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More on Performance-Based Payments

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Reader Dave asked us to expand on our previous post re: PBPs, focusing on the following comment:

Never mind that (from the contractor’s side) use of PBPs leads to enhanced cash flow and reduced audit support efforts. Never mind that (from the government’s side) use of PBPs leads to reduced oversight requirements and increases depth of competition. Nope. PBPs are not well-understood and they are hard to plan, and so the contracting parties have learned to avoid them in favor of the traditional cost-based progress payments that offer reduced cash flow, increased audit oversight …

Dave commented: “I initially read this as PBP lead to enhanced cash flow THAT IS BETTER THAN progress payments (but now I think you mean generally over cost type), and also that there is less audit with PBPs than progress payments (but now I think you also meant this generally over other cost type).”

No, Dave. I meant what I wrote. Use of PBPs leads to enhanced cash flow that IS better than that offered by use of progress payments calculated as a percentage of cost incurred. Or, at least, it should. And there is definitely less oversight on PBPs than there is with progress payments.

Let’s dive in.

Contract Financing

In general, the government provides contract financing payments when the contractor needs funds in advance of delivery. For example, if you have a 24 month-long contract with delivery at the end of 24 months, and the government only pays you on delivery, then you have to wait 24 months to get any cash in the door. That means you have to pay your employees (and suppliers) for two years, while waiting to get the funds to cover those payments. Most contractors don’t have two years of cash flow in the bank and, even if they do, that’s essentially a two-year interest-free loan to the Federal government. Not a good situation.

Thus, the government offers the ability to get paid prior to actual delivery. There are various types of contract financing payments; they are discussed in FAR Part 32. What’s interesting about these payments is that not all contracts are eligible to receive them (see the qualification criteria at FAR 32.104). Also note that contract financing payments are limited to fixed-price contract types; you can’t get them on cost-reimbursement contracts, because the government is already paying invoices based on costs incurred (and not on delivery). Another interesting aspect is that many smaller contractors don’t know about them or are hesitant to request them, even when the contract would qualify. In other words, many of the contractors most in need of enhanced cash flow don’t request contract financing payments.

On the other hand, the bigger contractors know all about contract financing payments and make sure they receive them at every opportunity. After all, “cash is king.”

Progress Payments

Traditional progress payments are a contract financing method that enhances contractor cash flow by reimbursing a fixed percentage of the contractor’s costs, as they are being incurred. Progress payments are discussed (in general) at FAR 32.5, but one needs to review the contract clause (52.232-16) to really understand the duties and obligations of the parties.

According to FAR 32.501-1, “The customary progress payment rate is 80 percent, applicable to the total costs of performing the contract. The customary rate for contracts with small business concerns is 85 percent.” Right there that tells us that a large contractor is on the hook for funding at least 20 percent of costs incurred (15 percent if you’re a small business). Importantly, note that we are talking about costs, not price. Any profit is realized upon delivery and not through progress payments received.

And the contractor cannot just tally up costs incurred, multiply by 0.80 (or 0.85), and then submit a progress payment request via SF 1443. Nope. It’s not total costs, it’s total costs as calculated in accordance with the 52.232-16 contract clause.

For example, “Costs that are not reasonable, allocable to this contract, and consistent with sound and generally accepted accounting principles and practices” must be excluded from the basis on which progress payments are calculated. Remember, this is a fixed-price contract, so normally nobody cares about your unallowable costs. But use of progress payments effectively converts your FFP contract to a cost-type contract, with respect to identification and segregation of costs made unallowable by FAR Part 31. That takes effort.

[Editor's Note: It's important to note that progress payments are not conditioned on cost allowability. When I said "unallowable costs" in the foregoing paragraph, I was speaking about unallocable costs and unreasonable costs. Costs that are not compliant with the requirements of the FAR 31.205 selected cost principles may still be used as the basis for establishing costs incurred for progress payment requests. Just so you know ....]

