A-12 termination sets harmful precedent for defense programs. (Viewpoint).

After more than a decade of litigation, the Department of Defense continues to seek vindication for its inappropriate use of a fixed-price contract and its faulty management of the $5 billion A-12 stealth aircraft research and development (R&D) project.

In 1991, the Pentagon terminated for default its contract with General Dynamics Corp. and McDonnell Douglas Corp. The resulting trials, whereby the companies sued the government for improperly terminating the contract for default have produced fear and distrust throughout the defense industry and have reduced confidence in defense contracting policies.

The government's insistence on its right to terminate the A-12 project for default is inappropriate, for several reasons. Certainly, the Defense Department always has the right to terminate a contract for its own convenience and at its own cost. Yet, in this case, the government terminated for default after the Navy had directed its contractors to implement newly approved design agreements, at a cost to the contractors of several hundred million dollars. The combination of these actions is not consistent with reasonable acquisition policy.

Nor is it consistent with defense-acquisition policy to terminate contractors for default for performance shortfalls that the Navy considered of minor importance. Defense-acquisition policy has a congressional mandate to be fair and equitable. Indeed, if the government were permitted to revoke its agreements by terminating contracts and shifting all of the cost burden to the contractors, few industrial firms would agree to undertake large research and development projects for this customer--especially one conducted with a fixed-price contract. Such a practice would therefore only impede the government's essential effort to develop state-of-the-art weapons systems and equipment.

The A-12 default finding currently is under appeal. If allowed to stand, it would create a severely unfair precedent for defense contractors, Nearly all contractors with fixed-price R&D contracts would be in jeopardy of default termination and the associated substantial penalties. Neither the government nor industry contemplated that the standard fixed price R&D default clause would expose contractors to such extreme risks.

Program History

This case has involved two trials. In the mid-1990s, the first trial concluded with the judge's decision that the government inappropriately terminated the A-12 contract for default. The government then appealed the decision. In 1999, the appeals court returned the case to the trial court for another hearing--but without overturning the original court's factual findings adverse to the government's case. Navy testimony by Adm. Jerome Johnson, vice chief of naval operations, and others during the second trial in 2001 revealed that the A-12 aircraft, as designed by the contractors, had satisfied the Navy's operational requirements. Indeed, the government contracting officer, along with the Navy acquisition and operations professionals, had planned to continue the A-12 project. But the office of the secretary of defense unexpectedly withdrew funding from the project on January 6, 1991--one day before the funds were required to be added on the contract.

In the second trial, the court reversed itself and ruled against the contractors, citing schedule slippage of an interim first-flight milestone. Yet, the court ignored the Navy's acceptance of that same minor delay. No court has found that the contractors were not going to achieve the Navy's ultimate objectives. Senior Navy civilians and military officers continued to support the A-12 R&D project until the day the Pentagon removed the funding, thereby terminating the project. Still, the second trial court's decision, if allowed to stand, could force the contractors to repay the government more than $2 billion of costs incurred on the A-12 project.

Nature of Defense R&D

Some background on the nature of large defense R&D projects may shed light on the fate of the A-12. Such R&D projects require contractor and government personnel to work together under conditions of significant uncertainty. Their goal is to generate comprehensive designs, test them, identify problems, revise designs, retest them, build prototypes, test again and create yet additional designs to ensure that the final products meet the government's requirements. Not surprisingly, these projects consume enormous resources and several years to complete. Management of these projects entails iterative trial and error, rather than a linear process of development.

A newcomer to defense contracting might assume, mistakenly, that a large R&D project has unchanging schedules and technical specifications from the outset. Indeed, to many people unfamiliar with these undertakings, the term project implies firmly defined work packages and a detailed description of the project's final content.

Typically, a large, complex project will experience schedule slippages of many months, as well as technical changes and cost growth as work progresses.

