Sea Mar Community Health Center, Inc., DAB No. 1459 (1994)

Department of Health and Human Services


Appellate Division

SUBJECT: Sea Mar Community Health Center, Inc.

DATE: January 24, 1994
Docket No. A-93-152
Decision No. 1459


Sea Mar Community Health Center, Inc. (Sea Mar) appealed a decision of
the Ad Hoc Grant Appeals Review Committee (Review Committee) of the
Public Health Service (PHS) disallowing $187,132 improperly charged to
PHS grants as a result of an embezzlement scheme by a former Sea Mar
employee. Sea Mar acknowledged throughout this case that the
embezzlement had occurred and that Sea Mar pursued legal remedies
against both the embezzler and its auditors, recovering substantially
all of the embezzled amounts. However, Sea Mar argued that it should
not have to repay the federal funds which were falsely claimed as a
result of the embezzlement.

We uphold the disallowance for the reasons explained below.

Factual Background

Sea Mar is a nonprofit corporation operating community health centers
providing medical care to low-income clients in Seattle. It received
grants from PHS during the fiscal years ending March 31, 1982 through
1989 through the Urban Health Initiative Program, Public Law No. 94-63,
Title V, as amended by Public Law No. 95-626, codified at 42 U.S.C. 
254c. Letter from Counsel for Sea Mar, dated Nov. 11, 1993, Attachment
C at 2. In 1988, Sea Mar discovered that its in-house accountant had
been embezzling funds believed to total more than $1,206,464 over the
preceding seven years. The accountant was convicted and imprisoned, and
Sea Mar succeeded in collecting a net amount of $161,800 from the
accountant. Sea Mar Br. at 4. Throughout the time period involved,
Arthur Andersen & Co. had conducted regular audits of Sea Mar and had
failed to discover the embezzlement. Sea Mar brought a malpractice claim
against the auditors and obtained a settlement recovery, the amount of
which cannot be disclosed under the terms of the settlement. However,
Sea Mar indicated that, between the two recoveries, it had collected
"substantially all of the embezzlement losses which it suffered." Sea
Mar Br. at 6.

While considerable confusion apparently attended the effort to track the
embezzled funds, the parties agreed that $187,132 was improperly charged
to federal grants. See Sea Mar Br. at 7. An audit report by the Office
of the Inspector General (OIG) found that $52,833 was directly charged
as costs, $31,960 was charged to overhead accounts, and an additional
$102,339 constituted program income that was not reported. See OIG
Audit Report at 3-4. The unreported program income occurred in fiscal
year 1988; the other items were claimed in various fiscal years from
1982 through 1988. Id. at 8. The OIG audit report stated in regard to
the unreported program income that, under the grant award conditions for
1988, since "program income was less than the amount specified in the
grant award, all program income had to be used to reduce the total
program costs before" federal funds were used. Id. at 3. Since the
understating of the program income therefore caused costs in the
corresponding amount to be wrongly claimed as expenditures for federal
funds, the OIG audit recommended that the $102,339 be refunded to PHS
along with the falsely-claimed direct and overhead amounts.


1. Arguments of the parties

PHS argued that the only issue before the Board was whether Sea Mar
could be allowed to retain funds claimed on the basis of false reports.
PHS contended that costs charged to Sea Mar's federal grants on the
basis of falsified claims as a result of the embezzler's actions cannot
satisfy the requirement that, to be allowable, costs must be reasonable
and necessary. PHS cited Office of Management and Budget (OMB) Circular
A-122, Attachment A,  A.2.a and A.3.a. (made applicable to PHS grants
to nonprofit organizations by 45 C.F.R.  74.174). PHS also pointed to
statutory and regulatory requirements that grant funds be used only to
further the purposes for which the grant was awarded. See 42 U.S.C. 
254c(i); 42 C.F.R.  51c.107; and 45 C.F.R.  74.170 (all in effect
throughout relevant period). Since the embezzled funds were indisputably
not used to further any grant purpose, PHS reasoned that they must be
repaid to the federal government. PHS Br. at 3.

