It’s inevitable, really.

Given the budget pressure on the Federal government—which already includes the use of Continuing Resolutions in lieu of budget appropriations, and may well include automatic sequestration cuts in the near future—it’s inevitable that, sooner or later, one of your contracts is going to be terminated “for the convenience” of your Federal customer.

Perhaps more than one contract will be terminated for convenience. Maybe all of your contracts will be terminated. Maybe none of them will be. Maybe it’ll be one or more of your subcontracts with a larger Prime. Obviously, we can’t predict the future with certainty (and neither can you)—but we’d bet that at least one of your current contracts will receive a T4C Notice within the next year.

So let’s say you receive the dreaded T4C Notice and you are directed to stop work immediately, wrap things up, and submit a Termination Settlement Proposal. What do you do?

Well, the first piece of advice we have for you is: Don’t Panic.

A T4C is obviously not good news, but it’s not terrible news either.

When you receive a T4C, do the following—

1. Stop.

2. Consider the situation.

3. Plan your actions.

4. Work your plan.

5. Profit.

Wait. Profit? How can you make a profit when your contract’s been terminated before completion?

Trust us, you can. You can profit on a T4C—you can perhaps make more profit than you initially planned, had the contract been performed to completion.

Before you scoff at that assertion, allow us to elaborate.

We had this client (who shall remain nameless), that had several contracts with the Department of Energy. Large ones. All the active contracts were losing money—they were hemorrhaging red ink like somebody had opened a major cash flow artery. The only (and we do mean only) contract that was recording a profit was the single contract that had been T4C’d. Termination had been the best thing that had ever happened to that particular contract. If only all the other ones had been T4C’d as well, the company might still be in business today.

So when we say that you can make a profit on your T4C, we mean it.

Back to the Termination for Convenience: when you receive that dreaded T4C Notice, you need to do a couple of things right away.

First, you need to stop work.

Now, that doesn’t mean turn off the lights and walk out the door. To the contrary, you must cease ongoing contract performance in a reasonable, prudent, and measured manner. For example, you don’t tell your procurement staff to stop work—because they need to flow down the T4C Notice to your contract suppliers and subcontractors, and they need to administer the supplier termination efforts. You also don’t stop the production machines, leaving materials in the middle of fabrication.

Instead, you take measures to shut down production like a prudent business person, and you protect the government’s interest. That means finishing production at a reasonable stopping place, carrying the finished and unfinished goods to property storage, and logging them in. That means saving all work and logging/indexing what’s been done and what’s not been done. Doing all this may take a few days. As we used to say, “You can turn off a faucet, but there’s still a few drops left to go.”

Remember, you’re going to have to justify all this work to Government auditors. So it’s not a license to permit employees to keep charging numbers beyond that which is necessary and prudent. Consider it a rapid ramp-down, or perhaps a safe landing without power. Approach the situation in a business-like and prudent manner.

(Did we mention the whole Don’t Panic thing? It’s going to become a recurring theme in this article.)

You’re going to want to establish a termination settlement charge number—separate from your ongoing program charge numbers—to accumulate the costs of preparing the termination settlement proposal. You may want to establish multiple charge numbers or a WBS in order to keep track of who’s charging what. You need to make sure that the personnel who will be working the termination settlement have a place to charge their time and expenses. In addition, you need to expect that certain indirect personnel will be charging that number as well. Yes, in the case of a termination, your finance, accounting, contracts, property, and other indirect functions may start record their time directly to that number. (You may need to figure out how to burden those costs.)

The foregoing strongly implies that you’re going to want to establish some initial budgets for the termination settlement efforts, much like you would for any project. That’s going to keep your Finance folks busy for a while; and they’ll be charging their time to the termination settlement effort as well.

Speaking of Finance, you will also need to make sure you have a current and valid Estimate-at-Completion, as of the T4C Notice date or as close to it as you can come. You need to know your actual costs incurred as of the T4C Notice Date and your at-completion variances (if any) as of that date as well. That’s going to prove to be absolutely critical downstream.

