And Speaking of Terminations
Recently we had occasion to comment on the end of the 23 year-long termination of the Navy’s A-12 stealth fighter program. Now we’ve come across another termination that seems worthy of comment. It’s the VH-71 Presidential Helicopter program, known as the “Kestral.”
The development contract was awarded by the US Navy to Lockheed Martin and Augusta Westland in 2004. As Flight Global reported in 2009—
The aircraft was marketed as a relatively simple adaptation of the successful EH101 helicopter. However, new requirements imposed on the programme after contract award forced the USN to launch a major re-design. The delays and cost overruns plaguing the VH-71 Kestral have become a rallying cry for reforming the DOD acquisition system.
Sound familiar?
Defense Industry Daily reported—
… the total amount paid to Lockheed over the entire contract ends up costing the taxpayer about $2.2 billion. The biggest reason for all that waste is a President’s own office that couldn’t stop adding requirements, but enforcing Navy certification requirements on a helicopter designed to commercial aviation standards wasn’t helpful, either.
Inside Defense reported that the final Termination Settlement payment was $91.1 million. That final payment included “$38.5 million for completed work and $51.6 million in termination fees.” According to the same source, “that brings the termination total to about $203 million.” Thus, it seems that the termination settlement expenses were roughly nine percent of ITD program costs.
Remember that longish article we wrote about Boeing and its inability to get the government to reimburse it for its settlement expenses, because Boeing had exceeded the Limitation of Funds ceiling? Well, when you are tracking your costs for compliance with the LoC/LoF clauses, we suggest you add another eight to ten percent on top of those costs, to cover your termination settlement expenses.
Just a thought ….
The Importance of the Limitation of Funds Clause
As consultants to a diverse group of government contractors, we frequently find ourselves in the position of having to explain requirements associated with various solicitation provisions and contract clauses. Our readers know, of course, that there is a host of provisions and clauses with which to comply, each with individual requirements. Some of them are fairly well known and most everybody has a fair idea of their basic compliance requirements; but others are less well understood and tend to fall towards the bottom of the compliance checklist.
The Limitation of Cost (LoC) and Limitation of Funds (LoF) clauses are two of the latter set. They’re insidious little clauses, because they seem so straight-forward and yet shift risk in subtle and far-reaching ways. A write-up of the clauses from the law firm of Watkins Meegan is entitled, “Two FAR Clauses that Are Sometimes Overlooked,” and, indeed, the clauses are often overlooked or ignored.
Let’s be clear: Contractors ignore the LoC/LoF clause requirements at their own peril.
The two clauses go together because they basically have the same set of requirements. The LoF clause (52.230-21) pertains to cost-type contracts that are incrementally funded, and the LoC clause (52.230-20) pertains to cost-type contracts that have been fully funded. Essentially, the clauses act to limit contractors’ ability to seek reimbursement for otherwise allowable costs they’ve incurred on their cost-type contracts.
It seems counter-intuitive that contractors would be limited in the amount of costs they could recover from their government customers. After all, doesn’t the fact that the contract is a “cost-type” mean that all allowable costs will be reimbursed? It’s the fixed-price contract types that have ceilings on contractor costs. Cost-type contracts are supposed to be low risk because they don’t have any such ceilings. The contractor incurs costs and, if they’re allowable, then the government reimburses them. How can cost-type contracts have cost limits?
We’ve heard that position being espoused many times over the years, and it’s wrong. The LoC/LoF clauses are what make that position wrong. The two clauses establish limits on recoverable costs incurred on cost-type contracts. It’s more than that, actually. The clauses require advance notification of expenditures before they reach certain prescribed limits. If the contractor fails to comply—and comply exactly—with the clause requirements, then the government has the right to refuse to pay allowable costs incurred for the contract if they exceed the specified ceiling. By failing to comply with the LoC/LoF clause requirements, the contractor has essentially converted its cost-type contract into a firm, fixed-price contract. That’s really not a good thing.
We’ve noted it in this blog when contractors run afoul of the clause requirements. For example, in this story we wrote about a hapless contractor that “had failed to comply with the administrative requirements of the Limitation of Cost clause and thus no increase to the contract value would be forthcoming,” but we’ve never really focused on the matter. We remedy that oversight today.
We’re going to assume that you, the reader, are going to mosey over to a FAR site and check out the exact wording of the clauses. We’re going to assume that you are going to actually read your contracts and make sure you understand what your contract clauses require of you. Thus, we are not going to recapitulate the standard FAR clause language here. It’s your responsibility to figure out what you need to do, not ours.
