Sequestration: It’s Not Over Yet
In previous LRN Risk Forecast Reports, I noted that government contracting requires a sharp calculation of risks versus rewards. Typically, that calculation has come out in favor of companies expending the necessary time and effort to maneuver a minefield of often complex and frustrating regulations in order to reap the financial benefits and stability associated with government contracting. For 2014, some companies might be recalculating their analysis and reconsidering whether the benefits still outweigh the risks of government contracting.
First, here’s a quick review of where we’ve been. The Budget Control Act (BCA) of 2011 required the federal government to reduce spending by more than $1 trillion by 2021. This amounts to cutting about $109 billion from the budget each year. To accomplish this, the BCA created the Joint Select Committee on Deficit Reduction (the “Super Committee”).1
“Sequestration” was the name given to the mandatory, across-the-board spending cuts (totaling about $1.2 trillion) that would occur automatically should the committee fail to compromise. As we know, there was no grand compromise, and Congress allowed the sequester to occur last year. Budget cuts were split equally between defense discretionary spending, non-defense mandatory (entitlement) and discretionary (non-entitlement) spending, without an increase in tax revenue. This represents about $55 billion in cuts from both the defense and non-defense budgets every year.2
Defense spending cuts were spread across all branches. While some programs were spared, other sections of the military have seen 7 to 10 percent of their budgets eliminated.
Non-defense spending cuts are typically program-specific and categorized as either mandatory or discretionary. Most mandatory programs such as Social Security, Medicaid, food stamps, and retirement benefits are currently exempt from reductions. Medicare is the exception, though cuts are capped at 2 percent per year ($11 billion in 2013) and limited to providers and insurers, not beneficiaries. The Government Accountability Office issued a decision on May 21, 2012 that Department of Veterans Affairs spending is exempt from sequestration (with the exception of limited administrative expenses).
Non-defense spending cuts were accomplished through broad reductions in funding for discretionary programs. Under sequestration, $1.2 trillion in budget cuts began on January 2, 2013, and are scheduled to continue through FY 2021.4
The BCA of 2011 also provided a way to avoid sequestration if Congress successfully acted to achieve equivalent deficit reduction savings. If Congress attained less deficit reduction savings than required, sequestration cuts could be reduced by the amount in savings actually realized. For example, if Congress created $80 billion in alternative deficit reductions, and the plan became law, the $1.2 trillion sequestration would be reduced by $80 billion.5
On January 1, 2012, the House passed a series of tax changes and revenue enhancements that avoided the “fiscal cliff” of across-the-board tax increases (the Senate passed the same bill late into the night of New Year’s Eve). This bill also delayed sequestration required by the BCA of 2011 by two months, literally “kicking the can” down the road for the new Congress to deal with in the first quarter of 2013.
As we all know too well, Congress failed to act. Instead of the 2012 “sequestration” process inspiring cooler heads to prevail, Congress failed to pass a continuing resolution to keep the government running after October 1, 2013, resulting in the first federal government shutdown since 1995.
Will 2014 Continue to Be a Budget Roller Coaster?
Although the world as we know it did not end with the sequestration in 2012, for government contractors, the 2013 government shutdown was like a tornado ravaging a town after an earthquake. Many contractors had to lay off staff assigned to affected government agencies and programs, further straining their already anemic bottom lines. One large government contractor reported that the shutdown cost the government about $30 million, while others reported profit declines by more than 25 percent. Contractors that provide services to the government reported declining sales, and many warned that 2014 could be even worse.6 The few contractors who are improving their profits are doing so not by boosting their sales, but by managing their costs. That means declining employment, freezing or reducing salaries and benefits and an overall shrinking in contractor capability. As one contractor recently told the Wall Street Journal, “[d]oing business with the government is not for sissies.”7
Unfortunately, the worst may be yet to come. Several federal agencies found extra funds that helped them survive the automatic budget cuts in FY 2013, allowing them to minimize draconian terminations of contracts. For example, the Pentagon used more than $5 billion in unspent money from previous years to ease its $39 billion budget cut. The Department of Justice (DOJ) found more than $500 million in similar money. Agencies that have thus far withstood the harshest effects of the 2013 cuts are preparing for a second round in 2014 that will likely be worse than the first. Senate Appropriations Committee Chair Barbara Mikulski (D-MD) said that agency budget chiefs “squeezed everything to get through the first year, thinking we would come to our senses.” Unfortunately, that didn’t happen. Most of those accounting maneuvers were one-time steps. The automatic spending cuts in 2014 promise to be far more painful to both federal agencies and the contractors that support them.8
Congress recently passed a budget deal to avoid the political fallout from another government shutdown. Nevertheless, fundamental issues involving spending priorities have been put on the back burner, as neither house of Congress can agree on a long-term spending plan. As a result, it remains increasingly difficult for contractors to plan for a 2014 (and beyond) with declining budgets, continued threats of shutdowns and uncertainty in their programs.
