DOD stops subcontract pass-through charges

Infotech and the Law | Legal insights for today's market

Richard Rector

How many layers? How many players? How many margins?

Those questions motivated the Defense Department to issue a new rule in April 2007. The rule aims to ensure that "pass-through" charges on DOD contracts and subcontracts ? such as indirect costs and profits charged by prime contractors and higher-tier subcontractors ? are not excessive.

The rule implements Section 852 of the 2007 Defense Authorization Act, which reflected concern that DOD was paying unnecessary pass-through charges to contractors who provide little or no added value on contracts. The new rule gives DOD greater visibility into the work to be performed by prime contractors and subcontractors, and a means for disallowing and recovering excessive pass-through costs. Notably, the rule applies not only to stand-alone contracts, but also to task orders and delivery orders.

Exempt from the rule are firm-fixed-price contracts and fixed-price contracts with economic price adjustment if the contracts are awarded on the basis of adequate price competition or are for commercial items. As a result, the rule will apply most often when cost or pricing data is provided.

The rule is implemented through two new Defense Federal Acquisition Regulation Supplement provisions: 252.215-7003 for solicitations and 252.215-7004 for contracts and orders. The solicitation clause requires an offeror to identify in its proposal the percentages of effort to be performed by the offeror and by each subcontractor.

In addition, if the offeror intends to subcontract more than 70 percent of the total value of the work, it must identify the amount of the offeror's indirect costs and profit applicable to the subcontracted work, as well as the value added by the offeror to the subcontracted work. Similar information must be provided if a subcontractor intends to pass more than 70 percent of its work to a lower-tier subcontractor.

The intent is to allow contracting officers to decide whether proposed pass-through charges are "excessive." The contract clause flatly states that the government "will not pay excessive pass-through charges."

So, what exactly are excessive pass-through charges? The contract clause states that excessive pass-through charges, with respect to a contractor or subcontractor that adds "no or negligible value," are charges for indirect costs or profit on subcontracted work (other than charges for the costs of managing subcontracts). "No or negligible value" means the contractor or subcontractor "cannot demonstrate to the Contracting Officer that its effort added substantive value" to the contract work.

This definition is awkward, to say the least, and it suggests ? if read in isolation ? that excessive pass-through charges could be found in any contract or order, even if less than 70 percent of the work was being subcontracted. In other words, a company's pass-through charges could be found "excessive" whenever the contracting officer believes they are not commensurate with the value provided by the company under the contract.

This obviously gives DOD contracting officers considerable discretion in negotiating ? and limiting ? indirect costs and profit when significant portions of a project are subcontracted. In addition, the rule gives contracting officers the right to audit and recover excessive pass-through charges on contracts and subcontracts.

If excessive charges are found on a fixed-price contract, the government is entitled to a price reduction. If found on other types of contracts, the charges are unallowable in accordance with the Federal Acquisition Regulation cost principles.

The net result is a rule that, if not administered properly, could open
the door to re-pricing DOD contracts on which significant subcontracting has occurred. Contractors would be wise to understand and manage this risk in both their contracts and subcontracts.

Richard Rector is chairman of the government contracts practice at DLA Piper US LLP in Washington. He can be reached at richard.rector@dlapiper.com.

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