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Apogee Consulting Inc

Teaming Agreements

Nick Sanders
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FAR 9.6 discusses “contractor team arrangements,” defined as “(1) Two or more companies form a partnership or joint venture to act as a potential prime contractor; or (2) A potential prime contractor agrees with one or more other companies to have them act as its subcontractors under a specified Government contract or acquisition program.” The FAR goes on to state that the teaming arrangements “may be desirable” in order to create teams that “offer the Government the best combination of performance, cost, and delivery” for the resulting contract award.

It is the policy of the U.S. Government to “recognize the integrity and validity of contractor team arrangements; provided, the arrangements are identified and company relationships are fully disclosed in an offer or, for arrangements entered into after submission of an offer, before the arrangement becomes effective.”

Importantly, the FAR notes that the government customer will still “hold the prime contractor fully responsible for contract performance, regardless of any team arrangement …” In other words, the prime contractor cannot transfer contract execution risk to its team members (which is an assertion we’ve made several times on this blog).

There is a long-standing controversy regarding the enforcement of teaming agreements. There are legal decisions that have held that teaming agreements are not enforceable; calling them mere “agreements to agree.” However, some legal forums have upheld the enforceability of such agreements. So it is critical to draft the teaming agreement so that a court will enforce it, should there be a dispute.

At last two legal practitioners believe that “A teaming agreement is only worthwhile if it is enforceable. Without an enforceable teaming agreement, a potential subcontractor could leave a prime contractor unable to perform or a prime contractor could simply disregard a subcontractor once it receives an award.”1 Those authors wrote—

In Cyberlock, a party to the teaming agreement sued for the right to a subcontract promised to it under that agreement. Despite the fact that the parties had a signed teaming agreement, the court found the agreement unenforceable because it (like most teaming agreements) did not include specific subcontract terms, and permitted the parties to terminate the agreement if they did not successfully negotiate the subcontract. For these reasons, the court concluded that a signed teaming agreement was simply ‘an agreement to negotiate in good faith to enter into a future subcontract,’ that is ‘precisely the type of agreement to agree that has consistently and uniformly been held unenforceable in Virginia.’

Thus, in that case the prime contractor won the subcontract award (perhaps based at least in part on the qualifications of the subcontractor it had teamed with) but the subcontractor received nothing.

Other issues that may arise with teaming agreements include: (1) teaming with a subcontractor that is debarred or proposed for debarment (not a good idea), (2) having a small business act as prime and a large business act as subcontractor, even though the large business will in fact manage and perform most of the work (the “ostensible subcontractor” issue), and (3) and evaluation of the past performance of the team as a single entity versus evaluation of the past performance of each of the team members. We have also written (and published an article) on the evaluation of joint ventures, which is a related topic.

However, having the right team member may well be helpful in contracting officer responsibility determinations. For example, in one bid protest at the GAO, the decision stated, “As a general rule, the experience of a technically qualified subcontractor or third party--such as an affiliate or consultant--may be used to satisfy definitive responsibility criteria relating to experience for a prospective prime contractor. In considering whether the experience of a third party subcontractor or affiliate may be relied upon by a prime bidder to meet an experience criterion, we examine the record for evidence of a commitment by the third party to the bidder’s successful performance of the work.” (Charter Environmental, Inc., B-297219, 12/05/2005.) Thus, one important reason for choosing a team member is that the company will bolster the prime’s experience assessment. But note the need for a committed relationship between the two entities; in the absence of evidence of a commitment, the GAO may find that a contracting officer should not have used the experience of a proposed subcontractor to bolster the experience of the proposed prime contractor. The right language in the teaming agreement can provide that evidence.

Looking to post-award matters, typically the biggest area of dispute between team members concerns the amount of workshare. Usually the teaming agreement specifies an amount of work that each team member will receive, should the team be successful and receive the contract for which it is submitting a proposal. The exact language regarding expected workshare is critically important to get right. For instance, on the WIFCON discussion forum, there was a recent post by somebody who was dealing with a workshare ratio based on revenue. If you think about it for a minute, you’ll see why basing the workshare ratio on revenue is a bad idea. Using a percentage of direct labor dollars, or direct labor hours, or full-time equivalent (FTE) heads is a much better idea.

Generally, the agreed-upon workshare is a target. It should be treated as a goal, not a contract term. There are many reasons why the exact workshare percentage may not actually come to pass, including (but certainly not limited to) customer changes to the initial statement of work, changes in personnel at one or both entities, and availability of funding at the CLIN or SLIN level. In other words, so long as the prime contractor is making a good faith effort to achieve the agreed-upon workshare, but falls short because of circumstances outside its control, the subcontractor likely has little if any legal recourse.

