Increased focus on compliance and heightened enforcement efforts by global regulators require awareness and oversight even from relatively passive investors. Private equity (“PE”) firms may be exposed to anti-corruption and fraud risks posed by their portfolio companies, especially when investment is made in mid-sized and developing companies active in industries with high level of government interaction. The expectation is that PE firms need to oversee and manage corruption and fraud risks within their portfolios. Failure to do so may result both insubstantial decrease in the investment value and financial exposure to the PE firm itself, not to mention significant reputational damage.
The extent of liability of a PE firm itself depends on the nature of the investment and the level of its involvement in management and corporate governance of the company. The greater oversight and control are, the greater is the likelihood of liability. But even minority investors cannot assume they are not exposed to risks, as both the DOJ and SEC put it repeatedly, “willful blindness is not a defense.” This is especially the case when a portfolio company’s business requires government authorization, permits, licenses or otherwise an extensive contact with the government. Life sciences, pharma and health care portfolio companies all pose additional risks and create increased supervision responsibilities for PE investors, so that they can protect both their investment and themselves.
With respect to investments in health care companies in the US, additional layer of complexity is created by those companies receiving federal funds (through federal reimbursement programs such as Medicare, Medicaid, or Tricare) and the government’s increased willingness to pursue violations of the False Claims Act (“FCA”) in connection with those federal programs. The government may pursue a FCA claim against a PE firm based on alleged violations of its portfolio company. In United States ex rel. Medrano and Lopez v. Diabetic Care Rx, LLC dba Patient Care America, et al., No. 15-CV-62617 (S.D. Fla.), a PE firm was a named defendant in an FCA action, where eventually it reached a multi-million settlement with the DOJ. Control and involvement in management of the portfolio company, which is an essential tool of PE firms in increasing the value of their investment, may also expose it to the risk of liability for FCA violations. Further, in Christine Martino-Fleming v. South Bay Mental Health Centers, et al (1:15-cv-13065-PBS) the court reasoned that a PE firm may be liable for causing false claims “where the submission of false claims by another entity was a foreseeable result of a business practice.” Passively observing and taking no action to correct the problem on the portfolio company’s level may create a liability for a PE firm.
The liability of a shareholder or PE investor arising from the fraudulent acts of its portfolio company rests on the expansive definitions of “knowledge” under the relevant federal enforcement statutes. Knowingly perpetrating a fraud or act of deception upon a government agency includes deliberate ignorance of the truth or false information. The issue of PE liability (even when holding a minority position) is driven by the government’s demand of oversight of portfolio companies dealing with governmental authorities. U.S. governmental enforcement agencies consider the failure of the PE firm to control, oversee and manage the activity of a portfolio company as a basis for determining “knowledge of fraud” in cases of false claims and fraudulent activity. It is the policy of the U.S. government to hold all culpable parties liable in fraud cases. This policy is not limited to individuals, such as officers and directors, but is used by government enforcement agencies to pursue PE firms owning health care providers. This expanded responsibility is derived from the nature of the medical device industry in the U.S.; its interaction with the federal regulator and its access to U.S. government healthcare reimbursement programs.
A PE firm may not be passive and ignore or fail to notice fraudulent activities by its portfolio company. On the opposite, a PE firm investing in a health care company doing business in the U.S., submitting requests to the FDA and inducing medical device practitioners to submit reimbursement claims, must take measures to ensure that its portfolio companies have adopted and implemented compliance programs designed to require the ethical conduct of business in their industry. These include procedures to bring compliance concerns to the attention of the PE firm; conducting independent audits of compliance, especially when dealing with FDA and reimbursement matters. These programs must ensure that best practices are followed with adequate internal controls and reporting system and robust audit and investigative procedures including receiving and relying on an appropriate advice from outside experts.
Investing in a health care company intent on doing business in the U.S. requires a high level of diligence and independent oversight. The absence of that independent oversight and compliance implementation creates significant culpability, financial exposure and reputational risk for PE investors.