Liberty Nursing Center, Inc. v. Department of Health & Mental Hygiene

ROBERT M. BELL, Judge. We granted certiorari to determine whether regulations pertaining to related organizations preclude reimbursing ⁴³⁶ the provider for interest paid to a non-related, commercial lender, pursuant to a loan the provider made to finance the purchase, from a related organization, of nursing home facilities. The Court of Special Appeals held that they do. Liberty Nursing Center, Inc. v. Dept. of Health & Mental Hygiene, 91 Md.App. 210, 220-21 , 603 A.2d 1344, 1348-49 , cert. granted, 328 Md. 35 , 612 A.2d 897 (1992).

We shall reverse. I. Liberty Nursing Center, Inc., t/a Granada Nursing Home (“Liberty”), the petitioner, is the operator of a 112 bed licensed nursing home in Baltimore City. It participates in the Maryland Medical Assistance Program (“Medicaid”), a State program partially funded by the federal government, which reimburses nursing homes for their patient related costs of medical care rendered to indigent or medically indigent persons. Almost 100 percent of Liberty patients receive medical assistance.

Michael DeFontes (“DeFontes”) currently owns 55 percent of Liberty, the remainder being owned by his brother. It was previously owned by DeFontes’s grandmother, Margaret Wessels, who also owned land and a building (“the facilities”), which she leased to Liberty for operation of the nursing home. After Wessels’s death, that lease was continued with, however, the Wessels estate as lessor. De-Fontes, who also is one of his grandmother’s heirs, qualified as personal representative of the estate.

In addition to the building and grounds leased to Liberty, the assets of the Wessels estate consisted of a personal residence, a promissory note, and other miscellaneous property. As a result, estate tax assessments totaled more than $400,000.00 — $373,012.30 for federal estate taxes and $37,-522.07 for Maryland estate taxes. Because the Wessels estate had insufficient liquid assets to pay them, counsel sought to postpone the payment of the federal estate taxes. That effort proved to be only partially successful, the IRS ⁴³⁷ agreed to defer payment for only one year, which prompted counsel to advise DeFontes that it would be necessary to sell the facilities to pay the estate taxes and close the estate.

Rather than sell to a third party, DeFontes purchased the facilities himself. He paid one million two hundred thousand dollars ($1,200,000) for them. The State had previously appraised the facilities, for Medicaid reimbursement purposes, at approximately two million dollars ($2,000,000). The purchase was financed with a loan DeFontes negotiated, at arms length, from First American Bank, at 11 percent interest and secured by a mortgage on the facilities.

De-Fontes has neither an ownership interest in, nor control of, First American Bank. As required by Medicare regulations, Liberty filed a cost report with the Maryland Medical Assistance Program at the end of the fiscal year. Included in that report as an allowable cost was an interest expense ($135,808) paid to First American Bank in connection with the DeFontes loan. Clifton, Gunderson & Company, the accounting firm under contract with the State of Maryland to perform audits of nursing homes cost reports, disallowed the interest on the grounds that Liberty, through DeFontes, and the Wessels estate were “related organizations.” Liberty appealed the proposed cost settlement incorporating this disallowance to the Nursing Home Appeal Board (“NHAB” or the “Board”). 1 When the Board affirmed, Liberty sought judicial review in the Circuit Court for Baltimore City, pursuant to Md.Code (1990, 1992 Cum.Supp.) § 15-108(f) of the Health General Article.

That court also affirmed, whereupon Liberty unsuccessfully appealed to the Court of Special Appeals. We granted its petition for certiorari to consider the important issue raised therein. ⁴³⁸ II. The Medicaid Program, Title XIX of the Social Security Act, 42 U.S.C. § 1396 et seq., which is subsidized by both state and federal funds, has as its purpose the provision of medical assistance to persons whose income and resources are insufficient to meet the cost of necessary medical care and services. See 42 U.S.C. § 1396 ; Md.Code (1990, 1992 Cum.Supp.) § 15-103 of the Health-Gen.

