Catholic Health Initiatives v. Sebelius

United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued May 10, 2010 Decided August 13, 2010

No. 09-5377

CATHOLIC HEALTH INITIATIVES, ET AL.,

APPELLANTS

v.

KATHLEEN SEBELIUS, SECRETARY, UNITED STATES

DEPARTMENT OF HEALTH AND HUMAN SERVICES,

APPELLEE

Appeal from the United States District Court

for the District of Columbia

(No. 1:07-cv-00555-PLF)

Paul D. Clement argued the cause for appellants. With him

on the briefs were Christopher L. Keough and J. Harold

Richards.

Irene M. Solet, Attorney, U.S. Department of Justice,

argued the cause for appellee. With her on the brief was

Michael S. Raab, Attorney. Dana L. Kaersvang, Attorney, and

R. Craig Lawrence, Assistant U.S. Attorney, entered appear-

ances.

Before: SENTELLE, Chief Judge, BROWN, Circuit Judge, and

RANDOLPH, Senior Circuit Judge.

2

Opinion for the Court filed by Senior Circuit Judge

RANDOLPH.

Opinion concurring in the judgment filed by Circuit Judge

BROWN.

RANDOLPH, Senior Circuit Judge: This is an appeal from an

order of the district court granting summary judgment to the

Secretary of Health and Human Services. Catholic Health

Initiatives, a nonprofit charitable corporation, and a group of its

affiliated nonprofit hospitals brought an action under the

Medicare Act to recover premiums the hospitals had paid for

malpractice, workers’ compensation, and other insurance. The

hospitals paid the premiums to First Initiatives Insurance Ltd.

from 1997 through 2002. Catholic Health wholly owns First

Initiatives, which is based in the Cayman Islands.

In general, the Secretary considers malpractice, workers’

compensation, and other liability insurance premiums to be part

of a hospital’s “reasonable costs” incurred in providing services

to Medicare beneficiaries. As such, the costs are reimbursable.

The Medicare Act defines the “reasonable cost of any services”

to be “the cost actually incurred, excluding therefrom any part

of incurred cost found to be unnecessary in the efficient delivery

of needed health services . . ..” 42 U.S.C. § 1395x(v)(1)(A).

The “reasonable cost” “shall be determined in accordance with

regulations establishing the method or methods to be used, and

the items to be included, in determining such costs for various

types or classes of institutions, agencies, and services . . ..” Id.

The regulations describe reasonable costs as “related to the

care of Medicare beneficiaries,” 42 C.F.R. § 413.9(c)(3), and

“determined in accordance with regulations,” id. § 413.9(b).

Reasonable costs include “all necessary and proper costs

incurred in furnishing” Medicare services. Id. § 413.9(a).

3

Necessary and proper costs are those direct and indirect costs

“that are appropriate and helpful in developing and maintaining

the operation of patient care facilities and activities,” and that

are not “substantially out of line with” the costs of similar

institutions. Id. § 413.9(b)(2), (c)(2).

The Secretary has issued a Provider Reimbursement

Manual. The Manual contains “guidelines and policies to

implement Medicare regulations which set forth principles for

determining the reasonable cost of provider services,” but it

“does not have the effect of regulations.” Centers for Medicare

and Medicaid Services, Provider Reimbursement Manual, Part

1, Foreword, at I (“PRM”). The Manual does bind Medicare’s

“fiscal intermediaries” – private firms under contract with the

Secretary to review provider reimbursement claims and deter-

mine the amount due. See 42 U.S.C. § 1395h; Yale-New Haven

Hosp. v. Leavitt, 470 F.3d 71, 80-81 (2d Cir. 2006); St. Mary of

Nazareth Hosp. Ctr. v. Schweiker, 718 F.2d 459, 463 (D.C. Cir.

1983).1

Rather than purchasing insurance in the market, some

Medicare providers have established their own insurance

companies – known as “captives” – for the purpose of insuring

themselves against malpractice and certain other claims. PRM

§ 2162.2.A. If the captive is a domestic corporation, and if the

premiums it charges are comparable to those of other insurance

companies, the Manual states that the affiliated provider is

entitled to reimbursement for premiums paid to the captive. Id.

But if the captive is offshore, the Manual prohibits reimburse-

ment for premiums if the captive’s investments do not comply

with the following rule:

1

In 2005, fiscal intermediaries were replaced by “medicare

administrative contractors.” See 42 U.S.C. 1395h; 42 C.F.R.

§ 413.24(f).

4

In the case of offshore captives, investments by a related

captive insurance company are limited to low risk invest-

ments in United States dollars such as bonds and notes

issued by the United States Government; debt securities

issued by United States corporations or governmental

entities within the United States rated in the top two

classifications by United States recognized securities rating

organizations at the time of investment; debt securities of

foreign subsidiaries of United States corporations rated in

the top two classifications by United States recognized

securities rating organizations at the time of investment

where the parent United States corporations guaranteed (on

the face of the securities) payment of the subsidiaries’

securities; and deposits (including Certificates of Deposit)

in United States banks or their foreign subsidiaries, and

foreign banks rated in the top two short term classifications

by United States recognized securities rating organizations.

Low risk investments may also include investments of non-

United States issuers including foreign governments and

corporations and supranational agencies rated in the top two

classifications by United States recognized securities rating

organizations (effective with investments made on or after

10/11/91). Effective for investments made on or after

10/06/95, the limitation on related offshore captive insur-

ance company investments is extended to include the above

described low risk investments rated in the top three

classifications by United States recognized securities rating

organizations. Additionally, investments may include

dividend paying equity securities listed on a United States

stock exchange provided that the investment in equity

securities does not exceed 10 percent of the company's

admitted assets, with the investment in any specific equity

issue further limited to 10 percent of the total equity

security investment. (All such captives are required to

annually submit to a designated intermediary a certified

5

statement from an independent certified public accountant

or actuary attesting to compliance or non-compliance with

these requirements for the previous period.) These invest-

ments cannot be pledged or used as collateral for loans

obtained by the captive or parties related to the captive

either directly or indirectly, nor may investments be made

in a related organization.

