(Editor’s Note. Few companies either can or want to finance longer term projects from their own resources when they must deliver supplies and services and wait months or years for payment. Recognizing this, the government offers an array of financing options designed to minimize cash flow drain. FAR Part 32 identifies a variety of financing techniques and describes the policies and procedures appropriate for each. John Chierrichella and David Gallacher of Sheppard, Mullin, Richter & Hampton LLC have written a comprehensive two part article on financing government contracts – noncommercial and commercial items - where the first is presented in the April 2004 issue of Briefing Papers. We have based our article on their insights as well as a close reading of the FAR.)
Contract financing methods are designed to be “self-liquidating through contract performance.” It is available to supplement working capital as opposed to acquiring fixed assets. Generally speaking, the FAR identifies two “customary” contract financing methods – progress payments and performance based payments - and allows for two others – advance payments and loan guarantees. Though we will not discuss these, the government is also authorized to make partial payments which are not technically financing since payment depends on delivery.
Progress payments are periodic payments made by the government as performance on the contract proceeds. Such payments are based either on cost incurred by the contractor or on a percentage of stage of completion achieved under the contract. Perfomance-based payments are contract financing payments of predetermined amounts that are made when a contractor satisfies predefined contract events or criteria. They are not payments for accepted items but rather advances based on work performed.
Progress payments made on percentage of completion are most common under construction, shipbuilding or ship conversion/repair contracts. They are quite similar to performance based contracts. Payments are made monthly. When the CO determines that satisfactory progress and quality are achieved, payments must be made in full for work under definitized contracts while for undefinitized contracts, payment is limited to 80%.
Progess payments based on costs may be “customary” or “unusual.” Customary progress payments are those made under the general guidance of FAR 32.5 where there is a progress payment rate, a cost payment and frequency of payments established by the Progress Payments clause in the contract. Any other payments are considered “unusual.” These unusual payments might prvide for a higher rate of progress payment or greater frequency than is customary and is usually available only if there are significant predelivery expenditures or the contractor fully documents the need for unusual payments.
The progress payment rate has varied over the years. Currently, the FAR rate is 80% for large business and 85% for small while for DOD contracts, the rate is 80% for large, 90% for small and 95% for small disadvantaged concerns. The total amount payable for fixed price contracts is limited to a specified percentage of the “contract price” which is defined as the current price plus any unpriced modifications for which funds have been obligated. Specific cost-reimbursement portions of the contract must be excluded from the contract price.
Availability. The Progress Payments clause (FAR 52.232-16) is sanctioned where the contractor cannot bill “for the first delivery of products for a substantial time after work begins” and must make substantial expenditures. “Substantial time” for large businesses is considered six months or more while for small businesses it means four months or more. The clause may also be sanctioned where the contractor demonstrates actual financial need or unavailability of private financing. The contract threshold for availability of progress payments to small businesses is the simplified acquisition threshold of $100,000 (for ID/IQ contracts the expected value must exceed that amount) while for other businesses the threshold is $2 million. A final requirement for progress payments is that the contractor has “an accounting system and controls adequate for the proper administration of the clause” where the ACO is to monitor the adequacy of these controls and suspend progress payments if government auditors deem them inadequate.
Award Evaluation. If a solicitation contains the Progress Payments clause then a bid indicating that progress payments will be sought cannot affect the validity of the bid. However, if it does not contain the clause or does not invite offerors to request progress payments, a bid that is conditioned on the receipt of progress payments will be considered nonresponsive. Contractors should review solicitations carefully to see whether they provide for financing payments and remember that the time to address the failure of the solicitation to provide for financing is before you submit your offer. Remember, if the solicitation does not provide for progress payments do not condition your bid on its availability for to do so makes your bid nonresponsive.
Billable Costs. The clause does not entirely describe the costs that may be billed but it accomplishes this purpose by setting forth the costs that may not be included in “total costs incurred” for purposes of calculating progress payments. These prohibited costs include (1) those not “reasonably allocable” to the contract – those concepts of allowable and allocable costs set forth in the FAR Part 31 and the Cost Accounting Standards (2) costs that are ordinarily capitalized or subject to depreciation except for the properly amortized or depreciated costs (3) those incurred by subcontractors or suppliers where the contractor has not acquired title (4) incurred costs for pensions until they are actually paid (unless it is the routine practice not to pay for them until 30 days after the end of the quarter). In order to avoid problems with indirect costs that the government may have reason to believe would not sustain an audit, you may want to add a decrement factor to your indirect rate that would, for example, take into account prior years proposed versus approved amounts.
