Scollick Memorandum Opinion—Sureties and Producers Can Breathe a Limited, Fact-Specific Sigh of Relief
By David Robbins of Jenner & Block
As a follow up to his analysis on August 1, 2022 in the NASBP Blog, titled, “Scollick Memorandum Opinion – Sureties and Producers Breathe a Limited, Fact-Specific Sigh of Relief,” David Robbins provides the following more detailed analysis.
The surety industry closely watched the False Claims Act case U.S. ex rel. Scollick v. Narula et al., Case No. 14-cv-1339 (D.D.C.), for years as the case wound its way through federal district court in Washington, D.C. A former employee of a construction company filed this False Claims Act lawsuit against several companies, their principals, a bonding agency, and a bond producer, and the sureties that bonded the federal construction projects. The complaint alleged that the principals established shell companies to obtain multiple types of set-aside government contracts.
What alarmed the surety industry most was that the court determined in 2018 that the allegations against the bond agency, the bond producer, and the sureties (the court uses the term “insurance defendants” in its memorandum opinion and the same will apply in this article when referencing the actual defendants) were sufficient to survive a motion to dismiss and forced the parties into discovery. Specifically, the complaint alleged that the surety defendants had obtained information through the underwriting process that should have tipped them off that the contractors were violating government contracting requirements.
This was alarming because the underwriting process, with its focus on the “three Cs” of character, capital, and capacity, may create file documents that determined plaintiffs or government agents might later argue (unfairly and incorrectly) evidence knowledge of government contracting violations. Character is focused on whether the company lives up to its commitments, keeps its promises, and deals with others fairly and honestly. This is more of a subjective analysis. Capital and capacity, however, refer to whether the contractor has the resources and experience to perform the work under contract.
Because of the unique nature of federal contracting rules, military base construction projects are generally awarded in a rush, at fiscal year-end, and to small businesses. Sureties, which want credit-worthy bonding opportunities, are likely to have notes in their underwriting files addressing subjects about a contractor, including a contractor’s reliance on other businesses to complete work (in order to analyze capacity) and the availability of other sources of financing to the contractor (in order to analyze capital). Under government contracting rules, however, at some point over-reliance on other companies or other sourcing of financing violates small business set-aside contracting rules. The Scollick case sought to hold surety companies, a bonding agency, and a bond producer liable for those types of alleged violations.
But the underwriting file is completed solely for the surety to understand its risk and whether the surety is likely to need to pay out the penal sum of its bond if a federal construction project is not completed. The language is not always reviewed by persons understand government contracts, especially small business set-aside contracting compliance requirements. And surety industry participants, it is fair to say, are not small business set-aside contracting experts. Indeed, there is no duty assigned by the Miller Act (the statute requiring surety bonds for government construction projects) that requires sureties to notify the federal government about the results of bonding-related diligence. See 40 U.S.C. § 3131.
So the surety industry breathed a collective sigh of relief on July 29, 2022, when Judge Lamberth unsealed his opinion ordering the dismissal of all claims against the Scollick insurance defendants at the Summary Judgement stage. (Memorandum Opinion, Scollick, No. 14-cv-01339 (D.D.C. July 29, 2022), ECF No. 400).
Judge Lamberth noted in his Memorandum Opinion as follows:
“[The] most important issue running through all [these claims] is the knowledge possessed by the [i]nsurance [d]efendants.” But plaintiff-relator has produced no evidence permitting a reasonable jury to find that the insurance defendants had knowledge of the construction defendants’ fraud—“that they were fraudulently asserting status as SDVOSBs.” Because such knowledge is an essential element of all of the claims brought against the insurance defendants, the Court must grant summary judgment in their favor.”
Id. at 23 (internal citations omitted).
The court observed that, in the context of the FCA, “knowledge” requires either “actual knowledge,” “acting in deliberate ignorance,” or “acting in reckless disregard.” Actual knowledge is “subjective knowledge,” while deliberate ignorance is “the kind of willful blindness from which subjective intent can be inferred, and reckless disregard is “an extension of gross negligence or gross negligence-plus.” The court stated that “summary judgment is appropriate when plaintiff provides no evidence to support a finding of knowledge of an FCA claim, since knowledge is an essential element of the claim.” (Citations omitted.)
The court found that “[n]o evidence suggests that the insurance [defendants] knew the bids were fraudulent. There is only evidence that the insurance defendants knew the details of the bid proposals and some details of the ownership of CSG. This is insufficient to proceed on a theory of actual knowledge.” (Citations omitted.)
