If discretion is the better part of valor, then administrative contracting officers must be feeling less valiant these days. When it comes to penalties for unallowable costs, ACOs and government auditors are beginning privately to admit what many contractors already know from experience – enforcement of FAR 42.709 is on the rise. This article is designed to clarify some key underlying concepts, to identify major risks – as well as opportunities for their mitigation – and to discuss a few emerging issues.
RECENT INCREASE IN PENALTY ASSESSMENTS
The increasing enforcement of FAR 42.709 should not come as a surprise. The DoD Inspector General repeatedly has called on ACOs to be more aggressive when it comes to enforcing the FAR cost principles and to do so by diligently assessing penalties. In April of 2007, for example, the IG’s review of DCMA Virginia found that “[c]ontracting officers failed to assess penalties or justify a waiver of the penalties on $3.7 million in expressly unallowable costs as required by FAR Subpart 42.7.” Report No. D-2007-6-004 at 2. Perhaps more ominously, the amount was based on a review of just 13 incurred cost audits, which showed that the DCMA had failed to act upon the DCAA recommendation for penalties in 42% of the cases. Because the “potential for additional penalty losses is high,” the IG’s report stated, the agency needs to revisit all of its incurred cost audit dispositions. Id. at 5.
In previous contract audit follow-up reviews the IG had identified similar issues across various contracting activities in different parts of the country. For instance, a report on the Naval Sea Systems Command found that ACOs had not properly assessed penalties or justified waivers in the amount of $5.6 million, which in turn “precluded the Government from applying double penalties to future incurred cost submissions that contained the same unallowable costs.” Report No. D-2004-6-006 at 19. In that case, 14 of the audits analyzed had recommended penalties, but only 3 penalties had been assessed. More recently, the IG found that the DCMA Santa Ana Office did not properly assess penalties in connection with 2 of the 4 audit reports reviewed. Report No. D-2005-6-003 at 2.
The last two examples are noteworthy in another regard as well. In its reports, the IG faulted the contract administration personnel for misunderstanding the statute and the implementing regulations. Ironically, however, the IG’s own interpretation of the relevant provisions also is somewhat confused. In both Report No. D-2004-6-006, at 5, and in Report No. D-2005-6-003, at 3 and 4, for example, the IG states:
The head of an agency may issue a waiver from penalties if one of three conditions exists:
1. The contractor withdraws the proposal before the formal initiation of an audit and resubmits a new proposal
2. The contractor demonstrates, to the satisfaction of the ACO, that it has established appropriate policies that preclude unallowable costs subject to penalties from being included in indirect cost proposals; or
3. The ACO is satisfied that the unallowable costs subject to penalties were inadvertently incorporated into the proposal.
As will be discussed later, the IG’s paraphrase of FAR 42.709 is inaccurate. For one, it is simply not the case that any of the listed conditions alone supports a waiver, nor that the list is exhaustive. More fundamentally, the decision to issue a waiver where warranted is not optional, and it certainly does not require the approval of the head of the agency.
The general lack of understanding of the regulations relating to penalties and their associated waivers can be ascribed partly to the paucity of judicial guidance. Only two reported decisions, discussed below, deal with these issues in any meaningful detail: General Dynamics Corp., ASBCA No. 49372, 02-2 BCA ¶31,888, rev’d in part on other grounds, Rumsfeld v. General Dynamics Corp., 365 F.3d 1380 (Fed. Cir. 2004); and the recent opinion in Fiber Materials, Inc., ASBCA No. 53616, 07-1 ASBCA ¶33,563. As penalties increase in frequency and amount, however, we can expect to see a corresponding increase in appeals from ACO decisions to assess and their refusals to waive. To appreciate the nuances of the issues involved in these decisions, it is first necessary to review the relevant statutory and regulatory foundations.
