A prime contractor’s exposure to liability under the civil False Claims Act (FCA) for misconduct by its subcontractors is well-established. Even where the misconduct occurred entirely at the subcontractor level, the Department of Justice (DOJ) and whistleblowers, who may bring claims on behalf of the government as “relators” under the FCA’s qui tam provisions, often view prime contractors—which tend to be larger companies with deeper pockets—as more attractive targets for FCA claims.
This type of claim against a prime contractor based on false claims submitted by the subcontractor typically turns on the FCA’s scienter, or knowledge, requirement. A prime contractor, of course, may be liable for its subcontractor’s improper conduct if the prime had actual knowledge of that conduct, including by participating directly in the alleged fraud. But a prime contractor also may be liable in the absence of actual knowledge if it acted with reckless disregard or deliberate ignorance toward a subcontractor’s compliance. In particular, liability may be imputed to prime contractors who ignore red flags about subcontractor misconduct.
This may seem harsh, but, given the overarching antifraud objectives of the FCA and its broad definition of “knowledge,” it might be fair to hold a prime contractor accountable if it buries its head in the sand or is in some way complicit in the underlying fraud. Efforts to recover under the FCA, however, can outstrip fairness when they impose inappropriate and unrealistic standards for prime contractors to ferret out wrongdoing by their subcontractors. DOJ and qui tam relators sometimes substitute their post hoc attempts to enforce the FCA for a prime contractor’s ex ante attempts to manage its compliance obligations.
Cases in which a subcontractor has allegedly caused the submission of a false claim pose difficult considerations for prime contractors, who might prefer to settle rather than face the risk, expense, and bad press involved in litigating an FCA case. On the other hand, conducting additional surveillance to reduce the chance of a subcontractor’s misconduct also would increase costs for prime contractors—costs that the government customer might not want to pay. So, what is a prime contractor to do?
This article first provides some examples of FCA settlements in which a prime contractor accepted liability based on its subcontractor’s misconduct, demonstrating that this question is not purely hypothetical. Second, the article recaps the legal framework for holding a prime contractor liable for its subcontractor’s misconduct. Third, the article highlights some examples of red flags that prime contractors should watch for and suggests some “best practices” for prime contractors to consider. Finally, this article discusses a prime contractor’s avenues for potential recourse if it finds itself in the difficult position of incurring FCA liability based on a subcontractor’s misconduct.
Based on DOJ’s public announcements of FCA settlements, examples of prime contractors accepting financial responsibility under the FCA for their subcontractors’ misconduct include the following:
These are just a few of many instances in which DOJ has pursued FCA allegations against prime contractors based on allegedly false certifications stemming from their subcontractors’ misconduct. The risk is not hypothetical.
The FCA’s knowledge, or scienter, requirement poses a statutory hurdle to holding prime contractors automatically liable for a subcontractor’s misconduct. Although not in privity of contract with the government, a subcontractor may be held liable for a violation of the FCA if it causes the prime contractor to submit a false claim. But at least in some circumstances, the prime contractor itself also might be liable for a subcontractor’s FCA violation if it knowingly presents a claim that is rendered false by the subcontractor’s conduct.
Merely passing along a false claim from a subcontractor is not enough to establish the prime contractor’s liability under the FCA. Instead, when the prime contractor presents the claim for payment to the government, it must have acted with the requisite scienter, or knowledge, that the subcontractor’s misconduct made the claim false. This knowledge requirement separates FCA liability from traditional contract liability, under which the prime contractor might be responsible for the actual damages that a subcontractor’s misconduct caused regardless of whether the prime contractor knew about the misconduct. A higher standard for FCA liability makes sense because, unlike a contractual recovery, the FCA may entitle the government to recover treble damages and additional money penalties for a contractor’s fraud, making the FCA remedies very different from routine contract remedies.
