FOR PUBLICATION

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

IN RE GARDENS REGIONAL HOSPITAL 

AND MEDICAL CENTER, INC.,

Debtor,

GARDENS REGIONAL HOSPITAL AND 

MEDICAL CENTER LIQUIDATING 

TRUST,

Appellant,

v.

STATE OF CALIFORNIA, AND ITS 

DEPARTMENT OF HEALTH CARE 

SERVICES,

Appellees.

No. 18-60016

BAP No.

17-1198

OPINION

Appeal from the Ninth Circuit Bankruptcy Appellate Panel

Lafferty, Kurtz, and Faris, Bankruptcy Judges, Presiding

Argued and Submitted October 16, 2019

Pasadena, California

Filed September 16, 2020
2 IN RE GARDENS REGIONAL HOSPITAL

Before: Kim McLane Wardlaw and Daniel P. Collins, 

Circuit Judges, and Joseph F. Bataillon,* District Judge.

Opinion by Judge Collins

SUMMARY**

Bankruptcy

The panel affirmed in part and reversed in part the 

Bankruptcy Appellate Panel’s decision affirming the 

bankruptcy court’s denial of a Chapter 11 debtor’s motion 

asserting that the State of California and its Department of 

Health Care Services violated the automatic bankruptcy stay 

by deducting certain unpaid fees from payments that the 

State was obligated to make to the debtor under Medi-Cal, 

the State’s Medicaid program.

To raise Medi-Cal funding, the State imposed a 

“Hospital Quality Assurance Fee” (“HQAF”) on non-public 

hospitals, such as the debtor, pursuant to a federal-law 

exception for certain broad-based healthcare taxes that do 

not contain an impermissible “hold harmless” provision. 

The debtor stopped paying its HQAF assessments before it 

filed for bankruptcy. The State recovered the prepetition 

HQAF debt by withholding a portion of the Medi-Cal 

payments it owed the hospital, including both fee-for-service 

* The Honorable Joseph F. Bataillon, United States District Judge 

for the District of Nebraska, sitting by designation.

** This summary constitutes no part of the opinion of the court. It 

has been prepared by court staff for the convenience of the reader.
IN RE GARDENS REGIONAL HOSPITAL 3

payments and “supplemental” payments under the HQAF 

program, and the State continued to make such deductions 

postpetition. 

The debtor argued that the State’s withholding of unpaid 

HQAF amounts constituted an improper “setoff” that 

violated the automatic stay imposed under 11 U.S.C. § 362. 

The bankruptcy court concluded that the limitation on setoffs

did not apply because the State’s withholdings amounted to 

equitable recoupment rather than setoff. The panel held that 

the claims or rights giving rise to recoupment must arise 

from the same transaction or occurrence that gave rise to the 

liability sought to be enforced by the bankruptcy estate. The 

test is whether the relevant rights being asserted against the 

debtor are sufficiently logically connected to the debtor’s 

countervailing obligations such that they may be fairly said 

to constitute part of the same transaction. 

The State deducted the unpaid HQAF assessments from 

two separate payment streams: (1) the supplemental 

payments that the State pays to hospitals out of the fund 

created by HQAF assessments; and (2) the fee-for-service 

payments that the debtor earned by treating Medi-Cal 

patients. The panel concluded that, in light of the legal and 

factual connections between the debtor’s unpaid HQAF 

assessments and California’s supplemental payments to the 

hospital, these countervailing obligations had the necessary 

logical relationship to justify characterizing them as arising 

from the same transaction for purposes of equitable 

recoupment. The fee-for-service payments made to the 

debtor, however, constituted a setoff that was subject to the 

restrictions of the Bankruptcy Code and was not a 

permissible equitable recoupment.
4 IN RE GARDENS REGIONAL HOSPITAL

The panel affirmed the judgment of the BAP insofar as 

it held that California’s deduction of unpaid HQAF 

assessments from the payments made to the debtor was 

permissible under the doctrine of equitable recoupment, but 

the panel reversed the BAP’s judgment as to the fee-forservice payments. The panel remanded to the BAP with 

instructions to remand to the bankruptcy court for further 

proceedings.

COUNSEL

Andrew H. Sherman (argued), Sills Cummis & Gross P.C.,

Newark, New Jersey; Samuel R. Maizel and John A. Moe II, 

Dentons US LLP, Los Angeles, California; for Appellant.

Kenneth K. Wang (argued), Deputy Attorney General; 

Jennifer M. Kim, Supervising Deputy Attorney General; 

Julie Weng-Gutierrez, Senior Assistant Attorney General; 

Xavier Becerra, Attorney General; Office of the Attorney 

General, Los Angeles, California; for Appellee.

OPINION

COLLINS, Circuit Judge:

This case requires us to address the extent to which a 

creditor can deduct the amounts that a bankrupt debtor owes 

to that creditor from other payments that the creditor owes 

to the debtor. The Bankruptcy Code imposes significant 

limitations on such deductions if they constitute a “setoff,” 

but the courts have consistently recognized an exception to 

those limitations in the case of deductions that fall within the 

equitable doctrine of “recoupment.” Here, after Gardens
IN RE GARDENS REGIONAL HOSPITAL 5

Regional Hospital and Medical Center, Inc. (“Gardens 

Regional”) filed for bankruptcy, the State of California and 

its Department of Health Care Services (collectively, 

“California” or “the State”) deducted certain “fees”—which 

Gardens Regional had failed to pay to the State—from 

various payments that the State was obligated to make to 

Gardens Regional under its Medicaid program. Gardens 

Regional contended that the deductions were impermissible 

setoffs, and California argued that there were instead 

permissible recoupments. The bankruptcy court and the 

Ninth Circuit Bankruptcy Appellate Panel (“BAP”) both 

agreed with California, but we conclude that they relied on 

an overbroad conception of “recoupment.” Because some of 

the deductions claimed by California constituted setoffs, and 

not recoupments, we affirm in part and reverse in part and 

remand for further proceedings.