To the extent you have at-completion variances, do you understand why they occurred? Do you have contract changes for which you need to seek contract modifications via Request for Equitable Adjustment?

And along that line, do you have authorized but unfunded work? Do you have REAs in process that have not yet been approved? You need to push those along. The best people to push those issues are the program team that was in place at the time of the T4C Notice. (We’ll discuss HR issues in a second.)

The point is, you need to push. And it may be the case that your customer is going to fail to fund those authorized changes, or deny those REAs. If so, you’re going to want to file certified claims as soon as possible. Waiting until the negotiations or, God forbid, the litigation, is a really bad idea. (See, e.g,, Systems Development Corp. v. McHugh, C.A. Fed, Sept., 2011.)

The goal is to have the contract value at the time of the T4C Notice be accurate, so that you can evaluate the contract’s profit or loss position at the time of the T4C Notice. If you were at a loss position, then the loss will affect your Termination Settlement. (There’s a fairly complex formula for calculating the impact of the at-completion loss on the eventual settlement, but you don’t need to bother with it if you can show that your program was not in a loss position at the time of termination.)

All of the foregoing actions comprise early responses to the T4C Notice. All of them should be worked immediately upon receipt.

While you are working your immediate actions, your property control folks will be inventorying all government property, including raw stock, unfinished goods, and finished goods that had not yet been accepted. They have 120 days from the T4C Notice date to submit termination inventory schedules (and a request for Plant Clearance action) to the Termination Contracting Officer (TCO), using the SF 1428.

Meanwhile, your procurement folks will be working with the suppliers to receive their Termination Settlement proposals and claims. Your Finance folks will be looking at whether you need to break any leases. Your accounting folks will be looking at capital assets (including test equipment and tooling) to see if there are any items that have lost all future economic value because of the termination.

You’re going to be busy, very busy. Lots of people are going to be employed full-time in shutting down the program and preparing the Termination Settlement proposal. But even so, there may be workforce impacts. Some of your direct charging workforce may need to be reassigned or even laid-off. So your HR folks are going to be busy as well.

The key HR aspect will be to retain your program team in the face of the termination. You need to retain those people until all questions have been answered and all termination actions have been taken. We are reminded of one program termination where the staff immediately was laid-off en masse, leaving unfinished work on desks. That turned out to be a huge mistake, as the company ended up hiring consultants—including consulting engineers and consulting project managers—to painstakingly reconstruct the history of the program and determine where the at-completion variances came from. Don’t make that same mistake.

Speaking of employee retention and potential lay-offs, what are your established cost accounting practices regarding severance pay? Is severance pay charged to an indirect cost pool, or are you going to try to convince your TCO that it should be a recoverable termination cost? That’s an issue best decided early in the termination process, we believe.

And speaking of indirect costs, the loss of the terminated work may impact your forecasted indirect rates. That needs to be addressed, if only with respect to potential impacts on the non-terminated work.

You are going to be preparing a Termination Settlement Proposal (TSP). You have one year to submit it. It’s going to use special termination forms, such as the SF 1439, but make no mistake: it’s a proposal. And it’s very likely to be audited by DCAA or other similar Government auditors. Consequently, your claimed costs will need to be supported, very much as if you were submitting a cost proposal subject to the Truth-in-Negotiation Act (TINA). Here’s a link to the DCAA audit program. Take a look at it and get ready for the audit. The costs of supporting the audit may be allowable termination settlement costs!

The auditors are going to use the Cost Principle at FAR 31.205-42 as their guide regarding what costs are allowable in the TSP. Regardless of the auditors’ strict interpretation, the reality is a bit different. The FAR Cost Principles are not strictly applied to terminations; instead, the FAR establishes that that the Cost Principles are to be applied subject to the general principle that a contractor is entitled to "fair compensation." (See FAR 49.201.)

Moreover, don’t forget to read FAR 49.303-5(d), which states—

If an overall settlement of costs is agreed upon, agreement on each element of cost is not necessary. If appropriate, differences may be compromised and doubtful questions settled by agreement. An overall settlement shall not include costs that are clearly not allowable under the terms of the contract.

