Since its issuance last week, the Third Circuit’s decision in United States ex rel. Customs Fraud Investigations, LLC v. Victaulic Co., No. 15-2169, 2016 U.S. App. LEXIS 18026 (3d Cir. Oct. 5, 2016), has engendered considerable interest for its ruling with respect to reverse false claims liability in the growing arena of False Claims Act (“FCA”) cases arising out of the failure to pay customs duties. In that regard, the court interpreted a 2009 amendment to the FCA’s reverse false claims provision in the expansive manner advocated by both the relator and the United States. The decision therefore is unwelcome news for importers who have been facing an onslaught of FCA actions.

Troubling as that circumstance may be for businesses attempting to comply with complicated customs regulations, another aspect of the decision may be even more consequential, with an impact felt by defendants across the entire spectrum of FCA cases. In particular, the court appears to have sanctioned the use by relators (and the government) of untested “statistical” allegations to satisfy Rule 8(a) and 9(b) pleading standards. If so, the court may have made it much easier for FCA plaintiffs to withstand motions to dismiss in the very large and complex cases where pleading discipline is needed most—to rein in speculative allegations and the enormous discovery burdens that inevitably follow. We focus on that aspect of the Victaulic decision in this Alert.

Background of the Case

Fitting another emerging trend that deserves scrutiny in its own right, the Victaulic case was filed by an entity—Customs Fraud Investigations, LLC (“CFI”)—that apparently was created for the sole purpose of pursuing qui tam claims. In its complaint, CFI alleged that Victaulic, a pipe fittings manufacturer, had violated the FCA’s “reverse false claims” provision, which imposes liability on a defendant who “knowingly makes, uses, or causes to be made or used, a false record or statement to conceal, avoid, or decrease an obligation to pay or transmit money or property to the Government.” 31 U.S.C. § 3729(a)(1)(G).

An importer is obliged to pay a “marking duty” if imported goods are not marked with country-of-origin information before they are released into the stream of commerce in the United States. CFI alleged that Victaulic engaged in a ten-year scheme to defraud the government by importing pipe fittings without disclosing that the fittings were improperly marked (or unmarked) and without paying marking duties. CFI did not claim to have any inside company information to support its claims. Instead, CFI admittedly based its FCA allegations on a supposed statistical analysis involving: (1) CFI’s review of shipping data that it had purchased through a subscription service, and CFI’s conclusion from those data that Victaulic imported the majority of its pipe fittings from outside of the U.S.; and (2) CFI’s conclusion, following its analysis of a “sample” comprised of postings and photos on eBay, that virtually none of the Victaulic products were properly marked with their country of origin. 

Initially, the district court dismissed the complaint for failing to satisfy the Twombly/Iqbal standard for plausibility. Then, the district denied CFI’s attempt to amend the complaint on the grounds that the motion to amend was not timely, did not satisfy Rule 9(b), and, in any event, would have been futile because any failure to mark the goods would not give rise to reverse false claims liability. Throughout, the district court found serious flaws with CFI’s allegations, including CFI’s failure to demonstrate that any of the unmarked pipe fittings it identified in its survey were not U.S.-made and CFI’s failure to show that Victaulic had not paid marking duties on any fittings imported from abroad.

On appeal, the United States filed an amicus curiae brief solely to challenge the district court’s ruling that omission of country of origin markings could not give rise to FCA liability. In a split decision, the Third Circuit reversed the district court. In so doing, not surprisingly, the court generally adopted the United States’ position that the alleged conduct would be actionable as a reverse false claim. Keying in on the 2009 FERA amendments to the FCA, which added an express definition of the term “obligation,” and a Senate Report discussing the definition of “obligation,” the appellate court held that “[t]he statutory text, legislative history, and policy rationale underlying the regulatory scheme all lead to one conclusion: reverse false claims liability may attach as a result of avoiding marking duties.” Victaulic, 2016 U.S. App. LEXIS 18026, at *28-29. Many observers have commented on this aspect of the decision and noted its significance to cases basing FCA violations on such marking omissions.

The Court’s Plausibility Ruling May Make It Much Easier for Relators to Survive Motions to Dismiss

Beyond its interpretation of Section 3729(a)(1)(G), the Third Circuit also addressed the plausibility of CFI’s sweeping allegations of fraud. In so doing, the court determined that CFI’s allegations passed muster under Rule 8(a) because they were supported by a so-called statistical analysis. The court’s acceptance of CFI’s untested methodology for pleading purposes—absent any other indicia of fraud—is remarkable, and it likely will spur other relators to present equally speculative and unsupported allegations in the belief that such claims can survive early dismissal motions. This outcome could change the landscape for FCA litigation (particularly in cases alleging widespread fraudulent schemes) and may inhibit the ability of defendants and the courts to weed out speculative claims at the pleading stage.

