United States: DOD Issues Interim Rule Authorizing Withholding Of A Percentage Of Contract Billings Upon Finding One Or More Significant Deficiencies In A Contractor's Business Systems

Following the publication of two proposed rules on 18 May 2011 the Defense Department (DOD) issued its long-awaited and controversial contractor business systems rule implementing Section 893 of the Ike Skelton National Defense Authorization Act for Fiscal Year 2011 (FY 2011 NDAA). See 76 Fed. Reg. 28856 (18 May 2011). Section 893 of the FY 2011 NDAA sets forth a series of specific requirements regarding the adoption of an "Improvement Program" for DOD contractor business systems.

Notably, rather than seeking additional public comment on what has been a highly controversial topic, the DAR Council determined that urgent and compelling circumstances warranted issuing the Business System Rule on an interim basis, although it invited additional comments through 18 July 2011. Specifically, the DAR Council concluded that the DOD had to immediately implement the business systems improvements called for by the FY2011 NDAA. To that end, the interim rule explains that it applies to solicitations issued on or after 18 May 2011. Contracting Officers are "encouraged" to amend existing solicitations for contracts to be awarded on or after 18 May 2011 to include the new DFARS clause 252.242-7005 "Contractor Business Systems," and "shall" amend solicitations to include that clause for contracts to be awarded on or after 16 August 2011. Inclusion of DFARS 252.242-7005 will allow the DOD to withhold a percentage of contract billings when there is a determination that a business system is subject to one or more significant deficiencies. Although it had been the practice of some contracting officers to institute withholdings when system deficiencies were found, this is the first time that the FAR specifically authorizes the practice.

Defining contractor business systems

The interim rule covers six different contractor business systems:

• Accounting Systems;
• Estimating Systems;
• Purchasing Systems;
• Earned Value Management Systems (EVMS);
• Material Management and Accounting Systems (MMAS); and
• Property Management Systems.

For each of the covered business systems, the interim rule would either add or amend a DFARS clause that defines the attributes of an acceptable system. The interim rule revises existing clauses for contractor estimating, EVMS, and MMAS systems and creates new clauses addressing contractor accounting, property, and purchasing systems.

What contracts are covered?

As noted above, the interim rule implements the DOD's authority to withhold a percentage of contractor billings through the new DFARS clause 252.242-7005 "Contractor Business Systems." Although the interim rule will affect current solicitations, existing contracts would have to be modified to incorporate the new clause. 

The interim rule also addresses the types of contracts that may be subject to the new clause. It explains that a "covered contract" is one that is subject to the Cost Accounting Standards (CAS) and includes at least one of the specific business system clauses (e.g., estimating, accounting, or property).¹ This is a departure from the most recent proposed rule, which would have established a U.S. $50 million threshold. The interim rule explicitly states that it will allow the government to withhold a percentage of contractor billings associated with:

• Cost-reimbursement contracts;
• incentive-type contracts;
• time-and-materials contracts;
• labor-hour contracts;
• progress payments; and
• performance payments.

76 Fed. Reg. 28856.²

Given the linkage of a "covered contract" to CAS, the interim rule will not apply to small businesses, because contracts with such concerns are exempt from CAS. See 48 C.F.R. 9903.201-1(b)(3). Likewise, the rule states that "[c]ontracts awarded under FAR part 12 regulations will generally be exempt from the requirements of this rule." 76 Fed. Reg. 28862; see also 48 C.F.R. 9903.201-1(b)(6).

The process for withholding a percentage of contract billings

The new DFARS clause 252.242-7005 "Contractor Business Systems" will be implicated when a Defense Contract Audit Agency (DCAA) auditor or other functional specialist determines that one or more of the aforementioned business systems has a "significant deficiency." A "significant deficiency" is defined as:

a shortcoming in the system that materially affects the ability of officials of the Department of Defense to rely upon information produced by the system that is needed for management purposes.

DFARS 252.242-7005(a). By setting the bar at the level of a "significant deficiency," the DAR Council has more closely linked the interim rule to Section 893 of the NDAA and has deleted language in the prior proposed rule that referred to deficiencies that "adversely affect[ ] the system" or deficiencies "leading to a potential risk of harm to the Government."

Under the terms of the interim rule, the contractor will be notified of any initial determination of a significant deficiency and will have 30 days to submit a written response. Upon receipt of that response, the cognizant contracting officer will make a written determination of whether there are one or more significant deficiencies in one or more of the contractor's business systems.³  If this determination concludes that significant deficiencies are present, the notice will also inform the contractor that a payment withhold will be implemented.⁴

The proposed rule would have established a regime under which payment withholdings would have been applied against all contracts that contained DFARS 252.242-7005. Under the interim rule, in contrast, the contracting officer has discretion to withhold payments from one or more contracts that include the clause. As a practical matter, however, there is a risk that contracting officers will exercise the discretion to implement across-the-board withholds.

