United States: Ten Myths Of Government Contracting: Myth No. 4 - Subcontractors Aren’t As Exposed As Primes

How many times have you heard this? My response is always the same: Have you actually read any of your subcontracts? I already know the answer to that question, of course, because no one who has read a properly drafted subcontract could ever utter the words above.

If a prime contractor is doing its job, it is going to "flow down" many of the clauses from its prime contract to its subcontractors. Primes go about this in a variety of ways. Some will actually print each and every clause verbatim and include it in your subcontract, and they will tell you that where the clause says "the Government" it means the prime and where it says "contractor" it means the sub. Others will simply list the clauses by title and leave it to you to look them up. Other primes might include clauses that look like they are standard clauses but, upon examination, have been altered in ways that are adverse to the sub. And these are just a few of the things that can happen!

Of course, with the volume of business that goes on, a sub might have several different deals pending at any time, and the common complaint is that there is never enough time to do the review that is necessary before signing a subcontract. In other words, they sign the deal without really knowing what is in it, and they hope for the best. In most situations, contracts can be performed with only minor glitches, so this ostrich approach has not caused any harm. But in those cases where major problems arise, this approach can cause a lot of heartburn.

While it is true that a subcontractor does not have "privity" with the Government, i.e., it does not have a direct contractual relationship, that merely presents a procedural impediment to the Government's ability to get to the sub. If the prime contractor has put the appropriate clauses into your agreement, there is almost no shield between your company and the Government. Let's say, for example, that the Government determines that your cost and pricing data are defective under the Truth in Negotiations Act. Because it has no privity with your company, the Government will lodge the defective pricing claim against the prime, and the prime will turn around and send it to you. You will then have to work with and through your prime to resolve the problem.

The same two-step process would hold true for most standard contract actions, but there are situations in which the Government, acting in its sovereign capacity rather than its contractual capacity, can come directly against a subcontractor. For example, let's say that your defective pricing matter has been referred to the Department of Justice (DOJ) and the DOJ concludes that your actions were criminal. The DOJ can file charges directly against your company even though it has no contractual relationship with you whatsoever. Likewise, if the Department of Labor (DOL) should conclude that your company failed to follow the Service Contract Act, the DOL can move directly against you without going through your prime.

There is one particular area where being a subcontractor actually exposes a company to more risk than being a prime, and that is payment. The prime is the beneficiary of a statute called the Prompt Payment Act, which puts pressure on the Government to make timely payments. This statute does not apply to subs; instead, the sub's payment is governed by the language in its subcontract. If that subcontract is silent on payment, or if the language is of the "paid when paid" variety, i.e., the prime agrees to pay the sub within a certain number of days after the Government has paid the prime, the subcontractor could be in a bind.

What happens, for example, if the agency fails to make its first payment to the prime until 60-90 days after contract performance begins? This is not an unusual occurrence. If the payment terms are "pay when paid," the sub is out of luck. That is why, to the extent possible, a subcontractor should insist on payment within 30 days of submitting an invoice to the prime, regardless of when the Government actually pays the prime. This often comes down to a matter of negotiating leverage. Most subcontractors believe that they have no leverage in such situations, but that is not necessarily true.

A subcontractor's exposure may depend on two other important concepts — choice of law and disputes. A well-drafted subcontract will always contain clauses addressing these two issues. Without such clauses, the prime will be in the driver's seat. The "Choice of Law" clause dictates which forum's law will govern the transaction. It is yet another reminder that a subcontract is between two commercial organizations, and the prime usually will try to ensure that the laws of its home state will govern. This is not necessarily a bad thing, but if a sub is aware that a particular state is inhospitable to manufacturers, for example, it might want to think twice before agreeing to be governed by that state's laws. One way to mitigate this effect would be to agree that the subcontract will be governed by the law of federal Government contracts and that, if a situation should arise where there is no such applicable law, then the law of the prime's home state will apply. This has become a fairly popular approach to the choice-of-law dilemma.

With respect to disputes, it is important to remember that there are two basic kinds of disputes that can arise in connection with a subcontract: disputes between the prime and the sub, and disputes that really are between the Government and the sub. Consequently, your subcontract should contain a disputes clause that addresses both kinds of situations. In devising the language addressing disputes between the prime and the sub, there are many possible approaches, but beware of a provision calling for binding arbitration. Arbitration may sound attractive because it avoids the courts, but in practice it can be an expensive and frustrating experience, with no way out. I recommend using language calling for some sort of alternative dispute resolution technique (there are many) that will minimize the role of lawyers and the risk of uncontrolled litigation expenses. If it is not possible to agree on such an approach, and litigation is the only available option, be careful to avoid language requiring that all such litigation be conducted in the prime contractor's jurisdiction.

With respect to the language addressing disputes that really are between the Government and the sub, it is important to track the disputes language from the prime contract so that the procedures in the subcontract parallel it.

Every contract presents risk. A smart subcontractor realizes this and takes careful and prudent steps to mitigate that risk. The failure to do so could lead to some serious consequences.

This article originally appeared on the blog of the Public Contracting Institute.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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