On July 14, 2020, the Federal Acquisition Regulatory Council issued an interim final rule (Interim Rule), which implements Section 889(a)(1)(B) of the John S. McCain National Defense Authorization Act for Fiscal Year 2019 and prohibits federal contractors from using equipment or services produced by Huawei Technologies and other Chinese telecommunications companies. The Interim Rule is broad in scope and only allows contractors a short time frame to come into compliance with it. Because of this, government contractors have widely expressed concern that the rule exposes them to liability under the False Claims Act (FCA), which imposes civil and criminal penalties for those contractors who falsely certify compliance with a “material” ancillary law, regulation, or contractual provision. This article examines the potential scope of FCA liability that could arise from noncompliance with the Interim Rule and whether noncompliance can be considered “material” as federal courts interpret the term. Whether a court will find noncompliance material in a given FCA case will be factually dependent, taking into account the nature and extent of the underlying violation. The case for materiality might be the strongest under a theory of fraud in the inducement, when contractors enter a federal contract knowing that they do not comply with the Interim Rule. As a general matter, however, contractors may have valid grounds to challenge materiality in certain cases. The fact that compliance with the Interim Rule is not an “express condition of payment,” and that General Services Administration policies allow continued payment to noncompliant contractors, offers relevant—but not dispositive—bases to contest materiality. Additionally, contractors will have a stronger case that their noncompliance was immaterial if the underlying violation did not adversely affect contract performance or supply chain security, or if the government does not routinely terminate contracts for comparable violations.
On July 14, 2020, the Federal Acquisition Regulatory Council (FAR Council) issued an interim final rule (Interim Rule) amending the Federal Acquisition Regulation (FAR) by prohibiting federal executive agencies from entering into, extending, or renewing contracts with entities that use equipment or services produced by Huawei Technologies and other Chinese telecommunications companies. The Interim Rule articulates three principal goals. First, it intends to protect key supply chains and federal information technology networks from interference by Chinese intelligence actors. Second, the Interim Rule aims to reduce corporate espionage by limiting the means through which Chinese companies can access industrial secrets. Third, the Rule intends to limit the reach of Chinese technology companies in domestic markets and to reduce national dependence on foreign technology.
Due to the broad scope of the Interim Rule, and the potential compliance difficulties that it presents for multinational companies, industry stakeholders have expressed concern that the rule exposes them to liability under the False Claims Act (FCA). The FCA is a federal statute which imposes civil and criminal penalties on government payees who falsely certify compliance with a “material” ancillary law, regulation, or contractual provision.
This article examines the potential scope of FCA liability that could arise from a contractor’s noncompliance with the Interim Rule, and, in particular, whether noncompliance can be considered “material” under the FCA as federal courts interpret the term. Determining materiality will necessarily depend on the facts of a given case, including both the nature and the extent of the underlying violation. Prosecutors and relators may have the strongest case for liability under a theory of fraud in the inducement or promissory fraud, when contractors fraudulently misrepresent their compliance prior to entering or renewing a contract with the government.
As a general matter, however, contractors may have valid grounds to challenge materiality in certain cases. Relevant grounds to contest materiality include that the Interim Rule is not an “express condition of payment,” and that General Services Administration (GSA) policies allow continued payment to noncompliant contractors. Those facts are potentially probative of a lack of materiality but are not necessarily dispositive. Additionally, if the government does not routinely terminate contracts for comparable violations of the Interim Rule and typically continues to pay for work performed, contractors will have a stronger case that their noncompliance was not material. Finally, if an underlying violation does not affect contract performance or pose any reasonable threat to supply chain security, a contractor can reasonably argue that the violation was insubstantial and did not go to the “essence of the bargain.”
This article will explain the requirements imposed by the Interim Rule, the legal framework of the FCA, and the meaning of materiality as courts interpret the term. The article will go on to discuss whether—and under what circumstances—a false certification of compliance with the Interim Rule can be considered material, as well as the legal arguments for and against imposing FCA liability in those cases.
In recent years, the federal government has created a series of laws and regulations intended to protect the security of federal information technology networks and domestic supply chains. The Trump administration focused particular attention on limiting the reach of Chinese technology companies in domestic markets, based on its belief that the Chinese government will exploit those companies to conduct espionage against the United States. To that end, Section 889 of the John S. McCain National Defense Authorization Act for Fiscal Year 2019 (2019 NDAA) prohibits executive agencies from doing business with companies that use equipment containing technology from certain Chinese telecom companies or from purchasing such equipment directly.
Section 889’s restrictions are divided into two parts. Section 889(a)(1)(A) (Section 889 Part A) prohibits federal agencies from obtaining products or services that use “covered telecommunications equipment.” Section 889(a)(1)(B) (Section 889 Part B) prohibits the same agencies from entering into, extending, or renewing contracts with entities that “use[] covered telecommunications equipment or services as a substantial or essential component of any system, or as critical technology as part of any system.” In July 2020, the FAR Council issued the Interim Rule, amending FAR 52.204-24 and 52.204-25 and implementing Section 889 Part B.
