United States: Cost Allowability: Supreme Court Tacitly Endorses Rejecton Of Business Judgment Rule When Gauging Cost Reasonableness

On October 6, 2014, the Supreme Court of the United States ("Supreme Court") denied certiorari in Kellogg Brown & Root, Inc.'s ("KBR") fight to recover $41 million in disallowed subcontractor costs incurred in performance of dining services in Iraq, bringing an end to KBR's longrunning claim litigation. Of significance for other contractors, the Supreme Court's denial leaves intact the decision by the Federal Circuit, Kellogg Brown & Root Servs., Inc. v. United States, 728 F.3d 1348, 1359 (Fed. Cir. 2013) opinion corrected on denial of reh'g, 563 F. App'x 769 (Fed. Cir. 2014) and cert. denied, 13-1558, 2014 WL 2919328 (U.S. Oct. 6, 2014) (KBR I), wherein the Federal Circuit discussed at length the significant regulatory discretion invested in the Government when assessing cost reasonableness. KBR I has caused a great deal of concern in the contracting community because it undermines contractors' real-time business judgments about cost reasonableness.

The underlying dispute stemmed from a cost-reimbursement contract between KBR and the DOD, under which KBR was required to provide dining services for up to 50,000 troops in support of military operations in Iraq. As the military action escalated, however, the dining service requirements quickly and dramatically expanded to supporting 200,000 soldiers at 56 sites throughout Iraq. After a "disastrous" attempt to self-perform certain portions of the expanded contract, KBR engaged a subcontractor, Tamimi Global Company, ("Tamimi") to provide dining services at one of the Army camps and sought payment for those subcontractor services. The Defense Contract Audit Agency ("DCAA") subsequently audited KBR and determined that KBR incurred $41 million in unreasonable subcontractor costs between July and December 2004. Acting on DCAA's audit report, the contracting officer then withheld $41 million from payment to KBR. KBR filed a claim against the agency, which the Government denied, and then filed its claim appeal with the COFC. The COFC denied KBR's claim, adopting DCAA's position that the costs were unreasonable because KBR did not engage in effective bargaining with Tamimi. The Court noted that although KBR's failed attempt at self-performance undermined its negotiating position, that complication did not mitigate KBR's failure or inability to negotiate better service rates with Tamimi.

Before the Federal Circuit, KBR argued that DCAA, the contracting agency, and the COFC impermissibly second-guessed KBR's business judgment in a wartime environment, contending that contractor's cost of performance should be presumed reasonable unless the result of "gross misconduct," "arbitrary action," or "a clear abuse of discretion." In substance, KBR advocated for application of the "business judgment rule" (a fundamental corporate law doctrine) to cost reasonableness determinations. The Federal Circuit rejected KBR's position, noting that earlier precedent deferring to contractor cost judgments does not outweigh the regulatory flexibility embodied in the cost principles contained in Federal Acquisition Regulation Part 31.

Now that the Supreme Court has denied certiorari and the Federal Circuit's decision is final, contractors, subcontractors, accountants, auditors, and counsel must adapt to the newly recognized regulatory discretion held by all agency contracting personnel who are called upon to make cost reasonableness determinations. A few important aspects of the KBR decision may prove helpful to that adaptation process:

• Documentation. Well-documented subcontractor price negotiations and flowdown provisions. KBR's exposure resulted from subcontract terms negotiated in and around the exigencies of a war zone at a time when performance was urgently needed. These unique circumstances left KBR without a comparable private marketplace benchmark for establishing cost reasonableness. KBR was forced to rely solely on its record of subcontract negotiations and the subcontract itself to establish reasonableness. Taking KBR's lessons learned to heart, cost-reimbursement contractors that are considering subcontracting should (i) look early (even at the time of proposal preparation) for a commercial market benchmark against which to make outsourcing price comparisons, and where no such counterpart exists, (ii) develop and pursue a robust plan for conducting and documenting subcontract negotiations, to include specially tailored clauses that enable the contractor to claw back costs paid and subsequently disallowed by the agency.
• Burden of Proof. KBR I preserves the fundamental tenet that the burden to prove cost reasonableness always falls on the contractor. To meet that burden, contractors performing on large complex cost reimbursement contracts should expect and prepare for cost controversies and claims with the Government by meticulously documenting costs in order to justify their claim.
• No Business Judgment Rule. The KBR I court took a dim view of KBR's argument that the costs were not unreasonable and were not the result of gross negligence. In short, there is no safe harbor in the form of a business judgment defense.
• Second-Guessing — the New Standard. Cost-reimbursement contracts are now even more susceptible to agency second-guessing. Contractors should consider stepping up their administrative efforts to justify and document costs to mitigate the risk of material second-guessing during audit and closeout actions.

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