False Claims and Private Equity: The Government's Increasing Focus on Private Equity Firms in False Claims Act Cases

For example, in Massachusetts, a relator recently brought a suit (in which the Commonwealth of Massachusetts intervened) against the operators of mental health care centers, alleging that they improperly billed the state Medicaid program for services provided by unlicensed and unsupervised employees. The relator and the government named not only the mental health care center and its former CEO as defendants, but also the private equity investor in the company. Similarly, in Washington, DC, a relator brought a suit (in which the federal government intervened) against a security contractor over allegations that it did not properly vet personnel working on a civilian-police training contract with the U.S. government in Afghanistan. The suit also named the company's owner, a private equity firm, as a defendant. More recently, in March 2018, the federal government intervened in a False Claims Act case and named a private equity firm as a defendant. In that suit, US ex-rel Medrano v. Patient Care America et al. (S.D. Fl.) 15-cv-62617, the government alleged that the private equity firm caused the submission of false claims through its management and control of the defendant pharmacy, on whose board two private equity partners sat.

In other instances, especially where a portfolio company is asserting an inability to pay, the government has heightened their scrutiny of the role of the investors since, as defendants, they may have a greater ability to fund a settlement. While standing alone there is no legal basis to chase PE firms for any return on their investment in a firm that is unable to satisfy a FCA judgment, prosecutors and relators do try to “follow the money” and after locating some, will then look for facts that might support direct liability or veil-piercing exposure.

Theories of Liability

There are two theories under which the government or a relator may seek to hold a private equity firm and its partners or employees liable under the FCA. The first is through a “veil piercing” theory of liability, in which a parent/investor and a subsidiary are treated as though they were a single entity, usually because the parent used the subsidiary to accomplish some misconduct and there was a failure to maintain an adequate separation between the two. PE firms are typically organized as limited partnerships that then own individual companies. While there is no clear test to determine how the government could establish PE firm liability under this theory, several factors are frequently identified as giving rise to “veil piercing.” These include a showing that the individual company was the “alter ego” of the PE firm, that the individual company was undercapitalized, that there was a failure to observe corporate formalities, or that the corporate form was used to promote fraud, injustice, or illegalities.

The second is a “direct” theory of liability, under which a private equity firm or its partners or employees may be held liable because of their direct participation in the alleged misconduct at the portfolio company. This second theory of liability should be particularly concerning for private equity firms, which are typically “hands on” investors and often have their own partners and employees serving as directors or temporary officers of their portfolio companies. The government and relators are increasingly claiming the PE individuals are not simply investors but instead caused false claims personally, thus leading to individual liability and entity exposure. This is the theory of liability pursued by the government in Patient Care America.

Steps to Minimize Risk

It goes without saying that pre-acquisition diligence into areas of potential FCA exposure is critical. But even if pre-acquisition diligence does not reveal any potential FCA issues, there are steps that should be taken in order to ensure that such issues are immediately identified and remedied if they do arise. After acquisition, a robust compliance program should be a priority. Such a program should include: 1) training to ensure that all employees are aware of the FCA and the company's compliance obligations; 2) a confidential hotline that allows employees to report potential violations; 3) protections for whistleblowers against retaliation; and 4) a strong internal response system that allows for a thorough investigation of any complaints.

Training for private equity partners and employees who serve as directors of portfolio companies is also important. Directors should be trained on the FCA and how to spot potential FCA issues. Two of the most common issues that give rise to FCA claims are: 1) a company's failure to comply with preconditions for payments under Medicare and Medicaid, including applicable licensing or certification requirements; and 2) company payments to physicians or other health care entities (whether in the form of consulting agreements, entertainment, or other arrangements), which may be viewed as kickbacks to induce medical services, in violation of the Anti-Kickback Statute. Financial arrangements which may be perfectly legal in other fields may run afoul of the FCA when undertaken in the health care field, and private equity investors should be aware of these differences.

Directors should also be careful to adhere to their roles, and not become so “hands on” as to incur direct liability, such as that alleged by the government in Patient Care America. Regular reporting to the board is helpful in keeping directors informed and ensuring that key decisions are made with board input, but directors should not be participating in day-to-day operations, such as processing or submitting claims.

To avoid potential “veil piercing,” it is important that the PE firm observe the proper corporate formalities — such as maintaining adequate capitalization, avoiding any commingling of funds, and generally creating a clear distinction between the firm and its portfolio companies. To receive the protections that the corporate form is designed to provide, the PE firms must show genuine adherence to the separate identity of the investment company and the portfolio company.

Conclusion

Given the frequency of FCA claims in the health care field, all private equity firms investing in this industry should be cognizant of the potential pitfalls and the preventive measures to be taken — both to protect themselves against the potential liability that may be imposed against the firm or its partners and employees, and to preserve the value of their investment. As prosecutors and relators counsel become increasingly aggressive in expanding the reach of FCA liability they will likely continue to focus on private equity investors in FCA cases. Well-trained investment professionals who maintain appropriate roles within the portfolio company as well as on behalf of these limited partners will be best positioned to avoid these attacks.

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Yvonne W. Chan ([email protected]) is a partner in the Boston office of Goodwin Procter LLP. Timothy H. Kistner ([email protected]) is an associate in the same office. Joseph F. Savage ([email protected]), a partner in the same office and a former federal prosecutor, also assisted in the preparation of this article.