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CHAPTER 2

Self-Insurance of Government Property

This chapter discusses the question of who should bear the risk of damage to Government property caused by defects in products purchased by the Government.

The scope of the topic perhaps can be explained best by a recent incident that has given rise to much concern among contractors and the insurance industry. Lockheed Aircraft Corporation was the manufacturer of the P-3B antisubmarine patrol aircraft, and the Menasco Manufacturing Company, as a subcontractor to Lockheed, furnished the landing gear. The U.S. Navy sold some P-3B's to Australia. In April 1968, an alleged failure in the landing gear, during flight training of Australian Air Force personnel, caused one of the aircraft to crash and burn on landing. The aircraft was a total loss, but no lives were lost and there was no other damage. In August 1969, the Australian Government sued Lockheed and Menasco for damages in the amount of $4 million against Lockheed and $5 million against Menasco.1 The money claimed covered the cost of replacing the plane, value of the equipment aboard, maintenance and operating costs, and loss of use of the aircraft. Exemplary damages were sought for gross recklessness and gross disregard for the safety of the aircraft and its crew. An out-of-court settlement was subsequently reached with Menasco, Lockheed, and the U.S. Government contributing to the price of a replacement aircraft.

The case illustrates two fundamental issues that will be considered in this chapter: (1) What is the extent of contractor and subcontractor obligations to repair, replace, or pay for loss of or damage to major, or high-cost,

1 Australia v. Lockheed Aircraft Corp., No. 69-1623-WPG (Cal. Cent. Dist. Ct., Complaint filed Aug. 18, 1969).

end-item supplies provided under the terms of a Government contract? (2) What is the extent of contractor or subcontractor obligations for loss of or damage to property other than the end item itself and for other expenses resulting from such loss or damage?

The second issue is the primary concern in the Menasco case. The case is notable because, prior to this incident, the DOD practice had been not to hold the manufacturer of a defective product liable for damage to Government property caused by the defect. While the military services long had used several different clauses providing for warranties and correction of defects, it was not until 1964 that DOD issued a comprehensive list of instructions for use of warranties in fixed-price contracts. This DOD action was based on the conclusion that in fixed-price contracts such provisions enforceable and any increase in price was outweighed by the added protection to the Government. In 1967, the Armed Services Procurement Regulation (ASPR) was expanded in this area by adding a "Correction of Deficiencies" clause and a "Warranty of Construction" clause." The latter clause imposed liability on a contractor for "consequential damages," which include damage to Government property and may be defined as follows:

4

Consequential damages. . . relate to all other recoverable losses from use or loss of use of the defective item, such as complete loss or damage to end item or the system in which it is used, injury to the person or

2 Payne, "Government Contract Warranties: Isn't the Caveat Venditor Rather Than Emptor?" 4 Nat'l Contract Management J., 31, 35 (1970).

ASPR 1-324.1-.6. ASPR 1-324.9.

ASPR 1-324.10.

property of the purchaser or third persons, loss of use or rental value, and loss of business, production or profits by the purchaser."

After 1967, the Air Force began seeking warranty coverage in its contracts. The question of liability for damage to Government property (other than in construction contracts) remained vague and uncertain. The matter was aired in 1967 by the Commander of the Air Force Logistics Command who observed that the Air Force did not intend to hold contractors liable for "secondary or tertiary damages." " On his suggestions, DOD chartered a working group to study problems involved in Government contract warranties. Specific review and recommendations were requested on five questions, one of which was, "What should DOD policy be with respect to liability for consequential damages when warranties are involved?" The 1969 Report of the Working Group on Contract Warranties stated that "DOD's current policy on recovery for consequential damages under contract warranty provisions is not clearly established" and recommended that ASPR guidelines be established for inclusion or exclusion in each procurement.10

In view of this background, the possibility that Menasco might be held liable for damages in excess of the cost of repair or replacement of the defective landing gear stunned industry. Defense contractors understood that the general practice of Government in military contracting was to accept risk for loss or damage except for the warranted item that was defective. The industry concept of the Government's policy of self-insuring Government property against loss or damage arising from defective products apparently was so universally accepted that industry, as a rule, did not

11

Industry Advisory Council, Report of the Working Group on Contract Warranties, June 12, 1969, at 7. See also note 8 infra. Address by Gen. Thomas P. Gerrity before the Dayton, Ohio, Chapter of the National Security Industrial Association, Jan. 25, 1967.

