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Successful case management: advanced planning, good communication with clients, and a well-managed accounts payable system are key for government contractors seeking to maximize their company's cash flow.

Thomas Jefferson once said, "Never spend your money before you have it." These words constitute good advice for one's personal budget, but government prime contractors may not be able to live by the letter of this guidance. However, if armed with a strong knowledge of regulations, coupled with advance planning and communication with clients and vendors, contractors can have successful cash management practices that satisfy their companies, their vendors, and their clients.

Every year, many good companies file for bankruptcy protection. These companies may have substantial assets, talented employees, significant contract backlog, and many other positive attributes. Despite these attributes, bankruptcies can result from the lack of one asset--the cash required to run day-to-day operations; pay vendors, subcontractors, and employees; and manage other short-term liabilities.

Companies that do not manage their cash flow may find themselves in a downward spiral. Lack of cash to pay vendors on time can lead to a diminished pool of vendors who will want to work for credit terms. This may result in more demands of up-front cash and higher prices for the good and services bought. These increased cash demands compound the problem, and the cycle starts all over again. Without additional outside financing, this spiral often leads to bankruptcy court.

Managing Accounts Receivable

Good cash flow management starts with accounts receivable management. No matter how aggressively you negotiate payment terms with subcontractors, if your revenue does not come in when expected, the company will be in a poor cash flow situation.

There are a number of tips for accounts receivable management that are good for both contractor and client. First, understand the payment terms of the prime contract. A client may be paying 30 days after receipt of invoice by the paying office, after acceptance of goods, or after some other milestone. Further, know the realities of that client's payment process.

While nearly all government contracts contain the prompt payment clause prescribed at FAR 32.9, (1) each activity has its own speed. For example, Client A may review and approve invoices in 14 days, while Client B may take 60 days. The Prompt Payment Act requires the government to pay interest on late payments at a rate set by the U.S. Office of Management and Budget. The rate has dropped consistently in our recent economy, and is currently set at 4.25 percent per annum for the period of January 1 to June 30, 2003. (2) Contractors should know what to expect; while the interest payment is statutory and required, it may be of little help. A small payment on receivables that are 90 days late will not help satisfy unpaid vendors or employees today. (3)

Therefore, it is incumbent for contractors to work with their clients up front to ensure invoices will be processed as quickly as possible. Follow the terms of the contract and the requirements of FAR 52.232-25; if invoicing is based on delivery, attach extrinsic evidence of the government acceptance. If the invoice is based on percentage of completion, ensure that both parties are in agreement about what that percentage is. Even a 1 percent disagreement will result in delayed payment.

When submitting a cost reimbursable invoice, have every backup document clearly marked, coded, and attached to the invoice, including all timecards, expense reports, subcontractor's invoices, materials reports, and so forth. Regardless of whether the contract is fixed price or cost reimbursable, contractors are advised to share the invoice format with clients prior to submitting the first invoice.

Certain formats and information can make the client's approval process smoother. It is better to learn of those formats during the kick-off meetings rather than 30 days after payment is due because the client is still trying to analyze the invoice. Many problems can be avoided (or client preferences learned) by having a quick pre-invoice meeting.

In such meetings, contractors also may learn other things that can help cash flow. For example, some clients will allow for bi-weekly or weekly billing versus the customary 30-day cycles.

Major contractors also should request a billing system review from the Defense Contract Audit Agency (DCAA). Contractors with approved billing systems are not usually required to send copies of invoices for cost-type contracts to the DCAA for review. A DCAA-approved billing system will save administrative time, and eliminate any potential delays that could occur from having a secondary review process on a single invoice.

Finally, strive to work on the basis of electronic invoices and electronic payments. Many government clients are amenable to receiving electronic invoices; some currently mandate it. A recently issued interim rule makes electronic payment requests mandatory for DOD contracts, with limited exceptions.4 Sending and receiving payments electronically eliminates transit time. When payment cycles are defined in terms of 30 days, eliminating a few days of "in the mail" time will help significantly. Even if you usually submit invoices through overnight delivery, sending them by e-mail and receiving electronic payments instantly eliminates two days of delay. This alone could accelerate your cash flow by 7 percent.

