Due Diligence In The Acquisition Of A Government Contractor - Part II

Monday, October 1, 2007 - 01:00

Part I of this article, which appeared in the September issue of The Metropolitan Corporate Counsel , discussed the procedural and financial aspects in the acquisition of a government contractor through a merger, stock purchase or asset sales agreement. It pointed out that with the increasing number of mergers, stock purchase agreements, and asset sales going on today in corporate America, increased due diligence has been a must for any responsible party to such transactions. If the target is a federal government contractor, there is an overlay of due diligence requirements because of the many statutes and regulations governing those who hold federal contracts that must be addressed before the transaction is closed to assure compliance and avoidance of later issues being raised by government procurement and audit officials.

Evaluation Of The Acquired Company's Federal Contract Assets

Validity Of The Contracts

Review all contracts to assess whether each was properly issued pursuant to the federal procurement statutes and regulations, determine the source of funds to satisfy the government obligations, and whether the contracts limit the government's obligations to annually appropriated funds.

Funding

The current contract prices should be identified and compared to the funds currently obligated to the contract, the amounts appropriated but not yet obligated to the contract, and the amount of funds needed for completion but not yet appropriated. Assess whether there will be a funding shortfall and if so whether termination or program cancellation is likely.

Overruns

Review the acquired company's methods for estimating the cost to complete contracts and whether they are reasonable. Assess whether there are projected losses. Cost reimbursable contracts, if any, should be reviewed to compare the costs that have been incurred to the amounts that have been obligated to the contracts and if such costs exceed seventy-five percent of the funds obligated, determine whether the government has been given notice of this fact as required in the contract and if the costs incurred exceed the amount obligated to the contract, whether performance has continued (i.e. whether there is an overrun issue). Fixed Price contracts should be reviewed that contain progress payments, determine the methodology used for determining progress billings, and then assess whether the contract is over-progressed by comparing the total amount of progress billings to the actual percent of contract completion.

Options And Multiyear Contracts

With respect to options contained in contracts, assess whether funds have been appropriated for the options and the likelihood that the options will be exercised and funds obligated for those options. As to multi-year contracts, it should be determined whether funds have been appropriated for future years. Check the contracts for cancellation charges for failure to authorize future years and assess whether those charges would cover the costs amortized over the expected life of the contract. Check for pre-priced options for the out years of any multiyear contracts to compare the value of those pre-priced provisions to the current estimate of cost needed to perform the work. Check for any price escalation clauses in the contracts that would protect the contractor.

Research Development Test And Evaluation Contracts (RDT&E)

A review of such contracts, if involved in the acquisition, is necessary to determine whether any of such contracts require the contractor to invest its own funds in the RDT&E effort and if so, how much additional contractor funding will be required. For any such contracts that anticipate the recovery of the contractor's investment through follow-on production contracts, the likelihood of a production contract award or cancellation of the program before the RDT&E is completed should be assessed.

Terminations For Convenience Of The Government

Something unique to federal contracting is the government's right to terminate a contract for the convenience of the government and such termination rights are in almost all federal contracts. In conducting due diligence the parties must determine whether there are any existing terminations in effect and if so whether the convenience termination funding is there to obligate the funds necessary to satisfy the contractor's termination claim in full. If the acquired company's operations are largely debt-financed based on the strength of anticipated contract revenues, the acquiring company should assess whether the termination claim would satisfy the debt obligations. One important question to address is whether the government is likely to contest the quantum of the termination claim.

Assignment Of Revenues

It should be determined whether the acquired company has assigned any contract payments to a financing institution and, if so, a review of all such assignments should be accomplished to ensure that they are in compliance with the procurement regulations and will not affect the transaction. (FAR 52.232-36 and 32.1110(d).

Pending Or Possible Government Claims

Default Terminations

If there are existent any default actions that have been taken or are threatened with cure notices or show cause letters, the parties need to explore whether the grounds under the particular default clauses of the contracts are valid and if not, should be challenged. An assessment must be made of what financial impact will occur as a result of the termination action. The government's rights under the standard Default Clause are to re-procure the item and charge the contractor with the delta between the new contract price and what the price was under the defaulted contract plus the government's expenses in having to re-procure the item or service.

Inspection And Acceptance

The main focus here would be to determine for contracts involving repetitious deliveries of the same item, the extent to which items have not passed inspection and have been rejected by the government. It should then be determined what cost impact there is in furnishing additional quantities to satisfy the contractual requirements to obtain acceptance by the government. If there are contracts which involve a few major items, assess whether such items have failed inspection tests and the cost impact to the contractor. Lastly, assess whether the government may have latent defect claims.