Sea Mar contended that the issues on appeal related to the disposition
of the funds which it recovered in litigation against the embezzler and
in settling its malpractice claims against its accounting firm for
failing to detect the embezzlement (and to the allowability of an offset
for the legal fees it incurred in that process). Sea Mar argued that it
should not have to repay the federal funds falsely claimed as a result
of the embezzlement, and that it should be permitted to retain the funds
recovered from the embezzler and accounting firm, for the following

(1) Sea Mar was not to blame for the embezzlement and should be
allowed to retain the funds which it recovered by its own efforts as an
incentive to grantees to pursue such recoveries vigorously.

(2) If the funds had not been embezzled, Sea Mar would have paid
wages to employees who donated services to keep the program operating
and so those unpaid wages should be treated as allowable costs.

(3) A 1988 amendment to the law governing community health centers
required that additional income, such as Sea Mar's recovered funds, be
retained by the center for use in improving its services.

(4) Sea Mar already submitted revised Financial Status Reports
(FSRs) which, it claimed, appropriately reflected the effects of the
embezzlement, making the disallowance unnecessary.

We first consider whether we are authorized to review issues related to
Sea Mar's retention of the funds recovered in settlement of its claims
and the allowability of related litigation costs. We then address Sea
Mar's arguments in opposition to the disallowance of the federal funds
falsely claimed as a result of the embezzlement.

2. Scope of our review regarding Sea Mar's retention ofthe funds
recovered in litigation

A major dispute between the parties throughout this appeal has been the
scope of the issues before the Board. PHS contended that the issue on
appeal was strictly limited to resolving Sea Mar's liability to return
federal funds claimed under false pretenses as a result of the
embezzlement from 1982 through 1988. Sea Mar argued that the focus of
this appeal should be "whether Sea Mar is entitled to retain the
recovered funds," rather than "whether embezzled funds constitute
allowable expenditures." Sea Mar Reply Br. at 2.

Clearly, the settlement funds may provide Sea Mar with a source of
non-federal funds from which to repay the embezzled amounts of federal
funds. However, PHS's claim against Sea Mar is not for the recovered
funds, but for reimbursement of federal funds wrongly claimed by Sea
Mar. Even if Sea Mar had been unable to recover any of the embezzled
funds, PHS would be entitled to disallow federal funds for costs which
were not actually incurred or which should have been covered by
non-federal program income which was not reported. We thus agree with
PHS that the disposition of the recovered funds is not at issue.

Sea Mar argued that, at a minimum, it should be allowed to offset any
obligation to repay the funds lost to embezzlement by subtracting the
proportional share of the attorney's fees (and other litigation costs)
which it incurred in its efforts to recover the funds. Sea Mar Br. at
13. The Review Committee found that it had inadequate information about
the amount and payment of such costs and therefore did not accept the
issue of whether the litigation costs might be a credit or offset.
Review Committee Report at 4. Some information was provided to the
Board concerning the amount of attorney's fees as a percentage of the
settlement recovery. See, e.g., Sea Mar Reply Br. at 6, n.1 and
exhibits cited therein. However, Sea Mar admitted that no such fees
have "to date, been taken as expense items" in any yearþs expenditure
reports to PHS. Letter from Sea Mar's Counsel at 2, dated Nov. 11,
1993. Clearly, the attorney's fees were not incurred during the grant
periods at issue here. An appeal relating to the attorney's fees is
thus not properly before us, since no claim for those costs has yet been
made by Sea Mar and hence PHS has made no determination about their
allowability. In any case, we do not see how the attorney's fees would
be germane to the disallowance of embezzled funds. The attorney's fees
might serve as an offset if the recovered funds were required to be
treated as program income in the year received. However, as discussed
below in relation to the 1988 statute, PHS indicated that it did not
consider the recovery to constitute program income.

