A recent U.S. Supreme Court decision, however, forecloses such a recovery for a common-law fraud claim. In Liu v. Securities and Exchange Commission, the Supreme Court explored the limitations on the use of disgorgement as an equitable remedy and explained that, when disgorgement is ordered as an equitable remedy, a court must deduct legitimate expenses from the amount that is to be disgorged. As discussed in this article, the principles articulated in Liu apply equally to a common-law fraud claim in the Court of Federal Claims and, in most cases, preclude disgorgement of amounts that exceed a contractor’s profit.
I. Introduction
In Liu v. Securities and Exchange Commission, the U.S. Supreme Court explored the limitations on the use of disgorgement as an equitable remedy. The Supreme Court explained that, when disgorgement is ordered as an equitable remedy, a court must deduct legitimate expenses from the amount that is to be disgorged. This decision is significant because a failure to deduct legitimate expenses from the amount that is to be disgorged would provide the prevailing party with a windfall by allowing that party to recover all monies paid under the contract, while also retaining all the benefits provided under the contract.
When the U.S. government asserts a common-law fraud counterclaim in the U.S. Court of Federal Claims (COFC) and requests rescission and disgorgement as remedies, the government is requesting equitable relief. As such, the government’s request is subject to the traditional limitations on equitable relief, including those discussed in Liu. Yet, in the past, the government has asserted, and the COFC has entertained, requests for disgorgement of all monies paid under a contract because of common-law fraud, regardless of the expenses incurred by the contractor in connection with performance of the contract.
This article begins with a discussion of common-law fraud, rescission and disgorgement, and the Supreme Court’s decision in Liu. The article then explains that, when the government requests rescission and disgorgement as remedies for a common-law fraud counterclaim, the government is requesting equitable relief. Next, this article asserts that, because the government is requesting equitable relief, that relief is subject to the traditional limitations on equitable relief, including the limitations discussed in Liu. The COFC, therefore, should reject requests for disgorgement of all monies paid under a contract as a remedy for common-law fraud, unless the wrongdoer did not incur any legitimate expenses in connection with the contract.
II. Background
As discussed below, the Supreme Court’s decision in Liu, although rendered in the context of a U.S. Securities and Exchange Commission (SEC) civil enforcement action, is relevant to the litigation of issues involving federal contracts because the government, when asserting a common-law fraud counterclaim in the COFC, has sometimes requested rescission of the contract and disgorgement of all monies paid under the contract.
A. Common-Law Fraud
Common-law fraud occurs when there is a knowing or reckless misrepresentation of a material fact that deceives a party and induces the party to act, which causes the deceived party to suffer an injury. It is a subsection of tort law. Common law claims are rooted in law created by court decisions, as opposed to being devised by statute. That said, the COFC lacks jurisdiction over tort claims asserted by contractors against the government, including common-law fraud claims.
However, when these claims are brought by the government, COFC possesses jurisdiction for and can hear tort cases, including common-law fraud claims, under 28 U.S.C. § 1503. Indeed, the U.S. Court of Claims, the predecessor to the U.S. Court of Appeals for the Federal Circuit, stated that, under 28 U.S.C. § 1503, “the [g]overnment may set up a counterclaim even though . . . it states a claim of a type (e.g. tort) of which we would not have jurisdiction if sought to be maintained by a plaintiff.” Additionally, COFC decisions have found that government common-law fraud counterclaims are not subject to the six-year statute of limitations set forth in 28 U.S.C. § 2501.
The government may raise a common-law fraud counterclaim independent of other fraud-related counterclaims that it may assert, such as counterclaims arising under the Special Plea in Fraud statute, 28 U.S.C. § 2514, or the False Claims Act, 31 U.S.C. §§ 3729–31. To succeed on a common-law fraud counterclaim, the government must prove:
(1) a representation of a material fact, (2) the falsity of that representation, (3) the intent to deceive or, at least, a state of mind so reckless as to the consequences that it is held to the equivalent of intent (scienter), (4) a justifiable reliance upon the misrepresentation by the party deceived, which induces him to act thereon, and (5) injury to the party deceived resulting from reliance on the misrepresentation.
The government must “prove the elements of its common law fraud counterclaim by clear and convincing evidence in order to prevail on the merits.” Moreover, the mere presence of fraud is not sufficient to satisfy the requirements of common-law fraud. Rather, the government must demonstrate that the fraud is a “but-for cause of the outcome to satisfy the requirements of common-law fraud.”
