¹ 42 U.S.C. § 1395x(v)(1)(A) (1976). The Health Insurance for the Aged Act, enacted in 1965, created Medicare. 42 U.S.C. §§ 1395-1395vv (1976 & Supp. IV 1980).

² This Note uses the term “reimbursement system" to refer only to the process by which Medicare authorities and the federal courts determine how much to pay to health care providers. Decisions such as who Medicare beneficiaries are and what health care services the program should cover are beyond the scope of this Note.

³ The Department of Health and Human Services (HHS) replaced the former Department of Health, Education and Welfare (HEW) effective May 4, 1980. Department of Education Organization Act, Pub. L. No. 96-88, § 509(b), 93 Stat. 668 (1979). All references to HEW in cases discussed in this Note are applicable now to HHS.

⁴ 42 U.S.C. §§ 1395c-1395i-2 (1976 & Supp. IV 1980).

⁵ 42 U.S.C. §§ 1395j-1395w (1976 & Supp. IV 1980). Part C of the Act contains definitions and general provisions applicable to Parts A and B. See 42 U.S.C. §§ 1395x-1395vv (1976 & Supp. 1980).

⁶ 42 U.S.C. § 1395i(a) (Supp. IV 1980).

⁷ Id.

⁸ 42 U.S.C. § 1395x(v)(1)(A) (1976).

⁹ In fiscal year 1979, 96 per cent of Part A payments were for inpatient hospital care. Health Care Financing Ad., Dep't of Health And Human Services, Fourteenth Annual Report on Medicare Covering Fiscal Year 1980 1 (1982)Google Scholar [hereinafter 1980 Medicare Annual report].

¹⁰ Other types of providers recognized by the Medicare Act are skilled nursing facilities, comprehensive outpatient rehabilitation facilities, and home health agencies. 42 U.S.C. § 1395x(u) (Supp. IV 1980).

¹¹ 42 U.S.C. § 1395cc (1976 & Supp. IV 1980). In fact, the Secretary delegated his functions under the Medicare Act to the Commissioner of Social Security. 33 Fed. Reg. 5836 (1968). The validity of the delegation was upheld in Pacific Coast Medical Enters. v. Califano, 440 F. Supp. 296, 305 (C.D.Cal. 1977), aff'd, 633 F.2d 123 (9th Cir. 1980). Despite this delegation, which was effective during the transactions at issue in most cases discussed by this Note, this Note adopts the convention used by the courts of referring to the Secretary as the administrator of the program.

In 1978, Congress delegated the Commissioner’s functions to the Administrator of the Health Care Financing Administration. Act of June 13, 1978, Pub. L. No. 95-292, § 5, 92 Stat. 307 (1978).

¹² 42 U.S.C. § 1395cc (1976 & Supp. IV 1980).

¹³ 42 U.S.C. § 1395h(a) (Supp. IV 1980). Providers may choose to receive their payments directly from the Secretary, but virtually all providers have chosen to use intermediaries. In 1979, 67 Blue Cross Plans and eight commercial insurers served as intermediaries. 1980 Medicare Annual Report, supra note 9, at 8.

¹⁴ See 42 C.F.R. § 405.401(c) (1982). This regulation is promulgated under the authority of 42 U.S.C. § 1395h(a) (1976 & Supp. IV 1980).

¹⁵ 42 C.F.R. § 405.405 (1981).

¹⁶ Congress established the present review procedure in Act of October 30, 1972, Pub. L. No. 92-603, § 243(b), 86 Stat. 1421, which is codified at 42 U.S.C. § 1395oo (1974). The amount in controversy must be at least $10,000. The PRRB consists of five members appointed by the Secretary for three year terms, and they must be knowledgeable in cost reimbursement. This procedure is effective for fiscal years ending June 30, 1973 and later. For earlier years, a different review procedure was effective. Initially, HEW did not provide any type of impartial administrative hearing for providers to contest adverse decisions of fiscal intermediaries. This failure was held to be a denial of due process in Coral Gables Convalescent Hosp. v. Richardson, 340 F. Supp. 646, 650 (S.D.Fla. 1972), and HEW responded by issuing regulations for reviews. See 42 C.F.R. §§ 405.1801-. 1890 (1981). These regulations are still effective for appeals after June 30, 1973 of amounts less than $10,000.

¹⁷ 42 U.S.C. § 1395oo(c) (1976). At the hearing, the provider’s rights include representation of counsel, introduction of evidence, and direct and cross examination of witnesses.

¹⁸ 42 U.S.C. 1395oo(f) (Supp. IV 1980).

¹⁹ Id.; judical review of intermediary decisions prior to June 30, 1973, was uncertain. The federal district and circuit courts declined to exert jurisdiction over the matters. Dr. John T. MacDonald Found. v. Califano, 571 F.2d 328, 331 (5th Cir. 1978); Chelsea Community Hosp. v. Michigan Blue Cross, 436 F. Supp. 1050, 1055-57 (E.D.Mich. 1977). However, the Court of Claims determined that it did have jurisdiction to hear appeals from intermediary decisions. St. Elizabeth Hosp. v. United States, 558 F.2d 8,11-12 (Ct. Cl. 1977). Thus, all pre-1973 claims are now heard by the Court of Claims. See MacDonald Found., 571 F.2d at 332.

²⁰ 42 U.S.C. § 1395f(b) (Supp. IV 1980).

²¹ See, e.g., American Medical Int'l, Inc. v. Secretary of HEW, 466 F. Supp. 605 (D.D.C. 1979), aff'd 677 F.2d 118 (D.C. Cir. 1982): "The Medicare program is structured around the concept of reasonable cost.” Id. at 609.

²² 42 U.S.C. § 1395x(v)(1)(A) (1976).

²³ Id.: "Such regulations [promulgated by the Secretary to define reasonable cost] shall take into account the direct and indirect costs of providers of services ... in order that, under the methods of determining costs, the necessary costs of efficiently delivering covered services to individuals covered by [Medicare] will not be borne by individuals not so covered, and the costs with respect to individuals not so covered will not be borne by [Medicare]. . . ."

²⁴ Id. The Secretary’s determination of “reasonableness" in the areas of indirect cost discussed in this Note extends to both the category of cost and the amount of the cost. In the Medicare reimbursement lexicon, reasonable costs (as determined by the Secretary) are “allowable"; unreasonable costs are not allowable.

