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On appeal, Teknowledge argued that the COFC erred in requiring it to demonstrate a benefit to the Government from the development of its TekPortal software. It argued that allocability may be determined by the costs' potential future benefit to the Government. Since its costs were "indirect" rather than "direct" costs, Teknowledge argued that the COFC improperly looked for a nexus between the costs and a specific government contract. 

The Federal Circuit disagreed with Teknowledge and focused on its decision in Boeing N. Am., Inc. v. Roche, 298 F.3d 1274 (Fed. Cir. 2002), which emphasized that "benefit," as used in FAR Part 31.201-4, required a contractor to show a nexus between the contractor's cost and the contractor's government work. Here, the development costs resulted from work done in anticipation of acquiring government contracts. Since Teknowledge could not point to any specific government contract for the development or use of its TekPortal software, the required nexus did not exist. The court found any benefit of the costs to the Government to be remote and insubstantial. 

In our previous posting on the COFC decision, we discussed the implications of the case on independent research and development (IR&D) costs. In these cases, both the COFC and Federal Circuit found a lack of benefit to the Government, in large part, because of the absence of a government contract.  However, IR&D costs by their nature are not tied to a specific contract. Under FAR Part 31.205-18, IR&D "does not include the costs of effort sponsored by a grant or required in the performance of a contract." Similar to the COFC decision, the Federal Circuit makes no mention of IR&D. Indeed, there is no evidence to suggest that Teknowledge even considered using the FAR's IR&D provisions to characterize the development costs. Nevertheless, until further clarification from the courts, these two cases have the potential to negatively hang over IR&D projects.

The Federal Circuit's full opinion is available here.

Authored By:

Christopher Noon
(202) 469-4918
cnoon@sheppardmullin.com

The saga now continues. The GAO recently issued a report on DCAA entitled, “Widespread Problems with Audit Quality Require Significant Reform” (GAO-09-468), and testified before Congress on the same subject (GAO-09-1009T).  These developments afford us the opportunity to revisit the issue of DCAA’s aggrandizement of authority properly belonging to COs and, for a change, allow us to indict DCAA with the Government’s own words.  With apologies to David Letterman, we will let the GAO make the case for CO independence and for the rightful relegation of DCAA to the advisory role for which it is better suited.

Reason No. 10 Why DCAA Should Not Have a Controlling Voice in Government Contract Decision Making

“On one billing system audit, the auditor performed testing on two vouchers. The auditor did not document how he selected the two vouchers, and he did not document the population of contractor vouchers in the work papers or the basis for his judgment on selecting the two vouchers for testing. When we asked the auditor why he selected two most recent vouchers for testing and did not document the voucher population, the auditor told us it was because “the file size was too large,” and he saves the population files on his desktop computer.” GAO-09-468 at 92.

Alternatively put, it was too hard to be thorough, or to base judgments on a representative sample.

Reason No. 9 Why DCAA Should Not Have a Controlling Voice in Government Contract Decision Making

“[W]e have concluded that DCAA’s quality control system for the period covered by the last DOD IG peer review was not effectively designed and implemented to provide assurance that DCAA and its personnel comply with professional standards.” GAO-09-468 at 11.

In the private sector, a lack of professional standards earns you a malpractice lawsuit. However, the reversal of the DIVAD malpractice judgment on appeal crushed any hope for the application of common standards on both sides of the procurement equation.

Reason No. 8 Why DCAA Should Not Have a Controlling Voice in Government Contract Decision Making

“DCAA’s human capital management practices of hiring auditors at the entry-level and assigning them to complex audits with little classroom training or on-the-job experience and minimal supervision have contributed to the audit problems we identified.” GAO-09-468 at 3.

Q: “Just how many heart transplants have you actually performed, doctor?”

A: “None, but I spent last night at a Holiday Inn.”

Reason No. 7 Why DCAA Should Not Have a Controlling Voice in Government Contract Decision Making

“According to DCAA officials, DCAA rescinded . . . 80 audit reports because the audit evidence was outdated, insufficient, or inconsistent with reported conclusions and opinions and reliance on the reports for contracting decisions could pose a problem. . . . Because the conclusions and opinions in the rescinded reports were used to assess risk in planning subsequent audits, they impact the reliability of hundreds of other audits and contracting decisions covering billions of dollars in DOD expenditures.” GAO-09-468 at 14.

Now, when a contractor does this, there is this thing called the False Claims Act with which it has to deal. Don’t audits of this type actually cause the Government to expend money on false premises? Oh, that’s right -- different standards.

Reason No. 6 Why DCAA Should Not Have a Controlling Voice in Government Contract Decision Making

“The most pervasive audit deficiency we identified was insufficient testing to support DCAA’s reported conclusions and opinions.” GAO-09-468 at 37.

Contractors, of course, cannot do this. That would be (What do we call it?) -- cheating.

