Physicians 

Group, which was made up of medical directors of NMC's 

dialysis facilities. Grace received options permitting it to 

purchase additional shares sufficient to give it 65% of the 

voting securities. Most of the money NMC Holding used to 

buy Old NMC came from bank borrowings ($315 million) and 

from the sale of NMC Holding stock to Grace ($65 million), 

with the Management Investors contributing only about $2 

million through the purchase of NMC Holding stock. The 

Management Investors and Grace could each chose four of 

the eight directors of NMC Holding. Several officers and 

directors of Old NMC occupied the same positions with NMC 

Holding.

C. Procedural History

For fiscal year 1985 the NMC providers claimed as allowable Medicare costs certain expenses relating to the transaction between Old NMC and NMC Holdings, including depreciation of tangible assets, amortization of intangible assets, 

and interest for financing the purchase of these assets. The 

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gages to determine the amounts payable to Medicare providers, see 42 U.S.C. § 1395h, disallowed some of these costs.

The NMC providers appealed that decision to the Provider 

Reimbursement Review Board. The PRRB held that the 

two-step merger between Old NMC and NMC Holding did 

not involve related entities and that most of the expenses the 

NMC providers incurred in connection with the merger were 

therefore reimbursable. Upon further appeal the Administrator of the HCFA, acting on behalf of the Secretary, held 

that the merger was between related parties and therefore 

disallowed all relevant costs.

The NMC providers filed suit in the district court challenging the regulation capping reimbursement for bad debts and 

the Secretary's final decision that Old NMC and NMC Holding were related entities. The court granted the Secretary's 

and denied NMC's motion for summary judgment. The court 

held the regulation was not "arbitrary and capricious" in 

violation of the Administrative Procedure Act, and was reasonable under the two-step analysis of Chevron U.S.A. Inc. v. 

Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). 

As to the related-party issue, the court held that the Secretary's decision that Old NMC and NMC Holding were related 

entities is supported by substantial evidence, and in particular 

by the role of the Management Investors in the transaction.

II. Analysis

We review the Secretary's Medicare reimbursement decisions pursuant to the standards of the Administrative Procedure Act. See 42 U.S.C. § 1395oo(f)(1). The NMC providers 

claim that (1) the Secretary's determination that Old NMC 

and NMC Holding were related by control is not supported 

by substantial evidence; and (2) the regulation governing bad 

debt reimbursement is (a) not in accordance with law, under 

the standards of Chevron steps one and two, and (b) arbitrary 

and capricious.

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A. The Merger Issue

The NMC providers claim that the 1984-85 change in the 

ownership of NMC did not involve a related-party transaction 

within the meaning of the Medicare regulations. Therefore, 

they maintain, the Secretary should have permitted them to 

include the costs associated with the merger in their 1985 cost 

reports, thereby increasing the amount for which they could 

be reimbursed under the bad debt cap.

In general, depreciation and interest costs incurred in the 

acquisition of assets used to provide covered services are 

allowable Medicare costs. 42 C.F.R. §§ 413.134(a), 

413.153(a)(1) (1996). Depreciation must be based upon the 

present owner's "historical cost" of acquiring the asset. Id.

§ 413.134(a)(2), (b)(1). When a Medicare provider is purchased by another organization the regulations permit the 

acquiring organization, for the purpose of calculating its 

allowable Medicare costs, to "revalue" the assets of the 

acquired provider up to the acquiring organization's cost of 

purchasing the assets. See id. § 413.134(g).

The regulations governing reimbursement of the cost of 

providing services to Medicare beneficiaries state that

costs applicable to services, facilities, and supplies furnished to the provider by organizations related to the 

provider by common ownership or control are includable 

in the allowable cost of the provider at the cost to the 

related organization.

Id. § 413.17(a). This rule is intended to prevent related 

parties from using transfer prices to inflate the cost of their 

inputs. See Biloxi Regional Med. Ctr. v. Bowen, 835 F.2d 

345, 349-50 (D.C. Cir. 1987). The rule also provides that a 

party is "related to the provider" if "the provider to a 

significant extent ... has control of or is controlled by the 

organization furnishing the services, facilities, or supplies." 

42 C.F.R. § 413.17(b)(1) (1996). Control is, in turn, defined 

as "the power, directly or indirectly, significantly to influence 

or direct the actions or policies of an organization or institution." Id. § 413.17(b)(3). The Secretary's guidance on the 

meaning of the regulation elaborates:

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The term "control" includes any kind of control, whether 

or not it is legally enforceable and however it is exercisable or exercised. It is the reality of the control which is 

decisive, not its form or the mode of its exercise.

