Catholic Health Initiatives v. Sebelius

United States Court of Appeals
FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued May 10, 2010 Decided August 13, 2010

No. 09-5377

CATHOLIC HEALTH INITIATIVES, ET AL.,
APPELLANTS

v.

KATHLEEN SEBELIUS, SECRETARY, UNITED STATES
DEPARTMENT OF HEALTH AND HUMAN SERVICES,
APPELLEE

Appeal from the United States District Court
for the District of Columbia
(No. 1:07-cv-00555-PLF)

Paul D. Clement argued the cause for appellants. With him
on the briefs were Christopher L. Keough and J. Harold
Richards.

Irene M. Solet, Attorney, U.S. Department of Justice,
argued the cause for appellee. With her on the brief was
Michael S. Raab, Attorney. Dana L. Kaersvang, Attorney, and
R. Craig Lawrence, Assistant U.S. Attorney, entered appear-
ances.

Before: SENTELLE, Chief Judge, BROWN, Circuit Judge, and
RANDOLPH, Senior Circuit Judge.
 2

Opinion for the Court filed by Senior Circuit Judge
RANDOLPH.

Opinion concurring in the judgment filed by Circuit Judge
BROWN.

RANDOLPH, Senior Circuit Judge: This is an appeal from an
order of the district court granting summary judgment to the
Secretary of Health and Human Services. Catholic Health
Initiatives, a nonprofit charitable corporation, and a group of its
affiliated nonprofit hospitals brought an action under the
Medicare Act to recover premiums the hospitals had paid for
malpractice, workers’ compensation, and other insurance. The
hospitals paid the premiums to First Initiatives Insurance Ltd.
from 1997 through 2002. Catholic Health wholly owns First
Initiatives, which is based in the Cayman Islands.

In general, the Secretary considers malpractice, workers’
compensation, and other liability insurance premiums to be part
of a hospital’s “reasonable costs” incurred in providing services
to Medicare beneficiaries. As such, the costs are reimbursable.
The Medicare Act defines the “reasonable cost of any services”
to be “the cost actually incurred, excluding therefrom any part
of incurred cost found to be unnecessary in the efficient delivery
of needed health services . . ..” 42 U.S.C. § 1395x(v)(1)(A).
The “reasonable cost” “shall be determined in accordance with
regulations establishing the method or methods to be used, and
the items to be included, in determining such costs for various
types or classes of institutions, agencies, and services . . ..” Id.

The regulations describe reasonable costs as “related to the
care of Medicare beneficiaries,” 42 C.F.R. § 413.9(c)(3), and
“determined in accordance with regulations,” id. § 413.9(b).
Reasonable costs include “all necessary and proper costs
incurred in furnishing” Medicare services. Id. § 413.9(a).
 3

Necessary and proper costs are those direct and indirect costs
“that are appropriate and helpful in developing and maintaining
the operation of patient care facilities and activities,” and that
are not “substantially out of line with” the costs of similar
institutions. Id. § 413.9(b)(2), (c)(2).

The Secretary has issued a Provider Reimbursement
Manual. The Manual contains “guidelines and policies to
implement Medicare regulations which set forth principles for
determining the reasonable cost of provider services,” but it
“does not have the effect of regulations.” Centers for Medicare
and Medicaid Services, Provider Reimbursement Manual, Part
1, Foreword, at I (“PRM”). The Manual does bind Medicare’s
“fiscal intermediaries” – private firms under contract with the
Secretary to review provider reimbursement claims and deter-
mine the amount due. See 42 U.S.C. § 1395h; Yale-New Haven
Hosp. v. Leavitt, 470 F.3d 71, 80-81 (2d Cir. 2006); St. Mary of
Nazareth Hosp. Ctr. v. Schweiker, 718 F.2d 459, 463 (D.C. Cir.
1983).1

Rather than purchasing insurance in the market, some
Medicare providers have established their own insurance
companies – known as “captives” – for the purpose of insuring
themselves against malpractice and certain other claims. PRM
§ 2162.2.A. If the captive is a domestic corporation, and if the
premiums it charges are comparable to those of other insurance
companies, the Manual states that the affiliated provider is
entitled to reimbursement for premiums paid to the captive. Id.
But if the captive is offshore, the Manual prohibits reimburse-
ment for premiums if the captive’s investments do not comply
with the following rule:

1
In 2005, fiscal intermediaries were replaced by “medicare
administrative contractors.” See 42 U.S.C. 1395h; 42 C.F.R.
§ 413.24(f).
 4

In the case of offshore captives, investments by a related
captive insurance company are limited to low risk invest-
ments in United States dollars such as bonds and notes
issued by the United States Government; debt securities
issued by United States corporations or governmental
entities within the United States rated in the top two
classifications by United States recognized securities rating
organizations at the time of investment; debt securities of
foreign subsidiaries of United States corporations rated in
the top two classifications by United States recognized
securities rating organizations at the time of investment
where the parent United States corporations guaranteed (on
the face of the securities) payment of the subsidiaries’
securities; and deposits (including Certificates of Deposit)
in United States banks or their foreign subsidiaries, and
foreign banks rated in the top two short term classifications
by United States recognized securities rating organizations.
Low risk investments may also include investments of non-
United States issuers including foreign governments and
corporations and supranational agencies rated in the top two
classifications by United States recognized securities rating
organizations (effective with investments made on or after
10/11/91). Effective for investments made on or after
10/06/95, the limitation on related offshore captive insur-
ance company investments is extended to include the above
described low risk investments rated in the top three
classifications by United States recognized securities rating
organizations. Additionally, investments may include
dividend paying equity securities listed on a United States
stock exchange provided that the investment in equity
securities does not exceed 10 percent of the company's
admitted assets, with the investment in any specific equity
issue further limited to 10 percent of the total equity
security investment. (All such captives are required to
annually submit to a designated intermediary a certified
 5

statement from an independent certified public accountant
or actuary attesting to compliance or non-compliance with
these requirements for the previous period.) These invest-
ments cannot be pledged or used as collateral for loans
obtained by the captive or parties related to the captive
either directly or indirectly, nor may investments be made
in a related organization.