I

An understanding of this case requires a brief summary 

of both the structure of California’s Medicaid program and 

the underlying background facts concerning the parties’ 

dispute.

A

Under the Medicaid program, the federal government 

provides financial support to qualifying state plans that 

provide “medical assistance” and other services to defined 

classes of individuals “whose income and resources are 

insufficient to meet the costs of necessary medical services.” 

42 U.S.C. § 1396-1. California’s approved Medicaid 

program, known as “Medi-Cal,” is managed by Defendant 

Department of Health Care Services (the “Department”) and 

provides benefits to covered individuals through two 

primary methods—a “fee-for-service” system and a 
6 IN RE GARDENS REGIONAL HOSPITAL

“managed care” system. See Marquez v. Dep’t of Health 

Care Servs., 192 Cal. Rptr. 3d 391, 397–98 (Cal. Ct. App. 

2015); Cal. Welf. & Inst. Code §§ 14016.5(a)–(b), 14062, 

14100.1. Under the “fee-for-service” system—which is the 

relevant payment method for purposes of this case—a 

covered individual may receive treatment at a participating 

healthcare provider, and Medi-Cal then directly pays that 

provider a specified amount for each covered service 

provided to the individual. See Marquez, 192 Cal. Rptr. 3d 

at 397. The amount paid for each service is determined “in 

one of two ways: (1) according to a specific contractual rate 

of payment negotiated between the hospital and an arm of 

the Department . . . ; or (2) for California hospitals that have 

not negotiated contracts . . . , on the basis of costs, in 

accordance with various regulatory formulas.” Mission 

Hosp. Reg’l Med. Ctr. v. Shewry, 85 Cal. Rptr. 3d 639, 647 

(Cal. Ct. App. 2008).1 Gardens Regional has not negotiated 

its own schedule of contractual rates and is therefore 

considered a “noncontract” hospital.2

Given that Medicaid is a federal-state cost-sharing 

program, it is not surprising that federal law places limits on 

how States can raise their share of Medicaid funding. Prior 

to amendments enacted in 1991, some States engaged in a 

1 By contrast, under the “managed care” system, the State “contracts 

with health maintenance organizations . . . and other managed care plans 

to provide health coverage to Medi-Cal beneficiaries, and the plans are 

paid a predetermined amount for each beneficiary per month, whether or 

not the beneficiary actually receives services.” Marquez, 192 Cal. Rptr. 

3d at 398 (citing CAL. WELF. & INST. CODE §§ 14204, 14301(a)).

2 Like all Medi-Cal providers, however, Gardens Regional was 

required to sign a “Provider Agreement,” see CAL. WELF. & INST. CODE 

§ 14043.2(a), and in Gardens Regional’s case that agreement is a 

standard-form contract issued by the Department.
IN RE GARDENS REGIONAL HOSPITAL 7

circular-funding practice in which they “would make 

payments to hospitals, collect the federal matching funds, 

and then recover a portion of the payments made to hospitals 

through the collection of a health care related tax imposed 

on the hospitals.” Abraham Lincoln Mem’l Hosp. v. 

Sebelius, 698 F.3d 536, 544 (7th Cir. 2012). Under such 

schemes, the States’ lower net payments to hospitals were 

effectively inflated for purposes of calculating federal 

matching funds. Congress eliminated this practice by 

providing that “the amount of federal matching funds 

provided to a State should be reduced by the amount of any 

revenues received by the State through a health care related 

tax that was not broad-based [or] that contained a hold 

harmless provision.” Id. (emphasis added) (citing 42 U.S.C. 

§ 1396b(w)(1)(A)(ii)–(iii)). In order to qualify as a “broadbased health care related tax,” a state exaction generally 

must be imposed uniformly on “all non-Federal, nonpublic 

providers in the State,” and not just on Medicaid providers. 

See 42 U.S.C. § 1396b(w)(3)(B). A broad-based tax will be 

considered as having an impermissible “hold harmless” 

provision if, inter alia, the Medicaid payments to a provider 

“var[y] based only upon the amount of the total tax paid”; 

the provider receives a waiver or offset of a portion of the 

tax; or the provider receives payments that “positively 

correlate[]” to the amount of the tax. Id. § 1396b(w)(4)(A)–

(C).

Invoking this federal-law exception for certain broadbased healthcare taxes, California in 2009 passed legislation 

that would lead to the imposition of a “Hospital Quality 

Assurance Fee” (“HQAF”) on non-public hospitals in the 

State. See Quality Assurance Fee Act, 2009 Cal. Stat. ch. 

627, § 2. In its current form, the HQAF is imposed on most 

non-public, “general acute care hospital[s]” without regard 

to whether they participate in Medi-Cal. See Cal. Welf. & 
8 IN RE GARDENS REGIONAL HOSPITAL

Inst. Code § 14169.52(a); see also id. § 14169.51(l) 

(exempting, inter alia, certain public hospitals, long-term 

care hospitals, and “small and rural” hospitals). If a hospital 

does not pay its HQAF assessments, the statute allows the 

State to “immediately begin to deduct the unpaid assessment 

and interest from any Medi-Cal payments owed to the 

hospital, or . . . from any other state payments owed to the 

hospital.” Id. § 14169.52(h).

The legislatively declared purpose of the HQAF is “to 

increase federal financial participation in order to make 

supplemental Medi-Cal payments to hospitals, and to help 

pay for health care coverage for low-income children.” Id.