That language is going to be helpful in negotiating a price in response to an adverse audit report.

However, despite the helpful FAR language, the fact of the matter is that, generally speaking, your TSP will be cost-based, even if your contract was firm, fixed-price in nature. That’s going to throw some smaller contractors for a loop—especially if their accounting systems were not set up for cost-reimbursement contracts. This is where hiring SME consultants, and perhaps experienced attorneys, makes good business sense. (Those costs are allowable TSP costs as well.)

You will also have to decide whether to price the TSP via the “inventory basis” or the “total cost basis”. The total cost basis of settlement pricing is preferred for complete terminations of construction and lump-sum professional services contracts. In other cases, the inventory basis is preferred—but it’s negotiable.

Profit will be allowed on work performed up to the date of the T4C Notice. Profit will not be allowed on the post-termination settlement efforts. The amount of profit to be recouped will be a matter of negotiation.

The amount of the termination settlement will be reduced if the contract was in a “loss position” at the time of termination. (That’s where the current EAC and maximized contract value come into play.) Here’s what one law firm has to say about this—

The burden of proving entitlement to a loss adjustment is on the Government. To prevail, the Government must prove (1) the contractor operated at a loss and (2) the amount of the loss. A contractor can often avoid application of the loss formula by holding the Government to this burden. If left to its own devices, the Government often fails to meet its burden of proof.

Note: those same attorneys say that if you have a FFP contract that was T4C’d, you shouldn’t perform an EAC, because doing so gives the Government insight into your contract’s loss position, if it was in a loss position. What can we say? We disagree.

Note that we stated that the TSP is due in one year. And indeed, it may well take a full year to prepare a major program TSP, including settling with all subcontractors and suppliers. It may well take even longer to get that TSP audited and reach a negotiated settlement with the TCO. Too many contractors think that they have to wait that entire period to get paid; as a result their cash flow needlessly suffers. The reality is that there are ample opportunities to get paid along the way, especially if the terminated contract was cost-type.

For instance, the FAR permits a terminated contractor to continue invoicing, using the SF 1034, for up to six months after the T4C Notice date. (See FAR 49.302(a).) That’s ample time to get significant costs reimbursed—especially if you focus on settling with your large subcontractors first. As you settle with them, any settlement payments become your costs, and you can seek quick reimbursement.

In addition, don’t forget to use the SF 1440 (“Application for Partial Payment”) to your advantage. Our same attorney friends quoted above offer this advice regarding the SF 1440—

The partial payment request may be submitted with or after submission of the termination settlement proposal or an interim settlement proposal. Contractors may receive a partial payment that includes, in the aggregate, the following:

(a) 100% of the contract price adjusted for items completed before the termination date or to be completed after the termination date with the CO's approval.

(b) 100% of subcontractor settlements the contractor has paid that were approved by the CO.

(c) 90% of the direct costs of termination inventory including materials, purchased parts, supplies, and direct labor.

(d) 90% of other allowable costs not included above that are allocable to the terminated requirements including settlement expenses.

(e) 100% of partial payments made to subcontractors.

The Government must "promptly" process the partial payment application.

And note that those same attorneys reference an “interim” TSP. This is encompassed by the following direction provided to DOD TCOs—

• With TCO consent, proposals may be filed in successive steps covering separate portions of the contractor's costs.

• Each interim proposal must include all costs of a particular type, unless otherwise authorized by the TCO.

As a reference, here’s the link to the official DOD TSP pricing direction.

You may note that that DOD pricing direction states—

The maximum amount of a termination settlement may not exceed the sum of:

• Total contract price as reduced by:
• The amount of any payments previously made, and
• The contract price of any work not terminated;

Plus

• Reasonable settlement costs including:
• Accounting, legal, clerical, and other expenses reasonably necessary for preparation of termination settlement proposals and supporting data;
• The termination and settlement of subcontracts (excluding the amounts of such settlements); and
• Storage, transportation, and other incurred costs reasonably necessary for the preservation, protection, or disposition or the termination inventory.

