On May 18, 2011, the Department of Defense ("DoD") published an interim rule amending the Defense Federal Acquisition Regulation Supplement ("DFARS") to require contractors on covered DoD contracts to establish and maintain acceptable business systems or risk partial withholding of contract payments if these systems have significant deficiencies.  The interim rule contains new or revised business system-related definitions and administrative procedures and requires compliance in the form of a new business systems clause.

The stated purpose of the interim rule is to improve the effectiveness of DoD's oversight of contractor business systems.  In recent years, contractor business systems have come under increased scrutiny by DoD, Congress, and the Commission on Wartime Contracting.  In publishing the rule, DoD stated that contractor business systems and internal controls "are the first line of defense against waste, fraud, and abuse" and that weak control systems "increase the risk of unallowable and unreasonable costs" on government contracts.

DoD has published proposed business system rules twice before.  In publishing the interim rule, DoD incorporated statutory requirements outlined in Section 893 of the Ike Skelton National Defense Authorization Act for Fiscal Year 2011 that related to the improvement of DoD's contractor business systems.

The interim rule adds a new "Contractor Business Systems" subpart to the DFARS that requires contracting officers to include a new Contractor Business Systems clause in solicitations and contracts that require the use of a business system and are covered by the Cost Accounting Standards ("CAS").  This clause exempts small business contracts and defines a business system to mean an accounting system, earned value management system ("EVMS"), estimating system, material management and accounting system ("MMAS"), property management system, or purchasing system.  The clause further requires a contractor to establish and maintain acceptable business systems in accordance with the terms of the contract.

The interim rule revises existing cost estimating system, EVMS, and MMAS DFARS clauses and adds new clauses for the administration of accounting, purchasing, and property management systems.  Each of the clauses that apply to the various business systems contains criteria that must be met in order for a specific type of system to be deemed acceptable.  In addition, each clause contains procedures that outline how a contracting officer will determine that a significant deficiency exists.  For all systems, a significant deficiency is defined as a "shortcoming in the system that materially affects the ability of officials of the [DoD] to rely upon information produced by the system that is needed for management purposes."

If the contracting officer initially determines that there are one or more significant deficiencies in one or more business systems, the contractor is required to respond, in writing, within 30 days.  The contracting officer will evaluate the contractor's response and notify the contractor in writing of the final determination as to whether the contractor's business systems contain significant deficiencies and are therefore disapproved.  The Contractor Business System clause provides for the withholding of 5 percent of amounts otherwise due the contractor upon the contracting officer's final determination that significant deficiencies exist.  The contractor must either correct the deficiencies or submit a corrective action plan to eliminate them.  The total withheld percentage cannot exceed 5 percent for one or more significant deficiencies in any single contractor business system or 10 percent for significant deficiencies in multiple contractor business systems.

If the contractor submits an acceptable corrective action plan within 45 days of the notice of the contracting officer's intent to withhold payment, the contracting officer, in consultation with the auditor or functional specialist, may reduce the withholding level to 2 percent.  The contractor is also required to provide written notice when the deficiencies are corrected, at which point the contracting officer may either authorize billing to resume without any withholding or continue to withhold the payments if significant deficiencies remain. 

If the contracting officer fails to act within 90 days of the contractor's written notification that the deficiencies have been corrected, the withholding directly related to the significant deficiencies will be reduced by at least 50 percent until the contracting officer makes the required determination.  If the contracting officer later determines that the contractor failed to correct the deficiencies, the contracting officer will reinstate or increase the withholding until the required corrections are implemented as directed by the contracting officer.

The interim rule applies to solicitations issued on or after May 18, 2011 and contracting officers are encouraged to amend existing solicitations to include the Contractor Business Systems clause for contracts to be awarded after that date.  Solicitations for contracts to be awarded on or after August 16, 2011 must include the Contractor Business Systems clause.  DoD's publication of the interim rule included a request for comments.  Comments are due by July 18, 2011. 

Defense contractors competing for contracts that are or will be subject to the interim rule should become familiar with the business system requirements outlined in the new DFARS clauses and be prepared to provide documentation establishing that their business systems are acceptable.  Given the new adverse consequences relating to systems that are significantly deficient, it is further incumbent on covered contractors to expeditiously address any shortcomings in their business systems that the government has identified through a proactive exchange with the contracting officer and supporting auditors and specialists.

© 2011 Perkins Coie LLP