Managing Contract Risk and Vendor Expectations

Ensuring timely incoming receivables is only half the battle--contractors also must ensure that subcontractors continue to get paid on time and that their expectations for payment are in line with the contractor's strategic plans for cash flow management.

Working with subcontractors to help get paid on time is important in all contracts and critical in the realm of cost-type contracts. The contractor's invoices must be satisfactorily detailed to provide the client (and if applicable, DCAA auditors) with sufficient detail to know what was purchased, when it was delivered and accepted, unit prices with backup, procurement information, and any other relevant information.

In cash flow, time is of the essence. Subcontractors and vendors must know when invoices are going to be submitted to the prime contractor; if they submit an invoice the day after the contractor invoices the client, their invoice will not be sent to the government for payment for an additional 29 days. To eliminate this risk, establish a fixed date each month (or a stated schedule, if invoicing occurs more frequently) in subcontracts and purchase orders. Let subcontractors know that if the invoice to the prime contractor goes out each month on the 15th, that their invoices must be received no later than the 10th. This gives contractors time to review and approve the invoice, request any additional backup that may be required, and submit the invoice with that month's voucher.

Paying Subcontractors--Timing and Discounts

When do I have to pay a subcontractor? Though it seems like a simple question, this query may have dozens of answers, depending on the state the contractor is operating in, the agency it is working for, and the type of contract the contractor is working under. Traditional payment terms reading "Net 30" or "Net 60" are easy to understand--the full amount of the invoice is due within the stated number of days. However, a common payment term for construction and other service industries is "Pay When Paid" or some variation thereof.

A "Pay When Paid" clause states that a subcontractor will receive payment only when payment for their services have been received by the prime contractor from the owner. While many state laws and decided cases have placed limits on (or even voided) this type of clause, they remain popular in many sectors. (5)

The Paid Cost Rule

In the past, under government cost-type contracts, large businesses had to certify with each invoice that all subcontractors and vendors contained within the invoice to the government had already been paid. Small businesses were exempt from this requirement. Recently, the paid cost rule was eliminated, deleting this requirement for large businesses, and now allows them to bill the government for goods and services invoiced, which may not have yet been physically paid. The new guidance states that these vendor payments must be scheduled usually within 30 days. (6)

Prompt Payment Discounts

Many prime and subcontractors will offer prompt payment discounts. These usually are stated in the purchase order or vendor's proposal, and should be carried over into any resulting subcontracts. Prompt payment or early payment terms usually are stated as a percentage with a time period. For example, "2 percent/10" means that the subcontractor will allow a 2 percent discount, if the invoice is paid in full within 10 days. Whether to make prompt payments or to offer them to the client is a business decision that must take into account each contractor's individual cash flow situation, the discount amount, cost of money, and the contract mechanism. For instance, prompt payment terms on a commodity supply contract may be easy to administer, whereas on a complicated cost-type construction project, contractors may not wish to add any additional pressure to the invoice review cycle by imposing an unnecessarily short approval deadline.

Tax Exemptions

On many government projects, the issue of tax exemptions will arise, particularly state or local sales tax exemptions. It is important to be proactive and clear with subcontractors when addressing the issue of tax exemptions. Often, subcontractors may assume the exemption, and provide quotes or bids that incorporate the exemption based on this assumption. If the exemption does not come through, the subcontractor may seek reimbursement for those taxes. This could add an additional 8 to 9 percent to the price, and require the contractor to either bear that cost or submit a change order to the client.

Additionally, this increased cost may call into question the initial procurement--if this vendor was evaluated with this tax differential, would they still have been the lowest responsible bidder?

When dealing with the issue of tax exemptions, contractors should state in the request for proposal or request for quote that all price quotes should be inclusive of taxes, fees, and permits. This ensures all bids will be evaluated equally. Contractors also should communicate with vendors so that they know the process for obtaining tax exemptions; just because the last government contract they worked on had an exemption does not mean the contractor will automatically get the same exemption on the new contract. Contractors should state in subcontract documents that in the event an exemption from any tax is obtained from the government, a change order will be issued to the subcontractor requesting a credit.

