COSTS, PRICING & ACCOUNTING REPORT

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1 Reprinted with permission from Government Contract Costs, Pricing & Accounting Report, Volume 8, Issue 4, K2013 Thomson Reuters. Further reproduction without permission of the publisher is prohibited. For additional information about this publication, please visit GOVERNMENT CONTRACT COSTS, PRICING & ACCOUNTING REPORT JULY 2013 VOLUME 8 ISSUE 4 29 Case Note: ASBCA Rejects Government's Four Damages Theories In Recent Defective Pricing Case Stephen D. Knight 1 Appeal of Lockheed Martin Aeronautics Company, A.S.B.C.A. No , 13-1 B.C.A. (CCH) 35220, 2013 WL (Armed Serv. B.C.A. 2013), is a failed Government attempt to impose defective pricing liability on the contractor. The Government proceeded on unsubstantiated assumptions and four theories of damages two before trial and two after trial leading to a predictable result. The only unanswered question is why the Government chose to assert such a claim at all. Note to litigators: If you are proceeding to trial with multiple and inconsistent damages theories, most of which your auditor witness does not support, you should reconsider the reason for going to trial. The Contracts at Issue common con guration implementation program (CCIP) involved changes to such hardware and software. One of the hardware items LM Aero supplied under the CCIP was the modular mission computer (MMC), which LM Aero purchased from Raytheon Systems Co. Prior to 1999, most production F-16s used an early version called the MMC The two contracts at issue involved a new version, the MMC The rst contract at issue was an engineering and manufacturing development (EMD) contract for the development of the MMC 5000 and other elements used in the CCIP retro t kits. The modules produced under the EMD contract were not production units and were not required to meet the same speci cations as production units. On June 25, 1998, LM Aero issued a purchase order to Raytheon (the Bridge PO) to satisfy short-term needs for MMC 3000 units and a few EMD components for the next generation MMC 5000 systems. The Bridge PO was not intended to cover components for Lockheed Martin Aeronautics Company (LM or LM Aero) provided retro t kits used by the Air Force to install hardware and software in F-16 aircraft. The 1 Stephen D. Knight is a member of Smith Pachter McWhorter PLC, and specializes in Government contract cost allowability, Cost Accounting Standards, defective pricing, audit and compliance issues. Mr. Knight has substantial experience in Government contract claims and litigation, including Government allegations of procurement fraud. A recognized author and lecturer, Mr. Knight has served as an adjunct professor with the George Washington University Law School's Masters in Procurement Law program for the past twenty years.

2 production of MMC 5000 to be supplied under the subsequent production contract. On July 9, 1998, LM Aero issued a solicitation to Raytheon for the material requirements contract ( MRC ), which was to procure MMC 5000 units in support of the CCIP production contract between LM Aero and the Air Force. The Government alleged that LM Aero failed to disclose data related to the Bridge PO negotiations with Raytheon, which resulted in defective pricing of MMC 5000 units purchased by the Air Force pursuant to the second contract at issue, the CCIP production contract. Signi cant di erences existed between the Bridge PO and the MRC solicitation. First, the Bridge PO envisioned a four-month delivery period; the MRC solicitation envisioned a ve-year delivery period. Second, although the Bridge PO contained no variable pricing, the MRC solicitation requested Raytheon to propose prices contingent on the average monthly delivery rate (AMDR), with the actual price to be determined later, after LM Aero's quantity requirements were set. LM Aero required Raytheon to submit prices that provided price breaks as lot size increased. Third, the Bridge PO supplied mostly MMC 3000 components, with some MMC 5000 development components consisting of approximately 46 shipsets, eight of which related to MMC By contrast, the MRC solicitation concerned MMC 5000 production units of approximately 620 systems. In terms of AMDR, the Bridge PO contemplated a monthly delivery rate (46 shipsets over a four-month period). Fourth, the Bridge PO MMC 3000 units had been in steady production for years and were considered o the shelf. The MRC solicitation, however, required a quantity adjustment factor in pricing to account for set-up time associated with