BRIEFING PAPERS SECOND SERIES

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1 This material from BRIEFING PAPERS has bee reproduced with the permissio of the publisher, West, a Thomso busiess. Further use without the permissio of the publisher is prohibited. For additioal iformatio or to subscribe, call or visit west.thomso.com/ fedpub. BRIEFING PAPERS is ow available o Westlaw. Visit westlaw.com BRIEFING PAPERS SECOND SERIES PRACTICAL TIGHT-KNIT BRIEFINGS INCLUDING ACTION GUIDELINES ON GOVERNMENT CONTRACT TOPICS ADMINISTERING SUBCONTRACTS AFTER A TERMINATION FOR CONVENIENCE By Patricia A. Meagher ad Greg S. Bigham A lthough the Departmet of Defese has see its budget grow by tes of billios of dollars uder the Bush Admiistratio, big-ticket major weapos programs are beig scaled back or cacelled as techology ad threat assessmets chage at uprecedeted rates. I February 2004, the U.S. Army termiated for coveiece the RAH-66 Comache Stealth Helicopter program. Oce regarded as the corerstoe of the U.S. Army s aviatio Iformig Subcotractors Decisio To Termiate Or Complete Notice Partial Termiatio Notice WARN Act & Other Prior Notice Requiremets IN BRIEF Immediate Issues After Termiatio Termiatio Team Ivetory Dispositio Estimate Of Termiatio Settlemet Cotiuig Work Special Istructios O Vouchers Cofereces Termiatio Ivetory Schedules Storage Dispositio Subcotractor Settlemet Proposal Submissio Istructios To Subcotractors Settlemet Proposal Forms Certificatios Subcotractor Settlemet Proposal Review Iitial Steps Audit Negotiatio Of Subcotractor Settlemet Proposal Preparig For Negotiatios Special Cosideratios For Fixed-Price Subcotracts Delay Or Impasse Submissio Of Proposed Subcotractor Settlemets Certificatio Govermet Approval Subcotractor Paymets Before Settlemet Vouchers Partial Paymet Fial Paymet & Subcotract Closeout Disputes Avoidig Litigatio Dispute Process Subcotractor Judgmets moderizatio pla, the Comache jois aother ill-fated multibillio dollar weapos program, the Crusader artillery system, which was termiated by the DOD i August O major Govermet programs such as these, it is commo for a sigificat portio of the work to be accomplished by subcotractors. For example, sigificat portios of the $39 billio Comache cotract 1 ad the $11 billio cotract for developmet of the Crusader artillery system 2 had bee assiged to subcotractors. The extet of subcotractig o the Navy s multibillio dollar A-12 attack aircraft program, termiated i 1991 for default rather tha for the Govermet s coveiece, was eve more extesive. 3 It therefore should ot be surprisig that some of the most complex ad time-cosumig Patricia A. Meagher is a member of the Sa Fracisco, Califoria law firm of Rogers, Joseph, O Doell & Phillips. She is a member of the firm s Govermet Cotracts ad Costructio Law Practice Groups. Greg S. Bigham is a Director i the Washigto, D.C. office of the iteratioal cosultig firm Navigat Cosultig, Ic. NO MARCH 2004 WEST, A THOMSON BUSINESS COPYRIGHT 2004 ALL RIGHTS RESERVED

2 issues that a prime cotractor must address after a termiatio for coveiece relate to its termiated subcotracts. 4 This is partially due to the hybrid ature of may subcotracts, especially lower-tier subcotracts, which are ofte a cross betwee a Govermet cotract with the associated Federal Acquisitio Regulatio clauses ad a commercial cotract. 5 Moreover, a prime cotractor must stad i the shoes of the Govermet ad protect the Govermet s iterests whe dealig with subcotractors, eve though most ofte this is doe without the prime cotractor havig settlemet authority. I additio, major subcotractors are ofte competitors of the prime cotractor ad, because of this, do ot allow the prime cotractor to gai access to sesitive accoutig records that may be required to perform the ecessary audits or reviews. This BRIEFING PAPER discusses the issues faced by a prime cotractor i admiisterig subcotracts after a termiatio for the coveiece of the Govermet. It addresses (1) how to iform subcotractors of the termiatio, (2) the issues that arise immediately after termiatio, (3) how to hadle termiatio ivetory, (4) the submissio of subcotractor settlemet proposals, (5) the review ad egotiatio of these proposals, (6) subcotractor settlemets ad paymet, ad (7) dispute avoidace ad litigatio. Although this PAPER is writte from the perspective of advisig the prime cotractor, it applies equally to subcotractors that are faced with admiisterig coveiece termiatios at the lower-tier subcotractor ad supplier level. Iformig Subcotractors Decisio To Termiate Or Complete It should ot be a foregoe coclusio that the prime cotractor will termiate all of its subcotracts oce it receives otice that the prime cotract is beig termiated for coveiece. If a fixed-price subcotractor or supplier is very ear completio of its assiged scope of work, it may actually be more expesive to termiate the subcotract for coveiece tha to allow the subcotractor to fiish its work ad pay it the subcotract price. For example, if a subcotract was 99% complete at the time it was termiated for coveiece, the fial termiatio settlemet with that subcotractor may legitimately exceed the fixed cotract price after takig ito accout the cost of preparig the settlemet proposal, dealig with termiatio ivetory, ad completig other termiatio tasks. I such cases, a prime cotractor may direct the subcotractor to complete its performace ad deliver the items uder the subcotract agreemet, otwithstadig the Govermet s termiatio of the prime cotract for coveiece. I such a situatio, however, it is prudet to obtai the Govermet s prior approval, if possible. Notice After receipt of a writte otice from the Govermet that the prime cotract has bee termiated for coveiece, 6 you should provide each of your subcotractors ad vedors with a similar otice of termiatio. This otice should provide the effective date of the termiatio ad track the directios ad istructios the BRIEFING PAPERS (ISSN ) is published mothly except Jauary (two issues) ad copyrighted 2004 Valerie L. Gross, Editor Periodicals postage paid at St. Paul, MN Published by West, a Thomso busiess / th Street, NW / Washigto, DC thomso.com/fedpub.com Postmaster: Sed address chages to Briefig Papers / PO Box / St. Paul, MN BRIEFING PAPERS West has created this publicatio to provide you with accurate ad authoritative iformatio cocerig the subject matter covered. However, this publicatio was ot ecessarily prepared by persos licesed to practice law i a particular jurisdictio. West is ot egaged i rederig legal or other professioal advice, ad this publicatio is ot a substitute for the advice of a attorey. If you require legal or other expert advice, you should seek the services of a competet attorey or other professioal. BRIEFING PAPERS is a registered trademark used herei uder licese. All rights reserved. Reproductio, storage i a retrieval system, or trasmissio of this publicatio or ay portio of it i ay form or by ay meas, electroic, mechaical, photocopyig, xerography, facsimile, recordig, or otherwise, without the writte permissio of West, a Thomso busiess is prohibited, except that the publisher grats permissio to reproduce portios of this publicatio (ot the etire issue) provided that a $2.50 per page per copy fee is paid directly to Copyright Clearace Ceter (CCC), 222 Rosewood Drive, Davers, MA (978) Fee Code: ( )/97/$0+$

