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In Lockheed Martin Integrated Systems, Inc. (ASBCA Dec. 20, 2016), a case involving a $100 million breach of contract claim stemming from purportedly unallowable direct subcontractor costs, the Board granted Lockheed Martin’s motion to dismiss the Army’s untenable claim “for failure to state a claim on which relief could be granted,” concluding that the government had “gone forward with a claim for over $100,000,000…based on nothing more than a plainly invalid legal theory.”

Specifically, the Board held that final decisions based solely on an audit report’s “conclusory assertions” and “unsupported conclusions” failed to satisfy the standards required by the Board’s rules for a valid claim and that although prime contractors have a generalized responsibility to manage subcontractors, the Army failed to establish that Lockheed Martin had breached any particular contractual obligation, express or implied, and specifically that Lockheed Martin had no obligation to (1) obtain or audit incurred cost submissions from subcontractors; or (2) to retain documentation supporting prime contractor billings for longer than the contract’s “applicable records retention” period.

On February 17, the Federal Register published a proposed rule that would amend the FAR to implement section 857 of the National Defense Authorization Act, making unallowable any “costs incurred by a contractor in connection with a Congressional investigation or inquiry into an issue that is the subject of a proceeding resulting in a disposition as described in 10 U.S.C. 2324(k)(2)” (i.e., criminal convictions, matters involving an allegation of fraud or similar misconduct, suspension and debarment, default termination). The proposed rule would also expand the applicability of section 857’s requirements beyond DoD to all agencies subject to the FAR, and, as written, is not clearly limited to the contractor that is actually the subject of the “proceeding or inquiry,” an important detail that should be addressed in contractor and industry comments submitted over the next 60 days prior to the publication of the final rule.

In a notice published in the Federal Register on February 8 that will almost certainly be unpopular with contractors and their customers, DoD asked for comments on its consideration of adding a requirement to the DFARS that would “require offerors to describe in detail the nature and value of prospective IR&D projects on which the offeror would rely to perform the resultant contract.” As described in the notice, that information would be used by DoD to “evaluate proposals in a manner that would take into account that reliance by adjusting the total evaluated price to the Government, for evaluation purposes only, to include the value of related future IR&D projects,” presumably by increasing the evaluated price of that offeror’s proposal to include the full value of the IR&D project.

The 2016 National Defense Authorization Act prohibits the Defense Contract Audit Agency from providing “audit support” to any non-DOD agency until the Secretary of Defense certifies that DCAA has reduced its backlog of incurred cost audits to 18 months or less, a restriction that could cause some disruption for contractors when DOD contracts are not a majority of the contractor’s government work and when audit support has been provided by DCAA in the past. On January 7, 2016, DCAA issued guidance to its auditors that appears to limit the prohibition on “audit support” to incurred cost audits, leaving DCAA auditors free to provide other accounting services to non-DOD agencies, specifically permitting DCAA to perform incurred cost audits that include both DOD and non-DOD contracts when auditors determine that inclusion of the non-DOD contracts involves “de minimis” incremental effort by DCAA, and offering guidance about how to handle such “mixed” audits when the non-DOD contracts will create more than “de minimis” incremental effort.

On October 1, the DoD IG released a report titled “Evaluation of Defense Contract Management Agency Actions on Reported DoD Contractor Business System Deficiencies,” asserting that DCMA contracting officers “repeatedly” failed to comply with DFARS requirements involving reported business system deficiencies.  The report, which is similar to a report issued on June 29, 2015 regarding DCMA’s treatment of estimating system deficiencies (available here), focused its criticisms on DCMA, despite DCMA’s comments noting flaws in the IG’s logic (such as the IG’s suggestion that DCMA, rather than DCAA, is responsible for determining whether a “significant” business system deficiency exists).

 

While DOD’s August 26 white paper “Enhancing the Effectiveness of Independent Research and Development” explains that the intent of new requirements announced in the white paper is “not to reduce the independence of IR&D investment selection, nor to establish a bureaucratic requirement for government approval prior to initiating an IR&D project,” contactors have good reason to doubt that assertion.  Most significantly for contractors, there will be a new DFARS rule under which “beginning in FY 2017, DoD will require contractors to record the name of the government party with whom, and date when, a technical interchange took place prior to IR&D project initiation and to provide this information as part of the required IR&D submissions made to [DTIC],” and DCMA and DCAA “will use these DTIC inputs when making allowability determinations for IR&D costs.”    