Reason No. 5 Why DCAA Should Not Have a Controlling Voice in Government Contract Decision Making

“DCAA’s audit quality assurance program was not properly implemented, resulting in an ineffective quality control process that accepted audits with significant deficiencies and noncompliance with [Generally Accepted Government Auditing Standards] and DCAA policy.” GAO-09-468 at 32.

Wasn’t there a new regulation promulgated last December that required contractors to develop and implement comprehensive internal control systems? We guess what’s sauce for the goose isn’t always sauce for the gander.

Reason No. 4 Why DCAA Should Not Have a Controlling Voice in Government Contract Decision Making

“The failure to perform quality audits leaves government contracting officers and disbursing officers with inadequate information, ultimately putting taxpayers at risk of improper contract payments and fraud, waste, abuse, and mismanagement.” GAO-09-468 at 36.

But contractors, we suppose, are not equally at risk of baseless, undocumented, untested allegations that cost them, in the aggregate, hundreds of millions of dollars in unnecessary legal and accounting fees defending against baseless claims. Because DCAA only makes mistakes that benefit the contractor, right?  COs who recognize the flaws in DCAA’s audits, audit techniques, and quality control procedures and make a decision based on a more informed basis, they are never wrongfully subjected to internal charges of favoritism or hauled before the IG for a public flaying, are they? No, because -- again -- DCAA’s mistakes all redound to the contractors’ advantage, don’t they?

Reason No. 3 Why DCAA Should Not Have a Controlling Voice in Government Contract Decision Making

“[W]e remain concerned that DCAA’s current approach of performing 30,000 to 35,000 audits and issuing over 22,000 audit reports with 3,600 auditors substantially contributed to the widespread audit quality problems we identified. Generating that many reports and doing that many audits with 3,600 auditors leaves very little time to perform in-depth, complex audits of contractors.” GAO-09-1009T at 17.

If contractors give their annual incurred cost submissions this type of superficial once over, bad things happen to them. As John’s eight-year old says, “It isn’t fair.” He’s right, it isn’t fair. It’s a travesty.

Reason No. 2 Why DCAA Should Not Have a Controlling Voice in Government Contract Decision Making

“DCAA’s policy to eliminate the 'inadequate-in-part' opinion for contractor internal control systems audits does not recognize different levels of severity of control deficiencies and weaknesses and could unfairly penalize contractors whose systems have less severe deficiencies by giving them the same opinion -- 'inadequate' -- as contractors having material weaknesses or significant deficiencies that in combination would constitute a material weakness. DCAA would benefit from outside expertise to develop effective audit policy guidance and training on auditing standards.” GAO-09-1009T at 15.

Let’s all reread that last sentence -- and let’s hope that IGs, US Attorneys, and the Government lawyers who handle board and court cases recognize that their “experts” have just been discredited by the Government’s own financial watchdog agency.

And finally -- Reason No. 1 Why DCAA Should Not Have a Controlling Voice in Government Contract Decision Making

“DCAA has not yet addressed the fundamental weaknesses in its mission, strategic plan, audit approach, and human capital practices.” GAO-09-1009T at 11-12.

Well, pardon our cynicism, but just what weaknesses has it addressed?

Our thanks to the GAO for its contribution to this ongoing saga. Its findings are no small town news; nor are they “fun facts” of the type in which the GEICO Gecko might revel. They are, in fact, scandalous, and they undermine the fabric of our procurement system.

The next time you are confronted with obstinacy from the Department of Justice or Office of the Inspector General, and waved before you is the latest DCAA audit that has you in its crosshairs, you may have to restrain yourself from reciprocating the gesture and waving this Blog piece in return. You shouldn’t do it, but it sure would make you feel good inside.

Authored by:

John W. Chierichella
(202) 218-6878
jchierichella@sheppardmullin.com

and

Daniel J. Marcinak
(202) 772-5391
dmarcinak@sheppardmullin.com

This interim rule applies:

• Civilian Agencies: Cost-reimbursement contracts that exceed the $100,000 simplified acquisition threshold.
   
• For DoD: cost reimbursement and certain fixed-price contracts that exceed $650,000, the threshold for requiring cost or pricing data. 

"Excessive pass-through charge" is defined as a charge by a contractor or higher-tiered subcontractor over their subcontractor's costs where the contractor/subcontractor "cannot demonstrate to the Contracting Officer that its effort added value to the contract or subcontract in accomplishing the work performed under the contract." Order processing, inventory management, schedule control, quality control, coordination, etc. are all considered to constitute "added value." 

To prevent such excessive pass-through charges, the interim rule effects how contractors and subcontractors manage and report subcontracting arrangements in three important ways: 

1. In their proposals, contractors must now disclose the total cost of work to be performed by the contractor and its subcontractors. Additionally, if a contractor proposes to subcontract more than 70 percent of the total cost of the work to be performed, then the contractor must disclose: a) the offeror's indirect cost and profit/fee applicable to subcontractor's work; and b) describe the value added by the work to be performed by the contractor. 
    