The foregoing is not strictly true—especially the part about the total contract price establishing the maximum amount of the termination settlement. In certain, relatively rare, circumstances, the contractor may be entitled to recover more than the total contract price. (See Jacobs Engineering Group v. U.S., 434 F.3d 1378, Jan. 2006. Here’s a link.)

To sum up: Don’t Panic.

You have a lot of work ahead of you. There’s a lot to manage and a number of hoops to jump through. But a T4C is not a catastrophe. Instead, it’s an opportunity to demonstrate your business acumen. If you treat your T4C as its own project, you’ll find yourself doing quite well.

We are holding in our hands an article published May 15, 2012 in Bloomberg BNA’s Federal Contracts Report™. Written by attorneys of the august firm of McKenna, Long & Aldridge, it has the happy-making title of “DCAA Malpractice: Recovery of Damages.”

This topic has been much on our minds as of late. As we’ve asserted before, contractors are giving up on the idea that they can actually negotiate a reasonable resolution to some of their pesky contract disputes—notwithstanding the FAR’s clear direction to Contracting Officers that they are supposed to give negotiation their best shot. Recognizing that too many COs simply rubber-stamp DCAA’s audit findings, contractors are becoming resigned to the fact that they will have to litigate in order to get a fair, impartial hearing on the merits of their positions. As we wrote (link above)—

… we believe that a tsunami of litigation is in the works. We base that impression not on any inside information, but simply on what we’ve heard around the watercooler. We think the Top 10 defense contractors are girding their loins for some slingshot work, aimed at the giant Federal government—and we expect to have a lot to write about when the stones start flying. …

Here’s the bottom-line, in our view. If you threaten a contractor with negative impacts to its current programs, you have leverage and it will likely try very hard to resolve the issue. If you threaten a contractor with nickel-and-dime cost disallowances, it will likely settle—because doing so is cheaper than litigating. But if you threaten a contractor with multi-million dollar cost disallowances related to ancient issues that have lain unresolved for years (or perhaps even decades)—issues that have nothing to do with its current operations—then it will likely lawyer-up and drag your government ass into court. Because you have left it no other alternative.

And indeed, that’s what seems to be happening, as we reported in this article. In addition, Law360 recently reported that Raytheon has filed suit at the Court of Federal Claims, “contesting $90 million in disallowed costs” related to the company’s development of its active electronically scanned array (AESA) radar, which is currently used in F/A-18 Super Hornet Navy fighters. We don’t have any more details about that lawsuit to share with you, mostly because the rest of the story lies behind Law360’s paywall (and we can’t afford a subscription). But our understanding is that more suits, from more contractors, are in process.

Indeed, we expect to see a deluge of similar suits, each contesting some aspect of a DCAA audit finding that was (allegedly) rubber-stamped by a Contracting Officer and thrown over the transom for attorneys to litigate rather than being the subject of a negotiation aimed at reaching an equitable resolution.

But that’s not what’s got our dander up and what got us thinking that somebody, somewhere needs to sue the bejeezus out of DCAA. No.

Over at Quimba Software, their saga of audit failure and its sad aftermath continues. As does the Quimba blog reporting that sad saga. For those not following the blog and its documentation of how inequitable “the system” can be to a small business that doesn’t appreciate the complexities of how “the system” works, let us just say that Quimba’s complaint to the DOD Inspector General does not appear to be progressing well. In fact, its progress (or lack thereof) is reminiscent of other actions Quimba has taken—or tried to take.

But Quimba’s documentary of its attempts to work the maze of defense contracting—and the dead-ends that it reaches at each turn—is not what’s cheesing us off today. That’s not why we’re studying the article on DCAA malfeasance. No.

What’s really frosted our biscuits today is this decision over at ASBCA in the matter of Lockheed Martin Aeronautics Company. (ASBCA No. 56547, January 22, 2013.)