When asserting a common-law fraud counterclaim, the government may assert that the contract is void ab initio. The treatment of contracts as void ab initio “is, of course, a legal fiction. In reality, an agreement, under which the parties performed, did exist prior to the court’s decision that it is void.”
The Federal Circuit has stated that “the general rule is that a government contract tainted by fraud or wrongdoing is void ab initio.” In other words, when “there exists the type of severe legal infirmity that would preclude the parties’ exchange of promises from giving rise to an enforceable agreement,” the contract at issue “may be adjudged void ab initio.” In order for a government contract “to be tainted by fraud or wrong doing and thus void ab initio, the record must show some causal link between the fraud and the contract.” As discussed below in Section II.B.2, when arguing that a contract is void ab initio due to common-law fraud, the government has, in the past, asserted that the contract should be subject to rescission and disgorgement.
The Armed Services Board of Contract Appeals (ASBCA) and the Civilian Board of Contract Appeals (CBCA) do not have jurisdiction over government fraud counterclaims arising under the Special Plea in Fraud statute or the False Claims Act. The Boards, however, may address fraud counterclaims when the counterclaims do not require the Boards to make factual findings of fraud and do not assert a government “claim.” Due to these limitations, “[w]hen litigation is commenced before a board in a case that the [g]overnment believes involves fraud, the agency will frequently try to obtain a fraud judgment against the contractor in U.S. district court.” We do not address further the jurisdiction of the ASBCA and CBCA over government counterclaims, as this article focuses on government common-law fraud counterclaims brought under 28 U.S.C. § 1503, which does not apply to the Boards.
B. Rescission and Disgorgement
When pursuing a common-law fraud claim, rescission and disgorgement are possible remedies. Indeed, as discussed below, the government has repeatedly requested that contracts allegedly tainted by fraud be subject to rescission and disgorgement.
1. Defining Rescission and Disgorgement
In the legal context, the words “rescission” and “rescind” have their “ordinary use” definitions, meaning to abrogate, annul, or revoke. “Rescission has the effect of voiding a contract from its inception, i.e., as if it never existed.” In other words, rescission provides “a power of avoidance.”
The Federal Circuit has explained that rescission “is an equitable doctrine which is grounded on mutual mistake, fraud, or illegality in the formation of a contract.” Rescission is available “only when one or more of these circumstances is present.” Additionally, rescission ordinarily will not be invoked when money damages will adequately remedy a contract claim.
Generally, there are two types of rescission: (1) legal rescission and (2) equitable rescission. Legal rescission occurs when “one of the parties to the contract unilaterally cancels the contract because the other party committed a material breach of the agreement or because of some other valid reason,” or when the rescission is effected by the agreement of the parties. Conversely, equitable rescission occurs when a party requests that a court rescind or nullify the contract. The nature of the rescission, therefore, will turn on the circumstances under which the rescission occurs.
The government’s request for rescission of a contract due to common-law fraud often has been accompanied by a request for disgorgement. Disgorgement “is a form of ‘[r]estitution measured by the defendant’s wrongful gain.’” It requires the wrongdoer to “give up ‘those gains . . . properly attributable to the [wrongdoer’s] interference with the claimant’s legally protected rights.’” Courts have described disgorgement as “an equitable remedy that provides ‘a method of forcing a defendant to give up the amount by which he was unjustly enriched.’”
As further discussed below in Section II.C, in Liu, the U.S. Supreme Court explained that disgorgement is an equitable remedy under which a wrongdoer is required to give up the net profits earned through the fraudulent activity.
2. The Government’s Requests for Rescission and Disgorgement When Asserting Common-Law Fraud Counterclaims
Previously, when asserting a common-law fraud counterclaim at the COFC, the government has argued that it was entitled to rescission of a contract “tainted” by fraud and disgorgement of all monies paid under the contract because of the presence of fraud.
For example, in Kellogg Brown & Root Services, Inc. v. United States, the government asserted a common-law fraud claim arising from the receipt of kickbacks by employees of Kellogg Brown & Root Services, Inc. (KBR) from employees of KBR’s subcontractor Tamimi Global Company (Tamimi) under KBR’s LOGCAP III contract. Under that contract, KBR had executed a subcontract referred to as “Master Agreement 3” with Tamimi, against which KBR issued “work release orders” to Tamimi. One of the task orders under KBR’s LOGCAP III contract that Tamimi supported as a subcontractor was known as “Task Order 59.” In total, KBR paid Tamimi $466,290,328.00 for work performed under Master Agreement 3.