U.S. Dep't of Health & Human Services, Medicare Provider 

Reimbursement Manual, Part I, § 1004.3, reprinted in 1 

Medicare & Medicaid Guide (CCH) ¶ 5700 (Nov. 1994) (hereinafter the Manual).

The appellants do not dispute that if the NMC merger was 

a related-party transaction, then the costs associated with the 

merger are not reimbursable by the Secretary. The question 

over which the parties are divided is whether the transaction 

between Old NMC and NMC Holding was in fact between 

related parties within the meaning of the regulations. The 

Secretary's decision that Old NMC and NMC Holding were 

related by control must be upheld if it is supported by 

substantial evidence in the record. 5 U.S.C. § 706(2)(E); see 

also Biloxi Regional Med. Ctr., 835 F.2d at 349 n.13.

There certainly is substantial evidence in the record supporting the Secretary's anterior determination that the Management Investors had the power significantly to influence 

the actions of both Old NMC and NMC Holding. That 

finding is itself sufficient to support the Secretary's conclusion that the firms were related by control. Because the 

Management Investors held key positions on the board and in 

the management of Old NMC, they were clearly in a position 

to influence the board to recommend, and the shareholders of 

Old NMC to approve, the transaction.

The Management Investors also had the ability significantly to influence NMC Holding. They had the power to appoint 

four of the eight members of the board and they held at NMC 

Holding essentially the same management and board positions that they had held with Old NMC. As a group they 

owned 37.20% of the voting securities of NMC Holding, and 

together with the Physician's Groupi.e. managers employed 

by the separate NMC facilitiescontrolled 50.01% of the 

voting shares. That the Management Investors were able to 

retain their positions and to come out owning a sizable 

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portion of the voting securities of NMC Holding, while contributing only a small portion of the purchase money (approximately $2 million), further supports the inference that they 

controlled NMC Holding.

In addition, the chief negotiator for Old NMC (Dr. Hampers) was also one of the Management Investors in NMC 

Holding. He was essentially negotiating on both sides of the 

transaction. In fact, he signed the Merger Agreement on 

behalf of all three partiesOld NMC, NMC Holding, and 

NMC Acquisition. There is, therefore, substantial evidence 

to support the Secretary's conclusion that the acquisition of 

Old NMC was a transaction between related parties.

The appellants raise several arguments in an attempt to 

avoid this conclusion. First, they argue that the Secretary's 

interpretation of the related-party rule runs afoul of this 

court's decision in PIA-Asheville, Inc. v. Bowen, 850 F.2d 

739, 741 (D.C. Cir. 1988), where we invalidated as unrealistic 

and therefore arbitrary the Secretary's rule that a two-step 

merger is per se a related-party transaction. The appellants 

contend that in this case the Secretary "artificially treated 

NMC Holding rather than Grace as the acquiring party and 

failed to analyze the transaction as a whole to determine if 

the purchase price for the NMC shares was the result of an 

arm's-length transaction." Indeed, they suggest that Grace 

and Old NMC had agreed upon the purchase price before 

NMC Holding even existed; therefore the focus of the inquiry should be upon the relationship between Grace and Old 

NMCtwo parties that clearly were not related.

The appellants err in thinking PIA-Asheville helps their 

cause; the Medicare provider in that case came to be controlled by a previously unrelated company through a two-step 

acquisition, which the court held should be treated as a single 

integrated transaction. In this case a group of individuals 

with a significant stake in the acquiring company were in 

control of the acquired company. In any event, to the extent 

that the appellants' argument goes to the validity of the 

Secretary's interpretation of the rule defining a "related 

party," the Secretary's reasonable interpretation is entitled to 

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our deference. See, e.g., Marymount Hosp., Inc. v. Shalala,

19 F.3d 658, 661 (D.C. Cir. 1994). The Secretary interpreted 

the definition to require an examination of the relationship 

between the seller and the actual buyerhardly an unreasonable interpretation of the rule.

Although Old NMC and Grace may have originally contemplated that Grace would be the buyer through an exchange of 

stock, in the actual transaction NMC Holding was the buyer. 

NMC Holding was owned by the Management Investors and 

the Physicians' Group as well as by Grace; indeed, Grace did 

not own even a controlling interest in NMC Holding. Moreover, the appellants' suggestion that the acquisition price 

"was negotiated between Grace and NMC at arm's length at 

a time when they were clearly unrelated" is contrary to the 

evidence. Dr. Hampers and representatives of Grace discussed price on only one occasion prior to the parties' decision 

to structure the transaction as a leveraged buy-out. Most of 

the price negotiations took place after the parties had decided 

that the Management Investors would be participating in the 

leveraged buy-out through NMC Holding. By that point Dr. 

