Life Care Center of New Market v. Department of Medical Assistance Services

COURT OF APPEALS OF VIRGINIA

Present: Judges Benton, Annunziata and Senior Judge Duff
Argued at Alexandria, Virginia

LIFE CARE CENTER OF
NEW MARKET
OPINION BY
v. Record No. 2022-96-4 JUDGE JAMES W. BENTON, JR.
SEPTEMBER 2, 1997
DEPARTMENT OF MEDICAL
ASSISTANCE SERVICES

FROM THE CIRCUIT COURT OF SHENANDOAH COUNTY
Perry W. Sarver, Judge Designate
Laura G. Aaron (Mezzullo & McCandlish, on
briefs), for appellant.

E. Paige Selden, Assistant Attorney General
(James S. Gilmore, III, Attorney General;
William H. Hurd, Deputy Attorney General;
Siran S. Faulders, Senior Assistant Attorney
General, on brief), for appellee.

This is an appeal from a circuit court's order affirming a

decision of the Department of Medical Assistance Services (DMAS),

which denied reimbursement for certain expenses incurred by Life

Care Center of New Market. New Market argues that the trial

judge erred in affirming DMAS's decision to deny reimbursement

for (1) overhead expenses incurred by Life Care Construction in

building an addition to the New Market facility, and (2) certain

interest expenses incurred to finance a loan borrowed to fund the

construction project. For the reasons that follow, we affirm, in

part, and reverse, in part, the trial judge's order.

I.

New Market is a nursing facility in Virginia that is owned

and operated by Life Care Centers of America. New Market
participates in the Medicaid program, which is administered by

DMAS. As a Medicaid participant, New Market is entitled to file

a cost report with DMAS and obtain reimbursement for expenses

incurred in providing health care services to Medicaid

recipients. Expenses properly incurred in constructing an

addition to an existing facility may be reimbursed by DMAS. See

Fralin v. Kozlowski, 18 Va. App. 697, 699-700, 447 S.E.2d 238,

239-40 (1994).
In March 1987, New Market obtained a certificate of need to

construct a forty-two bed addition to its facility. New Market

received a loan commitment in 1987 and constructed the addition

in 1988 and 1989. After a field auditor for DMAS denied

reimbursement for certain overhead and interest expenses incurred

in the construction project, New Market appealed.

During the informal fact finding conference, New Market

argued that the $73,572 paid to Life Care Construction was

primarily for overhead expenses. When DMAS questioned New

Market's methodology for computing overhead and its lack of

supporting documentation, New Market requested and was granted

additional time to submit documentation to support its claim for

overhead costs. Although New Market supplied a summary chart of

Life Care Construction's fees and expenses for the two years the

project was under construction, it provided no documentation to

support the data in the chart. The record indicates that DMAS

"was concerned that . . . the overhead that was allocated to New

2
Market would have been disproportionate to the overhead that

would be allocated to other projects that were overseen by Life

Care Construction." Although James Branham, DMAS's audit

supervisor, offered to assist New Market in arriving at a

methodology that would be acceptable to DMAS, New Market did not

pursue that offer. Instead, New Market prepared a second

analysis based on revenues because it believed "that was the best

available information."
New Market also argued at the informal fact finding

conference that because the partnership distributions were a

customary and legitimate business practice, DMAS erroneously

disallowed reimbursement for interest on a portion of the loan

equivalent to those distributions. DMAS asserted that the

records established that New Market made distributions to the

partnership accounts from the construction loan proceeds and that

those loan funds therefore were not reasonably related to the

delivery of patient care. Following the informal fact finding

conference, the Director of the Division of Cost Settlement and

Audit affirmed the original decision. New Market again appealed.

A formal hearing was held before a hearing officer appointed

by the Supreme Court. The primary facts proved at the hearing

are not in dispute. The testimony at the hearing proved that New

Market initially entered into a contract with a local

construction company to build the contemplated addition to New

Market's facility. Before construction began, however, the

3
principal owner of the construction company died. Life Care

Centers of America, New Market's owner, then decided to build the

addition itself and formed for that purpose a new company, Life

Care Construction. New Market hired Life Care Construction to

build the addition. DMAS and New Market agree that Life Care

Construction is a "related party," i.e., that it was under common

ownership or control with New Market.