PRM § 2162.2.A.4. First Initiatives Insurance did not satisfy
these requirements. During the contested period it invested as
much as forty to fifty percent of its assets in equity securities.

In light of First Initiatives’ noncompliance with the Manual,
the hospitals disallowed their premium payments on the annual
cost reports they submitted to Medicare’s fiscal intermediaries.
See 42 C.F.R. § 405.1801(b)(1). The hospitals then sought to
recover those premiums by challenging § 2162.2.A.4 at a
hearing before the Provider Reimbursement Review Board, a
five-member panel with authority to affirm, modify, or reverse
an intermediary’s decision. 42 U.S.C. § 1395oo(a), (d), (h).
(Here the intermediary decision was merely to accept the
hospitals’ own disallowance of their premium costs.) The Board
must give the Manual “great weight,” but – unlike an intermedi-
ary – is not bound by it. 42 C.F.R. § 405.1867.

In a three to two decision, the Board held that the invest-
ment limitations in § 2162.2.A.4 of the Manual were a “valid
extension” of the statute and the regulations governing “reason-
able cost.” Therefore the Board majority treated the provision
as “compulsory.” Catholic Health Initiatives v. Mutual of
Omaha Ins. Co., PRRB Decision No. 2007-D14 (Jan. 24, 2007)
(“Board Decision”). The majority explained that, unlike
domestic captive insurance companies, offshore captives present
an “inherent risk”: “offshore captives are under the control of
foreign governments and are not subject to the same level” of
 6

regulation as domestic insurers, which are regulated by the
states. In addition, the ten percent limit on equity investments
“is in line with the asset allocations found among domestic
insurance companies.” The two dissenting Board members
believed that § 2162.2.A.4 of the Manual was not an “appropri-
ate application of Medicare statutory reasonable cost principles,”
that it was “devoid of any link to the standards expressed in the
regulations,” and that it could not be justified as an interpretive
rule “exempt from the notice and comment provisions of the
Administrative Procedure Act . . ..” The ten percent provision
was, the dissenters stated, an example of “why the rulemaking
process is critical to establishing standards such as those
involved here.”

Catholic Health and the hospitals brought this action in the
district court after the Secretary’s delegate – the Administrator
of the Centers for Medicare and Medicaid Services – declined
to review the Board’s decision. See 42 U.S.C. § 1395oo(f); 42
C.F.R. § 405.1877. The district court viewed the issue as
“whether the Board’s ruling – which found the reimbursement
standard expressed in the PRM to be consistent with both the
Medicare statute and the Medicare regulations – was lawful, not
whether the PRM provision itself was lawful.” Catholic Health
Initiatives v. Sebelius, No. 07-555, slip op. at 7, 2009 WL
3112575 (D.D.C. Sept. 30, 2009). Granting summary judgment
in favor of the Secretary, the court found that the Board’s
adherence to the Manual’s interpretation was “not plainly
erroneous or inconsistent with the statute or the regulation . . ..”
Id. at 15.

The Secretary defends the Manual’s investment limitations
on the ground that the limitations comprise an “interpretative”
rule. See 5 U.S.C. § 553(b)(A); American Mining Congress v.
Mine Safety & Health Admin., 995 F.2d 1106 (D.C. Cir. 1993).
As the Secretary puts it, “the cost of insurance premiums that
 7

Medicare is asked to reimburse can be considered ‘reasonable’
only if those premiums actually purchase reliable coverage.”
Reliability depends on “the financial soundness of the insurer,”
Br. of Appellee at 15, which depends on the competence of the
insurer’s regulator and the pervasiveness of its regulations, id.
at 29-31.2 The rule, the Secretary contends, is consistent with
the statute and regulations, supported by substantial evidence,
and not arbitrary or capricious. Id. at 14-17, 28.

The hospitals dispute each of these assertions. They claim
that the rule regulates insurance investment decisions and
therefore lies outside the scope of the Secretary’s “reasonable
cost” authority under the Medicare Act. In addition, the
hospitals believe that an important premise of the rule is wrong.
The Board majority believed that offshore captives “are not
subject to the same level of industry regulations applied to
onshore agencies by State insurance companies.” Board
Decision at 6. But the evidence submitted at the hearing before
the Board showed “that the level of state regulation of equity
investments by domestically domiciled captives is essentially
zero.” Br. of Appellants at 39. In fact, “only a minority of
states – twenty-three – regulate captive insurers at all.” Id. at
40. The hospitals argue that to the extent that the Manual’s
limitations were intended to promote the financial strength and
solvency of the offshore insurer, the limitations are arbitrary
because they are both overbroad and underinclusive. The
limitations are overbroad, for instance, because they permit
equity investments only in securities that pay dividends. Yet the
hospitals point out that many companies that appear to be
financially sound – such as Microsoft during the years at issue

2
The Secretary’s argument assumes that the less heavily regulated an
insurance company is, the more likely it will fail. There may be
reason to doubt the assumption at least as applied to captive insurers,
but we will make nothing of this.
 8

and Google – do not pay dividends. The Manual’s investment
limitations are underinclusive, the hospitals claim, because there
is no requirement that a captive diversify its investments.
Although no one equity investment may make up more than ten
percent of a captive’s equity holdings (and thus one percent of
its total assets), nothing in the Manual prevents a captive from
having all of its assets in, for instance, one corporation’s bonds.
See PRM § 2162.2.A.4.

We do not decide whether the Medicare Act’s reasonable
cost provision would authorize the ten percent rule, or whether
the reasoning and evidence in support of the Board’s decision
enforcing the Manual provision are sufficient. There is an
antecedent question, discussed by the dissenting Board members
and raised – although without much elaboration – by the
hospitals. The question is whether the Manual’s investment
limitations for offshore captives is, as the Secretary contends, an
“interpretive rule.”