Article. It requires that providers of necessary medical care and services be reimbursed at “reasonable and adequate” rates, 42 U.S.C. § 1396a(a)(13)(A), which is the cost actually incurred, as determined in accordance with federal regulations, promulgated pursuant to the Medicare Program, Title XVIII of the Social Security Act, 42 U.S.C. § 1395 et seq., “establishing a method or methods to be used, and the items to be included[.]” 42 U.S.C. § 1395x(v)(l)(A). The regulations provide that, to be reimbursable, costs must be “reasonable,” “necessary,” and “related to the care of beneficiaries.” 42 C.F.R. § 413.9 (a). Costs incurred by nursing homes participating in the Medicaid program are reimbursed: ... through the use of rates (determined in accordance with methods and standards developed by the State) ... which the State finds, and makes assurances satisfactory to the Secretary, are reasonable and adequate to meet the costs which must be incurred by efficiently and economically operated facilities in order to provide care and services in conformity with applicable State and Federal laws, regulations, and quality and safety standards____ 42 U.S.C. § 1396a(a)(13)(A).

In Maryland, the Department of Health & Mental Hygiene is authorized to “adopt rules and regulations for the reimbursement of the providers under the [Medicaid] program.” Md.Code (1990, 1992 Cum.Supp.) § 15-105(a) of the Health-Gen. Article. Pursuant to that authority, it has chosen to calculate a provider’s “final per diem rate” “according to the principles established under Title XVIII of the Social Security Act, 42 U.S.C. § 1395 et seq., and con ⁴³⁹ tained in the Medicare Provider Reimbursement Manual, HCFA [ 2 ] Publication 15-1, unless otherwise specified by this chapter[.]” Md.Regs.Code tit. 10, § 09.11.08B(1) and § 09.-11.10B. The federal regulations specifically address reimbursement in the “related organizations context.” In 42 C.F.R. § 413.17 , it is provided: (a) Principle.

Except as provided in paragraph (d) of this section, costs applicable to services, facilities, and supplies furnished to the provider by organizations related to the provider by common ownership or control are includable in the allowable cost of the provider at the cost to the related organization. However, such cost must not exceed the price of comparable services, facilities, or supplies that could be purchased elsewhere. (b) Definitions — (1) Related to provider. Related to the provider means that the provider to a significant extent is associated or affiliated with or has control of or is controlled by the organization furnishing the services, facilities, or supplies.

(2) Common ownership. Common ownership exists if an individual or individuals possess significant ownership or equity in the provider and the institution or organization serving the provider. (3) Control. Control exists if an individual or an organization has the power, directly or indirectly, significantly to influence or direct the actions or policies of an organization or institution. 2 3 Section 413.153 provides, in pertinent part: (a)(1) Principle.

Necessary and proper interest on both current and capital indebtedness is an allowable cost. ⁴⁴⁰ (c) Borrower — Lender relationship. (1) Except as described in paragraph (c)(2) of this section, to be allowable, interest expense must be incurred or indebtedness established with lenders or lending organizations not related through control, ownership, or personal relationship to the borrower. Presence of any of these factors could affect the “bargaining” process that usually accompanies the making of a loan, and could thus be suggestive of an agreement on higher rates of interest or of unnecessary loans. Loans should be made under terms and conditions that a prudent borrower would make in armslength transactions with lending institutions.

The intent of this provision is to assure that loans are legitimate and needed, and that the interest rate is reasonable. Thus, interest paid by the provider to partners, stockholders, or related organizations of the provider would not be allowable. If the owner uses his own funds in a business, it is reasonable to treat funds as invested funds or capital, rather than borrowed funds. Therefore, if interest on loans by partners, stockholders, or related organizations is disallowed as a cost solely because of the relationship factor, the principal of such loans is treated as invested funds in the computation of the provider’s equity capital under § 413.-157.[ 4 ] Section 413.134(g)(3), relating to cost basis upon purchase of a facility as an ongoing operation, provides: (3) Transaction other than bóna fide.