But we’re not done yet.

Contracts that are in a loss position require that the progress payment request be adjusted, because the government doesn’t want to finance a contractor’s loss. (Losses happen, especially on FFP contract types.) This issue is discussed in great detail at FAR 32.503-6(g). This can be an onerous calculation, as it involves estimates-to-complete and estimates-at-completion. But it is a calculation that must be made, because the government has the right to reduce or suspend progress payments when it believes the contractor is not complying with the requirements associated with them.

In order to do all the back-office accounting associated with properly administering progress payments, the contractor essentially needs to have an adequate accounting system. Normally, accounting system adequacy is a necessary prerequisite associated with cost-reimbursement contracts (or maybe T&M contracts); it’s not usually associated with award of FFP contracts. But use of progress payments (once again) effectively converts your FFP contract to a cost-type contract, because your contract financing payments are associated with costs incurred.

And DCAA will be looking to see how you are doing.

DCAA has an entire audit program dedicated to audits of contractor progress payments requests. They will be looking to ensure you are complying with all the little administrative details associated with that Progress Payment contract clause. Thus, not only must you comply in all respects, but you will need to have trained staff on hand who can respond to audit requests and provide the requested support (including the ETC and EAC information that will inevitably be requested).

Summary: Progress payments can be a good thing! They can enhance cash flow and reduce the stress associated with making payroll and paying suppliers while working to deliver. However, they don’t cover all costs, and they require additional resources, and lead to additional government oversight. They are certainly better than nothing, but I believe that Performance-Based Payments are better.

Performance-Based Payments

PBPs are discussed (in general) at FAR 32.10. PBPs are simple, at least in theory. The contracting parties agree, up front, on “events” that represent significant programmatic or technical milestones. Those events are valued—importantly, they are valued up front and memorialized by the parties. At the end of discussions, the parties have agreed on a series of milestones that represent program performance, each of which has an agreed-upon value. As the contractor achieves the event, it submits a request for contract financing payment equal to the negotiated value of that event.

Simple, right? It was designed to be.

FAR 32.1002 states:

Performance-based payments may be made on any of the following bases:

(a) Performance measured by objective, quantifiable methods.

(b) Accomplishment of defined events.

(c) Other quantifiable measures of results.

Talk about a blank slate! Any quantifiable measure of results can be used! Where else in the FAR do you find an opportunity for the parties so sit down and figure out how to measure program performance? Indeed, the origin of PBPs was the realization in the mid-1990’s that progress payments didn’t correlate to program performance; they correlated to the contractor’s ability to spend money. Hence, PBPs were an attempt to link contracting financing payments to actual program performance and accomplishment.

Another aspect of PBPs is that the cumulative value of all PBP events cannot exceed 90 percent of the contract (or delivery item) price. Price. Price is not cost; price includes anticipated profit. Thus, instead of receiving up to 80 percent of adjusted contract costs, a contractor using PBPs can receive up to 90 percent of the negotiated contract price. Right there, one can see why PBPs enhance contractor cash flow.

However, it needs to be said that PBPs only enhance cash flow if the contractor is making progress. If the program is in trouble, those pre-negotiated milestone events may not be achieved as planned. In such circumstances, the contractor will lack the anticipated cash flow enhancement, and it will be on its own to make payroll and pay suppliers. So PBPs should not really be used on immature technology or where delivery problems are probable.

Other collateral benefits come with use of PBPs. They include: no need to adjust for unallowable costs; no need to adjust for contract losses; no need to have an adequate DCAA-audited accounting system; and no need for DCAA to deep-dive into your books and records. Accordingly, a lot of effort and resource-use (for both government and contractor) is avoided.

The only substantive guidance for valuation of PBPs is found at FAR 32.1004(b). Included therein is this snippet, which needs to be kept in mind as milestone events are being negotiated:

Performance-based payment amounts are commensurate with the value of the performance event or performance criterion, and are not expected to result in an unreasonably low or negative level of contractor investment in the contract. To confirm sufficient investment, the contracting officer may request expenditure profile information from offerors, but only if other information in the proposal, or information otherwise available to the contracting officer, is expected to be insufficient.

