Revised Audit Guidance on Auditing Subcontract Costs

The Defense Contract Audit Agency (DCAA) has moved to resolve an inconsistency in its coverage of incurred costs by issuing new guidance on when subcontract audit coverage is necessary.

Until now, once a subcontract has been identified for audit, the resultant request for audit stays in effect for the duration of the subcontract. Under the new guidance, the need for a subcontract audit is to be determined each year, based on a variety of risk factors.

Say for example, Contractor with a $50 million contract awards a $20 million subcontract to Subcontractor. The auditor at the prime notifies the auditor of the subcontractor and requests audit coverage of the $20 million subcontract over the life of the subcontract - which may extend several years. In the meantime, the Contractor is placed in the low-risk pool which means its chances of being audited, barring some newly discovered risk factor, is reduced to nil. Meanwhile, the auditors at the subcontractor continue performing their incurred cost procedures of Subcontractor as if nothing changed. And even if there are audit findings at the subcontractor, the Government cannot recover because the incurred costs and rates at the prime contract have already been settled.

The prime contract auditor will no longer request assist audits for the life of the subcontract based on the total expected subcontract value at the time of award. Rather, the prime auditor, in coordination with the subcontractor auditor, will assess the risk and need for assist audit effort based on subcontract costs included in the prime contractor's annual incurred cost proposal.

Under the new contract audit guidance, auditors at both the prime and subcontractor have coordination requirements. The auditor at the prime contractor takes the lead.

• Prime auditor: prior to issuing a request for an assis audit, the prime auditor should communicate with subcontract auditors about audit history, prior issues, eligibility for the low risk sampling pool, reliability of the indirect rates/budgets, and other issues that affect audit risk.
• Subcontract auditor: whenever subcontract auditors become aware of significant subcontractor risks, they should initiate a discussion prior to hearing from the prime auditor.

Here's some advice for subcontractors. When a contract auditor tells you that he/she is initiating an incurred cost audit of one or more of your subcontracts, request the coordination documentation with the auditors at the prime contractor. You are entitled to know what risk factors have been identified and considered as justification for an audit.

The new audit guidance can be found here.

Subcontractor Cost/Price Analyses Not Completed When Prime Proposal Submitted

DFARS (DoD FAR Supplement) 252.215-7009 is the Proposal Adequacy Checklist that companies should complete whenever a proposal to DoD requires the submission of cost or pricing data. The requirement is not mandatory, its only suggested as a means of facilitating submission of a thorough, accurate, and complete proposal (see DFARS 215.408(5). Although DFARS only suggests that it be prepared, often times procurement offices will make it a requirement for proposal submission thus making it effectively a mandatory document. Its a nice tool and we usually recommend contractors complete the checklist for any proposal. Whether prospective contractors choose to submit one or not, someone in the Government probably will prepare one so its best that contractors be prepared to respond to any queries that might result from a "no" answer.

One of the more problematic questions has been No. 17 which asks whether the prime contractor or higher-tier subcontractor has included the required cost or price analyses that establishes the reasonableness of each of its proposed subcontracts included with the Proposal. If not, the question further asks whether the offeror has included a matrix identifying (i) dates for receipt of subcontractor proposal, (ii) completion of fact finding for purposes of price/cost analysis, and (iii) submission of the price/cost analysis.

DCAA (Defense Contract Audit Agency) is playing hard-ball with this question. In recent guidance to its audit staff, it makes the following observation.

Question: If the prime contractor or higher-tier subcontractor has not completed the required cost or price analyses but has included a matrix identifying dates for receipt of subcontractor proposals, should Question No. 17 be marked as adequate or inadequate? Additionally, should the audit team consider the overall proposal adequate or inadequate for audit and proceed with the audit if this inadequacy exists?

Answer: FAR 15.404-3(b) requires the prime contractor or higher-tier subcontractor to conduct appropriate cost or price analyses to establish the reasonableness of the proposed subcontract prices and include the results of these analyses in the prime contractor’s proposal.

 As such, the inclusion of a matrix does not overcome the inadequacy of the prime contractor not submitting the cost or price analyses with the proposal. If the prime contractor or higher-tier subcontractor has not completed the cost or price analyses, as required by FAR 15.404-3(b), Question No. 17 ... should be marked as inadequate (i.e., answer “no” under “Adequate?”

We're not sure how the DCAA position serves any useful purpose. The DoD in its checklist has already allowed for a time-phased matrix when an offeror's cost/price analysis of subcontractor proposals cannot be completed by the proposal due date. If the offeror did not complete the cost/price analysis and did not supply a schedule for completing them, then the proposal might not be adequate for negotiating a price.

Responsibility Determinations of Prospective Subcontractors

When submitting proposals to the Government, there are two things a prospective contractor must concern itself when proposing subcontract costs; cost/price reasonableness and subcontractor "responsibility". This post is about the latter, subcontractor responsibility.

