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Special termination cost clause: the ultimate tool; the STCC is a key weapon that program managers should include to develop effective defense systems.

A famous politician, Theodore Roosevelt, once said that it was eminently sensible to "speak softly, but carry a big stick." In the case of major weapon systems acquisition, it is also sensible to carry a big STCC, but for other less obvious reasons.

What exactly is a special termination cost clause (STCC), and how does it fit in with tools available to program managers in their quest for development and production of an operational weapon system? The ability of the program manager to convince the air force leadership (as well as several influential congressional staffers) on the wisdom of approving the use of the STCC may ultimately affect the program's eventual success (or failure).

The Defense Federal Acquisition Regulation Supplement (DFARS) defines the rules for using the STOC as follows:

(a) The clause at 252.249-7000, Special Termination Costs, may be used in an incrementally funded contract when its use is approved by the agency head.

(b) The clause is authorized when

(1) The contract term is two years or more;

(2) The contract is estimated to require

(i) Total RDT&E financing in excess of $25 million; or

(ii) Total production investment in excess of $100 million;

(3) Adequate funds are available to cover the contingent reserve liability for special termination costs.

(c) The contractor and the contracting officer must agree upon an amount that represents their best estimate of the total special termination costs to which the contractor would be entitled in the event of termination of the contract. Insert this amount in paragraph (c) of the clause.

(d) (1) Consider substituting an alternate paragraph (c) for paragraph

(c) of the basic clause when

(i) The contract covers an unusually long performance period; or

(ii) The contractor's cost risk associated with contingent special termination costs is expected to fluctuate extensively over the period of the contract.

(2) The alternate paragraph (c) should provide for periodic negotiation and adjustment of the amount reserved for special termination costs. Occasions for periodic adjustment may include:

(i) The government's incremental assignment of funds to the contract;

(ii) The time when certain performance milestones are accomplished by the contractor; or

(iii) Other specific time periods agreed upon by the contracting officer and the contractor.

What does all of that mean? Basically, the agency guarantees to find required funds, in the event that a specific contract is terminated. The clause frees the program from funding the contingent liability associated with termination costs that must be paid in the event that the contract is terminated. In order to appreciate the effect of such a provision, you must first understand two things.

First, in every incrementally funded contract, there is a requirement to identify funds to cover the contingent liability for termination. This is to ensure that the funds are available to cover the costs associated with the termination of the contract. Some organizations obligate the funds on the contract; some merely commit the funds within their financial management office. This means that a funds-certifying official effectively guarantees that funds are set aside for this purpose and may not be used to pay costs for work being performed on the contract. As with any contingent liability, the funds are only required in the event that a specific circumstance transpires--in this case the termination of the contract.

Second, in the event that this provision is approved for use by the agency head, the agency is effectively guaranteeing that they will find the necessary funds to cover termination, in the unlikely event that the contract is terminated. Why is the event unlikely? Because the agency head is required to get data from the organization administering the contract that demonstrates why the contract is not likely to be terminated.

The clause itself is written as follows:

SPECIAL TERMINATION COSTS (DEC 1991)

(a) Definition. "Special termination costs," as used in this clause, means only costs in the following categories as defined in Part 31 of the FAR:

(1) Severance pay, as provided in FAR 31.205-6(g);

(2) Reasonable costs continuing after termination, as provided in FAR 31.205-42(b);

(3) Settlement of expenses, as provided in FAR 31.205-42(g);

(4) Costs of return of field service personnel from sites, as provided in FAR 31.205-35 and FAR 31.20546(c); and

(5)Costs in paragraphs (a)(1), (2), (3), and (4) of this clause to which subcontractors may be entitled in the event of termination.

(b) Notwithstanding the Limitation of Cost/Limitation of Funds clause of this contract, the Contractor shall not include in its estimate of costs incurred or to be incurred, any amount for special termination costs to which the Contractor may be entitled in the event this contract is terminated for the convenience of the Government.

(c) The Contractor agrees to perform this contract in such a manner that the Contractor's claim for special termination costs will not exceed $_____. The Government shall have no obligation to pay the Contractor any amount for the special termination costs in excess of this amount.

(d) In the event of termination for the convenience of the Government, this clause shall not be construed as affecting the allowability of special termination costs in any manner other than limiting the maximum amount of the costs payable by the Government.

(e) This clause shall remain in full force and effect until this contract is fully funded. (End of clause) (2)

This provision effectively frees the program office from setting aside (or obligating) funds to cover those termination costs identified in the clause. In some cases, this may amount to millions of dollars. These millions of dollars may then be used in the performance of the contract (or rescinded by Congress).

Role of Congress and Other Issues

What does Congress have to do with this matter, since it is an agency head's decision to take the risk that funds will be available to cover termination costs in the event of a termination?

The reality is that congressional staffers have a vested interest in program funding. Any consequential savings will be seen by Congress as a potential reduction in the budget, or as a source of funding for its members' pet projects.