As a prerequisite to doing business with the government, the Interim Rule requires contractors to conduct a “reasonable inquiry” and submit a representation to the government that they do not “use covered telecommunications equipment or services, or use any equipment, system, or service that uses covered telecommunications equipment.” Those representations must be submitted with either each offer that the contractor submits or annually in the System for Award Management. If the contractor identifies any use of covered equipment following its inquiry, the contractor must notify the government and seek a waiver. In addition, under FAR 52.204-25, contractors must report any “uses” of covered telecommunications discovered during performance of the contract within one business day.
Federal contractors and industry groups have expressed widespread concern regarding the scope of the Interim Rule and the short timeline that contractors are given to meet its requirements. Because the Interim Rule prohibits any “use” of covered equipment or services, “regardless of whether that usage is in performance of work under a Federal contract,” the prohibition has the potential to reach every aspect of a contractor’s commercial activities. Beyond that, the Interim Rule covers a wide array of equipment and services: subject to certain exceptions, the Rule applies to all equipment and services that use the prohibited technology as a “substantial or essential component of any system, or as critical technology as part of any system.” Contractors’ difficulties are compounded by the fact that they might be held liable if they use the equipment or services of an affiliate or commercial partner and those entities in turn use covered equipment. The consequences of violating the Interim Rule are severe: a contractor that fails to comply could be liable for breach of contract or violation of the FCA.
The FCA imposes civil and criminal penalties on those who present false or fraudulent claims for payment to the United States and allows the government to collect treble damages for each violation. A civil action under the FCA may be brought either by the United States directly or by private individuals on behalf of the United States, known as qui tam “relators”. Under the FCA, liability attaches to several specific actions, including knowingly presenting a false claim for payment to the government, knowingly presenting false statements or records material to a false claim, or knowingly making false statements in order to conceal or avoid an obligation to pay the U.S. government.
The false claims provision, 31 U.S.C. § 3729(a)(1)(A), imposes liability on any person who “knowingly presents, or causes to be presented, a false or fraudulent claim [to the government] for payment or approval.” To establish liability for a false or fraudulent claim, the statute requires a plaintiff to show that: (1) the defendant presented or caused to be presented a claim for payment to the U.S. government, (2) the claim was false or fraudulent, and (3) the defendant knew the claim was false or fraudulent. Federal courts further require proof that the alleged misrepresentation was “material” to the government’s decision to pay the defendant. Knowledge under the FCA is defined as acting with “actual knowledge of the information,” in “deliberate ignorance,” or “with reckless disregard for the truth.”
For a claim to be actionable under the FCA, it must be “false.” A claim may be considered either “factually” false or “legally” false. A claim is factually false if it “misrepresents what goods or services [were] provided to the Government.” A claim is legally false if the claimant knowingly, “falsely certifies that it has complied with a statute or regulation the compliance with which is a condition for Government payment.” Claims can be considered legally false under two theories: “express” false certification and “implied” false certification. The express false certification theory applies if a government payee explicitly and falsely “certifies compliance with a particular statute, regulation or contractual term, where compliance is a prerequisite to payment.” In contrast, “the pertinent inquiry for implied-false-certification claims is not whether a payee made an affirmative or express false statement, but whether, through the act of submitting a claim, a payee knowingly and falsely implied that it was entitled to payment.”
For many years, federal courts of appeals were divided as to both the scope of implied false certification liability and the legal standard for proving a violation. Some circuits limited liability to cases in which the defendant misrepresented compliance with a regulatory, statutory, or contractual requirement that was an “express condition of payment.” Others circuits held more broadly that defendants could be liable if the misrepresentation was “material” to the government’s decision to pay, regardless of whether the misrepresentation concerned an express condition of payment.
In Universal Health Servs., Inc. v. United States ex rel. Escobar, the Supreme Court resolved many aspects of that circuit split and imposed a new minimum standard for establishing implied false certification liability. In Escobar, the Supreme Court held that implied false certification liability can be a basis for FCA liability at least“where two conditions are satisfied: first, the claim does not merely request payment, but also makes specific representations about the goods or services provided; and second, the defendant’s failure to disclose noncompliance with material statutory, regulatory, or contractual requirements makes those representations misleading half-truths.” Emphasizing that the FCA is not “a vehicle for punishing garden-variety breaches of contract or regulatory violations,” the Court held that the alleged “misrepresentation about compliance with a statutory, regulatory, or contractual requirement must be material to the Government’s payment decision in order to be actionable.” The standard for materiality is “demanding” and must be particularized to the facts of each individual case.
The Court reasoned that materiality under the FCA is rooted, at least in part, in the common law meaning of materiality, which is traditionally determined by “the effect on the likely or actual behavior of the recipient of the alleged misrepresentation.” Under common law tort principles, for example, a matter can be material only if:
(1) “‘a reasonable man would attach importance to [it] in determining his choice of action in the transaction’; or (2) if the defendant knew or had reason to know that the recipient of the representation attaches importance to the specific matter ‘in determining his choice of action,’ even if a reasonable person would not.”