3. The allowability of the embezzled funds

There was no dispute that the disallowance represented funds which could
not have been expended for the benefit of any proper grant purpose,
since they were claimed on the basis of false reports by the embezzler.
Under the federal statutes and regulations cited above, there is no
basis for retaining federal funds for expenditures which were not made
for grant purposes and which cannot possibly be classified as reasonable
or necessary. The Board has previously upheld disallowances of funds
embezzled by employees of federal grantees. See, e.g., Hualapai Tribal
Council, DAB No. 597 (1984); Orange-Chatham Comprehensive Health
Services, Inc., DAB No. 749 (1986). In so doing, the Board has pointed
out repeatedly that it is "an elementary principle of grants
administration" that grantees are required to "have documentation that
claimed expenditures were incurred to further the purposes of the"
grant. Hualapai at 3-4. A grantee cannot avoid this responsibility by
claiming that the inability to provide such documentation was the result
of its being the victim of embezzlement, since the legal relationship
and responsibility for compliance with federal standards runs between
the federal agency and the grantee (not the grantee's employees). Id.
at 5.

Sea Mar argued that its situation should be distinguished from that of
the grantees in other embezzlement cases. Sea Mar asserted that it had
in place proper internal control systems for financial management, that
it reasonably relied on its auditor's reports, and that its subsequent
recovery in litigation against its accountant and auditor was "unique
among grantees." Sea Mar Br. at 7. However, the Board found in
Orange-Chatham that the grantee in that case had also "acted
appropriately in terms of conducting audits and exercised due diligence
in monitoring the funds and taking follow-up action once the
embezzlement was discovered." Id. at 6. The grantee was nevertheless
found to be obligated to repay the misappropriated funds to the federal
government. That grantee also obtained a judgment against the
embezzler, although the judgment could not be collected successfully.
We fail to see any reason to relieve Sea Mar from the obligation of
repaying misspent federal funds simply because it had more success in
collecting its judgments. If anything, the grantee in Orange-Chatham
was more severely impacted since it lacked the funds recovered from the
malefactors to use in repayment.

At one point Sea Mar suggested that the embezzled funds might be
reclassified as a loss that would be allowable under the cost
principles, as "[c]osts incurred because of losses not covered under
nominal deductible insurance coverage provided in keeping with sound
business practice." OMB Circular A-122, Attachment B,  18.a(3); Sea
Mar Supplemental Br. at 10. Sea Mar argued that this provision allowed
federal participation in losses not covered by insurance so long as the
lack of insurance coverage was prudent. However, PHS interpreted the
provision only to allow participation in a nominal deductible, if
insurance coverage was obtained in accordance with sound business
practices. PHS Br. at 6. We find PHS's interpretation to be more
consistent with the language of the provision, since it refers to the
insurance being "provided in keeping with" sound business practice and
not to sound business practice justifying the failure to provide
insurance. Therefore, reclassifying the falsely-reported costs (or
unreported income) as losses would not make them allowable under
applicable cost principles.

Sea Mar also compared itself to a grantee that suffers a loss for which
it is able to recover from insurance. Sea Mar Br. at 12. It quoted an
internal memorandum from a PHS official which suggested that if Sea Mar
could "recover all or part of its loss from [fidelity bond coverage]
insurance, this amount is a legitimate offset against its liability to
the government." Id. at 12, quoting Sea Mar Ex. 26 at 1 (memorandum
from Richard C. Bohrer, dated Aug. 1, 1991). Sea Mar interpreted this
as supporting its position that it should be permitted to retain any
insurance recovery and make no restitution of lost funds to the
government. However, the point made in the memorandum seems rather to
be that the loss by the federal government could be covered by funds
recovered if insurance were available, not that Sea Mar could profit
from the federal government's loss by retaining any insurance proceeds
without recompensing the federal loss. In any event, the memorandum is
merely an internal recommendation; Sea Mar presented no evidence that
the author of the memorandum had authority to override statutory and
regulatory conditions on federal funding, or even to interpret those