Life Care Construction employed a local contractor, Paul

Thompson, who had a general contractor's license, to act as an

"on-site daily superintendent" for the project. Life Care

Construction "acted as owner's representative; it acted as

developer." According to the testimony, Life Care Construction

"studied [the project], listened to the operators of Life Care

Centers of America on the needs of the addition; . . . worked

with the architect; . . . designed with the architect the

blueprints, helped design the specifications for the project,

deciding the equipment, the finishes, [and] worked through the

process of the blueprints being drawn by the architect firm."

Life Care Construction also "prepared the liens for all the

subcontractors, paid the bills, coordinated with equipment

suppliers, the decorator and operations as it got near the end,

and then turned the building over to operations when it was

finished." Most of the contracts with the subcontractors were

executed by Life Care Construction.
New Market's analyst, Randy Martin, who is a certified

4
public accountant and an employee of Life Care Centers of

America, testified that New Market sought reimbursement for the

overhead costs (or "indirect costs") of the project that were

billed by Life Care Construction. 1 He testified that the

indirect costs of Life Care Construction were not separately

incurred in relation to individual projects and that they had to

be allocated among all of Life Care Construction's building

projects. To support New Market's claim for reimbursement,

Martin proposed two analyses that attempted to isolate the

indirect costs Life Care Construction incurred in relation to the

New Market construction project. In those analyses, which were

based on revenues that Life Care Construction received, Martin

attempted to eliminate any profits from the analysis because DMAS

will not permit reimbursement for profits earned by a related

party.
In the first calculation, Martin determined that two percent

of Life Care Construction's total revenues for the year

represented profits. Martin then determined the amount of

profits earned on the New Market project by multiplying by two

percent the total revenues received from New Market. After
1
"[O]verhead costs are those that are expended for the
benefit of the whole business, which by their nature cannot be
attributed or charged to any particular contract." Altmayer v.
Johnson, 79 F.3d 1129, 1132 (Fed. Cir. 1996); see also Alvey
Conveyor Mfg. Co. v. Kansas City Terminal Ry. Co., 203 S.W.2d
606, 609 (Mo. 1947) ("Overhead . . . includes the continuous
expense of a business irrespective of the direct costs on
particular contracts."); Neumiller Farms, Inc. v. Cornett, 368
So. 2d 272, 276-77 (Ala. 1979).

5
eliminating that amount of profit from the revenues, Martin

concluded that the resulting figure represented both direct and

indirect costs. Martin testified that overhead costs represented

approximately eight percent of the total cost of the New Market

project. The record does not reveal Martin's methodology for

arriving at the eight percent figure.

Martin testified that this method of computing overhead

costs has been accepted by Medicare in the past. In addition, he

testified that DMAS accepted this methodology when used by Total

Designs, the company that provided furnishings and decorations to

New Market for the same project.
Glen Walker, a certified public accountant licensed in

Virginia, testified as New Market's expert witness that Martin's

overhead figure of eight percent was unusually low. He indicated

that ten percent is a more typical overhead amount on commercial

construction projects. Walker also testified that the technique

Martin used to calculate overhead expenses has been used in

Virginia in the Medicaid program and is generally used 90% of the

time.

In the second calculation, Martin determined the total

amount of overhead costs billed by Life Care Construction for all

of its projects that year. Martin then "took the percentage of

. . . New Market's overhead billings to the total overhead

billings for those two years and applied that percentage to the

total [actual] overhead costs to identify . . . approximately

6
$79,000 of overhead that should be allocated to . . . New

Market." That amount "actually exceed[ed] the billings that . .

. Life Care Construction made to . . . New Market." Martin

testified that this method "had been used for Medicare and . . .