In any case, let’s remember that the cost principle at FAR 31.205-47(f)(5) speaks to the allowability of legal costs in disputes between a prime and a subcontractor, or between team members. It states—

Costs of legal, accounting, and consultant services and directly associated costs incurred in connection with the defense or prosecution of lawsuits or appeals between contractors arising from either—

(i) An agreement or contract concerning a teaming arrangement, a joint venture, or similar arrangement of shared interest; or

(ii) Dual sourcing, coproduction, or similar programs, are unallowable, except when—

(A) Incurred as a result of compliance with specific terms and conditions of the contract or written instructions from the contracting officer, or

(B) When agreed to in writing by the contracting officer.

So if teaming partners are thinking about litigating any dispute about workshare, they should remember that the legal costs will be unallowable.

The DCAA publication, Selected Areas of Cost Guidebook, Chapter 37, discusses how DCAA auditors will audit teaming arrangements. It states—

The accounting for teaming arrangements should be consistent with the form of business organization that the teaming contractors have agreed to and disclosed in their proposal(s). For example, if the agreed-to arrangement is in the form of a joint venture, then this should be disclosed in the proposal(s) and the accounting principles applicable to a joint venture should be followed. FAR 9.603 requires contractors to fully disclose all teaming arrangements in their offers. If an arrangement is entered into after submitting an offer, then disclosure is required before the arrangement becomes effective.

Thus, it is important to know, and to document, and to disclose, the form of the post-award business organization within the teaming agreement itself. Further, the cost accounting practices used to estimate contract costs need to be consistent with the (future) business organization.

One issue that is likely to come up for the teaming partners is whether the post-award business organization is a separate CAS business unit or segment for purposes of allocating home office expenses. If the joint business organization is being treated as a separate business segment, then CAS 403 will require an appropriate allocation of all home office expenses for which the joint business organization receives a benefit. To the extent that certain home office expenses (e.g., IR&D or B&P expenses, HR expenses, etc.) are not being allocated, the teaming partners should be prepared to defend their decisions to DCAA. Conversely, if the joint business organization is not being treated as a separate business segment by one or more of the teaming partners, then that decision should also be defensible when the DCAA auditors inquire about it.

Finally, the post-award joint business organization may need a separate CASB Disclosure Statement. The decision regarding preparing and filing an individual Disclosure Statement will turn on the nature of the joint organization, its cost accounting practices, and how the teaming partners are treating it. The DCAA guidance states—

The need for a joint venture CAS Disclosure Statement depends upon the characteristics of the venture itself. The determination must be made on a case-by-case basis. Where the joint venture is the entity actually performing the contract, has the responsibility for profit and/or producing a product or service, and has certain characteristics of ownership or control, a Disclosure Statement should be required. Where the venture merely unites the efforts of two contractors performing separate and distinct portions of the contract with little or no technical interface, a separate joint venture disclosure may not be required.

As readers can tell, this is a complex topic. Typically, once a decision is made to enter into a teaming agreement (and that decision is usually made by the business development folks), the details are left to the legal or contracts folks to hammer out. But (as we trust we’ve demonstrated) the number of decisions to be made afterwards is daunting. Each decision, at each stage—from drafting the teaming agreement to choosing the workshare metric to choosing the nature of the post-award business organization—is critical. Mistakes at any juncture can result in a failed proposal effort or in disputes after contract award. Further, the DCAA audit considerations need to be addressed early in the relationship, lest the parties see significant margin degradation from adverse audit findings.

To sum this up: teaming agreements are important. The right teaming partner can help win a contract. But the wrong teaming partner, or the wrong teaming agreement language, can result in difficulties. You can avoid those difficulties by devoting appropriate attention to the details, and keeping in mind the various landmines that we’ve noted in this article.

 

1 See “Ten Tips for Drafting Enforceable Teaming Agreements,” by C. Apfel and D. Specht, at https://jenner.com/system/assets/publications/13413/original/Apfel_Specht_bloomberg.pdf?1415089419

 

 

DCAA Audits – Another Point of View

Nick Sanders
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It’s no secret that we’ve taken a hard line on recent DCAA audit statistics, pointing out decreased productivity and decreased audit quality as well. Not only is DCAA issuing fewer audit reports and questioning fewer costs than ever, the sustention rate is nothing to brag about either. (The sustention rate is the ratio of auditor questioned costs that are upheld by a contracting officer.) We’ve been hard on DCAA, no question about it.