Prospective prime contractors are responsible for determining the responsibility of their prospective subcontractors (see FAR 9.104-4). Determinations of prospective subcontractor responsibility may affect the Government's determination of the prospective prime contractor's responsibility. Accordingly, a prospective contractor's deficient subcontractor responsibility determination procedures and practices may influence the Government's responsibility determination of the prime contractor. The logic goes something like if the prime cannot or will not determine whether its proposed subcontractors are responsible, then how can the prime contractor be responsible since FAR requires such determinations. Sometimes, the Government will require a prospective contractor to provide written evidence of proposed subcontractor's responsibility. If that happens, prime contractors must be prepared to furnish such evidence and not wait until requested before compiling such evidence.

So how does a contractor (or prospective contractor, or higher-tier subcontractor, or higher-tier prospective subcontractor) go about determining a subcontractor's "responsibility". Essentially, the prime contractor must perform the same steps that the Government performs when determining whether the prime contractor is responsible. These seven considerations are also found in FAR at 9-104.1. To be determined responsible, a prospective subcontractor must

1. Have adequate financial resources to perform the contract, or the ability to obtain them.
2. Be able to comply with the required or proposed delivery or performance schedule, taking into consideration all existing commercial and governmental business commitments.
3. Have a satisfactory performance record.
4. Have a satisfactory record of integrity and business ethics.
5. Have the necessary organization, experience, accounting and operational controls, and technical skills, or the ability to obtain them.
6. Have the necessary production, construction, and technical equipment and facilities, or the ability to obtain them.
7. Be otherwise qualified and eligible to receive an award under applicable laws and regulations.

Sometimes contractors (or prospective contractors) succumb to the temptation to perform superficial responsibility determinations. We've seen some that take the form of negative assurance, i.e. nothing came to our attention that would lead us to believe the prospective subcontractor is not responsible. After all, it takes a lot of time and effort to request supporting data and document the review steps and conclusions. And, in many cases, the Government never asks for the data anyway. While such a gamble may have been worth the risk up until a few years ago, contracting officers are coming under increased scrutiny (by the Inspector Generals and other oversight) to document their own responsibility determinations and that will include steps to ensure that prospective contractors have performed their own required responsibility determinations.

Eliminating Excessive Pass-Through Costs

According to Section 802 of the 2013 NDAA (National Defense Authorization Act), the Department of Defense as well as the State Department and the Agency for International Development (AID) were required to issue guidance and regulations to ensure that contracting officers complete additional analyses prior to awarding contracts over $700 thousand ($150 thousand for State and AID) where the prime contractor proposes to subcontract 70 percent or more of the total cost of work to be performed (these are called pass-through contracts). The concern, of course, is that with significant subcontracting activity, the Government might not be getting much value out of the prime contractor’s involvement in the contract.

The NDAA requires a “Notification, Review, and Determination” procedure for pass-through contracts. Under these procedures, if an offeror intends to award subcontracts for more than 70 percent of the total cost of work to be performed, it must inform the Government and identify the amount of the indirect costs and profit/fee applicable to the subcontracted work as well as a description of the value-added the offeror will provide to the Government.

The contracting officer then, must (i) consider the availability of alternative contract vehicles and the feasibility of contracting directly with a subcontractor or subcontractors that will perform the bulk of the work, (ii) make a written determination that the contracting approach selected is in the best interest of the Government and (iii) document the basis for such determination.

In June of this year, the GAO (General Accountability Office) initiated a review to determine how well the Agencies had implemented this new rule. The GAO found that nothing had really changed in the interim. In fact, DoD had done nothing because the Department was waiting for revisions to its FAR Supplement. As a result, the GAO concluded that the Government continues to be at risk for paying excessive contract prices.

As a result of its review, the GAO recommended that DOD, State, and AID issue guidance to assist contracting officers by identifying approaches for or examples of how to assess alternative contracting approaches to include the feasibility of contracting directly with proposed subcontractors, and documenting a determination that the approach selected is in the best interests of the Government. Additionally, the GAO recommended that the Agencies revise the processes and guidance governing management reviews of procurements to ensure that such reviews assess whether contracting officers are complying with the provisions of the 2013 NDAA.

You can read the entire GAO report here.

Consultants vs. Subcontractors

There is sometimes confusion concerning whether something or someone is a consultant or a subcontractor. Not only are Government contractors and prospective contractors uncertain about the definitions and status but Government procurement officials are as well. From an "administration" standpoint, there is a great difference between the two. Subcontracts must be solicited, analyzed, negotiated, and administered by the prime contractor much like the Government would handle the prime contract. Consultants on the other hand, only need to comply with FAR 31.205-33 provisions (provide a consulting agreement, work product,and invoice).

There is a general rule of thumb to apply when distinguishing between subcontractors and consultants. A subcontractor is hired to perform a part of the prime contractor's statement of work (SOW). Such work might include subsystems, finished parts, or skilled labor to perform specific functions. For example, a base maintenance contractor might subcontract barracks painting requirements to a painting company. Or, an aircraft manufacturer might subcontract the avionics portion of a contract to a company that specializes in avionics.

