On October 14 the FAR Councils issued two interim rules that will significantly shift the burden to contractors for demonstrating that costs incurred in cost-reimbursement contracts are billable to government contracts and that incentive award fees are properly earned. By congressional mandate, both rules apply government-wide and became effective immediately upon publication.

And both will have a significant impact on contractors and their business relationships.

Congressional concerns about “excessive pass-through” costs on contracts have risen since Katrina and since the Government Accountability Office provided several reports to Congress. Congress imposed similar restrictions on the Department of Homeland Security (DHS) in 2007 and on DoD in 2008 before imposing this restriction government-wide and those agencies already have rules on the books.Both agency-specific rules will be repealed when this interim rule is finalized.I covered the DHS rules in my June 2007column.

Excessive pass-through limitations.The first rule, “Limitations on Pass-Through Charges,” is designed to minimize the “excessive pass-through” of subcontractor charges and prime contract expenses when a substantial amount of actual work will be (or was) performed by subcontractors. For civilian agencies, the rule applies to cost-reimbursement contracts greater than the simplified acquisition threshold ($100,000). For DoD, the rule applies to certain fixed price contracts, and to cost-reimbursement contracts, greater than the threshold to obtain cost or pricing data ($650,000).

The rule requires that proposals disclose the total value of work to be performed by the prime and each subcontractor, respectively. If subs are to perform over 70 percent of the total value of work, additional detail is required on the prime’s indirect costs and profit/fee applicable to the subs’ work and a description of the prime’s“added value” to the  subcontractor’s work.It’s then up to the contracting officer to “determine” – by an analysis not described in the rule – if that added-value work is a benefit to the government.If not, those costs are “excessive” and will not be allowed.

Second, the rule provides that, if a subcontractor’s effort exceeds 70 percent of the value of the work actually performed, the prime must demonstrate to the contracting officer that the prime added value to the subcontracted work; if not, the “excessive” costs will be disallowed. Finally, where “excessive” pass-through costs are not allowable, even in certain fixed-price DoD contracts, the government is entitled to a price reduction equal to the amount of those costs in the contract price.

To monitor compliance, the rule gives the contracting officer access to subcontractor records to determine whether the subcontractor proposed, billed or claimed excessive pass-through charges.

Award fee restrictions. This interim rule imposes restrictions on the use and implementation of new  cost-reimbursement, award fee, contracts. No award fee contract may be awarded unless (i) all of the FAR limitations on
cost-reimbursement contracts are met; (ii) the government completes an award fee plan as required by the FAR; and (iii) the head of the contracting activity issues a “determination and finding” that addresses the three FAR suitability factors relating to incentive contracts.

Any proposed award fee must be linked to the contractor’s cost, schedule and technical performance as measured against the contractor’s objectives. A contractor’s performance will be ranked according to a five-level adjectival award-fee evaluation scale detailed in the interim rule. Each performance level assigns a fixed range of available fee percentages. Furthermore, no award fee can be earned if the contractor’s cost, schedule and performance is rated “below satisfactory.”No unearned award fee may be rolled over into subsequent rating periods.

Five agencies – Defense, NASA, Energy, Homeland Security, and Health and Human Services – award over 95 percent of all federal government award fee contracts, and many of the provisions in this rule are already used by these agencies. In addition, in December 2007, the Office of Federal Procurement Policy published a memo entitled “Appropriate Use of Incentive Contracts” providing additional guidance to agencies when considering using award fee contracts.

This past August, I testified on award-fee contracts before a subcommittee of the Senate Committee on Homeland  Security & Governmental Affairs. I’m pleased that several of my recommendations were adopted in this rule.

While their substance has been around in various forms for several years, these interim rules introduce new elements
and significant compliance challenges for both government and contractors. In both cases, the rules put a premium on up-front contractor planning and proposal disclosures, along with careful monitoring during contract performance. For example, a prime could demonstrate added value where it is integrating the work of several subcontractors and  synthesizing their input to meet government requirements, or, where it is providing the supervision, security controls and billing for several task-oriented small businesses.

Expect both of these new requirements to be included in all new contracts but you should strongly resist having them applied to existing contracts.

What’s a contractor to do?

First, examine your internal “make-buy” and small-business subcontracting processes and be sure they are up-to-date. Both of these processes are pivotal in the determination of “excessive” pass-through and contribute to your decision of what work will be done with your workforce and what will be subcontracted.

New proposals will have to address both the excessive pass-through requirements as well as the significant criteria that benchmark an award fee plan, if applicable.As a prime contractor, you will want to contribute to both elements. If you’re a subcontractor, be prepared to address how your efforts will add significant capabilities to the prime and be ready to
work with the prime on addressing both the “added value” they bring and the award fee criteria you contribute to during your teaming negotiations and the prime’s proposal submission.

Second, if either rule applies, all primes and subs should be particularly alert to the performance and compliance challenges that kick in immediately after contract award.By creating the necessary reporting and monitoring provisions from the outset, you significantly minimize the risk of losing substantial costs and fees during performance.

Finally, prime contractors should involve your key subcontractors and vendors early in the proposal strategy to ensure that they are familiar with your processes and decisions, as well as the critical importance of satisfying the compliance and performance obligations under both new rules.

With these rules, the government is further intruding into a contractor’s business relationships and further dictating how it will manage its prime contractor relationships. Those firms that promptly address the requirements of the new rules, that demonstrate the significant value they bring, and that pay attention to the cost, schedule and technical performance elements of the contract stand to minimize their financial risk exposure and maximize successful contract execution.

The usual suspects in the acquisition community had been implying for months that if only the position were filled,  reforms could proceed. Now that the position is almost filled, let’s take a deep breath.

