SEQUESTRATIONAND

BUDGET CUTS

SURVIVAL STRATEGIESFOR CONTRACTORS

November 9, 2012

Government Contracts . . . Federal Law & PolicyDLA Piper LLP

Washington, D.C.

AGENDA

Sequestration and the Fiscal Cliff

Debt Valley

Government Strategies for Reducing Contract Spending

Contractor Actions to Mitigate Risks of Sequestration and Budget Cuts

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How did we get to the fiscal cliff?

US federal debt is at historic levels At the end of 2008, debt equaled 40 percent of the Gross Domestic

Product (GDP) … slightly above the 40-year average of 37 percent

At the end of 2011, debt was roughly 70 percent of GDP — highest percentage since shortly after World War II

In 2011, political parties locked horns about raising the debt ceiling

“Poison Pill” Solution: raise the debt ceiling and agree on $1.2 trillion in budget cuts for FY2013-FY2021… but if commission does not agree, “sequestration” of $1.2 trillion would be imposed in January 2013 … and Bush-era tax cuts would expire

Sequestration = uniform, across-the-board cuts in all covered federal accounts, equally split between defense and non-defense accounts Exempted accounts include Social Security, Medicaid, Veterans, and

military pay … Medicare cuts capped at 2%

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What is the fiscal cliff?

The combination of sequestration cuts and tax increases that are scheduled to go into effect January 2013 absent an agreement by the President and Congress Also, debt ceiling must be raised again early in 2013 and FY13

Continuing Resolution expires in March 2013

The total of all spending reductions and tax increases would be $607 billion

According to the Congressional Budget Office, the U.S. economy would slide into a "significant recession" as a result of the spending cuts and tax increases Economy would shrink by 2.9 percent in the first half of 2013 and by 0.5

percent for the whole year

Unemployment rate would likely increase from 7.8% to 9.1% in the near term

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How would the fiscal cliff affect jobs with government contractors?

Congressional Research Service issued report on October 1, 2012 entitled “Sequestration: A Review of Estimates of Potential Job Losses” Summarizes studies related to Defense, Education, FAA, NIH, and SSA

Study commissioned by Aerospace Industries Association included the following estimates: 2.1 million jobs lost throughout entire economy in FY2013 277,000 federal civilian jobs 469,000 prime contractor jobs 433,000 subcontractor/supplier jobs 959,000 “induced” jobs – i.e., jobs throughout economy supported by workers in

above categories spending their paychecks In private sector, manufacturing jobs (223,000) most affected by defense

cuts … professional and business-service jobs most affected by nondefense cuts Largest job losses estimated in California, D.C., Maryland, Texas, and

Virginia

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How would sequestration amounts be calculated?

Define the required spending cuts: Total reduction required = $1.2T Savings on debt service = $216B Total spending cuts required = $984B Spending cuts divided by nine years in sequestration period (FY-13-21) =

$109.4B per year Divide between defense and nondefense = $54.7B for each

Define the covered accounts to be cut: For FY13, identify FY13 funds already obligated from 10/112 to 1/2/13 …

cuts must be allocated to remaining FY13 budgets Apply exemptions and special rules

For FY13 only, allocate the required spending cuts across the covered accounts using a uniform percentage

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What is the estimated magnitude of the required sequestration cuts?

September 14, 2012: Office of Management & Budget (OMB) estimated the effects of sequestration as: 9.4% cut for defense 8.2% cut for non-defense

But OMB used FY13 Continuing Resolution as basis for calculation. If President’s actual budget is used, effects could be slightly higher: 10.1% cut for defense 8.2% cut for non-defense

Also, since cuts must be allocated to the remaining three quarters of the FY13 budgets, the cuts for balance of FY13 have been estimated as: 12.25% cut for defense 11.20% cut for non-defense

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At what level would the sequestration cuts be applied?

