Troll Update

I'm Larry Friedman. You may remember me from such blog posts as Customs Trolls and the False Claims Act. In that post, we talked about the case brought by a company called Customs Fraud Investigations LLC alleging that Victaulic Company had avoided the payment of marking duties by making false statements to Customs and Border Protection. At the time of the first post, the United States District Court for the Eastern District of Pennsylvania dismissed the case as failing to state a cause of action. The Court subsequently refused CFI's motion to amend its complaint in an effort to correct the deficiency. The Court of Appeals for the Third Circuit has now reversed the District Court and sent the case back down for further proceedings.

The case was brought under the False Claims Act. This law was passed after the Civil War as a means of ensuring that the government was not paying out on fraudulent claims. In a typical FCA case, the "relator" alleges that someone submitted a bill to the government for payment without a legal right. You hear about this a lot in cases where health care providers submit false bills to Medicare for payment. Someone, often an insider, who has evidence of the fraud can file a case on behalf of the United States and, if there is a recovery, share in the proceeds.

The amount that goes to the relator depends on what happens. After the case is filed, the Department of Justice reviews the complaint and decides whether to take over the case and prosecute it. In that case, the relator may receive between 15% and 25% of the recovery, If the DOJ does not take on the case, the relator can proceed with its own counsel. If successful, the relator may recover between 25% and 30% of the recovery. In addition, attorneys fees can be reimbursed. This is a good thing as it creates a private incentive to root out fraud on the taxpayers. It has also generated a plaintiffs bar of attorneys who file these claims.

CFI, the relator in this case, is a new kind of enterprise. According to the dissenting Third Circuit opinion, the company appears to have been created solely for the purpose of bringing this case, and presumably similar cases. That makes it similar to what patent lawyers politely call "non-practicing entities." These folks are more often called patent trolls. Non-practicing entities, or "Patent Assertion Entities," collect patents for the purpose of monetizing them not through manufacturing, production, or sales. PAEs, make money by purchasing large numbers of patents and threatening litigation against companies that actually make or sell things in related industries. They threaten litigation in the hope of securing license fees or settlements. They never have an interest in using the patented invention.  The FTC recently released a very thorough report on patent trolls with recommendations that courts take steps to limit the impact of PAEs.

CFI is analogous, which is why I dubbed it a "customs troll." Rather than collect patents, it mines the publicly available data showing what has been imported into the United States via ship and by whom. From that information, it can make some assumptions about the country of origin of various products moving in the commerce of the United States. It can then look for those products and determine whether they have been properly marked with their country of origin. To the extent it find evidence of products imported without proper country of origin marking, it can file an FCA case as a relator and hope for a recovery. This is exactly what it did to Victaulic, a Pennsylvania-based manufacturer of pipe fittings. CFI might also use the ships manifest data to find products subject to antidumping or countervailing duties and, based on resale price in the U.S., deduce that duties had not be properly deposited.

The reason this is analogous to a patent troll is that CFI is not in the pipe fitting business. It is not individually harmed by any alleged misrepresentation as to country of origin. It is also not a purchaser looking to support local business by purchasing American-made pipe fittings. CFI is also no a petitioner in any antidumping or countervailing duty case seeking to protect the domestic industry nor is it an importer of such products who paid the additional duties and wants to ensure that other importers do as well. CFI's only interest in these pipe fittings is as a relator and potential recipient of proceeds from the case.

CFI's complaint does not allege that Victaulic made a fraudulent request for payment from the government. Rather, it asserted that to the extent Victaulic imported improperly marked pipe fittings and failed to tell Customs that fact, it avoiding having to pay the 10% ad valorem marking duties that can be assessed under 19 USC 1304(i). This is a so-called "reverse false claim." By failing to disclose the non-compliant marking, Victaulic avoided the payment of marking duties.

How could CFI possibly know that the pipe fittings were improperly marked? From the manifest data, CFI determined that Victaulic imported 83 million pounds of fittings over a ten-year period. To determined whether the fittings were properly marked, CFI looked on eBay for pictures of Victaulic products. By treating eBay as a proxy for the entire U.S. market, Victaulic calculated that virtually none of the products in the U.S. marketplace are properly marked. In an effort to bolster its argument that it should be permitted to amend its complaint, Victaulic produced an expert witness report stating that its approach is statistically valid, a photograph of an allegedly unmarked part, and a witness who expressed a recollection of seeing an unmarked product.

That is all background, which is really the most interesting part. The third Circuit did not have to decide the merits of the case. The only question before it was whether the District Court properly denied the motion to amend. That is a lawyerly question on which we need not dwell here.

The salient points for customs and trade professionals are:

1. The FCA is broad enough to encompass as reverse claims "contingent, non-fixed obligations including those relationships with the government that result in a duty to pay the government money.
2. This extends to marking duties that would be applicable to improperly marked or unmarked goods imported into the United States.
3. Knowingly concealing from Customs that goods are unmarked results in the releass of merchandise without the payment of marking duties can give rise to a reverse FCA claim.
4. At least at the pleading stage, it is sufficient to use a statistical model, rather than direct evidence of fraud.