§ 14169.50(d). Towards that end, the statute requires that 

HQAF proceeds be deposited into “segregated funds” that 

are to be used only for certain enumerated purposes. Id.

§ 14169.50(f)(2). Those purposes are: (1) supplemental 

payments to private hospitals based upon their overall 

provision of outpatient and inpatient services, id. 

§§ 14169.54, 14169.55; (2) increased payments for MediCal managed health care plans, id. § 14169.56; (3) direct 

grants to public hospitals, id. § 14169.58; (4) funding for 

health coverage for low-income children, id. § 14169.53(b); 

and (5) administrative costs, id. Any supplemental 

payments made to private hospitals under the HQAF 

program are “in addition to any other amounts payable to 

hospitals with respect to those services.” Id. § 14169.54(a); 

id. § 14169.55(a) (same).

B

Gardens Regional was a private nonprofit hospital in 

Hawaiian Gardens, California, and since at least November 

2014 it was a participating Medi-Cal provider. After 

Gardens Regional began experiencing significant financial 

difficulties, it stopped paying its HQAF assessments in 
IN RE GARDENS REGIONAL HOSPITAL 9

March 2015, and it ultimately filed for Chapter 11 

bankruptcy in June 2016. It ceased operations in February 

2017.

According to the State, Gardens Regional owed 

California $699,173 in missed HQAF payments at the time 

it filed for bankruptcy. Thereafter, the State fully recovered 

this prepetition debt by withholding a portion of its MediCal payments to the hospital, which included both fee-forservice payments and “supplemental” payments under the 

HQAF program. As additional HQAF assessments accrued 

postpetition and were likewise not paid by Gardens 

Regional, the State continued to deduct a portion of the feefor-service and supplemental payments to the hospital. All 

told, the State withheld a total of $4,306,426 from Gardens 

Regional, and it claims that Gardens Regional still owes 

$2,550,667 in HQAF debt.

In May 2017, as debtor in possession, Gardens Regional 

filed a motion with the bankruptcy court attempting to 

compel the State to return the amounts it had withheld, so 

that those funds would then be available for the benefit of 

the bankruptcy estate and the hospital’s other creditors.3 

Gardens Regional argued that, in withholding the funds, 

California had violated the Bankruptcy Code’s “automatic 

stay,” which generally prohibits creditors from attempting to 

collect on their claims against the debtor after the filing of a 

bankruptcy petition. 11 U.S.C. § 362(a). The automatic stay 

3 The funds withheld by California constitute the largest contested 

asset in the bankruptcy estate. As it stands, the State has already 

recovered approximately 63% of the hospital’s HQAF obligation. By 

contrast, according to Gardens Regional, the hospital’s other unsecured 

creditors are set to receive between 8% and 42% of their claims, with the 

final percentage depending in large part on whether the money withheld 

by the State must be returned.
10 IN RE GARDENS REGIONAL HOSPITAL

specifically prohibits, inter alia, the “setoff of any debt 

owing to the debtor that arose before the commencement of 

the case under this title against any claim against the debtor,” 

id. § 362(a)(7), and Gardens Regional argued that 

California’s withholding of a portion of the payments due to 

the hospital constituted such an impermissible setoff. The 

State disagreed, contending that its actions were exempt 

from the automatic stay under the non-statutory equitable 

doctrine of “recoupment.”

The bankruptcy court denied Gardens Regional’s 

motion, holding that California had the right to recoup the 

funds because there was enough of a “logical relationship” 

between both the fee-for-service payments and the 

supplemental payments, on the one hand, and the HQAF 

assessments, on the other. In re Gardens Reg’l Hosp. & 

Med. Ctr., Inc., 569 B.R. 788, 794–99 (Bankr. C.D. Cal. 

2017). Gardens Regional appealed to the BAP, which 

affirmed the bankruptcy court. In re Gardens Reg’l Hosp. 

& Med. Ctr., Inc., 2018 WL 1354334, at *4–6 (B.A.P. 9th 

Cir. March 12, 2018). Gardens Regional appealed to this 

court, and we have jurisdiction under 28 U.S.C. § 158(d).4

II

In the proceedings below, Gardens Regional argued that 

the State’s withholding of unpaid HQAF amounts 

constituted an improper “setoff” that violated the automatic 

stay imposed under § 362 of the Bankruptcy Code. 

However, we have held—and Gardens Regional 

4 After the bankruptcy court subsequently confirmed a plan of 

liquidation for Gardens Regional, we granted the liquidating trustee’s 

motion to substitute the Gardens Regional Hospital and Medical Center 

Liquidating Trust as the Appellant.
IN RE GARDENS REGIONAL HOSPITAL 11

acknowledges—that to the extent a creditor’s actions were 

covered by the related but distinct doctrine of equitable 

“recoupment,” the Code’s limitations on “setoffs” would not

apply. See Newbery Corp. v. Fireman’s Fund Ins. Co., 

95 F.3d 1392, 1403 (9th Cir. 1996) (referring to recoupment 

“‘as a non-statutory, equitable exception to the automatic 

stay’” (citation omitted)); see also id. at 1399 (“‘[T]he chief 

importance of the recoupment doctrine in bankruptcy is that,

unlike setoff, recoupment is often thought not to be subject 

to the automatic stay.’” (citation omitted)). Thus, while 

“[r]ecoupment and setoff have much in common,” the 

differences between these two doctrines have “important 

consequences in the bankruptcy context.” Sims v. U.S. Dep’t 

of Health & Human Servs. (In re TLC Hosps., Inc.), 224 F.3d 

1008, 1011 (9th Cir. 2000). Here, the bankruptcy court and 

the BAP held that all of the State’s withholdings of unpaid 

HQAF amounts constituted legitimate instances of equitable 

recoupment rather than setoff, but in our view this holding 

rested on an overly generous conception of what qualifies as 

“the same transaction or occurrence” for purposes of 

recoupment. See id.