And then we came across a report from the Department of Treasury that shows another point of view. It shows how valid DCAA audit findings can be thwarted because of contracting officer inaction. To be fair to the audit agency, we wanted to share that point of view with our readers.

The report in question was issued by the Department of Treasury Inspector General for Tax Administration (TIGTA). Audit report no. 2017-10-019, dated March 15, 2017, can be found here. The report is entitled “Resolution of Defense Contract Audit Agency Findings of Questioned Contractor Costs Needs Significant Improvement”.

DCAA performed audits for the IRS on a reimbursable basis, meaning that DCAA received funds from the Department of Treasury intended to reimburse it for its efforts. (Readers may recall that such audits for non-DOD agencies were curtailed by Congress for a brief period of time, so that DCAA could focus on its core mission of auditing Department of Defense contractors.) The funds that the IRS actually paid DCAA were trivial, amounting to some $5.7 million over a period of 9 years (2005 through 2014). Nonetheless, TIGTA auditors were upset that their agency didn’t see a better return on those payments. Although DCAA auditors questioned more than $80 million in IRS contractor dollars during that period, the agency only recovered about $1.4 million of that amount—leading to a situation in which less than 2 percent of questioned costs were recovered.

Actually the situation may have been worse than that, according to TIGTA. Only $540,000 of the claimed cost recoveries of $1.4 million “could be documented.” But let’s go with the $1.4 million figure because why would anybody lie about it? Anyway, here’s the summary from the report:

IRS contracting officers fully recovered questioned costs in response to six DCAA audit reports. In four of the remaining 19 instances, the IRS was able to justify its decisions not to recover the full amount of costs questioned by the DCAA. However, in 13 instances, sufficient documentation to justify IRS decisions could not be located or attempts to recover funds from the contractor were unsuccessful. Two instances were still pending a final resolution.

What went wrong? According to TIGTA the fundamental issue could be summarized in one sentence: “the IRS did not timely pursue questioned costs.”

TIGTA reported that “For 22 (96 percent) of the 23 cases we reviewed, the disposition memorandum indicated that the CO agreed with the DCAA findings overall. However, for 10 (45 percent) of these cases, the COs did not take action in response to the DCAA findings or did not recover the majority of the questioned costs identified in the related DCAA reports.”

TIGTA found that “the IRS took action to resolve the findings of DCAA reports within six months of receiving the report in only one … instance for the 25 audit reports we reviewed. Action was often deferred until contract closeout.”

By then it was often too late to collect questioned costs, because of that pesky Contract Disputes Act Statute of Limitations.

As TIGTA reported—

The Contract Disputes Act of 1978 imposes a six-year SOL on all claims, whether they are asserted by the contractor or by the Government. The limitations period begins to run upon accrual of a claim (when the contractors certified cost proposal is submitted), which is ‘the date when all events . . . that fix the alleged liability of either the Government or the contractor and permit assertion of the claim . . . were known or should have been known.’ We found that the SOL on recovery of disallowed questioned costs expired in six instances prior to the IRS either initiating or completing actions to recover the related funds, based on the date of the contractors’ cost proposal submissions. In two of the six instances, the SOL expired before the IRS received the DCAA report. However, in the remaining four instances, the expiration of the SOL occurred after the IRS received the DCAA report. The IRS was unable to recover the questioned costs in one of the four instances because it did not maintain sufficient documentation to substantiate its position for legal action regarding whether commercial labor rates charged by the contractor were appropriate. In the remaining instances, the IRS discontinued the demand for payment when notified by the contractor that the SOL had expired on the IRS’s claims. In these three instances, the IRS COs had time (which ranged from two-to-37 months after receipt of the DCAA report) to research the audit’s questioned cost findings, decide if the questioned costs were unallowable, and issue a claim to the contractor to recover funds before the SOL expired. However, while the COs may wait for the receipt of a DCAA audit report before making a decision about whether to bring a potential claim against a contractor, it will not extend the SOL time periods for those claims if the underlying facts should have been known earlier. The COs have authority under FAR § 42.801 to disallow costs on their own authority over the life of the contract. The statutory period begins to run when the Government knows or reasonably should know of an alleged violation and the resulting impact, not when DCAA audits identify it. Because the responsible COs did not take action within the six-year SOL period, the IRS lost the opportunity to recoup more than $22 million in questioned costs identified by the DCAA. These delays occurred in part because the Office of Procurement had not established specific procedures for monitoring the date of the contractors cost proposal submission and the time remaining to recover questioned costs before the SOL expires, and because the COs did not place a high priority on making cost recoveries.

