DOD Issues Final Rule on Contractor Business Systems

David M. Nadler and Justin A. Chiarodo

On February 24, 2012, the Department of Defense (DOD) published a final rule amending the Defense Federal Acquisition Regulation Supplement regarding contractor business systems [77 Fed. Reg. 11355]. With only minor changes from the interim rule (effective as of May 18, 2011), the final rule provides for oversight of a contractor’s business systems and empowers the government to withhold payments on contracts when a Contracting Officer determines that a contractor’s system contains “significant deficiencies.”

Consistent with the interim rule, the final rule applies to all contracts governed by the Cost Accounting Standards (CAS) and regulates six categories of “business systems”– Accounting Systems, Estimating Systems, Earned Value Management Systems, Purchasing Systems, Material Management and Accounting Systems, and Property Management Systems. The regulation is implemented by a contract clause that, where inserted, allows the government to withhold payments if one or more “significant deficiencies” are found in any of the above-mentioned business systems.

The final rule defines a “significant deficiency” as a “shortcoming in the system that materially affects the ability of officials of the DOD to rely upon information produced by the system that is needed for management purposes.” Once a significant deficiency is identified, the contractor must be promptly notified in writing and an evaluation process by the Contracting Officer begins. If the Contracting Officer concludes that significant deficiencies exist at the end of that evaluation process, a contractor faces payment withholdings until the Contracting Officer determines “that there are no remaining significant deficiencies.” The Contracting Officer may withhold five percent of payments where there is one or more deficiencies in a single business system and up to ten percent if deficiencies are spread across multiple business systems.

The final rule clarifies a few points from the interim rule. The final rule states that if the contractor provides evidence of corrective action that is “expected to correct” identified significant deficiencies, the Contracting Officer must stop payment withholdings. Also, the final rule more clearly states that the business systems contract clause only applies to contracts subject to the CAS (i.e., the clause does not apply if the CAS do not apply). The commentary to the final rule also confirms that the new requirements cannot be retroactively applied to contracts that do not contain the clause unless the parties execute a bilateral modification.

However, many of the key issues presented by the interim rule remain, despite a barrage of comments seeking clarification. Notably, the final rule fails to provide specific guidance on what constitutes a “significant deficiency” (the trigger for payment withholding) or to present a clear resolution process if a significant deficiency is found. What constitutes a “significant deficiency” continues to depend fully on the Contracting Officer’s discretion. In the final rule, the DOD failed to address comments asking for a more instructive definition of “significant deficiency.” Further, the final rule fails to address concerns that a Contracting Officer may lack the technical expertise necessary to evaluate the suitability of business systems, and that the Defense Contract Audit Agency lacks the resources to adequately address the requirements of the rule.

In sum, the final Business Systems Rule continues to present a wide range of new compliance requirements and implications for covered contractors such as payment withholding (including progress and performance-based payments), determination of eligibility for future covered contracts, and a protracted dispute resolution process.