Many federal contractors and subcontractors are in store for a bumpy ride. On March 1, 2013, sequestration went into effect, requiring the federal government to cancel $85 billion in budgetary resources between now and September 30, 2013 — the remaining seven months of fiscal year 2013. Contractors for both defense and civilian agencies face potential impacts from sequestration, primarily in the form of lost work and revenue as agencies cut existing contracts and delay or cancel new awards.

But contractors are far from helpless. The implementation of sequestration will be an intricate dance involving many stakeholders and much discretion (within the framework imposed by Congress). To have any influence on outcomes, contractors must learn to dance their part. The purpose of this alert is to help contractors understand the processes, tools, and resources they can use to manage the risks created by sequestration.

Contractors should understand how federal agencies will react to sequestration, the criteria they will use to implement cuts, and the risks posed to contractors' current inventory of contracts. Proactive contractors will develop strategies for avoiding cuts or, when they cannot be avoided, minimizing their impact. Contractors who approach the sequester implementation proactively — by understanding how their customers are thinking about this problem and their legal rights and options under contracts — are more likely to achieve the best possible outcome.

Understanding Your Dance Partner: Federal Agencies' Response to Sequestration

Contractors must understand how federal agencies are likely to prioritize current contracts and allocate sequestration cuts. Although sequestration involves across-the-board cuts to programs, projects and activities within a budget account, not all contracts are at this level. This leaves agencies with some discretion regarding how to apply sequestration cuts to contracts; not all contracts will receive equal treatment. Much will depend on how an agency views each contract with respect to its overall mission, life, health and safety impacts, impacts on small businesses, and the cost-effectiveness of reducing particular contracts. Contractors can use these priorities to frame a response.

The Office of Management and Budget (OMB) estimates that the effective percentage reductions are approximately 8 percent in funding for non-exempt defense programs (mandatory and discretionary alike), and 5 percent in funding for non-exempt nondefense programs (mandatory and discretionary alike). However, because these cuts must be achieved over the seven months remaining in fiscal year 2013 (rather than a full fiscal year), the OMB estimates that the effective percentage reductions will be approximately 13 percent for non-exempt defense programs and 9 percent for non-exempt nondefense programs.

Agencies are required to apply the same percentage reduction to all "programs, projects, and activities within a budget account" in accordance with section 256(k)(2) of the Balanced Budget and Emergency Deficit Control Act.¹ At this time, agencies are in the process of implementing sequestration, including identifying contracts that they plan to cancel, re-scope, or delay. In its February 27, 2013 guidance, OMB directed federal agencies to undertake certain steps to implement sequestration.² Key OMB directives are summarized below:

• Agencies must "[e]nsure that any contract actions are both cost-effective and minimize negative impact on the agency's mission to the extent practicable." In guidance issued on January 14, 2013, OMB characterized "negative impact" as "significant deleterious effect on the agency's mission" or "life, safety, or health concerns."
• Agencies must "only enter into new contracts or exercise options when they support high-priority initiatives" or where failing to do so "would expose the government to significantly greater costs" going forward.
• Agencies have been advised to consider "de-scoping or terminating for convenience contracts that are no longer affordable within the funds available for Fiscal Year 2013," particularly in those instances where no other options exist to reduce contracting costs.
• Procuring officials should evaluate the "associated costs and benefits of such actions, and appropriately inform and negotiate with contractors" — a step intended to keep lines of communication open and constructive.
• Each agency must take into account "funding flexibilities, including the availability of reprogramming and transfer authority" with every procurement action.
• Additionally, agencies must take "all appropriate steps" to minimize the impact of reduced contracting activities on small businesses.

Preparing for the Dance: Sequestration Risk Assessment

As procuring agencies undertake the task of implementing sequestration, a contractor can (and should) ready itself by conducting a review of its inventory of current and future contracts, and an assessment of the risks that sequestration poses to each. This assessment should involve a team of individuals drawn from key business functions, including program management, contract management, business development, finance/accounting, human resources, and legal. Once the contractor has assembled its team, conducting a meaningful assessment of each contract becomes a much more manageable task. Undertaking the following steps will help enable the contractor to face the effects of sequestration from solid footing.

• A prudent contractor will consider the size of the contract and its potential impact on the agency's core mission if reduced, delayed, or terminated.
• The contractor's evaluation team should consider the potential impact on life, safety, or health concerns if the contract is reduced, delayed, or terminated.
• The contractor should review and analyze contract clauses which give the agency customer the option to implement funding cuts. It is important to consider any associated costs/benefits to the agency of each of the following options:
  • stopping or suspending work under current contracts
  • modifying contracts to de-scope work
  • increasing threats or issuance of cure/show cause notices and default terminations
  • more frequent funding of incrementally-funded cost-type contracts at reduced levels
  • aggressive contract interpretations by agencies regarding scopes of work and payment
  • declining to exercise options
  • using the six-month "Option to Extend Services" clause rather than the typical one-year" Option to Extend Term of Contract" clause
  • terminating contracts for convenience
  • delaying new contract awards and engaging in more aggressive negotiations
• The contractor's team should research any funding flexibilities available to the agency customer, including the availability of reprogramming and transfer authority.
• Consideration must also be given to any potential impact on small businesses (either at the prime or subcontractor level) if the contract is reduced, delayed, or terminated.
• Contractors must consider any potential human resource actions in the event of cuts, including the possibility of layoffs that may trigger notice obligations under the Worker Adjustment and Retraining Notification (WARN) Act.
• Because agreements with subcontractors and vendors that may be affected by sequestration, contractors should understand their rights to de-scope, delay, terminate, or decline to extend subcontracts. To avoid liability, contractors must also fully appreciate their obligations to communicate and notify subcontractors and vendors of potential impacts.
• Meaningful analysis of any potential impacts on the company's short-term and long-term cash flow must be undertaken. Consider whether cuts to certain contracts will cause the company to experience a cash shortfall. Evaluate how the company will manage such a shortfall.

