FEATURE COMMENT: Closing The Gate On Unabsorbed Overhead Claims

Since its emergence nearly 50 years ago, a contractor's right to recover fixed costs incurred during Government-caused delays has flourished. Within the last three years, however, two decisions by the U.S. Court of Appeals for the Federal Circuit have abruptly ended the evolution of this right, resulting in the entire species of unabsorbed overhead claims becoming virtually extinct. This FEATURE COMMENT, which examines the most recent of the court decisions that "closed the gate" on contractor recovery of unabsorbed overhead claims, Satellite Electric Co. v. Dalton, 16 FPD ¶ 12, 105 F.3d 1418 (Fed. Cir. 1997), 39 GC ¶ 99, concludes that extinction of unabsorbed overhead claims is clearly the result of negligent human interference, and not the course of the natural evolutionary process.

Background
When the Government's actions have delayed contract performance, contractors have been able to recover fixed costs, or unabsorbed overhead, that they have incurred during the delay. When a contractor is entitled to such delay damages under the contract's "Changes" clause, or one of the other clauses covering Government delay, suspension, or stop work, a method for quantifying the damages frequently used by contractors and accepted by the boards of contract appeals and the courts has been the so-called Eichleay formula, named after the 1960 Armed Services Board of Contract Appeals decision in Eichleay Corp., ASBCA 5183, 60-2 BCA ¶ 2688, 61-1 BCA ¶ 2894, 2 GC ¶ 485.
The Eichleay formula provides for the allocation of fixed overhead to all work performed in the performance period of the delayed contract based on billings in that same period. The first operation of the formula determines the delayed contract's share of fixed overhead. The next operation under the formula is to compute the delayed contract's daily allocation of fixed overhead. The last operation is to compute the "unabsorbed overhead" by extending the daily rate by the number of days in the delay period. For a discussion of the history and status of the formula, see generally Schechter & West, "Recovery Of Home Office Overhead-Resurrection Of The Eichleay Formula," 94-3 CP&A Report 3 (Mar. 1994).
There are several obvious and significant flaws in the formula that have been recognized over the years. Briefly, they are that under the formula (a) billings rather than cost are used as the allocation base for fixed overhead, (b) the extent of reserved capacity is not recognized, (c) the original contract could be repriced, (d) the actual increased cost to the contractor is not addressed, (e) the actual capacity reserved for the restart of the delayed work is not distinguished or isolated, and (f) established cost and pricing principles for Government contracts are not observed.

The Two Decisions
The first decision of the Federal Circuit that marked the beginning of the end of recovery of unabsorbed overhead is Wickham Contracting Co. v. Fischer, 13 FPD ¶ 1, 12 F.3d 1574 (Fed. Cir. 1994). In Wickham, despite all the deficiencies in the Eichleay formula noted above, the Federal Circuit eliminated all classes of unabsorbed overhead claims within the species except for the Eichleay class. The Court there held that the Eichleay formula was the only method by which a contractor could recover unabsorbed overhead resulting from Government delay of work. As a result, all other methods were determined inappropriate and correspondingly exterminated.

In its more recent Satellite decision, which is the focus of this FEATURE COMMENT, the Federal Circuit misapplied the Eichleay formula, thereby killing the last remaining class of unabsorbed overhead claims. Since the Court handed down its Satellite decision, nearly a dozen cases involving a contractor's delay damages have gone to the boards of contract appeals or the Court of Federal Claims and all have met similar fates denial of the contractor's claim by citing Satellite.
The fallacies of the Wickham decision have already been exposed. See Fordham, "Wickham Contracting: A Holocaust," The Clause, Vol. 5, No. 4 (1995), at 13-29. See also Schechter & Cassidy, "The Eichleay Formula Revisited-Stepping Back From Federal Circuit Standards?", 38 GC ¶ 600. The purpose here is to demonstrate the error of the Court's decision in Satellite.

Three-Part Test
The dilemma in Satellite was that the delay occurred after the contractor's work was nearly complete. Consequently, the capacity required by the contractor to complete the work, and the contractor's related fixed costs, were minimal. Since the Eichleay formula was the only method available to the contractor, it submitted an Eichleay-based delay claim. Based on that calculation, the contractor would have received a windfall because the Eichleay formula does not incorporate the contractor's actual cost increases.

