Stormy weather ahead for government contractors.

Ten to 15 years ago, Congress and the federal government took every opportunity to entice the private sector into doing business with federal agencies by changing the rules for government contracting to more closely approach those for commercial contracts. Expansion of the "commercial item" concept as an exemption from the more onerous government contract regulations, "dual use technologies" and other "acquisition reform" initiatives were the order of the day.

Those efforts to make the government marketplace look more like the commercial environment are over. Contractors face a skeptical Congress, eager prosecutors and investigators and aggressive auditors who firmly believe that contractors overprice their goods and services sold to the federal government.

In a recent report, the Senate Armed Services Committee observed that "over the last five years, a series of audits of Department of Defense contracts ... have revealed case after case of inadequate acquisition planning, insufficient competition, overpriced contracts, inappropriate expenditures of funds, and lack of attention to contract management."

The Committee also endorsed the efforts of the U.S. Attorney for the Eastern District of Virginia, Paul J. McNulty, to establish a Procurement Fraud Working Group. McNulty has brought together more than 40 agencies to collaborate and exchange ideas "in developing new strategies to prevent and to promote early detection of procurement fraud."

One such idea is termed "embedding," wherein government fraud investigators work with government employees in the receipt, analysis and negotiation of contractor proposals. Now, contractors' proposals and negotiations with the government may be subject to simultaneous review by government fraud investigators.

Other government agencies are also pursuing aggressive theories of recovery against contractors. In the recently settled whistleblower case, United States ex rel. Woodlee v. Science Applications International Corp., the Air Force, through the Department of Justice, charged SAIC with fraud, charging that SAIC had not disclosed certain risk analyses that the company had done in setting its negotiation position for an environmental remediation contract.

The government based its fraud charge on the Truth in Negotiations Act, a statute requiring contractors to disclose certain "cost or pricing data" during price negotiations. What's striking about the SAIC case is that the definition of "cost or pricing data" in the regulations makes it clear that a contractor need only disclose facts--not judgments such as risk analyses.

The government's aggressive theories to reduce contractor cost recovery also extend to traditional cost accounting requirements under government contracts. For example, the government is moving to cut off contractor recovery of independent research and development (IR & D) costs. The government's position is that a contractor's IR & D costs can no longer be charged as an overhead or indirect cost item, and must be charged as a direct cost, once the contractor obtains a contract that either explicitly or implicitly requires that IR & D effort. This position is an extraordinary reversal of government policy established over the past several decades, and a rejection of the practice of "parallel IR & D" on which the government has relied during that same period.

In Alliant Techsystems Inc. v. United States, the government disallowed Alliant's recovery of IR & D costs allocated indirectly to all of its contracts, including government contracts, contending that the IR & D costs were the direct costs of a commercial contract for delivery of improved rocket motors. The government has taken this position even though the commercial contract required and funded only the manufacture and delivery of the motors, not the IR & D effort necessary to make the improvements in design and development.

Previously, the government has benefited from contractor IR & D effort, the cost of which contractors allocated to their entire business base, including commercial contracts, to produce improved weapons systems and other products. The government relied on contractor IR & D so that it did not bear the entire burden of funding those improved products for the government market.

Now the shoe is on the other foot, and the government seeks to avoid the rule it insisted should be applied to others. In Alliant, the government goes so far as to maintain that certain tangible capital assets must be expensed in the period incurred rather than capitalized and depreciated, as required by the government's own cost accounting regulations.

The bottom line for any company doing business with the federal government is to understand that the acquisition reform efforts of a decade ago are on the wane; the government is now increasing its prosecution and scrutiny of contractors. Contractors must redouble their efforts to meet aggressive government audits, investigations and challenges to recovery of legitimate costs of doing business.

Robert E. Lewis Jr. ([e-mail]) is Manager of Government Affairs in FEI's Washington, D.C., office. He wishes to acknowledge the contributions to this article of Stephen D. Knight, a partner with Smith Pachter McWhorter & Allen and a long-time government contracts attorney.

by Robert E. Lewis Jr.