(Editor’s Note. In the last few years, we have been seeing both Board decisions and auditors rejecting the allowability of a variety of costs based on assertions the costs "do not benefit the government." In both our consulting engagements and writings we have been quite critical of this trend and the following case comes close to vindicating our criticism.)

Rockwell paid out a total of $25.5 million in civilian and criminal fines to settle allegations involving a civil False Claims Act lawsuit, criminal charges for making false statements under government contracts, defective pricing and environmental violations. Shareholders brought suit (Citron v. Beal, No. C728809) against the Rockwell directors and officers alleging they had breached their fiduciary duties by failing to establish internal controls sufficient to ensure business was carried out in a lawful manner. Between 1989 and 1991, Rockwell incurred about $4,576,000 in various legal and other fees defending against the shareholder suit. It included these costs in its home office G&A pool and claimed reimbursement for a portion of the costs on its various government contracts. When the contracting officer denied these costs, Rockwell appealed to the Armed Services Board of Contract Appeals (ASBCA).

While the appeal was pending before the board, the Federal Circuit decided a case Caldera v. Northrop Worldwide Aircraft Services Inc., 192 F.3e 962 (1999). The case also involved legal costs that were incurred in defense of an action charging that the contractor wrongfully terminated several employees because they refused to participate in fraud against the United States (72 FCR 355, 520, 633). The Northrop court concluded the costs were not allowable because they were not allocable under FAR 31.201-4(b) which states " a cost is allocable to a Government contract if it…benefits both the contract and other work, and can be distributed to them in reasonable proportion to benefits received." The Court found recovery of the costs should be barred "because the government did not benefit from defense of the wrongful termination lawsuit.

Citing the Northrop case, the Board concluded that Rockwell’s legal costs were unallowable because there could be "no benefit to the government in a contractor’s defense of a third party lawsuit in which the contractor’s prior violation of federal laws and regulations were an integral element of the third party allegations." The board reasoned that "but for" Rockwell’s wrongdoing, the Citron suit would not have been brought and the costs would not have been incurred.

Rockwell (later succeeded by Boeing who bought out Rockwell) appealed to the Federal Circuit court. The Appeals Court stated the Board’s decision erroneously confused allowability with allocability and ruled a cost cannot be considered unallowable because it does not "benefit the government." Whether a cost is allowable or not is based on public policy decisions or contract stipulations where specific regulations such as the FAR cost principles govern. The word "benefit" stated in FAR 31.201-4 is an "allocation" concept and the Court admitted its prior rulings in Northrup had "caused confusion." The word "benefit" as used in FAR 31.201-4 refers only to an accounting concept which describes the "nexus" required between the cost and the contract to which it is allocated; it does not impose a separate requirement that a cost must benefit the government’s interest for it to be allowable. "The requirement of a ‘benefit’ to a government contract is not designed to permit…an amorphous inquiry into whether a particular cost sufficiently benefits the government so that the cost should be allowable." The question of allowability is to be based upon "specific allowability regulations."

Though the Court rejected the use of the confusing criteria of "benefit" for determining cost "allowability", Boeing is not out of the woods in its lawsuit costs appeal. Boeing claimed its legal costs were allowable because there was no cost principle that disallowed the legal costs but the Court rejected this line of reasoning. It noted the failure of various subsections of the FAR cost principles to cover every element of cost does not imply the cost is either allowable or unallowable. Rather, FAR 31.204 (c) "instructs" that allowability under such circumstances should be based on the principle covering similar or related cost items. The Court stated that Northrop and FAR 31.205-47 established the principle that an unsuccessful defense of a private suit charging contractor wrongdoing makes the legal cost unallowable if the "similar" costs would be disallowed under the regulations.

The Court stated the most "similar" costs are covered by FAR 31.205-47 (legal proceedings). FAR 31.205-47 reflects a policy judgement that where an action is brought by a government entity and the defense costs would be disallowed because, for example, the proceeding brought a criminal conviction or a civil liability for fraud then the defense costs likewise in a settlement situation should be disallowed unless the government specifies otherwise. Such a relationship would exist if, for example, there was a Court decision that Rockwell directors had failed to maintain adequate controls to prevent wrongdoing against the government. Since the Citron case was settled without a judicial decision, there was no such determination. The Court ruled FAR 31.205-47 and the Northrup case state that legal defense costs are unallowable when the underlying suit has merit while the costs are allowable when the suit lacks merit. Here, where there was a settlement, the Court ruled that the contractor must show the underlying lawsuit had "very little likelihood of success on the merits" to allow recovery of the legal costs. The Court remanded the case back to the Board to decide the merits (Boeing North Am., Inc. v. Roche, 2002 WL 398756).

{TAG_FORM_TITLE}