In Raytheon Co., ASBCA Nos. 57801 et al. (May 7, 2015), the Board held that under FAR 30.606 contractors may not offset cost impacts from simultaneous accounting changes within the same business segment, which if not reversed on appeal will cause major disruptions when contractors make multiple changes in cost accounting practices made after 2005 (the date of the FAR change), effectively giving the Government the benefit of decreased costs without offsetting them against increased costs of simultaneous accounting changes.  The Board decision ignores the language of CAS 9903.306(b)-(c), which states that when there is a change in accounting practice the Government should not pay more than the “contract costs, price, or profit” that “would have been agreed to” had the accounting changes been known, which would logically include all simultaneous changes, not just changes that decrease the costs.

On January 7, 2015, DCAA issued guidance to auditors for determining whether certain costs are “expressly unallowable” – and therefore subject to penalties – even when the regulations “do not state in direct terms that the cost is unallowable.” This guidance, which is intended to “enhance” the equally troubling December 18 guidance to similar effect, is inconsistent with the CAS 405 definition of “expressly unallowable cost” (i.e., “a particular item or type of cost which, under the express provisions of an applicable law, regulation, or contract, is specifically named and stated to be unallowable“) and will likely lead to confusion in the audit process and undoubtedly result in DCAA auditors assessing more penalties against contractors on dubious grounds.

On May 18, 2011, the DoD released an interim Business Systems rule with request for comments.  76 Fed. Reg. 28856.  Comments are due July 18, 2011.  The current version of the rule reflects comments received on the prior two proposed Business Systems rules (published January 15, 2010 and December 3, 2010), requirements in the National Defense Authorization Act for FY 2011, and additional revisions to the rule.

 Six business systems are covered by this rule:

·       Accounting System

·       Earned Value Management System (“EVMS”)

·       Estimating System

·       Material Management and Accounting System (“MMAS”)

·       Property Management System

·       Purchasing System

DoD characterizes these business systems as the “first line of defense against waste, fraud, and abuse.”  Accordingly, DoD sees this rule as improving the effectiveness of DoD oversight of contractors and achieving more effective and efficient management of DoD programs.  Notable changes with this version of the rule include the following:

Covered Contracts – The rule makes clear that contracts covered by the withholding provisions of the Contractor Business System rule will be contracts subject to the Cost Accounting Standards, but the substantive requirements of the interim rule specifying requirements for compliant business systems are not limited to CAS –covered contracts.  Therefore, small businesses will not be subject to withholding under the rule, but they may be required to meet relevant requirements for compliant business systems.  There is also nothing in the rule that would suggest that subcontracts are covered by the withholding requirements, although they are covered by some of the systems requirements, as described below.  

“Significant Deficiency” – The interim rule defines a “significant deficiency” as “a shortcoming in the system that materially affects the ability of officials of the Department of Defense to rely upon information produced by the system that is needed for management purposes.”  This term is used throughout, and replaces phrases such as “deficiency that adversely affects the system” or “deficiency that adversely affects the system, leading to a potential risk of harm to the Government.”  A determination by the government that a “significant deficiency” exists with a contractor’s business system will be grounds for issuing a notice of withholding of payment and will require the contractor to submit a corrective action plan.  The rule allows for contractor response to an initial finding of a “significant deficiency” and the contracting officer (“CO”) will have final authority to determine whether a “significant deficiency” exists. The CO is required to describe the deficiency in sufficient detail to allow the contractor to understand the deficiency.

Withholding – The rule provides that if a CO issues a final determination that a contractor’s business system contains significant deficiencies, that final determination that there is a significant deficiency “will” include a notice of payment withholding.  However, unlike versions of the proposed rule, the CO will be required to make a final determination that a significant deficiency exists before withholding will be permitted.  The CO is directed to withhold 5% of amounts due from progress payments and performance-based payments.  Also, the CO will direct the contractor to withhold 5% from its billings on interim cost vouchers on cost, labor-hour, and time-and-materials contracts.  The withholding will continue until the CO determines that the contractor has corrected all significant deficiencies.  However, if the contractor submits, within 45 days of notice of the significant deficiency determination, a corrective action plan, the CO could determine to reduce the withholdings to 2%.  Because the withholding provisions apparently apply only to CAS-covered prime contracts, it is not clear what remedy the Government could invoke for system deficiencies on contracts and subcontracts not subject to the withholding provisions.  

