An interim rule published by the Department of Defense authorizes DoD contracting officers to withhold payment from contractors whose business systems they deem deficient. Issued on May 18, 2011, the rule implements Section 893 of the Ike Skelton National Defense Authorization Act of 2011, which we discuss here. It authorizes COs to withhold up to ten percent of progress payments if the CO determines that the contractor’s business systems contain significant deficiencies. The new rule applies to solicitations issued on or after May 18, 2011. COs are encouraged to amend existing solicitations with the new requirements “to the extent feasible.”

The Withholding Mechanism

The interim rule creates and modifies six clauses outlining the requirements for contractors’ business systems dealing with accounting, cost estimating, earned value management, material management, contractor purchasing, and contractor property management. The “Contractor Business Systems” clause authorizes the CO to withhold five percent from progress and performance-based payments for a significant deficiency in a single contractor business system.  It authorizes withholding of up to ten percent for a significant deficiency in multiple contractor business systems. The new rule defines a “significant deficiency” as one that “materially affects DoD’s ability to rely upon information produced by the contractor’s system that is needed for management purposes.”

Withholding is not automatic.  If the CO makes an initial determination that there is a significant deficiency in the contractor’s business system(s), the contractor is notified and has 30 days to respond. The CO will review the response before making a final determination as to whether a significant deficiency exists.  If the final determination concludes that a deficiency does exist, the CO will issue a withholding notice and a directive to the contractor to reduce its billings to implement the withholding. The contractor then has 45 days to correct the deficiency or to submit a corrective action plan outlining the remedial steps and milestone dates. Once an acceptable corrective action plan is in place, the CO is required to reduce the withholding to two percent until the deficiencies are corrected.

Once the contractor has remedied the deficiencies, the CO must issue a final determination eliminating the withholding and directing the contractor to bill for the outstanding amount. If the CO fails to issue the final determination within 90 days, he must reduce the withholding “by at least 50 percent” until the determination is issued.

The Uncertainty

The current interim rule is a revision of two previous proposed rules that received substantial public comment. While the rule purports to address many of the concerns raised during the comment period, there is still substantial uncertainty surrounding its implementation. The rule offers little practical guidance as to what constitutes a “significant deficiency” or when COs will seek to withhold payments.  Because this determination is nominally in the CO’s “sole discretion,” there is likely to be substantial variation among COs as to which deficiencies are “significant.”

The rule also fails to offer any guidance to the CO for describing a “significant deficiency” when finding that one exists. Insufficient detail in describing the deficiency will place the contractor in the difficult position of trying to remedy a problem that is not entirely clear. In addition to the increased cost of remedying a problem that is not clearly specified, a lack of clarity in describing a deficiency will delay the contractor’s receipt of payment.  Even in the best of circumstances, a contractor may have to wait up to 135 days to recover payments withheld under this rule (45 days to correct + 90 days for a determination to end withholding).

Hopefully these uncertainties will be addressed during the current public comment period, which closes on July 18, 2011. Even if the final rule makes changes to resolve these issues, the short term response is clear. Contractors should respond promptly to any CO determination and act quickly to address any identified deficiencies. If the deficiency cannot immediately be remedied, contractors should submit a corrective action plan within the 45-day window to reduce any withholding while implementing the corrective action.