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Inside This Issue:

  • Insurers Bear Environmental Damages and Defense Costs on Pro-rata basis Under Consecutive CGL Policies
  • Contractor’s Express Warranty Takes Precedence Over Owner’s Implied Warranty of Specs
  • Washington State DOT’s application of Affirmative Action Goals Held Unconstitutional
  • Federal Strings Attached to Faith-Based Grants

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Article 1
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Insurers Bear Environmental Damages and Defense Costs on
Pro-rata basis Under Consecutive CGL Policies

J. Kent Holland

Owners of sixty stucco homes brought claims against the builder, Wooddale Builders Inc., alleging that defective construction or faulty workmanship resulted in water-infiltration and mold-growth.  The claims were first filed beginning in 2000.  The homes were built from 1990 through 1996. Wooddale tendered the claims to each of the insurance carriers that provided commercial general liability (CGL) policies to Wooddale from November 13, 1990 through November 13, 2002.  Five different carriers had policies covering part of this twelve year period.   Each of the carriers declined to make payment for repairs.  Wooddale then filed suit against Maryland Casualty whose policy covered 1997 through 2000.  Maryland Casualty in turn filed third party complaints against the other four carriers.

Affidavits from experts stated that the damage resulted from repeated water-intrusion events, occurring over an extended period of time, with continual, progressive, and indivisible damage occurring to the homes.  An affidavit by an environmental health consultant stated that “all that one can say with a degree of reasonable scientific certainty is that the mold damage to any given building began during or after construction and that it continued or will continue until such time as the mold colonies are deprived of one or more of the conditions required for continued growth: food, water and warmth.”

The carriers agreed that liability should be allocated among them on a pro-rata-by-time-on-the-risk basis, and that the starting point for the allocation of damages is the closing date on the purchase of each individual home.  They could not, however, reach agreement on the ending point for allocation of damages.  They also disagreed over the allocation of defense costs and investigative costs.   In issuing summary judgment in favor of the builder against the carriers, the district court decided that the ending date for allocation purposes was the date Wooddale received notice of a pending claim.  In addition, the court allocated the costs of defending Wooddale and investigating the homeowners’ on an equal basis between all the carriers.

On appeal, the appellate court explained that the law of Minnesota which applies to the parties in this case follows the “actual injury” or “injury-in-fact” theory to determine which policies have been triggered by an occurrence causing damages for which an insured is liable.  Only those policies in effect when damages occurred would be triggered.  The court quotes from a Minnesota Supreme Court decision, N. States Power Co. v. Fidelity & Casualty Companies of New York, as follows: “The essence of the actual injury trigger theory is that each insurer is held liable for only those damages which occurred during its policy period.”

Citing that decision, the court goes on to say that “Because the discharge of environmental pollutants is continuous and repetitive and cannot be traced to one discrete, identifiable event, ‘the unidentifiable individual instances [merge] into one continuing occurrence,’ and there is one occurrence during each triggered policy period.”

The court states that applying the N. States Power reasoning, if contamination occurred over a period of ten years, one-tenth of the damage would be allocated to the insurer that was on the risk for one year.  Likewise, three tenths of the damage would be allocated to the period of time a three-year policy was in force, and so on.

In the current case, the district court allocated the damages proportionate to the number of years each carrier was on the risk, “relative to the number of years between the date of closing and the date that Wooddale received notice of a pending claim.”  The district court did not assign liability for damages resulting from ongoing decay to the homes between the date of claim notification and the date of remediation. It isn’t clear whether that means that no insurer would be liable for post-notification damages or whether every insurer should share equally even if a separate insurer provided Wooddale coverage during that final period of time.

The carriers argued in the appeal that the “known-loss” rule or the “loss-in-progress” rule compelled the district court’s conclusion that the ending date of purposes of allocation was the date that Wooddale received notice of a homeowner’s intent to file a claim. In rejecting that argument, the appellate court concluded that Wooddale did not seek indemnification for homeowner claims from insurers that had issued policies after the homeowner claims had been tendered to Wooddale.  Therefore, the court found that Wooddale did not purchase the triggered policies with knowledge of an actual loss.  The known-loss defense was therefore not applicable.

