Texas Neighborhood Services v. HHS

United States Court of Appeals

FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued May 5, 2017 Decided August 8, 2017

No. 16-5150

TEXAS NEIGHBORHOOD SERVICES,

APPELLANT

v.

UNITED STATES DEPARTMENT OF HEALTH AND H UMAN

SERVICES AND THOMAS E. PRICE, IN HIS OFFICIAL CAPACITY AS

SECRETARY OF HHS,

APPELLEES

Appeal from the United States District Court

for the District of Columbia

(No. 1:14-cv-01545)

Alexandra R. Rosenblatt argued the cause for appellant.

With her on the briefs were Edward T. Waters and Christopher

J. Frisina.

Joshua M. Kolsky, Assistant U.S. Attorney, argued the

cause for appellees. With him on the brief was R. Craig

Lawrence.

Before: T ATEL, PILLARD and WILKINS, Circuit Judges.

Opinion for the Court filed by Circuit Judge PILLARD.

2

PILLARD , Circuit Judge: Year-end performance bonuses

can be a useful tool for motivating employees, so long as the

employees know in advance that the quality of their work will

be reflected in their paychecks. The federal government

accordingly allows federal grantees to award performance

bonuses that are reasonable, announced in advance, and

adequately documented. Between 2010 and 2012, plaintiff

Texas Neighborhood Services received Head Start grant

money to provide childcare services to low-income families in

Texas. During that time, Neighborhood Services used $1.3

million in federal funds to award performance bonuses to its

staff. In 2013, the Department of Health and Human Services

(HHS), which administers Head Start grants, required

Neighborhood Services to repay the bonus money to the

government, explaining that the bonuses were unreasonable

and inadequately documented. After the repayment decision

was sustained by HHS’s Departmental Appeals Board

(Appeals Board or Board), Neighborhood Services filed suit,

arguing that the Appeals Board’s ruling was arbitrary and

capricious in violation of the Administrative Procedure Act

(APA). Finding no prejudicial error in the Board’s decision,

the district court rejected the APA challenge. We affirm.

I.

HHS’s Administration for Children and Families (the

Administration) provides grants to Head Start organizations

across the country to support their provision of “health,

education, parental involvement, nutritional, social, and other

services” to low-income, preschool-aged children. 42 U.S.C.

§ 9833; see 45 C.F.R. §§ 1301.1 et seq. The Office of

Management and Budget’s Circular A-122 (OMB Circular or

Circular) explains when and how the government will

reimburse federal grantees, including organizations receiving

Head Start money, for different types of expenses. See 2 C.F.R.

3

Pt. 230 (2007).1 For our purposes, the key provisions in the

Circular are those governing employee salaries and

performance bonuses.

The OMB Circular’s salary and bonus provisions

authorize federal grantees to use performance bonuses to

motivate their staffs, so long as: (1) the “overall compensation”

paid to employees—including performance bonuses—is

“reasonable,” 2 C.F.R. Pt. 230, App. B ¶ 8.j; (2) the bonuses

are paid “pursuant to an agreement entered into in good faith

between the organization and the employees before the services

were rendered, or pursuant to an established plan followed by

the organization so consistently as to imply, in effect, an

agreement to make such payment,” id.; and (3) the incentive

payments are “adequately documented,” id., App. A ¶ A.2.g.

If a grantee does not follow those rules in awarding

performance bonuses, HHS may disallow—i.e., refuse to cover

the cost of—the bonuses. See id., App. A ¶ A.2, App. B ¶ 8.j.

In 2007, Neighborhood Services decided to develop a way

to use performance bonuses to motivate its employees. The

Neighborhood Services Board of Directors adopted an

Incentive Compensation Policy (the 2007 Policy), which

contemplated that senior Neighborhood Services staff would

develop a “plan” for rewarding “consistent or exemplary job

performance.” J.A. 100. Two years later, senior staff

announced the 2009 Plan: Neighborhood Services staff would

implement a series of “cost reductions,” with a goal of

operating at 95% of its annual budget and, if those cost

reduction strategies were effective, Neighborhood Services

would use the savings to implement an “incentive” system.