The uncertainties inherent in these projects stem from a variety of factors: the hundreds or thousands of design details required; the incorporation of new technologies, processes and materials, and the use of specialized equipment brought together to produce first-of-a-kind products. As such, neither the military sponsor nor its contractors can anticipate with absolute certainty the time or costs a project will require. Nor, for that matter, can they know for certain whether it is even possible to achieve all the goals of a project. Thus the detailed specification of work on these projects evolves as the project content changes. In the case of the A-12, the Navy project office and the Navy contracting officer knew from the start that uncertainties existed. They also were aware that if and when the project encountered serious difficulties in the work to he performed, then the specifications and/or schedule would need to change, or the Navy would need to allocate additional funds for the work.

The Navy intended the A-12 R&D project to design and develop eight new carrier-based aircraft with stealth characteristics, requiring a dramatic advance in the structure and manufacture of the aircraft. Each of the eight test aircraft would undergo extensive testing and evaluation. The schedule also stipulated "first flight" as one of several interim milestones. Indeed, neither the Navy nor the office of the secretary of defense expected initial operating capability of the aircraft for many years after the first-flight milestone.

The General Accounting Office has found that according to "cost and schedule data from 93 major acquisitions started since 1975, the acquisitions overran original schedule estimates by an average of 24 percent." Defense Department studies have concluded that "weapon system development projects typically overrun costs by 20 to 40 percent," said GAO.

Below are just a few examples of such overruns, cited by GAO.

* The F-117A, the B-2 and other projects all "suffered from cost growth, schedule slippage, and performance shortfalls," as did the B1-B and C-17 aircraft programs.

* The F-22 "test aircraft took longer to manufacture and assemble than planned because of design changes and modifications to the aircraft, parts shortages, and the need to complete certain assembly tasks out of sequence.

* In the C-17 program, all seven aircraft covered by the development contract "either ha[d] been or [would] be delivered three to six months behind schedule."

There are two primary types of defense contracts: cost reimbursement and fixed price. Since the 1970s, defense acquisition policy traditionally has favored cost-reimbursement contracts on large R&D projects, because the uncertainties usually preclude the adoption of fair and reasonable fixed prices. A fixed-price contract makes sense for government or industry only under two conditions: (1) The risks or uncertainties in the work to be performed can be reduced so that the contractors can reliably estimate schedule, cost, and technical performance, and (2) the military sponsor will be able to control the innovation tendencies of its scientists and engineers.

Because of the problems experienced with fixed-price R&D contracts, Congress in 1988 passed Section 8118 of the Defense Appropriations Act. The new law prohibited the use of R&D funds on fixed-price type contracts in excess of $10 million without a written determination by the undersecretary of defense that "program risk has been reduced to the extent that realistic pricing can occur, and that the contract type permits an equitable and sensible allocation of program risk between the contracting parties."

In November 1985, before initiation of the A-12 R&D contract, Navy Secretary John Lehman issued Instruction 4210, which established conditions to be met by the A-12 and all other Navy R&D projects before employment of any fixed-price contracts. These conditions required the military service sponsor to reduce uncertainties to the point where contractors could confidently establish schedules and costs and expect fair and reasonable returns. Federal Acquisition Regulations state that government contracting officers in these situations must ensure that contractors receive fair and equitable treatment.

Lehman also insisted that the Defense Department share technical information among projects using similar technology, to avoid costly duplication of efforts. Indeed, he maintained that the commanders of the Navy systems commands must certify that any proposed hardware of software development reflects the maximum practical commonality. Finally, Lehman directed the government to eliminate unnecessarily demanding technical specifications and requirements.

The A-12 project failed to meet Lehman's prerequisites with respect to risk reduction and removal of unnecessary specifications. Yet, the Navy proceeded to use a fixed-price contract despite the well-known problems associated with such agreements. Notwithstanding, the A-12 contractors produced a design that satisfied Navy requirements and that the Navy deemed acceptable. The contractors then proceeded to implement the A-12 design according to the agreements and the direction they received from the Navy sponsor.

Nonetheless, the A-12 ultimately suffered problems that had plagued previous fixed-price development projects. The cause of these problems seems to lie in the failure to meet some or all of Lehman's preconditions-risk reduction before full-scale development, information sharing from multiple defense projects and avoidance of overly ambitious specifications. Indeed, Lehman told the Washington Post (1/5/91) that the Pentagon should not have imposed fixed-price contracts on companies working on the development phase of projects, in which obstacles-and thus budgets-are impossible to predict.