2. After award, contractors must notify the Contracting Officer in writing if changes to their actual subcontracted effort make that effort exceed 70 percent. At that time, the contractor must also provide a "verification that the contractor will provide added value."
    
3. The rule equips the government with mechanisms to ensure that it does not pay excessive pass-through charges. For example, the interim rule changes FAR 31.203 to disallow indirect costs that meet the definition of  "excessive pass-through charge" in 52.215-23. Likewise, the interim rule changes FAR 52-215-23(d) to entitle the government to a price reduction equivalent to any excessive pass-through changes included in the contract price for certain fixed-price DoD contracts. Additionally, interim FAR clause 52.215-23(e) permits the Contracting Officer to review subcontractor records to ensure the government is not paying excessive pass-through charges. 

As a result of this rule, contractors and subcontractors must now affirmatively prove that their management efforts over subcontracted effort benefit the government and provide "added value," just one more way in which the Government can micromanage contractor performance. 

Interested parties must submit comments no later than December 14, 2009. 

Authored By:

John S. Tobey
(202) 469-4920
jtobey@sheppardmullin.com

Under the interim regulation, commercial services not offered and sold competitively in the commercial marketplace can be considered commercial items if the Contracting Officer makes a written determination that the offeror submitted enough information to evaluate the reasonableness of the price of the services using price analysis. To supplement the price analysis, the Contracting Officer may obtain from the offeror the prices paid, by the Government or commercial customers, for similar commercial items under "comparable terms and conditions." See 74 Fed. Reg. 52852. If the Contracting Officer still cannot make a determination on the reasonableness of the price, the Contracting Officer can request other relevant information such as labor costs, material costs, and overhead rates. See 74 Fed. Reg. 52852. In other words, if the services are "of a type offered and sold competitively," then they can qualify as “commercial services.”

This interim rule implements section 868 of the Duncan Hunter National Defense Authorization Act for 2009 ("Section 868") and scales back the widened "of a type" Truth in Negotiations Act ("TINA") exemption for commercial services enacted in 2003 by Services Acquisition Reform Act ("SARA"). Congress enacted Section 868 (entitled "Minimizing Abuse of Commercial Services Item Authority") largely in response to a series of DoD Inspector General reports critical of the use of commercial item exceptions and comments by the Federal Acquisition Advisory Panel, established by SARA. Hence, expect to see diminished use of "of a type" commercial service contracts. When this contract authority is used, be prepared to provide cost or pricing data.

Comments on this interim rule must be submitted by December 14, 2009.

Authored By:

Jessica M. Madon
(202) 469-4919
jmadon@sheppardmullin.com 

Among the more important changes, the addition of FAR 16.401(e):

• Requires that award fees be linked to an offeror's performance in the areas of cost, schedule, and technical performance;
   
• Prohibits award fees if the contractor's overall performance is below satisfactory in a given evaluation period;
   
• Mandates the contracting officer document an award-fee determination;
   
• Places sole discretion in the government to devise the methodology and determine the award fee; and
   
• Requires an award-fee plan that establishes an award-fee Board for conducting the award-fee evaluation and the procedures for evaluating the award fee. 

In rendering award-fee determinations, FAR 16.401(e) specifies the use of pre-determined adjectival ratings and associated descriptions. This evaluation scheme is set forth in Table 16-1, contains five adjectival ratings, provides an accompanying description of the rating, and specifies an exact percentage range of award fee a contractor may earn based on each rating. The percentage of award fee corresponding to each rating is as follows:   

Additionally, although § 867(b)(6) of the Fiscal Year 2009 NDAA requires amendments to the FAR for non-Department of Defense agencies to provide direction as to when it may be appropriate to roll-over award fees that are not earned in one award period to a subsequent period, 16.401(e)(4) prohibits rollover of award fees altogether. The Councils explain their belief that permitting rollovers "diminishes the effectiveness" of the award-fee rating in a given evaluation period, since the unearned award fee could be earned in a subsequent evaluation period. One must question how the Government is harmed in these circumstances, since such roll-over fee is only earned where the contractor’s performance warrants it.

As a result of this interim rule, contractors are subject not only to a potentially more formalized system, but one with potentially harsh results for which future recovery is precluded. 

Interested parties must submit comments to the Regulatory Secretariat by December 14, 2009. 

Authored By:

John S. Tobey
(202) 469-4920
jtobey@sheppardmullin.com

In Teknowledge Corp. v. United States, 85 Fed.Cl. 235 (Fed. Cl. 2009), the COFC held that the cost of development of its TekPortal software program was not allocable to Government contracts even though (a) the contractor had originally developed the software with the intent to use it as a “dual use” asset in connection with its Government and commercial businesses, (b) had proposed its use in three unsuccessful responses to Government solicitations, and (c) the commercial contracts on which it had been used since development had sufficiently expanded the contractor’s business to absorb some $3,000,000 in G&A that otherwise would have been allocated to the company’s Government contracts. Citing to the Federal Circuit’s decision in Boeing N. Am., Inc. v. Roche, 298 F.3d 1274, 1281 (Fed. Cir. 2002), the COFC held that the above-described facts were insufficient to establish the requisite “nexus” between the challenged cost and a Government contract to support allocability. 