J.A. 103. Under that system, Neighborhood Services would

1

At all relevant times, the Circular was codified at 2 C.F.R. Pt. 230.

We will therefore cite Pt. 230 throughout this opinion, even though

the Circular is now codified at 45 C.F.R. §§ 75.400 et seq.

4

use a “matrix” to assess employee performance, rewarding

“superior”-rated employees with more generous bonuses than

employees with “average or below average” performance

records. J.A. 103.

In February 2013, the Administration conducted a

“monitoring review” of Neighborhood Services’s use of

federal funds in Fiscal Years 2010 through 2012 (FY 2010-

2012). J.A. 86, 90-91. That review resulted in a Monitoring

Report. Among the Report’s negative findings was an

allegation that Neighborhood Services had issued performance

bonuses without taking adequate steps to ensure that “overall

compensation” for its employees was reasonable and without

“document[ing] the basis for amounts awarded as incentive

compensation,” as required by the OMB Circular. J.A. 90

On September 19, 2013, the Administration sent

Neighborhood Services a letter stating that, in light of the

Monitoring Report’s conclusion that Neighborhood Services

had paid performance bonuses in violation of the OMB

Circular, the Administration would disallow the $1,332,698.09

in federal funds that Neighborhood Services had used to issue

the bonus checks (the Disallowance Letter). See J.A. 82-83.

The Disallowance Letter instructed Neighborhood Services to

repay that amount to the government.

Neighborhood Services appealed the Disallowance Letter

to the Appeals Board, which rejected the challenge. The Board

explained that Neighborhood Services failed to carry its burden

of demonstrating that the performance bonuses were

reasonable. The Board emphasized that Neighborhood

Services had not established that it was reasonable to pay a

relatively large percentage of employees’ overall

compensation as performance bonuses. Further, based on

Neighborhood Services’s own documentation, the Board found

5

that it had not consistently given higher bonuses to employees

who performed better than their peers. The lack of correlation

between employees’ performance and the size of their bonuses

suggested that the monetary awards were “based on factors

such as favoritism, rather than performance.” Id. at 311.

Regardless of whether such favoritism was barred by

Neighborhood Services’s own policies, the Board concluded,

the suggestion that favoritism motivated bonus decisions might

have turned the awards into a “disincentive rather than an

incentive to achieve superior performance,” so the awards

could not be considered reasonable under the OMB Circular.

Id.

The Appeals Board also concluded that Neighborhood

Services’s documents established that the organization “either

did not follow its incentive compensation policies when

making [performance] awards or failed to provide adequate

documentation to support the awards.” J.A. 305. According to

its documents, Neighborhood Services had codified its

incentive compensation system in the 2007 Policy and 2009

Plan. Nevertheless, the record contained evidence that

Neighborhood Services routinely disregarded that system. For

example, Neighborhood Services’s 2009 Plan stated that the

organization should use its performance matrix to determine

how large employees’ bonuses should be. Yet employees’

matrix scores did not correlate with the size of their bonuses.

Similarly, while the 2009 Plan stated that performance bonuses

for “superior work performance” should be “higher than for

average or below average perform[ance],” J.A. 103, the record

showed that, in FY 2010, Neighborhood Services gave each

permanent, non-managerial employee a bonus “equal to 160

hours of his or her unit pay,” regardless of how he or she

performed, J.A. 305. In light of that evidence, the Appeals

Board concluded that Neighborhood Services had either

ignored its incentive compensation policy or had failed to

6

introduce enough documentary evidence to show that—despite

appearances—Neighborhood Services was in fact following

that policy.

After the Appeals Board issued its initial decision,

Neighborhood Services sought reconsideration, arguing that

the Board had used the incorrect legal standards to determine

whether Neighborhood Services had complied with the

incentive compensation provisions in the OMB Circular. The

Board denied Neighborhood Services’s motion. Neighborhood

Services then sued HHS in district court, arguing that the

Board’s decision was arbitrary and capricious in violation of

the APA, 5 U.S.C. § 706(2)(a). See Tex. Neighborhood Servs.

v. U. S. Dep’t of Health & Human Servs., 172 F. Supp. 3d 236

(D.D.C. 2016). Embracing the Board’s analysis, the district

court granted HHS’s motion for summary judgment, and this

appeal followed.