Scienter under the FCA does not require actual knowledge. Instead, the statute provides that “deliberate ignorance” or “reckless disregard” regarding the truth of information in a claim satisfies the knowledge requirement. Simple negligence does not establish knowledge under the statute; the “deliberate ignorance” and “reckless disregard” standards set a higher bar. In the context of ascribing a subcontractor’s misconduct to the prime contractor, liability attaches where the prime contractor’s “ostrich-like behavior itself becomes ‘a course of conduct that allowed fraudulent claims to be presented to the federal government.’”
But what qualifies as “ostrich-like behavior” by the prime contractor? The Federal Acquisition Regulation (FAR) does not require a prime contractor to take over quality control and testing from a subcontractor, so a prime contractor is not necessarily liable under the FCA for a subcontractor’s quality lapses and the associated false claims for payment. Instead, the prime contractor must ensure that subcontractors “have an acceptable quality control system” of their own and keep “substantiating evidence, when required by the contract, that the supplies or services conform to contract quality requirements.” The FAR thus adopts a practical approach to balancing the duties of a prime contractor and its subcontractors.
The FCA itself appears to recognize this balance. In 2004, the US District Court for the District of Columbia delved into this question in a case involving a program to conduct online auctions for the US Department of Housing and Urban Development’s portfolio of foreclosed properties. When the financial model underlying the auction did not work properly and the government thus received less money than it should have, a qui tam whistleblower claimed the prime contractor had recklessly disregarded evidence that the model was defective. The court observed, however, that Congress expected only a “reasonable and prudent” level of inquiry “under the circumstances,” which is “a limited duty to inquire as opposed to a burdensome obligation.” Only “gross negligence” will violate this duty. As the court explained, “[p]roof of reckless disregard requires much more than errors, even egregious errors.”
Applying this test, the court rejected the relator’s arguments that the prime contractor had not instituted “proper channels of communication” for complaints and “deploy[ed] only one employee” to oversee the subcontractors’ work. Nor did the court accept the argument that the prime contractor violated its supposed obligation to test its subcontractors’ results. On this point, the court found it important that the prime “did not represent that it would specifically test” its subcontractors’ work, that the subcontractors in question were “a prestigious scientific laboratory” and “a major financial services firm,” and that there was insufficient time for the prime contractor to perform a full audit or check that the system worked perfectly. The court noted that “[w]hile more extensive quality controls could have been in place (as is always the case),” the prime contractor’s failure “to create a system better attuned to the possibility of error . . . did not constitute ‘reckless disregard’ within the meaning of the [FCA].” And the court found it important that the prime contractor did not ignore warning signs but instead asked the subcontractor to double-check its work when doubts first arose. Perfection is not the standard for overseeing a subcontractor’s work.
Even the existence of potential red flags may not be enough to trigger the FCA’s scienter requirement for a prime contractor submitting false claims on behalf of its subcontractor. For example, in United States ex rel. Folliard v. Government Acquisitions, Inc., the US Court of Appeals for the DC Circuit held that a prime contractor was entitled to rely on its supplier’s certification that its products complied with the Trade Agreements Act (TAA). The court discounted an email from a lower-tier vendor stating that some of its products were produced in China, both because the email came after the sales that the whistleblower claimed were “false” and because the email referred to multiple versions of the product, including versions from TAA-compliant countries. The email thus was ambiguous and insufficient to put the prime contractor on notice that it might be selling noncompliant products to the government. The court likewise afforded no weight to an unsolicited price list that the supplier’s competitor shared with the prime contractor because there was no evidence the prime contractor ever reviewed it and because, like the email, it was not sufficiently clear. As Folliard demonstrates, the flags in question must truly be red, not merely pink—that is, they must be timely and unambiguous.