Consultants are not usually hired for a specific contract or to complete a portion of the prime contractor's SOW. They are often subject matter experts whose expertise is not tied to a single contract.

FAR Definitions. The Federal Acquisition Regulations (FAR) have a few definitions that will help clarify the difference between subcontractors and consultants.

Subcontractor

FAR 3.502-1: Subcontractor (1) means any person, other than the prime contractor, who offers to furnish or furnishes any supplies, materials, equipment or services of any kind under a prime contract or a subcontract entered into in connection with such prime contract and (2) includes any person who offers to furnish or furnishes general supplies to the prime contract or a higher tier subcontractor.

FAR 3.1001: Subcontractor means any supplier, distributor, vendor, or firm that furnished supplies or services to or for a prime contractor or another subcontractor.

Consultant

FAR 31.205-33: Professional and consultant services ... means those services rendered by persons who are members of a particular profession or possess s special skill and who are not officers or employees of the contractor. Examples include those services acquired by a contractor or subcontractor in order to enhance their legal, economic, financial, or technical positions. Professional and consultant services are generally acquired to obtain information, advice, opinions, alternatives, conclusions  recommendations, training or direct assistance, such as studies, analyses, evaluations, liaison with Government officials, or other forms or representation.

Proposed Rule on Prohibiting Excessive Subcontracting

Yesterday we discussed a provision in the Senate version of the Fiscal Year 2013 Defense Authorization Act that, if enacted, will give the Government statutory access to contractor internal audit reports. This week, we will be looking at a number of provisions in the bill that affect government contractors. Today, we will discuss a provision that would limit the amount of subcontracting that a prime contractor can include in a price proposal.

The impetus behind this proposed regulation is the recent revelations, both in the news and later in Congressional hearings that large companies were using small companies as fronts for obtaining contracts that were intended for small businesses. Although the contracts were awarded to small businesses, the large businesses, acting as subcontractors, were essentially performing the entire contract. 

The proposed legislation prohibits the award of contracts (or task orders) above $150 thousand unless the contractor agrees that at least 50 percent of the direct labor cost of services to be performed under the contract will be expended for employees of the contractor or of a subcontractor that is specifically identified and authorized to perform such work.

Exceptions are available if the contracting officer prepares a written justification that reliance on subcontractors making up more than 50 percent of the direct labor is in the best interest of the DoD. Also, the Secretary of Defense will have authority to override this provision.

It seems to us that this prohibition can be easily circumvented. Two parties can easily transfer employees from one to the other making it look like the small business has sufficient employees to perform at least 50 percent of the work.

What is a Subcontract? (Who Knows)

There has always been a lot of confusion over the definition of a subcontract - and with good reason. FAR (Federal Acquisition Regulations) does not contain an overarching definition of "subcontract". Instead, it contains several definitions of those words, each of which has specific application in the context of the rules. Here are some examples:

• FAR 3.502-1 (Subcontractor kickbacks) - "Subcontract" means a contract or contractual action entered into by a prime contractor or subcontractor for the purpose of obtaining supplies, materials, equipment or services of any kind under a prime contract.
• FAR 12.001 (Commercial items) - "Subcontract" as used in this part, includes, but is not limited to, a transfer of commercial items between divisions, subsidiaries, or affiliates of a contractor or subcontractor.
• FAR 15.401 (Contract pricing) - "Subcontract" also includes a transfer of commercial items between divisions, subsidiaries, or affiliates of a contractor or a subcontractor.
• FAR 19.701 (Small business subcontracting program) - "Subcontract" means any agreement entered into by a Government prime contractor or subcontractor calling for supplies and/or services required for performance of the contract, contract modification, or subcontract.
• FAR 22.801 (Equal employment opportunity) - "Subcontract means any agreement or arrangement between a contractor and any person (in which the parties do not stand in the relationship of an employer and an employee) (i) for the purchase, sale, or use of personal property or non personal services that, in whole or in part, are necessary to the performance of any one or more contracts or (ii) under which any portion of the contractor's obligation under any one or more contracts is performed, undertaken, or assumed.
• FAR 44.101 (Notice and consent to subcontract: purchasing system review) - "Subcontract" means any contract as defined in Subpart 2.1 entered into by a subcontractor to furnish supplies or services for performance of a prime contract or a subcontract. It includes but is not limited to purchase orders, and changes and modifications to purchase orders.
• FAR 52.204-10 (Reporting subcontract awards) - "Subcontract" as used in this clause, means any contract as defined in FAR Subpart 2.1 entered into by the Contractor to furnish supplies or services for performance of this contract. It includes, but is not limited to, purchase orders and changes and modifications to purchase orders, but does not include contracts that provide supplies or services benefiting two or more contracts.

Its no wonder then that the Government and contractors often bicker over what constitutes a subcontract. From a purchasing system perspective, it makes a difference. The policies and procedures for subcontracting are significantly different than those for purchasing raw materials or purchased parts.