A

The doctrines of setoff and recoupment trace their 

origins back to “the era of common law pleading,” when 

they allowed a defendant to assert certain countervailing 

claims that might not otherwise have been allowed under the 

then-stricter joinder rules. Lee v. Schweiker, 739 F.2d 870, 

875 (3d Cir. 1984). As developed in that pleading context, 

“[s]etoff allowed a reduction of [the] plaintiff’s claim by the 

amount of a liquidated claim of the plaintiff to the defendant; 

recoupment allowed a defendant to assert a claim arising out 

of the same transaction as the plaintiff’s claim.” Id. at 875 

n.5. Both doctrines were subsequently recognized in 
12 IN RE GARDENS REGIONAL HOSPITAL

bankruptcy, “setoff by statute and recoupment by decision.” 

Id. at 875 (citation and footnote omitted). Although their 

function as pleading doctrines has not entirely disappeared 

in the bankruptcy context, see Reiter v. Cooper, 507 U.S. 

258, 265 n.2 (1993), the two concepts now play a role in 

bankruptcy that is “very different from their original role as 

rules of pleading,” Lee, 739 F.2d at 875.

As the Supreme Court has explained, the right of setoff 

“allows entities that owe each other money to apply their 

mutual debts against each other, thereby avoiding ‘the 

absurdity of making A pay B when B owes A.’” Citizens 

Bank of Maryland v. Strumpf, 516 U.S. 16, 18 (1995) 

(quoting Studley v. Boylston Nat’l Bank, 229 U.S. 523, 528 

(1913)). “The defining characteristic of setoff”—as opposed 

to recoupment—is that, in a setoff, “‘the mutual debt and 

claim . . . are generally those arising from different

transactions.’” Newbery, 95 F.3d at 1398 (citation omitted). 

Although the Bankruptcy Code does not itself create setoff 

rights, it imposes certain federal-law limitations on their 

recognition in bankruptcy. For example, we have stated that, 

under § 553(a) of the Code, “each debt or claim sought to be 

offset must have arisen prior to [the] filing of the bankruptcy 

petition.” Id. Section 553(a) also limits setoff in bankruptcy 

to the setting off of “‘a mutual debt’ owed by a creditor to 

the debtor against the creditor’s claim against the debtor,” 

and this “mutuality requirement” is “strictly construed.” Id. 

at 1399 (emphasis added) (citation omitted). And, as noted 

earlier, a creditor’s right to assert a “setoff” is expressly 

limited by the Code’s automatic-stay provision. See

11 U.S.C. § 362(a)(7).

By contrast, the conceptual foundation of equitable 

recoupment is not the adjustment of separate mutual debts 

but the process of defining the amount owed under a single 
IN RE GARDENS REGIONAL HOSPITAL 13

claim. See Reiter, 507 U.S. at 265 n.2 (“Recoupment 

permits a determination of the ‘just and proper liability on 

the main issue[.]’”) (citation omitted); Chicago Title Ins. Co. 

v. Seko Inv., Inc. (In re Seko Inv., Inc.), 156 F.3d 1005, 1008–

09 (9th Cir. 1988) (“If recoupment applies, the creditor’s 

claim arises from the same transaction as the debtor’s claim, 

and it is essentially a defense to the debtor’s claim against 

the creditor rather than a mutual obligation.” (simplified)). 

Because “recoupment is in the nature of a right to reduce the 

amount of a claim, and does not involve establishing the 

existence of independent obligations,” 5 Collier on 

Bankruptcy ¶ 553.10 (Richard Levin & Henry J. Sommer, 

eds., 16th ed. 2019) (emphasis added), the caselaw has 

recognized that recoupment is not subject to all of the same 

strictures in bankruptcy as setoff. For example, because “the 

limits placed on setoff under section 553 generally do not 

apply to recoupment claims,” Newbery, 95 F.3d at 1399, 

“[u]nlike setoff, recoupment is not limited to pre-petition 

claims and thus may be employed to recover across the 

petition date,” Sims, 224 F.3d at 1011. And as noted earlier, 

“‘unlike setoff, recoupment is often thought not to be subject 

to the automatic stay.’” Newbery, 95 F.3d at 1399 (citation 

omitted).

We have emphasized that the “limitation of recoupment 

that balances [these] advantage[s]” under bankruptcy law “is 

that the claims or rights giving rise to recoupment must arise 

from the same transaction or occurrence that gave rise to the 

liability sought to be enforced by the bankruptcy estate.” 

Sims, 224 F.3d at 1011. Accordingly, we have defined 

recoupment in the bankruptcy context as “‘the setting up of 

a demand arising from the same transaction as the plaintiff’s 

claim or cause of action, strictly for the purpose of abatement 

or reduction of such claim.’” Newbery, 95 F.3d at 1399 

(second emphasis added) (citation omitted). In addressing 
14 IN RE GARDENS REGIONAL HOSPITAL

whether the countervailing claims or rights asserted by the 

creditor arise from the same transaction or occurrence—and 

therefore qualify as a permissible recoupment for federal 

bankruptcy purposes—we “have held that the crucial factor 

. . . is the ‘logical relationship’ between the two.” Sims, 

224 F.3d at 1012 (quoting Newbery, 95 F.3d at 1403).

In Newbery, we derived this “logical relationship” test 

from the Supreme Court’s analysis of pleading standards 

governing compulsory counterclaims in the era prior to the 

Federal Rules of Civil Procedure. 95 F.3d at 1402 (citing 

Moore v. N.Y. Cotton Exch., 270 U.S. 593, 610 (1926)). That 

makes sense, given the common-law-pleading origins of the 

doctrine, Lee, 739 F.2d at 875, and indeed, recoupment has 

been described as “the ancestor of the compulsory 

counterclaim and setoff of the permissive counterclaim,” 

