Due Diligence In The Acquisition Of A Government Contractor - Part I

With the increasing number of mergers, stock purchase agreements, and asset sales going on today in corporate America, increased due diligence has been a must for any responsible party to such transactions. If the target is a federal government contractor, there is an overlay of due diligence requirements because of the many statutes and regulations governing those who hold federal contracts that must be addressed before the transaction is closed to assure compliance and avoidance of later issues being raised by government procurement and audit officials. There are: (a) procedural aspects of the transaction, including novation requirements, sub-contracts, national security implications, status of proposals to the Government or cost accounting compliance considerations and (b) financial aspects of the transaction, including allowability of costs relating to the transaction, pension cost implications and asset evaluation. These matters are covered in Part I of this article. Part II to be published in a subsequent article, will cover (a) evaluation of the contract assets acquired, including validity of the contracts, funding, overruns, status of options, research and development status if applicable, terminations pending, and assignment of revenues, and (b) pending or possible government claims and contractor claims, defaults, convenience terminations, inspection and acceptance, warranties, cost disallowances, cost accounting violations, defective pricing, change orders and constructive changes, and contractor fraud matters unique to federal contracting. The majority of due diligence concerns are covered in these Parts.

1. Procedural Aspects Of The Transaction

A. Novation Agreements

Because of the Anti-Assignment Statute (41 U.S.C.15), prohibiting transfer of a government contract to a third party unless the government in its discretion agrees to recognize the third party as successor in interest, it is important to understand the regulations governing the novation of contracts and change of name requirements as set forth in the Federal Acquisition Regulations Part 42.1200 et seq. Those regulations provide for formal notice to the government, the submission of detailed information to the contracting officials, and the execution of a standard novation agreement that details the rights and obligations of the transferor and the transferee, certain documentation specified that must be submitted with the agreement and certain affirmations of the parties. Novation agreements are required when all of the contractors assets are being transferred, or the entire portion of the assets involved in performing the contract or contracts are being transferred. Novation agreements are not necessary when there is a change of ownership as a result of a stock purchase with no legal change in the contracting party, and when that contracting party remains in control of the assets and is the party performing the contract. Even then, the regulations note that there may be issues related to the change in ownership that should be addressed in a formal agreement. The genesis of the Anti-Assignment Statutes and regulations is simply that the government needs to know who it is dealing with when such transactions take place and the contracts change hands. It behooves the parties to know the regulations well when a sale or merger is being negotiated.

B. Subcontracts

Regardless of whether the acquisition is a stock or asset sale, review of all existing subcontracts of the acquired company is necessary to ensure that they will not be affected by the acquisition. If any subcontracts include provisions regarding assignment, the parties must ensure that the assignment can take place and all necessary actions are taken. The subcontracts should also be reviewed to make sure they contain all of the flow-down clauses required in the Federal Acquisition Regulations ("FAR") and to determine whether the prime or subcontractor has pending or potential claims against the other.

C. Security Clearances

If applicable, it shall be critical to determine whether the acquired company has facility clearances at any of its facilities if the transferor holds such clearances because of the nature of the contracts it holds that are national security contracts that will be transferred. If so, proper notification must be given to the agency's cognizant security offices that in most cases are the Department of Defense, State or other such agencies which award contracts with classified and national security requirements for facilities and the persons working on such contracts. Failure to give the required notices could result in the revocation of the clearances that were held by the transferor. If the acquired company does not have such clearances, they must be applied for and approved prior to the closing so as not to jeopardize the transaction. On a related matter, and if applicable, it should be determined whether the acquiring company is subject to foreign ownership, control or influence (FOCI). If FOCI exists, the parties must ensure that a special arrangement is reached with the Department of Defense in order to prevent the termination of existing security clearances.

D. Outstanding or Future Proposals For Government Work

The parties need to identify all of the proposals the acquired company has outstanding for possible award. If such proposals relate to negotiated procurements where the Truth In Negotiations Act applies (contract actions where the price is expected to exceed $500,000), it should be determined whether any additional cost and pricing data disclosure needs to be made to the government and ensure that they are made. This will avoid later audit if award is made and thence possible adjustments downward in the contract price agreed to if the acquired company failed to submit and certify accurate, current, and complete cost and pricing data that could have affected the price at the time of the hand shake at the completion of negotiations with the government. If subcontracts are being used in the procurement to fulfill the needs of the procurement and cost and pricing data are required, the parties should ensure that the subcontractors proposed fulfill their obligations to submit accurate, current and complete cost and pricing data. Since there is no privity of contract between a subcontractor and the government, the prime will be held responsible for the failures of the subcontractor in failing to submit the required data. 10 U.S.C. 2306a and 41 U.S.C. 254b.

Another facet to be reviewed, if applicable, is where the acquired or acquiring company qualified as a small business and thus was eligible for small business set-asides. If either qualifies as a small business, it should be determined whether the transaction will result in the company no longer being a small business. If so, they must ensure that any future proposals are not submitted for small business set-asides and that the company does not certify itself as a small business to the procuring agencies.

E. Cost Accounting Standards

41 U.S.C. 422 requires that certain contractors and subcontractors comply with the Cost Accounting Standards and disclose and follow consistently their cost accounting practices. The Cost Accounting Standards ("CAS") represent a comprehensive set of rules to ensure that contractor's accounting systems are reasonable and provide assurance that work billed to the government is properly accounted for. 48 CFR 9903-9904; FAR Part 30. There are exemptions from coverage which should be reviewed. The Standards cover consistency in allocating costs; allocation of home office expenses to segments; capitalization of tangible assets; accounting for unallowable costs under the FAR; use of standard costs; accounting for costs of compensated personal absence; depreciation of tangible capital assets; allocation of business unit general and administrative expenses to final cost objectives; accounting for acquisition costs of materials; composition and measurement of pension costs; cost of money as an element of the cost of facilities capital; deferred compensation; accounting for insurance costs, allocation of direct and indirect costs, cost of money as an element of the cost of capital assets under construction; and accounting for independent research and development and bid and proposal costs. Due diligence requires a determination of whether the acquired or acquiring company is subject to CAS or whether as a result of the acquisition will become subject to CAS. If currently applicable, the parties will need to determine whether revisions must be made to the CAS disclosure statements and what standards as noted above will apply.

2. Financial Aspects Of The Transaction

A. Costs of the Transaction

It will be necessary to determine how both the acquiring and acquired companies plan to account for the costs of the acquisition. The FAR must be reviewed to ensure that those organization costs currently identified in these regulations as unallowable are accounted for in a manner as not to be charged to the government through the contracts.

B. Pension Plans

Because of requirements in the FAR, it must be determined whether any pension plan of the acquired company is over-funded and if so, whether the acquiring company intends to terminate the plan or continue contributions. The government takes the position that it is entitled to share in any gain realized from the termination of an over-funded pension plan and that it may disallow any further contributions to an over-funded plan. The parties should determine whether the government has already made any such claims.

C. Asset Valuation

The parties need to ensure that the acquiring company computes depreciation charges on the appropriate asset value whether the purchase method or pooling of interest methods are used.

Published September 1, 2007.