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By Michael C. Loulakis and Lauren P. McLaughlin

There are myriad ways in which public and private owners seek to ensure that subcontractors and suppliers get paid for their work. Every state has some type of mechanic’s lien statute that, in general, enables an entity providing improvements to a property to place a lien on that property if it is not paid. Many states also have construction trust fund and/or prompt payment statutes.

However, perhaps the most common form of payment protection is through a payment bond, whereby a surety will financially guarantee the general contractor’s payment obligations to subcontractors and suppliers. This is especially important on public projects for which government land cannot be liened.

The obligation for general contractors to post payment bonds on federal projects is codified in the Miller Act, and most states have so-called Little Miller Acts that serve the same function. What happens, however, when the government does not enforce the requirement for a bond and subcontractors go unpaid? This issue’s case, Constructora Guzman S.A. v. the United States, addresses this situation on a federal project in which the subcontractor sued the government, arguing that its actions in waiving the bond requirement created a legal obligation for the government to pay the unpaid subcontractors.

The case

The disputes arose from an embassy renovation project in Guyana. In September 2013, the U.S. Department of State awarded a firm-fixed price contract to Enviro-Management & Research Inc. for the renovation. The total adjusted contract value was approximately $17 million. EMR engaged Guzman to perform construction-related services for $8.3 million. Guzman completed its work, but EMR failed to pay Guzman approximately $1.5 million. Under the State Department and EMR prime contract, the Miller Act bonding requirement was incorporated:

The Contractor shall furnish (1) performance and payment bonds ... in the amount of 100% of the contract price for the performance bond and 100% of the contract price for the payment bond, or (2) comparable alternate security approved by the Government as authorized and in accordance with Federal Acquisition Regulation (FAR) Section/Part *690 28.204, Alternatives in Lieu of Corporate or Individual Sureties.

The Miller Act, however, also allows for waiver of the bonding requirement in foreign countries if the contracting officer “finds that it is impracticable for the contractor to furnish the bonds.”

In October 2013, EMR sent a letter to the government’s contracting officer stating that it was unable to obtain the required Miller Act bonds. EMR proposed an alternative arrangement in which the government would retain additional moneys from each invoice until certain completion milestones were met, at which point the retainage would be released to EMR. The contracting officer agreed and issued a contract modification waiving the bonding requirement.

During the project, the government began receiving complaints that EMR was not fulfilling its payment obligations. The government enclosed a list of subcontractors from which it had received complaints and ordered EMR to demonstrate that they had been paid or resolved. The government also expressed concerns about the truthfulness of EMR’s partial releases and certifications submitted in connection with monthly payment requisitions.

Just as the project neared completion, the government made an inquiry to an EMR subcontractor (unnamed in the decision) regarding payment. Specifically, the contracting officer stated: “Before the (government) pays out the remaining contract amount, please confirm your company has received final payment by contractor EMR.” The subcontractor responded with its unpaid invoices and stated it had not yet received payment.

The government responded by assigning negative ratings to EMR in its contractor performance assessment report. In disputing this negative rating, EMR responded that there were several reasons that some subcontractors had not been paid, including but not limited to: “invoices not received, invoices that are inaccurate, incorrect banking information on invoices, invoices that do not belong to EMR, and accounts that need to be reconciled for final payments.”

EMR submitted a final payment application for $982,134, which was the amount that had been withheld by the government pursuant to the modified retainage agreement and for potential liquidated damages and overtime. The payment application certified that “all payments due to subcontractors and suppliers” were paid. The government paid EMR, but Guzman did not receive payment of the approximately $1.5 million that it alleged it was due.

Guzman ultimately filed suit against the U.S. in the Court of Federal Claims, even though it had no privity of contract with the government. Guzman did so by asserting that either it was a third-party beneficiary of the prime contract with EMR or that it had an implied-in-fact contract with the government. Under both theories, Guzman alleged that the government failed to withhold funds to pay it for its work on the project.

