CONGRESS EYES “CONTRACTING-IN”;
COST DECISIONS ARE SUSPECT
Smith Pachter McWhorter PLC
Government Contracts Update:
Vol. II, No. 1 February, 2006

By Stephen D. Knight Smith Pachter McWhorter constantly tracks current events, issues, and trends in Government Contracts to keep clients on the cutting edge of legal and policy developments. This e-letter highlights the most important issues, and the attached index provides weblinks to the source documents of these and many more developments. I. Legislation Three statutes directly relevant to government contractors became law recently. Those statutes continue familiar policies favorable to government employees in the public/private competition arena, but they also contain provisions that should worry contractors: Congress is actively examining the possibility of “contracting in” work now under contract, for performance by federal employees. In Section 343 of the FY 06 DOD Authorization Act, Congress ordered DOD to “prescribe guidelines and procedures for ensuring that consideration is given to using Federal Government employees for work that is currently performed or would otherwise be performed under [DOD] contracts.” Congress instructed DOD to give “special consideration” to contracts that: “(A) have been performed by Federal Government employees at any time on or after October 1, 1980; (B) are associated with the performance of inherently governmental functions; (C) were not awarded on a competitive basis; or (D) have been determined by a contracting officer to be poorly performed due to excessive costs or inferior quality.” Congress passed a similar provision in Section 842(b) of the FY 06 Transportation, Treasury and HUD Appropriations Act. There, Congress ordered that OMB Circular A-76 “shall provide procedures and policies for these [public-private] competitions [to convert work from contract to federal employee performance] that are similar to those applied to competitions that may result in the conversion of work from performance by Federal employees to performance by a contractor.” The language in these provisions is problematic because it is so broad. For example, under the criteria in the DOD Authorization Act, any work that federal employees performed at any time in the last quarter century, that contractors now perform, must be given “special consideration” for conversion to federal employee performance. Similarly, contract work that is “associated” with inherently governmental functions must be given such special consideration, along with any contract “not awarded on a competitive basis,” or determined by a contracting officer to have excessive costs or inferior quality. Congress provided no measures to indicate how “excessive” or “inferior” costs and quality must be to qualify for “contracting-in.” Title VIII of the DOD Authorization Act contains a number of acquisition polices to expand congressional oversight of increased costs in major defense acquisition programs (Sec. 801-802, 804), and control over the treatment of a major weapon system as a “commercial item.” In Section 805, Congress sought to gain visibility into the role of “lead system integrators” in major systems, focusing on organizational conflicts of interest and the use of “pass-through charges” by such integrators. Congress defined these charges as “a charge for overhead or profit on work performed by a lower-tier contractor (other than charges for the direct costs of managing lower-tier contracts and overhead and profit based on such direct costs) that does not, as determined by the Secretary [of DOD] for purposes this section, promote significant value added with regard to such work.” This provision continues the attack on prime contractor recovery of indirect costs and profit on subcontractor effort. It is especially troubling because DOD appears to have the discretion to determine what “does not promote significant value added with regard to” subcontracted work. Section 841 of the DOD Authorization Act orders GAO to “conduct a review of efforts by [DOD] to identify and assess the areas of vulnerability of [DOD] contracts to fraud, waste, and abuse.” GAO must submit a report to Congress within six months, including findings and recommendations. Section 847 establishes a consolidated Civilian Board of Contract Appeals, in place of the numerous agency boards that previously existed. The FY 06 DOD Appropriations Act contains familiar provisions, including Sections 8014 (“Limitation on Conversion to Contractor Performance”), 8029 (public/private competition for depot maintenance work), and 8030 (rescission of blanket waiver of Buy American Act for products produced in a foreign country). The DOD Appropriations Act also contains Title X , prohibiting “cruel, inhuman, or degrading treatment or punishment” for any individual “in the custody or under the physical control of the United States Government, regardless of nationality or physical location.” This provision defines cruel, inhuman, or degrading treatment as that prohibited by the U.S. Constitution and other sources. Contractors, especially contractors performing security functions, must be alert to the fact that they may be considered “agents” of the U.S. Government and open to liability for mistreatment of any individual “in the custody or under the physical control” of the government. Section 1004 provides for a limited defense in any civil action or criminal prosecution if the person charged “did not know that the practices were unlawful and a person of ordinary sense and understanding would not know the practices were unlawful.” II. Regulations and Policies Important regulatory proposals include several relating to Cost Accounting Standards (CAS). On January 26, 2006 , the CAS Board invited comments on the staff discussion paper regarding CAS 416, “Accounting for Insurance Costs.” 71 Fed. Reg. 4335 . The focus of the paper is the use of the term “catastrophic losses” in CAS 416 as opposed to the use of that term in FAR 31.205-19. The concern is that the lack of a definition in CAS 416 may lead to a requirement to allocate “catastrophic losses” beyond the segment experiencing the loss, to the segment’s home office, while FAR 31.205-19 will render such allocated cost unallowable. The CAS Board staff paper questions whether “catastrophic losses” in CAS 416 should be changed to “significant” or “very large.” Another proposed CAS change is an exemption from CAS for time-and-materials (T&M) and labor-hour (LH) contracts for the acquisition of commercial items. 