Physician-owned medical device companies are enforcement nightmares

The current financial crisis reminds us that investment opportunities that seem too good to be true inevitably end badly. The proliferation of physician-owned companies (POCs) as intermediaries in the medical device supply chain seems destined to teach that same hard lesson.

Although presented as opportunities for physicians to supplement their practice revenues with investment income, many POCs present serious legal risks and so may ensnare doctors in a web of enforcement activity and lawsuits. They also raise serious ethical concerns.

POCs come in a variety of forms—distributorships, outsourced manufacturing arrangements, group purchasing organizations (GPOs), even commission sales relationships—but most are little more than shell entities, with no real infrastructure or capital investment. They exist primarily to provide direct remuneration to physicians for their ability to control the selection of surgical implants sold through the arrangement.

The POC structure depends on the proposition that it is acceptable for the physician-owners to receive financial benefits based on their choice of devices to treat patients. Yet that proposition ignores basic fraud and abuse principles, disregards the last decade of enforcement activity in the healthcare sector and creates a fundamental conflict of interest.

Unlike legitimate independent distributors, sales agents, and GPOs, POCs present an obvious and unavoidable potential for patient and government program abuses arising from the inherent conflict when a physician’s choice of which device to use for a patient has the potential to deliver a financial benefit. POCs may also distort the physician-investors dealings with hospitals and eventually cause higher costs.

POCs and the Anti-Kickback Statute
Because of the potential for these abuses, POC arrangements are likely to be found illegal. In October 2006, the Office of Inspector General (OIG) of the Department of Health and Human Services indicated it was “aware of an apparent proliferation” of POCs. “[G]iven the strong potential for improper inducements between and among physician investors, the entities, device vendors, and device purchasers,” the OIG believed “these ventures should be closely scrutinized under the fraud and abuse laws.” OIG officials recently confirmed in Congressional testimony that POCs “raise substantial concerns that a physician’s return on investment from the venture may influence the physician’s choice of device.”

The legal analysis is not complicated. The federal anti-kickback statute prohibits, among other things, giving or receiving any financial benefit or “remuneration” in exchange for, or to induce, the referral of any patients for, or the purchase, lease, order, or recommendation of, any item or service for which payment may be made under Medicare or other federal healthcare programs. Although the policy objectives of that statute include avoiding unnecessary utilization and spending, protecting competition, and ensuring quality of care, no showing of improper utilization, spending, or patient care is required for a violation.

Penalties for violating the statute include substantial criminal and civil fines, imprisonment, and exclusion from participation in federal healthcare programs. Courts and administrative bodies have ruled that the statute is violated if even “one purpose”—as opposed to a sole or primary purpose—of a payment arrangement is to induce referrals for services or purchases of items reimbursable under a federal healthcare program.

Thus, the anti-kickback statute can be implicated if one purpose of offering referring physicians an opportunity to invest in a POC is to induce those physicians to order implants for their patients through that POC. Likewise, hospital agreements to buy, and manufacturer agreements to sell, products through a POC could violate the anti-kickback statute if one purpose was for the physicians’ return on investment in the POC to act as an inducement to perform procedures at a particular hospital or to order a particular manufacturer’s products. The only real question is one of intent.

Identifying illegal intent
The structure and marketing of the POC business models provide an ample source of evidence for enforcers to infer an intent to induce referrals and product selection. The typical POC likely contains most of the following “questionable features” identified by the OIG in its 1989 Special Fraud Alert on fraudulent physician joint ventures:

Choice of investors—Investment interests are offered exclusively or primarily to surgeons who lack any particular purchasing, distribution, or management expertise, but are in a position to order implants for their own patients through the POC. Those interests typically may not be transferred without the consent of the POC, which ensures that ownership remains in the hands of referring physicians. If there are other investors, a sufficient number of referring physician-investors is retained to maintain the business’ profitability.

As the OIG has noted, where physicians are specifically targeted as investors, a joint venture may be suspect as “intended not so much to raise investment capital legitimately to start a business, but to lock up a stream of referrals from the physician investors and to compensate them indirectly for these referrals.”

“Shell” entity—POCs need not own any assets, have any employees, or perform any actual business functions. Instead, the organizer of the POC typically provides comprehensive management services for the venture, including negotiating contracts. Because the organizer provides the operating capacity for the joint venture entity, the POC is essentially a shell. The fact that POCs typically do not acquire or maintain any product inventory also minimizes the need for investment capital.

Financing and profit distribution—With little need for investment capital, the investment may be disproportionately small (reportedly as little as $5,000 per physician in some cases) and the returns disproportionately large compared to a typical investment in a new business enterprise, and the amount of return may be extraordinary based on the level of risk involved.

Captive referral base—The POC typically serves the physician-investors’ own patients and does business predominantly with the hospitals where the physician-investors refer their patients. The POC typically does not make any real efforts to expand the business to serve new customers except by recruiting new physician-investors who also would self-refer. Unlike legitimate manufacturers and distributors, POCs do not spend money on product research and development, customer service, or patient education.

Little or no bona fide business risk—Because the physician-investors determine the amount of business that is done with the POC through their own captive patient referrals, and because hospitals and product manufacturers who want the physician-investors’ business must deal with their POC, there is little business risk as long as the number of referring physician-investors is sufficient.

