Mergers and acquisitions involving government contractors are on the rise again, after several years of restrained volume. This increase is being driven by a variety of factors, including a growing interest in government contractors by private equity firms, emerging efficiencies and economies of scale and scope in the IT and professional services sectors, as well as divestitures and realignments caused by the evolving regulation of organizational conflicts of interest. With this increased deal volume comes increased attention to the unique aspects of government contracting that affect the ability of buyer and seller to successfully consummate a transaction.
Critical but often overlooked aspects of government contracting affect many of the tasks that must be performed during the early stages of any transaction, including: (1) understanding what is "material"; (2) valuing the seller's government-contracts backlog; (3) identifying special risks that may require adjustment to the purchase price (either pre-closing or post-closing) or other special attention in the purchase agreement; (4) obtaining financing; and (5) negotiating and executing a purchase agreement. If one party's government contracts counsel must educate the other party's general corporate counsel on issues unique to government contracting - such as the Anti-Assignment Act and the novation process, Truth in Negotiations Act certifications, incurred cost audits, organizational conflicts of interest, or terminations - delays and unnecessary friction will almost certainly result. This article explores some of the unique government contracts issues that often surface during each of the tasks listed above and that can fundamentally affect the allocation of risk between buyer and seller.
Understanding "Materiality" And The Scope Of Information Needed For Due Diligence
Due diligence generally involves generating and presenting accurate information on the seller's side and obtaining and analyzing information on the buyer's side about the target company and its assets, strengths, and weaknesses, as well as potential for future operations. Very quickly, the question arises what information is "material" to these inquiries, but this term can have a very different meaning for transactions involving government contractors than it does for transactions involving firms engaged solely in private commercial activity. All too often, "contract value" is used as a proxy for materiality, which can distort the buyer's understanding of the assets and liabilities of the seller.
Certainly, it is important to review the seller's largest dollar value contracts, and one approach to due diligence is to begin by reviewing information related to the contracts that comprise a given percentage of the seller's revenue from the government. A buyer, however, cannot focus on dollar value alone when doing so will exclude consideration of smaller contracts where the seller has had performance problems or where the seller faces disproportionate liability from pending or future government/third-party claims. Another critical issue that can be overlooked when smaller contracts are ignored is organizational conflicts of interest, or "OCIs." For a variety of reasons, a government contractor's work under one contract may be deemed to conflict with work under other present and future contracts of the seller or the buyer. When these OCIs surface after a transaction is consummated, they can undermine the buyer's expectations regarding the value of the seller's current business, as well as the buyer's and target's prospects for future business after closing. And, in a recent case, undisclosed OCIs on a relatively minor consulting contract resulted in a civil False Claims Act suit by the government five years after the contract ended.
Ultimately, the buyer will want the seller to make a broad set of representations and warranties regarding the validity and performance status of all of its contracts. In addition to OCIs, the buyer will want the seller to represent and warrant, inter alia , that there have been no defaults, that it has received no "show cause" or termination notices, and that all Truth in Negotiations Act ("TINA") cost or pricing data submitted in connection with any bid were properly certified as "current, accurate and complete." The seller, in turn, will resist making such representations and warranties and will demand that the buyer reach its own conclusions from the information provided in the data room. The organization and population of the data room therefore becomes critical.
At a minimum, the seller's data room should contain all documents relating to the key programs, assets, plans, and risks identified in the seller's Offering Memorandum (and any subsequent Management Briefings), and documents related to the items that the seller plans to "schedule" in the purchase agreement. This latter category would include copies of all "material" contracts (however defined), draft and final government audit reports and related submissions by the seller, any pending government litigation, claims, demands, or investigations, and any "mandatory disclosures" by the seller to the government under recent regulations requiring contractors to report "credible evidence" of certain misconduct. The data room should also include all performance assessments and fee determinations related to the material contracts, as well as any adverse assessments or determinations received on other contracts within a given time period. For contractors with cost-reimbursable contracts, the data room should include the seller's Cost Accounting Standards Disclosure Statement and the government's determinations whether that statement is adequate and compliant, the seller's forward pricing rate agreements and submissions, and any advance agreements with the government regarding the accounting treatment of particular costs. Finally, the data room should contain information regarding the seller's internal controls and compliance systems, as well as any government, seller, or third-party reviews of those systems. Achieving confidence that these systems are adequate and operating as they should is critical to assessing the risk of the severe penalties and liabilities unique to government contracting.
To the extent that the seller has classified contracts, the parties will need to address how and when these contracts are reviewed by the buyer. At a minimum, the seller should be upfront about the existence of classified contracts and be willing to provide the buyer a summary of whatever limited information it can about these contracts in accordance with the existing security procedures. A prudent buyer may insist on reviewing these classified contracts before closing the transaction, and it is even possible that the buyer will ask for a "walk away" in the purchase agreement if the buyer's eventual review of these classified contracts reveals information unacceptable to the buyer. This is just one example of why the buyer's due diligence review is not a one time review for a set period of time and will instead continue right up to the closing of the transaction.
Important additional information also may be available from third parties. For instance, a prospective buyer might want to contact the seller's key customers and suppliers, an action that usually occurs after the possibility of a deal becomes firm and in coordination with the seller. Such contact would be especially prudent in the case of key government contracts, particularly if they involve classified programs. Depending on the nature of the transaction and the parties involved, and consistent with non-disclosure obligations that may exist, valuable information also might be available from former employees of the seller.
The ultimate scope of documentation made available for review in the data room will also depend on the nature of the proceedings. For example, fewer documents might be made available to first round participants in an "auction" situation. In setting up the data room, restrictions on the disclosure of information subject to Non-Disclosure Agreements (NDA) and other customer-sensitive documents need to be considered along with information the seller believes to be proprietary or competition-sensitive. Proprietary seller information such as audit reports, for example, might be segregated in a separate "Red Room" which would be subject to additional restrictions, e.g ., allowing a buyer to review them but not take notes or make copies.
Finally, the due diligence process should continue right up through closing. In particular, the identification and negotiation of particular provisions in the purchase agreement almost always will generate a need for additional specific information to assess risks associated with those provisions. In addition, further information always will be necessary for updating schedules between the time the purchase agreement is signed and the deal is closed.
This article is the first in a four-part series that will be published in The Metropolitan Corporate Counsel over the next four months.
Published May 31, 2011.