Medicaid [in other] states and was a rather commonly accepted

method of determining the related party costs." However, he

added that he had "never had to do this type of [calculation] for

another DMAS audit" because New Market was Life Care Centers of

America's only facility in Virginia. Walker, the certified

public accountant, testified that methods similar to this second

analysis are used ten percent of the time.
Martin testified that he had offered to provide "back-up

documentation" to support his calculations. However, James

Branham, the audit supervisor for DMAS, testified that Life Care

Construction's documents were not made available to him for

review during the audit. He said that he had only received "some

compiled financial statements." Branham also testified, however,

that an analysis that is based upon revenues is "not an

acceptable basis of allocating costs." He stated that such an

analysis is inappropriate in related party cases because the

revenue is not determined in an arms length transaction. Branham

further testified that although Martin had initially agreed to

work with him to "develop this cost information" in a manner that

was "more in accordance with the Medicare and Medicaid

regulations," Martin did not contact him.

7
 Wendall Gatlin, a senior officer for DMAS, testified that he

sought the additional documentation because he "wanted to

determine what services [New Market] received" from Life Care

Construction. He was concerned that there was a "duplication of

duties" between Life Care Construction and Thompson, the local

contractor.

On the issue of DMAS's denial of reimbursement for a portion

of the interest expense incurred in financing the construction

loan, Martin testified that New Market borrowed $1,200,000 to

finance the project and that the actual total cost of the project

was $1,075,474. Because the loan exceeded the actual cost, New

Market only sought reimbursement of the interest expense for the

portion of the loan that actually was needed, the $1,075,474

total cost of the project.
Martin testified that DMAS initially disallowed $104,461 of

the total costs and that a large portion of that amount was the

overhead cost disallowance. To avoid reimbursing the interest on

the portion of the loan attributable to an expense DMAS

disallowed, the total amount of the loan was adjusted to $971,013

for interest reimbursement purposes. The amount was adjusted

again to account for a portion of management fees that exceeded

amounts allowable under the Medicare regulations. DMAS

determined that the money used to pay the management fees "was

cash that the facility could have withheld and not paid to the

management company and used to fund the construction rather than

8
paying it to the management company." In addition, DMAS

determined that partnership distributions and loans had been made

in the amount of $263,266. DMAS determined that New Market

should have used those funds to reduce its need to borrow.

Finally, the amount of the loan was also adjusted to account for

expenditures of operating funds made during the construction

process. DMAS determined that because only $573,923 of the total

loan was necessary for the project, interest attributable only to

that portion of the loan would be reimbursed.
Based on this evidence, the hearing officer reversed the

decision to deny the reimbursements and ruled in favor of New

Market. DMAS then appealed. After review by DMAS's Director,

DMAS issued a final agency decision that rejected the hearing

officer's conclusions of law and denied the reimbursements New

Market sought. On appeal to the circuit court, the trial judge

affirmed DMAS's ruling as contained in the final agency decision.

New Market now appeals.

II.

STANDARD OF REVIEW

Recently, this Court specifically addressed the standard of

review applicable to similar cases.
In reviewing decisions by DMAS, an
appellate court accords great deference to
both the agency's factual findings and
interpretation of the laws applicable to "the
reimbursement due qualified providers for
their reasonable cost incurred while
delivering health care services." This Court
will overturn DMAS' "interpretations of the
statutes and regulations governing Medicaid

9
 and Medicare principles of reimbursement
. . . only . . . when found to be arbitrary
and capricious."

Beverly Health and Rehab. Servs., Inc. v. Metcalf, 24 Va. App.

584, 592, 484 S.E.2d 156, 160 (1997) (citations omitted).

III.

