By Michael McGill and Paul Pompeo

Law360 (April 24, 2020, 7:03 PM EDT) --

Michael McGill

Paul Pompeo

This is the second installment in a two-part article that highlights the critical aspects of the U.S. Department of Defense implementation of Section 3610 of the Coronavirus Aid, Relief, and Economic Security, or CARES, Act, and offers a practical road map to help contractors best position themselves to try to recover not only the costs for which relief is authorized under Section 3610 but also other costs resulting from the COVID-19 public health emergency.

The first installment yesterday focused on the DOD's guidance concerning eligibility requirements and prerequisites to relief under Section 3610 and the new cost principle, defense federal acquisition regulation supplement, or DFARS, 231.205-79.

This second installment focuses on the DOD guidance concerning the application of Section 3610 and DFARS 231.205-79 to fixed-price, cost-reimbursement, and time-and-material and labor hour contracts. It also identifies numerous questions that remain notwithstanding the DOD guidance, and provides a concise list of best practices that contractors can consider while awaiting additional guidance and the Federal Acquisition Regulation, or FAR, rulemaking.

Summary of the DOD Implementation of CARES Act Section 3610

Administration of Relief Under DOD Contracts

The DOD has provided guidance to contracting officers to apply Section 3610 and the DOD class deviation by contract type, with specific instructions for cost-reimbursement contracts, fixed‑price contracts, and time-and-material and labor hour contracts.

Relief Under Cost-Reimbursement Contacts

As discussed in the first installment of this article, entitlement to relief for increased paid leave costs under DOD contracts will be subject to the conditions in DFARS 231.205-79. The DOD guidance for contracting officers administering cost-reimbursement contracts makes clear that DFARS 231.205-79 will not apply automatically.

As discussed, the contractor cannot make its own determination that it is an affected contractor and start treating its paid leave costs as allowable without an affirmative written determination from the contracting officer finding that the contractor qualifies for this status.

The DOD directs contracting officers to work with contractors to establish cost procedures, adjust estimated costs (with the Section 3610 costs segregated), provisionally approve and pay interim vouchers, and retain the contractor's supporting documentation for audit. The FAQs indicate that costs for which a contractor is seeking relief under Section 3610 and DFARS 231.205-79 should be charged to a separate account.

The DOD guidance states that "[b]y creating a new category of costs, any potential issues with disclosed accounting policies and procedures, cost accounting standards, or a contractor's cost accounting standards disclosure statement may be avoided." The segregation and separate handling of such costs will no doubt ease the administrative burden on both contractors and contracting officers, but it is wishful thinking to suggest all issues will be avoided.[1]

For instance, one issue that is almost certain to create headaches for contractors and government auditors alike is the handling under flexibly-priced contracts of amounts or credits a contractor receives from other federal programs intended to provide relief to companies and employees adversely affected by the COVID-19 crisis. The DOD's guidance indicates that the contractor is obligated to credit the government for any loan proceeds received pursuant to the CARES Act's Paycheck Protection Program, or PPP.[2]

The DOD guidance is unclear on whether increased costs associated with paid leave resulting from the COVID-19 public health emergency should be charged as direct or indirect costs under cost-reimbursement contracts. The DOD notes that contractors usually treat costs associated with employee leave as indirect costs. Such treatment would depend on existing practices of allocating paid leave as an indirect expense.[3]

In the FAQs, the DOD leaves open the possibility that "[t]here may be circumstances in which the cost can be directly identified with particular contracts." The DOD recommends that contracting officers ask contractors to charge these paid leave costs under a new cost category named "Other Direct Costs (ODC) COVID-19."

Despite the name implying that these are other direct costs, the guidance indicates that costs in this category can be allocated to applicable contracts "based on some reasonable, agreed upon allocation" and that, at least "in some situations," they could be included in indirect cost pools.[4]

Relief under Fixed-Price Contracts

The DOD guidance states that "[f]ixed-price contracts and contract line item numbers, or CLINs, remain fixed-price."[5] The guidance, however, also acknowledges that contractors will seek, and the DOD may provide, relief through modifications to fixed-price contracts and CLINs. The DOD contemplates that contractors will submit requests for equitable adjustments, or REAs, to seek relief for impacts resulting from the COVID-19 public health emergency under fixed-priced contracts and has provided direction to contracting officers who receive those REAs.[6]

The DOD has instructed contracting officers to establish a separate CLIN for Section 3610 payments under fixed-price contracts. This special CLIN is intended to enhance traceability and avoid the possibility that these payments could be deemed to constitute acceptance of products or services under other CLINs.[7]

