Interview transcript
Terry Gerton We’re going to talk about the National Defense Authorization Act. It’s in its final stages. It’s not a short read, 3100 pages. But there’s a lot of particular detail in there, especially around changes to cost and pricing rules. Start kind of at the headline level. What’s the big news that you want people to know?
Zach Prince Sure. So we’re still digesting this. So, you know, I wanna caveat that, you know, it is 3,100 pages and there’s a lot here, and it might not become final. But I think Congress has been listening while industry over the past many years has been saying that they’re reluctant to invest too heavily in defense when Congress makes programs subject to annual appropriations that might, for seemingly no apparent reason, go away after major investments have been made, when huge regulatory burdens can get imposed, like the cost accounting standards, which deviate substantially from generally accepted accounting principles or GAP, and things like certified cost of pricing data are required and just a slew of regulatory requirements that come with doing business with the government. These are real burdens to industry and real burdens to investors thinking about getting involved in the space. So listening to all of that, Congress took quite a bit of action in this NDAA.
Terry Gerton Let’s talk about some of those. You mentioned cost accounting standards. One of the biggest shifts is bumping that threshold from $50 million to $100 million. Who does that help? And what kind of burden does it remove?
Zach Prince So just as a bit of background, the cost accounting standards are accounting rules that apply to certain contractors, contractors that have contracts over size thresholds when otherwise exemptions don’t apply. They were imposed starting in the late ’60s, an effort spearheaded by the late Admiral Rickover and this I think mistaken belief that contractors were using accounting practices to get something over on the taxpayer. And so all these rules mostly came into effect in the ’70s and have stayed essentially the exact same since then, with some slight tweaks around the edges. But they deviate substantially from the accounting practices that most companies would otherwise have implemented. So they require really sweeping shifts in the way that you do a lot of your basic accounting as a company, and they apply on a contract by contract basis. So you might only have one or two contracts that are subject to CAS as opposed to your general gap rules. But because it’s very challenging to have two different sets of books and records, you might just have to implement these very annoying onerous rules across your entire organization, at least across your segment. I don’t want to go too far into the weeds. There’s a lot of complication here. It’s a burden and It doesn’t apply to small businesses, but it does apply to quite a lot of companies that would have large government contracts. And companies don’t want to trigger the threshold that gets them into CAS-covered contract performance because of the burden.
Terry Gerton And so by raising it to a $100 million, more folks will not have to worry about that conversion, right?
Zach Prince Yeah, that’s right. But the — I’d say the bigger item here that’s kind of buried, and if you look at the congressional report that they issued from the conference, it kind of ignores this, even though I think it’s a much bigger deal. It raises the exemption floor. So there are two different types of CAS coverage. There’s modified CAS coverage and there’s full CAS coverage. The full is the much more onerous one, but a contract is entirely exempt from CAS, full and modified if it’s below certain dollar threshold. So the $100 million, formerly $50 million, that’s for full CAS. But a contract is totally exempt from CAS no matter what under the previous rules, if it was below $2 million or $2.5 Million, with the threshold changed. Now they’re raising that to $35 million. So huge, huge difference. And it makes a difference not just for modified CAS, but also for full CAS, because full CAS coverage is triggered by either a single contract of $100 million or greater, or net $100 million in the prior cost accounting period. So if you had $200 million in contracts in the prior year, none of which exceeded $35 million under this new regime, you still are not going to have a contract subject to full CAS. So I don’t know what the numbers exactly are in terms of impacted contractors, but I have to imagine that this is gonna exempt. A whole slew of contracts that previously would have been subject to CAS.
Terry Gerton I’m speaking with Zach Prince. He’s a partner at Haynes Boone. So some people may be wiping their brow and thinking they’re gonna get a reprieve here. But Congress has asked for a report on how many of these changes are gonna play out. What would success look like? What do you think they’re hoping the impact of some of these changes will be?
Zach Prince So I think that they’re hoping this is going to spur greater investment, particularly by successful commercial technology companies and by successful investors in the defense space and particularly cutting edge defense tech. If you look at the multi-year appropriation provisions that are part of this NDAA, I mean they touch on some of the really interesting and important areas for advancement, like material composition issues, hypersonics, things along those lines, autonomous programs of various sorts, that we really are concerned that we could lose an edge to competitors overseas and that there needs to be substantial private sector money to go into because there needs to be huge scientific breakthroughs and that stuff’s costly.
Terry Gerton Tell us a little bit more about the multi year provision because you mentioned up front that companies are reluctant to invest if they’re gonna be on an annual appropriation cycle.
Zach Prince Yeah, and we’ll see how some of this plays out. But I think we all are familiar with major defense programs over the years that have been abruptly cut back for various reasons. But if you look at the Zumwalt class destroyer, for example, where there was a huge buy that was initially authorized and that was then cut back, which of course means that suddenly the R and D costs that were distributed over, say 20 ships, are now bunched into three or four. And now the program looks like it costs way more than initially was planned on a ship by ship basis, which technically is true, but is not really true overall and it results in scrutiny and program cancelation. So yeah, I think from my experience talking to folks in the private sector, they hear about programs like that where there’ve been huge investments that things are then abruptly cut, and they don’t want to get involved in the ecosystem that has those problems. And they know that, especially recently, when we’ve got CR after CR, you can’t rely on Congress necessarily to provide funding in a timely fashion, even for pretty important programs.
Terry Gerton There’s another newsy bit in here. You and I talk quite a bit about contract protests. There’s a provision that allows DoD to withhold payments during protests. Spin that out for us a bit.
Zach Prince Yeah, this is one that I’ve been watching pretty closely for a while, and we’ll see how it plays out, but there’s been a concern I continue to maintain that this concern is not supported by the data, but concern that incumbent contractors will protest at GAO, which has a mandatory stay that kicks in, in order to take advantage of a bridge contract that might be issued. Then the government says, Okay, well, you’ve lost the contract, but you’re still doing the work, we need the work to continue. We can’t go ahead and override the stay without some scrutiny. So we’ll just give you a 100-day bridge contract while this plays out. You’ll get whatever revenues you’re gonna get from that period, and continue. You know, I do think that this is a non-issue. it ignores the fact that protests are very expensive. The revenues you might get over a 100-day period are really not particularly significant in the grand scheme of things, especially when you’re irritating your customer. The data don’t show that this is abused very much, other than the idea that incumbents do protest more, but they also win more, which suggests that they’re in a better position to know when their problems in a procurement. But set all that aside, DOD in prior years has said, Well, Congress, we can’t require disgorgement of profits for these bridge contracts, which is what Congress had considered before as something that might remedy the situation because we don’t track the data. How do you calculate what a profit is for this period of time? So in response, Congress has come back and said, okay, so we’re just going to authorize contracting officers to withhold payments, period, under these bridge contracts up to 5 percent of total amounts that would be owed, and that those amounts up to that 5 percent threshold, which I think they established because it’s a rough order of magnitude of what profits might be, that could be deemed forfeit if there’s a decision ultimately that the protest lacked any legal or factual basis. So there are a lot of terms here that are gonna need careful definition and a lot of uncertainty of who’s implementing this, how you’ll challenge it, where you’ll challenge it. I mean, I think that this is a can of worms to address a problem that’s not real, but nonetheless, this is this is what Congress ended up doing.
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