²⁵ 42 C.F.R. §§ 405.401-.488 (1981). The Secretary has also promulgated Medicare regulations dealing with other aspects of the program. See 42 C.F.R. §§ 405.101-.2430; §§ 420.1-.296; §§421.1-.205 (1981).

²⁶ Equity capital is the money invested in a corporation by its shareholders. Equity and debt are the two major means by which corporations can raise capital. Debt is money that is lent to a corporation.

²⁷ When Medicare reimburses providers for indirect costs of health care, it does so on a pro-rata basis, so that the costs are spread between Medicare and non-Medicare patients. 42 C.F.R. § 405.402(b) (1981). The costs can be apportioned in one of two ways. 42 C.F.R. §405.404 (1981).

²⁸ For a listing of ancillary costs, see infra note 59 and accompanying text. “Ancillary costs" in this sense refers to costs that are incurred in raising capital, but that are not paid to those from whom the capital is obtained. The costs paid to the capital contributors are the “direct" costs. For debt, the direct cost is the interest expense. For equity, there is no required direct cost, but stockholders typically expect to receive dividends and appreciation in the value of their stock.

²⁹ The federal securities laws, 15 U.S.C. §§ 77a-78kk (1976 & Supp. IV 1980), impose many disclosure and reporting requirements on the public issuance and exchange of securities.

³⁰ Provider Reimbursement Manual, § 2134.9, reprinted in [1979] 1 Medicare & Medicaid Guide (CCH) ¶ 5994:

There is a similar provision in § 2150.2B of the Manual.

³¹ One study indicated that the expenses of a public stock issuance, aside from underwriters’ fees, averaged up to 6.8 percent of the value of the issuance. Smith, Alternative Methods for Raising Capital: Rights vs. Underwritten Offerings, 5 J. Fin. Econ. 273, 277 (1977)CrossRefGoogle Scholar. In American Medical, the provider sought $299,000 for just two years worth of stock maintenance costs. PRRB Hearing Dec. No. 77-D61 (Sept. 8, 1977), reprinted in [1977 Transfer Binder] Medicare & Medicaid Guide (CCH) ¶ 28,657.

³² Compare American Medical, 466 F. Supp. at 616 (upholding the Secretary) with AMI- Chanco, Inc. v. United States, 576 F.2d 320, 326 (Ct.Cl. 1978) (overruling the Secretary).

³³ Supra notes 21 & 22 and accompanying text.

³⁴ 42 U.S.C. § 1395x(v)(1)(A) (1976).

³⁵ AMI-Chanco, 576 F.2d at 323; American Medical, 466 F. Supp. at 613.

³⁶ American Medical, 466 F. Supp. at 612-13.

³⁷ Id. at 614; AMI-Chanco, 576 F.2d at 326-27.

³⁸ 42 U.S.C. § 1395x(v)(1)(B) (1976).

³⁹ Pub. L. No. 89-713, § 7, 80 Stat. 1107 (1966).

⁴⁰ See 112 Cong. rec. 28,220 (1966) (comments of Congressman Byrne), noted in American Medical, 466 F. Supp. at 613-14.

⁴¹ Although the statute on its face applies only to extended care facilities, i.e. nursing homes, the Congressional Conference Report directed the Secretary to apply the same principle to proprietary hospitals. H.R. Rep. No. 2317, 89th Cong., 2d Sess. 3, reprinted in 1966 U.S. Code Cong. & Ad. News 3676, 3692-93.

⁴² The Secretary promulgated the proposal in June, 1966. 31 Fed. Reg. 7871 (1966). It was subsequently published, with modifications, as 20 C.F.R. § 428(a). See 31 Fed. Reg. 14,808 (1966). (Title 20 was redesignated Title 42 in 1977). For an extensive judicial analysis of the legislative history behind the return on equity amendment and the 2 percent allowance, see Hospital Auth. of Floyd County, Ga. v. Schweiker, 522 F. Supp. 569, 570 (N.D.Ga. 1981).

⁴³ For a discussion of the lobbying efforts, see Somers, H. & Somers, A. Medicare and the Hospitals: Issues and Prospects 179-80 (1967)Google Scholar.

⁴⁴ See discussion of legislative history in Hospital Auth. of Floyd County, 522 F. Supp. at 574.

⁴⁵ Id.

⁴⁶ The non-profit providers continued to receive the full 2 percent special allowance. 20 C.F.R. § 405.428. See 31 Fed. Reg. 14,808 (1966). However, the Secretary eliminated the allowances entirely in 1969 by amending § 405.428. 34 Fed. Reg. 9,927 (1969).

⁴⁷ AMI-Chanco, 576 F.2d at 326-327.

⁴⁸ American Medical, 466 F. Supp. at 614.

⁴⁹ Id.:

Senator Long, in the Congressional debate leading to the passage of the return on equity capital provision, stated:

112 Cong. Rec. 27,608 (1966) (emphasis added). Several days later, Congressman Byrnes reiterated the fact that reasonable costs for providing Medicare care does not include costs for investment.

112 Cong. Rec. 28,220 (1966) (emphasis added).

⁵⁰ It is possible to interpret the silence of the legislative history as an understanding by Congress that “stock maintenance costs" were not part of the return on equity, because stock maintenance costs are “actually incurred.” See Hospital Auth. of Floyd County, 522 F. Supp. at 573 (comments of Senator Anderson).

⁵¹ These are among the grounds listed in the Administrative Procedure Act upon which a federal court may overrule the action of an administrative agency. The scope of judicial review is set out in 5 U.S.C. § 706 (1976).

⁵² AMI-Chanco, 576 F.2d at 322; American Medical, 466 F. Supp. at 613-15. In addition, the providers have sought to invalidate the rule on the ground that its issuance failed to follow the requirements of the Administrative Procedure Act (APA). In brief, that contention was that the stock maintenance costs rule was a substantive rule rather than an interpretative rule. This distinction is important because the APA requires notice of a proposed rule to appear in the Federal Register, with interested members of the public given an opportunity to comment. 5 U.S.C. § 553(b) (1976). Only one court decided this issue; it held that the stock maintenance cost rule was interpretive, because it was “issued to advise the public of the agency’s construction of the statute.” American Medical, 466 F. Supp. at 616. The issue was raised but not decided in AMI-Chanco, 576 F.2d at 321-322, n.3.