Giving a nod to this concern—and perhaps prompted to do so by the arguments of a dissenting panelist (as discussed below)—the Third Circuit noted: “[t]he District Court was skeptical of the validity of CFI’s methods of determining whether Victaulic had imported unmarked goods. We, too, are skeptical.” Id. at *33. The Third Circuit also stated that “[t]here is little evidence to show that CFI’s unusual procedure of reviewing eBay listings is an accurate proxy for the universe of Victaulic’s products available for sale in the United States.” Id. Yet, remarkably, the Third Circuit reasoned that “such skepticism is misplaced at the Rule 12(b)(6) stage” and “CFI’s [amended complaint] contains just enough … to allege a plausible course of conduct by Victaulic to which liability would attach.” Id. at *33, 35.

While the Third Circuit noted that there is “great expense and difficulty that may accompany False Claims Act discovery and…burden on defendants and their shareholders and investors of having unresolved allegations of fraudulent conduct in pending proceedings,” id. at *35-36, it seemingly did not appreciate that such burden, difficulty, and expense is exactly why “skepticism” must be explored at the pleading stage. Instead of dismissing the complaint under Rules 8(a) and 9(b), the Third Circuit instead looked to “controlled discovery” as a panacea for such concerns. Id. at *37.

Dissent Explains the Flaws and Dangers Stemming from CFI’s Reliance on “Statistical” Allegations

While the Third Circuit’s majority decision acknowledged that CFI’s allegations “must of course be based on a reliable methodology,” id. at *30, it failed to ensure that CFI’s claims satisfied this standard. In so doing, it essentially left the “plausibility” determination to be decided at a later stage of the action. Yet, that day of pleading reckoning likely will never come. Instead, armed with evidence obtained in discovery, CFI almost certainly will rely on other information in an attempt to prove its claims at trial. Indeed, the likelihood that any court would admit at trial the “statistical” analysis proffered by CFI at the pleading stage is virtually nil.

The dissent recognized this problem and, in a methodical fashion, criticized CFI’s unscientific eBay methodology as unreliable evidence that did not support the plausible inference of liability required by Rule 8(a), let alone that “surpasses the high bar to allege fraud” required under Rule 9(b). Id. at *65-66 (Fuentes, J., dissenting). The dissent made clear that “CFI’s investigation into Victaulic’s imports is incapable of supporting the kinds of statistical inferences that CFI wants us to draw,” id. at *42, and listed a chain of no fewer than nine CFI assumptions, extrapolations, and inferences that did not validly and scientifically support the allegations of fraud, including the following:

  • Step three: Assume that Victaulic products available on eBay constitute a perfectly representative sample of Victaulic products for sale in the United States.
  • Step four: Assume that photographs on eBay are not stock images but rather accurate depictions of the physical items being sold. 
  • Step five: Assume that a nonrandom sample of 221 of Victaulic items for sale on eBay is also perfectly representative of Victaulic products sold in the United States.
  • Step six: While 40 items out of this 221-item sample contain unclear photographs, assume that we can rectify that problem with a nonrandom sample of ten items, examined in person.

Id. at *55-56 (emphasis in original). The full list goes on, but from this excerpt, it is clear that the statistical evidence did not reliably support the allegations against Victaulic because CFI had failed to follow two basic tenets of statistical sampling: (1) survey the correct population, and (2) use a random sample.

The dissent also demonstrated why the majority’s reliance on CFI’s “expert” declaration (attached as an exhibit to CFI’s proposed amended complaint) was misplaced, describing the declaration’s “rhetorical gambit” of merely repeating CFI’s conclusions using technical-sounding terms. Id. at *61.

Key Take-Aways

The Third Circuit’s decision to permit CFI to proceed with its FCA claims based on a flawed and untested statistical analysis in the absence of any other evidence of fraud lays the groundwork for future abuse. The plausibility and particularity pleading standards of Rules 8(a) and 9(b)—and the policy rationales on which they are based—are not so easily satisfied. It is of little comfort that the Third Circuit recognized and sought to mitigate this danger by suggesting that the district court employ “controlled discovery.”

Moreover, even where plaintiffs present an admissible statistical study, FCA allegations should not be allowed to proceed to discovery simply because fraud could have occurred, in a mathematical or scientific sense. There also must be factual allegations, or a level of proof, that make other plausible explanations unlikely and that allow defendants to be on notice, with particularity, of the allegations against them. As the dissent pointed out, “a federal lawsuit is not a mechanism to confirm a vague suspicion that fraudulent conduct occurred.” Id. at *66 (emphasis in original).