Maryland Casualty argued, however, that an extension of the known-loss rule supports the district court’s decision.  Specifically, it argued that continuing insurance coverage beyond the date the insured is placed on notice of a loss is at odds with the basic principle that insurance is purchased to cover risk of loss, not an exiting loss.   Once the homeowner placed Wooddale on notice of a claim, Maryland Casualty says there was no longer any risk of loss.  Western National similarly argued that any damage occurring after the builder had notice is not accidental, and, therefore, did not result from an occurrence.  It would be fundamentally unfair, argued Western National, to hold an insurer liable for additional property damage on account of conditions known to the insured.

In disagreeing with the above-described arguments by the carriers, the appellate court stated that when a homeowner placed Wooddale on notice of a claim, the risk of loss remained the same because the occurrence was still continuing.  The appropriate ending date, when allocating liability among consecutive insurers according to the pro-rata-by-time-on-the-risk method, is, therefore, the date of remediation.   The court, therefore, reversed the district court decision in this respect.

On the issue of defense costs allocation, the court also reversed the district court.  It held that defense costs should be apportioned according to the same methodology as indemnity costs.  To do otherwise and allocate defense costs equally based on the number of insurers would, said the court, lead to inequitable results.   Wooddale Builders Inc. v. Maryland Casualty Company d/b/a Zurich North America, ( Minn. A04-1442).

About the author: Kent Holland is a construction lawyer  in Tysons Corner, Virginia, and is a risk management consultant for environmental and design professional liability insurance and contracts.   He is also publisher of ConstructionRisk.com Report.  He may be reached at Kent@ConstructionRisk.com.  This article is published in ConstructionRisk.com Report, Vol. 8, No. 5.

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Article 2
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Contractor’s Express Warranty Takes Precedence Over
Owner’s Implied Warranty of Specifications

J. Kent Holland

A contractor’s express warranty takes precedence over a project owner’s implied warranty of plans and specifications.   The contractor agreed to use materials provided by homeowner, as well as plans and specifications provided by homeowner, and gave an express warranty that his work would result in a roof that would not leak.  After a contractor installed the skylights and completed the roof, there was persistent leaking every time it rained.  Although the homeowner devised plans and specifications and provided materials for the construction of skylights and roof over his indoor swimming pool, thereby creating an implied warranty of design, a court held that the contractor  could not avoid liability by asserting a right to rely on the implied warranty because the his own express warranty took precedence.

In Graham Construction Company, Inc. v. Roscoe T. Hall, ( Ark. No. 04-769, 2005), a homeowner entered into a verbal contract with a general contractor, Graham, for the installation of a large skylight over an indoor swimming pool.  The homeowner, Roscoe Earl, told the contractor that he would supply the skylights and stainless steel borders.  He also consulted with two engineers on how to put on the roofing.  Based on their recommendations, the owner chose a six-millimeter Lexan plastic panel for the skylight. The owner also conducted research on the Lexan product and drafted his own set of installation procedures.  He then requested that the contractor use those procedures to install the skylight.  The contractor agreed to use the procedures, and he represented that he would install new roofing material and the new skylights, and that they would not leak.

Contractor completed the work, using the installation procedures provided by the homeowner.  Two weeks later the roof leaked in several places during the first rain.  Contractor made four to six attempts at repairing the roof, but it continued to leak with each rain.  Homeowner then filed suit to recover the amount paid to the contractor, plus incidental and consequential damages resulting from the defective roof.

The homeowner testified at trial that the contractor “guaranteed me it [the roof] would not leak.”  The contractor testified that although he told the homeowner the roof would not leak, he did not guarantee that it would not leak as a result of the skylights and materials being supplied by the homeowner.

Contractor’s expert witness at the trial testified that the skylights were installed improperly “every which way it could be installed improperly.”  They were installed horizontally instead of vertically, which the expert stated was essential for allowing the water to run out.  He also stated that he saw gaps in the flashing and that the skylights were not the proper thickness to withstand the weather of the area.

The trial court found that the contractor gave an express warranty that the roof would not leak.  On the other hand, the trial court found that the homeowner had given the contractor an implied warranty of the adequacy and suitability of the materials, plans, and specifications that he supplied.   Judging the facts of the case and how these two warranties would be reconciled, the trial judge found that the contractor, as a “competent and experienced contractor” “should have been aware that the plans and specifications could not produce the proposed results.”  The judge further found that there was insufficient evidence to prove that the leaks resulted from the inadequacy of the plans provided by the homeowner.  For these reasons, the trial court decided the matter against the contractor.