71 Fed. Reg. 313. The proposed language would exempt from CAS “Firm fixed-priced, fixed-priced with economic price adjustment (provided that price adjustment is not based on actual costs incurred), time-and-materials, and labor-hour contracts and subcontracts for the acquisition of commercial items.” The CAS Board noted that under the provisions of legislation and a proposed FAR rule on T&M and LH contracts, “T&M and LH contracts for commercial items must be awarded on a competitive basis. In addition, the contracting officer is precluded from obtaining cost or pricing data … Therefore, the application of CAS, from a pricing standpoint, is similar to a firm fixed-price contract awarded on the basis of competition without submission of certified cost or pricing data.” The CAS Board also published a proposed rule on adjustment of dollar thresholds for CAS applicability, waiver authority, and CAS Disclosure Statement requirements. 70 Fed. Reg. 73423. FAR and DFARS regulators also published proposed changes to dollar thresholds for applicability of various requirements. 70 Fed. Reg. 73415, 71 Fed. Reg. 3446. DOD contractors should note the proposed DFARS change to Earned Value Management Systems (EVMS) regulations. 71 Fed. Reg. 3449. That proposal would apply various EVMS requirements to cost or incentive contracts and subcontracts valued at thresholds of $20 million and $50 million. Currently, EVMS requirements apply to RDT&E contracts over $73 million, and procurement or O&M contracts over $315 million. Finally, on December 22, 2005 , DOD published proposed rules on “Criminal Jurisdiction Over Civilians Employed by or Accompanying the Armed Forces Outside the United States, Service Members, and Former Service Members.” 70 Fed. Reg. 75998. DOD followed this proposed rule with a related final rule on February 22, 2006 . 71 Fed. Reg. 8946. The final rule implements the Military Extraterritorial Jurisdiction Act of 2000 which establishes federal criminal jurisdiction over whomever engages in conduct outside the United States constituting a felony “while employed by or accompanying the Armed Forces outside the United States .” The final rule corresponds to DOD Instruction 5525.11. Significantly, the rule’s effective date is retroactive to March 3, 2005 , which could raise issues for contractors deployed with the armed forces overseas. III. Litigation Contractors should pay attention to several recent cases decided by the courts and boards recently. Some of the decisions show the continuing difficulty contractors face in cost allowability and cost allocability cases, especially at the Federal Circuit. For example, in Information Systems & Networks Corporation v. United States, the Federal Circuit reversed a Court of Federal Claims decision in favor of the contractor on the allowability of tax payments made by that S Corporation’s sole shareholder. The court rejected the lower court’s examination of the state code provisions establishing the purpose, structure, and tax liabilities of an S Corporation. The lower court had found that “the obligations of an S corporation and its shareholders to pay state income taxes are therefore closely intertwined, and an S corporation is very much required to ensure the payment of its state income taxes. The rigid argument that the tax liabilities of plaintiff and [the shareholder] are completely separate does not suffice to prohibit reimbursement” under FAR 31.205-41. The Federal Circuit reversed, stating: “The plain language of [FAR 31.205-41(b)] states that taxes from which the contracting entity is exempt are not allowable costs. This is the case here. ISN is free from taxation on [the shareholder’s] income derived from ISN’s corporate dividends.” The Federal Circuit, contrary to the detailed discussion by the Court of Federal Claims, took an overly simplistic approach to FAR 31.205-41 and found that ISN was “exempt” from state taxes. In Richlin Security Service Company v. Chertoff, the Federal Circuit decided that a contractor cannot obtain interest under the Contract Disputes Act “for amounts found due” unless the contractor was out-of-pocket on the underlying claim. The Armed Services Board of Contract Appeals issued a decision interpreting CAS 418 in AM General LLC, ASBCA Nos. 53610 , 54741 (February 2, 2006). That decision upheld a DCAA challenge to the contractor’s single manufacturing overhead pool as not in compliance with CAS 418’s homogeneity requirement. There, the undisputed facts showed that declining government requirements for HMMWV vehicles would have made the government’s price per vehicle prohibitive. AM General, with the government’s encouragement, launched a commercial version of the HMMWV, known as the HUMMER, in order to subsidize the government’s diminished requirements so that the company could continue to produce HMMWV’s at an affordable price. The parties incorporated AM General’s commercial program into their negotiations. At about the same time, the company changed its cost accounting practice for accumulation and allocation of manufacturing overhead to a single pool allocated over a units of production base. The pool included costs of several sites, including “the Armour building” which only housed commercial production. DCAA objected to the single pool because of the inclusion of the Armour building for allocation to all units. The ASBCA agreed with the government in what appears to be an analysis based solely on geography rather than the analysis of the causal-beneficial relationship between the pooled costs and cost objectives through the allocation base. The ASBCA stated: “[I]t is undisputed that AM General’s indirect manufacturing overhead cost pool included the indirect costs from the Armour building. It is also undisputed that the military HMMWV derived no benefit from the costs incurred in the Armour building because none of the military HMMWVs were manufactured in that building. Consequently, we agree with the government that the indirect manufacturing overhead cost pool was not homogeneous because the costs included therein did not have the same or bear a similar beneficial or causal relationship to all activities whose costs were included in the cost pool.”