In addition, the court found that there was no deliberate indifference or reckless disregard on the part of the insurance defendants to support an FCA claim. In addition to faulting Plaintiff-relator for failing to proffer facts about producer and surety knowledge of violation of SDVOSB set-aside rules, the court noted the tremendous duty Mr. Scollick’s theory would impose on the industry. In declining to impose a need to understand specifics of government contracting rules, the court notes that doing so is “no ‘simple step,’ for the insurance defendants. This would impose a significant duty on third party insurers to familiarize themselves with Veterans Administration regulations before bonding companies. It is a significant leap in terms of liability. Without facts indicating that the insurance defendants knew of the specific SDVOSB requirements, this Court will not impose an affirmative duty on insurance and bonding companies to double-check the government’s verification.” Id. at p. 25 (internal citations omitted).
Particularly helpful in future cases, the court places the burden of complying with small business set aside rules in this case squarely upon the construction businesses. “[W]hile there is no doubt that participants in federal programs must familiarize themselves with the requirements, the insurance defendants are not “participants” in the federal VA SDVOSB program—the construction defendants are. It is the construction defendants who are obligated to familiarize themselves with the SDVOSB regulations, because they are dealing with and seeking payment from the federal government. . . . Plaintiff-relator has cited no cases—and the Court can find none—that place this obligation on a third-party insurer or bond underwriter.” Id. at pp. 25-26 (internal citations omitted, emphasis in original).
Indeed, the court faults Plaintiff-relator for trying “to construct a duty out of thin air” that insurance industry participants should have a “basic familiarity” with the concepts behind set-aside contracting. “But plaintiff-relator cannot point to any court recognizing this third-party burden for bonding companies, which ensure [sic] all federal contracts—not just SDVOSB-eligible ones.” Id. at pp. 26-27 (internal citations omitted, emphasis in original).
While this decision is not a panacea for sureties, bonding agencies, and bond producers, because it places emphasis on the existence of evidence of surety industry participants’ knowledge of government contracting rules, the decision will help the surety industry push back on the increasingly common claims that affirmative knowledge of a principal’s business, without more, is sufficient for False Claims Act liability. Additionally, surety defendants in False Claims Act cases can avail themselves of a legislative history argument that should further advance these arguments.
However, the legislative history for The Small Business Act of 1978 offers still more arguments for future surety defendants in False Claims Act actions. Where the Small Business Administration itself has judged a contractor eligible for a particular set-aside program, sureties can argue that, as long as the sureties are acting in good faith, the legislative history of the Small Busines Act permits sureties to rely on the SBA’s determination.
The conferees recognize the difficulty that prime contractors may have in determining whether a firm is owned and controlled by a socially and economically disadvantaged person [a key element to False Claims Act cases against sureties]. Contractors may therefore rely on written representations by their small business subcontractors that they are either a small business or a small business owned and controlled by a socially and economically disadvantaged person.
H.R. Conf. Rep. 95-1714, at 26-27 (1978), as reprinted in 1978 U.S.C.C.A.N. 3879, 3887.
As we see, the Small Business Act’s history is expressed in terms of when a prime contractor can rely on a subcontractor’s status and representations. If, according to Congress, prime contractors can rely on these indicia of eligibility, surety industry participants should be able to do the same. Indeed, doing otherwise may frustrate the purpose of the government’s small business contractor programs. Sureties may decide to exit the federal construction marketplace entirely, leaving the federal government to be the guarantor of federal construction projects, or sureties may make their own subjective determinations of a principal’s eligibility for set-aside programs. Which is precisely what Congress ought to avoid in small business subcontracting:
The myriad of differing fact patterns would lead to a host of varying interpretations at best, and an extreme potential for abuse at worst. . . . [P]rime contractors should be allowed as much certainty in dealing with the Government as practicable. A definitive statement as to the status of their subcontractors permits them to calculate the consequences of their actions with reasonable certainty.
H.R. No. 95-959, Rep. No. 95-949, at 11 (1978).
While the recent Scollick ruling dismissing claims against the insurance defendants is helpful and may slow the trend of False Claims Act suits against sureties and bond producers, more can be done to make future cases less likely to succeed. The legislative history arguments covered in this article may help courts further narrow the risk of potential False Claims Act liability for surety industry participants. After all, there is no reason why surety industry players, which by necessity are outside of the performance chain of a government contract, should be held to a higher standard than a prime contractor performing on that contract.
David B. Robbins is Co-Chair, Government Contracts Practice and a partner in Jenner & Block’s (https://jenner.com/) Washington, D.C. office and has extensive experience with False Claims Act litigation and investigations, including in the surety industry related to the construction of government buildings. Robbins ran the U.S. Air Force’s global Procurement Fraud Remedies Office and served, among other roles, as Deputy General Counsel (Contractor Responsibility). Robbins has a broad-based practice, and he is also the principal author and editor of the American Bar Association peer-reviewed book entitled The Procurement Fraud Guidebook: The System, Stakeholders, and Response Strategies. He can be reached at DRobbins@jenner.com or 202.639.6040.