Coplay Cement Co. v. Willis & Paul Grp., 983 F.2d 1435, 

1440 (7th Cir. 1993) (citations omitted); see generally

6 Charles Alan Wright, Arthur R. Miller, & Mary K. Kane, 

Federal Practice & Procedure § 1401 (3d ed. 2010). In both 

Newbery and Sims, we noted that the Supreme Court in 

Moore had held that whether claims or rights arise from the 

same transaction “‘depend[s] not so much upon the 

immediateness of their connection as upon their logical 

relationship.’” Sims, 224 F.3d at 1012 (quoting Moore, 

270 F.3d at 610); see also Newbery, 95 F.3d at 1402 (same). 

In Sims, we therefore expressly rejected “the Third Circuit’s 

narrow definition of ‘transaction,’” which in our view 

improperly gave dispositive weight to the temporal 

immediacy of the countervailing claims rather than to their 

logical relationship. 224 F.3d at 1014 (citing University 

Med. Ctr. v. Sullivan (In re Univ. Med. Ctr.), 973 F.2d 1065, 

1081 (3d Cir. 1992)).
IN RE GARDENS REGIONAL HOSPITAL 15

While we have thus noted the “flexible meaning” of the 

same-transaction requirement, see Newbery, 95 F.3d at 

1402, we have also cautioned that “the ‘logical relationship’ 

concept is not to be applied so loosely that multiple 

occurrences in any continuous commercial relationship 

would constitute one transaction,” Sims, 224 F.3d at 1012. 

The test remains whether the relevant rights being asserted 

against the debtor are sufficiently logically connected to the 

debtor’s countervailing obligations such that they may be 

fairly said to constitute part of the same transaction. Sims, 

224 F.3d at 1012; Newbery, 95 F.3d at 1401–02. Moreover, 

while we have rejected the Third Circuit’s narrow focus on 

temporal proximity, we have stated our express agreement 

with that court’s separate “observation that courts should 

apply the recoupment doctrine in bankruptcy cases only 

when ‘it would . . . be inequitable for the debtor to enjoy the 

benefits of that transaction without meeting its obligations.’” 

Newbery, 95 F.3d at 1403 (alteration in original) (quoting 

University Med. Ctr., 973 F.2d at 1081); see also Sims, 

224 F.3d at 1014. Furthermore, as Collier explains, “care 

should be taken” in applying the doctrine of recoupment in 

the bankruptcy context, given that “improper application of 

the doctrine, coupled with its ostensibly exempt status under 

sections 553(a) and 362, could undermine the fundamental 

purposes of these statutory provisions.” 5 Collier on 

Bankruptcy, supra, ¶ 553.10[3]. “[A]pplication of the 

doctrine in any particular case” is therefore “sometimes 

scrutinized from the perspective of its effect on the 

fundamental policies of these provisions.” Id.; see also 

Malinowski v. N.Y. State Dep’t of Labor (In re Malinowski), 

156 F.3d 131, 134 (2d Cir. 1998) (recoupment should not be 

broadened “in contravention of the federal bankruptcy 

policies of debtor protection and equal distribution to 

creditors”).
16 IN RE GARDENS REGIONAL HOSPITAL

B

The proper application of these principles is illustrated 

by our decisions in Newbery and Sims.

The facts of Newbery are somewhat complex, but they 

are important to a proper understanding of that decision. 

Newbery, an electrical subcontractor, obtained from its 

surety, Fireman’s Fund, “performance and payment bonds” 

that “guaranteed that Newbery’s work would be completed 

and its employees and suppliers paid.” 95 F.3d at 1396. In 

procuring the bonds, Newbery in turn agreed to indemnify 

Fireman’s Fund against any losses stemming from the 

bonds. Id. Newbery subsequently abandoned its projects 

and “defaulted on the bonds,” leaving unpaid its 

indemnification obligation to Fireman’s Fund. Id. As part 

of an agreement between Newbery, Fireman’s Fund, and 

Citibank (which held a security interest in Newbery’s 

equipment), Newbery agreed to transfer the relevant projects 

to Fireman’s Fund, which hired a subcontractor to complete 

them. Id. As part of that agreement, Citibank agreed to rent 

out Newbery’s equipment to Fireman’s Fund. Id. at 1396–

97. Shortly after the agreement was signed, Newbery filed 

for bankruptcy. Id. at 1397. During bankruptcy 

proceedings, Newbery asserted a separate, multi-milliondollar claim against Citibank, and Newbery and Citibank 

ultimately entered into a settlement in which, inter alia, 

Citibank transferred to Newbery its right to receive rental 

payments from Fireman’s Fund. Id. The result of this 

complex series of interrelated agreements was that Newbery 

was entitled to receive equipment rental payments from 

Fireman’s Fund for Fireman’s Fund’s use of Newbery’s 

former equipment to complete Newbery’s former projects. 

Id. After Fireman’s Fund failed to pay the rent on the 

equipment, Newbery brought suit. Id. Fireman’s Fund 
IN RE GARDENS REGIONAL HOSPITAL 17

asserted alternative defenses of recoupment and setoff, 

noting that Newbery was liable to Fireman’s Fund for 

indemnification of its losses, which Fireman’s Fund suffered 

due to Newbery’s failure to complete the projects in the first 

place. Id. at 1397 & n.4.