Contractor appealed the decision, arguing that he was entitled to rely upon the implied warranty of the plans and specifications provided by the homeowner and that this relieved him of any liability.  He relied upon an earlier decision of the appellate court in Housing Authority of the City of Texarkana v. Johnson Construction Co., 573 S.W.2d 316.  That decision held that an owner who furnished faulty plans and specifications was liable to the contractor for resulting damages.  That decision stated that where the owner provides plans and specifications, the implied warranty is not nullified by any stipulation requiring the contractor to make on-site inspection or a requirement that the contractor examine and check the plans and specifications.  That decision went on to hold however, that “a competent and experienced contractor cannot rely upon submitted specifications and plans where he is fully aware, or should have been aware, that the plans and specifications cannot produce the proposed results.”

Applying this exception to the general rule that generally allows reliance upon an implied warranty of plans and specifications, the appellate court in this case of Graham Construction, concluded that Graham was a competent and experienced contractor and that that he installed the Lexan material for the skylights improperly.  The trial court’s rulings concerning this issue were therefore held to be correct.  In addition, the court stated that by operation of law, a builder-vendor gives implied warranties of habitability, sound workmanship, and proper construction.  “The implied warranty does not rest upon an agreement, but arises by operation of law and is intended to hold the builder-vendor to a standard of fairness.”  The court thus found that the contractor’s express warranty that the roof would not leak, coupled with his implied warranty of sound workmanship and proper construction take precedence over the homeowner’s implied warranty of his material, plans, and specifications.  For these reasons, the court affirmed the trial court decision against the contractor.

Comment: It is worth noting in this case that the contract that created the implied and express warranties at issue in this case was oral—not written.   Although it is certainly preferable to get a signed contract before doing work, the fact that work proceeds without a written contract does not negate basic principles of contract and common law that will apply to an agreement for construction (whether oral or written).    The fact that the court was addressing a situation involving a relatively unsophisticated homeowner versus a licensed, qualified contractor had a significant impact on the outcome.  Had this been a large commercial project where the project owner provided plans and specifications drafted by an independent design firm, the result may have been different – particularly with regard to the contractor’s ability to rely upon the owner’s implied warranty of design.  But the owner’s implied warranty does not excuse a contractor from performing competently and satisfying his own express and implied warranties.  In a situation like this one, the specifications for a large commercial job would probably have required the contractor to at least do a general review of plans, specifications, and documents for any patent ambiguities or defects before proceeding with construction.

About the author: Kent Holland is a construction lawyer  in Tysons Corner, Virginia, and is a risk management consultant for environmental and design professional liability insurance and contracts.   He is also publisher of ConstructionRisk.com Report.  He may be reached at Kent@ConstructionRisk.com.  This article is published in ConstructionRisk.com Report, Vol. 8, No. 2.

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Article 3

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Washington State DOT’s Application of Affirmative
Action Goals Held Unconstitutional

By J. Kent Holland

The manner in which Washington State ’s DOT applied the Transportation Equity Act of the 21st Century (TEA-21) was held to violate the constitutional guarantee of equal protection. The state failed to proffer evidence of discrimination within its own contracting market.  In fact the record was devoid of any evidence suggesting that minorities currently suffer or ever suffered discrimination in the Washington transportation contracting industry.  Washington thus failed to meet its burden of demonstrating that its DBE program is narrowly tailored to further Congress’s compelling remedial interest.

In Washington States Paving Co., Inc. v. Washington State Department of Transportation, (No. 03-35783, 2005),  the Washington State Department of Transportation (WSDOT) mandated that a City of Vancouver project obtain 14 percent minority participation on a project.  A subcontract bidder, Western States, was rejected by the prime contractor in favor of a higher bidder because Western States failed to meet the minority utilization requirement.

Western States sued  WSDOT and the city, seeking declaratory judgment that the TEA-21 minority preference program violates equal protection under the Fifth and Fourteenth Amendments of the U.S. Constitution either on its face or as applied by the State of Washington.  The U.S. district court held that TEA-21’s minority preference program is constitutional on its face.  It also found that the manner in which WSDOT applied the statue was satisfactory.  Western States appealed to the U.S. Ninth Circuit Court of Appeals.