Trapped by its own prior precedent in Wickham, the Federal Circuit's options for wiggle room in Satellite were limited, since its ability to adopt a more realistic quantification was impossible. Consequently, it looked to Eichleay's "three-part test" for its remedy. In doing so, the Court allowed the Government to rebut the contractor's prima facie evidence that it was "standing by" during the delay, merely by showing that the contractor was attempting to make use of its other idled capacity by bidding on new work. Such attempts are routine for any contractor continuing in business, as part of efforts to mitigate damages. As a result, it is now all but theoretically impossible for contractors to recover delay damages when they prudently attempt to minimize damages.
The three-part test has its origins in the Eichleay decision, where Government-caused intermittent interruptions, and delays of indefinite duration preventing the contractor from replacing the delayed work with other work, were the basis for Government liability and the contractor's entitlement to "unabsorbed overhead." Using these same criteria over the years, the Federal Circuit has evolved a paradigm of three prerequisites for Government liability in Eichleay type unabsorbed overhead claims.

In short, the three-part test requires the contractor to demonstrate that (1) there was a compensable, Government-caused delay, (2) the contractor was required to stand by during the period of delay, and (3) the contractor was unable to take on other work during the period of delay. Frequently cited as the basis for the three prerequisites are C. B. C. Enterprises, Inc. v. U. S., 11 FPD 140, 978 F.2d 669 (Fed. Cir. 1992), 34 GC ¶ 670, Interstate General Govt. Contractors v. West, 12 FPD ¶ 120, 12 F.3d 1053 (Fed. Cir. 1993), 36 GC ¶ 89, and Mech-Con Corp. v. West, 14 FPD ¶ 65, 61 F.3d 883 (Fed. Cir. 1995), 37 GC ¶ 514. Since the Wickham decision decreed that the Eichleay formula was the only formula that could be used in making unabsorbed overhead claims, any unabsorbed overhead claim now must be accompanied by the contractor showing that is has met the three prerequisites.

Limitations of Three-Part Test-With the exception of the first, these prerequisites do not raise the questions that would normally be asked to determine if a contractor had a claim for damages. Indeed, the questions normally expected would be (a) was there a compensable delay, and (b) by how much was the contractor damaged.
The first prerequisite of the three-part test is to determine whether there was a compensable, Government-caused delay. It should be noted that this is the only part of the test that specifically addresses potential Government liability. The remaining prerequisites consider quantification issues.

In determining whether there is potential Government liability for unabsorbed overhead, four major questions must be answered. The first is whether there was actual delay as opposed to additional work extending the performance period. See C.B.C. Enterprises, supra. The second is whether the delay impacted the critical path and thus extended the completion date. See American Intern. Contractors, Inc./ Capitol Indus. Const. Groups, Inc., ASBCA 39544, 95-2 BCA ¶ 27920. The third is whether the delay was caused solely by the Government. See Eichleay Corp., supra. The fourth is whether the contractor assumed any of the risk of delay, e.g., reasonable delays covered by the "Suspension of Work" clause at Federal Acquisition Regulation 52.242-14. Generally, an affirmative answer to each is needed, except for the last question, which requires a negative finding to establish potential Government liability. The subjects of these four questions and their related subsidiary questions of degree, circumstances, and exceptions have been fairly well settled and are not discussed further here.

The second prerequisite of the three-part test is to determine whether the contractor was required to stand by during the period of delay.

However, once potential Government liability has been established, the next logical question that should be posed is whether the contractor has been damaged. The second prerequisite ignores this obvious question in favor of the standby determination. This part of the test introduces several practical problems.
As an initial matter, the term "standby" is not well defined. It appears from C.B.C. Enterprises, supra, and other cases holding that the interruptions or delays of work must be "intermittent" or "indefinite" in order for a contractor to claim standby. While these two characteristics may be indicative of prima facie delay damage, however, they should not be necessary to show that the contractor is on standby. But regardless of the precise meaning intended for standby, the prerequisite presumes that capacity was reserved for the restart of performance. otherwise, why would the third prerequisite be necessary?