The DOD's guidance states that adjustments to fixed-price contracts should compensate the contractor "only for the costs of providing paid leave as permitted by Section 3610, for maintaining the workforce, and shall not increase profit."[8] Interestingly, however, the guidance suggests that this CLIN should compensate the contractor on the basis of a fixed rate (a "fixed price per appropriate unit of measure, e.g. 'Hours' or 'Days,' exclusive of profit") on a monthly basis.[9]

Yet billings under fixed-price contracts will not be immune from scrutiny. The invoice, according to the guidance, should contain supporting documentation to "identify and explain why claimed hours could not be worked, along with a statement that these costs are not being reimbursed under other authorities." The guidance indicates that the contracting officer will verify the existence of conditions entitling the contractor to invoice for the paid leave applying the test for affected-contractor status outlined in the FAQs.[10]

The DOD guidance reminds contracting officers and contracting officers' representatives to only accept completed services under fixed-price contracts. The COVID-19 public health emergency inevitably will give rise to scenarios where there is a question surrounding whether the contractor fully completed the required services. Such scenarios will present a host of issues, one of which is whether the contractor is entitled to bill at the full contract prices or only at the special COVID-19 rates drained of profit.

For instance, under a fixed-price level of effort contract, a contractor that is idled by the pandemic could invoice under a special CLIN tied to costs resulting from employees on paid leave, but the contractor could not invoice for the standard level-of-effort CLIN if the contractor is not actually providing the level of effort required under the contract.

The upshot is that even if the contractor is able to recover its costs for the additional paid leave provided during the COVID-19 public health emergency and, importantly, retain its workforce, the contractor likely will not be able to realize profit for this time period unless it is performing under other CLINs, and the contractor must be vigilant to avoid overcharging.[11]

Relief under Time-and-Material and Labor Hour Contracts

The DOD's limited guidance on time-and-material and labor hour contracts suggests that they should be treated similarly to cost-reimbursement contracts. The DOD expects contractors to submit interim vouchers for payment of increased paid leave costs and contracting officers to review and, if acceptable, provisionally approve and pay them.

Given the hybrid nature of time-and-material and labor hour contracts, contractors might consider asking their contracting officer for leave to treat the adjustment to those types of contracts along the lines outlined for fixed-price contracts, with the addition of a fixed-rate CLIN dedicated to compensation for paid leave associated with the COVID-19 public health emergency.

Practical Takeaways from DOD's Implementation of CARES Act Section 3610

Notwithstanding the DFARS class deviation and the DOD's efforts to explain its approach to implementing Section 3610, and provide guidance for contractors and contracting officers, numerous questions remain. For instance, does the DOD intend to extend relief beyond the limits of a plain reading of Section 3610? Does it intend to reimburse contractors for any other special costs unique to the present emergency situation other than paid employee leave? Does the DOD really intend for reimbursement to be discretionary where the elements of the new cost principle are satisfied and funding is available?

How will the DOD respond if the impact of the pandemic on contractors extends beyond the end of September? Moreover, the biggest outstanding question surrounding the implementation of Section 3610 concerns how civilian agencies will implement the law.

Unfortunately, contractors affected by the COVID-19 public health emergency cannot wait indefinitely to take action without risking waiving their contractual rights and other negative repercussions. It is critical for contractors and subcontractors to be mindful that neither Section 3610 nor the DOD class deviation modifies any existing contracts or entitles a contractor to relief under any specific contract. Contractors and subcontractors will need to take affirmative steps to secure relief.[12]

The DOD's class deviation, consistent with Section 3610, only applies to contracts subject to the DFARS and only covers certain cost impacts of the COVID-19 public health emergency. Yet the DOD's implementation of Section 3610 is enlightening, and even companies that contract strictly with civilian agencies would likely be well served to consider the DOD's implementation as they develop their own response to the crisis while awaiting the promulgation of government wide regulations and guidance from other agencies.

Best practices inevitably will evolve based on the issuance of regulations and additional guidance and with experience. In the meantime, most contractors affected by the COVID-19 public health emergency could benefit from considering the following steps:

• Identify and meticulously document the impact of the COVID-19 public health emergency on business and operations. This effort should not be confined to employee leave and paid leave costs.

• Record and segregate costs incurred solely as a result of the COVID-19 public health emergency and document the reasons that certain ongoing costs are unavoidable.

• Implement measures to mitigate the impacts of the COVID-19 public health emergency on active contracts and document both the mitigation measures and measures necessary to retain employees in a ready state.

• Communicate regularly with the contracting officer and contracting officer's representative on the steps taken.

• Seek a written determination from each cognizant DOD contracting officer confirming status as an affected contractor under DFARS 231.205-79 for the relevant contracts and consider seeking a comparable determination for contracts not subject to the DFARS pending further implementation of Section 3610. Subcontractors can request such a determination from the prime contractor or, if they are not in privity, from the next higher-tier subcontractor.

