Cost Recovery Issues After A Termination For Convenience

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2 Cost Recovery Issues After A Termination For Convenience Breakout Session # C15 Leslie Anderson, Program Manager, BAE Systems Greg Bingham, Vice President, The Kenrich Group Chelsea Taylor, Manager, The Kenrich Group July 28, :00pm

3 Agenda 1. Overview of 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 Termination Cost Principle 6. FAR Part 12 Commercial Item Termination 7. Audit Issues in Terminations for Convenience 8. Questions & Answers 2

4 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. 3

5 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. 4

6 Overview of Termination Process 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. Contractor also begins the process of settling with its subcontractors. 5

7 Termination Settlement The contractor has one year from the effective date of the termination to submit a settlement proposal to the Contracting Officer. The amount of the settlement proposal reflects all of the costs for which the contractor believes it is entitled to be reimbursed. 6

8 Details of Termination Process FAR Part 49 Subpart General Principles Subpart Additional Principles for Fixed-Price Contracts Terminated for Convenience Subpart Additional Principles for Cost- Reimbursement Contracts Terminated for Convenience Subpart Termination for Default Subpart Contract Termination Clauses Subpart Contract Termination Forms and Formats 7

9 General Principals FAR Contractor Responsibilities Stop Work Immediately Terminate All Subcontractors Advise TCO of Special Circumstances Precluding Work Stoppage Perform the Continued Portion of the Contract Protect and Preserve Government Property Notify the TCO of any Legal Proceedings Settle with Subcontractors/Suppliers (Subject to TCO Approval) Submit a Termination Settlement Proposal (TSP) Dispose of Termination Inventory 8

10 General Principals Additional Termination Activities Cost Accumulation Budgeting/Forecasting Inventory Identification and Classification Data Management Reductions in Force Training/Reassignment Any Other Tasks Requested by TCO 9

11 General Principals FAR 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 10

12 Details of Termination Process FAR Part 49 Subpart General Principles Subpart Additional Principles for Fixed-Price Contracts Terminated for Convenience Subpart Additional Principles for Cost- Reimbursement Contracts Terminated for Convenience Subpart Termination for Default Subpart Contract Termination Clauses Subpart Contract Termination Forms and Formats 11

13 Fixed-Price Contracts FAR Subpart 49.2 Key Points FAR Reference Settlement Profit Factors Loss Contract Recovery Adjustment Settlement Proposal Bases

14 The Fair Compensation Principle "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 (a) See also - FAR (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... And - FAR (d) If an overall settlement of costs is agreed upon, agreement on each element of cost is not necessary... 13

15 Do the Cost Principles Apply? YES - Relevant clauses read that all termination costs shall be in accordance with the applicable Cost Principle (See FAR ) NO - See the Fair Compensation Principle at FAR YES / NO - See case law precedent 14

16 Settlement Profit Factors FAR (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 15

17 Settlement Profit Factors FAR (b), (cont.) 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 Summary: Broad TCO discretion to determine profit 16

18 Equitable Adjustment After Partial Termination FAR Contractor may request an Equitable Adjustment on continued work Contracting Officer has authority, unless delegated to the TCO Follow Cost/Pricing Proposal Format (15.408) Costs included in a Request for Equitable Adjustment shall not also be included in the termination settlement proposal ( TSP ) Subcontractor shall complete TINA Certification 17

19 Details of Termination Process FAR Part 49 Subpart General Principles Subpart Additional Principles for Fixed-Price Contracts Terminated for Convenience Subpart Additional Principles for Cost- Reimbursement Contracts Terminated for Convenience Subpart Termination for Default Subpart Contract Termination Clauses Subpart Contract Termination Forms and Formats 18

20 Additional Principles for Cost Reimbursement Contracts FAR Subpart 49.3 Key Points FAR Reference Vouching Fee Adjustment

21 Vouching FAR 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 20

22 Fee Adjustment FAR 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. (49.115) Target Fee Applies 21

23 Contract Termination Forms FAR Subpart 49.6 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

24 General Principles Cost Principles Use FAR Termination Costs - 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. FAR (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 23

25 Common Items FAR (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 24

26 Cost Continuing After Termination FAR (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 - Unabsorbed or Extended Overhead - Severance Pay 25