“Paid Cost” Rule. Contractors should be reminded of the elimination of the “paid cost” rule – large contractors (small contractors were exempt) could not recognize incurred costs for purposes of progress billing unless they were actually paid. This had the effect of “fronting” (paying) subcontractors before they could submit a progress payment. Though this paid cost rule has recently been eliminated – the “incurred cost” can now be submitted for progress payment as long as the incurrence is consistent with the contractor’s procedures for recognizing costs – the Standard Form (SF) 1443 used to present progress payment requests has not been amended to reflect this new rule change.
Liquidation. Progress payments, in effect, represent “loans” or “debt” owed by the contractor to the government and rather than being paid back, they are “liquidated” by contract performance. Liquidation can occur in a number of ways. Progress payments are liquidated by deducting them, up to a point, from payments due for completed contract preformance. The amount of unliquidated progress payments cannot exceed either (1) the progress payments made against incomplete work or (2) the value of the incomplete work. Normally the liquidation rate is the same as the progress payment rate but the CO can adjust the liquidation rate under certain circumstance e.g. the contractor requests a reduction and the rate has not been reduced in the preceding 12 months, data on actual costs are available, etc. (see FAR32.503-9(a)). Liquidation can occur in other ways as well. For example, if the amount of unliquidated progress payments exceed the limits, then the CO may require immediate liquidation and repayment by the contractor. The government may also liquidate at an “increased” rate or even “call” for the repayment of progress payments if the CO determines on substantial evidence the contractor is in danger of non-performance, failed to comply with material contract requirements or is delinquent in paying vendors or subcontractors.
Financing Subcontractors. If you are a prime contractor receiving progress payments, the FAR requires you to flow down the Progress Payments clause to all of your subcontracts, enabling your subcontractors to also receive progress payments or some other type of financing. The prime contractor must pay its suppliers and subcontractors in a timely manner and if delinquent, the government may suspend progress payments. However, if there is a good faith dispute in the amount owed to a supplier, the CO should not consider the prime delinquent. While there was, historically no absolute requirement to make timely payments, changes made in the mid-1990s provided greater recourse for suppliers and subcontractors. If a contractor is delinquent in its payments to its suppliers or subcontractors, the supplier may ask the CO if progress payments have been made to the contractor. If yes and the supplier has not received payment, the supplier may inform the CO of the delinquency whereupon the CO may investigate the matter to see whether the contractor’s certifications for progress payments indicated payment to the supplier. If the CO determines the subcontractor is correct and that payments have not been made the CO may encourage the contractor to make payments to the supplier or reduce and even suspend progress payments to the contractor. If the certification was inaccurate, the CO may initiate remedial action including assertions of violations of the False Claims Act.
Title and Risk of Loss. As security for progress payments, the government obtains title to all property chargeable to the contract. With the exception of selling scrap, the contractor may not dispose of any property to which title has vested to the government and there cannot be any compromises to the property by other encumbrances. Nonetheless, the FAR is clear that risk of loss to the property remains with the contractor before delivery to and acceptance by the government. If the property is lost, stolen or destroyed, the CO will require you to repay the government an amount equal to the unliquidated progress payments allocable to that property.
Performance-base payments are addressed in FAR 32.1003. Instead of basing payments on costs and a pre-set payment rate, a performance-based payment schedule identifies mutually agreed-to payment amounts based on meeting contract events or criteria. Events must represent integral and meaningful aspects of contract performance and should signify true progress in completing the contract effort. Events or criteria may be either “severable or cumulative.” The successful completion of a severable event or criterion is independent of accomplishment of any other event while if cumulative, the successful accomplishment of an event or criterion is dependent on the previous accomplishment of another event.
The Defense Department has issued, which is frequently revised, the “Users Guide to Performance Based Payments.” It states that events to be selected must be clearly and precisely defined so their accomplishment can be factually determined. The guide offers several examples but stresses the parties themselves must arrive at clear definitions of events. Though performance-based payments may “feel” like payment for work completed, performance-based payments are contract financing payment and hence are not subject to interest penalties under the Prompt Payment Act.