Scope of services provided—To the extent it purports to perform any services, the POC offers distributor or GPO services that are already offered by competitors without referring physician-investors. The competition is inevitably better qualified to furnish those services more cost-effectively than the POC. Most of the services that a POC could offer—contract negotiation, product fulfillment, operating room support services—are not services that require physician involvement or expertise. And the services where physicians could add value—product selection and standardization—are exactly the kinds of services that should not be influenced by a financial interest in the product choice. The POC thus serves no apparent function other than to give its physician-owners the opportunity to profit from the orders they make through the product supply chain.

Given the disparity between the offerings of legitimate manufacturers, GPOs, and independent distributors and a barebones POC, the unavoidable question is why any hospital would contract with a POC other than because the physicians have the leverage.

Do safe harbors apply?
The applicable safe harbor for investment interests in nonpublicly traded entities limits safe harbor protection to entities that derive no more than 40 percent of their gross revenues from referrals or business otherwise generated by investors, such as physicians. Few POCs could likely meet this standard.

Normally, 100 percent of the POC’s business is generated by the referring physician-owners. As the OIG has noted, “the fact that a substantial portion of a venture’s gross revenues is derived from participant-driven referrals is a potential indicator of a problematic joint venture.” Although failure to qualify for a safe harbor does not necessarily mean that the anti-kickback statute has been violated, arrangements outside of the safe harbors are subject to strict scrutiny and challenge.

Ethical conflicts
Physician-investment in a POC through which the physician orders implants for his or her own patients also raises serious ethical concerns. The Council on Ethical and Judicial Affairs (CEJA) of the American Medical Association has cautioned against a physician prescribing drugs, devices, or appliances if that physician is otherwise influenced in the prescription by a direct or indirect financial relationship with the supplier.

In a separate opinion, CEJA has stated that physicians should severely restrict their sale of items directly to patients because this “presents a financial conflict of interest, risks placing undue pressure on the patient, and threatens to erode patient trust and undermine the primary obligation of physicians to serve the interests of their patients before their own.”

POCs essentially exist to create opportunities for physicians to profit from their own referrals, a proposition antithetical to the fraud and abuse laws. Given the confluence of legal problems and ethical concerns, the question is not whether POCs will come under regulatory and enforcement scrutiny, but when.

Stephen J. Immelt, JD, a partner with Hogan & Hartson, LLP, represents device companies and hospitals in enforcement matters. This article is based on a white paper he prepared with his partners Thomas Bulleit Jr. and Ronald Wisor Jr. He can be reached at sjimmelt@hhlaw.com

Additional Referenes:

1. Letter from Vicki Robinson, Chief, Industry Guidance Branch, HHS Office of Inspector General (Oct. 6, 2006), available at http://oig.hhs.gov/fraud.pdf
2. Testimony of Gregory Demske, Assistant Inspector General for Legal Affairs, before the U.S. Senate Special Committee on Aging Examining the Relationship Between the Medical Device Industry and Physicians (Feb. 27, 2008), available at http://oig.hhs.gov/testimony/2008.pdf
3. 42 U.S.C. § 1320a-7b(b)
4. 42 U.S.C. § 1320a-7 (exclusion from Federal Health Care Programs); § 1320a-7a (civil monetary penalties of up to $50,000 per act plus three times the remuneration); § 1320a-7b(b) (imprisonment of up to five years or criminal fines of $25,000 or both); 18 U.S.C. § 3571 (augmenting penalties: $250,000 per violation for individuals and $500,000 per violation for entities).
5. See, e.g., United States v. Greber, 760 F.2d 68, 72 (3d Cir. 1985), cert. denied, 474 U.S. 988 (1985).
6. See Bay State Ambulance and Hospital Rental Services, Inc., 874 F.2d 20, 29 (1st Cir. 1989) (“[g]iving a person an opportunity to earn money may well be an inducement to that person to channel Medicare payments toward a particular recipient”).
7. See Hanlester Network v. Shalala, 51 F.3d 1390, 1401 (9th Cir. 1995) (affirming the finding of the Department of Health and Human Services Departmental Appeals Board that the opportunity for physician-investors to earn money from their investment in a laboratory partnership was remuneration for purposes of the anti-kickback statute).
8. The 1989 Special Fraud Alert is available on the OIG’s website at http://oig.hhs.gov/fraud/docs/alertsandbulletins/121994.html
9. Some have claimed that the advent of physician-owned companies will result in lower implant costs. In fact, the opposite is likely to occur. Because physicians can control the venue for their implant procedures, they can use that leverage to insist that hospitals buy through their companies. That same leverage will make it harder for hospitals to negotiate for lower implant prices, because the physician can simply refuse to use products from other implant suppliers. That same dynamic would apply once an incumbent physician-owned company decides to raise prices.
10. See 42 C.F.R. § 1001.952.
11. Id. § 1001.952(a)(2)(v).
12. See supra note 1.
13. 54 Fed. Reg. 3088, 3089 (1989); 56 Fed. Reg. 35,952, 35,954 (July 29, 1991). Although not the subject of this commentary, physician-owned company arrangements also create financial relationships between their physician-owners and their hospital customers that implicate the federal physician self-referral law, commonly known as the “Stark” law. 42 U.S.C. § 1395nn. CMS has raised serious doubts about physician-owned company compliance with Stark, noting that “[i]n many instances, the [financial] arrangement . . . would . . . run afoul of the physician self-referral statute.” 73 Fed. Reg. 23528, 23695 (April 30, 2008).
14. American Medical Association Council on Ethical and Judicial Affairs, Opinion E-8.06, Prescribing and Dispensing Drugs and Devices.
15. American Medical Association Council on Ethical and Judicial Affairs, Opinion E-8.063, Sale of Health-Related Products from Physicians’ Offices.