Law requires percentage reduction to be uniformly applied to each “program, project or activity” (PPA) … as defined by appropriation laws Congress: the most specific level of budget items identified in

DoD appropriations act and related budget justification documents

DoD: 2500+ individual line items below the department’s “procurement” accounts

OMB: did not issue guidance … need more time to work with agencies

Bottom Line: PPAs vary widely in size and scope, providing agency officials

either very limited or substantial discretion in making cuts

E.g., Littoral Combat Ship (LCS) Program: one PPA is $1.45B, and other PPAs are as low as $1M

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PPAs Within the LCS Program ($1.785B)

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Littoral Combat Ship (LCS): $1,785M

Detailed budget line items constrain DoD flexibility on

taking reductions

Lump sum appropriation allows degree of flexibility

Level of budget detail within PPAs defines how much flexibility there is for program managers

What types of funding and contracts would be affected by sequestration?

Affects all discretionary and mandatory spending (unless exempted) for FY2013-FY20-21

For DoD, also affects all unobligated balances from prior years Unobligated balances consist almost entirely of Procurement and

RDT&E funding

So cuts to DoD Procurement and RDT&E accounts increase proportionately … from roughly $21.4B to $26.1B

Will affect contracts signed on or after October 1, 2012

Will not affect current contracts funded with FY12 funds

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What’s the process for sequestration?

OMB will determine percentage cuts for defense and nondefense accounts OMB will apply cuts at the “program, project or activity” level OMB will impound the sequestered funds by issuing an

“apportionment” to each agencyOMB and agencies can shift funds between programs (i.e.,

“reprogram”) if authorized by existing law

Agencies will decide how – and when – to implement cuts in each program, project, or activity without further OMB guidance Personnel actions (furloughs, reductions in force)? Reprogramming? Contract actions (deferral of awards, stop work orders, reductions

in scope, terminations, etc.)?

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What’s the likelihood that sequestration occurs?

Obama’s win coupled with Democratic gains in Senate give Senate Democrats increased leverage when negotiating with House Republicans during the upcoming Lame Duck session of Congress

Given Obama victory, it is more likely that sequestration will be addressed and avoided – at least in its current form -- during the Lame Duck session

Possible Scenarios: Mini-sequester: Most likely … smaller package of cuts (e.g., $100 billion

over 10 years) Kicking the can: Less likely … a short-term punt to avoid sequestration

and seek a potential deal in 2013 Congressional Democrats seem unlikely to support this, even if

revenue issues are addressed Cliff dive: Remote possibility … Congressional leaders and most

members of both parties want to avoid sequestration

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What’s the impact of the election on DoD?

FY 13 Defense Authorization bill is likely to pass during the Lame Duck … DoDAuthorization is becoming more relevant now that earmarks are gone

A second Obama term ensures a build down in the defense sector

Strategic Realignment: New defense strategy calls for increased focus in Asia-Pacific region … will lead to increased resources and movement of troops to Asia Pacific

Secretary Panetta has said 60% of naval assets will be based in the Pacific by 2020

Afghanistan Winding Down: Congressional leaders on both sides agree that US forces should exit Afghanistan … total withdrawal by 2014 or continuing presence?

Doing more with less: Large, expensive weapons programs are ripe for budget cuts … increased competition for defense contractors … pressure to achieve program objectives faster and cheaper

More special operations … troop levels cut by 100,000

Frank Kendall, Undersecretary of Defense for Acquisition, will be issuing new instructions for the acquisition system (Better Buying Power 2.0)

Revised BRAC proposal possible?

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What if sequestration doesn’t happen?

Government contractors are rightly focused on the potential disaster of the Fiscal Cliff

But even if we don’t go over the Cliff, we clearly are headed for significantly reduced levels of federal spending – i.e., Debt Valley Spending on federal contracts increased from $205.6B in FY00 to a peak

of $541.2B in FY08 … then declined slightly over the next three years to $536.8B in FY11

Former Head of Office of Federal Procurement Policy (Dan Gordon): “You may see significantly lower figures spent on contracts, but that only takes us back to 2004-2008. It’s not a disaster for contractors or government to spend $400 billion a year on contracts.”

So it’s important to see the big picture and take actions not just to survive the potential Fiscal Cliff, but to survive and thrive in Debt Valley

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What guidance has Govt provided so far regarding sequestration?

