Can the False Claims Act1 be used as a payment bond defense for a surety? The issue comes to mind as a result of the United States Court of Appeals for the Eighth Circuit’s recently published decision in the performance bond case of Hanover Insurance Company v. Dunbar Mechanical Contractors, LLC.2 The Court’s overturning of summary judgment for the surety on its defense to a performance bond claim on a potential violation of the False Claims Act creates the possibility for similar results in a payment bond context. However, the case law on point in the payment bond context appears to be slim. Perhaps the lack of cases demonstrates that sureties have been doing better than other industries to avoid such costly snares in the payment bond context. Or, perhaps the Hanover case presents a novel decision at the circuit court level. Given a void in the jurisprudence to provide guidance on this issue, research for this article revealed another line of somewhat analogous case law which may point the way for understanding how some courts might address such issues as they arise in the future.
This article first briefly provides background on the federal False Claims Act for context. A review of the Hanover case and its unique circumstances sets the stage for the potential defense that the Eighth Circuit rejected at the relatively early stage of the project. We will then provide background on the use of equitable estoppel as a defense and related case law to discern a possible future direction for analyzing federal False Claims Act issues arising in circumstances similar to the Hanover case, but in a payment bond context.
I. The False Claims Act
Generally, the federal False Claims Act3 (“FCA”) is grounded in the concept of fraudulently conducted transactions and imposes significant liability on a defendant who knowingly presents fraudulent claims or makes a false record to support fraudulent submissions for payment by the federal government.4 Possible FCA violations may arise due to contractual relationships that are either entered into in a fraudulent manner or are conducted within the performance of the contract in a fraudulent manner. A founded violation of the FCA exposes the fraudster to potential liability for a civil penalty, treble damages sustained by the government, and the costs (including attorneys’ fees) of recovering the penalty or damages.5 It is conceivable that a surety could be charged with and found liable for an FCA violation in relation to its handling of a payment bond claim. As a result, sureties may attempt to use the FCA as a defense to discharge their obligation under a payment bond claim. The surety may assert, for example, that if it makes payment for stated claims, it risks triggering an FCA complaint against itself by participating in an illegal contract or scheme to improperly elicit payment from the federal government.6
II. Hanover v. Dunbar
While in the context of a performance bond claim, in Hanover Insurance Company v. Dunbar Mechanical Contractors, LLC, the Eighth Circuit announced its stance on sureties attempting to discharge bond obligations in relation to a default leading to an FCA violation.7 Arguably, the case reflects that the timing of the surety’s assertion is critical. In Hanover, the Army Corps of Engineers awarded a contract to Dunbar Mechanical Contractors, LLC (“Dunbar”) based on a Service Disabled Veteran Set-Aside Project (“SDVSAP”). Under the SDVSAP rules, Dunbar was required to qualify as a Service Disabled Veteran Owned Small Business (“SDVOSB”).8 Additionally, the rules required that Dunbar complete, or enlist other SDVSOB entities to complete, at least fifteen percent of the contract.
Dunbar subsequently entered into a subcontract with Harding Enterprises and separately its sole member (collectively “Harding”) to perform work on the project, subject to changes in its scope of work at the discretion of Dunbar.9 Hanover issued a performance bond related to Harding’s work on the subcontract, naming Dunbar as the obligee. As the project proceeded in its early stages, Dunbar informed Hanover that Harding’s subcontract was in default and that Dunbar planned to terminate Harding based upon the defaults. Dunbar demanded that Hanover perform its bonded obligations.10
Following Dunbar’s notification of claim and demand, Hanover investigated and subsequently filed a declaratory judgment action in federal district court seeking a declaration that it had no obligation to Dunbar under the bond because Harding was not an SDVOSB and Dunbar had subcontracted in excess of eighty-five percent of the work under the prime contract to Harding. Hanover alleged that Dunbar was violating the requirement for an SDVOSB to perform at least fifteen percent of the work required by the prime contract, a likely FCA violation.11 Hanover reasoned that if it completed the subcontracted scope of work as currently specified, it could be seen as contributing to the submission of claims to the federal government in violation of the FCA. In a motion for judgment on the pleadings that the district court converted into a motion for summary judgment, the district court agreed with Hanover that over ninety percent of the contract work had been subcontracted to non-qualifying subcontractors.12 The district court entered summary judgment in favor of Hanover and discharged the surety’s obligation under the bond.13 Dunbar appealed and requested that the Eighth Circuit examine whether the subcontracts between Dunbar and Harding violated the SDVOSB rules, and whether Hanover, if it performs its bonded obligations, was subject to potential liability under the FCA.14
In addressing the federal regulation violation, the Eighth Circuit found that there was insufficient evidence to determine whether the fifteen percent requirement was satisfied because Dunbar had the power to alter the scope of Harding’s work up to the point of completion.15 The Eighth Circuit held that Hanover could not presently avoid its bonded obligations because there was insufficient evidence to support the contention that it would indeed be subject to liability under the FCA in the future.16 Until there was more evidence – likely until the contract was fully performed and any actual breach of the minimum 15% subcontracting requirement occurred – Hanover would be incapable of proving a defense under the FCA based on the mere possibility that Dunbar could be fraudulently failing to perform its requirements under the SDVSAP.17 As a result, the Eight Circuit reversed the judgment of the district court and remanded the case for further proceedings.18 However, the court also provided some guidance for a surety caught on the horns of potential FCA liability under the circumstances presented: “[A surety] could either pay the obligee and, having satisfied its obligations, remove itself entirely from any further involvement, or perform under the bond while giving notice to the government of the potential for false claims if there is no further modification of contract performance.”19
As a result of the findings in Hanover, it appears likely that the Eighth Circuit would similarly rule on a payment bond matter involving a factually related potential FCA violation. However, different timing, facts, or a different FCA violation could potentially lead to an allowable discharge of a payment bond obligation.
