Background Facts

A United States District Court in California recently dismissed a False Claims Act (FCA) suit in which the plaintiff (the "Relator") alleged that Honeywell International Inc. ("Honeywell") fraudulently charged license fees for software provided to the government.[1]

Honeywell supplied navigation software for certain military aircraft programs through a subcontract with General Atomics, which served as the prime contractor for the government.  The Relator worked as a subcontract administrator for General Atomics.  During subcontract negotiations, the Relator disagreed with Honeywell’s position that its software was a commercial item.  The subcontract manager also disputed Honeywell’s contention that the “core EGI” software delivered to the government had been developed by Honeywell at private expense.  Instead, the Relator contended that the software was not “commercial” because it had never been sold to a government customer and, further, that it had not been developed purely at private expense.  The Relator claimed that the core EGI software had been materially changed through the integration of government-funded software.  The Relator contrasted this materially changed version of the software with other navigation software that Honeywell sold to the commercial market.  The Relator contended that because the government had partially funded the software, it had acquired “government purpose” rights in it.  The Relator alleged that Honeywell committed fraud by charging the government $250 million in license fees.

Honeywell acknowledged that it had never sold the particular software used for military aircraft to the government, but argued that it still qualified as a commercial item because it was “of a type” available in the commercial marketplace.  The court declined to resolve this particular dispute because it found that the case had to be dismissed on other grounds.  In particular, the court found that the Relator had failed to establish an essential element of his fraud claim—that Honeywell had knowingly or recklessly misled the government concerning the nature of its license fees.  Instead, the court found that Honeywell had consistently advised the government that it considered its core EGI software to be a commercial item, and that its license fees applied only to software developed entirely at private expense and not to any additional development or other work funded by the government.  While the court acknowledged that the Relator disputed Honeywell’s interpretation of the regulations covering “commercial items” and “segregability,” it did not deem Honeywell’s interpretation, and its reliance on that interpretation, to be fraud.  

A Growing Trend

The Honeywell case is a good example of a growing trend in which relators pursue fraud claims based not on an alleged misrepresentation of fact but on a defendant’s use of “incorrect” legal theories during the course of contract performance to justify costs charged to the government.  In the Honeywell case, for example, the Relator knew that Honeywell had fully disclosed its position during the course of contract negotiations and that the Contracting Officer had accepted Honeywell’s interpretation of the regulations.  For example, the CO had agreed that Honeywell’s core EGI software was a commercial item.  Nonetheless, the Relator argued that because Honeywell’s legal interpretation was “without foundation,” the CO’s determination had to be ignored.

The briefs filed in the Honeywell case show that the Relator failed to grapple successfully with the doctrine of segregability.  Under that doctrine, the determination of the source of funds used to develop computer software (and technical data) is made at the “lowest practicable segregable portion of the software”[2]—for example, a software subroutine that performs a specific function.  For practical purposes, the doctrine permits a contractor to assert proprietary rights in portions of deliverable software that were developed exclusively at private expense.  As a consequence, it is a widely held view that a contractor may charge the government a license fee for commercial or privately developed segregable portions of software developed with government funding.

The Relator in Honeywell acknowledged in his pleadings that the company may have funded the core EGI software with private funds.  Yet the Relator failed to allege that the core EGI software was not segregable from government-funded portions.  Instead, the Relator alleged that the lowest practicable level of the core EGI software was the core EGI software itself and the core EGI software was “materially changed” by the integration of government-funded software.

As noted above, the court did not announce a “winning” legal theory, but focused instead on plausibility.  The court found that a plausible explanation for Honeywell's assertion of its right to charge a license fee was that Honeywell believed in good faith that it had a right to charge for privately funded segregable functions and capabilities of the core EGI software.  The court noted that the Relator had provided no basis for his assertion that the lowest practicable level of the core EGI software was the core EGI software itself.  And the court emphasized that the government was aware that its software license did not cover the EGI software as a whole, but only the individual software “functions and capabilities” of that software.  The court further observed that it was plausible for Honeywell to have believed in good faith that the core EGI software was a “commercial item.”

Practice Tips

Honeywell helps illustrate how important it is for contractors to act based on plausible legal theories and to communicate those legal theories to the government.  In the case of contractors that provide computer software, this communication would tend to focus on the following three areas to the extent there are supportive facts: (1) software that meets the commercial item definition; (2) software that was developed at private expense; and (3) software portions that are segregable from otherwise government-funded software.

More specifically, to the extent facts are supportive, contractor disclosures to the government might explain:

1. Deliverable software is commercial item software[3] and/or developed exclusively at private expense.
2. Alternatively, a “core” portion of the software is commercial item software and/or developed exclusively at private expense; and
   • The core portion is segregable from the government-funded portion, and
   • The company is charging license fees only for the core portion.

Communicating with the government in this way helps the contractor avoid FCA liability.  Such communication shows that the contractor acted openly and in good faith and, therefore, could not have possessed the mental state necessary to establish liability under the FCA.[4]

[1] United States v. Honeywell International Inc., Case No. 12-02214 (C.D. Cal. 2014).  The FCA allows individuals to sue on behalf of the United States to recover damages for fraud and to retain a percentage of the recovery.  Such plaintiffs are known as “relators” because they have “related” the existence of the fraud to the government.  The United States has the right to intervene and take over any such lawsuit.  Typically, relators hope for such intervention so that they can let Department of Justice (DOJ) attorneys take up the laboring oars, and then collect their percentage of any judgment or settlement.  DOJ intervention also signals to the court that the government takes the allegations seriously, although technically no adverse inference is supposed to be drawn if the government declines to intervene.  In this case, the government declined to intervene.

[2] Department of Defense Federal Acquisition Regulation Supplement 227.7203-4(b).

[3] This explanation might include in some detail the reasons why the software meets the “commercial item” definition at FAR 2.101.

[4] See, e.g., United States ex rel. Oliver v. Parsons Co., 195 F.3d 457, 464 (9th Cir. 1999) ("A contractor relying on a good faith interpretation of a regulation is not subject to [FCA] liability . . . because the good faith nature of his or her action forecloses the possibility that the scienter requirement is met.").