THE STATUTORY BASES – 10 U.S.C. §2324 AND 41 U.S.C. §256
The source of ACO authority to impose penalties for unallowable costs derives from two statutes: 10 U.S.C. § 2324, applicable to the DoD, and 41 U.S.C. § 256, covering all civilian agencies. The civilian statute is copied after 10 U.S.C. § 2324, which provides, in subsection (b):
(1) If the head of the agency determines that a cost submitted by a contractor in its proposal for settlement is expressly unallowable under a cost principle referred to in subsection (a) that defines the allowability of specific selected costs, the head of the agency shall assess a penalty against the contractor in an amount equal to –
- (A) the amount of the disallowed cost allocated to covered contracts for which a proposal for settlement of indirect costs has been submitted; plus
- (B) interest (to be computed based on provisions in the [FAR]) to compensate the United States for the use of any funds which a contractor has been paid in excess of the amount to which the contractor was entitled.
(2) If the head of the agency determines that a proposal for settlement of indirect costs submitted by a contractor includes a cost determined to be unallowable in the case of such contractor before the submission of such proposal, the head of the agency shall assess a penalty against the contractor in an amount equal to two times the amount of the disallowed cost allocated to covered contracts for which a proposal for settlement of indirect costs has been submitted.
The stated purpose of these penalties is “to ensure that contractors, rather than the Government, bear the burden of assuring that contractor submissions for reimbursement of costs on government contracts do not include unallowable costs.” H.R. Conf. Rep. No. 102-966, 728, reprinted in 1992 U.S.C.C.A.N. 1769, 1819. The original drafters of the provision were concerned with a “cat-and-mouse game” in which “the cost of an item is submitted regardless of whether it’s allowable, and the burden is placed on the Government auditors to identify and disallow the item.” General Dynamics, 02-2 BCA ¶31,888, at 157,568 (citation omitted).
The original version of the legislation was passed in 1985. The current language, however, is the result of several significant revisions adopted in 1992. In the initial version, for instance, the concept of “expressly unallowable” costs did not exist. Instead, the level one penalties, i.e., penalties under subsection (b)(1), applied where the Government determined “by clear and convincing evidence” that a submitted cost was unallowable. P.L. No. 99-145, Sec. 911(a), 8 November 1985, 99 Stat. 682. The adoption of the “expressly unallowable” concept in 1992 was meant to soften the impact of the rule in situations where the parties had a reasonable difference of opinion on the issue of allowability. S. Rep. No. 102-352, at 237 (1992). The 1992 legislation also made clear that the penalty amount is to be based not on the total unallowable costs submitted, but only on the portion that is allocated to contracts covered by the proposal. H.R. Conf. Rep. No. 102-966, 728, reprinted in 1992 U.S.C.C.A.N. 1769, 1819.
Another qualitative addition made in 1992 was the waiver provision, currently found at 10 U.S.C. § 2324(c):
- The [regulation] shall provide for a penalty under subsection (b) to be waived in the case of a contractor’s proposal for settlement of indirect costs when –
- (1) the contractor withdraws the proposal before the formal initiation of an audit of the proposal by the Federal Government and resubmits a revised proposal;
- (2) the amount of unallowable costs subject to the penalty is insignificant; or
- (3) the contractor demonstrates, to the contracting officer’s satisfaction, that –
- (A) it has established appropriate policies and personnel training and an internal control and review system that provide assurances that unallowable costs subject to penalties are precluded from being included in the contractor’s proposal for settlement of indirect costs; and
- (B) the unallowable costs subject to the penalty were inadvertently incorporated into the proposal.
The Federal Acquisition Streamlining Act of 1994 made identical provisions applicable to civilian agencies under 41 U.S.C. § 256(a) through (d) and mandated that a uniform implementing regulation be issued in the FAR. P.L. 103-355, Sec. 2151, 13 October 1994, 108 Stat. 3309. The regulations were promulgated under FAC 90-31, 60 FR 42648, and went into effect on October 1, 1995.
