Court Opinion

ID: 4566012
Source: CourtListenerOpinion
Date Created: 2020-09-16 17:00:59.302591+00
Date Added: 2024-06-11T12:48:57.935827
License: Public Domain

FOR PUBLICATION

  UNITED STATES COURT OF APPEALS
       FOR THE NINTH CIRCUIT

IN RE GARDENS REGIONAL HOSPITAL            No. 18-60016
AND MEDICAL CENTER, INC.,
                             Debtor,         BAP No.
                                             17-1198

GARDENS REGIONAL HOSPITAL AND
MEDICAL CENTER LIQUIDATING                  OPINION
TRUST,
                      Appellant,

                 v.

STATE OF CALIFORNIA, AND ITS
DEPARTMENT OF HEALTH CARE
SERVICES,
                        Appellees.

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-for-
service 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 “broad-
based 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 broad-
based 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 Medi-
Cal 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 Medi-
Cal payments to the hospital, which included both fee-for-
service 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 fee-
for-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-million-
dollar 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 rental-
payment 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 fee-
for-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 Medi-
Cal 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-for-
service 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.