The Working Group was established on May 1, 1968, by the then Deputy Secretary of Defense, Paul H. Nitze. Seven members were from the Dep't of Defense and seven from industry. Gen. James O. Lindberg, USAF, served as chairman. The Group's final report, Report of the Working Group on Contract Warranties, was submitted in June 1969.

Industry Advisory Council, supra note 6, at 1.

10 Ibid., at 7.

11 See Payne, supra note 2, at 49. See also Spriggs, "Implied Warranties Under Government Contracts," 4 Pub. Contract L.J. 80, 83-89 (1971).

request increased contract prices even when the new ASPR warranty clauses came into use.

The history of the Government's pursuit of claims for lost or damaged property supports the industry understanding of the unwritten policy of self-insurance. Except for nominal repairs and replacements, there is little precedent in the courts, boards of contract appeals, or the General Accounting Office on claims against contractors or subcontractors for recovery of such damages. 12 This is not to say that the Government has never asserted claims of this nature against contractors. However, they have apparently been settled on broader bases usually involving forward or long-term commitments.13

14

Acting on the Report of the Working Group on Contract Warranties, and in the wake of the Menasco incident, the ASPR Committee undertook a special case study to revise and clarify DOD's policy on warranties and consequential damages.15 The committee held discussions with member company representatives of the Council of Defense and Space Industries Associations (CODSIA), with stock and mutual property companies, and with casualty and aviation insurers. In October 1970, the committee proposed new ASPR coverage on contractor liability for defective supplies including limitations on liability for defects. The letter of transmittal stated that:

The proposed coverage would establish a policy that the Department of Defense should, in the interests of economy, generally be a self-insurer with regard to casualty losses or damages which result from defective supplies furnished by a contractor.16

It stated that the policy, however, would not exempt contractors from liability for loss or damage to the contract end items themselves or when an express warranty provision otherwise included in the contract made the contractor liable for such loss or damage.

In February 1971, DOD issued Defense Pro

12 Australia v. Lockheed Aircraft Corp., supra note 1, affidavit by Barry J. Shillito, Assistant Secretary of Defense, Apr. 27, 1971. 13 Ibid., supplemental affidavit by Barry J. Shillito, July 26, 1971. 14 Industry Advisory Council, supra note 6.

15 U.S. Dep't of Defense, Office of the Assistant Secretary for Installations and Logistics, Warranties Consequential Damages, ASPR Case 69-131, initiated in June 1969.

16 Letter from E. C. Chapman, Chairman, ASPR Committee, to Theodore Haetel, Executive Secretary, CODSIA, Oct. 19, 1970.

curement Circular (DPC) No. 86. The circular provided:

The purpose. . . is to establish Department of Defense policy with respect to contractor liability for loss of or damage to property of the Government occurring after final acceptance of supplies delivered to the Government and resulting from any defects or deficiencies in such supplies. The policy announced . . . [is] the result of a long period of study and [is] aimed at reducing Government procurement costs by limiting the contractor's risk.

A new paragraph was added to the ASPR providing:

It is the policy of the Department of Defense generally to act as a self-insurer for loss of or damage to property of the Government occurring after final acceptance of supplies delivered to the Government and resulting from any defects or deficiencies in such supplies.17

There were a number of exceptions and limitations to this policy of self-insurance. In April 1971, Revision No. 9 to ASPR incorporated DPC No. 86 into ASPR. The fact that the ASPR Committee did not consider the new coverage on warranties and consequential damages as conclusive or exhaustive was clearly stated in DPC No. 86:

Still under consideration are additional revisions concerning express or implied warranty provisions and extension of the policy established by this item to contracts other than those calling for delivery of supplies. The ASPR Committee has continued its study and expects to issue additional regulations to cover warranties and consequential damages.

No other procuring agency appears to have studied the issues as extensively as has DOD. No other formal policy or regulation has been issued similar to the ASPR provisions on the subject of contractor liability for defective supplies which cause loss of or damage to other Government property.18

17 ASPR 1-330 (a).

18 A review was made of the Federal Procurement Regulations and those issued by the General Services Administration, Coast Guard, Federal Aviation Administration, Dep't of Transportation, Atomic Energy Commission, and National Aeronautics and Space Administration (NASA). NASA has followed the ASPR clauses of Dep't of

PRIME CONTRACTORS

Recommendation 1. That the Government, with appropriate exceptions, generally act as a self-insurer for the loss of or damage to Government property resulting from any defect in items supplied by a contractor and finally accepted by the Government.