Limitations on and Flexibility with Withholding – The rule establishes the ceiling on the withhold percentage as 5% for one or more significant deficiencies in any single business system and 10% for significant deficiencies in multiple business systems.  Note that payment withholding is not permitted on fixed-price line items where performance is complete and the items accepted by the government.  The interim rule also provides that the CO can identify one or more covered contracts containing the Contractor Business Systems clause (252.242-7005) from which to withhold payments.  In other words, the CO is no longer required to withhold payment from every contract containing the Contractor Business Systems clause, and the CO has the sole discretion to identify the contracts from which to withhold payments.  

Recognition of Government Delays – The interim rule recognizes, to a certain extent, that delay on the government’s part occurs and takes steps to decrease the impact on contractors resulting from any such delay.  For example, normally, withholding of payments will be discontinued when the CO determines that the contractor has corrected all significant deficiencies.  Because there can be delay between when a contractor notifies its CO of a corrected significant deficiency and when the CO makes a determination that the significant deficiency is, indeed, corrected, the rule requires a reduction of the withhold percentage, by at least 50%, if 90 days has passed since the CO received notification of the correction and the CO has not yet verified that the significant deficiency has been corrected.  Nevertheless, the 50 percent withholding could continue indefinitely under the rule as promulgated, unless that contractor initiates a dispute under the CDA to seek payment.  Also, whereas the proposed rule required initial validation of an EVMS within 16 months, the interim rule allows for the CO to extend the deadline by which the initial validation must be done. 

System Approvals – The government will be permitted to issue approval of a business system only when there are no remaining significant deficiencies.  Although the rulemakers say that system approval will not be issued for “substantially corrected” systems, if the deficiencies have been corrected so that no “significant deficiencies” remain, withholding should cease.

An overview of the requirements, as set forth in the interim rule, for each of the six systems is provided below (as noted above, these substantive requirements are not limited to CAS-covered prime contracts):

Accounting System – Contractors receiving cost-reimbursement, incentive type, time-and-materials, or labor-hour contracts, or contracts which provide for progress payments based on costs or a percentage or stage of completion, are required to maintain an accounting system.  An accounting system is required to provide for, for example, a sound internal control environment, accounting framework, and organizational structure; proper segregation of direct and indirect costs; identification and accumulation of direct costs by contract; accumulation of costs under general ledger control; periodic monitoring, and a timekeeping system that identifies employees’ labor by intermediate or final cost objectives.  If a CO determines that an accounting system deficiency affected a contractor’s proposal, the CO can allow the contractor additional time to correct the deficiency, consider another type of contract (e.g., fixed-price incentive instead of a firm-fixed-price contract), use additional cost analysis techniques to determine cost reasonableness, or reduce the  negotiation objective for profit or fee.  It is not clear how these provisions relate to the FAR prohibition on awarding a cost-reimbursement contract in the absence of an “adequate” accounting system (see FAR 16.301-3(a)(1)).  

Earned Value Management System – The EVMS requirements apply to contractors that receive cost or incentive contracts valued at $20,000,000 or more and other contractors as determined by the CO.  The interim rule requires a contractor to use (a) an EVMS that complies with the EVMS guidelines in the American National Standards Institute/Electronic Industries Alliance Standard 748, Earned Value Management Systems (ANSI/EIA-748) and (b) management procedures that provide for generation of timely, reliable, and verifiable information for the Contract Performance Report (“CPR”) and the Integrated Master Schedule (“IMS”) required by the CPR and IMS data items of the contract.  If the contract has a value of $50 million or more, the contractor will be required to use an EVMS that has been deemed acceptable by the Cognizant Federal Agency (“CFA”).  Any changes proposed by the contractor to its EVMS will need to be approved in advance by the CFA.  If the contract is less than $50 million, the government will not make a formal determination of compliance with ANSI/EIA-748, and advance government approval of changes will not be required.

Estimating System – Contractors with contracts awarded on the basis of cost or pricing data are required to maintain an estimating system that is reliable and consistent, produces verifiable, supportable, documented, and timely cost estimates, is consistent with and integrated with the contractor’s related management systems, and is subject to financial controls systems.  For those contractors who received in their preceding fiscal year DoD prime contracts or subcontracts exceeding $50 million, they must disclose their estimating system in writing to the Administrative Contracting Officer (“ACO”).  Additionally, the same disclosure requirement applies to those contractors who received in their preceding fiscal year DoD prime contracts or subcontracts exceeding $10 million and who were also notified by their CO that disclosure would be required.

