Today, the President issued a Sequestration Order that requires
federal agencies to make uniform percentage reductions in each
separate item in their budgets. Under that Order, the
agencies will be obliged to apply a mandatory percentage cut
(effective reductions of 13% from national security programs and 9%
from civilian programs) to each covered line item in their budgets,
resulting by September 30 in equal reductions of roughly $42.7
billion each from Defense and civilian programs.
After the drama of the announcement, the first days of
implementation of the sequester will be an anti-climax. The
sequestration statute does not require the agencies to take any
action on March 2, March 3, or March 4, etc.. Their only
legal duty is that by September 30, they must have reduced the
amount of FY 2013 budget authority they obligate by the required
percentage amount. The agencies can delay as long as they
want in making the cuts. But the longer they wait and the
more slowly they phase in the spending reductions, the larger and
more abrupt the cuts would have to be in the later months of the
fiscal year.
There are only three basic things the agencies can do to reduce
spending – cut their outputs (fewer grants to the states,
less mail delivery); furlough their employees; and delay entering
into new contracts and terminate or reduce the scope of existing
contracts. Two of these categories will be the subject of
extensive media coverage in the days following the Sequestration
Order. The White House will roll out a carefully planned
strategy to emphasize the adverse effects of sequestration on the
delivery of vital government services. The media also will
publicize the agencies giving their workers the required 30-day
notice that furloughs will be imposed. This Government
Contracts Update discusses the third category – the
silent killer that will not receive as much media attention –
how the agencies actually will cancel or reduce government
contracts.
When Will the Effects of Sequestration Hit With Full Force?
Where possible, the agencies will try to defer imposition of
important spending cuts until at least April, to give Congress and
the President a final opportunity to reconcile their differences
once they understand the public's reaction to the initial
reductions in services. The more important date for
implementation of the sequester may not be March 1, but March 27:
the day the existing Continuing Regulation that funds all
government agencies expires. This "must pass"
legislation providing appropriations for the second half of FY 2013
would provide a logical vehicle for deferring the sequester or
modifying the current indiscriminate, across-the-board nature of
the cuts for each line item, by giving the President and the agency
heads greater discretion in allocating the reductions to better
preserve vital government services.
The Department of Defense has explicitly advocated that Congress
use the Continuing Resolution to modify or abolish the sequester,
and to provide it with discretion to transfer funds from accounts
that are overfunded (investment accounts) to those that are
underfunded (including critically those that support the training
of troops to be deployed to battle zones). The steps Defense
has announced to implement sequestration will not have their most
significant impacts until April. They include:
- Slowing the obligation of FY 2013 funds, instituting a civilian hiring freeze, ordering layoffs of temporary and term employees, and cutting back on base operations and maintenance (the deferred deployment of the Harry S. Truman carrier group is the most visible example of this policy).
- Furloughs for virtually all civilian Defense employees of up to 22 days, or approximately one day per week, will begin "in late April" and continue through September. Thirty days before the furloughs begin, the agency will issue a formal notice informing employees of the possible furloughs.
Defense has given no indication as to when it might start taking significant contract actions to reduce obligations beyond the $4-5 billion available from furloughs. Since it is asking Congress to reform the sequester mechanism by March 27, Defense likely will take some initial steps to address inefficient agreements in March but will try to defer the major contract actions until April 1 or later.
Which Contracts Will Agencies Terminate or Reduce?
Within budget line items, the agencies will have enormous
discretion as to which contracts to cut and by how much. To
determine which contracts actually will be affected, the agencies
have been conducting, and OMB has been overseeing, an extensive
review of how each line item can be cut the required percentage
while minimizing the adverse effect on the public interest of
applying a rigid, unprioritized, across-the-board spending
reduction. Defense alone is conducting 2,500 separate
sequestration analyses for each of the 2,500 separate line items in
its budget.
As part of the implementation process, the agencies have been
conducting computer simulations to determine the adverse effects of
various patterns of cuts. By a process of trial and error,
they will determine which allocation will minimize the harm to the
public interest. The agencies will continue to run such
scenarios up to and past the date of the Sequestration Order.