Contract Spending Anecdotal evidence of agencies deferring orders and contract awards …

waiting to see what happens with sequestration

Sept. 25, 2012: Deputy Secretary of Defense sent memo to DoD officials warning them to “continue normal spending and operations” and perform missions “without taking any steps that assume sequestration will occur.”

Advising Employees of Potential Layoffs July 30th, DoL: Possibility of sequestration does not trigger obligation

under WARN Act to advise employees of mass layoffs or plant closings Obligations under State laws or Collective Bargaining Agreements?

Sept. 28th, OMB & DoD: if sequestration occurs and contractor follows DoL guidance, employee compensation costs for WARN Act liability and related litigation costs would be “allowable costs”

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How can the Government reduce contract spending? And how can contractors respond?

Prospective Work Cancel Solicitations Govt has broad discretion unless cancellation is a “pretext” or “sham” Help customer find alternative contract vehicle with attractive pricing? Identify potential for future restart and stay close to customer?

Delay Issuance of Solicitations or Contract Award Govt has broad discretion, but cannot delay award indefinitely Stay close to customer and closely monitor solicitation changes Be attuned to pricing increases and competitive changes during delays

Use Fixed-Price Contracts Rather Than Cost-Type Contracts Fixed-Price contracts are required for most FAR Part 12 contracts Fixed-price contracts are not appropriate for R&D or other situations in

which pricing and performance risks are unknown (see FAR Part 16)

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How can the Government reduce contract spending? And how can contractors respond?

Prospective Work – Cont. Place Heightened Value on Price in Competitive Acquisitions This is happening and will continue … even if “best value” evaluation Identify “price to win” based on competitive analysis Get creative: monetize and highlight life-cycle savings and value-added

features … identify cost-savings and value-engineering options for agency consideration

Obtain Cost-Related Data and Negotiate Thin Margins Obtaining cost-related data is typically prohibited in FAR Part 12

procurements and in competitive FAR Part 15 procurements But Govt has ability to request cost-related data if it cannot otherwise

determine a fair and reasonable price Need to make good judgments about providing cost-related data Develop alternate solution that includes a mix of “comparable” pricing

and high-level cost data?

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How can the Government reduce contract spending? And how can contractors respond?

Prospective Work – Cont. Decline to Place Orders Under ID/IQ Contracts Govt has broad discretion to stop issuing orders, without any further

obligation, once “minimum quantity” is reached on ID/IQ contract Can make pricing on competitive ID/IQs risky … need reliable Govt

estimate Include express assumption in proposal and incorporate proposal into

contract? Decline to Exercise Options Govt typically has unilateral right to exercise option periods … broad

discretion to recompete early or acquire work through another contract or perform work within agency …only limit is “bad faith” Option exercise must be in strict accordance with contract’s terms (e.g.,

timing and form of notice) … “escape hatch” for repricing of unfavorable option? Prior to exercising option, Govt must determine that option is “the most

advantageous” in terms of need, price and other factors … basis for challenging option award to competitor?

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How can the Government reduce contract spending? And how can contractors respond?

Existing Work – “Commercial Item” Contracts Agree With Contractor on Changes to Contract In most commercial-item contracts, Govt cannot unilaterally direct

changes in the work or the contract Rather, changes “may be made only by written agreement of the

parties” (FAR 52.212-4(c)) This is a critical distinction from non-commercial-item contracts … it

significantly limits Govt’s ability to change commercial-item contracts

Order a Partial or Complete Termination of the Contract In most commercial-item contracts, Govt can unilaterally terminate “any

part” of the contract. (FAR 52.212-4(l)) Such termination is valid unless Govt acts in “bad faith” Contractor would be entitled to a % of the contract price equal to the %

of work performed prior to termination, plus other unrecovered costs/charges that have resulted from the termination

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How can the Government reduce contract spending? And how can contractors respond?

