Contractor legal costs, including the costs to settle third party lawsuits (i.e., suits brought against a contractor by an individual or non‑governmental entity), are allowable if the costs are reasonable, allocable, consistent with CAS (or GAAP), comply with the terms of the contract and are not limited by the cost principles of FAR Subpart 31.2. The primary cost principle relevant to settlement costs is FAR 31.205-47, which disallows contractor settlement costs for a very narrow category of third party "proceedings" brought by relators against a contractor on behalf of the government for violation of False Claims Act or brought by whistleblowers against a contractor for alleged reprisal, unless the contractor can demonstrate that there was "very little likelihood" the third party would succeed on the merits of its claim. FAR 31.205-47(c)(2). Not long ago, this was understood to mean that contractor costs incurred reasonably to settle a third party lawsuit constitute allowable costs of doing business. Since the Federal Circuit's decision in Geren v. Tecom, Inc., 566 F.3d 1037 (Fed. Cir. 2009), however, the allowability of settlement costs incurred in just about any type of third party lawsuit has been unclear.

In Tecom, the Federal Circuit addressed the allowability of settlement costs arising out of a third party employment discrimination lawsuit. In doing so, it relied on the two-pronged standard earlier adopted by the Court in Boeing: “(1) we ask whether, if an adverse judgment were reached, the damages, costs, and attorney's fees would be allowable; (2) if not, we ask whether the costs of settlement would be allowable.” Id. at 1041 (citing Boeing N. Am., Inc. v. Roche, 298 F.3d 1274, 1285-89 (Fed. Cir. 2002)).

Under this framework, the Federal Circuit determined that an employee’s Title VII sexual harassment claim, if proven, would establish a contractor breach of its government contract and, therefore, would result in unallowable legal costs—meeting the first prong of the test. The Tecom decision, if read broadly, created a risk that nearly any type of third party lawsuit could be characterized as a breach of contract and result in unallowable costs. See, e.g., DEAR 970.5204-2 (requiring DOE contractors to “comply with the requirements of applicable Federal, State, and local laws and regulations (including DOE regulations)”). The Federal Circuit then remanded the case for determination of whether the contractor should recover settlement costs based on the second prong of the test. Under the second prong, the Tecom decision stated that, because there is no blanket presumption that a private suit is meritorious, there must be an inquiry to determine whether the plaintiff is likely to prevail. The Federal Circuit determined that, based on the standard for recovery of settlement costs brought by a relator in the FCA context, contractors must establish that the private litigant had a “very little likelihood of success” in order to recover third party settlement costs. Tecom, 566 F.3d T1037, 1045-46. The Federal Circuit did not address what evidentiary support is required to establish a “very little likelihood” to succeed. Id.

Most recently, the Court of Federal Claims (COFC) in Bechtel National, Inc. v. United States had the opportunity to analyze the Tecom standard for the first time since that decision. Bechtel specifically addressed the allowability of contractor settlement costs arising out of discrimination suits brought by employees in the context of a Department of Energy (DOE) contract which included a contract provision designed to shift the risk of third party liability arising out of the hazardous nuclear activities work from contractors to the government. Bechtel asserted that the contract's inclusion of the DOE contract clause meant that Tecom should not apply in the context of a dispute involving that clause. The COFC disagreed and determined that, based on the “expansive public policy” against employee discrimination, Tecom applied irrespective of the DOE contract clause.

The COFC, however, declined to endorse a broader application of Tecom. Specifically, the COFC observed that:

Using Tecom to give [the DOE contract clause] a very broad reading, under which the provision would preclude the recovery of liability costs whenever such costs result from any breach of contract (even if such breach was not the result of willful misconduct, lack of good faith, or a failure to exercise prudent business judgment within the meaning of subparagraph (h)), could significantly undermine that unique purpose. The Court, accordingly, declines to read the rationale of Tecom as applicable whenever liability costs arise out of conduct that could also constitute a breach of contract. Instead, the Court reads the decision as resting upon the unique public policies that underlie the anti-discrimination provisions of the Executive Order, which would be undermined if the government were to effectively subsidize a contractor's discriminatory conduct.

Bechtel Nat'l, Inc. v. United States, No. 17-657C, 2018 WL 1603333, at *5 (Fed. Cl. Apr. 3, 2018) (emphasis added).

Importantly, in a footnote that coincides with the emphasized language above, the Bechtel decision highlights that its narrow interpretation of Tecom is "difficult to square" with the broadly worded language used in Tecom that "costs resulting from a breach of a contractual obligation are not allowable under the contract." Id. at *8 fn. 5. The COFC, however, appropriately sought to limit the relevance of this language by pointing to Tecom’s holding, rather than its dicta: “the holding in Tecom was that where a contract contains a non-discrimination clause, costs resulting from the breach of that clause are not allowable under the terms of the contract. This Court’s decision is faithful to that holding.” Id.

Consequently, contractors should continue to assess the allowability of private settlement costs under the two-pronged test used in Tecom, understanding that despite Bechtel’s clarification of Tecom and its scope (i.e., limiting the breach of contract language to a non-compliance with the terms of the employment discrimination clause), it is likely that there will be continued future litigation concerning the relevance of Tecom with respect to third party lawsuits not involving employment discrimination. Such an assessment is relevant to a contractor’s evaluation and comparison of the appropriateness of pursuing a lawsuit to conclusion, which could be more expensive but result in allowable costs if the contractor were to prevail, with the decision to settle and potentially have the costs deenomed unallowable. Should contractors decide to settle employment discrimination cases, contractors—to the extent possible—primarily should focus on establishing an evidentiary record that supports a position that the third party litigants had very little likelihood to succeed in any underlying proceeding. Unfortunately, the Bechtel decision did nothing to advance a clearer understanding of what level of evidence is necessary to prove the negative -- that the plaintiff involved in a settlement had very little likelihood of success on the merits. Greater clarity on that confusing standard remains for another day.