The government moved to dismiss the complaint, arguing that Guzman’s claim for breach of an implied-in-fact contract was not viable. The court quickly agreed that Guzman did not allege facts sufficient to establish the existence of an implied contract with the government. However, the court allowed Guzman’s third-party beneficiary claim to proceed. After the parties exchanged discovery, the government moved for summary judgment, asking the court to dispose of the third-party beneficiary claim again.

The ruling

The court began its analysis by noting the general principle that the government only “consents” to be sued by those with whom it has direct privity of contract. However, there are exceptions to that general rule. One such exception exists when the suit brought against the government is by an “intended third-party beneficiary” to a government contract. “In order to prove third-party beneficiary status, a party must demonstrate two things: (1) that the contract not only reflects the express or implied intention to benefit the party but (2) that it reflects an intention to benefit the party directly” — in this case, Guzman, according to court documents.

Guzman argued that it was a third-party beneficiary to the prime contract with EMR because by retaining money from each payment to EMR in lieu of the bonding requirement, the government clearly stated its intention to guarantee payment to EMR’s subcontractors. The court found, however, that although Guzman met the first prong (the contract reflected an intention to benefit the subcontractors), Guzman was not able to meet the second. Guzman could not demonstrate that the government intended to confer a direct benefit to it. As such, the court disposed of Guzman’s claim summarily.

With respect to the second prong, the court stated that to determine whether a subcontractor is a direct beneficiary to a contract, the critical distinction is based on whether a payment is made directly to the third party. For example, no joint payment clause was present in this contract.

Additionally, the court looked to the government’s actions during the project upon learning of the nonpayment to subcontractors. In that regard, upon learning of EMR’s payment issues, the government sent a letter to EMR requesting that it provide a project accounting. The court found that the government placed the burden on EMR to resolve its own debts.

Ultimately, the court found that the contract modification did not establish a mechanism for the government to pay EMR’s subcontractors directly, nor did it change the express terms of the contract that made EMR solely liable for paying its subcontractors.

The analysis

Subcontractors will certainly find this ruling unjust, as they are the parties least able to control what payment protections exist in the prime contract. Here, the government knew of nonpayment to subcontractors. And while it specifically established a mechanism to protect against that nonpayment, it nevertheless released all the money to EMR without demanding proof that subcontractors did not have unpaid invoices.

The legal result is not surprising. Stated simply: It is very difficult to sue the federal government under a third-party beneficiary theory. However, the facts here make the ruling especially harsh. The court found that the government’s oversight of EMR’s payments to its subcontractors conveyed “nothing more than its interest, present in all government projects, in ensuring timely and compliant completion of the project.”

That finding seems to be at odds with the contract modification that required an extra 10% retainage held every month in lieu of the payment bond requirement.

From our view, the government had more than a passing interest in timely completion. It even went so far as to state in writing to one subcontractor that it would not be paying out the final contract amount without assurances that subcontractors had been paid to date. However, for reasons that are unexplained, the government paid out moneys anyway.

What is the takeaway? At the highest level, contractors need to know that working on federal government contracts is fraught with risk. There are compliance issues, reporting requirements, false claims exposure, and layers of agency-specific regulations to consider. However, this case highlights that one of the protections that subcontractors/suppliers believe they have under the Miller Act might be taken away by a government waiver.

Some of you may ask, “I don’t work on international projects, so what difference does it make to me?” What happens if, for some reason, the government either: (a) waives a Miller Act requirement on a domestic project, such as a project that you think is a construction project but the government disagrees, or (b) by mistake, there is no Miller Act payment bond posted on a project.

The ruling of this case tells you that you are likely out of luck in chasing the federal government for relief. 

Michael C. Loulakis ([email protected]) is the president and CEO of Capital Project Strategies LLC in Reston, Virginia. Lauren P. McLaughlin ([email protected]) is a partner of Smith, Currie & Hancock LLP in Tysons, Virginia.

This article first appeared in the May/June 2023 print issue of Civil Engineering as “When Payment Protections Fall by the Wayside, Subcontractors Bear the Brunt.”