⁵³ AMI-Chanco, 576 F.2d at 325.

⁵⁴ See supra note 23.

⁵⁵ AMI-Chanco, 576 F.2d at 323; American Medical, 466 F. Supp. at 614.

⁵⁶ See AMI-Chanco, 576 F.2d at 324.

⁵⁷ Id.; American Medical, 466 F. Supp. at 615.

⁵⁸ See American Medical, 466 F. Supp. at 615.

⁵⁹ Id.; AMI-Chanco, 576 F.2d at 325. Ancillary costs of debt issuance include professional fees, underwriters’ fees, appraisers’ fees, and similar costs. Provider Reimbursement Man Ual, § 212.1, reprinted in [1982] 1 Medicare & Medicaid Guide (CCH) ¶ 4983.

⁶⁰ 42 C.F.R. § 405.406(a) (1981) provides that Medicare will reimburse costs determined according to “[s]tandardized definitions, accounting statistics, and reporting practices which are widely accepted in the hospital and related fields. . . .” InAMI-Chanco, 576 F.2d at 324, the court noted that this language signalled an intent to reimburse general and administrative costs.

⁶¹ AMI-Chanco, 576 F.2d at 323-24.

⁶² Id. at 325-26.

⁶³ Id. at 325.

⁶⁴ 576 F.2d 320 (Ct.Cl. 1978).

⁶⁵ 466 F. Supp. 605 (D.D.C. 1979), aff'd 677 F.2d 118 (D.C. Cir. 1982). Oddly, the case does not mention the earlier Court of Claims decision, although the Court of Claims decision preceded American Medical by over eight months.

⁶⁶ American Medical, 466 F. Supp. at 612-13.

⁶⁷ See supra notes 57 & 58 and accompanying text.

⁶⁸ Feldstein, M. The Rising Cost of Hospital Care 68-69 (1971)Google Scholar.

⁶⁹ These effects are marginal, of course. It is not intended to suggest that this reimbursement policy will absolutely prevent the formation of new proprietary hospitals or the acceptance of Medicare patients; rather, the policy is just a disincentive to do so.

⁷⁰ The reimbursement statute prohibits cross-subsidization. 42 U.S.C. § 1395x(v)(1)(A) (1976). See supra note 23 and accompanying text.

⁷¹ Most hospital costs are paid by insurers, and their payment principles resemble those that Medicare uses. See Meyer, J. Health Care Cost Increases 8 (1979)Google Scholar.

⁷² The market value of a firm rises with increases in the expected profitability of the firm, and it falls when the expected profitability decreases. Lorie, J. & Hamilton, M. The Stock Market: Theories and Evidence 124 (1973)Google Scholar.

⁷³ This policy may also reduce stock prices and therefore discourage investment by limiting the information available to investors. As one court noted, the purpose of these expenditures is to protect investors by providing information through annual meetings and various reports. American Medical, 466 F. Supp. at 613. Denial of reimbursement for these expenditures may cause providers to minimize the amount spent on the effort, thus reducing the information flow. Investors would then evaluate the providers more cautiously and might discount their estimates of value accordingly.

This argument is not very strong. If the reduced flow of information did reduce the firm’s value, then a rational manager seeking to maximize the value of the provider he manages would certinly spend more on the effort. Cf. Posner, R. Economic Analysis of Law 332 (2d ed. 1977)Google Scholar (opining that disclosures required by the federal securities laws have not increased information available to investors).

⁷⁴ See supra note 59 and accompanying text.

⁷⁵ “Capital structure" is the mix of different securities (debt and equity) of the firm. BREALY, R. & MYERS, S. Principles of Corporate Finance 350 (1981)Google Scholar.

⁷⁶ Id. at 360; see AMI-Chanco, 576 F.2d at 325. A firm that has a high proportion of debt in its capital structure is riskier than a firm that has less debt, ceteris paribus, because the high-debt firm has greater fixed costs (in the form of interest payments) that it must meet before it can show a profit.

⁷⁷ Interest expenses are reimbursable under 42 C.F.R. § 405.419 (1981).

⁷⁸ The purchaser may pay for the stock in the provider with cash, notes, stock in itself, other consideration, or any combination thereof.

⁷⁹ In a leading case on the sale of corporate control, the defendant owned only 28.3 percent of the stock. In Essex Universal Corp. v. Yates, 305 F.2d 572, 575 (2d Cir. 1962), the court noted: "[I]t is commonly known that [power sufficient to elect a majority of the board of directors] usually accrues to the owner of 28.3 percent of the stock.” See Sommer, A.A. Jr. Who’s “In Control?"-S.E.C, 21 Bus. Law. 559, 567-72 (1966)Google Scholar.

⁸⁰ Delaware’s corporate law, for example, authorizes corporations to purchase and own shares of stock or other securities of other corporations. Del. Code Ann. tit. 8, § 123 (1974).

⁸¹ This would be a merger or consolidation, technically, with only one corporation surviving. Del. Code Ann. tit. 8, § 251 (1974).

⁸² In Pacific Coast Medical Enters. v. Harris, 633 F.2d 123, 127 (9th Cir. 1980), the purchaser paid $7 million in stock for the provider. Of that amount, the reimbursement of $6,075 million was in dispute. See Dec. No. 75-D8, (August 19, 1975), reprinted in [1975 Transfer Binder] Medicare & Medicaid Guide (CCH) ¶ 27,485

⁸³ An asset is simply an economic resource controlled by an entity and for which it paid a measurable price. Anthony, R. & Reece, J. Accounting: Text and Cases 35 (6th ed. 1979)Google Scholar.

⁸⁴ Assets can be conveniently divided into two types, long-lived and current. Current assets are normally used up in a year or less, while long-lived assets are consumed over a longer period. Examples of current assets are cash, marketable securities, accounts receivable, and inventory. Types of inventory that are normally stored for more than a year, such as tobacco and liquor, are still classified as current assets. Common long-lived assets include property, plant, equipment, investment securities, and goodwill. Id. at 37-39.

⁸⁵ Id. at 209.

⁸⁶ Id. at 62-63. Accountants use several different depreciation methods to write off assets at varying rates. See generally id. at 216-22.

⁸⁷ Id. at 214-15.