3 Govermet has provided i its termiatio otice to you. I geeral, the otice should advise subcotractors to take the followig actios: 7 (a) Stop all work uder the subcotract ad advise you promptly of ay circumstace that precludes immediate stoppage of the work. (b) Place o further orders uder the subcotract. (c) Termiate lower-tier subcotracts ad cacel outstadig vedor orders. (d) Protect, preserve, ad ivetory all cotract property. (e) Submit a termiatio settlemet proposal to you as provided i the subcotract agreemet (which ideally refereces FAR Part 49 ad sets the submissio deadlie at six moths after receipt of otice of termiatio). (f) Settle with lower-tier suppliers ad subcotractors ad request that they advise you promptly of ay legal dispute. (g) Dispose of termiatio ivetory as directed. You should obtai a writte ackowledgemet of receipt of the otice of termiatio from each of your subcotractors. Although a otice of termiatio may be supplemeted by further istructio letters, a termiated subcotract caot be uilaterally reistated; ay such reistatemet of a termiated subcotract must be by mutual agreemet of the prime cotractor ad the subcotractor. Partial Termiatio Notice If the Govermet termiates the ucompleted work uder your prime cotract i part rather tha i its etirety, it is referred to as a partial termiatio for coveiece. I such cases, you must review the scope of work for each of your subcotracts ad determie whether the work is (1) subject to the termiatio ad therefore must stop, (2) ot subject to the termiatio ad therefore should cotiue, or (3) some mixture such that part of the subcotractor s work should be termiated while the remaiig work should cotiue (e.g., partial termiatio). You must the commuicate this determiatio to all affected subcotractors as promptly as possible. Your otice to subcotractors iformig them of the termiatio must be tailored to the scope of the Govermet s partial termiatio of the prime cotract. For example, you may eed to istruct your subcotractors to stop performace of certai tasks uder the subcotract statemet of work but cotiue with the performace of other tasks ecessary for completio of the otermiated portio of the prime cotract. Similarly, there may be some purchase orders that your subcotractors will eed to maitai, but others that should be cacelled. I additio, you will eed to address what property will cotiue to be used by the subcotractor as well as what property should be subject to dispositio as part of the partial termiatio. To the extet such decisios caot be made at the time you provide your subcotractors with the otice of partial termiatio, you should sed supplemetal istructio letters to them as soo as possible. A subcotractor whose work is subject to a partial termiatio for coveiece is etitled to submit a termiatio settlemet proposal for the termiated portio of the work. For the most part, the rules that apply to submissio of a settlemet proposal after a full termiatio apply to the submissio of a settlemet proposal after a partial termiatio. Oe importat exceptio, however, is that a fixedpriced subcotractor is etitled to seek a equitable adjustmet to the price of the otermiated portio of the fixed-price work. 8 You will eed to address this issue of a equitable adjustmet to the subcotract price of the cotiued portio of the fixed-price work before, or i cojuctio with, the settlemet of the subcotractor s partial termiatio. I this regard, you should esure that o portio of the icrease i the price of the otermiated work is icluded i the subcotractor s termiatio settlemet. 9 3

4 WARN Act & Other Prior Notice Requiremets Uder the Worker Adjustmet ad Retraiig Notificatio (WARN) Act, 10 a compay that employs 100 or more employees must give 60- day otice of (a) a plat shut-dow that will result i a loss of 50 or more employees or (b) a mass layoff of (1) 500 employees or (2) 1 /3 of the workforce ad at least 50 employees. If you are advised i advace of a proposed termiatio for coveiece of a major Govermet cotract, it may trigger WARN Act obligatios. I additio, with regard to DOD cotracts, a Cotractig Officer must provide prior otice to a cotractor that fudig of a major defese program is likely to be termiated or substatially reduced. 11 DOD cotractors, i tur, must provide similar otices to their employees (or their uio represetatives) withi two weeks of receivig the Govermet otice. 12 DOD cotractors must also provide otice to all first-tier subcotractors with a subcotract of $500,000 or more o later tha 60 days after the Govermet otice to the cotractor. Each subcotractor must the give otice, ad flow dow the requiremet, to all lower-tier subcotractors with subcotracts of $100,000 or more uder the program. 13 It is icumbet upo the prime cotractor ad subcotractor to moitor lower-tier subcotractors after termiatio of a DOD program for compliace with these otice requiremets. Immediate Issues After Termiatio Termiatio Team As soo as possible after receipt of a otice of termiatio for the coveiece of the Govermet, you should assemble a termiatio team to perform the various tasks required to properly admiister the termiatio. Persoel from the followig orgaizatios are usually members of the termiatio team: (1) Cotract admiistratio persoel prepare the prime cotract termiatio settlemet proposal, egotiate various issues icludig settlemet with the Govermet, ad close out the termiated cotract. (2) Subcotract maagemet persoel direct subcotractors i the termiatio process, coordiate review ad audit of subcotractor settlemet proposals, egotiate various issues with subcotractors icludig provisioal settlemet, ad close out the termiated subcotracts. (3) Supplier maagemet persoel termiate or cacel smaller purchase orders or retur goods to suppliers. (4) Fiace ad accoutig persoel cotiue voucherig if appropriate, accumulate prime cotract ad subcotracts costs as ecessary for the prime cotract settlemet proposal, review ad provisioally approve partial paymet requests from subcotractors, roll up these partial paymet requests ito the prime cotractor s submissio to the Govermet, ad support Defese Cotract Audit Agecy audit of the prime cotractor settlemet proposal. (5) Iteral audit, fiace, or accoutig persoel review or audit subcotractor settlemet proposal submissios. (6) Property, plat clearace, or ivetory maagemet persoel hadle the dispositio of both subcotract ad prime cotract termiatio ivetory. (7) Huma resources persoel address layoffs ad WARN Act issues as well as moitor severace pay, retraiig costs, ad similar expeses that may be recoverable as part of the prime cotract settlemet proposal. Ivetory Dispositio Termiatio ivetory is defied as ay property purchased, supplied, maufactured, furished, or otherwise acquired for the performace of a cotract subsequetly termiated ad properly allocable to the termiated portio of the cotract. 14 The term icludes Govermet-furished property. 15 It does ot iclude special toolig, special test equipmet, material, or facilities subject to a separate cotract or a separate cotract pro- 4

