Who Assumes the Risk of Material Cost Increases? As Always, It Depends!
When a client asks me about a particular contract provision and why it is “unfair” or “uneven”, we began a discussion about risk allocation. You see, the contract is used to shift the various risks on the project to the party most appropriate to handle it. In other words, you are negotiating about who takes the risk on a particular issue. For instance, the risk of performance is traditionally placed on the contractor, while the risk of payment is traditionally placed on the owner. That is why subcontractors feel that a “pay if paid” clause is unfair because it places the risk of payment entirely on the subcontractor who cannot control the payment process. What about the risk of escalation in material costs?
The United States Court of Appeals for the Federal Circuit Contract recently addressed this issue in a government contract dispute where the parties’ agreement required the contractor to pay for fuel at the prevailing rate. According to the court, this put the risk of rate increases on the contractor.
The Case. In DG21, LLC v. Mabus (pdf), the Navy solicited proposals for a firm-fixed-price contract to provide support services for a Navy facility in the Indian Ocean. The contractor was also required to implement a fuel conservation program, there being two types of fuel: (1) Government-furnished fuel that was provided to the contractor by the Navy without charge; and (2) contractor-furnished fuel that was also provided by the Navy, but the contractor was required to pay for that fuel “at the prevailing [Department of Defense] rate.” The solicitation also provided historical fuel prices and usage rates for contractors to use in crafting their bids.
The Back-and-Forth. When the contractor submitted its proposal, it said that it would submit a request for an equitable adjustment if the fuel rates varied by more than 10% from the historical rates. The Navy responded that the historical fuel consumption and rates were “provided for informational purposes only.” The Navy also said that the solicitation was firm-fixed-price and that the contractor assumed the full risk of consumption and/or rate changes. Notably, the Navy also questioned the contractor’s decision not to include an escalation clause in its proposal.
The contractor did not change its estimate of fuel costs, and the Navy ultimately awarded the contract to the contractor. During performance, fuel prices doubled! Ultimately, the contractor requested an equitable adjustment of $1.17 million, which reflected the amount it spent on fuel above the pre-contract average price of $1.75 per gallon. The contracting officer denied the request and the board of contract appeals affirmed.
The Decision. On appeal, the Federal Circuit concluded that the contractor was not entitled to an equitable adjustment based upon fuel cost increases. The general rule under a firm-fixed-price contract is that contractor assumes the risk of unexpected costs. Likewise, the “prevailing DOD rate” provision in this contract allocated the risk of fluctuating fuel prices to the contractor. The contractor could have bargained for protection from price increases by including a price escalation clause in its proposal…but it did not. Accordingly, the Federal Circuit held, the contractor assumed the full risk of consumption and rate changes.
So what? The decision in Mabus provides a few lessons. First, contractors who regularly do business with the government should be aware of the world of public procurement decisions. There are literally hundreds of thousands of claims filed against federal agencies every year, and many of those cases make it through agency and court system. It is very likely that your current problem has been addressed before and you will find some guidance on the issue.
Second, your proposal is where you address contingencies, exclusions and other areas of concern. For the contractor in Mabus, fuel cost increase was raised by the contractor in its proposal, and the government responded accordingly. As a business decision, the contractor chose to remove certain language from its proposal that may have allowed it to file a request for equitable adjustment at a later date. In addition, the contractor could have included an escalation provision in its property, but it did not.
Finally, the Mabus decision reminds contractors that the parties’ written agreement is about risk allocation. If you take more risk, then your price should increase. If you have more reliability in the final cost of performance, then your fee should reflect the lower risk. But make sure you are reading the general conditions of a proposed contract and assessing the risks involved before you submit your final bid.