There is a need for a uniform, stated Federal policy in this area of potential liability, and we support the DOD policy that the Government, with certain exceptions, act as a self-insurer for the loss of or damage to Government property resulting from any defect in items supplied by a contractor and finally accepted 19 by the Government. Moreover, the DOD policy should be expressly extended to include subcontractors and third-party transferees. The latter extension is considered separately in Recommendations 2 and 3, infra.

CURRENT CONTRACT CLAUSES AND REGULATIONS

The procurement regulations of various executive agencies include prescribed contract clauses that govern postacceptance rights, obligations, and remedies for defective supplies. The terms of these clauses provide the Government with a number of different remedies, including the rights to (1) correct or replace defective or deficient supplies during the manufacturing process or prior to delivery, (2) reject such supplies at the time of delivery, (3) correct or replace after acceptance, (4) an equitable adjustment of price for deficient supplies that are not corrected or replaced, and (5) recovery of reprocurement costs if the contractor fails to correct or replace deficient or defective supplies. Except for latent defects,

Defense in section 1-324. The warranty of construction clause in NASA PR 1.324-10 states:

[T]he Contractor shall remedy at his own expense any damage to Government owned or controlled real or personal property, when that damage is the result of the contractor's failure to conform to contract requirements or any such defect of equipment, material, workmanship, or design. The contractor shall also restore any work damaged in fulfilling the terms of this clause. This imposes an express obligation to repair damaged Government property other than the end item of the contract under which defective supplies or services are sold.

19 Prior to acceptance by the Government, the property would of course belong to the contractor. If, because of defects, it caused damage to Government property at that point, either tort law or special contract clauses presumably would govern.

fraud, or gross mistakes discovered in the end item after its inspection and acceptance by the Government, such acceptance is binding and conclusive upon the Government.

The rights and obligations created by loss of or damage to Government property caused by defective supplies are subject to a number of variables. These include the type of contract used by the parties, the Government agency involved, and the contract end item.

The extent of a supplier's liability for damage to Government property caused by defective supplies generally has not been specifically stated in the clauses. One exception is found in construction. The "Warranty of Construction" clause obligates the contractor to:

remedy at his own expense any damage to Government owned or controlled real or personal property, when that damage is the result of the contractor's failure to conform to contract requirements or any such defect of equipment, material, workmanship, or design.20

The uncertainty and confusion over the rights. and obligations arising out of current contract clauses are compounded by differences in interpretation and application by the executive agencies and their purchasing activities. The agency boards of contract appeals, courts, or other tribunals that rule on questions of contract language may be confronted with difficulties because of inconsistent and conflicting positions.

Defense Procurement Circular No. 86, incorporated in ASPR by Revision No. 9 in April 1971, established a policy with respect to contractor liability for loss of or damage to Government property occurring after final acceptance of supplies delivered to the Government and resulting from any defects or deficiencies in such supplies. While the policy provides that DOD generally will act as a self-insurer for loss of or damage to property of the Government occurring after final acceptance, there are a significant number of exceptions and exclusions.

First, in procurement of high dollar value (major) items, the DOD policy relieves the contractor from liability from loss or damage to Government property, including the

20 ASPR 1-324.10. See supra note 18.

contract end item, occurring after final acceptance. Where a low dollar value (minor) item is purchased, the contractor is relieved of liability, excluding the contract end item. • Second, when it is the contractor's practice to obtain insurance or maintain a reserve for self-insurance for the liability for loss or damage to Government property, including major end items, the DOD policy does not afford it relief unless it can be ascertained that the contract price includes no part of the cost of the insurance or reserve for insurance.

Third, no relief from liability is given where the defects in the items furnished are the result of fraud or gross negligence of any personnel of the contractor.

Finally, no relief is afforded from liability where the defects are the result of willful misconduct or lack of good faith on the part of the contractor's directors, officers, or other designated managerial personnel.

MOTIVATIONAL CONSIDERATIONS

There is much disagreement as to whether there is any significant relationship between safety, quality, and reliability of products procured by the Government and assignment of the risk of liability for loss of or damage to Government property. Many do not believe that warranties actually motivate a contractor to be more careful in the performance of its contract.

Since the Government normally maintains an extensive inspection system during the manufacture and testing of the products it buys, it does not rely exclusively on warranty provisions to remedy defective or deficient products. Primary reliance is placed on the inspection system rather than on the normal type of commercial warranty. Concern for a contractor's exposure to risk of liability for defective products and any resulting motivational impact on employees actually involved in the physical aspects of manufacturing and testing of the product is doubtful. We believe the underlying issue with regard to the Government self-insurance is simply the assignment of risk for defective workmanship and performance

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