On 24 February 2011, the Department of Defense (DOD) issued its long-awaited final rule to govern contractor business systems.1 The final rule, which took effect immediately, is the fourth version of the Business Systems Rule that DOD has published within the past 26 months, following an initial 10 January 2010 proposed rule, a 3 December 2010 revised proposed rule, and a 18 May 2011 interim rule with a request for comments.2 During DOD’s extended rulemaking process, the rule created considerable controversy and generated extensive public comments, and Congress intervened by mandating, through the Fiscal Year (FY) 2011 National Defense Authorization Act (NDAA), that DOD take steps to improve contractor business systems.

In the May 2011 interim rule, DOD changed several important aspects of the Business Systems Rule.3 These changes included, among others, clarifying the definitions of the various business systems requirements and reducing the mandatory withhold percentages for inadequate business systems. Despite these changes, government contracts industry groups still expressed significant concerns about the rule in response to DOD’s request for comments. Foremost among industry’s concerns were the mandatory decrement for any significant system deficiencies and the Defense Contract Audit Agency’s (DCAA’s) apparent intention to treat any business system deficiency as “significant.”

The final rule includes several changes from the interim rule. For example, DOD amended DFARS 252.242-7005, the Contractor Business Systems clause, to clarify that it is self-deleting for contracts that are not covered by the Cost Accounting Standards (CAS). DOD also amended that clause to create a “reasonable expectation” that a contractor’s corrective actions will resolve system deficiencies. DOD revised the rule to state explicitly that University Associated Research Centers are exempt from the clause. Also, DOD made several changes to clarify the wording throughout the final rule. Most of these changes, however, are relatively limited in nature and could be described fairly as pertaining only to the margins of the Business Systems Rule. On the more significant areas of concern, DOD largely stood its ground, as discussed below.

The final rule retains the fixed mandatory percentage withholding for business system deficiencies.

Throughout the rulemaking, one of the most hotly-contested issues has been whether DOD’s ability to withhold payments in instances when a system was determined to be inadequate should be tied to the perceived (or calculated) risk to the government or set by regulation. In the initial proposed rule, the contracting officer would have been directed to withhold 10 percent for each business system deemed deficient, up to a maximum of 50 percent, unless the contracting officer determined that the deficiency (or deficiencies) was “highly likely” to lead to an improper payment or represent an “unacceptable risk” of loss to the government, in which case a 100 percent withhold would have been required. The interim rule maintained the mandatory withhold but reduced the percentage to five percent for one significant deficiency and 10 percent for significant deficiencies across multiple systems. Despite the change, several commenters continued to argue that the withhold percentage should be tied to the potential risk to the government.

The final rule retains the existing framework under which the amount of the withholding is set by regulation and rejects a more flexible approach based on a case-by-case assessment of the risk to the government. In explaining this decision, DOD stated that if a system contains a deficiency, in most cases it cannot be relied upon to produce the kind of quantifiable financial impact necessary to make a risk assessment. Potentially more concerning is that DOD went on to state that when a financial impact to the government can be determined, the contracting officer should “take appropriate actions to reduce fees, recoup unallowable costs, or take legal action if fraudulent activity is involved.”4 This suggests that DOD may plan, in certain cases, to utilize other contractual or legal remedies to withhold additional money beyond the rule’s mandatory percentages.

DOD also rejected arguments that the rule would harm contractors or perhaps even undermine the industrial base by imposing excessive and unnecessary costs. It noted that contract prices are established based on the understanding that contractors will maintain adequate business systems on which the government can rely, thereby reducing the amount of resources and money that the government must allocate to its audit function. According to DOD, when a contractor does not maintain adequate business systems, the government must bear audit costs that should have been borne up front by the contractor in establishing effective business systems. In DOD’s view, this shifting of costs harms DOD and effectively provides a windfall for the contractor.

Additionally, throughout the rulemaking process, government contractors expressed concern that DOD might extend withholds to contracts that were not affected by a particular deficiency. To allay that concern, industry suggested that contracting officers should be restricted by rule from applying a withholding to any contracts not covered by a specific system deficiency. For example, an issue related to a contractor’s purchasing system might have no potential effect on a contract that called strictly for the performance of services without any ancillary materials. In that case, there is no risk to the government. DOD rejected that suggestion and decided that this was a matter that should be left to the contracting officer’s discretion. As a result, nothing in the final rule limits a contracting officer’s ability to apply the withholding to contracts not specifically affected by the deficiency so long as the contract includes the Contractor Business Systems clause.

Finally, a somewhat related issue is the question of how to address a single deficiency that could affect multiple systems. One commenter feared that this situation could result in significant withholds for a single, potentially discreet problem. DOD responded that it would be appropriate to implement multiple withholds for related systems deficiencies across multiple systems, and the final rule allows contracting officers to implement a 10 percent withhold based on a determination that one problem affects multiple systems.