The agency head is required to provide notification to Congress of his/her intent to authorize the use of a STCC. Congress then has 45 days in which to notify the head that they agree/disagree with this determination. This is necessary, so Congress can be involved in the decision regarding the use of the clause. While their approval is not required, they have leverage to make an agency head's life rather unpleasant. Consequently, no agency head would risk displeasing a congressional committee (or their professional staff).

An ancillary issue that is related to the STCC concerns the need to fund effort that will not be accomplished during the current fiscal year but will be a "must-pay" bill in one of the out (future) years. An example of this contingent liability would be the cost of shutting down a facility on a contractor's property at the end of contract performance. This requirement must be done--but it will not be accomplished until much later in contract performance. The work will still be required, however, in the event of a termination. The effort is not a termination liability per se, since termination liability normally covers work that is required only in the event of a termination, and is not required if there is no termination.

The problem is twofold. First, will the funds be made available in the future year that the effort will occur? Normally, this is not a concern, since incrementally funded contracts do not provide for future year effort. From the standpoint of the contractor, he has no guarantee that the funds will ever show up. The agency may say that they will attempt to fund the requirement, but the air force cannot guarantee that Congress will fund this need in the out years.

Second, in the event of a termination, if the money is not included in termination liability, will it be available to pay for the work that must take place? If it is not, is this a potential anti-deficiency act violation, since the liability exceeds the amount funded for this purpose on the contract? Congressional staffers may not recognize the commitment to complete this effort by providing funds required to complete the work. This puts the contractor in a position that the work must be done (as a non-cancelable task), but he must go to court to receive funds from the government. This is not a pleasant prospect, considering the "time-value of money."

The provision for STCC allows for modifying the clause as necessary. But there is some concern among government lawyers about the legality of such a modified "super" STCC. For example, those costs associated with the shutdown of a government facility on contractor property would not normally be considered as termination liability, since they represent a "must pay" bill that will come clue, even in the event that the contract is not terminated.

The STCC Scarcity

The STCC provision would seem to make sense for the vast majority of major weapon systems, inasmuch as most of these systems are not terminated and would therefore not require termination costs to be paid out from the contingent fund against which they are accounted. In any year, it is unlikely that more than one or two major program contracts will be terminated; however, hundreds of millions of dollars are set aside for the unlikely event that termination will occur on their contracts.

This seems like a veritable no-brainer. By issuing language in law, that programs are no longer required to budget for termination, these hundreds of millions of dollars should then be freed up for use in the performance of the contracts rather than sitting unused, providing no value other than insurance against a very unlikely occurrence.

Why then, are more STCCs not requested and approved? To some degree, it is because of the agency head's sensitivity to the potential of violating the Anti-Deficiency Act (ADA). This violation would occur, if there were not enough funds after a contract termination to cover that actual termination liability.

This is a potentially serious violation. Therefore, the heads of agencies may appear rather hesitant to authorize use of such a provision. There may also be some concerns about the legality of this provision, as it may represent a possible violation of the ADA--at the time of approval, no specific funds are identified for payment of the contingent liability associated with termination. The agency head makes a promise to "find" the requisite funding to cover the cost of termination identified in the STCC clause.

As a suggested solution to the concern of Congress that the funds are not budgeted in a given fiscal year, perhaps a "tax" against all major programs that would be used as an insurance pool" to cover programs that are eventually terminated. This would ameliorate those concerns that there would be inadequate funds available to cover terminated programs, but would allow all programs to not set aside termination liability funding. Thus, although the programs would be "taxed" on the likelihood of termination--for example, a shaky program would be taxed a greater amount than a stable one--all programs would be relieved of the need to set these costs aside.

STCC and Contingent Liabilities

What are the specific rules with regard to contingent liabilities? The "Financial Management Regulation" identifies contingent liabilities as follows:

5-14. Contingent Liabilities. A contingent liability is related to a transaction or event which, depending on a future event, may or may not result in an actual liability. ADA violations may occur if adequate funds are not committed to cover the Air Force's contingent liabilities under contracts. These liabilities include such items as amounts for fees, inflation adjustments, unpriced options, and cancellation ceilings. Amounts committed for contingent liabilities are over and above amounts may be recorded as valid obligations. It is the legal responsibility of the funded activity to ensure only valid obligations are recorded and that enough funds remain available to cover all probable increases in obligations?

Termination liability is a contingent liability in the following context:

At times it is difficult to determine what the precise amount of some liabilities will be at the time a contract is entered into. These uncertain, or contingent liabilities (CLs) include such things as the amounts required for fees, inflation adjustments, price adjustment provisions, and cancellation ceilings. Regardless of the difficulty, adequate funds must be committed to cover the Air Force's liabilities under contracts, including any potential or CLs. These amounts represent additional funds over and above the amount, which may be recorded as a valid obligation. The funded activity must ensure that only valid obligations are recorded and that enough funds remain available to cover all probable increases in obligations. (4)

The "Financial Management Regulation" further explains:

Contingent Liabilities (CLs)

* CLs are related to a transaction or event which may or may not occur in the future. The financial manager must commit funds to cover potential liabilities for these contingent events.

