Private Equity Put on Notice: The False Claims Act and Investor Liability


A recent Wall Street Journal article spotlighted a series of legal cases with a common aim—requiring private equity firms to accept responsibility for the actions of their portfolio companies. Author Chris Cumming notes that the settlements in these matters “mark a break from the usual practice of treating private-equity firms as passive investors that aren’t liable for misconduct by companies they own.” 

While the trend of laying responsibility for the actions of acquired companies on private equity firms is a fairly recent Department of Justice (DOJ) move, the source of the charges is positively historic. To prosecute private equity firms, government attorneys are relying on the False Claims Act, which was introduced in 1863 at the height of the Civil War. The DOJ’s commitment to prosecuting False Claims Acts cases is underscored by its records for fiscal year 2020 during which the department recovered more than $2.2 billion in settlements and judgments through civil cases.

Though the majority of recent False Claims Act suits have involved the medical sector, risk to private equity investors reaches much wider. Notably, “any private-equity firm whose investments touch the federal government—from defense contractors to infrastructure-construction companies—could potentially be at risk,” according to attorneys contacted by the Wall Street Journal. In a June 2020 speech before the U.S. Chamber of Commerce’s Institute for Legal Reform, then Principal Deputy Assistant Attorney General Ethan Davis advised private equity firms to be cognizant of anti-fraud laws and regulations. Davis’ warning that the actions of acquired companies can expose private equity firms to False Claims Act liability captured the attention of both at-risk investors and opportunistic legal professionals.

An interesting aspect of False Claims Act litigation dating back to its wartime origin is its provision for awarding whistleblowers. This aspect of the law has not only survived several revisions but has seen an increase in whistleblower incentives. The Wall Street Journal article highlighted a whistleblower lawsuit filed in 2015 by an employee of a Massachusetts mental health treatment provider previously owned by a Miami-based buyout firm, H.I.G. Capital. Allegations of poorly trained and inadequately supervised employees resulted in $6.75 million in payments to the whistleblower out of a total payment of $25 million following six years of litigation. Commenting on the lawsuit, attorney Alexander Owens warned in the article that the size of the payment to the whistleblower “may have a ‘blood in the water’ effect in incentivizing future investigations and lawsuits in the [private equity] space.”

The uptick in False Claims Act suits combined with the eye-opening whistleblower awards arising out of these matters emphasizes the need for private-equity firms to know their investments inside and out. In consideration of the influential role played by whistleblowers in cases charged under the False Claims Act, special precautions should be taken by private equity investors when conducting pre-investment due diligence with the aim of sussing out internal issues that could prove problematic down the line.

Especially pertinent is the need for prospective investors to obtain an understanding of both current and former employee attitudes concerning their acquisition target. This can be accomplished through human intelligence, namely the use of discreet source inquiries. When pursuing this strategy, it is advisable to cast as wide a net as possible to cover all levels of the employee hierarchy. Similarly, opinions should not be restricted to a single department but represent the diversity of the subject entity’s business lines. While specialized efforts increase both the cost and delivery time of a due diligence investigation, such inconvenience pales in comparison to the expense, time commitment and lost business opportunities resulting from involvement in False Claims Act litigation.

Enhance your company’s pre-acquisition business intelligence by partnering with an award winning due diligence provider. Reach out to Vcheck Global to gain the peace of mind afforded by the exhaustive reporting of experienced investigators equipped with industry leading technology and a commitment to client satisfaction.

Seth Harlan is Senior Associate, Market & Regulatory Affairs at Vcheck Intelligence. 

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