Attorneys for a U.S.-based security company accused of setting up sham companies in a multimillion-dollar fraud scheme in Iraq are contending that the company cannot be sued under...

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ALEXANDRIA, Va. — Attorneys for a U.S.-based security company accused of setting up sham companies in a multimillion-dollar fraud scheme in Iraq are contending that the company cannot be sued under a key federal anti-corruption law because the allegedly stolen money belonged to Iraqis, not Americans.

The potentially precedent-setting case could undercut fraud claims involving billions of dollars in reconstruction contracts issued by the U.S.-led Coalition Provisional Authority (CPA) and paid for with about $20 billion from the Development Fund for Iraq.

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The fund consisted of Iraqi oil revenue, seized assets and money and other valuables recovered from Saddam Hussein’s regime and was labeled as belonging to the Iraqi people.

Arguments broke out in federal court Friday over two fundamental questions: whether the CPA, which ruled occupied Iraq until June 28, can be considered a U.S. agency, and whether fraud involving Iraqi money can be subject to suits under the False Claims Act, considered one of the federal government’s most important tools against fraud.

John Boese, an attorney for the security company, Custer Battles, asked a judge to dismiss the case as “fatally defective.” Boese argued that the act did not apply to his clients since the CPA, not the U.S. government, was the victim.

“The funds that were used were Iraqi funds, not U.S. funds,” Boese said.

Custer Battles has denied any fraud was committed, attributing the allegations to disgruntled former employees who have since emerged as competitors to Custer Battles.

Those employees are now suing Custer Battles under the False Claims Act, which allows citizens to sue U.S. contractors on behalf of the federal government to seek damages for fraud.

If successful, the citizens get a share of the money the contractor is forced to pay back to the U.S. government. In 2003, the act resulted in $2.1 billion in fraud recovery, with $319 million going to the whistle-blowers.

Custer Battles was one of the first U.S. contractors on the ground following the fall of Saddam in April 2003. The company’s two founders, Scott Custer and Mike Battles, were former special-forces soldiers who opened for business with almost no money and little experience.

Nonetheless, the company won at least four contracts in Iraq worth millions of dollars, including a deal to provide security at Baghdad’s international airport and another to help Iraqis swap their old currency for new dinars minted by the CPA.

Several former employees accused Custer Battles of creating a series of shell companies that were used to bilk the CPA out of millions of dollars. Company officials allegedly submitted false invoices and also billed for work done by other companies.

Earlier this year, the Defense Department suspended Custer Battles from winning future contracts with the U.S. government. That was thought to be the first time a company doing business in Iraq had faced such a judgment.

In addition, a criminal investigation of the company’s actions continues, according to an Air Force spokesman.

Despite the criminal inquiry, the plaintiffs’ lawyer said it was important to allow the False Claims Act suit to proceed to avoid giving a green light to contractors in Iraq to commit fraud with Iraqi money.

“It’s perfectly clear that if the judge dismisses [the case], then all fraud against the Coalition Provisional Authority will never be punished,” attorney Alan Grayson said. “They may not get away with murder. But they will get away with $50 million.”

The Department of Justice declined to pursue recovery of the alleged ill-gotten money from Custer Battles, usually an indication government lawyers think evidence of fraud is weak.

Grayson said the government declined to become involved because the Justice Department had determined that no U.S. taxpayer money was at stake.

The Justice Department has declined to comment on the reasons it turned down the case.