Subcontract Costs Based on Commercial Item Pricing

A couple of weeks ago, we ran a three part series dealing with the Government's purchases of commercial items and some of the factors that the Government considers in determining whether items meet the precise definition of "commercial items". Today we want to focus on prime contractor responsibilities when they include subcontract costs based on commercial item pricing in a proposal or public voucher.


When a prime/higher-tier contractor includes proposed subcontract costs for commercial items in its proposal, the prime/higher-tier contractor is required to make a commercial item determination (CID) and perform the appropriate cost or price analysis to establish a fair and reasonable price, in accordance with Department of Defense FAR Supplement (DFARS) 244.402 and Federal Acquisition Regulation (FAR) 15.404-3. The Government auditor (e.g. DCAA) or the price analyst/contracting officer (e.g. DCMA) will review the adequacy of the prime/higher-tier contractor’s CID and associated cost/price analysis as a basis for opining on the adequacy of the CID and the reasonableness of the proposed subcontract costs included in the prime/higher-tier contractor’s proposal.


Prime contractors and all of their subcontractors are required to purchase supplies and services from responsible sources at fair and reasonable prices, including those determined to be commercial items. DFARS 244.402(a) states "Contractors shall determine whether a particular subcontract item meets the definition of a commercial item.” Prime/higher-tier contractors are expected to exercise reasonable business judgment in making the CID and documenting its determination. In addition, FAR 15.404-3(b) states that the prime contractor shall conduct appropriate cost/price analyses to establish the reasonableness of proposed subcontract prices and include these analyses in its proposal.

An adequate CID clearly identifies and supports how the item meets the commercial item definition in FAR 2.101. Generally, support for a CID would include market analysis and sales history. Failure to include adequate support could result in an estimating system deficiency and possible withholds on billings.

In some cases, the contracting officer may not agree with a prime contractor/higher-tier subcontractor's CID. FAR 15.403-1(c)(3) states in part, “If the contracting officer determines that an item claimed to be commercial is, in fact, not commercial and that no other exception or waiver applies, … the contracting officer shall require submission of certified cost or pricing data.”

Prime Contractors Have a Duty to Ensure Subcontract Costs are Accurate

The other day, we came across an item that illustrates the importance of prime contractors maintaining adequate oversight of their subcontractors. It involved a cost-reimbursable contract with the Department of Labor and a cost-reimbursable subcontract between that contractor and a subcontractor. Somewhere along the way, the subcontractor falsified its timekeeping/payroll records and inflated billings to the prime contractor. The prime contractor, in turn, submitted the subcontractor's "inflated" billings to the Government and was reimbursed. The scheme was eventually uncovered (not by the prime contractor but by a whistle-blower) and the Department of Labor has demanded restitution from the prime contractor.

Besides restitution however, the Government has additional tools it can use to mete out justice. Consider the Government's comments addressing this situation.

...both the prime and its subcontractor's could be charged under 18.U.S.C 1001 for making false statements by submitting false payroll information. Additionally, both may be prosecuted for making false claims under the Civil False Claims Act, 31 U.S.C. 3729-33 for submission of false payroll information. Moreover the prime may be liable under the criminal statute for False Claims, 18 U.S.C. Section 287 as well. This is because both the prime contractor and its subcontractors are responsible for the accuracy of claims filed with the government.

In the case of the criminal false claim, the statute imposes liability on "Whoever makes or presents to any person or officer in the civil, military, or naval service of the United States, or to any department or agency thereof, any claim upon or against the United States, or any department or agency thereof, knowing such claim to be false, fictitious, or fraudulent, shall be imprisoned not more than five years and shall be subject to a fine in the amount provided in this title." While there may be certain defenses for the prime, since it has a duty to ensure the claims of its subs are accurate, it can be held accountable. Filing of charges against either the prime or its subs whether criminal or civil is at the discretion of the Justice Department. In the case at hand, the prime may have a defense to responsibility depending on the facts.  

 

A contractor's responsibility to the Government is not limited just to subcontract cost issues. It would also extend to qualitative and quantitative aspects of subcontract performance - parts meeting specifications and product substitutions are a couple of things that come to mind.

 

This is a good reminder on the need for contractor's to maintain an active oversight roll in any subcontract it awards.

 

 

Audits of Direct Costs - Subcontracts

For the past few days, we have been discussing audits of direct costs that are performed as part of the review of contractor annual incurred cost submissions. As previously discussed, some contractors are surprised when the contract auditor makes inquiries concerning claimed direct costs, thinking that their incurred cost submissions are primarily about indirect costs. But, at the end of the day, an audit of an incurred cost proposal is opining on the allowability, allocability, and reasonableness of all costs charged to flexibly priced contracts. Previously, we discussed material costs, direct labor costs, and ODCs (other direct costs). Today we conclude this series with a discussion of subcontract costs.

For the purpose of this discussion, the term "subcontract" means an auditable subcontract, purchase order, or other form of agreement under which materials or services are to be furnished on a flexibly priced basis to a prime contractor under a flexibly priced contract subject to audit. As discussed earlier in this series, flexibly priced contracts include all cost-type, fixed-price-incentive, and fixed-price-redeterminable contracts, orders issued under indefinite delivery contracts where final payment is based on actual costs incurred, and portions of time-and-material and labor-hour contracts.

