SEQUESTRATION: Preparing Government Contractors for Uncertainty, Cut-Backs and Contract Termination

by Snell & Wilmer

Current reports from Congress suggest that “sequestration” will likely take effect as early as March 1, 2013. The sequestration is a key part of the Budget Control Act of 2011, which requires the federal government to immediately cut at least $85 billion from the budget. The cuts will be split equally between the defense and domestic spending budgets. Although the president and Congress are negotiating a possible alternative to sequestration, it is clear that any future solution will result in very large reductions in federal government spending. Because substantial budget cuts will occur in some form, companies that provide goods and services to government entities should have a strategy to ensure that the government meets its contractual and statutory obligations.      

Although some governmental agencies have announced planned responses to the potential cuts, agencies have not always specifically identified contracts or programs that will be scaled back or terminated outright. But, in many cases, government internal plans do identify anticipated individualized cuts. Even if sequestration is avoided, many government agencies will carry out the cutbacks and contract terminations because the sequestration analysis demonstrates that the agency may be able to do without certain contracts or programs.

Preparation is Critical
Preparation by prime contractors, subcontractors, local governments and other stakeholders is key. First, a company must understand how a “cutback” will occur. In some cases, termination will be for the government’s convenience. In others, especially those where disputes about performance have plagued a project, termination for default may occur—especially if the contracting officer is under pressure to eliminate the costs associated with termination for convenience. Anticipation and prompt, effective responses to the “for cause” gambit may have a huge impact on a contractor’s potential loss.

Most likely, the prime contractor will receive notice of a “stop work order” or a modification in the contract that significantly reduces the scope of work. In this latter scenario, “constructive termination” may occur because the original bid was for a larger scope of work that spread the economies of scale. By reducing the contract through modification, the economies of scale are eliminated and the contract may not only be worthless, but the company may actually lose money performing the remainder of the diminished contract.

For those that decide to continue to do business with the federal government, bid protests over fewer contract opportunities will become more frequent. Cost data should be carefully scrutinized and companies should be aware of competitors that are “preferred” government vendors that may be awarded contracts based on non-bid criteria.

Responding to Sequestration—Documentation
Documentation will be critical. Although proper recordkeeping is required under any government contract, to properly prepare for a termination, claim or other dispute, it is essential that companies doing business with the government carefully document interactions regarding contract performance.

Companies that do not document proceed at their own peril. Some companies believe they have a “special” relationship with contracting officers (or their representatives) and believe there is no need to document because the government agent will always support the company. Other companies simply do not want to offend the government representative by documenting interactions. Others are fearful about documenting events that may raise performance issues in the future.

Documentation protects all parties in the contract: the government, the prime contractor and the subcontractors. The importance of documentation often becomes blindingly clear in its absence—i.e., if there is a dispute about a procurement and a company has not sufficiently papered the record. In federal contracting, when a dispute occurs, the government agency is responsible for creating an “administrative record” upon which it made its decisions related to the contract (e.g., selection of awardee, performance evaluations, claims, contract modifications, termination, etc.). The rules of the dispute reviewing body (e.g., Court of Federal Claims, Government Accountability Officer, Civilian Board of Contract Appeals, etc.) dictate what records the governmental agency must include in the administrative record to substantiate its decisions. The contractor, however, has the right to request supplementation of the administrative record. But, if documentation to support the contractor’s position is not available, judicial review will be backed only on the government agency’s documents.

Monitor Modifications Closely
Companies should carefully review all change orders, releases, vouchers, claims or other documentation either presented to or received by the government. The government in recent years has slipped very broad “release” language into its change orders and modifications. Although a company is required to sign a modification to acknowledge receipt of the change order, it is not required to “release” the government from its obligation to essentially “make the contractor whole” through equitable adjustments.

Prepare for Tight Timeframes
If there is a dispute, there are very specific timeframes that must be met to avoid waiver of a claim or protest. If the timelines, ranging between three days to several years, are not met, the company’s ability to seek recourse and relief is limited.

Know Where to Seek Relief
As part of the dispute analysis, the company must determine where to seek relief. Prime contractors may seek relief through the governmental agency, Court of Federal Claims, Government Accountability Officer, Civilian Board of Contract Appeals or other venues.  Subcontractors may only seek relief as outlined in the subcontract agreement, which is typically the hometown location of the prime contractor’s headquarters.

Regardless of venue, government contract law is unlike the standard commercial business agreements between two non-governmental entities. This is true at every government and contract tier level. It is important to retain legal and accounting advisors who are well-versed in the complex regime of government process and statutes, regulations, standard contract language and case precedent. Government contracting officers are usually well-versed in the law and will easily pull out nuances to defeat a company’s claim. Only experienced procurement specialists and attorneys have the resources to deal effectively with this process.

Protect Against Cumulative Losses
Identifying the “cutback” and protecting a company’s contractual rights to maximize its return is only the beginning. By entering into a government contract, at any tiered level, the contractor has agreed to certain socio-economic requirements. These include settling fairly with small business subcontractors, providing proper notification to local governmental entities about potential layoffs under the Worker Adjustment and Retraining Notification (WARN) Act, and a host of other requirements. The company should seek reimbursement from the government through the equitable adjustment process to cover the costs of such requirements.

In addition to complying with the socio-economic requirements, the company will also need to meet its accounting requirements. In cases of termination or dispute, an audit by the Defense Contract Audit Agency, or another auditing agency, should be expected. Although audits may significantly delay the process, there are opportunities to obtain interim payment for the majority of the contract. Expect audits to be rigorous. In a period of fiscal austerity, the government will scrutinize all claims for payment. If a company’s submission is incorrect, it is possible that the government will bring a False Claims Act action against the company (or, at least use it for leverage in the negotiations of a claim). A company may consider utilizing outside auditors to verify its claims.

Conclusion: Be Prepared
A company that is prepared for the cutback will maximize its recovery. There are many other issues that companies must consider when preparing for the potential disputes, protests and claims that will follow sequestration. Companies that contract with government agencies should start now to defend their investments and the profit potential of their projects. This process requires critical analysis, intense effort to build an effective case for the company and an effective collaboration with consultants and attorneys who know government procurement and dispute resolution processes.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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