To fall within the category of interpretive, the rule must
“derive a proposition from an existing document whose meaning
compels or logically justifies the proposition. The substance of
the derived proposition must flow fairly from the substance of
the existing document.” Robert A. Anthony, “Interpretive”
Rules, “Legislative” Rules, and “Spurious” Rules: Lifting the
Smog, 8 ADMIN. L. J. AM. U. 1, 6 n.21 (1994). If the rule cannot
fairly be seen as interpreting a statute or a regulation, and if (as
here) it is enforced, “the rule is not an interpretive rule exempt
 9

from notice-and-comment rulemaking.”3 Central Tex. Tel.
Coop. v. FCC, 402 F.3d 205, 212 (D.C. Cir. 2005) (citing
Syncor Int’l Corp. v. Shalala, 127 F.3d 90, 95 (D.C. 1997));
United States v. Picciotto, 875 F.2d 345, 347-49 (D.C. Cir.
1989); Hoctor v. USDA, 82 F.3d 165, 170 (7th Cir. 1996).4

Although § 2162.2.A.4 of the Manual does not identify
what it is purporting to interpret, the Manual’s Foreword claims
that every Manual provision rests on the “reasonable cost”
language in the statute and the regulations. But as Professor
Anthony has written, if the relevant statute or regulation
“consists of vague or vacuous terms – such as ‘fair and equita-
ble,’ ‘just and reasonable,’ ‘in the public interest,’ and the like
– the process of announcing propositions that specify applica-
tions of those terms is not ordinarily one of interpretation,
because those terms in themselves do not supply substance from
which the propositions can be derived.” Lifting the Smog, 8
ADMIN. L. J. AM. U. at 6 n.21. This court’s opinion in Paralyzed
Veterans of America v. D.C. Arena L.P., stated much the same.

3
The Medicare Act, 42 U.S.C. § 1395x(v)(1)(A), requires “reasonable
cost” to “be determined in accordance with regulations establishing
the method or methods to be used, and the items to be included . . ..”
This necessarily allows the Secretary to construe her regulations, but
it does not appear to allow “reasonable cost” to be based on a rule that
is neither part of a regulation nor an interpretation of a regulation.
4
In Central Texas, 402 F.3d at 212, we acknowledged that the “APA’s
definition of ‘rule’ contemplates that . . . [both] legislative and
interpretive [rules] may interpret ‘law.’ The EPA regulations at issue
in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc.,
467 U.S. 837 (1984), for instance, interpreted the term ‘stationary
source’ in the Clean Air Act (and did a good deal more). Nor may one
say there is a clear ‘line between interpretation and policymaking.’
John F. Manning, Nonlegislative Rules, 72 GEO. WASH. L. REV. 893,
924 (2004).”
 10

117 F.3d 579, 588 (D.C. 1997). In support, Paralyzed Veterans
cited United States v. Picciotto, a case in which the Park Service
issued a detailed rule specifying types of property that “may not
be stored” in Lafayette Park. 875 F.2d at 346. The rule
supposedly interpreted a regulation allowing “additional
reasonable conditions” to be added to demonstration permits.
The court held that the rule did not interpret this “open-ended”
regulation and therefore could not be enforced because it was
not issued after notice and comment. Id. at 346, 349.

Another general principle cuts against the Secretary.
Among other things, § 2162.2.A.4 of the Manual provides that
an offshore captive insurer’s “investments may include dividend
paying equity securities listed on a United States stock exchange
provided that the investment in equity securities does not exceed
10 percent of the company’s admitted assets, with the invest-
ment in any specific equity issue further limited to 10 percent of
the total equity security investment.” Judge Friendly wrote that
when an agency wants to state a principle “in numerical terms,”
terms that cannot be derived from a particular record, the agency
is legislating and should act through rulemaking. HENRY J.
FRIENDLY, Watchman, What of the Night?, in BENCHMARKS
144-45 (1967). We too have recognized that “numerical limits
cannot readily be derived by judicial reasoning,” although courts
occasionally draw such limits.5 Missouri Pub. Serv. Comm’n v.
FERC, 215 F.3d 1, 4 (D.C. Cir. 2000). Our statement in
Missouri Public Service relied on Hoctor v. USDA, 82 F.3d 165,

5
See, e.g., United States v. Thirty-Seven Photographs, 402 U.S. 363
(1971), which construed a federal statute authorizing the seizure and
forfeiture of imported obscene materials to mean that judicial
forfeiture proceedings had to be instituted within 14 days and
completed within 60 days. The Court held that reading these time
limits into the statute was necessary to save it from being declared
unconstitutional in violation of the First Amendment.
 11

170 (7th Cir. 1996). Hoctor held that an agency performs a
legislative function when it makes “reasonable but arbitrary (not
in the ‘arbitrary or capricious’ sense) rules that are consistent
with the statute or regulation under which the rules are promul-
gated but not derived from it, because they represent an arbitrary
choice among methods of implementation. A rule that turns on
a number is likely to be arbitrary in this sense.” Hoctor cau-
tioned that the court did not mean “that an interpretive rule can
never have a numerical component.” 82 F.3d at 171. Examples
in this circuit include American Mining Congress v. Mine Safety
& Health Administration, 995 F.2d 1106 (D.C. Cir. 1993), and
Chippewa Dialysis Services v. Leavitt, 511 F.3d 172, 176-77
(D.C. Cir. 2007) (dicta). “Especially in scientific and other
technical areas, where quantitative criteria are common, a rule
that translates a general norm into a number may be justifiable
as interpretation.” Hoctor, 82 F.3d at 171.