The responsibility of the prime contractor for managing its subcontracts is stated in FAR 42.202(e)(2). Essentially, the prime contractor is primarily responsible for subcontract award, technical and financial performance monitoring, ensuring that indirect rate proposals and annual rate adjustments are submitted on a timely basis, and payment to the subcontractor for the work accomplished under subcontract terms. To accomplish this responsibility, the prime contractor should have adequate internal controls to identify and notify the Government of auditable type subcontracts and intracompany orders under auditable type Government contracts, and to assure that subcontract/intracompany costs are allowable, allocable, and reasonable.

Prime contractors must notify the Government of awards of subcontracts (as well as intracompnay orders) as soon as practicable after award, and as part of the prime contractor's annual incurred cost proposal submission. The schedule of subcontracts (known as "Schedule J" in the DCAA's standardized incurred cost model) submitted with the proposal should include the prime contract number, subcontract number, amount, and type of order (e.g. CPFF, T&M, etc).

Auditors will review the prime contractors internal control system over subcontracts to ensure that appropriate flow down clauses are included in the subcontract. Key clauses that auditors tend to focus on include:

• Provide either the Government or the prime contractor access to the subcontractor's books and records for the purposes of performing the annual incurred cost audit.
• Require that billings include only allowable costs pursuant to FAR 52.216-7, and
• Require the subcontractor to submit annual incurred cost proposals pursuant to FAR 42.7

Failure to maintain adequate controls could impact a contractor's ability to stay on the direct billing program.

It is the prime contractors responsibility to audit its subcontracts. The Government auditor will review the adequacy of the work performed by the prime contractor. The contract auditor has a pretty good idea of what is required in an audit so when it looks at the work performed by the prime contractor, it is expecting to find something that looks similar to the kind of audit it would perform, if it were to perform one on the particular subcontractor.

Under certain circumstances, it is desirable that the Government auditor audit the subcontractor. Examples of these conditions include

1. the subcontract dollar value is significant in amount and in relation to the prime contract dollar value
2. the subcontractor objects, usually for competitive reasons, to an upper-tier contractor auditing its records,
3. a Government auditor is already performing audit work at the subcontractor's plant and can perform the audit more economically or efficiently,
4. the contract or subcontractor has a substantial financial interest in the other.

Improving Subcontractors' Cash Flows - Part III

This is the final part of our three part series on prime contractors behaving badly. You can read Parts I and II here and here.

Slow paying prime contractors (customers) are no small problem for many subcontractors who are dependent upon reimbursements to maintain profitability and in some cases, stay in business. Over-aged receivables means that the company is either incurring interest to finance those receivables or foregoing interest if they happen to have some cash on hand. Either way, profits suffer. We sense the significance of the problem as we're out and about with our clients and, as we reported yesterday, a GAO survey found significant issues as well - subcontractors responding to the GAO survey were experiencing an average of 146 days to get their invoices (e.g. progress payments or cost reimbursement vouchers) paid. In a purely commercial environment, this would be unacceptable - companies would not extend credit to customers with such poor payment history.

So, what is a subcontractor to do? What kind of recourse does a subcontractor have when it is not receiving timely payments from the prime. We have a few suggestions. Some of these are preventative measures and won't do much good once problems arise. If you have other ideas, please feel free to leave a comment.

1. Find out everything you can about your customer (the prime contractor). There have been cases where the prime is experiencing its own financial and technical capability issues and is using amounts due to subcontractors for other purposes.
2. Know the payment terms of your subcontract. Don't agree to extraordinary terms like we saw recently - 90 days.
3. Treat the prime contractor like any other commercial customer. Send out dunning notices at 30, 60, and 90 days overdue. Alternatively, notify them, in writing, when they do not comply with payment terms and conditions.
4. Charge interest on overdue balances (if not precluded by the terms of the subcontract).
5. Offer discounts for early payments. We caution everyone on this because discounts may "cost" you more than late payments. A term of "2/10,n30" (two percent discount if paid within 10 days, otherwise balance due in 30 days), works out to 36 percent when annualized.
6. Solicit assistance from the contracting officer cognizant of the prime contract. See yesterday's posting for details on this strategy. This is especially recommended if there is a pattern of late payments.
7. If there is a dispute over the payment, agree to accept payment for the items not in dispute. Sometimes there are issues over indirect billing rates or a deliverable not meeting spec. Subcontractors should be able to resubmit an invoice with the disputed items omitted until resolution is reached. Some cash flow is better than no cash flow.

Improving Subcontractors' Cash Flows - Part II

This is the second of three parts on an all to frequent occurrence - prime contractors not making timely payments to their subcontractors. If you missed Part I, go here.