THE REGULATORY FRAMEWORK – FAR 42.709
The implementing regulations, consisting of six subsections to FAR 42.709, include a few additional critical details in relation to both assessments and waivers. According to FAR 42.709(a), penalties for unallowable indirect costs are assessable only on costs submitted in a “final indirect cost rate proposal; or the final statement of costs incurred or estimated to be incurred under a fixed-price incentive contract.” The latter category implicitly excludes fixed-price contracts with performance incentives because FAR 42.709(b) and FAR 42.709-6 remove fixed price contracts without cost incentives, as well as firm-fixed price contracts and contracts under $650,000, from under the coverage of the prescribed penalties clause, FAR 52.242-3 Penalties for Unallowable Costs. Also implicit in the language of these provisions, and expressly recognized in the DCAA Manual, DCAM 6-609.1.f(2), is that “[t]he penalty statutes and implementing regulations do not flow down to subcontracts.” So, costs that are allocated to these categories of contracts and to subcontracts – even if unallowable – are not subject to penalties.
The indispensable element of liability under the penalties clause is that the cost be either:
- “expressly unallowable under a cost principle in the FAR or an executive agency supplement,” FAR 42.709-3(a), or
- “determined to be unallowable for that contractor prior to submission of the proposal,” FAR 42.709-3(b).
Elsewhere, at FAR 31.001, the regulations define “expressly unallowable cost” as “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.” Examples of penalty-inducing prior determinations are listed at FAR 42.709-3(b)(1) through (4) and include (a) unappealed final decisions from the contracting officer, (b) unappealed notices from the DCAA, (c) a board or court decision, or (d) the parties’ prior agreement.
What exactly constitutes “expressly unallowable” in any given situation has been a recurring question and one that the ASBCA addressed in General Dynamics, 02-2 BCA ¶31,888, discussed below. Suffice it to point out here that, as a strategic matter, contractors should be reluctant to accede to a penalty assessment based on “expressly unallowable” costs unless the cost principles leave no room for doubt and the unallowability can be determined objectively from the face of the FAR or other applicable provisions. In this regard, the term “expressly unallowable” should be understood as something of a legal fiction, created by the penalties statute to describe the determination reached by the ACO under FAR 42.709-3(a), not the intrinsic nature of the cost itself. The distinction may be relevant where, for example, the contractor repeatedly has claimed costs that are later alleged by the Government to have been “expressly” unallowable under the FAR cost principles, but that have not been the subject of any prior formal finding or agreement. In that situation, each instance of the inclusion of the cost should give rise to penalties only for being “expressly unallowable,” and not for the penalty associated with costs previously “determined to be unallowable” within the meaning of FAR 42.709-3(b), which are quantitatively steeper.
Once the contractor falls within FAR 42.709-3(b), i.e., it has conceded that a cost is unallowable, its recidivism carries a hefty price tag. Whereas the penalty for submitting an “expressly unallowable” cost is the amount of the cost claimed plus interest, it is twice that amount for submitting a cost previously “determined to be unallowable.” FAR 42.709-1(a)(1) and (2). In effect, the contractor is handed a suspended sentence on costs that are not “expressly unallowable” but “determined to be unallowable” – there is no penalty for the instance that gives rise to the determination, but twice the amount if the cost is ever claimed again.
The assessment is mandatory, unless the ACO issues a waiver. FAR 42.709-3. As previously mentioned, DoD IG reports incorrectly interpret the waiver regulations. Notably, the regulations treat the waiver provisions as mandatory in the three circumstances specified by Congress. Waiver is not discretionary if the regulatory conditions are met. FAR 42.709-5 (“The cognizant contracting officer shall waive the penalties . . . .”) (emphasis added). These conditions are as follows:
- The first basis for a waiver, i.e., timely withdrawal of the proposal, requires withdrawal to have occurred before “the Government provides a written notice, or holds an entrance conference, indicating that audit work on a specific final indirect cost proposal has begun.” FAR 42.709-5(a).
- The second waiver basis, i.e., where the amounts are “insignificant,” is interpreted as applying “if the amount of expressly or previously determined unallowable costs which would be allocated to the contracts specified in 42.709(b) is $10,000 or less.&rdquo
- The third, and probably the most often invoked circumstance warranting a waiver is based in the statute on two conjunctive prongs: (1) having established policies and procedures adequate to preclude unallowable costs from being included in the proposals, and (2) inadvertent incorporation of the costs into the proposal. The regulations, at FAR 42.709-5(c)(1), add the following examples of the requisite policies and procedures:
the types of controls required for satisfactory participation in the [DoD] sponsored self-governance programs, specific accounting controls over indirect costs, compliance tests which demonstrate that the controls are effective, and Government audits which have not disclosed recurring instances of expressly unallowable costs.