Unless you want to hire us. In which case, let us know how we can assist you!
Instead of reciting the clause language, we are going to focus on a recent decision over at the Armed Service Board of Contract Appeals (ASBCA) in which Boeing learned the hard way about the requirements associated with the LoF clause. Note: this is Boeing we’re talking about—one of the largest defense contractors in the USA. So if Boeing hasn’t figured out the clause requirements with respect to all of its defense programs, you may rest assured that the answer is far from obvious. Here is an opportunity to learn along with Boeing, and for a very small fraction of the company’s cost.
Let us set the stage for you.
Boeing had a cost-plus-award-fee (CPAF) engineering services contract, awarded by the US Air Force. The contract was a Task Order type, meaning that the government would issue orders for certain amounts of services from time to time. Crucially, the contract was “incrementally funded”—meaning that the government would dole out certain amounts of funding from time to time. The contract period of performance encompassed one base year and nine (9) option years.
One Task (Contract Mod 112) was an engineering assignment for Boeing to design, develop, fabricate, install, test and FAA certify a Global Air Traffic Management System for 3 KC-10 aircraft. (That Task was called "the KC-10 GATM assignment".) The specified total estimated cost-plus-award-fee for the assignment was $79,250,000. The specified completion date for the assignment was 30 April 2003. Contract Mod 112 also increased the obligated (allotted) funds in the contract Schedule to a total amount of $133,123,763.97.
The thing about cost-type contracts is that they don’t always go as planned. If the parties could foresee every eventuality, they likely would not use a cost-type contract format. The KC-10 GATM assignment did not seem to go as planned. On 7 January 2002, bilateral Mod 179 increased the total estimated cost-plus-award-fee of the KC-10 GATM assignment to $97,477,602.00 and extended the period of performance to 31 March 2004. On 11 August 2003, Boeing reported to the government that the GATM assignment would not be completed until 31 March 2005 (a two-year delay) and that it was willing to enter into "a Cost Share Arrangement” so as to complete the Task.
A month later (10 September 2003), Boeing and the government “agreed in principle” that the KC-10 GATM assignment would be continued on a cost-reimbursable basis "upon agreement of a new EAC [estimate at completion] and schedule between Boeing and the Government". On 24 September 2003, Boeing provided the government with a schedule showing completion of the assignment on 30 September 2005 (note another six month delay) and an estimated cost at completion of $154.7 million (a cost-growth of roughly $57 million against the original budget of $97.5 million).
As you might suspect, the Air Force customer was not thrilled with the state of affairs. Indeed, although the customer provided some additional funding, it was not as much as Boeing forecasted it would need. On 15 October 2003, Modification 220 increased the total estimated cost-plus-award-fee for the KC-10 GATM assignment to “only” $107,309,826 and extended its performance time to 31 March 2005. A couple of more Mods increased the available funding to $121,603,858—still significantly below the amount Boeing had told the Air Force it would need. Apparently, that was as much funding as the Air Force was willing to provide to Boeing.
After roughly three months of negotiation, on 10 March 2004, the Contracting Officer issued a Stop-Work Order to Boeing. A couple of weeks later, he issued a Termination for Convenience Notice, terminating the KC-10 GATM assignment.
(Familiarity with the T4C process is going to be assumed. If you feel as if you need some background reading, try this piece.)
In response to the T4C Notice, Boeing terminated its subcontract with Honeywell. A few months later, Honeywell submitted its Termination Settlement Proposal (TSP) and asked Boeing for $22,100,059. Boeing looked at that request and then notified its Termination Contracting Officer (TCO) that it would need as much as $154 million to pay off various supplier claims and settle its own situation. (Funny how that amount was really, really, close to the $154.7 million it had told it customer it would need to finish the assignment.) The TCO replied to Boeing’s notification as follows—
It is rare that the TCO requests additional funds to be added to the terminated cost type contracts. There are, at times, the PCO may have reason(s) to add additional funds to the terminated cost type contracts. However, the Government, usually, will stand by the ‘Limitation of Funds’ clause. Per your funding status, we only have $4,719,870.15 remaining in the contract.
Apparently in denial over its financial situation, Boeing came back with another request for more funds, to which the TCO replied—
I have discussed with you before in that this contract is a cost type contract, and the ‘Limitation of Funds’ clause does apply; therefore, no additional funds will be requested. The amount remaining in the contract is it. As discussed earlier, if for some reason the PCO wants to obligate more funds to the contract, he can do so.
Boeing continued to act as if it were ignorant of its precarious financial position, going so far as to submit a “Settlement ROM Proposal” in which it asked for $37.1 million in additional funds. The government did not deign to reply to that request.