Existing Work – Non-Commercial-Item ContractsOrder a Suspension or Stoppage of Work Suspension of Work clause (FAR 52.242-14) may apply to fixed-price

construction or architect-engineer contracts Stop-Work Order clause (FAR 52.242-15) may apply to any negotiated

contract Contractor entitled to price & schedule adjustment if timely notice is

provided and costs are adequately tracked and segregatedOrder a Deductive Change or Partial Termination Govt may be able to unilaterally delete portions of a contract through

either: A “deductive change” under an applicable “Changes” clause; or A partial termination under an applicable “Termination for Convenience”

clause Contractor’s recovery is measured differently under the two clauses, so

it’s critical to evaluate which of these actions is appropriate

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How can the Government reduce contract spending? And how can contractors respond?

Existing Work – Non-Commercial-Item Contracts – Cont.Order a Complete Convenience Termination Govt can terminate an entire contract for convenience … without any

advance notice … if in the Govt’s best interests Contractor entitled to be “made whole” for all costs incurred prior to

termination and for expenses related to termination Termination cannot be challenged, and contractor cannot recover lost

profits, unless Govt acted in “bad faith”

Cancel a Multi-Year Contract In a multi-year contract, Govt can cancel all subsequent years’

requirements/quantities if incremental funds are not available (FAR 52.217-2) Contractor entitled to a “cancellation charge” that reflects most costs

incurred on the contract prior to cancellation

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How can the Government reduce contract spending? And how can contractors respond?

Existing Work – Non-Commercial-Item Contracts – Cont. Elect Not to Add Funds to a Cost-Reimbursement Contract Limitation of Cost clause (FAR 52.232-20) applies to a fully funded

cost-reimbursement contract Limitation of Funds clause (FAR 52.232-22) applies to incrementally

funded cost-reimbursement contract Clauses require advance notice to Govt when contractor expects to

incur 75% of, respectively, the “estimated cost” of the contract or the “total amount so far allotted” to the contract Clauses also require notice when, respectively, total cost will be greater

than previously estimated or additional funds will required to continue timely performance If Govt does not add funds to the contract, Govt is not obligated to pay

contractor for any costs incurred in excess of the estimated cost or the total amount allotted to the contract Requires contractor to carefully track, manage, and report on costs to

avoid overruns that cannot be recovered

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What can a contractor do tomitigate risks of sequestration?

Understand portfolio of existing contracts Contract types – e.g., commercial item? ID/IQ? Cost-type?

Periods of performance, including option periods

CLIN structure, quantities, and pricing

Funding limits and notice requirements

Contractual clauses for changes, downscoping, and terminations

Strategic importance – to company? to customer?

Evaluate Pipeline of New WorkWhat’s at risk?

What will be delayed?

What pricing strategies/improvements are needed in future?

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What can a contractor do tomitigate risks of sequestration?

Evaluate risks of contract expirations/changes/ terminations Known price risks vs. competition? Severable or easily reduced scopes of work? Readily available alternatives for customer (e.g., other contract

vehicles, performance within agency, available funding)?

Engage With Key Customers Be a partner in helping customer evaluate and solve funding

problems Ask for reasonable guidance and transparency on program

planning, funding, renewals, timelines, etc. Anticipate and recommend program changes where needed …

protect high-margin work where possible while still accommodating required changes

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What can a contractor do tomitigate risks of sequestration?

Evaluate Subcontractor/Supplier Risks Do teaming and other agreements adequately protect company in

event of changes, downscoping, and terminations? Do they allow substitution of lower-cost subcontractors/suppliers?

Are any subcontractors/suppliers at risk of failure in event of changes, downscoping, and terminations?

Closely monitor other cost and payment risksWorking “at risk” or as “volunteer”

Withholding of payments for deficiencies in business systems

Reduction in award fees

Change Control/Management Delays and impacts due to Government furloughs or cutbacks?

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SEQUESTRATION AND BUDGET CUTS

QUESTIONS??

Contact Information:

Richard P. Rector Nathaniel J. BellGovernment Contracts Federal Law & PolicyDLA Piper LLP (US) DLA Piper LLP (US)500 Eighth Street, NW 500 Eighth Street, NWWashington, DC 20004 Washington, DC 20004T +1 202.799.4400 T +1 202.799.4000 E richard.rector@dlapiper.com E Nat.Bell@dlapiper.com

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