Last month, the Justice Department filed a civil False Claims Act (“FCA”) complaint that could be a harbinger of new enforcement activity against private equity firms. While the allegations alleged in the complaint, if true, are egregious, the PE firm defendant in that case (“PE Firm”) took various actions that enhanced its risk of being targeted for FCA enforcement. At a minimum, private equity firms should assess how this development may impact their operations and portfolio company oversight, and it should serve as reminder for private equity firms to review their practices with respect to portfolio company management.

The civil FCA allows the United States to recover treble damages and penalties from companies and individuals who make false claims for payment from the federal government or who fail to return government overpayments. Defendants can include individuals and related entities even if they do not submit the claims themselves. One unique FCA feature is its empowerment of private parties – referred to as relators or whistleblowers – to initiate FCA suits in the name of the government and to ultimately receive as much as 30% of any government recovery. If the Justice Department concludes that the relator’s suit – also referred to as a “qui tam” suit –has merit, the government can intervene in the action. In recent years, annual FCA recoveries have averaged more than $4 billion, making the FCA fertile ground for qui tam suits and Justice Department investigations and enforcement.

For the last twenty years or so, companies doing business with the government – e.g., healthcare companies (who seek reimbursement from federal healthcare programs, such as Medicare), government contractors (mainly aerospace and defense businesses, but also commercial companies who sell to the government), financial institutions (primarily lenders of federally insured loans), and major import/export companies – have been the targets of FCA enforcement. Until very recently, it was unusual for FCA claims to be brought against individuals, and it was even more unusual for businesses who did not provide goods or services (directly or indirectly) to the government to be sued under the FCA.

Based on the Justice Department’s actions last month, those settled expectations may no longer be valid. In a federal court case in Florida, U.S. ex rel. Medrano v. Diabetic Care Rx, LLC, d/b/a Patient Care America, et al., No. 15-62617-CIV-BLOOM (S.D. Fla. Feb. 16, 2018), the Justice Department intervened in FCA whistleblower suit and filed a new complaint, seeking to impose FCA liability not only on Patient Care America (“PCA”) – the pharmacy company that did direct business with the government – but also on two PCA officers and the private equity firm that controlled PCA. The complaint alleges that the pharmacy company violated the FCA by paying illegal kickbacks to marketing companies in order to secure prescriptions for drugs that ultimately were reimbursed by a federal healthcare program. While that fact pattern is nothing unusual in the FCA world – dozens of such cases are filed each year – what makes this suit different is the Justice Department’s decision to also name the company’s PE Firm sponsor as a defendant. The Justice Department’s theory against the PE Firm is that it exerted control over PCA’s operations, including by installing PE Firm partners as officers of PCA, the operating company, shortly after making a controlling investment.

The Justice Department’s complaint is filled with allegations of the PE Firm directing PCA’s business activities and the PE Firm’s alleged direct knowledge of unethical practices. And, while the complaint does not name the two PE Firm partners as defendants, the Justice Department is pursuing claims against two other PCA officers hired after the PE Firm made its investment.

Obviously, none of these allegations is proven, and the PE Firm has yet to respond to the complaint or tell its side of the story. But, for present purposes, this case demonstrates a new willingness on the part of the Justice Department to look past the portfolio company itself and to evaluate – and pursue – potential FCA liability against the private equity firm that owns it. In light of this action, private equity firms should be assessing whether they are insulated from similar claims that would be based on the activities of their portfolio companies.

While many of the facts alleged by the Justice Department with respect to the management and oversight of PCA by its private equity sponsor raise concerns for private equity firms, there are a few facts in the complaint that seem to increase the chances that a private equity firm is targeted in a FCA action.

The Justice Department’s complaint highlighted certain portfolio company management practices that most private equity firms would view as customary, including that (i) the PE Firm “planned to increase [PCA]’s value and sell it for a profit in five years,” (ii) the PE Firm led the company’s switch to a new corporate focus towards products with “extraordinarily high profitability” after regulatory changes reduced the profitability of its original focus, (iii) the PE Firm was actively involved in the search for a new CEO and the CEO’s compensation plan incentivized the CEO to significantly grow the value of the business, and (iv) the PE Firm regularly received financial statements for the company and updates on the primary sources of its revenues. In industries such as healthcare and aerospace and defense, which are frequently targeted for FCA enforcement, these routine private equity firm practices can now carry added risk and garner increased scrutiny.

Even so, in its complaint against PCA, the Justice Department included a few additional allegations that, in our view, materially heightened the risk for the PE Firm. Those include that (i) the PE Firm installed its investment professionals not only as directors and officers of the holding company that owned PCA, which would be customary, but also as officers of PCA, the operating company, a practice that most private equity firms do not undertake, (ii) the PE Firm seemed to be actively involved in the day to day management of the company, including the PE Firm’s expectation that the CEO consult with them for any contract exceeding $50,000 in annual payments or $150,000 in total payments, (iii) the PE Firm knowingly funded PCA’s commission payments to marketers (i.e., the payments constituting the alleged kickbacks) in advance of PCA receiving reimbursement for the prescriptions that generated the commissions; and (iv) the PE Firm and its professionals did not react to red flags in the information that was available to them that either did or should have alerted them to potential unethical activity. 

We suggest that private equity firms take this complaint seriously and review their practices around portfolio company management, especially in industries where there is increased FCA risk, and make sure that the portfolio companies over which they can exert control have adequate compliance programs in place to limit – as much as possible – any FCA exposure.