The agency Contracting Officers will play a relatively small role
in determining how the cuts will be allocated. At some point,
the COs will be informed by higher-ranking officials how much they
should reduce the portfolio of contracts they manage and how
quickly they should act to generate the required savings. The
COs then will choose the appropriate contract action to produce the
necessary savings and inform the contractor of the agency's
decision. By contrast, the agency policy officials in charge
of the program that a contract supports – the actual agency
clients – will be the ones who conduct the policy debate with
headquarters officials (generally the Comptroller or another
officer in charge of the budget) to advocate that their function
should be spared or suffer only a relatively modest reduction, and
that the cuts should be allocated elsewhere.
Through months of planning, the agencies have developed a broad
policy sense as to how they will allocate the reductions and have
cleared their analyses with the President through OMB. The
agencies are now determining at a level of detail precisely how
those reductions should be spread among individual functions that
support the program to be cut, and then to the individual contracts
that support each specific function. On February 27, OMB
instructed agency heads on behalf of the President that their
sequester plans "should identify any major contracts that they
plan to cancel, re-scope or delay..."
As a general matter, agencies should only enter into new
contracts or exercise their options when they support high-priority
initiatives or where failure to do so would expose the government
to significantly greater costs in the future. Agencies also
may consider descoping or terminating for convenience contracts
that are no longer affordable within the funds available for Fiscal
Year 2013, should no other options exist to reduce contracting
costs in these instances. Should such steps be necessary,
agencies must evaluate the associated costs and benefits of such
actions, and appropriately inform and negotiate with
contractors.
Defense is ahead of the other agencies in informing the public of the general steps it will take to implement the sequester. It will:
- Protect troops in combat and provide full readiness support for forces deploying or preparing to deploy (especially to Afghanistan), but will stretch out readiness support for units to be deployed later. Units with such lower priorities may experience reductions in equipment repairs, training exercises, and new purchases of equipment.
- Reduce training, base operating expenses, and facilities maintenance.
- Cut back on Air Force flying time, reduce Navy readiness and fleet operations, and both services will defer maintenance.
The civilian agencies also have developed similar broad action
plans but have not yet announced them to the public at the same
level of detail as Defense.
Even if it understands which functions are likely to be reduced,
an individual company has little actionable information about
whether its specific contract(s) will be cancelled, in whole or in
part, or scaled back; whether the orders it receives in FY 2013
will be reduced toward the minimum level required by its agreement;
or whether the agency may decide not to exercise an option as had
been expected. Unless it takes proactive steps to engage its
agency clients and its CO, a contractor may not know its fate until
the CO notifies it of the agency's formal contract
action(s).
What to Expect on March 2 and the Days Thereafter
Now that the Sequestration Order has been issued, the agencies
will start implementing their expenditure reduction plans by
reducing their level of services, furloughing staff, and reducing
contract expenditures. The mass media and the trade press
will pay great attention to reductions in services (for example,
closing air traffic control towers) and issuance of employee
furlough notices. But there will be less coverage of which
specific contracts the agency will cut, by how much, and on what
schedule. That information will emerge slowly over time, as
COs inform contractors on an individual basis as to how their
contracts may be cancelled or modified.
This period of uncertainty may last for some time because, as
noted above, (1) the agencies do not have to act immediately on
March 2 and have an obligation only to make the required cuts by
September 30; and (2) Defense (and perhaps other agencies) may have
sequenced their reductions so that many of their contract actions
will occur only after April 1, in the hope that Congress will
eliminate or reduce the scope of their sequester obligations in
adopting the Continuing Resolution for the second half of FY
2013. In the face of this uncertainty, a contractor that has
not been told its fate must be proactive and push its agency client
and its CO for as much information as possible concerning its
position.
On February 27, OMB on behalf of the President authorized agency
heads to communicate with government contractors "regarding
elements of the agency's planning that have a direct
impact" on them. OMB stated that the communications
"should be as specific as possible in order to provide
sufficient detail to be helpful to these stakeholders in
understanding the implications" of the reduction in
spending.
From a contractor's perspective, the most
important defensive measure to be followed during the
implementation of sequestration is to avoid the agency's
unilaterally establishing the reduction in
scope. If a contractor learns from the agency
that its contract(s) may be eliminated or reduced, it should
immediately develop its own proposed restructuring strategy and
approach the agency CO on its own initiative to present these
alternatives. In many cases, this will be the only way in
which the contractor can play some role in deciding its
fate.
