Part 2
Under the "Termination for Convenience of the Government" clause (FAR 52.249-2), the government may cancel the contract simply if its needs change. In return for this unique privilege it agrees to reimburse the contractor for certain costs. In the previous article in the last issue, we addressed how to present your termination while in this article we will focus on what costs to claim with the intent of maximizing your recovery. Incomplete understanding of what costs to claim is one of the greatest impediments for full cost recovery we encounter. We are still indebted to the excellent article by Paul Seidman and Robert Banfield of the law firm of Seidman & Associates in the April 1995 edition of Briefing Papers.
Basic Rules
The above clause and FAR Part 49 address terminations. The basic formula is that when a fixed price contract is terminated the contractor is entitled to recover (1) allowable costs incurred in the performance of the work (2) reasonable profit for work performed (3) reasonable settlement expenses and (4) certain continuing or post-termination costs. Recovery of these costs and profit are limited to the "total contract price" which as we discussed last issue can include the original price plus any equitable adjustments the contractor may be entitled to. If the government can prove the contract would have been completed at a loss, the contractor is not entitled to profit and its other termination costs (excluding settlement expenses) are subject to a loss adjustment that reduces the allowable cost by the percentage of loss.
Cost Principle. Because a contract termination is considered to cause the incurrence of certain costs that would not arise had there been no termination, the Federal Acquisition Regulation includes a "termination cost" principle (FAR 31.205-42) that is to be used in conjunction with the other cost principles of FAR Part 31. These unique costs, some of which we will discuss in detail later, include:
Common items. These are items reasonably usable on contractor’s other work which are usually not allowable unless the contractor submits evidence the items cannot be retained without sustaining a loss.
Costs continuing after termination. These costs are allowable if the contractor took reasonable efforts to eliminate them. "Idle facilities and idle capacity" are examples of these costs.
Initial Costs not fully absorbed because of the termination are allowable. Examples include "starting load costs" such as learning curve and training as well as "prepatory costs" such as initial plant rearrangement and production planning.
Loss of useful value of special tooling and special machinery and equipment is allowable.
Rental costs under expired leases are allowable for a reasonable period.
Costs of alterations of leased property when such costs were necessary for performance of the contract
Subcontractor claims are generally allowable along with an appropriate share of the contractor’s indirect expense
Settlement expenses for preparing and presenting a termination claim as well as termination and settlement of subcontracts are allowable. These expenses include costs of in-house personal and outside experts such as consultants and attorneys.
Fair Compensation. The FAR cost principles are not to be applied strictly in determining allowability but are applied "subject to" the general principle that a contract whose contract is terminated for convenience is entitled to "fair compensation". This overriding principle states "a settlement should compensate the contractor fairly for the work done and the preparations made for the terminated portions of the contract, including a reasonable allowance for profit. Fair compensation is a matter of judgment and cannot be measured exactly. In a given case, various methods may be equally appropriate for arriving at a fair compensation. The use of business judgment, as distinguished from strict accounting principles, is the heart of a settlement" (FAR 49.201(a)). The strategies we discuss below for maximizing your claim is based on this "fair compensation" principle.
General Strategies
Seek Fair Compensation. Despite a long history, this principle is commonly overlooked by auditors, contracting officials and even contractors. If disallowance of a cost would be unfair you should claim it even if it is not allowable under one of the cost principles. Whatever form you are using (e.g. SF 1435 or 1436), you should take an aggressive approach and include a narrative that explains why a claimed cost is necessary to provide fair compensation.
Avoid Government Second Guessing. It is quite common for contracting officers and auditors to disallow costs (e.g. subcontracting decisions, lease arrangements, personnel decisions) alleging they would have performed the contract in a different manner. Case decisions (e.g. Aeronica Mfg. Corp., ASBCA 3844) have held contractors are allowed great discretion in performing their contract and unless there is a clear abuse of discretion, the choice along with its resulting costs are to be considered reasonable. The FAR also has long held that a cost is reasonable if it passes the prudent person test.
Reject Impractical Proof Requirements. Though a fixed price contractor is not required to document its costs of performance, COs and auditors commonly attempt to disallow costs that do not have the type of documentation required under a cost-type contract. Both FAR 49.201(a) and numerous decisions (e.g. Algonac Mfg. Co., ASBCA 10534) have established a "liberal approach" of proving costs under a terminated fixed price contract. Though it has the burden to prove its termination costs are "more than mere speculation" use of estimates that have a reasonable basis in fact have been held to be sufficient when accounting records are unavailable due to no fault of the contractor. The burden of proof, however, is higher for settlement expenses and other costs incurred after a contract is terminated. As long as you incurred the expense and provide a reasonable factual basis to substantiate the amount, disallowance for lack of proof is improper.
Charge Indirect Costs Directly. After a termination, the contractor is often left in a position where normal treatment of indirect costs result in unfair compensation (i.e. absence of direct costs prevents application of an indirect cost rate to recoup indirect costs). Numerous Boards of Appeals decisions have routinely permitted normal indirect costs to be charged direct for termination purposes (e.g. Agronautics, ASBCA 21512) These costs include: supervisory personnel, freight charges, factory supplies, equipment repairs, small tools, travel, telephone and other office expenses, engineering labor, quality assurance, purchasing, office labor and the company president. This different treatment of similar costs has been held not to violate CAS 402 (consistency of like costs under like circumstances) because costs of terminated contracts are not considered to be incurred "in like circumstances". Of course, these costs charged direct should be removed from an indirect cost pool(s) to avoid "double counting".
