DEPARTMENTAL GRANT APPEALS BOARD
Department of Health and Human Services
SUBJECT: Maternal and Family
Health
Services, Inc. Docket No. 86-192 Decision No. 839
DATE: February 17, 1987
DECISION
The Maternal and Family Health Services, Inc. (MFHS) appealed a
September 2, 1986 determination by the Public Health Service (PHS)
Grant
Appeals Board, disallowing $11,745 of the federal share of
alleged
rental costs charged by MFHS for the grant year 1985-86 to
Family
Planning Grant No. 03-H-000,013. PHS found that the rental
charges were
based on a less-than-arms-length lease transaction between MFHS
and
Health-Med Associates (HMA) which exceeded the limitations on
such
charges.
The issue before the Board is whether MFHS was "able to control
or
substantially influence the actions of" HMA, or vice versa, under
the
provisions of Office of Management and Budget (OMB) Circular
A-122,
attachment B, para. 42(c), made applicable to family planning grants
by
42 CFR 59.10 and 45 CFR 74.174. As we discuss below, we find that
the
record of common control and coordination of activities between the
two
organizations indicates sufficient influence between them for us
to
conclude that the lease was not an arms-length agreement. Thus,
we
conclude that the determination of the PHS Grant Appeals Board was
not
clearly erroneous, and we uphold the disallowance.
I. Case Background
The undisputed facts are that on July 24, 1984, MFHS contracted
to
purchase a building and land for its own use. MFHS determined that
the
purchase of the facility would limit rental cost escalations and
reduce
charges to its family planning grant. When MFHS became aware
of
restrictions on federal participation in charges for
grantee-owned
facilities, described below, MFHS "investigated other
alternatives to
complete the purchase." MFHS Brief in the PHS GAB
appeal, p. 2.
On October 19, 1984, MFHS approved a "plan for reorganization" under
which
MFHS would assign the agreement to purchase the facility to a
new
organization, HMA. As a part of the plan, MFHS was to loan to
HMA
whatever sum was necessary to complete the transaction, and three
of
HMA's seven directors were to be selected from MFHS officers and
staff.
On November 15, 1984, MFHS approved a $75,000 loan to HMA, to
be
subordinated to a mortgage on the facility, and HMA purchased
the
facility. On November 21, 1984, a lease agreement was signed
between
MFHS and HMA.
On April 25, 1986, PHS' regional office disallowed $11,745, asserting
that
the lease between MFHS and HMA was a "less-than- arms-length
lease."
The amount disallowed was the federal percentage of the
difference between
the amount budgeted for rental costs and the amount
allowable using a
depreciation method of calculating the cost of the
facility. MFHS
appealed the determination that the lease agreement was
a less-than-arms-
length transaction to the PHS Grant Appeals Board,
which upheld the regional
office, and, subsequently, to this Board.
MFHS did not dispute PHS'
calculation of costs under the depreciation
method, but argued that this
method should not be applied since the
lease had resulted from arms-length
negotiations.
II. Relevant_Regulations and Principles
The cost principles for nonprofit organizations contained in OMB
Circular
A-122, made applicable under 42 CFR 59.10 and 45 CFR 74.174,
generally allow
rental costs if reason-able in light of market rates and
conditions, as well
as alternatives available and the nature of the
property leased. A-122,
Attachment B, para. 42(a). If, however, the
lease agreement is entered
into between parties when "one party to the
lease agreement is able to
control or substantially influence the
actions of the other," then the rental
costs are treated under a special
rule for "less- than-arms-length
leases." See A-122, Attachment B,
para. 42(c). 1/ Allowable
rental costs for a less-than-arms-length
lease are limited to the amount
which would be allowable if the grantee
held title to the property, under a
depreciation or use allowance method
of calculation under A-122, attachment
B, para. 9.
III. Discussion
MFHS argued that PHS produced no evidence that MFHS was able to control
or
substantially influence HMA. MFHS asserted that HMA was independent
of
MFHS and that the lease agreement and other transactions linking
the
organizations had been negotiated freely by each party. MFHS
stressed
that HMA had only three directors out of seven who were
formally
affiliated with MFHS, which would not be sufficient to control
HMA.
MFHS pointed out that HMA was incorporated separately, had
obligations
separate and distinct from MFHS, and conducted separate
corporate
meetings. MFHS contended that there was no evidence that
the
MFHS-affiliated directors had asserted any direct influence on
the
actions of HMA. MFHS contended that, while PHS may have shown
a
potential for such influence, PHS' determination was deficient
because
PHS did not show any actual influence exerted by MFHS in the
lease
transaction at issue. To support its arguments, MFHS pointed to
lease
provisions which protected the interests of each party to
the
disadvantage of the other.
We disagree with MFHS. Looking at the record as a whole, it is
clear
that the PHS Grant Appeals Board was correct in finding that MFHS
and
HMA were never distinct organizations with truly independent
identities,
and it is clear that these organizations had substantial
influence over
each other. Our decision is based on a number of factors
indicating
substantial influence, including the following:
o Common directors: Three of
HMA's seven directors
were
formally
affiliated with MFHS and a fourth was
the
brother-in-law of
MFHS' Executive Director. MFHS
contended
that the
brother-in-law was chosen for reasons independent
of
any affiliation
with MFHS and that, therefore, MFHS did
not
control a majority
of HMA's board of directors. It is
not
necessary for MFHS
to control an absolute majority,
however,
for MFHS to
exercise "substantial influence" over HMA.