The Hoctor court concluded that “[w]hen agencies base
rules on arbitrary choices they are legislating, and so these rules
are legislative or substantive and require notice and comment
rulemaking.” Id. at 170-71. Section 2162.2.A.4 falls within that
category. With respect to the ten percent limits “it is impossible
to give a reasoned distinction between numbers just a hair on the
OK side of the line and ones just a hair on the not-OK side.”
Missouri Pub. Serv. Comm’n, 215 F.3d at 4. Here the Secretary
has not even made the attempt.

The short of the matter is that there is no way an interpreta-
tion of “reasonable costs” can produce the sort of detailed – and
rigid – investment code set forth in § 2162.2.A.4.6 This is

6
It might have been a closer case if the Secretary’s Manual had
indicated that premiums paid to financially unstable captive offshore
(or domestic) insurance companies do not represent “reasonable
costs.” But § 2162.2.A.4 of the Manual embodies a “flat” rule, and
 12

essentially the point of the dissenting Board members. The
statute gives the Secretary authority to promulgate regulations
defining “the method or methods to be used, and the items to be
included, in determining” what constitutes a provider’s “reason-
able costs.” 42 U.S.C. § 1395x(v)(1)(A). We may assume,
without deciding, that the Manual’s investment limitations are
an “extension” of the reasonable cost provisions in this section
and the corresponding regulation, as the Board majority thought,
and we may assume that the limitations are “consistent” with
those provisions, as the Secretary has argued. But neither
assumption leads to the conclusion that the Manual’s limitations
represent an interpretation of the Medicare Act or of the
regulations. See Hoctor, 82 F.3d at 170.7 Consistency with the
statute may be enough to sustain a rule duly promulgated after
notice and comment, just as consistency with the Commerce
Clause, Art. I, § 8, cl. 3, may be enough to sustain the constitu-
tionality of a statute. But no one would say, for instance, that
the detailed provisions of the Clean Air Act were interpretations
of the language of the Constitution. The same is true here. The
connection between § 2162.2.A.4 of the Manual and “reasonable

the “‘flatter’ a rule is, the harder it is to conceive of it as merely
spelling out what is in some sense latent in a statute or regulation . . ..”
Hoctor, 82 F.3d at 171.
7
Hoctor analyzed whether a U.S. Department of Agriculture rule
requiring a fence of at least eight feet to enclose lions, tigers, and
leopards was an interpretation of a regulation providing that the
enclosure had to be of “such material and of such strength as appropri-
ate for the animals involved.” 82 F.3d at 167-68. Writing for the
court, Judge Posner held that “[e]ven if . . . the eight-foot rule is
consistent with, even in some sense authorized by, the structural-
strength regulation, it would not necessarily follow that it is an
interpretive rule. It is that only if it can be derived from the regulation
by a process reasonably described as interpretation.” Id. at 170.
 13

costs” is simply too attenuated to represent an interpretation of
those terms as used in the statute and the regulations.

Our concurring colleague agrees with us that § 2162.2.A.4
of the Manual cannot be sustained as a valid interpretation of
“reasonable cost.”8 Based on her reading of Shalala v. Guernsey
Memorial Hospital, 514 U.S. 87 (1995), our colleague does not
put her conclusion in those terms and then criticizes us for
determining that the Manual provision is not a proper interpre-
tive rule. Our colleague’s approach rests on what we perceive
as a misreading of Guernsey. At no point did the Supreme
Court suggest that interpretive rules do not have to interpret.
The issue was not presented. Guernsey simply recognized that
a particular provision in the Manual constituted “a prototypical
example of an interpretive rule,” id. at 99, something that cannot
be said about the provision we have in front of us.

For the reasons given, the judgment of the district court is
reversed. We remand the case to the district court with instruc-
tions to set aside the decision of the Provider Reimbursement
Review Board and for such other relief as the district court
deems appropriate in view of this decision.

So Ordered.

8
Thus we are told that the “investment restrictions in the Manual are
clearly outside [the] scope” of the Secretary’s authority “to define the
‘reasonable cost’,” Concurring Op. at 10; that there is no “nexus”
between the Manual provision and “reasonable cost,” id.; that the
“rigid” rule in the Manual lacks “any rational connection” to the
statute’s “‘reasonable cost’ principle,” id. at 4-5; and so forth.
 BROWN, Circuit Judge, concurring in the judgment: The
court holds section 2162.2.A.4 of the Secretary’s Provider
Reimbursement Manual is invalid because the Secretary
failed to promulgate it by notice-and-comment rulemaking.
The court thus leaves the door open for the Secretary to
promulgate an identical provision restricting the investment
decisions of a provider’s offshore captive insurance company
as a full-fledged rule. But a deeper flaw runs through the
Manual provision that cannot be cured by more procedure: it
exceeds the Secretary’s authority under the Medicare statute
to determine the “reasonable cost” for which providers are
reimbursed. Accordingly, I would close the door left
enticingly ajar by the court and hold the Manual provision
invalid as beyond the Secretary’s authority.

I

Catholic Health Initiatives and its affiliated hospitals (the
hospitals) challenge the Manual provision as exceeding the
Secretary’s authority under the Medicare statute. It is a
cardinal principle of administrative law that an agency may
act only pursuant to authority delegated to it by Congress.
See Lyng v. Payne, 476 U.S. 926, 937 (1986) (“[A]n agency’s
power is no greater than that delegated to it by Congress.”);
Transohio Sav. Bank v. Dir., Office of Thrift Supervision, 967
F.2d 598, 621 (D.C. Cir. 1992) (“It is central to the real
meaning of the rule of law . . . that a federal agency does not
have the power to act unless Congress, by statute, has
empowered it to do so.”). When an agency has acted beyond
its delegated authority, a reviewing court will hold such action
ultra vires, Transohio, 967 F.2d at 621, or a violation of the
Administrative Procedure Act (APA), 5 U.S.C. § 706(2)(C)
(directing courts to “hold unlawful and set aside agency
action . . . in excess of statutory jurisdiction, authority, or
limitations, or short of statutory right”).
 2
Congress delegates authority to agencies through
legislation, and we therefore look to the agency’s enabling
statute to determine whether it has acted within the bounds of
its authority or overstepped them. See Univ. of the D.C.
Faculty Ass’n/NEA v. D.C. Fin. Responsibility & Mgmt.
Assistance Auth., 163 F.3d 616, 620 (D.C. Cir. 1998)
(explaining ultra vires claim requires the court to review
statutory language to determine whether “Congress intended
the [agency] to have the power that it exercised when it
[acted]”). The Secretary defends the Manual provision as
within her authority under 42 U.S.C. § 1395x(v)(1)(A), which
provides:

The reasonable cost of any services shall be the cost
actually incurred, excluding therefrom any part of
incurred cost found to be unnecessary in the efficient
delivery of needed health services, and shall be
determined in accordance with regulations establishing
the method or methods to be used, and the items to be
included, in determining such costs for various types or
classes of institutions, agencies, and services . . . .

The Secretary argues, and the hospitals agree, that she has
considerable discretion under this section to define what
“reasonable cost” means. See Richey Manor, Inc. v.
Schweiker, 684 F.2d 130, 134 (D.C. Cir. 1982) (“It is well
established that Congress granted the Secretary broad
discretion to develop the ‘reasonable cost’ concept, subject, of
course, to the general standard enunciated in 42 U.S.C. §
1395x(v)(1)(A).”). However, the Secretary and the hospitals
disagree over whether the Manual provision is a permissible
exercise of that discretion.

The Manual provision, which the court quotes in full,
places three specific investment restrictions on “offshore
 3
captives”: (1) an offshore captive seeking to invest its assets
must invest 90% or more of them in “low risk investments,”
defined to include certain categories of government bonds,
debt securities, and bank deposits; (2) an offshore captive may
invest 10% or less of its assets in “dividend paying equity
securities listed on a United States stock exchange”; and (3)
an offshore captive must limit its investment in any one equity
issue to 10% of the captive’s total equity security investment.
Manual ch.21 § 2162.2.A.4. The Secretary will consider the
insurance premiums a provider pays its offshore captive
insurance company to be “reasonable costs” reimbursable
under the Medicare program only if the captive satisfies all
three investment restrictions. But, as the hospitals argue
persuasively, none of the restrictions fits comfortably, or even
plausibly, within the plain meaning of “reasonable cost.”

II

First, the investment restrictions exceed the Secretary’s
“reasonable cost” authority because they cause a blanket
disallowance of reimbursement of a provider’s insurance
premiums, even though liability insurance coverage generally
is an allowable cost of the provider’s Medicare program. The
Secretary freely admits “[t]here is no dispute that the costs of
purchasing malpractice and workers’ compensation insurance
are, as a general matter, necessary and proper costs of
furnishing health services to Medicare beneficiaries.”
Appellee’s Br. at 23. Nevertheless, if a provider’s offshore
captive fails to observe just one of the three investment
restrictions, the Secretary disallows 100% of the provider’s
premiums.

The absurd results arising from the investment
restrictions’ blanket disallowance rule are easy to grasp. For
example, if a provider’s offshore captive insurer invested in
 4
ten dividend-paying equity securities listed on a United States
stock exchange, placing 1% of its assets in each security, the
Secretary would reimburse the provider for all premiums paid
to the captive. But if the captive insurer invested 1% in
eleven divided paying U.S. equity securities, the Secretary
would refuse to reimburse the provider for a single penny of
its premiums. Likewise, if the captive invested 98% of its
assets in what the Manual defines as “low risk investments”
but placed 2% of its assets in a single U.S.-listed equity
security, the Secretary would deny any reimbursement. And
in both of these illustrations, the Secretary’s reimbursement
decision would not change even if the captive remained
solvent and paid substantial claims on behalf of the provider.

When the Secretary has established rigid all-or-nothing
approaches to reimbursement under section 1395x(v)(1)(A),
this court and others have rejected them as lacking any
rational connection to “reasonableness.” See, e.g., St. Mary of
Nazareth Hosp. Ctr. v. Schweiker, 718 F.2d 459, 467 (D.C.
Cir. 1983) (rejecting Manual section 2345 because “for all
practical purposes [it] would mean that hospitals would not be
reimbursed at all for the costs of rendering care to Medicare
patients in special care units. This result is ridiculous,
contrary to the letter of 42 U.S.C. § 1395x(v)(1)(A) . . . .”);
County of L.A. v. Sullivan, 969 F.2d 735, 741 (9th Cir. 1992)
(explaining that “because the 100% limitation unnecessarily
restricts reimbursement for ancillary services provided to
Medicare patients, we hold that it contravenes the statutory
requirements that the Secretary reimburse the hospitals for
their reasonable costs and not shift Medicare patients’ costs to
non-Medicare patients or the hospitals themselves”); Nw.
Hosp., Inc. v. Hosp. Serv. Corp., 687 F.2d 985, 992 (7th Cir.
1982) (holding a “blanket disallowance of related-party
interest expense . . . is broader than either the language or the
purpose of the Medicare statute can be construed to authorize
 5
[where] the government concede[d] interest expense is
generally considered to be part of the ‘reasonable cost’ of
providing Medicare services”); see also Samaritan Health
Serv. v. Bowen, 811 F.2d 1524, 1531 (D.C. Cir. 1987) (noting
that “[u]nder § 1395x(v)(1)(A), the sanction for [a provider’s
request for reimbursement of] ‘high costs’ would be
nonreimbursement for the unduly high portion, not denial for
the whole fee”). The investment restrictions in section
2162.2.A.4 of the Manual are no less harsh than the blanket
disallowances struck down in prior decisions as exceeding the
Secretary’s “reasonable cost” authority under section
1395x(v)(1)(A).

