updated 8/19/2006 3:36:09 PM ET 2006-08-19T19:36:09

A federal judge has overturned on a technicality a $10 million jury verdict against a military contractor accused of defrauding the U.S. government in the first months of the Iraq war.

The award, levied in March against Fairfax-based Custer Battles LLC, had been the first civil fraud verdict arising from the Iraq war.

A former Custer Battles employee had sued under a whistle-blower statute, alleging that the company used shell companies and false invoices to vastly overstate its expenses on a $3 million contract to assist in establishing a currency to replace the Iraqi dinar used during Saddam Hussein's regime.

The verdict reached $10 million because the law calls for triple damages, plus penalties, fines and legal costs.

But U.S. District Judge T.S. Ellis III, in a ruling made public Friday, ruled that Custer Battles' accusers failed to prove that the U.S. government was ever defrauded. Any fraud that occurred was perpetrated instead against the Coalition Provisional Authority, formed to run Iraq until a government was established.

Ellis ruled that the trial evidence failed to show that the U.S. government was the victim, even though U.S. taxpayers ultimately footed the bill.

Alan Grayson, lawyer for whistle-blowers Robert Isakson and William Baldwin, said he would appeal. He faulted the Bush administration for creating the CPA in a manner that essentially allowed it to act as a money launderer for unscrupulous military contractors.

"The Bush administration incompetently created this Frankenstein monster called Coalition Provisional Authority. They did it without thinking about it. They blundered into it," Grayson said.

In pretrial motions, Custer Battles' lawyers had advanced a similar argument about CPA's status. Ellis allowed the trial to go forward and said a case could be made to show that defrauding the CPA was tantamount to defrauding the United States.

Ellis had prodded the Justice Department to weigh in on the CPA's status. Government lawyers argued that the CPA should be considered a U.S. entity, but only for the purpose of the whistle-blower law.

The judge said in his ruling that the plaintiffs failed to establish the CPA as a U.S. entity during the three-week trial this year.

Custer Battles' attorneys portrayed Ellis' ruling as a broad vindication of their clients' actions.

"The fact of the matter is that (Custer Battles founders) Scott Custer and Mike Battles did what they were contracted to do under unimaginably difficult circumstances," defense lawyer Robert Rhoad said in a statement.

Ellis left intact the jury's $165,000 wrongful termination verdict in favor of Baldwin, one of the whistle-blowers.

A lawsuit involving an even larger Custer Battles contract to provide security at the Baghdad airport has not yet gone to trial. That lawsuit will face similar obstacles, Grayson said.

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