Before the COFC, the government presented a common-law fraud counterclaim and sought rescission and disgorgement of Master Agreement 3 and Task Order 59. Regarding Master Agreement 3, which had a value of $466,290,328.00, the government argued that it was
entitled to the rescission of the portion of the LOGCAP III contract involving all work performed by KBR through its Master Agreement 3 subcontract with Tamimi, inasmuch as that subcontract was tainted by kickbacks and it would be contrary to public policy for the [g]overnment to pay for such unlawfully awarded work. The [g]overnment is also entitled to disgorgement of all sums paid to KBR as compensation related to the tainted subcontract.
The government also asserted that the kickbacks tainted KBR’s Task Order 59 and that it was “entitled to disgorgement of all fees paid to KBR pursuant to Task Order 59.”
The “kickback scheme” that the government asserted “tainted” Master Agreement 3 involved kickbacks totaling $45,000.00. The COFC described the kickback scheme as follows:
In November 2002 Tamimi’s vice-president and chief of operations, Mohammad Shabbir Khan, offered Mr. Hall [of KBR] a kickback, stating that they could “‘make a lot of money together.’” Def.’s Am. Answer & Countercls. Filed Mar. 15, 2011, ¶ 114 (“Countercls.”). At that time Mr. Hall did not accept money from Mr. Khan, but he also did not report the kickback offer to anyone. However, eventually, both Messrs. Hall and Holmes [of KBR] did accept kickbacks from Mr. Khan.
Beginning in late 2002 through the end of 2003, Messrs. Hall and Holmes received a combined $45,000.00 in cash kickbacks from Mr. Khan. “Mr. Hall understood that the money was being provided so that Tamimi would remain in KBR’s good graces and continue to get DFAC contracts from KBR.” Id. ¶ 115. In 2003 Messrs. Hall and Holmes each accepted $5,000.00 in cash that Mr. Khan delivered to them at an airport in Kuwait. Mr. Khan also gave Mr. Hall an automated teller machine (ATM) card to withdraw cash from a bank account into which Mr. Khan had deposited another $5,000.00. Mr. Hall used the ATM card to withdraw $3,500.00 in cash. Mr. Holmes withdrew the remaining $1,500.00. Mr. Holmes accepted an additional $10,000.00 in cash from Mr. Khan, which Mr. Holmes gave to his secretary. Towards the end of 2003, Mr. Hall accepted $20,000.00 from Mr. Khan, which purportedly was to be used as an investment in a “Golden Corral” restaurant. However, Mr. Hall made no such investment, and Mr. Khan did not request that the money be paid back.
Because of the $45,000.00 in kickbacks, the government requested “rescission of Master Agreement 3 and disgorgement of all funds previously paid to Tamimi under this agreement.” Therefore, the government was seeking disgorgement of $466,290,328.00 due to $45,000.00 in kickbacks. Ultimately, the COFC concluded that the government had “failed to establish the requisite causation element of common law fraud,” but not until after it had denied KBR’s motion to dismiss the government’s common-law fraud counterclaim. The U.S. Court of Appeals for the Federal Circuit affirmed the COFC’s determination regarding liability for common-law fraud and did not address the proper measure of damages for such a claim.
Similarly, in Jasmine International Trading & Service, Co. W.L.L. v. United States, the government argued, under a common-law fraud theory, that it was “entitled” to rescission of two contracts and multiple purchase orders issued under a blanket purchase agreement (BPA), as well as to “disgorgement of all sums paid to” the contractor under the two contracts and the purchase orders. The value of the contracts and purchase orders totaled $6,774,093.00. The government asserted that it was entitled to “disgorgement of all sums paid” because the contracts and purchase orders “were tainted by bribery, conflict of interest, and fraud.” Specifically, the contractor’s chief executive officer had promised to pay a government official “$1 million in exchange for the award of [g]overnment contracts.” Although the contractor never paid the government official the one million dollars, it did pay the government official $1,200.00 and the government official’s sister $60,000.00. Based on the contractor’s promise to pay $1,000,000.00 and the $61,200.00 in actual payments, the government asserted that it was entitled to recover the total value of the contracts and purchase orders, $6,774,093.00.
The COFC in Jasmine International Trade & Service, Co. found that the government’s common-law fraud counterclaim “suffice[d] to meet the pleading requirement for but-for causation” as required for common-law fraud. The Court stated that “[w]hether or not the alleged fraud was, in fact, the but-for cause of the awards to Plaintiff is a matter to be determined following trial.” However, the case settled prior to trial.