II.

We review the district court’s grant of summary judgment

de novo. See Se. Ala. Med. Ctr. v. Sebelius, 572 F.3d 912, 916

(D.C. Cir. 2009). Like the district court, we defer to the

agency, asking only whether the Appeals Board’s action was

“arbitrary, capricious, an abuse of discretion, or otherwise not

in accordance with law.” 5 U.S.C. § 706(2)(a). The scope of

review under the arbitrary and capricious standard is “narrow”

and we cannot “substitute [our] judgment for that of the

agency.” Motor Vehicle Mfrs. Ass’n of the U.S., Inc. v. State

Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983). We must

ensure that the agency “examine[d] the relevant data and

articulate[d] a satisfactory explanation for its action including

a rational connection between the facts found and the choice

made.” Id. (internal quotation marks omitted). Agency action

is arbitrary and capricious “if the agency has relied on factors

7

which Congress has not intended it to consider, entirely failed

to consider an important aspect of the problem, offered an

explanation for its decision that runs counter to the evidence

before the agency, or is so implausible that it could not be

ascribed to a difference in view or the product of agency

expertise.” Id.

Neighborhood Services contends that the Appeals Board’s

decision was arbitrary and capricious for four reasons: (1) the

Board overlooked the OMB Circular’s provision that

compensation is reasonable if it is comparable to that for

similar work in the same labor market; (2) the Board

disallowed the performance bonuses based on the theory that

the bonuses were inconsistent with Neighborhood Services’s

internal policies when, Neighborhood Services contended,

HHS had not asserted that theory in its briefing; (3) the Board

found that the performance bonuses were inadequately

documented, even after Neighborhood Services provided all of

the documentation required by Board precedent and by the

Disallowance Letter; and (4) the Board held that Neighborhood

Services’s bonuses collectively violated the Circular, rather

than considering whether each individual bonus was consistent

with the Circular’s requirements. We agree that the Board

failed adequately to grapple with the Circular’s definition of

reasonable compensation when it assessed the reasonableness

of Neighborhood Services’s bonuses, but we conclude that

error was harmless. Because we see no other arbitrariness in

the Board’s decision, we affirm the district court’s judgment.

A.

As noted above, the OMB Circular provides that a grantee

can only award performance bonuses to its employees if the

employees’ “overall compensation” is “reasonable.” 2 C.F.R.

Pt. 230, App. B ¶ 8.j. A grantee bears the burden of showing

8

that compensation satisfies that reasonableness standard. See,

e.g., Tex. Migrant Council, Inc., DAB No. 1743, 2000 WL

1310757, at *2-3 (Dep’t of Health & Human Servs. Sept. 7,

2000).

To determine whether compensation for Neighborhood

Services employees was reasonable, the Appeals Board looked

to Appendix A of the Circular, which provides that “[a] cost is

reasonable if, in its nature or amount, it does not exceed that

which would be incurred by a prudent person under the

circumstances.” 2 C.F.R. Pt. 230, App. A ¶ A.3. The Board

then considered Neighborhood Services’s only evidence that it

had compensated its employees in a prudent manner: A “wage

comparability study” showing that Neighborhood Services’s

overall wage payments to employees were less than or roughly

equal to wages paid by similar organizations in the same

geographic area. J.A. 310. The Board found that the study was

not dispositive because it did not address whether it was

reasonable for a daycare center to pay employees relatively low

base salaries combined with relatively large bonuses (as

Neighborhood Services did). The Board therefore concluded

that Neighborhood Services had not carried its burden of

demonstrating that its total employee compensation was

reasonable.

Neighborhood Services contends that the Appeals Board

arbitrarily applied the Circular’s general standard for

reasonable costs in Appendix A, rather than the specific

standard for reasonable compensation set out in Appendix B.

As just noted, the general cost standard asks what a prudent

person would pay under the circumstances, 2 C.F.R. Pt. 230,

App. A ¶ A.3, whereas under the compensation-specific

standard, compensation is “reasonable to the extent that it is

comparable to that paid for similar work in the [same] labor

market[].” Id., App. B ¶ 8.c.2. Applying the principle that

9

specific rules typically displace general rules on the same

subject, see, e.g., RadLAX Gateway Hotel, LLC v.