Why did the Navy use a fixed-price type contract in the uncertain environment of this R&D project? Once or twice every decade, an appointed secretary or assistant secretary adopts the view that fixed-price contracts are appropriate for large R&D projects, shifting the cost risk to the contractors, in the hope of reducing the government's burden of directing and overseeing these large, complex projects.

That theory has not been successful on any of the 15 or 20 large Defense Department R&D projects initiated during the past 40 years. Examples of projects where fixed-price type contracts have failed include the C-5A, the Cheyenne helicopter, the Navy F-14, and the Air Force F-22 and F-111 projects. Still, despite evidence to the contrary, civilian appointees in the Pentagon frequently underestimate the uncertainties and risks involved. In the case of the A-12, their assumptions had dire consequences for the Navy and for the contractors.

Government Role

Throughout any large R&D project, the relationship between a contractor and its government customer is necessarily close. Owing to the iterative design, test, and fabrication efforts, large numbers of government personnel must work with contractors daily to solve complex technical and management problems; develop and refine designs; and implement tradeoffs among schedules, costs, and technical performance. Tradeoffs are inherent in any large R&D project in which contractors must evolve specifications, prototypes, hardware, and software that satisfy complex military requirements..

On the A-12, the government assigned between 50 and 100 technical specialists to work full-time at the two leading contractor plants. Serving as the eyes and ears of the government A-12 project office, these specialists participated in all aspects of the project. They also oversaw schedules, costs, and technical performance.

Several hundred additional government personnel-from the Navy project office, the Naval Air Systems Command, and various offices throughout Navy headquarters and the office of the secretary of defense-also visited the A-12 contractors throughout the year. By themselves, these government representative were integral parts of the decision-making process, representing thousands of person-days of reviews and interaction with A-12 contractor personnel at the two plants each year.

As an example of the tightly knit working relationships between government and contractor personnel, large defense R&D projects routinely require periodic, formal design reviews, in which the military customer determines the acceptability of the contractor's designs. These reviews serve as building blocks, requiring the government customer to pause and decide whether the current version of the design is sufficient to satisfy its needs, and to identify any changes that need to be made. At each building block, if the customer is satisfied, the contractor proceeds to the next stage of the project.

As the A-12 entered full-scale engineering development in the late 1980s, the Navy structured the contract to include a series of formal design reviews culminating in the Critica Design Review--the key decision point is the process. Navy and contractor technical specialists reviewed hundreds of designs making design tradeoffs and finally agreeing on a design to be developed, tested and produced.

Throughout 1990, the A-l2 R&D pro. gram encountered commonplace challenge and difficulties, which were intensified where stealth requirements caused A-12 engineer to experience composite-manufacturing problems similar to those encountered earlier by the Air Force on the B-2 stealth bomber program. Indeed, these problems were a primary reason why the A-12 contractors missed the scheduled date for first flight o the first test aircraft.

Missing an interim performance milestone. such as the scheduled date for first flight, has long been a commonplace occurrence on large R&D projects. Moreover, the Army, Navy, Au Force and Marine Corps typically accept these schedule slip-pages as commonplace. On the A-12, the Navy accepted the few months' slip. Page--in the context of the five-year project. The trial court appears not to have recognized that the creation of a stealth combat aircraft--the ultimate purpose of the A-12 contract--was not in jeopardy. Rather, the court focused inappropriately on the schedule of the missed interim milestone, even though the Navy itself did not consider this milestone date essential to the success of the project.

Though Navy representatives identified a number of technical concerns during the A-12 critical design review, they viewed none of them as insurmountable. In fact, during the ensuing months (July to November 1990), the Navy and the contractors discussed and resolved hundreds of technical issues to the Navy's satisfaction. Their successful resolution became one of the most important turning points in the development of the A-12. Indeed, the A-12 trial court reached this same conclusion, determining that the contractors technical performance was not a ground for a default termination.

As the A-12 design-review issues were resolved, the Navy directed the contractors to proceed with the agreements the parties had reached during the CDR. During mid-1990--months before the contract termination--the Navy directed the contractors to design the aircraft to a weight that was 7,930 pounds higher than the weight specified in the contract. By late 1990, the Navy had asked that the contractors plan for first flight in March 1992. Adm. Johnson, the vice chief of naval operations, confirmed that the Navy--recognizing the nature of the massive R&D undertaking and its technical complexity--would have accepted a first-flight date even as late as September 1992.