The Manual itself reveals that the Secretary appreciates
the stark difference between a blanket disallowance and
application of section 1395x(v)(1)(A)’s “reasonable cost”
principle. For instance, in disallowing reimbursement of
luxury items or services, the Manual instructs that once the
intermediary has concluded a luxury item or service was
furnished to a patient, the “allowable costs must be reduced
by the difference between the costs of luxury items or services
actually furnished and the reasonable costs of the usual less
expensive items or services furnished by a provider to the
majority of its patients.” Manual ch.21 § 2104.3.C. The
Secretary has no credible explanation why reimbursement of
insurance premiums should be treated any differently.

The investment restrictions also do not accurately reflect
the “cost actually incurred” by a provider at the time it
submits the insurance premiums to its offshore captive.
Section 1395x(v)(1)(A) states “[t]he reasonable cost of any
services shall be the cost actually incurred.” 42 U.S.C. §
1395x(v)(1)(A) (emphasis added). A provider incurs the cost
of obtaining liability insurance coverage when it submits the
premiums to the offshore captive. Regardless of whether or
 6
how the offshore captive subsequently invests the premiums
and regardless of whether the captive ever pays a claim, the
provider has “actually incurred” a cost of providing services
to Medicare patients at the moment it pays the premiums.
The Secretary’s reimbursement for the “reasonable cost” of
the provider’s liability insurance therefore should be a
function of the premiums paid, not of the coverage that the
offshore captive may eventually provide. The Secretary’s
investment restrictions thus are an inaccurate measure of the
provider’s cost “actually incurred” in obtaining insurance
coverage from its offshore captive and exceed her authority
under section 1395x(v)(1)(A).

This principle was explored extensively by a number of
courts after the Secretary, in 1979, promulgated a new
regulation for calculating reimbursement of providers’
malpractice insurance premiums (the Malpractice Rule). See
Menorah Med. Ctr. v. Heckler, 768 F.2d 292, 293 (8th Cir.
1985). Providers successfully challenged the Malpractice
Rule before many courts as exceeding the Secretary’s
authority under section 1395x(v)(1)(A). See, e.g., id. at 296
(noting Secretary could not prove “a system of reimbursing
malpractice premiums based solely on the proportion of
malpractice losses will accurately reflect premium costs”);
Bedford County Mem’l Hosp. v. Health & Human Servs., 769
F.2d 1017, 1023–24 (4th Cir. 1985) (holding the Malpractice
Rule contrary to section 1395x(v)(1)(A) because “[b]y basing
reimbursement of malpractice costs solely on loss history, the
Secretary has failed to take account of administrative
expenses, a disproportionate share of which will be borne by
non-Medicare patients under the Secretary’s system”).

In striking down the Malpractice Rule, one court
perceptively explained why the Secretary’s approach to
reimbursement was inconsistent with insurance cost
 7
principles: “[T]he Malpractice Rule violates the Medicare Act
[by] fail[ing] to recognize that malpractice insurance protects
against the risk of future loss. Even if a provider has never
incurred any actual malpractice losses, for example, it must
still purchase malpractice insurance because of the risk that
losses will be incurred in the future.” St. James Hosp. v.
Heckler, 760 F.2d 1460, 1472 (7th Cir. 1985). The court
noted that “[t]he carrying of malpractice insurance must be
deemed a reasonable cost, and thus reimbursable by
Medicare, regardless of whether a hospital has paid one dollar
or one million dollars in malpractice claims over the relevant
five-year period.” Id. Thus, “[t]o the extent that the
Malpractice Rule does not reimburse these costs, . . . it
violates the Medicare Act’s mandate that providers are
entitled to government reimbursement for the ‘reasonable
cost’ of the services they provide for Medicare patients.” Id.

When we considered a challenge to the Malpractice Rule,
we were more cautious than many courts. See Walter O.
Boswell Mem’l Hosp. v. Heckler, 749 F.2d 788, 799 (D.C.
Cir. 1984). We recognized the Malpractice Rule required the
Secretary to reconcile the statutory obligation to reimburse
reasonable costs with the related obligation to prevent cross-
subsidization between Medicare and non-Medicare patients.
See id. at 799–800. Recognizing the tension between section
1395x(v)(1)(A)’s reasonable cost and cross-subsidization
requirements, we remanded the case to the district court
because the agency had failed to consider an alternative to the
Malpractice Rule—separate pools of risk for Medicare and
non-Medicare patients—that might more accurately reflect the
actual Medicare costs incurred by the providers. Id. at 802–
03. However, we still required the Secretary’s approach to be
consistent with both the reasonable cost and cross-
subsidization requirements, and with the ultimate purpose of
fairly reimbursing hospitals for their Medicare-related
 8
insurance premiums. See id. at 801 (noting Secretary’s
interpretation of the Medicare statute to deny hospitals “some
of their premium costs” was not arbitrary and capricious
because “paying the percentage of premiums reflecting losses
from Medicare patients would in the long run fairly
compensate the insurance companies for their expenses, and
thus would fairly reimburse the hospitals for necessary
expenditures”).

In contrast to the Malpractice Rule, the investment
restrictions here blatantly contravene section 1359x(v)(1)(A)
by preventing the hospitals from obtaining any reimbursement
of their insurance premiums, while at the same time forcing
the hospitals’ non-Medicare patients to pay all of the cost of
purchasing liability insurance coverage for Medicare patients,
thereby violating section 1395x(v)(1)(A)’s prohibition on
cross-subsidization. The courts that found the Malpractice
Rule problematic undoubtedly would be even more troubled
by section 2162.2.A.4 of the Manual since it makes no
attempt to fairly approximate the provider’s costs for
obtaining insurance coverage if the offshore captive has failed
to comply with one or more of the investment restrictions.