Consequently, neither party should be planning on accelerated cash flow (when compared to contractor expenditure profiles). The contractor should not plan on being “cash rich” when PBPs are used. If it happens, it happens. But don’t plan on it happening.

Summary: A bit more work up front to plan and negotiate the value of PBP event milestones. However, that up-front investment is more than offset by the reduced effort to be expected post-award. And, as I hope we’ve demonstrated, the contractor’s cash flow should be accelerated in comparison to traditional progress payments based on costs incurred (all things being equal).

Dave, have I adequately addressed your question?

Last Updated on Tuesday, 10 September 2019 16:43
 

DOD Issues Direction to Deviate from DFARS When Dealing with Performance-Based Payments

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Performance-Based Payments (PBPs): a topic many people, on both the government and contractor sides of the table, are not comfortable with—because use of PBPs involves extra effort. Never mind that (from the contractor’s side) use of PBPs leads to enhanced cash flow and reduced audit support efforts. Never mind that (from the government’s side) use of PBPs leads to reduced oversight requirements and increases depth of competition. Nope. PBPs are not well-understood and they are hard to plan, and so the contracting parties have learned to avoid them in favor of the traditional cost-based progress payments that offer reduced cash flow, increased audit oversight, and keep non-traditional companies from entering the defense marketplace.

The bias against PBPs has been exacerbated by recent DOD policies and DFARS rules that have made it harder to use them. In my view, the DFARS rules and associated DOD policies have been illegal since they contradicted the FAR direction that PBPs are the “preferred” form of contract finance payments—and no agency supplement is permitted to contradict FAR language. And it’s not just me: Congress has expressed its frustration with DOD policy and DFARS language in the past few NDAAs (National Defense Authorization Acts).

The DAR Council finally got around to doing something about the situation. (Interestingly, the most progress in addressing Congress’ comments has been made since Shay Assad departed DOD. Just a coincidence, I’m sure.)

I have been interested in PBPs since the late 1990’s, when Jacques Gansler’s DOD focused on “partnerships” with defense contractors and creating more opportunities for private industry to join the marketspace. It was under his watch that the DOD published its first (and best) User’s Guide to PBPs. Since then, I watched the DOD retreat from the bold policies and guidelines he had established—to the point that, until recently, there was no reason to actually avail oneself of the “preferred” contract financing payment method.

However, recently there has been movement. As we reported to readers, at the end of April the DAR Council issued a proposed rule that would, if implemented as drafted, lead to some significant improvements in the administration of PBPs. However, as we told readers (and as we told the DAR Council in the letter we submitted to them), the proposed rule still had one fatal flaw: it required contractors using PBPs to maintain a job cost accounting system, and thus imposed a requirement unique to government contractors—which violated both the letter and intent of the NDAA language.

We’re not sure what the DAR Council will make of our input, which was but one public comment out of eleven submitted. (We noted that several other commenters made some of the same points we had made.) But whatever the DAR Council does in moving the proposed rule to a final rule, the DOD isn’t waiting around for the final language to be published. As if growing impatient with a DAR Council that is seemingly “taking its sweet time” to follow Congressional direction (in the words of one WIFCON poster), DOD recently issued a Class Deviation that tells its contracting officers how to deal with PBPs—and that Class Deviation seems to address every concern we had with the proposed rule.

Class Deviation 2019-O0011 provides a solicitation provision and contract clause that are to be used (“effective immediately”) to deviate from the current (problematic) DFARS regulatory language. Notably, the clause language contains strong language that supersedes both the current and proposed regulatory language.