Hampers was dealing on both sides of the transaction, not at 

arm's length.

Second, the appellants argue that even if the transaction is 

viewed as one between NMC Holding and Old NMC, there 

was no control relation because NMC Holding could not 

control the decision of the Old NMC shareholders to approve 

the transaction. The appellants also point out that the independent directors, whom the Management Investors did not 

control, approved the transaction.

The appellants' implicit reliance upon the "fairness" of the 

transactionas reflected in the participation of the independent directorsis insufficient to undermine the Secretary's 

conclusion. As long as the parties are related, fairness is 

irrelevant: the Secretary need not show that the terms of 

their transaction are unfair, see Stevens Park Osteopathic 

Hosp., Inc. v. United States, 633 F.2d 1373, 1379 (Ct. Cl. 

1980); cf. Biloxi Regional Med. Ctr., 835 F.2d at 350; West 

Seattle Gen. Hosp., Inc. v. United States, 674 F.2d 899, 904 

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(Ct. Cl. 1982), and the parties may not show that they were 

fair. Nor does the Old NMC shareholders' having final 

authority to approve the transaction mean that Old NMC and 

NMC Holding were not in fact related by common control. 

Such control may obtain in fact "whether or not it is legally 

enforceable." Manual § 1004.3, supra, at ¶ 5700.

In sum, there is overwhelming evidence in the record that 

the Management Investors had the power "significantly to 

influence or direct the actions or policies" of both the buyer 

and the seller. Therefore, the Secretary's decision that the 

two parties were related by control is supported by substantial evidence.

B. Cap Upon Reimbursement for Bad Debts

The appellants claim that the rule capping reimbursement 

for bad debt at the provider's cost of service is inconsistent 

with the statute and therefore invalid under the familiar tests 

of Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). The appellants also maintain 

that the regulation is arbitrary and capricious and therefore 

invalid under 5 U.S.C. § 706(2)(A).

Under Chevron step one the court asks "whether Congress 

has directly spoken to the precise question at issue," Chevron,

467 U.S. at 842; if so, then we "must give effect to the 

unambiguously expressed intent of Congress." Id. at 843. If 

the Congress has not addressed the issue, however, then 

under Chevron step two we must determine whether the 

agency's interpretation of the statute is reasonable. Id.

The NMC providers argue that the bad debt reimbursement regulation fails under Chevron because (1) the Congress 

required a prospective-rate system, whereas the cap upon 

reimbursement for bad debts is based upon a retrospective 

calculation; and (2) the Congress intended to provide an 

incentive for increased efficiency in the provision of dialysis 

services, whereas the cost limitation upon reimbursement for 

bad debts reduces the provider's incentive to hold down its 

costs.

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We conclude that the regulation passes muster under Chevron step one because the statute does not speak directly to 

the question of bad debt. The statute generally requires the 

Secretary to pay 80% of a prospectively determined rate. 

See 42 U.S.C. §§ 1395rr(b)(2)(A) & (b)(7). No provision in 

the statute, however, specifically addresses how bad debt is to 

be reimbursed; indeed, there is no clear requirement in the 

statute that bad debt be reimbursed at all. Therefore, we 

must defer to the Secretary's interpretation unless it is 

unreasonable.

We are unable confidently to evaluate the reasonableness of 

the Secretary's statutory interpretation under Chevron step 

two, however, because the Secretary has provided an incoherent justification for her decision to cap reimbursement for 

bad debts. The only statutory authorization the Secretary 

relied upon in the rulemaking record for her decision to cap 

reimbursement for bad debts is the prohibition of crosssubsidization in 42 U.S.C. § 1395x(v). In the preamble to the 

final rule the Secretary decided to cap reimbursement for bad 

debts at the provider's reasonable cost because "the statute 

requires that [Medicare] pay only for the costs of services 

related to care of beneficiaries." 48 Fed. Reg. at 21,273.

Before this court counsel for the Secretary understandably 

wants to present a different account of the Secretary's reasoning. The Secretary's brief thus suggests that the cap 

upon bad debt reflects the balance she struck between the 

prohibition of cross-subsidization and the statutory requirement that Medicare pay 80% and beneficiaries pay 20% of the 

prospective rate. She argues that historically Medicare reimbursed providers for their bad debts based upon the Secretary's statutory mandate to avoid cross-subsidization. When 

the Congress amended the statute to require a prospective 

payment system it retained, in the section directing the 

Secretary to promulgate regulations governing the rate to be 

paid for dialysis services (§ 1395rr(b)(2)(B)), the express 

cross-reference to the provision defining reasonable cost and 

prohibiting cross-subsidization (§ 1395x(v)). That is, the statute permitted the Secretary to set the rate upon "any basis 

authorized under" § 1395x(v), which apparently would include 

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a rate based upon "reasonable cost" and the prohibition of 

cross-subsidization. Because the Secretary based the prospective rate upon reasonable cost principles, she argues, "it 

makes perfect sense" that she chose to cap bad debt at cost in 

order to comply with the prohibition of cross-subsidization.