Inadvertence is defined to mean that the “inclusion resulted from an unintentional error, notwithstanding the exercise of due care.” The third waiver basis is the only one where the contractor bears the burden of demonstrating its eligibility for a waiver “to the contracting officer’s satisfaction.” FAR 42.709-5(c).
The regulations also expressly recognize other aspects of the penalty process that are implicit in the statute. FAR 42.709-1(c), for example, provides that penalties apply irrespective of whether the costs were paid to the contractor. At the same time, the interest portion of the penalty is assessed only on the paid portion of the disallowance, and the computation of that amount is the responsibility of the contracting officer in consultation with the contract auditor. FAR 42.709-4(d). Contracting officers will not infrequently ignore this aspect of their responsibility, leaving to the contractor the task of ensuring that the penalties are limited to the costs allocated to the proper types of contracts and that the interest is limited to the paid portion of their unallowable costs. Finally – and importantly, lest one lose sight of the war in the midst of the penalties battle – FAR 42.709-1(b) reminds the reader that “these penalties are in addition to other administrative, civil, and criminal penalties provided by law” and, in cases where there is evidence of a knowing violation, both the contracting officer and the auditor are responsible for referring the matter to the appropriate criminal investigative organizations. FAR 42.709-2(a)(3) and 42.709-2(b)(3).
LIABILITY FOR FALSE CERTIFICATION
Apart from criminal charges, a knowing violation of the express provisions of the cost principles can also lead to liability under the civil False Claims Act (the “FCA”), 31 U.S.C. § 3729. The penalties statutes explicitly provide that “the submission to an agency of a proposal for settlement of costs for any period after such costs have been accrued that includes a cost that is expressly specified by statute or regulation as being unallowable, with the knowledge that such cost is unallowable, shall be subject to the provisions of . . . [the FCA].” See 10. U.S.C. § 2324(i); 41 U.S.C. § 256(i). See also, e.g., U.S. ex rel Schumer v. Hughes Aircraft Co.,63 F3d 1512 (9th Cir. 1995), vacated on other grounds, Hughes Aircraft Co. v. U.S. ex rel. Schumer, 520 U.S. 939 (1996).
The upper limit of exposure for an FCA violation is $11,000 per false claim and treble damages. 31 U.S.C. § 3729(a). The FCA penalty arithmetic can quickly dwarf the FAR 42.709 assessments because of the unique interplay between the FCA definition of a “claim” and the nature of indirect costs, which are generally allocable to large numbers of contracts and virtually every request for payment under flexibly priced contracts. No reported decision has involved an FCA action authorized under 10. U.S.C. § 2324(i) or 41 U.S.C. § 256(i). Most likely, such situations would be treated like other false certification cases. In fact, a knowing inclusion of unallowable costs in a proposal would be a violation of the Certification of Final Indirect Costs, FAR 52.242-4, which is required to be filed with the proposal. Where a contractor “makes a false certification but solicits 51 separate payments on the basis of the certifications, many, but not all, courts have concluded there were 51 false claims.” John T. Boese, Civil False Claims and Qui Tam Actions, §3.05[B], at 3-87 (3d ed. 2006). If we were looking for some “upside” for the contractor’s certifying official, since 1997 the signature on the Certificate of Final Indirect Costs has no longer carried the penalty of perjury. Compare FAR 52.242-4, Certification of Indirect Costs (JAN 1997), with FAR 52.242-4, Certification of Indirect Costs (OCT 1995). That “upside,” while of some value to the individual certifying official, is of little comfort to the company under the FCA.
THE STATISTICAL (SOMEWHAT) SAFE HARBOR
Contractors legitimately may be concerned that, despite their best efforts, some unallowable costs inevitably will slip through their internal cost coding and verification systems. It is not rare for indirect cost proposals to involve millions of dollars incurred in hundreds of thousands of transactions. Such voluminous submissions have a high probability of including at least some unallowable costs, if only because of the “human factor.” Acknowledging this limitation is one thing; fixing it is altogether different. It usually requires a Herculean effort to verify that all unallowable costs, in fact, have been segregated. From an efficiency standpoint, the cost of this effort rarely is proportionate to the economic benefit received by the Government as a result.
