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Private Equity in Healthcare: Full Speed Ahead (with Guardrails): DOJ Complaint Highlights Regulatory Risks but Firms Should Stay the Course

06.07.18


A recent healthcare fraud complaint filed by the Department of Justice has sent ripples through private equity circles. Earlier this year the DOJ alleged that a private equity-backed pharmacy company – Diabetic Care Rx, LLC d/b/a Patient Care America – had violated the federal anti-kickback statute. In an unusual move, the government also named the company’s private equity investor, Riordan, Lewis & Haden, Inc. (RLH), as a defendant.

Many investment firms may be wondering what this means regarding stricter limits over operations and strategic decisions when it comes to their investments. While the case is still in its early stages, private equity investors have questions and concerns about the details of the complaint. The initial response for firms may be to tap the brakes on new healthcare investments, but private equity investments are essential to the growth and innovation in healthcare. This unprecedented case will serve as a teaching moment to learn from RLH’s mistakes. In the meantime, the government’s complaint reinforces the business practices that prudent private equity firms have long followed.

Bad Facts Make Bad Law (and Bad Investment Strategies)

There is an old adage that lawyers learn their first year in law school: “Bad facts make bad law.” It means an extreme set of facts is a poor basis on which to develop a more general approach that applies across the board. In this case, the alleged conduct of the parties was indeed an example of very bad facts in two specific ways: 

  1. RLH assumed control over day-to-day clinical and marketing functions to a remarkable degree, and
  2. The alleged underlying regulatory violations were egregious. 

In 2012, RLH made its investment in PCA and two RLH partners, Michel Glouchevitch and Kenneth Hubbs, actually became officers of PCA. PCA was the legal entity that provided the clinical services and products, was  enrolled in government payor programs, and submitted claims for payment. Prior to 2012, PCA’s primary source of revenue was the provision of nutritional therapy products. Shortly after the investment, Medicare reimbursement dropped substantially for this service. In response, RLH directed PCA to enter a new line of business with higher margins: non-sterile compounding of topical creams for pain management. These products had healthy margins and were in high demand, particularly in the military and veteran community.

In 2014, RLH partner Glouchevitch hired Patrick Smith as Chief Executive Officer of PCA. He directed Smith to consult with RLH before entering into any type of contract with annual payments over $50,000. Glouchevitch and Smith then decided to hire independent contractor marketing teams and pay them a percentage of profits from the prescriptions they sent to the pharmacy. These incentives had the desired effect: orders for the topical cream compounds skyrocketed and marketers earned millions of dollars in bonuses and commissions. Significantly, RLH on a number of occasions specifically funded these commissions when PCA’s cash flow required it.

The marketers in turn paid kickbacks to both patients and physicians to induce them to seek and provide these prescriptions. Often the physicians never saw the patient. According to the government, the marketers actually worked with the pharmacy clinical staff to devise compounding formulas that maximized the reimbursement for each prescription without regard to the clinical needs of the patient. The government’s position is that these predicate kickbacks rendered the subsequent reimbursement claims to TRICARE fraudulent.

With the help of a whistleblower, the government’s complaint details the occasions on which RLH and PCA were told by lawyers that the marketing and referral scheme could violate federal law. The government alleges PCA received $68 million from TRICARE under the kickback scheme.

Let Private Equity Be Private Equity

Private equity firms are uniquely equipped to bring capital and fresh ideas to an enterprise. They challenge assumptions and identify strategic opportunities. They often work hand-in-glove with management to set the strategic vision for the company, and they can assume fiduciary duties commensurate with these functions. The government’s complaint, however, does not focus on breaches of fiduciary duty, lack of oversight, or other types of passive errors in judgment. Instead, the heart of the complaint reveals extraordinary, affirmative conduct on the part of RLH that formed the basis of the government’s theory of liability for both RLH and PCA.

Don’t Become an Officer of the Clinical Entity Submitting Claims

It is unusual for a private equity representative to assume an officer position in the entity that is rendering clinical services and submitting bills to government payors. Even the most sophisticated private equity investor will not have experience delivering clinical services and submitting claims in the highly regulated healthcare industry. As an officer of the billing entity, the government’s theory will be that they knew or should have known of any errors or conduct that rendered a claim false.

Private equity firms bring value to an organization with capital, management experience, operational best practices, and insights into industry trends. Becoming an officer of a clinical entity doesn’t typically add material value but can trigger substantial regulatory risk for the individual and the private equity firm.

Respect Corporate Structure

If the government’s theory had been that RLH simply failed to implement proper controls, then there is a strong case to be made that private equity firms may need to re-evaluate their approach to healthcare investments. Instead, the government appears to have documented specific, affirmative acts by RLH representatives that made them participants not just in the submission of false claims, but also the underlying kickback scheme. Specifically, if PCA owed the marketing team a bonus for their referrals but did not have the cash flow to pay them, RLH would actually step in and fund them on PCA’s behalf.

Not only were RLH representatives serving as officers of the entity submitting the bills, they actually participated in the marketing payments that rendered these claims false and fraudulent. The nexus between RLH’s conduct and PCA’s claim for payment was far more direct than is typical for private equity sponsors and their healthcare investments.

Engage and Manage Experts

According to the complaint, a consultant all but warned RLH against hiring the CEO Patrick Smith:
“[A]lthough Patrick Smith had ‘the skills and experiences needed to successfully drive significant growth…, he would ‘require more careful management than [RLH] may wish to provide.’” On three separate occasions, PCA or RLH received guidance from lawyers that the marketing strategy was problematic and perhaps illegal. It appears that these warnings were in writing and disregarded by RLH and PCA.

It is never a good idea to seek legal advice and then disregard it without further analysis or careful explanation. Healthcare regulations are not intuitive. They are often ambiguous and nearly always require technical knowledge to ensure compliance. For private equity firms stepping into the healthcare space, it is critical to have advisors you trust and upon whose recommendations you can rely.

In Healthcare, Compliance Cannot Be Separated from Operations

The facts alleged in the complaint demonstrate unusual conduct by the private equity firm and the pharmacy entity, and the underlying marketing scheme was a clear and present risk to the organization. That being said, the government did reference a number of occasions where red flags presented themselves with absolutely no additional review or remedial steps taken. For example, patients were calling PCA and sending emails complaining that they did not need the pharmacy product that was sent to them. No mechanisms were in place to train, monitor and manage marketers – the source of the vast majority of the company’s revenue.

This oversight function is a core responsibility of private equity representatives who become board members or executives at a company. Compliance at healthcare organizations requires significant infrastructure, training and proactive education. The government has published specific guidance about what a compliance program should include. In the due diligence stage of an investment review, a private equity firm should work closely with a healthcare regulatory lawyer to spot-check the company’s compliance function. If representatives formally assume responsibilities at the company, it is critical that they proactively identify areas of potential risk, develop mitigation strategies, and ensure that processes are in place to monitor the progress of these strategies.

Healthcare System Needs Private Equity

Private equity firms are driving innovation and consolidation in the country’s healthcare system. It is critical that individuals and companies have access to the capital and expertise these firms can provide. Private equity firms have proven adept at identifying and managing risks while they maximize value for an organization. Government enforcement activity is one of those risks, and with the right safeguards in place, the risk can be managed successfully.

Waller will continue to monitor the case and provide updates as developments occur. For additional information, please contact Jesse Neil or any member of Waller’s Healthcare Compliance & Operations practice.



The opinions expressed in this bulletin are intended for general guidance only. They are not intended as recommendations for specific situations. As always, readers should consult a qualified attorney for specific legal guidance.