Applying the “logical relationship” test, we concluded 

that Fireman’s Fund was entitled to recoupment. 95 F.3d at 

1401–04. In reaching this conclusion, we relied on two key 

features of the resulting relationship between the rental 

payments due to Newbery and the claims for indemnification 

asserted by Fireman’s Fund. Id. at 1402–03. First, we found 

it significant that the agreement between Newbery, 

Fireman’s Fund, and Citibank that created the rentalpayment obligation also incorporated by reference 

Newbery’s original indemnification agreement with 

Fireman’s Fund. 95 F.3d at 1402. As a result, under the 

applicable Arizona contract law, the two countervailing 

claims each arose from the same contract. Id. Second, we 

emphasized that the two obligations at issue in Newbery

arose “from the very same acts.” 95 F.3d at 1403. That 

conclusion made perfect sense, because Fireman’s Fund was 

renting Newbery’s equipment to complete the very same 

projects for which Fireman’s Fund had bonded Newbery. 

We held that this factual “intertwining of opposing claims” 

distinguished Newbery from the Third Circuit’s decision in 

University Medical Center, which had rejected the view that 

a common grounding in the same underlying contract was 

alone sufficient to support recoupment. Id. (citing 

University Med. Ctr., 973 F.3d at 1081). We also rejected 

the Third Circuit’s overly restrictive recoupment test, which 

further required that both debts “‘arise out of a single

integrated transaction,’” and held that the requisite factual 

connection was present in Newbery. Id. (quoting University 

Med. Ctr., 973 F.3d at 1081) (emphasis added). Based on 
18 IN RE GARDENS REGIONAL HOSPITAL

these legal and factual connections between the two 

countervailing obligations in Newbery, we found the 

necessary “logical relationship” to justify recoupment. Id. at 

1403.

In Sims, we likewise emphasized both the legal and 

factual connections between the two claims in applying the 

logical-relationship test. 224 F.3d at 1012–14. There, we 

addressed Medicare’s system of making payments to 

providers “on an estimated basis prior to an audit which 

determines the precise amount of reimbursement due to the 

provider.” Id. at 1011. At the end of each reporting year, a 

“fiscal intermediary under contract” with the Government 

would “conduct[] an audit of the provider” and determine 

whether the amount due for the provider’s actual services 

were lower than the estimate, resulting in an overpayment. 

Id. at 1012. One option for recovering overpayments was to 

“adjust subsequent reimbursement payments,” meaning that 

“overpayments from one fiscal year may be recovered by 

adjusting the interim payments for a subsequent fiscal year.” 

Id. After TLC Hospitals, Inc. filed for bankruptcy, it argued, 

inter alia, that the Government could not recapture 

prepetition overpayments from postpetition reimbursements, 

because that would constitute an impermissible setoff 

“across the petition date.” Id. at 1010. The Government, in 

turn, asserted that such recapture would constitute a 

permissible equitable recoupment. Id.

We agreed with the Government, holding that “under 

this specialized and continuous system of estimated 

payments and subsequent adjustments, [the Government’s] 

overpayments and its underpayments in a subsequent fiscal 

year were parts of the same transaction for purposes of 

recoupment.” 224 F.3d at 1012. In light of the “continuous 

balancing process between the parties,” we “conclude[d] that 
IN RE GARDENS REGIONAL HOSPITAL 19

the distinctive Medicare system of estimated payments and 

later adjustments does qualify as a single transaction for 

purposes of recoupment.” Id. (emphasis added). We further 

explained that “[t]he fact that the overpayments and 

underpayments relate to different fiscal years does not 

destroy their logical relationship or indicate that they pertain 

to separate transactions.” Id. at 1013. The temporal delay 

was the inescapable result of a system in which payments 

were made initially on an estimated basis, subject to 

“retroactive adjustment” after the necessary audit could be 

conducted. Id. Because the timing had “‘little to do with 

how one conceptualizes the relation between past 

overpayments and current compensation due,’” we reasoned 

that the “timing of the audit is not material to the logical 

relationship between the overpayments and 

underpayments.” Id. (quoting United States v. Consumer 

Health Servs. of Am., Inc., 108 F.3d 390, 395 (D.C. Cir. 

1997)). Given the factual and legal connections between the 

countervailing obligations, we held that there was a 

sufficient logical relationship and that sound equitable 

considerations supported allowing the Government to 

invoke recoupment. Id. at 1014.

III

In this case, California deducted the unpaid HQAF 

assessments from two separate payment streams: (1) the 

supplemental payments that the State pays to hospitals out 

of the fund created by HQAF assessments and (2) the feefor-service payments that Gardens Regional earned by 

treating Medi-Cal patients. The bankruptcy court and the 

BAP found that the deductions from both payment streams 

qualified as permissible recoupment. We review decisions 

of the BAP de novo, and we apply the same standard of 

review to the bankruptcy court’s decision that the BAP 
20 IN RE GARDENS REGIONAL HOSPITAL

applied. Boyajian v. New Falls Corp. (In re Boyajian), 

564 F.3d 1088, 1090 (9th Cir. 2009). We review the 

bankruptcy court’s legal conclusions de novo and its factual 

findings for clear error. Willms v. Sanderson, 723 F.3d 1094, 

1099 (9th Cir. 2013).

A

We conclude that, in light of the legal and factual 

connections between Gardens Regional’s unpaid HQAF 

assessments and California’s supplemental payments to the 

hospital, these countervailing obligations have the necessary 

logical relationship to justify characterizing them as arising 

from the same transaction for purposes of equitable 

recoupment.

