Volume IV - Key Issues in Government Contracts Due Diligence

This posting is the fourth in our ten-part series on unique issues that arise in connection with mergers and acquisitions involving government contractors and subcontractors.  Parts 1 through 3 focused on the structure of the transaction and the implications of that structure on the transfer of pending contracts and proposals.  This posting, Part 4, introduces some of the most important issues that potential buyers should consider and address during the due diligence and negotiation process.  The posting is not intended to be a detailed “due diligence checklist,” but rather a high level overview of certain key factors that are likely to impact the “go/no go” decision and the buyer’s valuation of the target company.

• Audits and Investigations: Government contractors are subject to scrutiny by a plethora of auditors.  The Comptroller General has the right to audit records involving transactions directly related to most government contracts and subcontracts.  In cases where a government contractor is required to disclose cost or pricing data to the Government, the Contracting Officer can audit records relating to the accuracy, completeness, and currency of the disclosed data.  The Defense Contract Audit Agency (“DCAA”) can audit virtually every aspect of a contractor’s accounting and business systems.  The Small Business Administration (“SBA”) has broad authority to conduct audits relating to small business issues, including, for example, compliance with a small business subcontracting plan.  The Department of Labor audits compliance with various socioeconomic requirements, including, for example, equal opportunity, affirmative action, and prevailing wage requirements.  The Office of Inspector General (“OIG”), which is charged with investigating fraud, waste, and abuse, also has broad audit rights.  Where a contractor has credible evidence of a False Claims Act (“FCA”) violation or the commission of certain crimes in the award, performance, or closeout of a government contract, the contractor is required to make a mandatory disclosure to the OIG.  Government audit reports, correspondence with government auditors and investigators, and mandatory disclosures are valuable tools for identifying and quantifying the regulatory compliance and liability risks associated with the acquisition of a government contractor.  Sophisticated buyers typically request copies of these documents as well as representations and warranties regarding the target’s knowledge of any pending audits and investigations. The definition of “knowledge” often becomes a point of contention.

• False Claims Act: The False Claims Act (“FCA”) is the government’s primary anti-fraud weapon against government contractors and subcontractors.  The Government can recover up to three times its actual damages, plus fines and penalties, if it can prove that the contractor “knowingly” submitted a false claim (often an invoice) to the Government.  “Knowingly,” under the FCA, is defined to include not only actual knowledge, but also deliberate indifference or reckless disregard of the truth or falsity of the claim.  Common examples of actions that can trigger FCA liability include invoicing the Government for work that was not delivered or performed, delivering work with “knowledge” that it does not meet contract requirements, and making a false certification that is material to payment of a claim (g.,  a certification of compliance with a regulatory or contractual requirement).  A miscertification of size status in connection with a set aside can also give rise to FCA liability.  Liability may be imposed on prime contractors directly or upon subcontractors on the theory that their actions caused the prime contractor to submit a false claim to the Government.  FCA cases can be brought directly by the Government or by a whistleblower on behalf of the Government.  The mere threat of an FCA suit, in some cases, is sufficient to extract a sizable settlement.  Thus, it is prudent for the buyer to require disclosure of information relating to any outstanding FCA actions or investigations, to evaluate the target’s policies and procedures generally to ensure that the target is not being reckless with respect to government contracts compliance, and to obtain representations relating to the absence of any violation of the FCA or related requirements.

• Intellectual Property: The Government generally obtains very broad license rights in computer software developed under government contracts and in technical data pertaining to items, components, or processes developed under government contracts.  Contractors can limit the Government’s rights in technical data and computer software pertaining to privately developed technologies, but this requires planning and discipline, including, for example, use of prescribed restrictive legends and maintaining adequate records to establish development at private expense.  With regard to patents, the Government generally obtains broad license rights in, and the contractor generally retains ownership of, inventions conceived or first actually reduced to practice under a government contract (i.e., “subject inventions”).  The contractor can lose all of its rights in a subject invention, however, if it does not timely disclose that invention to the Government.  In addition to the standard data and patent rights clauses, government contracts also may include less frequently used clauses that grant the Government ownership of data and patents.  Most government contracts data and patent rights clauses must be flowed down to subcontractors.  Thus, whether the target is a government contractor or subcontractor, the buyer should analyze the specific clauses included in each material government contract, what technology was developed at private versus government expense, and whether the target has complied with the administrative burdens necessary to protect its intellectual property rights, including obligations relating to disclosure, marking, and recordkeeping.  Some buyers also seek robust government contracts intellectual property representations and warranties, particularly where intellectual property is an important aspect of the target’s business.