Sometimes, though, the flags are red enough that ignoring them can qualify as deliberate indifference or at least reckless disregard. For example, in United States v. Kellogg Brown & Root Servs., Inc., the US District Court for the Central District of Illinois held Kellogg Brown & Root (KBR)—the prime contractor—liable under the FCA when its employees questioned a subcontractor’s cost submissions, but KBR nonetheless billed the government for the inflated costs without any further investigation. Specifically, the subcontractor submitted costs so high that KBR’s employees stated in internal emails that the costs must have been inflated. KBR failed to investigate whether the costs actually were inflated and instead submitted a claim for payment to the government that included the inflated costs. Perhaps not surprisingly, the court found that it was reckless for KBR to trust the subcontractor’s claimed costs despite KBR’s own employees’ concerns.
A prime contractor also may be charged with knowledge of subcontractor misconduct when the prime contractor fails in its contractual duty to supervise the subcontractor’s work. For example, in a 2018 FCA settlement, Alutiiq Diversified Services, LLC, agreed to pay $683,987 for its failure to supervise a subcontractor on a project at Fort Drum, NY. Alutiiq had a contract to build a “shoot house” for a live-fire, close-quarters combat training facility, which had to be made from a specialized form of concrete. Alutiiq hired a subcontractor to manufacture the concrete blocks and assemble the building. The subcontractor failed to meet requirements for the specialized concrete and did not document any testing. Although Alutiiq failed to seek proper documentation of testing, it nevertheless certified compliance to the government. DOJ thus obtained an FCA recovery from Alutiiq under the theory that the prime contractor failed to perform the minimum level of supervision the contract required.
The caselaw discussed above charts out some general parameters for when a prime contractor is entitled to rely on its subcontractors, thus negating the scienter required to establish the prime contractor’s liability under the FCA for a subcontractor’s conduct.
First, although a prime contractor does not need to duplicate its subcontractor’s quality and compliance programs, the prime contractor should institute an appropriate quality surveillance regime.
Second, it seems generally safer for a prime contractor to rely on assurances from larger subcontractors with established reputations, particularly where the government knows the prime is relying on those assurances.
Third, a prime contractor should follow up on legitimate red flags, but those red flags should be sufficiently clear and unambiguous, and more than mere rumor or innuendo.
Guided by these general parameters, a prime contractor should ensure it conducts an appropriate level of quality surveillance for its subcontractors, particularly for smaller subcontractors with a less robust track record of compliance. To ensure its ability to perform that surveillance, a prime contractor should include a clause in its subcontracts giving it the right to conduct audits and investigations, especially (but not only) when there is some cause for concern. In addition, even where FAR 52.203-13, Contractor Code of Business Ethics and Conduct, is not a mandatory flowdown, a prime contractor should consider including a requirement for its subcontractors to report potential disclosure issues to the prime contractor, in addition to the agency Office of Inspector General and the contracting officer.
There are, however, at least two potential pitfalls to heightened scrutiny of a subcontractor’s compliance. First, prime contractors should be wary of unintentionally creating duties to supervise that might not otherwise exist, particularly where an increased duty of care ultimately could expose prime contractors to more liability down the road. Second, extra surveillance could be expensive, and the government customer might choose to award a contract to a lower-priced competitor or refuse to pay the increased compliance costs after award. As much as DOJ or a whistleblower may demand perfection after the fact, that is not the relevant legal standard under the FCA, and government customers are unlikely to be willing to pay the cost of pursuing such additional oversight in the first place—particularly where the additional oversight might not be necessary to meet the program’s requirements.
A prime contractor thus should think carefully about the appropriate level of scrutiny it gives to each subcontractor, and the prime contractor should document that assessment. That documentation might take the form of a quality assurance surveillance plan that specifies what level of subcontractor surveillance the prime contractor will and will not perform. To bolster its ability to point to the plan later in response to FCA allegations, the prime contractor should consider sharing the plan with the government, for example, in a proposal or a business systems audit. This will help give the prime contractor the protection enjoyed by the defendant in Folliard, which avoided FCA liability in part because it advised the government in advance about its reliance on its subcontractor’s certifications. Disclosures to the government not only put the government on notice of the limits of a prime contractor’s oversight, but they also help negate the impression that the prime contractor was trying to commit a fraud.
