Second Circuit Closes Down Government's "Materiality Manufacturing"

As 2020 drew to a close, the Second Circuit issued one of the most consequential materiality decisions of the year. In United States v. Strock, No. 19-4331, 2020 WL 7062274 (Dec. 3, 2020), the court held that the relevant "payment decision" under Escobar, at least in fraudulent inducement cases, includes both the government's decision to award a contract in the first instance and the subsequent decisions to pay claims under the contract. The court also emphasized that post-payment enforcement efforts are of little probative value in determining materiality as they allow the government to engage in consequence-free "materiality manufacturing."

The government in Strock alleged that the defendants fraudulently induced the government to award a contract reserved for service-disabled veteran-operated small businesses (SDVOSBs) by mispresenting their status as a SDVOSB. The defendants moved to dismiss on materiality grounds, arguing there was no allegation that the government refused to pay claims under the contract. The government, however, argued that the relevant "payment decision" was the government's initial decision to enter into the contract, not the ultimate decision to pay claims, and the defendants' misrepresentation was material to that initial award decision. The district court adopted the defendants' approach and granted the motion to dismiss.

The Second Circuit reversed, providing (to our knowledge) the most in-depth look yet at how the Escobar framework applies to fraudulent inducement cases. The court first rejected the district court's view, reasoning that the decision to enter into a contract "undergirds any decision to ultimately pay claims arising under the contract." The court further noted that Escobar itself contemplates liability for "misrepresenting compliance with a condition of eligibility to . . . participate in a federal program." (emphasis added). But the court did not endorse the government's singular focus on the initial award decision. Instead, emphasizing that Escobar "eschew[ed] a materiality analysis that prioritizes the government's claims about how it would treat a requirement over how the government actually treats a requirement upon discovering a violation," the Second Circuit held that, in fraudulent inducement cases, both the initial decision to enter into the contract and the subsequent decisions to ultimately pay claims under it must be considered in assessing materiality.

Applying this rule, the Second Circuit held the government had sufficiently alleged materiality because defendants would never have received the contract had they not misrepresented their eligibility for SDVOSB contracts, and the SDVOSB requirement was "at the very heart" of the statutory and regulatory scheme. In so doing, however, the court made some noteworthy observations (applicable to all False Claims Act cases, not just those based on a fraudulent inducement theory) about the relevance of post-payment government enforcement efforts. The government's principal post-award materiality allegation in Strock was that it "regularly prosecuted, both criminally and civilly, parties that fraudulently obtain SDVOSB set-aside contracts." The Second Circuit held that such allegations "do not carry the same probative weight as allegations of nonpayment," reasoning that "[a]llowing the government to rely on post hoc enforcement efforts . . . would allow [it] to engage in . . . materiality manufacturing, and at relatively low cost." While enforcement efforts might carry "some weight" in certain contexts, the key question is "whether the government 'consistently refuses to pay claims,' not whether [it] later pursues damages or criminal prosecution."

Strock teaches a few lessons. Although both the initial award decision and the decision whether to pay actual claims are relevant to materiality in a fraudulent inducement case, misrepresentations about eligibility for the award will likely be afforded significant weight—at least at the motion to dismiss stage. If, however, there is evidence of continued government payment despite knowledge of noncompliance, the government should not be able to rely solely on the initial award decision to survive summary judgment. Strock also has broader significance outside the fraudulent inducement context, offering a powerful response to DOJ's frequent refrain that its own enforcement efforts establish materiality despite continued payment by the agency.

© Arnold & Porter Kaye Scholer LLP 2021 All Rights Reserved. This blog post is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.