Materiality under the FCA, therefore, depends upon the actual or likely effect of a misrepresentation on the government’s decision to pay. A matter can be material “either because a reasonable person would find the misrepresentation important or because the defendant knew the government actually considered it important to the payment decision.” Escobar’s test for materiality is primarily objective, “but subjective understandings may be relevant to what a reasonable person would consider material, as well as to what the defendant understood to be material.”
The Escobar Court did not provide a bright-line test for determining materiality and instead set forth several principles intended to guide what is a fact-intensive inquiry. First, a “misrepresentation cannot be deemed material merely because the Government designates compliance with a particular statutory, regulatory, or contractual requirement as a condition of payment.” Rather, the government’s designation of a requirement as a condition of payment “is relevant, but not automatically dispositive.” Similarly, a misrepresentation is not material simply because “the Government would have the option to decline to pay if it knew of the defendant’s noncompliance.”
In addition, materiality “cannot be found where noncompliance is minor or insubstantial.” Instead, the misrepresentation must be of such significance as to go to the “very essence of the bargain.” The government’s past conduct in response to noncompliance can also be probative of materiality. For example, materiality can be proved through “evidence that the defendant knows that the Government consistently refuses to pay claims in the mine run of cases based on noncompliance with the particular statutory, regulatory, or contractual requirement.” On the other hand, if the government routinely pays claims with full knowledge of noncompliance with certain requirements, that is “strong evidence that the requirements are not material.”
Federal courts construe Escobar to require “a holistic approach to determining materiality in connection with a payment decision, with no one factor being necessarily dispositive.” Perhaps because Escobar requires such a fact-intensive inquiry, federal case law interpreting Escobar is not entirely uniform. Courts have reached different conclusions regarding the materiality of certain statutory and regulatory requirements, even when presented with similar factual scenarios. Despite those differences, however, federal courts consistently distill the Escobar standard for materiality into several discrete factors:
(1) “the Government’s decision to expressly identify a provision as a condition of payment; (2) whether the Government consistently refuses to pay claims in the mine run of cases based on noncompliance with the particular statutory, regulatory, or contractual requirement or if, with actual knowledge of the non-compliance, it consistently pays such claims and there is no indication that its practice will change; and (3) whether the noncompliance is minor or insubstantial or if it goes to the very essence of the bargain.”
Since the Interim Rule obliges contractors to certify (annually or with each contract solicitation) that they comply with its requirements, FCA claims premised on a violation of the Interim Rule will likely be brought under a theory of legal falsity. How a court applies the Escobar standard for materiality, therefore, could be a central issue in determining a defendant’s liability under the Rule.
Because materiality under the FCA depends on the facts and circumstances of every individual case, one cannot predict in the abstract whether courts will consider violations of the Interim Rule to be material. Additionally, because the test for materiality under Escobar is “holistic,” with no one factor being dispositive, courts have discretion to weigh the applicable legal factors differently. Thus, in addition to potential variation based on the facts of each case, courts may also reach different legal conclusions regarding the materiality of the Interim Rule.
Prosecutors and relators might have the strongest case that noncompliance with the Interim Rule is material under a theory of fraud in the inducement, if a contractor’s initial or annual certification of compliance was false when it was made. In many cases, however, contractors might have reasonable grounds to contest materiality. The fact that the Interim Rule and GSA policies allow noncompliant contractors to continue to receive payment for the work that they perform might weigh against materiality in certain cases. Additionally, if a contractor’s violation of the Interim Rule did not adversely affect its performance of the contract or pose any reasonable threat to supply chain security, that contractor could plausibly argue that its noncompliance was insubstantial and did not go to the “essence of the bargain.”
The Interim Rule requires federal contractors to represent to the government, annually or with each contract solicitation, that they do not use covered telecommunications equipment or services or use equipment or services that use covered telecommunications equipment. The Interim Rule further requires contractors to report to the government the discovery of any “uses” of covered telecommunications equipment within one business day. Either of those certifications of compliance could reasonably be considered a “specific representation” about a contractor’s services—one of the prerequisites for false certification liability under Escobar.
There are at least two potential avenues for claims to be treated as legally false under this theory. First, if the initial or annual certification of compliance was “false when made” (i.e., the contractor knew that it used covered telecommunications equipment at the time), subsequent claims for payment could be considered legally false. Alternatively, if a contractor begins to use covered telecommunications equipment during performance and knowingly continues to submit claims to the government, the claims could also be considered legally false. To prove legal falsity in either case, however, a plaintiff must prove that the misrepresentation of compliance was material to the government’s decision to pay.