5 visio goverig use or dispositio. 16 After receipt of a otice from the Govermet that your cotract is termiated for coveiece, you are obligated to dispose of termiatio ivetory as directed by the Termiatio Cotractig Officer. 17 You therefore must clearly commuicate with your subcotractors about their obligatios with regard to termiatio ivetory so that you ca fulfill your obligatios to the Govermet. As a practical matter, it is frequetly ecessary to clear a plat or productio area of termiatio ivetory shortly after a termiatio for coveiece so that the area ca be used for other work. Prompt istructio to subcotractors o ivetory dispositio will avoid the loss, damage, or iadvertet destructio of termiatio ivetory. You should immediately istruct your subcotractors to segregate ad move termiatio ivetory to a termiatio area ad to create a complete listig of all ivetory ivolved. Your subcotractors should be directed to scree the termiatio ivetory for possible diversio to other cotracts or work that will remove items from the termiatio claim. 18 I additio, if your cotract was o a cost-reimbursemet basis, you should advise your subcotractor that ay diversio of ivetory requires the prior approval of both yourself ad the TCO. 19 Although ot specifically addressed i the regulatory guidace, it is importat as a practical matter to segregate the termiatio ivetory withi a subcotractor s electroic ivetory cotrol system. May aerospace ad maufacturig compaies have itegrated material requiremets plaig (MRP) ad ivetory cotrol systems that allow ivetory to be trasferred from cotract to cotract rapidly ad ofte. Withi these itegrated systems, the termiatio ivetory ca be desigated as available for trasfer so that the MRP system ca automatically detect requiremets for, ad trasfer, specific parts from termiatio ivetory to other cotracts. You eed to esure that your subcotractor s cotract cost records reflect that the cost of this ivetory has bee trasferred to the receivig cotract ad removed from the termiated cotract. A further discussio of termiatio ivetory is provided later i this PAPER. Estimate Of Termiatio Settlemet The TCO geerally requests, withi 30 days of the Govermet s issuace of a otice of termiatio of a prime cotract, that you submit a estimate of the total amout of your termiatio settlemet proposal. 20 (For this ad other key dates i the termiatio process, see Appedix A at the ed of this PAPER.)The estimate should iclude costs icurred before the termiatio as well as settlemet expeses, cotiuig costs, ad the cost of subcotractor settlemets projected to be icurred i the future. It is ulikely that you ca prepare a closetolerace estimate i such a short period of time. Your best efforts toward a high-level estimate will suffice as log as you disclose your estimatig methods to the Govermet so that the TCO ad other Govermet officials are advised of the maturity of your estimate. To prepare your estimate of your termiatio settlemet proposal, you will eed to obtai similar estimates from your subcotractors. It is therefore a best practice to sed a request to your subcotractors, either i the termiatio otice or i a supplemetal letter issued shortly thereafter, to submit a estimate of their termiatio settlemet proposals withi 15 days. As a practical matter, it will be helpful for you to istruct your subcotractors regardig the format for submissio of the iformatio you are requestig. For example, if you ited to provide the TCO with a estimate that segregates costs by moth ad by cost elemet, you should istruct your subcotractors to provide their estimated costs i a similarly segregated maer rather tha o a lump-sum basis. Cotiuig Work A issue that may arise shortly after issuace of a otice of termiatio relates to cotiuig work. As discussed above, except where the termiatio is a partial termiatio, your otice to your subcotractors should direct the stoppage of all work ad should istruct your subcotractors to otify you if work caot be 5

6 stopped immediately. Thus, there may be occasios whe a subcotractor otifies you of the eed for some work to cotiue ad asks for further istructio. Your respose should cosider that costs that are ot discotiued immediately after the effective date of the termiatio (e.g., cotiuig costs) are recoverable if all reasoable efforts are made to discotiue the costs ad the costs are otherwise allowable. 21 Costs icurred i completig work-i-progress after the effective date of the termiatio have bee allowed where completio was ecessary to avert the total loss of the item, as would be the case, for example, where the item was i the midst of a heat treatmet. The best practice, however, is for your subcotractors to request, ad for you to obtai, authorizatio from the TCO to complete work-i-progress otwithstadig the otice of termiatio. Termiatio ivetory, of which work-i-process is a part, is ofte scrapped because it is ot usable o other programs. For this reaso, the TCO may istruct you to discotiue work o work-i-process eve if it reders the ivetory uusable. Aother example of a cotiuig cost is employee salaries. I geeral, some period of time lapses betwee the effective date of the termiatio ad the reassigmet of employees. Salaries durig this stad-by period are allowable as log as all reasoable efforts are made to mitigate these costs. 22 I other words, you should advise your subcotractors that this provisio is by o meas a blak check ad that idle time charges will be closely scrutiized. You may wish to suggest to your subcotractors that they ecourage affected employees to take accrued vacatio time or time off without pay or perhaps to eroll i a educatioal or traiig course pedig reassigmet. Such actios demostrate a subcotractor s efforts to mitigate costs ad icrease the likelihood that the cotiuig costs that are icurred will be allowed. Special Istructios O Vouchers Whe a cost-reimbursemet prime cotract has bee completely termiated, the prime cotractor may (but is ot required to) cotiue usig vouchers util the last day of the sixth moth followig the moth i which the termiatio is effective. 