It is also noteworthy that, notwithstanding comments requesting that the DAR Council require that the Government establish a causal link between a purported deficiency and actual financial harm, the interim rule does not do so. The commentary accompanying the interim rule explains that

"[d]eficiencies that do not directly relate to unallowable or unreasonable costs still pose risks to the Government, and may lead to harm that may not be calculated readily when the deficiencies are discovered." 76 Fed. Reg. 28859. Consequently, contractors may continue to encounter situations where a billing decrement greatly outweighs the possible risk related to a system deficiency.

What percentage of payments may the government withhold?

The interim rule provides that upon a determination of a significant deficiency, the government will withhold:

five percent of amounts due from progress payments and performance-based payments, and direct the Contractor, in writing, to withhold five percent from its billings on interim cost vouchers on cost, labor-hour, and time-and-materials contracts until the Contracting Officer has determined that the Contractor has corrected all significant deficiencies as directed by the contracting officer's final determination.

DFARS 252.242-7005(d)(1).

The interim rule also sets forth payment withhold limits that reflect a reduction from the most recent proposed rule, which would have capped withholding at 20 percent.⁵ Specifically, the interim rule provides that the total percentage of payments withheld may not exceed:

five percent for one or more significant deficiencies in any single contractor business system; and

ten percent for significant deficiencies in multiple contractor business systems.

DFARS 252.242-7005(d)(3)(i). Although the automatic withholding regime is still problematic for contractors and divorced from any standard of risk to the government, the five and ten percent caps in the interim rule mark a significant improvement over the proposed rules. 

Removing a payment withhold

Under the terms of the interim rule, a contractor has 45 days to prepare and submit a corrective-action plan. The contracting officer is required to consult with auditors and any necessary functional specialists to assess the plan. If the contracting officer determines that the contractor is effectively implementing the plan, the withhold will be reduced to two percent for all significant deficiencies covered by the plan until such time as all significant deficiencies are corrected.⁶  

The clause also provides contractors with some protection against government delay in assessing whether a significant deficiency has been cured. Under the terms of the interim rule, the contractor must notify the contracting officer when all significant deficiencies have been corrected. If the contracting officer fails to act on that submission within 90 days, the contracting officer must reduce any withhold by at least 50 percent. Given the challenges contractors have been facing with respect to DCAA reassessment of prior audit findings, this provision is a significant and welcome change from the proposed rules. 

The commentary accompanying the interim rule highlights that although under the proposed rule the contracting officer could "approve" a system after a determination that the contractor "substantially corrected" deficiencies, the interim rule requires that "there are no remaining significant deficiencies before a system is approved." 76 Fed. Reg. 28864. Thus, the hurdle for removing a billing withhold has now been raised.

Finally, the commentary accompanying the section of the interim rule addressing satisfactory accounting systems contains a potentially significant discussion about the interplay of CAS noncompliances and the new withholding authority. A question was raised about whether an audit finding pertaining to CAS 405 "Segregating Unallowable Costs" could result in an accounting system being deemed deficient and a payment withhold even though FAR Part 30 already provides a stand-alone process to remedy CAS noncompliances. The DAR Council responded by essentially taking the position that neither the CAS-specific remedies nor the FAR Allowable Cost & Payment clause (FAR 52.216-7) are adequate to protect the government's interest. It is, therefore, reasonable to infer that the impact of a CAS noncompliance may now subject a contractor not only to the FAR Part 30 resolution process but also to a billing decrement. Given the time generally associated with resolving adverse CAS findings, this may become a significant issue.

Footnotes

1. The rule also specifically exempts contracts with educational institutions and Federally Funded Research and Development Centers. 

2. The commentary to the interim rule explains that "DOD has interpreted the definition of 'covered contract' to include CAS-covered cost type contracts as well as CAS-covered fixed-price contracts and performance based contracts." See 76 Fed. Reg. 28862.

3. The cognizant contracting officer may not always be the Administrative Contracting Officer (ACO) because "[t]he contract administration functions in FAR 42.302 are sometimes performed by procurement contracting offices." 76 Fed. Reg. 28860.

4. The use of written notices is a departure from the proposed rule, which called for unilateral modifications.

5. The original proposed rule would have allowed up to 100 percent withholding.

6. The rule is unclear as to what would happen if there is only a single significant deficiency that is covered by the corrective-action plan.

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