The case concerns a Contracting Officer Final Decision (COFD), issued May, 2008, that Lockheed Martin had “defectively priced” its proposal for the Common Configuration Implementation Program (CCIP), because DCAA alleged that LM Aero had failed to disclose “significantly lower prices” for the Modular Mission Computer (MMC), which was supplied via a subcontract with Raytheon. The CCIP was a program to retrofit U.S. Air Force F-16 fighters. LM Aero submitted and negotiated its USAF CCIP production prime contract proposal during 1998 and 1999. The contract price was finalized in July 1999. During this time, Raytheon was negotiating with LM Aero on the “Bridge Contract”. DCAA alleged that LM Aero failed to update its cost or pricing data on the production contract based on its negotiations for the Bridge Contract. The CO demanded the LM Aero cough-up $14.58 Million (plus interest). LM Aero declined and appealed the COFD.

DCAA issued its post-award audit report, alleging defective pricing in September 2002. So the COFD was just a hair under six years after the audit report was issued. Consequently, LM Aero did not assert that the CDA Statute of Limitations had passed (to our knowledge, anyway). But let’s note here that we are discussing as 2013 ASBCA decision about a 2008 COFD about negotiations that had taken place a full decade before that.

And people wonder if our system is broken.

Anyway, the bottom-line is that LM Aero won the case. Judge Peacock, writing for the Board, found that “any nondisclosure of the Bridge prices did not contribute to an overstatement of the CCIP prices.” Thus, LM Aero’s appeal was sustained. The decision might be appealed, of course. But right now LM Aero gets to celebrate a victory

So what’s chapping our britches? Just this: the case should never have been litigated.

According to the Statement of Facts in the decision, the original DCAA audit report confused the pricing negotiated between LM Aero and Raytheon for the MMC 3000 system—which was a fully mature production unit—with the pricing negotiated for the MMC 5000 system—which was in development and intended to supply LM Aero’s Engineering and Manufacturing Development (EMD) program. In addition, the DCAA auditors attributed non-recurring engineering development costs to the recurring costs of production, thus inflating the alleged price difference even more.

The two subcontracts had negotiated price points based on volume. Judge Peacock found that the DCAA auditors had used an inappropriate volume price point that also inflated the price difference.

In other words, the DCAA “post-award” audit was a colossal screw-up—an example of professional malpractice in which every aspect seemed designed to increase the amount of costs alleged to have been “defectively priced” rather than to reach an accurate, “apples-to-apples” comparison between the disclosed and negotiated prices of the MMCs.

But don’t take our word for it. Let’s quote Judge Peacock—

If the original price adjustment set forth in the post-award audit and final decision were recalculated by changing only the MMC 5000 system price ($382,868), the government's recommended price adjustment would have been $3,603,962 rather than the initially claimed total of approximately $14,982,578.

The government's auditor conceded at the hearing that the price of MMC systems is very sensitive to, and significantly impacted by, the AMDR [Average Monthly Delivery Rate] and a valid comparison of prices between the Bridge and MRC subcontracts requires that the AMDR be considered. If the price adjustment calculations in the post-award audit and final decision were revised using the Bridge price for an MMC 5000 system shipset ($382,868) at a 10-15 AMDR and comparing it to the proposed and lower MRC price of an MMC 5000 system shipset in the 10-15 AMDR range ($380,220) the entire recommended price adjustment would be eliminated for both years.

[Emphasis added. Internal citations omitted.]

In other words, had the DCAA auditor done a decent job, there would have been zero questioned costs. The Recommended Price Adjustment (RPA) would be zero. And the Air Force’s Revised RPA (RRPA)—in which it jettisoned the auditor’s analysis and the CO’s findings—would also have been zero.

Yes, that’s right. Realizing the fatal flaws in the auditor’s analysis, the Air Force attorneys—in a show of adversarial chutzpah, if not actually an abuse of the trial process and their positions as officers of the court—came up with their own damage theories and calculations of quantum. The Air Force RRPA theories did not impress Judge Peacock, who wrote—

There is no evidence in the record that the Air Force's RRPA and/or proposed decrement were reviewed, analyzed, or approved by, negotiators or the CO prior to its presentation in the AF cross-motion, and its assumed decrement is based solely on the above-described price reduction between the first and second period of the MRC in AMDR 4-9 range. It is otherwise unsupported by documents or testimony in the record. The post-award auditor (the only auditor who examined the RRPA after the motion was filed) disclaimed any theoretical justification for the calculation, admitting at trial that his calculations were for the purpose of ‘trying to prepare something for the trial attorney’ and not based on new information or his own independent judgment. The auditor did not discuss the RRPA with his supervisors and no supplemental audit report was issued. …