PRM § 2162.2.A.4. First Initiatives Insurance did not satisfy

these requirements. During the contested period it invested as

much as forty to fifty percent of its assets in equity securities.

In light of First Initiatives’ noncompliance with the Manual,

the hospitals disallowed their premium payments on the annual

cost reports they submitted to Medicare’s fiscal intermediaries.

See 42 C.F.R. § 405.1801(b)(1). The hospitals then sought to

recover those premiums by challenging § 2162.2.A.4 at a

hearing before the Provider Reimbursement Review Board, a

five-member panel with authority to affirm, modify, or reverse

an intermediary’s decision. 42 U.S.C. § 1395oo(a), (d), (h).

(Here the intermediary decision was merely to accept the

hospitals’ own disallowance of their premium costs.) The Board

must give the Manual “great weight,” but – unlike an intermedi-

ary – is not bound by it. 42 C.F.R. § 405.1867.

In a three to two decision, the Board held that the invest-

ment limitations in § 2162.2.A.4 of the Manual were a “valid

extension” of the statute and the regulations governing “reason-

able cost.” Therefore the Board majority treated the provision

as “compulsory.” Catholic Health Initiatives v. Mutual of

Omaha Ins. Co., PRRB Decision No. 2007-D14 (Jan. 24, 2007)

(“Board Decision”). The majority explained that, unlike

domestic captive insurance companies, offshore captives present

an “inherent risk”: “offshore captives are under the control of

foreign governments and are not subject to the same level” of

6

regulation as domestic insurers, which are regulated by the

states. In addition, the ten percent limit on equity investments

“is in line with the asset allocations found among domestic

insurance companies.” The two dissenting Board members

believed that § 2162.2.A.4 of the Manual was not an “appropri-

ate application of Medicare statutory reasonable cost principles,”

that it was “devoid of any link to the standards expressed in the

regulations,” and that it could not be justified as an interpretive

rule “exempt from the notice and comment provisions of the

Administrative Procedure Act . . ..” The ten percent provision

was, the dissenters stated, an example of “why the rulemaking

process is critical to establishing standards such as those

involved here.”

Catholic Health and the hospitals brought this action in the

district court after the Secretary’s delegate – the Administrator

of the Centers for Medicare and Medicaid Services – declined

to review the Board’s decision. See 42 U.S.C. § 1395oo(f); 42

C.F.R. § 405.1877. The district court viewed the issue as

“whether the Board’s ruling – which found the reimbursement

standard expressed in the PRM to be consistent with both the

Medicare statute and the Medicare regulations – was lawful, not

whether the PRM provision itself was lawful.” Catholic Health

Initiatives v. Sebelius, No. 07-555, slip op. at 7, 2009 WL

3112575 (D.D.C. Sept. 30, 2009). Granting summary judgment

in favor of the Secretary, the court found that the Board’s

adherence to the Manual’s interpretation was “not plainly

erroneous or inconsistent with the statute or the regulation . . ..”

Id. at 15.

The Secretary defends the Manual’s investment limitations

on the ground that the limitations comprise an “interpretative”

rule. See 5 U.S.C. § 553(b)(A); American Mining Congress v.

Mine Safety & Health Admin., 995 F.2d 1106 (D.C. Cir. 1993).

As the Secretary puts it, “the cost of insurance premiums that

7

Medicare is asked to reimburse can be considered ‘reasonable’

only if those premiums actually purchase reliable coverage.”

Reliability depends on “the financial soundness of the insurer,”

Br. of Appellee at 15, which depends on the competence of the

insurer’s regulator and the pervasiveness of its regulations, id.

at 29-31.2 The rule, the Secretary contends, is consistent with

the statute and regulations, supported by substantial evidence,

and not arbitrary or capricious. Id. at 14-17, 28.

The hospitals dispute each of these assertions. They claim

that the rule regulates insurance investment decisions and

therefore lies outside the scope of the Secretary’s “reasonable

cost” authority under the Medicare Act. In addition, the

hospitals believe that an important premise of the rule is wrong.

The Board majority believed that offshore captives “are not

subject to the same level of industry regulations applied to

onshore agencies by State insurance companies.” Board

Decision at 6. But the evidence submitted at the hearing before

the Board showed “that the level of state regulation of equity

investments by domestically domiciled captives is essentially

zero.” Br. of Appellants at 39. In fact, “only a minority of

states – twenty-three – regulate captive insurers at all.” Id. at

40. The hospitals argue that to the extent that the Manual’s

limitations were intended to promote the financial strength and

solvency of the offshore insurer, the limitations are arbitrary

because they are both overbroad and underinclusive. The

limitations are overbroad, for instance, because they permit

equity investments only in securities that pay dividends. Yet the

hospitals point out that many companies that appear to be

financially sound – such as Microsoft during the years at issue

2

The Secretary’s argument assumes that the less heavily regulated an

insurance company is, the more likely it will fail. There may be

reason to doubt the assumption at least as applied to captive insurers,

but we will make nothing of this.

8

and Google – do not pay dividends. The Manual’s investment

limitations are underinclusive, the hospitals claim, because there

is no requirement that a captive diversify its investments.

Although no one equity investment may make up more than ten

percent of a captive’s equity holdings (and thus one percent of

its total assets), nothing in the Manual prevents a captive from

having all of its assets in, for instance, one corporation’s bonds.

See PRM § 2162.2.A.4.

We do not decide whether the Medicare Act’s reasonable

cost provision would authorize the ten percent rule, or whether

the reasoning and evidence in support of the Board’s decision

enforcing the Manual provision are sufficient. There is an

antecedent question, discussed by the dissenting Board members

and raised – although without much elaboration – by the

hospitals. The question is whether the Manual’s investment

limitations for offshore captives is, as the Secretary contends, an

“interpretive rule.”