27 Cost Continuing After Termination FAR Example 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

28 Cost Continuing After Termination FAR (g) Example 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... 27

29 Cost Continuing After Termination Reduction in Force (RIF) Issues Separate policies for divisions/locations Differing benefits for each employee category Calculation of required reductions (all related to the termination?) Bumping (termination of personnel not assigned to the terminated contract) 28

30 Cost Continuing After Termination Reduction in Force (RIF) Issues (cont.) Relevant Costs Severance payments Job search costs Outplacement services COBRA benefits (subject to HIPAA restrictions) Key Issues: comply with policies and document steps taken 29

31 Termination Costs FAR (c) Initial Costs 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... 30

32 Termination Costs FAR (d) Loss of Useful Value (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. 31

33 Termination Costs FAR (e) Rental Under Unexpired Leases (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. 32

34 Termination Costs FAR (f) Alteration of Leased Property (f) The cost of alterations and reasonable restorations required by the lease may be allowed when the alterations were necessary for performing the contract. 33

35 Termination Costs FAR (g) Settlement Expenses (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. 34

36 Termination Costs FAR (h) Settlement with Subcontractors Limited to settlements allocable to the termination ( ) 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 35

37 Termination Costs 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. 36

38 Commercial Item Termination FAR (a) General the requirements of Part 49 do not apply when terminating contracts for commercial items 37

39 Commercial Item Termination FAR (c) 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 38

40 Commercial Item Termination FAR (d) Termination for the Government s Convenience 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 39 (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.

41 Audit Issues Encountered After A Termination 1. Limitation of Funds vs. Termination Responsibilities which contract clause rules? 2. Funding for lower-tier suppliers and subcontractors 3. Unsettled contract changes with Lower-Tier or Upper-Tier Contractors (e.g., undefinitized changes, Requests For Equitable Adjustments) 4. Scope of Ongoing Work (e.g., charge numbers, scope definition, continuing to voucher past the six month period) 5. Form of Termination Settlement proposal on fixed-price contracts (i.e., SF 1435 Inventory Basis vs. SF 1436 Total Cost Basis) 40

42 Audit Issues Continued 6. Recovery of the cost of layoffs and severance (e.g., demonstrating that the termination caused the severance, how much of the severance cost should the terminated contract bear) 7. Cash Flow Issues (e.g., vouchering for six months, SF 1440 Application for Partial Payment, Recovery Of Settlement Expenses, and Settlements with Subcontractors) 8. Inventory (e.g., Ongoing Protection, Physical Count, Spoilage, Inventory Schedules Within 120 Days) 9. Auditing of subcontractors who are also competitors (e.g., obtaining Cost or Pricing Data, DCAA Audits, Third Party Audits) 41

43 Audit Issues Continued 10. Fee on Cost-Plus Contracts and FAR Fixed fee and measurement of completion percentage Award fee and the application of award fee plans which do not anticipate termination 11. Profit on fixed-price contracts and the nine factors at FAR Loss on fixed-price contracts and the loss ratio provisions of FAR Termination Forms (e.g., SF1439 Schedule of Accounting Information) 42

44 Audit Issues Continued 14. Dealing with DCAA Audit Reports Extensive qualifications or limitations We do not consider to be acceptable as the basis for the settlement of a fair and reasonable amount. Extensive delay in conducting audit 15. Fraud Referrals and other allegations 16. Records Retention 17. Reliance on copies 43

45 Audit Issues Continued 18. Interpretation of FAR (d) 19. Questioning completion of work 20. DCAA s audit standards compared to preponderance of the evidence 21. Settlement Negotiation Memorandum and FAR and FAR Settling prior to the finalization of indirect rates 23. Settlement contingent on subcontractor settlements or other issues 44

46 Audit Issues Continued Interpretation of FAR (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 45

47 Audit Issues Continued Reliance on copies [The Contractor] did not maintain original source documentation for all transaction selected for testing [S]upport provided included documentation received by [the Contractor] in an electronic formation (invoices received via ). [W]e are unable to evaluate [the Contractor s] process for maintaining the integrity of documents received electronically. Accordingly, we were unable to determine whether reliance could be placed on the copies provided and relied on during our audit. Example DCAA Audit Report 46

