The ongoing federal movement to prevent fraud waste, and abuse in the contracting process continues. And as demonstrated in a recent federal court decision, the government retains its ability to refuse to pay a procurement contract tainted by fraud.

In the recent decision of Laguna Construction Company, Inc. v. Ashton Carter, Appeal Number 15-1291, the U.S. Court of Appeals for the Federal Circuit affirmed that a procurement contract tainted by violations of the Anti-Kickback Act is voidable under the doctrine of prior material breach.

In 2003, the government awarded Laguna Construction Company a contract to perform work in Iraq. Under the contract, Laguna received 16 cost-reimbursable task orders to perform the work, and awarded subcontracts to a number of subcontractors.

In 2008, the government began investigating allegations that Laguna’s employees were engaged in kickback schemes with its subcontractors. In October 2010, Laguna’s project manager pleaded guilty to conspiracy to pay or receive kickbacks, conspiracy to defraud the United States, and violations of the Anti-Kickback Act, which broadly prohibits prime contractors from soliciting or accepting kickbacks in exchange for awarding subcontracts. The project manager admitted that, for approximately three years, he allowed subcontractors to submit inflated invoices to Laguna, and profited from the difference.

In February 2012, three principal officers of Laguna were charged with receiving kickbacks for awarding subcontracts. The company’s Executive Vice President and Chief Operating Officer also was charged with conspiring to defraud the United States by participating in a kickback scheme from December 2004 to February 2009, which he pleaded guilty to in July 2013.

After performing work until 2015, Laguna sought payment of past costs. The government refused a portion of these costs alleging that it was not liable because Laguna had committed a prior material breach by accepting subcontractor kickbacks under the contract. The Armed Services Board of Contract Appeals agreed, stating that Laguna “committed the first material breach under this contract, which provided the government with a legal excuse not to pay [Laguna’s] invoices.”

Laguna appealed to the Federal Circuit.  Laguna argued, in part, that any alleged breach was not material because the Government may audit and reconcile costs, thereby “assur[ing] that the Government will incur no damages.”

The Federal Circuit explained that, the prior material breach doctrine, a contractor’s claim against the government may be barred when the contractor breaches the contract through “fraud-based” contract.”  The court further explained that its decision comported with the Supreme Court’s instruction “that the government must be able to ‘rid itself’ of contracts that are ‘tainted’ by fraud, including kickbacks and violation of conflict-of-interest statutes,” citing to the Supreme Court’s prior rationale that:

[E]ven if the Government could isolate and recover the inflation attributable to the kickback, it would still be saddled with a subcontractor who, having obtained the job other than on merit, is perhaps entirely unreliable in other ways. This unreliability in turn undermines the security of the prime contractor’s performance–a result which the public cannot tolerate, especially where, as here, important defense contracts are involved.

In this case, the court wrote that Laguna “committed the first material breach” by agreeing to accept kickbacks from its subcontractors. The court held that “[t]he Board properly determined that these criminal acts constituted material breach that may be imputed to Laguna, since both employees were operating under the contract and within the scope of their employment when they ‘manipulated the contracting process.'”  The court denied Laguna’s appeal, and affirmed the ASBCA’s decision.

This decision provides a cautionary example of one of the many risks involved in accepting kickbacks for awarding subcontracts. The Anti-Kickback Act continues to provide for criminal, civil, and administrative penalties–and some of those penalties were assessed against Laguna’s employees. But the Laguna case demonstrates that violations of the Anti-Kickback Act (and other fraud-based breaches of a government contract) also may excuse the government from paying a contractor’s claim for additional contract costs.