Because the Interim Rule does not expressly condition a contractor’s eligibility for payment on compliance, and because GSA policies allow noncompliant contractors to continue to receive payment for work performed, compliance with the Interim Rule most likely does not qualify as an express condition of payment as federal courts interpret the term. If a contractor violates the Interim Rule during the course of contract performance, those facts will likely weigh against a finding of materiality. If a contractor entered a contract knowing it does not comply with the Rule, however, a plaintiff could plausibly bring an FCA claim based on a theory of fraud in the inducement. Under those circumstances, the fact that a contractors’ eligibility for federal contracts is conditioned on compliance with Interim Rule might weigh in favor of the Rule’s materiality.
Escobar articulated several factors for assessing the materiality of a statutory, regulatory, or contractual requirement, including whether the government identified the requirement as an express “condition of payment.” This factor is “relevant, but not automatically dispositive.” Whether a regulatory, statutory, or contractual requirement is an express condition of payment depends on both the language of the requirement and its function in the underlying regulatory or statutory scheme. Courts draw a distinction between express conditions of payment, which directly control the government’s payment decisions, conditions of participation, which affect a contractor’s eligibility to perform work for the government, and other ancillary regulatory or statutory requirements. For a regulatory or statutory requirement to be considered an express condition of payment, “the court must find that payment of the claim was contingent on the defendant’s compliance with the underlying provision.” Conditions of participation, in contrast, “usually focus on the continuing eligibility of a provider who did not enter the program under false pretenses.” Conditions of participation, “as well as a provider’s certification that it has complied with these conditions, are enforced through administrative mechanisms, and the ultimate sanction for violation of such conditions is removal from the government program.” The “varying penalties for violating conditions of participation reflect the fact that ‘periodic noncompliance is anticipated and built into the administration of’ many federal programs.”
Under Escobar, the government’s designation of a regulatory or statutory requirement as an “express conditions of payment” is one of several discrete factors that can be indicative of materiality. Many courts apply the materiality factor in a relatively straightforward manner: if the underlying statute or regulation expressly conditions payment on compliance, it is probative of materiality; if not, it weighs against materiality.
The distinction between express conditions of payment and conditions of participation can be less relevant in other cases, however. If liability is premised on fraud in the inducement—i.e., on the idea that the contractor’s misrepresentations induced the government into entering the contract —then the fact that a regulation is a condition of participation can itself be probative of materiality. Alternatively, if violating a regulation would result in immediate contract termination, then that regulation might be considered the practical equivalent of an express condition of payment. To evaluate the materiality of the Interim Rule, therefore, it is valuable to consider both the express language of the regulations and the extent to which compliance is linked with payment.
Compliance with the Interim Rule can most accurately be characterized as a condition of participation, rather than an express condition of payment. By its plain language, the Interim Rule does not prevent the government from paying noncompliant contractors for the work that they perform, but rather prohibits agencies from “entering” into, “extending,” or “renewing” a contract with an entity that uses covered telecommunications equipment. Although compliance with the Interim Rule controls the government’s ability to award contracts, therefore, it does not necessarily control the government’s payment decisions under existing contracts. In fact, GSA policies provide that existing contractors may generally continue performance if they violate the Interim Rule. Compliance is thus a condition of eligibility for federal contracts but does not constitute a per se condition for payment. Neither the text of the Interim Rule nor its explanatory materials indicate that the Rule will have legal implications for the government’s payment decisions under existing contracts: the only reference to payments is the FAR Council’s acknowledgement that the Interim Rule will “lead to the Government paying higher prices for services and products it buys.”
Instead of making payment contingent on compliance, the Interim Rule requires the government to follow administrative procedures if a contractor violates or misrepresents its compliance with the Interim Rule—as is typical of conditions of participation. Specifically, the Interim Rule requires contractors who use covered telecommunications to submit a full report to Contracting Officers (COs) and to seek a waiver. A violation will “normally” not require the termination of a contract, but will rather affect the government’s decisions to “extend” or “renew” the contract in question. According to guidance documents issued by the GSA, the government will allow contractors that initially misrepresent their compliance with the Interim Rule to continue to do business with the government under certain circumstances. In this respect, the Interim Rule is distinguishable from many other conditions of participation that courts have found to be material. Notably, the GSA acknowledged in its guidance documents that “GSA communications with industry indicate that there may be widespread use of prohibited telecom throughout GSA’s industry base.”
The fact that the Interim Rule is not a condition of payment, and that noncompliance does not result in automatic contract termination, might weigh against its materiality in many cases. FCA case law concerning the International Traffic in Arms Regulations (ITAR) and the Trade Agreements Act (TAA) is instructive in this regard. In United States ex rel. McGrath v. Microsemi Corp., for example, the District Court for the District of Arizona held, and the Ninth Circuit affirmed, that a contractor did not violate the FCA by falsely certifying that it complied with the export control requirements imposed by the ITAR. Although the Defense Federal Acquisition Regulation Supplement (DFARS) requires contractors to certify that they comply with the ITAR as a condition of eligibility, both courts held that such a requirement is “not the equivalent of regulations conditioning payment upon compliance.” Similarly, in United States v. Comstor Corp., the District Court for the District of Columbia held that compliance with the TAA was not an express condition of payment and that a contractor’s false certification of compliance with the TAA was not material to the government’s payment decisions. The court reasoned that the existence of “exceptions to the rules requiring TAA compliance,” and the GSA’s “expressed willingness to ‘work with’ vendors in order to address compliance issues instead of outright rejecting claims,” suggested that “the government may continue to make payments even when TAA violations are known.”
