On May 18, 2011, the Department of Defense (DoD) published an interim rule amending the Defense Federal Acquisition Regulation Supplement (DFARS) and defining the elements of and process for determining the acceptability of six contractor business systems. The interim rule would require Contracting Officers (COs) to withhold a percentage of payments from contracts with DoD contractors that fail to maintain "acceptable business systems." This interim rule took effect on May 18 and applies to solicitations issued on or after that date. It does not require modification of existing contracts, with the exception of Indefinite Delivery/Indefinite Quantity (IDIQ) contracts.

The interim rule follows two earlier proposals on the same topic, published on January 15, 2010, and December 3, 2010. These proposals elicited widespread criticism on a number of fronts. Specifically, comments highlighted the lack of objective standards by which COs might identify and evaluate deficient business systems, as well as the financial burden the requirements would place on contractors relying on predictable Government revenue streams on relatively low-margin projects. Section 893 of the Ike Skelton National Defense Authorization Act, Pub. L. 111-383 (2011) ("FY11 NDAA"), passed during the comment period to the second proposed rule, sets forth statutory requirements for the improvement of contractor business systems that do not entirely match the terms of the earlier proposals. DoD issued the interim rule in response to this new statutory mandate as well as the comments directed toward its earlier proposals. Although the interim rule makes several positive and significant changes, it continues to raise some of the same concerns voiced during the notice and comment period for the previous two proposals. These concerns are made more pressing due to the interim rule's immediate effect.

Like the previous proposal, described in detail in our earlier Client Alert, the interim rule requires contractors to maintain acceptable accounting, estimating, purchasing, earned value management, material management and accounting, and property management business systems. The interim rule includes relatively detailed guidance for the evaluation of individual business systems. It also establishes a procedural framework for resolving determinations of significant deficiencies. Although this procedural framework imposes specific deadlines for responses to Government inquiries and determinations, it fails to impose meaningful time constraints on a CO's efforts to reach a final determination.

The interim rule incorporates the FY11 NDAA's definition of a "significant deficiency" for the purposes of evaluating a business system. Section 893(f)(4) of the FY11 NDAA defines the term as "a shortcoming in the system that materially affects the ability of officials of the Department of Defense and the contractor to rely upon information produced by the system that is needed for management purposes." Although this could be read as supplying the "materiality" element that many thought absent from earlier proposals, both the text of the definition and the interim rule's preamble leave room for concern. Under the definition above, a significant deficiency need materially affect only the "ability" of officials to "rely upon information produced" by a system that is "needed for management purposes." This definition is seemingly more expansive than the quantifiable risk-linked materiality requirement requested in many earlier comments. However, in light of the definition's broad scope, COs must now provide "a description of each significant deficiency in sufficient detail to allow the contractor to understand the deficiency."

The interim rule further reflects the FY11 NDAA by expanding the universe of covered contracts. Whereas the second proposed rule would have been limited to DoD contracts in excess of $50 million, the interim rule applies to all DoD contracts that are subject to the Cost Accounting Standards (CAS). The definition of a "covered contract" as one subject to CAS was offered as a more efficient method to exclude CAS-exempt small businesses from the potentially serious financial effects of both compliance with the interim rule and its enforcement.

Responding to a wave of criticism regarding the cumulative amount of withholdings permitted under the previous proposed rule, as well as the FY11 NDAA, the interim rule limits the size of withholdings for deficiencies in business systems, and it provides more options for contractors to decrease withholdings by achieving compliance through corrective action. The second proposed rule potentially applied payment withholdings against all contracts that contained the contractor business systems clause in the face of a deficiency on a single contract. The interim rule backs away from this position, granting the CO discretion to withhold payments from one or more contracts containing the clause. Further concessions include a mandate that withholdings from a given contract due to deficiencies within a single business system may not exceed five percent of total contract payments. Withholdings for a given contract may not exceed ten percent of total contract payments for deficiencies across multiple business systems. Finally, once a deficiency is found and the CO issues its final determination, the withholding must be reduced by 50 percent unless the CO determines that the contractor has not corrected all significant deficiencies and that there is no reasonable expectation that the contractor will soon take corrective action to solve them.

The interim rule thus clearly offers some limited measure of relief for contractors struggling to translate its requirements and guidance into necessary strategic and operational changes, at least vis-à-vis earlier versions of the rule. However, the interim rule continues to raise many troubling concerns.

One notable change in the interim rule is the apparent shift in the standard upon which a business system with a previous deficiency could be approved as acceptable. The second proposed rule would have allowed the approval of a business system following the discovery of a deficiency once a contractor had "substantially" corrected it. The interim rule allows approval of a business system only when there are "no remaining significant deficiencies." The preamble states that DCAA will apply the definition of "significant" contemplated in Sec. 893 of the FY11 NDAA, as well as the "consistent" definition supplied by the Generally Accepted Government Accounting Standards ("GAGAS"), rather than the more expansive interpretation described in DCAA's audit guidance.

The interim rule explicitly cautions that withholding of funds under the rule is not the only measure a CO may take in response to allegedly significant business system deficiencies. Moreover, DoD failed to heed calls for the creation of an auditing period during which business systems would be approved, as opposed to the open-ended liability implied under the interim rule.

The interim rule mandates the creation and maintenance of a number of business systems with new requirements and applicable guidance. Contractors face significant risk in a number of areas due to this rule. For example, COs must now grapple with determinations that would seemingly require experienced private sector business judgment. Similarly, it remains to be seen whether the existing inter- and intra-agency bureaucratic processes impacted by this rule can accommodate quick resolution after payments have been withheld. As noted by one of the comments referenced in the preamble to the interim rule, "DCAA does not have resources to perform timely follow-up audits/system reviews or coordinate in a timely manner with contracting officers to remove payment withholdings, and contracting officers do not have the training to determine if a deficiency makes a system inadequate." This concern received the somewhat eyebrow-raising response that "[t]he need to have effective oversight is unrelated to resources." Additionally, while the increase in discretion afforded to the CO with regard to the scope and duration of a withholding may be a welcome change, contractors may find such discretion utilized as leverage to force costly and potentially ineffective changes on business systems, or even in unrelated areas.

Contractors should review the interim rule and conduct a careful analysis of their current business systems to determine what changes are required. Contractors should also consider providing relevant personnel with training on the interim rule's requirements. Comments on the interim rule are due no later than July 18, 2011.