Over the past year, we have seen a new trend in healthcare fraud cases in which the government has chosen to target private equity firms (PEFs). Traditionally, the government has chosen to name the healthcare company and its officers as defendants in healthcare fraud suits. However, the government has recently begun to aggressively target upstream private equity firms when one or more of the following exist (i) the PEF has a controlling interest in the healthcare company, (ii) the PEF has a role in the strategic or financial operations of the healthcare company, and/or (iii) PEF leadership serves as board members of the healthcare company’s board. The two cases demonstrating this trend (Martino-Fleming1 and Medrano2) have heated up in the past week with new developments, as discussed below.

PEF Liability for Unlicensed Mental Health Providers. In the Martino-Fleming case, a mental health company (South Bay) was allegedly providing mental health services through people who were not properly licensed or supervised, to provide the services in question.3 The complaint named South Bay and the private equity firm investor in South Bay (H.I.G.) as defendants in the case.4 Even though this was a new theory of liability to name the private equity firm in the suit, the court in Martino-Fleming held that H.I.G. could be equally liable with South Bay for healthcare fraud under the theory that an upstream corporate entity may be liable when “the submission of false claims by another entity was the foreseeable result of a business practice.”5

Specifically, the court in Martino-Fleming held that H.I.G. could be liable for healthcare fraud because “H.I.G. members and principals formed a majority of the C.I.S. and South Bay Boards, and were directly involved in the operations of South Bay …”.6

PEF Liability for Kickbacks to Pharmacy Marketers. In the more recent Medrano case, a compounding pharmacy was allegedly participating in a kickback scheme by paying marketers a percentage of pharmacy net revenues in return for generating business for the pharmacy.7 The complaint named the pharmacy and the private equity firm that held a controlling interest in the pharmacy (Riordan, Lewis, Haden, Inc., or “RHL”) as defendants in the case.8 The court held that RHL could be equally liable with the pharmacy for healthcare fraud because “RLH knew of and approved [the pharmacy’s] agreements with the Marketers, knew of the [Anti-Kickback Statute’s] prohibition against kickbacks, and nevertheless funded $2 million in commissions to the Marketers.9

Continued Government Focus on PEFs for Healthcare Fraud. It is interesting to note that in both cases, Martino-Fleming and Medrano, the government has recently filed amended pleadings (on January 3, 201910 and March 18, 2019,11 respectively). The amended pleadings primarily address the additional facts that would be necessary to hold the private equity firms directly liable for the alleged healthcare fraud in each case. Thus, the federal government does not appear to be backing down on its new approach to hold private equity firms liable for healthcare fraud committed by healthcare companies in private equity firm portfolios.

Next Steps—Existing Healthcare Companies in PEF Portfolios. In light of these developments, private equity firms with existing healthcare companies in their portfolios may benefit from performing internal healthcare compliance audits of their companies. Private equity firms may also benefit by ensuring that each company has implemented a good faith healthcare compliance program because a compliance program is a common tool for shielding corporate entities from upstream liability in many healthcare fraud cases.

Next Steps—New Healthcare Company Investment Targets. For proposed investments in new healthcare companies, private equity firms could benefit from performing rigorous healthcare compliance due diligence at the beginning of the investment process to uncover any possible healthcare fraud issues with the target company when deciding how to best structure the investment, or if not to invest at all.12

For example, if the private equity firm in Martino-Fleming had discovered during due diligence that the licensing credentials of most of South Bay’s healthcare providers were not operating in compliance with state law (which would have been easy to uncover), then South Bay’s value to the private equity firm may have been much lower than originally negotiated. South Bay would have been less valuable because South Bay would have needed to hire more costly, and properly-licensed, providers for South Bay to begin operating in compliance with the law.

Will Reps and Warranties Insurance and Indemnification Suffice? In light of these developments, an obvious question is whether the common reps and warranties insurance and indemnification provisions in stock purchase agreements between private equity firms and healthcare companies will still be viable solutions to address this new theory of liability for private equity firms. Because of the unique potential legal penalties for healthcare fraud, these current investment protections measures will likely not suffice. For example, one of the government’s enforcement tools for healthcare fraud is to “exclude” a healthcare company from participation in the federal Medicare program or state Medicaid program if an entity, that has committed healthcare fraud, holds a 5% ownership interest in the healthcare company.13

And, as you can imagine, if a private equity firm is held liable for healthcare fraud related to the operations of one of the healthcare companies in its portfolio, then the private equity firm may need to relinquish its ownership interests in all healthcare companies in its portfolio—to prevent those other companies from being excluded from treating Medicare or Medicaid patients.

Thus, it is probably unlikely that the currently-used reps and warranties insurance or indemnification provisions in current stock purchase agreements will adequately cover the losses that a private equity firm might incur from being required to relinquish all investments it holds in healthcare companies that bill Medicare or Medicaid in the event of a healthcare fraud finding. The same theory of liability would apply to healthcare companies that bill other government payors, like TRICARE, workers compensation, the Veterans Administration, the Department of Defense, etc.

In addition, for healthcare companies that solely bill private health insurance or have a patient self-pay or concierge practice, there are also state healthcare fraud laws that could have a similar effect on a private equity firm’s healthcare industry portfolio in the event of a healthcare fraud allegation.

Healthcare Fraud Legal Expertise. Therefore, if you would like further guidance on anything related to this client alert, we encourage you to reach out to our firm for that expertise, on the following type of legal guidance: (i) developing and implementing a healthcare compliance program, (ii) conducting an internal investigation of possible healthcare fraud issues, (iii) performing investment due diligence to identify potential healthcare fraud hot spots, and/or (iv) defending a private equity firm in a healthcare fraud proceeding.