One final issue of note on taxes is that in non-competitive circumstances, FAR 52.229-4 may apply. This clause will allow contractors to recover any after-imposed federal, state, or local taxes if they specifically exempt them from the proposal. Similarly, the clause requires contractors to provide the government a credit for any federal, state, or local taxes that were estimated but that the contractor was not required to pay, as well as any taxes that were refunded.

Managing Payment Communications

Occasionally, prime contractors may have a dispute with a subcontractor over quality, delivery, or change order negotiations. Despite efforts to proactively resolve these disputes, there are certain subcontractors who may call the government directly to complain that they have not been paid. While contractors may not be able to predict every case of a subcontractor taking this route, they can minimize the occurrence and impact by advance planning and a well-written subcontract.

If a subcontractor indicates they want to contact the client, do not react negatively. The better course is to educate the subcontractor about the likely outcome of such a call. FAR 32 states that contracting officers can do several things in response to a subcontractor's assertion of non-payment by a prime. First, they can tell the subcontractor whether the prime has been paid for the services in question. Second, they can encourage the prime to make timely payments. Finally, they can, if authorized by the contract, withhold payments until proof of payment is provided. They cannot pay the subcontractor or any second-tier subcontractors directly.

In most cases, prime contractors should have no problem with a contracting officer telling a subcontractor whether they have been paid. If a contractor suspects a subcontractor will contact its client, it should contact the contracting officer first and explain the situation. No client likes surprises. They are likely to deal with the subcontractor appropriately (and in accordance with FAR 32.112), if they have heard the full details of the dispute before they are surprised by a potentially one-sided account of the story from the subcontractor.

Prime contractors should ensure that the subcontract agreement and purchase order terms and conditions contain a clause restricting the subcontractor's ability to communicate directly with the client. While this may not prevent the subcontractor from breaching those terms, it will provide some ammunition, should the dispute end up in litigation or arbitration. To avoid this type of situation, contractors need to craft a well written subcontract agreement, communicate frequently with the subcontractor, implement a consistent process for documenting changes or conversations, and develop a "win-win" approach to resolving disputes.

Second-Tier Subcontractors

On occasion, a prime contractor may receive an inquiry from one of its subcontractor's subcontractors or vendors (also known as second-tier subcontractors) inquiring about payment that the first-tier subcontractor has not made. While prime contractors may have more options available than their government counterparts, they are essentially in the same situation and should follow the guidance provided in FAR 32.112.

Most importantly, take all complaints seriously and promptly follow up; where cash is involved, the issue will not get better with age. In addition, failure to act quickly usually means the party's next call will not be to the contractor--it will be to the contractor's client, bank, Congressman, news media, or other third party. Gather enough information to have a reasoned discussion with the first subcontractor about the issue, but do not take sides or give the second-tier subcontractor a heightened expectation of guaranteed, immediate results. Once the prime contractor has gathered the necessary information, contact the subcontractor, get their feedback, and place the responsibility on them to resolve the situation.

There are some things that can minimize the effect of second-tier subcontractors not getting paid. These include:

* Have first-tier subcontractors provide payment bonds. Under the Miller Act, a payment bond will provide protection in the event a subcontractor does not pay their subcontractors, employees, or materialmen. (7) While the Miller Act applies to government-prime relationships, a prime can require his subcontractor to provide a payment bond anytime; the principles and protections are essentially the same. Payment bonds are an inexpensive, preventative measure, depending on the size of the procurement and payment history of the subcontractor. Payment bonds are required for most fixed-price construction projects. In addition, many clients will pay for bonds for second-tier subcontractors, or cost-type prime contracts of any scope, due to the benefits of decreased overall project risk. It is not just that a payment bond itself decreases risk; to be bonded, a subcontractor must be qualified by a rated surety on the U.S. Treasury list. A subcontractor's mere ability to obtain a payment bond may be a good indicator th at the contractor may never have to use it.

* Run a pre-award credit check. Dun and Bradstreet and other sources can provide invaluable information about a subcontractor's current financial status and payment history. Eliminating non-responsible contractors in the initial procurement will prevent possible payment problems downstream. In a bestvalue procurement, the low bidder will not be the best value, if time and resources must be spent to resolve disputes involving unpaid second tier subcontractors.