The appellate court held that TEA-21 and its implementing regulations create a narrowly tailored remedial program.  The court concluded “Race-conscious remedies are used only when race-neutral means prove ineffective, these race-conscious measures are employed in a flexible manner and for a limited duration, and the program is tied to the labor market in each State and is designed to minimize the burden on non-minorities.”  For these reasons, the court rejected the subcontractor’s challenge to the statute and regulations, and affirmed the constitutionality of TEA-21.

In analyzing the second aspect of subcontractor’s challenge, however, the court reached several significant decisions.  The court concluded that WSDOT was not required to demonstrate an independent compelling interest for its DBE program since Congress had already accomplished that when it enacted TEA-21.  Even if discrimination does not exist in Washington , says the court, “the State’s implementation of TEA-21 nevertheless rests upon the compelling nationwide interest identified by Congress.”

But the inquiry does not end there, says the court.  It is necessary to undertake an as-applied inquiry into whether the state’s DBE program is narrowly tailored for the particular facts involved.  It is not sufficient for the state to merely show that it complied with the federal program’s requirements.  “Whether Washington ’s DBE program is narrowly tailored to further Congress’s remedial objective depends upon the presence or absence of discrimination in the State’s transportation contracting industry.  If no such discrimination is present in Washington , then the State’s DBE program does not serve a remedial purpose; it instead provides an unconstitutional windfall to minority contractors solely on the basis of their race or sex.”

The court went on to state that “even when discrimination is present within a State, a remedial program is only narrowly tailored if its application is limited to those minority groups that have actually suffered discrimination.”  According to the court, the only figure that Washington can rely upon to demonstrate discrimination is the disparity between the proportion of DBE firms in the state (11.17%) and the percentage of contracting funds that are awarded to DBEs on race-neutral contracts (9%).   But this was entitled to little weight by the court because it fails to account for factors that could affect the relative capacity of DBEs to undertake contracting work.

The fact that DBEs constitute a certain percentage of the market does not establish that they are able to perform that same percentage of the work.  A number of factors could prevent that.  For example, “DBE firms may be smaller and less experienced than non-DBE firms (especially if they are new businesses started by recent immigrants) or they may be concentrated in certain geographical areas of the State, rendering them unavailable for a disproportionate amount of work.”

The court states that “to the extent that this small disparity has any probative value, it is insufficient, standing alone, to establish the existence of discrimination against DBEs.”  “The WSDOT [   ] did not introduce any anecdotal evidence of discrimination.”  Claims of general societal discrimination and generalized assertions about discrimination in an industry “cannot be used to justify race-conscious remedial measures.”

In this case, the court found that “The State of Washington [   ] has not proffered any evidence of discrimination within its own contracting market and has thus failed to meet its burden of demonstrating that its DBE program is narrowly tailored to further Congress’s compelling remedial interest.”   For these reasons, the court reversed the district court’s grant of summary judgment as to WSDOT, the city and the county, and remanded the matter to the district court with instructions to enter summary judgment in favor of the subcontractor on its challenge to how the Act and regulations were applied.

Comment:  This decision continues a line of decisions clarifying what must be proved by state agencies in order to create racial preferences in their various construction programs.  The Eight Circuit Court of Appeals, in the case of Sherbrooke Turf, Inc. v. Minnesota Dept. of Transportation, 345 F.3d 964 (8th Cir. 2003), required the state to show that its program was narrowly tailored to achieve Congress’s remedial objective. The court considered whether discrimination had actually occurred in the state.  “To be narrowly tailored, a national program must be limited to those parts of the country where its race-based measures are demonstrably needed.”  Id. At 971.

The U.S. Supreme Court in the case of City of Richmond v. J.A. Croson Co., 488 U.S. 469 (1989), invalidated a program that required contractors to subcontract a minimum of 30 percent of funds to minority owned businesses.  This was deemed by the Court to be a “rigid racial quota.”  The TEA-21 regulations prohibit the use of quotas.  Instead, the TEA-21 allows states to establish race-conscious contracting “goals.”  These can be satisfied by a contractor either meeting the numeric goal or by demonstrating that, despite “good faith efforts” to meet the goal, it couldn’t do so.  This flexibility provided by TEA-21 has been approved by a number of U.S. circuit courts as constitutionally permissible.

