Terminations for Convenience

Since 1987, the Defense procurement budget has steadily declined and is expected to continue its downward movement. The direction of spending, however, can often trail changes in the budget by several years. In recent years, decreases in spending were evidenced mostly by reductions in contract awards or program stretch-outs rather than by contract terminations. As the declines in both budget and spending accelerate, terminations will become predominate. Thus, terminations are inevitable for every defense business.

The Right to Terminate

The government's right to terminate for convenience is provided in a required contract clause. The termination clause provides that the government may terminate performance of work under the contract in whole or in part.

Since the termination for convenience clause is required, the prime contract can be interpreted to contain the clause even if it is not actually present or referenced in the contract. For a subcontract to be terminated, however, the clause must actually be present or referenced in the subcontract; otherwise, the contract is breached when terminated. It is the contractor's responsibility to include the termination clause in all of its subcontracts or purchase orders.

Contractor Entitlement

Under a termination for convenience the contractor is entitled to the reasonable costs of terminating the work--cost of the terminated work, termination costs and settlement expenses--plus a reasonable profit. This differs from a contract breach where the contractor could be entitled to its costs, a reasonable profit, consequential damages and anticipatory profits.

In the current budgetary environment, the government may try to use many techniques to reduce its financial liabilities. For example, the government may try to terminate for default or to reduce quantities using the changes clause. In many if not most cases, neither of these techniques will be appropriate.

Normally, termination for default should not apply unless the contractor has failed to perform the contract in accordance with a material provision of the contract. Even then, default may not be appropriate in all cases. In some cases a termination for convenience will still be the government's most appropriate course of action and clearly a more preferable outcome for the contractor than a default.

The changes clause is frequently cited by both government and industry as the basis for negotiating contract adjustments arising from reductions in quantity. The changes clause, however, does not normally permit reductions in the quantity ordered by the government. As a result, reductions in quantity should generally be treated the same as a constructive partial termination.

For deductive changes there can also be important reasons for pricing the change as a partial termination. When separately priced items are deleted, they are frequently removed at their contract price without providing any adjustment in the price of the remaining contract items. Similarly, when work is simply deleted the cost of the deleted work plus applicable overheads are subtracted from the contract price. Again, there may be no adjustment in the price of the remaining work.

Clearly both of these approaches can have substantial adverse consequences. If termination pricing procedures were used the contractor could have many ways of increasing its cost recovery that are not otherwise available under the changes clause. Furthermore, under termination procedures the contractor's financial entitlements are clearly described which should facilitate settlement.

Cost Limitations

The total amount payable to a contractor for a fixed price termination settlement proposal is limited by the total contract price less payments that have been made or are to be made under the contract. The limitation is considered prior to deducting disposal or other credits arising from the termination but it does not include the costs of termination settlement.

The total amount payable to the contractor under a termination for convenience of a fixed price contract may also be limited by the contract's loss ratio. Care should be taken in computing the loss ratio, however. It should be computed as if the terminated work was still going to be performed. The ratio from that computation is what should be applied to the termination costs. Since a termination decreases the allocation base the overhead rates subsequent to termination could be higher than those that would have otherwise been experienced. A higher loss ratio would result if the higher overhead rates were used.

Cost type contracts are not constrained by settlement limits or loss ratios. Cost type contracts, however, can be constrained by the limitation of cost or limitation of funds clauses.

A Potpourri of Opportunity

Since the termination settlement proposal represents only the costs of terminating the work, a termination may give rise to the preparation of numerous other proposals. For example, unsettled changes from ordered or constructive changes can increase the cost ceiling so that more of the termination costs may be recovered when they might otherwise be limited. In the case of a partial termination, an adjustment in the price of the unterminated work is also in order. This proposal provides another vehicle for increasing a contractor's cost recovery.

In essence, a termination can result in many proposals being submitted by the contractor. Utilizing these various opportunities is important for maximizing a contractor's cost recovery and increasing its current period revenue stream. Moreover, when the issues to be resolved are particularly contentious these various opportunities can provide contractors with multiple bites at the apple so that cost recovery is maximized and cash flow is expedited.

Settlement Methods

Prime contractor termination settlement proposals may be settled through negotiation, by vouchering in the case of the cost type contract or by unilateral determination. Under negotiation, there are two principle techniques for quantifying and settling the termination settlement proposal. These methods are the inventory basis and the total cost basis.

Under the inventory basis, only the uncompleted, undelivered goods/services are quantified using the termination cost principles and procedures. The value of completed and delivered goods/services are quantified using their contract unit price.

Under the total cost basis, the contract becomes in essence a cost reimbursement contract. Thus, under the total cost basis even completed and delivered goods/services are quantified in the termination settlement proposal using the termination cost principles and procedures.