As explained earlier, the California Legislature first 

created the HQAF program in order to take advantage of a 

provision in federal law allowing a State’s Medicare plan to 

make use of certain broad-based health-care-related taxes. 

See supra at 7–8. A central feature of California’s HQAF 

program is that it establishes a “segregated fund[]” known as 

the “Hospital Quality Assurance Revenue Fund” (“HQAR 

Fund”) into which all HQAF proceeds must be deposited, 

and those HQAF funds may then only be used for specified 

purposes. Cal. Welf. & Inst. Code §§ 14167.35(a), 

14169.50(f)(2). Among those purposes are, inter alia, 

“supplemental Medi-Cal payments to hospitals.” Id. 

§ 14169.50(f)(2). As a result, there is a direct factual and 

legal connection between the HQAF payments into the 

segregated HQAR Fund and the supplemental payments 

made to hospitals from that very same segregated fund.

Moreover, the overall linkage between these two streams 

of money is a critical feature of the HQAF program. Federal 

law generally does not permit a State to use circular state 
IN RE GARDENS REGIONAL HOSPITAL 21

funding systems (e.g., taxing hospitals only to then pay them 

back) as a vehicle for increasing federal Medicaid matching 

payments, but the California HQAF program is specifically 

tailored to fit within a statutorily created exception to that 

rule. See supra at 6–8. Indeed, California’s HQAF statute 

is explicit in declaring this circular funding mechanism to be 

a central purpose of the HQAF program: “It is the intent of 

the Legislature to impose a quality assurance fee to be paid 

by hospitals, which would be used to increase federal 

financial participation in order to make supplemental MediCal payments to hospitals[.]” Cal. Welf. & Inst. Code 

§ 14169.50(d) (emphasis added). This fundamental goal of 

the HQAF system cannot be achieved unless there is an 

overall connection between the HQAF assessments paid by

hospitals into the segregated funds and the supplemental 

payments made to hospitals from those same funds.

We disagree with Gardens Regional’s contention that the 

necessary logical relationship is missing in light of the fact 

that, in the context of any given hospital, there is no 

connection between the specific amount it must pay in 

HQAF assessments and the specific amounts it receives as 

supplemental payments. It is true that the two amounts are 

calculated according to separate, complex formulas,5 and 

many hospitals receive supplemental payments without 

having paid any HQAF assessments.6 Indeed, Gardens 

5 HQAF assessments and supplemental payments are independently 

calculated on a hospital-by-hospital basis based on technical factors that 

generally reflect the volume of treatment provided by the hospital to 

patients. See, e.g., CAL. WELF. & INST. CODE §§ 14169.51(as), 

14169.52(a), 14169.54(b), 14169.55(b).

6 HQAF assessments are collected only from private hospitals, 

including those that do not participate in Medi-Cal, but the resulting 

funds can be distributed both to private hospitals and to public hospitals 
22 IN RE GARDENS REGIONAL HOSPITAL

Regional notes that federal law generally prohibits any such 

hospital-specific linkage between the amount of HQAF 

assessments levied on a particular taxpayer and the amount 

of any Medicaid payments to that taxpayer. See 42 U.S.C. 

§ 1396b(w)(4); 42 C.F.R. § 433.68(f). In our view, 

however, Gardens Regional’s argument that this feature 

precludes any finding of a logical relationship is foreclosed 

by Sims. In Sims, we found the requisite logical connection 

even though the two payment streams at issue there 

“relate[d] to different fiscal years” and therefore were 

independently calculated from one another. 224 F.3d 

at 1013. We held that this fact did “not destroy [the 

payments’] logical relationship” because the relevant 

statutory scheme “create[d] a sufficient relationship” 

between the separately calculated amounts “to permit 

recoupment.” Id. Analogously, the distinctive features of 

the HQAF program create an essential overall linkage 

between the payment streams into and out of the HQAR 

Fund, and the resulting countervailing obligations of any 

individual hospital, even though independently and 

separately calculated, are sufficiently logically related to 

permit recoupment.

In view of the strong logical relationship among payment 

streams that is reflected in these unique features of the 

HQAF program, we conclude that this “distinctive . . . 

system” of continuously managing hospital payments into 

segregated funds against hospital payments out of those 

same funds is properly treated as “a single transaction for 

purposes of recoupment.” Sims, 224 F.3d at 1012. Given 

that do not pay the HQAF. See supra at 7–8. Moreover, HQAF funds

are also used for purposes other than supplemental payments to hospitals, 

such as for providing health coverage for low-income children. CAL.

WELF. & INST. CODE §§ 14169.53(b)(1)(B).
IN RE GARDENS REGIONAL HOSPITAL 23

these singular features of the HQAF program, it would be 

“‘inequitable for the debtor to enjoy the benefits of that 

transaction without meeting its obligations.’” Newbery, 

95 F.3d at 1403 (citation omitted). And for the same 

reasons, allowing recoupment in the unique context 

presented here would not encroach upon, or undermine, the 

policy judgments reflected in the Bankruptcy Code’s 

limitations on setoffs. See 5 Collier on Bankruptcy, supra, 

¶ 553.10[3]. California therefore properly recouped 

Gardens Regional’s unpaid HQAF assessments into the 

segregated funds from the HQAF-funded supplemental 

payments that Gardens Regional was due to receive out of 

those same funds.

B

We reach the opposite conclusion with respect to 

California’s deduction of the unpaid HQAF assessments 

from the fee-for-service payments made to Gardens 

Regional. Those deductions constitute a setoff that is subject 

to the restrictions of the Bankruptcy Code and not a 

permissible equitable recoupment.