So what? At his confirmation hearing this week, Gordon disclosed an agenda that had no surprises. It contained the same hardy perennials that the community has ruminated over for years: grow the acquisition workforce, strengthen acquisition planning, reduce the government’s risk, improve contract oversight, and cut wasteful contract spending.

To play on Hillary Clinton’s book title, it will “take a village” to reform procurement. The energizers are a committed president, an understanding Congress, agencies that give a darn, and an industry that will accommodate some changes.

Unfortunately, the White House procurement reform campaign set itself up with the $40 billion savings bogie. As a result, it is already playing oddly: forcing agencies by rote, and in the exact same proportions, to reduce contract spending and high-risk contract cuts; letting the agencies believe there is an insourcing mandate when there is
none, allowing way too many lobbyists into political posts, and letting the mice play on fair cost comparisons between contractor and government employee costs.

Congress keeps on adding regulations, some of them sensible, some over-reaching (see Alan Chvotkin’s column in the Insider). The agencies, with a few exceptions such as VA, are not buckling down to weeding their weak contracts and gearing up seriously for stronger oversight.

The industry is playing defensive ball after trying to get along with the new administration on every issue. That’s probably unavoidable.

So look for Dan Gordon to do more than fill an empty chair. He can coordinate policy better, ride herd on the agencies that are weaker in contracting, and open up a more effective dialog with industry that many in government still hesitate to
do. He can also interpret acquisition to the White House, which still is not sufficiently aware of how reform can actually be accomplished. That alone would be a great contribution. But moving mountains? That’s not Dan Gordon’s job.

Here are seven reasons that suggest partnering never really existed, and may be unhealthy for contractor and customer alike.

1. Federal contracts don’t read like partnership agreements as known in the private sector.  There’s no equitable  risk-sharing or provisions that reflect a high degree of trust between partners. And there’s no discernible trend in that direction.  Rather, it’s for more regulation and forced disclosure of contractor business details.

2. The re-emphasis on contract oversight that emerged when Rep. Henry Waxman’s became chair of the Government Oversight and Reform Committee in January 2007 noticeably rattled the industry. Since then, the rising tide of regulation proposed and signed into law suggests the Federal customer-partner has had declining trust in supplier-partners for a few years.

3. The ever-tightening rules and enforcement concerning organizational conflicts of interest demonstrate less government faith in companies’ ability to identify and mitigate such issues. And just wait for the soon to be unveiled personal conflict-of-interest regs.

4. Both government and industry routinely show their reservations about operating more transparently. On the government’s side, FOIA transactions still seem to take forever.  Contractors’ disclosures to government and the public are almost always in response to government requirements and pressure and are often opposed by industry in the rule-making process. What publicly owned companies reveal is mainly driven by SEC regs and to please Wall Street equity analysts, not taxpayers or government customers.

5. Small businesses—the vast majority of the contractor population but with constant market share of federal prime contract dollars—act less satisfied, and often aggrieved, concerning government set-aside program spending and enforcement of the rules. The government hasn’t delivered any more dollars in percentage terms for years.  And some large companies still get a startling amount of “small-business” set-asides due to unsettled policy guidelines and  administrative error.

6. Government agencies, according to the Professional Services Council, are acting as if there were a mandate to insource, even though there is none.  The Administration has been careful to state its goals for program budget cuts and procurement and management reforms in source-neutral terms.

7. When troubled contracts and programs come to light in audits, reviews, and hearings, contractors remain muzzled by their customers, who prohibit releases of information unless approved by the government. Either (1) the customer-partner wants only its side of the story to be heard, or, (2) it is protecting the contract or contractor.  Come to think of it, there may be a spirit of partnership in this behavior, but it’s not one that’s good for the taxpayers.

Answer:  any that posture themselves as free of pertinent, unmitigated OCI and in a position to be objective advisers upstream of big buys of defense systems. Booz Allen Hamilton comes to mind, particularly in services like cost and economic analysis, and because it, too, is (~70 percent) owned by private equity investors, Carlyle Group.

Scanning the KKR portfolio, even a paranoid govt customer won’t find other government-contractor or overseas stakes owned by the parent that could spawn OCI worries about TASC at this time. The other TASC owner, General Atlantic, has more technology and country stakes, e.g. Lenovo/China, that could provide a wisp of worry for a few potential customers.

Carlyle, on the other hand, has had for decades full ownership or control of a variety of military hardware or government services firms (e.g., ARINC) suppliers, as well as overseas investors from the Middle East and potential-threat countries in its funds.  These other interests under the Carlyle umbrella reportedly gave pause to certain agencies when Carlyle’s purchase of BA was being reviewed.  Obviously, the government could accommodate those interests and any OCI  mitigations, which have not been publicly disclosed.

But OCI concerns remain a pop-up potential for any firms like TASC and Booz Allen owned by aggressive PEs.  It’s a  nature of the beast that they acquire aggressively, steadily diversify their portfolios, and are more open than ever to  foreign investors.

Congress may not believe the PE ownership structure is as insulating from organizational conflicts of interest, as the principals and agency customers do at this time.  It will be interesting to see how the TASC transaction refracts when it comes up in Congressional hearings, investigations, and plain old politics.

Finally, we got a kick out of the PR spin of the new TASC owners.  In their releases they speak of TASC as a national resource in the same sense that the FFRDCs,  often present themselves. But that’s for customer consumption rather than the PE investors grasping for high returns.  We doubt that MITRE and RAND are quaking.

Time will tell whether the claimed unique nonconflicted status of TASC makes a difference in the marketplace.