Contracting with the Department of Defense (DoD) can provide healthy opportunities for businesses of all sizes.  That said, it is no secret that contractors without the cash resources to finance their performance while awaiting payment from the Government may find themselves swallowed whole by their contractual obligations. Many defense contracts are long-term endeavors; consequently, a contractor’s sustainability and profitability can be impacted by the sapping of available manpower while also requiring significant capital investment to manage material, labor, overhead, and other expenses incurred when performing a contract. In many cases, the upfront financial investment required serves as a barrier to entry into the government marketplace for nontraditional defense contractors. However, the DoD has recently unearthed and reanimated one of the more impressive dinosaurs buried in the Federal Acquisition Regulation. Welcome to the world of performance-based payments (PBPs).

On April 8, 2020, the DoD issued a final rule—effective immediately— amending the Defense Federal Acquisition Regulation Supplement (DFARS) to (1) permit—consistent with best commercial practices—all contractors (including nontraditional defense contractors) to receive performance-based payments, (2) remove prohibitions limiting PBPs to amounts not greater than costs incurred up to the time of payment, and (3) require contractor financial statements to be compliant with Generally Accepted Accounting Principles (GAAP) for the contractor to receive PBPs.

For the uninitiated, PBPs are a mechanism available to the Government intended to encourage cash-strapped contractors to enter and flourish in the federal marketplace. PBPs are a form of contract financing that predicates payment on objective, quantifiably measurable milestones that take the place of a more traditional periodic payment.  In a PBP context, when a contractor meets the criteria for a designated milestone, it receives the corresponding payment. PBPs are also theoretically symbiotic because they benefit the Government by reducing oversight and compliance requirements while ensuring that properly performing contractors receive a steady cash flow as performance proceeds.

The highlights of the final rule, the significant changes it makes to the proposed rule, and how the final rule affects contractors receiving PBPs are discussed below.

The DNA of PBPs

In the final rule—and throughout the rulemaking process—the DoD made clear its intention to move away from the traditional contract financing method of progress payments in favor of PBPs. The impetus for this evolution is Section 831 of the National Defense Authorization Act (NDAA) for Fiscal Year (FY) 2017, which amended 10 U.S.C. § 2307(b) to, inter alia:  (1) establish a preference for fixed-price, performance-based payments for contractor financing, whenever practicable, (2) provide that, for a contractor to receive PBPs, its accounting system must be compliant with Generally Accepted Accounting Practices (GAAP), and (3) ensure that nontraditional defense contractors and other private sector companies are eligible for performance-based payments, consistent with best commercial practices.

To address the revisions in Section 831, the DoD issued on August 24, 2018 a proposed rule to amend the DFARS. The proposed rule was immediately met with a chorus of criticism from industry groups that took issue with, among other perceived shortcomings, the proposed reduction of the customary performance-based payment rate from 80 percent to 50 percent. In response, the DoD rescinded the proposed rule in October 2018, issued a new proposed rule in April 2019, and then, after considering comments, issued the now-operative final rule on April 8, 2020.

Highlights of the Final Rule

• Establishes that all contractors are eligible for PBPs – Consistent with 10 U.S.C. § 2307(b), the final rule revises DFARS 232.1001(a) to state, in part, that “[s]ubject to the criteria in 232.1003-70, all companies, including nontraditional defense contractors, are eligible for performance-based payments, consistent with best commercial practices.” Nontraditional defense contractors are entities not currently performing and that have not performed any DoD activities subject to full coverage under the cost accounting standards for at least the one-year period preceding the solicitation for the procurement. See DFARS 202.101; 10 U.S.C. § 2302(9). Both Congress and the DoD have made concerted efforts over the past few years to encourage innovation in defense contracting by relaxing or streamlining regulations to attract nontraditional and commercial entities, and the shift to PBPs for fixed-price contracts tracks this course.

Notably, the DoD explicitly declined to make PBPs the default financing choice for fixed-price contracts in the final rule, stating that “the Government reserves the right to determine the best option for contract financing based on the individual contract action.” This position is consistent with the sentiment in both the text and legislative history of NDAA FY 2017 Section 831, reflecting that PBPs are the preferred, but not mandated, method of contract financing for fixed-price contracts.

• Removes prohibitions limiting PBPs to amounts not greater than costs incurred up to the time of payment – Specifically, the final rule revises DFARS 232.1001, 252.232-7012, and 252.232-7013 to remove the previous cap limiting PBPs to amounts not greater than costs incurred up to the time of payment. These revisions track the language of the changed 10 U.S.C. § 2307(b)(2), which states that PBPs shall not be conditioned on costs incurred in contract performance but rather on the achievement of negotiated performance outcomes. The removal of the prior limitation will primarily benefit contractors, as PBPs based on the negotiated value of the completed milestone events in excess of the total costs incurred up to the time of payment results in decreased costs for short-term contractor borrowing and an increase in contractor cash flow.

However, contractors must continue to report costs incurred when requesting PBPs so the DoD may have the “data necessary for negotiation of [PBPs] in future contracts.” Although the final rule remains opaque as to how a contractor should track incurred costs—stating only that “incurred cost is determined by the Contractor’s accounting books and records”—the DoD modified the proposed rule by adding language in DFARS 232.1001, 252.232-7012, and 252.232-7013 to make it clear that a contractor need not have a “‘Government-unique’ cost accounting system” to report incurred costs under the clause. Indeed, even if the contractor’s accounting system is not capable of tracking costs on a job-order basis, under the revised DFARS 252.232-7012 and 7013, the contractor need only “provide a realistic approximation of the allocation of incurred costs attributable to this contract in accordance with the Contractor’s accounting system.” Regardless of the prescribed method, the DoD makes it clear in the final rule that it would “be highly unlikely” for a competent contractor to be without means of identifying its contracting performance costs.

• Requires contractor financial statements to be GAAP-compliant before receiving PBPs – In the final rule, the DoD modified DFARS 232.1003-70 and 252.232-7015 to now require the contractor’s financial statements to be GAAP-compliant to receive PBPs, rather than the “output” of the contractor’s accounting system as stated in the proposed rule. In explaining the change from “output” to “financial statements,” the DoD noted that Section 831’s language requiring “a contractor’s accounting system” to be in compliance with GAAP is not feasible, and, in its view, “compliance with GAAP” means “financial statements are fairly presented, e., that the information contained within the financial statements complies with GAAP in all material respects.”

Conclusion

We expect these significant changes to the DFARS will be welcomed by both established and nontraditional defense contractors. In general, the movement to implement PBPs as the preferred method for fixed-price contract financing better aligns the interests of the Government and private industry by attributing payments to performance, rather than just costs incurred. In return, the Government potentially reduces its oversight and compliance costs while expanding the pool of contractors doing business with the DoD by encouraging nontraditional and other entities to enter the defense marketplace. However, contractors should not expect this change to happen overnight.  Many contracting officers have spent careers administering contracts financed through progress payments. We recommend that contractors interested in benefitting from this newly revamped financing model engage with their agency partners to take this evolutionary leap together. To that end, we suggest asking questions early and often in the solicitation stage to elicit the use of PBPs in new opportunities. We also encourage contractors to open a dialogue with the contracting officer on existing projects to discuss whether modifications to current contracts for the accommodation of PBPs may be appropriate. The evolution may take time, but to paraphrase Jeff Goldblum’s character, Dr. Ian Malcolm, in the film Jurassic Park—government contractors will find a way.