To fall within the category of interpretive, the rule must

“derive a proposition from an existing document whose meaning

compels or logically justifies the proposition. The substance of

the derived proposition must flow fairly from the substance of

the existing document.” Robert A. Anthony, “Interpretive”

Rules, “Legislative” Rules, and “Spurious” Rules: Lifting the

Smog, 8 ADMIN. L. J. AM. U. 1, 6 n.21 (1994). If the rule cannot

fairly be seen as interpreting a statute or a regulation, and if (as

here) it is enforced, “the rule is not an interpretive rule exempt

9

from notice-and-comment rulemaking.”3 Central Tex. Tel.

Coop. v. FCC, 402 F.3d 205, 212 (D.C. Cir. 2005) (citing

Syncor Int’l Corp. v. Shalala, 127 F.3d 90, 95 (D.C. 1997));

United States v. Picciotto, 875 F.2d 345, 347-49 (D.C. Cir.

1989); Hoctor v. USDA, 82 F.3d 165, 170 (7th Cir. 1996).4

Although § 2162.2.A.4 of the Manual does not identify

what it is purporting to interpret, the Manual’s Foreword claims

that every Manual provision rests on the “reasonable cost”

language in the statute and the regulations. But as Professor

Anthony has written, if the relevant statute or regulation

“consists of vague or vacuous terms – such as ‘fair and equita-

ble,’ ‘just and reasonable,’ ‘in the public interest,’ and the like

– the process of announcing propositions that specify applica-

tions of those terms is not ordinarily one of interpretation,

because those terms in themselves do not supply substance from

which the propositions can be derived.” Lifting the Smog, 8

ADMIN. L. J. AM. U. at 6 n.21. This court’s opinion in Paralyzed

Veterans of America v. D.C. Arena L.P., stated much the same.

3

The Medicare Act, 42 U.S.C. § 1395x(v)(1)(A), requires “reasonable

cost” to “be determined in accordance with regulations establishing

the method or methods to be used, and the items to be included . . ..”

This necessarily allows the Secretary to construe her regulations, but

it does not appear to allow “reasonable cost” to be based on a rule that

is neither part of a regulation nor an interpretation of a regulation.

4

In Central Texas, 402 F.3d at 212, we acknowledged that the “APA’s

definition of ‘rule’ contemplates that . . . [both] legislative and

interpretive [rules] may interpret ‘law.’ The EPA regulations at issue

in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc.,

467 U.S. 837 (1984), for instance, interpreted the term ‘stationary

source’ in the Clean Air Act (and did a good deal more). Nor may one

say there is a clear ‘line between interpretation and policymaking.’

John F. Manning, Nonlegislative Rules, 72 GEO. WASH. L. REV. 893,

924 (2004).”

10

117 F.3d 579, 588 (D.C. 1997). In support, Paralyzed Veterans

cited United States v. Picciotto, a case in which the Park Service

issued a detailed rule specifying types of property that “may not

be stored” in Lafayette Park. 875 F.2d at 346. The rule

supposedly interpreted a regulation allowing “additional

reasonable conditions” to be added to demonstration permits.

The court held that the rule did not interpret this “open-ended”

regulation and therefore could not be enforced because it was

not issued after notice and comment. Id. at 346, 349.

Another general principle cuts against the Secretary.

Among other things, § 2162.2.A.4 of the Manual provides that

an offshore captive insurer’s “investments may include dividend

paying equity securities listed on a United States stock exchange

provided that the investment in equity securities does not exceed

10 percent of the company’s admitted assets, with the invest-

ment in any specific equity issue further limited to 10 percent of

the total equity security investment.” Judge Friendly wrote that

when an agency wants to state a principle “in numerical terms,”

terms that cannot be derived from a particular record, the agency

is legislating and should act through rulemaking. HENRY J.

FRIENDLY, Watchman, What of the Night?, in BENCHMARKS

144-45 (1967). We too have recognized that “numerical limits

cannot readily be derived by judicial reasoning,” although courts

occasionally draw such limits.5 Missouri Pub. Serv. Comm’n v.

FERC, 215 F.3d 1, 4 (D.C. Cir. 2000). Our statement in

Missouri Public Service relied on Hoctor v. USDA, 82 F.3d 165,

5

See, e.g., United States v. Thirty-Seven Photographs, 402 U.S. 363

(1971), which construed a federal statute authorizing the seizure and

forfeiture of imported obscene materials to mean that judicial

forfeiture proceedings had to be instituted within 14 days and

completed within 60 days. The Court held that reading these time

limits into the statute was necessary to save it from being declared

unconstitutional in violation of the First Amendment.

11

170 (7th Cir. 1996). Hoctor held that an agency performs a

legislative function when it makes “reasonable but arbitrary (not

in the ‘arbitrary or capricious’ sense) rules that are consistent

with the statute or regulation under which the rules are promul-

gated but not derived from it, because they represent an arbitrary

choice among methods of implementation. A rule that turns on

a number is likely to be arbitrary in this sense.” Hoctor cau-

tioned that the court did not mean “that an interpretive rule can

never have a numerical component.” 82 F.3d at 171. Examples

in this circuit include American Mining Congress v. Mine Safety

& Health Administration, 995 F.2d 1106 (D.C. Cir. 1993), and

Chippewa Dialysis Services v. Leavitt, 511 F.3d 172, 176-77

(D.C. Cir. 2007) (dicta). “Especially in scientific and other

technical areas, where quantitative criteria are common, a rule

that translates a general norm into a number may be justifiable

as interpretation.” Hoctor, 82 F.3d at 171.

