Article: The Cuts Are Coming, Payments May Not Be: How Defense Contractors Can Prepare

Government contractors are facing a year of unprecedented uncertainty. Three things contribute to this: (1) reduced funding requested by the Pentagon; (2) the prospect of sequestration (the automatic cuts triggered when a congressional committee could not agree on deficit reduction); and (3) the prospect that the government will hit the debt ceiling late this year. This article discusses each of the three and suggests some proactive steps that defense contractors can take to protect themselves.

The Pentagon’s Lower Budget Request. In February, the Pentagon unveiled a 2013 budget plan that would cut $487 billion in spending over the next decade by trimming approximately 100,000 ground troops, purchasing fewer ships and cutting back on air defense. For 2013, the Pentagon has asked for a base budget of $525 billion—down from $531 billion approved last year and the first reduction that the Pentagon has requested since 9/11. Only $108 billion of the total 2013 budget will be available for procurement of weapon systems, including guns, ships and jet fighters, down from $120 billion in 2012. As of the date of this writing, President Obama has announced that he would veto the House’s 2013 defense spending bill in its current form.

The Impact of Sequestration on Defense Spending. Although the Pentagon’s proposed 2013 budget takes into account spending caps mandated by the Budget Control Act, it does not address the additional $492 billion in defense cuts over nine years that will go into effect on January 2, 2013. Because the Joint Select Committee on Deficit Reduction did not agree on a comprehensive spending-reduction package, the Department of Defense and its agencies, like other parts of the government, are facing across-the-board, automatic and indiscriminate cuts, known as “the sequester.” These cuts, which are estimated to be in the magnitude of 15 percent at the Program, Project and Activities level, will touch almost all discretionary defense programs and contracts. In late April, the Chairman of the House Armed Services Committee announced a plan that would eliminate the sequester and set the base defense budget at $554 billion—roughly $8 billion above the cap set by the Budget Control Act. While efforts to eliminate the sequester are gaining momentum on Capitol Hill, it is unclear whether those efforts will succeed.

The Debt Ceiling. There is—once again—a very real possibility that the government will reach the debt ceiling before year-end and potentially default on its obligations to contractors. It is, of course, impossible to predict when the government will hit the debt ceiling. Treasury Secretary Timothy Geithner recently reiterated his position that lawmakers will have until the end of 2012 to decide whether to raise the debt ceiling. It is possible, however, that the government will hit the debt ceiling in early-November 2012 if tax receipts fall short, economic growth continues to languish, and spending continues to outpace receipts. If the debt ceiling is not raised and the government is unable to pay its bills or, more likely, is forced to prioritize which bills it does pay, it may require contractors to continue performing. The government will likely take the position that, unless and until its failure to pay amounts to a material breach, contractors are obligated to continue contract performance and must attempt to recoup payments for their performance after-the-fact.

Given the present reality of reduced spending and fiscal uncertainty, defense contractors can take steps now to prepare for whatever lies ahead.

1. Classify existing contracts. Determine the nature of the work being performed and how existing contracts are funded. Contracts that support an essential government function are less likely to be impacted negatively by a potential default than are contracts funded with multi-year or revolving appropriations. Additionally, the sequester should not apply to contracts for which funds have been obligated prior to January 2, 2013.
   
   
2. Confirm the status of existing contracts. Review the statement of work, period of performance and funding level of existing contracts. If the performance period is about to end and the company has an option to extend, ensure that the contracting officer exercises the option prior to continuing performance. Performing after expiration of a contract, in excess of contract requirements or above the appropriated funding level, is risky and may not be compensated.
   
   
3. Anticipate a Reduction in Spending. For contracts that are coming up for renewal, have unexercised options or will be bid for as part of the 2013 budget, determine the impact of a 15-percent reduction in funding. Be prepared to renegotiate, taking this reduced spending level into account and take the lead on suggesting ways to implement the cut.
   
   
4. Submit ripe requests for equitable adjustment. Given funding uncertainties and the likelihood that the Department of Defense will put off executing new contracts, efforts should be undertaken to increase cash reserves. Getting paid for outstanding requests for equitable adjustment on existing contracts is an excellent way to do that.
   
   
5. Collect interest penalties. Review the status of progress payments on existing contracts and redouble efforts to submit timely progress payment requests going forward. Pursuant to the Prompt Payment Act, 31 U.S.C. § 3901 et seq., federal agencies are required to pay their bills on time and to pay interest penalties when payments are late. Collecting interest penalties for late payments will improve liquidity. Moreover, it is critical to submit, on time, progress payment requests when they come due. Interest penalties accrue only if a request for payment has been submitted.
   
   
6. Track expenses. Develop procedures to track expenses associated with government-caused delays and terminations, including creating separate charge items. In the event of default or as a means to reduce spending, contracting officers may (depending on the terms of the contract) descope, issue stop work orders, order production breaks, suspend work, delay performance, or terminate contracts in whole or in part. The government generally must compensate contractors for the impact of such actions, but may avoid doing so if the impact on the contractor is not adequately documented.
   
   
7. Cure defects. Cure defects in existing contracts and, if appropriate, respond to show-cause notices. Contracting officers faced with slashed budgets may see terminating underperforming contractors for default as an easy way to save money. Contractors should eliminate every possible ground for default termination.
   
   
8. Review subcontractor agreements.  Understand obligations to pay any subcontractor, and, correspondingly, entitlements to demand performance from that subcontractor. A prime contractor’s obligation to pay a subcontractor depends on the terms of the agreement, as does the subcontractor’s obligation to continue performance if it is not paid. Newly executed subcontracts should include a “payment-when-paid” clause that makes payment to the subcontractor contingent on the prime contractor’s receipt of payment from the government.
   
   
9. Develop a communication protocol. While effective communication is always the touchstone of successful contract administration, constant communication with the contracting officer, the contracting officer’s technical representative, subcontractors and employees is vital during this period of uncertainty. Developing an effective communication plan will ensure that complete and accurate information is obtained from the government and is properly disseminated to subcontractors and employees.