Let the Buyer and Seller Beware
With the only certainty being future reductions in contracting dollars, today’s marketplace poses several new risk areas which government contractors, and those considering either buying a government contractor or entering the business for the first time, need to consider.
Buying a Government Contracting Business
In periods of market growth, it is common for companies or investors who have not traditionally played in the government market space to become active in this area. However, the main attraction of government contracting has been its stability in terms of revenue and profits. In this period of downturn, investors need to be exceedingly cautious about the underlying funding streams supporting company revenues. While this is often more stable in the case of prime contractors, it is less so for subcontractors. With a shift in government contracting strategy to “technically acceptable, lowest cost,” primes have little option but to cut costs, squeeze subs and even bring in-house certain functions that were previously subcontracted. Therefore, it is more important than ever for subcontractors to establish themselves as critical to a project, and for potential buyers to assess just how necessary they are given these external budget pressures.
Assessing Risks and Adjusting Prices
Government contractors with cost-reimbursable contracts often have six or more years where final costs and expenses have not yet been agreed to by the government (usually pending audit by the Defense Contract Audit Agency (DCAA)). The risk of contract adjustments unfavorable to the contractor increases as time goes on without a resolution. DCAA auditors, under pressure from Congress, are more aggressively questioning costs that could impact the final bottom line for companies. This could, or should, impact the analysis of the company’s value and the value of their future contracts as they enter into negotiations for mergers or acquisitions with outside companies.
The Impact of 2014 Budget Reductions on Existing Contracts
Government contractors should continue to consider several possible impacts of budget reductions on the government procurement process:
- Existing Contracts: During 2013, we saw agencies reduce the scope and quantity of products or services purchased on existing contracts. Agencies may continue to “de-scope” the quantity, capability or breadth of contract performance through change orders, as well as partial or even complete contract terminations for convenience. Depending on the budget pressures from the Hill, contractors should expect agencies to propose restructuring existing contracts to defer costs to the future. Such restructuring may result in more term contracts, extensions of contract schedules to match funding and requests for waiver of existing contractor claims. Contractors may see their option periods waived, forcing them to negotiate new contracts at lower prices and face increasingly price-sensitive competition.
- New Contracts: During 2013, government contractors saw a decrease in the number of new contracts awarded, and we expect to see this continue. Types of contracts may also change, with agencies moving away from contract vehicles that place cost and performance risk on the government. For example, agencies are less likely to use cost-reimbursement and labor-hour contracts (previously favorites in the government services arena), instead favoring fixed-price contracts for a greater degree of cost certainty and lower risk. Indefinite delivery/indefinite quantity contracts will also become more attractive for the government because they allow agencies to negotiate at the task order level. In addition, government contractors are already seeing a trend away from “best value” procurements toward lowest price, technically acceptable sources.
- Bid Protests: Stiffer competition for contracts will likely bring an increase in bid protest litigation, particularly from incumbents seeking to extend their performance on contracts, and offerers who need the awards to remain viable players in the government contracting space.
- Procurement Integrity Violations: Intensified competition for fewer contracting opportunities can create a high-risk environment within companies, making them susceptible to employee misconduct, particularly with regard to following the rules of the competitive contracting process. In an effort to win contracts and curb layoffs and staff reductions, employees (particularly those in the contract “capture” process) may feel motivated to ignore or marginalize their company ethics and compliance programs and use whatever information is at their disposal—even prohibited government or competitor acquisition data—to give them an edge in the bidding process. Such ill-advised actions will lead to government investigations, prosecutions, suspensions and debarments and increase the risk for contracting officials who might be entirely unaware of such behaviors within their companies.
- Small Business Contracting: The number of firms allowed to compete for federal small-business contracts has been increasing. Since 2010, the Small Business Administration (SBA) has raised the size limits for firms in hundreds of industries competing as small business contractors. For example, in July 2013, the agency raised the annual revenue limit for firms in the transaction processing industry from $7 million to $35.5 million to be eligible for small business contracts. This move made it possible for more than 7,400 additional firms to begin competing for contracts as small firms.9 This increased competition will, as a result, drive down prices.
What Risk Mitigation Steps Can Contractors Take?