It is this last point that requires additional attention. Under the Federal Rules of Civil Procedure, allegations of fraud require an enhanced level of specificity. General assertions will not do. But the Third Circuit allowed CFI to amend its complaint on the basis of shipping data and eBay pictures. That is a long way from being able to tie a specific unmarked pipe fitting to a specific entry, which is more detail than is required. Despite that conclusion, the Third Circuit expressed its skepticism at this case. Further, it took the unusual step of instructing the District Court to be mindful of the burden this case is likely to place on Victaulic and to manage discovery accordingly.

That may open the door to more cases based on nothing but data mining and statistical modeling by professional customs trolls, which is a far cry from the traditional whistle blower with inside information. While that might expose real fraud, I'm not sure it is how the law was supposed to work.

This is a preliminary ruling. The case has to go back to the District Court.

Note that CFI is the relator in another case involving an alleged failure to pay antidumping duties on standard pipe from Mexico. The complaint in that case was recently unsealed.

Reminder to importers: If you want to avoid being on the receiving end of one of these suits, please make a formal request that Customs designate your manifest data as confidential. Customs will do that.

Thank You, Otterbox

As previously discussed, the tariff classification of plastic cases for mobile phones, tablets, and similar electronic devices has been subject to much dispute. Customs and Border Protection has long held that they are usually, but not always, classified in Heading 4202 as if they are trunks, attaché cases, or musical instrument cases. I previously explained, in a fair amount of detail, why I think this is wrong. Turns out, barring interventions from the Court of Appeals, that I was right. Being right is a circumstance that always makes me happy.

In a thorough and thoroughly well reasoned decision, the Court of International Trade has decided that cases for iPhones and similar products imported by Otter Products ("Otterbox") are not classified in Heading 4202. Rather, they are articles of plastic in Heading 3926.

Customs had classified the goods in 4202 on the basis of Note 2(m) to Chapter 39, which excludes from Chapter 39 "containers" of Heading 4202. The primary question, therefore, is whether the cases are containers of 4202. Specifically, to be excluded from 3926, the containers would have to be "similar" to the exemplars in the first clause of Heading 4202, including "[t]runks, suitcases, vanity cases, attaché cases, briefcases, school satchels, spectacle cases, binocular cases, camera cases, musical instrument cases, gun cases, holsters and similar containers." To do that, the cases would have to have the same essential characteristics and purposes that unite all of the items in the list. According to prior court decisions, that means that the cases must be useful for organizing, storing, protecting, and carrying the contents of the case.

Before jumping into an analysis of those four factors, the Court of International Trade took the wise step of looking at the bigger picture. Are these cases even "containers?" If not, they cannot be similar containers.

The government proposed various definitions of "container" as things that contain or enclose other things. These definitions included examples such as boxes, crates, and jars. While the list of examples is not complete or dispositive, it does illustrate the nature of a container as something that completely encloses an article in a way that makes it inaccessible without some effort to open the container. That is not true for an iPhone case. When fully "encased," the iPhone remains completely accessible and useful to the owner. That is important. An iPhone in an Otterbox case is not "put away" like dried beans in a can or dirty socks in a suitcase. I cannot wear my socks (clean or dirty) when they are in a trunk. I cannot read my newspaper when it is in my attaché case. Thus, an iPhone case is not a container.

It seems to me that the Court might have stopped there. If these cases are not containers, they are not "similar containers." But, to avoid any confusion for later proceedings, the Court analyzed the four factor test as well. On that front, both parties agreed that the cases at issue "protect" the electronic devices. That is not disputed.

But, the cases do not provide any organizational functionality at all. There is no organizational difference between your phone in a case and your naked phone. You can lose it just as easily and the cases do not facilitate holding any other items with the phone. "Organization" is the act of putting more than one item in some kind of useful order. These cases do not do that.

Nor are they useful for storing the phone or other device. To "store" something is to put it away for later use. These cases are designed to permit use while inside the case. Thus, they are not for storage.

Regarding the feature of "carrying" the contents of the case, the Court noted evidence that some of the cases included a belt clip for the fashion impaired. While the belt clip may facilitate carrying the phone, it is not always used. Further, and this is my thought, the phone continues to be fully functional while clipped to a belt. In fact, it is there so that the owner can get a call, possibly from a stylist or from Steve Urkel. This was not an important factor.

What was important is that the function of continuing to be fully functional while inside the case is inconsistent with all of the exemplars in Heading 4202. That divergent functionality separates the electronic cases from containers of 4202, some inconsistent Customs rulings notwithstanding.

That's that. A thorough, thoughtful, and to my way of thinking, correct analysis of the tariff classification of plastic electronic cases.

There is a second and also interesting point in this case.

The protests in this case were addressed to the classification question. In Court, the plaintiff sought a refund based on the change in tariff classification applied to the full value of the merchandise including an assist voluntarily disclosed after the time of entry. I suspect, but do not know for certain that this disclosure relates to the False Claims Act case involving Otter Products. According to the government, because the assist was voluntarily paid, it was not a "charge or exaction" subject to protest.