For example:

Incurred cost is determined by the Contractor’s accounting books and records, to which the Contractor shall provide access upon request of the Contracting Officer for administration of the clause. An acceptable job order cost accounting system (per DFARS 252.242-7006) is not required for reporting of incurred costs under this clause. If the Contractor’s accounting system is not capable of tracking costs on a job order basis, the contractor shall provide a realistic approximation of the allocation of incurred costs attributable to this contract in accordance with [GAAP] and the Contractor’s accounting system.

Or:

If the Contractor’s accounting system is not capable of identifying and tracking through the build cycle the property that is allocable and properly chargeable to the contract, the Contracting Officer may consider acceptance of one or a combination of the following forms of security … and so specify in the contract. [Five alternate forms of security are listed.]

In summary, the use of the Class Deviation solicitation provision and contract clause addresses our fundamental problems with recent DOD administration of PBPs. As such, we welcome their use.

As we noted at the beginning of this article, many acquisition professionals are uncomfortable with planning and/or negotiating PBP plans. We here at Apogee Consulting, Inc. are available to assist you. Why not give us a call?

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Last Updated on Tuesday, 27 August 2019 17:51
 

DCAA Does Materiality

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I was going to write about the latest DCAA audit report and do a bunch of charts showing trends, but then DCAA issued this MRD entitled “Audit Guidance on Using Materiality in Incurred Cost Audits,” and it seemed a bit more important … so here you go.

Section 803 of the 2018 National Defense Authorization Act (NDAA) had a lot to say about DCAA, most of them in relation to the then-current backlog of “incurred cost” audits. Among the requirements imposed by that public law was the following—

Not later than October 1, 2020, the Secretary of Defense shall comply with commercially accepted standards of risk and materiality in the performance of each incurred cost audit of costs associated with a contract of the Department of Defense.

In response to that direction, DCAA issued a MRD (link in the first sentence) that, for the first time, provided auditors with direction regarding how to assess materiality. This is important because, historically, contractors have complained about the lack of materiality in DCAA audit procedures. For example, contractors have complained publicly about having to spend thousands of dollars to chase down a receipt for $53.00 (or something like that; we’re paraphrasing here). Of course, those anecdotal “thousands of dollars” were allowable overhead costs, so it was the Department of Defense that was footing the bill for the overzealous auditors’ demands.

But now DCAA has an official materiality standard. In the words of the MRD, “The use of a quantified materiality threshold is intended to facilitate a consistent approach that helps an auditor determine the nature, timing, and extent of audit procedures on those cost elements and accounts that are significant, or material, to the audit opinion.”

DCAA has provided its auditors with the following formula for calculating materiality for its incurred cost audits:

For values up to $1 billion, use the formula $5,000 x ((Total Subject Matter / $100,000) .75), which in Excel looks like: =5,000*((1,000,000/100,000)^.75). For an incurred cost proposal with an Auditable Dollar Volume (ADV) of $1 million, the materiality threshold is $28,117.

For ADV in excess of $1 billion, the MRD directs auditors to use a materiality threshold of 0.50 percent of the ADV value.

What does this mean?

First, it’s not clear. We think it means that transactions below the materiality threshold will not be subject to audit procedures. That would seem to be reasonable. On the other hand, who knows? It may well depend on each individual auditor’s approach to conducting the audit.

Second, it’s not dispositive. By that we mean that the audit guidance permits auditors to adjust the materiality threshold based on auditor judgment. In the words of the MRD—

Materiality requires the use of two separate thresholds: quantified materiality to identify significant cost elements, and adjusted materiality to identify significant accounts recorded in the significant cost elements. Adjusted materiality is less than quantified materiality and is applied to accounts within a cost element. For purposes of selecting accounts for audit testing, adjusted materiality can be stated as a reduction of the quantified materiality threshold by 20 percent to 80 percent based on auditor judgment.

So while the materiality threshold may be a nice theoretical concept, it may actually mean close to nothing when applied during an incurred cost audit.