Furthermore, the Secretary has utterly failed to explain
why it is unreasonable for a provider to purchase insurance
coverage from an offshore captive that fails to invest
according to the Secretary’s mandate. One does not have to
be a hedge fund manager to recognize it may be extremely
unreasonable to invest one’s assets as dictated by the Manual
provision. A captive insurer, like any other prudent investor,
may need to adjust its investment portfolio multiple times in a
given year to respond to changing market conditions. What
may be a wise investment one year may be foolish the next.
If it is often reasonable for an offshore captive to invest its
assets contrary to the investment restrictions in the Manual
 9
provision, then it can hardly be unreasonable for a provider to
pay premiums to the captive. And as the hospitals note,
Medicare does not reimburse providers for malpractice
claims, so the providers have every incentive apart from the
Secretary’s involvement to ensure they receive coverage from
their insurers. The close alignment of interests between a
provider and its captive insurer only adds to this incentive.
The senselessness of punishing a provider for the investment
decisions of its offshore captive insurer is underscored by the
irrational nature of the investment restrictions themselves.

The Secretary’s primary justification for the restrictions
is that they are necessary to ensure offshore captives maintain
sufficient reserves to pay future claims on behalf of Medicare
providers. See Appellee’s Br. at 23–24. The Secretary
argues, “On a very practical level, [insurance premium]
costs—even if in line with those paid by other, similarly
situated providers—can be considered ‘reasonable’ only if
they actually purchase reliable coverage for the insured
providers.” Id. at 23. Unmasked, however, the Secretary is
asserting section 1395x(v)(1)(A) permits her to micromanage
the investment decisions of offshore captive insurers, despite
her lack of expertise in either investment strategy or
insurance. See St. Mary of Nazareth Hosp. Ctr., 718 F.2d at
466 (declining to defer to Secretary’s statutory interpretation
announced in Manual provision where agency’s expertise was
not implicated). The Medicare statute grants the Secretary
authority to administer a reimbursement program for
providers, not authority to establish an investment
management program for vendors. It is unsurprising then that
the Secretary’s interpretation is far afield from Congress’
intent for section 1395x(v)(1)(A) to meet providers’ actual
costs, both direct and indirect, of providing services to
Medicare patients. See S. Rep. No. 89-404 (1965), reprinted
in 1965 U.S.C.C.A.N. 1943, 1976 (June 30, 1965) (“The
 10
provision in the bill for payment of the reasonable cost of
services is intended to meet the actual costs, however widely
they may vary from one institution to another, except where a
particular institution’s costs are found to be substantially out
of line with those of institutions similar in size, scope of
services, utilization, and other relevant factors.”).

In sum, although the Secretary has broad authority under
section 1395x(v)(1)(A) to define the “reasonable cost,” this
authority is not unlimited, and the investment restrictions in
the Manual provision are clearly outside its scope. This case
does not require us to determine what may be the outer limits
of the Secretary’s authority. Because the Manual provision
has no discernible nexus with the Secretary’s authority to
determine reimbursement of “reasonable costs” under section
1395x(v)(1)(A), it is invalid.

III

The court’s opinion raises several issues warranting a
response. First, because the Manual provision exceeds the
Secretary’s authority, we need not and, indeed, should not
address whether the provision should have been passed
through notice-and-comment rulemaking. The court
describes the notice-and-comment issue as “antecedent” to the
question of the Secretary’s statutory authority, Maj. Op. at 8.
Not so. Where the agency has acted outside its statutory
authority, notice and comment is no cure for the disease. See
Lyng, 476 U.S. at 937; Transohio, 967 F.2d at 621. In
contrast, a holding that the agency has exceeded its statutory
authority negates any need to delve into the notice-and-
comment issue. See Am. Bus Ass’n v. Slater, 231 F.3d 1, 7–8
(D.C. Cir. 2000) (“Because we hold [the agency] had no
authority to promulgate that rule in the first instance, the
Court finds it unnecessary to take up [appellant’s] notice-and-
 11
comment claim. The agency has exceeded the scope of the
authority delegated to it by Congress, and it matters not that
they adhered to the APA’s procedural requirements in doing
so.”). Thus it was pointless for the hospitals to argue the
Manual provision should have been passed by notice-and-
comment rulemaking when it plainly exceeded the Secretary’s
authority. This explains why the hospitals raised the notice-
and-comment issue in a single footnote of their opening brief,
see Appellants’ Br. at 32 n.13, or as the court describes it,
“without much elaboration,” Maj. Op. at 8, while devoting the
lion’s share of their briefs to challenging the Secretary’s
statutory authority. And counsel for the hospitals confirmed
this was their position at oral argument:

The Court: So your position is that if [the Secretary]
had gone through a notice-and-comment
rulemaking and received whatever
substantial evidence support what appears in
the Manual, that even then [she] couldn’t
promulgate this rule?

Counsel: . . . That is both our position and,
obviously, the logical import of our
position.

Oral Arg. Recording at 11:21–40.

The hospitals paid the insurance premiums for which
they seek reimbursement during the period from 1997 to
2002. The Board conducted a hearing on the hospitals’
appeal from the intermediary’s denial of reimbursement in
2004 but did not issue its decision until 2007. The district
court issued its decision in 2009. It is time for this dispute to
end. Fortunately for the hospitals, the court’s opinion should
allow for quick resolution of their reimbursement claims,
 12
since, even if the investment restrictions are passed through
notice-and-comment procedures, the Secretary will be unable
to apply them retroactively to the hospitals. See Bowen v.
Georgetown Univ. Hosp., 488 U.S. 204, 208–213 (1988)
(holding Secretary lacks authority under section
1395x(v)(1)(A) to promulgate cost-limit rules with retroactive
effect). Nevertheless, there is no good reason for the court to
give the Secretary the opportunity to prospectively
promulgate a rule implementing precisely the same
restrictions when she has offered no basis to believe her
statutory authority reaches that far in the first place. See PIA-
Asheville, Inc. v. Bowen, 850 F.2d 739, 740–41 (D.C. Cir.
1988) (noting “the Secretary offers no new substantive
justification for his erstwhile policy, but instead claims that
the existence of the new regulation incorporating that policy
should change our view” and rejecting this argument where
court had held in prior decision that the policy violated the
statutory requirement to reimburse reasonable costs). Instead,
we should do as courts ordinarily do and answer the question
the parties have put before us—particularly since that answer
would resolve this dispute for good.