An additional problem with the second prerequisite is one of relevance. After determining from the first prerequisite whether a compensable delay occurred, the next question should be simply the amount of damages. Instead, the second prerequisite refines the quantification question by evaluating the nature of the damages standby or not standby. But is this even the right question to ask? In the event that a contractor could immediately shift resources from a delayed contract to another in queue, e.g., in some engineering endeavor, the contractor would be on standby with respect to the delayed contract, although it may not necessarily have reserved any capacity for its restart. Thus, the only relevant question is whether the contractor reserved capacity for the restart and not whether the contractor was "standing by."
The third prerequisite is to determine whether the contractor was unable to take on other work during the period of delay. Since the second prerequisite only requires that the contractor be on standby, this third prerequisite is needed to complete the description of a condition of reserving capacity for restart while on standby. From this reserved capacity, fixed costs flow, and a contractor's damages can be determined. So like the second, the third prerequisite is a refinement to the quantification methodology.

Misinterpretation in Satellite

The Federal Circuit in Satellite was able to make its way through the first two prerequisites, but strayed from the original Eichleay concept on the third. Its principal error is that it interpreted the third prerequisite literally, and held that since the Government-caused delay did not prohibit the contractor from acquiring any other work, the contractor failed the third prerequisite. Clearly, the Federal Circuit confused (1) capacity reserved for the restart of the delayed contract, with (2) available capacity. A distinction between the two was never made by the Court, and a contractor's ability to take on other work with other capacity is treated as an amorphous condition canceling any right to recover the cost of capacity reserved for the delayed contract.

In its Eichleay decision, the ASBCA recognized that the delayed contract must absorb a share of the fixed costs during the period of delay regardless of new business. The board stated that “[f]urthermore, if there were new business the delayed contracts would still have to bear their fair share of the corporate overhead." This statement evidences an understanding by the board that there are two identified classes of capacity-one reserved for the delayed contract and the other that is used or potentially usable for other work.

Yet the Federal Circuit did not recognize this distinction-between capacity needed for the restart and all other capacity-in its Satellite decision. It stated: "(Contractor) also contends that the Board erred in not requiring the government to show that the additional work sought was intended to replace the suspended work. We decline to impose upon the government the additional burdens that (contractor) proposes." Instead of facing the heart of the issue when the opportunity presented itself, the Federal Circuit side stepped it as if it were a trivial matter.

This clearly demonstrates the Court's degradation of the original Eichleay concept. The ASBCA in Eichleay held that "[t]he mere showing of these facts is sufficient to transfer to the Government the burden of going forward with proof that [contractor] suffered no loss or should have suffered no loss." Now, the Federal Circuit is saying that the Government should not even be burdened with making a showing that the contractor suffered no loss.

Impenetrable Shield-The Satellite decision is the impenetrable shield sought by all delay claim defendants. Plaintiffs who could not mitigate are denied recovery as quickly as those who could. What is more, the case now permits buyers to hold sellers hostage to their contracts indefinitely without chance of compensation. It would seem, therefore, that the problems with the Satellite decision are patently obvious. But there are more, less obvious, problems.

For example, the Federal Circuit's interpretation of the third prerequisite in Satellite results in a practice that is inconsistent with the established principles of damage recoveries. Essentially, the decision is at odds with the principle that cost to the contractor is the basis for measuring damages (which was established by the Court of Claims' decision in Bruce Const. Corp. v. U.S., 324 F.2d 516 (Ct. Cl. 1963), 5 GC ¶ 554). Under this general principle, to conclude that a contractor suffered no loss or damage, the Government would have to show at least one of the following: (a) that capacity was not reserved; (b) the capacity had no cost; (c) the costs were not allocable; or (d) the costs of the capacity were not allowable. Yet the Court in its Satellite decision did not focus on these four conditions, and it disregarded the "cost to the contractor principle" established in Bruce Const. It instead established a de facto "loss in value to the contractor" principle.
Determining usability of capacity addresses market value, not cost. This approach resulted in the Federal Circuit holding in its Satellite decision that since the Government did not prevent the use of available capacity, its action did not impinge upon the value of that capacity. Therefore, the contractor suffered no loss or damage from the Government-caused delay. This is clearly a shift from cost-based damages to loss in market value damages.

