Readers of this blog should not be surprised by the news that DCAA is going to stop auditing all the final indirect cost billing rate (“incurred cost”) proposals submitted by contractors and, instead, will adopt a “risk-based” approach that will involve waiving audits on a subset of those proposals. There have been many signs foreshadowing this new approach and it’s a fairly predictable tactic when one realizes just how ginormous of a backlog is crushing the file cabinets of DOD’s premier audit agency. So let’s not waste energy getting too upset about it; instead, let’s look at the new approach, which was spelled out in a July 6, 2012 memorandum from Pat Fitzgerald’s office to Richard Ginman (Director of Defense Procurement and Acquisition Policy). Mr. Ginman transmitted that memo along with an official DFARS Class Deviation marking his official approval of DCAA’s new approach and implementation within the DAR System.

Here’s a link to the various documents we’ll be discussing.

Let’s start with DCAA’s new approach. As detailed in the DCAA memo to Mr. Ginman, the new audit approach starts with an assessment of the adequacy of the contractor’s proposal to establish final billing rates. Unfortunately, the memo continues the usurpation of official Contracting Officer authority by blithely declaring, “if the incurred cost proposal is not adequate and the deficiencies cannot be remedied with minor effort, the proposal will be returned to the contractor with written instructions on required corrective actions, in accordance with CAM Chapter 6.”

Notice, readers, that no mention is made of the language found at FAR 42.705-1(b) that states—

The required content of the proposal and supporting data will vary depending on such factors as business type, size, and accounting system capabilities. The contractor, contracting officer, and auditor must work together to make the proposal, audit, and negotiation process as efficient as possible. … The cognizant auditor will review the adequacy of the contractor’s proposal for audit in support of negotiating final indirect cost rates and will provide a written description of any inadequacies to the contractor and contracting officer. If the auditor and contractor are unable to resolve the proposal’s inadequacies identified by the auditor, the auditor will elevate the issue to the contracting office to resolve the inadequacies.

We’ve ranted before about DCAA’s policy that effectively writes the Contracting Officer out of the picture, by making the adequacy determination on its own, despite the clear regulatory authority granted to the CO. This is more of the same, only this time Mr. Ginman appears to be endorsing DCAA’s claim of authority. We wonder what Mr. Williams has to say about that?

Anyway, once the DCAA auditor has determined that the contractor’s proposal is adequate, the next step is to look at the “auditable dollar value” (or “ADV”) being proposed. The term “auditable dollar value” has never (to our knowledge) been officially defined, but our understanding is that it means the value of all flexibly priced contract activity. In other words, if you add up the value of the cost-reimbursement and Time & Material type contracts (burdened at the proposed final billing rates), then that’s the ADV number. If the ADV is $250 million or more, then the contractor’s proposal definitely will be audited. If the ADV is less than $250 million, then the proposal will be “assessed for risk.” Some of those submissions will not be selected for audit. Ever.

The risk assessment is (apparently) primarily based on the amount of “exceptions” found in the audit of the contractor’s previous year’s submission. The term “risk assessment” is itself perhaps a bit misleading, since DCAA only classifies the submissions as either “high” or “low” risk. It’s a binary determination with no gradations of scale. So the “assessment” is simply putting the submission into one bucket or the other.

Being assessed as a “low risk” proposal is a good thing, because that will allow DCAA to treat the submission differently than it will be treating “high risk” submissions. Being assessed as “low risk” means that there’s a decent chance the contractor’s submission will not be audited, whereas all “high risk” submissions will be audited.

In order to be classified as a “low risk” proposal, the submission must meet all of the following criteria:

• DCAA must have performed at least one previous incurred cost audit on the contractor.

• DCAA must have no identified “significant audit leads” or “other significant risks” such as inadequate business systems whose identified deficiencies “would have a significant impact on the final indirect rate proposal” for the Fiscal Year being submitted.