We conclude that there is no basis for treating funds lost to
embezzlement as an allowable cost of Sea Mar's federal grant activities.
4. Sea Mar's argument for overturning the disallowance asan incentive
for grantee diligence

Sea Mar argued that, notwithstanding the fact that the disallowed funds
were not applied for any program purpose, Sea Mar should be "permitted
to apply the recovered amounts to its current federal program projects"
because of its careful stewardship and its diligence in obtaining
recovery of the embezzlement losses. Sea Mar Br. at 9-11. Such a
policy, Sea Mar argued, would be an incentive to other grantees to act
with similar prudence in seeking to recover federal funds in similar
circumstances. Id. at 10. By contrast, Sea Mar said, requiring
repayment in this case would allegedly send other grantees the þwrong
message,þ i.e., that extraordinary efforts to protect grant funds go

It is true that PHS did not point to any action which Sea Mar should
have taken to prevent or discover the embezzlement nor to any inadequacy
in its internal controls. The Review Committee stated that it did not
find that "Sea Mar acted in any way but responsibly once the embezzler's
actions were known." Review Committee Report at 2. The Review
Committee also praised Sea Mar's efforts in litigation. Id. at 4.
However, the disallowance here is not in the nature of a penalty against
Sea Mar for irresponsible stewardship. Instead, it simply reflects the
general rule that a grantee may claim federal funds only for allowable
costs. As the Board has commented in an earlier case, occasionally
"money is embezzled from a grant program . . . ; however, the federal
program cannot be expected to bear these costs when the program has not
received any benefit." Community Action Agency of
Chambers-Tallapoosa-Coosa, Inc., DAB No. 1066, at 8 (1989).

We are not persuaded by Sea Mar's argument in favor of incentives for
grantees who are successful in recovering embezzled funds. First, the
Board is not the appropriate forum to decide questions of policy.
Second, we note that grantees already have an obligation to account for
and act to safeguard federal funds without regard to any special
incentive to do so. See also Review Committee Report at 2-3. In any
case, Sea Mar certainly benefitted from its successful recovery efforts,
both because it apparently recovered substantial non-federal funds which
were also affected by the embezzlement and because the settlement funds
provide a source of money with which to repay the federal government for
the false claims which Sea Mar made as a result of the embezzlement (and
which it would have had to repay even if it had failed to obtain the

5. Sea Mar's claim for its employees' unpaid hours

Sea Mar argued before the Review Committee that it should be permitted
to retain the embezzled funds because its employees worked without pay
during the period in question and the funds could have been used to pay
their wages. The Review Committee rejected this position because Sea
Mar did not incur any actual costs, since it did not pay the wages.
Review Committee Report at 2.

Sea Mar did not provide any evidence in this appeal to support the
argument that the time which its employees worked without pay could be
reclassified as a cost of the program in the period in question. Sea
Mar submitted no documentation of the actual hours worked or their
allocability to the federal grant purposes. Moreover, applicable cost
principles state that the value of "donated or volunteer services . . .
is not reimbursable either as a direct or indirect cost" (although such
services may be used to meet cost sharing or matching requirements in
some situations not relevant here). OMB Circular A-122, Attachment B, 
10.a(1). We conclude that Sea Mar may not replace the amounts falsely
reported as costs by the embezzler with costs that it would have
incurred if it had paid wages for services which were in fact donated by
its employees.

Sea Mar suggested that allowing it to retain the federal funds would be
"analogous to [making] . . . retroactive support awards" to recipients
of Social Security benefits for periods when the recipients were found
to have been entitled to them, "even though the recipient[s] presumably
found a way to survive." Sea Mar Br. at 9. The analogy is inapt. A
recipient of benefits who was mistakenly denied them may be entitled to
later receive them, regardless of how the recipient covered expenses in
the interim. However, Sea Mar's situation is more like that of a
recipient who mistakenly received benefits to which the recipient was
not entitled. The funds must be repaid.