Finally, DCAA did the minimum it was required to do. (Actually, the agency did a bit less because it was supposed to tie the materiality threshold(s) to commercial audit standards; that did not seem to happen.) The NDAA required a materiality standard for incurred cost audits, and that’s exactly what DCAA did. However, the audit agency did not impose a materiality threshold for its CAS-related audits or associated cost impact proposal audits. There is no materiality threshold for defective pricing or for MAAR audits. As was the case with “incurred cost” audits, a risk-based approach to audit procedures, using a quantified materiality standard, is needed.

Let’s hope DCAA takes this precedential approach and applies it to other areas.

 

Another Small Business Stumbles When Calculating its Rates

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It’s correct to note that Apogee Consulting, Inc., is in the business of assisting government contractors in the back-office administrivia associated with government contracts. It’s also correct to note that there is a certain amount of “we-told-you-so” in this article.

Yet, further note the maxim that every consultant in this business knows to be true: “It’s harder to sell services that prevent problems; whereas it’s much easier to sell services that fix the problems into which the contractor has got itself.” Nobody is a hero when problems are prevented; but lots of people can be heroes when confronted with preventable problems that "suddenly" need to get fixed.

If one were of a mind to peruse previous articles found on this blogsite, one might note a certain amount of repetition on the above statements, particularly with regard to small businesses that simply do not know what they don’t know. They often don’t understand the intricacies associated with their government contracts and thus fail to make accurate risk assessments. They don’t invest in their back-office controls because they don’t really understand the probabilities and consequences associated with their contract risks. They do not understand that those investments have a quantifiable return on investment, in terms of disputes avoided.

In September, I will be presenting at the Society of Corporate Compliance and Ethics (SCCE) 18th Annual Compliance & Ethics Institute. (If you are interested: link here.) The catchy title of my presentation is “Taking a Dynamic Approach to Compliance Risk Assessments for U.S. Government Contractors.” My presentation is described as follows:

  • Learn how to manage a changing risk profile as your business evolves in size and transitions from sub to prime contractor and contracts change from fixed-price to cost-reimbursable

  • Increase your organization’s ability to identify and assess risks associated with organizational and contractor evolution using revenue, contract-type and acquiring agency as key differentiators

  • Better understand Federal Acquisition Regulation contract clauses and changing non-compliance risk

So, yeah. This is a topic that’s on my mind. When you couple a small business’ inability to properly identify and assess risks with an evolving environment, you often get problems. For example, when a small business moves from FFP contracts to its first Cost-Type contract—as is often the case when a SBIR Phase 2 contract is awarded—then that small business really needs to be prepared for its new risk environment. However, such is not always the case.

With all that in mind, let’s discuss the situation faced by Falmouth Scientific, Inc., a successful small business that performed on a four-year Cost-Type SBIR contract for SPAWAR. Falmouth’s problems stared with its initial proposal, in which Falmouth failed to apply G&A expenses to its three project subcontractors. In the first year of contract performance, DCAA “informed the company that it was required to apply G&A to its subcontractors and it would have to redo the invoices it had submitted on the contract to that point. Falmouth worked with DCAA to revise its prior payment requests.” (Internal citations omitted.)

Why would DCAA tell Falmouth that it had to apply G&A to its subcontractors? It’s not particularly clear. The notion that government contractors are required to use a Total Cost Input allocation base for G&A expenses has been dead for more than 30 years. Of course, perhaps Falmouth had an accounting policy or procedure, or practice, that described its G&A expense allocation base—and perhaps that G&A expense allocation base was TCI. But there was nothing that required Falmouth to apply G&A expense to its subcontractors unless it had chosen to do so. Nonetheless, apparently Falmouth agreed with DCAA that G&A expenses should be applied to its subcontractors, because it subsequently revised its previously submitted invoices. Thus, Falmouth was committed to applying G&A on a TCI allocation base (even though, presumably, its SBIR proposal had been priced without such an application and was therefore going to burn through contract funding faster than the parties had anticipated.)