The sorts of legal and factual connections that link the 

HQAF assessments and the HQAF supplemental payments 

are simply not present in the distinct context of the State’s 

fee-for-service payments. In contrast to the supplemental 

payments, the fee-for-service payments are not drawn from 

the same segregated fund as the HQAF assessments. See

Cal. Welf. & Inst. Code § 14169.50(f)(2). Nor is there 

anything comparable to the express statutory policy 

establishing an overall link between payments into and out 

of the HQAR Fund in order to accomplish a distinct 

objective (obtaining greater federal matching funds) that is 

directly tied to that unique linkage. See supra at 20–23. 

Rather, Gardens Regional earned the fee-for-service 
24 IN RE GARDENS REGIONAL HOSPITAL

payments by providing services to individuals covered by 

Medi-Cal, and that fee-for-service system was an established 

part of California’s Medi-Cal plan long before the HQAF 

program, with its segregated funding, was established. See 

supra at 5–8.

Moreover, the fee-for-service payments lack any factual 

connection to the HQAF assessments comparable to the 

direct factual link between the countervailing obligations in 

Newbery, both of which arose from the “very same acts” in 

completing Newbery’s projects. 95 F.3d at 1403. And they 

lack the sort of close connection established by the 

“specialized and continuous system of estimated payments 

and subsequent adjustments” we addressed in Sims. 

224 F.3d at 1012. To recognize a logical relationship 

between the HQAF assessments and the fee-for-service 

payments would be to ignore Sims’s admonition that “the 

‘logical relationship’ concept is not to be applied so loosely 

that multiple occurrences in any continuous commercial 

relationship would constitute one transaction.” Id.

The State makes two arguments in response, but neither 

is persuasive. First, California insists that a sufficient logical 

relationship is created by a provision of the HQAF statute 

that specifically authorizes the State to deduct unpaid HQAF 

assessments “from any Medi-Cal payments owed to the 

hospital, or, in accordance with Section 12419.5 of the 

Government Code, from any other state payments owed to 

the hospital.” Cal. Welf. & Inst. Code § 14169.52(h). This 

argument proves too much. As the reference to California 

Government Code § 12419.5 confirms, this provision of the 

HQAF statute asserts a broad right to “offset any amount due 

a state agency from a person or entity”—here, the HQAF 

assessments—“against any amount owing that person or 

entity by any state agency.” Cal. Gov. Code § 12419.5 
IN RE GARDENS REGIONAL HOSPITAL 25

(emphasis added). Were we to accept California’s 

contention that its statutory assertion of such a sweeping 

right of setoff alone establishes a sufficient logical 

relationship to warrant recoupment, we would effectively 

obliterate the distinction between recoupment and setoff and 

thereby exempt California entirely from the Bankruptcy 

Code’s restrictions on setoffs. To qualify as recoupment, 

rather than setoff, California’s deduction of HQAF fees from 

fee-for-service payments must rest upon factual and legal 

connections beyond the mere assertion of a statutory right to 

make such deductions. See Sims, 224 F.3d at 1012–13; 

Newbery, 95 F.3d at 1403; cf. also Malinowski, 156 F.3d 

at 134 (“[A] state may not choose to define its rights in a way 

that defeats the ends of federal bankruptcy law.”).

Second, the State argues that the necessary logical 

relationship between the HQAF assessments and the fee-forservice payments is shown by the fact that they both are 

ultimately rooted in Gardens Regional’s provider agreement 

with the State. California notes that that contract, in turn, 

requires compliance with all applicable state and federal 

laws, including the broad setoff rights asserted by California 

in § 14169.52(h). For the reasons we have already 

explained, California’s mere assertion of a broad setoff 

right—whether by statute or by contract—remains subject to 

the limitations of federal bankruptcy law. The recitation of 

such a setoff right, without more, does not establish that the 

resulting deduction is actually a recoupment for purposes of 

bankruptcy law.

Nor does anything else about Gardens Regional’s 

standard-form provider agreement supply the necessary 

logical relationship between the HQAF assessments and the 

fee-for-service payments. Contrary to what California 

suggests, we did not hold in Newbery that the mere fact that 
26 IN RE GARDENS REGIONAL HOSPITAL

both countervailing obligations were in some sense rooted in 

the parties’ contract was alone sufficient to establish the 

requisite logical relationship. Indeed, such an overbroad 

proposition would be contrary to Sims’s admonition that “the 

‘logical relationship’ concept is not to be applied so loosely 

that multiple occurrences in any continuous commercial 

relationship would constitute one transaction.” 224 F.3d at 

1012; see also 5 Collier on Bankruptcy, supra, ¶ 553.10[1] 

(“[T]he mere fact that the relevant obligations arise under a 

single contract does not automatically mean that recoupment 

is warranted.”). Rather, as explained earlier, in Newbery we 

emphasized that there was also a close factual link between 

the two obligations, because they both arose from the same 

underlying actions (namely, the completion of the projects 

that Newbery had abandoned). 95 F.3d at 1403. No such 

comparable link is present here. The mere fact that both 

payment streams arise within the overarching context of the 

larger Medi-Cal program is not enough, and acceptance of 

such a view would expand the concept of recoupment in a 

way that would “undermine the fundamental purposes” of 

the Bankruptcy Code’s express limitations on setoffs. See 

5 Collier on Bankruptcy, supra, ¶ 553.10[3].

IV

We affirm the judgment of the BAP insofar as it holds 

that California’s deduction of unpaid HQAF assessments 

from the supplemental payments made to Gardens Regional 

was permissible under the doctrine of equitable recoupment, 

but we reverse its judgment as to the fee-for-service 

payments. We remand to the BAP with instructions to 

remand to the bankruptcy court for further proceedings 

consistent with this opinion.

AFFIRMED IN PART, REVERSED IN PART, AND 

REMANDED.