The final rule does not directly address industry’s concerns related to the DCAA audit practices related to Contractor Business Systems.

Underlying industry’s concerns with the Business Systems Rule is their increasingly contentious relationship with DCAA and DCAA’s own issues in recent years with the Government Accountability Office and other oversight bodies. For example, one commenter questioned whether DCAA “should be viewed as the experts” in light of its recent challenges. The commenter noted, for example, that DCAA currently lacks a clean peer review opinion that is necessary for it to conduct audits under the generally accepted government auditing standards (GAGAS). DOD flatly responded that, notwithstanding the peer review requirement, DCAA is conducting audits according to GAGAS and that contracting personnel will make appropriate determinations under the rule.

Industry’s concerns are not without merit because the practical effect of the Business Systems Rule will depend to a significant extent on how DCAA applies the definition of “significant deficiency.” While contracting officers within the Defense Contract Management Agency (DCMA) will make the ultimate determination on the adequacy of contractor business systems, in many cases, they will do so based on recommendations from DCAA.5 The reliability of DCAA’s audits and the reasonableness of its auditing practices are central to the implementation of the final rule.

A respondent pointed out that DCAA has not updated its definition of “significant deficiency” to align with the language of the Business Systems Rule and the FY 2011 NDAA.6 The commenter cited DCAA’s definition of a material deficiency as a “potential unallowable cost that is not clearly immaterial.” When that definition is considered along with DCAA’s December 2008 position that it only audits material contractor systems and that any failure to achieve a control objective is a material weakness, it is easy to see why contractors are concerned that any fault in a business system would likely be deemed a material weakness and therefore a significant deficiency under the Contractor Business Systems clause. DOD responded that DCAA is updating its guidance and will report significant deficiencies consistent with the definitions in the final rule. Moreover, DOD stated that contracting officers will administer the rule in a manner consistent with the NDAA. While DOD’s faith in DCAA reasonably construing the rule is commendable, given DCAA’s approach in recent years, it is likewise easy to understand why the government contracting community is concerned about the role DCAA will play in applying the rule.

The final rule does not resolve remaining questions about the timeliness of lifting decrements and the availability of appeals

In our prior Alert, we noted that even with the prompt correction of a significant deficiency, contractors might face lengthy delays before the contracting officer lifts the withhold. This concern was largely due to DCAA’s limited resources, which are hindering its ability to conduct follow-up audits. In the interim rule, DOD included a partial safeguard that requires the contracting officer to reduce the withhold by half if he or she does not make a final determination within 90 days of receiving notice that the contractor has corrected the significant deficiencies. In the comments submitted prior to the issuance of the final rule, industry asserted that the 50 percent reduction was not sufficient to protect contractors from protracted delays and again highlighted the possibility that withholds could remain in place well after significant deficiencies are corrected and that such events would impose unreasonable burdens on affected contractors. DOD’s response was to stand by the interim rule’s approach and again to ask the contracting community to proceed on faith that audit resources will be timely deployed and that having more efficient business systems will reduce long-term administrative costs for both the government and contractors.

Although DOD rejected any changes that would ensure the timely lifting of the full decrement following correction of significant deficiencies, it did adopt a new — and arguably less strict — rationale for removing withholds. In the interim rule, withholds were to be withdrawn once the contracting officer “determines that the Contractor has corrected all significant deficiencies as directed by the [contracting officer]’s final determination.”7 The final rule additionally provides that if “the [contracting officer] determines, based on the evidence submitted by the Contractor, that there is a reasonable expectation that the corrective actions have been implemented and are expected to correct the significant deficiencies, the [contracting officer] will discontinue withholding payments ...”8 This gives contracting officers additional discretion to remove a withhold without specifically testing the system and making a determination that a contractor’s business system lacks any significant deficiencies. Whether contracting officers will utilize this provision to remove withholds before DCAA conducts a follow-up audit remains to be seen.

In prior Alerts, we discussed whether a contractor might obtain interest on wrongly withheld funds through a Contract Disputes Act (CDA) claim. One commenter suggested that DOD should add a reference to the availability of contract disputes to the Contracts Business Systems clause. The commentary accompanying the final rule states that nothing in the rule limits a contractor’s ability to pursue a dispute or to collect CDA interest on a claim. Another commenter asked DOD to clarify whether a decision to implement a withhold would represent final decisions appealable under the CDA. DOD responded that determinations regarding the adequacy of a business system do not represent final decisions for purposes of the CDA even though they may result in a mandatory withhold. Presumably this means that as a prerequisite to appealing such a decision, a contractor would first need to submit a certified claim to the contracting officer calling into question the decision to issue a withhold.9 In sum, it appears that a contractor’s ability to challenge determinations related to its business systems will remain an open question and one on which we can expect to see litigation in coming years.