We reject the Secretary's attempt in this litigation to 

articulate a new justification for the cap upon bad debt. The 

record does not support the Secretary's contention that she 

engaged in a balancing of the kind she describes. The 

Secretary acknowledges that her balancing is "not detailed" 

in the rulemaking record, but we do not think it is even 

implicit.

More important, we conclude that the Secretary's explanation for the cap upon bad debt reimbursement that is in the 

record is inconsistent with the prospective rate scheme of the 

statute. A prospective payment rate based upon the median 

provider's cost per treatment by definition overcompensates 

some Medicare providers and undercompensates others. Insofar as the Secretary reimburses some providers more than 

their actual cost of treating Medicare beneficiaries, she is 

effectively subsidizing services for non-beneficiariesat least 

as contemplated by the Congress in § 1395x(v)(1)(A). Conversely, if the Secretary reimburses other providers less than 

their actual costs, then those providers will shift costs to nonbeneficiariesagain, at least so far as the statute is concerned.2

Nonetheless, with respect to bad debt the Secretary suggested in the preamble to the final rule that the prohibition of 

cross-subsidization required her to cap reimbursement at the 

individual provider's actual cost. The rulemaking record, 

__________

2 We are aware of no reason to believe that a Medicare provider 

that is overcompensated by Medicare would take the occasion to 

subsidize its non-Medicare patients; nor can we imagine why a 

Medicare provider that is undercompensated would continue to 

participate in the Medicare program. The Congress appears to 

have assumed in § 1395x(v)(1)(A), however, that just such costshifting would occur. As neither party to this case takes issue with 

that premise, nor shall we.

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however, provides no clear rationale for why the statute 

requires her to consider the prohibition of cross-subsidization 

in reimbursing for bad debt, when the requirement of the 

statute that she set a prospective rate is itself inconsistent 

with the prohibition of cross-subsidization. Until the Secretary provides such an explanation we cannot conclude that the 

prohibition of cross-subsidization justifies the cap upon bad 

debt reimbursement.

The appellants also argue that the cap upon reimbursement 

for bad debts is arbitrary and capricious because there is not 

a similar cap upon reimbursement for bad debts under Part 

A, which applies to dialysis treatments provided to hospital 

inpatients. See 42 C.F.R. § 412.115(a) (1996). The Secretary 

counters that the section of the Medicare statute creating the 

Part A prospective payment system, 42 U.S.C. § 1395ww, 

does not authorize her to draw upon the prohibition of crosssubsidization in § 1395x(v).

The appellants' argument further highlights the difficulty 

with the Secretary's reliance upon the prohibition of crosssubsidization as the sole justification for the cap upon reimbursement for bad debt. If, as the Secretary argues, the only 

statutory basis for reimbursing bad debt is the prohibition of 

cross-subsidization, then she must not be authorized to reimburse bad debt under Part A because Part A does not refer to 

the prohibition of cross-subsidization.

In sum, the Secretary's only explanation for the cap upon 

reimbursement for bad debt is the necessity to avoid crosssubsidization, but a prospective rate scheme necessarily entails a certain amount of cross-subsidization. Because the 

Secretary's explanation of the rule is inadequate, we cannot 

evaluate whether the Secretary's interpretation of the statute 

is reasonable within the meaning of Chevron step two. For 

the same reason, we cannot resolve the appellants' argument 

that the cap upon reimbursement for bad debt is severable 

from the rest of the regulation. Accordingly, we vacate the 

rule and remand this matter for the Secretary either to 

provide a more adequate explanation of the bad debt cap or to 

jettison it.

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III. Conclusion

We hold that: (1) The Secretary's decision that the merger 

between Old NMC and NMC Holding was a related-party 

transaction is supported by substantial evidence; but (2) the 

Secretary has not adequately justified the rule capping reimbursement for bad debts, as a result of which her order 

adopting the rule is arbitrary and capricious. At the same 

time we are unable to evaluate whether the Secretary's 

interpretation of the statute is permissible under Chevron

step two. Therefore, we vacate and remand this matter for 

further proceedings not inconsistent with this opinion.

So ordered.

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