Texas Neighborhood Services v. HHS

United States Court of Appeals
FOR THE DISTRICT OF COLUMBIA CIRCUIT

Argued May 5, 2017 Decided August 8, 2017

No. 16-5150

TEXAS NEIGHBORHOOD SERVICES,
APPELLANT

v.

UNITED STATES DEPARTMENT OF HEALTH AND H UMAN
SERVICES AND THOMAS E. PRICE, IN HIS OFFICIAL CAPACITY AS
SECRETARY OF HHS,
APPELLEES

Appeal from the United States District Court
for the District of Columbia
(No. 1:14-cv-01545)

Alexandra R. Rosenblatt argued the cause for appellant.
With her on the briefs were Edward T. Waters and Christopher
J. Frisina.

Joshua M. Kolsky, Assistant U.S. Attorney, argued the
cause for appellees. With him on the brief was R. Craig
Lawrence.

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

Opinion for the Court filed by Circuit Judge PILLARD.
 2
PILLARD , Circuit Judge: Year-end performance bonuses
can be a useful tool for motivating employees, so long as the
employees know in advance that the quality of their work will
be reflected in their paychecks. The federal government
accordingly allows federal grantees to award performance
bonuses that are reasonable, announced in advance, and
adequately documented. Between 2010 and 2012, plaintiff
Texas Neighborhood Services received Head Start grant
money to provide childcare services to low-income families in
Texas. During that time, Neighborhood Services used $1.3
million in federal funds to award performance bonuses to its
staff. In 2013, the Department of Health and Human Services
(HHS), which administers Head Start grants, required
Neighborhood Services to repay the bonus money to the
government, explaining that the bonuses were unreasonable
and inadequately documented. After the repayment decision
was sustained by HHS’s Departmental Appeals Board
(Appeals Board or Board), Neighborhood Services filed suit,
arguing that the Appeals Board’s ruling was arbitrary and
capricious in violation of the Administrative Procedure Act
(APA). Finding no prejudicial error in the Board’s decision,
the district court rejected the APA challenge. We affirm.

I.

HHS’s Administration for Children and Families (the
Administration) provides grants to Head Start organizations
across the country to support their provision of “health,
education, parental involvement, nutritional, social, and other
services” to low-income, preschool-aged children. 42 U.S.C.
§ 9833; see 45 C.F.R. §§ 1301.1 et seq. The Office of
Management and Budget’s Circular A-122 (OMB Circular or
Circular) explains when and how the government will
reimburse federal grantees, including organizations receiving
Head Start money, for different types of expenses. See 2 C.F.R.
 3
Pt. 230 (2007).1 For our purposes, the key provisions in the
Circular are those governing employee salaries and
performance bonuses.

The OMB Circular’s salary and bonus provisions
authorize federal grantees to use performance bonuses to
motivate their staffs, so long as: (1) the “overall compensation”
paid to employees—including performance bonuses—is
“reasonable,” 2 C.F.R. Pt. 230, App. B ¶ 8.j; (2) the bonuses
are paid “pursuant to an agreement entered into in good faith
between the organization and the employees before the services
were rendered, or pursuant to an established plan followed by
the organization so consistently as to imply, in effect, an
agreement to make such payment,” id.; and (3) the incentive
payments are “adequately documented,” id., App. A ¶ A.2.g.
If a grantee does not follow those rules in awarding
performance bonuses, HHS may disallow—i.e., refuse to cover
the cost of—the bonuses. See id., App. A ¶ A.2, App. B ¶ 8.j.

In 2007, Neighborhood Services decided to develop a way
to use performance bonuses to motivate its employees. The
Neighborhood Services Board of Directors adopted an
Incentive Compensation Policy (the 2007 Policy), which
contemplated that senior Neighborhood Services staff would
develop a “plan” for rewarding “consistent or exemplary job
performance.” J.A. 100. Two years later, senior staff
announced the 2009 Plan: Neighborhood Services staff would
implement a series of “cost reductions,” with a goal of
operating at 95% of its annual budget and, if those cost
reduction strategies were effective, Neighborhood Services
would use the savings to implement an “incentive” system.
J.A. 103. Under that system, Neighborhood Services would
1
At all relevant times, the Circular was codified at 2 C.F.R. Pt. 230.
We will therefore cite Pt. 230 throughout this opinion, even though
the Circular is now codified at 45 C.F.R. §§ 75.400 et seq.
 4
use a “matrix” to assess employee performance, rewarding
“superior”-rated employees with more generous bonuses than
employees with “average or below average” performance
records. J.A. 103.