(Emphasis added; internal footnotes omitted.

It wasn’t a high priority.

This from the IRS, the agency that’s responsible for pursuing delinquent tax payments. For pursuing under-payments of taxes lawfully owed. That’s kind of ironic; are we right?

But there’s more to the story. According to the TIGTA report—

According to the COs we interviewed, the organizational focus for the COs at the IRS is to expeditiously make awards and obligate funding, not to recover unallowable costs paid to contractors. The COs also cited significant workloads, resource constraints, and a dwindling acquisition workforce due to a hiring freeze at the IRS as reasons for not recouping questioned costs. In some cases, the COs indicated that the questioned cost amount did not warrant the effort and potential expense to make the recovery. In another example, IRS Office of Chief Counsel stated that the COs did not sufficiently develop their position or assemble the documentation that was necessary for them to pursue legal actions to recover disallowed costs from the contractor.

Put yourself in the shoes of the DCAA auditors performing these audits. You do your job. The contracting officer agrees with your findings. Only the government never gets the money it’s owed. That’s gotta suck, big time.

Or put yourself in the shoes of the government agency that paid DCAA for performing audits, audits its contracting officers never had the time or inclination to effectively resolve in a timely manner. That would be disappointing, as well.

So here’s another viewpoint of government audits, one filled with bureaucracy and frustration. The audit is performed the way it’s supposed to be performed, but there is no tangible result as one would expect.

No wonder DCAA has trouble retaining its workforce.

 

 

Why Companies Don’t Contract with the DOD (Again)

Nick Sanders
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One of the persistent themes on this blog is that the Pentagon is its own worst enemy when it comes to partnering with its contractors. We didn’t seek that theme out; it was handed to us by report after report, from sources such as the RAND Institute and the Defense Science Board. The overwhelming consensus is that the Department of Defense is a bad contracting partner.

Now you can point the finger of blame elsewhere, of course. You can point at legislation that mandates certain business practices. You can mention the Competition in Contracting Act and the Anti-Deficiency Act and the Buy America Act and the Fly America Act and a host of other legislative mandates that force the DOD to do business in a certain way—a way that seems contrary to normal commercial business practices. You can point at the number of bid protests and the number of attorneys salivating at the thought that a contracting officer made a mistake during the Pentagon’s astoundingly long acquisition cycle.1 (Mistakes are common because the rules are so hard to follow.)

You can also note (as we have done in the past) that the Pentagon’s official policy has changed over time. Whereas in the late 1990’s and early 2000’s the Pentagon desired to “partner” with its contractors, the current policy is to maintain an arms-length distance. Some would say that many in the DCMA and DCAA have taken that philosophical change a bit further than intended: moving from a distant contracting relationship to an adversarial relationship.

So, yeah, there’s plenty of blame to spread around but, regardless of whose fault it may be or how we got here, the overwhelming consensus is that the defense acquisition system is broken. As a result, many companies choose not to do business with the Pentagon—companies with whom the Pentagon greatly desires to do business.

The Government Accountability Office (GAO) recently released another study that addressed the barriers that keep the Pentagon from attracting the kind of companies it says it needs. The barriers included:

  • Complexity of the DOD’s [acquisition] process

  • Unstable budget environment

  • Long contracting timelines

  • Intellectual property rights concerns

  • Government-specific contract terms and conditions

  • Inexperienced DOD contracting workforce

None of the foregoing points are new, of course. We’ve heard it before (and we’ve written about it before). Some of those barriers are cultural, others are legislative requirements. Regardless of the rationale, the end result is a business partner who seems to be the partner of last resort. For example, GAO wrote—

… collectively these challenges have created an environment where companies choose to either not pursue DOD business or believe that their resources could be better spent pursuing commercial business where the cost to compete is lower and selection decisions are made faster. For example, 1 of the 12 companies GAO spoke with conducted a cost comparison study and found that it took 25 full time employees, 12 months and millions of dollars to prepare a proposal for a DOD contract. In contrast, the study found that the company used 3 part time employees, 2 months, and only thousands of dollars to prepare a commercial contract for a similar product .

The GAO study goes into more detail about the challenges that deter companies from selling to the Department of Defense. We choose not to repeat the details and invite you to follow the link (above) to see for yourself. We note for the record that DOD reviewed the report and declined to offer any comments.

