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Sequestration Brief

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    SEQUESTRATIONANDBUDGET CUTS

    SURVIVAL STRATEGIESFOR CONTRACTORS

    November 9, 2012

    Government Contracts . . . Federal Law & PolicyDLA Piper LLP

    Washington, D.C.

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    AGENDA

    Sequestration and the Fiscal Cliff

    Debt Valley

    Government Strategies for Reducing Contract Spending

    Contractor Actions to Mitigate Risks of Sequestration andBudget Cuts

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    How d id w e ge t t o the f i sc a l c l i f f?

    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 trillionin budget cuts for FY2013-FY2021 but if commission does notagree, sequestration of $1.2 trillion would be imposed in January2013 and Bush-era tax cuts would expire

    Sequestration = uniform, across-the-board cuts in all covered federalaccounts, equally split between defense and non-defense accounts

    Exempted accounts include Social Security, Medicaid, Veterans, andmilitary pay Medicare cuts capped at 2%

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    What is t he f isc a l c l i f f?

    The combination of sequestration cuts and tax increases thatare 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 nearterm

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    How w ould the f isca l c l i f f af fec t j obs

    w i th government c ont rac t o rs?

    Congressional Research Service issued report on October 1, 2012entitled Sequestration: A Review of Estimates of Potential JobLosses

    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 bynondefense cuts

    Largest job losses estimated in California, D.C., Maryland, Texas, andVirginia

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    How w ould seques t ra t i on am oun ts be

    ca lcu la ted?

    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 thecovered accounts using a uniform percentage

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    What i s t he es t im at ed magn i tude o f

    t he requ ired seques t ra t ion c u t s?

    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 forcalculation. 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 threequarters of the FY13 budgets, the cuts for balance of FY13have been estimated as:

    12.25% cut for defense

    11.20% cut for non-defense7

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    At w hat l evel w ould the sequest rat i on

    c u t s be app lied?

    Law requires percentage reduction to be uniformly applied toeach 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 withagencies

    Bottom Line:

    PPAs vary widely in size and scope, providing agency officialseither 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 $1M8

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    PPAs Wit hin t he LCS Progra m ($1.785B)

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

    Detailed budget line items

    constrain DoD flexibility ontaking reductions

    Lump sum appropriationallows degree of flexibility

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

    program managers

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    What t ypes o f fund ing and c on t rac t s

    w ou ld be a ffec t ed by seques t ra t ion?

    Affects all discretionary and mandatory spending (unlessexempted) 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 increaseproportionately 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 t he process fo r sequest ra t ion?

    OMB will determine percentage cuts for defense andnondefense 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 OMBguidance

    Personnel actions (furloughs, reductions in force)?

    Reprogramming?

    Contract actions (deferral of awards, stop work orders, reductionsin scope, terminations, etc.)?

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    What s t he l i k e l ihood t ha t

    seques t ra t ion occ urs?

    Obamas win coupled with Democratic gains in Senate give SenateDemocrats increased leverage when negotiating with House Republicansduring the upcoming Lame Duck session of Congress

    Given Obama victory, it is more likely that sequestration will be addressedand 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 billionover 10 years)

    Kicking the can: Less likely a short-term punt to avoid sequestrationand seek a potential deal in 2013

    Congressional Democrats seem unlikely to support this, even ifrevenue issues are addressed

    Cliff dive: Remote possibility Congressional leaders and mostmembers of both parties want to avoid sequestration

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    What s t he im pac t o f the e lec t ion 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-Pacificregion 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 by2020

    Afghanistan Winding Down: Congressional leaders on both sides agree that USforces 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 programobjectives 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 i f sequest ra t ion doesn t happen?

    Government contractors are rightly focused on the potential disasterof the Fiscal Cliff

    But even if we dont go over the Cliff, we clearly are headed forsignificantly reduced levels of federal spending i.e., Debt Valley

    Spending on federal contracts increased from $205.6B in FY00 to a peakof $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): Youmay see significantly lower figures spent on contracts, but that only takesus back to 2004-2008. Its not a disaster for contractors or government tospend $400 billion a year on contracts.

    So its important to see the big picture and take actions not just tosurvive the potential Fiscal Cliff, but to survive and thrive in DebtValley

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    What gu idanc e has Govt prov ided so

    far regarding sequest ra t ion?

    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 officialswarning them to continue normal spending and operations and performmissions without taking any steps that assume sequestration will occur.