Meanwhile, Boeing and Honeywell settled for $10.8 million (roughly 50 cents on the dollar). The Honeywell settlement figure was included in Boeing’s certified TSP, which was audited by DCAA. DCAA “questioned all but $182,185 of the $10.8 million settlement,” and the TCO refused to approve it. On 3 August 2010, the TCO issued a final decision denying ratification of all but $280,294 of the $10,800,000 Honeywell settlement agreement. The final decision was based “primarily on cost allowance [allowability?] and cost allocation grounds, but also invoked the LoF clause as a bar to recovery of any amount that would exceed the funds allotted to the KC-10 GATM assignment.”
Boeing appealed that TCO final decision to the ASBCA.
Judge Freeman first found that the LoF clause applied to the total contract funding and not to the funding of individual Task Orders. This is an important finding because it contradicts other decisions in which each Task Order was found to be a separate contract. (See, for example, this article.) However, Judge Freeman reasoned that the government intended the LoF clause to apply to the entire contract as a whole because there was another contract clause (H-841) that also covered funding allocated to individual Task assignments, and he need to interpret the contract has a whole, giving meaning to all clauses. Readers interested in that aspect of the decision are invited to go read it (page 8).
However, the rest of the decision did not go Boeing’s way.
Judge Freeman found that the Government never promised to increase contract funds to the level sought by Boeing. Importantly, the Judge found that there had been no agreement on the EAC or the performance schedule. Furthermore, the Judge didn’t agree with Boeing’s argument that, by terminating the contract when it was in an overrun condition, the Government waived the LoF requirements. He wrote—
Boeing had notice that the government considered the LOF clause to be applicable to the termination settlements eight months before it concluded the Honeywell settlement agreement. Boeing also knew, or is chargeable with knowing, the terms of the LOF clause, the amount of the allotted funding in the contract and the amount of its incurred costs in performing the contract. Subparagraphs (f) and (h) of the LOF clause expressly provided that Boeing was not obligated to incur, and the government was not obligated to reimburse, any costs of performing the contract, including termination activities, that would exceed the allotted funding in the contract. If Boeing did incur termination costs in excess of the allotted funding, it was a volunteer and did so for its own account.
In other words, Boeing should have included potential subcontract termination liability in its “incurred” costs when reporting pursuant to its LoF clause requirements. When that calculated number approached the funding amount provided by its USAF customer, it should have stopped work. Because Boeing exhausted the funding before subcontractor termination settlement liability was incurred, it was not able to have its subcontractor settlements reimbursed, even though it had received a Termination for Convenience.
This is a great lesson on how the two little understood clauses (Limitation of Cost and Limitation of Funds) turn out to be critically important when a contractor wants the government customer to fund an overrun on a cost-type contract.
Do not ignore the Loc/LoF clause requirements.
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A-12 Nightmare Finally Over
The A-12 is the poster child for a failed defense program.
Don’t take our word for it. Read this article written by Herb Fenster, Esq. and published in 1999 in the U.S. Naval Institute’s Proceedings. It’s called: “The A-12 Legacy: It Wasn’t an Airplane—It Was a Trainwreck.” It’s really a very important set of observations regarding how the Navy put General Dynamics and McDonnell Douglas into the firm, fixed-price, mess they found themselves in, and the implications of Secretary of Defense Dick Cheney’s program Termination for Default, which lasted through multiple rounds of litigation starting in roughly 1992 and lasting through until very recently. Even the Supreme Court of the United States weighed-in on the never-ending litigation circus.
Mr. Fenster summed up the situation in a footnote, as follows—
Eleanor Spector was DoD's most knowledgeable procurement executive. She had the additional advantage of having spent several years at NavAir. She later revealed what knowledgeable procurement people all know: A program such as this to produce a new highly sophisticated aircraft, incorporating unproven technologies to accomplish unproven mission objectives presented huge risks. She also had the advantage of having been advised of these risks by Brigadier General Keith Glenn, U.S. Air Force, who had been the B-2 program director and was then functioning as the special access programs director for DoD. He had told her, in unequivocal terms, that the program was far too risky for fixed-price contracting.
In another article published in Air Force Magazine just after the program was terminated, author David Montgomery wrote—
The Secretary's summary execution of the A-12 abruptly ended the saga of a plane that, six months earlier, enjoyed broad congressional support and appeared problem-free. The stealthy, carrier-based attack plane had been naval aviation's top priority since 1984. What caused it to nosedive from preeminence to oblivion?