• In the previous incurred cost audit(s), DCAA must not have questioned a “significant total exception” amount. The guidance includes a table that defines “significant total exception” amounts in terms of ADV. For example, for an ADV between $50 and $250 million, any questioned costs in excess of $100,000 would be considered to be a significant amount.

All submissions that do not meet the criteria for being assessed as “low risk” will be assessed as being “high risk”. As noted above, the key difference between “high risk” and “low risk” submissions is that not every low risk submission will be selected for audit. The lower the ADV, the less chance a “low risk” submission has of being audited by DCAA. For example, only one out of 5 low risk submissions with an ADV of between $50 and $250 million will be audited by DCAA. The other 4 submissions will not be audited. Ever.

(For the record, we noted that the memo states that every contractor submitting a proposal to establish final billing rates, where the ADV is between $50 and $250 million, must have a proposal selected for audit at least once every three years. That direction will tend to compensate for the otherwise 20% chance of being audited in any particular year.)

To continue, only one percent of submissions with an ADV of $1 million or less will be selected for audit. Yes, you read that correctly. Of all contractor submissions with an ADV of $1 million or less, only one out of a hundred will be audited. The other 99 will not be audited. Ever.

And for those particular low-value ADV submissions, that percentage is to be applied to contractor proposals received after 9/30/2011. Any proposals in that ADV range that were received by DCAA before that date, and for which field procedures have not yet started, will not be audited. At all.

None of them.

We encourage readers to review the DCAA risk sampling table found on Page 2 of the DCAA Process Description to determine the likelihood of your incurred cost submission being audited, based on ADV value (assuming you believe it might qualify as being “low risk”.)

If your submission is not selected for audit, how will your cognizant Administrative Contracting Officer negotiate final billing rates with your organization? How will you close-out your completed contracts? The DCAA Process Description includes a section covering “closure methods” to be used in such circumstances. There are two parts to the new DCAA closure method.

1. DCAA will issue a Memorandum to the cognizant Contracting Officer, listing the audit steps taken to assure that the contractor’s submission was “adequate”. (As if this had anything to do with the propriety of the claimed costs.)

2. DCAA’s internal records will record the ADV as “dollars examined” with a code that states “Assignment completed but no report issued.” Questioned costs and total exception dollars will be reported as zero.

And that’s it.

How DCAA will get from “was not selected for audit” to “dollars examined, assignment completed, but no report issued” is a bureaucratic mystery too impenetrable for us to fathom.

But we should note that we think the number of contractor final indirect billing rate proposals that will actually be classified as “low risk” is likely to be relatively low. The criteria DCAA has established for assessing a submission as “low risk” are actually going to be tough for many companies to meet. For example, former DCAA Director Stephenson once testified that as many as two-thirds of contractor business systems were inadequate. If that testimony was accurate, then none of those contractors will have their final billing rate proposals assessed as being “low risk” by DCAA. Thus, we expect that many contractors will see their submissions targeted for audit, regardless of the size of their ADV.

What is DCMA going to do with DCAA Memoranda it receives, the ones that have no questioned costs or total exception dollars? How is DCMA going to negotiate final billing rates with no DCAA audit report on which to rely?

Our sources tell us that DCMA is preparing guidance to its Contracting Officers even as we type these words. In the meantime, Mr. Ginman issued a DFARS Class Deviation that permits DCMA Contracting Officers to use the DCAA Memoranda “for purposes of satisfying the audit requirements at FAR 4.804-5(a)(12), 42.705-1(b)(2), and 42.705-2(b)(2)(i).” We’re not quite sure how a Contracting Officer will actually use the DCAA Memoranda as the basis to negotiate rates—since it will not be expressing any opinion on those rates—but, again, that’s a bureaucratic mystery too impenetrable for us to fathom.

Consequently, it seems that DCMA Contracting Officers are being directed to proceed with negotiating final billing rates whether or not they actually have an audit report to use. That ought to speed things up! The buying Commands might be able to finally close some ancient contracts. (And let’s be clear that this is direction with which we are in complete agreement. DCMA should stop relying on DCAA like a crutch and start negotiating regardless of what DCAA has said or not said.)

