When Riordan, Lewis & Haden Inc. (RLH), a private equity firm, found itself ensnared in a False Claims Act (FCA) litigation for its role in a prescription drug kickback scheme orchestrated by one of its portfolio companies, it moved to have the United States’ suit dismissed by invoking the familiar concept of the “butterfly effect.” How could RLH’s mere “entry into a new line of business with honest intentions and the hope of turning a profit”—actions that RLH characterized as “the proverbial flutters of a butterfly wing”—create a sufficient basis for FCA liability when the actual misconduct, RLH asserted, was conducted by a wholly different entity? In other words, how could a private equity (PE) firm be held accountable under the FCA for the independent actions of its portfolio company? 

Seventeen months later—after a federal magistrate judge rejected RLH’s efforts to distance itself from its portfolio company and after the district court refused to dismiss the United States’ case with prejudice—RLH entered into a $21 million settlement with the Department of Justice. Does this settlement portend a new frontier of FCA liability for PE firms with holdings in the healthcare sector? And if so, how can these firms guard against being punished for the sins of their portfolios?  

Two Recent Cases Open the Door to Liability

In February 2018, the United States intervened in an FCA case brought against RLH, a pharmacy company in its portfolio called Patient Care America (PCA), and two PCA executives. In its complaint, the United States alleged that the defendants had paid kickbacks to “marketers” targeting military members and their families for prescriptions for compounded medications. These medications were manipulated, the United States alleged, “to ensure the highest possible reimbursement” from TRICARE, the federal health program for military personnel and their dependents.  

In its motion to dismiss, RLH argued that the United States had taken the “unprecedented step” of imposing FCA liability on a PE firm for “the alleged wrongdoing of one of its portfolio investment companies.” RLH asserted that it had merely directed and funded PCA’s entry into a new line of business and the hiring of PCA’s new CEO. RLH contended that these actions were too far removed from the submission of any false claims to fairly assign it responsibility for the alleged scheme. In its opposition, the United States responded that “RLH does not get a special pass because it happens to be a private equity firm.” RLH’s principals, the United States contended, “actively managed and led PCA through the scheme” and provided the very funding that was used to “pay the kickbacks to marketers.” Writing in a report and recommendation, the magistrate judge agreed, noting that RLH “initiated PCA’s entry into the business” and was allegedly directly advised by counsel about the possible legal risks its portfolio company was incurring long before the scheme came to an end. RLH’s settlement with the United States followed less than a year thereafter.

In a second case, a federal district court refused to dismiss an FCA complaint brought against a PE firm and a mental health facility it had acquired for failure to adequately license and supervise its therapists. Rejecting the PE firm’s argument that it was too far removed from the misdeeds of its portfolio facility to be held liable under the FCA, the court concluded that the firm’s majority position on the facility’s board and its “direct[] involve[ment]” in the facility’s operations rendered it fair game for an FCA suit. The court pointed out that three PE firm employees—a managing director and two principals—held three of the five seats on the facility’s board, and noted that those board members were “heavily involved in the operational decisions of [the facility], including approving contracts, strategic planning, budgeting, and earnings issues.” The active roles these employees played were key, the court noted, as a “parent may be liable for the submission of false claims by a subsidiary where the parent had direct involvement in the claims process.” A resolution in the case has not yet been reached, but it is certainly a case to watch.

Best Practices for PE Firms

There are several lessons for PE firms to learn and implement moving forward to help shield themselves from potential liability:

First, in its press release announcing the RLH settlement, the United States emphasized its “continuing commitment to hold all responsible parties to account for the submission of claims to federal health care programs” (emphasis added). The FCA is a broad statutory regime applicable to “any person” who “causes to be presented” false claims. The statute contains an expansive intent standard that includes not only actual knowledge but also reckless disregard or deliberate ignorance. Importantly, specific intent to defraud is not required. PE firms should, accordingly, expect that any healthcare companies in their portfolios will be carefully scrutinized by government regulators, and should now be on notice that the mere separation of legal identity between the fund and the platform company will not excuse funds from liability for the misdeeds of their platform companies.

Second, since ignorance is no defense against liability, PE firms investing in healthcare companies should be more informed than ever of the federal and state FCA regimes and recent government enforcement activities in the healthcare space. 

Third, PE firms should be mindful of their approach to portfolio company oversight. In the wake of these cases, the more intimately a PE firm is involved in the operational decisions of its portfolio companies, the easier it is for governments to link the PE firm to the misconduct of those companies. However, it is not realistic or appropriate for funds to avoid involvement in platform company operations altogether. Rather, PE firms should:

• ensure that, as part of a robust compliance program, their platform companies adopt policies and procedures around the extent of PE firm involvement in FCA-related decisions and operations; and
• monitor and enforce companies’ compliance programs and provide ongoing training to company personnel involved in FCA-related matters.

Fourth, PE firms investing in healthcare businesses should carefully scrutinize companies’ compliance with applicable reimbursement regimes and government contracts, as well as their compliance programs generally, error rates, and related reporting functions. They should also appraise the risks of compliance lapses and regulatory developments across the field of companies that are most likely to form the universe of potential add-on acquisition candidates down the road.

Retaining experienced counsel can help PE firms monitor the rapid-fire developments in healthcare policy emanating from Washington DC and from statehouses across the country, and adopt compliance programs and diligence procedures to help minimize PE firms’ exposure to direct FCA liability.