According to the Supreme Court, several factors must be considered in determining whether a racial classification is narrowly tailored.  These include “the efficacy of alternative remedies; the flexibility and duration of the relief, including the availability of waiver provisions; the relationship of the numerical goals to the relevant labor market; and the impact of the relief on the rights of third parties.” United States v. Paradise, 480 U.S. 149, 171 (1987).  And the Supreme Court has also stated that “[A]ll racial classifications, imposed by whatever federal, state, or local government actor, must be analyzed by a reviewing court under strict scrutiny.” Adarand Constructors, Inc. v. Pena, 515 U.S. 200, 227 (1995).

States that are utilizing federal funds such as those granted by the U.S. Department of Transportation, must be prepared to demonstrate the specific facts upon which they have “narrowly tailored” their minority preference criteria.  A contractor’s challenge to how the state agency has applied preference programs is the challenge most likely to succeed.  Since the courts demand “strict scrutiny” of how the programs are applied, the state agency has the burden of presenting evidence of discrimination in the affected construction industry and showing that its preference program is “narrowly tailored to remedy the discrimination.

About the author: Kent Holland is a construction lawyer  in Tysons Corner, Virginia, and is risk management consultant for environmental and design professional liability.  He is also publisher of ConstructionRisk.com Report.  For several years in the early mid 1980s, as an attorney with the U.S. Environmental Protection Agency (U.S. EPA),  Mr. Holland served as legal advisor to the Small and Minority Business Enterprise Office of the Agency and was involved in advising the Agency on numerous disputes involving MBE and WBE goals, and “good faith efforts” to achieve the goals. Since leaving the Agency, he has represented contractors in bid protests, and various claims involving DBE and MBE matters.  He may be reached at Kent@ConstructionRisk.com.

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Article 4

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Federal Strings Attached to Faith-Based Grants

By:  J. Kent Holland

There are significant financial requirements that may prove to be insurmountable hurdles tripping unwary faith-based grantees and causing severe financial pain and loss. An organization that takes federal grant funds must formally apply for a grant and then sign a formal grant agreement.  This is a contract with the government agreeing to abide by all the applicable federal laws, regulations, and terms and conditions of the agreement.  With the acceptance of federal grant funding comes intrusion of the government, including reviews and audits to determine whether the government’s rules for running grant programs have been satisfied.  This includes a requirement that funds be used only for the social services intended and not for any religious activities or purposes.

When audited, a grantee must present evidence, including documentation, to prove how it spent the federal funds.  It must be able to prove that all government funds were spent on costs deemed allocable, allowable and reasonable under the federal grant cost principles.  If a grantee cannot meet this burden of proof, the federal grantor agency may terminate the grant, demand repayment of grant funds and take other legal action as it deems appropriate.

This article will briefly explain some of the basic requirements of all federal grants, including administration of the grants and application of federal cost principles, and will in particular focus on grants under the umbrella of the U.S. Department of Health and Human Services (HHS).

Grantee Required to Return Federal Funds

To understand how the federal grant process works it may be easiest to explain the requirements by way of example.   In one reported grant appeal, a faith-based organization was required to repay funds it had accepted under its federal grant because it failed to perform the grant purposes within the requirement time limitations of the grant.

Oakwood Child Development Center, Inc. (Oakwood) appealed a decision by
the Family Support Administration (FSA/Agency) denying a request by
Oakwood for a no-cost, one year extension of a grant under the Community
Services Block Grant Act.  ((DAB No. 1092).  Six reasons were given by the FSA for denial of the requested no-cost extension of Oakwood’s grant.  The three most significant reasons were, in
substance:

(1) Even though Oakwood received emergency funding it failed to
implement its proposed renovation project in the one year
project period;

(2) At the time the grant expired Oakwood had not achieved any of
its proposed goals or provided any other benefits to the
proposed low-income beneficiaries of this project; and

(3) Oakwood drew down the $300,000 for renovations of the building
soon after receiving grant approval but had not begun any renovations over one year later.

The terms of the grant prohibited Oakwood from using any part of the building
for any sectarian purposes.   Oakwood is a non-profit affiliate of The Yeshiva Rav Isacsohn (the Yeshiva) an educational institution serving more than 700 children from pre-school through high school in Los Angeles , California . The focus of this case is on Oakwood’s acquisition and proposed renovation of a building for use as a Child Development Center .  Oakwood applied for a $2.3 million grant under section 681 of the Community Services Block Grant Act. Oakwood sought
$1.5 million for purchase of the Azteca Building and $800,000 for renovations.  Oakwood received $1.8 million: $1.5 million for acquisition of the building and $300,000 for renovation.