The best advice may be one of the oldest adages on the books: If it seems too good to be true, it probably is. Or, put another way, you get what you pay for. A prime contractor should be wary of a subcontractor’s surprisingly low prices or vague but implausible assurances about compliance. When in doubt, “trust but verify” might help manage the prime contractor’s FCA risks.
Following the steps outlined above should help prime contractors reduce their risk of FCA liability for a subcontractor’s misconduct. Sometimes, however, liability happens. When it does, what can a prime contractor do to mitigate the financial consequences? There are at least two strategies worth considering: First, reduce the amount of an FCA settlement, and second, obtain reimbursement from the subcontractor for the amount the prime contractor might pay the government due to the subcontractor’s misconduct.
A recent decision by the DC Circuit sheds useful light on how a prime contractor might be able to reduce the amount it must pay for a subcontractor’s FCA violation. In United States v. Honeywell International Inc., a case involving defective bulletproof vests, the court considered the apportionment of FCA damages among multiple parties in the supply chain, ranging from materials suppliers all the way up to the prime contractor. Honeywell was in the middle of that chain, buying the defective material from third-party vendors and selling it to the prime contractor. By the time the government litigated its case against Honeywell, it had already recovered $36 million from the other parties. By the government’s own calculation, though, the total FCA damages—even after trebling—were only $35 million. The government nevertheless argued that Honeywell should pay a proportionate share based on its own conduct, even though doing so would push the government’s recovery well beyond the maximum total damages.
Rejecting the government’s argument, the DC Circuit adopted the “pro tanto” rule urged by Honeywell, reducing Honeywell’s liability dollar-for-dollar by the other parties’ payments, even if that meant Honeywell would pay less than its proportionate share of the liability—or even nothing at all. The court rejected the “proportionate share rule,” under which “the government could recover more than its total damages solely because some parties settled.” As the court observed, avoiding a proportionate-share rule preserved the government’s discretion to choose which defendants to pursue and in what order, while keeping the courts out of the difficult business of assigning relative blame. The court also remarked that, although the Supreme Court had not expressly decided on the correct apportionment rule, it had applied the pro tanto approach in the Bornstein case. Under the pro tanto rule, the government is barred from recovering more than the full amount of its trebled damages, and a defendant is entitled to have its potential liability reduced by the amount of any earlier settlements or judgments for the same conduct.
The upshot of this rule is that it might pay to go last. Still, this strategy is not without its drawbacks. DOJ may choose to target the prime contractor first, or even exclusively, due to its privity with the government and (at least in many cases) its relatively deeper pockets. And if DOJ does target the prime contractor first, the prime’s dilatory tactics or refusal to settle could risk losing cooperation credit, which could lead to a larger liability and possibly other negative consequences, such as an increased risk of suspension or debarment. At the least, though, it is worth considering whether and how a prime contractor could position itself at the end of the payment line rather than at the beginning.
In the worst-case scenario, when a prime contractor is forced to bear most or even all of the potential FCA liability for its subcontractor’s misdeeds, the prime contractor may want to consider whether it can recover any of those costs from the subcontractor. Although the caselaw on this point is challenging, it may allow some avenues for recovery.
The US Court of Appeals for the Ninth Circuit has held that the defendant in a qui tam whistleblower case is prohibited from seeking contribution from thewhistleblower, even if the whistleblower was implicated in the misconduct at issue. This rule may preclude a prime contractor from seeking indemnification or contribution from a responsible subcontractor at least in some circumstances. For example, the Ninth Circuit’s decision might be read broadly to mean that a prime contractor cannot interplead and demand contribution from a subcontractor based on the theory that the subcontractor was responsible for the prime contractor’s violation.
