Cost Recovery Issues After a Termination For Convenience Breakout Session #: D10

Beth Ferrell, Partner, Bradley Arant Boult Cummings LLP

Chelsea Taylor, Principal, The Kenrich Group

Date: Tuesday, July 26

Time: 11:15am–12:30pm

2

Agenda

1. Overview of Termination for Convenience Process 2. FAR 49.1 General Principles 3. FAR 49.2 Additional Principles for Fixed-Price

Contracts 4. FAR 49.3 Additional Principles for Cost-

Reimbursement Contracts 5. FAR 31.205-42 Termination Cost Principle 6. FAR Part 12 and Commercial Item Terminations 7. DCAA Audits 8. Supplier Settlements 9. Other Issues 10.Questions & Answers

3

Termination for Convenience Overview

• Federal Acquisition Regulation (FAR) requires that a Termination for Convenience clause be included in most federal procurement contracts.

• This grants the Government the right to terminate contracts, or partially terminate contracts, for convenience.

4

Overview of Termination Process

The process for terminating a contract for convenience is specified in FAR Part 49. • Contracting Officer must send a written

Termination Notice to the contractor. • Upon receiving the Notice of Termination,

the contractor is required to stop all work immediately under the terminated portion of the contract, and terminate all related subcontracts.

5

• The contractor must deliver to the Government a “Termination Inventory” that lists materials produced or acquired under the contract and Government-furnished property and account for all inventory related to the terminated portion of the contract.

• Contractor must dispose of all remaining property in accordance with the Government’s directions

• Contractor also begins the process of settling with its subcontractors.

Overview of Termination Process (continued)

Details of Termination Process FAR Part 49

• Subpart 49.1 -- General Principles • Subpart 49.2 -- Additional Principles for Fixed-

Price Contracts Terminated for Convenience • Subpart 49.3 -- Additional Principles for Cost-

Reimbursement Contracts Terminated for Convenience

• Subpart 49.4 -- Termination for Default • Subpart 49.5 -- Contract Termination Clauses • Subpart 49.6 -- Contract Termination Forms and

Formats

6

When There Are Rumors That a Termination Is Imminent

Prior to termination… • Review contract for inconsistencies and

common interpretation with the Procuring Contracting Officer (PCO)

• If applicable, prepare Request for Equitable Adjustment proposals

• Set internal expectations on timing and results

7

General Principles FAR 49.104

Contractor Responsibilities • Stop Work Immediately

• Terminate All Subcontractors • Advise Termination Contracting Officer (TCO) of

Special Circumstances Precluding Work Stoppage • Perform the Continued Portion of the Contract, if any • Protect and Preserve Government Property • Notify the TCO of any Legal Proceedings • Dispose of Termination Inventory • Settle with Subcontractors/Suppliers (Subject to TCO

Approval) • Submit a Termination Settlement Proposal (TSP)

8

Termination Settlement Proposal • The contractor has one year from the

effective date of the termination to submit a settlement proposal.

• The amount of the settlement proposal reflects all of the costs for which the contractor believes it is entitled to be reimbursed.

9

Termination Forms FAR Subpart 49.6

10

Cost Type Fixed Price

Form Form No.

SF- Short Form

Inventory Basis

Total Cost Basis

Amendment of Solicitation / Contract Modification 30

Inventory Schedule B 1428/29

Inventory Schedule E for Use With Short Form Settlements 1434

Inventory Basis Settlement Proposal 1435

Total Cost Basis Settlement Proposal 1436

Cost Reimbursement Settlement Proposal 1437

Short Form Settlement Proposal 1438

Schedule of Accounting Information 1439

Partial Payment Request 1440

General Principles Additional Termination Activities

• Cost Accumulation • Budgeting/Forecasting • Inventory Identification and Classification • Data Management • Reductions in Force • Training/Reassignment • Any Other Tasks Requested by TCO

11

General Principles FAR 49.112-1

Partial Payments • Available after submission of Interim or

Final TSP, if authorized in the contract • Submit requests on SF 1440 • No fee on SF 1440 terminated effort,

except for undelivered acceptable finished product

• SF 1440 eligible cost recovery ranges from 90% - 100% of costs incurred

12

The “Fair Compensation Principle” • FAR 49.201(a) - "A settlement should compensate

the contractor fairly for the work done and the preparations made for the terminated portion of the contract, including a reasonable allowance for profit. (Emphasis Added)”

• FAR 49.206-1(c) “Settlement proposals must be in reasonable detail supported by adequate accounting data. . . . When actual, standard, or average costs are not reasonably available, estimated costs may be used . . .”

• FAR 49.303-5(d) “If an overall settlement of costs is agreed upon, agreement on each element of cost is not necessary. . .”

