Qui Tam Claims and Derivative Actions

The decline of class actions has been accompanied by an expansion of lawsuits under the FCA (sometimes called 'qui tam' actions after their common-law ancestor) in which a private citizen (the 'relator') with knowledge of a party's fraud against the government may bring an action on the government's behalf. In recent years, Congress has struggled to find an appropriate balance between encouraging private citizens to report fraudulent activity through qui tam actions and discouraging purely parasitic suits based on information about which the government was already aware.

Following a number of lawsuits perceived as parasitic, Congress amended the Act for the first time in 1943. The amendments were largely inspired by United States ex rel. Marcus v. Hess, 317 U.S. 537 (1943), in which the relator recovered part of the resulting award despite copying the allegations outlined in his complaint from publicly disclosed material to which the government already had access. By reducing the relator's share of any recovery and eliminating qui tam suits where the relator was not an original source of the information, the 1943 amendments effectively eliminated such suits altogether.

In response to public concern surrounding wasteful and fraudulent defense spending in the early Eighties, the 1986 amendments to the FCA encouraged private citizens to bring qui tam actions again by: 1) increasing the relator's share; 2) allowing for treble damages; 3) protecting employee whistleblowers; 4) extending the statute of limitations; and 5) reducing the burden of proof to establish fraud. These changes were extraordinarily successful resulting in over $20 billion in civil penalties.

Notwithstanding these changes, the 1986 Amendments attempt to limit parasitic suits by requiring that a qui tam suit satisfy certain jurisdictional requirements before a court may consider it. The statute provides in 31 U.S.C. ' 3730(e)(4) that no court shall have jurisdiction over a qui tam suit based upon allegations that have been publicly disclosed unless 'the person bringing the action is an original source of the information' (emphasis added). For many years, the circuit courts struggled to define and apply this 'original source' requirement, generating a myriad of divergent opinions. While some courts ruled that an original source needed direct and independent knowledge of the allegations and must also have played some role in publicly disclosing the fraud, see, e.g., United States ex rel. Wang v. FMC Corp., 975 F.2d 1412 (9th Cir. 1992), others held that the relator who independently discovered the information must also have been the first party to provide the government with that information. See, e.g., United States v. Bank of Farmington, 166 F.3d 853 (7th Cir. 1999).

The Rockwell Decision

A recent ruling by the Supreme Court, however, clarifies the FCA's 'original source' mandate and rejects those decisions that took a more expansive view. In Rockwell Int'l Corp. v. United States, ' US ', 123 S. Ct. 1397 (2007), a former employee, James Stone, reported to the FBI that while he had worked there, Rockwell had manufactured faulty 'pondcrete' that was leaking toxic waste into the environment. A government investigation into Stone's allegations led Rockwell to plead guilty to ten environmental violations and to pay $18.5 million in criminal fines. Shortly thereafter, Stone filed a qui tam suit based on his claims. His amended complaint, however, relied solely on the government's post-intervention allegations to the exclusion of his original claims.

The Supreme Court, in a decision authored by Justice Scalia, concluded that Stone did not satisfy the statutory requirement as an 'original source' of the information because the term 'allegations' in the FCA's definition of original source, which requires the relator have 'direct and independent knowledge of the information on which the allegations are based,' relates to the allegations made in the last amended qui tam complaint and not to the allegations that have been publicly disclosed. Because the amended complaint focused only on events that had occurred after Stone was no longer working at Rockwell, the Court held that Stone lacked the direct and independent knowledge of the allegations in the amended complaint as required under the FCA.

Congressional Response

While Rockwell continues the judicial tightening of the qui tam requirements, some members of Congress are pushing in the opposite direction. The proposed False Claims Act Correction Act of 2007, S. 2041, 110th Cong., would (among other things) eliminate the requirement that the relator have 'direct and independent knowledge of the information' on which the claim is based. Instead, it would bar only claims based exclusively on information that has been made on the public record or has 'otherwise been disseminated broadly to the general public.' Thus, claims could be based solely on information obtained under the Freedom of Information Act so long as it had not been publicly disclosed. This bipartisan legislation was introduced by Senators Charles Grassley (R-IA) and Dick Durbin (D-IL) and is cosponsored by Judiciary Committee Chairman Patrick Leahy (D-VT) and Ranking Member Arlen Specter (R-PA). Companion legislation will also be introduced in the House by Rep. Howard Berman (D-CA) who, together with Senator Grassley, sponsored the 1986 amendments to the FCA. The bill has been referred to the Senate Judiciary Committee.

Liability Resulting from Derivative Actions

Just as a qui tam relator becomes a vicarious plaintiff for the government, in derivative suits the plaintiff shareholders vicariously assert the rights of the corporation against the corporation's officers or directors for breach of fiduciary duty. Derivative suits may be increasing as well to fill the gap left by diminishing class actions.