    Advising Employees of Potential Layoffs

    July 30th, DoL: Possibility of sequestration does not trigger obligationunder 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 followsDoL guidance, employee compensation costs for WARN Act liability andrelated litigation costs would be allowable costs

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    How c an t he Government reduce con t rac t

    spend ing? And how c an con t rac t o rs 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 inwhich pricing and performance risks are unknown (see FAR Part 16)

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    How c an t he Government reduce con t rac t

    spend ing? And how c an con t rac t o rs respond?

    Prospective WorkCont.

    Place Heightened Value on Price in Competitive Acquisitions

    This ishappening 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-addedfeatures identify cost-savings and value-engineering options foragency consideration

    Obtain Cost-Related Data and Negotiate Thin Margins

    Obtaining cost-related data is typically prohibited in FAR Part 12procurements 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 pricingand high-level cost data?

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    How c an t he Government reduce con t rac t

    spend ing? And how c an con t rac t o rs respond?

    Prospective WorkCont.

    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 contractor 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 forchallenging option award to competitor?

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    How c an t he Government reduce con t rac t

    spend ing? And how c an con t rac t o rs respond?

    Existing Work Commercial Item Contracts

    Agree With Contractor on Changes to Contract

    In most commercial-item contracts, Govt cannot unilaterally directchanges in the work or the contract

    Rather, changes may be made only by written agreement of theparties (FAR 52.212-4(c))

    This is a critical distinction from non-commercial-item contracts itsignificantly 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 anypart 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 unrecoveredcosts/charges that have resulted from the termination

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    How c an t he Government reduce con t rac t

    spend ing? And how c an con t rac t o rs 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-priceconstruction or architect-engineer contracts

    Stop-Work Order clause (FAR 52.242-15) may apply to any negotiatedcontract

    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 througheither: A deductive change under an applicable Changes clause; or

    A partial termination under an applicable Termination for Convenienceclause

    Contractors recovery is measured differently under the two clauses, soits critical to evaluate which of these actions is appropriate

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    How c an t he Government reduce con t rac t

    spend ing? And how c an con t rac t o rs respond?

    Existing Work Non-Commercial-Item ContractsCont.

    Order a Complete Convenience Termination

    Govt can terminate an entire contract for convenience without anyadvance notice if in the Govts best interests

    Contractor entitled to be made whole for all costs incurred prior totermination and for expenses related to termination

    Termination cannot be challenged, and contractor cannot recover lostprofits, unless Govt acted in bad faith

    Cancel a Multi-Year Contract

    In a multi-year contract, Govt can cancel all subsequent yearsrequirements/quantities if incremental funds are not available (FAR

    52.217-2)

    Contractor entitled to a cancellation charge that reflects most costsincurred on the contract prior to cancellation

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    How c an t he Government reduce con t rac t

    spend ing? And how c an con t rac t o rs respond?

    Existing Work Non-Commercial-Item ContractsCont.

    Elect Not to Add Funds to a Cost-Reimbursement Contract

    Limitation of Cost clause (FAR 52.232-20) applies to a fully fundedcost-reimbursement contract

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

    Clauses require advance notice to Govt when contractor expects toincur 75% of, respectively, the estimated cost of the contract or thetotal amount so far allotted to the contract

    Clauses also require notice when, respectively, total cost will be greaterthan previously estimated or additional funds will required to continuetimely performance

    If Govt does not add funds to the contract, Govt is not obligated to paycontractor for any costs incurred in excess of the estimated cost or thetotal amount allotted to the contract

    Requires contractor to carefully track, manage, and report on costs toavoid overruns that cannot be recovered

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    What c an a c ont rac t o r do to

    m i t igat e r isk s o f seques t ra t ion?

    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 c an a c ont rac t o r do to

    m i t igat e r isk s o f seques t ra t ion?

    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 contractvehicles, 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 accommodatingrequired changes

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    What c an a c ont rac t o r do to

    m i t igat e r isk s o f seques t ra t ion?

    Evaluate Subcontractor/Supplier Risks

    Do teaming and other agreements adequately protect company in

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

    Are any subcontractors/suppliers at risk of failure in event ofchanges, 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 Nathaniel J. BellGovernment Contracts Federal Law & PolicyDLA Piper LLP (US) DLA Piper LLP (US)500 Eighth Street, NW 500 Eighth Street, NW

    Washington, DC 20004 Washington, DC 20004T +1 202.799.4400 T +1 202.799.4000E [email protected] E [email protected]

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