⁸⁸ The regulations allow providers to use straight-line depreciation or, in certain circumstances, accelerated depreciation by the declining balance method. 42 C.F.R. § 405.415(a) (1981). It is important to note that financial depreciation methods are not tied to, or dependent on, cost recovery provisions of the tax laws. Most companies use different depreciation techniques for tax purposes than for financial accounting purposes. Anthony & Reece, supra note 83, at 221-22.

⁸⁹ Anthony & Reece, supra note 83, at 223.

⁹⁰ Id. at 228.

⁹¹ Accountants often write off long-lived assets over too short a period, with the result that assets which are still productive have a net book value of zero.

⁹² The asset may be written off by use of accelerated depreciation, thus assigning most of its cost to its first few years, when in fact it loses the bulk of its value in its later years. See Chirelstein, M. Federal Income Taxation: A Law Student’s Guide to the Leading Cases and Concepts 133 (3d ed. 1982)Google Scholar.

⁹³ Anthony & Reece, supra note 83, at 29.

⁹⁴ Id. at 28.

The Secretary originally permitted reimbursement of goodwill purchased in acquisitions in 20 C.F.R. § 405.429(a) (1970), but that rule was changed effective August 1, 1970. See 35 Fed. Reg. 12,330 (1970). The regulations now deny reimbursement for goodwill purchased in the acquisition of assets or facilities on or after August 1, 1970. 42 C.F.R. § 405.429(b) (1982). This regulation has been upheld as consistent with the reasonable cost statute. See North Clackamas Community Hosp. v. Harris, 664 F.2d 701 (1980). This Note does not discuss the issue of whether the regulation is justified.

⁹⁵ 42 C.F.R. § 405.415(b) (1981).

⁹⁶ 42 C.F.R. § 405.415(g) (1981). This regulation was amended in 1979. 44 Fed. Reg. 6912 (1979). The earlier version, under which the cases discussed in this Note were litigated, provided:

§ 405.415(g) (1978).

The regulation now reads:

⁹⁷ 42 C.F.R. § 405.415(a) (1981).

⁹⁸ See Homan & Crimen, Inc. v. Harris, 626 F.2d 1201, 1207 (5th Cir. 1980); American Medical Int'l v. Secretary of HEW, 466 F. Supp. 605, 610 (D.D.C. 1979), aff'd 677 F.2d 118 (D.C. Cir. 1982).

⁹⁹ E.g., Pacific Coast Medical Enters. v. Harris, 633 F.2d 123, 128 (9th Cir. 1980).

¹⁰⁰ 42 C.F.R. § 405.415(a) (1981).

¹⁰¹ “Basic corporate law indicates that assets of a corporation are owned by the corporate entity, not the stockholders.” American Medical, 466 F. Supp. at 622.

¹⁰² Homan & Crimen, 626 F.2d at 1207-09; American Medical, 466 F. Supp. at 622-23; Monterey Life Sys. v. United States, 635 F.2d 821, 825-26 (Ct. Cl. 1980). See also Richey Manor, Inc. v. Schweiker, 684 F.2d 130, 134-35 (D.C. Cir. 1982) (disallowing revaluation for a 100 percent purchase of stock followed by a transfer of the provider’s assets to a new nonprofit corporation).

¹⁰³ The purchaser or its subsidiary becomes the new owner of the assets of the acquired provider. See supra note 81 and accompanying text.

¹⁰⁴ See Memorial, Inc. v. Harris, 655 F.2d 905, 909 (9th Cir. 1980); Pacific Coast, 633 F.2d at 129; Chateau Gardens v. Harris, 497 F. Supp. 133, 134-35 (E.D.Mich. 1980); West Seattle Gen. Hosp. v. United States, 674 F.2d 899, 901 (Ct.Cl. 1982).

¹⁰⁵ See supra notes 100-02 and accompanying text.

¹⁰⁶ The prohibition of revaluation for related party transactions is based on 42 C.F.R. § 405.427(c) (1981). For a discussion of the related party rule in the context of loans, see infra notes 164 & 165 and accompanying text.

¹⁰⁷ References to related parties are found in 42 C.F.R. §§ 405.415, 405.419, and 405.427 (1981).

¹⁰⁸ “Related parties" are “organizations related to the provider by common ownership or control “ 42 C.F.R. § 405.427(a) (1981). The regulation provides further:

¹⁰⁹ 42 C.F.R. § 405.427(c) (1981) explains the basis for the related party rule:

For an early case discussing and upholding the validity of 42 C.F.R. § 405.427, which is the general related party rule, see Fairfax Hosp. Ass'n v. Califano, 585 F.2d 602 (4th Cir. 1978).

¹¹⁰ 42 C.F.R. § 405.427(a) (1981). This provision is paralleled by § 405.415(g)(3), quoted supra note 96 and applying to acquisitions of facilities from related parties, and § 405.419(c)(1), discussed infra note 164 and applying to loans from related parties.

This rule applies to all types of transactions, not only acquisitions of providers. See, e.g., Marina Mercy Hosp. v. Harris, 633 F.2d 1301 (9th Cir. 1980) (management fees paid to related party); American Hosp. Management Corp. v. Harris, 638 F.2d 1208 (9th Cir. 1981) (rental payments pursuant to sale and leaseback with related party); Fairfax Hosp. Ass'n, Inc. v. Califano, 585 F.2d 602 (4th Cir. 1978) (pharmacy supplies furnished by related parties); American Medical, 466 F. Supp. at 616 (respiratory care services furnished by related party).

¹¹¹ E.g., Pacific Coast, 633 F.2d at 129.

¹¹² Id. at 136; Memorial, Inc., 655 F.2d at 912-13; Chateau Gardens, 497 F. Supp. at 137; West Seattle, 674 F.2d at 905 (100 percent stock purchase followed by merger into subsidiary of purchaser). But see Rickey Manor, 684 F.2d at 135 (purchase of stock followed by conversion of provider from proprietary to non-profit status). In dictum, the Rickey Manor court also disapproved of the reasoning of the preceding cases.

¹¹³ Homan & Crimen, 624 F.2d at 1208; Monterey Life Sys., 635 F.2d at 825; American Medical, 466 F. Supp. at 624.

¹¹⁴ E.g., Homan & Crimen, 624 F.2d at 1208. The providers seek to disregard the distinction between the corporation and its shareholders in order to establish the shareholders as the owner of the corporations’s assets.