Like the statutes at issue in Microsemi and Comstor, the Interim Rule does not expressly condition payment on compliance and allows noncompliant contractors to continue to receive payment. That fact might have important implications for contractors. For example, in practice, a large percentage of FCA cases predicated on conditions of participation (rather than express conditions of payment) are dismissed on motions for summary judgment if they proceed to court. When contractors fail to comply with the Interim Rule during performance, therefore, they will likely have the strongest case for immateriality, because they may still be entitled to payment under the Interim Rule.
The fact that compliance with the Interim Rule is not an express condition of payment does not necessarily mean that compliance is immaterial, however. When a regulation has a significant effect on a contractor’s eligibility for payment, it might be treated as the practical equivalent of an express condition of payment. Several aspects of the Interim Rule might be seen as indicative of materiality in this regard. Although the Interim Rule does not expressly condition payment on compliance, the Interim Rule does require contractors to strictly comply with the Rule to do business with the federal government.
In addition, even if noncompliance with the Rule will not result in immediate contract termination, the government will have discretion to terminate federal contracts if contractors violate the Interim Rule. Some courts might conclude from those facts that compliance with the Interim Rule is material to the government’s ongoing payment decisions or that a contractor’s initial certification of compliance was material to the government’s decision to enter a contract in the first instance, and hence to the contractor’s eligibility for payment.
In this regard, the government or a private plaintiff could potentially bring an FCA claim under a theory of fraud in the inducement. Under the fraud in the inducement theory, when a contractor procures a government contract through fraud, all subsequent claims for payments are tainted by that fraud and are considered “false” within the meaning of the FCA. Thus, if a contractor’s initial certification of compliance with the Interim Rule is found to have fraudulently induced the government to enter into a contract, that contractor’s requests for payment could potentially be considered false claims. Under that theory of liability, the fact that compliance with the Interim Rule is a condition of participation could be considered probative of its materiality.
The Second Circuit recently discussed the materiality of conditions of participation at length in United States v. Strock. In Strock, the Second Circuit reversed the decision of the District Court for the Western District of New York, which had dismissed an FCA claim for failure to plead materiality. The defendant in that case had been awarded a government contract reserved under a federal program for veteran-owned businesses. To qualify for the federal program, contractors must certify that they are a “service-disabled veteran owned small business” (SDVOSB). The defendant allegedly misrepresented the ownership of his company in order to qualify for a contract, and, upon discovering the alleged misrepresentation, the government brought an FCA claim under a theory of fraud in the inducement. The district court dismissed the claim for failure to plead materiality, largely on the grounds that the regulatory requirement at issue was not an “express condition of payment.” Because the SDVOSB requirement affects a contractor’s eligibility for the contract, rather than a contractor’s entitlement to payment, the district court reasoned that the requirement was not material to the government’s “payment decisions.”
The Second Circuit reversed the district court’s decision, holding that “at least in fraudulent inducement cases, the government’s ‘payment decision’ under Escobar encompasses both its decision to award a contract and its ultimate decision to pay under that contract.”The court reasoned that excluding conditions of participation from a materiality analysis “makes little sense in a fraudulent inducement case, where a defendant’s alleged misrepresentations at the time the government awarded the contract are what render any subsequent claim under that contract fraudulent at all.” The Second Circuit concluded, therefore, that—at least in fraud in the inducement cases—courts should assess the materiality of a requirement based on its effect on the government’s decision to award a contract, as well as its effect on the government’s decisions to render payments under that contract.
The Second Circuit emphasized, however, that not all conditions of participation can be considered material per se. As the court reasoned, Escobar rejected the rule that “a provision is necessarily material where the Government would be entitled to refuse payment if made aware of the violation.” Instead, Escobar requires courts to look beyond labels and consider a range of factors, including the government’s actual response to a regulatory violation.
The Second Circuit’s reasoning, in many ways, makes good sense. As that court pointed out, the “government’s decisions to enter a contract in the first place in some sense undergirds any decision to pay claims under that contract.” However, Strock also illustrates why any analysis of materiality must be individualized to the facts of a given case. In Strock, the condition of participation at issue played a direct role in the government’s decision to award the contract: the underlying federal program was designed to support businesses owned by disabled veterans, and, by definition, only those businesses were eligible for the program. Not all conditions of eligibility, however, play so affirmative a role in the government’s decisionmaking. Federal contractors must certify compliance with a large number of regulations as a prerequisite to doing business with the government: it would be at odds with common sense to say that each and every one of them is so material as to provide a basis for fraud. Moreover, potential lapses in compliance with certain regulations are “‘anticipated and built into the administration of’ many federal programs.”