Another case in which the government asserted that it was entitled to all monies paid under a contract is Gulf Group General Enterprises Co. W.L.L. v. United States. There, the government sought “disgorgement of all monies the United States paid for calls issued under the camp package BPA, plus costs,” because the calls allegedly “were obtained by plaintiff through bribery, conflict of interest, and fraud.” The COFC did not determine the appropriate remedy for the government’s common-law fraud counterclaim, as the COFC concluded that the government had not established liability.
A request for rescission and disgorgement is often premised on the idea that it would be “unjust” to allow a person who made a misrepresentation “to retain the fruits of a bargain” induced by fraud. Indeed, the idea behind the government’s requests for disgorgement of all monies paid under allegedly fraud-tainted contracts appears to be that, but for the fraud, the contracts would never have existed at all (i.e., the contracts should be rescinded). The government reasons that, because the contracts never would have existed, the government never would have paid the contractors any money under the contracts. The government, therefore, asserts that it should be entitled to recover all the money that it would not have paid but for the fraud (i.e., all amounts paid under the contracts allegedly tainted by fraud).
This argument, however, overlooks that the contractors may have satisfactorily performed all the work the government required under the contracts, and that the contractors may have incurred legitimate expenses in doing so. Likewise, it fails to recognize that the government may have received benefits in the form of the contractors’ work, and that the government may intend to retain, and continue to use, those benefits notwithstanding the fraud. The legitimacy of the government’s argument is further addressed later in Section III.B.1.
C. The Supreme Court’s Decision in Liu
In June 2020, the U.S. Supreme Court issued its opinion in Liu v. Securities and Exchange Commission, in which the Supreme Court analyzed whether disgorgement was an equitable remedy.
In Liu, Charles Liu and Xin Wang solicited nearly $27 million from investors that Mr. Liu and Ms. Wang had represented would go toward the construction of a cancer-treatment center. Mr. Liu and Ms. Wang, however, spent nearly $20 million on ostensible marketing expenses and salaries. Ultimately, the SEC investigated and brought a civil action against Mr. Liu and Ms. Wang in federal district court. The district court found in favor of the SEC, and, as part of the remedy, the district court “ordered disgorgement equal to the full amount petitioners had raised from investors, less the $234,899 that remained in the corporate accounts for the project.” Mr. Liu and Ms. Wang appealed, and the U.S. Court of Appeals for the Ninth Circuit affirmed.
The U.S. Supreme Court granted certiorari to determine whether 15 U.S.C. § 78u(d)(5) permits the SEC to seek a disgorgement award that goes “beyond a defendant’s net profits from wrongdoing.” The statute at 15 U.S.C. § 78u(d)(5) states that, in any action brought by the SEC, the SEC “may seek, and any Federal court may grant, any equitable relief that may be appropriate or necessary for the benefit of investors.”
When analyzing whether disgorgement was an equitable remedy, the Supreme Court observed that it had previously “described ‘disgorgement of improper profits’ as ‘traditionally considered an equitable remedy.’” The Supreme Court further stated that “a remedy tethered to a wrongdoer’s net unlawful profits, whatever the name, has been a mainstay of equity courts.” The Supreme Court noted that disgorgement restores the status quo, thereby “situating the remedy squarely within the heartland of equity.” The Supreme Court also stated that a “foundational principle” of disgorgement is that it “‘would be inequitable that [a wrongdoer] should make a profit out of his own wrong.’” Thus, the Supreme Court concluded that the SEC could seek disgorgement of profits under 15 U.S.C. § 78u(d)(5).
The Supreme Court also addressed the limitations that courts have imposed on disgorgement, so as “to avoid transforming [disgorgement] into a penalty outside their equitable powers.” Specifically, the Supreme Court stated that, in the past, “courts limited awards to the net profits from wrongdoing, that is, ‘the gain made upon any business or investment, when both the receipts and payments are taken into the account.’” Stated differently, “courts consistently restricted awards to net profits from wrongdoing after deducting legitimate expenses.”
Regarding the SEC’s disgorgement award issued by the district court and affirmed by the U.S. Court of Appeals for the Ninth Circuit, the Supreme Court noted that the district court failed to deduct expenses incurred for lease payments and cancer-treatment equipment from the amount to be disgorged by Mr. Liu and Ms. Wang. The Supreme Court reiterated that “[c]ourts may not enter disgorgement awards that exceed the gains ‘made upon any business or investment when both the receipts and payments are taken into the account’” and that “courts must deduct legitimate expenses before ordering disgorgement.” The Supreme Court stated that, on remand, the Ninth Circuit should determine whether the lease and equipment expenses should be deducted from the disgorgement award.