The GAO study noted that DOD has commissioned several studies (some at the behest of Congress) to see what can be done about the challenges. We’ve written about the Section 809 Panel before. In addition, there is a DOD Regulatory Reform Task Force. Within the Task Force is a subgroup dedicated to evaluating DFARS rules for elimination or reform. The subgroup is seeking input; feel free to help them out.

Meanwhile, the wheels of defense acquisition continue to grind, albeit slowly. For example, here’s a link to a Memo that cautions contracting officers that the “tools and techniques” they use to acquire goods and services for the warfighters “must be thoughtful and deliberate”. It reminds Defense contracting officers that they must “ensure that we have done the necessary due diligence that we are paying a fair and reasonable price….” In other words, while one hand is evaluating reforms that would streamline acquisitions and make contracting easier, the other hand is telling contracting officers to slow down and make sure they are complying with the myriad Byzantine rules associated with defense acquisition.

Sure seems confusing, at least to us.

 

1 How long is “astoundingly long”? See, for example, Vern Edward’s recent blog article “When a Source Selection Takes Longer than World War II”. (“It is in the CICA requirement to evaluate cost that we find a 19th Century procurement system at work to the Government’s detriment.”)

 

Limitation of Cost/Limitation of Funds

Nick Sanders
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Many people believe that, when they receive a cost-type contract, they will be reimbursed for all costs incurred on that contract. That belief is wrong. First, the government customer will only reimburse the contractor for allowable costs (as defined at FAR 31.201-2). Costs that are not allowable will not be reimbursed. Second, there are a couple of contract clauses that impose a ceiling on the amount of costs that may be reimbursed, even if those costs are allowable. Those contract clauses are 52.232-20 (Limitation of Cost) and 52.232-22 (Limitation of Funds). The Limitation of Funds clause applies when the contract is being incrementally funded and the Limitation of Cost clause applies when the contract has been fully funded.

In order to have an adequate accounting system for government contracts, a company must show that it can comply with those contract clauses. Accordingly, it is very important that you understand those clauses and comply with them to the letter.

It’s difficult to define the clauses with much specificity, because the contracting officer can tailor them for the individual contract. Suffice it to say that the clauses require the contractor to track its costs (and earned fee) against the amount funded to date (or against the total contract’s estimated cost and fee), and report to the contracting officer before it has incurred a specified percentage of those values. Typically, the contractor must report 60 days before incurring 75 percent of the values, but that’s not a given.

Right away it’s clear that the contractor must be managing its costs and projecting its future expenditures, because if you wait until after you’ve passed the reporting values then you are already in noncompliance with the clause requirements. It’s a difficult challenge, but one that must be met in order to have an adequate accounting system and receive cost-type contracts.

The challenge is even more daunting when one has received an ID/IQ contract with multiple task/delivery orders, each with its own ceiling values. The challenge is even more daunting than that when one thinks the ceiling values are associated with the ID/IQ contract instead of the individual task/delivery orders, but then one is informed by a court that the belief was wrong. Let’s look at the recent Court of Federal Claims decision in the appeal of Interimage, Inc.

Interimage is a small woman-owned IT business, qualified under the 8(a) program to receive special set-aside awards. In 2005, the Naval Criminal Investigative Service (NCIS) awarded Interimage a cost-plus-fixed-fee (CPFF) contract. The contract contained included eleven individual delivery orders.

Interimage performed the work satisfactorily and then submitted a (single) final invoice in the amount of $990,000, which “represented the difference between the amount paid and the amount InterImage claimed it was owed for both costs and fee.” The problem was that NCIS lacked sufficient funding to pay the full amount of the final invoice. Interimage submitted a certified claim in the amount of $695.6K (the amount not paid). The contracting officer agreed but Interimage was unable to obtain payment. Interimage “was told that funding would need to come from other appropriations because the funds to pay InterImage had been de-obligated.”

Subsequently, the Navy asserted that it did not owe Interimage anything more, because “the Navy had determined that InterImage was seeking payment for both costs and fee above various delivery order ceiling limitations.”

Thus, the dispute centered on whether the contract established the limitation of cost/funds values, or whether it was each delivery order that did so. From the decision—

InterImage argues that it is undisputed that the amounts claimed for costs are within the base contract ceiling, as amended, and that the contract, and not the individual delivery orders, is controlling with regard to the contract ceiling limitation. InterImage also argues that the government’s objections to InterImage’s claim for its fee must be rejected on the ground that the government can only change the fixed fee through an equitable adjustment, which was not done. InterImage further argues that the amount InterImage has claimed for the fixed fee is justified based on the total hours of work performed under the contract as a whole.