6. The 1988 amendment on retention and use of excess fees, premiums,
and third-partyreimbursements

Congress amended the law relating to the use of certain kinds of income
by community health centers in 1988. Pub. L. No. 100-386 (1988),
amending 42 U.S.C.  254c(d)(4)(B). The statute as amended provides
that federal grant awards may generally not exceed the amount by which a
center's costs of operation are greater than the combination of (i) the
State, local, and other operational funding and (ii) the fees, premiums,
and third-party reimbursements reasonably expected to be received by the
center for the fiscal year. However, if the combination of the grant
and the other sources listed above exceeds the costs of operation
because the center's fees, premiums, and third-party reimbursements were
greater than expected, "an adjustment in the amount of the grant to the
center in the succeeding fiscal year shall be made in a manner that the
center shall be entitled to retain the additional amount of the fees,
premiums, and third-party reimbursements" to use for specified purposes
in expanding and improving its program. 42 U.S.C.  254c(d)(4)(B).

Sea Mar argued that this law precluded PHS from collecting any program
income which Sea Mar obtained from other sources. Sea Mar Reply Br. at
2-5. PHS argued that the 1988 law was simply irrelevant because the
settlement recovery "would not be considered excess program income," but
rather "a source of income other than from service activities." PHS
Submission at 5, dated Sept. 24, 1993. In any case, PHS argued, whether
the settlement recovery is program income or not, and whether Sea Mar
may retain it or not, is simply irrelevant to whether Sea Mar must repay
the federal government for improperly claimed funds.

The OIG audit expressly found, and Sea Mar provided no evidence to the
contrary, that the unreported program income in 1988 combined with the
reported program income for that year was less than the amount expected
in making the grant award. OIG Audit Report at 3. Therefore, no excess
program income was received by Sea Mar in 1988 as that concept is
defined in the statutory language set forth above, i.e., no amount
exceeding its costs of operation as a result of greater-than-expected
receipt of fees, premiums, and third-party reimbursements. Sea Mar had
no entitlement to retain for its use program income that was not excess
income within the meaning of the statute. In general, Sea Mar was
required to use other sources to cover its costs before using federal
grant funds. 1/

In any case, we agree with PHS that the 1988 law is not applicable to
embezzled funds recovered through litigation. These funds do not appear
to constitute program income as that term is commonly understood in this
Department's grant programs. See 45 C.F.R.  74.71. Even if they did,
the statute does not refer to program income in general, but to three
specific categories of program income: fees, premiums, and third-party
reimbursements. These categories all relate to potential sources of
compensation for services provided by a center to its clients, such as
fees paid by clients or reimbursements from insurers or workmen's
compensation programs. A settlement for malpractice by the center's
auditors is not remotely of the same nature as these sources of program

Sea Mar argued that the statute was not intended to limit the affected
income to service-related sources, but rather was broadly intended to
provide an incentive to community health centers to maximize non-federal
income. Confronted with the narrow language actually used in the
legislation, Sea Mar argued that the word þpremiumþ indicated a meaning
beyond revenues resulting from services to clients because it might
cover þa cash reimbursement from, for example, a supplier of medicinesþ
without relation to a specific patient. Sea Mar Supplemental Br. at 4,
dated Oct. 6, 1993. Clearly, however, the example offered by Sea Mar
directly relates to income offsetting the costs of providing medical
services, in this case drugs, to clients, whether or not a particular
client is identifiable. Sea Mar did not explain how, even defining
"premium" broadly enough to include a rebate from a medical supplier,
the term would encompass the recovery of embezzled funds in litigation.