Derivative actions have long been a popular vehicle for recouping some of a corporation's lost profits that are the result of wrongdoing by the corporation's directors and officers. Now they have been given a boost by recent legislation, long promoted by business groups and tort reformers, that attempts to curb perceived abuses by class action lawyers. Just two years ago, Congress passed the Class Action Fairness Act of 2005, which was aimed at preventing state court forum shopping to avoid the strictures of Rule 23, Fed. R. Civ. P., useless coupon settlements, and excessive attorneys' fees. Given these new limits, many attorneys have shifted their focus to derivative actions instead.

For example, in March 2007, Chiquita Brands International pled guilty to knowingly engaging in transactions with groups in Colombia listed by the U.S. government as terrorist organizations in violation of 50 U.S.C. ' 1705(b) and 31 C.F.R. ' 594.204. As part of its plea agreement, Chiquita was required to admit to its wrongdoing in a written proffer. Those admissions became the basis of a shareholder derivative suit, which alleged that several members of Chiquita's board of directors violated their fiduciary duties by allowing the company to pay Colombian terrorists despite receiving warnings that the payments were illegal. Complaint at 13-19, City of Phila. Pub. Employees Ret. Sys. ex rel. Chiquita Brands Int'l, Inc. v. Aguirre et al., No. 1 :07-cv-851, 2007 WL 3092978 (S.D. Ohio Oct. 12, 2007). The case is currently pending.

Conclusion

What does all of this mean for corporations preparing to voluntarily disclose their fraudulent activities to the government or enter into pleas? It's one more expansion of parallel civil actions that must be considered when representing a corporation trying to resolve criminal investigations. While the primary concern will remain the criminal case, companies will need to factor into their decision-making process how to address these types of civil cases.

Jonathan S. Feld ([email protected]), a member of this newsletter's Board of Editors and a former federal prosecutor, is a partner in the Chicago office of Katten Muchin Rosenman LLP, where he handles internal investigations for corporate clients and represents corporations and individuals in complex criminal and civil matters. Tiffani C. Siegel is a litigation associate at the firm.

'Parallel proceedings' is a term with which white-collar criminal defense lawyers and in-house counsel are very familiar. It describes the private civil actions that often are concurrently filed when a criminal investigation or charges are disclosed. The civil impact of criminal investigations and prosecutions begin and continue long after resolution of the criminal case. Indeed, once the corporation's alleged fraudulent actions or resulting settlement become public knowledge, often it is only a matter of time before an action is filed against its officers and directors.

For decades, parallel proceedings often took the form of a class action based on a corporate criminal guilty plea. Now that recent legislation has made the requirements for class actions much more stringent, two types of claims may well begin to appear as alternatives: False Claim Act (FCA) lawsuits (see 31 U.S.C.
” 3729 et seq.) and derivative actions. While a recent Supreme Court decision placed more stringent requirements on persons entitled to bring FCA cases, those restrictions may be overturned by the proposed legislation liberalizing FCA requirements. In addition, there has been an upsurge in derivative actions instead of class actions to seek damages.

Liability under the False Claims Act

The decline of class actions has been accompanied by an expansion of lawsuits under the FCA (sometimes called 'qui tam' actions after their common-law ancestor) in which a private citizen (the 'relator') with knowledge of a party's fraud against the government may bring an action on the government's behalf. In recent years, Congress has struggled to find an appropriate balance between encouraging private citizens to report fraudulent activity through qui tam actions and discouraging purely parasitic suits based on information about which the government was already aware.

Following a number of lawsuits perceived as parasitic, Congress amended the Act for the first time in 1943. The amendments were largely inspired by United States ex rel. Marcus v. Hess , 317 U.S. 537 (1943), in which the relator recovered part of the resulting award despite copying the allegations outlined in his complaint from publicly disclosed material to which the government already had access. By reducing the relator's share of any recovery and eliminating qui tam suits where the relator was not an original source of the information, the 1943 amendments effectively eliminated such suits altogether.

In response to public concern surrounding wasteful and fraudulent defense spending in the early Eighties, the 1986 amendments to the FCA encouraged private citizens to bring qui tam actions again by: 1) increasing the relator's share; 2) allowing for treble damages; 3) protecting employee whistleblowers; 4) extending the statute of limitations; and 5) reducing the burden of proof to establish fraud. These changes were extraordinarily successful resulting in over $20 billion in civil penalties.

Notwithstanding these changes, the 1986 Amendments attempt to limit parasitic suits by requiring that a qui tam suit satisfy certain jurisdictional requirements before a court may consider it. The statute provides in 31 U.S.C. ' 3730(e)(4) that no court shall have jurisdiction over a qui tam suit based upon allegations that have been publicly disclosed unless 'the person bringing the action is an original source of the information' (emphasis added). For many years, the circuit courts struggled to define and apply this 'original source' requirement, generating a myriad of divergent opinions. While some courts ruled that an original source needed direct and independent knowledge of the allegations and must also have played some role in publicly disclosing the fraud, see, e.g., United States ex rel. Wang v. FMC Corp. , 975 F.2d 1412 (9th Cir. 1992), others held that the relator who independently discovered the information must also have been the first party to provide the government with that information. See, e.g., United States v. Bank of Farmington , 166 F.3d 853 (7th Cir. 1999).