After considering these factors, a contractor should be in a position to identify each current and future contract to which sequestration poses a meaningful risk and the potential severity of any impact. Contracts more important to an agency's core mission or more impactful of health, life, or safety are less susceptible to sequestration risk. For those contracts facing a likelihood of some impact, the severity of the cuts should be governed by the following calculus: cost to the government of the various contract administration options, and the level of funding flexibility available to the customer. In addition, contracts with a significant impact on small businesses may be less susceptible to severe cuts than those primarily benefitting other-than-small contractors and subcontractors.

Having undertaken this risk assessment, a contractor should identify risk mitigation measures for each current and future contract. Such measures may include one or more of the following:

• Sequestration Risk Avoidance or Reduction Measures with the Customer. Develop a communication strategy with the customer. Prepare to explain to the customer why, if reduced, delayed, or terminated, a particular contract will negatively impact the agency's core mission; increase risks to life, safety, or health; subject the agency to costly liabilities, such as requests for equitable adjustment or termination settlement costs; and, when applicable, adversely impact small businesses. When possible, the contractor should make the agency aware of potential funding flexibilities to minimize cuts, including the availability of reprogramming and transfer authority.
  
  If a contract is particularly susceptible to sequestration risk, be proactive. Develop a proposal regarding the best way to implement funding reductions. Which tasks could be reduced or eliminated? Could some tasks be delayed rather than cut? What other changes to schedule, staffing, or work scope would reduce the impact of funding cuts on the program? Contractors are often much closer to the details of the work than distant contracting officers and program managers. A contractor can use its informed perspective to demonstrate to its customer agency how funding cuts can be designed to achieve the customer's and contractor's shared interest in maintaining performance levels and minimizing disruption.
• Sequestration Risk Avoidance or Reduction Measures with Subcontractors and Vendors. Sequestration cuts may affect subcontracts and vendor agreements. Prime contractors should be prepared to promptly provide notices and, in accordance with contractual provisions applicable to this process, flow down the cuts to affected subcontractors and vendors.
• Sequestration Risk Reduction Measures Regarding Internal Functions. The contractor's human resources personnel should be in regular communication with the contractor's contract management team. In the event of potential layoffs, contractors should understand their obligations under the WARN Act and prepare to comply. Furthermore, prudent contractors will take the time to identify key personnel and develop a retention plan in the event their work is affected by sequestration.
  
  Also during this time, contractors should ensure that their accounting systems are capable of tracking and segregating costs from suspension, delay, or changes arising from sequestration impacts. Properly tracking such costs will be essential to successful recovery of costs under requests for equitable adjustment arising from government-caused delays, changes, or under termination settlement proposals in response to terminations for convenience. Given current budgetary pressures, such requests for payment will be acutely scrutinized by government auditors.
• Sequestration Risk Reduction Measures Regarding Future Business. Following sequestration, business development strategies should be revisited and revised as necessary. Contractors should consider adjusting business development strategies toward programs and requirements considered mission-critical, necessary for life, safety and health concerns, or that benefit small businesses. Contractors should identify key teaming partners and key personnel for such opportunities.
  
  In a post-sequestration world, agencies considering new contract awards will likely move to firm-fixed-price, "low-price" acquisition strategies. Contractors should begin contemplating "low-price" bidding strategies. Additionally, contractors should carefully review solicitations and ask questions to clarify requirements and resolve ambiguities that could provide a competitor a pricing advantage in a low-price bidding environment. Contractors should consider pre-award protests to clean up solicitations if an agency fails to appropriately respond to questions.

Leading Your Dance Partner: Implement the Sequestration Mitigation Strategy

After developing a plan, a contractor must be prepared to execute. Move forward with the communication strategy — explain why cuts should not be made to a particular contract. If cuts are inevitable, consider offering a defunding proposal — demonstrate how cuts should be implemented and why the proposed methodology is the best approach in light of the agency's mission. When necessary, communicate with vendors and subcontractors about pending reductions — be aware of any notice requirements. Perform appropriate actions with regard to employees, accounting systems and procedures, and other internal actions. Adjust business development strategies to match the new funding environment.