When discussing how equity courts traditionally dealt with disgorgement, the Supreme Court identified one exception to the principles discussed above. That exception applies when the claimed expenses are “dividends of profit under another name,” i.e., when a claimed expense, such as an unreasonably high salary paid to the perpetrator of the fraud, is not a legitimate business expense. To utilize that exception, a court must ascertain “whether expenses are legitimate or whether they are merely wrongful gains ‘under another name.’” If a court finds that the exception applies, the court is not required to deduct those expenses from the disgorgement award.
III. Analysis
As discussed above in Section II, when asserting common-law counterclaims related to government contracts, the government has sometimes requested rescission and disgorgement as remedies and has requested that the contractor repay all the monies paid under the contract. As discussed below, the government’s request for rescission and disgorgement of a contract allegedly tainted by fraud is a request for equitable relief. Although equity is “flexible,” it “is confined within the broad boundaries of traditional equitable relief.” Thus, in most cases, the COFC should reject requests that a contractor repay all monies paid under a contract due to common-law fraud because such an award usually would exceed the traditional bounds of a rescission and disgorgement award.
A. When Requested in Connection with a Common-Law Fraud Counterclaim, Rescission and Disgorgement Are Equitable Remedies.
To determine whether the government’s requested remedies of rescission and disgorgement constitute equitable relief, a court would need to analyze whether the remedies “fall[] into ‘those categories of relief that were typically available in equity.’” In doing so, courts should examine the “true character” of the action, not the label given to the action by the parties. Courts, therefore, “must look to the remedy sought and determine whether it is legal or equitable in nature.”
The common-law fraud principles applied in the United States today are derived from English courts. Those principles were aptly summarized in a decision in 1898 as follows:
According to the decisions of those [English] courts, made in many cases, if a party undertakes positively to assert that to be true which he does not know to be true, and which he has no sufficient or reasonable grounds for believing to be true, in order to induce another to act upon the faith of the representation, and the representation is acted upon and it turns out to be false, and the person who has acted upon the representation has been deceived to his damage, he is entitled to maintain an action for the deception. For whoever pretends to have positive knowledge of the existence of a particular fact, or state of things, when in truth he knows nothing about it, does in reality make a wilful [sic] representation which he knows to be false; and if such representation is made in order that another may rely upon it, and act upon it, and it is acted upon, and damage results therefrom, the person making the representation is in principle guilty of wilful deception and fraud.
As explained by the U.S. Court of Claims, “[u]nder the common law, fraud vitiated the contract and allowed, in the absence of any equitable considerations at least, recovery of actual damages sustained as a result of the fraud.” For example, in an early American common-law fraud case involving the sale of “diseased sheep,” the court explained that the plaintiff was “entitled to such damages as necessarily and naturally flow from the [fraudulent] act of the defendants.” The common-law, therefore, “did not permit recovery of money paid on a contract induced by fraud, unless actual monetary damage was sustained as a result of the fraud.”
English courts of equity, however, developed a rule providing that a contract induced by fraud is “void.” Early decisions from courts in the United States followed this rule, with Samuel Williston, author of the well-known treatise Williston on Contracts, remarking in 1911 that “the redress which equity gives for fraud is rescission.” More recently, tribunals have consistently referred to rescission as an equitable remedy for fraud. In fact, the U.S. Court of Appeals for the Federal Circuit has stated that rescission “is an equitable doctrine which is grounded on mutual mistake, fraud, or illegality in the formation of a contract.”
As further stated by the Federal Circuit, “[b]ecause rescission is essentially an equitable remedy, it will not ordinarily be invoked where money damages—in this case damages for breach of contract—will adequately compensate a party to the contract.” The Federal Circuit’s position that rescission should not be invoked when money damages adequately compensate the party is consistent with “the traditional rule that courts will not grant equitable relief when money damages are adequate.” The refusal to provide equitable relief, including rescission, when money damages adequately remedy a claim makes sense, as money “damages are always the default remedy for breach of contract.”
