The Importance of a Disputes' Clause in Your Subcontract

Don’t become a subcontractor with a “garden variety” lawsuit. Service Disabled Veteran Owned Small Businesses (SDVOSB), and other small businesses, strive to become subcontractors to entities with prime government contracts. But, subcontractors beware – unless a prime contract contains mandatory “flow down” requirements, or the subcontract demonstrates an intent to create privity, a subcontractor has no privity of contract with the government. Thus, if a prime contractor defaults, a subcontractor has no recourse against the Government.

What is Privity?

The doctrine of privity provides that a contract cannot confer rights or impose obligations on any person except the parties to the contract. Only parties to contracts are generally able to sue to enforce their rights or claim damages against each other.

A U.S. Court of Federal Claims case that discusses government contract privity in detail is Lockheed Martin Corporation and Lockheed Martin Advanced Environmental Systems, Incorporated V. The United States of America (No. 98-468c, October 16, 2001). In this case, a Lockheed subsidiary subcontractor sought damages from the government under the Contract Disputes Act of 1978 (CDA) for a default termination.

The government asserted a lack of privity and the Court found that “Despite extensive documentary discovery and dogged advocacy” it was “unpersuaded by the Plaintiffs' theories of privity. (because) At its core, this is little more than a garden-variety lawsuit by a subcontractor lacking privity with the Government, and therefore must be dismissed.”

The Court’s opinion buttresses the rule that subcontractors “generally do not have the right to seek and collect contract damages from the Government pursuant to the CDA because they usually are not in contractual privity with the Government.” The government enters into contracts with a prime contractor and the prime contractor enters into contract(s) with a subcontractor. This system creates a legal buffer between the subcontractor and the Government. It provides the Government with a means of "administering its procurement through a single point of contact, [thereby making] the Government's job. . . simpler and cheaper."

Subcontracts Needs a Disputes' Clause

In the world of government contracting, in most instances, for the subcontractor to recover against the Government it must go through the prime contractor. Two approaches are usually taken:

  1. A subcontractor’s claims are sponsored or certified by a prime contractor and are brought in the prime contractor's name; or,

  2. A prime contractor includes its liability to a subcontractor in its own damages against the Government.

In the Lockheed case, where the subcontractor went directly to the Government, the Court cited and discussed a seminal case addressing the issue of whether a subcontractor may directly sue the Government under the CDA, United States v. Johnson Controls, Inc., 713 F.2d 1541 (1983).

In Johnson, a subcontractor appealed to the Armed Services Board of Contract Appeals (ASBCA) after the contracting officer refused to issue a final decision on the merits of a claim that the prime contractor, had certified for Johnson. The ASBCA found that Johnson could bring direct action against the Government because privity existed between the two. The Federal Circuit reversed the ASBCA's decision, holding that Johnson did not "present the factors necessary to fall within any recognized exception to the well-entrenched rule that a subcontractor cannot bring a direct appeal against the government."

The Johnson decision clarified the ways in which a subcontractor would be in privity with the Government. The first and main way to create privity is when contractual provisions expressly indicate the parties intend to give the subcontractor the right to direct appeal against the Government. The second and following indirect ways to create privity are when the contract provides that the subcontractor is acting as an agent for the Government.

Privity Theories

The Court in Lockheed considered each of the subcontractor privity theories:

  • Contractual Theory.This theory relies on the parties' contractual intent. It focuses upon the "contractual nexus between the Government and the subcontractor." Privity can be established when a subcontractor enters a subcontract that contains a flow-down disputes clause, giving it the contractual right to direct appeal.

  • The Day-to-Day Control Theory. This theory seeks to establish privity when Government exerts day-to-day direct control over the subcontractor.

  • Direct Dealings Theory. This theory relies on the direct dealings between a subcontractor and the Government. A direct dealings relationship can be created when employees of the prime contractor and the subcontractor deal with the Government in such a way as to “create a relationship in which the original prime contract was superseded or supplemented by express oral contracts and implied contracts…”

  • Purchasing Agent Theory. This is a pre-CDA exception in which the parties stipulate to the presence of a "purchasing agent" relationship and where the subcontractor supplier is therefore a "contractor" for purposes of the CDA. This exception rests on the interpretation of the contract and requires that (1) the contractor was acting as a purchasing agent for the Government; (2) the agency relationship between the Government and the contractor was established by clear contractual consent; and (3) the contract stated that the Government would be directly liable to vendors for the purchase price.

Unfortunately for Lockheed, which in preparing its case: “discovered” 5 million pages of documents; produced a factual presentation totaling over 500 pages; filed over 200 pages of substantive legal briefings; submitted a four-volume appendix in support of its positions; and, prepared an eight-volume appendix in support of its opposition to the Government’s motion for summary judgment, failed to convince the Court that privity existed under any theory.

The Court indicated that to prove privity (and therefore for a subcontractor to have a case against the Government), four factors have been examined:

  1. What is the intent of the parties (was it the intent of the Government for the Subcontractor to be the agent);

  1. Is there an express flow down clause (such as a disputes clause) in the contract;

  1. Does the prime contract require a “Miller Act” bond (prime contractors on some government construction contracts must post bonds guaranteeing both the performance of their contractual duties and the payment of their subcontractors and material suppliers); or,

  1. Does the contract expressly claim or disclaim privity with the Government.

In Lockheed, the four elements that led the Court to interpret the contract as not intending privity were: (1) the Government and the subcontractor never entered into a direct contractual relationship; (2) the "ABC" clause, contained both in the prime contract and the subcontract, specifically disclaimed a contractual relationship between the Government and the subcontractor; (3) the prime contractor was required to obtain a Miller Act payment bond, which provided a recourse by the subcontractor other than a direct appeal; and (4) there was no provision in any of the contract documents that clearly authorized a direct appeal by a subcontractor.

The Court said that the most importantfactor to establish privity is the existence of a flow-down disputes clause that contractually guaranteed the subcontractor the right to direct appeal against the Government.

Court Findings

The Court found the Lockheed subsidiary never entered a direct contractual relationship with the Government. The Government did not sign the subcontract, the subcontract does not list the Government as a party to the contract; and the subcontract does not discuss how the prime contractor would submit a sponsored claim on behalf of subcontractor. Thus, there were no contractual provisions demonstrating an intent to create privity of contract between the subcontractor and the Government.

The lesson to be learned by prime contractors and subcontractors is to examine your contracts carefully. If necessary, bargain for the inclusion of provisions that provide contractual consent for direct subcontractor appeals. The most important such provision   is a flow-down disputes clause that expressly or implicitly gives a subcontractor the right of appeal. Such disputes clauses are not only important in government contracts, but also in commercial and construction contracts.

Flow Down Clause

An effective flow-down clause will not simply “incorporate” prime contract documents by referring to them. A crafted flow-down clause will go further, providing that the individual promises in the referenced documents apply as between the contractor and the subcontractor to the same extent as they apply between the owner and the contractor. Otherwise, a court may find that prime contract documents are only incorporated into a subcontract for a limited purpose.

We excel at helping our Clients make the most effective use of their contracts. We work to ensure that conscious decisions are made about each contract provision and that each provision furthers a business decision and appropriately assigns risk commensurate with the work to be performed. Please call (303) 534-1958 or complete an online contact form.

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