The Hoctor court concluded that “[w]hen agencies base

rules on arbitrary choices they are legislating, and so these rules

are legislative or substantive and require notice and comment

rulemaking.” Id. at 170-71. Section 2162.2.A.4 falls within that

category. With respect to the ten percent limits “it is impossible

to give a reasoned distinction between numbers just a hair on the

OK side of the line and ones just a hair on the not-OK side.”

Missouri Pub. Serv. Comm’n, 215 F.3d at 4. Here the Secretary

has not even made the attempt.

The short of the matter is that there is no way an interpreta-

tion of “reasonable costs” can produce the sort of detailed – and

rigid – investment code set forth in § 2162.2.A.4.6 This is

6

It might have been a closer case if the Secretary’s Manual had

indicated that premiums paid to financially unstable captive offshore

(or domestic) insurance companies do not represent “reasonable

costs.” But § 2162.2.A.4 of the Manual embodies a “flat” rule, and

12

essentially the point of the dissenting Board members. The

statute gives the Secretary authority to promulgate regulations

defining “the method or methods to be used, and the items to be

included, in determining” what constitutes a provider’s “reason-

able costs.” 42 U.S.C. § 1395x(v)(1)(A). We may assume,

without deciding, that the Manual’s investment limitations are

an “extension” of the reasonable cost provisions in this section

and the corresponding regulation, as the Board majority thought,

and we may assume that the limitations are “consistent” with

those provisions, as the Secretary has argued. But neither

assumption leads to the conclusion that the Manual’s limitations

represent an interpretation of the Medicare Act or of the

regulations. See Hoctor, 82 F.3d at 170.7 Consistency with the

statute may be enough to sustain a rule duly promulgated after

notice and comment, just as consistency with the Commerce

Clause, Art. I, § 8, cl. 3, may be enough to sustain the constitu-

tionality of a statute. But no one would say, for instance, that

the detailed provisions of the Clean Air Act were interpretations

of the language of the Constitution. The same is true here. The

connection between § 2162.2.A.4 of the Manual and “reasonable

the “‘flatter’ a rule is, the harder it is to conceive of it as merely

spelling out what is in some sense latent in a statute or regulation . . ..”

Hoctor, 82 F.3d at 171.

7

Hoctor analyzed whether a U.S. Department of Agriculture rule

requiring a fence of at least eight feet to enclose lions, tigers, and

leopards was an interpretation of a regulation providing that the

enclosure had to be of “such material and of such strength as appropri-

ate for the animals involved.” 82 F.3d at 167-68. Writing for the

court, Judge Posner held that “[e]ven if . . . the eight-foot rule is

consistent with, even in some sense authorized by, the structural-

strength regulation, it would not necessarily follow that it is an

interpretive rule. It is that only if it can be derived from the regulation

by a process reasonably described as interpretation.” Id. at 170.

13

costs” is simply too attenuated to represent an interpretation of

those terms as used in the statute and the regulations.

Our concurring colleague agrees with us that § 2162.2.A.4

of the Manual cannot be sustained as a valid interpretation of

“reasonable cost.”8 Based on her reading of Shalala v. Guernsey

Memorial Hospital, 514 U.S. 87 (1995), our colleague does not

put her conclusion in those terms and then criticizes us for

determining that the Manual provision is not a proper interpre-

tive rule. Our colleague’s approach rests on what we perceive

as a misreading of Guernsey. At no point did the Supreme

Court suggest that interpretive rules do not have to interpret.

The issue was not presented. Guernsey simply recognized that

a particular provision in the Manual constituted “a prototypical

example of an interpretive rule,” id. at 99, something that cannot

be said about the provision we have in front of us.

For the reasons given, the judgment of the district court is

reversed. We remand the case to the district court with instruc-

tions to set aside the decision of the Provider Reimbursement

Review Board and for such other relief as the district court

deems appropriate in view of this decision.

So Ordered.

8

Thus we are told that the “investment restrictions in the Manual are

clearly outside [the] scope” of the Secretary’s authority “to define the

‘reasonable cost’,” Concurring Op. at 10; that there is no “nexus”

between the Manual provision and “reasonable cost,” id.; that the

“rigid” rule in the Manual lacks “any rational connection” to the

statute’s “‘reasonable cost’ principle,” id. at 4-5; and so forth.

BROWN, Circuit Judge, concurring in the judgment: The

court holds section 2162.2.A.4 of the Secretary’s Provider

Reimbursement Manual is invalid because the Secretary

failed to promulgate it by notice-and-comment rulemaking.

The court thus leaves the door open for the Secretary to

promulgate an identical provision restricting the investment

decisions of a provider’s offshore captive insurance company

as a full-fledged rule. But a deeper flaw runs through the

Manual provision that cannot be cured by more procedure: it

exceeds the Secretary’s authority under the Medicare statute

to determine the “reasonable cost” for which providers are

reimbursed. Accordingly, I would close the door left

enticingly ajar by the court and hold the Manual provision

invalid as beyond the Secretary’s authority.

I

Catholic Health Initiatives and its affiliated hospitals (the

hospitals) challenge the Manual provision as exceeding the

Secretary’s authority under the Medicare statute. It is a

cardinal principle of administrative law that an agency may

act only pursuant to authority delegated to it by Congress.

See Lyng v. Payne, 476 U.S. 926, 937 (1986) (“[A]n agency’s

power is no greater than that delegated to it by Congress.”);

Transohio Sav. Bank v. Dir., Office of Thrift Supervision, 967

F.2d 598, 621 (D.C. Cir. 1992) (“It is central to the real

meaning of the rule of law . . . that a federal agency does not

have the power to act unless Congress, by statute, has

empowered it to do so.”). When an agency has acted beyond

its delegated authority, a reviewing court will hold such action

ultra vires, Transohio, 967 F.2d at 621, or a violation of the

Administrative Procedure Act (APA), 5 U.S.C. § 706(2)(C)

(directing courts to “hold unlawful and set aside agency

action . . . in excess of statutory jurisdiction, authority, or

limitations, or short of statutory right”).