Amalgamated Bank, 566 U.S. 639, 645 (2012); Nevada v.

Dep’t of Energy, 400 F.3d 9, 16 (D.C. Cir. 2005),

Neighborhood Services argues the Board should have confined

its reasonableness analysis to the question whether, when the

incentive compensation and base pay were considered together,

Neighborhood Services paid its employees an amount that was

“comparable to that paid for similar work in the [same] labor

market[].” 2 C.F.R. Pt. 230, App. B ¶ 8.c.2. From

Neighborhood Services’s perspective, its wage comparability

study was dispositive of that question, because it conclusively

showed Neighborhood Services employees earned the same or

less overall compensation than individuals performing “similar

work” at other daycare centers in the area.

We need not decide whether the Appeals Board should

have given the definition of reasonable compensation

precedence over the general definition of reasonable costs or

whether there is any difference between the two that might be

material here. For our purposes, it is enough to note that the

Board did not grapple with both standards; rather, it looked

principally at the reasonableness of bonus payments as a

percentage of total compensation, and failed to consider

whether overall compensation was nonetheless reasonable

because it was comparable to that paid for similar work in the

relevant market. By disregarding a definition that was “still on

the books,” the Board acted arbitrarily. FCC v. Fox Television

Stations, Inc., 556 U.S. 502, 515 (2009).

Nevertheless, we conclude that the Board’s error was

harmless. See 5 U.S.C. § 706 (instructing courts reviewing

agency action to apply “the rule of prejudicial error”). As we

will explain below, the Board reasonably concluded that

Neighborhood Services either failed to follow its stated

10

incentive compensation policies or, at least, failed to provide

adequate documentation to prove that it had followed its

policies. And that conclusion amply supported the decision to

disallow Neighborhood Services’s bonus payments. See

Bally’s Park Place, Inc. v. NLRB, 646 F.3d 929, 939 (D.C. Cir.

2011) (“[W]hen an agency relies on multiple grounds for its

decision, some of which are invalid, we may nonetheless

sustain the decision as long as one is valid and the agency

clearly would have acted on that ground even if the other[s]

were unavailable.” (internal quotation marks omitted)).

B.

According to Neighborhood Services, the Appeals Board

also acted arbitrarily by considering whether Neighborhood

Services consistently followed its agreement or plan to pay

performance bonuses without soliciting briefing from the

parties on that issue. Neighborhood Services claims that the

Board’s decision of that issue betrayed its partiality toward the

Administration. At the same time, Neighborhood Services

insists, the Board denied Neighborhood Services the

“opportunity to rebut” the argument that it was not consistently

following its own policies. Appellant Br. 19.

But the issue was briefed. The Appeals Board

appropriately resolved the parties’ long-running dispute over

whether Neighborhood Services adequately showed it was in

practice following its written bonus policies. As noted above,

a grantee like Neighborhood Services can only award

performance bonuses to its employees if the bonuses are

“adequately documented.” 2 C.F.R. Pt. 230, App. A ¶ A.2.g.

Bonuses cannot be considered “adequately documented”

unless a grantee maintains sufficient documents to prove that

the bonuses are “allowable,” i.e., consistent with applicable

regulations. Touch of Love Ministries, Inc., DAB No. 2393,

11

2011 WL 3251319, at *3 (Dep’t of Health & Human Servs.

June 29, 2011). Neighborhood Services’s bonuses thus could

not be considered adequately documented unless

Neighborhood Services maintained documents sufficient to

show that its bonuses were paid pursuant to an “agreement” or

“established plan,” as required by 2 C.F.R. Pt. 230, App. B

¶ 8.j.

Both parties addressed that issue in their briefs to the

Appeals Board. The Administration argued that Neighborhood

Services’s documents were inadequate because they failed to

show that Neighborhood Services complied with written

policies; in fact, the documents showed that Neighborhood

Services disregarded those policies on several occasions. For

example, the Administration explained, in FY 2010,

Neighborhood services paid all of its non-management

employees the same size bonuses, in violation of “the 2009

Plan.” J.A. 251. Similarly, Neighborhood Services awarded

bonuses to employees who had only received ‘C’ grades, which

was “not consistent” with Neighborhood Services’s policy “to

reward ‘[consistent or] exemplary job performance.’” J.A.