CONSTRUCTION COSTS

New Market first argues that the trial judge erred in

affirming DMAS's decision to deny reimbursement of certain

construction costs. New Market contends that DMAS erroneously

arrived at its decision without first reviewing New Market's

supporting documentation. DMAS argues that New Market failed to

provide adequate supporting documentation and that, therefore,

the denial of reimbursement was supported by 12 VAC 30-90-110

(1990). DMAS also argues that New Market's methodology for

isolating the overhead costs applicable to the New Market project

was inadequate.
The trial judge made the following rulings:
It was New Market's responsibility to
furnish evidence in support of its claim for
reimbursement for management fees and
overhead costs. . . . DMAS insisted that New
Market furnish information on a cost and not
a revenue basis. After the Informal Fact
Finding Conference, there was a general
agreement that the parties would meet for the
purpose of developing procedures for
providing cost information and the supporting
data for such costs. The time for
accomplishing this was extended by DMAS, and
New Market's response has been to insist on
reimbursement on a revenue basis.

The evidence supports that ruling.

10
 To facilitate the process of auditing health care providers,

DMAS requires providers to keep and make accessible adequate

documentation to support their claims for reimbursement. See 12

VAC 30-90-110 (1990). In relevant part, 12 VAC 30-90-110

provides as follows:
II. Types of records to be maintained.
Information which must be maintained for the
duration of the provider's participation in
the DMAS includes, but is not limited to:

* * * * * * *
D. Copies of all cost reports filed with
the DMAS together with supporting financial
statements.

III. Record Availability. The records must
be available for audits by DMAS staff. Where
such records are not available, costs shall
be disallowed.

(Emphasis added). As pertinent to this case, DMAS would have

grounds to deny New Market's claim if New Market failed to make

available its cost reports or supporting financial statements.

See 12 VAC 30-90-110 (II)(D).

The evidence reveals that DMAS sought to audit the financial

documents that would support New Market's request for

reimbursement. Branham, the audit supervisor for DMAS who

oversaw the audit of New Market, testified that "[w]hen [they]

requested [the documentation], what was furnished were some

financial statements." Branham stated that he sought more

detailed information than the "compiled financial statements"

provided by New Market; he sought documents demonstrating "the

11
various components of [the] . . . costs and the revenue."

Gatlin, a senior officer for DMAS, testified that the auditors

"were after the detail of the services" that Life Care

Construction provided to New Market. Gatlin stated that DMAS

initially "wanted to determine what services . . . [New Market]

received" from Life Care Construction.

Branham testified that when New Market initially sought

reimbursement for money paid to Life Care Construction, DMAS

"questioned the need" for the payment "because they had a general

contractor, . . . Thompson, who was on-site and was doing . . . a

lot of the subcontracting." DMAS also questioned "the

methodology" that New Market used. New Market had only submitted

a "profit computation" as justification for the fees charged by

Life Care Construction. DMAS informed New Market that it

required additional financial documents because New Market had

merely submitted statements using a "revenue basis" for

calculating the payment it made to Life Care Construction.

Branham testified that the Medicaid regulations require that

providers be reimbursed only for actual costs incurred by related

parties. He testified that revenue based methodologies are not

acceptable because related party transactions are "not . . .

arms-length transaction[s]" and, thus, "revenue[s] can be set at

whatever the related parties agree." Branham testified that when

the DMAS auditors requested supporting financial statements for

the requested reimbursement they only received "compiled

12
financial statements" that did not provide adequate "back-up"

financial documentation to support New Market's methodology.

Branham further testified that at the informal conference

DMAS informed New Market "that the more appropriate method would

be to identify all of the various project costs and use that

basis for allocating the indirect costs or the overhead

components." Although DMAS believed that it had reached an

agreement with New Market to develop the cost information, New

Market did not follow through. Instead, it submitted another

revenue based proposal. New Market also did not submit financial

documentation to support the second proposal.
Accordingly, we hold that the evidence supports the trial

judge's finding that New Market failed to meet its burden, under

12 VAC 30-90-110, to provide documentary evidence to support its

claim for reimbursement. "Because the trial [judge's] decision

upholding DMAS's denial of payment to [New Market] is consistent

with Medicare principles of reimbursement, [the] decision was not

arbitrary or capricious and must be affirmed." Fralin, 18 Va.

App. at 705, 447 S.E.2d at 243.

IV.

INTEREST EXPENSE

New Market sought reimbursement for interest expenses it

incurred to finance the construction loan. DMAS found that

portions of the loan were unnecessary and denied reimbursement

for the interest that accrued on those portions of the loan.