A number of years ago, the GAO (Government Accountability Office) sent out a questionnaire to 33 contractor organizations, asking them to survey their members about their experiences in receiving payments from prime contractors. There were 151 responses from subcontractors that complained about late payments. These late payments totaled $345 million or about 23 percent of the subcontractors' revenues. Payments took an average of 146 days from the time the subcontractors submitted their invoices to their prime contractors. This was not a scientific survey by any means and the GAO did not attempt to project these results. However, in absolute terms alone, the survey clearly identified some significant problems.

The National Defense Authorization Act for Fiscal Years 1992 and 1993 requires DoD to disclose payment information about prime contracts and allows contracting officers to respond to subcontractor assertions of nonpayment, even though these is no "privity of contract" between the Government and subcontracts. The act stated that under procedures established in regulations, when the prime contractor has not complied with subcontract payment terms, a contracting officer may encourage a prime contractor to make timely payment to the subcontractor; or reduce or suspend progress payments to the contractor if contract terms allow it. The act also authorizes the contracting officer to pursue administrative or legal action if the contractor's certification that accompanies a payment request is inaccurate.

The regulations coming out of these authorization acts eventually wound up in FAR (Federal Acquisition Regulation) 32.112. This FAR provision provides that, upon assertion by a subcontractor or supplier of a Federal contractor that the subcontractor or supplier has not been paid in accordance with the payment terms of the subcontract, purchase order, or other agreement with the prime contractor, the contracting officer may look into the matter and if the subcontractor assertion is found to be true can (i) encourage the prime to make timely payments to the subcontractor or supplier or reduce or suspend payment to the prime contractor. Additionally, if the contracting officer determines that a prime contractor's certification is inaccurate, the contracting officer shall initiate administrative or other remedial action.

A subcontractor has a regulatory right to payment information relative to the prime contractor. FAR 32.112 states that upon the request of a subcontractor or supplier under a Federal contract for a non commercial item, the contracting officer shall promptly advise the subcontractor or supplier as to whether the prime contractor has submitted requests for progress payments or other payments to the Federal Government under the contract and whether final payment under the contract has been made by the Federal Government to the prime contractor.

Tomorrow we will wrap up this series by offering some strategies to consider when subcontractors are faced with slow paying primes.

Improving Subcontractors' Cash Flows - Part I

Subcontractors depend on cash flow generated by progress or other periodic payments from prime contractors to meet payrolls and pay other bills. Payments to subcontractors sometimes constitute well over 50 percent of prime contract costs.

The federal government provides interim financing to prime contractors. On fixed-price contracts, the government uses progress payments, which can reimburse contractors for 75 to 100 percent of allowed incurred costs each month. On cost-reimbursement contracts, the government can reimburse contractors for all allowable incurred costs on a biweekly basis. Under both types of contracts, the prime contraators' payment requests to the government will often include costs incurred to pay subcontractors.

Prime contractors have primary responsibility for managing payments to subcontractors. Although the federal government has concerns about payment protection for subcontractors, the government does not have a contractual relationship with the subcontractors. As a result, the federal government has been a reluctant participant in resolving payment problems between its prime contractors and their subcontractors.

A number of statutes and regulations provide payment protection to subcontractors. For example, large business prime contractors working on non-construction projects are required to pay subcontractors before billing the government. In contrast, prime contractors working on federal construction projects are allowed to bill the government before paying their subcontractors, however, they are required to pay their subcontractors within seven days after receiving payment from the government and certify that they will make timely payment to their subcontractors.

Tomorrow we will look at some of the remedies available to subcontractors when they don't receive timely payment from their prime contractors.

Recent Case Illustrates Dangers in Prime/Sub Relationships

Last week, a subcontractor prevailed in a suit brought against a prime contractor in Virginia's Fairfax Circuit Court. In this case, the prime subcontractor refused to reimburse its subcontractor for interim indirect rate variance invoices until the Defense Contract Audit Agency (DCAA) completed a final audit of the rates. (That could take a long long time given how far behind DCAA is in auditing final indirect rates - especially at small contractors) The prime contractor's position is of course, contrary to FAR 52.216-7, which allows for interim rate adjustments prior to contract closeout. Besides, the parties went through a lengthy and time consuming reconciliation process to verify the invoices and correct any mistakes. In addition, during the reconciliation process, a supervisor at the prime contractor stated in an e-mail to the subcontractor that "[i]t is unreasonable to expect you [the subcontractor] to wait for some undetermined amount of time for the DCAA to work your rate adjustments" and offered to pay 70% of the invoices.

However, before the prime contractor made the partial payments on the variance invoices, it reversed course and refused to pay the invoices. This decision occurred at a time when the prime and sub began competing for the same government contracts to provide linguistic services to support the war effort. In addition to failing to pay the invoices due, the prime also refused to provide past performance (when it had done so previously) and trashed the sub to the government client by falsely stating (without solicitation) in an e-mail "[t]he solvency of [the subcontractor] is an issue (not sure if they even still exist)…" The Court found that this was an attack on a competitor.

The Court ruled in favor of the subcontractor. The prime had to pay up $2.8 million In unreimbursed costs plus about a half million dollars in interest. Although we don't believe this happen very often, it does illustrate some of the dangers in subcontracting.

