U.S. ex rel. Rose v. Stephens Institute: The Ninth Circuit Considers Escobar and its Materiality Mandate

Stephen_Wood_03032014Featured Expert Contributor, False Claims Act

Stephen A. Wood, Chuhak & Tecson, P.C.

Ed. Note: This is Mr. Wood’s inaugural post as the WLF Legal Pulse‘s latest Featured Expert Contributor. Mr. Wood is a Principal in Chuhak & Tecson’s Chicago, IL office and chairs the litigation practice group. He has authored numerous WLF publications over the past five years on the False Claims Act and other complex litigation matters.

Ever since the Supreme Court issued its opinion in Universal Health Services, Inc. v. United States ex rel. Escobar, 136 S. Ct. 1989 (2016), the lower courts have wrestled with the interpretation and application of the Supreme Court’s holding. The United States Court of Appeals for the Ninth Circuit became one of the latest reviewing courts to consider Escobar and its effect on that Circuit’s existing False Claims Act precedent.  The result in United States ex rel. Rose v. Stephens Institute, No. 17-15111, 2018 WL 4038194 (9th Cir. Aug. 24, 2018) was mixed.  The Court of Appeals held that Escobar overruled one precedent, but, in a sharply divided opinion, not another, thus demonstrating that Escobar continues to divide courts, especially over the element of materiality, foreshadowing further Supreme Court involvement in False Claims Act jurisprudence.  That involvement could come soon given that a petition for writ of certiorari is pending based on the Ninth Circuit’s decision in United States ex rel. Campie v. Gilead Sciences, Inc., 862 F.3d 890 (9th Cir. 2017), a case that also turned on whether the defendant’s claimed violations were material. 

Rose arises from false-claims litigation against the private, for-profit education industry.  The defendant operated a private art school in San Francisco.  Like many for-profit educational institutions, defendant offered financial aid to its students funded under Title IV of the Higher Education Act.  Relators in this qui tam action were former employees of the admissions department of the defendant, evidently responsible for finding and enrolling students.  They brought this action against the defendant for violation of provisions of the Act precluding incentive compensation related to student enrollment.

Specifically, both the statute and regulations prohibit schools from providing “any commission, bonus, or other incentive payment based directly or indirectly on success in securing enrollments or financial aid to any persons or entities engaged in any student recruiting or admission activities.”  See 20 U.S.C. § 1094(a)(20); 34 C.F.R. § 668.14(b)(22).  In addition, to qualify for Title IV funds schools must enter into a “program participation agreement’ with the Department of Education.  This contract contains yet a third statement of the prohibition on incentive compensation.

Relators alleged that defendant had a long-standing incentive component to its employee compensation in one form or another, in violation of the incentive compensation ban.  Starting in 2006, the defendant established a policy to increase enrollments by setting a target for admissions personnel.  To encourage people to meet or exceed this target, employees could earn up to $30,000 in additional compensation.  Failure could lead to a decrease in compensation by the same amount.

Although defendant’s policy contained a qualitative element, its employees understood that the numbers were what really mattered.  Later, defendant modified its incentive compensation program, implementing a “scorecard” system that rated admissions personnel on a variety of metrics, both qualitative and quantitative.  Still, an employee could earn up to $23,000 in additional compensation based on enrollment numbers alone.  Evidence also showed that managers were instructed not to share these scorecards with admissions employees out of concern that the policy ran afoul of the incentive compensation ban.

In this case, the relators asserted a theory of false certification, that is, they claimed defendant falsely certified compliance with regulations or contractual requirements, specifically the incentive compensation ban.  In Ebeid ex rel. United States v. Lungwitz, 616 F.3d 993, 998 (9th Cir. 2010), the Ninth Circuit first considered the implied false certification theory of False Claims Act liability.  The Court of Appeals noted that certification may either be express or implied.  In the latter case, the defendant’s certification of compliance with regulations and other requirements is not so much stated as inferred from the submission of a claim for payment.  In Ebeid, the Ninth Circuit joined other circuits in recognizing implied false certification as a basis for liability under the False Claims Act.

Of course, implied false certification was at the heart of the dispute in Escobar, and while the Supreme Court placed its imprimatur on the theory, it did so subject to clear limits.  And so, given the Supreme Court’s pronouncements on the subject in Escobar, the Ninth Circuit rightly took the opportunity to consider the vitality of both Ebeid and another long-standing, oft-cited precedent, United States ex rel. Hendow v. University of Phoenix, 461 F.3d 1166 (9th Cir. 2006).

In Ebeid, the Ninth Circuit held that to establish a claim under this theory, “a relator must show that (1) the defendant explicitly undertook to comply with a law, rule or regulation that is implicated in submitting a claim for payment and that (2) claims were submitted (3) even though the defendant was not in compliance with that law, rule or regulation.”  Id. at 998.  Under Ebeid, therefore, noncompliance was the linchpin of an implied false certification claim.

That standard, the Ninth Circuit held in Rose, was effectively overruled by Escobar.  An implied false certification claim under Escobar requires more than noncompliance: “first, the claim does not merely request payment, but also makes specific representations about the goods or services provided; and second, the defendant’s failure to disclose noncompliance with material statutory, regulatory, or contractual requirements makes those representations misleading half-truths.”  Rose, 2018 WL 4038194 at *4, quoting Escobar, 136 S. Ct. at 2001.  The Rose court concluded that the two-part test must be met in all implied certification cases without exception, until the Ninth Circuit, sitting en banc, decides otherwise.  Thus, Ebeid’s lower threshold standard of noncompliance was no longer good law.