The Rockwell Decision

A recent ruling by the Supreme Court, however, clarifies the FCA's 'original source' mandate and rejects those decisions that took a more expansive view. In Rockwell Int'l Corp. v. United States, ' US ', 123 S. Ct. 1397 (2007), a former employee, James Stone, reported to the FBI that while he had worked there, Rockwell had manufactured faulty 'pondcrete' that was leaking toxic waste into the environment. A government investigation into Stone's allegations led Rockwell to plead guilty to ten environmental violations and to pay $18.5 million in criminal fines. Shortly thereafter, Stone filed a qui tam suit based on his claims. His amended complaint, however, relied solely on the government's post-intervention allegations to the exclusion of his original claims.

The Supreme Court, in a decision authored by Justice Scalia, concluded that Stone did not satisfy the statutory requirement as an 'original source' of the information because the term 'allegations' in the FCA's definition of original source, which requires the relator have 'direct and independent knowledge of the information on which the allegations are based,' relates to the allegations made in the last amended qui tam complaint and not to the allegations that have been publicly disclosed. Because the amended complaint focused only on events that had occurred after Stone was no longer working at Rockwell, the Court held that Stone lacked the direct and independent knowledge of the allegations in the amended complaint as required under the FCA.

Congressional Response

While Rockwell continues the judicial tightening of the qui tam requirements, some members of Congress are pushing in the opposite direction. The proposed False Claims Act Correction Act of 2007, S. 2041, 110th Cong., would (among other things) eliminate the requirement that the relator have 'direct and independent knowledge of the information' on which the claim is based. Instead, it would bar only claims based exclusively on information that has been made on the public record or has 'otherwise been disseminated broadly to the general public.' Thus, claims could be based solely on information obtained under the Freedom of Information Act so long as it had not been publicly disclosed. This bipartisan legislation was introduced by Senators Charles Grassley (R-IA) and Dick Durbin (D-IL) and is cosponsored by Judiciary Committee Chairman Patrick Leahy (D-VT) and Ranking Member Arlen Specter (R-PA). Companion legislation will also be introduced in the House by Rep. Howard Berman (D-CA) who, together with Senator Grassley, sponsored the 1986 amendments to the FCA. The bill has been referred to the Senate Judiciary Committee.

Liability Resulting from Derivative Actions

Just as a qui tam relator becomes a vicarious plaintiff for the government, in derivative suits the plaintiff shareholders vicariously assert the rights of the corporation against the corporation's officers or directors for breach of fiduciary duty. Derivative suits may be increasing as well to fill the gap left by diminishing class actions.

Derivative actions have long been a popular vehicle for recouping some of a corporation's lost profits that are the result of wrongdoing by the corporation's directors and officers. Now they have been given a boost by recent legislation, long promoted by business groups and tort reformers, that attempts to curb perceived abuses by class action lawyers. Just two years ago, Congress passed the Class Action Fairness Act of 2005, which was aimed at preventing state court forum shopping to avoid the strictures of Rule 23, Fed. R. Civ. P., useless coupon settlements, and excessive attorneys' fees. Given these new limits, many attorneys have shifted their focus to derivative actions instead.

For example, in March 2007, Chiquita Brands International pled guilty to knowingly engaging in transactions with groups in Colombia listed by the U.S. government as terrorist organizations in violation of 50 U.S.C. ' 1705(b) and 31 C.F.R. ' 594.204. As part of its plea agreement, Chiquita was required to admit to its wrongdoing in a written proffer. Those admissions became the basis of a shareholder derivative suit, which alleged that several members of Chiquita's board of directors violated their fiduciary duties by allowing the company to pay Colombian terrorists despite receiving warnings that the payments were illegal. Complaint at 13-19, City of Phila. Pub. Employees Ret. Sys. ex rel. Chiquita Brands Int'l, Inc. v. Aguirre et al., No. 1 :07-cv-851, 2007 WL 3092978 (S.D. Ohio Oct. 12, 2007). The case is currently pending.

Conclusion

What does all of this mean for corporations preparing to voluntarily disclose their fraudulent activities to the government or enter into pleas? It's one more expansion of parallel civil actions that must be considered when representing a corporation trying to resolve criminal investigations. While the primary concern will remain the criminal case, companies will need to factor into their decision-making process how to address these types of civil cases.

Jonathan S. Feld ([email protected]), a member of this newsletter's Board of Editors and a former federal prosecutor, is a partner in the Chicago office of Katten Muchin Rosenman LLP, where he handles internal investigations for corporate clients and represents corporations and individuals in complex criminal and civil matters. Tiffani C. Siegel is a litigation associate at the firm.