When assessing the materiality of a condition of participation, therefore, courts should consider the substantive role of that requirement in the government’s decisionmaking and its connection to the underlying contract. In the case of the Interim Rule, an argument could potentially be made either way. The Interim Rule heavily conditions a contractors’ eligibility for contracts on compliance, and Section 889 itself flatly prohibits the government from entering contracts with businesses that use covered telecommunications equipment. Where a business enters a federal contract knowing that it does not comply with the Interim Rule, those facts might weigh in favor of materiality under a theory of fraud in the inducement. Nevertheless, the Interim Rule does not play as affirmative a role in the government’s decisionmaking as the requirement at issue in Strock. The Interim Rule imposes generally applicable requirements that govern all federal contracts, unlike in Strock, where the condition of participation was essential to a specific federal program. Regardless of the conclusion that a court reaches on this issue, however, the Interim Rule’s status as a condition of participation cannot be considered dispositive: Escobar makes clear that courts must consider a range of factors, including the government’s actual response to noncompliance.
This section discusses the second criterion that courts apply to assess materiality under the FCA: the government’s conduct in response to violations of the statutory, regulatory, or contractual requirement at issue. The government will have the strongest case that a contractor’s violation of the Interim Rule was material if federal agencies routinely terminate contracts for comparable violations. Conversely, contractors will have a stronger case for immateriality if the government does not generally terminate contracts for comparable violations of the Rule and typically continues to pay contractors for work performed. GSA policies suggest that, in many cases, noncompliance with the Interim Rule will not result in immediate contract termination.
The materiality of a regulatory, statutory, or contractual requirement can be judged in part by “the government’s past response to claims violating the same requirement.” If the government “consistently refuses to pay claims in the mine run of cases based on noncompliance with the particular statutory, regulatory, or contractual requirement,” it is highly probative of materiality; conversely, if “with actual knowledge of the non-compliance, [the government] consistently pays such claims and there is no indication that its practice will change,” compliance is much less likely to be material.
Because the Interim Rule only recently went into effect, it cannot yet be said with certainty how the government will respond to noncompliance with the Rule in the “mine run of cases.” However, guidance documents issued by the GSA offer some insight into the government’s possible response to violations. For current contracts, GSA policies require COs to take remedial action within three business days if a contractor discloses that it uses covered telecommunications equipment or reports that it previously misrepresented compliance with the Interim Rule. In such cases, COs must assess whether the reported “use” of prohibited equipment in fact violates the Interim Rule, determine whether a prior waiver or exception applies, submit a report to the Supply Chain Risk Management Review Board (SCRM Review Board), and, as a “last resort,” seek a waiver. Waivers may only be granted in two narrow circumstances and require contractors to submit a phase-out plan to eliminate all use of prohibited telecom equipment. A contractor’s violation of the Interim Rule will not automatically result in contract termination: “[n]ormally, if the CO determines that continuing performance of or extending the contract (or order) will result in a violation, the only action required of the CO is to not extend the contract.” However, “[i]f stronger action is contemplated,” COs are instructed to consult with management and the SCRM Review Board to determine the appropriate response, which could include contract termination.
Because materiality under Escobar looks to the effect of a misrepresentation “on the likely or actual behavior” of the government, the government’s response to a violation of the Interim Rule can be probative of materiality to the extent that “it offers insight into the [g]overnment’s actual payment decisions.” GSA policies generally indicate that noncompliance with the Interim Rule will primarily affect the government’s payment decisions for future contracts: “normally . . . the only action required of the CO is to not extend the contract.” When the government continues to pay a contractor after a violation has been reported, and the only adverse taken is “to not extend the contract,” the case for materiality will arguably be weaker. However, the argument for materiality could be significantly stronger if the government routinely terminates contracts for comparable violations of the Interim Rule, or if the government in fact terminated the defendant’s contract. Under such circumstances, there is a stronger case that the government’s payment decisions “would likely or actually have been different,” but for the false certification, because the contractual relationship might have been terminated.
The final consideration in determining materiality looks to the extent of the contractor’s violation of the regulatory, statutory, or contractual requirement at issue and the importance of the requirement to the contract. A contractor’s false certification of compliance is not material if the noncompliance was “minor or insubstantial;” however, if the violation was of such significance as to “go to the very essence of the bargain,” noncompliance is more likely to be material. This issue is intertwined with the central question under Escobar: whether a misrepresentation is sufficiently important as to affect the government’s payment decisions. The Supreme Court suggested in Escobar that this issue is both subjective and objective: a condition can be said to go to the “essence of the bargain” if a reasonable person “would attach importance to [it] in determining his choice of action in the transaction” or if “the defendant knew or had reason to know that the recipient of the representation attaches importance to the specific matter ‘in determining his choice of action,’ even though a reasonable person would not.”