New Reporting Requirement for Government Contractors - Part 3

Earlier this week we reported on a couple of new reporting requirements that will have a significant impact on the contracting community, particularly the one that, effective immediately, will require prime contractors to report the award of every subcontract over $25,000. This requirement applies to contracts over $20 million but this threshold drops to $550 thousand on October 1st and to $25 thousand on March 1, 2011.

Prime contractors must report data about their subcontract awards at the FFATA (Federal Funding Accountability and Transparency Act) Subaward Reporting System (FSRS). That site has user guides, a webinar, and frequently asked questions to assist contractors in fulfilling their reporting requirements.

On July 15th, the Department of Defense issued guidance to its acquisition community concerning the deployment of this new system. The key point of the memorandum is this, contracting officers must complete a contract action report in the Federal Procurement Data System (FPDS) before contractors can add subcontractor information in the FSRS. The FPDS pre-populates many fields in the FSRS. Contracting Officers have only 3 days to complete their FPDS contract action report (FAR 4.6). If contractors encounter any issues with pre-populated information, the FSRS help desk will simply refer contractors back to their contracting officers. If the contracting officer has entered incorrect data or omitted data in some fields, the contractor cannot correct it. Only the contracting officer can make the corrections.

Agencies will be required to conduct reviews of the prime contractors' reports. It is not clear at this time the intended scope of these reviews or their frequency. Although not specifically addressed, it is reasonable to expect that Government audit organizations (such as DCAA) will use the publicly available FSRS to assist it in their audit activities. You can read the DoD guidance memo here.

New Reporting Requirements for Government Contractors

The Federal Funding Accountability and Transparency Act (FFATA) was signed on September 26, 2006. The Law was designed to empower American's with "... the ability to hold the government accountable for each spending decision. The end result is to reduce wasteful spending in the government". The FFATA legislation requires information on federal awards (federal financial assistance and expenditures) be made available to the public via a single, searchable (and free) website. Government procurement agencies have already been populating that website and there is considerable information available already. We don't imagine that most contractors would find the information too useful expecpt perhaps to figure out awards made to the competition. The website  is http://www.usaspending.gov/.

 

Now its the contractors' turn to begin populating the database. On July 8th, the FAR Councils published an interim rule requiring contractors to furnish (i) executive compensation data and (ii) information on first-tier subcontract awards over $25 thousand.

The newly created FFATA Subaward Reporting System (FSRS) (see https://www.fsrs.gov/) will collect data from Federal prime contractors on subcontracts they award. Prime Contractors awarded a federal contract or order that is subject to Federal Acquisition Regulation clause 52.204-10 (Reporting Executive Compensation and First-Tier Subcontract Awards) are required to file a FFATA subaward report by the end of the month following the month in which the prime contractor awards any subcontract greater than $25,000. This FAR clause, by the way, applies to nearly all contracts, except classified contracts. This reporting requirement will be phased-in as follows:

 

• Phase 1: Reporting subcontracts under federally-awarded contracts and orders valued greater than or equal to $20,000,000, reporting starts now.
• Phase 2: Reporting subcontracts under federally-awarded contracts and orders valued greater than or equal to $550,000, reporting starts October 1, 2010.
• Phase 3: Reporting subcontracts under federally-awarded contracts and orders valued greater than or equal to $25,000, reporting starts March 1, 2011.

Tomorrow we will discuss the specifc reporting requirements for executive compensation. In the meantime, you might want to become acquainted with the FSRS system.

Homeland Security Proposes to Limit Subcontracting

Whenever Homeland Security kicks into action as a result of a natural disaster, man-made disaster, or terrorism, it hires private companies to do whatever work has to be done. In the wake of Hurricane Katrina, Congress heard a lot of testimony on how excessive tiering of subcontractors under disaster recovery cost-reimbursement type contracts led to inflated costs (overhead and fees), and poor prime contractor oversight on subcontractor work. As a result, the Post-Katrina Emergency Management Reform Act was passed to limit the amount of subcontracts under these situations.

Homeland Security has now published a proposed FAR Supplemental regulation to implement this Act. The regulation applies to cost-type contracts (greater than $100 thousand) awarded under emergency situations and restricts the value of subcontracts to 65 percent of direct costs. When bidding on a contract, prospective contractors will be required to submit sufficient evidence to the contracting officer to permit him/her to make a determination that the offeror will or will not award subcontras that exceed 65 percent of the cost (excluding indirect costs and fee) of the contract, or any individual task or delivery order under the contract. The proposed regulation includes a process where the contracting officer can request a waiver from someone higher up in their organization. For contractors, its rarely a good strategy to request and hope for a waiver. If there are competing proposals, the contracting officer will go down the path of least resistence and award to an offeror that is not requesting a waiver.

The comment period for this proposed regulation expires on August 9th.

Prime Contractor Surveillance of Subcontractors

Government contracting officers are responsible for determining price reasonableness of prime contracts. Those contracts often include subcontract costs. It is the prime contractors' responsibility to fulfil certain obligations related to those subcontracts including performing adequate subcontract pricing and monitoring.