13
 Under the Nursing Home Payment System, "cost shall include

actual allowable . . . interest." NHPS § 2.1 (A) (1989-1991).

All costs, including interest, must be necessary and reasonable.

See NHPS App. I, § 1.1 (A) (1989-1991). As the NHPS does not

define "necessary" and "reasonable," we must look to the Medicare

principles of reimbursement as set forth in the Provider

Reimbursement Manual for guidance. See Beverly, 24 Va. App. at

594, 484 S.E.2d at 161. "Necessary and proper interest on both

current and capital indebtedness is an allowable cost." Prov.

Reimb. Man., Part 1, § 200 (1968). "To be allowable under the

Medicare program, interest must be . . . necessary and proper for

the operation, maintenance, or acquisition of the provider's

facilities." Prov. Reimb. Man., Part 1, § 202.1 (1968).

"Necessary means that the interest [must] be incurred on a loan

made to satisfy a financial need of the provider . . . ." Prov.
2
Reimb. Man., Part 1, § 202.2 (1983).
Interest Incurred to Pay Management Fees
The record reveals that DMAS reduced the amount of the loan

for which it would pay the interest expense in part to account

for management expenses New Market incurred. No authority

supports that reduction. DMAS made the adjustment on the ground

that because related party management fees are not reimbursable,

the management fees should not have been incurred; rather, New
2
§ 202.2 has been amended since 1983; however, the 1983
version is applicable to the cost reports for 1989, 1990, and
1991 involved in this case.

14
Market should have used those funds to reduce its need to borrow.

DMAS misapplies the law. To determine whether interest for

a loan is reimbursable, the relevant inquiry is the necessity for

the loan. See Prov. Reimb. Man., Part 1, § 202.1 (1968).

Whether DMAS will reimburse a given expenditure is a different

question than whether an expenditure is necessary. DMAS does not

reimburse all expenditures made by providers that are necessary

for the ongoing operation of their facilities. Thus, regardless

of whether DMAS would reimburse New Market for related party

management fees, the interest on the loan is reimbursable so long

as the management fees were a necessary expense incurred in

operating New Market's health care facility.
At the evidentiary hearing, Martin described the management

services as "accounting services, data processing services, risk

management services, [and] . . . general overall supervision."

No evidence was offered at the hearing that would tend to show

that the management services were not a necessary expense of the

health care facility. Accordingly, we hold that the trial judge

erred in affirming DMAS's decision to deny reimbursement for

interest on the portion of the loan that was equivalent to the

amount of management fees paid by New Market.
Partnership Distributions

DMAS determined that the amount of the loan necessary for

New Market's project should be reduced by $263,266, the amount of

the partnership distributions made between 1987 and 1989. DMAS

15
reasoned that New Market had those funds available and could have

used them to reduce its need to borrow. Thus, DMAS found that

$263,266 of the loan was not "necessary."

New Market argues that under Pioneer Hosp. v. The Travelers

Ins. Co., 1983-1 Medicare & Medicaid Guide, New Developments

(CCH) Para. 32,400 (PRRB Jan. 7, 1983), DMAS's consideration of

the partnership distributions was erroneous. We agree. In

Pioneer, the Provider Reimbursement Review Board held that when

determining whether a loan was "necessary" for interest

reimbursement purposes, the availability of funds and

distributions to partners after the loan was made are not
relevant. Rather, a reviewing tribunal should only consider the

provider's financial condition as it existed at the time the loan

was made. Therefore, we hold that DMAS erred in using the

partnership distributions made after the loan commitment as a

basis for reducing the amount of interest it would reimburse.

Accordingly, we affirm the trial judge's decision to uphold

DMAS's denial of reimbursement for the related party overhead

expenses. However, we reverse the remainder of the decision and

remand the case to the trial judge. The trial judge shall remand

the case to DMAS to remove the interest deductions it imposed on

account of the management fees and partnership distributions.
Affirmed in part, reversed in part,
and remanded.

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