Virginia Contractors Can Overcome Sovereign Immunity and Sue the State Government, Even Where the Remedy Is "Equitable" Relief Instead of Damages

5 min

On May 9, 2024, the Supreme Court of Virginia held that a lawsuit alleging that the state government had procured a contractor's settlement of a contract dispute using economic duress and bad faith could proceed, rejecting lower court decisions finding that the doctrine of sovereign immunity barred the lawsuit. This important decision prevents the state government from avoiding its contractual obligations by attempting to frame a contract dispute as an "equitable" matter outside the jurisdiction of Virginia's courts.

How did the case start?

In 2014, the Virginia Department of Transportation (VDOT) awarded three contracts to NXL Construction Co., Inc. (NXL) for construction inspection services, the rights to which NXL later assigned to Montalla, LLC (Montalla). See Montalla, LLC v. Commonwealth, No. 230365, 2024 WL 2063963, at *1 n.1 (Va. May 9, 2024).

A dispute arose over whether NXL could properly bill VDOT for NXL's use of rental vehicles to perform the contracts. See id. at *1-*2. VDOT argued that NXL's billings violated Federal Acquisition Regulation (FAR) provisions in VDOT's own agreement with the Federal Highway Administration (FHWA) because the expenses for which NXL was seeking reimbursement were allegedly being paid to a company owned by a relative of NXL's chief executive officer. See id. NXL disagreed with VDOT's interpretation of the FAR provisions and argued that, even if they did limit what expenses VDOT could pass through to FHWA, the FAR provisions did not affect what expenses NXL could pass through to VDOT under their contracts. See id.

Based on its interpretation of the FAR provisions, VDOT only reimbursed NXL for a portion of its eligible costs and at rates far lower than the original rates in the contracts. See id. at *2. The parties entered mediation and reached a settlement in October 2017, which did not become effective until February 2018. See id. As part of the settlement, NXL paid VDOT $3,850,000. See id. at *3.

Why did the contractor believe duress and bad faith warranted reopening the settlement?

As to economic duress, Montalla alleged that NXL "had no choice but to agree to VDOT's terms and settle the dispute" because VDOT had "threatened NXL with the termination of its services contracts and a lawsuit under the Virginia Fraud Against Taxpayers Act," and because of NXL's "dire financial strain—having lost $5,753,762.77 on VDOT contracts alone[.]" Id. at *2.

With regard to bad faith, Montalla learned that VDOT had submitted a formal letter to FHWA regarding the FAR provisions in August 2017—prior to the settlement—which "noted that the majority position within [VDOT] was the one for which NXL had been advocating." Id. at *3. In addition, VDOT published an Instructional and Informational Memorandum (IIM) in December 2017—before the settlement agreement became final—stating "that companies were entitled to reimbursement regardless of who owns the vehicles being leased, which is the precise position NXL had been advocating[.]" Id. "According to Montalla, the IIM demonstrate[d] that the FHWA endorsed the position taken by NXL" regarding the correct interpretation of the FAR provisions. Id. Finally, NXL alleged that VDOT had "pressured the Secretary of Transportation into cancelling an IIM—which was approved by the FHWA—that was set to be issued in July 2016 and would have supported NXL's position[.]" Id. at *4.

After Montalla acquired NXL's rights under the contracts, it sued VDOT, alleging that:

  1. The settlement agreement was void because of economic duress
  2. The settlement agreement should be vacated under Va. Code Ann. § 8.01-581.26, which addresses agreements that are unconscionable or procured by fraud or duress
  3. VDOT breached its duty of good faith and fair dealing
  4. VDOT breached the contracts by underpaying NXL and
  5. VDOT's actions were a regulatory taking without just compensation under the Virginia Constitution

What was the Supreme Court's ruling?

The Circuit Court dismissed Montalla's complaint against VDOT on the basis that the state government was immune to suit in its capacity as sovereign. See id. The Virginia Court of Appeals agreed and affirmed. See id. at *5.

In contrast, the Supreme Court of Virginia held that sovereign immunity did not bar Montalla's claims and reversed.

The Supreme Court acknowledged that sovereign immunity "is alive and well in Virginia" and that the doctrine "protects the state from burdensome interference with the performance of its governmental functions and preserves its control over state funds, property, and instrumentalities." Id. But it also noted that sovereign immunity "has no application in actions based upon valid contracts entered into by duly authorized agents of the government." Id. at *6.

The Supreme Court held that the lower courts had erred in concluding that Montalla's claims were not based upon valid contracts, such that sovereign immunity applied. Reasoning from prior case law, the Supreme Court explained that "it is the nature of the dispute and not the remedy sought that determines whether an action is based upon a contract." Id. at *7.

For example, even though Montalla sought to rescind its settlement agreement with VDOT—which the law may treat as an off-contract, "equitable" remedy—Montalla's claims still sounded in contract. See id. (noting that "[t]he cause of action underlying [a] rescission claim is a breach of contract action"). The Supreme Court also noted that "[a] contrary conclusion, that equitable contract remedies are never available against the Commonwealth, would, at least in some circumstances, allow the Commonwealth to avoid completely obligations it undertook in validly entered contracts." Id.

Similarly, while Montalla did raise a claim under a statute (Va. Code Ann. § 8.01-581.26), the "nature of the claim" was still "based upon a contract, and thus, outside the protections of sovereign immunity." Id. at *8.

Why is this decision important?

The decision by the Supreme Court of Virginia in Montalla confirms that contractors can raise contract-related claims against the state government without fear that the type of relief sought (equitable remedies vs. contract damages) will result in the claim being dismissed based on sovereign immunity. The Supreme Court abhorred the "absurd result[s]" that would obtain in such scenarios, id. at *7, and applied the law to prohibit "the Commonwealth [from] avoid[ing] completely obligations it undertook in validly entered contracts[.]"