Investigators and officials place the blame on four factors:
- Overly protective Navy officials, who didn't want to endanger the plane by pointing out problems. A Pentagon analyst first detected a possible cost overrun two years ago, but the Navy program manager continued to describe the A-12 as being on track until after a major Pentagon review last year.
- A ‘don't-rock-the-boat’ segment of the Pentagon bureaucracy, which was aware of the problems but apparently reluctant to buck its superiors to press its case. In one incident, a report noting A-12 problems was tucked away and forgotten.
- Overly optimistic A-12 contractors, who miscalculated the extent of the technical difficulties in producing such a plane and shielded the problems from the government. An inquiry by Navy Deputy General Counsel Chester Paul Beach found that General Dynamics and McDonnell Douglas discovered "increasing cost and schedule variances" but did not alert the Navy in a timely fashion.
- Excessive secrecy, which blanketed the project and prevented examinations that might have brought problems to light. Officials assigned to Secretaries Cheney and Garrett were kept away, standard reporting procedures were abandoned, and information was transmitted verbally rather than in writing.
One important outcome of the A-12 debacle was a critical look at the Earned Value reporting metrics used by the program, which eventually led to a reinvention of EVMS in the early 2000’s. Another important outcome was the recognition that use of cost-based progress payments didn’t reward contractors for making progress; instead, they rewarded contractors for spending money. That recognition led to the creation of Performance-Based Payments in the late 1990’s, which are still considered to be the Federal government’s “preferred” contract financing option, despite Shay Assad’s direction to walk away from their use.
But although there were some positive outcomes, they did not outshine the problems with the program and its termination, much like a silver lining fails to outshine the dark clouds accumulated over 23 years of constant litigation.
The parties finally reached a settlement a week ago, as reported by Reuters. At one point, the government wanted the contractors to repay about $1.5 Billion each, and the contractors wanted to keep their progress payments plus get another $1 Billion plus interest.
Reuters reported that the contractors will not have to repay their progress payments, but the government will not have to pay anything more. In addition, “the Navy will receive three EA-18G electronic attack aircraft from Boeing, and a $200 million credit from General Dynamics toward its work on a new DDG-1000 destroyer.”
So that’s it then.
Our long national nightmare is over.
The multitude of attorneys involved in the legal battles can get back to other clients.
And the Navy will make do with its F-35 variant.
Confusion Concerning Allowable Compensation
The Federal Acquisition Regulation (FAR) (also known as Title 48 of the Code of Federal Regulations) establishes the general rules for cost allowability—i.e., the rules regarding which costs the government will pay for and under what circumstances it will pay for those costs. Now that’s not the only thing the FAR establishes, not by a long shot. But it’s the part we are going to discuss today.
We say the FAR “establishes the general rules for cost allowability” because the FAR has supplementary regulations that may apply, depending on which Department or Agency of the Executive Branch you are dealing with. For example, the Department of Defense has its own “Defense Federal Acquisition Regulation Supplement” (aka, “DFARS”). Digging deeper, there may be additional rules and regulations established by local commands. For example, there’s a FAR Supplement for the U.S. Army. And there’s another one for the U.S. Air Force. Et cetera. You get the picture.
So the FAR is not the be-all-and-end-all in the discussion of cost allowability. But it is the start of the discussion.
The FAR establishes cost allowability rules in Part 31 (“Contract Cost Principles and Procedures”). Subpart 31.2 (“Contracts with Commercial Organizations”) discusses cost principles and procedures that are to be followed by for-profit entities that do business (or want to do business) with the Federal government. Subpart 31.2 can, somewhat simplistically, be broken down into two pieces: nine “general principles” (called by the late Mel Rishe “the cornerstone principles”), and principles governing “selected costs”. There are 52 selected cost principles (though several are “reserved” and Not Applicable to contractors). So for-profit contractors need to be aware of about 55 individual rules governing cost allowability.
(Note: We are of course eliding any discussion of the Cost Accounting Standards (CAS) found in Part 30 or contract financing/billing rules found in Part 32.)
Looking at the roughly 55 individual cost allowability rules, there is one rule that stands out among all the others, because of its complexity and sheer length and breadth of coverage. We’re talking about the Cost Principle found at 31.205-6, Compensation for Personal Services. Actually, there are (at least) 17 separate rules found within that single Cost Principle, ranging from 31.205-6(a) (“general rules”) to 31.205-6(q) (“allowability of employee stock ownership plans”). It covers such wide-ranging compensation topics as back pay, severance pay, pension costs, bonuses and other incentive compensation, postretirement benefits, fringe benefits, etc. It’s a bear.