The performance based clause mirrors the Progress Payments clause in many respects
Advanced payments are covered in FAR 32.106. While progress payments and performance-based payments are the preferred methods of providing contract financing for noncommercial purchases, advance payments are the least preferred method used by the government and is supposed to be used “sparingly.” Unlike the two others, the availability of advanced payments are not keyed to performance though the contract price serves as the ceiling for the advance payments. They are unique payments made to a prime contractor only “before, in anticipation or for the purpose of complete performance under one or more contracts.” In the normal course of events, advance payments, like progress payments, are liquidated from payment due the contractor for completed performance.
Restrictions. Generally government agencies are prohibited from paying for goods and services in advance of their receipt. However both military and civilian statues authorize advanced payments where (1) the contractor provides adequate security (2) such payment do not exceed the unpaid contract price and (3) the head of the agency determines, in writing, either before award or during performance that such payment facilitates the national interests. Certain restrictions apply such as: (a) advanced payments may not exceed interim cash flow needs (b) such payments must be necessary to supplement other funds or credit available to you (c) the CO must find that you otherwise qualify as a “responsible” contractor (d) the government must obtain some type of prospective benefit from such payments and (e) the contract to be financed must fall within categories discussed below.
Who qualifies? The FAR identifies certain contracts as potential candidates for advanced payment based on the subject matter of the contract and legal status of the contractor. For example, contracts for experimental research or development work at nonprofit educational or research institutions are appropriate as well as with small business concerns, management and operations at government-owned facilities and classified contractors whose sensitive subject matter bars more traditonal financing vehicles. In addition, FAR recognizes a number of factual situations such as where commercial financing is as a practical matter, unavailable such as where commercial interest rates are excessive, a financial institution refuses to carry a portion of the risk under a guaranteed loan or where the remote location of contract performance precludes effective administration of a guaranteed loan. Other “exceptional circumstances” might include where urgent supply schedules and delivery delays exist. Additionally, advanced payments may be authorized in conjunction with progress payments when, for example, you are having trouble arranging financing. If one or more of these conditions exist the CO “shall generally recommend” the advance payments be authorized.
Application. Your request for advanced payments, whether sought before or during contract performance, must be submitted in writing to the CO. The application must include a reference to the solicitation or contract, a cash flow forecast for the contract period, total amount of advance payment sought, name of financial institution designated to hold such payments and a statement of your efforts to obtain alternative financing. Though not required you may want to include in your application any additional information such as that having a bearing on your overall financial condition, your ability to perform the contract without loss to the government and any anticipated financial safeguards to protect the government’s interests.
Security. In addition to a priority lien on your special bank account the government is further secured by a paramount lien on all materials, supplies, equipment and other things acquired for the contract. You will be required to identify and segregate all such equipment and supplies subject to the lien. The government may, at its discretion, seek supplemental security in the form of personal or corporate endorsements or guarantees, pledges of collateral, subordination of other debts or limitations on, for example, profit distributions, salaries, bonuses and capital expenditures. In rare cases, a bond may be sought.
Interest. You will be required to pay interest on the daily unliquidated balance of all advanced payments at the higher of (1) the published prime rate at the bank where your advanced payments are deposited or (2) the federal rate established by the Treasury Department. Interest will be computed monthly and will be adjusted for prime rate variations. The government has the authority to exempt interest charges and remember, interest payments are unallowable costs on contracts.
Federal loan guarantee are the last method under the FAR Part 32.3 to finance noncommercial contracts. Loan guarantees are available only to borrowers performing contracts related to “the national defense” – “military, atomic energy production or construction, military assistance to any foreign nation, stockpilling or space.”
Procedure. Under the regulations a contractor does not receive a guaranteed loan directly from the government nor a loan guaranteed at the request of the contractor. Instead, a contractor or subcontractor or supplier requiring operating funds to perform applies to a financial institution for a loan and then the institution applies to the Federal Reserve Bank in its district.
Eligibility. The FAR generally warns COs that the contract financing methods should only apply to finance working capital, not expansion or capital asset but in the case of loan guarantees it may be used for expansion of a contractor’s permanent facilities. Contractor eligibility is determined by COs at the request of the agency’s financing office or other interested agency.
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