United States: Second Circuit Adds To Case Law Addressing Whether A Relator's Release Of FCA Claims Is Enforceable

The Second Circuit recently added to case law addressing the issue of whether a relator's release of False Claims Act (FCA) claims prior to the relator's qui tam action is enforceable. United States ex rel. Ladas v. Exelis, Inc. The circuit reversed the district court's holding that the release was enforceable, disagreeing with the court's conclusion that the Government had sufficient knowledge of the allegations of fraud prior to the release. The circuit, however, affirmed the Court's dismissal of the amended complaint because the plaintiff did not plead fraud with sufficient particularity, and the district court did not abuse its discretion in denying leave to amend.

In 2005, defendant ITT Power Solutions, Inc.'s (Power Solutions) parent, ITT Corporation (ITT), was awarded a contact to provide the United States with certain devices. The contract required that the devices meet particular specifications. For instance, equipment produced after any change to the manufacturing materials or process that had the potential for causing a deviation from the specifications was required to be subjected to product qualification tests, and such changes were required to be submitted to the Government for approval.

Power Solutions entered into a subcontract with defendant, Innovative Mold Solutions, Inc. (IMS), to manufacture casing devices. IMS delivered components to Power Solutions, which sent them to another ITT business unit for assembly of the devices.

In 2007, IMS made substantial changes in the manufacture of one of its components. Specifically, it used less expensive adhesive material and changed the process for applying that material. An engineering professor alerted the ITT assembly unit that IMS' change related to adhesive application would require significant additional testing, but no testing was performed, and the changes were not submitted to the Government for approval. In 2009, Power Solutions began documenting problems with the IMS components. IMS admitted to Power Solutions that it had introduced changes in 2007.

Plaintiff Michael Ladas was Director of Quality at Power Solutions from 2006 until March 2010. In mid-2009, after Power Solutions became aware of the IMS changes, the Power Solutions quality assurance department advocated disclosure of the contract violations to the Government and drafted a request for a Government waiver of the deviations, but the waiver request was never sent. Instead, ITT assembly unit employees sent the Government a "white paper" and a letter stating falsely that ITT had recently become aware of an IMS change; stating that no tests had identified degradation; and stating falsely that the adhesive used had not changed. The letter stated that there was no major change having any potential to affect any specification requirement. ITT continued to ship devices to the Government, fraudulently certifying that they had been produced in accordance with contract specifications and requirements.

In March 2010, Ladas' employment with Power Solutions was terminated, and he signed a separation agreement with a broad release of claims. He then commenced the qui tam action. ITT spun off its defense business in 2011, including Power Solutions and the assembly unit, to Exelis, Inc., which was substituted for ITT as a defendant. The Government did not intervene. Defendants moved to dismiss the amended complaint on several grounds. Relevant here, the defendants contended that Ladas lacked standing under Rule 12(b)(1) because he had released any claims against the company in his separation agreement. The district court granted the motions to dismiss, ruling in part that Ladas lacked standing because allegations of fraud were sufficiently disclosed to the Government before Ladas signed the separation agreement.

The Second Circuit disagreed with that holding, ruling that the release was unenforceable as a matter of public policy. The circuit court relied on two Ninth Circuit cases – United States ex rel. Green v. Northrop Corp. and United States ex rel. Hall v. Teledyne Wah Chang Albany – as providing a framework that courts have widely applied, focusing the inquiry on whether the allegations of fraud were sufficiently disclosed to the Government to make enforcement of the release consistent with public policy. The court in Green explained that a release of a qui tam claim entered into without the Government's knowledge or consent is unenforceable because it would impair a substantial public interest by nullifying the incentives the FCA gives to file such claims. Applying that framework, the Second Circuit held that Ladas' release was unenforceable because the Government did not have sufficient knowledge of Ladas' allegations, explaining that the white paper and accompanying letter disclosed only a change in "method" or "process" but not the change in adhesive. The court further explained that the white paper's conclusion– that the change in process should have no significant effect–was premised on a false statement that the adhesive used in the original process and the new process were the same. Also, ITT representations repeatedly emphasized that the change in process was inconsequential. Nothing in the white paper or the letter indicated that there was any fraud or that anyone had alleged fraud.

The Circuit nonetheless affirmed another ground for dismissal. The court ruled that the amended complaint failed to allege fraud with particularity required by Rule 9(b). The circuit also rejected Ladas' contention that the district court was required to allow him to file a further amended complaint to cure the Rule 9(b) deficiencies.

Originally published June 9, 2016

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