The ASBCA decision jumps the track in comparing pooled activities to other pooled activities, and its refusal to analyze the functions of the activities in the single overhead pool as related to the allocation base. CAS 418-50(b)(1) states that an indirect cost pool is homogeneous “if each significant activity whose costs are included therein has the same or a similar beneficial or causal relationship to cost objectives as the other activities whose costs are included in the cost pool.” The proper analysis is to examine the pooled activities vis-à-vis the cost objectives; the expression of that relationship is the allocation base. CAS 418-40(b)(c). Here, the ASBCA assumed the government production units “received no benefit” because the Armour building housed only commercial production. Yet, the facts more than suggest that AM General’s commercial production saved the military program from ending, because the undisputed facts showed that the absence of the commercial program would have meant that the military vehicles would become cost prohibitive. The ASBCA did not perform the analysis called for by CAS 418.

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For a complete list of Recent Developments in Government Contracts, please see the attached index with weblinks to the source documents. If you wish to discuss these or any other government contract issues, please contact the following individuals or view our website at www.smithpachter.com to view additional attorney biographical information:

LINKS TO RECENT DEVELOPMENTS IN GOVERNMENT CONTRACTS  

I. LEGISLATION

• Pub. L. No. 109-163, “National Defense Authorization Act for Fiscal Year 2006” ( January 6, 2006)
• Pub. L. No. 109-148, “Making appropriations for the Department of Defense for the fiscal year ending September 30, 2006” ( December 30, 2005)
• Pub. L. No. 109-115, “Making appropriations for the Departments of Transportation, Treasury, and Housing and Urban Development, the Judiciary, District of Columbia, and independent agencies for the fiscal year ending September 30, 2006” (November 30, 2005)

II. REGULATIONS & POLICIES

• FAC 2005-07, 71 Fed. Reg. 198 ( January 3, 2006)
• Proposed Rule; withdrawal, “Share-In-Savings Contracting,” 71 Fed. Reg. 4854 ( January 30, 2006)
• Proposed Rule, “FAR: Inflation Adjustment of Acquisition-Related Thresholds,” 70 Fed. Reg. 73415 ( December 12, 2005)
• Final Rule, “DFARS: Contracting by Negotiation,” 71 Fed. Reg. 3413 ( January 23, 2006)
• Final Rule, “DFARS: Contract Financing,”70 Fed. Reg. 75412 ( December 20, 2005)
• Final Rule, “DFARS: Contract Period for Task and Delivery Order Contracts,” 70 Fed. Reg. 73151 ( December 9, 2005)
• Proposed Rule, “DFARS: Inflation Adjustment of Acquisition-Related Thresholds,” 71 Fed. Reg. 3446 ( January 23, 2006)
• Proposed Rule, “DFARS: Earned Value Management Systems,” 71 Fed. Reg. 3449 ( January 23, 2006)
• Proposed Rule, “DFARS: Contract Pricing and Cost Accounting Standards,” 70 Fed. Reg. 75440 ( December 20, 2005)
• Proposed Rule, “CASB: Accounting for Insurance Costs,” 71 Fed. Reg. 4335 ( January 26, 2006)
• Proposed Rule, “CASB: T&M Contracts for Commercial Items,” 71 Fed. Reg. 313 ( January 4, 2006)
• Proposed Rule, “CASB: Changes to Acquisition Thresholds,” 70 Fed. Reg. 73423 ( December 12, 2005)
• Proposed Rule, “DOD: Criminal Jurisdiction Over Civilians Employed by or Accompanying the Armed Forces Outside the United States, Service Members, and Former Service Members” 70 Fed. Reg. 75998 ( December 22, 2005)
• OUSD, “Class Deviation – Exemption from Limitations on Procurement of Foreign Information Technology that is a Commercial Item, FY 2006” ( December 9, 2005)
• DCAA Memorandum, “Audit Guidance on Recovery Audits” ( December 29, 2005)
• DCAA Memorandum, “Audit Guidance on Interest Rate January-March 2006 for Determining Interest Applicable to Postaward Audit Adjustments” ( December 27, 2005)
• DCAA Memorandum, “Audit Guidance on Revision to FAR 31.205-35, Relocation Costs” ( December 19, 2005)
• DCAA Memorandum, “FY 2006 Audit Management Guidance for Iraq Reconstruction” ( November 22, 2005)
• DCAA Memorandum, “Audit Guidance on Revised FAR 31.205-44, Training and Education Costs” ( November 9, 2005)
• DCAA Memorandum, “Audit Guidance on the Allowability of Administrative Leave Costs and Other Employee Assistance Costs, and the Impact of Insurance Coverage on the Allowability of Costs Resulting from Hurricane Katrina” (October 28, 2005)