In 2007, Congress required the Department of Defense to set up a Panel on Contracting Integrity. The purpose of the panel was to conduct a department-wide review to identify vulnerabilities that might lead to contracting fraud, waste, and abuse. In 2008, the Panel issued its report identifying 28 actions for implementation in 2009. One of those actions required the Panel's Adequate Pricing subcommittee to review and assess the current regulations related to contracting officer surveillance over prime contractor's pricing of its subcontracts. This recommendation was spurred by an IG report which identified cases where the Government failed to ensure fair and reasonable prices because the prime contractors failed to fulfill their responsibilities.

The Adequate Pricing subcommittee's initial assessment concluded that existing subcontract pricing coverage in FAR, DFARS, and applicable policies, guidance, and instructions appear adequate. The committee was very concerned however that these regulations have not been implemented effectively.

Contractors should be aware that there will be increased emphasis on requiring them to fulfill their pricing and monitoring obligations with respect to their subcontractors.

Excessive Pass-Through Costs

Last month, the FAR councils published an interim rule that limits excessive pass-through costs charged to Government contracts. The limit on excessive pass-through costs has applied to DoD contracts since 2007. The new interim rule covers all Government contracts.

 We will discuss how the new rule works, but first, some definitions.

• Pass-through costs are defined as indirect costs and profit or fee.
• Excessive pass-through costs arise when a contractor (or a higher-tier subcontractor) subcontracts out all or a substantial portion of the work and adds no or negligible value to contract performance. Excessive pass-through indirect costs are unallowable.
• No or negligible value means that the contractor cannot demonstrate to the contracting officer that its effort added value to the contract in accomplishing the work performed under the contract.
• Added value means that the contractor performs subcontract management functions that the contracting officer determines are a benefit to the Government (e.g. processing orders of parts or services, maintaining inventory, reducing delivery lead times, managing multiple sources for contract requirements, coordinating deliveries, and performing quality assurance functions.

For DoD contracts, this regulation applies to negotiated cost-type and fixed price contracts greater than $650 thousand (cost or pricing data threshold). For civilian agencies, it apples to cost-type contracts over $100 thousand (simplified acquisition threshold).

The interim rule includes requirements for both offerors/contractors and Government contracting officers.

Proposal preparation phase:

1. Offerors must identify the total cost of the work to be performed by the offer and the total cost of the work to be performed by each subcontractor.
2. If the offeror intends to subcontract more than 70 percent of the total cost of work to be performed under the contract, the offeror shall identify
• the amount of indirect costs and profit/fee applicable to the work to be performed by subcontractors
• a description of the added value provided by the offeror as related to the work to be performed by the subcontractors

Negotiation and award phase:

• If the offeror intends to subcontract more than 70 percent of the cost of work to be performed, the contracting officer must make an affirmative determination that pass-through costs are not excessive.

After contract award phase:

1. Contractor must notify the contracting officer (in writing) if it changes the amount of subcontract effort after award such that it exceeds 70 percent of the total cost of work to be performed.
• must identify the revised cost of the subcontract effort.
• must include verification that the contractor will provide added value
2. If the contracting officer determines that excessive pass-through charges, the Government can recover.
• for cost-type contracts - unallowable for reimbursement
• for fixed price contracts - contract price reduction
3. Contracting officer or authorized representative (e.g. DCAA) has right to examine and audit contractor records necessary to determine whether the contractor proposed, billed, or claimed excessive pass-through charges.

PNWC observations.

1. A contractor's G&A base will influence whether indirect pass-through costs are excessive. The three most common G&A allocation bases are total cost input (TCI), modified TCI (excludes subcontract costs) and single-element (usually direct labor costs). Modified TCI and single-element allocation bases already exclude subcontract costs which means that subcontract costs are not burdened with G&A and therefore could not have excessive pass-through indirect costs.
2. Profit/Fee percentages might already reflect the anticipated level of subcontracting. When the Government uses the weighted guidelines method to establish negotiation targets for profit or fee (most of the time), it assigns weights to various risk factors. One of those factors is the degree of management effort necessary to ensure that contract requirements are met. Many contracting officers weight this element lower when the offeror has proposed significant subcontract costs.
3. Subjectivity of the contracting officer determination: The determination of whether contractor activities benefit the Government include an assessment of such things as processing orders of parts or services, maintaining inventory, reducing delivery lead times, managing multiple sources for contract requirements, coordinating deliveries, performing quality assurance functions. This is a very subjective assessment and contractors should not underestimate the benefit of "good writing" when describing the value it intends to add to the subcontracted effort. 
4. GAO Review: The GAO reviewed DoD implementation of the earlier interim regulation (see GAO-08-269, Contract Risk a Key Factor in Assessing Excessive Pass-Through Charges). The GAO stated that contracting officers needed guidance in how to assess whether proposed pass-through costs are reasonable for the work performed. Additionally, they should obtain DCMA and DCAA input. DoD responded that it willl issue guidance once the regulation becomes final.