SEQUESTRATION AND BUDGET CUTS

SURVIVAL STRATEGIES FOR CONTRACTORS November 9, 2012

Government Contracts . . . Federal Law & Policy DLA 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

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%

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

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

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 Presidents 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 departments 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)

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

Lump sum appropriation allows degree of flexibility

Detailed budget line items constrain DoD flexibility on taking reductions

Level of budget detail within PPAs defines how much flexibility there is for program managers
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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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Whats 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 agency
OMB 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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Whats the likelihood that sequestration occurs?

Obamas 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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Whats the impact of the election on DoD?

FY 13 Defense Authorization bill is likely to pass during the Lame Duck DoD Authorization 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 doesnt happen?

Government contractors are rightly focused on the potential disaster of the Fiscal Cliff But even if we dont 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. Its not a disaster for contractors or government to spend $400 billion a year on contracts.

So its 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 contracts 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 Govts 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 Contracts

Order 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 segregated

Order 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

Contractors recovery is measured differently under the two clauses, so its 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 Govts 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 to mitigate 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 Work

Whats at risk? What will be delayed? What pricing strategies/improvements are needed in future?

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What can a contractor do to mitigate 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 to mitigate 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 risks

Working 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 Government Contracts DLA Piper LLP (US) 500 Eighth Street, NW Washington, DC 20004 T +1 202.799.4400 E richard.rector@dlapiper.com Nathaniel J. Bell Federal Law & Policy DLA Piper LLP (US) 500 Eighth Street, NW Washington, DC 20004 T +1 202.799.4000 E Nat.Bell@dlapiper.com

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