While DCMA is trying to figure out how to negotiate indirect rates with its contractors, DCAA has figured out how to reduce its incredible backlog in one fell swoop, and without performing any audits. That would seem to be a doubleplusgood outcome from a bureaucratic point of view, and no doubt many contractors will like the new approach as well. But we wonder what POGO and Congress and GAO will make of it?

Finally, we noted that Mr. Ginman stated in his Class Deviation that DCAA’s new approach was not really a change from DCAA’s past audit practices. He stated that “this DCAA policy represents a continuation of a risk-based sampling process in use since 1994.” Well, if that’s true, we wonder why his Directorate felt that a Class Deviation was necessary in order to implement it. Perhaps, like Mr. Fitzgerald, Mr. Ginman also believes that Oceania has always been at war with Eastasia?

We have another U.S. Court of Federal Claims decision to discuss today. But before we do so, you need some background.

1. Sikorsky Aircraft Corporation has been enmeshed in complex litigation with the U.S. Government over an alleged noncompliance with Cost Accounting Standards (CAS 418), appealing the Government’s demand for roughly $80 million at the Court of Federal Claims. In December 2011, we told readers about the factual background of the case and expressed some layperson-type approval for Judge Lettow’s interpretation of the requirements found in CAS 418. Subsequently, Judge Lettow ruled against the Government’s argument that its claim was not time-barred by the Statute of Limitations found in the Contract Disputes Act of 1978 (as implemented in the Federal Acquisition Regulations). As we told readers, the Judge helpfully ruled that an agency’s administrative procedures—even those mandated by the FAR—do not act to delay accrual of a Governmental claim. The clock starts ticking when the Government knew—or should have known—that it had suffered an injury. Period. That’s not to say the Judge Lettow ruled for Sikorsky that the Government’s claim was time-barred; rather, the Judge simply ruled against the Government’s argument as to why it should not be time-barred, finding there were genuine issues of material fact that needed to be addressed in a trial.

2. The DCAA has recently issued audit guidance that (1) auditors are to report that a contractor is denying them access to records when the contractor asserted that any of its records were protected by attorney-client privilege, and (2) auditors are to obtain contractors’ internal audit reports (and, where helpful, the associated working papers), and to report that a contractor is denying them access to records if the contractor refuses to provide the requested information—even when the contractor asserts that that requested internal audit reports were generated under attorney-client privilege. We discussed the two pieces of audit guidance right here. Our concerns revolved around the fact that Courts have consistently denied DCAA access to contractors’ internal audit reports—whether or not they were prepared under attorney-client privilege. DCAA seems to be ignoring legal precedent in its quest for contractor information. Attorney Karen Manos’ excellent article on the topic can be found over here. Further, we were concerned about DCAA’s attack on the time-honored concept of attorney-client privilege. As Ms. Manos noted (and as we subsequently wrote about), disclosing attorney-client privileged documents to DCAA may well result in a broad waiver of that privilege, to the detriment of the contractor. So it’s kind of a big deal and every contractor’s counsel should be in the process of drafting policy positions regarding what information will and will not be released to DCAA.

With that background in mind, let’s now look at Judge Lettow’s September 13, 2012 decision in the continuing Sikorsky CAS 418 litigation, in which he ruled on a motion by the Government to strike e-mails between DCAA auditors (used by Sikorsky as evidence in its arguments that the Government’s claim was time-barred by the CDA Statute of Limitations), because those e-mails were subject to the “deliberative process privilege.”

Yeah, you read that right. The Government asserted that e-mails between DCAA auditors were subject to privilege and should not be disclosed to the contractor, even though the contractor is using those e-mails in its appeal of a Government claim for some $80 million dollars.

On one hand the DCAA is mounting a concerted attack on attorney-client privilege and may well be recommending that contractors’ costs be suspended if the contractor refuses to provide protected documents—and this is with respect to an ongoing audit where no wrong-doing has been alleged. But on the other hand, DCAA has declared that its own internal communications (where no attorney was present) are privileged and should not be provided even in the midst of on-going litigation, where the contractor might use those communications to its advantage.

