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Restructuring Costs

Editor’s Note. During the recession many of our clients were going through extensive efforts to reduce costs and become more efficient to better compete in the crowded government market. During that period, we wrote articles on the distinction between allowable restructuring costs incurred by a company to become more efficient and cost effective and unallowable organization costs incurred during a corporate reorganization following an acquisition or divestment. As the economy has been improving more and more of our clients have been going through mergers, acquisitions or divestments where we frequently get involved in due diligence and contract novation efforts. As a result we are finding more frequent questions related to whether any of the resulting reorganization costs are allowable where we have been looking into the issue. We were quite happy to come across a recent article by Andy Howard and Jake Dean of Ashton & Bird’s Construction & Government Contracts Group in the Feb 3, 2015 issue of the Federal Contracts Report that addresses business restructuring costs incurred as a result of a reorganization where we summarize many of the points they make. It should be noted our reading of the relevant FAR and DFARS section does differ somewhat and in those cases, where we have divulged our different interpretation.)

Business combinations have been increasing recently where the authors ask whether a company has the ability to recoup corporate restructuring resulting from the combination. The authors make a distinction between restructuring costs that may be allowable and hence reimbursable and organization costs which are not. FAR 31.205-27(a) defines unallowable “organization costs” as costs that are expended in connection with planning or executing the organization or reorganization of the corporate structure of a business including (1) mergers and acquisitions (2) resisting or planning to resist the reorganization of the corporate structure, and (3) raising capital. Examples of such unallowable costs include costs of attorneys, accountants, brokers, etc. Simply stated, the costs incurred to form a business or to combine two or more businesses into a new corporate structure are almost always unallowable. On the other hand, common types of costs a contractor is likely to incur that may be reimbursable are certain restructuring costs that include but is not limited to (1) costs to maintain facilities or costs resulting from idle capacity (FAR 31.205-7) (2) employee retraining and relocation costs (31.205-35, 44, 46) (3), employee severance costs (31.205-6(g) and (4) new employee recruiting costs (31.205-34).

Under defense contracts the DFARS further provides the ability of contractors to recover “external restructuring” costs resulting from a business combination where some cost savings to DOD will result from the restructuring (DFARS 21.205-70(b). “Restructuring activities” are considered to be those activities occurring after a business combination that affect operations of companies not previously under common ownership or control. They are defined as “a transaction whereby assets or operations of two or more companies not previously under common ownership or control are combined, whether by merger, acquisition or sale/purchase of assets.” “Restructuring activities” are defined as “nonroutine, nonrecurring or extraordinary activities to combine facilities, operations, or workforce in order to eliminate redundant capabilities, improve future operations and reduce overall costs.” However, contrary to the authors assertions, allowable “restructuring activities” are allowable if they are ongoing repositionings or redeployments of productive facilities or workforce (e.g. plant rearrangements, relocation costs) or if they include ordinary or routine activities charged as indirect costs that would have otherwise been incurred (planning and analysis, contract administration or recurring financial and administrative support) (231.205-70(b) (3). The authors clarify that some costs after a business combination may nonetheless be allowable if they affect only one of the companies not previously under common ownership. Of course, if there had been no business combination, restructuring activities undertaken solely by one company are allowable (231.205-70(b)(2). In addition, restructuring costs under the DFARS that may be allowable include but are not limited to severance pay for employees, early retirement incentive payments, employee retraining costs, relocation costs for retained employees and relocation and rearrangement of plant facilities.

Practical Considerations

1. The process of seeking reimbursements of otherwise allowable restructuring costs can vary depending on whether the contractor is seeking reimbursement under a civilian or defense contract. For example, under a DOD contract, for restructuring costs to be allowable the projected savings must exceed projected costs by a factor of at least two to one or the business combination must result in the preservation of a critical capability that would otherwise be lost to DOD. In addition, the process usually includes a DCAA audit of the projected restructuring costs as well as the projected savings. The FAR does not have similar detailed procedures where the criteria is they be reasonable meaning they not exceed the amount a prudent person would incur in the conduct of competitive business. The authors state though the FAR does not explicitly adopt the procedures in the DFARS Part 231.205-70 they are implicit meaning contractors seeking reimbursement under civilian contracts should seek an advance agreement from the CO. Though such an agreement is prudent it is still not an absolute requirement where failure to obtain one will not affect the reasonableness, allocability or allowability required under FAR 31.109.
2. A contractor needs to also consider the effects of a contract novation whether there are differences in the FAR and DFARS. The model novation in the FAR may foreclose the possibility of recovering restructuring costs because the model agreement contains broad waiver language that may arguably prevent recovery of restructuring costs (FAR 42.1204).
3. On the other hand, the model novation agreement provided in the DFARS recognizes restructuring costs due to a merger or acquisition, where it may be in the interests of the government. Accordingly, all costs associated with a restructuring would be reimbursable as long as the restructuring will reduce overall costs to the DOD.
4. To reduce uncertainty, contractors are advised to seek an advance agreement, they should be ready to prepare a restructuring proposal that would probably be audited, complete forward priced restructuring costs and implement separate charge codes to capture actual restructure costs against estimates. The steps should be done in advance of the close of a merger or acquisition.