lower quantities. Fifth, escalation was a signi cant risk factor for the MRC solicitation, but not for the Bridge PO. The Negotiation Process Raytheon responded to the Bridge PO on July 29, 1998, with a proposed price of $13.4 million in accordance with its most economical delivery schedule, and an additional $2.02 million if LM Aero opted for a delayed delivery schedule. On May 12, 1999, Raytheon submitted a proposal for the Bridge PO, assuming early delivery, of $18.5 million, and indicated that the price per equivalent shipset was $345,082. On July 16, 1999, Raytheon revised its o er on the Bridge PO to $15.68 million, re ecting its decision not to develop an alternate power supply source. On July 23, Raytheon and LM Aero reached agreement on the price for the Bridge PO in the amount of $15.45 million. Raytheon and LM Aero did not break out and allocate the price to individual MMC 3000 and MMC 5000 components until Aug. 6, During negotiations, LM Aero obtained a subcontract decrement amounting to a four-percent reduction. 2 During this same period, LM Aero and Raytheon negotiated the MRC solicitation to support the Air Force's CCIP production contract. The Air Force issued its request for proposal for the CCIP production contract to LM Aero on Sept. 1, On Oct. 15, 1998, Raytheon submitted its proposal to LM Aero for MMC 5000 production units in AMDR ranges of 1 3, 4 9, and Unit prices decreased over time as well as for increased quantities. Raytheon updated its proposal on April 1, 1999, with prices that were highly sensitive to delivery rate. For example, for an AMDR of 4 9, the proposed price was $538,784 for the rst delivery period and $397,177 for the second. For an AMDR of 10 15, the proposed price was $ for the rst delivery period, and $322,785 for the second. LM Aero and the Air Force reached price agreement on the CCIP production contract on July 30, 1999; LM Aero submitted its certi cate of current cost or pricing data on that date. Because LM Aero had not completed its negotiations with Raytheon for the MRC quantities of MMC 5000 units, this element of the negotiated price was based on Raytheon's proposals, especially the April 1, 1999 proposal and supporting cost data. LM Aero and Raytheon reached price agreement on the MRC on Jan. 28, 2000, about six months after the conclusion of CCIP contract negotiations. 2 K 2013 Thomson Reuters

3 Postaward Audit and CO's Final Decision; Pre- Hearing Revised Recommended Price Adjustments In September 2002, the Defense Contract Audit Agency issued a postaward audit report alleging that LM Aero's pricing on the CCIP contract was defective because LM Aero failed to disclose signi cantly lower prices for MMC computer components under the Bridge subcontract, and that these prices were available to LM Aero on July 23, 1999, before the July 30, 1999 nal price agreement on the CCIP contract. DCAA recommended a price adjustment of $14.58 million. On May 8, 2008, the contracting o cer issued a nal decision upholding the DCAA position. The DCAA position derived the Bridge PO MMC shipset price by dividing the recurring price of the Bridge PO by the total number of equivalent units of MMC 5000 and MMC 3000 systems purchased under the Bridge PO, for comparison with the MMC systems purchased under the CCIP contract. DCAA made no distinction between the older MMC 3000 and the new MMC 5000 systems. In comparing delivery rates between the Bridge PO and the MRC, DCAA assumed a delivery rate for the entire performance period of the Bridge PO from June 1999 to September For purposes of comparing the Bridge PO to the MRC, DCAA used the AMDR 4 9 prices under the MRC. The Armed Services Board of Contract Appeals determined that if the DCAA price adjustment were recalculated by changing only the MMC 5000 system price (separating it from the MMC 3000 system price) in the Bridge PO, the Government's recommended price adjustment would have been $3.6 million, rather than the initially claimed $14.98 million. The Board also determined that a valid comparison of prices between the Bridge and MRC subcontracts required consideration that the appropriate AMDR was 10 15, not 4 9. If both of these adjustments were made, the Board noted, the entire recommended price adjustment would be eliminated. In its pretrial cross-motion for summary judgment, the Government o ered a revised damages theory, the revised recommended price adjustment (RRPA). The Air Force's RRPA assumed a 26.3-percent decrement K 2013 Thomson Reuters for the Bridge PO between scal years 1999 and 2000, based on the same decrease in Raytheon's