Legal and Settlement Costs - Cases Settled Out of Court

Government contractors, and all companies for that matter, face the risk of lawsuits filed for discrimination, anything from equal opportunity, equal opportunity for veterans, affirmative action for workers with disabilities, sexual harassment, and the list goes on and on. Contractors will expended usually significant amounts of money defending against these sometimes frivolous lawsuits. Usually they are settled before going to court with the company agreeing to pay a specified amount. When the suit is settled out of court, there is no guilty verdict and contractors often try to include settlement and legal expenses as allowable costs under their cost-reimbursable contracts.

Not so fast.

A 2009 Court of Federal Claims decision, Secretary of the Army v. Tecom, 566 F.3d 1037, establishes a standard for allowability of such costs.

Tecom addresses the allowability of contractor costs associated with defense and settlement of legal claims brought against a contractor by a third party. Tecom, Inc. was awarded a negotiated cost-reimbursement contract for military housing maintenance. The contract contained various FAR clauses, including FAR 52.222.26 (Equal Opportunity). During the contract period, a former employee sued Tecom under Title VII of the Civil Rights Act of 1964 (“Title VII”), alleging sexual harassment and retaliation for filing a harassment charge. Tecom incurred more than $96,000 in legal bills defending the case. It settled the plaintiff’s claims for $50,000. Tecom sought reimbursement from the Army for $146,000 in defense and settlement costs as a direct cost under the contract. Tecom contended that it had not violated the law; that the former employee’s allegations were false; and that taking the case to trial would have cost approximately $300,000. The Army Contracting Officer found Tecom’s defense and settlement costs unallowable, and Tecom appealed the decision to the Armed Services Board of Contract Appeals (“Board”). The Board found for Tecom, and the Army appealed to the United States Court of Appeals for the Federal Circuit.

The Federal Circuit reversed the Board and rejected Tecom’s claims that the costs were allowable. In doing so, the court made two rulings. First, the Federal Circuit held that a contractor’s costs associated with an adverse judgment involving claims under Title VII are not allowable: a trial verdict that the contractor violated Title VII means the contractor breached FAR 52.222-26’s prohibition on discrimination on the basis of race, color, religion, sex, or national origin. Because costs are allowable only when they comply with the terms of the contract, and FAR clause 52.222-26 was a term of the contract, costs associated with a Title VII violation (including defense costs and any damages awarded by the court) are unallowable.

Second, the Federal Circuit held more broadly that the rule against reimbursing contractors for discriminatory conduct goes beyond trial verdicts; under Tecom, the rule also applies to settlements in certain circumstances. The Federal Circuit was concerned that a contractor that violated Title VII might try to avoid application of the rule against allowability by simply settling the matter before a trial verdict in the plaintiff’s favor. Thus, the court held that, where a contractor settles a Title VII case before judgment, the costs of litigation are allowable only if plaintiff’s claims had “very little likelihood of success on the merits.”

Significantly, the Federal Circuit did not define "very little likelihood of success," but instead adopted the standard based on FAR's treatment of legal costs associated with contractor defense of third-party False Claims Act suits. In those cases, FAR 31.205-47(c)(2) provides that costs may be allowed where "the contracting officer, in consultation with his or her legal advisor, determines that there was very little likelihood that the third party would have been successful on the merits."

Contractors who wish to settle matters out of court and who wish to include settlement and legal expenses as allowable costs under Government contracts, should first contact their contracting officers regarding allowability. Tomorrow we will identify the data that may be required by a contracting officer to help him/her make that decision.