Working its way through FAR 31.201-4, the court held, first, that the costs were not allocable under FAR 31.201-4(b) as costs that benefit the contract and other work because there was no underlying Government contract that benefited from the costs. Noting that the Government “has never purchased TekPortal,” the court accepted the Government’s argument that “benefit” in the context of FAR 31.201-4(b) cannot be “some vague, prospective potential benefit to the Government,” which in this case was twofold:  the potential utility of the software on future Government contracts and the $3,000,000 in G&A absorption that otherwise would have visited itself on the Government contracts that Teknowledge did have in-house. This finding seems curious -- the company had existing Government contracts and they appear to have benefited in a concrete and objectively verifiable monetary fashion. 

Interestingly, the Claims Court had previously held in KMS Fusion, Inc. v. United States, 24 Cl. Ct. 582 (1991) that the costs of “government affairs consultants” were allocable to Government contracts in part because a DOE contract had “benefited in a specific sense by seeing a reduction of indirect costs allocated to the contract where marketing efforts succeeded in bringing in additional business for the company.” Teknowledge, 85 Fed. Cl. at 240. The court seemed to find no inconsistency between the results in Teknowledge and KMS Fusion. That conclusion seems strained -- the benefits were identical, i.e., in Teknowledge other Government contracts “benefitted in a specific sense by seeing a reduction of indirect costs allocated” to those contracts. In both cases the incurrence of the costs in question resulted in reduced allocations of indirect costs to one or more Government contracts from an expansion of general sales. 

The court’s analysis under FAR 31.201-4(b) does not bode well for Government contractors. IR&D ought not need to succeed in the actual delivery of a Government contract in order for it to benefit the Government or any individual Government contract. If that is the rule, IR&D becomes a literal game of chance in which downstream, after-the-fact success becomes determinative of allocability. This can most assuredly have a chilling effect on the willingness of companies to invest in "dual use" technologies for which success in the Government marketplace is less than assured.

Turning to FAR 31.201-4(c) -- allocability based on the necessity of the costs to the overall operation of the business -- the court held that “even under the third prong of the allocability test, the contractor must show some nexus to a government contract.” While this is true under the language of Boeing North American, it finds no expression in FAR 31.201-4(c), which is completely silent as to the benefits of the cost to any given contract and, to the contrary, merely requires a showing that the cost   “[i]s necessary to the business, although a direct relationship to any particular cost objective cannot be shown.” The only test articulated in the regulation, thus, is one of business necessity. With respect to that issue, the court found an evidentiary failure in that no evidence was offered “explaining how TekPortal keeps Teknowledge afloat.” Teknowledge, 85 Fed. Cl. at 241.

Where Teknowledge takes us ultimately is an open question. Where it takes DCAA is more clear -- into a fresh new inquiry with respect to the “benefit” of IR&D projects that have not yielded products used or produced in the performance of Government contracts.

Authored by:

John W. Chierichella
(202) 218-6878
jchierichella@sheppardmullin.com

The FAR Councils' reasons for delaying removal of these two lines are, and likely will forever remain, a mystery. Surely, however, the FAR Councils could reasonably have foreseen that significant delay in updating the form would be confusing, disruptive, and costly for both contractors and Government personnel. The Councils' delay of almost seven years is bewildering, especially in light of the fact that the elimination of the paid cost rule was part of a major effort commencing in 2000 in which the FAR Councils sought to revise the contract financing provisions "to make them easier to understand and to minimize the burdens imposed on contractors and contracting officers." 65 Federal Register 16276 (Mar. 27, 2000).

The Demise of the Paid Cost Rule

FAR Subpart 32.5 and FAR 52.232-16 allow the Government to make financing payments to a contractor based on the contractor's costs incurred to date. While the FAR generally prefers performance-based financing payments (based on a pre-defined performance schedule and achieving certain milestones) (as outlined in FAR Subpart 32.10 and FAR 52.232-32), making progress payments to contractors based on their costs continues to be an important financing tool for the Government.