* Require interim releases and payment certifications. These documents should accompany each invoice, and certify that all vendors, employees, and subcontractors have been paid (or will be paid promptly from the receipts of this invoice). While a prime cannot prevent a subcontractor from submitting a false certification, such a document would be "Exhibit A" in any subsequent proceedings, and would assist in limiting any potential liability for the contractor.

* Have a dispute reporting outlet for subcontractors to contact before the situation escalates. Company hotlines should be implemented and well publicized. They should be posted at each facility, project site, and Web site, as well as cited in subcontract agreements. If a subcontractor or second-tier subcontractor contacts a prime about an issue, the contractor should consider it an opportunity to resolve the issue before the client is involved.

Finally, prime contractors should never pay second-tier subcontractors directly. In certain circumstances, a subcontractor will ask for an assignment of debt and this is acceptable if properly documented with legal review. In other rare instances, an agency (such as the U.S. Department of Labor or Internal Revenue Service) may direct the contractor to garnish or withhold payments. However, direct payments to a second-tier subcontractor can put contractors in jeopardy of having to pay twice. If the first-tier subcontractor files for bankruptcy, the prime will be at risk for any "offset" receivables, and could end up having to pay the amount twice.

Measure Performance

As a parallel note to implementing the earlier strategies, contractors also must accurately measure and maintain key statistics on their cash flow situation. If a contractor is unaware of its accounts receivable, sales outstanding/days payable outstanding ratios, quick and current ratios, available credit line utilization, paydex scores, or other financial ratios, it will be unable to assess the success or failure of its actions. Contractors must maintain these ratios to set goals and expectations for the company's future cash management performance.

Have a Solid Plan

The first step to managing cash flow is to have a solid plan and good communication with clients regarding their requirements. Well-managed receivables are critical to a good overall cash management program. The second step is to have an accounts payable plan that starts with procurement and subcontract clauses, and then to manage subcontractor and vendor expectations to those clauses.

Advance planning will help provide timely, properly documented invoices that are easier to review and approve. Good communications will help minimize non-payment to second-tier subcontractors, and help resolve any issues that may arise during performance. Finally, measuring cash flow metrics should illustrate that these steps are paying dividends, and resulting in a beneficial cash flow situation that exceeds expectations.

Endnotes

(1.) See FAR 52.232-25 (Prompt Payment) for full text.

(2.) See www.fms.treas.gov/prompt for additional information and current rate.

(3.) See 5 CFR 1315, Prompt Payment Act requires payments to be made within 30 days of receipt of invoice or acceptance of goods or services, and within 14 days for construction contracts (FAR 52.232.27).

(4.) See 68 Federal Regulation 8450 (February 21, 2003).

(5.) See Moore Brothers Co. v. Brown & Root Inc. 207 F3d 717(4th Cir. 2000). ("Pay when Paid" is unenforceable where the prime contractor contributed to nonpayment by owner.) See also Capitol Steel Fabricators Inc. vs Mega Construction Co., Inc. (October 28, 1997) D.A.R. 13399. ("Pay when Paid" clauses are unenforceable in California public works projects.)

(6.) The elimination of the paid cost rule (FAR 52.216-26 and 52.232-7) occurred in March 2000. The final rule was issued November 22, 2002. Federal Register, Vol. 67, No. 226.

(7.) 40 U.S.C. Section 270a et seq. The Miller Act requires 100 percent payment bonds on contracts for construction, alteration, or repair of any building or public work in the United States over $100,000. It covers both subcontractors and second tier subcontractors. Third-tier subcontractors and below are not covered.

RELATED ARTICLE: Managing Tax Exemptions

When managing tax exemptions, government contractors should:

* Include all taxes in vendor quotes;

* Require a credit in the event an exemption is received when drafting subcontract clauses; and

* Communicate with all clients--just because their last prime contractor had an exemption does not mean you will have the same benefit.

About the Author

GLENN SWEATT, ESQ., CPCM, is general counsel for Environmental Chemical Corporation, based in Burlingame, California. He has more than 12 years of government contracting, business, and legal experience, and is an active member of the California State Bar. He is affiliated with the Golden Gate Chapter. and is a speaker at other chapter events. Send comments on this article to cm@ncmahq.org.
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Author:Sweatt, Glenn
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Date:May 1, 2003
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