In February 2013, the Administration conducted a
“monitoring review” of Neighborhood Services’s use of
federal funds in Fiscal Years 2010 through 2012 (FY 2010-
2012). J.A. 86, 90-91. That review resulted in a Monitoring
Report. Among the Report’s negative findings was an
allegation that Neighborhood Services had issued performance
bonuses without taking adequate steps to ensure that “overall
compensation” for its employees was reasonable and without
“document[ing] the basis for amounts awarded as incentive
compensation,” as required by the OMB Circular. J.A. 90

On September 19, 2013, the Administration sent
Neighborhood Services a letter stating that, in light of the
Monitoring Report’s conclusion that Neighborhood Services
had paid performance bonuses in violation of the OMB
Circular, the Administration would disallow the $1,332,698.09
in federal funds that Neighborhood Services had used to issue
the bonus checks (the Disallowance Letter). See J.A. 82-83.
The Disallowance Letter instructed Neighborhood Services to
repay that amount to the government.

Neighborhood Services appealed the Disallowance Letter
to the Appeals Board, which rejected the challenge. The Board
explained that Neighborhood Services failed to carry its burden
of demonstrating that the performance bonuses were
reasonable. The Board emphasized that Neighborhood
Services had not established that it was reasonable to pay a
relatively large percentage of employees’ overall
compensation as performance bonuses. Further, based on
Neighborhood Services’s own documentation, the Board found
 5
that it had not consistently given higher bonuses to employees
who performed better than their peers. The lack of correlation
between employees’ performance and the size of their bonuses
suggested that the monetary awards were “based on factors
such as favoritism, rather than performance.” Id. at 311.
Regardless of whether such favoritism was barred by
Neighborhood Services’s own policies, the Board concluded,
the suggestion that favoritism motivated bonus decisions might
have turned the awards into a “disincentive rather than an
incentive to achieve superior performance,” so the awards
could not be considered reasonable under the OMB Circular.
Id.

The Appeals Board also concluded that Neighborhood
Services’s documents established that the organization “either
did not follow its incentive compensation policies when
making [performance] awards or failed to provide adequate
documentation to support the awards.” J.A. 305. According to
its documents, Neighborhood Services had codified its
incentive compensation system in the 2007 Policy and 2009
Plan. Nevertheless, the record contained evidence that
Neighborhood Services routinely disregarded that system. For
example, Neighborhood Services’s 2009 Plan stated that the
organization should use its performance matrix to determine
how large employees’ bonuses should be. Yet employees’
matrix scores did not correlate with the size of their bonuses.
Similarly, while the 2009 Plan stated that performance bonuses
for “superior work performance” should be “higher than for
average or below average perform[ance],” J.A. 103, the record
showed that, in FY 2010, Neighborhood Services gave each
permanent, non-managerial employee a bonus “equal to 160
hours of his or her unit pay,” regardless of how he or she
performed, J.A. 305. In light of that evidence, the Appeals
Board concluded that Neighborhood Services had either
ignored its incentive compensation policy or had failed to
 6
introduce enough documentary evidence to show that—despite
appearances—Neighborhood Services was in fact following
that policy.

After the Appeals Board issued its initial decision,
Neighborhood Services sought reconsideration, arguing that
the Board had used the incorrect legal standards to determine
whether Neighborhood Services had complied with the
incentive compensation provisions in the OMB Circular. The
Board denied Neighborhood Services’s motion. Neighborhood
Services then sued HHS in district court, arguing that the
Board’s decision was arbitrary and capricious in violation of
the APA, 5 U.S.C. § 706(2)(a). See Tex. Neighborhood Servs.
v. U. S. Dep’t of Health & Human Servs., 172 F. Supp. 3d 236
(D.D.C. 2016). Embracing the Board’s analysis, the district
court granted HHS’s motion for summary judgment, and this
appeal followed.