23 I those istaces where you cotiue to voucher, you should advise your cost-reimbursemet subcotractors that they too are permitted to cotiue their ormal voucherig process. You may wish to remid your subcotractors, however, that fee is ot recoverable o settlemet expeses or o lower-tier subcotractor settlemet amouts other tha cotiuig work ad therefore fee o these costs should ot be icluded i the voucher. 24 You should cosider istructig your subcotractors to segregate the costs icluded i their vouchers ito differet categories to esure that fee is oly added to the appropriate categories of costs. You may also wish to istruct your subcotractors to submit more detailed cost records to support the subcotract vouchers so that you ca perform a more detailed review or audit of the voucher costs tha was ecessary before the termiatio. It is ofte the case that, before the termiatio, the subcotractor had a detailed scope of work agaist which you could measure progress ad the reasoableess of the costs icurred (e.g., cost performace reportig). The post-termiatio work ofte is ot as welldefied. Your subcotractor may be istructed to perform cotiuig work that ecessarily has a more broadly defied scope of work. Accordigly, you should closely scrutiize the post-termiatio work from a cost ad techical perspective to esure that you allow paymet oly for progress made ad work accomplished. I additio, your subcotractors will likely iclude icurred settlemet expeses i their vouchers. Settlemet expeses must be closely moitored ad reviewed or audited to esure they are reasoable ad allowable. The FAR cost priciple goverig termiatio costs provides as follows regardig the allowability of settlemet expeses: 25 (1) Settlemet expeses, icludig the followig, are geerally allowable: (i) Accoutig, legal, clerical, ad similar costs reasoably ecessary for 6

7 (A) The preparatio ad presetatio, icludig supportig data, of settlemet claims to the cotractig officer; ad (B) The termiatio ad settlemet of subcotracts. (ii) Reasoable costs for the storage, trasportatio, protectio, ad dispositio of property acquired or produced for the cotract. (iii) Idirect costs related to salary ad wages icurred as settlemet expeses i (i) ad (ii); ormally, such idirect costs shall be limited to payroll taxes, frige beefits, occupacy costs, ad immediate supervisio costs. Note that the regulatios provide special istructios i paragraph (iii) regardig the allowability of idirect costs assiged to settlemet expeses. As a practical matter, the method used to assig idirect costs to settlemet expeses almost always differs from the method used to allocate idirect expeses to performace costs before the termiatio. Fially, you should direct your cost-reimbursemet subcotractors to idetify their fial voucher as their completio voucher ad advise them of the eed to be prepared for provisioal audits of selected vouchers. 26 Cofereces The TCO commoly schedules a coferece with the termiated cotractor shortly after the termiatio. 27 The coferece geerally addresses issues such as those metioed above as well as the resposibilities of the termiated cotractor. I additio, the coferece ofte results i a schedule for submissio of the various termiatio forms, icludig the prime cotract ad major subcotract termiatio settlemet proposals, as well as egotiatio of the settlemet. 28 With the TCO s cocurrece, you may wish to ivite all subcotractors to this coferece (or selected subcotractors for which there are more complicated termiatio issues or for which the dollar amout of the settlemet may be sigificat). If this approach is ot possible or desirable, you should cosider schedulig a separate coferece with all termiated subcotractors as promptly after the TCO coferece as possible. The coferece is a excellet opportuity for compaies ivolved i the termiated program to lear what is expected of them ad to ask questios about cotiuig work, ivetory dispositio, settlemet proposal preparatio, the ratificatio or approval for proposed settlemets with lowertier subcotractors, access to books ad records for audit, ad settlemet egotiatios. Aticipated equitable adjustmet to the price of the otermiated work, outstadig chage orders, ad udefiitized work are ofte discussed as well. Attedace at the TCO s coferece is ofte most helpful to those subcotractors that are commercial firms or otherwise ufamiliar with the special rules ad procedures associated with a termiatio for the coveiece of the Govermet. I additio, as the termiatio process ofte takes much loger tha iitially aticipated by may subcotractors, the coferece provides a opportuity for the various participats to become familiar with all the required steps. Fially, you may wish to distribute to your subcotractors copies of the applicable regulatios ad termiatio forms or a listig of the websites providig this iformatio. 29 Termiatio Ivetory As discussed above, your termiatio team should iclude a member from your property, plat clearace, or ivetory maagemet groups sice most termiated cotracts icluded some items of termiatio ivetory. This termiatio team member should be resposible for both the prime cotract termiatio ivetory ad the subcotract termiatio ivetory. Schedules At the time of the termiatio, it is likely that a umber of your subcotractors will have i their possessio property associated with the termiated work. For example, your subcotractors may have purchased parts, raw materials, work-i-process, fiished compoets or fiished product, ad perhaps Govermetfurished property. These items are part of 7