III. CASES

• Information Systems & Networks Corporation v. United States, Nos. 04-5151, -5154 (Fed. Cir. Feb. 6, 2006) (state income tax payments made by ISN’s sole shareholder resulting from dividends received from ISN were unallowable under FAR 31.205-41)
• Richlin Security Service Company v. Chertoff, No. 05-1085 (Fed. Cir. Jan. 31, 2006) (CDA interest denied because “contractor can recover interest only on amounts it actually paid”)
• Jacobs Engineering Group, Inc. v. United States, No. 05-5052 (Fed. Cir. Jan. 19, 2006) (contractor recovers all costs on convenience termination, not limited by performance cost-share provision)
• TennesseeValley Authority v. United States, No. 01-249C (COFC Jan. 31, 2006) (detailed discussion of damages recovery where government breached contract for disposal of spent nuclear fuel)
• General Dynamics Corporation v. United States, No. 01-664T (COFC Dec. 30, 2005) (GD cannot treat A-12 contract as completed on default termination in 1991, and thus cannot take losses in that year under completed contract method of tax accounting)
• Amtec Corporation v. United States, No. 02-1396C (COFC Dec. 12, 2005) (fixed fee in CPFF contract not payable on additional labor hours which government could have acquired by exercising options; contractor only entitled to fixed fee for labor hours actually exercised under a given option)
• Stanley K. Mann v. United States, No. 98-312C (COFC Dec. 7, 2005) (denying government summary judgment motion on recoverability of lost profits due to breach of lease)
• ATK Thiokol, Inc. v. United States, No. 99-440C (COFC Nov. 30, 2005) (rejecting government disallowance of IR&D costs as “required in the performance of” a commercial contract, and upholding contractor’s treatment of tangible asset costs under CAS 404, 409 and FAR 31.205-11)
• AM General LLC, ASBCA Nos. 53610, 54741 ( Feb. 2, 2006) (contractor’s change to single manufacturing overhead pool allocated on unit of production base was in noncompliance with CAS 418)
• DynCorp, ASBCA Nos. 49714, 53098 (Jan. 26, 2006) (on remand from Federal Circuit, ASBCA determines separate investigations for purposes of Major Fraud Act and FAR 31.205-47 allowability of legal costs)
• ITT Federal Services International Corporation, ASBCA No. 54001 ( Dec. 29, 2005) (contractor recovers additional fee under CPFF contract)
• Bath Iron Works Corp., ASBCA No. 54544 (Dec. 22, 2005) (contractor recovered costs incurred to repair and replace fuel oil fill and transfer piping damaged by corrosion during construction of guided missile destroyer)
• Crane & Company, Inc., B-297398 ( Jan. 18, 2006) (GAO sustains protest against RFP where government violates statute placing four-year limitation on currency paper contract)
• Greenleaf Construction Company, Inc., B-293105.18, -293105.19 ( Jan. 17, 2006) (GAO sustains protest due to, among other reasons, organizational conflicts of interest)

IV. REPORTS

• Letter to Hon. William J. Haynes II from Richard C. Johnson, addressing title passage under government contracts (Jan. 10, 2006; Letter to Laurieann Duarte from Richard C. Johnson addressing proposed rewrite of FAR Part 45, Government Property (Sept. 20, 2005)
• GAO Report No. 06-66, “DOD Has Paid Billions in Award and Incentive Fees Regardless of Acquisition Outcomes” (Dec. 2005)
• GAO Report No. 06-5, “Offshoring of Services, An Overview of the Issues” (Nov. 2005)

• GAO Report No. 06-72, “Competitive Sourcing, Health Benefits Cost Comparison Had Minimal Impact, but DOD Needs Uniform Implementation Process” (Dec. 2005)

The information in this newsletter is not, nor is it intended to be, legal advice. You should consult an attorney for individual advice regarding your own situation.