2

Congress delegates authority to agencies through

legislation, and we therefore look to the agency’s enabling

statute to determine whether it has acted within the bounds of

its authority or overstepped them. See Univ. of the D.C.

Faculty Ass’n/NEA v. D.C. Fin. Responsibility & Mgmt.

Assistance Auth., 163 F.3d 616, 620 (D.C. Cir. 1998)

(explaining ultra vires claim requires the court to review

statutory language to determine whether “Congress intended

the [agency] to have the power that it exercised when it

[acted]”). The Secretary defends the Manual provision as

within her authority under 42 U.S.C. § 1395x(v)(1)(A), which

provides:

The reasonable cost of any services shall be the cost

actually incurred, excluding therefrom any part of

incurred cost found to be unnecessary in the efficient

delivery of needed health services, and shall be

determined in accordance with regulations establishing

the method or methods to be used, and the items to be

included, in determining such costs for various types or

classes of institutions, agencies, and services . . . .

The Secretary argues, and the hospitals agree, that she has

considerable discretion under this section to define what

“reasonable cost” means. See Richey Manor, Inc. v.

Schweiker, 684 F.2d 130, 134 (D.C. Cir. 1982) (“It is well

established that Congress granted the Secretary broad

discretion to develop the ‘reasonable cost’ concept, subject, of

course, to the general standard enunciated in 42 U.S.C. §

1395x(v)(1)(A).”). However, the Secretary and the hospitals

disagree over whether the Manual provision is a permissible

exercise of that discretion.

The Manual provision, which the court quotes in full,

places three specific investment restrictions on “offshore

3

captives”: (1) an offshore captive seeking to invest its assets

must invest 90% or more of them in “low risk investments,”

defined to include certain categories of government bonds,

debt securities, and bank deposits; (2) an offshore captive may

invest 10% or less of its assets in “dividend paying equity

securities listed on a United States stock exchange”; and (3)

an offshore captive must limit its investment in any one equity

issue to 10% of the captive’s total equity security investment.

Manual ch.21 § 2162.2.A.4. The Secretary will consider the

insurance premiums a provider pays its offshore captive

insurance company to be “reasonable costs” reimbursable

under the Medicare program only if the captive satisfies all

three investment restrictions. But, as the hospitals argue

persuasively, none of the restrictions fits comfortably, or even

plausibly, within the plain meaning of “reasonable cost.”

II

First, the investment restrictions exceed the Secretary’s

“reasonable cost” authority because they cause a blanket

disallowance of reimbursement of a provider’s insurance

premiums, even though liability insurance coverage generally

is an allowable cost of the provider’s Medicare program. The

Secretary freely admits “[t]here is no dispute that the costs of

purchasing malpractice and workers’ compensation insurance

are, as a general matter, necessary and proper costs of

furnishing health services to Medicare beneficiaries.”

Appellee’s Br. at 23. Nevertheless, if a provider’s offshore

captive fails to observe just one of the three investment

restrictions, the Secretary disallows 100% of the provider’s

premiums.

The absurd results arising from the investment

restrictions’ blanket disallowance rule are easy to grasp. For

example, if a provider’s offshore captive insurer invested in

4

ten dividend-paying equity securities listed on a United States

stock exchange, placing 1% of its assets in each security, the

Secretary would reimburse the provider for all premiums paid

to the captive. But if the captive insurer invested 1% in

eleven divided paying U.S. equity securities, the Secretary

would refuse to reimburse the provider for a single penny of

its premiums. Likewise, if the captive invested 98% of its

assets in what the Manual defines as “low risk investments”

but placed 2% of its assets in a single U.S.-listed equity

security, the Secretary would deny any reimbursement. And

in both of these illustrations, the Secretary’s reimbursement

decision would not change even if the captive remained

solvent and paid substantial claims on behalf of the provider.

When the Secretary has established rigid all-or-nothing

approaches to reimbursement under section 1395x(v)(1)(A),

this court and others have rejected them as lacking any

rational connection to “reasonableness.” See, e.g., St. Mary of

Nazareth Hosp. Ctr. v. Schweiker, 718 F.2d 459, 467 (D.C.

Cir. 1983) (rejecting Manual section 2345 because “for all

practical purposes [it] would mean that hospitals would not be

reimbursed at all for the costs of rendering care to Medicare

patients in special care units. This result is ridiculous,

contrary to the letter of 42 U.S.C. § 1395x(v)(1)(A) . . . .”);

County of L.A. v. Sullivan, 969 F.2d 735, 741 (9th Cir. 1992)

(explaining that “because the 100% limitation unnecessarily

restricts reimbursement for ancillary services provided to

Medicare patients, we hold that it contravenes the statutory

requirements that the Secretary reimburse the hospitals for

their reasonable costs and not shift Medicare patients’ costs to

non-Medicare patients or the hospitals themselves”); Nw.

Hosp., Inc. v. Hosp. Serv. Corp., 687 F.2d 985, 992 (7th Cir.

1982) (holding a “blanket disallowance of related-party

interest expense . . . is broader than either the language or the

purpose of the Medicare statute can be construed to authorize

5

[where] the government concede[d] interest expense is

generally considered to be part of the ‘reasonable cost’ of

providing Medicare services”); see also Samaritan Health

Serv. v. Bowen, 811 F.2d 1524, 1531 (D.C. Cir. 1987) (noting

that “[u]nder § 1395x(v)(1)(A), the sanction for [a provider’s

request for reimbursement of] ‘high costs’ would be

nonreimbursement for the unduly high portion, not denial for

the whole fee”). The investment restrictions in section

2162.2.A.4 of the Manual are no less harsh than the blanket

disallowances struck down in prior decisions as exceeding the

Secretary’s “reasonable cost” authority under section

1395x(v)(1)(A).

