Caldera v. Northrop: Federal Circuit Says Legal Costs Are Not Allowable

On December 13, 1999, the Federal Circuit denied a petition for rehearing on a decision that significantly changes existing law governing allowability and allocability of legal costs under federal contracts. See Caldera v. Northrop, 192 F.3d 962 (Fed. Cir. 1999). The decision, rendered by a three-judge panel on September 10, 1999, reversed an ASBCA ruling and held that legal costs incurred by a federal contractor in unsuccessfully defending against a state court wrongful termination action were not allowable under Federal Acquisition Regulation (“FAR”) ' 31.201-4. the unanimous panel ruled that the contractor must show that there was a “benefit to the government” in order for legal costs to be “allocable” to a federal contract under FAR ' 31.201-4.Id. at 972. In the process, the Court rejected Northrop’s argument that the costs clearly were allocable under the standards set forth in FAR ' 31.201-4 and that the only remaining question was the allowability of the costs, which should be analyzed as an issue of reasonableness. Instead, the Court adopted the Army’s position that “the cost is allocable only if there is some benefit to the government for incurring the cost.”

In adopting the Army’s position, it appears that the Federal Circuit has effected a significant change in the existing law relating to allocability of legal defense costs. The Court has also blurred the distinction between an “allocability” inquiry under FAR ' 31.201-4 and a “reasonableness” determination under FAR ' 31.201-3 (A cost must be both “allocable” and “reasonable” to be “allowable” under a government contract.) The interpretation espoused by the Army and adopted by the Court establishes a new test for determining allocability that appears to be at odds with the relevant FAR provisions and existing law.

For example, FAR ' 31.201-4, which sets forth the standards for the “allocability” of costs, does not limit allocability only to situations in which there is “a benefit to the Government.” To the contrary, FAR ' 31.201-4 provides that:

“[a] cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship. Subject to the foregoing, a cost is allocable to a Government contract if it:

(a) Is incurred specifically for the contract;

(b) Benefits both the contract and other work, and can be distributed to them in reasonable proportion to the benefits received; or

(c) Is necessary to the overall operation of the business, although a direct relationship to any particular cost objective cannot be shown.”

Thus, a contractor only need show that it meets one of the three prongs to demonstrate that a cost is allocable to a federal contract. The contractor then must show that the cost was reasonable (see FAR ' 31.201-3) in order for the cost to be considered allowable under the contract. See FAR ' 31.201-2.

Northrop’s brief discussion on allocability, however, effectively rewrites FAR ' 31.201-4 to require a contractor to show a “benefit to government work from an expenditure of a cost that it claims is ‘necessary to the overall operation of the [contractor’s] business’” in order for the cost to be allocable. Applying this principle to the facts in the Northrop case, the Court noted that “[w]e can discern no benefit to the government in a contractor’s defense of a wrongful termination lawsuit in which the contractor is found to have retaliated against the employees for the employees’ refusal to defraud the government.” But, the FAR does not contain a requirement that “benefit” be demonstrated in order to allocate to a government contract a cost “necessary to the overall operation of the business.”

Whether the costs of defending employment litigation are allowable arguably should have turned, under Northrop’s facts, not on allocability, but rather on reasonableness. Specifically, the issue the Federal Circuit should have addressed was whether, under the circumstances known to Northrop at the time, it was prudent and reasonable for Northrop to defend the case. Instead, the Court’s decision hinges upon a what appears to be a misapprehension of allocability.

In the end, the Court denied rehearing and has left the government contracting community with an opinion that has potentially far-reaching implications for the allocability and allowability of legal defense costs. Although the impact of this decision remains to be seen, the Court’s interpretation of the FAR arguably has created a “benefit to the government” requirement for legal defense costs that is not contemplated by the FAR and confuses the concepts of allocability and reasonableness of costs. Moreover, the Court’s interpretation of the FAR has generated significant concern in the government contracting community that the government may try to apply the principles outlined in the Court’s decision to question and disallow normal business costs other than litigation expenses that fall under the rubric of G&A expenses on the ground that a particular benefit to government contracts has not been demonstrated.