252. In its reply brief, Neighborhood Services challenged that

characterization of its documents, claiming that the documents

showed Neighborhood Services’s compliance with “its

established policies.” J.A. 282. As discussed in more detail in

the next subsection, the Appeals Board ultimately sided with

the Administration. While Neighborhood Services may have

been unhappy with that decision, it cannot claim that it lacked

notice or a chance to address the point.

C.

Neighborhood Services also contends that the Appeals

Board acted arbitrarily when it concluded that the performance

bonuses were inadequately documented, despite the fact that

12

Neighborhood Services provided all of the documentation

Board precedent required. Neighborhood Services explains

that, in Seaford Community Action Agency, DAB No. 1433,

1993 WL 742548, at *3-4 (Dep’t of Health & Human Servs.

Aug. 17, 1993), the Board allowed reimbursement of most of

the performance bonuses paid by a grantee who had provided

“payroll registers, minutes of Policy Council meetings,

evaluation sheets, and lists of awardees” showing that the

bonuses were awarded to employees who had performed

above-average work. Neighborhood Services insists that it

provided at least as much documentation to support its

performance bonuses as the grantee in Seaford, and as a result,

it was arbitrary for the Board to hold that Neighborhood

Services’s bonuses were insufficiently documented. See

Etelson v. Office of Pers. Mgmt., 684 F.2d 918, 926 (D.C. Cir.

1982) (“Government is at its most arbitrary when it treats

similarly situated people differently.”).

As the Board recognized, however, the key question in this

case is not whether Neighborhood Services submitted the same

type of documents as the grantee in Seaford, but whether the

documents in Neighborhood Services’s files painted the same

kind of picture as the documents at issue in Seaford.

Answering that question in the negative, the Board noted that

the documents in Seaford showed substantial compliance with

the terms of the OMB Circular. By contrast, the documents

submitted by Neighborhood Services were prima facie

evidence that Neighborhood Services had entirely disregarded

its bonus policy for several years in a row, in violation of 2

C.F.R. Pt. 230, App. B ¶ 8.j. Thus, it was reasonable for the

Board to conclude that, unlike the grantee in Seaford,

Neighborhood Services had not submitted documentation

sufficient to show that it had complied with relevant rules and

regulations. See Muwekma Ohlone Tribe v. Salazar, 708 F.3d

209, 216 (D.C. Cir. 2013) (suggesting that agency action is not

13

arbitrary if the agency offers good reasons for treating

regulated parties differently).

Additionally, Neighborhood Services argues that the

Appeals Board arbitrarily countenanced the Administration’s

“escalating demands for documentation.” Appellant Br. 23. In

its Disallowance Letter, the Administration contended that the

bonuses were inadequately documented because

Neighborhood Services had not submitted documents showing

precisely how much money each employee received. The

Disallowance Letter also faulted Neighborhood Services for

failing to produce “plans of performance” to show how

individual employees had performed over the course of the

year. J.A. 82.

In its opening brief to the Board, Neighborhood Services

laid out its response to the Disallowance Letter’s concerns: It

provided payroll documents showing the magnitude of each

employee’s bonus and clarified that it did not keep “individual

plans of performance” for specific workers; instead,

Neighborhood Services used a single matrix to reflect its

evaluation of all employees. J.A. 77. Neighborhood Services

submitted a copy of the matrix along with its brief.

Neighborhood Services contends that, after it thus

responded to the Disallowance Letter, the Administration

“moved the goalposts” and requested more records. Appellant

Br. 23. The Administration countered before the Board that

Neighborhood Services should have produced data sufficient

to show how it had calculated each employee’s matrix score.

With its reply brief, Neighborhood Services provided sample

data for one of its employees, but the Board held that the

sample failed to show that the bonuses had been adequately

documented. Neighborhood Services claims that, had it been

given clear notice that Board would want to see the data

14

underlying the matrix scores, it could have provided that

information, but the Board arbitrarily deprived Neighborhood

Services of the opportunity to do so.