13

Profit/Fee or Loss on Terminated Contracts

• Profit or Loss on Fixed Price Contracts

• Fee on Cost-Plus Contracts

• Fixed Fee • Award Fee • Incentive Fee

14

Fixed-Price Contracts FAR Subpart 49.2

15

Key Points FAR

Reference Settlement Profit Factors 49.202(b)

Anticipatory Profit 49.202

Adjustment for Loss 49.203

Settlement Profit Factors FAR 49.202(b)

1. Extent and difficulty of work performed as compared with the total contract requirements

2. Engineering work, production scheduling, planning, technical study and supervision

3. Contractor efficiency related to (i) quality, (ii) cost reduction, (iii) resource management and (iv) inventory disposal

4. Capital investment and risk assumed 5. Inventive and developmental contributions 6. Complexity of manufacturing techniques 7. Contractor’s profit rate assuming a completed contract 8. Profit rate contemplated by the parties during contract

negotiations 9. Subcontracting environment, including effort to negotiate settlements

of terminated subcontracts

TCO has broad discretion to determine profit

16

Anticipatory Profits FAR 49.202(a)

• “Anticipatory profits and consequential damages shall not be allowed…”

17

Adjustment For Loss FAR 49.203(a)

• “In the negotiation or determination of any settlement, the TCO shall not allow profit if it appears that the contractor would have incurred a loss had the entire contract been completed.”

18

Fee Adjustment On Cost Plus Contracts

• FAR 49.305-1

– (a) Generally based on percent complete

• Considers extent and difficulty of work performed

• Fee does not include subcontract effort included in subcontractor TSPs

– (b) “The ratio of costs incurred to the total estimated cost of performing the contract… is only one factor in computing the percentage of completion.”

19

Fee Adjustment On Cost Plus Contracts

• FAR 49.115

• Fee adjustment is based on FAR 49.3 provisions

• Incentive provisions do not apply to the terminated portion of the contract

20

Vouchering FAR 49.302

• Continue normal cost-reimbursement billing procedures after termination

• Voucher period ends the last day of the sixth month following the month of termination

• Creates incentive to maximize termination effort during voucher period

• Important for cash flow

21

Termination Costs FAR 31.205-42

• Definition - “Contract terminations generally give rise to

the incurrence of costs or the need for special treatment of costs that would not have arisen had the contract not been terminated.”

22

(a) Common Items

(b) Continuing Costs

(c) Initial Costs

(d) Loss of Useful Value

(e) Rental Under Unexpired Leases

(f) Alterations of Leased Property

(g) Settlement Expenses

(h) Subcontractor Claims

Common Items FAR 31.205-42(a)

• Transfer items to other work when reasonable

• Contemporaneous purchases indicate items are usable on other work

• Common items charged to termination should exceed requirements on other work

23

Continuing Costs FAR 31.205-42(b)

•“Despite all reasonable efforts by the contractor, costs which cannot be discontinued immediately after the effective date of termination are generally allowable . . .” • Examples Include:

- Idle Facilities - Severance Pay

24

Continuing Costs FAR 31.205-17 Idle Facilities

(b) The costs of idle facilities are unallowable unless the facilities --

(1) Are necessary to meet fluctuations in workload; or

(2) Were necessary when acquired and are now idle because of changes in requirements, production economies, reorganization, termination, or other causes which could not have been reasonably foreseen . . .

25

Continuing Costs FAR 31.205-6(g) Severance Pay

• (2) Severance pay is allowable only to the extent that, in each case, it is required by -- (i) Law

(ii) Employer-Employee agreement

(iii) Established policy that constitutes, in effect, an implied agreement on the contractor’s part; or

(iv) Circumstances of the particular employment.

26

Continuing Costs FAR 31.205-6(g) Severance Pay

• Contractor must demonstrate that the termination caused the reduction in force

• Must comply with written company policy regarding:

• Severance amount • Selection criteria (including bumping) • Other benefits including COBRA and

outplacement services

27

Initial Costs FAR 31.205-42(c)

Starting Load & Preparatory Costs

(c) Initial Costs. Initial costs, including starting load and preparatory costs, are allowable as follows:

(1) Starting load costs not fully absorbed because of termination are nonrecurring labor, material, and related overhead costs incurred in the early part of production . . .

(2) Preparatory costs incurred in preparing to perform the terminated contract include such costs as those incurred for initial plant rearrangement and alterations, management and personnel organization, and production planning . . .

28

Loss of Useful Value FAR 31.205-42(d)

(d) Loss of useful value of special tooling, and special machinery and equipment is generally allowable, provided --

(1) The special tooling, or special machinery and equipment is not reasonably capable of use in other work of the contractor;

(2) The Government’s interest is protected by transfer of title.