¹¹⁵ Id.

¹¹⁶ In addition to contesting the regulations’ validity, some providers have raised other arguments. One provider argued that Medicare should allow revaluation because that practice would accord with generally accepted accounting principles. It urged that regulation § 405.406(a) allows generally accepted accounting principles to control reimbursement unless other regulations clearly indicate otherwise, and that these principles allow revaluation. But the court disagreed and denied revaluation. The court gave three reasons. First, other regulations provide to the contrary; §§ 405.414, 405.419, and 405.427 all establish the net book value rule. Second, the cited regulation—§ 405.406—does not require that generally accepted accounting principles determine reimbursement. Third, generally accepted accounting principles themselves do not require revaluation. American Medical, 466 F. Supp. at 623-24.

Another provider contended that regulation § 405.415(g) allows revaluation even when the assets themselves are not purchased. This section allows revaluation “for the assets of a facility purchased as an ongoing operation. . . .” However, the court construed the section to apply only to acquisitions of facilities, not of stock. The purchaser, rather than acquiring the provider facility directly, acquired only stock in a corporation that owned the facility. Therefore, revaluation was not allowed. Homan & Crimen, at 1207-08.

¹¹⁷ See supra note 112.

¹¹⁸ E.g., Pacific Coast, 633 F.2d at 132; West Seattle, 674 F.2d at 903.

¹¹⁹ Pacific Coast, 633 F.2d at 132.

¹²⁰ Id. at 132-33; West Seattle, 674 F.2d at 904.

¹²¹ See supra note 112.

¹²² 674 F.2d 899 (Ct.Cl. 1982).

¹²³ Id. at 900-01.

¹²⁴ Id. at 904.

¹²⁵ Id. at 904-05. The case also raised a subsidiary issue, not directly relevant to this Note, of the date upon which the purchase of assets should be deemed to have occurred. That matter was important because the purchaser sought reimbursement for goodwill purchased in the acquisition as well as for revalued assets. If the purchase of assets were deemed to have occurred in 1969 (when the purchase of stock occurred) then the provider could receive reimbursement for goodwill; but if it were deemed to have occurred in late August 1970 (when the merger was effected), then the provider could not receive reimbursement for goodwill, because the regulations disallow all goodwill incurred after August 1, 1970 (42 C.F.R. § 405.429(b)(2) (1981)). Id. at 902.

¹²⁶ 684 F.2d 130 (D.G. Cir. 1982).

¹²⁷ Id. at 134.

¹²⁸ Id.

¹²⁹ Id.

¹³⁰ Id. at 135.

¹³¹ 42 C.F.R. § 405.415(f) (1981).

¹³² Rickey Manor, 684 F.2d at 135.

¹³³ See supra notes 90-92 and accompanying text.

¹³⁴ See Nicholson, Intermediate Microeconomics and its Application 467 (1975)Google Scholar.

¹³⁵ Investors value assets at their fair market value, notwithstanding accounting conventions that misstate value. One of the best examples of investors’ ability to see through financial illusions is the effect on stock prices of a change in the method of depreciation for financial accounting purposes. When a company switches from accelerated depreciation to straight line, the effect is to reduce depreciation expense and therefore raise reported earnings. However, this paper change does not fool investors into paying more for the company’s stock; indeed, the long-term effect seems to be a lower price for the stock, whch probably reflects the economic factors that prompted management to change its depreciation method in the first place. (Note that this scenario does not include a change in depreciation for tax purposes.) See Kaplan, & Roll, Investor Evaluation of Accounting Information: Some Empirical Evidence, 45 J. Bus. 225, 245 (1972)CrossRefGoogle Scholar. In general, financial accounting conventions do not deceive investors, particularly professional financial analysts who evaluate companies. See Brealey & Myers, supra note 75, at 268-70.

¹³⁶ When inflation causes fair market value to rise above net book value, recapture of the gain on sale should not be required. This gain is illusory; it represents only a nominal increase in value. An example will best illustrate this point. A provider buys an asset in 1973 for $ 100,000 (the book value). The asset has a known useful life of 20 years, and it wears out evenly over that period, with no residual value. By 1983, the asset’s net book value is $50,000. If the provider serves only Medicare beneficiaries, the provider has received $50,000 reimbursement from Medicare. But if inflation has been 10% annually for the last 10 years, the actual value of the asset (if new) is about $260,000, and its current net book value is about $130,000. Although the fair market value substantially exceeds the old net book value, Medicare has not reimbursed too much depreciation. In fact, it has paid too little, because it is repaying the provider’s historical cost with dollars that are worth much less than the dollars used by the provider to buy the asset. In this example, one 1983 dollar is worth 38.6 percent of one 1973 dollar (1/1.1¹⁰ = 1/2.59 = .386).

A related issue that this Note does not address is the time value of money. One could also argue that providers are not fully reimbursed for the cost of assets when reimbursement is spread out over several years, even if they receive 100 percent of their costs and there is no inflation, because the present value of the “reimbursement stream" will be less than the price paid. For a discussion of present value, see Brealey & Myers, supra note 75, at 11-12. This issue is important to the decision of whether overall Medicare reimbursement is adequate, not just reimbursement after acquisitions.

¹³⁷ See supra notes 91 & 92 and accompanying text.

¹³⁸ This can be accomplished by forming a new corporation around the provider or by merging the provider into a new wholly-owned subsidiary. The latter technique was approved in West Seattle, 674 F.2d at 900-01, 905.

¹³⁹ B. Blttker & J. Eustice, Federal Income Taxation of Corporations and Share Holders § 11.44 (4th ed. 1979).

¹⁴⁰ A straight purchase of stock acquisition allows a step-up in basis under I.R.C. § 1012; a two-step purchase of assets is treated similarly under I.R.C. § 334(b)(2).

¹⁴¹ I.R.C. § 362(a) allows the purchasing corporation to increase its basis in property only to the extent that the transferors (the selling shareholders) recognize gain on the transaction.

¹⁴² Compare supra note 113 with supra note 112.

¹⁴³ See American Medical, 466 F. Supp. at 622-23.

