Private Equity in the Crosshairs as Qui Tam Case Heads Toward Trial
- The District of Massachusetts issued the very first summary judgment decision in a False Claims Act (FCA) lawsuit involving a private equity (PE) firm. The decision provides valuable insight into how the FCA may apply to PE firms.
- Equity and board control will remain relevant, albeit not dispositive in assessing PE liability. Most PE buyouts involve majority equity stakes and board control. Those basic facts will come up again and again. With greater power, comes greater responsibility.
- Widespread non-compliance raises the risk that the PE firm’s board representatives and other employees will be (or should be) on notice of fraud. If allegedly fraudulent conduct within the portfolio company is widespread or involves significant revenue, the more likely it is that the PE firm knows about it. Big operational problems are often addressed by the board, but blips on the compliance radar are less likely to make it to the top.
- PE firms have a duty to put an end to fraudulent conduct which they know is occurring. While not akin to a common law duty of care, Martino-Fleming shows that PE firms must, to an extent, be watchful shepherds of their portfolio companies. Once a PE firm knows of fraudulent conduct, it may face FCA liability if it does not act to put an to end to the wrongdoing. PE firms cannot sit back and reap the rewards of fraudulent conduct then duck responsibility if the government comes knocking.
On May 19, 2021 we witnessed the first time a False Claims Act lawsuit has proceeded through summary judgment. District Judge Patti Saris denied a motion for summary judgment filed by defendant private equity firm H.I.G. Capital, LLC and its subsidiary H.I.G. Growth Partners, LLC (H.I.G.), in U.S. ex rel. Martino-Fleming v. S. Bay Mental Health Centers (D. Mass.), an FCA lawsuit. The case hinges on allegations that H.I.G. permitted its portfolio company to engage in fraudulent conduct.
PE and the FCA—A Litigation Frontier: Until recent years, PE firms with significant holdings in the healthcare industry have avoided any substantial exposure under the FCA. While portfolio companies frequently found themselves in the regulatory crosshairs, their PE firm owners did not face liability. That dynamic is changing. 2019 brought the government’s first FCA settlement with a PE firm (with Riordan, Lewis & Haden Inc.) and 2020 brought the government’s second such settlement (with The Gores Group). Both cases settled long before summary judgment, leaving open the question as to how a court would wrangle with the novel issues impacting PE liability under the FCA.
Martino-Fleming has now answered that lingering question, It is the first time an FCA lawsuit has proceeded through summary judgment. Judge Saris’s highly anticipated opinion deserves close scrutiny by the defense bar, relators’ counsel, federal and state prosecutors, and the PE industry.
The Court’s Decision: In Martino-Fleming, H.I.G. purchased a provider of mental health services. The provider’s patient base was primarily composed of MassHealth (i.e., Medicaid) patients. Relators alleged that the provider used unlicensed and unqualified social workers and counselors to provide services to government beneficiaries and provided inadequate supervision of clinical personnel. The Department of Justice declined to intervene, but the Commonwealth of Massachusetts intervened in this novel case, pursuing claims against the PE firm.
The record developed during discovery revealed that certain red flags emerged during H.I.G.’s pre-buyout due diligence (e.g., inadequate supervision) and that, following the H.I.G. takeover, the pressure to grow was virtually “astronomical.” The evidence suggested that H.I.G., which owned most of the equity in the provider and controlled its board, was aware of the company’s apparently extensive compliance failures. The District Court found that sufficient to establish scienter as to H.I.G.
H.IG. also claimed that evidence of causation was lacking. The District Court disagreed. Judge Saris recognized that even though the portfolio company’s compliance problems existed before H.I.G.’s acquisition, H.I.G. had effectively ratified the ongoing misconduct at issue, which would satisfy the causation element under the FCA for claims postdating the buyout. The court explained that, ultimately, “H.I.G. had the power to fix the regulatory violations which caused the presentation of false claims but failed to do so.” Martino-Fleming highlights the growing dangers that PE firms face under the FCA. As an adjudication on the merits, it provides a roadmap for how relators, their counsel, and government attorneys may seek to establish liability for deep-pocketed PE firms – firms that are increasingly focusing their investments in the highly regulated healthcare sector. Martino-Fleming shows that the established principles of scienter and causation can be applied to a new breed of FCA actor, the PE firm. The opinionmakes clear that board members and others working on behalf of PE firms cannot ignore red flags that emerge during due diligence or thereafter. Otherwise, the extensive liability provided by the FCA, with its treble damages and substantial civil monetary penalties, lurks in the background.