Escobar is internally inconsistent as to whether materiality is determined primarily from the perspective of a reasonable person or that of the government. Reading the opinion as a whole suggests that materiality is primarily objective, but it can be indicative of materiality if compliance is in fact central to the government’s payment decisions and a contractor is aware of that fact. In practice, courts analyze this issue based on a “common sense” evaluation of the centrality of the requirement to the contract and to the government’s course of conduct. That issue is relevant with respect to the Interim Rule, as some of the goals of the Rule might be considered material to a reasonable person, while others are arguably less so.
Generally speaking, regulatory or statutory conditions that implicate price and payment or are “part and parcel of the necessary performance of the contract” are more likely to go to the essence of the bargain than those that are “largely unrelated to performance of the contract.” In some cases, however, regulatory or statutory violations that implicate the government’s security or financial interests can also go to the “essence of the bargain.” In United States v. Aerojet Rocketdyne Holdings, Inc., for example, the court rejected the defendant’s argument on a motion to dismiss that compliance with DFARS cybersecurity requirements did not go to the “essence of the bargain” in a federal contract to develop missile defense technology. The court found the argument “unavailing” at that point in the proceedings, reasoning that the defendant’s ability to securely handle sensitive data could have affected its ability to perform the contract and could have been a factor in the government’s decision to award the contract. Similarly, in United States ex rel. MacDowell v. Synnex Corp., the court denied the defendant’s motion to dismiss for immateriality because the plaintiff showed that the defendant’s failure to comply with the TAA could have created “backdoors” into federal information technology networks.
Like the DFARS requirements at issue in Aerojet, the Interim Rule is intended to address cybersecurity threats to the federal government. Although violating cybersecurity regulations in and of itself will not establish materiality, some violations of the Interim Rule might be of such significance as to go to the essence of the bargain. For example, a reasonable person might find that a violation went to the “essence of the bargain” if it affected the contractor’s ability to adequately perform the work required, as in Aerojet, or if the violation created cybersecurity vulnerabilities that would have made it unreasonable for the government to have entered the transaction, as in MacDowell. Alternatively, noncompliance might be material if the government considered compliance with the Interim Rule to be central to the contract and the contractor “knew or had reason to know” of that fact.
Here, the government has arguably demonstrated that it considers compliance to be important to eligibility for federal contracts, based on the strict compliance standards that the Rule imposes, the Rule’s annual certification requirement, and the fact that violations must be reported in one business day. Under FCA case law, however, it is unclear whether the government’s subjective view of the importance of the Interim Rule is sufficient to establish that it goes to the “very essence of the bargain.” In most cases, regulations that have been found to go to the “very essence of the bargain” have some objectively reasonable connection to performance of the contract, administration of payment, or the policy objectives of the underlying federal program.
A violation of the Interim Rule will not be material if it is “minor or insubstantial,” irrespective of whether materiality is judged using an objective or subjective standard. Certain violations of the Interim Rule can arguably be considered substantial, such as if the noncompliance poses a threat to federal networks or undermines a contractor’s ability to adequately perform a contract. In some cases, however, the adverse consequences of a violation of the Interim Rule might be minor for the government. The Interim Rule has an extraordinarily broad reach, which can impose liability on contractors for conduct that they could not have reasonably prevented—for example, where a third party providing services to a contractor “uses” prohibited telecom equipment—or for conduct that has a de minimis effect on supply chain security. Arguably, if a contractor uses prohibited equipment for purposes unconnected to a federal contract, in a context that poses no reasonable threat to the federal government, then no reasonable person “would attach importance [to it] in determining his or her choice of action with respect to the transaction.” Although one of the stated objectives of the Interim Rule is to reduce domestic “reliance on foreign-owned or controlled telecommunications equipment,” that policy goal is arguably too attenuated from the purposes of a contract to go to the “very essence of the bargain.”
If the potential adverse consequences of a violation are de minimis, there is a stronger argument for courts to circumscribe liability based on principles of common sense and reasonableness. In such cases, courts might be justified in adhering to Escobar’s admonition that “materiality is [not] too fact intensive for courts to dismiss FCA cases on a motion to dismiss or at summary judgment.”
As is the case under Part B, noncompliance with Section 889 Part A and its implementing regulations could potentially give rise to liability under the FCA. Part A prohibits agencies from obtaining or procuring covered telecommunications equipment and requires contractors to certify that they do not provide covered telecommunications equipment or services to the government. Because Part A imposes substantively different requirements than Part B, it necessarily raises a distinct set of issues with respect to FCA liability. Among other things, noncompliance with Part A could implicate the issue of factual falsity, because Part A requires contractors to make specific assertions about the nature of the goods that they provide to the government. A full analysis of FCA liability with respect to Part A, therefore, warrants a separate discussion, which necessarily falls outside the scope of this article. Broadly speaking, however, many of the principles of Escobar materiality that are relevant to Part B will also be relevant to Part A.
