Legal Insights: Government May Invoke Prior Breach of Contract to Trigger Dismissal of Contractor Claim
08/01/2017

Legal Insights: Government May Invoke Prior Breach of Contract to Trigger Dismissal of Contractor Claim

By Ross Crown

In July of last year, the U.S. Court of Appeals for the Federal Circuit handed the government an important new weapon for defeating contractor claims. In Laguna Construction Company Inc. v. Carter, 828 F.3d 1364 (Fed. Cir. 2016), the Federal Circuit ruled that a contractor’s prior material breach of the contract excused the government from any further payment obligations under the contract.

Facts of the Case

Laguna Construction Company was awarded by the Air Force one of 27 contracts for Worldwide Environmental Remediation and Construction in November 2003. The company received 16 cost-reimbursable task orders to perform work in Iraq and awarded subcontracts. Physical work under the contract was completed by 2010.

In 2009, the Defense Contract Audit Agency began an audit of Laguna’s incurred costs for fiscal year 2006. In 2011, the DCAA disapproved approximately $17.8 million of subcontract costs due to insufficient proof that the government paid a fair and reasonable price for the subcontracted services. Laguna submitted a claim to recover approximately $2.9 million of these costs. After the contracting officer failed to issue a decision, Laguna filed a notice of appeal with the ASBCA.

Meanwhile, in October 2010, Laguna’s Project Manager pled guilty to conspiracy to pay or receive kickbacks, including violations of the Anti-Kickback Act. In addition, in 2013, Laguna’s Executive Vice President and Chief Operating Officer pled guilty to participating in a kickback scheme. After this second guilty plea, the government moved to amend its answer in the Board appeal to include the affirmative defense of fraud. Thereafter, the government filed a motion for summary judgment arguing that Laguna’s claim should be denied because even if the government breached the contract by not paying all reimbursable costs, Laguna committed an earlier breach of the contract by violating the Allowable Cost and Payment clause through the fraud of its employees. The Board granted summary judgment to the government. Laguna appealed to the Federal Circuit.

Court Ruling

In analyzing the government’s defense of prior material breach of the contract, the Federal Circuit noted that this defense has already been recognized by the federal courts when the government breaches a contract after the other party had already breached the same contract. This rule is applicable even if the government’s later-occurring breach happened without knowledge of the first breach. Laguna pointed out, however, that these earlier federal cases applying the prior breach rule did not arise pursuant to the Contract Disputes Act. Laguna contended that the CDA displaced the prior breach rule. Unfortunately, the Federal Circuit disagreed, observing that nothing in the CDA suggested that Congress intended to supersede earlier federal case law and not finding any sound reason for the Court to do so. According to the Court, the purpose of the CDA is to streamline the procedural aspects of government contract disputes, not to displace existing government defenses and remedies. While the CDA was intended to be comprehensive, the Court said it did not foreclose the applicability of previously established legal precedent.

The Federal Circuit justified its application of the prior breach rule in CDA proceedings as consistent with United States v. Acme Process Equip. Co., 385 U.S. 138 (1966). In that case, the U.S. Supreme Court ruled that the government must be able to “rid itself” of contracts that are “tainted” by fraud, including kickbacks and violations of conflict of interest statutes. The Federal Circuit relied on the Supreme Court’s comment that even if the government could isolate and recover the cost increase attributable to a kickback, it would still be saddled with a subcontractor who, having obtained the job other than on merit, is perhaps entirely unreliable in other ways. This unreliability in turn undermines the security of the prime contractor’s performance. Such a result the public cannot tolerate, especially where important defense contracts are involved.

Laguna contended that the government’s prior breach allegation should properly have been addressed under the termination and Anti-Kickback clauses of the contract. The Federal Circuit agreed that these clauses provided alternative methods of dealing with Laguna’s fraud, but they are not exclusive remedies. In other words, the government could have chosen to terminate the contract for default or sought relief under the Anti-Kickback Act instead of seeking to dismiss Laguna’s claim, but it was not required to do so.

Laguna further argued that any alleged breach due to fraud is not material because even if the government’s payments to the contractor included compensation for illegal kickbacks, the government may audit and reconcile costs, thereby assuring that the government will incur no damages. The Federal Circuit rejected this contention, again referring to the Supreme Court’s observation that government contracts tainted by kickbacks are hurtful because the government is saddled with an unreliable subcontractor. Thus, there are resulting harms that go beyond recovering overpayments made to the contractor.

Implications

Laguna Construction is a significant case because the Federal Circuit has recognized for the first time in a CDA proceeding that the government may force the dismissal of an otherwise valid contractor claim due to the contractor’s prior material breach of the contract. This new weapon is powerful for a number of reasons. For one thing, a claim can be deemed forfeited by a prior breach even if the breach had nothing to do with the subject matter of the contractor’s claim.

In addition, a contractor’s claim will be dismissed under the prior breach rule regardless of the merits of that claim. That is, there may be no doubt that the contractor is entitled to sought, but that is irrelevant if the government can prove the contractor breached the contract first.

Further, any disparity between the amount of damages resulting from a prior breach of the contract and the size of the contractor’s claim makes no difference. In Laguna Construction, the statutory damages and penalties under the Anti-Kickback Act and False Claims Act resulting from the subcontractor kickbacks would have totaled only a small fraction of the $2.9 million Laguna sought in its claim. Nevertheless, Laguna’s claim was dismissed in its entirety. Since the Federal Circuit gives the government a choice between pursuing statutory remedies and seeking a forfeiture of the contractor’s claim, the government can be expected to seek the latter where the amount of the claim is greater.

Now that the Federal Circuit has given the government a potent new defense, agencies can be expected to increasingly apply this defense to future claims, especially where fraud is alleged. How should contractors respond to this unfavorable development? An obvious action is for contractors to ensure that they have adopted effective internal compliance programs. These programs must be focused on preventing contract breaches.

If, notwithstanding a contractor’s best efforts, it breaches a contract, the contractor needs to be aware of the breach as soon as it occurs and immediately do what it can to remedy the breach before the contractor needs to assert a contract claim. By proactively addressing such a breach, the contractor may be able to negotiate a prompt remedy. This remedy may end-up being much cheaper than allowing the government to later ambush the contractor with a prior contract breach and thereby obtain the dismissal of a much larger claim alleged by the contractor.

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Ross is a partner in the Albuquerque office of Lewis Roca Rothgerber Christie LLP where his practice emphasizes government contracts. This article is intended for general information only and should not be construed as legal advice or opinion. Any questions concerning your legal rights or obligations in any particular circumstance should be directed to your lawyer.

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