In some cases like supply contracts the inventory basis is preferred. In other cases like construction contracts the total cost basis is required. In many cases where the inventory basis is preferred, however, the total cost basis may be used if approved by the contracting officer. When there are completed and delivered goods/services the two techniques can yield different outcomes. When there are no completed or delivered goods/services, however, both techniques yield identical results.

Terminated cost type contracts may continue vouchering their costs for six months after the termination date. The termination costs are vouchered in the same manner as normal interim billings.

Unilateral determination is the final method for settling prime contractor termination proposals. The Terminating Contracting Officer (TCO) may issue a unilateral determination when the contractor fails to submit its termination proposal within the prescribed time period or when the parties cannot mutually agree on the settlement amount.

Termination Costs

Termination costs are guided by the cost principle at FAR §§31.205-42. In the cost principle, eight types of costs are identified that may be included in the contractor's termination settlement proposal.

Common items The costs of items reasonably usable on the contractor's other work are not allowable costs of a termination. Thus, in order for the costs of common items to be allowable costs of a termination they must be in excess of the reasonable quantitative requirements of other work. Furthermore, in order for them to be usable on other work they must be suitable for use in the contractor's normal course of business. Thus, even if they are items normally used in the contractor's industry they do not qualify as common items if they are not normally used in the contractor's normal course of business. Finally, even if the items were inventoried by the contractor prior to the receipt of the contract the items should not be considered common items if they are of no value to the contractor subsequent to the termination.

Cost continuing after termination Costs that cannot be discontinued immediately after the effective date of termination are generally allowable costs of a termination as long as they are not attributable to the negligent or willful failure of the contractor to discontinue those costs. These costs can include idled facilities costs; the costs of deactivating, reassigning, returning or relocating employees; severance payments required by law, agreement or established company policy; the costs of early retire ment; the costs of completing parts in order to avoid loss; costs incurred while the contractor determines how to terminate the contract; and plant reconversion costs if their exclusion would be inequitable.

Initial costs Initial costs include various types of non-recurring costs such as excessive spoilage, idle time, reduced productivity and increased training costs encountered in the early period of perfor mance. They also include various preparatory costs, such as plant rearrangement and alterations; management and plant organization; and manufacturing and production engineering. A contractor's bid and proposal costs can even be claimed if proper adjustments are made.

Loss of useful value The costs associated with the loss of useful value for special tooling, special test equipment and special machinery are also allowable costs of the termination. The definitions provided in FAR §45.101 should be used in determining whether these items exist under the contract. The treatment of these items as either a direct or indirect cost is not a determinant factor to their existence.

Rental under unexpired leases Rental costs under unexpired leases, less the residual value of such leases, are generally allowable when it can be shown that they have been reasonably necessary for the performance of the terminated contract provided that the amount of rental claimed does not exceed the reasonable use value of the property leased for the period of the contract and such further period as may be reasonable and that the contractor makes all reasonable efforts to terminate, assign, settle, or otherwise reduce the cost of such leases.

Alterations of leased property The cost of alterations and reasonable restorations required by the lease may be allowed when the alterations were necessary for the performance of the contract.

Settlement expenses Accounting, legal clerical and similar expenses necessary for the preparation and presentation of the proposal to the contracting officer are allowable as are the costs of terminating and settling any subcontracts. In addition, the costs of inventorying, storing, transporting, protecting and disposing of any termination property are also allowable. The indirect costs associated with the salary and wages incurred as settlement expenses are also allowable. Frequently, these indirect costs are limited to payroll taxes, fringe benefits, occupancy costs and the costs of immediate supervision; however, the allowable indirect costs are not absolutely limited to those areas.

Subcontractor claims The prime contractor and each subcontractor are responsible for prompt settlement of their respective subcontractors. Contractors are required to settle with subcontractors in general conformity with the policies and principles relating to settlement of prime contracts. Thus, subcontractor settlements are generally allowable provided that the settlement is not more favorable than what the subcontractor would have been able to obtain had it contracted directly with the government. This requirement includes a prohibition against permitting the prime contractor to recover anticipatory profits or consequential damages that were included in a subcontractor's settlement proposal.

If the subcontractor obtains a final judgment against the prime contractor, however, the judgment should be treated by the Government's TCO as a cost of settling the terminated subcontract. In this case, the final judgment amount can include conse quential damages and anticipatory profits provided that the prime contractor had made reasonable efforts to include a termination clause or similar language prohibiting the recovery of consequential damages or anticipatory profits in the subcontract.

Generally, the Government's TCO must approve or ratify any prime contractor settlements with subcontractors. The TCO, however, may, after written request from the prime contractor, give written authorization to the prime contractor to settle terminated subcontract proposals of $100,000 or less without approval or ratification. For contracts awarded prior to January 22, 1991 the threshold is $25,000.

While the government reserves the right to approve or ratify first tier subcontractor termination settlement proposals, no such requirement exists for lower-tier subcontracts. Instead, each level of subcontractors and the prime contractor must submit certifications that there is no known information about lower-tier sub contract settlements that would serve to cast doubt on the reasonableness or allocability of the settlements to the terminated portion of the prime contract.