Not all circuit courts of appeals have specifically addressed a surety’s attempt to discharge a payment bond obligation based upon an FCA violation. However, there is analogous case law under the doctrine of equitable estoppel which seems to provide some direction in how an FCA defense could work in favor of a surety. While these cases are not “on all fours” with Hanover, there are some similar fact patterns which allow for an intelligent comparison.
III. Equitable Estoppel
Generally, equitable estoppel prevents a party from “taking unconscionable advantage of [its] own wrong by asserting [its] strict legal rights.”20 The elements of equitable estoppel are:
(1) There must have been a false representation or a concealment of material facts; (2) the representation must have been made with knowledge of the facts; (3) the party to whom it was made must have been ignorant of the truth of the matter; (4) it must have been made with the intention that the other party should act upon it; (5) the other party must have been induced to act upon it.21
Of course, these elements vary by jurisdiction. Equitable estoppel is a possible defense available to sureties and may allow sureties to claim that improper or fraudulent actions by other parties could operate to discharge the surety of its payment bond obligations.22
A. Fifth Circuit
The Fifth Circuit recognizes a defense of equitable estoppel in the context of a payment bond claim.23 In Graybar Electric Co v. John A. Volpe Construction Co, Graybar was a material supplier to a subcontractor on a Miller Act project.24 The general contractor was concerned about its subcontractor’s finances early in the project and required several checks to be endorsed by the subcontractor to Graybar in an attempt to ensure proper payments under the contract.25 Unfortunately, Graybar then endorsed the checks back to the subcontractor.26 At the end of the project, Graybar made a payment claim for less than the value of the previously re-endorsed checks.27 Despite the fact that Graybar had provided its notice of the claim to the general contractor (which still held retainage on behalf of the subcontractor), the general contractor nevertheless released the retainage to the subcontractor.28 When the district court denied Graybar’s claims, on appeal Graybar refocused solely on the retainage paid to the subcontractor after Graybar provided notice of its claim.29 The Fifth Circuit affirmed that equitable estoppel may indeed be a defense to a Miller Act case.30 The court went on to find that the highly remedial nature of the Miller Act is meant to protect the innocent, which Graybar was not considering its re-endorsement of checks back to the subcontractor.31 In the circuit court’s view, the general contractor had done “everything it reasonably could do to protect itself short of completely taking over the operation of [its subcontractor]” and Graybar’s claims were properly equitably estopped and dismissed.32
B. Ninth Circuit
In United States ex rel. Westinghouse Electric v. James Stewart Co., the United States Court of Appeals for the Ninth Circuit reviewed a case wherein a surety successfully argued that a material supplier to a Miller Act project could be estopped from recovery under the payment bond.33 Westinghouse was a material supplier to a subcontractor on the project.34 The general contractor on the project became concerned that the subcontractor was not making payments to Westinghouse and made direct inquiry with Westinghouse.35 While Westinghouse was not being fully paid for its deliveries to the project, Westinghouse denied the general contractor’s offer to redirect payments as appropriate to meet Westinghouse’s needs. The general contractor and Westinghouse then agreed that Westinghouse would inform the general contractor if satisfactory payments were not being made to Westinghouse and, if no notice was received from Westinghouse, payments under the contract would continue to be made directly to the subcontractor.36 When no further word was received from Westinghouse related to payment issues, interim and final payments were made in due course to the subcontractor.37
As it turned out, Westinghouse received no further payments from the subcontractor through the remaining course of the project, and Westinghouse filed a payment bond claim related to its unpaid invoices after the subcontractor received its final payment.38 Westinghouse filed its lawsuit against the general contractor, the subcontractor, and the payment bond surety, and the case proceeded to a jury trial.39 The subcontractor became bankrupt.40 The general contractor and its surety relied on the affirmative defense of estoppel, related to the general contractor’s agreement with Westinghouse concerning ongoing payments under the subcontract.41 When the jury accepted the estoppel defense, Westinghouse sought appellate review and asserted that estoppel does not lie in a Miller Act case.42 Westinghouse further argued on appeal that because it had no direct contract with the general contractor, the law and public policy behind the law would not support the discharge of the general contractor and surety.43 The Ninth Circuit reviewed case law directly adverse to Westinghouse’s position and affirmed the jury’s verdict against Westinghouse.44
In another Ninth Circuit Case, Reliance Insurance Company (“Reliance”) issued a payment bond on a Miller Act project wherein a material supplier provided timely notice and filed suit because of non-payment from the general contractor.45 Reliance defended the payment claim on the basis of a pay when and if paid clause.46 The district court agreed with Reliance and granted summary judgment against the material supplier.47
