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Federal Circuit Affirms Decision of the Armed Services Board of Contract Appeals Finding the Government Suffered No Harm Resulting from Contractor's Technical Noncompliance with Cost Accounting Rules: Defense v. Northrop Grumman Corporation, Case No. 2018-1943 & 2018-1990 (Nov. 15, 2019)

Summary

On Nov. 15, 2019, the U.S. Court of Appeals for the Federal Circuit affirmed a decision of the Armed Services Board of Contract Appeals (ASBCA) finding that the government improperly disallowed certain retirement benefits costs that the contractor, Northrop Grumman, asserted were eligible for reimbursement. The Federal Circuit reached its decision after concluding substantial evidence supported the ASBCA's conclusion that the government had not suffered damages as a result of Northrop's noncompliance with the accounting methodology mandated by the Federal Acquisition Regulation (FAR) because Northrop's amendment to its post-retirement benefits plan effectively eliminated $253 million in disputed costs, which never were and never will be charged to the government.

Facts

The dispute between the Secretary of Defense and Northrop concerned the defense company's cost accounting for providing post-retirement benefits (PRBs). PRBs are non-pension benefits, such as post-retirement healthcare or life insurance, paid by an employer to its retired employees. Unlike pension benefits, PRBs can be modified or eliminated by the employer. The FAR permits contractors to seek reimbursement for PRB costs, provided they are "allowable" under the FAR. FAR 31.205-6(o) requires PRB costs assigned to a given year to be funded by that year's tax return deadline to be allowable. Starting in 1995, the FAR required contractors to use the accounting standards set forth in the Statement of Financial Accounting Standards 106 (FAS) to determine the allowability of PRB costs.

Between 1995 and 2006, Northrop accounted for its PRB costs using an accounting method established by the Deficit Reduction Act of 1984 (DEFRA), instead of FAS 106. Both the DEFRA and FAS 106 require accrual accounting, but differ in their method for calculating PRB costs: "the DEFRA method calculates PRB costs based on current medical costs, while the FAS 106 method calculates PRB costs to include future increases in medical costs." As a result, annual PRB costs calculated under the DEFRA method start lower and increase over time, whereas PRB costs calculated under the FAS 106 method start higher and decrease over time. The government was aware of Northrop's continued use of the DEFRA accounting method and that it did not comply with the FAR. However, it did not object.

In 2006, Northrop shifted from the DEFRA method to the FAS 106 method, which required the government contractor to calculate its "transition obligation" – "the difference between the PRB costs that would have accrued had Northrop adopted the FAS 106 method in 1995 and the PRB costs that actually accrued due to its continued used of the DEFRA method." Northrop determined that its transition obligation was approximately $305 million (meaning that it would have owed its employees approximately $305 million in PRBs). 

At the same time the company switched from DEFRA to FAS 106, it amended its PRB plans, capping the annual amount Northrop would contribute to the PRBs without regard to future increases in healthcare costs. This "negative plan amendment" effectively limited the benefits available to employees under the PRB plans and reduced Northrop's cost obligations by roughly $307 million. Northrop deducted this amount (savings, essentially) from its transition obligation, as required by FAS 106.

Following this switch, the Defense Contract Management Agency (DCMA) issued Northrop a notice of intent to disallow costs. DCMA took the position that approximately $253 million of Northrop's transition obligation was unallowable in future accounting periods because "Northrop did not measure or fund its PRB plans between 1995 and 2006 using the required FAS 106 method[.]" DCMA issued a Final Determination, disallowing approximately $253 million from Northrop's post-2006 reimbursement submissions on this basis. Northrop submitted a certified claim seeking these funds, which DCMA denied. Northrop appealed to the ASBCA.

The ASBCA determined that Northrop's negative amendment to its PRB plans, creating a fixed dollar cap, saved $307 million from its future obligations. The Board looked to the primary difference between the DEFRA and FAS 106 method ("the DEFRA method calculates PRB costs based on current medical costs, while the FAS 106 method calculates PRB costs to include future increases in medical costs"). The Board explained that the disputed $253 million in costs were effectively eliminated by Northrop's negative amendment to its PRB plans and that "Northrop never has and never will incur and claim reimbursement for the disputed $253 million in PRB costs because it did not incur those costs between 1995 and 2006." The government appealed the Board's decision to the Federal Circuit.

Holding

The Federal Circuit affirmed the Board's decision, finding "substantial evidence supports the Board's decision that Northrop's negative amendment to its PRB plans effectively eliminated the $253 million in disputed PRB costs from its transition obligation such that those costs were never and will never be charged to the government." The government made several arguments that the $253 million had already been or would be charged to the government, including the argument that "because Northrop underfunded its PRB costs by $253 million between 1995 and 2006 by using a noncompliant accounting method, those costs will always remain 'unallowable' pursuant to FAR 31.205-5(o)(3), and the government is therefore required to disallow that amount from Northrop's future PRB reimbursement claims." The Federal Circuit acknowledged that this argument would have merit, but only if Northrop had not simultaneously amended its PRB plans, because the underfunded amount would then have become part of Northrop's transition obligation. The negative amendment effectively "mooted the issue of allowability by eliminating the disputed $253 million from the transition obligation." "Thus, Northrop never actually submitted any unallowable costs for reimbursement, and the government had no basis to disallow that amount from Northrop's post-2006 reimbursement submissions." 

