Jonathan Cain | A bill of rights for subcontractors

Infotech and the Law | Legal insights for today's market

Jonathan Cain

Government subcontractors are usually
thought of as being at the mercy of their
prime contractors in obtaining payment
for goods and services delivered by the
subcontractor to government customers.
This problem becomes most acute when, for example,
the prime defaults on its obligations to the government
or has contract payments withheld for other reasons,
such as to pay prior debts to the government.

The subcontractor that has
faithfully performed its prime
contract and is entitled to payment
is left with a claim against
the prime, but that claim may
not be worth much if the prime
is weak financially. A subcontractor
typically is unable to obtain
relief from the government
because the subcontractor is not
a party to the prime contract and
thus lacks privity, the standing
required to enforce a contract,
against the government.

If the subcontractor could
obtain that standing, it would have a
way to obtain payment for the goods
and services that it provided to the
government under its subcontract
directly from the source of the funding.
One of the few ways in which the
subcontractor achieves standing
to make a direct claim
against the government is to be
deemed a third-party beneficiary
of the prime contract.

A subcontractor can claim
third-party beneficiary status
when the government's contracting
office knows, or should
have known, that the government's
payment on the prime contract
was intended to directly benefit the
subcontractor. A difference exists
between the contracting officer's
knowledge that a subcontractor will
be contributing to the performance of
the prime contract and knowing that
the government's payments are
intended to directly benefit the subcontractor.
Establishing this relationship
is not easy for the subcontractor.

The U.S. Court of Appeals for the
Federal Circuit gave some guidance in
a recent case. A prime contractor
agreed to manufacture goods for the
government and subcontracted part of
the work. After several months, the
prime stopped making timely payments
to its subcontractor. The subcontractor
notified the prime and the government
that it would make no further deliveries
until it was paid. Upon receipt of this
notice, the contracting officer notified
the prime that it was aware of the payment
problem and threatened default
termination and debarment if the issue
was not resolved.

The prime and the subcontractor
then negotiated an agreement by
which the prime agreed to have the
agency make its contract payments to
a bank and for the bank to pay the
subcontractor out of the receipts. The
contracting officer agreed to this.

When the government made the
payments to the bank, it withheld
amounts that the prime owed to the
government under other contracts.

As a result of the holdback, however,
the payments were not sufficient
to pay the subcontractor. The subcontractor
sued the government, the government
argued that the subcontractor
lacked privity, and the Court of
Federal Claims dismissed the case.

On appeal, the Federal Circuit held
that government could not withhold
from the subcontractor money that
the government could have withheld
from the prime contractor because
the subcontractor had become a
third-party beneficiary of the contract.
By entering into the bank payment
arrangement with the contracting
officer's consent, the subcontractor
established that the payments
were for its direct benefit, and it
could not be liable for any amounts
due the government from the prime.

Entering into such a payment
arrangement as part of the subcontract
may be worthwhile when dealing
with a prime that is financially
troubled or has significant unsatisfied
obligations to the government.

Jonathan Cain is a member of the law firm
of Mintz Levin. The opinions expressed in this
article are his. He can be reached by e-mail
at jtcain@mintz.com.

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