II.

We review the district court’s grant of summary judgment
de novo. See Se. Ala. Med. Ctr. v. Sebelius, 572 F.3d 912, 916
(D.C. Cir. 2009). Like the district court, we defer to the
agency, asking only whether the Appeals Board’s action was
“arbitrary, capricious, an abuse of discretion, or otherwise not
in accordance with law.” 5 U.S.C. § 706(2)(a). The scope of
review under the arbitrary and capricious standard is “narrow”
and we cannot “substitute [our] judgment for that of the
agency.” Motor Vehicle Mfrs. Ass’n of the U.S., Inc. v. State
Farm Mut. Auto. Ins. Co., 463 U.S. 29, 43 (1983). We must
ensure that the agency “examine[d] the relevant data and
articulate[d] a satisfactory explanation for its action including
a rational connection between the facts found and the choice
made.” Id. (internal quotation marks omitted). Agency action
is arbitrary and capricious “if the agency has relied on factors
 7
which Congress has not intended it to consider, entirely failed
to consider an important aspect of the problem, offered an
explanation for its decision that runs counter to the evidence
before the agency, or is so implausible that it could not be
ascribed to a difference in view or the product of agency
expertise.” Id.

Neighborhood Services contends that the Appeals Board’s
decision was arbitrary and capricious for four reasons: (1) the
Board overlooked the OMB Circular’s provision that
compensation is reasonable if it is comparable to that for
similar work in the same labor market; (2) the Board
disallowed the performance bonuses based on the theory that
the bonuses were inconsistent with Neighborhood Services’s
internal policies when, Neighborhood Services contended,
HHS had not asserted that theory in its briefing; (3) the Board
found that the performance bonuses were inadequately
documented, even after Neighborhood Services provided all of
the documentation required by Board precedent and by the
Disallowance Letter; and (4) the Board held that Neighborhood
Services’s bonuses collectively violated the Circular, rather
than considering whether each individual bonus was consistent
with the Circular’s requirements. We agree that the Board
failed adequately to grapple with the Circular’s definition of
reasonable compensation when it assessed the reasonableness
of Neighborhood Services’s bonuses, but we conclude that
error was harmless. Because we see no other arbitrariness in
the Board’s decision, we affirm the district court’s judgment.

A.

As noted above, the OMB Circular provides that a grantee
can only award performance bonuses to its employees if the
employees’ “overall compensation” is “reasonable.” 2 C.F.R.
Pt. 230, App. B ¶ 8.j. A grantee bears the burden of showing
 8
that compensation satisfies that reasonableness standard. See,
e.g., Tex. Migrant Council, Inc., DAB No. 1743, 2000 WL
1310757, at *2-3 (Dep’t of Health & Human Servs. Sept. 7,
2000).

To determine whether compensation for Neighborhood
Services employees was reasonable, the Appeals Board looked
to Appendix A of the Circular, which provides that “[a] cost is
reasonable if, in its nature or amount, it does not exceed that
which would be incurred by a prudent person under the
circumstances.” 2 C.F.R. Pt. 230, App. A ¶ A.3. The Board
then considered Neighborhood Services’s only evidence that it
had compensated its employees in a prudent manner: A “wage
comparability study” showing that Neighborhood Services’s
overall wage payments to employees were less than or roughly
equal to wages paid by similar organizations in the same
geographic area. J.A. 310. The Board found that the study was
not dispositive because it did not address whether it was
reasonable for a daycare center to pay employees relatively low
base salaries combined with relatively large bonuses (as
Neighborhood Services did). The Board therefore concluded
that Neighborhood Services had not carried its burden of
demonstrating that its total employee compensation was
reasonable.

