Thursday, January 3, 2019

Waivers of Penalties for Unallowable Costs

Expressly unallowable costs are particular items or types of costs which under the express provisions of an applicable law, regulation, or contract, is specifically named and stated to be unallowable (FAR 31.001). Contractors who include expressly unallowable costs in their final indirect cost rate proposals are subject to penalty equal to the amount of the expressly unallowable costs (FAR 42.709-1). We have written extensively about expressly unallowable costs in past years and how DCAA (Defense Contract Audit Agency) continuously tries to expand the definition to make almost any cost exception an "expressly unallowable" costs with the ASBCA countering their push by narrowing the definition and throwing out the Agency's charges. For a recap of these issues, see "Expressly Unallowable Costs - ASBCA Narrows the Definition" and follow the various links.

The distinction between "unallowable costs" and "expressly unallowable costs" is significant. The latter carries penalties while the former classification does not. The broad purpose of the penalty provisions was to ensure that contractors, rather than the Government, bear the burden of assuring that contractor submissions for reimbursement of costs on Government contracts do not include unallowable costs. Congress was concerned with ending the "cat-and-mouse game", namely, "a game in which the cost of an item is submitted regardless of whether it's allowable, and the burden is placed on the Government auditors to identify and disallow the item(s).

The contracting officer can (and must) waive penalties in certain situations. The contracting officer must waive any penalties if the contractor withdraws the proposal before the Government formally initiates an audit, the amount of the unallowable costs which are subject to the penalty is less than $10 thousand, or the contractor demonstrates, to the contracting officer's satisfaction, that (i) it has established policies and personnel training and an internal control and review system that provides assurance that unallowable costs subject to penalties are precluded from being included in the contractor's final indirect cost rate proposal and (ii) the unallowable costs subject to the penalty were inadvertently incorporated into the proposal (i.e. their inclusion resulted from an unintentional error, notwithstanding the exercise of due care (see FAR 42.709-5).

In a recent ASBCA (Armed Services Board of Contracts Appeals) decision (Energy Matter Conversion Corporation (EMC2), ASBCA No. 61583), a contractor attempted to avoid penalties with other rationale.

EMC2 argued that the Government failed to inform EMC2 that it was disallowing legal costs for 2010/2011 until after it submitted its 2012/2013 incurred cost submissions. The Board was not persuaded stating that EMC2 cannot avoid the penalty by placing the burden of identifying and disallowing legal costs on the Government.

EMC2 further asserted that it had updated its accounting policies in 2017 but provided no evidence to support the assertion. Even if it had, that would not be a basis for a penalty waiver because those policies would have had to have been in place at the time it submitted its erroneous incurred cost proposal in 2016.

Thirdly, EMC2 argued that it had underbilled the Government. The Board found no evidence that EMC2 underbilled but also noted that underbilling was not one of the enumerated bases for penalty waiver.

Fourth, EMC2 pointed to the fact that the contracting officer waived the penalty in prior years. The Board stated that a contracting officer's decision is not binding in any subsequent proceeding.

Finally, EMC2 areued that it should be liable for only 55 percent of the penalty reflecting an apportionment of legal costs attributable to its "success" in the investigation. The Board noted that FAR 42.709-5 does not authorize such apportionment and added that the Court of Appeals has rejected apportionment arguments in similar circumstances.

There is one aspect to the penalty provision that seems very unfair to contractors - the idea that there is no waiver if the expressly unallowable costs did not result in increased costs to the Government. Say for example, a contractor spent $2 million on an SBIR contract for $750 thousand. Because the amount incurred was so far in excess of the contract amount, the contractor did not perform adequate screening of unallowable costs. The contract auditor audited the full $2 million and found expressly unallowable costs of $20 thousand - not nearly enough to bring the $2 million incurred below the $750 thousand contract amount. The contract auditor recommended penalties be assessed but thankfully in this real case, the contracting officer exercised its discretion not to assess penalties. But the contracting officer was certainly with his rights to do so.

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