A recent case from the Armed Services Board of Contract Appeals provides us with a reminder of what can happen to a prime contractor when it settles a subcontractor claim and then seeks to pass through the settlement amount to the government. In Kellogg Brown & Root Services, Inc., (November 19, 2018), the prime contractor ("KBR") sought to pass through to the government the cost of settling two subcontractor requests for equitable adjustment. The board held that KBR had failed to demonstrate that the cost of settlement was reasonable and denied KBR's claim in its entirety.

The underlying prime contract was for the provision of logistics during the United States' military operation in Iraq. The subcontract out of which the REAs arose involved the transport of prefabricated housing through Iraq. The subcontractor, whom the board described as "sophisticated," was impacted by the limitations on the United States' ability to provide security for the transport convoys due to the many demands placed on the military during the time of contract performance.

The first subcontractor REA sought over $30 million and, as the board pointed out, was based on "rates" and "prices" rather than costs. The board pointed out that the subcontractor did not provide actual costs to support its REA. The board further noted that, although KBR initially sought backup information, it lost interest in that information and focused on what a reasonable rate should be. Furthermore, the board noted that KBR did not verify what equipment was actually added as a consequence of the impact to the subcontractor's performance. KBR ultimately settled the REA for approximately $24 million, deciding that the subcontractor's pricing was "fair and reasonable."

The subcontractor subsequently submitted a second REA for approximately $42 million that sought reimbursement for idle truck time. The subcontractor's claim was based on rental rates rather than actual costs. In fact, the subcontractor redacted the actual rates when it provided KBR with the truck leases that supported its REA. Moreover, the subcontractor did not provide KBR with actual days of delay upon which its REA was based. Instead, it provided a model that contained several assumptions which the board found unrealistic and inaccurate

After negotiation, including an ignored request by KBR for actual costs, KBR settled the second REA for approximately $24 million based on price rather than cost. The board pointed out KBR never received any data or records showing the actual costs that the subcontractor had incurred.

KBR paid the subcontractor the agreed upon amounts and sought to pass the amounts paid to the government with administrative markup. The DCAA audit ultimately disapproved of the two payments, finding KBR had failed to obtain accounting and cost data that would support either of the settlement amounts. The ACO ultimately issued a decision that denied reimbursement of almost all of the settlement amounts, the only exception being the cost of a land lease, which the ACO determined had been adequately supported.

The board upheld the denial of payment of the settlement costs, noting that FAR 31.201-2 limits payment to costs that are "reasonable" as defined by FAR 31.201-3. The board noted it was KBR's burden to establish cost reasonableness, and reasonableness is based on the circumstances at the time the costs were incurred.

The board first found that the government's actions in providing convoy protection were reasonable, notwithstanding the impact incurred by the subcontractor. As such, since the government fulfilled its promise to provided protection, it was not prudent for KBR to have paid its subcontractor additional compensation.

The board then held that, even if the government had breached its promise, a prudent person engaged in a competitive business would not make the payments that KBR made to its subcontractor. The board pointed out that the subcontractor's model was flawed, the fact KBR did not require the subcontractor to provide its cost support even though there was no proof that such support was lacking and that the subcontractor was sophisticated and indeed there was evidence that such costing was available. The board rejected KBR's argument that the subcontract was for "commercial items" and, as such, justified a departure from the requirement that the pricing be reasonable. Finally, the board rejected KBR's assertion that the claim was akin to a "jury verdict" method of calculating damages, noting that there were other means available to determine costs and a "jury verdict" method of establishing damages does not relieve the claimant from the burden of proving reasonableness.

The result was that the board did not attempt to determine what a reasonable settlement amount should have been. Instead, the board found that KBR had failed to establish a "reasonable" cost and denied KBR's claim in its entirety. The teaching points are these: (a) as a prime contractor considering a settlement with your subcontractor, make sure you require the subcontractor to establish and support its equitable adjustment with evidence that will be accepted by the government, and (b) consider whether your contractual language and the statutory framework you are operating under allows you to "pass through" the subcontractor's REA as a claim rather than paying the claim and then prosecuting the claim on your own behalf.