In part, the Assurance required that Oakwood agree  that “that no portion of any property or facility acquired or renovated in whole or in part with funds awarded or otherwise acquired pursuant to this Application will be used for religious worship, sectarian instruction or any other religious purpose.”

In response to the FSA’s refusal to extend the time period of the grant, Oakwood filed an appeal to the Grant Appeals Board of the Department of Health and Human Services.  In the briefs submitted to the appeals board, the  FSA devoted much of its argument to the religious factor. It claimed that Oakwood had “improperly devoted itself to the religious objectives of the Yeshiva,” rather than implementation of the purposes of the grant. FSA further alleged that Oakwood’s “overriding goal” was to circumvent the Assurance of Non-Sectarian Activity so that the Azteca Building could be made available “for the religious activities of the Yeshiva.”

Rather than addressing the question of these religious factors, the Board instead focused on whether FSA acted within its legal discretion in denying the requested grant extension.  As explained by the Board, the standard of appellate review is very strict.  The decision of the grantor agency (FSA) must be upheld “unless it was arbitrary”  since it is a “general of administrative law, that a certain presumption of regularity attaches to
the actions of government officials.”  The Board stated: “In our view . . . the grantee must show that this decision was arbitrary and discriminatory.”

In federal grant dispute cases the burden of proof is always on the grantee – the recipient of the grant funds.  The federal agency action is presumed reasonable unless proved otherwise by the grantee.  This is a heavy burden.  For this reason, a brief perusal of federal grant dispute decisions will demonstrate that the vast majority of cases are decided against the grant recipients and in favor of the federal grantor agency that has terminated a grant, disallowed expenditures under grant, or taken other action adverse to the grantee.

It is important to understand how difficult it is for a grantee to prove the federal agency wrong.  As The Board in Oakwood explained, the only question for the Board is whether the grantor agency made “a reasonable decision, not was it the only decision, or even the best decision, or even the decision that others might have made . . . [was it simply] a reasonable, rational decision.”

In this case, the Board concluded that the decision whether to grant a no-cost extension was a discretionary determination and that the FSA had amble reason not to extend the grant.  Having lost its grant, Oakwood was directed by the Board to comply with the decisions of the FSA to return the grant funds.  To do so, Oakwood could have to sell the affected property to generate the necessary funds for repayment.

What are the Rules?

Rules Specific to Faith-Based Organizations

The federal regulations state that grantees may not engage in inherently religious instruction or proselytization as part of the programs or services funded with grant money.  To the extent such activities are conducted by an organization they must be offered separately in time or location from the federally funded programs or servides, and participation must be voluntary.  No discrimination against a program beneficiary on the basis of religion or religious belief is permitted.  And all eligible activities under a grant must be carried out “ in accordance with all program requirements and other applicable requirements governing the conduct of Department-funded activities.”  45 CFR 87.1

(c)  (e) and  (f).

Financial Management Requirements

All grant recipients are required to maintain financial management systems that provide “accurate, current and complete disclosure of the financial results of each HHS-sponsored project or program in accordance with the reporting requirements” of the HHS regulations.  45 CFR 74.21 (b).   This includes maintaining “Written procedures for determining the reasonableness, allocability and allowability of costs in accordance with the provisions of the applicable Federal cost principles and the terms and conditions of the grant” and “ Accounting records, including cost accounting records, that are supported by source documentation.”

To be accepted , costs must meet all of the following criteria:

(1)  Are verifiable from the recipient’s records;

(2)  Are not included as contributions for any other federally-assisted project or program;

(3)  Are necessary and reasonable for proper and efficient accomplishment of project or program objectives;

(4)  Are allowable under the applicable cost principles….

Moreover, the allowability of costs incurred by nonprofit organizations … is determined in accordance with the provisions of OMB Circular A-122, ‘Cost Principles for Nonprofit Organizations and the grantor agency regulations. 45 CFR  74.27 (a) …

Federal Cost Principles of the OMB

When grantee are audited by their grantor agency, any costs failing to meet the allowability requirements of OMB Circular A-122 will be disallowed.  So what does the Circular require the grantee to prove in order that costs be deemed allowable?  The grantee must be able to show that the costs meet each of the following general criteria:

“a) Be reasonable for the performance of the award and be allocable thereto under these principles.

b) Conform to any limitations or exclusions set forth in these principles or in the award as to types or amount of cost items.

c) Be consistent with policies and procedures that apply uniformly to both federally financed and other activities of the organization.

d) Be accorded consistent treatment.

e) Be determined in accordance with generally accepted accounting principles (GAAP).

f) Not be included as a cost or used to meet cost sharing or matching requirements of any other federally financed program in either the current or a prior period.

g) Be adequately documented.”