8 the termiatio ivetory ad require special treatmet. As the prime cotractor, you are required to submit a ivetory schedule to the TCO withi 120 days from the effective date of the termiatio. 30 The Govermet expects to receive a schedule or set of schedules that icludes all of the termiatio ivetory whether it is i the prime cotractor s physical possessio or located at oe of the subcotractors facilities. Accordigly, you will eed to obtai ivetory schedules from your subcotractors to submit to the Govermet i coectio with your ow ivetory schedules. Your otice of termiatio to your subcotractors should therefore direct the submissio of ivetory schedules to you withi a shorter time period perhaps 60 or 90 days after receipt of the otice of termiatio as ecessary to allow you to meet your 120-day deadlie. Note, however, that ay such directio should be cosistet with ay applicable subcotract provisio. Termiatio ivetory is a importat issue i admiisterig a subcotractor termiatio for coveiece. As the prime cotractor, the Govermet will look to you directly for a full accoutig of the termiatio ivetory, eve if the subcotractor has physical possessio of the property or ivetory. It is therefore importat that you work with your subcotractors to esure that the termiatio ivetory is properly idetified ad segregated ad that accurate ad complete ivetory schedules are submitted to you by your subcotractors. There are several forms that a subcotractor may be required to submit. 31 (For a complete listig of the FAR termiatio forms, icludig forms relatig to ivetory, see Appedix B to this PAPER.) The forms address differet types of ivetory that may be i the possessio of the subcotractor at the time of the termiatio for coveiece. For cotracts awarded before May 5, 2004, the Stadard Forms relatig to termiatio ivetory are the followig: 32 (a) SF 1426, Ivetory Schedule A (used for metals i mill product form), ad SF 1427, Cotiuatio Sheet. (b) SF 1428, Ivetory Schedule B (required for raw materials (other tha metals), purchased parts, fiished product, plat equipmet, ad fiished compoets), ad SF 1429, Cotiuatio Sheet. (c) SF 1430, Ivetory Schedule C (used for work-i-progress), ad SF 1431, Cotiuatio Sheet. (d) SF 1432, Ivetory Schedule D (required for special toolig ad special test equipmet), ad SF 1433, Cotiuatio Sheet. (e) SF 1434, Ivetory Schedule E (oly form required if settlemet is less tha $10,000). Effective May 5, 2004, the oly forms required are the ew SF 1428, Ivetory Disposal Schedule ad SF 1429, Cotiuatio Sheet. Note that a separate ivetory schedule is ow required for each of five differet property classificatios. 33 Sigificat time will be spet by your subcotractors (ad you) i segregatig ivetory, verifyig the accuracy of ivetory records ad completig the requisite forms. Such costs are allowable termiatio expeses if they are reasoable i amout. Although the above-listed Stadard Forms are available for listigs of termiatio ivetory, a computer-geerated pritout will usually be acceptable as log as the certificatio from the ivetory schedules is siged. (This is a good example of a topic to discuss with the TCO at the termiatio coferece.) A practical solutio used by may cotractors is to complete the top part of the Stadard Form, execute the required certificatio, attach a pritout from the cotractor s ivetory cotrol system, ad the referece the attachmet o that part of the Stadard Form where the ivetory is to be listed. The Govermet ivetory schedules, which are required eve o a total cost basis settlemet proposal (discussed below), have colums for cost iformatio. Although may MRP ad accoutig systems are equipped to assig a cost to ivetory, it is importat that you disclose what cost elemets are icluded i the cost of ivetory. For example, you should dis- 8

9 close (a) whether the ivetory cost show icludes direct material oly or also icludes overhead, (b) whether the cost of purchased parts is based o a average of may purchases over multiple cotracts or is based o specific purchases o the termiated cotract, ad (c) whether direct labor is icluded. Storage The Govermet has the right to require the delivery of termiatio ivetory. I practice, it may take some time weeks if ot moths (or loger) after the effective date of the termiatio for the Govermet to determie what, if ay, termiatio ivetory it would like to receive. I the iterim, it is the cotractor s resposibility to store the ivetory i a secure locatio. As a prime cotractor, you must esure that your subcotractors uderstad the obligatio to store termiatio ivetory i a secure locatio pedig receipt of dispositio istructios. Subcotractors should be wared of the likelihood that their settlemet recovery will be reduced if termiatio ivetory is lost, damaged, or destroyed. Subcotractors should be remided that settlemet expeses iclude reasoable storage costs. 34 They also should be remided that subcotractors are etitled to a separate writte storage agreemet at the expiratio of the plat clearace period for ay items the Govermet does ot remove. 35 The plat clearace period begis o the effective date of termiatio ad eds 90 days after receipt by the TCO of acceptable ivetory schedules. 36 Dispositio After submissio of the ivetory schedules, the prime cotractor ad the TCO (or the TCO s appoited plat clearace officer) will discuss the issue of dispositio, ad the TCO will provide directio to the prime cotractor. The prime cotractor, i tur, should provide directio to its subcotractors cosistet with the TCO s directio. For termiatio ivetory that the Govermet does ot require to be delivered, dispositio icludes, i order of priority, purchase or retetio at cost, retur of property to the supplier, use withi the Govermet, doatio, sale, ad the abadomet or destructio. 37 Accordigly, you have two resposibilities as a prime cotractor. First, you must esure that your subcotractors are aware of ad comply with the istructios you receive from the TCO relatig to the delivery of termiatio ivetory. Secod, you should work with your subcotractors to determie whether ay of them wish to purchase termiatio ivetory at cost. Note that if a item of the termiatio ivetory is a commo item, the subcotractor is obligated to trasfer the material to its ow or aother s use at cost, so log as this does ot cause the subcotractor to sustai a loss. 38 But eve if the material is ot a commo item, a subcotractor may wish to, ad should be ecouraged to, purchase the ivetory at cost or make a offer to purchase ivetory at less tha its recorded cost. Sice the Govermet does ot always fid a alterative use for the termiatio ivetory, ad ofte evetually directs the cotractor to scrap some portio of the termiatio ivetory, the most ecoomical outcome for the Govermet ad the subcotractor may be for the subcotractor to purchase ay termiatio ivetory for which it has eve a margial use. You will eed to obtai the approval of the TCO, however, before sellig ay portio of the termiatio ivetory at less tha cost. Where the subcotractor trasfers or purchases termiatio ivetory, the subcotractor s settlemet proposal amout should reflect a reductio. Termiatio ivetory ot retaied by the subcotractor must be retured, sold, or otherwise disposed of as provided i the regulatios. Subcotractors are etitled to recover as a termiatio cost all reasoable expeses icurred i returig, sellig, or otherwise disposig of termiatio ivetory. 39 Ay reveue geerated i dispositio of the property is accouted for as a reductio o the subcotractor s termiatio settlemet proposal. As illustrated above, the goal of the regulatios relatig to termiatio ivetory is to verify 9