In a subsequent decision, however, the Ninth Circuit clarified that an FCA defendant is not barred from pursuing claims that are “independent” from the FCA allegations, such as claims for unjust enrichment or negligent misrepresentation, rather than fraud. In addition, the court explained that, unlike a judgment in a litigated case, “a settlement agreement under the FCA should not, absent specific and clearly identified intent to the contrary, be viewed as an admission of liability that precludes non-FCA claims against third parties.” This latter point is key, given that many or even most FCA matters end in settlements rather than litigation and that DOJ’s standard settlement agreement provides that it does not constitute an admission of liability. A prime contractor that settles allegations of subcontractor misconduct thus may be able to seek indemnification or contribution from the subcontractor.
Bringing such a claim against the subcontractor, with the prime contractor serving as a qui tam whistleblower under the FCA, might be possible, but it likely would be challenging. The FCA contains no prohibition on parties who are potentially liable for FCA violations from serving as relators and indeed anticipates that some relators might have played a role in the misconduct. However, as discussed below, the FCA’s statutory bars might prevent a prime contractor from bringing an FCA suit against a subcontractor.
For example, the “public disclosure” bar could prevent the prime contractor from bringing an FCA suit where the conduct in question has already been made public. That seems particularly true if DOJ has described the conduct in an announcement of its settlement with the prime contractor.
Alternatively, if there is already an existing FCA case, the “first-to-file” bar might prevent a prime contractor from bringing its own FCA claim against its subcontractor. The first-to-file bar does not apply, though, when a subsequent FCA action is based on different “material elements” of fraud against the government, and adding a new defendant might be deemed a new material element. On the other hand, the US Court of Appeals for the Sixth Circuit has said that “the fact that the later action names different or additional defendants is not dispositive as long as the two complaints identify the same general fraudulent scheme.” In an attempt to reconcile these holdings, a court recently explained that a second action is allowed if it alleges “similar but different schemes and a separate injury caused by different defendants.” At the least, navigating the statutory bars to an FCA action would be both complicated and contentious.
Given the hurdles facing an FCA suit against a subcontractor, a prime contractor would likely have more luck with a plain-vanilla breach of contract or indemnification claim against the subcontractor. Although such an action would likely need to avoid the prohibition articulated by the Ninth Circuit, which prohibits a prime contractor from seeking contribution from the relator even if the relator was implicated in the misconduct, a prime contractor could still likely bring a contractual or common law claim for recovery of an FCA settlement payment and associated legal and other costs as long as the settlement did not include an admission of liability. Consistent with this approach, the US District Court for the District of Maryland recently allowed a complaint that sought only indemnification and contribution (without any independent claims) to proceed past the motion-to-dismiss stage. In that case, Blair Pharmacy and its owner were the only defendants in an FCA suit, but they filed a third-party complaint claiming that others took part in the alleged kickback scheme and should be forced to contribute to any judgment. Citing Cell Therapeutics, the court allowed Blair’s claim for common law contribution to proceed past a motion to dismiss, staying the new claim pending the resolution of Blair’s FCA liability. If Blair prevails on the claims against it or settles its FCA exposure with no admission of liability, the court presumably will allow Blair’s claim for contribution to proceed. This approach could be a model for prime contractors that find themselves paying to resolve a subcontractor’s violation of the FCA. Of course, strong indemnification terms in the subcontract will help the prime contractor make that case.
Prime contractors understandably may think it unfair for DOJ or a qui tam whistleblower to pursue the prime contractor for the misdeeds of its subcontractors, particularly where the prime contractor had neither direct involvement in nor knowledge of those misdeeds. To avoid this type of risk, prime contractors should take reasonable steps to monitor their subcontractors’ performance and to investigate clear and timely red flags when they come up. If, despite its best efforts, the prime contractor is nonetheless stuck with the tab, it should assess whether it has viable contract or common law claims to recover from the subcontractor who ran up the bill in the first place.