If the purchaser cannot demonstrate that the sale was bona fide, in addition to the limitations specified in paragraph (g)(1) and (2) of this section, the purchaser’s cost basis may not exceed the seller’s cost basis, less accumulated depreciation. ⁴⁴¹ Although this provision does not, in terms, refer to related organizations, the cases that have considered it have determined that a sale between related parties is not “bona fide”. See Hosp. Affiliates Int’l, Inc. v. Schweiker, 543 F.Supp. 1380, 1389 (E.D.Tenn.1982); Northwest Hosp., Inc. v. Hosp. Service Corp., 500 F.Supp. 1294, 1297 (N.D.Ill.1980); South Boston Gen.

Hosp. v. Blue Cross of Virginia, 409 F.Supp. 1380, 1385 (W.D.Va.1976), disapproved on other grounds, Pasadena Hosp. Assoc., Ltd. v. United States, 618 F.2d 728 , 223 Ct.Cl. 72 (1980). Affirming the disallowance of the interest payment, the NHAB, by a two to one vote, ruled: The Board reviewed the written and oral arguments of both parties, and the majority of the Board agreed with the State that as the Provider purchased the land and building, utilized by the Provider from the late grandmother’s estate, this transaction is between related parties and does not constitute a bonafide purchase. In other words there is no effective change in the ownership/operation which should be recognized for reimbursement purposes, therefore the loan obtained by Mr. Michael DeFontes is a refinancing.

Further, COMAR Regulations states [sic] that “Refinancing not normally allowed will be permitted as the basis for reimbursement calculations if the Department determines that lower cost to the State would result”, and the financing in question cannot result in lower cost in view of the fact that a $1,200,000 mortgage at 11% exists where prior to July 2, 1987, it did not exist, therefore its financing cannot be recognized for reimbursement purposes. As the Court of Special Appeals noted, the NHAB, equated Liberty with DeFontes, referring only to the provider, when, in actuality, it was DeFontes, not Liberty, that purchased the facilities. The intermediate appellate court had “no problem” with DeFontes being referred to as the provider, however, since he owned 55 percent of Liberty ⁴⁴² and, therefore, is “in effect, the ‘Provider.’ ” 5 91 Md.App. at 218 , 603 A.2d at 1348 . Neither party has questioned that holding; therefore, for purposes of the application of the Medicare regulations, we, too, shall assume that the facilities were purchased by the provider.

III

Judicial review of agency fact finding is narrow in scope and requires the exercise of a restrained and disciplined judicial judgment. Supervisor v. Asbury Methodist Home, 313 Md. 614, 626 , 547 A.2d 190, 195 (1988). Where the agency’s findings of fact are supported by substantial evidence, in the form either of direct proof or permissible inference, in the record before the agency, an appellate court may not substitute its judgment, even on the question of the appropriate inference to be drawn from the evidence, for that of the agency. Md.Code (1984) § 10-215(g) of the State Govt.

Article. 6 Bd. of County Comm’rs v. Holbrook, ⁴⁴³ 314 Md. 210, 218 , 550 A.2d 664, 668-69 (1988); Ramsay, Scarlett & Co. v. Comptroller, 302 Md. 825, 832 , 490 A.2d 1296, 1300 (1985); Bulluck v. Pelham Wood Apartments, 283 Md. 505, 513 , 390 A.2d 1119, 1124 (1978); Snowden v. Mayor & City Council of Baltimore, 224 Md. 443, 445 , 168 A.2d 390, 391 (1961). Thus, if reasoning minds could reasonably reach the conclusion reached by the agency from the facts in the record, then it is based upon substantial evidence, and the court has no power to reject that conclusion. Snowden, 224 Md. at 448 , 168 A.2d at 392 . Moreover, the decision of an administrative agency carries with it a presumption of validity; consequently, judicial review is limited to determining whether a reasoning mind could have reached the factual conclusion reached by the agency.

Asbury Methodist Home, 313 Md. at 626 , 547 A.2d at 195 . When, however, the issue before the agency for resolution is one solely of law, ordinarily no deference is appropriate and the reviewing court may substitute its judgment for that of the agency. Ramsay, 302 Md. at 837 , 490 A.2d at 1302 . In that circumstance, the scope of review is much broader.