… the government argues that the individual delivery orders and not the base contract set ceilings for costs and that InterImage is seeking payments above the ceilings set in the delivery orders in contravention of the limitation of cost and funds clauses in the Federal Acquisition Regulations (‘FAR’) and incorporated into the contract and delivery orders. With regard to the fixed fee, the government argues that InterImage’s fixed fee also must be adjusted under the terms of the contract because the delivery orders provide limitations inclusive of fee and because InterImage did not perform the required hours under certain delivery orders and is thus not entitled to the amount of fixed fee now claimed.

Judge Firestone denied Interimage’s motion for summary judgment, finding that there were issues of fact that needed to be adjudicated. In the meantime, she also found that the task/delivery orders established individual values that should be used in lieu of the overall contract values.

One of the problems was how DCAA had audited the contract and documented values in the Cumulative Allowable Cost Worksheet (CACWS). The DCMA Closeout Specialist stated “’[p]art of the issue appears to be DCAA’s audit did not limit the direct and indirect cost to the contract ceiling and funding limitations for each [delivery order] on The Schedule of Cumulative Allowable Cost by Contract.’” He also stated that he believed the DCAA’s schedule of cumulative allowable cost was incorrect in that the worksheet should have included entries for contract ceilings for each delivery order ….”

“DCAA stated that although DCAA had ‘potentially made an ‘error’ on the [cumulative allowable cost worksheet] . . . we all agree that the [cumulative allowable cost worksheet] is only a guideline for the Contracting Officer and the actual contract terms and ceiling limitations hold the ultimate authority.’”

(Contractors who have disputes with DCAA regarding the CACWS should memorize that quote, above, and use it as necessary.)

Long story short: DCAA and the contracting officer were willing to use the values at the overall contract level when establishing how much more Interimage should have been paid, but the more that Interimage complained about the lack of payment, the less willing the government was to see things the contractor’s way. Eventually the CO was switched out and a new DCAA auditor was assigned, and suddenly Interimage owed the government $434,000 instead of the government owing Interimage $700,000! (Interesting to note that the new DCAA auditor was unable to locate the working papers of the previous auditor.)

Perhaps the parties will settle this dispute, now that Judge Firestone has made her ruling. Regardless, this is a good lesson on the importance of understanding contract terms (as well as individual task/delivery order terms) and making sure one is complying with them. Among the various contract terms for which compliance is required, the Limitation of Cost and Limitation of Funds stand out as being some of the most important.

 

It’s Complicated But Northrop Won

Nick Sanders
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People who don’t know very much about government contract cost accounting and associated compliance rules think it’s just a matter of reading FAR and CAS, and there you go. Just read the rules and follow them. How hard can that be?

People who know more about the topic realize that it’s not only a matter of an individual’s interpretation of the regulations. You also need to have a basic familiarity with judicial decisions that have supplied the official interpretation. You need to understand how judges (particularly those at the Armed Services Board of Contract Appeals and the Court of Federal Claims) have interpreted those regulations and rules. And you probably need to know whether the U.S. Court of Appeals (Federal Circuit) has sustained or remanded those decisions. You don’t need to be a lawyer but it helps to have read a few legal decisions.

People who know a lot about the topic realize just how complex it is. It’s not just all of the foregoing; there are new issues constantly being raised. The truth of the matter is that reality is more complicated than the regulations can possibly envision, and so new issues arise and need to be addressed. It’s a never-ending cycle and people who do this for a living understand just how complicated some of the issues that arise can become.

Today’s article is about one such issue. It’s so complicated that we skipped writing about it in 2014, when the first ASBCA decision was issued. It’s so complicated that we debated for some time before writing about it today, just after the latest ASBCA decision was issued. Finally we decided to acknowledge the decision without getting into the (complex and complicated) details, just as a lesson regarding how deep the government contract cost accounting rabbit hole can go.

At stake was some $253 million dollars. As we’ve stated before, when the government decides to question big dollar costs, contractors will lawyer-up. They will fight. The stakes are too high. This is one of those times where there was so much money at stake that Northrop had to litigate the issue.

Note that we are not lawyers, we are not actuaries, and we are not experts in the accounting requirements associated with Post Retirement Benefits (PRBs). Northrop Grumman was represented by the top-tier inside-the-Beltway law firm of Crowell & Moring, and if you want better information we suggest you reach out to the attorneys who litigated the matter on Northrop’s behalf.

All that being said, here is a brief summary of the facts as we understand them.

