Interim Business Systems Rule Issued

On May 18, 2011, the DoD released an interim Business Systems rule with request for comments.  76 Fed. Reg. 28856.  Comments are due July 18, 2011.  The current version of the rule reflects comments received on the prior two proposed Business Systems rules (published January 15, 2010 and December 3, 2010), requirements in the National Defense Authorization Act for FY 2011, and additional revisions to the rule.

Six business systems are covered by this rule:

• Accounting System
• Earned Value Management System ("EVMS")
• Estimating System
• Material Management and Accounting System ("MMAS")
• Property Management System
• Purchasing System

DoD characterizes these business systems as the "first line of defense against waste, fraud, and abuse."  Accordingly, DoD sees this rule as improving the effectiveness of DoD oversight of contractors and achieving more effective and efficient management of DoD programs.  Notable changes with this version of the rule include the following:

Covered Contracts – The rule makes clear that contracts covered by the withholding provisions of the Contractor Business System rule will be contracts subject to the Cost Accounting Standards, but the substantive requirements of the interim rule specifying requirements for compliant business systems are not limited to CAS –covered contracts.  Therefore, small businesses will not be subject to withholding under the rule, but they may be required to meet relevant requirements for compliant business systems.  There is also nothing in the rule that would suggest that subcontracts are covered by the withholding requirements, although they are covered by some of the systems requirements, as described below. 

"Significant Deficiency" – The interim rule defines a "significant deficiency" as "a shortcoming in the system that materially affects the ability of officials of the Department of Defense to rely upon information produced by the system that is needed for management purposes."  This term is used throughout, and replaces phrases such as "deficiency that adversely affects the system" or "deficiency that adversely affects the system, leading to a potential risk of harm to the Government."  A determination by the government that a "significant deficiency" exists with a contractor's business system will be grounds for issuing a notice of withholding of payment and will require the contractor to submit a corrective action plan.  The rule allows for contractor response to an initial finding of a "significant deficiency" and the contracting officer ("CO") will have final authority to determine whether a "significant deficiency" exists.  The CO is required to describe the deficiency in sufficient detail to allow the contractor to understand the deficiency.

Withholding – The rule provides that if a CO issues a final determination that a contractor's business system contains significant deficiencies, that final determination that there is a significant deficiency "will" include a notice of payment withholding.  However, unlike versions of the proposed rule, the CO will be required to make a final determination that a significant deficiency exists before withholding will be permitted.  The CO is directed to withhold 5% of amounts due from progress payments and performance-based payments.  Also, the CO will direct the contractor to withhold 5% from its billings on interim cost vouchers on cost, labor-hour, and time-and-materials contracts.  The withholding will continue until the CO determines that the contractor has corrected all significant deficiencies.  However, if the contractor submits, within 45 days of notice of the significant deficiency determination, a corrective action plan, the CO could determine to reduce the withholdings to 2%.  Because the withholding provisions apparently apply only to CAS-covered prime contracts, it is not clear what remedy the Government could invoke for system deficiencies on contracts and subcontracts not subject to the withholding provisions. 

Limitations on and Flexibility with Withholding – The rule establishes the ceiling on the withhold percentage as 5% for one or more significant deficiencies in any single business system and 10% for significant deficiencies in multiple business systems.  Note that payment withholding is not permitted on fixed-price line items where performance is complete and the items accepted by the government.  The interim rule also provides that the CO can identify one or more covered contracts containing the Contractor Business Systems clause (252.242-7005) from which to withhold payments.  In other words, the CO is no longer required to withhold payment from every contract containing the Contractor Business Systems clause, and the CO has the sole discretion to identify the contracts from which to withhold payments.  

Recognition of Government Delays – The interim rule recognizes, to a certain extent, that delay on the government's part occurs and takes steps to decrease the impact on contractors resulting from any such delay.  For example, normally, withholding of payments will be discontinued when the CO determines that the contractor has corrected all significant deficiencies.  Because there can be delay between when a contractor notifies its CO of a corrected significant deficiency and when the CO makes a determination that the significant deficiency is, indeed, corrected, the rule requires a reduction of the withhold percentage, by at least 50%, if 90 days has passed since the CO received notification of the correction and the CO has not yet verified that the significant deficiency has been corrected.  Nevertheless, the 50 percent withholding could continue indefinitely under the rule as promulgated, unless that contractor initiates a dispute under the CDA to seek payment.  Also, whereas the proposed rule required initial validation of an EVMS within 16 months, the interim rule allows for the CO to extend the deadline by which the initial validation must be done. 

System Approvals – The government will be permitted to issue approval of a business system only when there are no remaining significant deficiencies.  Although the rulemakers say that system approval will not be issued for "substantially corrected" systems, if the deficiencies have been corrected so that no "significant deficiencies" remain, withholding should cease.

An overview of the requirements, as set forth in the interim rule, for each of the six systems is provided below (as noted above, these substantive requirements are not limited to CAS-covered prime contracts):

Accounting System – Contractors receiving cost-reimbursement, incentive type, time-and-materials, or labor-hour contracts, or contracts which provide for progress payments based on costs or a percentage or stage of completion, are required to maintain an accounting system.  An accounting system is required to provide for, for example, a sound internal control environment, accounting framework, and organizational structure; proper segregation of direct and indirect costs; identification and accumulation of direct costs by contract; accumulation of costs under general ledger control; periodic monitoring, and a timekeeping system that identifies employees' labor by intermediate or final cost objectives.  If a CO determines that an accounting system deficiency affected a contractor's proposal, the CO can allow the contractor additional time to correct the deficiency, consider another type of contract (e.g., fixed-price incentive instead of a firm-fixed-price contract), use additional cost analysis techniques to determine cost reasonableness, or reduce the  negotiation objective for profit or fee.  It is not clear how these provisions relate to the FAR prohibition on awarding a cost-reimbursement contract in the absence of an "adequate" accounting system (see FAR 16.301-3(a)(1)). 