The Manual itself reveals that the Secretary appreciates

the stark difference between a blanket disallowance and

application of section 1395x(v)(1)(A)’s “reasonable cost”

principle. For instance, in disallowing reimbursement of

luxury items or services, the Manual instructs that once the

intermediary has concluded a luxury item or service was

furnished to a patient, the “allowable costs must be reduced

by the difference between the costs of luxury items or services

actually furnished and the reasonable costs of the usual less

expensive items or services furnished by a provider to the

majority of its patients.” Manual ch.21 § 2104.3.C. The

Secretary has no credible explanation why reimbursement of

insurance premiums should be treated any differently.

The investment restrictions also do not accurately reflect

the “cost actually incurred” by a provider at the time it

submits the insurance premiums to its offshore captive.

Section 1395x(v)(1)(A) states “[t]he reasonable cost of any

services shall be the cost actually incurred.” 42 U.S.C. §

1395x(v)(1)(A) (emphasis added). A provider incurs the cost

of obtaining liability insurance coverage when it submits the

premiums to the offshore captive. Regardless of whether or

6

how the offshore captive subsequently invests the premiums

and regardless of whether the captive ever pays a claim, the

provider has “actually incurred” a cost of providing services

to Medicare patients at the moment it pays the premiums.

The Secretary’s reimbursement for the “reasonable cost” of

the provider’s liability insurance therefore should be a

function of the premiums paid, not of the coverage that the

offshore captive may eventually provide. The Secretary’s

investment restrictions thus are an inaccurate measure of the

provider’s cost “actually incurred” in obtaining insurance

coverage from its offshore captive and exceed her authority

under section 1395x(v)(1)(A).

This principle was explored extensively by a number of

courts after the Secretary, in 1979, promulgated a new

regulation for calculating reimbursement of providers’

malpractice insurance premiums (the Malpractice Rule). See

Menorah Med. Ctr. v. Heckler, 768 F.2d 292, 293 (8th Cir.

1985). Providers successfully challenged the Malpractice

Rule before many courts as exceeding the Secretary’s

authority under section 1395x(v)(1)(A). See, e.g., id. at 296

(noting Secretary could not prove “a system of reimbursing

malpractice premiums based solely on the proportion of

malpractice losses will accurately reflect premium costs”);

Bedford County Mem’l Hosp. v. Health & Human Servs., 769

F.2d 1017, 1023–24 (4th Cir. 1985) (holding the Malpractice

Rule contrary to section 1395x(v)(1)(A) because “[b]y basing

reimbursement of malpractice costs solely on loss history, the

Secretary has failed to take account of administrative

expenses, a disproportionate share of which will be borne by

non-Medicare patients under the Secretary’s system”).

In striking down the Malpractice Rule, one court

perceptively explained why the Secretary’s approach to

reimbursement was inconsistent with insurance cost

7

principles: “[T]he Malpractice Rule violates the Medicare Act

[by] fail[ing] to recognize that malpractice insurance protects

against the risk of future loss. Even if a provider has never

incurred any actual malpractice losses, for example, it must

still purchase malpractice insurance because of the risk that

losses will be incurred in the future.” St. James Hosp. v.

Heckler, 760 F.2d 1460, 1472 (7th Cir. 1985). The court

noted that “[t]he carrying of malpractice insurance must be

deemed a reasonable cost, and thus reimbursable by

Medicare, regardless of whether a hospital has paid one dollar

or one million dollars in malpractice claims over the relevant

five-year period.” Id. Thus, “[t]o the extent that the

Malpractice Rule does not reimburse these costs, . . . it

violates the Medicare Act’s mandate that providers are

entitled to government reimbursement for the ‘reasonable

cost’ of the services they provide for Medicare patients.” Id.

When we considered a challenge to the Malpractice Rule,

we were more cautious than many courts. See Walter O.

Boswell Mem’l Hosp. v. Heckler, 749 F.2d 788, 799 (D.C.

Cir. 1984). We recognized the Malpractice Rule required the

Secretary to reconcile the statutory obligation to reimburse

reasonable costs with the related obligation to prevent cross-

subsidization between Medicare and non-Medicare patients.

See id. at 799–800. Recognizing the tension between section

1395x(v)(1)(A)’s reasonable cost and cross-subsidization

requirements, we remanded the case to the district court

because the agency had failed to consider an alternative to the

Malpractice Rule—separate pools of risk for Medicare and

non-Medicare patients—that might more accurately reflect the

actual Medicare costs incurred by the providers. Id. at 802–

03. However, we still required the Secretary’s approach to be

consistent with both the reasonable cost and cross-

subsidization requirements, and with the ultimate purpose of

fairly reimbursing hospitals for their Medicare-related

8

insurance premiums. See id. at 801 (noting Secretary’s

interpretation of the Medicare statute to deny hospitals “some

of their premium costs” was not arbitrary and capricious

because “paying the percentage of premiums reflecting losses

from Medicare patients would in the long run fairly

compensate the insurance companies for their expenses, and

thus would fairly reimburse the hospitals for necessary

expenditures”).

In contrast to the Malpractice Rule, the investment

restrictions here blatantly contravene section 1359x(v)(1)(A)

by preventing the hospitals from obtaining any reimbursement

of their insurance premiums, while at the same time forcing

the hospitals’ non-Medicare patients to pay all of the cost of

purchasing liability insurance coverage for Medicare patients,

thereby violating section 1395x(v)(1)(A)’s prohibition on

cross-subsidization. The courts that found the Malpractice

Rule problematic undoubtedly would be even more troubled

by section 2162.2.A.4 of the Manual since it makes no

attempt to fairly approximate the provider’s costs for

obtaining insurance coverage if the offshore captive has failed

to comply with one or more of the investment restrictions.

