* Government's sovereign standing allows some unilateral contract changes
* Companies may not be entitled to compensation in all cases
* Cuts of 25 pct or more have been found within scope of contract
By Andrea Shalal-Esa
WASHINGTON, Aug 29 (Reuters) - A little-known aspect of U.S. contract law may provide a road map for how the Obama administration can implement billions of dollars of automatic budget cuts due to take effect in January without having to pay massive change fees to its contractors.
U.S. courts have found that the government has certain contractual rights because of its sovereign standing, including the right to unilaterally change the terms of its contracts, delay or stop work on contracts or terminate them outright, a congressional report found.
Companies would be entitled to some compensation for contract changes in some cases, according to a report by the nonpartisan Congressional Research Service that was issued in April but has not been made public until now.
In other cases, "the government could potentially avoid liability for actions that delayed or increased the costs of the contractor's performance because it acted in its sovereign capacity," said the report, which was completed in April but has not been widely publicized or circulated.
The report could be bad news for U.S. weapons manufacturers and others, who have warned that the U.S. government could face billions of dollars in change fees if it is forced to renegotiate thousands of contracts as a result of $1.2 trillion in automatic budget cuts that are due to take effect on Jan. 2 under a process known as sequestration.
Top defense industry executives have met repeatedly with Defense Secretary Leon Panetta and White House officials to get details on how the Obama administration plans to implement the additional budget cuts, which became mandatory after lawmakers failed last year to agree on other deficit-cutting plans.
They say the uncertainty is depressing their ability to invest, hire new workers or look at possible new acquisitions.
Government officials usually prefer bilateral contract modifications, but federal contract law also gives the government the flexibility to reduce order quantities in the event of funding gaps or budget cuts, according to the report.
"The government has broad contractual and inherent rights that give it some flexibility in responding to funding gaps, funding shortfalls, and budget cuts," the report said.
It said the government could avoid change fees in certain contracts, including certain indefinite-quantity deals that set a minimum quantity of goods or services to be bought from the contractor, but do not spell out the total buy in advance.
The report said other contracts give the government the express or implied right to change the quantity of goods or services to be purchased, to delay or accelerate performance of a contract, or to scrap the contract outright -- all without incurring liability for breaching the contract.
It said a 25 percent cut in one service contract was deemed to be within the general scope of the contract, but cuts of 50 percent and 73 percent to other procurement programs were later found to be beyond the scope of the changes clause.
"While there is no "bright-line test" for determining when a change is within the scope of the contract, the greater the magnitude of the change, in comparison to the total work called for, the more likely it is that the change will be found to be beyond the scope of the contract," the report found.
If the reductions were found to be within the scope of the contract, any downward adjustments could make the government eligible for downward price adjustments,
One congressional source familiar with the report said the defense spending reductions being discussed now were estimated to be around 10 percent each year, well below the 25 percent cut level that had already been deemed allowable.
The sophistication of the products involved was also a factor, the report noted in a footnote, citing a court case brought by General Dynamics Corp against the government in which the court found that changes that increased the price by 165 percent and extended the contract by three years were to be "expected in a contract for nuclear submarines."
The report did note that government contracts were subject to interpretation by various courts and boards of contract appeals, which have had differing opinions on recovery of costs.
It said individual contracts could also contain specific terms that were contrary to the general rules of contract law, and which would generally prevail over more standard terms.