Illegal 8(a) Subcontract is Unenforceable

A fundamental rule of contract law is that an illegal contract is not enforceable in a Court. As a rule, a court "cannot enforce an otherwise valid contract that is made in derogation of statutes designed to protect the public." Consequently, a subcontract is unenforceable if it (1) is against public policy; or (2) is an agreement in furtherance of an unlawful purpose; or (3) is an agreement in furtherance of the unlawful performance of a government prime contract.

The question arises, then, as to how can a small business subcontract under a government prime contract be illegal? Is it possible that the prime contract issued by the government can be illegal?

This question was discussed by the United States District Court for the Eastern District of Virginia, Norfolk division (the "Court") in the decision regarding Morris-Griffin Corporation ("MGC") v. C&L Service Corporation ("CLS"), Civ. No.2:10cv298 dated August 16, 2010. MCG was an 8(a)¹ contractor in the mortgage loan servicing business, and had an 8(a), 2003, prime contract with the Dept. of Housing and Urban Development ("HUD"). By 2007, MCG revenues exceeded the size standard, so they were not eligible for a follow-on contract. CLS was a janitorial and property maintenance company with no prior experience in the mortgage loan servicing business, and no capacity to provide the related and necessary IT or accounting services for HUD.

The HUD contract was set to recompete in 2007 as an 8(a) set aside, but MGC was no longer eligible as an 8(a) contractor. CLS, however, was an eligible 8(a) contractor. MGC and CLS agreed to submit a proposal to HUD with CLS as the prime contractor and MGC as a subcontractor. Over the objections of the SBA, the HUD ultimately awarded an 8(a) contract to CLS in September 2007. It was a fixed price contract for one year and two option years. The contract required that at least 50% of all personnel costs must be incurred by the prime contractor. MGC was a named subcontractor.

MCG and CLS executed a subcontract agreement on December 28, 2007. The subcontract contained a budget provision that provided for expenses in excess of budget to be paid at the end of the year rather than monthly. Any excess expenditure over budget must be approved by the principals before payment. A so-called Contract Master Account would reimburse MCG for the remainder of costs and expenses. CLS “flowed down” the Limitations on Subcontracting clause in the subcontract to MCG that prohibited MCG from incurring more than 50% of the labor costs.

A dispute between the parties arose a year later when CLS received a reconciliation invoice in December, 2008 because it was nearly 30% more than the amounts paid to date. Thereafter, relations between the companies deteriorated and CLS first delayed and then eventually stopped payments to MCG and attempted “to squeeze out MCG.” When arbitration failed to resolve the dispute, MGC filed a motion for a Preliminary Injunction and Temporary Restraining Order at the Court. CLS responded that MGC has filed demands for payment as high as 20% more than their 49% share of the contract. MGC demanded to be paid the full amount of the invoiced amounts. CLS stated that the prime contract contains the 51% rule³ thus prohibiting payment in any greater amount to MGC.

In its opinion, the Court first looked at the prime contract between CLS and HUD, and decided that the prime contract was illegal. “As a general rule, a federal court cannot enforce an otherwise valid contract that is made in derogation of statutes designed to protect the public."⁴ The Court then stated that “the prohibition on the enforcement of illegal contracts is not limited to contracts that are unlawful on their face. A court cannot enforce a contract if it would enforce the conduct made unlawful by statute or regulations even if the underlying contract itself is not unlawful.”

The Court determined that CLS was not eligible for the HUD contract. Because the HUD contract was unlawful, the Subcontract between CLS and MGC was an agreement to carry out an unlawful contract, so it was also unlawful. The Court further determined that MGC was an “ostensible subcontractor” because CLS was unusually reliant upon them. CLS had no prior mortgage loan servicing experience so MGC had the majority of management personnel and performed day-to-day operations. The Court determined that CLS and MGC were affiliates and they failed to comply with the 50% rule. MGC incurred 62% of combined labor costs in 2008 and 59% of combined labor cost in 2009. In addition, CLS submitted a false certification through ORCA that it was a small business. Hence, the CLS proposal was also fraudulent.

"A government contract tainted by fraud or wrong doing is void ab initio and is unenforceable." The Court decided the HUD contract was void ab initio. It is unenforceable because it promotes an unlawful purpose. Moreover, MGC acted in bad faith towards both CLS and HUD. In the subcontract, MGC agreed to perform the work with compensation of no more than 49%, and then failed to comply with this provision. Apparently, HUD received the benefit of the work as required by the contract. The Court stated, however, that "whether HUD is damaged...is unimportant." Hence, the government will void a contract if it is illegal regardless of whether the government has received the benefit of the work or product.

The moral of the story is that you – the business owner – must ensure that you enter into a legal contract. You must comply with all statutes and regulations and insist that the other party do the same. It will be financially catastrophic to you if a court decides your contract illegal and void ab initio and demands that you refined all payments received from commencement – after you have spent the money!!! You have to ensure that the Contracting Officer has entered into a legal contract. If you are uncertain, ask questions, or walk away from the deal. And obtain expert contracts professional support to help you with legal contracts and agreements.

Tom Petruska

Contracts Unlimited, Incorporated

The foregoing discussion is not intended to be legal advice or a legal opinion. Please see your attorney for legal support.

Footnotes:

Small Business Act, 15U.S.C.637(a)
13 C.F.R. 125.6(a) and FAR 52.219-14
13 C.F.R. 125.6
Smithy Braedon Co. v. Haded 825F.2d (4th Cir. 1987)

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