Caucus Distrib., Inc. v. Maryland Securities Comm’r, 320 Md. 313, 324 , 577 A.2d 783, 788 (1990); Maryland State Police v. Lindsey, 318 Md. 325, 334 , 568 A.2d 29, 33 (1990); State Election Bd. v. Billhimer, 314 Md. 46, 58 , 548 A.2d 819, 825 (1988), cert. denied, 490 U.S. 1007 , 109 S.Ct. 1644 , 104 L.Ed.2d 159 (1989); Washington Nat’l Arena v. Comptroller, 308 Md. 370, 378-79 , 519 A.2d 1277, 1281-82 (1987); Ramsay, 302 Md. at 836 , 490 A.2d at 1300 . Having made the finding that Liberty and DeFontes are the same person for purposes of the facilities purchase, the Board purported to apply the applicable regulations to that ⁴⁴⁴ finding of fact. Our review is of the accuracy of its application of the law, not its fact finding.

IV

DeFontes is related to Liberty, both as a shareholder and as the lessor of the nursing home facilities. That relationship is by common ownership. See Provider Reimbursement Manual — I § 1002.2. 7 See also Cuppett & Weeks Nursing Home, Inc. v. Dept. of Health and Mental Hygiene, 49 Md.App. 199, 207 , 430 A.2d 875, 879 , cert., denied, 291 Md. 773 (1981). As his grandmother’s heir, DeFontes is also related to her estate, 8 from whom he purchased the facilities.

And when DeFontes leased the facilities to Liberty, that transaction was also between parties related by common ownership. The NHAB and the Court of Special Appeals perceive the critical transaction to be DeFontes’s purchase of the facilities from his grandmother’s estate, rather than his ⁴⁴⁵ lease of those facilities to Liberty. Thus, having equated DeFontes with Liberty, i.e., treated them as one and the same, for purposes of the Medicare regulations, the NHAB analyzed the transaction as a sale between the related organizations, Liberty and the Wessels estate. 9 This was the only way in which the analysis which the NHAB found dispositive could work. The NHAB, as did the Court of Special Appeals, viewed 42 C.F.R. §§ 413.17 , 413.130(g), 10 and 413.134(g) 11 as dispositive. ⁴⁴⁶ Liberty does not challenge the NHAB’s fact finding; 12 it does not argue that, for purposes of the application of the Medicare regulations, Liberty and DeFontes are not the same person.

It argues, instead, that § 413.153 is dispositive; by its terms, i.e., subsection (a)(1), all interest payments not covered by an exception are reimbursable. Section 413.153 is explicit, “Necessary and proper interest on both current and capital indebtedness is an allowable cost.” § 413.153(a). Interest, as defined in subsection (b), recognizes that “[i]nterest on capital indebtedness is the cost incurred for funds borrowed for capital purposes, such as acquisition of facilities and equipment, and capital improvements.” Subsection (b)(2) addresses when interest is necessary. Subsection (b)(2)(ii) provides that interest is necessary when it is “[i]ncurred on a loan made for a purpose reasonably related to patient care.” Since interest may be paid on capital indebtedness, which includes indebtedness incurred for the acquisition of facilities, by implication, interest may be reimbursable, as reasonably related to patient care, when paid on a loan incurred for the acquisition of facilities.

Interest is proper when it is “[ijncurred at a rate not in excess of what a prudent borrower would have had to pay in the money market existing at the time the loan was made” and it is not paid to a related lender. Subsection (b)(3)(i) and (ii). ⁴⁴⁷ Subsection (c) sets forth the purpose of § 413.153: “[T]o assure that loans are legitimate and are needed, and that the interest rate is reasonable.” It has been described as a “blanket disallowance” of related-party interest, Northwest Hosp., Inc. v. Hosp. Service Corp, 687 F.2d 985, 995 (7th Cir.1982) and upheld as a valid prophylactic measure. Mourning v. Family Publications Services, Inc., 411 U.S. 356, 372-73 , 93 S.Ct. 1652, 1662 , 36 L.Ed.2d 318, 331 (1973); Goleta Valley Community Hosp. v. Schweiker, 647 F.2d 894 , 897 (9th Cir.1981).

