Contract Transfers Not a Sure Thing

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Infotech and the Law James C. Fontana

James C. Fontana

Contract Transfers Not a Sure Thing

The recent rash of mergers and acquisitions in the information technology business is likely to continue, with many IT companies destined to be either acquirers or targets of acquirers. Unlike companies engaged in strictly commercial activities, however, federal government contractors face unique challenges in the acquisition process.

For example, a company purchasing a federal contractor should be especially mindful of whether it can legally assume performance of the contracts it picks up from the deal. Federal law prohibits the transfer of public contracts, although the government may recognize the purchaser as the successor in interest to a contract. This occurs when an acquiring company gets interest in a contract through the transfer of all the assets of the contractor, or at least all the assets involved in the performance of the contract to be transferred.

In what is referred to as the novation process, the government must approve the transfer of contract performance to the purchaser through a special novation agreement. Under such an agreement, the terms of which are dictated by federal regulations, the purchaser agrees to assume the contractor's performance obligations, the contractor waives all rights against the government, and both parties agree to comply with federal law.

In addition, the transferring contractor continues to guarantee contract performance even after the acquisition process is complete. This is particularly critical for a selling contractor who should not be under the false assumption that it is off the hook once the transaction is closed.

Accordingly, the sales agreement should contain appropriate indemnity or escrow provisions to protect the seller in the event the government seeks remedies against it for the purchaser's failure to perform on the contracts.

From a practical standpoint, agencies scrutinizing the proposed novation worry whether the purchaser has the financial and technical means to perform the contract, and whether the selling company will still be sufficiently solvent in case the purchaser defaults. In many cases, the purchaser is acquiring the contractor's entire company, making the purchaser both the successor and transferring contractor.

Another key consideration is whether the contractor being acquired is a small, disadvantaged business under the so-called Section 8(a) program. When a contract awarded under the 8(a) program is transferred, the Small Business Administration, which acts as the prime contractor, is required under federal law to terminate the contract for the government's convenience, unless it waives that termination requirement upon request by the agency that uses the goods or services.

While many agencies may request such a waiver, it is still within the SBA's discretion to grant it, leaving the purchaser the risk of losing the contract.

In reviewing a company's current or threatened litigation - a standard for any due diligence effort - purchasers of government contractors should consider claims against or by the government, including disallowances of certain contract costs the government is expected to reimburse. Although these matters may not be considered initially as litigation, they can often lead to litigation between the contractor and government.

Other contingent liabilities unique to government contractors may arise from pending or threatened audits by the Defense Contract Audit Agency, an agency inspector general's investigation and similar actions by other governmental agencies.

From a financial standpoint, it is difficult to conduct a valuation of government contracts that are awarded on an indefinite delivery-indefinite quantity basis, since the total award value may not - and in many cases, will not - reflect the actual revenues realized on those contracts. Such IDIQ contracts do not obligate the government to order beyond stated minimum quantities, and they are often associated with multiple awards, resulting in more competition among a group of vendors for these same limited quantities.

Just as important, and risky, is the contractor's record of past performance. Federal procurement law now requires that agencies include past performance as a mandatory non-cost evaluation factor in the source selection process.

The purchaser needs to review the contractor's past performance ratings issued by prior government and commercial customers to determine how those ratings may affect its future business opportunities. The risk here is the purchaser may be saddled with a contractor's negative past performance rating after the acquisition is complete.

Other considerations in acquiring government contractors include whether the purchaser will be able to retain the contractor's key employees in a market where IT talent is scarce. In addition, intellectual property issues will abound in many proposed transactions, especially where the government has some rights to the technology being sold.

Mergers and acquisitions involving government contracts are a tricky business. These transactions are fraught with regulatory and business considerations that are virtually unheard of in the commercial sector. They have the potential for disastrous consequences for the uninformed who sell, and especially who buy, a government contractor.

James C. Fontana is vice president and corporate counsel of Wang Government Services Inc. of McLean, Va. His e-mail address is james.fontana@wang.com.


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