10 that the ivetory is accouted for, is segregated ad protected, ad was required for the termiated cotract i the quatities purchased, ad that commo ivetory has bee trasferred to other cotracts alog with the associated cost if such trasfer does ot cause the cotractor to sustai a loss. The process described above, however, applies most ofte where the cotractor ad subcotractors do ot ecessarily have a Govermetapproved property system. There are shorter, more efficiet, ad less paper-orieted processes that ofte are allowed by the TCO uder blaket authority whe the particular cotractor or subcotractor has a Govermet-approved property system. I at least two major termiatios of which the authors of this PAPER are familiar, the prime cotractors, ad a umber of subcotractors, had access to the Plat Clearace Automated Reutilizatio Screeig System (PCARSS) ad employed this system at the Govermet s directio to facilitate greatly the verificatio ad dispositio of termiatio ivetory. I these istaces, the PCARRS system was used i lieu of the ivetory schedules described above ad specified i the FAR. Subcotractor Settlemet Proposal Submissio Subcotractor settlemet proposals, although hadled separately from the prime cotractor s ow settlemet proposal, are a essetial part of the overall resolutio of the termiatio. Whe a major prime cotract is termiated, the result is ofte a chai reactio through several tiers of subcotractors. Each lower-tier subcotractor submits its settlemet proposal to the cotractor with whom it has privity of cotract, ad proposals are submitted back up the chai to evetually become embodied i the settlemet proposal submitted by the prime cotractor to the Govermet. Accordigly, clear commuicatio ad close coordiatio are ecessary to esure that the process is successful ad that the rights of cotractors at all tiers as well as the iterests of the Govermet are protected. Istructios To Subcotractors A best practice for prime cotractors is to prepare letters of istructio to subcotractors addressig the submissio of the termiatio settlemet proposal, cotiued voucherig if applicable, termiatio of lower-tier subcotractors ad suppliers, ad the dispositio of termiatio ivetory. Oe letter should be prepared for fixed-price subcotractors. A separate letter should be prepared for cost-reimbursemet subcotractors, which should the be tailored for time-ad-materials or labor-hour subcotractors. For fixed-priced subcotracts, there are three bases for preparig settlemet proposals: (1) the ivetory basis uder which the cotractor s costs are allocated to termiatio ivetory items such as raw materials, purchased parts, worki progress, ad fiished compoets, (2) the total cost basis uder which all costs icurred through the effective date of the termiatio as well as the cotiuig costs ad termiatio settlemet expeses are claimed as a lump sum (ote that costed ivetory schedules are also required whe usig the total cost basis settlemet proposal forms), ad (3) the short form (a abbreviated versio of the ivetory basis settlemet proposal) for settlemet proposals with a et paymet requested of less tha $10, You should advise your fixed-price subcotractors that settlemet proposals must be submitted o the ivetory basis uless the TCO approves i advace the use of the total cost method. 41 Circumstaces that may warrat the use of the total cost method iclude where the subcotractor has ot commeced productio, where ivetory uit costs caot readily be established uder the subcotractor s accoutig system, where the subcotract does ot specify uit prices, or where the termiatio is complete ad ivolves a letter cotract. 42 If a subcotractor requests your approval to use the total cost method, you should forward this request to the TCO ad advise the subcotractor that, although it may proceed with preparatio of its settlemet proposal as it deems appropriate, uless ad util the TCO approves of the use of the total cost method, ay work o such a proposal is doe at the subcotractor s ow risk. If your subcotractor submits a settlemet proposal o a total cost basis without the prior writte coset of the TCO, you should (abset uique circumstaces) reject it. 10

11 Cost-reimbursemet subcotractors should use the settlemet proposal form for cost-reimbursemet-type cotracts (SF 1437). As with the total cost basis settlemet proposal form for fixed-price cotracts (SF 1436), the completio of SF 1437 primarily requires the accumulatio of costs from the accoutig books ad records of the termiated subcotractor. As discussed above, you should istruct your subcotractors to submit a fial settlemet proposal o later tha six moths after the effective date of the termiatio. You should also ecourage your subcotractors to submit fial settlemet proposals earlier tha this deadlie, which would provide the opportuity for you to obtai correctios ad clarificatio of the submissio from the subcotractor. Settlemet Proposal Forms You should istruct your fixed-price subcotractors to submit their termiatio settlemet proposal o SF 1435, Settlemet Proposal (Ivetory Basis), alog with SF 1439, Schedule of Accoutig Iformatio. 43 Fixed-price subcotractors give prior approval for submissio o a total cost basis should be istructed to submit Stadard Form 1436, Settlemet Proposal (Total Cost Basis), rather tha Stadard Form Subcotractors with a termiatio settlemet claim of less tha $10,000 may use the short form, SF 1438, Settlemet Proposal (Short Form). 45 You should istruct your cost-reimbursemet subcotractors to submit their termiatio settlemet proposal usig SF May prime cotractors fid it helpful ad efficiet to direct their subcotractors to submit both paper ad electroic revisios of their settlemet proposals. You may wish to advise your subcotractors that a electroic versio of the termiatio forms ca be obtaied from the Geeral Service Admiistratio s Forms Library available at For a complete listig of the FAR termiatio forms for each type of settlemet proposal see Appedix B at the ed of this PAPER. Certificatios Each settlemet proposal form icludes a certificate that the cotractor is required to execute to certify that its settlemet proposal ad supportig schedules (a) were prepared from the books of accout ad records of the cotractor i accordace with recogized commercial accoutig practices, (b) iclude oly those charges allocable to the termiatio portio of the cotract, (c) were prepared with kowledge that they may be used as the basis for the settlemet of a claim agaist the Uited States, ad (d) state oly fair ad reasoable charges. 