• Organizational Conflicts of Interest: An organizational conflict of interest (“OCI”) arises where, in connection with the performance of a government contract, a contractor:  (1) obtains confidential or proprietary  information under one contract that may place it at an unfair competitive advantage in obtaining another contract (“unequal access to information”); (2) sets the ground rules for another procurement, such as by preparing specifications or a statement of work (“biased ground rules”); or (3) a contractor’s objectivity may be impaired, such as where it could be required to evaluate its own products or services (“impaired objectivity”).  The Government cannot award a contract to a contractor that has an OCI unless the conflict has been mitigated or waived.  OCIs are often mitigated by some agreed upon preclusion on future work.  Moreover, a contractor and its affiliates are generally treated as a single entity for purposes of biased ground rules and impaired objectivity OCIs.  Purchasing a target that advises the Government on acquisitions or evaluates products or services for the Government, for example, could preclude the buyer – not just the target – from competing to supply those same products or services to the Government under other contracts.  Thus, the buyer should evaluate not only whether the target itself has any OCIs (based on a review of its contracts and mitigation plans) but also whether acquiring the target will create any OCIs for the buyer (based on an analysis of both the target’s and the buyer’s contracts and mitigation plans).  It is also important to consider whether and how those OCIs could be mitigated and what impact they will have on both existing business and the ability to compete for future opportunities.  In addition, some buyers will require representations and warranties relating to the absence of OCIs and/or compliance with all OCI mitigation plans.

• Cost/Pricing/Accounting Issues: Contracts for commercial items and services, e., those of a type generally available to the public and used for non-government purposes, are exempt from many government contracts statutes and regulations, and thus present a lower compliance risk than contracts for non-commercial items and services.  At the opposite end of the spectrum, cost-reimbursement contracts and contracts awarded on a non-competitive basis impose a higher level of risk.  Depending on the dollar value of the relevant contract or subcontract, the Truth in Negotiations Act (“TINA”) may require the government contractor or subcontractor to certify that it has disclosed current, accurate, and complete cost or pricing data, i.e., that it has disclosed to the Government all facts that one would reasonably expect to affect price negotiations.  Again, depending on the dollar value, such contracts also may require the contractor or subcontractor to comply with complex Cost Accounting Standards (“CAS”), which govern the allocation of costs to government contracts.  In addition, cost reimbursement contracts and subcontracts are subject to the Cost Principles, which address the types of costs for which the Government will and will not reimburse the contractor.  Failure to comply with TINA, CAS, or the Cost Principles can result in significant liability, including cost disallowances, and potential FCA violations.  Thus, if a target has contracts that are subject to TINA, CAS, or the Cost Principles, the buyer should assess the adequacy of the target’s policies, procedures, and systems for ensuring compliance with these requirements.  It is also common for buyers to identify these issues specifically in connection with a general representation of compliance with law and contract requirements.

• Small Business Issues: Agencies have goals for awarding contracts to small businesses.  They take those goals seriously.  Some government contracts are set aside for small businesses.  In other cases, small businesses may receive preferential treatment in the evaluation and source selection process.  The Government determines whether a contractor is a small business based on its revenue or number of employees plus the revenue or number of employees of all of its affiliates.  The rules define affiliation very broadly.  Acquiring a small business or even making a substantial investment in a small business can result in a loss of small business size status.  Once a contractor loses its small business status as the result of an acquisition, it is no longer eligible for small business set-asides, agencies can no longer count awards toward their small business goals, and there is some risk that existing awards could be terminated for convenience.  Thus, the buyer should identify the contracts that were awarded to the target as small business set-asides and determine whether the target will continue to qualify as a small business after the acquisition.  If the target will not continue to qualify as a small business, the buyer should consider:  (1) the risk that the Government will terminate existing contracts for convenience or decline to exercise options; (2) whether there are opportunities for large businesses for the type of work the target performs (e., whether contracts for such work are typically set aside for small businesses); and (3) the likelihood that the target will be able to compete with those large businesses for such work.

• Socio-Economic Requirements: Government contractors and subcontractors must comply with a host of socio-economic requirements, including, for example, those relating to equal opportunity and affirmative action, small business subcontracting, prevailing wage rates, and employment eligibility verification.  These requirements are contained in mandatory contract clauses, which, in most cases, must be “flowed down” to subcontractors.  In addition to imposing substantive obligations, these clauses include burdensome recordkeeping and reporting requirements.  Noncompliance can result in consequences ranging from the assessment of liquidated damages to contract termination and, potentially, suspension or debarment from government contracting.  Thus, the buyer should determine whether the target has adequate policies and procedures to ensure compliance with these clauses.  The buyer should also review the target’s standard form subcontracts to ensure that the target is flowing down all mandatory clauses to its subcontractors.