48 Greg Bingham Greg Bingham is a Vice President with The Kenrich Group, LLC. He has over 25 years of experience in the fields of business and litigation consulting including investigation of allegations of fraud or overbilling. Professional Experience Mr. Bingham has assisted clients on Government Contract matters including: 1) regulatory consulting on allowable costs issues arising from the Cost Principles found at Part 31 of the Federal Acquisition Regulation ( FAR ) as well as allocation of cost issues associated with the Cost Accounting Standards ( CAS ), 2) consulting on matters involving allegations of defective pricing, false claims, mischarges and other improper billings to the Government, 3) the Earned Value Management Systems requirements of Department of Defense regulation R (April 5, 2002), 4) financial statement and special purpose auditing, 5) management consulting and 6) Foreign Military Sales issues and foreign sales issues. This experience has provided him with substantial knowledge of the program management, financial and accounting records and systems maintained by companies who sell to the Federal Government. Greg s work has included the quantification of cost impacts and negotiation with Government auditors and oversight personnel. Greg has planned and performed reviews of various defense contractors systems including material management, accounting, inventory and internal policies and procedures along with the evaluation of operating inefficiencies and internal control deficiencies. Masters of Business Administration University of Texas at Austin Bachelor of Science in Electrical Engineering University of Kentucky Contact Information: 1919 M Street, NW Suite 620 Washington, DC Tel: (202) Fax: (202) gbingham@kenrichgroup.com 47

49 Selected Termination Experience Future Combat System Termination. Various roles. Army Armed Reconnaissance Helicopter (ARH)-70A Termination USPS Convenience Termination and Dispute with Subcontractor Convenience Termination of Crusader Artillery Program. Oversaw evaluation and settlement with approximately 50 subcontractors A-12 Termination. Primary Focus was More Than Three Hundred Subcontractors and Suppliers Convenience Termination of Power Plant Construction Project Compaq v Hardware Technologies Dispute Over Convenience Termination of IDIQ Contract Earth Tech v IT Corporation Dispute Over Costs in Convenience Termination of IDIQ Contract InTown Termination for Default Overturned and Convenience Termination Settlement. Provided Testimony at Mediation Which Proved Successful Obayashi Super Collider Convenience Termination Raytheon v Datatape Termination of Subcontractor for Default. Default Converted to Convenience. Evaluated Termination for Convenience Claims Raytheon Default Termination and Claims 48

50 Chelsea Taylor Chelsea Taylor is a Manager with The Kenrich Group, LLC. She is a Certified Fraud Examiner with extensive experience in government contracts, construction, utilities, and other commercial industries. The support she provides to clients has included compliance review, damages analysis, and litigation support.. Professional Experience Chelsea has worked on multiple government contract matters helping government contractors with: (1) consulting on compliance with FAR Part 31 Cost Principles for Government audits and disputes between contractors and the Government; (2) the preparation, review, and negotiation of termination settlement proposals (TSPs), (3) the preparation and review of Incurred Cost Submissions; (4) preparation, review, and analysis of Requests for Equitable Adjustment ( REAs ) and claims; (5) damages analysis resulting from defective pricing, false claims, Truth in Negotiations Act (TINA) claims, Contract Disputes Act (CDA) claims, and (6) analyzing cost realism in bid protests, among other matters. Bachelor of Science in Commerce, with Concentrations in Finance and International Business University of Virginia Contact Information: 1919 M Street, NW Suite 620 Washington, DC Tel: (202) Fax: (202) ctaylor@kenrichgroup.com Chelsea s experience in terminations has included auditing TSPs in accordance with FAR Part 49 and CAM Chapter 12, as well as other termination-related regulations. 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 with TSPs ranging from the hundreds of dollars to the hundreds of millions of dollars. Chelsea has worked with numerous foreign suppliers in Canada, Belgium, Turkey, the United Arab Emirates, and the United Kingdom, among others. 49

51 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 Termination Cost Principle 6. FAR Termination Cost Reimbursement 7. Selected Termination Forms 8. DCAA Contract Audit Manual Chapter Auditing Contract Termination, Delay/Disruption, and Other Price Adjustment Proposals or Claims (excerpt relating to terminations) 9. Administering Subcontracts After A Termination For Convenience, by Patricia Meagher and Greg Bingham, Briefing Papers, March 2004, Thomson West Publishers 50