MRC proposal for an AMDR of 4 9. The Board stated, There is no evidence in the record that the Air Force's RRPA and/or proposed decrement were reviewed, analyzed, or approved by, negotiators or the CO prior to its presentation in the [Air Force] cross-motion, and its assumed decrement is based solely on the abovedescribed price reduction between the rst and second period of the MRC in [the] AMDR 4 9 range. It is otherwise unsupported by documents or testimony in the record... The post-award auditor (the only auditor who examined the RRPA after the motion was led) disclaimed any theoretical justi cation for the calculation, admitting at trial that his calculations were for the purpose of trying to prepare something for the trial attorney and not based on new information or his own independent judgment. The auditor did not discuss the RRPA with his supervisors and no supplemental audit report was issued. Slip op. at 13. The Board found LM Aero's expert persuasive that the di erences between the rst and second period CCIP prices were reasonable and most likely attributable to other factors: most likely the result of frontloading costs on the early units of a multi-year contract not by production e ciencies in later years. Id. at 23. The Board also noted that if the RRPA were adjusted using the MMC 5000 system shipset at a AMDR and compared to the proposed MRC price, the proposed price adjustment would also be eliminated. Post-Trial Damages Theories In its post-trial brief, the Air Force proposed, for the rst time, two new alternative theories of damages. The rst reached a damage calculation of $9.93 million; the second was $9.32 million. The Board stated, There is no reasonable basis or good cause o ered for the government's failure to timely present the quantum calculations. There is nothing in the evidentiary record, or even the government post-hearing briefs that adequately explains the assumptions underlying the calculations. The computations and assumptions inherent in the theories are far from clear, obvious and logical without testimony or record support. They are not reconcilable with the original damages computation prepared by the auditor and adopted by the CO. As 3

4 noted above, the DCAA auditor declined to endorse fundamental assumptions associated with the pre-trial RRPA... There is nothing in the record that post-trial RRPAs were endorsed by government auditors, negotiators and/or the CO. To the limited extent the calculations and assumptions underlying the post-trial revisions can be understood and analyzed without explanatory and supporting testimony, they appear to su er from the same or similar conceptual problems and de ciencies discussed above. Slip op. at 15. The Board stated that those de ciencies included the same awed 4 9 AMDR assumption and an assumed decrement between the rst and second delivery periods. The Board rejected the Government's assertion that the di erence between Raytheon's February and May 1999 Bridge proposals resulted from a negotiated reduction. No record testimony supports the latter conclusion. Id. at 24. Government Positions Unsupported by Facts The Board was blunt in its determinations that none of the Government's four damages theories was supported by the facts. All four proceeded on the basis of unsupported assumptions without any evidentiary support. Unfortunately, this is not the rst time the Government has pushed a bad position. At least two decisions last year Appeals of J.F. Taylor, Inc., A.S.B.C.A. No , 12-1 B.C.A. (CCH) 34920, 2012 WL (Armed Serv. B.C.A. 2012), and Appeals of Metron, Inc., A.S.B.C.A. No , 12-2 B.C.A. (CCH) 35066, 2012 WL (Armed Serv. B.C.A. 2012) show the Government acting the same way in the context of cost disallowance cases. When contractors have advanced what a judge determined to be inconsistent damages theories not supported by facts, contractors have been found liable for civil fraud. No similar consequence results from the same actions by the Government. For example, in Daewoo Engineering and Const. Co., Ltd. v. U.S., 73 Fed. Cl. 547 (2006), judgment a 'd, 557 F.3d 1332 (Fed. Cir. 2009), the court upheld the Government's counterclaims based on civil fraud because the court found that Daewoo had led its equitable adjustment claim as a negotiating ploy. In so holding, the court noted that Daewoo's expert wanted it known that they had nothing to do with the certi ed claim and the certi ed claim, became an orphan during trial, supported by no one and barely acknowledged by plainti 's attorneys. 