Next, the Ninth Circuit turned to the question of whether Hendow’s materiality standard remained viable in the wake of Escobar.  In Hendow, a case also predicated on an alleged violation of the incentive compensation ban, the Ninth Circuit held that the requirement of materiality was met insofar as the prohibition on incentive compensation was set forth in three places, the Higher Education Act itself, a Department of Education regulation, and finally in the program participation agreement that the defendant executed.  This redundancy, the appellate court opined, was surely sufficient to demonstrate that the ban on incentive compensation was material to the Department’s decisions to provide Title IV funding for students: “the question [of materiality] is merely whether the false certification . . . was relevant to the government’s decision to confer a benefit.”  Hendow, 461 F.3d at 1173.

In Rose, the Ninth Circuit recognized that the “mere relevance” standard articulated in Hendow fell well short of Escobar’s materiality standard, which mandated consideration of not only whether payment was expressly dependent upon compliance (a relevant, but not dispositive, factor), but also whether the affected agency was aware of, and how it responded to, the claimed violation.  At this point, the members of the Rose panel parted ways, the majority, in essence, limiting Hendow’s materiality analysis to its facts, concluding that Escobar, rather, was merely “a gloss” on the Hendow materiality analysis, a gloss that nevertheless required consideration of the facts of each case.

Reviewing the record, the majority held that the evidence did not establish a lack of materiality as a matter of law.  Evidence of the Department’s past enforcement response and the magnitude of the defendant’s violation could lead a reasonable factfinder to the conclusion that the violation was material.  In arguing that its violations were not material as a matter of law, defendant relied on Government Accountability Office reports of violations of the incentive compensation ban and the Education Department’s response thereto between 1998 and 2009.  In none of those instances, defendant claimed, were the alleged violators terminated or their access to Title IV funds limited.  Although true insofar as it went, defendant’s argument ignored other enforcement responses contained in the data.  Most of the schools were ordered to initiate corrective action, some were fined, and others required to repay “improperly awarded federal funds.”  Fact issues, therefore, precluded summary judgment based on lack of materiality.

The dissent severely criticized the majority in three respects.  First, Hendow’s materiality standard was completely incompatible with Escobar.  Second, the majority’s discussion of materiality did not accurately describe the burden imposed on plaintiffs in proving a material violation.  And third, the majority erred in concluding that the evidence was sufficient to deny the defendant’s motion for summary judgment.  Regarding the first issue, to establish materiality Hendow relied solely on the triple redundancy of the incentive compensation ban, characterizing evidence of the Department’s enforcement power as “academic.”  Escobar held that labels while relevant are not dispositive.  Lower courts must consider evidence of whether the defendant knew it violated a requirement material to the government’s payment decision.  Thus, because materiality in Hendow turned solely on the wording of the requirements, it could no longer serve as precedent in such cases.

On the second issue, the materiality standard articulated in Escobar, the dissent noted, was demanding and rigorous, something the majority acknowledged but characterized as “flavoring.”  The Supreme Court’s statements were not mere flavoring, but informed the very manner of the materiality test’s application.  What it requires is evidence bearing on materiality specific as to the government’s likely or actual response to the alleged misrepresentation at issue in the case.  The relator in this case offered no evidence whatsoever as to the government’s likely or actual response to the defendant’s alleged violations of the incentive compensation ban.  The aggregate data relied upon by the majority was not specific to the defendant, and insufficient to demonstrate that the defendant’s violations in this particular case were material.  By failing to insist on specific evidence as required by Escobar’s rigorous materiality standard, the majority was in effect applying Hendow.  The dissent would have remanded the case for further discovery and further briefing in light of Escobar’s rigorous materiality standard.

Given the Rose court’s rift over application of the Escobar materiality standard, this case may be a candidate for en banc review.  Although the majority relied on something more than evidence of a redundant requirement, the dissent has a point in that the majority’s evidence lacks context.  That is, the majority opinion contains no discussion comparing the regulatory violation at bar with the government enforcement data the majority relied upon as evidence of materiality.  Likewise, the majority’s evidence does not show how the actions taken by the Department of Education summarized in the cited data were distinguishable from violations that either failed to trigger any agency action or led to comparatively minor sanction.

Whether or not the entire Ninth Circuit considers this appeal, the lower courts’ application of Escobar’s materiality standard bears continued monitoring, particularly as the cases consider and clarify the weight to be given to certain types of proof.  The Supreme Court intended a rigorous materiality standard as a check on a potentially sweeping theory of liability that assumes falsity from circumstances, where, in other words, fraud is inferred from undisclosed noncompliance.  As the Supreme Court made clear, the materiality analysis places great emphasis on proof beyond the government’s mere entitlement to refuse payment in a given case, cautioning that “[t]he False Claims Act does not adopt such an extraordinarily expansive view of liability.”  Escobar, 136 S. Ct. at 2004.

It is possible that the Supreme Court will soon take the opportunity to provide welcome guidance on proof of materiality in False Claims Act cases.  In Gilead Sciences, Inc., the Court of Appeals reversed the district court’s dismissal of an implied false certification claim based on lack of materiality and in doing so rejected arguments that the Food and Drug Administration’s failure to withdraw approval for the drug at issue, despite awareness of alleged violations, was “strong evidence” of a lack of materiality.

On December 26, 2017, the defendant filed a petition for writ of certiorari, and on April 16, 2018, the Supreme Court invited the Solicitor General to file a brief expressing the federal government’s views.  As of this writing, the Solicitor General’s office has not filed its brief.  Of course, a request for input from the Solicitor General is no guarantee that the High Court will grant review, but it is an encouraging sign that this area of the law may receive timely clarification.

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