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DoD Watchdog Urges DCMA to Assess Penalties on Contractors That Claimed Expressly Unallowable Indirect Costs

On January 14, 2020, the Department of Defense (“DoD”) Office of the Inspector General (“DoDIG”) publicly released a report criticizing contracting officers at the Defense Contract Management Agency (“DCMA”) for not assessing penalties recommended by the Defense Contract Audit Agency (“DCAA”) against contractors that had claimed unallowable indirect costs. The DoDIG found that DCMA contracting officers did not comply with the Federal Acquisition Regulation (“FAR”) and DoD policies; that they should have assessed penalties on $43 million in costs; and that they failed to assess the correct amount of penalties or interest on additional amounts. As a result, the DoDIG recommended that the DCMA contracting officers reassess their decisions to not penalize contractors that claimed expressly unallowable indirect costs.

Settling final indirect cost rates is a cumbersome annual process for many DoD contractors with flexibly priced contracts. Within six months following the close of the fiscal year, a DoD contractor must submit to the Government a final indirect cost rate proposal setting forth the contractor’s actual incurred indirect costs, including administrative employee salaries, leases, legal costs, and marketing costs. FAR 52.216-7(d)(2)(i). The contractor must certify that “[a]ll costs … are allowable in accordance with the cost principles of the [FAR] and its supplements applicable to the contracts to which the final indirect cost rates will apply,” and that it has not included “any costs which are expressly unallowable under applicable cost principles of the FAR or its supplements.” FAR 52.242-4(c). DoD policy outlines specific procedural requirements for DCAA’s and contracting officers’ roles in the audit and negotiation of a contractor’s indirect cost rate proposal. DoD Instruction 7640.02 at 7-10.

If DCAA finds a contractor has claimed costs that are “expressly unallowable” under FAR Part 31, DCAA may recommend that the contracting officer assess penalties and interest against the contractor. FAR 42.709-3. The penalties are normally equal to the amount of the expressly unallowable costs allocated to the contracts. FAR 42.709-1(a). Contracting officers are vested with the final authority whether or not to assess penalties, and are free to disagree with DCAA, so long as they document their reasons for not following a DCAA recommendation in a negotiation memorandum. FAR 42.705-1(b)(5)(iii)(C); DoD Instruction 7640.02 at 9. In addition, contractor officers have discretion to waive penalties in certain circumstances. FAR 42.709-5.

The Inspector General investigated DCMA contracting officers’ decisions to waive or disagree with penalties by reviewing contracting officer actions on 28 DCAA audit reports that recommended assessing penalties against contractors that claimed expressly unallowable costs. Altogether, the 28 audit reports represented $154 million in costs that DCAA identified as expressly unallowable, with common unallowable costs being labor, consulting, travel or per diem, legal, advertising or membership dues, entertainment, and merger and acquisition costs.

The Inspector General concluded that, in 18 of the 28 audits reviewed, DCMA contracting officers failed to comply with federal regulations and DoD policy by not adequately explaining why they either waived or disagreed with the DCAA-recommended penalties. These failures involved a total of $43 million of expressly unallowable costs.  Therefore, while also recommending management changes to improve contracting officers’ performance, DoDIG recommended that DCMA review the contracting officers’ decisions not to assess penalties on the $43 million in expressly unallowable costs, and directed DCMA to “explore available remedies for recouping the expressly unallowable costs, and obtain payment from the contractor for any penalties due to the government.” The Inspector General also found that on the other $111 million in costs for which DCMA contracting officers had adequately documented the rationale for their actions, contracting officers had failed to properly calculate penalties and interest in some instances. DoDIG thus recommended that DCMA reassess penalty and interest calculations and again “explore available remedies for recovering any amounts due to the Government.” DCMA has concurred with these recommendations.

What This Means For You

The FAR and DFARS establish that contracting officers have the final say on whether or not to assess penalties and make clear that DCAA recommendations are not binding. Reports such as this, however, remind contracting officers that their decisions can be reviewed and criticized by other stakeholders, such as Inspectors General, the Government Accountability Office, and Congress. Although contracting officers may react by better documenting their reasons for disagreeing with a DCAA recommendation, other contracting officers may unfortunately conclude that the benefit of making the right decision in the first instance is not worth the risk of criticism in a published Inspector General report such as this. That may have a chilling effect on contractors’ ability to challenge DCAA recommendations in their settlement of final indirect rates or seek more information on potentially expressly unallowable costs during negotiations in order to document their disagreement, and contractors should be prepared to have such information available to ensure that allowable costs are not unfairly determined to be unallowable.

In addition, those DoD contractors whose 2018 indirect cost audits were included in the DoDIG evaluation should be prepared to answer questions about their costs, as DCMA has agreed to review these audits and attempt to recoup penalties and interest owed to the Government. The DoDIG report lists the DCAA audit numbers for the audits it evaluated in Appendix B. It is also possible that DCMA will expand its review to other audits in other years if it is successful on early attempts to recoup costs per the Inspector General’s recommendations.

More broadly, the DoDIG report represents another development in the area of expressly unallowable costs. As we have previously discussed, the Federal Circuit has weighed in on what qualifies as an expressly unallowable cost, finding that a cost does not need to be expressly listed in the regulations to be considered “expressly unallowable.” Between the Federal Circuit adopting a broader definition of “expressly unallowable” and DCMA agreeing to scrutinize contracting officer decisions to not assess penalties for expressly unallowable costs, contractors may see a changing landscape on how contracting agencies handle indirect cost proposals and their audits.

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This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.