Fortunately, FAR 42.709 is not a strict liability provision and the duty of due care it imposes on contractors is less than absolute perfection. For one, FAR 42.709-5(c)(2) expressly recognizes that due care will not always guarantee the absence of unallowable costs in cost proposals. Therefore, an unallowable cost included in the proposal through inadvertence qualifies for a waiver of penalties, provided the contractor has established proper policies and procedures. Furthermore, the statistical sampling provisions of FAR 31.201-6(c) provide contractors with something akin to a limited safe harbor against any undetected unallowable costs included in the proposal.
In promulgating the current FAR 31.201-6(c), which permits contractors to use appropriate statistical sampling to determine the amount of unallowable costs in their incurred cost claims, the FAR Councils specifically addressed the question of what level of accuracy is required of government contractors in preparing incurred cost claims. Their statement appeared in connection with one commenter’s expressed view
that the use of statistical sampling should not replace accounting policies and procedures for identifying and segregating unallowable costs when the costs are initially incurred and recorded. The respondent assert[ed] that initial identification of unallowable costs is necessary to meet the requirements of 10 U.S.C. 2324, which provides penalties against a contractor if expressly unallowable costs are included in its claims to the Government.
FAR Case 2004-006, 69 FR 58014, September 28, 2004, at 58015 To paraphrase, the commenter was pointing out a seeming inconsistency between allowing contractors to use statistical sampling to ferret out unallowable costs and the penalty provisions of FAR 42.709. Would an unallowable cost that is not captured by the statistical sample still be subject to penalties? In responding, the FAR Councils disagreed with the premise that perfection is required under current law:
The Councils do not believe that sampling is precluded by 10 U.S.C. 2324. The Councils note that there is no requirement in 10 U.S.C. 2324 to specifically segregate every item of unallowable cost. Statistical sampling, when properly applied, is acceptable for both segregating unallowable costs and verifying that such costs have been properly segregated (either by specific identification or using appropriate sampling techniques). However, the Councils recognize that the sampling must appropriately consider the requirements of 10 U.S.C. 2324 related to the application of penalties on unallowable costs. To avoid potential disputes in this area, a new paragraph (c)(3) has been added at 31.201-6 to explicitly include these appropriate considerations.
Id. (emphasis added). The new FAR 31.201-6(c)(3), referenced in the above quote, provides that for "any indirect cost in the selected sample that is subject to the penalty provisions at 42.709, the amount projected to the sampling universe from that sampled cost is also subject to the same penalty provisions." Hence, where a contractor selects a statistically valid sample, it is only responsible for the unallowable costs in that sample as extrapolated to the projected universe, regardless of what kind of costs actually might be detected later outside the sample. This approach, while obviously of some salutary benefit to the contractor, can also have negative repercussions if the sample chosen includes a disproportionately high incidence of unallowable costs that are subject to penalties. Moreover, reliance on sampling will not insulate a contractor from liability for penalties or from FCA liability where unallowable costs are knowingly included in the indirect cost pool and the sampling technique is structured to bypass the offending costs.
CONTESTING THE ASSESSMENT AND THE FAILURE TO WAIVE
The penalties statutes provide that the act of assessing a penalty constitutes a final decision appealable under the Contract Disputes Act of 1978. 10 U.S.C. § 2324(d); 41 U.S.C. § 256(d). Authoritative interpretations of the statutory and regulatory provisions are limited to two decisions of the ASBCA. In General Dynamics, 02-2 BCA ¶31,888, the appeal was based on the contracting officer’s decision to disallow, pursuant to FAR 31.205-47(b)(4), the total legal expenses incurred by the contractor in defending against the Government’s civil fraud claims. Because the costs were included in the corporate overhead proposal, the disallowance decision was accompanied by the decision to impose about $1.7 million in penalties under 10 U.S.C. § 2324(b)(1), i.e., for submission of costs that are “expressly unallowable.” The Board’s decision on the underlying disallowance – that FAR 31.205-47(b)(4) requires apportionment of the legal costs among successful and unsuccessful claims – was ultimately reversed. Rumsfeld v. General Dynamics Corp., 365 F.3d 1380 (Fed. Cir. 2004). The holding on penalties, however, remains good law and provides some helpful guidance on some of the basic principles involved.
