When Is Subcontractor Fraud Imputed to the General

The Court of Federal Claims has held that fraudulent acts of subcontractors will not be imputed to general contractors for purposes of the "special plea in fraud" statute unless (a) the general contractor was aware of or complicit in the fraud, or (b) the general contractor’s claims are actually pass-through claims by the fraudulent subcontractor. N.R. Acquisition Corp. v. United States, 52 Fed. Cl. 490 (May 14, 2002).

The special plea in fraud statute (28 U.S.C. § 2514) requires dismissal of all claims by a government contractor when any aspect of that contractor’s performance is found to be fraudulent. The claimant may not segregate its claims. Rather, fraud in one aspect of performance taints the entire performance, and the fraudulent contractor loses all claims, regardless of whether those claims are specifically related to the fraud or not.

In 1993, N. R. Acquisition Corp. (NRA) signed an agreement with the Department of Defense’s Defense Reutilization and Marketing Service (DRMS), agreeing to purchase the decommissioned aircraft carrier the USS Coral Sea. NRA would then dismantle the vessel, and sell the scrap. The contract specifically noted the presence of multiple hazardous materials remaining in the 1947 vessel, including PCBs and asbestos. NRA was required to abide by federal regulations governing workplace exposure to and disposal of these materials.

Almost immediately, the contract went awry. Seawitch, the subcontractor hired by NRA to perform the scrapping, complained that it was encountering unexpectedly high quantities of hazardous materials. As it turned out, Seawitch was also violating many federal laws during its performance of the subcontract: asbestos was removed by unlicensed personnel; Seawitch lied on several required submissions to DRMS; and PCBs, debris and oil were unlawfully dumped into the ocean. In 1996, Seawitch’s CEO was indicted for multiple environmental crimes for Seawitch’s activities while working on the USS Coral Sea.

NRA attempted to recover by subcontracting out to one, then another salvage yard, then attempting a sale of the vessel to an Indian company, which was blocked by DRMS. In 2000, DRMS finally terminated the contract for default, citing missed scrapping deadlines and a failure by NRA to demonstrate ability to complete the contract. NRA filed suit, claiming damages from lost profit, failure of the government to disclose the scope and expense required by the environmental problems, the government’s frustration of the Indian sale, and a number of other claims totaling more than eight million dollars.

Faced with competing motions for summary judgment after a tortuous series of litigation maneuvers, Judge Bush of the Court of Federal Claims reduced the essential question to this: does the special plea in fraud statute operate so broadly that the environmental crime of a subcontractor taints the performance of the general contractor? In support of its contention that it does, the government cited Supermex, Inc. v. United States, 35 Fed. Cl. 29 (1996), wherein the court broadly interpreted the scope of 28 U.S.C. § 2514’s applicability. In Supermex, however, no subcontractor claims were presented, and so, although it recognized the case as a strong statement of the general application of the special plea in fraud statute, the Court held that Supermex did not support the attribution of subcontractor fraud to the general contractor. The court also discussed the government’s reliance upon United States v. Mississippi Valley Generating Co., 364 U.S. 520 (1961), in which the Supreme Court found that the fraud of a subcontractor could be attributed to the general contractor under 28 U.S.C. § 2514, and destroy the general contractor’s claims. In Mississippi Valley, however, the Supreme Court had specifically examined the claimant’s knowledge of and involvement in the demonstrated fraud, and found that they had been complicit in the scheme. The Court of Federal Claims held, therefore, that such knowledge was an essential step in allowing attribution of a subcontractor’s fraud to taint the performance of a general contractor. Since the record contained conflicting evidence on this point, the Court determined that summary judgment was inappropriate for either side.

The Court also examined the government’s claim that NRA’s claims were simply pass-through claims ascribable to the fraudulent contractor, Seawitch. Under Irwin & Leighton v. United States, 65 F.Supp. 794 (U.S. Ct. Cl. 1946), an innocent contractor may not act as a conduit for the fraudulent claim of its subcontractor, without putting its own claims at risk under 28 U.S.C. § 2514. The court did not disagree with this ruling, but stated that summary judgment on this point was not warranted. The court noted that NRA alleged damages from many sources, including all of the subcontractors and failed-deal partners, and neither side had attempted to break down exactly what claims arose from what aspect of the disastrously collapsed transaction. Therefore, the court ruled again that further development of the facts was warranted.

The special plea in fraud statute provides the government with a powerful weapon against contractors who attempt to submit or enforce claims tainted by fraud. The N.R. Acquisition Corp. case, however, clarified that an innocent contractor will not be stripped of his rightful claims based upon the fraud of a subcontractor of which he is innocent and unaware. This is a significant protection for a general contractor that acts in good faith but finds itself accused of another’s fraud. However, this case also makes clear that if a general contractor is complicit in the fraud of a subcontractor, or fails to investigate the claims that it is passing on from the subcontractor to the government, the consequences to the contractor’s own position may be dire.