Warranties

The acquiring party should review all delivery records of all government contracts to determine how many units or services already delivered to the government are subject to a warranty provision and, if so, the cost impact of any warranty claims already asserted by the government or likely to be asserted.

Cost Disallowances And Cost Allowability

The acquiring company should review the acquired company's policies and procedures for segregating costs which are unallowable under the Federal Acquisition Regulations Cost Principles, Part 31. Check the relative proportion of fixed price to cost type contracts. A review of all outstanding government audit reports and an ongoing audit should be undertaken to assess whether any costs will be disallowed. Determine whether any public vouchers issued under cost type contracts have been rejected for the inclusion of unallowables.

Defective Pricing

The Truth In Negotiations Act, implementing regulations and contract clauses discussed above apply to negotiated contracts and/or contract actions over $500,000 and require the submission of and certification by the contractor of accurate, current, and complete cost and pricing data as of the date of the agreement on price. Accordingly, due diligence will require first determining the number of contract actions that are subject to the Act. Next, a review of all post-award government audit reports should be conducted to learn whether any defective pricing allegations have already been made. Lastly, the acquiring company should also review the acquired company's policies and procedures covering the negotiation of contracts to ensure compliance with the Act and to minimize or eliminate the risk of defective pricing claims.

Cost Accounting Standards Violations

It is first to be determined as noted above whether the acquired company is subject to the Cost Accounting Standards and, if so, the extent of its coverage as noted in the earlier discussion on the Procedural Aspects of the Transaction. Due diligence next dictates that the acquiring company review the most current CAS Disclosure Statement by the acquired company to the government to detect any CAS violations. Lastly, all audit reports relating to CAS should be reviewed to learn of any violations or possible violations.

Pending Or Possible Contractor Claims

Formal Change Orders

All open contracts should be reviewed to identify formal change orders issued by the government and whether they have been priced, negotiated, or pricing is still under development. In the case of unilateral changes under the Changes clause of the contracts, an assessment of the validity of an increase in price should be made.

Constructive Change Orders

These types of changes claims have been recognized in government contract law for many years when the government without the issuance of a formal change order or bi-lateral supplemental agreement directs work to be performed. In due diligence, the history of performance of any open contract should be undertaken to learn whether the acquired company has been or is performing work not called for by the contract itself. Assess whether any constructive changes claims have been or will be filed and the likelihood of success of such claims.

Contractor Liability For Fraud

It is first to be determined whether any procuring agency has referred any contract-related activities for investigation for civil or criminal fraud against the government. It should also be determined whether any activity of the acquired company whether contract related or not is the subject of a Grand Jury investigation. Lastly it should be determined whether the acquired company has been suspended or debarred from future contracting under the suspension and debarment regulations set forth in the Federal Acquisition Regulations Part 9.405 or has received notices to this effect proposing such sanctions. These regulations were promulgated on the basis that federal contractors using public funds must be responsible sources of supply and that any activities they engage in that reflect negatively on their responsibility as a contractor requires consideration of the application of these regulations. An assessment should be made as to the extent of the suspension or debarment, in other words, whether it is company wide (where divisions or subsidiaries are involved), what the length of time is for the suspension or debarment, what impact this has or will have on the acquired company's contracts and its business base.

Internal Government Contract Compliance Programs

The central inquiry here is whether the acquired company has conducted any government contract compliance reviews or audits and, if so, whether it has been determined that the company is in compliance and has policies to insure compliance with the laws and regulations which apply to government contracting. It should be determined also whether corrective action has been taken if noncompliance issues have surfaced. Compliance reviews cover principally the following areas: Government Cost Accounting; Purchasing Systems; Material Management (if applicable); Government Furnished Property; Ethics; Bid and Proposal Development and Negotiation Practices; Contract Administration, Financial Control and Quality Assurance; and International Contracting (if applicable).

The above represents the principal areas of due diligence concerns when the target is a government contractor. Careful review of the matters set out herein will give assurance to the buyer that the acquisition is a wise one and presents limited risks legally and financially.

Ray Pushkar is a Partner in McKenna Long & Aldridge's Washington, DC office. He joined the firm in 1970 and served as chair of the Government Contracts Department from 1987 to 1995. Mr. Pushkar's practice encompasses government contracts counseling and litigation and commercial contracting.

Please email the author at rpushkar@mckennalong.com with questions about this article.