Key Takeaway

While contractors must comply with the FAR and cost accounting rules, the Federal Circuit's decision strikes a balance in a case where the government suffered no actual harm as a result of Northrop's technical noncompliance.

Introduction

Constructora Guzmán, a subcontractor to Enviro-Management & Research Inc. (EMR) on an embassy renovation project, filed suit against the U.S. Department of State alleging that it is a third-party beneficiary to a breached provision of the prime contract. On Nov. 19, 2019, the U.S. Court of Federal Claims found Constructora Guzmán's allegations sufficient in support of its third-party beneficiary theory, denying the government's motion to dismiss for failure to state a claim and allowing the dispute to proceed to fact discovery.

Facts

The State Department entered into a $39 million contract with EMR for renovation of an embassy in Georgetown, Guyana. The contract required EMR to certify that it had paid all payments due to subcontractors and suppliers before it received payment from the State Department. The contract also required EMR to furnish payment and performance bonds or comparable alternative security under FAR 28.204 for ensuring subcontractor payment.

Approximately five months after entering the contract, the State Department issued a modification purporting to de-obligate $697,867 "in lieu of Performance and Payment Bonds stated in Cost/Price proposal." The modification further provided: "Retain 10% per invoice in lieu of bonds and additional 10% if the contractor is not performing."

A month later, the State Department issued another modification, this time seeking to add $682,867 back "for overages taken when de-obligating funds for Performance and Payment Bonds not received." The modification explained: "Initially $697,867 was mistakenly removed in lieu of Bonding; the correct de-obligation cost is $15,000 from the contract award. All other terms and conditions remain unchanged." Notably, the second modification did not remove the retainage requirement in lieu of the bond provisions required by the first modification. 

EMR later entered into a subcontract with Constructora Guzmán for various construction requirements. Constructora Guzmán completed its work, for which the State Department issued a letter of commendation. Constructora Guzmán invoiced EMR $1.4 million for its completed work and EMR failed to pay.

Constructora Guzmán filed suit against the State Department, seeking payment for its work. Constructora Guzmán alleged that it was a third-party beneficiary to EMR's contract. A plaintiff is a third-party beneficiary to a contract made between two other parties, where the contract reflects an intent to benefit the plaintiff directly, or a class that the plaintiffs falls within. Constructora Guzmán also alleged that an implied-in-fact contract existed between it and the State Department. The government moved to dismiss for failure to state a claim on which relief can be granted as to the third-party beneficiary theory and for lack of subject matter jurisdiction over the implied-in-fact contract theory.

As to Constructora Guzmán's first theory, the government alleged that EMR's contract obligated EMR to furnish payment and performance bonds for the protection of its subcontractors and that the State Department, instead of requiring those bonds, elected to modify the contract to permit retainage of 10 percent per invoice. Constructora Guzmán argued that these facts were sufficient to show that the modification, allowing retainage in lieu of performance and payment bonds, was for EMR's subcontractor's benefit, i.e., that Constructora Guzmán was a third-party beneficiary to the modification and that the State Department's decision to pay EMR when EMR had not paid all payments due to its subcontractors breached the contract. The government argued that these facts were insufficient to allege that Constructora Guzmán was an intended beneficiary or that the State Department breached the EMR contract.

Holding

The Court of Federal Claims denied the government's motion to dismiss as to the third-party beneficiary theory, concluding that Constructora Guzmán plausibly alleged that the State Department "intended to put itself in the position of retaining payment for the protection of subcontractors." The court noted that it was unclear why the State Department waived the bonding requirement and why the contracting officer chose to include the retainage provision, rather than including comparable alternative security endorsed by FAR 28.204, but decided these issues were not appropriate to resolve under a motion to dismiss.

As to Constructora Guzmán's second theory, the implied-in-fact contract, the court was not so keen. The court granted the government's motion to dismiss for lack of subject matter jurisdiction, finding Constructora Guzmán failed to state "a non-frivolous allegation of an implied-in-fact contract with the State Department."

Key Takeaway

Subcontractors are rarely found to be third-party beneficiaries under government contracts. While Constructora Guzmán overcame the initial challenge of the government's motion to dismiss the complaint, this does not mean that Constuctora Guzmán ultimately will win a favorable decision on the merits of its case. Here, the court simply said Constructora Guzmán alleged facts in its complaint sufficient to show that the subcontractor could be found to be a third-party beneficiary in this case. In order to prevail on the merits of its case, Constructora Guzmán will need to demonstrate that the government intended to guarantee that EMR's subcontractors would benefit from the contract modification.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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