U.S. Department of Defense Issues Revised Proposed Rule to Require Withholding of Payments to Contractors with Deficient Business Systems

December 7, 2010

On December 3, 2010, the Department of Defense (DoD) published a proposed rule amending the Defense Federal Acquisition Regulation Supplement (DFARS) to require Contracting Officers (COs) to withhold a percentage of payments from all contracts with DoD contractors that fail to maintain "acceptable business systems."

This revised proposed rule follows an earlier proposed rule on the same topic published at 75 Fed. Reg. 2457 on January 15, 2010. The earlier proposal elicited widespread criticism on a number of fronts. Specifically, comments highlighted the lack of objective standards by which COs might identify deficient business systems, as well as the financial burden the requirements would place on contractors that rely on regular government payments. DoD has therefore published a second proposed rule in response to this criticism. Although the new proposal makes several significant changes, it raises many of the same concerns voiced during the initial notice and comment period.

First, the revised proposed rule describes more specifically what qualifies as a deficiency within a business system. A contractor must develop six different business systems: accounting systems, estimating systems, purchasing systems, earned value management systems, material management and accounting systems, and property management systems. The new proposed rule provides different criteria for finding deficiencies in each system. For example, the proposal sets forth eighteen separate criteria for an acceptable accounting system, including that it must create a "sound internal control environment" that is "adequate for producing accounting data that is reliable." A deficiency is "a failure to maintain one or more system criteria of an acceptable business system." DoD declined to provide further guidance, noting that the government already employs similar guidelines to evaluate the adequacy of contractor business systems in other contexts, and that the public "is encouraged" to comment on the proposed criteria.

Second, the revised proposed rule at least attempts to limit the financial burden on contractors posed by the withholding of funds. It eliminates an earlier provision allowing COs to withhold 100 percent of payments for a deficiency that is "highly likely to lead to improper contract payments" or pose "an unacceptable risk" to the government. Moreover, the proposal reduces the amount withheld for an individual deficiency from ten percent to five percent (or two percent for small businesses). If the contractor thereafter submits an acceptable corrective action plan to remedy the deficiency, the CO will reduce the withholding to two percent (one percent for small businesses). The proposed rule also limits the compounding of percentages withheld to a maximum of 20 percent (10 percent for small businesses) for multiple deficiencies in one or more systems. Finally, to shield small businesses from the compliance demands imposed on larger contractors, the proposed rule would apply only to contractors awarded at least $50 million in defense contracts. DoD "invites comments from small business concerns" on these proposed changes.

Third, the proposed rule fashions a more consistent and reliable auditing and enforcement process. For example, it requires a CO to withhold payments from contractors until "all deficiencies have been corrected." This language appears throughout the new proposal, replacing several confusing references to "substantial compliance" in the earlier version. Although these revisions add more certainty, they may also result in a longer withholding period and thus a greater financial burden on affected contractors. The amended proposal also provides increased guidance to the DCAA as it oversees contractors’ business systems. If an audit uncovers deficiencies, the DCAA must file a report that "shall describe the deficiencies in sufficient detail to allow the contracting officer to understand the deficiencies and the potential adverse impact to the Government." DoD acknowledges that "staffing challenges" in the DCAA may complicate the auditing process. Nevertheless, it emphasizes the need for ongoing auditing, rather than a one-time business systems audit period for new contractors, because "contractor conditions could change" after initial auditing.

Although the new proposed rule attempts to ease some of the financial burden and uncertainty created by DoD’s earlier proposal, it nevertheless mandates the creation and maintenance of a number of business systems and could result in substantial risk to contractors through improperly withheld payments as COs grapple with determinations that often require significant business judgment. The new proposal underscores the importance of establishing robust business systems to meet strict government oversight. Although DoD expressed its willingness to review and amend its proposal again in light of new comments, this new effort makes clear DoD’s intent to increase the extent to which it involves itself in the function and organization of contractors’ internal business systems in an attempt to prevent waste, fraud, and abuse.

Comments on the second proposed rule are due no later than January 3, 2011. 

Gibson, Dunn & Crutcher LLP 

Gibson, Dunn & Crutcher’s Government and Commercial Contracts Practice Group is available to assist in addressing any questions you may have regarding this issue. Please contact the Gibson Dunn attorney with whom you work, or any of the following attorneys in the firm’s Washington, D.C. office:

Karen L. Manos (202-955-8536, [email protected])
Joseph D. West (202-955-8658, [email protected])
Diana G. Richard (202-887-3572, [email protected])

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