When the government requests rescission as a remedy for common-law fraud related to a government contract, the government’s request for rescission is not a request for monetary damages; in asking that the court rescind the contract, the government is asking for a return to the status quo before the fraudulent action occurred. This is a request for equitable rescission, as opposed to legal rescission, because the government is requesting that the court rescind the contract due to common-law fraud. Thus, when the government requests that a contract be rescinded because of common-law fraud, the government is requesting that the COFC award equitable relief.
In the context of a common-law fraud claim, the government’s request for rescission often is paired with a request for disgorgement. Rescission, on one hand, “contemplates a return by the parties to the status quo,” while disgorgement “is a form of ‘[r]estitution measured by the defendant’s wrongful gain.’” In cases at the COFC, the government has premised its requests for disgorgement on the idea that allowing the contractor to keep the monies it was paid for work performed under an allegedly tainted contract would allow the contractor to be unjustly enriched and would allow the contractor to profit from its wrongdoing.
Similarly, early disgorgement remedies were based on the concept that a wrongdoer should not be allowed to profit from its wrongdoing. Likewise, the argument that a contractor should not be allowed to be unjustly enriched “is rooted in the equitable principle that a person shall not be allowed to enrich himself unjustly at the expense of another.” As the U.S. Supreme Court has explained, a remedy measured by a wrongdoer’s gain “has been a mainstay of equity courts.” Indeed, the U.S. Supreme Court acknowledged that disgorgement is “traditionally considered . . . equitable.” Thus, the government’s request for disgorgement, which typically is paired with a request for equitable rescission and asserts that the contractor should not be allowed to benefit from a contact it allegedly obtained through fraud, is a request for equitable relief.
In sum, when the government requests rescission and disgorgement as remedies for its common-law fraud claim under a government contract, it is requesting equitable relief.
B. The COFC Generally Should Reject Requests for Disgorgement of Amounts That Exceed the Contractor’s Net Profit.
For the reasons set forth below, in most cases, a rescission and disgorgement award that requires a contractor to repay all monies paid under a contract should be rejected because it typically would exceed the traditional bounds of a rescission and disgorgement award.
1. A Rescission and Disgorgement Award Must Take into Accountthe Wrongdoer’s Legitimate Expenses.
Courts have discretion when fashioning equitable relief. However, when granting equitable relief, courts are guided by the traditional use of the equitable remedy, and the court’s discretion “must be exercised consistent with traditional principles of equity.” Equitable relief, therefore, “is confined within the broad boundaries of traditional equitable relief.” In fact, the U.S. Supreme Court has stated that “[e]quitable relief in a federal court is of course subject to restrictions: the suit must be within the traditional scope of equity as historically evolved in the English Court of Chancery . . . .” This limitation on equitable relief has been applied by the U.S. Court of Claims, which explained that the “general principles of equity are applicable in a suit by the United States to secure the cancelation of a conveyance or the rescission of a contract.”
Traditional principles of equity provide that, when the equitable remedies of rescission and disgorgement are requested under a common-law fraud theory, courts may not enter disgorgement awards that exceed the wrongdoer’s net profits, after accounting for legitimate business expenses. Yet the government, when asserting that a contractor obtained a contract through fraud, has on multiple occasions, requested repayment of all monies paid under the contract. These requests generally should be rejected because “[c]ourts may not enter disgorgement awards that exceed the gains ‘made upon any business or investment, when both the receipts and payments are taken into the account.’” The COFC, therefore, must “deduct legitimate expenses” when ordering disgorgement as an equitable remedy. As the U.S. Supreme Court has explained, failing to deduct legitimate expenses when ordering disgorgement “would be ‘inconsistent with the ordinary principles and practice of courts of chancery.’”
Additionally, ordering disgorgement of all monies paid under a contract, regardless of legitimate expenses, would result in a windfall for the government. When applying the common law, federal courts have, for many years, attempted to “to develop and establish just and practical principles of contract law for the federal government.” Notably, in the cases discussed above, the government has not offered to return the goods or services provided under the contract at issue, to the extent that doing so is even possible, when requesting rescission and disgorgement. Instead, in its request for a return to the purported status quo, the government would be seeking to keep all the work provided under the contract, while also recovering all the monies paid under the contract. This result would run afoul of the traditional equitable limitations of disgorgement and would result in a windfall to the government because the government would essentially be receiving goods and services at no cost. This windfall could be significant if the government, for example, were allowed to recover $466,290,328.00 as a remedy for a common-law fraud counterclaim based on $45,000.00 in kickbacks, as the government attempted to do in KBR.