While it is true that the Administration requested one set

of documents in the Disallowance Letter and then requested

more in its brief to the Board, it was neither unlawful nor unfair

for the Administration to proceed in that manner. Under Board

precedent, the Administration is allowed to make new

arguments and requests in its brief to the Board, so long as

“there is [an] opportunity during the Board’s process for the

grantee to respond.” Neb. Health & Human Servs. Sys., DAB

No. 1660, 1998 WL 354969, at *5 (Dep’t of Health & Human

Servs. May 26, 1998). That rule tracks the requirements of the

Due Process Clause, which guarantees regulated parties a

meaningful opportunity to respond to the allegations against

them. See Partington v. Houck, 723 F.3d 280, 289 (D.C. Cir.

2013) (Due Process Clause).

Indeed, it is a matter of simple logic that, when an agency

points out apparent inconsistencies like those the

Administration identified in Neighborhood Service’s

application of its incentive compensation policy, it is

incumbent on the grantee to provide a coherent explanation.

The particular documents capable of doing so might vary

depending on the nature of the inconsistencies. Here, we need

not determine precisely what type of documentation

Neighborhood Services needed to produce; we can simply note

that, if it had good answers as to why it paid all employees the

same bonuses when its policy called for bonus amounts keyed

to performance, or why employees with lower performance

scores received the same or larger bonuses than those who

scored higher, it was up to Neighborhood Services to make its

case. Its failure was not for want of opportunity.

15

Neighborhood Services had multiple chances to submit

individual performance evaluations, explanatory memos

regarding the apparent disconnect between matrix scoring and

bonus levels, declarations by staff involved in implementing

the plan that described the process, or any other documents that

could have responded to the Administration’s request in its

brief to the Appeals Board. Neighborhood Services could have

submitted the relevant documents in its reply brief to the Board,

or appended them to its Motion for Reconsideration of the

Board’s decision, but it did not. Remanding this case to give

Neighborhood Services a third bite at the apple would only

encourage grantees to make half-hearted responses to

document requests, thereby encumbering the administrative

process of ensuring compliance with federal regulations.

D.

Finally, Neighborhood Services claims that the Board

acted arbitrarily by considering whether Neighborhood

Services’s bonuses collectively satisfied the terms of the OMB

Circular, rather than considering whether each individual

bonus was consistent with the Circular. Neighborhood

Services insists that, if “even one” of the incentive payments

was reasonable, consistent with the 2009 Plan, and adequately

documented, the Board should have allowed that payment.

Reply Br. 1. Under the circumstances of this case, the Board

reasonably held that a bonus-by-bonus analysis was

unnecessary because Neighborhood Services’s apparent

wholesale failures to follow its plan affected all of the bonus

payments.

As noted above, Neighborhood Services had an obligation

to produce enough documentation to show that its bonus

payments were paid pursuant to an “agreement” or “established

plan,” 2 C.F.R. Pt. 230, App. B ¶ 8.j, and the Board reasonably

16

concluded that Neighborhood Services failed to do so. As the

Board acknowledged, Neighborhood Services had a written

agreement or plan to pay performance bonuses to its

employees. Under Board precedent, however, a written

compensation agreement can be vitiated if an employer has a

“pattern over a number of years of violating [it],” Seaford,

DAB 1433, at *4 n.6. Similarly, a “plan” to make performance

bonuses may cease to qualify as a plan if it is not followed

“consistently.” 2 C.F.R. Pt. 230, App. B ¶ 8.j. The Board

reasonably concluded that Neighborhood Services’s

documents raised a strong inference that the organization

“failed to follow its compensation policies in many respects”

over a number of years. J.A. 308. Thus, the documents failed

to establish that Neighborhood Services had a functioning

bonus agreement or plan in place. And without evidence of an

agreement or plan that Neighborhood Services followed in

practice, none of Neighborhood Services’s bonuses were

allowable. See Seaford, DAB 1433, at *3-4.

***

Because Neighborhood Services failed to produce

documentation sufficient to show that it was awarding

performances in accordance with the OMB Circular, we affirm

the judgment of the district court.

So ordered.