Under Escobar, a court considering the materiality of a violation of Part A will consider: (1) whether the government designated compliance as an express condition of payment; (2) the government’s actual conduct in response to noncompliance; and (3) whether compliance was minor or insubstantial or whether it went to the essence of the bargain.
The first relevant issue, therefore, is whether Part A can be considered an express condition of payment and its connection to the government’s payment decisions. Despite the similarities in the language and structure of Part A and Part B, Part A arguably has a closer nexus to the government’s payment decisions than Part B. Because Part A expressly prohibits the government from “obtaining” goods or services that use covered telecommunications equipment, the government is likely to refuse to accept or use noncompliant goods. In contrast, if a contractor discloses that it has violated Part B, GSA policies provide that “[n]ormally . . . the only action required of the CO is to not extend the contract.” In this respect, noncompliance with Part A may be more likely to be considered material than Part B. While a contractor who fails to comply with Part B might still be permitted to continue performance (and receive payment), a substantial violation of Part A might lead the government to refuse to pay for a contractor’s goods.
For similar reasons, the government’s conduct in response to violations of Part A might often be considered probative of materiality. Relative to Part B, Part A appears to afford less discretion to the government when faced with a violation. Part A provides that agencies may not “procure or obtain or extend or renew a contract to procure or obtain” products or services that use covered telecommunications equipment as a substantial component. Part A thus directly prohibits the government from obtaining covered telecommunications equipment or services. In contrast, Part B provides that the government may not “enter into a contract (or extend or renew a contract)” with entities that use covered telecommunications equipment. The language of Part B, therefore, provides greater leeway to the government if a violation occurs mid-performance: federal agencies may not enter into, extend, or renew a contract with companies that use covered telecommunications equipment, but they are not required to immediately terminate relations with contractors that violate Part B during contract performance. In contrast, Part A provides little discretion to the government with respect to noncompliant goods. A court’s determination of this issue, however, must ultimately depend on the government’s actual response to the violation and to comparable violations.
The final consideration set forth in Escobar asks whether the underlying violation constituted “minor or insubstantial [noncompliance]” or went to the “very essence of the bargain.” The process for determining whether a violation of Part A qualifies as “insubstantial noncompliance” is arguably built into Part A’s regulations. If contractors discover that they have provided (or will provide) prohibited telecommunications equipment to a federal agency, Part A requires them to disclose the nature of that equipment to a contracting officer. The CO will then “determine if the items in question will be used as a substantial or essential component, or to determine if a waiver request may be appropriate.” If the government determines that the use is substantial or essential, that a waiver is not permissible, and that the government must reject the goods or services provided, then the underlying violation of Part A likely cannot be considered “insubstantial noncompliance.” The fact the regulations would prohibit the government from accepting the contractor’s goods or services is a strong indication of the “likely or actual effect” of the contractor’s noncompliance on the government’s payment decisions.
Similarly, in many cases, violations of Part A could be considered to go to the “essence of the bargain.” Part A is designed to protect the integrity of government networks by excluding potentially compromising technology from the federal supply chain. If the government acquires and uses prohibited telecommunications equipment, then the purpose of Part A is defeated, and there is potentially a greater risk of cyber exposure to the government. However, that issue must ultimately depend on the facts of the case, the nature of the goods or services provided, and the extent of the contractor’s noncompliance.
The government contracting community has expressed reasonable concerns that Section 889 and the Interim Rule could bring about a significant number of FCA claims. Although it may offer cold comfort to companies that face the prospect of costly litigation, FCA case law provides reasons to believe that many of those claims may be successfully challenged on their merits. As the Supreme Court reiterated in Escobar, the FCA is not an “all-purpose antifraud statute or a vehicle for punishing garden-variety breaches of contract or regulatory violations.” Although the compliance challenges created by the Interim Rule may cause some contractors to unwittingly breach their contracts, there is a distinction between a breach of contract and fraud against the government.
Whether a false certification of compliance is material will necessarily depend on the facts and circumstances of each individual case. Because the Interim Rule makes clear that compliance is, at minimum, important to eligibility for federal contracts, prosecutors and relators might have the strongest case when contractors enter or renew a contract under false pretenses. In such circumstances, the underlying violation of the Interim Rule is more likely to be material if it adversely affected contract performance or supply chain security. The case for materiality will also be stronger if the government routinely terminates contracts for comparable violations.
In many cases, however, contractors may have persuasive grounds to contest materiality. Because the Interim Rule and GSA policies allow noncompliant contractors to continue to receive payment for work performed, contractors might have a more persuasive case when the underlying violation occurs during contract performance. In those circumstances, the argument for immateriality will be stronger if the government does not routinely terminate contracts for similar violations. Additionally, contractors could argue that their noncompliance was minor or insubstantial if it had no adverse effects on their performance of the contract or supply chain security. In light of the Interim Rule’s extraordinarily broad reach and its potential to impose liability for conduct that contractors cannot reasonably prevent, contractors might reasonably argue that courts should limit liability for de minimis violations.