To prepare for this eventuality, a contractor should conduct a
vulnerability assessment of its portfolio of government contracts
to determine which ones are funded from line items subject to
sequestration. For these contracts, the company should:
- Determine how much of its portfolio has already been funded;
- Determine how its subcontracts or teaming agreements address the impact of less work in calculating the parties' workshare;
- Review existing contracts for potential cost growth or schedule slippage;
- Review performance assessments to identify and resolve problems quickly, because in the climate created by sequestration, a contractor cannot afford to take the blame for government-caused problems; and
- Ensure that relevant company employees know the terms of its primary contracts and subcontracts. They should be alert for potential scope creep and should understand the notice provisions and the clauses governing the requirements to continue performance.
It is particularly important that company officials who deal with
the government know the difference between apparent authority and
actual authority. In the constrained climate
post-sequestration, clients at an agency may urge a contractor to
modify some aspect of its performance or ask it to undertake some
work on the promise that the obligational authority to fund the
request will be forthcoming. It is very difficult to say
"no" to a major customer, especially when that person has
been able to deliver funding to support similar requests in the
past. But post-sequester, that may no longer be possible, and
the contractor could find itself in a position where it has
undertaken work without authorization from the CO for the contract
and is unable to obtain payment.
Contractors should alert the requisite employees of this risk and
remind them of the importance of dealing only with officials who
have actual authority. The contractor also should have a
process in place under which any such requests from agency clients
are referred to senior corporate officials so that they, and not
the line client relations contact, can consider the risks and
decide whether to proceed.
The difference between apparent authority and actual authority
also will have special significance in a period of agency
furloughs. In some situations, a contractor may need to
receive permission to proceed from a specific agency official, but
that person may be on furlough on the day the company calls to seek
approval. The corporate officials who make such calls must
understand that in the absence of that particular official, the
company may not be authorized to proceed based on a statement by
another person in that office who answers the call.
In addition, it is important that the contractor determine what
clauses in its government contracts and its subcontracts will be
relevant to issues arising from sequestration. One of the
"implications" of learning that a contract(s) may be
adversely affected is that the contractor will have to turn around
and perform the same type of analysis. It will need to determine
whether its subcontracts should be de-scoped or terminated, based
on an analysis of the legal rights of its subcontractors and
consideration of what type of downstream contract action would make
the best sense under the circumstances.
Finally, in the period before it receives formal notification from
the CO about whether its contract(s) are on the chopping block, a
contractor may face difficult questions about how to respond to
employee questions about their status and whether to issue notices
under the WARN Act or more liberal State counterpart
legislation.
During the period of uncertainty before the contractor receives
definite word on the status of its contract(s), the most important
consideration in responding to employee questions is that the
employer must be open and truthful about its best understanding, if
any, of the steps an agency intends to take. The
communications an employer makes to employees also must take into
account the requirements of the WARN Act, state laws, and the
provisions of collective bargaining agreements, if any, by which it
is bound.
The WARN Act obligations are not always simple for contractors to
understand. These difficulties rose to the upper reaches of
the Administration prior to the Fall elections. To provide
guidance to contractors — and to head off the issuance of
large numbers of WARN Act notices prior to the election based on
the possible, but not certain, risk that their contract(s) would be
affected — the Administration issued a Memorandum on
September 28, 2012 informing contractors that:
[I]f (1) sequestration occurs and an agency terminates or
modifies a contract that necessitates that the contractor order a
plant closing or a mass layoff of a type subject to WARN Act
requirements; and (2) that contractor has followed a course of
action consistent with DOL guidance, then any resulting employee
compensation costs for WARN Act liability as determined by a court,
as well as attorneys' fees and other litigation costs
(irrespective of litigation outcome), would qualify as allowable
costs and be covered by the contracting agency, if otherwise
reasonable and allocable.
This Guidance remains outstanding today and should provide some
comfort to a contractor wrestling with the risks presented by
various courses of action.
Conclusion
Over the next few months as the agencies implement their sequestration plans, government contractors may face a series of difficult questions about what the law requires and how they should respond to various communications from the contracting agency. The Venable Government Contracts team would be happy to assist you in thinking through the problems that you may face.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.