The realities of September 11 and the conflicts in Iraq, Afghanistan, and Israel have focused the attention of the Bush Administration on homeland security as both a domestic policy and procurement priority. Facilitated by congressional willingness to enact special legislation and to allocate staggering amounts of appropriated funds to protecting against terrorist attacks, the United States government has created unprecedented business opportunities for companies developing and selling anti-terrorism products and services. These companies - whether they develop and sell vaccines to combat bioterrorism, sensors to detect biological, chemical, and radiological substances, or physical security services to protect citizens and property - are likely to experience strong growth and increased value in the foreseeable future.
Companies operating in the homeland security market, however, face a special business and legal landscape. The bedrock of that landscape remains that Uncle Sam is the dominant market customer. Government contractors are subject to a host of legal requirements that do not apply to commercial sales. The government’s business methods and procurement process present real challenges to companies unfamiliar with this environment. In addition, the sale of anti-terrorism technologies offers the prospect of substantial revenues, but brings unique risks. In particular, homeland security contractors face potentially overwhelming legal liabilities from third-party lawsuits in the event of a terrorist attack. The litigation aftermath of September 11 confirms the staggering scope of this liability exposure.
Whether considering a mergers and acquisitions (M&A) transaction targeting a homeland security company or showcasing a company as an attractive investment opportunity, you should examine the following legal factors which directly impact corporate value in this unique marketplace:
- The Government’s Spending Priorities. The Department of Homeland Security (DHS), in cooperation with other agencies such as the Department of Defense and the Department of Health and Human Services, has identified the country’s funding and procurement priorities for homeland security. The extent to which a company’s technology corresponds with major spending initiatives can determine ultimate business success in government contracting.The Government’s Procurement Cycle. Forget what you know of the pace of procurement in the commercial world. The wheels of government procurement typically grind slowly. As a general rule, government agencies must make purchase decisions based on full and open competition. Competitive solicitations inevitably extend the timeline for award of a government contract. As a result, sales to government customers can be a frustrating process for uninitiated companies. Patience is a necessary virtue, and sufficient corporate resources are required for long-term survival. Moreover, an agency must formally justify any sole-source procurement, as an exception to full and open competition. When examining an M&A target, you should be skeptical of any company claims of exceptional treatment from a prospective government customer.
- The Company’s Current Contracts. While a company’s backlog is always an important factor for valuation, government contracts raise special issues affecting the expectation of revenue and risk. For example, the government pays close attention to contract performance and often demands precise satisfaction of specifications and standards under threat of default termination. Also, government agencies generally are allowed to terminate a contract at will, pursuant to the standard "Termination For Convenience" clause. The "Changes" clause permits the government to unilaterally amend contract specifications and delivery terms in return for fair compensation to the contractor. Most importantly, an agency’s ability to fund a contract is subject to the appropriation process controlled by Congress. Examination of current contracts should include a diligent analysis of the risks associated with potential terminations, cost overruns, and funding vulnerabilities, in order to provide a complete picture of the contractor’s likely future revenue.
- The Company’s Intellectual Property. Intellectual property (IP) rights are the corporate jewels for high-tech companies, and anti-terrorism technology is no exception. Government contracting, however, applies special rules to the allocation of IP rights, including inventions, patents, technical data, and software. Any company selling products or services to the government should understand this peculiar IP terrain and protect itself from unwittingly transferring its critical IP to federal customers. Similarly, any M&A due diligence should include a detailed review of government contracts to identify IP transfer that might impact corporate value.
- The Company’s Compliance Systems. Statutes and regulations impose a variety of compliance obligations on government contractors. There are ethical obligations, socio-economic requirements (such as Equal Employment Opportunity and Affirmative Action), subcontracting requirements, and cost accounting rules governing the recovery of contract costs, just to name a few. A top-quality compliance program is an excellent corporate investment and an important asset when evaluating the risk of legal exposure and sanctions for violating government contracting rules.
- The Company’s Mitigation of Liability Risk. Homeland security contracting is rife with exposure to immense legal liabilities, given the possibility of terrorist acts on American soil. As a practical matter, commercial insurance usually excludes this dangerous contingency, exposing a company to terminal lawsuits. Although the "government contractor defense" provides protection for contractors performing according to government specifications, such circumstances typically don’t apply to companies that develop and manufacture technologies without government direction. While certain government agencies are authorized to indemnify contractors against "unusually hazardous risks," the Bush Administration has been reluctant to utilize this authority except in extreme circumstances.
To address this liability crisis, Congress enacted the SAFETY Act in November 2002. This new statute provides liability protection for sellers of anti-terrorism technologies who are otherwise unable to obtain sufficient commercial insurance by restricting third-party lawsuits and capping damages at the level of the seller’s insurance coverage. Notably, this legal protection extends to the buyer of the anti-terrorism technology, whether a government agency or commercial customer. DHS administers the SAFETY Act application process and grants approval to technologies judged to be effective, reliable, and safe in protecting against terrorism. SAFETY Act eligibility offers a valuable competitive advantage to companies selling homeland security products and services. When analyzing corporate value, don’t underestimate the importance of mitigating liability for anti-terrorism technologies.
Valuation of homeland security companies involves legal and business issues with which many executives and their due diligence teams are unfamiliar. In this regard, your business team should include lawyers and consultants who can provide strategic advice backed by real government contracts expertise and experience. A true appreciation for the homeland security market from a legal perspective will place you in a better position to capitalize on business and investment opportunities related to the protection of the United States.
Kevin P. Mullen is a partner in the Washington, D.C., office of Piper Rudnick LLP, where he is a member of the Government Contracts and Homeland Security practice groups.
This article is intended to provide information on recent legal developments. It should not be construed as legal advice or legal opinion on specific facts. Pursuant to applicable Rules of Professional Conduct, it may constitute advertising.
