United States: Escrowed Payments May Leave Federal Subcontractors High And Dry

Companies providing products or services as subcontractors to prime federal contractors often struggle with how best to ensure prompt and full payments from primes. Prime contractors, particularly small business concerns, often struggle to manage competing cash flow demands with the result that subcontractors are left paid late or not at all. Including appropriate payment clauses in the subcontract is important but of limited value – ultimately they are enforceable only as contract claims that may need to be resolved in litigation.

Increasingly, subcontractors who are able will attempt to remove the prime contractor from the payment stream by obligating the prime to instruct the Government to pay contract revenues to an escrow agent for appropriate disbursement to the parties, believing this constitutes an enforceable assignment to the agent of the right to make a claim on contract revenues. But, is that the result?

Imagine the following scenario. A Request for Quote ("RFQ") for hose assemblies is issued to Prime Contractor ("Prime") in a sole source solicitation by the United States Defense Logistics Agency ("DLA"). Prime responds to the RFQ with a quote proposing to obtain the hose assemblies from Subcontractor ("Sub"). The quote contains the following "remit to" and "contractor" addresses respectively: (i) Michael Kawa, Esq., 300 Crown Building, 304 S. Franklin St., Syracuse, N.Y. 13202; and (ii) 1872 Mills St., Bldg F, Tallahassee, FL. The contracting officer believes that payment should be remitted to Mr. Kawa at the address in the Purchase Order ("PO") and that he is somehow associated with Prime, most likely as a banker.

In fact, Mr. Kawa is an escrow agent that Sub insisted be included as the remittee in Prime's POs for which Sub is acting as supplier due to Sub's substantial previous difficulty collecting payments from Prime. Mr. Kawa, a lawyer, prepared an escrow agreement for the purpose of ensuring that Sub would get paid in connection with its work performed pursuant to its subcontracts with Prime. Mr. Kawa consented to act as the escrow agent himself, to receive funds payable on Prime's contracts where Sub is supplier to Prime, and to release those funds in accordance with the escrow agreement agreed to by the parties. The escrow agreement requires both Prime and Sub to take all action necessary to ensure that DLA would pay Mr. Kawa rather than Prime. Sub believes that the PO with Mr. Kawa's name in the "remit to" block constituted DLA's acceptance of an assignment of payments from Prime to Sub and controls the payee and method of payment.

Once the PO is issued, contract management responsibilities shift from the pre-award contracting officer to a post-award contracting officer. Sub ships the items ordered in the PO to the Defense Department Depot and issues an invoice to Prime the same day. However, DLA does not send payment for the PO to Mr. Kawa but rather, and without informing Prime or Sub, makes payment via Electronic Funds Transfer ("EFT") to Prime. When Sub attempts to expedite payment with DLA, Sub is informed that payment was already made to Prime. Sub is informed by DLA that in light of the conflicting "remit to" address on the PO and the U.S. Department of Defense directive requiring all payments to be made by EFT, DLA chose to remit payment to Prime via EFT.

Sub telephones Prime who denies receipt of the payment. Sub attempts to collect the money from Prime but Prime declares bankruptcy. The Sub's escrow agent, Mr. Kawa, files a complaint against the United States arguing that as the escrow agent of the Sub designated on the PO as the intended "remittee" the Government should have paid him, not the Prime, because he has been assigned the right to payments under the prime contract. Will the Court be persuaded?

Not a hypothetical, the above scenario describes an actual case ruled on by the U.S. Court of Federal Claims.1 The Court – definitely unpersuaded – dismissed the escrow agent's complaint and, in particular, rejected the claim that the agent had been assigned the right to receive prime contract revenues and to make a claim against the Government for failure to pay those revenues. The Court invoked the Anti-Assignment Acts (the "Acts"),2 which broadly prohibit assignment of claims against the United States unless the Government chooses to waive the Acts and recognize the assignment of a claim. To determine if the Government properly exercised its discretion to waive the Acts, the court must look to "whether: 1) the assignor and/or assignee sent notice of the purported assignment to the Government; 2) the contracting officer signed the notice of assignment; 3) the contracting officer modified the contract according to the assignment; and 4) the Government sent payments to the assignee pursuant to the assignment."3 In the case at hand, no "notice of assignment" was ever sent to DLA, only a request for a name change in the "remit to" address. Moreover, DLA did not sign a notice of assignment and did not make payments according to any purported assignment.

But, the Court could have gone further. Under the Acts, a contractor may only assign moneys due or to become due under a contract if "[t]he assignment is made to a bank, trust company, or other financing institution, including any Federal Lending Agency."4 The escrow agent in the case before the Court of Federal Claims was not a "financing institution." Courts have determined that the term "financing institution" only encompasses an organization whose primary business is the provision of financing and capital.5

While not specifically addressed in the above scenario, additional concerns arise in the case of a traditional escrow arrangement even where there is an assignment to a "financing institution." That is, the government may make a claim for setoff against an assignee "When the assignee has neither made a loan under the assignment nor made a commitment to do so..."6 An escrow account is simply an account for safekeeping and disbursing money that is the property of a third party—it is in no way a loan or financing event. Should the government make a claim for setoff against payments owed to a prime contractor, the subcontractor/assignee may be completely unprotected in the absence of a loan or other financing event. The market has started to respond and at least one specialty finance company now provides "financing escrow accounts" that combine financing with disbursement of monies owed.

The lesson is clear. The only enforceable assignment of claim under a federal government contract is an assignment to a bank, trust company, or other financing institution. Any other arrangement purporting to assign the right to make a claim for revenues under a federal contract is not enforceable against the Government.

Notes

1 Kawa v. United States, 86 Fed. Cl. 575 dismissed, 368 F. App's 106 (Fed. Cir. 2009).

2 31 USC § 3727 and 41 USC § 6305.

3 Id. at 591 (citing Tuftco Corp. v. United States, 222 Ct.Cl. 277, 614 F.2d 740 (1980)).

4 FAR § 32.802(b). See FAR § 52.232-33(g) ("[P]ayment to an ultimate recipient other than the Contractor, or a financial institution properly recognized under an assignment of claims pursuant to Subpart 32.8, is not permitted.").

5 Fireman's Fund Ins. Co. v. Eng., 313 F.3d 1344, 1350 (Fed. Cir. 2002) ("A 'financing institution' supplies financing. That is its business. It lends money or provides capital.").

6 FAR § 32.804(c).

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