Avoid Loss Adjustments. If a contract is performed at a loss (i.e. it would have been completed at an amount in excess of the contract price), the contractor is not entitled to profit and termination costs are subject to a downward adjustment for the percentage of loss. This can be avoided by (1) submitting an equitable adjustment claim that will increase the price of the contract and hence avoid the loss or (2) avoid submission of information that auditors can use to infer a loss (e.g. estimate-to-complete for the terminated portion of the contract, verbal assent to a loss, etc.).
Request Partial Payment. As we discussed last issue, request for partial payments will often result in significant accelerated payment that will reduce the incentive to accept an unreasonably low offer.
Obtain Professional Help. Terminations often involve very complex legal and accounting problems where professional help can usually result in greater recovery. Expense should not be a concern since reasonable fees are allowable as settlement costs.
Specific Costs
We have selected the following costs to discuss because they offer significant recovery opportunities that are most often overlooked.
Precontract Costs. The allowbility of precontract costs for a Termination of Convenience (T of C) need not be limited to the FAR 31.205-32 "Precontract cost" cost principle. Whereas the cost principle limits allowability to costs incurred (a) to meet schedules (b) directly pursuant to negotiations in anticipation of award and (c) that are otherwise allowable contract prices, these limitations need not apply to T of C costs. Rather, the CO is required to adhere to the "fairness" principle discussed earlier if such costs do not clearly meet the FAR criteria.
Idle Facilities and Idle Capacity. Though often substantial and allowable under the "costs continuing after termination", contractors surprisingly fail to claim these costs. These allowable costs refer to maintenance, repair, housing, rents and other related costs such as property taxes, insurance, and depreciation. Facilities are the contractor’s plant and any portion of it including land and equipment whether leased or owned. Idle facilities are completely unused while idle capacity refers to unused capacity of partially used facilities.
Several unsupportable grounds for refusing payment are often asserted by auditors such as:
"The period exceeds one year". The cost principle states these costs "are allowable for a reasonable period, ordinarily not to exceed 1 year" and the government often misinterprets this to be a maximum of one year. Several cases (e.g. General Dynamics , ASBCA 19607) have rejected this approach entitling contractors to longer periods as long as "reasonable steps" are taken to eliminate these costs. The Board has recognized several years to be appropriate.
"The facilities are not completely idle". Auditors frequently confuse "idle capacity" as "idle facilities" and disallow these claimed costs because the "facilities" were not completely idle. If a contractor manages to find some use for a facility left idle by a termination, the idle facilities become, by definition, "idle capacity" or partially used facilities. Underutilization is all that is required to recover the costs of "idle capacity" (e.g. Fiesta Leasing & Sales, Inc. ASBCA 29311)
"Sales have increased". The government sometimes examines revenue trends and if sales have increased, disallows costs claimed for idle facilities or idle capacity. This, of course, begs the question – the issue is whether the contractor experiences idle capacity or idle facilities, not whether sales volume has changed.
"The facilities are not ‘special tooling’". For facilities to qualify for "loss of useful value" it must meet the criterion for special tooling – tooling, machinery, or equipment that is limited to only the contract. The government sometimes confuses "special tooling" with idle facilities or idle capacity – no similar requirement of loss of useful value is required for the latter categories of cost.
Rental Costs. Unexpired rental costs should be claimed if the lease cannot be terminated or the property sublet even if the lease is longer than the contract provided it was necessary when acquired. In addition, auditors, citing FAR 31.205-36, "rental costs" may sometime limit rental charges between related parties to the cost of ownership rather than fair market value(which is usually lower). Unlike the rental cost principle, the termination cost principle does not limit rental cost paid to a related person or organization to ownership costs (see FAR 31.205-42(e)).
Cost of Money. Facilities Cost of Money (imputed cost of capital for facilities used on contract performance) must usually have been included in the original cost proposal to be recoverable on contracts. If the termination settlement proposal is the first cost proposal (e.g. the contract was awarded on a competitive basis, no cost or pricing data was originally submitted) then cost of money can and should be included to maximize recovery. Appeals Boards have also allowed cost of money under the "fair compensation" principle even when all the record keeping requirements were not met.
Common Items. Though "common items" (e.g. materials, tooling, inventory) are not allowable if they are reasonably usable on other work, the mere fact the contractor has other work where the items may be used is not sufficient to justify disallowance. Disallowance is justified only when the contractor has existing projects for the items or can hold the items for future work without incurring a loss. To rebut a disallowance assertion, the contractor should demonstrate the items cannot be retained at cost without sustaining a loss.
G&A Costs on Subcontractor Settlements. G&A costs that are normally applied to subcontractor costs are allowable for terminations. The format of SF 1435 and SF 1436, however, provides the G&A block before the subcontractor block, often leading contractors to not charge G&A on subcontractor costs. Claiming G&A costs should not be prevented because of the layout of the termination forms.
Costs Under First Article Contract. When the contractor produces a prototype of a new product for a subsequent production run – the first article – and terminates the contract before first article approval, the "First Article Approval" clause prevents recovery of costs incurred for production units. This rather harsh rule has been moderated by the courts for termination costs when:
It is necessary to order a minimum order that is more than necessary for the first article, the excess is allowable (Switilick Parachute Co., ASBCA 18024)
Extra material was necessary to meet delivery schedules of the initial production items (Young Metal Prods., Inc. ASBCA 15701)
The government effectively waives the "First Article Approval" clause by, for example, insisting on a delivery schedule prior to first article approval, approving progress payments for production items or taking possession of production items.
In-House Settlement Costs. In addition to outside services, in-house accounting, legal and administrative costs of preparing and negotiating the termination proposal are also considered settlement costs. These costs can be charged direct (remember to credit them from indirect pools) so a separate charge number should be set up and timesheets should reflect charges to that charge number.
© 2024 Government Contract Associates. All Rights Reserved.