To be deemed “allowable,”  a cost must also be found to be “reasonable.”   The OMB Circular explains that: “A cost is reasonable if, in its nature or amount, it does not exceed that which would be incurred by a prudent person under the circumstances prevailing at the time the decision was made to incur the costs.”   The Circular further provides that in determining reasonableness, “consideration shall be given to whether the cost is of a type generally recognized as ordinary and necessary for the operation of the organization or the performance of the award.”   The cost must also be considered in light of restraints that would be imposed by sound business practices and arms length bargaining.  There also must not be “significant deviations from the established practices of the organization which may unjustifiably increase the award costs.”

Even if the cost is  “reasonable” and “allowable ” it will not be accepted under the grant unless it is also an “allocable cost.”    As explained by the Circular, “A cost is allocable to a Federal award if it is treated consistently with other costs incurred for the same purpose in like circumstances and if it: (1) Is incurred specifically for the award; (2) Benefits both the award and other work and can be distributed in reasonable proportion to the benefits received, or (3) Is necessary to the overall operation of the organization, although a direct relationship to any particular cost objective cannot be shown.”

What Happens if the Government Agency Disallows Costs?

Federal grantor agencies have the authority to take legal action they deem necessary to recoup disallowed costs.  As explained above, the disallowance could be due to any number of reasons such as the grantee’s failure to expend the funds on allocable costs for the specific grant purpose.  An example of misspending funds would be the expenditure of federal money for the religious purposes and programs of the grantee instead of on specified social services.   Assuming the grantee can prove that it kept its religious and social services separate from each other in either time or location, the government may still disallow costs if they were unreasonable, for example, excessive in comparison what other prudent persons would have paid.  That are certain costs that are unallowable for federal grant funding no matter how reasonable they may appear.  For example, grant funds cannot be used for lobbying efforts.

Even if the grantee did everything correctly under the grant, it may lose its grant funding if it cannot show with written documentation how it expended the funds and that the costs were reasonable.  The burden of proof falls to the grantee.  If it cannot present adequate documentation, the federal agency is within its rights to presume that the funds were misspent.  The federal agency is not required to prove any wrong doing.  Instead, the grantee must prove that it did everything by the book.

For HHS grants, once the grant award official has determined that a costs is unallowable, the agency must take action to collect the money from the grantee.  As explained by the HHS Grants Administration Manual (Chapter 1-105-60), “if a determination is made that a cost is unallowable, the Action and Approving Officials do not have the authority to “waive” (forgive) collection of the disallowance. These disallowances constitute claims by the Government, and may be waived or reduced only under the limited conditions prescribed in the Federal Claims Collection Act.”

A grantee may feel that because it accomplished its program objectives the government should be kind, patient, and understanding when it comes to auditing the grant.  But this is not the case.  In fact, the HHS Manual specifically admonishes the HHS grant officials as follows:  “In determining whether a cost is allowable or unallowable, factors such as the good faith of the organization, its successful accomplishment of program objectives or its ignorance of the provisions of the awards, although important for other purposes, shall not be used as a basis for allowing costs which are unallowable under the provisions of the awards. The organization’s ability to make restitution also has no bearing on the allowability of a cost, but should be considered, where necessary, in establishing recovery periods and in determining whether there is justification for reducing or waiving collection of a claim under the Federal Claims Collection Act and implementing procedures.”

What I Learned as a Qausi-Judge at EPA

For several years in the 1980s, I served as a Standing Member (quasi-judge) of the grant appeals board of the U.S. Environmental Protection Agency.  Following audit reviews of grants to municipalities under the Clean Water Act, many cities were directed to return millions of dollars to the EPA.  When grantees appealed the adverse decisions, it was my job to determine whether the grantee had met its burden of proving that the questioned costs were “allowable” and properly expended for the allocable grant purposes.   This had to be accomplished with written documentation showing that the grantee satisfied the EPA program regulations, and the relevant cost principles.  In most cases that came before me for review and decision, I found in favor of the EPA against the grantee.  This was so even though virtually every grantee had accomplished the basic grant purpose of building a project to help clean up water or improve water quality.

