9 Months After Mallory: Keeping Independent Contractors Independent

By Nathan Downing, J.D.

The use of third-party sales consultants for sales and marketing purposes (e.g., “1099s” or independent contractors) is relatively common, especially for start-up drug and device makers, given the flexibility these arrangements afford. Such 1099 sales reps are typically compensated based on a percentage of sales or other volume-based compensation arrangements. As year-end sales goals approach, companies may be looking for ways to boost sales performance with financial incentives. It is important to note that certain incentive-based programs may run afoul of both the Federal Anti-Kickback Statutes (AKS) and the Federal False Claims Act (FCA). Below, we will revisit the Mallory case to understand its impact on certain compensation structures.

In light of the 4th Circuit decision in U.S. v. LaTonya Mallory et al. (No. 18-1811, filed February 22, 2021) and DOJ’s corresponding press release, it is critical to review any agreements with sales agents who are 1099 independent contractors, and the volume-based compensation provisions in particular.

Legal Context

The medical device and pharmaceutical industries should understand the framework that the government used to prosecute in Mallory as its use goes well beyond incentives for independent contractors. The AKS prohibits the offer, payment, solicitation, or receipt of remuneration in exchange for referral to a federally funded healthcare program. The AKS includes a safe harbor for bona fide employees (42 U.S.C. 1320a-7b(b)(3)(B)), which the Office of Inspector General for the U.S. Department of Health & Human Services (hereinafter “OIG”) has interpreted to align to the IRS definition of W-2 employees.

OIG has expressly rejected the application of the employee safe harbor to 1099 independent contractors (citing, in part, concern regarding “abusive sales practices by sales personnel who are paid as independent contractors and who are not under appropriate supervision” (54 Fed. Reg. 3088, 3093 (Jan. 23, 1989)); see also Advisory Opinion No. 06-02, stating that “[p]ercentage compensation arrangements are inherently problematic under the Anti-Kickback Statute, because they relate to the volume or value of business generated between the parties.”).

The AKS additionally includes a safe harbor for Personal Services and Management Contracts (42 C.F.R. § 1001.952(d)) whereby:

“[r]emuneration” does not include any payment made by a principal to an agent as compensation for the services of the agent, as long as all of the following standards are met:

(i) The agency agreement is set out in writing and signed by the parties.
(ii) The agency agreement covers all of the services the agent provides to the principal for the term of the agreement and specifies the services to be provided by the agent.
(iii) The term of the agreement is not less than 1 year.
(iv) The methodology for determining the compensation paid to the agent over the term of the agreement is set in advance, is consistent with fair market value in arm’s-length transactions, and is not determined in a manner that takes into account the volume or value of any referrals or business otherwise generated between the parties for which payment may be made in whole or in part under Medicare, Medicaid, or other Federal health care programs.
(v) The services performed under the agreement do not involve the counseling or promotion of a business arrangement or other activity that violates any State or Federal law.
(vi) The aggregate services contracted for do not exceed those which are reasonably necessary to accomplish the commercially reasonable business purpose of the services.

While the lack of a safe harbor protection does not make an arrangement illegal per se, the government has historically used a facts-and-circumstances analysis to determine the legality of activities. OIG previously provided an exemplary list of “suspect characteristics” used to perform this analysis, aligning to the potential for program abuse, which include: (1) compensation based on a percent of sales; (2) promotion of items or services separately billable; (3) sellers’ direct-billing of federal programs; (4) direct contact between the independent contractor and federal program beneficiaries or their HCPs; and (5) independent contractor sales agents who are HCPs. (See, OIG Advisory Opinion No. 99-33.)

Mallory Case – Are the tides changing?

In the Mallory case, the 4th Circuit affirmed a $114 million FCA judgment for illegal kickbacks in violation of the AKS for commissions to a non-employee marketing firm which were based on the number of procedures sold. While the alleged facts in this case were particularly egregious (e.g., defendants acted in contravention of legal advice obtained internally and from outside counsel (which the government argued evidenced knowledge and intent to pay kickbacks), and certain remuneration was paid to physicians for laboratory tests conducted), it was perhaps the DOJ’s Mallory press release that drew the most attention. In the press release, the OIG boldly characterized non-employee commission-based compensation arrangements where the actions of the independent contractor amount to the “arranging for or recommending” procedures, as kickbacks. The industry has broadly viewed this case and corresponding press release as “putting industry on notice” that it may take a more aggressive enforcement stance regarding independent contractor commission-based payments in the future.

Considerations – We have 1099 sales reps, now what?

Even where an arrangement lacks the alleged egregious facts in Mallory, we believe that 1099 engagements may be subject to increased government scrutiny in the future. It would be wise to review your company’s volume-based contracts with 1099 independent contractors, to the extent that 1099 independent contractor sales agents’ marketing activities do or could foreseeably result in federal program business, as this practice could pose potential AKS and federal FCA risk (for both the company and its customers). Additionally, even for commercially-insured patients or those purchasing individual or family plans on- or off-exchange, state anti-kickback laws substantially mirror the federal statute and could introduce additional risk.

As a best practice, we recommend companies review its 1099 contracts to ensure that they align with the AKS Personal Services and Management Contracts Safe Harbor. Additionally, companies may consider adding certain representations and contractual prohibitions related to the actions of the independent contractors in the consulting agreement.

Sales incentives should be carefully structured to avoid government scrutiny. In Mallory, the government took seriously the issue of independent contractor compensation packages, shouldn’t you?

Have questions? Contact us.

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