Second, the court’s opinion may cause unintended and
unwelcome consequences by calling into question the
procedural legitimacy of many other provisions in the
Manual. In Shalala v. Guernsey Memorial Hospital, the
Supreme Court affirmed the Secretary’s use of the Manual to
provide guidance to providers and intermediaries, describing
its interpretive rules as part of “a sensible structure for the
complex Medicare reimbursement process,” 514 U.S. 87, 101
(1995). As we have noted, the Court in Guernsey explained
the Secretary “does not have a statutory duty to promulgate
regulations that ‘address every conceivable question in the
process of determining equitable reimbursement.’ Rather, for
‘particular reimbursement details not addressed by’
 13
regulations, [the Secretary] properly ‘relies upon an elaborate
adjudicative structure which includes the right to review by
the [Board].’” Tenet HealthSystems HealthCorp. v.
Thompson, 254 F.3d 238, 248 (D.C. Cir. 2001) (quoting
Guernsey, 514 U.S. at 96).

The court’s opinion ignores Guernsey’s test for whether a
Manual provision must be promulgated by notice-and-
comment rulemaking. See Guernsey, 514 U.S. at 100 (noting
“APA rulemaking would still be required if [the Manual
provision] adopted a new position inconsistent with any of the
Secretary’s existing regulations [but the Manual provision]
does not . . . effec[t] a substantive change in the regulations”)
(internal quotation marks omitted). Moreover, the court fails
to identify clear limiting principles by which the Secretary
and providers can distinguish Manual section 2162.2.A.4
from other Manual provisions. For instance, the court states,
“[T]he process of announcing propositions that specify
applications of [vague] terms [such as “just and reasonable”]
is not ordinarily one of interpretation, because those terms in
themselves do not supply substance from which the
propositions can be derived.” Maj. Op. at 9 (internal
quotation marks omitted). But this perspective fails to
account for the way complex regulatory regimes such as
Medicare really work. The Secretary relies on a hybrid of
rulemaking and adjudication—an approach approved by the
Court in Guernsey. See 514 U.S. at 96–97 (“The APA does
not require that all the specific applications of a rule evolve
by further, more precise rules rather than by adjudication.
The Secretary’s mode of determining benefits by both
rulemaking and adjudication is, in our view, a proper exercise
of her statutory mandate.”). Interpretive rules are the glue
that holds this regulatory structure together. The Secretary’s
administration of the Medicare program frequently calls for
specific applications of vague statutory terms, including
 14
“reasonable cost,” and, as we have noted, “an agency may use
an interpretive rule to transform a vague statutory duty or
right into a sharply delineated duty or right.” Cent. Tex. Tel.
Co-op, Inc. v. FCC, 402 F.3d 205, 256 (D.C. Cir. 2005); see
also id. (“[A]n interpretive rule does not have to parrot
statutory or regulatory language but may have the effect of
creating new duties.”).

By ignoring these principles, the court’s opinion calls
into question many other provisions in the Manual. See, e.g.,
Manual ch.2 § 215.1 (“An exception to this limitation is
permitted when the debt cancellation costs are less than 50
percent of the amount of interest cost and amortization
expense that would have been allowable in that period had the
indebtedness not been cancelled, in which case, the full
amount will be allowable in the period incurred.”); id. ch.21,
§ 2162.5 (establishing a 10% test for determining when losses
relating to insurance deductible are allowable costs); id.
ch.21, § 2109.2.D (“The allowance for membership in
professional associations and continuing medical education is
limited to the lesser of actual cost or 5 percent of the
applicable [Reasonable Compensation Equivalent] base
amount.”); id. ch.22 § 2208.1.E (establishing the specified
percentages for the per diem method of cost apportionment as
93% for short-term hospitals and 98% for long-term
hospitals); id. ch.22 § 2202.7.II.A.5 (“A minimum nurse-
patient ratio of one nurse to two patients per patient day must
be maintained . . . .”).

As the Secretary’s counsel explained during oral
argument, “Guernsey . . . stands for the proposition that the
technical specifics of the application of the broad Medicare
standards are appropriately resolved through adjudication by
the agency with the Manual guideline as a tool . . . .” Oral
Arg. Recording at 21:22–51. In light of Guernsey’s
 15
endorsement of the Secretary’s “sensible structure” for
administering the Medicare program, courts should refrain as
much as possible from tinkering with this regulatory
framework. See Nat’l Med. Enters., Inc. v. Shalala, 43 F.3d
691, 693, 696–97 (D.C. Cir. 1995) (deciding Manual section
2203 which “provide[d] a three-part guide for allocating costs
to routine or ancillary centers” was an interpretive rule rather
than a substantive rule requiring notice and comment);
Sentara-Hampton Gen. Hosp. v. Sullivan, 980 F.2d 749, 759–
60 (D.C. Cir. 1992) (per curiam) (holding Manual provision
not subject to notice-and-comment rulemaking). Invalidating
the Manual provision as exceeding the Secretary’s authority
thus is less intrusive than declaring the provision must be
enacted, if at all, by notice-and-comment rulemaking. The
first approach affects only the investment restrictions while
the second casts doubt upon the procedural legitimacy of the
Manual as a whole.

* * *

The investment restrictions in the Manual provision are
beyond the Secretary’s authority because they have no
connection to the “reasonable cost” language in section
1395x(v)(1)(A) of the Medicare statute. I would hold the
provision invalid on that basis alone.