The hypocrisy burns, doesn’t it?

Judge Lettow explained the situation thusly—

Germane to Sikorsky’s statute of limitations defense is the string of e-mails (identified as ‘Exhibit P,’ …) at the nexus of the current dispute. Exhibit P comprises exchanged e-mail messages between Mr. Robert Boyer, an auditor, and Ms. Janice Berardi, his superior at the Defense Contract Auditing Agency (‘DCAA’), regarding audits of Sikorsky. The exhibit has an extensive history in this litigation. It was originally produced to Sikorsky by the government on February 17, 2011, more than eighteen months ago, as part of an unremarkable (and unremarked) set of discovery responses. … Five months later, on July 20, 2011, Sikorsky deposed Mr. Boyer and questioned him about Exhibit P, without any contemporaneous objections from the government. … At the end of Mr. Boyer’s deposition, however, counsel for the government stated, ‘[i]t’s come to my attention that [Exhibit P] may be the subject of deliberative process privilege, because it . . . refers to an ongoing DCAA audit. So I would like to request that [Exhibit P] and the deposition transcript be sealed for now, until this deliberative process issue can be determined.’ … Sikorsky agreed to the government’s request. ….

Sikorsky’s counsel spent the next six months trying to get the Government to determine whether it would or would not be asserting “deliberative process privilege” over the Exhibit P e-mails, to no avail. Meanwhile, DCAA was wrestling internally with establishing procedures regarding when and how the deliberative process privilege would be asserted. Finally, on December 19, 2011, DCAA Director Pat Fitzgerald “officially delegated the authority to assert the deliberative process privilege to certain subordinates. … A month later, on January 19, 2012, DCAA Regional Director Ronald C. Meldonian asserted the deliberative process privilege over, among other documents, Exhibit P.”

Let’s digress here and delve into the concept of “deliberative process privilege,” courtesy of Judge Lettow. He wrote—

The deliberative process privilege protects ‘documents reflecting advisory opinions, recommendations and deliberations comprising part of a process by which governmental decisions and policies are formulated.’ …

The deliberative process privilege asserted here is one of the several branches of ‘executive privilege.’ Those branches relate to a range of executive functions and actions and may be considered as having a hierarchical ranking in importance. The strongest branch of executive privilege consists of what may be termed the ‘Presidential privilege,’ which rests in large part on the constitutional separation of powers, affords the President of the United States considerable autonomy and confidentiality, and gives ‘recognition to the paramount necessity of protecting the Executive Branch from vexatious litigation that might distract it from the energetic performance of its constitutional duties.’ … Still another branch of the executive privilege consists of the ‘state secrets’ or ‘national security’ privilege, which protects from disclosure the executive branch’s military, diplomatic, and foreign policy secrets. … Other aspects of executive privilege include a quasi-judicial privilege that protects the mental processes of executive officials when acting in a judicial capacity… the informer’s privilege, which protects the identity of criminal informants … and the law enforcement investigatory privilege, which protects information produced pursuant to investigations of potential violations of the law. …

The deliberative process privilege ‘was created to encourage ‘open, frank discussion between subordinate and chief concerning administrative action,’ and to ‘prevent injury to the quality of agency decisions.’’ … The privilege is a creation of federal common law and thus is recognized under Fed. R. Evid. 501. … The privilege is delineated by several procedural and substantive requirements. Procedurally, the privilege can only be invoked by an agency head or his or her subordinate after careful, personal review … and that head or designee must identify the specific information that is subject to the privilege and provide reasons for maintaining the confidentiality of the pertinent record … Substantively, the government must demonstrate that the allegedly privileged material is both pre-decisional and deliberative. Material is pre-decisional if it addresses activities ‘antecedent to the adoption of an agency policy.’ … ‘Subjective documents which reflect the personal opinion of the writer, rather than the policy of the agency are considered privileged information because they are predecisional.’ … Material is deliberative if it addresses ‘a direct part of the deliberative process in that it makes recommendations or expresses opinions on legal or policy matters.’ … Thus, the privilege does not protect purely factual material, ‘except as necessary to avoid indirect revelation of the decision making process.’ ….