Thus, the Board held that the penalty assessment decision is (1)the Government’s claim on which the Government bears the burden of proof; and (2) reviewed de novo. General Dynamics, 02-2 BCA ¶31,888 at 157,569. Furthermore, an assessment for “expressly unallowable” costs will not be upheld unless the Government shows “that it was unreasonable under all the circumstances for a person in the contractor’s position to conclude that the costs were allowable.” Id., at 157,570. While it is not sufficient for the contractor merely to engage in a subjective good faith effort to comply with the cost principles, the Board will consider whether the contractor hid the proposed costs from the Government and whether the contractor’s “basic position with respect to the apportionment and allowability of the costs . . . is sound” under the applicable statutes, regulations, and the parties’ agreements. Id. Finally, in assessing the double penalty under 10 U.S.C. § 2324(b)(2), i.e., for submission of costs that were previously “determined to be unallowable,” that prior determination must have expressed the intent to disallow the cost in “unmistakable terms.” Id., at 157,572.
The Board’s more recent decision interpreting FAR 42.709, Fiber Materials, Inc., ASBCA No. 53616, 07-1 ASBCA ¶ 33,563, again touched upon the meaning of “expressly unallowable,” but also answered a few more arcane questions regarding the waiver of penalties under FAR 42.709-5. In that case, the appellant contested the disallowance and associated penalty assessments on several categories of costs included in indirect cost rate proposals for two consecutive years. In particular, the ACO had assessed penalties on disallowed leased aircraft costs, patent amortization costs, and the costs of a lake cabin in Maine, under respective FAR cost principles.
With respect to the leased aircraft costs, the Board held that the ACO properly disallowed the costs in excess of the applicable standard airfare because the contractor had failed to justify the excess costs, as required by FAR 31.205-46(c)(2). Citing General Dynamics, however, the ASBCA ruled that these excess costs were not “expressly unallowable” because the ACO had discretion to accept them as long as they were supported. “We think that appellant’s claim was sufficiently colorable to preclude penalties.” Id., at166,257.
The Board held that penalties also were unwarranted for the patent amortization and the lake cabin costs, regardless of whether those costs were “expressly unallowable.” In both cases, the amount of the unallowable costs allocated to covered contracts was below $10,000 per fiscal year. FAR 42.709-5(b) requires the waiver of penalties “when the amount of the unallowable costs subject to the penalty is $10,000 or less.” Significantly, the Board decided that the waiver was mandatory even though the FAR clause set forth at 52.242-3 (“Penalties for Unallowable Costs”) provides that the contracting officer “may” waive penalties pursuant to the criteria in FAR 42.709-5. Id., at 166,260 – 166,261.
LEGAL AND POLICY ISSUES
While the decisions in General Dynamics and Fiber Materials provide useful guidance on a number of issues, many more await judicial and/or regulatory attention. For example, the Board in Fiber Materials appears to have taken for granted that the $10,000 threshold calculation is based on each category of costs separately, e.g., patent costs, lake cabin costs, as opposed to the aggregate amount of “assessable” costs included in the proposal. The approach is highly sensible, but it does not leap off the ink of the regulations.
In a related vein, where the indirect cost proposal is submitted by a home office, should the $10,000 threshold calculation be based, not on the costs accumulated at the home office, but rather on the portion of the unallowable costs distributed by the home office to the business units that hold the contracts and actually allocate the costs to those contracts? For example, a home office may submit an incurred cost proposal that includes $15,000 in unallowable costs. Those costs are then allocated in equal $5,000 amounts to three business units, which include them in their respective indirect cost rate proposals. If the waiver calculation is done at the business unit level, the penalties qualify for a waiver because, in each case, they are less than $10,000. This appears to be the logical approach, and one advocated in the DCAA Manual, DCAM 6-609.1.f(4), because the contracts are held at the business unit level and not the home office. But it is not an interpretation that is always followed by ACOs. Moreover, the $10,000 figure itself is something of an anachronism – a 1992 interpretation by the drafters of the regulations of the term “insignificant” in the penalties statute. Certainly inflation and the sheer rise in the dollar volume of indirect cost proposals, which have a direct relationship to the amount of the penalty assessment, also should have a similar correlation to the waiver threshold. This, however, is an issue for the FAR Councils, not the boards or the COFC.