¹⁴⁴ The statute does not specify that costs be actually incurred by the provider. 42 U.S.C. § 1395x(v)(1)(A) (1976). The fact that costs were incurred in the acquisition of the provider should satisfy the statute. Indeed, in the two-step procedure of West Seattle, discussed supra notes 122-25 and accompanying text, it was the parent-purchaser that incurred the cost of the acquisition. Further, the allowance of a return on equity at a variable rate indicates congressional recognition that not all costs are static. The return on equity allowed for providers varies with the interest rate on certain government securities. See 42 U.S.C. § 1395x(v)(1)(B)(1976).

¹⁴⁵ See supra note 112.

¹⁴⁶ 5 U.S.C. §§ 701-06 (1976), made applicable to Medicare reimbursement by 42 U.S.C. § 1395oo(f)(1) (Supp. 1980).

¹⁴⁷ 5 U.S.C. § 706(2)(A) (1976).

¹⁴⁸ West Seattle, 674 F.2d at 904.

¹⁴⁹ In terms of burden of proof, the Secretary need not offer any reason until the plaintiff has made a prima facie case.

¹⁵⁰ See supra note 113.

¹⁵¹ Homan & Crimen, 626 F.2d at 1208. See Barber, Piercing the Corporate Veil, 17 Willamette L. Rev. 371, 376-77 (1981)Google Scholar.

¹⁵² Generally accepted accounting principles (GAAP) are the basis of accounting. They are principles promulgated by the Financial Accounting Standards Board and its predecessor, the Accounting Principles Board. GAAP are not legally binding, but accountants rarely deviate from them. Anthony & Reece, supra note 83, at 222-23.

¹⁵³ The generally accepted accounting principles discussed infra note 154 apply only to purchasers, not to acquired companies. See American Medical, 466 F. Supp. at 624.

¹⁵⁴ American Medical considered the applicability of Opinion No. 16 of the Accounting Principles Board, entitled “Business Combinations,” to this issue. 466 F. Supp. at 624. That opinion dealt with the proper financial accounting treatment for business combinations, which it defined as an event in which “a corporation and one or more incorporated or unincorporated businesses are brought together into one accounting entity.” Accounting Principles Board, Opinion No. 16, at ¶ 1. The primary issue which the Opinion addresses is whether the transaction should give rise to a new basis of accounting; i.e., whether assets of the acquired firm should be revalued to market value. See id. at ¶ 16. Although this Opinion seems directly applicable to the Medicare reimbursement issue, it is not. The difficulty is that the Opinion approaches the question solely from the perspective of the consolidated books of the entity. Id. at ¶ 2. It does not say how the acquired company, if it continues to exist separately, should account for the acquisition. American Medical, 466 F. Supp. at 624.

¹⁵⁵ Anthony & Reece, supra note 83, at 7.

¹⁵⁶ Under the historical cost concept, an asset is initially valued at the price paid to acquire it, and that value is systematically reduced by depreciation. Accountants realize that it would be more relevant to continually revalue assets at their fair market value, but they reject that approach as too uncertain and costly. Therefore, accountants will only revalue assets when they are purchased in a market transaction. Id. at 27-29.

A straight purchase of stock acquisition is a market transaction that conclusively establishes the value of a firm. When this type of transaction occurs, generally accepted accounting principles usually require the purchaser to revalue the assets of the acquired company on the purchaser’s books. This process means that the accountant must estimate the fair market value of each asset. If the sum of the estimated values does not equal the purchase price, then the balance is assigned to (positive or negative) goodwill. Id. at 335-36.

¹⁵⁷ See Financial Accounting Standards Board, 103 Status Rep. 3 (July 9 , 1980)Google Scholar, in which the Board “decided not to add to its agenda a project to determine whether a major change in the ownership of an enterprise should establish a new accounting basis for the enterprise’s assets and liabilities."

¹⁵⁸ For example, in American Medical the plaintiff providers did not revalue their assets on their own books following Chanco Medical Industries’ acquisitions of them. However, when Chanco merged with American Medical International several years later, the providers did revalue their assets on their own books. 466 F. Supp. at 621.

¹⁵⁹ The reason that accountants prefer to avoid revaluation, absent reimbursement concerns, is that revaluation will reduce the business’ stated earnings because of the larger depreciation deductions. Although this reasoning may be economically questionable, it seems persuasive to accountants. For example, in 1973 the Securities and Exchange Commission proposed a rule that would require revaluation after a 50 percent or more purchase of stock within a 12-month period. The SEC characterized the proposal as “a relatively simple extension of ‘purchase’ accounting.” Accountants reacted strongly against the proposal and persuaded the SEC to withdraw the proposal. See [1972-73 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 79,256.

¹⁶⁰ The Secretary has made efforts to eliminate revaluation after two step purchase of assets acquisitions. He has promulgated a new regulation, 42 C.F.R. § 405.415(l) (1981). As yet untested in court, this regulation simply puts into print the interpretation that the Secretary had earlier unsuccessfully urged on the courts. This Note argues that this regulation is invalid for precisely the reasons that the preceding interpretation was. The mere promulgation of the regulation does not add any greater force to the Secretary’s position, as it is still without a rational basis and contrary to established practice. This regulation should be declared invalid by the courts. Compare id. at § 405.415(/)(2)(ii) with West Seattle, 674 F.2d at 901-02.

¹⁶¹ 42 C.F.R. § 405.419(c)(1) (1981).

¹⁶² A “related party" is an organization that is tied to the provider by common ownership or control. 42 C.F.R. § 405.427(b) (1981). See supra note 108 for the text of the regulation. For cases in which providers have contested the finding of a relationship, see, e.g., American Hosp. Management Corp. v. Harris, 638 F.2d 1208, 1211 (9th Cir. 1980); Marina Mercy Hosp. v. Harris, 633 F.2d 1301, 1303 (9th Cir. 1980); Jackson Park Hosp. Found. v. United States, 659 F.2d 132, 135 (Ct. Cl. 1981); Northwest Community Hosp. v. Califano, 442 F. Supp. 949, 949 (S.D. Iowa 1977).

¹⁶³ Supra notes 107-110 and accompanying text.

¹⁶⁴ 42 C.F.R. § 405.419 (1981) provides in part:

¹⁶⁵ 42 C.F.R. § 405.419(c)(1) (1981).

¹⁶⁶ Id.

¹⁶⁷ The fiscal intermediary is the Secretary’s agent. See supra note 14 and accompanying text.