Beginning in the mid-1990s, the Government undertook a number of initiatives to revise and simplify the policies and procedures relating to federal procurement. One revision was the elimination of the paid cost rule. Historically, the paid cost rule required prime contractors to "front" payments to subcontractors before they could submit a progress payment request for the subcontractor's bills. However, beginning in 2000 the FAR was amended to eliminate (in part) the rule. See 65 Federal Register 16276 (Mar. 27, 2000) (revising the paid cost rule by creating exceptions, while still leaving the principle in other sections of the FAR); 65 Federal Register 56454 (Sep. 18, 2000) (removing the paid cost rule with regard to time & materials and labor hour contracts). In 2002, the FAR Councils finally amended the applicable contract clause, FAR 52.232-16, Progress Payments. This change allowed all contractors (both large and small) to invoice the Government for unpaid amounts determined to be due and payable to subcontractors, as long as the contractor ordinarily pays the amount within 30 days of the submission of the contractor’s payment request to the Government. See 67 Federal Register 70520 (Nov. 22, 2002). Notably, however, SF 1443, the form by which progress payments are requested, was not amended in 2002, with Lines 9 and 10 of SF 1443 continuing to request information as to "paid costs eligible under Progress Payment clause" and "incurred costs eligible under Progress Payment clause." The elimination of the rule in 2002 had the instantaneous effect of rendering the information requested on Line 9 completely and obviously irrelevant -- yet SF 1443 remained unchanged, like a fossil frozen in time.

Government Sanctioned "Fudging" In Completing the Old SF 1443

For Department of Defense contracts, the Defense Contract Audit Agency (DCAA) is charged with: (1) verifying the amounts included on a SF 1443 to the contractor's accounting records; (2) evaluating the propriety of the progress payment request in accordance with the provisions of the contract; and (3) determining whether undue financial risk to the Government will result if the request is granted. See DCAA Contract Audit Manual (DCAM) § 14-203(a) (2008). Perhaps ironically for an agency that insists on contractor compliance with numerous counterproductive and sometimes nonexistent rules, DCAA recognized in 2003 the irrelevance of the information on Lines 9 and 10, advising its auditors that "large contractors should not complete [Line 9] and should follow the same instructions to complete SF 1443 as provided for small contractors. All contractors should complete [Line] 10." DCAM § 14-205(d) (2003). While DCAA's internal guidance ignored a glaring irregularity to achieve the overall regulatory purpose behind the form, the fact remains that large contractors have long been required to certify their SF 1443s, which have been outdated and inaccurate for the past seven years. We have previously observed as to this exact issue that "a form that is outdated and requires contractors to ignore the form's own instructions has no place in the Federal system. For such a form to require certification is an outrage."

The failure to update the form was also necessarily costly. The cost to Government and industry alike over the past several years in addressing the problems with the SF 1443 has been significant, as demonstrated by the DCAA audit guidance instructing contractors and auditors (essentially) "to fudge the numbers." We would like to see the procedures implementing the Paperwork Reduction Act (44 U.S.C. § 3501 et seq.) used for once to develop an honest estimate of the time and labor associated with completing and modifying the old, inaccurate SF 1443 -- only this time, the Government can report on the cost of the delay in implementing these new and extraordinarily simple changes to SF 1443.

The New, Updated Form SF 1443

Recognizing the inadequacy of the old SF 1443 the Department of Defense eventually requested comments in 2004 – yes, it took them two years to get around to this, but let’s not carp, OK? – on “what improvements could be made to the form,” hoping to simplify the form and hoping to improve consistency with the revised Progress Payments clause. See 69 Federal Register 67899 (Nov. 22, 2004). But, recognizing a problem and taking prompt action to resolve it are two different things; in this case, the FAR Councils waited four more years until April 2008 to publish a proposed rule amending SF 1443 and proposing the deletion of Lines 9 and 10. See 73 Federal Register 19035 (Apr. 8, 2008). It was not until June 2009 that the FAR Councils ultimately issued the final amendment. See 74 Federal Register 28430 (Jun. 15, 2009).

Conclusion

We have discussed the FAR Councils' tendency to delay issuance of regulations in prior postings and did not set out to do so again in this case. However, the long and tortured course of events leading up to the red-letter day when SF 1443 was finally updated to allow contractors to file straightforward and understandable payment requests seems to confirm that, as to the FAR Councils' mode of operation, such delay is representative rather than anomalous. We can take some comfort, however, that in this case, after nearly seven years of what must have been intense internal deliberations (Steven Spielberg has reportedly purchased the movie rights), the FAR Councils got it right. Thus it has not always been.

Authored by:

W. Bruce Shirk
(202) 741-8426
bshirk@sheppardmullin.com

and

David S. Gallacher
(202) 218-0033
dgallacher@sheppardmullin.com

Many contractors will have no doubt noticed that over the last year of so the DCAA has shown a new fondness for issuing Form 1s, which are then used as the basis for withholding interim payments for incurred costs.  Form 1s were the subject of DCAA’s September 7, 2007 Memorandum to Regional Directors (MRD ) 07 – PPD – 031(R), which directed auditors to use then to suspend unsupported costs and to disapprove unallowable costs.  “[W]ith the issuance of a DCAA Form 1, auditors should take the necessary steps to effect the withhold of the appropriate funds identified in the DCAA Form 1 from current payments.”  Moreover, the MRD not so delicately reminded auditors, the issuance of a Form 1 also “may require the contractor’s direct billing authority to be temporarily rescinded.”