Furthermore, the Secretary has utterly failed to explain

why it is unreasonable for a provider to purchase insurance

coverage from an offshore captive that fails to invest

according to the Secretary’s mandate. One does not have to

be a hedge fund manager to recognize it may be extremely

unreasonable to invest one’s assets as dictated by the Manual

provision. A captive insurer, like any other prudent investor,

may need to adjust its investment portfolio multiple times in a

given year to respond to changing market conditions. What

may be a wise investment one year may be foolish the next.

If it is often reasonable for an offshore captive to invest its

assets contrary to the investment restrictions in the Manual

9

provision, then it can hardly be unreasonable for a provider to

pay premiums to the captive. And as the hospitals note,

Medicare does not reimburse providers for malpractice

claims, so the providers have every incentive apart from the

Secretary’s involvement to ensure they receive coverage from

their insurers. The close alignment of interests between a

provider and its captive insurer only adds to this incentive.

The senselessness of punishing a provider for the investment

decisions of its offshore captive insurer is underscored by the

irrational nature of the investment restrictions themselves.

The Secretary’s primary justification for the restrictions

is that they are necessary to ensure offshore captives maintain

sufficient reserves to pay future claims on behalf of Medicare

providers. See Appellee’s Br. at 23–24. The Secretary

argues, “On a very practical level, [insurance premium]

costs—even if in line with those paid by other, similarly

situated providers—can be considered ‘reasonable’ only if

they actually purchase reliable coverage for the insured

providers.” Id. at 23. Unmasked, however, the Secretary is

asserting section 1395x(v)(1)(A) permits her to micromanage

the investment decisions of offshore captive insurers, despite

her lack of expertise in either investment strategy or

insurance. See St. Mary of Nazareth Hosp. Ctr., 718 F.2d at

466 (declining to defer to Secretary’s statutory interpretation

announced in Manual provision where agency’s expertise was

not implicated). The Medicare statute grants the Secretary

authority to administer a reimbursement program for

providers, not authority to establish an investment

management program for vendors. It is unsurprising then that

the Secretary’s interpretation is far afield from Congress’

intent for section 1395x(v)(1)(A) to meet providers’ actual

costs, both direct and indirect, of providing services to

Medicare patients. See S. Rep. No. 89-404 (1965), reprinted

in 1965 U.S.C.C.A.N. 1943, 1976 (June 30, 1965) (“The

10

provision in the bill for payment of the reasonable cost of

services is intended to meet the actual costs, however widely

they may vary from one institution to another, except where a

particular institution’s costs are found to be substantially out

of line with those of institutions similar in size, scope of

services, utilization, and other relevant factors.”).

In sum, although the Secretary has broad authority under

section 1395x(v)(1)(A) to define the “reasonable cost,” this

authority is not unlimited, and the investment restrictions in

the Manual provision are clearly outside its scope. This case

does not require us to determine what may be the outer limits

of the Secretary’s authority. Because the Manual provision

has no discernible nexus with the Secretary’s authority to

determine reimbursement of “reasonable costs” under section

1395x(v)(1)(A), it is invalid.

III

The court’s opinion raises several issues warranting a

response. First, because the Manual provision exceeds the

Secretary’s authority, we need not and, indeed, should not

address whether the provision should have been passed

through notice-and-comment rulemaking. The court

describes the notice-and-comment issue as “antecedent” to the

question of the Secretary’s statutory authority, Maj. Op. at 8.

Not so. Where the agency has acted outside its statutory

authority, notice and comment is no cure for the disease. See

Lyng, 476 U.S. at 937; Transohio, 967 F.2d at 621. In

contrast, a holding that the agency has exceeded its statutory

authority negates any need to delve into the notice-and-

comment issue. See Am. Bus Ass’n v. Slater, 231 F.3d 1, 7–8

(D.C. Cir. 2000) (“Because we hold [the agency] had no

authority to promulgate that rule in the first instance, the

Court finds it unnecessary to take up [appellant’s] notice-and-

11

comment claim. The agency has exceeded the scope of the

authority delegated to it by Congress, and it matters not that

they adhered to the APA’s procedural requirements in doing

so.”). Thus it was pointless for the hospitals to argue the

Manual provision should have been passed by notice-and-

comment rulemaking when it plainly exceeded the Secretary’s

authority. This explains why the hospitals raised the notice-

and-comment issue in a single footnote of their opening brief,

see Appellants’ Br. at 32 n.13, or as the court describes it,

“without much elaboration,” Maj. Op. at 8, while devoting the

lion’s share of their briefs to challenging the Secretary’s

statutory authority. And counsel for the hospitals confirmed

this was their position at oral argument:

The Court: So your position is that if [the Secretary]

had gone through a notice-and-comment

rulemaking and received whatever

substantial evidence support what appears in

the Manual, that even then [she] couldn’t

promulgate this rule?

Counsel: . . . That is both our position and,

obviously, the logical import of our

position.

Oral Arg. Recording at 11:21–40.

The hospitals paid the insurance premiums for which

they seek reimbursement during the period from 1997 to

2002. The Board conducted a hearing on the hospitals’

appeal from the intermediary’s denial of reimbursement in

2004 but did not issue its decision until 2007. The district

court issued its decision in 2009. It is time for this dispute to

end. Fortunately for the hospitals, the court’s opinion should

allow for quick resolution of their reimbursement claims,

12

since, even if the investment restrictions are passed through

notice-and-comment procedures, the Secretary will be unable

to apply them retroactively to the hospitals. See Bowen v.

Georgetown Univ. Hosp., 488 U.S. 204, 208–213 (1988)

(holding Secretary lacks authority under section

1395x(v)(1)(A) to promulgate cost-limit rules with retroactive

effect). Nevertheless, there is no good reason for the court to

give the Secretary the opportunity to prospectively

promulgate a rule implementing precisely the same

restrictions when she has offered no basis to believe her

statutory authority reaches that far in the first place. See PIA-

Asheville, Inc. v. Bowen, 850 F.2d 739, 740–41 (D.C. Cir.