The regulations do make clear that, for purposes of typical flexibly-priced contracts, the penalty provisions apply to “final indirect cost rate proposals.” FAR 42.709(a). As in the example above, incurred cost submissions of a home office that does not hold or perform any contracts may not qualify as “rate proposals” if the home office simply distributes costs and the rate calculation is performed at the business unit level, where the resulting rates are used to allocate the costs to contracts. Such a reading of the regulation not only mandates the application of $10,000 waiver at the business unit level, it effectively excludes home office incurred cost submissions from the penalties regime altogether.
Other, procedural issues arise in connection with the FAR 42.709-5(c) requirement that the contractor demonstrate to the contracting officer’s satisfaction that it meets certain criteria. Because an assessment is a final decision, the contractor’s only hope to make an adequate pre-final decision showing of its entitlement to a waiver depends on receiving some type of courtesy notice from the ACO that a penalty decision is in the offing. Even assuming that such notice is provided and the contractor makes an initial showing, does the ACO have an obligation to provide an opportunity for the contractor to supplement those portions of the record that the ACO views as insufficient?
Some unresolved questions under FAR 42.709-5(c) have broader procurement policy implications as well. One of the prongs of the waiver test is a demonstration that the inclusion of the unallowable costs “resulted from an unintentional error, notwithstanding the exercise of due care.” FAR 42.709-5(c)(2). It remains unsettled whether this standard is applied to the contractor as a business entity or to each of the contractor’s employees. It should be the former, and the language of the regulation in fact speaks to the adequacy of contractor’s policies and procedures. If the business entity is exercising the appropriate level of care, then imposition of penalties for the behavior of one negligent employee borders on strict liability for the company and hardly provides any additional deterrence against future noncompliance.
Another policy issue implicated by FAR 42.709 is the conspicuous absence of any offset provisions. Under FAR 42.709-1(a)(1) and (2), the penalty amount is based on the “disallowed costs allocated to contracts that are subject to this section.” Other similar statutory and regulatory schemes, such as cost impacts under CAS, provide for offsetting the increased cost to the Government with decreases across various contract types. When the contactor improperly allocates an unallowable cost to an incentive contract, for example, it also reduces the contractor’s incentive fee by a fraction of that cost, typically between 10 and 30 per cent. That reduction is a saving to the Government and there does not appear any support for recognizing such savings when disallowing a cost as noncompliant with the CAS, but not when calculating penalties. Similarly, if the contractor includes $100,000 of expressly unallowable costs in the proposal, but later discovers that the same mistake resulted in $200,000 of unclaimed allowable costs being overlooked in the original submission, what policy rationale justifies the imposition of a penalty for having, in the aggregate, undercharged the Government?
FAR 42.709 is about to receive much more attention from the government contracting community. The ASBCA interpretations of the regulation in General Dynamics and Fiber Materials provide some guidance on issues such as the burden of proof, the standard of review, the meaning of “expressly unallowable,” the mandatory nature of waivers and the basis of their calculation. The recent FAR amendments authorizing statistical sampling also create new safe harbors for segregating and verifying unallowable costs, even if it comes with a potentially significant extrapolation downside.
Yet there is little reason for contractors to be sanguine and expect a painless resolution of disputes over penalties. ACOs are under pressure to levy higher assessments and grant fewer waivers. Unfortunately, many questions that are critical to these decisions have no ready answer. Perhaps most importantly, there exists no established standard as to what level of care, and at what organizational level, is sufficient to protect against liability under FAR 42.709. This uncertainty is more than an academic curiosity — not only can it lead to unequal treatment of contractors, but a heightened compliance standard also requires a willingness by the Government to treat as allowable the increased costs of such compliance.