Moreover, failing to deduct legitimate expenses before ordering disgorgement would impermissibly transform equitable remedies (rescission and disgorgement) into penalties. For instance, as noted, the government in KBR sought disgorgement of $466,290,328.00 based on $45,000.00 in kickbacks. The government argued it was entitled to $466,290,328.00 because “it would be contrary to public policy for the government to pay for such unlawfully awarded work.” The government, at least in KBR, appears to have been improperly using a common-law fraud counterclaim to punish conduct that contravened public policy.
The “basic function” of rescission, however, “is manifest in the requirement that one who seeks rescission return any benefits that he received from the misrepresenting party; rescission does not seek to punish the defendant but merely to force him to return his profits.” Indeed, the U.S. Court of Claims has stated that, “while the perpetrator of the fraud has no standing to rescind, he is not regarded as an outlaw.” The U.S. Supreme Court also has stated that disgorgement is not intended to be a penalty. That rescission and disgorgement are not penalties makes sense, as “equity never ‘lends its aid to enforce a forfeiture or penalty.’” Thus, a rescission and disgorgement award requiring repayment of all monies paid under the contract, regardless of the costs incurred during performance or the value the government received from such performance, would exceed the purpose of those equitable remedies and transform rescission and disgorgement into penalties.
If the government intends to seek a remedy for fraud that punishes the wrongdoer, it must do so through an action at law. For example, the government could seek to penalize the wrongdoer for its fraud by bringing a counterclaim under the False Claims Act, which expressly contemplates civil penalties and treble damages. In fact, the government has sought damages equal to the entire value of the contract under the False Claims Act. The government, therefore, has remedies other than a common-law fraud counterclaim that it can use to punish fraud.
Finally, one counterargument that could be made regarding the above analysis is that Liu involved the SEC’s ability to request “equitable relief” under 15 U.S.C. § 78u(d)(5) and, therefore, does not apply to common-law counterclaims brought by the government under 28 U.S.C. § 1503. The Supreme Court’s decision in Liu, however, was not limited to equitable relief sought under 15 U.S.C. § 78u(d)(5). Rather, the decision analyzed the traditional bounds of disgorgement when sought as an equitable remedy, including in cases that did not arise under 15 U.S.C. § 78u(d)(5). Thus, the principles discussed in Liu apply to equitable disgorgement requests generally, including the government’s requests for disgorgement that are brought in the COFC under 28 U.S.C. § 1503.
In sum, when awarding rescission and disgorgement as equitable relief for a common-law fraud counterclaim, the COFC must deduct legitimate business expenses from the award. In most cases, doing so will result in the government receiving disgorgement awards that are less than the total amount of money paid under the contract.
2. The Court of Claims Decision in K & R Engineering Co. Does Not Provide a Basis for Requiring, as a Result of Common-Law Fraud,a Contractor to Repay All Amounts Paid Under a Contract.
In the past, the government has relied on a Court of Claims’ decision from 1980, K & R Engineering Co. v. United States, when requesting disgorgement of all monies paid under the contract because of common-law fraud.
In K & R Engineering Co. v. United States, the government “counterclaimed to recover the amount it already paid plaintiff under” three contracts. The government alleged that the contracts were awarded in violation of the “conflict-of-interest statute,” 18 U.S.C. § 208(a), because a government employee and two officers of a company entered into an agreement whereby the government employee would be paid twenty-five percent of all profits earned under the contracts awarded by the government employee to the company. The Court of Claims determined that the arrangement between the government employee and the contractor violated the conflict-of-interest statute.
Regarding the government’s counterclaim, the Court of Claims stated that “[e]ffective implementation of the conflict-of-interest law requires that once a contractor is shown to have been a participant in a corrupt arrangement, he cannot receive or retain any of the amounts payable thereunder.” According to the Court of Claims, “[t]he policy underlying the conflict-of-interest statute requires that the contractor be required to disgorge the amounts received under the tainted contract.” The Court of Claims concluded that, under the “federal conflict-of-interest law,” a contractor which “has participated in an illegal conflict-of-interest situation is not entitled to retain the amounts received under the tainted contract.”