• Past Performance and Responsibility: The Government is required by law to consider past performance as an evaluation factor in most procurements.  The Government maintains a database, known as the Contractor Performance Assessment Reporting System (“CPARs”), into which contracting agencies upload their evaluations of a contractor’s performance on a contract-by-contract basis.  Agencies use records from this database in their past performance evaluations.  Adverse past performance ratings, particularly anything below a “Satisfactory” rating, can have a significant impact on a contractor’s ability to obtain future work.  Thus, buyers should consider requesting CPARs for material contracts and requesting representations and warranties regarding adverse past performance.  It is also advisable to identify any contracts that have been terminated, to request any “cure” or “show cause” notices that have been received, and to analyze those records to determine the level of risk they present to the business, in terms of both any immediate financial impact and the long-term ability to secure future work.  Finally, the buyer should consider the target’s present responsibility.  Contractors that fail to comply with their contractual or regulatory obligations, or that engage in other conduct that calls into question their integrity, can be suspended or debarred from government contracting.  This is often referred to as the “death penalty” for a government contractor.

• Multiple Award Schedule Contracts: The Multiple Award Schedule (“MAS”) program allows contractors to have a catalog of commercial products and services that can be purchased, through simplified means, by any federal agency (as well as certain other authorized purchasers).  A MAS contract is a great way to sell commercial products and services to the Government, but there are risks.  Obtaining a MAS contract requires a contractor to disclose its commercial sales practices and discounts to the Government and to offer an automatic price reduction to the Government whenever the contractor reduces its price to a specified commercial customer or a specified category of customers.  Failure to make an accurate disclosure of commercial sales practices to the Government, or failure to provide the Government an automatic price reduction when required, can trigger significant liability, including not only contract damages but potentially treble damages under the FCA.  In addition, MAS contractors are required to pay a fee, known as the Industrial Funding Fee (“IFF”), equal to a percentage of revenue under the contract in order to cover the Government’s contract administration cost.  Failure to report sales accurately or failure to pay the IFF can also result in significant liability, including the potential for treble damages under the FCA.  Thus, when purchasing a contractor that holds a MAS contract, it is important to review the adequacy of their disclosures to the Government as well as the adequacy of their procedures for complying with the price reductions clause and paying the IFF.  Depending on the circumstances, the buyer also may wish to seek representations and warranties relating specifically to compliance with MAS contract requirements.

• Security Clearances: Acquiring a contractor that performs classified work presents unique challenges and risks.  It is often difficult and sometimes impossible for the buyer to gain access to classified contracts.  This limitation on the ability to conduct due diligence can be mitigated somewhat by obtaining robust representations.  The existence of classified work is more problematic, however, if the buyer is subject to foreign ownership, control, or influence (“FOCI”).  There is an obligation to mitigate FOCI and, depending on the nature and extent of the FOCI, the acceptable methods of mitigation may range from a simple Board Resolution to “wall off” foreign interests from access to classified contracts, to a Proxy Agreement or Voting Trust (in which the actual owners are deprived of most day-to-day management prerogatives) or a Special Security Agreement.  The contractor will also need to file an updated SF 328 (“Certificate Pertaining to Foreign Interests”) and will need to consider whether to file a “voluntary” notice of the transaction with the Committee on Foreign Investment in the United States, aka “CFIUS.”

This post has provided a high level overview of the issues that most commonly arise in the acquisition of a government contractor.  Our upcoming posts will address these issues in further detail, including a discussion of relevant due diligence requests, representations and warranties, and other risk mitigation strategies.

Part 1: What You Need to Know About Mergers and Acquisitions Involving Government Contractors and Their Suppliers

Part 2: What Else You Need to Know

Part 3: What Happens to Pending Proposals - Mergers and Acquisitions Involving Government Contractors and Their Suppliers

Part 4: Key Issues in Government Contracts Due Diligence

Part 5: Land Mines Strewn Throughout: What You Need to Know About Mergers and Acquisitions Involving Government Contractors and Their Suppliers Data Room

Part 6: Organizational Conflicts of Interest: When Whole Is Less Than Sum of Parts

Part 7: Investing in Small Businesses

Part 8: Foreign Buyers Do Make a Difference

Part 9: Unclassified Contracts? Foreign Buyers Still Make a Difference

Part 10: Accounting for Cost of Business Combinations Under Government Contracts