On appeal, the Ninth Circuit focused on the statutory terms of when a claimant is entitled to recover under the Miller Act and whether there was a conflict between the contract clause (“when and if paid”) and the terms of the statute.48 The court recognized that the statute expressly allows a right of recovery on a payment bond that accrues ninety days after completion of the subcontractor’s work, “not when and if the prime contractor is paid by the government.”49 The court concluded that the pay when and if paid clause was not a valid waiver of Miller Act rights, as it lacked sufficient and express terms of a clear and explicit waiver.50 As a result, the court appeared to equitably estop the surety’s use of the pay when and if paid clause as an appropriate defense, and reversed the summary judgment in this regard.51
C. Second Circuit
The United States Court of Appeals for the Second Circuit allowed the application of the equitable estoppel defense to a payment bond claim.52 In United States ex rel. Hyland Electrical Supply Co. v. Franchi Bros. Construction Corp., a material supplier to a subcontractor accepted joint checks with the subcontractor on the project from the general contractor, endorsed the checks, then later booked payment, by agreement with the subcontractor, for part of the funds to the bonded project, and the other part to a previously incurred debt owed by the subcontractor.53 When the subcontractor went bankrupt, the material supplier provided notice and filed a claim for all unpaid supply invoices – not including credit for the full payments made under the joint check arrangement.54 The material supplier sought to estop the general contractor from disputing the altered payment stream based upon its alleged notice to the general contractor in regard to how the payments were actually booked.55 However, the appellate court found that the material supplier failed to prove its prejudicial reliance on the silence of the general contractor and, therefore, allowed the general contractor’s equitable estoppel defense to payment.56 While equitable estoppel was not utilized by the surety in the Hyland matter, the case additionally supports the use of the defense in the proper setting.
D. Eleventh Circuit
The United States Court of Appeals for the Eleventh Circuit also recognized the defense of equitable estoppel in relation to a payment bond claim.57 In the case of United States ex rel. Krupp Steel Products, Inc. v. Aetna Insurance Co., the court reviewed a procedurally complex matter.58 This was the second time the case came before the Eleventh Circuit. In Krupp, a material supplier to a subcontractor raised issues of non-payment.59 During the course of the project, the subcontractor presented two lien waivers that contained both an effective date and a distinct execution date.60 The surety claimed that the confusing dating on the documents led the general contractor to reasonably rely on the documents in making payments, which later turned out to be to its detriment, creating a disputed difference in the alleged claim.61 Based upon the jury instructions, the appellate court determined the case should be remanded for yet another proceeding to determine the factual issues related to the surety’s equitable estoppel claim.62
E. Fourth Circuit
In the case of United States ex rel. Damuth Services, Inc. v. Western Surety Co., Damuth supplied HVAC parts to a Miller Act project subcontractor.63 As the subcontractor was experiencing financial difficulties and not paying Damuth on its bills, Damuth agreed to various payment plans with the subcontractor in order to avoid informing the general contractor and surety of the defaults.64 Damuth continued to receive no payments from the subcontractor, despite the subcontractor’s agreements and receipt of payments from the general contractor.65 Damuth subsequently filed its notice and payment bond claim. The surety defended the claims based upon equitable estoppel and the district court entered summary judgment in favor of the surety on that basis.66 On appeal to the United States Court of Appeals for the Fourth Circuit, Damuth sought to downplay its role as merely remaining silent in relation to the failure of payments from the subcontractor.67 The appellate court found the agreement of Damuth and the subcontractor to be a violation of the appropriate payment protections and indemnity obligations, which attach to a properly and timely filed notice of claim.68 The court likened the behavior as “analytically similar to the false receipts provided in [another case] and the misleading arrangement undertaken in [yet another case],” and, therefore, affirmed the surety’s invocation of equitable estoppel to defeat the payment bond claim of Damuth.69
From the various cases discussed above, a potential for violation of the FCA does appear to be a defense for a surety. Situations where a subcontractor or material supplier fails to properly and adequately protect its payment stream, or where there are mismatches in documentation or contract documents versus the controlling statutory/regulatory authority, raise issues that may present a potential false claim and provide the surety with an opportunity to raise an FCA defense to a payment claim. However, the timing of the violation in connection with the defense by the surety seems to be the critical factor in relation to the result reached by the Eighth Circuit in Hanover. Moreover, the practitioner may also utilize the defense of equitable estoppel to defeat certain claims where a defense under the FCA may not be factually or procedurally proper.