  1. Prior to 1995, Northrop Grumman (NGC) accounted for the cost of its PRB expenses using a method that conformed to the requirements of the 1984 Deficit Reduction Act (DEFRA), using generally accepted actuarial principles.
  2. In 1995, the FAR was revised at 31.205-6(o). The government’s position was that the revised FAR required NGC to change its PRB accounting methodology, and to fund its PRB liability before filing of Federal income tax returns.
  3. Between 1995 and 2006, NGC continued to account for its PRB costs using the DEFRA methodology. “NGC documented its accrual costing method in the company's cost accounting standards (CAS) Disclosure Statement that was reviewed and approved by the government. No allegation was made during that period that NGC's accounting for the Plan's PRB costs using the DEFRA method was noncompliant with NGC's disclosed practices or with CAS. Further, during that period, no unallowable Plan costs were identified by DCAA in any audit of the NGC Corporate Home Office final indirect cost submissions for any period between 1995 and 2005 (the last year audited).”
  4. In 1990, the Financial Accounting Standards Board (FASB) issued FAS 106, which required a different PRB accounting method than was permitted by DEFRA. NGC implemented FAS 106 for financial reporting purposes (as it had to), but continued to use its DEFRA methodology for government contract cost accounting purposes until 2006. Importantly: “NGC's PRB costs calculated during this period were less than the costs would have been had NGC instead used FAS 106 to measure and assign costs.” (Emphasis added.)
  5. Starting in 2006, NGC entered into discussions with DCMA regarding its PRB accounting methodology. NGC initially proposed continuing to use its DEFRA methodology but, after that approach was rejected, it proposed transitioning to the FAS 106 methodology. NGC attempted to obtain an Advance Agreement for its practices, but DCMA declined.
  6. The government asserted that, had NGC used the FAS 106 method after 1995 (as it contended FAR 31.205-6(o) required), it would have had higher PRB expenses in those years. In the government’s view, NGC’s methodology shifted PRB costs from past years to future years. Because NGC hadn’t funded its PRB liability in the current period, those future costs were unallowable. “If NGC had used the FAS 106 method instead of DEFRA, the costs assigned to that period [1995 to 2006] would have been approximately $253 million more (the amount of the disallowance) than were assigned under DEFRA.”
  7. Importantly: “At some future point, costs calculated using the DEFRA method would exceed FAS 106 calculated costs, barring reduction in Plan benefits. NGC's position is that when and if the cross-over occurred, allowable costs would be limited to the amounts calculated using FAS 106 (pursuant to FAR 31.201-2(c)).”
  8. In the first decision, addressing entitlement only, the Board found that “for government contract accounting purposes, NGC failed to measure, accrue, assign and fund its PRB costs in accordance with FAS 106 and FAR 31.205-6(o) allowability criteria during FYs 1995-2006, prior to NGC's 2006 ‘transition’ to the FAR-compliant methodology.”
  9. However, in the second decision, addressing quantum (the amount NGC would owe the government for its failure to comply with the regulatory requirements), the Board found that “the government unreasonably interpreted the cost principle and ultimately suffered no damages as a result of appellant's use of DEFRA from 1995-2006 for government accounting purposes because of appellant's 2006 Plan amendment implemented concurrently with NGC's transition to FAS 106.”

See? We told you it was complicated.

Another important point is that DCMA’s own Contractor Insurance/Pension Review experts disagreed with the position taken by DCMA and, ultimately, the government at trial. The DCMA’s own actuarial experts were fine with the methodology that NGC used, and they were not at all worried about cost-shifting.

So where did the disallowance come from? Where did the DCMA’s initial disallowance and Contracting Officer Final Decision come from?

You guessed it.

DCAA.

From the (second) ASBCA decision—

NGC discussed the possible changes with the DCAA auditor who had been primarily responsible for auditing NGC's PRB costs during most of the period at issue. In those conversations, the auditor suggested that the DEFRA method was not compliant with the FAR and that NGC might have created a pool of ‘forever unallowable’ costs by failing to accrue and charge the maximum amount permitted by the FAR.

This is not the first time a DCAA theory has been rejected by a Court, as documented on this blog. When will DCMA contracting officers stop relying on DCAA auditors for anything other than audit findings? We noted that Northrop tried several times to avoid this dispute, but DCMA (possibly spurred on by DCAA) was having none of it. We’re sure that $253 million in questioned costs looked great to Fort Belvoir and was a nice addition to the DoD OIG Semi-Annual Report to Congress, but the fact of the matter is that the auditor’s flawed legal theory—which was contrary to the findings of the DCMA actual experts—wasted millions of taxpayer dollars.