Material Management and Accounting System –  Except for contracts awarded to small businesses, educational institutions, and nonprofit organizations, the MMAS requirements apply to non-commercial item contracts over the simplified acquisition threshold awarded on a cost-reimbursement basis or on a fixed price basis with progress payments made on the basis of incurred costs.  The interim rule requires contractors to (a) maintain an MMAS that reasonably forecasts material requirements, ensures that costs of purchased and fabricated material charged or allocated to a contract are based on valid time-phased requirements, and maintain a consistent, equitable, and unbiased logic for costing of material transactions and (b) assess its MMAS and ensure it has adequate internal controls in place to ensure system and data integrity.  The rule identifies a number of internal controls required for an MMAS, including having policies, procedures, and operating instructions describing its MMAS, ensuring that material costs are charged to a contract based on time-phased requirements identified in the rule, and implementing mechanisms to identify, report, and resolve system control weaknesses and manual override.  

Property Management System – The property management system requirements apply to cost reimbursement, time-and-material, and labor-hour type contracts as well as fixed price contracts where the Government will provide Government property.  The interim rule requires contractors’ property management system, which manages and controls government property, to comply with FAR 52.245-1.  This FAR clause requires contractors to maintain a system that creates and maintains records of all government property accountable to the contract; periodically performs, records, and discloses physical inventory results; has a process to create and provide reports of discrepancies, loss, theft, damage, or destruction; and complies with property closeout requirements.

Purchasing System – The purchasing system requirements apply to cost reimbursement contracts; letter contracts, time-and-materials contracts, and labor-hour contracts over the simplified acquisition threshold; and fixed price contracts over the simplified acquisition threshold under which unpriced contract actions are anticipated.  Contractors will be required to maintain a purchasing system that meets a number of criteria set forth in the rule.  These criteria include having an adequate system description, including policies, procedures, and purchasing practices that comply with the FAR and DFARS; ensuring that all applicable purchase orders and subcontracts contain all flowdown clauses; maintaining an organization plan that establishes clear lines of authority and responsibility; ensuring all purchase orders are based on authorized requisitions; maintaining adequate documentation of the history of purchase transactions; and applying a consistent make-or-buy policy.  The rule addresses methods for the government to mitigate the risk of purchasing system deficiencies on specific proposals, which include segregating the questionable areas as a cost-reimbursable line item, including a contract reopener clause that provides for adjustment of the contract amount after award, and reducing the negotiation objective for profit or fee.  The criteria for purchasing systems in the clause DFARS 252.244-7001 Contractor Purchasing System Administration includes several new requirements that may be problematic.  Subparagraph (c)(16) of the clause requires that the purchasing system must enable the contractor to “notify” the Government of the award of all subcontracts that include flowdown clauses authorizing the Government to audit the subcontractor and “ensure the performance of audits of those subcontractors.”  There is no explanation of how or when the required notice is to be provided to the Government or how the contractor is expected to “ensure the performance” of authorized Government audits.  Subparagraph (c)(24) of the clause requires that the contractor provide “timely notice” to the Government if the prime contractor changes the amount of subcontract effort after award so that it exceeds 70 percent of the value of the contract or order and to provide the same notice if any subcontractor makes such a change as to lower-tier subcontract effort.  While such situations are likely to be uncommon, it is not clear how contractors, particularly large companies with thousands of active contracts, will monitor those contracts to identify the few unusual cases that may require notification. 

As the press reports about delays in the appropriations process have multiplied in recent days, we have received a number of calls from clients about the contractual issues that might arise if there is a government shutdown this Friday. Although the issues that might arise in connection with a shutdown will likely be specific to the circumstances of individual contracts, there are several broad issues that all contractors should be considering. Based on our experience with the issues that arose during the last shutdown in the mid-nineties and on the standard provisions in most contracts, we recommend that contractors consider at least the following:

  • Where Is the Money? For incrementally funded contracts, a “shutdown” situation is likely similar to those experienced at the end of any fiscal year when there is a “gap” between appropriations. Contractors will need to consider the implications of the various standard clauses (Limitation of Costs, Limitation of Funds, Limitation of Government Obligations) that may affect the government’s obligation to pay costs in excess of the amounts obligated to their contracts. Of particular concern will be the standard provisions in those clauses that may limit the government’s liability for termination costs in the event that the contracts are eventually terminated without new funding. As is the case when there is a gap in funding, contractors will need to decide whether to continue to perform or to take the actions authorized under the various relevant clauses when funding is insufficient to pay for anticipated costs. But for contracts that are fully funded or that have incremental funding sufficient to cover all anticipated costs, including termination costs, a shutdown would not normally create any additional risk.
  • Delay and Disruption. During the last federal shutdown, due to the unavailability of appropriated funds, the principal contractual issues reported related to the disruption and delay caused by the inability of contractors to gain access to closed government facilities or to obtain timely direction and support from the government. For example, a contractor that performs services in a federal facility may find that the facility is closed, so the contractor’s employees do not have access to their workplace. In that situation, contractors will need to decide whether to (1) continue to pay the employees for idle time caused by the shutdown, (2) force the employees to take vacation or other paid leave for the duration of the shutdown, or (3) furlough or lay off the employees. In connection with those decisions, contractors need to consider not only their contractual requirements, but also the applicability and requirements of federal, state, and local labor and employment laws (including the federal WARN Act and state analogs), the terms of their employment contracts and collective bargaining agreements, the impact that their decisions may have on employee relations, and other relevant factors. In a situation in which the duration of the shutdown is unclear, those decisions can be even more difficult, involving a variety of competing and largely unattractive options.
  • Remedy. Contract type and the availability of a remedy from the government for the consequences of a shutdown will also be important in the decision-making process. For contractors with cost-reimbursement contracts, the reasonable costs of coping with a shutdown should be recoverable, although there may be issues about the allocability and allowability of specific items of cost. On fixed-price contracts, any recovery from the government will likely depend on whether the contractor is entitled to an equitable adjustment. And, on T&M contracts, there are likely to be contract-specific issues about whether the contractor is entitled to be paid under the contract for idle time or would need to make a claim for an equitable adjustment. Again, every situation should be assessed separately, based on specific facts. But, in general, contractors should take steps to ensure that any increased costs associated with the shutdown are collected in a way that will support an equitable adjustment claim, if the contractor ultimately decides that a claim is warranted.
  • Don’t Ask, Don’t Tell? Contractors should also weigh whether it is prudent to seek direction from the government in advance of a shutdown. Indeed, by asking, a contractor might prompt direction from the government that puts the contractor in a situation worse than attempting to gauge the uncertainty.
  • Mission Creep. Some contractors may actually be approached by their government customer seeking to off-load, at least temporarily, work that cannot be performed by the government during the shutdown period. If the contract funding is available, the government may want to increase the scope of the contract in order to ensure that certain work is not disrupted or delayed. Contractors should ensure that any increases in scope and associated cost or price adjustments are appropriately reflected in a contract modification.
  • Timing of Payment. There may be delays in payment. As noted above, the government’s ultimate legal liability for payments due on contracts that are already funded at the time of the shutdown are unlikely to be at issue, but if the government employees who process contractor invoices and make contractor payments are not at work, there will obviously be no payments made. For large contractors with substantial bills that may involve payments of millions of dollars on a daily basis, the consequences of even a short delay in payment could be economically significant, although probably not an existential threat to the company. For contractors without readily available cash or credit lines, the consequences of more than a brief delay in payment could be catastrophic. Again, each situation needs to be evaluated based on the circumstances of the contractor and the consequences of delay in payment. Suspension of performance for non-payment may be justified legally, but for contractors performing in war zones or under other circumstances where suspension of performance would have significant collateral consequences, decisions to suspend performance, even if legally justified, may be exceptionally difficult.

When the Government was last forced to shut down because of delays in the appropriations process, the shutdown was relatively short, and the consequences were relatively modest. Although, there were claims and there was some litigation, the impact on industry was not substantial. However, in some cases — both then and today — even a very brief shutdown could have material economic consequences for individual contractors. A shutdown that lasts more than a few days might have devastating effects, particularly on service contractors that perform in government facilities. Even if it seems improbable that a shutdown will occur or that it will last long if it does occur, it would be prudent for all contractors to assess the likely impact of a shutdown on their specific operations and to make contingent plans for dealing with the consequences of a shutdown. Finally, the Office of Federal Procurement Policy announced last week that if there is actually a shut down, it will issue some sort of guidance, at least internally in the government of how to move forward.