And just recently, in a December 19, 2008 MRD regarding the Denial of Access to Records, 08-PAS-042(R), the DCAA again instructed auditors to use Form 1s “to effect a suspension and/or withhold of unsupported costs due to the contractor’s denial of access to records.”  This latest guidance is no idle threat – it says that “support for proposed labor hours should be provided the same day requested.”  In other words, contractors should not necessarily expect to receive the next interim payment if they fail to hand over their time sheets by COB on the day requested by the auditor.

All of this is made possible through the ostensible powers of a Form 1.  Or is it?  Does the DCAA really have the authority, under the current regulatory regime, to withhold payments because an auditor – not a contracting officer -- decides that a cost is unsupported or unallowable?

Under the FAR, the mechanism for collecting any payments from contractors is set out in one place – Subpart 32.6.  Revisions to these regulations went into effect on October 17, 2008, and were covered on this blog here.  To recap, FAR 32.6 applies to all contract debts, meaning amounts that “have been paid to a contractor to which the contractor is not currently entitled under the terms and conditions of the contract.” FAR 32.601(a)(1).  The regulation provides a nonexhaustive list of 14 examples of what this definition includes, including reductions for defective cost or pricing data, CAS noncompliances, and “duplicate or erroneous payments.”  FAR 32.601(b).  Unallowable costs, of course, are unallowable because they violate the terms Allowable Cost and Payments Clause.  This makes them costs to which the contractor “is not currently entitled under the terms and conditions of the contract.”  Under the plain language of FAR 32.601, therefore, the collection of monies that are unallowable must be accomplished through the procedures of FAR Subpart 32.6.

Yet nothing in FAR Subpart 32.6 provides for the withholding of current payments because a DCAA auditor decides to issue a Form 1.  Under FAR 32.606, withholding of payments by the payment office is authorized only after the expiration of 30 days after the due date for the payment set out in the demand issued by the Contracting Officer pursuant to FAR 32.604.  The demand, in turn, is based on the debt determination that is made by the Contracting Officer under FAR 32.603.  A Form 1 issued by the auditor is neither a debt determination nor a demand for payment and it is legally incapable of even triggering the 30 day payment term.  Consequently, it would appear that withholding of payments as a result of the issuance of a Form 1 is an illegitimate circumvention of the FAR.  There is a word for people who take money from others without authorization or permission, isn’t there?

Authored by:

John W. Chierichella

(202) 218-6878

jchierichella@sheppardmullin.com

and

Aleksander Lamvol

(202) 218-0006

alamvol@sheppardmullin.com

The changes are primarily directed at streamlining the identification, collection and deferral of contract debts.  Under the new 32.601, “contract debt” is broadly defined as any amounts that either have been paid to the contractor, or are otherwise due from the contractor, where the contractor is not entitled to such amounts under the terms of the contract.  This includes, for example, “breach of contract obligations concerning progress payments, performance-based payments, advance payments, commercial item financing, or Government-furnished property.” FAR 32.601(b)(10).  Under FAR 32.602, the responsibility for identifying contract debts, and demanding payment, rests primarily with the contracting officer.  But the contracting officer is prohibited from collecting the amounts, which is the responsibility of the payment office.  If the contracting officer receives “any indication that a contractor owes money to the Government,” FAR 32.603 imposes an affirmative obligation to promptly make a determination whether an actual debt is due and the amount. 

As soon as a debt is determined to be owed, FAR 32.604 obligates the contracting officer to issue a “demand for payment,” even if the contractor “has agreed to repay the debt.”  The demand must include the debt amount and, to the maximum extent practicable, identify all affected lines of accounting.  Where data regarding the distribution of the principal to varioius contracts and lines of accounting is unavailable, the demand needs to include a date by which the contracting officer will provide such information.  The demand also must notify the contractor that, unless payment is received before, interest will start running 30 days from the date of the demand, unless the contract debt results from a contract clause that provides for a different start date for purposes of accruing interest.  For example, under contract clauses regarding defective pricing and CAS noncompliances, interest is computed from the date of overpayment.

If the contractor disagrees with the demand and the disagreement is not resolved in a “timely manner,” FAR 32.605 prescribes that the contracting officer must issue a final decision with the same payment due date as the previously issued demand.  A final decision also is required if the contractor fails to pay the demand without a request for an installment payment agreement, or if the contractor requests a deferment of collection.  These requests are not approved or denied by the contracting officer.  Rather, a designated office within each agency will have that responsibility.  FAR 32.607(a).