There were cases that I decided against a grantee for the sole reason that the grantee didn’t maintain proper paper documentation to prove how the funds were expended and that they were used for allocable and allowable costs.  It didn’t matter that I believed the project worked great and accomplished its intended purpose.  It didn’t matter that I personally believed the Mayor and city personnel acted with integrity and honesty in managing their grant.  It didn’t matter that I thought the EPA and its auditors were being unduly demanding and perhaps interpreting and applying the regulations in a overly strict manner.

As explained by the HHS Grant Appeal Board decision at the beginning of this article, the burden of proof is on the grantee to prove that the federal agency acted arbitrarily and capriciously in disallowing the questioned costs.  On review to an appeals board, the only question is whether the grantor agency decision was reasonable, not whether it was the “only decision, or even the best decision.”  This same standard applies if a grantee files suit in court against the federal grantor agency.  The court will review the administrative record to determine whether the agency acted within its legal discretion.   There will not be a trail with witnesses and a jury.

I have seen judges frustrated that they had to abide by this strict standard.  One judge in one of my EPA cases even chastised the agency for issuing a decision based on a regulatory interpretation that the judge said he disagreed with and would have interpreted the way the grantee wanted it interpreted.   Nevertheless, the judge went on to explain that he couldn’t reverse the agency merely because he didn’t like the agency’s position as well as that of the grantee since there was nothing about the agency position that was arbitrary and capricious.   It was not long afterwards that I decided to leave the agency and go into private practice representing EPA grantees to help them survive the audit and preserve their funds for their programs.

Conclusion

Before accepting a federal grant, a faith-based organization needs to learn the requirements of the federal regulations, cost principles, and the specific terms and conditions of its grant agreement.   The consequences of failing to document that every dollar is spent consistent with the requirements could be devastating.   If it is determined that grant funds were expended for costs that are unreasonable, unallowable or for items unallocable to the grant purposes (such as proselytizing or conducting religious services), the federal agency must recoup recover the unallowable costs from the grantee.  As explained by the HHS grants manual, the grant award official has not discretion to show mercy when it comes to recovering unallowable costs.

When an organization accepts federal grant funds, it better be prepared to document, using written records, showing that religious services were kept strictly apart from the social services funded under the grant. They also will need to be able to prove where, how and why the funds were spent, and that they were spent on allocable and allowable costs.  This may not be an easy task, but it is too important not to do it right.  Indeed, some grantees that have been unable to repay their grant debt to the federal agency have been sued in federal court by the agency to collect the debt.  In the event that liquid funds are not available, it is conceivable that the government could attach and sell off physical property (perhaps church buildings) belonging to the grantee organization in order to recover the debt.

Carefully weigh the requirements and the risks before accepting federal grant funds!

About the author: Kent Holland is a construction lawyer  in Tysons Corner , Virginia .  He is also publisher of ConstructionRisk.com Report.  For several years in the early mid 1980s, as an attorney with the U.S. Environmental Protection Agency (U.S. EPA) Office of General Counsel, Grants and Contracts Branch.  he served several years on the EPA Board of Assistance Appeals, deciding grant appeals filed by recipients of wastewater treatment construction grants and Superfund cooperative agreement funds.  Since leaving the Agency, he has successfully represented numerous municipalities in disputes with EPA over the eligibility and allowability of costs claimed under grant programs. He may be reached at Kent@ConstructionRisk.com.

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ABOUT THIS NEWSLETTER & A DISCLAIMER

This newsletter Report is published and edited by J. Kent Holland, Jr., J.D., a construction lawyer and risk management consultant.  The Report is independent of any insurance company, law firm, or other entity, and is distributed with the understanding that ConstructionRisk.com, LLC, and the editor and writers, are not hereby engaged in rendering legal services or the practice of law.  Further, the content and comments in this newsletter are provided for educational purposes and for general distribution only, and cannot apply to any single set of specific circumstances. If you have a legal issue to which you believe this newsletter relates, we urge you to consult your own legal counsel. ConstructionRisk.com, LLC, and its writers and editors, expressly disclaim any responsibility for damages arising from the use, application, or reliance upon the information contained herein.

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Publisher & Editor: J. Kent Holland, Jr., Esq.

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