Neighborhood Services contends that the Appeals Board
arbitrarily applied the Circular’s general standard for
reasonable costs in Appendix A, rather than the specific
standard for reasonable compensation set out in Appendix B.
As just noted, the general cost standard asks what a prudent
person would pay under the circumstances, 2 C.F.R. Pt. 230,
App. A ¶ A.3, whereas under the compensation-specific
standard, compensation is “reasonable to the extent that it is
comparable to that paid for similar work in the [same] labor
market[].” Id., App. B ¶ 8.c.2. Applying the principle that
 9
specific rules typically displace general rules on the same
subject, see, e.g., RadLAX Gateway Hotel, LLC v.
Amalgamated Bank, 566 U.S. 639, 645 (2012); Nevada v.
Dep’t of Energy, 400 F.3d 9, 16 (D.C. Cir. 2005),
Neighborhood Services argues the Board should have confined
its reasonableness analysis to the question whether, when the
incentive compensation and base pay were considered together,
Neighborhood Services paid its employees an amount that was
“comparable to that paid for similar work in the [same] labor
market[].” 2 C.F.R. Pt. 230, App. B ¶ 8.c.2. From
Neighborhood Services’s perspective, its wage comparability
study was dispositive of that question, because it conclusively
showed Neighborhood Services employees earned the same or
less overall compensation than individuals performing “similar
work” at other daycare centers in the area.

We need not decide whether the Appeals Board should
have given the definition of reasonable compensation
precedence over the general definition of reasonable costs or
whether there is any difference between the two that might be
material here. For our purposes, it is enough to note that the
Board did not grapple with both standards; rather, it looked
principally at the reasonableness of bonus payments as a
percentage of total compensation, and failed to consider
whether overall compensation was nonetheless reasonable
because it was comparable to that paid for similar work in the
relevant market. By disregarding a definition that was “still on
the books,” the Board acted arbitrarily. FCC v. Fox Television
Stations, Inc., 556 U.S. 502, 515 (2009).

Nevertheless, we conclude that the Board’s error was
harmless. See 5 U.S.C. § 706 (instructing courts reviewing
agency action to apply “the rule of prejudicial error”). As we
will explain below, the Board reasonably concluded that
Neighborhood Services either failed to follow its stated
 10
incentive compensation policies or, at least, failed to provide
adequate documentation to prove that it had followed its
policies. And that conclusion amply supported the decision to
disallow Neighborhood Services’s bonus payments. See
Bally’s Park Place, Inc. v. NLRB, 646 F.3d 929, 939 (D.C. Cir.
2011) (“[W]hen an agency relies on multiple grounds for its
decision, some of which are invalid, we may nonetheless
sustain the decision as long as one is valid and the agency
clearly would have acted on that ground even if the other[s]
were unavailable.” (internal quotation marks omitted)).

B.

According to Neighborhood Services, the Appeals Board
also acted arbitrarily by considering whether Neighborhood
Services consistently followed its agreement or plan to pay
performance bonuses without soliciting briefing from the
parties on that issue. Neighborhood Services claims that the
Board’s decision of that issue betrayed its partiality toward the
Administration. At the same time, Neighborhood Services
insists, the Board denied Neighborhood Services the
“opportunity to rebut” the argument that it was not consistently
following its own policies. Appellant Br. 19.

But the issue was briefed. The Appeals Board
appropriately resolved the parties’ long-running dispute over
whether Neighborhood Services adequately showed it was in
practice following its written bonus policies. As noted above,
a grantee like Neighborhood Services can only award
performance bonuses to its employees if the bonuses are
“adequately documented.” 2 C.F.R. Pt. 230, App. A ¶ A.2.g.
Bonuses cannot be considered “adequately documented”
unless a grantee maintains sufficient documents to prove that
the bonuses are “allowable,” i.e., consistent with applicable
regulations. Touch of Love Ministries, Inc., DAB No. 2393,
 11
2011 WL 3251319, at *3 (Dep’t of Health & Human Servs.
June 29, 2011). Neighborhood Services’s bonuses thus could
not be considered adequately documented unless
Neighborhood Services maintained documents sufficient to
show that its bonuses were paid pursuant to an “agreement” or
“established plan,” as required by 2 C.F.R. Pt. 230, App. B
¶ 8.j.