There are several proactive steps government contractors can take to mitigate the risk of inevitable budget and contracting cuts in 2014, improve their competitive posture and survive the unpredictable environment that has become the “new normal” of government contracting:
- Develop strategies for an increasingly competitive market. It is important for government contractors to consider new ways to make themselves attractive and differentiate themselves from their competitors. Strong ethics and compliance (E&C) programs, for example, have become a competitive differentiator on government contracts, as agencies can ill afford to deal with ethics and integrity problems in either the bidding or execution phases of mission-critical projects. Regular independent assessments of a contractor’s ethical culture and E&C programs can help make the case that a company deserves the public trust. In addition, proposals that incorporate ethics assessments, training and education at the project level provide evidence of commitment to controls and accountability important to government agencies in this new environment.
- Submit claims early. When a contractor has legitimate claims against the government, it makes sense to try to resolve them as early in the process as possible. This is especially true when the federal budget is tight; a contract with unresolved or unexplained cost overruns makes an easy target for budget watchdogs. If a contractor can establish—through a request for equitable adjustment or contract claim, for example—that the government bears responsibility for some or all of the cost growth, the agency may reconsider its plan to terminate a program. At minimum, a valid claim can reduce the likelihood that the government will terminate the contract for default rather than for convenience.
- Pay attention to quality and performance. It bears repeating that in a tightening budget environment, the quality of contractor performance will be scrutinized and there will be other companies claiming that they can do a better job. Contractors can help themselves by helping agencies document the results achieved, outcomes realized and reasons why their activities are mission-essential. Contractors should review performance assessments and seek to promptly correct reports that unduly attribute blame to them for matters beyond their control. Adverse assessments not only affect future business, they can weaken arguments for maintaining current budget levels on existing programs. Contractors should understand the circumstances under which they may challenge performance assessments under the Contract Disputes Act.
- Pay attention to subcontractors and team members. With potential partial terminations and deductive changes, prime contractors are apt to face disputes among subcontractors and team members over remaining work share. Contractors who anticipate these scenarios and address them in teaming agreements and subcontracts will be in a better position to resolve such matters favorably. In addition, contractors should be aware that agencies are paying attention to the activities of their subcontractors, vendors and suppliers and exercise effective third-party due diligence to ensure that these team members meet expectations.
- Be ready for increased government oversight. Suspensions and debarments of contractors by government agencies reached an all-time high in 2012, with no signs of abating in 2013. It is likely that decreasing budgets and the increasing importance of contract integrity and performance will drive even more aggressive enforcement of Federal Acquisition Regulations in 2013. For its part, the Defense Contract Audit Agency (DCAA) has more tools than ever to collect monies from contractors, including the ability to withhold payments if the agency finds a significant deficiency in the contractor’s business systems. Contractors will need to guard against unsupportable payment withholds by DCAA. Finally, the political discourse in 2013 indicated that declining taxpayer tolerance for waste, fraud and abuse of public funds will continue to drive prosecutorial priorities in 2014 and beyond.
- Assess the opportunities and risks of international markets. With declining U.S. government budgets, many contractors are setting their sights overseas. While foreign governments and international markets present opportunities, contractors should be aware of potential pitfalls associated with international business, including the complexities of complying with export control laws and the Foreign Corrupt Practices Act, which both the DOJ and SEC (Securities and Exchange Commission) are vigorously enforcing.
- Strengthen corporate ethics and compliance programs. The DOJ, SEC and government suspension and debarment officials are placing increasing emphasis on corporate ethics and compliance programs as a critical factor in their decisions to resolve both criminal and civil cases involving contractor misconduct. Many deferred, non-prosecution and settlement agreements will continue to contain ethics and compliance-related provisions, including requirements for remediation in areas of values-based ethics, internal controls, and ethical culture. Companies that take a proactive stance in this area will be better positioned to face the challenges in government contracting during 2014 and beyond.
The full LRN Risk Forecast Report can be accessed at: http://pages.lrn.com/risk-forecast-report-2014
1 Conference Report on H.R. 2112, Consolidated and Further Continuing Appropriations Act, 2012,
Congressional Record, November 14, 2011
2 Ousley, Jeff. Sequestration Could Have Serious Consequences for Military Members, Veteran’s United, August 7, 2012 (www.veteransunited.org)
3 Ousley, Jeff.
5 Martin, Willard. “Preparing for Government Sequestration and Budget Cuts,” Government Contracts Update, Winter 2012.
6 Larking, Tim. “Sequestration II: Expect Budget Rollercoaster In 2014”, Information Week, September 17, 2013
7 Needleman, Sarah, “Shutdown Means More Pain”, Wall Street Journal, October 17, 2013
8 Taylor, Andrew. “Automatic Spending Cuts Would Bite More in 2014.” Huffington Post, November 11, 2013.
9 Burroughs, Mark. “New World: The Future of Government Contracting”. Dixon, Hughes, Goodman LLP.November 2013