29

Rental Under Unexpired Leases FAR 31.205-42(e)

(e) Rental costs under unexpired leases, less the residual value of such leases, are generally allowable when shown to have been reasonably necessary for the performance of the terminated contract, if --

(1) The amount of rental claimed does not exceed the reasonable use value of the property . . .; and

(2) The contractor makes all reasonable efforts to terminate, assign, settle, or otherwise reduce the cost of such lease.

30

Alteration of Leased Property FAR 31.205-42(f)

(f) The cost of alterations and reasonable restorations required by the lease may be allowed when the alterations were necessary for performing the contract.

31

Settlement Expenses FAR 31.205-42(g)

(1) Settlement expenses, including the following, are generally allowable:

(i) Accounting, legal, clerical, and similar costs reasonably necessary for -

(a) The preparation and presentation . . . of settlement claim to the Contracting Officer; and (b) The termination and settlement of subcontracts.

(ii) Reasonable costs for the storage, transportation, protection, and disposition of property acquired or produced for the contract.

(iii) Indirect costs related to salary and wages incurred as settlement expenses in (i) and (ii); . . .

(2) If settlement expenses are significant, a cost account or work order shall be established to separately identify and accumulate them.

32

Settlement with Subcontractors FAR 31.205-42(h)

• Limited to settlements allocable to the termination (31.201-4)

• Appropriate Indirect Costs (31.203) • Proportionate to benefits received • Not claimed elsewhere

• Contractor does not earn profit on subcontract effort included in the termination settlement proposal

33

“Reaccounting” - A General Explanation

• The issue generally is the reclassifying of indirect costs to direct and the inclusion of them in a settlement proposal.

• The premature end of a contract can throw askew the Contractor’s original business plans for cost absorption. This may necessitate a new approach to recovery of costs.

34

FAR Part 12 and Commercial Item Terminations

• General • “…the requirements of Part 49 do not apply

when terminating contracts for commercial items”

• Termination For Cause – (a) Notify Contracting Officer as soon as

possible of any excusable delay – (b) Government remedies – (c) Written notice of termination from

Contracting Officer

35

Commercial Item Terminations for Convenience

• FAR 12.403(d): “… the contractor shall be paid --

(i)(A) The percentage of the contract price reflecting the percentage of the work performed prior to the notice of the termination for fixed- price or fixed price with economic price adjustments, or (B) An amount for direct labor hours (as defined in the Schedule of the contract) determined by multiplying the number of direct labor hours expended before the effective date of termination by the hourly rate(s) in the Schedule; and

36

Commercial Item Terminations for Convenience (continued)

• FAR 12.403(d) continued: “(ii) Any charges the contractor can demonstrate directly resulted from the termination. The contractor may demonstrate such charges using its standard record keeping system and is not required to comply with the cost accounting standards or the contract cost principles in Part 31. The Government does not have any right to audit the contractor’s records solely because of the termination for convenience.”

37

DCAA Audits • FAR 49.107 requires the TCO to refer all

gross settlements over $100K to the appropriate audit agency, though current DCMA waiver requires TCO to refer all gross settlements over $750k for audit

• Extensive delays in conducting TSP audits may occur because of DCAA’s workload, backlog, and focus on incurred cost audits

38

DCAA Audits: Potential Issues • FAR 31.201-3 and Reasonableness • Extensive qualifications or limitations • “We do not consider… to be acceptable as

the basis for the settlement of a fair and reasonable amount.”

• DCAA’s audit standards compared to “preponderance of the evidence”

39

DCAA Audits: Potential Issues (continued)

• Interpretation of FAR 31.201-2(d): A contractor is responsible for accounting for costs appropriately and for maintaining records, including supporting documentation, adequate to demonstrate that costs claimed have been incurred, are allocable to the contract, and comply with applicable cost principles in this subpart and agency supplements. The contracting officer may disallow all or part of a claimed cost that is inadequately supported.

40

Supplier Settlements • Ratification of suppliers’ TSPs may be a

primary reason for delays in a final settlement

• Most suppliers will need help with inventory and preparing TSPs

• In addition to preparing written directions, be prepared for more verbal instructions and hands on help

• Supplier site visits are often helpful, where possible

41

Supplier Settlements (continued)

• FAR 49.107(b)(2): “The review by the audit agency does not relieve the prime contractor or higher tier subcontractor of the responsibility for performing an accounting review.”

