Buyer beware: DOJ pursuing private equity investors in healthcare

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As many in the healthcare industry have come to appreciate, the Civil War-era False Claims Act (“FCA”) is an exceptionally broad statute that has been the Department of Justice’s (“DOJ”) primary lever over the last twenty years in extracting billions of dollars of recoveries from healthcare providers accused of conduct ranging from clear fraud to regulatory infractions.

The FCA has broad liability provisions, extending to “any person who” submits claims for payment to the federal healthcare programs or who “causes to be presented” false claims, and a broad intent standard, including actual knowledge, reckless disregard, or deliberate ignorance, with no proof of specific intent to defraud required. In 2018, we have seen DOJ and the private whistleblower bar bring these broad liability and intent provisions to bear in their search for deep pockets, including against private equity firms that are active in the operations of their portfolio healthcare companies.

Private whistleblowers can bring FCA actions on behalf of the federal and state governments, motivated by a chance at capturing a 30% bounty on any recovery. In one such case that is playing out in federal court in Boston, a licensed mental-health counselor brought suit against her former employer, South Bay Mental Health Center, its President and Chief Clinical Officer, alleging South Bay provided services at various clinics in violation of regulatory obligations imposed by Massachusetts Medicaid, including by providing services by individuals who were not properly qualified or supervised. U.S. ex rel. Martino-Fleming v. South Bay Mental Health Center, Civ. Action No. 15-13065, D. Mass. To that extent, the complaint is a run-of-the-mill attempt by a whistleblower to convert regulatory violations into FCA treble damages and statutory penalties. The complaint is notable for the claims it asserts under the FCA against the private equity funds that purchased South Bay in 2012. While the DOJ has declined to intervene in this litigation, the Commonwealth of Massachusetts has joined the case.

The defendants filed motions for dismissal. The PE fund defendants argued they should be dismissed from the case on the ground that there were no allegations that they had “directly” caused South Bay to submit any false claims or engage in improper conduct. Mere awareness of and failure to stop the practices of one of many portfolio companies, they argued, cannot meet even the broad liability and intent standards of the FCA. Judge Patti Saris agreed that “mere knowledge of the submission of claims and knowledge of the falsity of those claims is insufficient to establish causation under the FCA.” Still, the court rejected the PE funds’ motion on the grounds that the whistleblower alleged that the PE fund “members and principals formed a majority of the . . . South Bay Board[], and were directly involved in the operations of South Bay.” Citing the general doctrine that parents can be held liable for the submission of false claims by subsidiaries where the parents have “direct involvement in the claims process,” the Court concluded the complaint adequately alleged – at the pleadings stage – that the PE funds had caused the submission of the false claims. Whether the whistleblower and Commonwealth will be able to establish as a matter of fact that the PE funds were directly involved in the claims submission process and acted with the requisite intent remains to be seen.

Separately in 2018, for the first time DOJ intervened in an FCA suit against a private equity sponsor, as well as the fund’s portfolio compounding pharmacy, and two pharmacy employees. U.S. ex rel. Medrano v. Diabetic Care Rx, LLC, Case No. 15-62617-CIV-BLOOM, S.D.Fl. The government alleges that the pharmacy violated the FCA by engaging in inappropriate compounding practices and by paying illegal kickbacks to induce prescriptions for drugs reimbursed by the federal health care programs. The DOJ’s Complaint also names as a defendant Riordan Lewis & Haden Equity Partners (“RLH”), a private equity firm that took a controlling interest in the pharmacy in 2012 and had principals who became both officers and directors of that entity. The government alleges the private equity fund was actively involved in the management of the pharmacy and helped implement the illegal tactics in service of a broader strategy to increase the pharmacy’s value and then sell it for a profit in five years.