As reflected in the above quotations, the court in K & R Engineering Co. was addressing a counterclaim arising under a statute prohibiting conflicts of interest in the award of government contracts. The government did not assert a common-law fraud counterclaim; indeed, the term “common law” does not appear in the decision, and there is no discussion of the elements of common-law fraud. Nor did the court in K & R Engineering Co. purport to adhere to the traditional limitations of equity, as is required when awarding equitable relief. The Court of Claims was not focused on returning the parties to the status quo, as the court does when awarding equitable rescission, or ensuring that the contractor did not profit from its wrongdoing, as the court does when ordering disgorgement. Instead, the Court of Claims specifically focused on the conflict-of-interest statute, its “[e]ffective implementation,” and “policy considerations.” Thus, K & R Engineering Co. is distinguishable from common-law fraud counterclaims because, in that case, the government was not asserting a common-law fraud counterclaim.
Moreover, effective implementation of a statute and the policy considerations around deterring fraud cannot override the traditional limitations on the equitable remedies of rescission and disgorgement. In K & R Engineering Co., the Court of Claims did not deduct legitimate expenses from the government’s award because requiring repayment of all money paid under the contract would, in the Claims Court’s view, protect “the integrity of the federal procurement process.” As discussed above in Section III.B.1, however, a court must deduct legitimate expenses when ordering disgorgement, regardless of whether doing so furthers the goal of protecting the procurement process. Additionally, the Court of Claims reasoned that requiring the company to repay all amounts paid under the contracts would punish contractors that engaged in fraud. But, as discussed above, disgorgement cannot be used to punish.
The Court of Claims’ decision in K & R Engineering Co., therefore, does not provide a basis for expanding a disgorgement award beyond the traditional limitations of equity, and its continued vitality—especially after Liu—is unclear.
3. Applying the Traditional Limitations of Equity When Assessing Government Common-Law Fraud Counterclaims Will Not Resultin Wrongdoers Profiting at the Government’s Expense
An argument could be made that, when the COFC finds that the government has succeeded on its common-law fraud counterclaim, a decision denying disgorgement of all monies paid under the contract would lead to the contractor profiting at the government’s expense.
Disgorgement, however, specifically addresses the concern that a wrongdoer should not profit at another’s expense. Only “legitimate” expenses incurred by the wrongdoer are to be deducted from the amount that the wrongdoer is required to pay. In Liu, for example, the Supreme Court indicated that, on remand, the court may require the wrongdoers in that case to disgorge costs incurred in connection with “ostensible marketing expenses and salaries,” while the wrongdoers might not be required to disgorge costs incurred for “lease payments and cancer-treatment equipment.” A contractor, therefore, would not be able to retain profits on its fraudulently obtained contract, and the government, under a common-law fraud counterclaim, would be able to recover all monies paid under the contract except for monies that went toward items or services that have “value independent of fueling a fraudulent scheme.”
Furthermore, the Supreme Court has long held that a wrongdoer may not retain “dividends of profit under another name.” Accordingly, if a contractor unreasonably inflates its expenses to reduce the amount it is required to disgorge because of common-law fraud, a court could look behind the contractor’s representation that it incurred certain expenses and require disgorgement of unreasonable expenses. The equitable remedy of disgorgement does not permit a wrongdoer “to diminish the show of profits by putting in unconscionable claims for personal services or other inequitable deductions.”
The Supreme Court also “has carved out an exception when the ‘entire profit of a business or undertaking’ results from the wrongful activity.’” If a contractor obtains a contract through fraud, and does not incur any legitimate expenses in connection with performance of the contract, the contractor, under a rescission and disgorgement theory, would be required to disgorge all monies paid under the fraudulently obtained contract. Application of “that exception requires ascertaining whether expenses are legitimate or whether they are merely wrongful gains ‘under another name.’” Consequently, the exception may not apply if the contractor incurred legitimate expenses when providing goods or services to the government under the contract obtained through common-law fraud.
IV. Conclusion
Considering the U.S. Supreme Court’s decision in Liu v. Securities and Exchange Commission, it would be inappropriate to order, as a remedy for a common-law fraud counterclaim, disgorgement of all monies paid under a contract obtained through fraud, unless the contractor did not incur any legitimate expenses in performance of the contract. The COFC, when crafting equitable relief, must be mindful of the traditional limitations on disgorgement as discussed in Liu and other binding precedent.
Moreover, a common-law fraud counterclaim is not a panacea for all the adverse effects of fraud, as the equitable remedies of rescission and disgorgement are only intended to restore the status quo and ensure that the wrongdoer does not profit at the counterparty’s expense. When pursuing alleged fraud by a contractor, the government has multiple options other than a common-law fraud counterclaim (e.g., the False Claims Act) that it can use to punish and penalize the perpetrators of fraud. Equitable relief, however, is not to be used as a vehicle for punishment or to provide the government with a windfall.
