February 01, 2019

Prime Contractor Breathes Sigh of Relief on Flow-Down Clause Enforcement in Prime-Sub Arbitration Debacle

6 min

On January 28, 2019, the U.S. Court of Appeals for the Ninth Circuit issued an opinion affirming that the terms of an arm's-length subcontract agreement cannot simply be set aside because they may operate to the detriment of one party. See Aspic Engineering and Construction Company v. ECC Centcom Constructors LLC; ECC International LLC, No. 17-16510, D.C. No. 4:17-cv-00224-YGR (9th Cir. Jan. 28, 2019) ("Aspic"). Aspic concerned the review of an arbitration award arising out of the termination for convenience of two subcontracts. Aspic served as a subcontractor in support of ECC's prime contracts with the U.S. Army Corps of Engineers (USACE) for construction work in Afghanistan. As is standard in many subcontracts involving a government prime contract, both subcontracts included, or "flowed down," various terms and conditions, including Federal Acquisition Regulation (FAR) clauses, such as those governing a termination for convenience (FAR 49.2 through 49.6). By agreeing to these terms in its subcontracts, Aspic agreed to allow ECC to terminate its subcontracts for convenience – a standard highly preferential to the prime contractor – and similarly to be bound by the corresponding FAR provisions requiring scrupulous documentation by the subcontractor, should it seek to recover costs associated with its termination by the prime contractor.

Ultimately, USACE terminated its two prime contracts with ECC for convenience, leading ECC to terminate Aspic's subcontracts under the same theory, pursuant to the explicit terms of the subcontracts. Following the terminations, Aspic sought to recover its termination costs by the submission of termination settlement proposals. Ultimately, ECC declined to award Aspic such costs, claiming in part that Aspic had failed to provide adequate documentation to support its claim of incurred costs – a principle present in the FAR's termination for convenience provisions incorporated into the subcontracts.

Aspic then invoked its subcontracts' arbitration provisions. In awarding Aspic a substantial sum, the arbitrator took an activist stance, concluding that the subcontract provisions were "onerous" as to ASPIC, and that the parties' expectations were not aligned. Specifically, the arbitrator stated:

Each subcontract included very detailed provisions relating to Federal regulations governing the work as well as pass through and 'Pay when/if Paid' clauses. The subcontracts were somewhat onerous as to ASPIC and were clearly drafted to give every advantage to ECC. In light of the fact that the ASPIC was a local Afghanistan subcontractor that had some experience with government contracting but not nearly as extensive as that of ECC, and in view of the fact that the normal business practices and customs of subcontractors in Afghanistan were more 'primitive' than those of U.S[.] subcontractors experienced with U.S[.] Government work, it was not reasonable to expect that Afghanistan subcontractors would be able to conform to the strict and detailed requirements of general contractors on U.S. Federal projects.

Id. at 8-9.

The arbitrator therefore held that "[i]t was not reasonable that when the parties entered into the subcontract agreements, they both had the same expectations as to the performance of the agreements. ECC could not expect that ASPIC would be capable of modifying their local business practices to completely and strictly conform to the US governmental contracting practices that were normal to ECC," and as a result, "[t]here was not a true meeting of the minds when the subcontract agreements were entered." Id. at 9. From the arbitrator's perspective, this meant that "ASPIC was not held to the strict provisions of the subcontract agreements that ECC had to the USACE." Id. at 10.

On review of this finding and corresponding award to Aspic, the U.S. District Court for the Northern District of California vacated the award, finding that "the arbitrator 'voided and reconstructed parts of the Subcontracts'" because it did not result in a meeting of the minds. Id. at 6. On appeal to the Ninth Circuit, the panel affirmed the lower court's vacatur, acknowledging that while an arbitrator has broad discretion in interpreting contract provisions, "[w]hat an arbitrator may not do, however, is disregard contract provisions to achieve a desired result." Id. at 10. Here, the subcontract terms required specific data and records be presented to support a contractor's termination settlement proposal, consistent with the standards outlined in the FAR, and there existed no course of dealing that augmented the subcontracts' clear terms. Id. at 11. Thus, the Court found that the arbitrator's award "disregarded specific provisions of the plain text in an effort to prevent what the Arbitrator deemed an unfair result." Id. at 12.

The Court concluded by noting that, as all government contractors are aware, FAR provisions, "while undoubtedly extensive, permit the government to maintain fairly uniform contracting standards in the many contracts it enters into with parties located in the United States and around the world…To allow contractors and subcontractors, foreign or domestic, to evade the FAR provisions because a subcontractor was too unsophisticated or inexperienced to fully understand them would potentially cripple the government's ability to contract with private entities, and would violate controlling federal law." Id. at 13.

The Aspic decision should come as a relief to prime contractors, especially those engaging less sophisticated subcontractors, or subcontractors unfamiliar with the rigorous regulatory framework inherent in the government contracting arena. While it should serve as comfort to prime contractors that subcontract provisions will be enforced, subcontractors should be cautioned that even their lack of sophistication or inexperience in the federal contracting space is unlikely to relieve them of the obligations contained in their contracts.

Other key takeaways from this case:

  • The Aspic opinion underscored how difficult it is for a contractor to overturn an arbitration award that may be considered unfair. The District Court's decision to vacate the award, and the Ninth Circuit's affirmance of the same, represent the exception, not the rule, in judicial review of arbitration awards.
  • Contractors should carefully consider whether arbitration makes sense for their company in every situation (i.e., whether your subcontracts should require arbitration across the board). In some instances, it may make sense to agree to jurisdiction before a particular court and to waive a jury trial. Where a contractor does elect arbitration, it should conduct research into available arbitrators to determine whether the individuals tend to strictly interpret contractual terms, or seek to reach a "just" result.
  • Prime contractors should ensure that their subcontract documents are clearly written and that the rights and obligations of the parties are fully delineated, so that the subcontractor's obligations are coextensive with the prime contractor's obligations to the U.S. Government to the extent necessary.
  • Prime contractors should ensure that its employees do not undertake a course of dealing or understanding with a subcontractor that would allow an arbitrator to conclude that the express terms of a subcontract have been modified.

Venable LLP frequently advises on and assists contractors through the subcontract negotiation process. For more information and assistance regarding the negotiation of subcontracts, please contact Paul Debolt at padebolt@Venable.com.