Allegedly, the pharmacy’s revenue dropped shortly after RLH’s acquisition due to Medicare reimbursement changes for renal nutrition therapy, the pharmacy’s primary business area. This allegedly motivated RLH to direct the pharmacy inappropriately to adjust the ingredients of topical creams to maximize reimbursements from TRICARE. RLH allegedly received regular updates regarding this business practice. In addition, DOJ alleges RLH directly funded certain payments to marketing companies that were in reality illegal kickbacks in exchange for the referral of patients.

In its complaint-in-intervention in Diabetic Care, the government focused its allegations against RLH in ways that are instructive to funds that invest in the industry. As the whistleblower in South Bay did, DOJ alleged that the fund had a “controlling interest” in the pharmacy; that two representatives of the fund served as both board members and officers of the pharmacy; and that these individuals played an active role in the management of the pharmacy. DOJ further alleged RLH acted with the requisite “intent” under the FCA alleging that “[a]s an investor in health care companies, [the fund] knew or should have known . . . . that health care providers that bill federal health care programs are subject to laws and regulations designed to prevent fraud.” RLH filed a motion to be dismissed from the case, arguing that the absence of allegations that it knew of, or participated in the fraud, inoculates it from FCA liability.

In November, the Magistrate Judge filed an opinion recommending the FCA claims be dismissed on one pleading deficiency, but nonetheless went on to hold that the government had adequately alleged the causation and materiality elements of FCA claims against the defendants. As to RLH, the Magistrate focused on allegations that the fund received legal advice that the payments to the marketing companies could violate the Anti-Kickback Statute but went on nonetheless to “approve” the plan and knew of and assisted in making some of the payments. On this basis, the Magistrate concluded the government had adequately alleged the fund caused the submission of false claims.

As private equity funds wait to see how the South Bay and Diabetic courts ultimately resolve the claims at issue, they should expect whistleblowers and the government will continue to examine whether they may be held liable under the FCA for the conduct of healthcare portfolio companies. While private equity investors and principals should not be subject to liability merely because of investments in a healthcare companies, and while they should generally have strong defenses to efforts by aggressive prosecutors and the whistleblower bar to bring FCA claims against them, given that potential liability under the FCA extends to “any person” who engages in relevant misconduct they – and in particular any principals who serve as directors or officers of portfolio companies – should be educated on and attentive to the particular fraud and abuse risks facing their portfolio healthcare companies. In that regard, there are common sense steps private equity investors in the industry should be taking:

• Proceed with caution and take appropriate measures if fund employees serve as officers of portfolio companies, and in particular where they take an active role in directing the conduct of the portfolio company, as the Diabetic Care principals allegedly did. Employees serving as directors of portfolio companies, like their counterparts on public company boards, should be advised (and reminded) of their obligations and the importance of avoiding direct involvement in day-to-day operations, and certainly in any part of the claims submission process. In addition to protecting the funds, exercising caution in this way will protect the individuals who also can be held personally accountable under the FCA.

• Understand the complex regulatory and federal healthcare program contract requirements applicable to their portfolio companies and the compliance, audit, and other mechanisms in place to ensure compliance with those requirements. Seeking advice of competent healthcare regulatory counsel during and after diligence, and steering clear of conduct counsel determines to cross a regulatory or fraud and abuse line, is critical to protecting both the portfolio company and investors.

• Ensure the portfolio companies have sound compliance programs that satisfy the HHS-OIG defined elements of effective compliance programs. Clear and documented insistence on sound compliance practices should be communicated to portfolio companies not only at the time of acquisition but throughout the life of a fund’s investment in any healthcare portfolio company.

• Require the portfolio company management promptly to follow-up on compliance issues that are raised. Document instructions to remediate any problematic activity and ensure refunds are issued where appropriate.

Conclusion
The government and whistleblower bar increasingly are willing to pursue private equity funds in False Claims Act cases, particularly ones based on alleged violations of healthcare fraud and abuse laws. Private equity funds and principals should generally have strong defenses against liability. However, active engagement in the management of portfolio companies potentially will increase the risk and the more active a private equity fund is in the management of its portfolio healthcare companies, the more important observing the safeguards outlined above becomes.

This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content therein does not reflect the views of the firm.

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