In response to customer attempts to implement sequestration cuts on particular contracts, contractors should consider the following strategies:

• Customer-Proposed Delays, Reductions, or Terminations. In response to contract changes or terminations proposed by an agency, contractors should be prepared to propose alternative approaches and to negotiate with the customer. Implementing funding cuts is not an exact science, and agency customers may be willing to listen to proposals that are more advantageous to their mission, reduce impacts on life, health, and safety, are less costly, or reduce impacts on small businesses. Contractors should be prepared to present detailed counter proposals that meet these agency goals and negotiate for the best possible outcome.
• Increased Threat of Cure/Show Cause Notices and Default Terminations. In order to terminate contracts without incurring termination for convenience ("T for C") liability, some customers may resort to aggressively threatening default terminations and then resolving the allegations on a "no cost" basis. Contractors should vigorously respond to unfounded cure/show cause notices. In general, contractors should communicate and document performance issues early (before they become potential bases for default) and ensure that the contracting officer is involved. If defaulted, contractors should promptly appeal and submit a termination settlement proposal and convert to a claim if not promptly resolved.
• More Frequent Funding of Incrementally Funded Contracts at Reduced Levels. If an agency begins funding contracts more frequently and at reduced levels, contractors are more likely to approach funding ceilings and face the possibility of working "at risk" before new funding is added. Contractors must timely comply with notice requirements under limitation of funding clauses and promptly document concerns and impacts of insufficient funding. A contractor should not continue to work "at risk" upon reaching a funding ceilings; given the economic climate, there is an increased risk that additional funding may not be forthcoming. Contractors should document all delays, disruption and other cost impacts if funding is provided late.
• Aggressive Contract Interpretations by Government. Agencies are likely to assert expansive interpretations of ambiguous work statements in contracts, in an attempt to get more work for the same price. In addition, under time and materials ("T&M") contracts with fully burdened labor rates and contract line items for other direct costs ("ODCs"), agencies may take the position that costs contractors planned to bill as ODCs are included in burdens on labor. Examples include employee physical and licensing requirements, shop supplies, and the like. In proposals, contractors should document assumptions regarding which costs are included within ODCs and labor rates. Contractors should also document "custom and usage" and "course of dealing" with respect to costs. Contractors should timely notify the contracting officer of any interpretation that is considered to be a change.
• Government Use of "Option to Extend Services" Rather than "Option to Extend Term of Contract" Clause. In order to reduce costs, agencies may be tempted to exercise the six-month "option to extend services" rather than full option periods. Case law has established that this is improper where there has been no change in the government's requirements and services are within the scope of the current contract, particularly where it appears the government is trying to deprive a contractor of bargained-for benefits. See Overseas Lease Group v. United States, 106 Fed. Cl. 644 (2012). Contractors should consider early communication with the contracting officer concerning the agency's intent to exercise options and provide early notice if use of the extension clause appears inappropriate. Documenting any cost impact is essential.
• Delayed Contract Awards and More Aggressive Government Negotiations. In the event an agency delays awarding a new contract and pushes for unreasonably low prices or terms and conditions, contractors should be prepared to challenge government negotiation positions and assumptions. Contractors should revisit their cost and price assumptions before agreeing to extend their proposals. When appropriate, contractors should ask for the opportunity to submit a revised proposal rather than stick with a stale offer that is becoming uneconomic.

Conclusion

Amidst the uncertainty surrounding sequestration, one thing is very clear: there is no benefit to being a wallflower. Contractors can approach the next several months as an opportunity for action and jump into this mix. Like much of federal procurement, implementing sequestration will require each agency to undertake its own individual approach to each contract on each program. How agencies apply sequestration's cuts to particular contracts will depend on available information, perceptions and assessments, and even bureaucratic and personal dynamics within agencies. To achieve the best possible outcome for themselves and their agency customers, contractors can (and should) utilize all available tools and processes to provide information and suggestions to agency stakeholders. As outlined above, contractors can prepare and plan for the potential impacts of funding cuts and design strategies for countering contract reductions, when possible. In many instances, through effective planning, understanding of legal rights and options, and proactive communication, contractors can help their federal customers implement sequestration in a manner consistent with minimizing impacts on the agency's mission and the contractor's performance.³

Notes

¹ In a March 1, 2013 report to Congress, OMB issued an appendix illustrating the application of the same percentage reduction to each type of budgetary resource within a budget account. See OMB Report to the Congress on the Joint Committee Sequestration for Fiscal Year, available at http://www.whitehouse.gov/sites/default/files/omb/assets/legislative_reports/fy13ombjcsequestrationreport.pdf.

² OMB's guidance to agencies dated February 27, 2013, is available at http://www.whitehouse.gov/sites/default/files/omb/memoranda/2013/m-13-05.pdf. OMB's guidance to agencies dated January 14, 2013, is available at http://www.whitehouse.gov/sites/default/files/omb/memoranda/2013/m-13-03.pdf.

³To listen to a recent webinar presented by co-author, Terry Elling, on the topic of sequestration strategies for contractors, please visit https://webinars.hklaw.com/e4k4c109lhq/event/registration.html.