Furthermore, although
MFHS stated that the four directors
not
formally
affiliated with MFHS were "randomly selected"
from
interested
members of the general public, MFHS did not
deny
PHS' assertion
that these directors were selected from a
list
of names
submitted by MFHS. Thus, even these
unaffiliated
directors
were linked to MFHS.
o Common management: MFHS'
Executive Director is a member
of
the HMA board of
directors. In this position, the
Executive
Director may
exercise significant influence on the actions
of
both
organizations.
o Coordination of
activities: The coordination of activities
to
effect the purchase
transaction, in a manner
uncharacteristic
of
ordinary business dealings, indicates that MFHS and
HMA
exercised
substantial influence over each other.
MFHS'
commitment on
October 20, 1984 to loan an uncertain amount
of
money to HMA, a new
organization without any assets or
record
of operations,
was not a usual business practice. We
agree
with PHS that
the subsequent subordinated loan of
$75,000,
payable on
demand, was not an ordinary market
transaction.
Clearly,
the transactions which occurred were part of
a
coordinated plan
which could only have taken place
between
organizations
confident of influence over each other.
o Economic control: The
coordinated economic structure of
the
transactions at
issue clearly indicates that HMA
was
economically
dependent on MFHS and susceptible to control
by
MFHS. The
$75,000 loan extended to HMA, an
organization
without
any substantial liquid assets, is payable on
demand.
Merely by
virtue of that loan, MFHS could exercise
substantial
influence
over the actions of HMA. We agree with PHS that
the
loan was extended
by MFHS for the purpose of creating
and
capitalizing an
organization under its control to purchase
the
facility and evade
the requirements contained in the
cost
principles with
respect to grantee-owned facilities.
o Lack of independent
organizational purpose: The
record
indicates that
HMA was created only to carry out the
purchase
of a facility
for MFHS without any of the restrictions
which
would be
applicable to MFHS. The record contains no
evidence
that HMA had
any purposes or interests independent of
MFHS.
None are
indicated in HMA's Articles of Incorporation, and
no
By-laws for HMA
were submitted. The "Plan for
Reorganization"
indicates that HMA was clearly created solely to carry out
the
purposes of
MFHS.
o Adjustment of Lease Terms:
As PHS pointed out,
some
adjustment of
lease terms occurred, which was not carried
out
in a manner
indicative of arms-length bargaining.
In
particular, PHS
pointed out that MFHS apparently agreed to
an
assessment of
"additional rent" and a $10,000 security
deposit
to HMA despite
the absence of any such obligation in
the
original lease
agreement. See MFHS Brief in the PHS
GAB
appeal, p.
19. This adjustment, despite the absence of
any
legal obligation
under the lease, indicates that MFHS did
not
act in a
disinterested manner in negotiating with HMA, but
was
substantially
influenced by the common control of
the
organizations, the
intertwined economic relationship
and
coordination of
activities to effect the purchase of
the
facility.
We give little weight to MFHS' claim that the presence of lease
clauses
protective of each party indicates that each party
negotiated
independently to protect its own interests; the clauses cited by
MFHS
seem to be fairly standard clauses which would have been contemplated
as
a part of the coordinated acquisition plan which was being pursued
by
MFHS and HMA. Although the inclusion of the clauses may indicate
that
each party was willing to permit the other party some protection,
there
is no evidence in the record that the provisions required
negotiation
because they were not mutually agreeable.
In sum, we find that the above-listed factors were sufficient
evidence
that the transactions were not arms-length. The cases cited by
MFHS are
not relevant because they focus on judicial standards for "piercing
the
corporate veil" to hold one organization liable for the obligations
of
another, and on the burden of proof applicable to tax disputes.
The
standard here is not as rigid. OMB Circular A-122 does not require
that
one corporation have absolute control or an absolute majority on
the
other organization's board of directors; it is sufficient that
the
common directors or officers have "substantial influence" over
the
affairs of one or both organization. Similarly, under the standard
in
OMB Circular A-122, there is no burden placed on PHS to
distinguish
between the actual exercise of influence and the potential
for
influence. Even if there were, the coordinated activities of MFHS
and
HMA clearly demonstrate the actual exercise of influence by
common
officers and directors in this case. Despite the existence of
separate
corporate meetings, some separate obligations and separate
corporate
forms, we find that the two organizations acted in
a
less-than-arms-length manner to effect the purchase of the facility
and
lease to MFHS.
Although MFHS asserted that the lease arrangement with HMA was
reasonable
and resulted in lower program costs for both MFHS and the
federal government,
these justifications are not a sufficient basis to
disregard regulatory
requirements. This Board is bound by all
applicable regulations, 45 CFR
16.14, and we do not have authority to
grant an exception to the unambiguous
directives of the cost principles
in 45 CFR Part 74.
Conclusion
For the reasons described above, we conclude that the PHS Grant
Appeals
Board determination was not clearly erroneous and that the
lease
agreement in question was a "less-than-arms-length" lease. We
uphold
the disallowance of rental charges in excess of depreciation and
other
allowable costs under the requirements of OMB Circular A-122.
__________________________________
Cecilia
Sparks Ford
__________________________________ Norval
D.
(John) Settle
___________________________________
Alexander
G. Teitz Presiding Board Member
1. OMB Circular A-122, Attachment B, para. 42(c) lists, as
examples,
leases between divisions of an organization; leases
between
organizations under common control (through common officers,
directors,
or members); and leases between an organization and a director,
trustee,
officer, or key employee of the organization (or his immediate
family)
either directly or indirectly. These principles are repeated
in
substantially the same form in the PHS Grants Administration
Manual,
section 6-10-