47 I additio, the cotractor must certify, with regard to its subcotractors charges, that (1) it has adequately examied the termiatio proposals of its immediate subcotractors; (2) the settlemets of immediate subcotractors charges (a) are fair ad reasoable, (b) are allocable to the termiated portio of the cotract, ad (c) were egotiated i good faith ad are ot more favorable to the immediate subcotractors because reimbursemet by the Govermet is ivolved; (3) it has received executed ad appropriate certificates from subcotractors with respect to their proposals; ad (4) it has o iformatio leadig it to doubt either the reasoableess of the settlemets with more remote subcotractors or that the charges for them are allocable to the cotract. The cotractor is also required to certify that, immediately upo receipt of amouts coverig settlemet with its immediate subcotractors, it will pay or credit subcotractors the appropriate amout. 48 Accordigly, as prime cotractor, you are required to certify both your ow settlemet charges ad those of your immediate subcotractors, although the terms of the certificatio are somewhat differet. Also, you eed to esure that your immediate subcotractors provide you with the requisite certificatios for their ow settlemet proposals as well as the settlemet proposals of lower-tier subcotractors ad suppliers. 11

12 Subcotractor Settlemet Proposal Review Iitial Steps To prepare for your review of subcotractor termiatio settlemet proposals, it is helpful to have check lists of the madatory forms ad items that are required to be submitted as part of the termiatio settlemet proposal as well as the steps you pla to take to review, egotiate, ad settle the termiatio proposals. A separate check list should be prepared for each type of subcotract proposal fixed price, costreimbursemet, or short form that you will be required to review. Upo receipt of a subcotractor s termiatio settlemet proposal, you should review the proposal ad supportig schedules for completeess. Specifically, you should determie whether all of the required forms have bee submitted (a listig of the required forms is provided i Appedix B at the ed of this PAPER), whether the proposal forms have bee properly prepared with all applicable blocks filled i ad all questios aswered, whether the required certificatios have bee siged ad submitted, ad whether the supportig schedules are i accord with the proposal. You should also check the mathematical computatios of the settlemet proposal for accuracy. Assumig the subcotractor s termiatio settlemet proposal is complete, there are three major areas for you to review. First, a techical review of the proposal iformatio should be coducted. This review would iclude a review of the work the subcotractor claims to have performed before receipt of the otice of termiatio as well as ay cotiuig work. You will eed to determie, for example, that all work performed was withi the scope of the subcotract agreemet ad that the labor hours icurred ad material charges appear reasoable. The techical review also may determie the estimate to complete ad the percetage of completio at the time of termiatio. The secod major area for review is cost. Most of the cost issues faced by termiated subcotractors are the same as those faced by the termiated prime cotractor. The primary issues relate to the differet roles ad resposibilities of the prime cotractor as both a seller of goods ad services to the Govermet ad a buyer of goods ad services from subcotractors. As a termiated seller, you accumulate ad report cost iformatio to your customer, the Govermet. As the buyer of goods ad services from termiated subcotractors, you are resposible for overseeig the subcotractors ad evaluatig the cost iformatio submitted to you. It is importat that you cosistetly ad fairly treat various cost issues, or that you uderstad ad ca articulate why you accepted a subcotractor s treatmet of a particular cost i its proposal eve though it may ot have bee cosistet with the treatmet you gave a similar cost i your prime cotractor termiatio proposal. Some of the more importat cost issues to iitially ivestigate iclude the followig: (a) Mathematical Cosistecy Esure the umbers flow correctly from the subsidiary schedules up to the summary termiatio schedules. For example, o a ivetory basis settlemet proposal, the total cost of Purchased Parts show o Ivetory Schedule B (SF 1428) should flow up to lie 3, Purchased Parts, o the Settlemet Proposal summary form (SF 1435). Also esure that the amouts show o the settlemet proposal are cosistet with records of costs icurred by the subcotractor. For example, review the last cost performace report (if applicable) you received from a cost-reimbursemet subcotractor to see if the actual cost of work performed just before the termiatio, plus ay vouchered cost, is approximately the same as the amout icluded o the settlemet proposal. (b) Loss Cotracts O fixed-price cotracts, the FAR provides that the TCO will ot allow profit if it appears that the cotractor would have icurred a loss had the etire cotract bee completed. Moreover, the TCO will reduce the settlemet to reflect the idicated rate of loss. 49 These provisios have a large impact o the fial settlemet if the subcotractor was i a loss positio. Partially because of this, there is ofte disagreemet over whether or ot the subcotractor would have icurred a loss. To fully ivestigate this issue, it is usu- 12

13 ally ecessary to obtai the subcotractor s cost estimate-at-completio from just before or just after the termiatio ad to compare this estimate-at-completio to the subcotract value. Note that the subcotractor s aswers provided o the Schedule of Accoutig Iformatio (SF 1439) to Questio 12 are desiged to assist you i this ivestigatio. (c) Completio Percetage The loss adjustmet provisio discussed above does ot apply to costreimbursemet cotracts. If a cost-reimbursemet cotract is termiated for coveiece the subcotractor is allowed to recover its reasoable, allowable, ad allocable costs (up to the cost ceilig), settlemet expeses, ad a percetage of the fee equal to the percetage of work completed. 50 The iitial ivestigatio of termiated cost-reimbursemet subcotracts should iclude a review of the cost ceilig to determie if it will limit the recovery of costs to the subcotractor as well as the subcotractor s completio percetage sice the fee received will be based o this completio percetage. (d) Profit/Fee You should esure that profit or fee has ot bee added to settlemet expeses or based o settlemets with lowertier subcotractors or suppliers. 51 The profit allowed o a fixed-price subcotract should be based, to the extet possible, o the ie factors listed i the FAR. 52 Although some of these ie factors may ot apply to your particular situatio, you should be able to obtai iformatio o at least a few of these factors (e.g., profit rate icluded i the origial subcotract proposal ad profit the subcotractor was projected to ear if ot termiated ad allowed to complete the subcotract). A recet decisio by the Armed Services Board of Cotract Appeals affects the fee that a cost-reimbursemet prime cotractor ca recover o cost-reimbursemet subcotracts uder somewhat limited circumstaces. 