Material Breach of Contract - Government Doesn't Have to Pay

Laguna Construction Company was awarded a government contract in 2003 to perform work in Iraq. After the work was completed, Laguna sought reimbursement of past costs, a portion of which the government refused to pay. Laguna sued the government for these costs at the Armed Services Board of Contract Appeals (ASBCA). The government alleged that it was not liable because Laguna had committed a prior material breach by accepting subcontractor kickbacks, thereby excusing the government’s nonperformance. The ASBCA granted the government’s motion for summary judgment on this ground, and declined to consider the merits of Laguna’s motion. Laguna then appealed to the U.S. Court of Appeals for the Federal Circuit. The Court of Appeals agreed with the ASBCA that Laguna committed the first material breach by violating the contract’s Allowable Cost and Payment clause and affirmed the ASBCA's ruling.

So what is this "prior material breach" all about and why does that give a right to the Government to withhold payment for work performed? Or, does it? We need to dig a little deeper to understand these decisions.

In February 2009, DCAA (Defense Contract Audit Agency) began an audit of Laguna's 2006 incurred cost submission. A couple of years later, DCAA disapproved about $18 million in subcontract cost, primarily because Laguna could satisfy the auditors that the subcontract prices were fair and reasonable for the services provided. In 2012, DCAA held up fourteen vouchers totaling $3 million. Laguna appealed to the ASBCA after the contracting officer failed to issue a decision.

A year before DCAA began its audit, the Government began investigating allegations that Laguna's employees were engaged in kickback schemes with its subcontractors. One Laguna project manager pleaded guilty to conspiracy to pay or receive kickbacks. He worked with subcontractors to inflate billings and personally profited from the difference. Later, a federal grand jury issued criminal indictments against three principal officers of Laguna - also for accepting kickbacks. They eventually pleaded guilty as well.

After the guilty pleas, the Government amended its answer to the ASBCA to include the affirmative defense of fraud. The Government maintained that it was not liable for Laguna's claim because Laguna breached the contract when its principal officers and employees solicited and accepted kickbacks for awarding subcontracts which constituted fraud against the United States.

Laguna argued that the Government was not authorized to withhold funds where it has accepted the subcontractor prices as reasonable during contract performance. The Government argued that Laguna's claim be denied because Laguna committed the first material breach of contract by the fraud of its employees.

According to the ASBCA and Court of Appeals,  Laguna committed the first material breach under the contract which provided the government with a legal excuse for not paying Laguna's invoices. Laguna breached the duty of good faith and fair dealing because its employees criminal acts in engaging in a kickback scheme were imputed to Laguna.

The Board found that the breaches were material because kickbacks are fraudulent. The fact that the Government has not proven that kickbacks were paid under ever voucher does not render the fraud any less material.

You can read the entire decision here.