The government knows—and exploits the fact—that loss amount is the driver of white collar sentences. In criminal contracting fraud cases, the government has taken the position that the relevant loss is the entire amount of the contract that was wrongfully obtained, even if the defendant fully performed under the contract and the government received everything it was promised under the contract.
This is an absurd position. Consider a typical breach of contract case. Party A sues Party B for breach of contract. During discovery, it becomes clear that Party A received everything it had bargained for under the contract. So what are the damages? Zero. Defendant wins.
A criminal case is, of course, not a civil breach of contract case. (The Civil Division has taken this same position in civil False Claims Act cases, too.) But that shouldn’t mean we leave common sense at the door when it comes to loss.
At least one court of appeals has pushed back on the government’s theory of loss in criminal cases. I wrote about the Third Circuit’s 2015 decision here.
Now, a second court of appeals has joined the Third Circuit in its skepticism about this calculation of loss. In a recent case out of the Fifth Circuit, United States v. Harris, the court of appeals reversed the defendant’s sentence in a government contracting fraud case because the lower court didn’t offset the contract values by the fair market value of the work performed by the defendant.
The Joint Venture
Thomas Harris, a former U.S. Army colonel, worked for Luster National, a contracting company with experience in large-scale government defense contracts. In an effort to secure lucrative contracts, he met up with Patricia and Charles Winters, who owned a “mom and pop” contracting company called Tropical Contracting. Tropical qualified under Section 8(a) of the Small Business Act, which is basically an affirmative action government-contracting program. To qualify, businesses must be owned and controlled by one or more socially and economically disadvantaged individuals.
Mr. Harris suggested to the Winters that Luster National and Tropical form a joint venture. Joint ventures are allowed under 8(a), subject to several important provisions. The two parties executed a joint venture agreement, acknowledging that they needed to ensure compliance with Section 8(a) and its related regulations.
The Problematic Contracts
Tropical did not have much experience with large-scale projects, so Mr. Harris served as the point of contact with procurement agencies. Over the course of its existence, the joint venture was awarded three contracts that were sole-sourced under Section 8(a), two of which are at issue in this case.
The first was the Galveston Project. The project was completed in two phases and Mr. Mr. Harris told Tropical from the get-go that Luster would do the project itself because “they knew what they were doing.” Tropical performed no work on this project. The joint venture was paid in several installments for the work, and 51% of the profits from the project went to Tropical.
The second contract was called the Fort Bliss Project. At the beginning of the project, the procuring agency informed Mr. Harris that there had been a change to the Small Business Act’s related regulations that stated that in the case of joint ventures, the qualifying agency must perform at least 40% of the work. Before the new regulation, the qualifying company was required only to perform a “substantial” portion of the work, without any specific percentage required.
Mr. Harris communicated with the Winters and his company regarding the new regulations. There were suggestions that Tropical put a few Luster employees on their payroll, but in the end, that never happened. Luster performed the whole contract without help from Tropical.
The Investigation, Trial and Sentencing
The FBI began an investigation, and the Winters agreed to cooperate against Mr. Harris. The Winters even recorded conversations with Mr. Harris, including one in which he said, “Well, you need to know Eric [Mullett] has been working very hard to try to make this look like, look to the SBA like we’re doing the right thing.”
Ultimately, Mr. Harris was indicted on 17 counts of wire fraud in the Western District of Texas. The 17 counts reflected the installment payments received for both projects. He was convicted on 16 of the 17 counts.
Here’s what happened at sentencing (as described in the court of appeals decision):
At sentencing, the district court began from a base offense level of seven. See U.S. Sentencing Guidelines Manual § 2B1.1(a)(1) (U.S. Sentencing Comm’n 2014). Harris received a two-level adjustment for his role in the offense, a two-level adjustment for abuse of a position of trust, and a sixteen-level increase under § 2B1.1(b)(1)(I) for the amount of loss sustained, resulting in a total offense level of twenty-seven. Because Harris was in the lowest criminal history category, his Guidelines range was 70–87 months. The district court departed downward and imposed a sentence of 24 months’ imprisonment followed by three years of supervised release, as well as a fine of $25,000.
The district court determined that an offense-level increase of sixteen levels was appropriate after having calculated the loss amount as approximately $1.3 million. That loss amount encompassed “the total amount awarded under both contracts,” “[n]ot including the payment corresponding to the count of wire fraud for which [Harris] was acquitted.”
The General Rule Beats the Government Benefits Rule
On appeal, Mr. Harris challenged the loss amount declared by the trial court, which encompassed the total amount ($1.3 million) awarded under both contracts, minus one payment on which he was not convicted.