53 The board i that case held that o fixed-price cotracts, the FAR specifically permits fee o completed subcotractor work. The board poited out that, by cotrast, the FAR laguage relatig to cost-reimbursemet cotracts does ot have a exceptio for completed work. 54 The FAR states simply that the cotractor s adjusted fee shall ot iclude a allowace for fee for subcotract effort icluded i subcotractors settlemet proposals. 55 The case makes clear that while the prime cotractor is ot etitled to recover fee o subcotractor cost icluded i subcotractors settlemet proposals, the prime is etitled to recover fee o subcotractor costs that were vouchered. (d) Reclassificatio of Costs It is ot ucommo for termiatios to give rise to situatios where it is ecessary to modify the treatmet of costs such that costs ormally treated as idirect costs become direct costs assigable directly to the termiated subcotract. 56 You should ivestigate the circumstaces ivolved to esure that the reclassificatio was proper ad that the reclassificatio does ot cause some elemets of cost to be double-couted (e.g., couted as both a direct cost ad as part of a idirect allocatio). Note that the subcotractor s aswers provided o the Schedule of Accoutig Iformatio (SF 1439) are desiged to assist you i this ivestigatio. The third major area of review of a subcotractors termiatio settlemet proposal is property. You should esure that your istructios were followed by the subcotractor, that the subcotractor s Govermet property list was received ad reviewed, that retaied parts were shipped as directed, ad that the proposal reflects the proper credit for scrapped or sold items. Audit It is the resposibility of the prime cotractor to perform all ecessary accoutig reviews ad field audits of subcotractor settlemet proposals. 57 Each subcotractor settlemet must be supported by sufficiet fiacial iformatio to permit adequate Govermet review sice i may istaces the DCAA or other audit agecy also reviews these settlemet proposals ad provides fidigs to the TCO. The FAR does ot madate the type of audit that you must coduct. Rather, the type of audit to be performed o a subcotractor s termiatio settlemet proposal is a matter for 13

14 the prime cotractor to determie ad will deped o a umber of factors icludig the dollar value of the settlemet proposal, whether the proposal is o the ivetory basis or the total cost basis, whether the subcotractor has a Govermet-approved accoutig system, ad the perceived level of risk ivolved. The DCAA Cotract Audit Maual addresses i detail the steps the DCAA believes are required for a proper coveiece termiatio audit. While ot bidig o the prime cotractor, the Cotract Audit Maual provides guidace for the cotractor i coductig subcotract termiatio audits. 58 This same material is addressed i the format of a Audit Program with specific audit steps available at the DCAA s website at Both the DCAA Cotract Audit Maual ad the various Audit Programs address the full rage of audit review that may be required from the desk review of a low-risk voucher to the full audit, icludig site visit, of a complex ad high-value termiatio settlemet proposal package. O large termiatio actios, it is ofte efficiet to create various thresholds ad decisio rules specifyig the types of audits or reviews that will be coducted for differet categories of the subcotractors. This allows audit resources to be prioritized ad expeded o the riskier areas. For example, short-form settlemet proposals of uder $10,000 would be reviewed i accordace with a abbreviated desk review procedure; for settlemet proposals of betwee $10,000 ad $100,000, a desk review would be coducted icludig a review of documets from the subcotractor ad a telephoic questio-ad-aswer dialogue betwee the prime cotractor ad the subcotractor. For settlemet proposals of over $100,000, all of the steps described above would be followed as well as oe or more visits to the subcotractor s site to test accoutig ad ivetory records. You should ot adhere to thresholds such as the oes described above too rigorously, however, sice there may be exceptioal cases that would warrat a higher stadard of review (e.g., a sigificat risk of overpaymet o a lowvalue settlemet proposal). For cost-reimbursemet type cotracts, the audit procedures are very similar to those established for a ormal icurred cost audit, which are addressed i Chapter Six of the DCAA Cotract Audit Maual. If the goal is to settle the termiatio ad close the subcotract, there will typically be two separate audit actios required: (1) preparatio of a cotract audit closig statemet addressig costs that were vouchered after the termiatio ad possibly before the termiatio, ad (2) preparatio of a audit report addressig the fial settlemet proposal. 59 As for the audit of a termiated fixed-price cotract, the DCCA Cotract Audit Maual describes the two acceptable settlemet proposal bases ivetory basis ad total cost basis. Regardig ivetory basis settlemet proposals, the Maual otes that the ivetory basis requires that the cotractor directly associate the costs ad profit i the settlemet proposal with uits or services termiated. It limits the proposal to those items which are residual due to the termiatio actio. Usig the ivetory basis for submittig settlemet proposals is the method preferred by the govermet. 60 Regardig total cost basis settlemet proposals, the Maual otes that [i] cotrast, a settlemet proposal o a total cost basis is for total costs icurred uder the etire cotract util termiatio, by elemets such as labor, material, ad idirect costs plus settlemet expeses ad profit, less the cotract price of delivered items. The auditor s mai iterest i the termiatio ivetory is ot its value, but whether all ivetory items are properly idetified ad made available to the govermet. The govermet ormally gives approval to use the total cost basis oly whe the ivetory basis is ot feasible or would uduly delay the settlemet. 61 Uder certai circumstaces, the Govermet may assist the prime cotractor i coductig a accoutig review or audit of subcotractor settlemet proposals. Most commoly, a TCO may request that the Govermet audit agecy perform the accoutig review where the subcotractor is a competitor of the prime cotractor ad therefore objects to the prime cotractor reviewig its accoutig records. May TCOs, however, will restrict the referral to competitively sesitive iformatio for example, overhead rates ad require that the prime cotractor coduct its ow accoutig review of 14