* CLs are categorized as probable, possible, or remote. Probable CLs must be covered by a commitment of funds. Probable CLs are most likely to become actual liabilities. Commitments are not required for possible CLs and should not be established for remote CLs.

* Funds are reserved for CLs through an Administrative Commitment Document (ACD), Purchase Request (PR), or Military Interdepartmental Purchase Request (MIPR).

* Commitments must be recorded against the same appropriation and fiscal year (FY) funds as the related effort as determined by the contract.

* CLs may be created for fixed price contracts, cost-reimbursable contracts, time and material contracts, cost overruns, award fee arrangements, and any unpriced options.

* CLs are created for the recurring (economic order quantity) portion of cancellation ceilings for multiyear contracts.

* CLs must be reviewed periodically, but not less than quarterly, to verify need and funding adequacy.

* All acquisition category Acquisition Category I&II (ACAT I & II) programs must report to Headquarters (HQ) Air Force Material Command/Directorate of Financial Management and Comptroller, Financial Analysis Division, Investment Funds Branch (AFMC/FMAI) semi-annually on their projections of CLs. These projections are submitted to the Deputy Assistant Secretary of the Air Force/(Budget) (SAF/FMB). (5)

Under that definition, termination liabilities may be any of the categories. For the most part, contracting officers tend to treat them as probable, to cover the possibility that there may be a need to terminate sometime in the future, and thus a need for available funds. The "Financial Management Regulation," Part 45-5 "CLs under Contracts," attempts to clarify the meaning of a contingent liability further.

(a) A CL is a potential liability involving uncertainty. A CL is related to a transaction or event which, depending on a future event, may or may not become an actual liability. The uncertainty as to whether there will be a legal liability differentiates a contingent from an actual liability. If the actual amount of the Air Force's liability is unknown when the contract is awarded, the funded activity should commit funds to cover the estimated contingent liability. This amount is in excess of that amount which may be recorded as an obligation.

(b) The financial manager must record commitments for CLs against the applicable fiscal year (FY) and appropriation cited on the contract. When recording commitments for CLs on contracts, amounts may be entered for each individual contract; several outstanding contracts under the same allotment, or a subdivision of funds may be grouped together and recorded as a single commitment item. The financial manager must maintain accurate records by contract to document the basis for and computations used to develop the contingent liability estimate. The financial manager should maintain the records so that they fully explain the situation to a potential auditor and future financial managers....

(e) Funds are committed for a contingent liability at the time of contract award, based on the amount provided by the contracting officer after consulting the financial manager and the program manager. The financial manager should have the contracting officer and program manager periodically (usually quarterly) review the contingent liability amounts to determine if they are still appropriate. The financial manager should make any necessary adjustments promptly.

(f) A discussion on how to estimate the contingent liability associated with various types of contracts follows: ...

(5) Commitments are not recorded for special termination cost clauses or contingent termination liabilities. Obligations are recorded when the action to terminate is taken." (6)

The Future of STCC

STCCs are excepted from the requirement to fund as contingent liabilities. Ironically, the STCC seems to be used fairly often on programs that are in trouble as a means of continuing work through the end of the fiscal year. Several high-risk programs have pursued STCC approval as a means of augmenting inadequate funding for a highly visible program. This would seem contradictory to its intended use--as a means of recognizing the unlikelihood that a program xviii terminate, in effect making the contingent liability remote, rather than probable or possible.

So, what should happen to the STCC? I would recommend that the requirement to commit/obligate funds for termination liability (except in rare cases, where a program is in trouble and a viable candidate for termination) be eliminated by Congress. Appropriated funds should be used for the purpose intended--that is, the work on contract. If necessary, to assuage congressional concerns, an insurance pool like that mentioned earlier in this article could be established to mitigate ADA concerns. This would allow program offices to manage funds more efficiently for other needs--such as developing critical weapon systems for the war fighter.

While it is true that most incrementally funded contracts are for research and development, the use of STCC on incrementally funded production contracts (such as the Air Force Titan Launch Program) would seem to be the most promising candidate for an STCC. No STCC, however, has been used on the Titan Program.

Endnotes

(1.) Defense Federal Acquisition Regulation Supplement, 249.501-70, Special Termination Costs.

(2.) Defense Federal Acquisition Regulation Supplement, 252.249-7000.

(3.) "Financial Management Regulation," Air Force Material Command Financial Management Handbook.

(4.) Ibid.

(5.) Ibid.

(6.) Ibid.

JAMES GILL is currently chief of contracts for the space-based radar program office at the Space and Missile Systems Center on Los Angeles Air Force Base. He was previously deputy chief of contracts for launch programs at SMC and has worked space and missile programs for the past 25 years. Send comments on this article to cm@ncmahq.org

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Author:Gill, James
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Geographic Code:1USA
Date:May 1, 2003
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