The Court started with the proposition that because CBP must liquidate an entry at the correct classification by applying the corresponding rate of duty to the correct value, a protest of the classification applied at liquidation necessarily requires a determination of the correct value to be applied to the rate of duty. That makes perfect sense. When CBP refunds the overpaid duties as a result of the change in classification, it should refund all of the excess duties paid. That necessarily includes the duty on the disclosed assist. Customs will presumably keep that portion of duty owed on the assist at the lower rate of duty. The issue here is not that Otterbox is disputing the appraised value of the merchandise. The issue is that any refund should be calculated on the undisputed value of the merchandise, which includes the assist.

Nice work Otterbox. High five.

Another Defeat for Customs Trolls

Do you remember the tale of Customs Fraud Investigations, LLC v. Victaulic Company? If not, you should go back and read that post.

CFI is an entity established to conduct research and analysis with the apparent goal of identifying customs fraud. The ultimate goal of which appears to be to profit by bringing False Claims Act cases against alleged fraudsters. Nice business model.

In the case of Victaulic, CFI claimed that the company was not labeling its products consistent with the country of origin marking laws and regulations. While doing so, Victaulic also allegedly failed to notify Customs and Border Protection of the violation and deposit marking duties. As a result, according to CFI, Victaulic has committed customs fraud and, by making a false claim, deprived the U.S. government of lawful revenue. CFI claims it should be able to maintain a False Claims Act case on this basis and receive a portion of the revenue eventually paid to the U.S.

As previously discussed, CFI based this assertion on a comparison of Victaulic's publicly available ships manifest data and pictures of Victaulic products offered for sale of eBay. CFI claims that the pictures lack any country of origin markings or in some cases lack adequate country of origin marking. From that CFI concludes, and asked the U.S. District Court for the Eastern District of Pennsylvania to conclude, that it can state a cause of action under the False Claims Act.

As you know, the Court previously dismissed this case with prejudice because it found CFI had failed to state a claim. CFI is back in Court seeking to file an amended complaint. In its decision denying the motion, the Court recounts the history of this case and the application of the marking laws to the False Claims Act. The Court notes that there is no spot on the customs entry summary (CBP Form 7501) where an importer is required to disclose a liability for marking duties potentially imposed under 19 U.S.C. § 1304(i).

In this phases of the case, CFI has argued that is should be permitted to amend its complaint to state a cause of action. What follows in the opinion is larger procedural and primarily of interest to lawyers. So, I will get it out of thew way to make room for the more interesting point.

First, CFI waited too long to move to amend the complaint. CFI did not move to amend until after the Court entered final judgment against it. That was despite knowing that the Court was skeptical of the "bare bones" complaint and was contemplating a dismissal. The Court waited eight months between the hearing and the dismissal, giving CFI time to move to cure the defects in its complaint. This delay weighs against granting a motion to amend now.

More important, the Court found that any effort to amend the complaint would be futile because there does not appear to have been a violation of the False Claims Act. This is because an importer does not owe marking duties at the time of importation. That obligation arises only if unmarked or improperly marked goods enter the U.S. and are not subsequently remarked, exported, or destroyed. An importer is simply not permitted to preemptively say to CBP, "these goods are not properly marked, so here is my 10% marking duty." That's not how it works. Because the obligation does not arise at the time of importation, Victaulic did not make a false statement by failing to disclose the lack of payment of marking duties, which were not yet owed and may never be owed.

The more interesting question presented here is what will CFI or other FCA plaintiffs have to do to make a FCA case involving customs fraud?  Federal Rule of Civil Procedure 9(b) requires that a complaint "state with particularity the circumstances constituting fraud." The complaint must contain more than evidence of the mere opportunity for fraud. In that context, the Court made an interesting observation that:

It is worth noting that CFI is essentially a stranger to Victaulic. It has no inside information, unlike the typical qui tam relator, who has usually seen direct or indirect evidence of a fraudulent scheme. A current or former employee of a defendant, or an individual who is otherwise in a position to have inside information about a defendant's practices and conduct, bears some level of reliability when he acts as a qui tam relator because he was in a position [to] have observed the alleged fraud through personal experience. . . . When a relator is a complete stranger to the defendant who has constructed a case of fraud entirely from the outside, his allegations do not necessarily bear the same reliability. That is not to say that a corporate outsider cannot function as a relator. However, any outside investigation into a private company's fraud must, in accordance with Rule 9(b), supply the Court with a level of reliable information that strongly supports an inference a FCA violation occurred.

That is a pretty strong statement that prospective customs trolls will need to meet a high burden of pleading fraud. We should keep in mind that this is a decision from one district court. There have been and will be other efforts to bring FCA cases involving customs fraud. Some of those will succeed. So, this remains a developing area of law.

One thing that continues to be certain is that companies should request that their import data be treated as confidential. That will help prevent the kind of data mining CFI has undertaken. You can get started on that here.