• Review the terms of all contracts that have been affected by the COVID-19 public health emergency and understand the relevant contractual rights and obligations, as well as the interplay between the current contract terms and Section 3610, DFARS 231.205-79 (for DOD contracts), and any relevant agency guidance and directives. Keep in mind that contract terms are not changed unless and until they are modified.

• Analyze eligibility for relief under other federal, state, and local laws and programs, and whether any relief that the company is eligible for overlaps with the relief it is seeking under Section 3610, DFARS 231.205-79, or other contract clauses (e.g., a changes clause).

• Timely assert entitlement to relief under relevant contract clauses (FAR, FAR supplements, and agency-specific Section H clauses, etc.) and/or an agency's implementation of Section 3610.

• Prepare and timely submit REAs to modify contract terms to address changes to price, cost ceilings, performance requirements, schedule and expectations in response to the public health emergency.

• For cost-reimbursement contracts, seek written approval from your contracting officer as to the charging of costs related to the COVID-19 public health emergency and be prepared to advocate for the treatment that is most advantageous.

• Where advantageous, consider asking the customer to renegotiate contract terms to address current or anticipated changes to schedule, price, cost ceilings, provisional billing rates or even to memorialize the parties' agreement on the applicability of particular terms that are deemed favorable.

• Where recovery for COVID-19 related causes (including paid leave) will increase the total costs to the government under a particular contract (including under fixed-price contracts), assess whether the cost increase is funded, and if not, request that the contracting officer modify the contract to add the necessary funding. Be mindful of how costs associated with COVID-19 will affect reporting obligations under the limitation of costs and limitation of funds clauses.

• Invoice on time and separately identify amounts associated with the COVID-19 public health emergency. If the contractor has not conducted diligence to confirm that it has reduced amounts sought under Section 3610 by amounts allowed under other programs related to the public health emergency, make that perfectly clear to the customer.

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Michael McGill and Paul E. Pompeo are partners at Arnold & Porter.

The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] The guidance states that, unsurprisingly, DFARS 231.205-79 does not apply to advance payments. See DOD FAQ #5.

[2] DOD FAQ # 23 ("We disagree that any PPP loan that has been forgiven can be treated as though it belongs to the company to use as it pleases. FAR 31.202-1, Composition of Total Cost, states that total cost is the sum of the direct and indirect costs allocable to the contract less any allocable credits. Accordingly, to the extent that PPP credits are allocable to costs allowed under a contract, the Government should receive a credit or a reduction on billing for any PPP loans or loan payments, regardless of whether the PPP loan is forgiven.").

[3] To the extent a contractor allocates the costs as indirect costs, it may be possible for an Administrative Contracting Officer to make a global determination of "affected contractor" status.

[4] A comprehensive assessment of the implications of charging these paid leave costs as direct costs as opposed to indirect costs is beyond the scope of this article.

[5] DOD FAQ #13.

[6] The DOD's very limited guidance on commercial-item contracts issued to date indicates that contracting officers can provide relief on a fixed-price or fixed-rate basis.

[7] DOD April 9 Memorandum at 2. The guidance also directs contracting officers to coordinate (generally through the administrative contracting officer ("ACO")) where necessary to allocate costs across multiple affected contracts (which could include a variety of contract types).

[8] DOD April 9 Memorandum at 2. 

[9] The FAQs state that the DOD intends that profit and fee will not be "reimbursed" under the DFARS class deviation. The memorandum, however, indicates that contracting officers may compensate contractors on a fixed-rate basis through the addition of a special CLIN to fixed-price contracts. Plus, the FAQs state elsewhere that increased costs under commercial item contracts "should be recognized separately as a fixed price CLIN." DOD FAQ #14.

[10] DOD April 9 Memorandum at 2; DOD FAQ #22. The DOD's guidance indicates that payments made to compensate contractors under Section 3610 and DFARS 231.205-79 should not be considered when measuring a contractor's performance against cost incentives. This makes sense, as the contractor should not be penalized for increased costs that resulted strictly from the COVID-19 public health emergency.

[11] The DOD's guidance indicates that where a contract includes both fixed-price and cost-reimbursement elements, the contracting officer generally should address a contractor's claim for relief, where relief is warranted, under the approach prescribed for cost-reimbursement contracts. Contractors, however, may identify scenarios where it is advantageous to ask the contracting officer to use the approach prescribed for fixed-price contracts.

[12] This article does not attempt to delve into the myriad issues relevant to subcontractors seeking relief for increased paid leave costs from prime contractors and higher-tier subcontractors. Subcontractors should be mindful that they are not in privity of contract with the government, and although the intent of congress and the DOD to support subcontractors and their employees through this crisis may be helpful, subcontractors likely will need to negotiate specific contractual relief with their direct customers.

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