But just two years later, Falmouth and the government reached a deal that retroactively approved use of a G&A expense allocation base that excluded subcontractor costs, and also capped the allowable G&A expense rate. At that point, presumably, the past two years of invoices needed to be revised once again.

At that point, one might well wonder exactly what Falmouth’s G&A expense allocation base was. Was it Total Cost Input, or Value-Added, or perhaps even Single Element? We don’t know but we hazard a guess that Falmouth didn’t really know, either. In the first two years of contract performance the company had three separate G&A expense allocation bases, which of course meant three separate G&A expense rates. And that third rate (whatever it was) had been capped by mutual agreement. It must have been a nightmare for the Program Manager to get a handle on the budget and to comply with the Limitation of Cost and/or Limitation of Funds clauses in that SPAWAR SBIR contract.

Let’s agree that there was a big red flag that Falmouth had indirect rate calculation problems.

At some point the company hired a former DCAA auditor to assist it with its problems. The results of that hiring decision were a bit mixed, in our view.

Between 2009 and 2011, Falmouth submitted five years’ worth of proposals to establish final indirect cost rates (commonly known as “Incurred Cost Proposals”). This tells us that they didn’t submit their proposals when they were required to do so (in accordance with the 51.216-7 clause in their contract). Perhaps the company didn’t know that such a proposal was required until DCAA (or their ex-DCAA auditor consultant) told them. Evidence once again that the small business didn’t know what it didn’t know.

Further, it’s a bit unclear what G&A expense allocation base Falmouth used in those proposals, since two of them were submitted prior to the contract modification that established a G&A expense allocation base that excluded subcontractor costs. If they used an allocation base that was subsequently revised by mutual agreement, they may have been required to withdraw and resubmit their final billing rate proposals using a different G&A allocation base. Or not. We really don’t know; but if you’re thinking the whole situation sounds chaotic, you’re on the same page as we are.

Surprising nobody who has experience with the back-office administrivia associated with government contracts, “DCAA's evaluation … identified numerous problems with Falmouth's financial management of its G&A and subcontract costs. After a second iteration, DCAA's analysis concluded that Falmouth received overpayment of $118,810 for its indirect costs for the contract. … Further DCAA analysis of the allowable cost limits in Falmouth's contract reduced its allegation of overpayment to $100,611.88.” (Internal citations omitted.)

Importantly, the foregoing was communicated to the DCMA Administrative Contracting Officer (ACO) via a Memorandum and not a formal audit report that would have been subject to GAGAS. Apparently, DCAA found Falmouth’s proposals to be inadequate for audit. That finding, if it was made, would be consistent with the situation as we are picturing it, years later and miles away from Falmouth’s headquarters.

Apparently, the DCAA finding was not the result of performing audit procedures; the finding came from application of a 20 percent decrement factor to both direct and indirect costs. (This is a thing that DCAA can do, though we believe that the audit agency currently applies a 16 percent factor, which is really not significantly better.) Readers may be interested to note that when DCAA applied such a factor in an audit report subject to GAGAS, the DOD Office of Inspector General found such a factor to be a violation of GAGAS. (See this article, in which we quoted the OIG as writing, “The auditor did not obtain sufficient evidence to conclude that the subcontract costs were unsupported … [and] the field audit office applied an arbitrary and unsupported 20-percent decrement factor to calculate the questioned costs.”) But while asserting an arbitrary decrement factor is a GAGAS violation if included in an audit report, apparently it’s just fine to include such a factor in a Memo to a Contracting Officer, which is not subject to GAGAS. We’re willing to bet the small business didn’t really understand the nuances of GAGAS compliance.

Let’s talk about the DCAA assertion. $100,000 may not seem like a lot of money to a bigger business, but to a small business that’s a huge amount. Thus, the parties negotiated and, eventually, agreed that Falmouth owed the government $83,295, which was a decent reduction but still quite a lot for a small business to swallow.