Where the contractor has appealed the debt under the Disputes clause, information submitted in support of deferment agreements may be limited to the contractor’s financial condition.  FAR 32.607-2(a)(1).  If no appeal is pending, the supporting information should include financial condition, contract backlog, projected cash receipts and requirements, and the feasibility of immediate payment.  FAR 32.607-2(a)(3).  The contracting officer then forwards this information to the respective agency office, together with its recommendation on the request.  The terms of any deferment agreement must contain much of the same information that was required under the previous regulations.  Importantly, under 32.607-2(g)(2), a contractor is required to pay the debt even if it has filed an action under the Disputes Clause challenging that debt.

Authored by:

Aleksander Lamvol

(202) 218-0006

alamvol@sheppardmullin.com

Auditing the Auditors

On July 23, 2008, the GAO issued a report finding that the DCAA had failed to follow generally accepted government auditing standards when audit opinions were revised by supervisors despite indications of contrary evidence or significant deficiencies. In response to the report, the DoD is establishing an independent advisory panel to review the activities of the audit agency. The advisory panel is to evaluate DCAA procedures and make recommendations for improvement. Also, DCAA has asked the DOD IG to review issues noted by the GAO and has implemented changes outlined in a memorandum by the DCAA Director, April Stephenson, including a reassessment of staffing and metrics across the agency, the cessation of participation in integrated product teams, and designation of August as “Audit Quality Month.” In this latter regard, we can hear the echoes of President Ford’s esteemed “Whip Inflation Now” Program reverberating across the audit landscape.

Click here for the GAO report, “DCAA Audits: Allegations That Certain Audits at Three Locations Did Not Meet Professional Standards Were Substantiated.” The DCAA Director’s memo is at www.governmentexecutive.com/pdfs/081408rb1b.pdf.

Southwest Marine Upheld

The 9th Circuit has affirmed the district court’s decision that legal costs incurred in the unsuccessful defense of a Clean Water Act action brought by a private entity are unallowable. In the appellate court’s view, these costs are similar to costs specifically disallowed under FAR 31.205-47(b), which addresses proceedings brought by government entities or on their behalf by third parties such as FCA relators -- the Clean Water Act authorizes suits by both private citizens and the Government, permits the Government to intervene in a suit brought by a private citizen, and mandates that any penalties for violating the statute are paid to the US Treasury. Southwest Marine Inc. v. United States, 9th Cir., No. 07-55229.

Authored by:

John W. Chierichella

(202) 218-6878

jchierichella@sheppardmullin.com

and

Aleksander Lamvol

(202) 218-0006

alamvol@sheppardmullin.com

In a related development, on March 4, 2008, the DCAA issued guidance on the method for application of the executive compensation cap.  Under the guidance, the cap only applies after determining the amount of allowable executive compensation.  Portions of executive compensation may not be allowable for reasons unrelated to the cap – e.g., the executive may be compensated for performing unallowable activities, the compensation may be based on changes in the stock price, which is unallowable under FAR 31.205-6(i)(1), or the amount may be unreasonable.  Such unallowable elements are to be subtracted from the total compensation amount before determining whether the compensation cap has been exceeded.  The DCAA also reminded the auditors that under FAR 31.205-6(p)(2) not all forms of compensation are subject to the cap, but only “wages, salary, bonuses, deferred compensation, and employer contributions to defined contribution pension plans.”

CAS Administration Provisions

Effective March 31, 2008, FAR Part 30 contains updates regarding CAS administration rules.  The proposed changes were first published in October 2006 and are the result of comments received following earlier revisions to FAR Part 30 made in March 2005.  The new provisions specify that the cost impact of a noncompliance that affects cost estimating and cost accumulation must be measured by combining impacts on both.  In addition, the provisons now require the CFAO to consider the auditor’s advice in administering the CAS and to evaluate the detailed cost impact proposals.

3% Tax Withholding

The IRS is seeking public input on the implementation of the statutorily mandated 3% tax withholding on payments to contractors for any service or property.  The withholding was added by Sec. 511 of the Tax Increase Prevention and Reconciliation Act of 2005, and requires federal, state, and local governments to withhold 3% from payments for goods and services as an effort to stem tax delinquency.  Although industry groups are advocating its repeal, the withholding requirement currently is scheduled to go into effect on January 1, 2010.  The comments are sought with respect to how the withholding should be applied to purchases with credits cards, to government contractors and subcontractors, etc., and how the withholding should be transmitted to the IRS.  Comments are due by April 28, 2008.  For more information, see Internal Revenue Bulletin 2008-13.

Prompt Payment Act Interest

In Essex Electro Engineers Inc. v. US, the Court of Federal Claims held on February 20, 2008 that the USG did not owe PPA interest where the due date of payment was not specified.  The parties had entered into a settlement agreement and contract modification under which the USG was to make a payment “as soon as possible” and to use its best efforts to obtain funding.  This imprecise language did not provide the date payment is due under the contract and was “fundamentally inconsistent with the underlying assumption” of the PPA.  Rather, the PPA interest accrued  30 days after the receipt of a proper invoice.