Following the CDR, the contractors proceeded to build the A-12 aircraft consistent with the Navy-approved design, spending more than $100 million per month for several months. During briefings less than a week before contract termination, the Navy reported that the contractors were developing "an excellent aircraft" and that "technical risks" were "decreasing and manageable."

Unexpected Change

In late 1990, the A-12 encountered an unexpected change. The end of the cold war and the reduction in sophistication of potential enemy air defenses resulted in defense budget cuts, or the "peace dividend." In response to the lower budgets, the Navy reduced the planned number of aircraft carriers. It also cut back sharply on the quantities of A-12 aircraft--from 850 to fewer than 400. These changes meant that the A-12 fixed costs would need to be absorbed by fewer than half the number of aircraft previously planned. The aircraft unit cost would soar, making the A-12 far less affordable than before. Yet, less than 10 percent of the higher unit cost was due to the increased cost of the R&D contract-the subject of the A-12 litigation.

On January 6, 1991, to the surprise of the Navy hierarchy, as well as the government contracting officer and the A-12 contractors, the Defense Department abruptly withdrew the A-12 funding--even though the Navy was satisfied with the contractors' schedule progress and even though the contracting officer believed that he could resolve any differences with the contractors.

Only three days earlier, the Navy chief engineer had reported that "technical challenges on the A-12 were typical for this type of development contract," and that "the contractors could resolve remaining technical challenges."

The termination of the A-12 was the governments right. But the Pentagon did not have the prerogative at that point to impose on the contractors the costs of the Navy R&D, given that the Navy (the executive agent for this project) did not believe that the contractors' performance justified termination of the contract.

At the end of the first week in January 1991, the Navy, in response to the unanticipated removal of the A-12 funding, terminated the contract for default. The government demanded that the contractors return more than a billion dollars in unliquidated progress payments for their work during 1990. Apparently, the reduction in threat and rising production costs--largely unrelated to the R&D contract itself--precipitated the decision to terminate.

The government's stated reason for the default termination was contractor failure to meet the original agreed-upon weight and schedule specifications that existed before the Navy's Critical Design Review. Yet at that point, the Navy had directed the contractors to implement the new design--including the increased weight and revised schedule.

The government's termination of the A-12 contract was highly unusual. Of the hundreds of major acquisition projects conducted by the Defense Department during the past 30 years, not one major R&D project--except for the A-12--has been terminated for default. While many programs have experienced significant schedule, cost, and technical-performance problems comparable to those encountered on the A-12, the Defense Department has either restructured the contracts or terminated them for its own convenience, and at its own cost.

EDITOR'S NOTE 

In August 2002, the Navy issued a demand letter seeking repayment from General Dynamics and Boeing of approximately $2.3 billion owed the government as a result of the termination for default of the A-12 aircraft development and production contract The letter also advised that if the companies failed to pay the amount owed, the government would initiate collection of the debt.

The Defense Department did not initiate any collection efforts between August and November.

On December 3, Undersecretary of Defense (Comptroller) Dov S. Zakheim instructed the Defense Finance and Accounting Office to begin offsetting against payments due on existing contracts with the companies.

On December 10, the U.S. Court of Federal Claims issued a stay of its August 2001 decision, ruling that the immediate collection action proposed by the government from Boeing and General Dynamics is not in the national interest and that the companies have raised "substantial issues" in the appeals process.

At issue is how the government terminated the A-12 military aircraft program in 1991 and whether Boeing and General Dynamics owe the government money as a result of the contract termination. The Court of Appeals for the Federal Circuit is scheduled to hear oral arguments in the case on January 9 with a decision expected later in the year.

J. Ronald Fox is professor of business administration emeritus at the Harvard Business School He is a former assistant secretary of the Army for procurement, contracting and logistics, has served as a consultant on defense acquisition to the Departments of Defense and justice. Most recently he served as consultant to the A-12 contractors while the case was in the trial court during the proceedings described in this article.