Clearly, the settlement of subcontracts can be extensive and expensive. Consequently, it is only appropriate that indirect costs may be allocated to the amount of settlements with subcontractors. Contractors should be careful, however, to avoid any double counting of costs arising from both subcontractor settlements and its own termination settlement costs.

Unabsorbed Overhead

Unabsorbed overhead is the misallocation of indirect costs to final cost objectives other than those for which the costs were incurred. This can occur when indirect costs are allocated using a cost base that is unexpectedly reduced because of a change. The change that is most often associated with unabsorbed overhead is a performance delay but a termination may also yield similar results.

Unabsorbed overhead is not an allowable termination cost because, whether correctly or incorrectly, it is not considered to be a cost of terminating the work. Unabsorbed overhead would be an allowable cost of any unsettled change proposals, however. Particularly if the termination was preceded by a stop-work-order--as is often the case.

While unabsorbed overhead is not an allowable termination cost many of the costs that otherwise comprise unabsorbed overhead can be recovered through other means. The termination cost principle recognizes that terminations represent an unusual circumstance that can warrant special treatment. This language, in essence, opens the door for contractors to change their cost allocation procedures on-the-fly. Similar opportunity exists even on terminated contracts that are covered by Cost Accounting Standards. Thus, contractors may successfully recover the costs comprising unabsorbed overhead by designing methods for allocating as a direct cost of the terminated contract as much as possible of the otherwise indirect costs.

Profit

The contractor is entitled to a reasonable profit on its termination costs. Considering, however, that profit may not be given on the cost of terminated subcontracts or settlement expenses the contractor may need to componentize its profit request so that it corresponds to particular contract efforts. By doing so, the contractor may be able to sustain higher earned profit values on tasks that were performed earlier in the contract than those that were terminated. Utilizing the inventory basis of settlement can also provide another means of retaining substantial profit amounts if the unterminated work contained the highest profit values.

Timing

Prime contractors should submit their termination settlement proposals within one year of the termination date. Extensions in time to submit the termination settlement proposal may be requested by the contractor and may be granted by the terminating contracting officer.

Within the one year time period the prime contractor should have also received subcontractor termination settlement proposals. Therefore, when including a termination clause in subcontracts and purchase orders, the prime contractor should have imposed a shorter period of time for receiving termination settlement proposals than it has for submitting its own proposal.

Audit

The government has the authority to audit the prime contractor's termination settlement proposal under several contract clauses. Principally these clauses are the Audit-Negotiation or Audit-Sealed Bidding clauses. Although contractors are required to include these clauses in their subcontracts, the government may not have subcontract audit privileges if these clauses or similar language are omitted from the subcontract.

For contracts awarded after January 22, 1991, the TCO must refer each prime contract termination settlement proposal of $100,000 or more and each subcontract termination settlement proposal submitted for ratification or approval to the appropriate audit agency for audit. Of course, for contract or subcontract termination settlement proposals of less than this value the TCO may still request audit review if desired. For contracts awarded prior to January 22, 1991 the audit threshold for prime contract settlement proposals was $25,000 while the audit threshold for subcontract settlement proposals was $50,000.

Summary

Terminating contracts is no simple matter. Contractors should expect to expend considerable effort in settling their terminated contracts. Understanding the consequences of the termination with respect to their own organizations and then maximizing the cost recovery for those consequences will prove substantial. Satisfying their responsibilities relative to subcontract settlement will also be expensive and time consuming.

Fortunately, all of these costs are recoverable. Furthermore, interim proposals may be submitted and partial payments requested. Thus, government financing is available for as much as 90 percent of the allowable costs incurred prior to final settlement.

Although a Contracting Officer may use his discretion in determining the amount of partial payments, that discretion must be reasonably exercised and directed at protecting the government's financial interest. Since the government will almost always have some amount of financial liability to the contractor, a Contracting Officer that denies the requests for partial payments will most likely abuse his authority and entitle the contractor to recover interest on the unpaid partial payment.

Naturally, if the contractor's settlement proposal exceeds applicable thresholds, the negotiation of final price will be subject to the Truth-in-Negotiations Act. Care should be taken, therefore, to ensure that all appropriate disclosures are made.

In a quickly dwindling defense market, a termination settlement proposal may represent a company's last best opportunity to maximize its current period revenue stream and to recover whatever investments may have been made. To that end, contractors are fortunate that there are no cookie-cutter formulas for settling terminated contracts.

The primary objective for contract terminations is to compensate the contractor fairly and negotiate a settlement by agreement. Toward that end, the FAR Part 31 cost principles are simply guides and a contractor need not have extensive accounting data to prove the settlement amount. Estimates, standards, and negotiated amounts are all suitable means of arriving at the settlement amount.