Authored by:

Aleksander Lamvol

(202) 218-0006

alamvol@sheppardmullin.com

In a related development, on February 19, the chairman of the House Armed Services Committee called upon the OMB to reconsider the decision to retain the 48 CFR 9903.201-(1)(b)(14) exemption, saying that it does not “recognize the significance of the waste and fraud that has occurred with contingency contracting in Iraq.” Federal Contracts Report, 02/26/08.

Residual Home Office Expense Allocation

On February 13, the CAS Board issued a notice soliciting public comments on potential revisions to the dollar amounts in the three-factor formula allocation thresholds, found at CAS 403-40(c)(2).  The current provision continues to use the threshold amounts established in 1972.  In recent years, both the Aerospace Industries Association and the Department of Defense have proposed revisions to these amounts in order to reflect inflation, as well as economic, industry, and acquisition policy changes.  Comments are due April 14, 2008.  73 FR 8259.

Excessive Pass-Through Charges

The GAO has issued recommendations for finalizing and implementing the new DoD rule on excessive pass-through charges.  The interim DFARS provision at 215.408, and associated clauses at DFARS 252.215-7003 and 7004, require contractors who subcontract more than 70 percent of their total cost to describe their value added and permit the DoD to recoup any pass-through charges that it determines to be excessive.  Because the regulations do not provide specific criteria for evaluating value added, the GAO recommends that the evaluation be based on certain risk factors (e.g., whether contract is complete, whether the contract is fixed price, whether the contract was awarded using full and open competition) and that it involve the assistance of the DCMA and the DCAA.  Defense Contracting, Contract Risk a Key Factor in Assessing Excessive Pass-Through Charges, GAO-08-269.

Disclosure of Line-Item Pricing Information

On January 29, in the reverse-FOIA case of Canadian Commercial Corp., et. al. v. Dept. of the Air Force, the DC Circuit Court of Appeals affirmed the lower court’s decision that disclosure of line-item pricing would cause substantial competitive harm, thereby precluding the release of that information under FOIA Exemption 4.  In reaching the decision, the court reaffirmed its previous holding in McDonnell Douglas Corp. v. Air Force, 375 F.3d 1182 (2004), and found that the record did not support the Air Force’s contention that the line-item pricing had been historically disclosed prior to FOIA or that their release would be harmless in this case.  In addition, the court rejected the argument that disclosure of otherwise protected trade secret information was required under any FAR provision.

Environmental Remediation Costs

In Shell Oil Co. v. US, the Court of Federal Claims held on February 8 that the “Taxes” clause found in World War-II era contracts authorizes the recovery of environmental remediation required under CERCLA, which was passed in 1978.  The clause at issue provided that the Government would pay any “new or additional taxes, fees or charges” incurred by the contractor by reason of performing the aviation gasoline production contract in support of the war effort.

The passage of CERCLA obligated the contractor to clean up the site used to dump a byproduct of the gasoline production process.  The cost of the remediation, the court held, fell within the meaning of “charges” under the “Taxes” clause and its recovery was precluded by neither the passage of time nor the Anti-Deficiency Act.

Authored by:

Aleksander Lamvol

(202) 218-0006

alamvol@sheppardmullin.com

Performance-Based Payment (PBP)

PBP is a contract financing technique pursuant to which payments are based on specifically described events, or measurable criteria of performance, other than the signing of the contract or modification, the exercise of options, or the passage of time.  Effective January 25, 2008, COs may use PBPs when the parties agree to the PBP terms, the contract or line item is fixed price, and the contract does not provide for progress payments.  PBPs are prohibited for cost-type line items and contracts awarded through sealed bidding.  PBPs are not limited to actual incurred costs, but the Government must be able to verify that the payment criteria have been successfully met.  FAR Case 2005-016.

Allowable Airfare

The FAR Councils are proposing to amend the limitation on the allowable airfare costs set forth in FAR 31.205-46, which currently limits such costs to "the lowest customary standard, coach, or equivalent airfare offered during normal business hours."  The proposal would delete the word "standard" since it does not refer to an existing class of service.  The proposal would also “clarify” that the airfare at issue is the lowest airfare available to the contractor, as opposed to that available to the general public.  This proposal is hardly a clarification and, if adopted, would be extraordinarily difficult to implement and should be expected to spawn numerous disagreements with respect discount and rebate agreements negotiated between contractors and airlines.  Companies with multiple airline agreements would need to reconcile the fare against each of those agreements.  Companies with flight-by-flight discount agreements might find themselves disadvantaged cost-wise in comparison to contractors whose travel discounts are triggered by periodic volume traffic that results in one-time, lump sum rebates.  The proposed rule does not come to grips with such disparate circumstances or the potential inequities inherent in the application of the rule to those differing circumstances.  Comments on the proposed rule are due February 19, 2008.  FAR Case 2006-024.

Authored by:

John W. Chierichella

202.218.6878

jchierichella@sheppardmullin.com

and

Aleksander Lamvol

202.218.0006

alamvol@sheppardmullin.com