This approach was tried by the General Services Administration Board of Contract Appeals in Capital Electric Co., GSBCA 5316, 83-2 BCA ¶ 16548, 25 GC ¶ 210 (Note), which cites a Missouri Supreme Court case, Kansas City Bridge Co. v. Kansas City Structural Steel Co., 317 S.W. 2d 370, 377 (1958), stating that "even though a percentage of that fixed overhead was properly allocated to the Leavenworth job during the period of delay, nevertheless any amount so allocated could not represent a loss or damage unless plaintiff would have, but for the delay, obtained other work (which it did not have or which it did not in fact obtain) sufficient in amount to have absorbed the allocated portion of general overhead." Rightly so, the GSBCA decision was overturned by the Federal Circuit in Capital Electric Co. v. U.S., 2 FPD ¶ 109, 729 F.2d 743 (Fed. Cir. 1984), 26 GC ¶ 49, notwithstanding the Court's current retrograde attitude.

To further contravene established principles of Government contracting, the implication of the Satellite decision is that contractors add to their bid estimates a contingency for expected Government delay of work. No longer can a contractor rely upon the clauses traditionally allowing for increased cost to the contractor occasioned by Government delay. The foreseeable consequence is that fewer contractors will be willing to undertake the increased risk of doing Government work, and that cost to the Government will be higher as a result.

Cost allocability is another area impacted by the Satellite decision. If in fact some fixed costs are allocable to the delayed contract during the period of delay in accordance with the FAR cost principles, but are made unallowable by the Court's decision, then these costs would not be allocable to any other contracts. So, despite the contractor not suffering any loss (according to the Court), the auditors, who follow the FAR cost principles, may identify a loss. The problem can be extended into other related areas, e.g., false certification of indirect cost rates due to unallowable costs in the indirect cost pool, and on to defective pricing and false claims.

The Satellite and Wickham decisions have set back the clock to some point predating Fred R. Comb Co. v. U.S., 103 Ct. Cl. 174 (1945) (one of the seminal cases establishing the right to unabsorbed overhead). The ASBCA in Eichleay resolved the liability issue, but the Federal Circuit in its Satellite decision (and others, including Wickham) misinterpreted it. The Eichleay decision used a quantification method proffered by the contractor since it was equitable and the Government's method was not. But the ASBCA recognized "that there is no set formula for determination of [unabsorbed overhead] costs." The Federal Circuit in its Wickham decision disagreed. And the three-part test does nothing to improve the determination whether a contractor is entitled to fixed-cost delay damages. Its entire purpose was to make more reliable a formula, the Eichleay formula, whose results bore only a chance relationship to a plaintiff's damages. Now, even that formula is useless, for it appears that delay claims are virtually extinct. The Satellite decision ensured their unnatural death.

Proposed Remedy
To remedy the problem, the Eichleay formula and the three-part test must give way to a truly equitable means of quantifying fixed-cost delay damages. After all, capacity to support contract work is a resource with a measurable cost and has some definable limits as to how much contract work it can support. The resource is allocated based on actual need and its cost should follow. See Kenyon, "Fixed Costs and Contract Delay," National Contract Management Journal, Vol. 27, No. 2 (1996), at 1-14. The problem with the Eichleay formula is that all of the capacity costs are allocated to the contracts existing in a given period, regardless of the amount of capacity actually required by those contracts, delayed or ongoing. The contractor or the Government can win or lose depending on a myriad of irrelevant factors.

In summary, the Federal Circuit has accomplished in three short years what auditors and defendants have been unable to accomplish for nearly 50 years. For comedians, this is a case of bureaucratic bungling rivaling Peter Sellers' best known character, Inspector Clouseau. For conspiracists, it is an easy season of X-Files episodes
that explain how the Government will eliminate the deficit by denying plaintiffs compensation for Government delays. For experts, there is no credible explanation.

This FEATURE-COMMENT was written for THE GOVERNMENT CONTRACTOR by Howard N. Kenyon, Jr., principal of K&F Consulting, Inc. in Bethesda, MD. Mr. Kenyon is a Certified Public Accountant with extensive experience in advising Government contractors in a variety of cost and compliance-related matters.

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