¹⁶⁸ See Jackson Park, 659 F.2d at 138-39. Cf. Stevens Park Osteopathic Hosp. v. United States, 633 F.2d 1373, 1379 (Ct. Cl. 1980) (“It is evident that inquiry into the fairness of transactions between related parties would be a demanding task indeed for the fiscal intermediary, while inquiry into the usually simpler issue of common control probably would have to take place anyway.”).

¹⁶⁹ See Goleta Valley Community Hosp. v. Schweiker, 647 F.2d 894, 897 (9th Cir. 1981); Jackson Park, 659 F.2d at 137; Stevens Park, 633 F.2d at 1381.

¹⁷⁰ See Caylor-Nickel Hosp. v. Califano, [1980 Transfer Binder] Medicare & Medicaid Guide (CCH) ¶ 30718 (N.D. Ind. Sept. 10, 1979); Hillside Community Hosp. of Ukiah v. Mathews, 423 F. Supp. 1168 1176-77 (N.D. Cal. 1976).

¹⁷¹ See Stevens Park, 633 F.2d at 1381.

¹⁷² See Northwest Hosp. v. Hospital Serv. Corp., 687 F.2d 985, 990 (7th Cir. 1982); Goleta Valley, 647 F.2d at 897; Jackson Park, 659 F.2d at 137; South Boston Gen. Hosp. v. Blue Cross of Va., 409 F. Supp. 1380, 1385 (W.D.Va. 1976).

¹⁷³ Caylor-Nickel Hosp. v. Califano, [1980 Transfer Binder] Medicare & Medicaid Guide (CCH) ¶ 30,718:

¹⁷⁴ See, e.g., Note, The Conclusive Presumption Shuffle, 125 U. Pa. L. Rev. 761 (1977)CrossRefGoogle Scholar; Note, Irrebuttable Presumptions: An Illusory Analysis, 27 Stan. L. Rev. 449 (1975)CrossRefGoogle Scholar; Note, The Irrebuttable Presumption Doctrine in the Supreme Court, 87 Harv. L. Rev. 1534 (1974)CrossRefGoogle Scholar; Note, The Conclusive Presumption Doctrine: Equal Process or Due Protection?, 72 Mich. L. Rev. 80 (1974)CrossRefGoogle Scholar.

¹⁷⁵ Caylor-Nickel, Medicare & Medicaid Guide (CCH) at ¶ 30,718.

¹⁷⁶ Id.

¹⁷⁷ Id. The presumption is valid despite its imprecision in denying reimbursement to some reasonable transactions between related parties, because it reflects the Secretary’s choice not to devote limited resources to individual determinations of reasonableness.

¹⁷⁸ Another potential constitutional objection to § 405.419 was raised in Northwest Hosp., 687 F.2d at 992, and Trustees of Ind. Univ. v. United States, 618 F.2d 736, 740 (Ct. Cl. 1980). Section 405.419(c)(2) exempts from the rule loans from religious orders to providers affiliated with the orders; the courts noted that such special treatment for a religious entity could raise constitutional questions under the first amendment. However, each court avoided the con stitutional issue by basing its decision on other grounds.

¹⁷⁹ See Stevens Park, 633 F.2d at 1381-82.

¹⁸⁰ 42 C.F.R. § 405.429(b)(ii) (1981). The reason for this practice is to allow the related party—who looks like an owner by virtue of being related to the provider and having invested capital in the provider—to realize a return on his investment. The Secretary treats the related party as a shareholder rather than as a lender. This practice is not available for non-profit providers, because they do not have equity investors.

¹⁸¹ Stevens Park, 633 F.2d at 1382-83. The court noted that the statute provides a return on equity for proprietary providers only, because a return on equity is not part of the “normal costs" of a nonprofit provider. Further, the court noted the financial advantages that non-profit providers had over their proprietary counterparts, including Hill-Burton funds, tax-exempt status, and charitable, grant-in-aid, and endowment contributions.

¹⁸² See supra note 172.

¹⁸³ In contrast, the general related party rule of § 405.427 allows reimbursement to the provider up to the net book value of the item in the related party’s hands, so the disallowance of reimbursement is only partial.

¹⁸⁴ See Trustees, 618 F.2d at 739-40; South Boston, 409 F. Supp. at 1385. These arguments are often made in cases which involve the purchase of facilities by a provider from a related party, financed with a loan from the related party-seller to the provider-buyer. Such a transaction raises two related party issues: the valuation of the assets and the interest on the loan. The argument that the provider should be allowed to demonstrate the fairness of the transaction is usually made with respect to the asset valuation question. See Goleta Valley, 647 F.2d at 897; Stevens Park, 633 F.2d at 1378. It would seem to apply, a fortiori, to the interest reimbursement question.

¹⁸⁵ See Goleta Valley, 647 F.2d at 897.

¹⁸⁶ See Trustees, 618 F.2d at 740.

¹⁸⁷ See Northwest Hosp., 687 F.2d at 996.

¹⁸⁸ See Goleta Valley, 647 F.2d at 897;Stevens Park, 633 F.2d at 1383-84; Caylor-Nickel, [1980 Transfer Binder] Medicare & Medicaid Guide (CCH) at ¶ 30,718; Hillside Community, 423 F. Supp. at 1177; Jackson Park, 659 F.2d at 137.

¹⁸⁹ See supra notes 107-10 and accompanying text.

¹⁹⁰ 618 F.2d 736 (Ct. Cl. 1980).

¹⁹¹ Id. at 738.

¹⁹² The Indiana University Hospitals were part of the University and therefore under common control of the Trustees. Id. at 737.

¹⁹³ Id. at 739, quoting Church of Holy Trinity v. United States, 143 U.S. 457, 459 (1892). Using this approach, a court will not apply the “plain meaning" of a statute when it would produce a result not intended by the statute or the policy behind the statute.

¹⁹⁴ Although the State of Indiana contributed funds to the University, state law did not allow the University to use any of those funds in the hospitals. The hospitals also claimed that they could not borrow money from other sources because they were not a separate legal entity. Trustees, 618 F.2d at 737.

¹⁹⁵ [W]e stress the limited scope of our decision. We are not holding that interest

Id. at 740-41.

¹⁹⁶ 687 F.2d 985 (7th Cir. 1982).