Both parties addressed that issue in their briefs to the
Appeals Board. The Administration argued that Neighborhood
Services’s documents were inadequate because they failed to
show that Neighborhood Services complied with written
policies; in fact, the documents showed that Neighborhood
Services disregarded those policies on several occasions. For
example, the Administration explained, in FY 2010,
Neighborhood services paid all of its non-management
employees the same size bonuses, in violation of “the 2009
Plan.” J.A. 251. Similarly, Neighborhood Services awarded
bonuses to employees who had only received ‘C’ grades, which
was “not consistent” with Neighborhood Services’s policy “to
reward ‘[consistent or] exemplary job performance.’” J.A.
252. In its reply brief, Neighborhood Services challenged that
characterization of its documents, claiming that the documents
showed Neighborhood Services’s compliance with “its
established policies.” J.A. 282. As discussed in more detail in
the next subsection, the Appeals Board ultimately sided with
the Administration. While Neighborhood Services may have
been unhappy with that decision, it cannot claim that it lacked
notice or a chance to address the point.

C.

Neighborhood Services also contends that the Appeals
Board acted arbitrarily when it concluded that the performance
bonuses were inadequately documented, despite the fact that
 12
Neighborhood Services provided all of the documentation
Board precedent required. Neighborhood Services explains
that, in Seaford Community Action Agency, DAB No. 1433,
1993 WL 742548, at *3-4 (Dep’t of Health & Human Servs.
Aug. 17, 1993), the Board allowed reimbursement of most of
the performance bonuses paid by a grantee who had provided
“payroll registers, minutes of Policy Council meetings,
evaluation sheets, and lists of awardees” showing that the
bonuses were awarded to employees who had performed
above-average work. Neighborhood Services insists that it
provided at least as much documentation to support its
performance bonuses as the grantee in Seaford, and as a result,
it was arbitrary for the Board to hold that Neighborhood
Services’s bonuses were insufficiently documented. See
Etelson v. Office of Pers. Mgmt., 684 F.2d 918, 926 (D.C. Cir.
1982) (“Government is at its most arbitrary when it treats
similarly situated people differently.”).

As the Board recognized, however, the key question in this
case is not whether Neighborhood Services submitted the same
type of documents as the grantee in Seaford, but whether the
documents in Neighborhood Services’s files painted the same
kind of picture as the documents at issue in Seaford.
Answering that question in the negative, the Board noted that
the documents in Seaford showed substantial compliance with
the terms of the OMB Circular. By contrast, the documents
submitted by Neighborhood Services were prima facie
evidence that Neighborhood Services had entirely disregarded
its bonus policy for several years in a row, in violation of 2
C.F.R. Pt. 230, App. B ¶ 8.j. Thus, it was reasonable for the
Board to conclude that, unlike the grantee in Seaford,
Neighborhood Services had not submitted documentation
sufficient to show that it had complied with relevant rules and
regulations. See Muwekma Ohlone Tribe v. Salazar, 708 F.3d
209, 216 (D.C. Cir. 2013) (suggesting that agency action is not
 13
arbitrary if the agency offers good reasons for treating
regulated parties differently).

Additionally, Neighborhood Services argues that the
Appeals Board arbitrarily countenanced the Administration’s
“escalating demands for documentation.” Appellant Br. 23. In
its Disallowance Letter, the Administration contended that the
bonuses were inadequately documented because
Neighborhood Services had not submitted documents showing
precisely how much money each employee received. The
Disallowance Letter also faulted Neighborhood Services for
failing to produce “plans of performance” to show how
individual employees had performed over the course of the
year. J.A. 82.

In its opening brief to the Board, Neighborhood Services
laid out its response to the Disallowance Letter’s concerns: It
provided payroll documents showing the magnitude of each
employee’s bonus and clarified that it did not keep “individual
plans of performance” for specific workers; instead,
Neighborhood Services used a single matrix to reflect its
evaluation of all employees. J.A. 77. Neighborhood Services
submitted a copy of the matrix along with its brief.

Neighborhood Services contends that, after it thus
responded to the Disallowance Letter, the Administration
“moved the goalposts” and requested more records. Appellant
Br. 23. The Administration countered before the Board that
Neighborhood Services should have produced data sufficient
to show how it had calculated each employee’s matrix score.
With its reply brief, Neighborhood Services provided sample
data for one of its employees, but the Board held that the
sample failed to show that the bonuses had been adequately
documented. Neighborhood Services claims that, had it been
given clear notice that Board would want to see the data
 14
underlying the matrix scores, it could have provided that
information, but the Board arbitrarily deprived Neighborhood
Services of the opportunity to do so.