73 Fed. Cl. at 573. Signi cantly, the court also stated, [A] failure to make a minimal examination of records constitutes deliberate ignorance or reckless disregard, and a contractor that deliberately ignored false information submitted as part of a claim is liable under the False Claims Act. Id. at 584 (quoting United States v. TDC Management Corp., 24 F. 3d 292 (D.C. Cir. 1994)). Misrepresentation of fact is de ned in the [Contract Disputes Act Fraud Statute] as a false statement of substantive fact, or any conduct which leads to a belief of a substantive fact material to proper understanding of the matter in hand, made with intent to deceive or mislead. Id. Plainti did not honestly believe that the Government owed it the various amounts stated when it certi ed the claim. Id. at 590. The U.S. Court of Appeals for the Federal Circuit underscored the positions articulated by the Court of Federal Claims. The Federal Circuit stated in part, Finally, Daewoo appears to argue that a claim can be fraudulent only if it rests upon false facts rather than on a baseless calculation. We disagree... By certifying a claim for damages in the amount of $64 million, Daewoo represented that the claim was made in good faith. It is well established that a baseless certi ed claim is a fraudulent claim. For instance, the First Circuit has held that if a party knows that its claim that it is entitled to funds under a letter of credit has no plausible or colorable basis, then the party's e ort to obtain the money is fraudulent. 557 F. 3d at These statements are relevant to the Government in Lockheed Martin Aeronautics. The original DCAAcalculated damages ignored clear di erences between the Bridge PO and the MRC subcontract that supported the Air Force production contract; DCAA's calculations were not based on facts. The Bridge PO related 4 K 2013 Thomson Reuters

5 to mostly MMC 3000 components, and only a few MMC 5000 components. What MMC 5000 components the Bridge PO covered were EMD, not production, components. MMC 3000 components were considered o the shelf, whereas the MMC 5000 components required quantity adjustments in price to account for set-up time. The AMDR di ered between the Bridge PO and the MRC production contract. Ignoring these di erences resulted in a DCAA calculation that understated the Bridge PO price, assuming the Bridge PO was even relevant. The Government compounded this problem with its assertion of three additional damages calculations one before trial and two afterward. These theories essentially made an orphan of the original DCAA calculation: the DCAA auditor disclaimed any theoretical justi cation for the RRPA. The Board made clear that none of these calculations was supported by any facts. The Board stated, The most fundamental problem with [the Government's] assertion here is that the pre-trial [RRPA] and the post-trial RRPAs are not based on the facts. They are based on a selective, out-of-context reading and/or unreasonable interpretation of the facts. They also ignore signi cant evidence as well as diametrically opposed interpretations by the [CO] and auditors of the same facts that provided the original foundation for the [Air Force's] defective pricing claim. Contemporaneously, the auditors and CO viewed the facts di erently. Even at the trial twelve years after the negotiation of the... contract in dispute, the auditor declined to support the revised damage theories.... At times, the multiple government damages theories are inconsistent and contradictory. It is a challenge to determine precisely what damages the government considers logically owed from the alleged nondisclosure... Slip op. at 20. The Government in Lockheed Martin Aeronautics acted the same as the court determined the contractor had acted in Daewoo: the Government asserted multiple baseless calculations of damages for defective pricing. Since little likelihood exists that the Government will assert fraud claims against either DCAA or itself, the Government should exercise some selfcontrol and refuse to litigate cases in which its position is unsupported by the facts. ENDNOTES: 2 Although Raytheon's May 12, 1999, proposal totaled $18.5 million and the nal Bridge price as $15.45 million (or a 16.5-percent reduction), most of this reduction was due to the elimination of nonrecurring costs associated with the decision to eliminate the development of an alternate power supply. Another part of the reduction was due to an extended delivery option that LM Aero decided not to exercise. 3 After execution of the Bridge PO, the delivery schedule slipped due to delays by Raytheon. K 2013 Thomson Reuters 5