In a footnote, Judge Lettow reported that the notion of deliberative process privilege can be traced back to the Eisenhower Administration. In other words, it is the creation modern jurisprudence and has no roots in English Common Law. (Let’s note here that we are not attorneys and we are deducing the lack of pedigree solely from Judge Lettow’s decision.)

The Judge spent several pages describing the tests for deliberative process privilege and discussing whether or not the DCAA e-mails met those tests. For example, he wrote—

… Exhibit P consists of communications between two government employees about DCAA audits that were ongoing at the time. In particular, the e-mail chain focuses on the subjective thoughts of a DCAA auditor, Mr. Boyer, regarding the status of the audits. Mr. Boyer uses his opinion of a past event, Sikorsky’s alleged violation of CAS 418 some years earlier, to convey to his superior his opinion about what action the DCAA should take in the ongoing audits. In short, Mr. Boyer’s impressions regarding the events surrounding the prior CAS 418 compliance issue are pre-decisional because the recounting of the past occurrence is subjective and was recited specifically to influence DCAA’s handling of an ongoing audits [sic]. In the same vein, the entirety of Exhibit P also is deliberative. In the commentary to his superior, Mr. Boyer recommends that the agency change course before it issues final audits. …

Disclosure of government employees’ correspondence — and a candid assessment of an agency’s ongoing policy-making activities — could lessen employees’ willingness to have a full and frank discussion about the merits of ongoing audits, thereby sapping the process of robust debate and collaborative analysis among audit team members. Overall, because Sikorsky has not demonstrated that its interest in Exhibit P outweighs the government’s interest in preserving the confidentiality of the document, the balance of interests favors the government, and Exhibit P is protected under the deliberative process privilege.

[Emphasis in original.]

Even though Judge Lettow found that the DCAA internal correspondence was protected by the deliberative process privilege, that wasn’t the end of the story. The Judge had to decide whether or not the Government had waived its claim of privilege when it delayed asserting it. The Judge wrote—

Applying the three-part test in Fed. R. Evid. 502(b), the court must determine whether the government’s disclosure of Exhibit P was inadvertent, whether the government took reasonable steps to prevent its disclosure, and whether the government promptly took reasonable steps to rectify the error.

Ultimately, Judge Lettow ruled that “the government did not act with sufficient alacrity to claw back the records produced in this case,” and thus had waived its ability to assert privilege with respect to Exhibit P. He wrote—

… Mr. Boyer’s deposition took place on July 20, 2011, yet the government waited until January 19, 2012, roughly six months later, to assert the deliberative process privilege over Exhibit P. Thereafter, inexplicably and inexcusably, the government waited until May 14, 2012, nearly four months after its assertion of privilege and two-and-one-half months after Sikorsky had used Exhibit P in a brief, to communicate its assertion of privilege to Sikorsky. In total, the government waited almost ten months, from July 20, 2011 until May 14, 2012, to convey its assertion of privilege over Exhibit P. By any measure, that is simply too long a time to try now to resuscitate the privilege. Its spirit has long since entered the Elysian Fields of the public domain.

At the end of the day, Sikorsky won its argument that the DCAA auditors’ e-mail correspondence was not subject to privilege and should be admissible. On the other hand, the fact that the Court of Federal Claims has blessed DCAA’s ability to assert deliberative process privilege over its internal communications may be a blow to those who are seeking to litigate DCAA-related issues.

We think it’s a shame that DCAA would seek to overturn contractor’s ability to rely on privilege while at the same time asserting privilege with respect to its own documents. That seems like the rankest kind of hypocrisy. We think DCAA should be ashamed of itself.