There is nothing in the record that post-trial RRPAs were endorsed by government auditors, negotiators and/or the CO. To the limited extent the calculations and assumptions underlying the post-trial revisions can be understood and analyzed without explanatory and supporting testimony, they appear to suffer from the same or similar conceptual problems and deficiencies discussed above. …

[Emphasis added. Internal citations omitted.]

So not only did the DCAA auditors and the Contracting Officer put LM Aero into the position of having to litigate something that never should have been an issue in the first place, but the Air Force attorneys delayed and exacerbated the litigation by introducing their own flawed damage theories, rather than admit the Government was wrong and had suffered no real damage, and asking the Judge to sustain the appeal. Nice job, folks.

And that’s why we’re pissed-off today.

The litigation costs forced upon LM Aero by the flawed DCAA audit, which was rubbed-stamped by the CO and formed the basis of a $14.58 Million (plus interest) payment demand, are damages. Damages might also include the burdened cost of the internal resources devoted to the litigation. Those damages stem from DCAA’s negligence and from the negligent review by the CO. We would love to see LM Aero sue DCAA and/or DCMA for the damages caused by their negligence.

If LM Aero sued for damages caused by the negligence of its government oversight officials, it wouldn’t be the first contractor to do so. See General Dynamics Corp. v. United States, 139 F.3d 1280, (9th Circuit, 1998).

But should LM Aero choose to follow in GD’s footsteps, what would its legal theory be for entitlement? That’s where we get back to the May 2012 FCR article by Tom Lemmer, Phil Seckman, and Joe Martinez. They wrote—

A DCAA failure to comply with GAGAS is a breach of professional duty, and constitutes malpractice, which creates opportunities for contractors to protect their interests. A Contract Disputes Act (CDA) litigation to overturn a decision based on a negligent audit is the move obvious example. Recovery under the CDA, however, often does not make the contractor whole from the injuries that a negligent audit can cause. … Fortunately, contractors may recover for these injuries caused by DCAA malpractice by suing the United States under the Federal Tort Claims Act (FTCA) for DCAA’s negligent acts. …

In order to establish entitlement under tort, contractors must demonstrate that, as a matter of law, the DCAA owes a duty to the contractor to audit the contractor in accordance with the applicable professional standards. Determining whether DCAA owes a duty to a contractor will depend upon the state law where the DCAA negligence occurred. … In the General Dynamics case, the district court, applying California law, held that the DCAA owed a duty to General Dynamics because the audit was intended to have an impact on General Dynamics, and it was reasonably foreseeable that a negligently prepared audit would injure General Dynamics.

[Internal citations omitted.]

Most readers would agree with the assertion that, in today’s audit environment; DCAA auditors too often forsake objectivity in its rush to “protect the taxpayers” by generating questioned costs. Most readers would agree with the assertion that, in today’s oversight environment, Contracting Officers too often fail to exercise independent judgment and instead rubber-stamp DCAA’s audit findings. As the attorneys at MLA wrote, “COs do not feel empowered to exercise the discretion and business judgment granted to them under the FAR. … The shift in authority [toward DCAA] is all the more worrisome because DCAA’s ability to meet its professional obligations repeatedly has been found lacking.”

As a result of the foregoing situation, contractors are being forced to litigate government claims that are clearly not meritorious. The LM Aero ASBCA case is a recent example of this trend. That the Air Force attorneys continued to litigate their case in the face of the obvious flaws in their position does not excuse the initial failures of DCAA and DCMA.

Sooner or later, a contractor is going to get fed up with the situation and sue DCAA for malpractice under the FTCA. We suspect it will be sooner, rather than later. And LM Aero would seem to have a strong case, should they decide to go in that direction. But if it’s not LM Aero, it will be somebody else.