While it is true that the Administration requested one set
of documents in the Disallowance Letter and then requested
more in its brief to the Board, it was neither unlawful nor unfair
for the Administration to proceed in that manner. Under Board
precedent, the Administration is allowed to make new
arguments and requests in its brief to the Board, so long as
“there is [an] opportunity during the Board’s process for the
grantee to respond.” Neb. Health & Human Servs. Sys., DAB
No. 1660, 1998 WL 354969, at *5 (Dep’t of Health & Human
Servs. May 26, 1998). That rule tracks the requirements of the
Due Process Clause, which guarantees regulated parties a
meaningful opportunity to respond to the allegations against
them. See Partington v. Houck, 723 F.3d 280, 289 (D.C. Cir.
2013) (Due Process Clause).

Indeed, it is a matter of simple logic that, when an agency
points out apparent inconsistencies like those the
Administration identified in Neighborhood Service’s
application of its incentive compensation policy, it is
incumbent on the grantee to provide a coherent explanation.
The particular documents capable of doing so might vary
depending on the nature of the inconsistencies. Here, we need
not determine precisely what type of documentation
Neighborhood Services needed to produce; we can simply note
that, if it had good answers as to why it paid all employees the
same bonuses when its policy called for bonus amounts keyed
to performance, or why employees with lower performance
scores received the same or larger bonuses than those who
scored higher, it was up to Neighborhood Services to make its
case. Its failure was not for want of opportunity.
 15
Neighborhood Services had multiple chances to submit
individual performance evaluations, explanatory memos
regarding the apparent disconnect between matrix scoring and
bonus levels, declarations by staff involved in implementing
the plan that described the process, or any other documents that
could have responded to the Administration’s request in its
brief to the Appeals Board. Neighborhood Services could have
submitted the relevant documents in its reply brief to the Board,
or appended them to its Motion for Reconsideration of the
Board’s decision, but it did not. Remanding this case to give
Neighborhood Services a third bite at the apple would only
encourage grantees to make half-hearted responses to
document requests, thereby encumbering the administrative
process of ensuring compliance with federal regulations.

D.

Finally, Neighborhood Services claims that the Board
acted arbitrarily by considering whether Neighborhood
Services’s bonuses collectively satisfied the terms of the OMB
Circular, rather than considering whether each individual
bonus was consistent with the Circular. Neighborhood
Services insists that, if “even one” of the incentive payments
was reasonable, consistent with the 2009 Plan, and adequately
documented, the Board should have allowed that payment.
Reply Br. 1. Under the circumstances of this case, the Board
reasonably held that a bonus-by-bonus analysis was
unnecessary because Neighborhood Services’s apparent
wholesale failures to follow its plan affected all of the bonus
payments.

As noted above, Neighborhood Services had an obligation
to produce enough documentation to show that its bonus
payments were paid pursuant to an “agreement” or “established
plan,” 2 C.F.R. Pt. 230, App. B ¶ 8.j, and the Board reasonably
 16
concluded that Neighborhood Services failed to do so. As the
Board acknowledged, Neighborhood Services had a written
agreement or plan to pay performance bonuses to its
employees. Under Board precedent, however, a written
compensation agreement can be vitiated if an employer has a
“pattern over a number of years of violating [it],” Seaford,
DAB 1433, at *4 n.6. Similarly, a “plan” to make performance
bonuses may cease to qualify as a plan if it is not followed
“consistently.” 2 C.F.R. Pt. 230, App. B ¶ 8.j. The Board
reasonably concluded that Neighborhood Services’s
documents raised a strong inference that the organization
“failed to follow its compensation policies in many respects”
over a number of years. J.A. 308. Thus, the documents failed
to establish that Neighborhood Services had a functioning
bonus agreement or plan in place. And without evidence of an
agreement or plan that Neighborhood Services followed in
practice, none of Neighborhood Services’s bonuses were
allowable. See Seaford, DAB 1433, at *3-4.

***

Because Neighborhood Services failed to produce
documentation sufficient to show that it was awarding
performances in accordance with the OMB Circular, we affirm
the judgment of the district court.

So ordered.