Subsection (c) provides quite clearly, that “to be allowable, interest expense must be incurred on indebtedness established with lenders or lending organizations not related through control, ownership, or personal relationship to a borrower,” and, conversely, that “interest paid by the provider to partners, stockholders, or related organizations of the provider would not be allowable.” See Univ. of Cincinnati v. Heckler, 733 F.2d 1171 , 1174 (6th Cir.1984); Northwest Hosp., 687 F.2d at 989 . Contrary to the respondent’s contentions and the focus of the intermediate appellate court’s opinion, for § 413.153 purposes, the relevant transaction is the loan transaction, not the transaction giving rise to it. Therefore, the critical relationship is that of lender to borrower, not seller to purchaser (except when all parties are the same): The regulation denies interest not so much because of the nature of the transaction for which the loan is obtained but because of the source of the loan. Section 405.419(c) [current § 413.153(c)] is not as concerned that the sale was between related parties (except to the extent that the necessity of such a sale, and hence of the loan to pay for it, is in doubt) as it is that the loan was between related parties.

Thus, even if the sale had been between strangers, § 405.419(c) would operate so long as the loan to pay for it came from a related entity. The Secretary considers it more likely that, when a loan is made between unrelated parties bargaining at arms length, the interest rate will prove reasonable and the loan itself necessary. ⁴⁴⁸ Jackson Park Hosp. Found. v. United States, 659 F.2d 132, 138 , 228 Ct.Cl. 448 (1981). See also Heckler, 733 F.2d at 1174.

This was recognized, albeit more by implication than explicitly, in Shaker Medical Center Hosp. v. Secretary of Health and Human Serv., 686 F.2d 1203 (6th Cir.1982). There, a single physician controlled both the hospital and the real estate company from whom the hospital leased the building in which it operated. At the physician’s advice — he was also the hospital’s board chairman — the hospital purchased the hospital building from the real estate company at a substantially inflated price. The purchase was financed by both commercial loans, i.e., $700,000.00, at nine and ten percent interest, and a loan from the physician, i.e., a $400,000.00 note at seven percent interest.

The Secretary allowed reimbursement of the interest paid on the commercial loans, but disallowed it on the physician’s note. The court affirmed, holding, “[T]he Secretary was justified in disallowing reimbursement for the interest paid [to the physician], since under 42 C.F.R. § 405.419 it was paid to a related entity____” Id. at 1208. Significantly, the allowance of interest on the commercial loans was not questioned. Similarly, in Stevens Park Osteopathic Hosp.

Inc. v. United States, 633 F.2d 1373, 1375 , 225 Ct.Cl. 113 (1980), interest payments on notes financing the purchase of a hospital building from a former stockholder were disallowed, while interest paid on a first lien deed of trust to a non-related lending institution was allowed. See also Northwest Hosp., 687 F.2d at 993 (“commercial interest expense [through a commercial lender] clearly qualifies as a reimbursable Medicare cost”); South Boston, 409 F.Supp. at 1385 (“A financing arrangement through a commercial lender might have been just as satisfactory____ Such an arrangement would have avoided consideration of the related parties doctrine____”). The purpose underlying § 413.153(c) is more important than the nature of the loan transaction. When the purpose is not otherwise contravened, i.e., the loan is legitimate and ⁴⁴⁹ needed and the interest rate is reasonable, interest expense on a loan between related parties has been allowed.

In Northwest Hospital, payment of interest on a loan from former stockholders to permit a new corporation to purchase their stock was reimbursable notwithstanding § 417.-153, where the loan was clearly needed to complete the transaction and the interest rate was reasonable. The court reasoned: In sum, to finance a sale consistent with the purposes of the Medicare program, funds must be supplied from some source. The supplying of such funds inescapably makes a cost (interest). It is entirely possible, particularly where loan funds are scarce, that the only available source of funds will be the sellers (who are related parties).

In such a case it would be egregiously unjust, as well as contrary to the Medicare statute, to disallow this inescapable interest cost. Even where other sources of funds can be found, moreover, the commercial rate of interest payable on those funds is likely to be considerably higher than the rate payable to a related-party seller. It is unreasonable as well as economically inefficient to force nonprofit hospitals to incur these higher (but unquestionably reimbursable) costs merely because no