The agreement that Falmouth owed $83.3K was duly executed but, apparently, Falmouth was still a bit confused about next steps. There was some back-and-forth correspondence that including the following bit:

As you know FSI is a small company and cash flow is a significant issue for us. In previous discussion [sic] between you and I when I agreed to accept the rate settlement you indicated that a long term penalty and interest free payment plan was possible in this kind of situation. This was one of the main reasons I agreed to accept the settlement and not contest it further. [Falmouth] requests that the payment be amortized over 5 years. Please call me to discuss or let me know what we need to do.

Thus, Falmouth sought to pay the $83.3K over five years, interest free. That goal was not attained.

In May, 2016, Falmouth received a Contracting Officer Final Decision (COFD) and a demand for payment in full. Falmouth reacted by undertaking the following actions: (1) submitted a deferral request, (2) submitted a request for an installment payment plan, and (3) filed an appeal with the ASBCA.

With respect to the appeal, Falmouth alleged that the dispute stemmed from a DCAA assertion that Falmouth’s accounting system was inadequate plus “untimely, inconsistent and erroneous guidance from DCAA auditors during the contract performance periods.” Okay. As we’ve stated publicly, getting guidance from DCAA regarding your contract costs is a lot like getting guidance from the IRS regarding how much taxes you owe. You certainly can rely on such guidance, but we suspect one does better by consulting tax preparation professionals. In addition, DCAA auditors are not supposed to actually provide guidance to the contractors under audit. Something about independence ….

With respect to Item #2 (the installment plan), Falmouth did receive a three-year payment plan from DFAS. Along with the payment plan came a promissory note stating “that Falmouth ‘will pay’ DFAS $83,294.88 plus interest at 1.875% and a penalty on its ‘indebtedness under’ the contract.” (Internal citations omitted.) The interest-free and penalty-free goal was not part of that installment plan. Falmouth signed the promissory note anyway.

With respect to Item #1 (the request for payment deferral), it appears that Falmouth thought that signing the promissory note was a part of the deferral request. Spoiler: it wasn’t.

With all that, the Board granted summary judgment in favor of the government. The decision did not give the government victory because Falmouth had signed the promissory note (as the government first argued), but the decision was for the government on the basis that the parties had entered into a bilateral agreement “which effectively established an agreed-upon figure owed to the government.” In other words, when Falmouth negotiated and agreed upon final rates that led to a situation where it owed the government money on its cost-type SBIR contract (based on application of the agreed-upon rates and the agreed-upon contract rate caps), and when Falmouth actually executed that agreement, at that point Falmouth had effectively agreed with the government’s position—and all the complaints about bad DCAA auditor advice were simply irrelevant.

Though the negotiations began because of the DCAA audits and were informed by them, the agreements do not rest upon them. Instead, they are a product of the negotiations of the parties as contemplated by FAR 52.216-7, which is incorporated into the contract. … Falmouth's generalized argument that there was no meeting of the minds between the parties because the rate agreements did not include the bottom-line number of the amount owed fails because the agreements specified what was required (the rates) and Falmouth well knew what the exact consequences of agreeing to those rates would be.

(Citations and footnotes omitted.)

Falmouth is a small business and it learned a hard lesson. When it signed its SBIR contract, it should have realized the back-office compliance requirements associated with cost-type contracting. But it didn’t realize what was required; we continue to believe the company simply didn’t know what it didn’t know.

A hard lesson, and also an expensive one.

Last Updated on Friday, 23 August 2019 06:17
 

Due Diligence Oopsie

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This story broke before we went on vacation and we’ve been meaning to write about it. The story concerns a risk associated with acquiring a smaller company. It’s a risk that most due diligence efforts would not identify.

Say you’re a large, well-established, company. You are acquiring a small company in the same marketspace. Naturally, as part of the due diligence efforts, you obtain a list of recent contract awards. You also obtain a list of what’s in the “pipeline”—i.e., what proposals have been submitted and are awaiting an award decision. You probably also get a list of proposals in process that will be submitted in the near future. You (presumably) have a good picture of what’s been happening, and what is likely to happen, with respect to the near-term future of the company you are acquiring.

