July 14, 2011

New DFARS Clause on Business Systems Authorizes Government to Withhold Payments

Gregory R. Hallmark

On May 18, 2011, the Department of Defense issued an interim rule that authorizes contracting officers to temporarily withhold payments from contractors whose business systems it deems inadequate. 76 Fed. Reg. 28,856. The rule applies to all contracts covered by the Cost Accounting Standards ("CAS"); small businesses are therefore exempt.

Though the interim rule is still open for comment until July 18, 2011, it is effective immediately—the rule applies to solicitations issued on or after May 18, 2011 and contracts issued on or after August 16, 2011, and contracting officers are encouraged to incorporate it into any other contracts to be awarded on or after May 18, 2011.

As stated by the DoD, "[r]eliable contractor business systems employ internal controls to prevent unallowable and unreasonable costs, as well as waste, fraud and abuse." 76 Fed. Reg. 28,864. Weak business systems increase the risk to the government of "overpayment, increased property losses, or nonconforming goods, among others." Id. at 28,861. The interim rule creates a mechanism for the government to mitigate its risk from a contractor's inadequate business systems: the temporary withholding of up to ten percent of payments due to contractors whose business systems have "significant deficiencies." DoD emphasized in responses to commenters that a withholding is not intended as punishment, but rather "a good-faith estimate of the potential loss that is at risk where the actual amounts are difficult to estimate or quantify." Id.

The rule defines six categories of "contractor business systems": accounting systems, estimating systems, purchasing systems, earned value management systems, material management and accounting systems, and property management systems. For each system, the rule revises an existing clause or creates a new clause that defines the requirements of an acceptable system and provides that a contractor's failure to establish and maintain an acceptable system may result in the contracting officer's disapproval of the system and withholding of funds in accordance with the new DFARS clause at 252.242-7005, Contractor Business Systems.

Notably, while the withholding clause only applies to CAS-covered contracts, each of the individual business system clauses defines its application in different terms. For example, the clause at 252.242-7006, Accounting System Administration, is to be included in all cost-reimbursement, incentive type, time-and-materials, and labor-hour contracts, as well as fixed-price contracts with progress payments made on the basis of costs incurred by the contractor or on a percentage or stage of completion. However, not all such contracts will be covered by CAS, and those that are not subject to CAS will not be subject to the withholding clause.

Under the new withholding clause at DFARS 252.242-7005, a contractor will face withholdings if the contracting officer determines that one or more of the contractor's business systems has a "significant deficiency." A "significant deficiency" is defined in the new clause as "a shortcoming in the system that materially affects the ability of officials of the Department of Defense to rely upon information produced by the system that is needed for management purposes." DoD added the materiality requirement since issuing the proposed rule, likely in response to industry concern that insubstantial deficiencies should not warrant withholdings.

The contracting officer will withhold five percent from invoices or other amounts due for each system that has a significant deficiency (not for each deficiency), but may withhold no more than ten percent of amounts due on all covered contracts. (This cap is reduced from a twenty percent cap in the last proposed rule.) It is in the contracting officer's discretion to identify the contract, or multiple contracts, from which amounts will be withheld. The contracting officer will release withheld amounts and cease withholding payments only after the contractor has shown that it has corrected the deficiencies.


In practice, the process of withholding payments under the business systems rule will likely begin when, in the course of an audit, DCAA discovers a deficiency in a contractor's business systems. Notably, DCAA has instructed its auditors to report deficiencies identified in the course of any type of audit—not just internal control audits. Technically speaking, though, only the contracting officer has the authority to determine that a contractor's business systems have any significant deficiencies. If the contracting officer identifies a significant deficiency, he or she must provide the initial determination to the contractor in writing, using sufficient detail to allow the contractor to understand the deficiency. The contractor has 30 days to respond in writing, including its rationale for any disagreements. Upon review of the contractor's response, the contracting officer makes a final determination as to whether any significant deficiencies remain.

If the contracting officer makes a final determination that significant deficiencies remain, the contractor has 45 days to either correct deficiencies or submit an acceptable corrective action plan. If the contractor submits an acceptable corrective action plan for a system within 45 days, the contracting officer will reduce the withholding for that system to two percent.

Once a contractor receives a final determination of substantial deficiencies, it could take months to get the government to discontinue withholding payments. The process to put an end to withholdings begins when the contractor notifies the contracting officer in writing that it has corrected the deficiency. The contracting officer will then request that an auditor (or other specialist) verify that deficiencies have been corrected. The contracting officer may cease withholding payments pending the auditor's or specialist's verification if the contractor submits evidence of correction and the contracting officer (in consultation with the auditor or specialist) determines that there is a reasonable expectation that corrective actions have been implemented.

The rule provides a measure of relief for contractors in the event of government delay: if the contracting officer fails to make a determination within 90 days of receipt of the contractor's notice, the withholding is reduced by at least fifty percent. But the rule does not set any automatic end to withholdings, so the contractor could remain subject to the reduced withholdings indefinitely.

If, after receiving the auditor's (or other specialist's) recommendation on verification, the contracting officer finds that significant deficiencies still exist, the withholding will continue. If the contracting officer finds that the contractor has corrected all deficiencies, the contracting officer will discontinue the withholding of payments and authorize the contractor to bill for the amounts previously withheld.

Recommendations for Contractors

The stakes will be higher than ever the next time DCAA comes knocking on the door, especially for contractors who depend on a steady cash flow. Contractors should familiarize themselves with the requirements of each business system and would be wise to promptly review their internal controls for compliance with the new rule. Identifying and resolving inadequacies in advance can save contractors the cost and difficulty of battling an adverse finding by DCAA. Once DCAA identifies any significant deficiencies, it may be an uphill climb to prevent a final determination and the withholding of funds.

However, if the government makes an initial determination of a significant deficiency, contractors should not take lightly the opportunity to respond. This is the contractor's last chance, prior to final determination, to persuade the government that its business systems are not significantly deficient. A final determination could result in a long wait for DCAA to perform a follow-up audit, during which the contractor will be forced to live with up to ten percent withholdings.

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