• TSP Certification: “The contractor has examined, or caused to be examined, to an extent it considered adequate in the circumstances, the termination settlement proposals of its immediate subcontractors…”

• Consider third-party independent auditors to review TSPs of lower tier suppliers who are also competitors

42

Other Issues • Funding – Timing and Type

• Termination responsibilities require prompt actions; however, funding may be an issue

• Limitation of Funds/Limitation of Costs • Special Termination Liability clause, if

applicable

• Unsettled Contract Changes • Undefinitized Contract Actions • Requests for Equitable Adjustment

43

Other Issues (continued) • Inventory accountability • Unabsorbed overhead claims • Abated rates for indirect employees

charging direct to termination activities • Allowability of international costs (e.g.,

severance) under FAR

44

Questions?

45

46

Elizabeth (Beth) Ferrell Elizabeth (Beth) Ferrell is a partner in Bradley Arant Boult Cummings LLP’s Government Contracts Practice in Washington, D.C. She has more than 30 years of experience representing government contractors in all aspects of federal procurements. Professional Experience Ms. Ferrell’s broad experience includes advising contractors on performance issues, claims, regulatory compliance, internal investigations, mandatory disclosures, audit and cost disallowances, organizational conflicts of interest, small business issues, labor/employment requirements, funding issues, and False Claims Act matters. Her practice focuses on performance disputes, contract claims, terminations, audits, and cybersecurity. She has litigated a wide range of disputes, including default terminations, government and contractor claims, bid protests, and prime/subcontractor disputes at the Federal Circuit, the Court of Federal Claims, the Boards of Contract Appeals, the GAO, U.S. District Courts, and in arbitration. Ms. Ferrell is a regular contributor, co-author, presenter and panelist on a wide variety of government contracts topics including terminations, funding constraints, performance issues, and cybersecurity. Ms. Ferrell currently serves as Vice-Chair of the Contract Claims & Dispute Resolution Committee and Vice-Chair of the Cybersecurity, Privacy & Data Protection Committee for the ABA Public Contract Law Section. She is also a member of The Government Contractor Advisory Board. She is listed in Washington, D.C. Super Lawyers, Government Contracts, 2014-2016.

• J.D., Order of the Coif, University of South Carolina Law School

• B.A., magna cum laude, University of South Carolina

• Contact Information 1615 L Street, NW Suite 1350 Washington, DC 20036 Tel: (202) 719-8260 Fax: (202) 347-1684 bferrell@bradley.com

47

Chelsea Taylor is a Principal in the Washington, D.C. office of The Kenrich Group. She is a Certified Management Accountant and Certified Fraud Examiner. The support she provides to clients has included damages analysis, compliance review, and litigation support.

Professional Experience Chelsea specializes in cost and pricing related government contract matters, helping government contractors with Requests for Equitable Adjustment and claims; damages analysis resulting from defective pricing, False Claims Act violations, Truth in Negotiations Act claims; consulting on compliance with FAR Part 31 Cost Principles; and the preparation, review, and negotiation of termination settlement proposals, among other matters. Chelsea has conducted extensive reviews of accounting records, accounting systems, and various government policies and procedures, including the FAR, Contract Pricing Reference Guides, and DCAA Contract Audit Manual.

Chelsea has assisted clients in construction and government contracts-related litigation in all phases of dispute resolution. She has conducted review and preparation of TSPs for numerous government contractors. Her termination experience in the Defense and Aerospace industry includes contracts for space launch system technology, space telecommunications, and military combat systems, including multi-billion dollar Department of Defense procurements. Chelsea has also assisted clients in negotiations with the client’s prime contractor, the Government’s Termination Contracting Officer, and negotiating termination settlements with hundreds of lower-tier subcontractors.

Chelsea Taylor • B.S. Commerce (Finance

and International Business), University of Virginia

• Contact Information 1919 M Street, NW Suite 620 Washington, DC 20036 Tel: (202) 556-2964 Fax: (202) 429-5673 ctaylor@kenrichgroup.com

Citations and Documents 1. Slides Relating to Termination for Convenience Issues 2. FAR 49.1 General Principles 3. FAR 49.2 Additional Principles for Fixed-Price Contracts 4. FAR 49.3 Additional Principles for Cost-Reimbursement Contracts 5. FAR 31.205-42 Termination Cost Principle 6. FAR 52.249-6 Termination Cost Reimbursement 7. Selected Termination Forms 8. DCAA Contract Audit Manual Chapter 12 -- Auditing Contract

Termination, Delay/Disruption, and Other Price Adjustment Proposals or Claims (excerpt relating to terminations)

9. Termination for Convenience of the Government: Key Issues for Contractor Recovery, by Patricia Meagher, Greg Bingham, Oliya Zamaray, and Jeffrey DuVal, Briefing Papers, September 2014, Thomson Reuters

48