Anyway, let’s wrap this up by quoting at length from the Board’s decision, written by Judge Peacock.

We consider that FAR 31.205-6(o), properly construed, establishes a cost allowability ‘ceiling,’ and focuses on whether the contractor overcharged the government for PRB costs in its relevant cost-related submissions. There is no dispute that for more than a decade preceding the ‘transition’ NGC did not. From the onset of the FAR requirement in 1995 through 2006, NGC's use of the DEFRA method resulted in the contractor annually charging the government less than it could have claimed had it elected to use the FAS 106 methodology for government accounting purposes during those pre-transition years. For that decade, the government unsurprisingly did not object. In fact, the government was well aware that appellant continued to use the DEFRA methodology but repeatedly approved its use as being in compliance with regulatory criteria. …

Interpretation of the provision with respect to ‘quantum’ was not even clear and uniform within the government. The CIPR team's analysis and interpretation differed from that proffered by DCAA and ultimately adopted by the DCE. We consider that the CIPR team correctly interpreted the principle in the first instance. …

The government interpretation advocated in this appeal regarding the pre-transition years also contradicts the general rule regarding the quantum consequences of noncompliance prescribed in FAR 31.201-2(c). That provision states, ‘When contractor accounting practices are inconsistent with this Subpart 31.2, costs resulting from such inconsistent practices in excess of the amount that would have resulted from using practices consistent with this subpart are unallowable.’ Here, NGC failed to comply with the FAR requirement that allowable costs be accrued in accordance with FAS 106 criteria where an accrual methodology was used by the contractor to determine its allowable PRB costs. Although appellant failed to use the proper accrual methodology, there is no evidence or government contention that the amount accrued by appellant pursuant to DEFRA in the pre-transition years exceeded the amount of costs that would have been allowable applying FAS 106 or even an amount calculable for the Plan using the ‘pay-as-you-go’ methodology. In fact, precisely the opposite is true. …

The requisite PRB funding levels (and costs flowing therefrom) are for NGC to determine. … It is illogical and shortsighted for the government to interpret the provision in a manner dictating that appellant must charge or should have charged the government the full FAS 106 amount, where the contractor determines it is not necessary to pay that full amount to attract and maintain a quality workforce. If NGC had done so, presumptively the excess compensation cost would also be unreasonable as beyond its agreement with covered employees as reflected in the Plan. The assignment and funding requirements are designed to protect the government from paying excessive costs. Any ‘failure’ to assign and/or fund, whether the result of the contractor's best business judgment or other factors specific to the contractor, benefits the government. …

Company-specific PRB costs in this appeal are not ‘incurred’ for government contract accounting purposes based on generic FAS 106 requirements established for purposes of cross-corporate financial comparisons and standardized public reporting. Nor is the amount of cost ‘incurred’ for government contract accounting purposes determined by, or equal to, allowability maximums calculable under the FAR. The regulation does not dictate PRB benefit levels and costs contractors must incur. It simply and solely sets a ceiling limiting the PRB cost allowable and payable under flexibly-priced government contracts. …

The government myopically alleges that appellant should have ‘assigned’ more than required by the Plan to each of those years. However, if PRB costs are not incurred, there is no requirement to assign, much less fund, ‘phantom’ costs. There is no evidence or allegation that a major contractor such as NGC would be unable or otherwise fail to fund properly incurred, measured and assigned costs. NGC funds what it properly accrues and assigns. … The regulation must be interpreted in the context of and in conformance with basic accounting principles of incurrence, assignment and accrual. …

The government has failed to sustain its burden of proving that any of the disallowed amount was or will be amortized as part of the transition obligation and claimed during the post-transition years. Its argument is founded on theoretical constructs that have no factual basis or evidentiary support here. In this case, the government's concerns were legitimate, albeit its legal and factual analysis was faulty.

(Emphasis in original.)

So sometimes government contract cost accounting can be complicated. This is one of those times. At the end of the day, Northrop Grumman spent millions of dollars on unallowable attorney fees, money that could have been used to fund IR&D projects or to attract scientists or engineers. The government took time and resources away from fighting overt contractor corruption in order to pursue one DCAA auditor’s legal theory, a theory that had been rejected by DCMA’s own Insurance and Pension experts. However, we need to keep in mind that the matter was complicated and, although the Board found the legal theory to be flawed, the situation was so complicated that it took two decisions over the course of more than three years to get to the answer.

Which may be appealed….

 
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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.