Earned Value Management System – The EVMS requirements apply to contractors that receive cost or incentive contracts valued at $20,000,000 or more and other contractors as determined by the CO.  The interim rule requires a contractor to use (a) an EVMS that complies with the EVMS guidelines in the American National Standards Institute/Electronic Industries Alliance Standard 748, Earned Value Management Systems (ANSI/EIA-748) and (b) management procedures that provide for generation of timely, reliable, and verifiable information for the Contract Performance Report ("CPR") and the Integrated Master Schedule ("IMS") required by the CPR and IMS data items of the contract.  If the contract has a value of $50 million or more, the contractor will be required to use an EVMS that has been deemed acceptable by the Cognizant Federal Agency ("CFA").  Any changes proposed by the contractor to its EVMS will need to be approved in advance by the CFA.  If the contract is less than $50 million, the government will not make a formal determination of compliance with ANSI/EIA-748, and advance government approval of changes will not be required.

Estimating System – Contractors with contracts awarded on the basis of cost or pricing data are required to maintain an estimating system that is reliable and consistent, produces verifiable, supportable, documented, and timely cost estimates, is consistent with and integrated with the contractor's related management systems, and is subject to financial controls systems.  For those contractors who received in their preceding fiscal year DoD prime contracts or subcontracts exceeding $50 million, they must disclose their estimating system in writing to the Administrative Contracting Officer ("ACO").  Additionally, the same disclosure requirement applies to those contractors who received in their preceding fiscal year DoD prime contracts or subcontracts exceeding $10 million and who were also notified by their CO that disclosure would be required.

Material Management and Accounting System –  Except for contracts awarded to small businesses, educational institutions, and nonprofit organizations, the MMAS requirements apply to non-commercial item contracts over the simplified acquisition threshold awarded on a cost-reimbursement basis or on a fixed price basis with progress payments made on the basis of incurred costs.  The interim rule requires contractors to (a) maintain an MMAS that reasonably forecasts material requirements, ensures that costs of purchased and fabricated material charged or allocated to a contract are based on valid time-phased requirements, and maintain a consistent, equitable, and unbiased logic for costing of material transactions and (b) assess its MMAS and ensure it has adequate internal controls in place to ensure system and data integrity.  The rule identifies a number of internal controls required for an MMAS, including having policies, procedures, and operating instructions describing its MMAS, ensuring that material costs are charged to a contract based on time-phased requirements identified in the rule, and implementing mechanisms to identify, report, and resolve system control weaknesses and manual override. 

Property Management System – The property management system requirements apply to cost reimbursement, time-and-material, and labor-hour type contracts as well as fixed price contracts where the Government will provide Government property.  The interim rule requires contractors' property management system, which manages and controls government property, to comply with FAR 52.245-1.  This FAR clause requires contractors to maintain a system that creates and maintains records of all government property accountable to the contract; periodically performs, records, and discloses physical inventory results; has a process to create and provide reports of discrepancies, loss, theft, damage, or destruction; and complies with property closeout requirements.

Purchasing System – The purchasing system requirements apply to cost reimbursement contracts; letter contracts, time-and-materials contracts, and labor-hour contracts over the simplified acquisition threshold; and fixed price contracts over the simplified acquisition threshold under which unpriced contract actions are anticipated.  Contractors will be required to maintain a purchasing system that meets a number of criteria set forth in the rule.  These criteria include having an adequate system description, including policies, procedures, and purchasing practices that comply with the FAR and DFARS; ensuring that all applicable purchase orders and subcontracts contain all flowdown clauses; maintaining an organization plan that establishes clear lines of authority and responsibility; ensuring all purchase orders are based on authorized requisitions; maintaining adequate documentation of the history of purchase transactions; and applying a consistent make-or-buy policy.  The rule addresses methods for the government to mitigate the risk of purchasing system deficiencies on specific proposals, which include segregating the questionable areas as a cost-reimbursable line item, including a contract reopener clause that provides for adjustment of the contract amount after award, and reducing the negotiation objective for profit or fee.  The criteria for purchasing systems in the clause DFARS 252.244-7001 Contractor Purchasing System Administration includes several new requirements that may be problematic.  Subparagraph (c)(16) of the clause requires that the purchasing system must enable the contractor to "notify" the Government of the award of all subcontracts that include flowdown clauses authorizing the Government to audit the subcontractor and "ensure the performance of audits of those subcontractors."  There is no explanation of how or when the required notice is to be provided to the Government or how the contractor is expected to "ensure the performance" of authorized Government audits.  Subparagraph (c)(24) of the clause requires that the contractor provide "timely notice" to the Government if the prime contractor changes the amount of subcontract effort after award so that it exceeds 70 percent of the value of the contract or order and to provide the same notice if any subcontractor makes such a change as to lower-tier subcontract effort.  While such situations are likely to be uncommon, it is not clear how contractors, particularly large companies with thousands of active contracts, will monitor those contracts to identify the few unusual cases that may require notification.