1988) (noting “the Secretary offers no new substantive

justification for his erstwhile policy, but instead claims that

the existence of the new regulation incorporating that policy

should change our view” and rejecting this argument where

court had held in prior decision that the policy violated the

statutory requirement to reimburse reasonable costs). Instead,

we should do as courts ordinarily do and answer the question

the parties have put before us—particularly since that answer

would resolve this dispute for good.

Second, the court’s opinion may cause unintended and

unwelcome consequences by calling into question the

procedural legitimacy of many other provisions in the

Manual. In Shalala v. Guernsey Memorial Hospital, the

Supreme Court affirmed the Secretary’s use of the Manual to

provide guidance to providers and intermediaries, describing

its interpretive rules as part of “a sensible structure for the

complex Medicare reimbursement process,” 514 U.S. 87, 101

(1995). As we have noted, the Court in Guernsey explained

the Secretary “does not have a statutory duty to promulgate

regulations that ‘address every conceivable question in the

process of determining equitable reimbursement.’ Rather, for

‘particular reimbursement details not addressed by’

13

regulations, [the Secretary] properly ‘relies upon an elaborate

adjudicative structure which includes the right to review by

the [Board].’” Tenet HealthSystems HealthCorp. v.

Thompson, 254 F.3d 238, 248 (D.C. Cir. 2001) (quoting

Guernsey, 514 U.S. at 96).

The court’s opinion ignores Guernsey’s test for whether a

Manual provision must be promulgated by notice-and-

comment rulemaking. See Guernsey, 514 U.S. at 100 (noting

“APA rulemaking would still be required if [the Manual

provision] adopted a new position inconsistent with any of the

Secretary’s existing regulations [but the Manual provision]

does not . . . effec[t] a substantive change in the regulations”)

(internal quotation marks omitted). Moreover, the court fails

to identify clear limiting principles by which the Secretary

and providers can distinguish Manual section 2162.2.A.4

from other Manual provisions. For instance, the court states,

“[T]he process of announcing propositions that specify

applications of [vague] terms [such as “just and reasonable”]

is not ordinarily one of interpretation, because those terms in

themselves do not supply substance from which the

propositions can be derived.” Maj. Op. at 9 (internal

quotation marks omitted). But this perspective fails to

account for the way complex regulatory regimes such as

Medicare really work. The Secretary relies on a hybrid of

rulemaking and adjudication—an approach approved by the

Court in Guernsey. See 514 U.S. at 96–97 (“The APA does

not require that all the specific applications of a rule evolve

by further, more precise rules rather than by adjudication.

The Secretary’s mode of determining benefits by both

rulemaking and adjudication is, in our view, a proper exercise

of her statutory mandate.”). Interpretive rules are the glue

that holds this regulatory structure together. The Secretary’s

administration of the Medicare program frequently calls for

specific applications of vague statutory terms, including

14

“reasonable cost,” and, as we have noted, “an agency may use

an interpretive rule to transform a vague statutory duty or

right into a sharply delineated duty or right.” Cent. Tex. Tel.

Co-op, Inc. v. FCC, 402 F.3d 205, 256 (D.C. Cir. 2005); see

also id. (“[A]n interpretive rule does not have to parrot

statutory or regulatory language but may have the effect of

creating new duties.”).

By ignoring these principles, the court’s opinion calls

into question many other provisions in the Manual. See, e.g.,

Manual ch.2 § 215.1 (“An exception to this limitation is

permitted when the debt cancellation costs are less than 50

percent of the amount of interest cost and amortization

expense that would have been allowable in that period had the

indebtedness not been cancelled, in which case, the full

amount will be allowable in the period incurred.”); id. ch.21,

§ 2162.5 (establishing a 10% test for determining when losses

relating to insurance deductible are allowable costs); id.

ch.21, § 2109.2.D (“The allowance for membership in

professional associations and continuing medical education is

limited to the lesser of actual cost or 5 percent of the

applicable [Reasonable Compensation Equivalent] base

amount.”); id. ch.22 § 2208.1.E (establishing the specified

percentages for the per diem method of cost apportionment as

93% for short-term hospitals and 98% for long-term

hospitals); id. ch.22 § 2202.7.II.A.5 (“A minimum nurse-

patient ratio of one nurse to two patients per patient day must

be maintained . . . .”).

As the Secretary’s counsel explained during oral

argument, “Guernsey . . . stands for the proposition that the

technical specifics of the application of the broad Medicare

standards are appropriately resolved through adjudication by

the agency with the Manual guideline as a tool . . . .” Oral

Arg. Recording at 21:22–51. In light of Guernsey’s

15

endorsement of the Secretary’s “sensible structure” for

administering the Medicare program, courts should refrain as

much as possible from tinkering with this regulatory

framework. See Nat’l Med. Enters., Inc. v. Shalala, 43 F.3d

691, 693, 696–97 (D.C. Cir. 1995) (deciding Manual section

2203 which “provide[d] a three-part guide for allocating costs

to routine or ancillary centers” was an interpretive rule rather

than a substantive rule requiring notice and comment);

Sentara-Hampton Gen. Hosp. v. Sullivan, 980 F.2d 749, 759–

60 (D.C. Cir. 1992) (per curiam) (holding Manual provision

not subject to notice-and-comment rulemaking). Invalidating

the Manual provision as exceeding the Secretary’s authority

thus is less intrusive than declaring the provision must be

enacted, if at all, by notice-and-comment rulemaking. The

first approach affects only the investment restrictions while

the second casts doubt upon the procedural legitimacy of the

Manual as a whole.

* * *

The investment restrictions in the Manual provision are

beyond the Secretary’s authority because they have no

connection to the “reasonable cost” language in section

1395x(v)(1)(A) of the Medicare statute. I would hold the

provision invalid on that basis alone.