In a recent decision, the United States Court of Appeals for the Eighth Circuit reversed a district court’s decision holding that a surety was not required to fulfill any of its obligations under payment and performance bonds because the subcontract between the prime contractor and the subcontractor violated the small business self-performance requirements.  Hanover Insurance Co. v. Dunbar Mechanical Contractors, LLC, No. 19-2226, 2020 WL 3864318 (8th Cir. July 9, 2020).  The Eighth Circuit held that the district court prematurely concluded that the prime contractor was not in compliance with the contract’s self-performance requirement.  It further held that the potential that the surety may have liability under the False Claims Act if it were to perform under the bonds did not justify discharging the surety from its obligations and rescinding the contract.

In the Hanover case, the USACE awarded Dunbar Mechanical Contractors, LLC, a service-disabled veteran-owned small business (“SDVOSB”), a SDVOSB set-aside contract to perform certain ditch and tributary construction work.  Under the terms of the contract, Dunbar was required to self-perform a portion of the work.  Specifically, the Small Business Administration regulations in effect at the time of the contract award in 2013 required for SDVOSB set-aside general construction contracts that the prime contractor perform at least 15% of the cost of the contract with its own employees (not including the costs of materials).[i]

Dunbar entered into a subcontract with Harding Enterprises LLC – a non-SDVOSB.  The subcontract stated that Harding Enterprises agreed to: “Provide all work that was provided in the proposal.”  Dunbar also entered into a separate employment agreement with Gregg Harding, the sole member of Harding Enterprises, to serve as the project manager for the project.

The subcontract required Harding to provide payment and performance bonds.  The bonds were guaranteed by Hanover.  After Dunbar terminated Harding Enterprises for default, Dunbar made a demand against the performance bond.  During its investigation of the claim, Hanover discovered that Dunbar had subcontracted more than 85% of the work to Harding Enterprises and denied the claim on this basis.

Hanover filed suit seeking a declaration that it had no obligations under the bond and seeking to have the bond rescinded based on the illegality of the subcontract.  The district court ultimately issued a decision holding that Hanover had no obligations under the bond because the subcontract violated federal law as the amount Dunbar was to pay Harding Enterprises under the subcontract exceeded 85% of the prime contract costs.  Citing to United States ex rel. Scollick v. Narula, No. 14-CV-01339-RCL, 2017 WL 3268857 (D.D.C. July 31, 2017), the district court noted that Hanover potentially could face liability under the False Claims Act if it were to perform in furtherance of an illegal subcontract.

Dunbar filed an appeal with the Eighth Circuit arguing that the district court erroneously granted summary judgment to Hanover because the district court could not conclusively determine whether Dunbar performed the requisite percentage of work on the project until the project was completed.  The Eighth Circuit agreed and reversed the district court.  The Eighth Circuit noted that the Small Business Administration regulations assessed compliance with the self-performance requirements in terms of the amount an SDVOSB spends relative to the cost of contract performance.  As spending is the benchmark for assessing compliance, a final determination of compliance cannot not be made until the contract is completed.  A key factor in the decision was the fact that the subcontract gave Dunbar the right to make changes including reducing Harding Enterprises’ scope of work.

The Eighth Circuit also downplayed Hanover’s potential liability under the False Claims Act.  The court stated that the potential for liability under the False Claims Act did not justify discharging Hanover from its obligations and rescinding the contract.  It stated that Hanover was not without recourse if it believed the bond presented potential liability.  Hanover could either pay the obligee and, having satisfied its obligations, remove itself entirely from any further involvement, or perform under the bond while giving notice to the Government of the potential for false claims.

[i] The regulations were revised in 2016 to prohibit the prime contractor from paying more than 85% of the amount paid by the Government to subcontractors who are not similarly situated (i.e., subcontractors that have the same small business program status as the prime contractor).