The district court calculated this amount using the government benefits rule, which is in comment note 3(F)(ii) of § 2B1.1 of the Guidelines:
In a case involving government benefits (e.g., grants, loans, entitlement program payments), loss shall be considered to be not less than the value of the benefits obtained by unintended recipients or diverted to unintended uses, as the case may be. For example, if the defendant was the intended recipient of food stamps having a value of $100 but fraudulently received food stamps having a value of $150, loss is $50.
The government benefits rule is a special one, which departs from the general rule for loss calculation, which is in the Application Note 3(A) in the Guidelines. The court explained that
[t]he general rule looks to the greater of actual loss or intended loss—that is, the greater of the pecuniary harm that foreseeably resulted or that was intended to result from the offense.
The district court had adopted the government’s position that the government benefits rule should be applied, given that the case involved government benefits under the Small Business Act. The joint venture in its entirety was ruled the “unintended recipient” of the contract funds and the loss was determined to be the entire value of the contracts.
Harris argued to the district court, and argues again on appeal, that the government did not show any harm to the procuring agencies—USACE Galveston and Fort Bliss—because they received the work for which they paid under their respective contracts with the Joint Venture. Harris further argues that the loss amount resulting from his offense should reflect the harm caused to Tropical, not the procuring agencies, but that in either case the true loss amount is zero, because neither Tropical nor the agencies suffered pecuniary harm.
In short, his team argued that the general rule, rather than the government benefits rule, should have been applied. They were right.
Why the General Rule Applies
The Fifth Circuit found that the trial court should have applied the general rule here, because there is a specific rule of construction related to the general rule dictating how to construe losses “in the case of procurement fraud, such as fraud affecting a defense contract award.”
The court also stated that the Guidelines’ description of the government benefits rule listed its application to certain types of benefits. It provides the examples of grants, loans, and entitlement programs. These are all unilateral benefits, much different from the bargained-for exchange in the case of procurement fraud.
In accordance with the general rule,
“[l]oss shall be reduced by . . . the fair market value of the property returned and the services rendered, by the defendant or other persons acting jointly with the defendant, to the victim before the offense was detected.” § 2B1.1 cmt. n.3(E)(i).
Calculating the loss in this manner focuses on the pecuniary impact on the victims. In this case, the victims are the procurement agencies, not Tropical. Co-participants in these types of cases are only victims when the scheme “amounts to extortion,” which certainly did not happen here.
As the Fifth Circuit explained in some detail (emphasis mine):
The difference between the contract price and the fair market value of services rendered reflects the contracting agencies’ losses under their respective contracts—the difference between what they paid and what they received. It should come as little surprise that such a loss calculation coincides with one measure of common-law contract damages in a civil action for fraudulent inducement: “the difference between the value expended versus the value received” by the defrauded party, a measure which “allow[s] the injured party to recover based on the actual injury suffered.” Zorilla v. Aypco Constr. II, LLC, 469 S.W.3d 143, 153 (Tex. 2015). . . .
Treating the loss amount as the difference between the contract price and the fair market value of services rendered also reflects a “realistic, economic approach.” Such a loss calculation “is consistent with the idea that fraud is not always the same as theft,” even though the loss amounts resulting from both types of crimes are treated under § 2B1.1(b)(1). Martin, 796 F.3d at 1108. In some procurement fraud cases, the defendant pockets the entire contract price; in others, the defendant obtains by fraud a contract that he would not have obtained legitimately, but nevertheless performs the contract, pocketing only the difference between the contract price and his costs. See United States v. Schneider, 930 F.2d 555, 558 (7th Cir. 1991) (distinguishing between the two scenarios for loss calculation purposes). . . . Reducing the contract price by the fair market value of any services provided avoids treating identically these two meaningfully different types of fraud and ensures that the economic realities of each are reflected in the loss amount used to calculate the sentencing range.
On remand, the government will have the burden of showing any difference between the fair market value of the services received by the procuring agencies and the contract price.
Other circuits are split as to which rule to apply in the case of procurement fraud. The Fourth, Seventh, and Eleventh Circuits all use the government benefits rule. Meanwhile, the Ninth has rejected its use, using the same logic as applied here by the Fifth Circuit. The Third Circuit has left the determination undecided thus far, but remanded a case for determination of fair market value, suggesting strongly that the general rule will apply there.
Calling all Supreme Court practitioners: This issue is quickly becoming the subject of a clear circuit split. Perhaps the evenly-divided Supreme Court can bring some clarity at last.