It’s an intentially complex Cost Principle for a variety of reasons, likely the foremost of which is the notion that the biggest driver of contractors’ costs is their labor costs. (Actually, with advances in factory automation, telecommunications/information technology, and process streamlining, we’re not sure that’s a valid assumption any longer. But we digress.) In addition, it’s undeniable that contractors have, in the past, “gamed” compensation costs to their benefit. For example, waiting until just before the books close at year-end in order to see how room there is in the estimated indirect rates for incentive compensation, and then awarding incentive compensation based on that amount of “room” is one way contractors have gamed their compensation costs—to their benefit and presumably to the detriment of their government customers, who may have ended-up paying less had a different methodology been used. As the government (and Congress) became aware of the compensation “games,” the rules evolved in order to close the regulatory loopholes that permitted them. Thus, here we are today, with a bear of a Cost Principle with which to comply.
Another important factor to consider is the impact of Federal government employees, the buyers and program managers, and quality assurance specialists, and cost monitors, and auditors, and pricing analysts, and logisticians, and all the folks who belong to the American Federation of Government Employees (AFGE). Not to engage in union-bashing (because we support the right of employees to organize and engage in collective bargaining), but it’s a fact that AFGE has, for years, waged a war against a perceived inequality between private sector compensation and benefits, and the compensation and benefits offered to Federal employees. In fact, as recently as its official 2013 “Issue Papers,” AFGE called for “capping taxpayer subsidies for contractors at $200,000 per annum” and devoted several pages of single-spaced arguments to supporting its position. The attacks by AFGE and others on contractor compensation have resulted in complex and somewhat arbitrary compensation “ceilings” that limit the amount of allowable employee compensation that can be priced and billed to the Federal government.
We have written several articles on the perceived inequality between civil servant pay and private sector pay. We finally concluded that there is insufficient information to reach a conclusion—and that there were too many contradictory studies for anybody to reach a conclusion. (Here’s a link to that article.) We have also attacked the notion that the compensation paid to contractor executives (who may be helming companies in which Federal revenue is but a pittance of total corporate sales) is a valid target for rule-makers. We opined that it would have long-term repercussions on the quality of the defense industrial base. We argued setting compensation allowability ceilings too low (e.g, at $200K or $230K) would be a bad idea.
But our opinions and arguments didn’t really stop Congress from passing Section 803 of the 2012 National Defense Authorization Act (NDAA), or Section 864 of the 2013 NDAA. Nor did it stop the FAR Councils from issuing an extremely complex and problematic interim rule in June, 2013, revising 31.205-6(p) employee compensation limits. We wrote about that piece of nefarious mischief right here.
Which brings us, by perhaps roundabout means, to the topic of this article: what the heck has Congress done to contractor compensation ceilings this year? Depending on what bill you read (either the Bipartisan Budget Act of 2013 or the 2014 NDAA), you get a different compensation cost allowability answer. In the Budget Act, allowable contractor compensation was capped at $487,000. In the 2014 NDAA, allowable contractor compensation was capped at $625,000. How is a contractor supposed to know what the official limit is? The attorneys argue that the ceiling imposed by the bill signed last governs, but we’re talking about a 24 hour timing difference. Does that really make a difference? Well, according to all the inside-The Beltway attorneys, yes. It does. Thus, according to pieces from Jenner & Block and Crowell & Moring, contractors should be working with the lower of the two compensation ceilings.
In fact, the world-class government contracts attorneys at Crowell & Moring prepared a really handy summary of the various compensation ceilings with which Federal contractors must comply. Here’s a link to that essential summary. It illustrates just how complex and confusing the contractor compensation situation has become. The Crowell & Moring attorneys describe the situation as “confusing, inconsistent, and in some cases unenforceable.”
But remember, dear readers, that contractors must comply with the Cost Principles in effect at the time their contract is awarded. If the FAR Councils revise the Compensation Cost Principles after contract award, perhaps in response to legislation such as the Bipartisan Budget Act or the NDAA, then the changes do not apply to that contract. (Yeah, some of the Compensation Cost Principle changes attempt to apply the changes retroactively. Thus: the comment about unenforceability.) Any attempt to apply post-award cost allowability requirements to an awarded contract should at least result in an equitable adjustment to the contract price. Failure to provide that adjustment may be deemed to be a contract breach. If you have a Federal customer attempting to apply post-award allowability requirements to your awarded contract, you probably want to consult a knowledgeable and experienced attorney, just like the ones at Jenner & Block or Crowell & Moring.
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