Editor's Note:The first part of this article, which appeared in the June issue of The Metropolitan Corporate Counsel, discussed understanding "materiality" and the scope of information needed for due diligence. It can be found at http://www.metrocorpcounsel.com/current.php?artType=view&EntryNo=12386. The second part, which appeared in July, discussed valuing the seller's government contracts backlog. It can be found at http://www.metrocorpcounsel.com/current.php?artType=view&EntryNo=12431.
Identifying Special Risks
Government contracting is a regulated industry. Thus, many aspects of the business exist that create risks greater than those assumed by companies under commercial contracts. This article cannot address all of those risk areas, but many standard checklists exist that can aid a buyer in this regard. Some of the key areas of risk are summarized below.
• Audits, Investigations, and Litigation. The government has extensive audit rights under most negotiated contracts, and with these rights come remedies that can result in retroactive adjustments to the contract price and other remedies under such statutes as the Truth in Negotiations Act. Government contractors who fail to comply with these statutory and regulatory requirements may be subject to investigations by agency inspectors general or the Department of Justice. These investigations can be disruptive to ongoing business, as well as harbingers of criminal and/or civil liabilities. Furthermore, contractors operate under a strict mandatory disclosure requirement that obligates them to self-report "credible evidence" of potential False Claims Act or criminal violations in connection with a government contract. A key component of due diligence is to assess any existing or potential investigations and/or ongoing litigation and the degree of attendant risk.
• Changes/Claims/Disputes . The government has the unilateral right under its contracts to change certain terms of performance and also to terminate a contract for virtually any reason for its convenience. In both cases, the contractor is entitled to be "made whole" through the Request for Equitable Adjustment (REA) or claims process. A buyer's due diligence must identify all existing or brewing claims the seller may have and assess the likelihood of recovery under the unique law that has evolved in specialized courts and tribunals created to adjudicate government contracts disputes.
Intellectual Property. A company doing business with the U.S. government must exercise considerable care to assure it does not grant to the government an "unlimited rights" license in that company's valued technology or some other license that would give away greater rights to its technology than it intends. That license could entitle the government to give the design - either in the form of technical data or computer software code - to other companies and to authorize those companies to copy and sell the product illustrated in the data or code to any customer, anywhere. In a nutshell, government contracts intellectual property rules are different from those in the commercial market, and a government contractor must protect any intellectual property that was not developed at public or government expense or delivered to the government. Even if such property were developed at private expense and delivered to the government, the contractor must institute business practices that will protect the property from transferring to the government with unlimited rights. A thorough due diligence must assess this issue carefully when a seller's proprietary technology accounts for a significant part of its value.
• Organizational Conflicts of Interest. As mentioned above, government contractors must avoid, mitigate or neutralize OCIs, and this issue is particularly important during the due diligence process. The failure to identify and address actual or apparent OCIs can lead to potential loss of lucrative business and may, when false statements or claims are involved, result in additional liability. As part of the due diligence process, the buyer must understand any lines of business in which both the buyer and the seller share a presence, and identify whether the integration of the two companies could result in potential OCIs and, if so, the steps that can be taken to avoid or mitigate those conflicts.
• Labor. Government contractors can be subject to a host of federal labor and employment rules, compliance with which must be assessed during due diligence. These rules include the Department of Labor's affirmative action requirements, the Service Contract Act, the Rehabilitation Act of 1973 (which imposes obligations on federal contractors with respect to the disabled), the Fair Labor Standards Act, and the Drug-Free Workplace Act.
• FCPA/OFAC/ITAR. If the seller is a government contractor that in whole or in part has foreign operations, due diligence must assess the seller's compliance programs regarding import-export controls, sanctions, customs and other issues related to the International Traffic in Arms Regulations (ITAR), the Export Administration Regulations (EAR), the sanctions regulations administered by the Office of Foreign Assets Control (OFAC), the Foreign Corrupt Practices Act (FCPA), the Bank Secrecy Act and the Foreign Agents Registration Act (FARA).
• Teaming Arrangements. Many government contractors "team" with other contractors to perform certain contracts. These teaming arrangements can involve a traditional prime contractor/subcontractor relationship, but they can also involve the creation of distinct legal entities, such as joint ventures. These entities may need to have their own accounting, internal controls, and other systems, and may have a separate record of contract performance that must be evaluated during due diligence. Similarly, the seller's rights under the joint venture agreement must be analyzed to determine whether and how the seller's interests in that entity can be transferred to the buyer.
• Government Indemnifications. Although there is such a thing as a "government contractor" defense to third-party tort suits, the scope of this defense is not settled and varies considerably by jurisdiction. Where the seller's performance of its government contracts involves hazardous activities, the seller's contracts may contain a variety of insurance and indemnification provisions that are unique to the federal government. Understanding what liabilities the government has agreed to assume or indemnify against and what insurance the seller is required to carry is vital to quantifying the impact of potential third-party claims on a seller's business.
Obtaining Financing
To the extent that the buyer intends to obtain financing by assigning to a financial institution moneys due or to become due under government contracts, the Anti-Assignment Act and the Assignment of Claims Act will be implicated. An attempted assignment that is prohibited by a contract or a failure to satisfy a precondition to assignment in a contract could run afoul of these statutes. A common disappointment in acquisitions involving government contractors is the buyer's discovery that standard Uniform Commercial Code grants of security interests in government contracts are not permitted.
The Anti-Assignment Act is intended to ensure that the entity awarded a government contract will actually perform it with its own resources and provides: "No contract or order, or any interest therein, shall be transferred by the party to whom such contract or order is given to any other party, and any such transfer shall cause the annulment of the contract or order transferred, so far as the United States is concerned." The Assignment of Claims Act addresses claims (including claims for payment) under government contracts for work that has already been performed. The Assignment of Claims Act is intended to ensure that the government does not lose its right to receive setoff from, or to bring counterclaims against, the assignor - defenses often unavailable to the government as against the assignee.
Recognizing the importance of private financing to successful contract performance, however, the Assignment of Claims Act, as implemented by FAR Subpart 32.8, permits an assignment of moneys due or to become due under a contract if certain conditions are met:
(a) The contract specifies payments aggregating $1,000 or more.
(b) The assignment is made to a bank, trust company, or other financing institution, including any Federal lending agency.
(c) The contract does not prohibit the assignment ;
(d) Unless otherwise expressly permitted in the contract, the assignment -
(1) Covers all unpaid amounts payable under the contract;
(2) Is made to one party, except that any assignment may be made to one party as agent or trustee for two or more parties participating in the financing of the contract;
(3) Is not subject to further assignment.
(e) The assignee sends a written notice of assignment together with a true copy of the assignment instrument to the -
(1) Contracting officer or the agency head;
(2) Surety on any bond applicable to the contract; and
(3) Disbursing officer designated in the contract to make payment.
FAR 32.802 (emphasis added).
Some government contracts expressly prohibit assignment of claims, often through the inclusion of FAR 52.232-24, which provides: "The assignment of claims under the Assignment of Claims Actis prohibited for this contract." (Emphasis added). Other contracts require the government to consent to any assignment pursuant to the Assignment of Claims Act or FAR Subpart 32.8. This more permissive approach is typically accomplished by inclusion of FAR 52.232-23, which permits assignments of money due under the contract subject to the conditions outlined above. Beyond these two paradigms, however, many agencies have their own standard assignment provisions that they use in lieu of the FAR clauses, and individual contracts may contain unique provisions affecting assignment where the contracting agency determines it appropriate to do so.
Part IV of this article, which will appear in the September issue, will discuss negotiating and executing a purchase agreement.
Published August 1, 2011.