If you are good at your job, you looked at the target’s business systems. You evaluated the accounting system and property control system. You looked at the estimating system. You looked at the purchasing system. As part of those efforts, you likely evaluated the risk that the target had material misstatements on its financial statements. You probably evaluated its anti-fraud and anti-corruption controls. You likely reached a conclusion regarding the accuracy of its cost proposal process, and the company’s ability to comply with Truthful Cost or Pricing Data requirements. In short, if you are good at due diligence you should have some idea as to whether or not you are buying contingent liabilities for which reserves need to be established at the time of acquisition.

But would you have evaluated the target company’s ability to tell the truth to potential customers? Would you have assessed its ability to comply with the False Statements Act in its interactions with government personnel?

We don’t think so. At least, we’ve never been part of such a rigorous due diligence process. In order to address those risks, you would have to start from the question: “What if much of the target company’s success wasn’t because of the quality of its product and/or services, or because it was a low-cost provider?” You would have to ask the question, “What if much of the target company’s success stemmed from its sales process, where it misrepresented its qualifications in order to win work?”

It’s possible you might ask those questions. But in our experience, those questions are almost unthinkable. In addition—even if you did ask them, how would you go about testing for them? It’s too out there, too hard. Plus, most due diligence efforts are sprints, and nobody has time for such small probability risks, even if the consequences might be significant.

What happens if the risk materializes after completion of the acquisition? What happens if the risk is materializing on the day of the acquisition?

Let’s ask IBM.

According to the Department of Justice press release (link above), on the exact day that IBM was closing its acquisition of Cúram Software Ltd (Cúram), the company (as a subcontractor) submitted a proposal to the State of Maryland for software and services. Less than a month later, “with IBM’s knowledge,” Cúram participated in a presentation to the source selection evaluators—a presentation that resulted in a contract award.

According to the DOJ, Cúram made “material misrepresentations” to the evaluators “including misrepresentations regarding the development status of the Cúram for Health Care Reform software; the existing functionality of the Cúram software to meet the State’s technical requirements, such as addressing life events and calculating tax credits under the Patient Protection and Affordable Care Act; and the integration of Cúram software with other software needed to provide a properly functioning HIX website.” Allegedly, the misrepresentations led to a contract termination after Cúram was unable to deliver on the promises it had made in its proposal and during its presentation.

Many long-time acquisition practitioners have learned not to fully trust verbiage contained in contractor proposals. We’ve heard contractor proposals called “fantasies” and evaluations termed “creative writing contests.” Maybe that’s true. But we’ve rarely heard those proposed deemed to be material misrepresentations, or violations of the False Statements Act, or of such a serious nature to have led to a situation where each contract invoice was alleged to be a violation of the False Claims Act.

What was the outcome of all this? IBM paid $14.8 million “to settle alleged violations of the False Claims Act arising from material misrepresentations to the State of Maryland during the Maryland Health Benefit Exchange (MHBE) contract award process for the development of Maryland’s Health Insurance Exchange (HIX) website and IT platform.”

Again, this is not something we’ve seen due diligence programs delve into. Accordingly, it’s tough to blame IBM for the situation. On the other hand, during each acquisition there should be a thorough evaluation of the probability that there are hidden contingent liabilities. The acquired company should not get its full payday until sufficient time has passed to reduce the likelihood that the contingent liabilities will materialize.

 

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Newsflash

Effective January 1, 2019, Nick Sanders has been named as Editor of two reference books published by LexisNexis. The first book is Matthew Bender’s Accounting for Government Contracts: The Federal Acquisition Regulation. The second book is Matthew Bender’s Accounting for Government Contracts: The Cost Accounting Standards. Nick replaces Darrell Oyer, who has edited those books for many years.