¹⁹⁷ Prior to the sale, the provider, Northwest Hospital, was a for-profit corporation with three stockholders. In 1966, the three stockholders and four other persons formed a new nonprofit corporation with themselves as trustees. In late 1967, the nonprofit corporation purchased the proprietary corporation for $5,000,000. The purchase price was $100,000 in cash, the balance in unsecured subordinated 15-year promissory notes at 4% interest, payable to the three former shareholders. The nonprofit corporation acquired the stock, liquidated the proprietary corporation, and began its operations as a nonprofit corporation. Id. at 987.

¹⁹⁸ Id. at 996.

¹⁹⁹ 42 C.F.R. § 405.419(a) (1981) states that “necessary and proper interest on both current and capital indebtedness is an allowable cost.” § 405.419(b)(2) defines “necessary"; § 405.419(b)(3) defines “proper.” See supra note 164.

²⁰⁰ 42 C.F.R. § 405.427(d) (1981) establishes four criteria that, if proved, will allow a provider reimbursement for the full price (rather than net book value) of services, facilities or supplies (products) purchased from a related party. Briefly, the requirements are: (1) the related organization must be separate from the provider; (2) a substantial part of the related organization’s business must be carried on with organizations other than the provider or other related entities, in a competitive market; (3) the related organization’s products must be of a type commonly obtained by hospitals from suppliers; and (4) the price paid by the provider must be the competitive price.

For a case interpreting this exception, see American Medical Int'l, Inc. v. Secretary of HEW, 466 F. Supp. 605, 616-20 (D.D.C. 1979), qff'd, 677 F.2d 118 (D.C. Cir. 1982).

²⁰¹ Northwest Hasp., 687 F.2d at 994.

²⁰² The court felt that the requirement that all interest be necessary and proper would protect the Medicare program from abuse due to related party loans. Providers will still have to show that the loans were made to satisfy a financial need of the provider, and were made for a purpose reasonably related to patient care, and that the interest rate was reasonable under then-existing money market conditions. Id. at 989, 992.

²⁰³ Id. at 985.

²⁰⁴ Goleta Valley, 647 F.2d 894 (9th Cir. 1981).

²⁰⁵ Northwest Hosp., 687 F.2d at 992.

²⁰⁶ Id. at 996.

²⁰⁷ Id. The court noted that if it were to allow reimbursement of interest expense on the entire loan, then the provider could circumvent the net book value rule that restricts reimbursement for assets by arranging a reasonable rate on a loan with an overly high principal amount. Id. at 992 n.11.

²⁰⁸ 409 F. Supp. 1380 (W.D.Va. 1976).

²⁰⁹ Id. The purchase price was $650,010, payable entirely in fifteen annual installments at 4 percent. Id. at 1383.

²¹⁰ Id. at 1385.

²¹¹ Id.

²¹² In an ordinary competitive market with many sellers, those whose prices are higher will sell less (or no) goods. It is the preference of consumers to buy goods at the lowest price available that creates competition among sellers to keep the price as low as possible. A provider whose costs were higher because of inefficient interested transactions would have to charge more to Medicare and non-Medicare patients. In a competitive market, the non-Medicare patients, if they were paying their own hospital bills, would go to other providers who charged less for the same services.

²¹³ In calendar year 1977, the federal government paid 54.4 percent of hospital care expenses for all ages, and private health insurance paid 36.2 percent. Muse, D. & Sawyer, D. The Medicare and Medicaid Data Book, 1981, at p.12 (1982)Google Scholar.

²¹⁴ See Feldstein, supra note 68, at 22-35, noting that private insurance coverage, government programs like Medicare and Medicaid, and the nonprofit status of many hospitals as major reasons why hospital costs have risen so rapidly.

²¹⁵ See 42 C.F.R. § 405.419(a),(b) (1981), which requires that all interest expense be incurred on loans that are “necessary" and “proper,” regardless of whether the parties are related.

²¹⁶ The evaluation of the fairness of a loan to decide whether it was necessary and proper would presumably involve scrutiny of accounting statements and the loan documents. The accounting statements, such as the balance sheet, income statement, and cash flow statement of the provider, are easily interpreted. Similarly, the loan documents should be relatively easy to interpret.

Moreover, there is little problem caused by an evaluation that occurs after the transaction is completed, in contrast to a short-lived good or a personal service, where an appraisal by the fiscal intermediary, after the good has been used up or the service rendered, would be more difficult and less useful.

²¹⁷ 42 C.F.R. § 405.419(b)(2) (1981).

²¹⁸ Interested transactions can involve any number of fact patterns in which one person is involved in the ownership, management, or control of both corporations. For example, in Abeles v. Adams Eng'g Co., 35 N.J. 411, 173 A.2d 246 (1961), a director of the defendant Adams Engineering Co. was also president of an investment banking corporation. The subject matter of the suit was a contract between the investment bank and the defendant; the defendant sought to escape liability on the contract on the ground that it was unfair because of the director-president’s dual capacity. Id. at 430, 173 A.2d at 256.

²¹⁹ The duty of loyalty doctrine is not confined to directors. It extends to officers and controlling shareholders as well. See generally Vagts, D. Basic Corporation Law 237-75 (2d ed. 1979)Google Scholar.

²²⁰ Stewart v. Lehigh Valley R.R. Co., 38 N.J.L. 505, 523 (1875).

²²¹ Phillips, Managerial Misuse of Property: The Synthesizing Thread in Corporate Doctrine, 32 Rutgers L. Rev. 184, 190-91 (1979)Google Scholar.

²²² Robotham v. Prudential Ins. Co. of Am., 64 N.J.Eq. 673, 709, 53 A. 842, 856 (Ch. 1903).

²²³ Id. at 709-10, 53 A. at 857.

²²⁴ Marsh, Are Directors Trustees?, 22 Bus. Law. 35, 43 (1966)Google Scholar.

²²⁵ Id..

²²⁶ The Robotham court realized as much: "Common directors abound, and common directors are better than dummies.” Robotham v. Prudential Ins. Co. of Am., 64 N.J. Eq. at 709, 53 A. at 856.

²²⁷ Vagts, supra note 219, notes that one investment banking firm once had members holding 100 seats on boards of directors.

²²⁸ Phillips, supra note 221, at 190-91.

²²⁹ Id.

²³⁰ See supra notes 212-14 and accompanying text.

²³¹ The Northwest Hosp. court pointed out that the interest rate on the loan from the related party was less than the provider would have paid for outside financing. 687 F.2d at 993.