January 02, 2007

While no business would buy the assets or stock of another company without performing appropriate due diligence, when Government contractors are acquired, there are many specialized issues that must be addressed. This article will briefly explore some of the important due diligence concerns that need to be considered when Government contractors are being acquired.

Federal Government contracts are highly regulated. The law even dictates the clauses that must be included in Government contracts. Required contract clauses are set forth in the Federal Acquisition Regulation ("FAR") at Part 52, which can be found at 48 CFR Part 52. For instance, most contracts must include the Termination for Convenience of the Government clause. 48 CFR 52.249-2. This clause, know as the "T for C" clause, basically allows the Government to terminate the contract at any time for any reason or no reason, as long as the Government's termination is not made in bad faith. The T for C clause permits termination when the Government decides that it no longer needs or wants the contracted goods or services, when it loses the appropriation for the item, or when it decides to combine the item in a new procurement. The only remedy available to the terminated contractor is to recover the costs of its performance prior to the termination, profit on those costs (unless the contractor was in a loss situation) and the costs of preparing a termination settlement proposal. Thus, if the Government properly terminates a $100 million contract, on which the contractor had performed $1 million of work, but had expected to have made $10 million in profits, the recovery of the contractor would be limited to $1 million plus a reasonable profit on that amount. Anticipatory profits are not recoverable under a proper T for C. This, of course, is very different than a termination under a commercial contract--where a contracting party does not have almost unfettered discretion to terminate the contract without liability. This does not mean that Government contracts being performed by a company that is being acquired will be terminated with future revenues being cut off. It only means that the acquiring company must explore the likelihood of such terminations.

Similarly, Government contracts are required to include a Changes clause. See, for example, FAR 52.243-1. This clause generally permits the Government to make changes within the scope of the contract to drawings, designs, specifications, method of shipment or place of delivery. It does not matter whether the contractor has the ability to make or finance the change. Failure to proceed with the change can result in the contract being terminated for default. The contractor may receive a quid pro quo for the change--an equitable adjustment to the contract price and/or delivery schedule. The equitable adjustment often is negotiated and includes reasonable additional costs plus profit. The challenge when performing due diligence is to try to devine what changes may be on the horizon, and the acquiring company must determine whether it will be able to perform any anticipated changes.

Of greater consequence than the standard contract clauses are the various criminal and civil laws that apply to Government contractors and the financial and other consequences of non-compliance. All statements, verbal and oral, to the Government must be truthful. False claims and invoices to the Government are subject to harsh penalties. Unfortunately, not all companies adhere to these very straight-forward rules and at any given time the Government is investigating or prosecuting fraud and abuse by contractors. Due diligence of Government contractors requires evaluation of all claims and allegations made by the Government to determine the likely outcome of such items. In addition, even if the Government has not notified the contractor of any areas of non-compliance, acquiring companies must be alert to fraud indicators. There literally are hundreds (or more) of fraud indicators. See for example the USAID Office of Inspector General/Investigations--Fraud Indicators at http://www.usaid.gov/oig/hotline/fraud_awareness_handbook_052201.pdf Fraud indicators may include unusually large year-end or end of month sales, timesheets with alterations that have not been initialed, winning certain contracts on a rotating basis, actions being taken without proper authorization and close relationships between contractor and Government personnel.

Acquiring companies must look at claims asserted by the contractor. If the claim is not well founded and documented, the Government could one day assert a "counter" claim against the contractor. Timekeeping systems and time records must be reviewed to make sure that Service Contract Act wages are being paid and, when required, overtime is being properly recorded, paid and charged. There should be verification that cost and pricing data submitted to obtain contracts and on outstanding proposals was and is accurate, complete and current. Otherwise, the contractor is subject to liability for defective pricing.

Serious violations of the law can result in serious contractual, administrative, civil and criminal penalties. If a contractor fails to perform a contract, the contract is subject to default under the standard Default clause. FAR 52.249-8. After a contractor is terminated for default, the Government can buy the same item or service from another source and may be able to assess excess reprocurement costs from the contractor. The termination for default is a negative mark that will greatly impact the ability of the contractor to obtain new work. Commission of offenses indicating a lack of business integrity can be a basis for debarring the contractor from doing business with the Government. FAR 9.406-2. Debarments often last three years. And, of course, false statements and claims can lead to prison sentences. Due diligence can turn up evidence of wrongdoing before the Government is aware of any wrongdoing.

Organizational conflict of interest ("OCI") issues are vital issues for due diligence reviews. FAR subpart 9.5 include complex rules which are calculated to prevent bias and unfair competitive advantage in Government procurements. Some of these rules preclude the type of work that a contractor can perform in the future. Taking a very simple example, if a contractor has a contract under which it must recommend specifications for a product which the Government plans to purchase in the future, it may be precluded from competing for the purchase of such products. Acquiring a contractor that has such a contract could prevent the acquiring company from selling its products to the Government in a future procurement that includes the specifications prepared by the contractor. Mergers, acquisitions and other consolidation of Government contractors can result in the new combined entity being precluded from markets in which one of the companies previously competed.

Similarly, a company that has received set-aside contracts based on it being a small business or a socially or economically disadvantaged business under the Small Business Administration's Section 8(a) program may no longer qualify for such set-asides in the future. And, under certain circumstances, the Government could decide not to exercise options under set-aside contracts that already have been awarded. This, of course, should be factored into the revenues that the acquiring company expects to receive after the acquisition.

The structure of the transaction also will dictate the type of due diligence performed. For instance, an asset purchase that includes the purchase of Government contracts requires that the new owner be recognized by the Government as a successor in interest. The sale must comply with detailed rules regarding the “novation” of the Government contracts. FAR subpart 42.12. If the rules are not followed, the Government can refuse to permit the “sale” of the contract.

In summary, issues that must be reviewed in connection with the acquisition of any Government contractor include:

1. Compliance with various Government contract laws and regulations including those dealing with affirmative action plans, the wage and hour laws, environmental requirements, and Buy-American rules.
   
2. The Anti-Assignment Act and the novation of Government contracts to new owners.
   
3. The valuation of Government contracts including option year provisions and indefinite quantity, indefinite delivery contracts.
   
4. The evaluation of the merits of contract changes, claims and other disputes.
   
5. Compliance with the cost accounting, allowability and regulatory requirements of Government contracting.
   
6. The evaluation of intellectual property rights related to Government contracts.

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KENNETH B. WECKSTEIN is a member of the firm of Epstein Becker & Green’s Washington, DC office. Mr. Weckstein is Chairman of the firm’s Government Contracts Department. In addition to government contracts representation, he focuses on complex civil litigation and trade secrets law. Mr. Weckstein can be reached at (202) 861-1860 or at [email protected].

DANIEL B. ABRAHAMS is also a member of the firm of Epstein Becker & Green in the Washington, DC office in the Government Contracts Department. Mr. Abrahams can be reached at (202) 861-1854 or at [email protected].

This publication is provided by Epstein Becker & Green, P.C. for general information purposes; it is not and should not be used as a substitute for legal advice.