Sea Mar also relied on language in the legislative history of the 1988
amendment to the effect that centers should have an incentive to
"maximize income from other sources" and to retain any "excess income."
Sea Mar Supplemental Br. at 3, quoting from Senate Report at 21. Sea
Mar argued that this language evidenced an intent to permit retention of
all excess income. The context of the quoted language makes clear that
no broader reading of the kinds of income affected should be grafted on
to the statutory language. Specifically, the quoted portion of the
Senate Report discussed Congress' discontent with administrative
responses to the prior 1978 enactment which included "incentives . . .
to increase collections for services from all sources," which it then
specifically referred to as meaning "revenues from fees, premiums, and
third-party reimbursement." Senate Report at 21 (emphasis added). The
Senate Report expressed distress that centers had sometimes been
required to make unrealistically high projections of such revenue (in
order to reduce the excess subject to retention) or had been permitted
to retain only a percentage rather than the full amount of the excess.
Id. The effect of the 1988 amendment was to clarify that centers should
be allowed to retain (for specified uses) 100% of revenues from services
beyond a realistic projection based on each centerþs experience.
Congress continued to use the terms "fees, premiums, and third-party
reimbursements" and gave no indication that it meant them to have any
expanded meaning beyond collections for services.

We therefore conclude that the 1988 amendments did not create any bar to
the recovery of embezzled funds by PHS from Sea Mar.

7. The revised FSRs

Sea Mar argued that it already made appropriate revisions in its FSRs
and therefore was not required to repay the disallowed funds. Sea Mar
Supplemental Br. at 7, n.2. FSRs generally report to the federal
grantor agency what the grantee's outlays have been during a fiscal
year, what program income was realized, and what the federal share of
the outlays was. At the Board's request, Sea Mar submitted copies of
the revised FSRs for the fiscal years at issue, along with a cover
letter showing their transmission in May 1990 to the Health Resources
and Services Administration of PHS. Letter from Sea Mar's Counsel,
dated Nov. 16, 1993, with attachments. PHS denied that it had ever
received the revised FSRs. Letter from PHS Counsel, dated Dec. 1, 1993.
Although Sea Mar then provided affidavits in support of its claim that
the FSRs were sent as part of Sea Mar's audit response, the Board need
not resolve the questions of whether the FSRs were filed in 1990 or with
whom. See Letters from Sea Mar's Counsel, dated Dec. 16 and 20, 1993,
with attachments.

The revised FSRs would be meaningful only if they were used by PHS as a
basis for reflecting an increase in Sea Mar's fund balance as a result
of correcting the understated program income and the overstated outlays
reported in the original FSRs. The revised FSRs would thus show an
increase in Sea Mar's fund balance for the relevant years which PHS
would have considered in determining its subsequent grant awards.
However, we have no indication that PHS used these FSRs, even if they
were received somewhere in the agency, as a basis for redetermining Sea
Mar's fund balances. Furthermore, the FSRs as revised do not, in any
case, show the corrections as increasing Sea Mar's available fund
balances in the years involved. Adjustments appear to have been made
only in regard to outlays from program income without properly
reflecting the impact in reducing the federal share of costs. Sea Mar's
counsel stated that, instead of showing increased fund balances, Sea Mar
simply showed the "disputed amount" as a liability on its financial
statements "pending the outcome of appeal." Letter from Sea Mar's
Counsel, dated Nov. 16, 1993, at 1. We see no basis for concluding
that the FSRs as revised would satisfy Sea Mar's obligation to repay or
properly account for the embezzled funds. 2/


For the reasons given above, we sustain the disallowance in full.

___________________________ Cecilia
Sparks Ford

___________________________ Norval D.
(John) Settle

___________________________ Judith A.
Ballard Presiding Board Member

1. The Senate Report on the 1988 amendment (which Sea Mar cited in
support of its interpretation of the law) in fact stressed that "Federal
grant funds are `last dollar' to other funds available to health
centers." S. Rep. No. 100-343, at 20, reprinted in 1988 U.S.C.C.A.N.
1178 (Senate Report).

2. We note that nothing in this decision precludes PHS in its
discretion from permitting Sea Mar to carry over and reprogram the fund
balances which result from correcting the embezzlement, once properly
revised FSRs have been received and reviewed.